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Unformatted text preview: ECO1IMA PROBLEM SET NO 1: SAMPLE SOLUTIONS 1) 2) 3) 4) 5) 6) 7) 8) PART A: The opportunity cost of an item is whatever must be given up to obtain the item, which is the next best alternative use of your money, time and anything else you have given up. The accounting cost of an item is only the money paid, so it is less than the opportunity cost. There is a trade off because increasing equity is associated with a reduction in the efficient use of resources. An example is collecting tax revenue and distributing it to the less fortunate in society, which improves equity but may lower the incentive to work, and hence efficiency. The marginal costs and marginal benefits of the incentive on offer are compared by a rational person. If the MBs are greater than the MCs (including opportunity costs), then a rational person will take up the incentive offered. A market economy is the grouping of firms and households which allocate resources through the decentralized decisions of many firms and households as they interact in markets for goods and services. Alternatives are ‘centrally‐planned’ economies (those of most socialist/communist countries), or a ‘mixed economy’ that combines the two approaches (most countries fall into this category, but the extent to which the government interferes with the markets differ substantially across countries). Economists are often unable to run repeated or controlled experiments like scientists. Instead Economists must rely on ‘natural experiments’. However, there are similarities with science: the method of devising theories, collecting data, then analyzing data in an attempt to verify or refute their theories about how the world works. An assumption is something which is taken to be true. Economists make assumptions to simplify problems hoping to not substantially affect the answer. Assumptions can make the world easier to understand. An example is the assumption of rational behaviour of consumers, sometimes referred to as “homo economicus”. But we know that in reality many people do not quite satisfy this assumption: we tend to be overconfident, give excessive weight to a small number of vivid observations in our decision making, reluctant to change our mind even if faced with convincing evidence etc. Because it would be too complex – have too many variables – to understand. A model is a simplification that lets the Economist see what is truly important. All models simplify reality to some extent and are therefore “wrong”. If the assumptions and relationships within the model are credible (believable) a model can be useful in order to improve our understanding and predictions. PART B: 9) a. If you go to the Lady Gaga concert you give up benefits of $150 (revealed by your willingness to pay to see Pink). But you ‘gain’ (save) the $140 that you would have had to pay for Pink. Therefore, the opportunity cost in net terms is 10=150‐140. There is no such thing as a free ticket. Think about it this way: if you also got the Pink ticket for free, then your opportunity cost of seeing Lady Gaga would be $150, but since you have to pay $140 for it, this reduces the net opportunity cost. b. The third alternative will NOT affect your answer. When you are calculating the opportunity cost (of your best option), you only reduce it by the actual ‘gain’ of not going ahead with the second‐best alternative (e.g. the Pink ticket price), not by its ‘opportunity cost’. 10) a+b. Example 1: Consider Paris Hilton, a Chihuahua‐toting celebrity paid AUD750,000 with her sister Nicky to be seen at the Melbourne Cup in a TV‐Channel tent. She most likely is not that interested in Melbourne, nor horses, nor the TV channel’s viewers nor advertisers. However, the TV channel considers her presence in their tent and other Spring Racing Festival activities will increase ratings, and hence advertising revenues and hence their profitability. The interactions in both the “celebrity‐services market” and the “advertising market” through the TV channel ensure that Paris, working in her own self‐interest, helps TV‐shareholders (and arguably some viewers) get what they want. That is, mutual self‐interest promotes general economic well‐being. Smith’s conclusion: Valid! Example 2: Consider student Jo working in a supermarket. She doesn’t know/care about the customers, but working in her own self‐interest, she helps customers and her managers get what they want. Again, mutual self‐interest promotes general economic well‐being. 11) a. COSTS: Opportunity cost to mother (could be working and earning); If already pregnant and due late June, the physical risk to mother and baby associated with waiting for a late baby by delaying caesareans and inductions; Lower income for women (even when working, associated with being the main child‐carer). Others? BENEFITS to mother: $3000; Emotional/family‐tie benefits; “Insurance benefits” in that some families consider children should look after their parents. Others? b. Changes in inheritance taxes often have a similar effect. For example, Gans, Joshua S. and Leigh, Andrew (2006) "Did the Death of Australian Inheritance Taxes Affect Deaths?," Topics in Economic Analysis & Policy: Vol. 6 : Iss. 1, Article 23 argue that: ‘In 1979, Australia abolished federal inheritance taxes. Using daily deaths data, we show that approximately 50 deaths were shifted from the week before the abolition to the week after. This amounts to over half of those who would have been eligible to pay the tax. Although we cannot rule out the possibility that our results are driven by misreporting, our results imply that over the very short run, the death rate may be highly elastic with respect to the inheritance tax rate.’ Similarly, there seem to be cases of students changing their “gap year” behaviour in the light of funding changes notified by the Australian Federal government. c. Don’t give any notice of changes (!), as is attempted to be done sometimes at Federal Budget night. In other words, apply the policy retrospectively. However this is going to further reduce the stimulating effect the policy is designed to have. Anything else? 12) a. The comparison tries to highlight the difference in the benefit of one’s labour in terms of what one can afford to buy for the pay. The time cost across countries is highly variable, with an average of about 100 minutes; from a low of less than 50 minutes in China to a high of more than 250 minutes in Mexico. The dollar costs are not in the same order of highest to lowest time; for instance the highest price is $23 in France, which is only about 90 minutes. b. Differentcosts of production and state of technology, not only wages but the cost nature of different markets. For instance in some markets where copyright law is more strictly enforced higher royalty payments are made to original producers and hence increase the costs of production. Further, the price also reflects the development of the country in terms of the relative value of skilled vs unskilled work, the preferences of the society in terms of watching DVDs relative to other leisure activities etc. c. The opportunity cost of watching a DVD is the time that could be spent on other leisure activities or paid work. Its value depends on various factors including the relative prices of various other products and services (e.g. in some countries a haircut may be more expensive than a DVD, and in others in may be the other way round. For that reason, one should be some representative consumption basket for such comparisons, not only one product). ...
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