midterm practice 1 sol

midterm practice 1 sol - Econ 1 Winter 2008 Dr. Narag 1...

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Unformatted text preview: Econ 1 Winter 2008 Dr. Narag 1 Additional Practice Questions: Chapter 1-4 (1) You have recently purchased a large estate in Napa valley and are deciding how to use your land. You can either grow grapes or raise llamas (both of which are actually done in Napa.) Your land includes flat, loamy areas which are excellent for grapes, as well as more rocky, hilly areas which are less good for grapes. Llamas can be grazed on any of the land equally well. You know that you can produce the following combinations of grapes and llamas, depending on how much land you use for grapes and how much for llamas. Llamas 0 200 400 600 800 1000 Grapes (bushels) 125,000 115,000 95,000 70,000 40,000 0 a) Draw the production possibility frontier that you face for grapes and llamas. b) You decide to raise 200 llamas and grow 115,000 bushels of grapes. What is the opportunity cost of these 200 llamas? Econ 1 Winter 2008 Dr. Narag 2 The opportunity cost of these 200 llamas is the number of bushels of grapes that you must forgo in order to get these 200 llamas. If you weren't producing any llamas, you could produce 125,000 bushels of grapes. Now you are producing only 115,000. So the opportunity cost of these 200 llamas is 10,000 bushels of grapes. c) Explain why the ppf is bowed outward. The PPF is bowed outward due to the law of increasing opportunity costs. Imagine you are producing at point A in the graph of part a). There you produce only grapes using all of your land. Now you want to consider raising 200 llamas (which means moving to point B). To raise llamas, you must allocate some land for grazing by the llamas and can't produce grapes on that part of your land. Since llamas graze equally well on any kind of land, you will allocate the areas that are least good for grapes, that is, the rocky, hilly areas; production of grapes will be reduced by only 10,000 bushels. But suppose now that you are producing at point D and want to increase your production of llamas by 200 again. You will have to allocate more land to the grazing of the llamas, probably some of the flat loamy areas since you are already producing 600 llamas. Those areas are better for producing grapes and the reduction in the production of grapes is larger: it goes from producing 70,000 bushels to only 40,000. The opportunity cost of these additional 200 llamas is now 30,000 bushels of grapes, 3 times larger than before. Since the slope of the PPF represents this opportunity cost, its shape shows that the higher the production of llamas (good on the x-axis) the higher the number of bushels of grapes (good on the y-axis) you must forgo to produce some additional number of llamas; that is, the higher the opportunity cost of llamas in terms of grapes. If you draw the line tangent to points B and E in your graph, you will see that the second line is steeper than the first, which means that the slope is higher, showing higher opportunity costs. d) You plan to sell the wool from the llamas as well as all the grapes that you grow. The wool from each llama can be sold for $120 apiece and grapes can be sold for $1 per bushel. Could you make more revenue by shifting your production toward more llamas and less grapes, or vice versa? Explain. (Recall that you are now producing 200 llamas and 115,000 bushels of grapes.) Given your current production levels (point B), the opportunity costs of producing 200 more llamas is 20,000 bushels of grapes (you go from producing 115,000 bushels to producing only 95,000). That is, if you produce 200 more llamas you must produce 20,000 fewer bushels of grapes. The 200 extra llamas would increase your revenues by $24,000 ($120 each times 200). The 20,000 fewer bushels of grapes would mean that you earn $20,000 less revenue from grapes ($1 for each bushel). Since $24,000 exceeds $20,000, you would make more revenue ($4000 more revenue to be exact) by producing 200 more llamas and 20,000 fewer bushels of grapes. You have just figured out that you will make more revenues by shifting your production toward more llamas and less grapes (that is, by moving along the PPF toward point C). Should you go beyond point C to point D? No. At point C, the opportunity cost of 200 more llamas is 25,000 bushels of grapes. If you produced another 200 llamas your revenues from Econ 1 Winter 2008 Dr. Narag llamas would increase by $24,000; however, your revenues from grapes would fall by $25,000. Overall you would earn less revenue. So you will be better off by producing (and selling) at point C. 3 e) You read an article that describes a way to grow grapes more effectively on any land. The method increases grape output per acre by 10%. Draw the new ppf that you would face if you implemented this method. The new table and graph look like: (2) Robinson Crusoe lives happily on a little island eating fish and coconuts. He is able to catch one fish for each hour he spends fishing, and he could collect 10 coconuts per hour. These rates are the same no matter how much time he spends in each activity. He refuses to work more than 6 hours each day. Econ 1 Winter 2008 Dr. Narag axes. 4 a) Draw Robinson's production possibility frontier. Be sure to show the units on the b) What is the opportunity cost of one fish? The opportunity cost of one fish is the amount of coconuts Robinson could be collecting if he were not fishing. It takes him an hour to catch one fish (a lousy, fisher, no doubt). Since he can collect 10 coconuts per hour, the opportunity cost of one fish is 10 coconuts. c) What accounts for the shape of the ppf? That is: what it atypical of this island economy that explains this shape? If you drew the graph asked in part a), you may have already noticed that the PPF on this island economy is a straight line instead of being bowed outward. The reason is that there is only one factor of production: Robinson's time (labor). If you remember the explanation in part c) of problem 1, we said that the reason for the bowed out shape was the existence of two different kinds of land (two factors of production). In this island economy, to produce one more fish costs Robinson the same hour, which always translates into 10 coconuts. The law of increasing opportunity costs does not apply here: regardless of how much of both goods Robinson is producing, the opportunity cost of one more fish will always be 10 coconuts (1 hour of labor). Also, that is why in part b) we could compute the opportunity cost of one fish without setting a specific point for our calculation. In summary, the law of increasing opportunity costs applies when there is more than one factor of production, each being better suited to produce one good than the others. (3) Use the following information to answer the next two questions. Econ 1 Winter 2008 Dr. Narag 5 Suppose that the number of bicycles demanded in the United States at various prices is as follows: Prices of a bicycle dollars) 80 100 120 Quantity demanded per year (millions of bicycles) 20 18 16 Suppose that the relationship between the quantity of bicycles supplied per year in the United States and the price per bicycle is as follows: Prices of a bicycle (dollars) 60 80 100 120 150 Quantity supplied per year (millions of bicycles) 14 16 18 19 20 a) Based on the data above, what is the equilibrium price of a bicycle in the United States? i) ii) iii) iv) v) 60 80 100 120 150 b) If the price is $80, i) ii) iii) iv) v) There is an excess demand of 4 million bicycles There is an excess supply of 4 million bicycles There is an excess demand of 2 million bicycles There is an excess supply of 2 million bicycles None of these (4) Suppose the government imposed an excise tax of $1 per pack of cigarettes and the entire tax burden fell on producers. Which of the following is the correct explanation about the possible combinations of supply and demand curves? i) Regular downward sloping demand curve and regular upward sloping supply curve. ii) Perfectly inelastic demand curve and regular upward sloping supply curve. iii) Regular downward sloping demand curve and perfectly elastic supply curve. Econ 1 Winter 2008 Dr. Narag iv) Regular downward sloping demand curve and perfectly inelastic supply curve. 6 v) Perfectly inelastic demand curve and perfectly elastic supply curve. (5) If the supply of a good increases and the demand for the good decreases, then we can definitively say that: i) ii) iii) iv) v) The equilibrium price will decrease The equilibrium quantity will increase The equilibrium quantity will decrease Both (i) and (ii) Both (i) and (iii) (6) Suppose that the equilibrium price of a gallon of gas is $1.40 per gallon. The government decides to place a price ceiling on gasoline and will not allow sellers to charge more than $1.50 per gallon. Draw this situation using a graph. Make sure that you show the original equilibrium and the effect of the price ceiling on the market. What will happen in this market? (Hint: Make sure you understand what a price ceiling is.) There will be no effect of this price ceiling on the market. If sellers try to charge a price of $1.50 per gallon, quantity demanded (QD) would be lower than quantity supplied (QS). This means that there would be a shortage. Because the price ceiling is a maximum price, it does not prevent the price from falling as it would in this case. Therefore, the price of gasoline will remain $1.40 per gallon. ...
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This note was uploaded on 04/16/2008 for the course ECON 1 taught by Professor Nagata during the Winter '08 term at UCLA.

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