Exercises and Practice Problems
Microeconomics for Business Decisions
Victor Brajer and Eric Solberg
California State University, Fullerton
To the Student
This exercise manual has been designed to be used with Eric Solberg’s Microeconomics for Business Decisions, but it can be used independently. The first thing you’ll notice about this workbook is that it is different from the typical study guide. There are no true-false questions, no multiple choices, and no simple fill-in-the-blank questions. Instead, we have constructed a series of exercises, practice problems, and questions that lead you through a step-by-step analysis of problems or hypothetical cases. Some of the situations are whimsical, and some are real. In all cases the lessons to be learned are important. What we feel is most important is learning to do micro-economic analysis by working problems that stress basic ideas and methods, not memorizing definitions, key phrases, or specific examples.
It is our belief that to learn economics you have to do economics. At this stage in your training, this means setting up basic models, solving these models for equilibrium or optimal values, and performing comparative static analyses and similar exercises. A wide variety of topics are discussed in Microeconomics for Business Decisions, and you may not have time to cover everything in a single course. Nonetheless, for each major idea presented in the textbook, we have tried to develop at least one exercise that leads you through the important points and implications involved. For the most part, the exercises appear in the same order as their corresponding topics appear in the textbook. If you conscientiously work through the exercises and questions provided here, you’ll learn a lot more about microeconomic analysis than you’d learn from an ordinary study guide.
For each problem or question, you will find a complete solution or answer at the end of this manual. Since you often learn more from your mistakes than from your successes, we strongly encourage you to think about, and work through the problems on your own before you turn to the back of the manual. It is all too easy to trick yourself into thinking that you could do a problem more easily if you “cheat” by looking at the answer first. Maybe so, but you won’t retain as much. Think of each exercise as a way to “test” yourself. Who knows? Your instructor may decide to include some of these exercises on examinations.
Chapter 1 Exercises 1
Chapter 1 Preliminaries
1.1 Indicate whether the following statements represent positive or normative thinking, and whether they involve microeconomic or macroeconomic issues:
(a) Wage-price controls should be used to control inflation: (positive, normative); (micro, macro).
(b)Tariffs and import quotas raise prices to consumers and reduce general economic welfare: (positive, normative); (micro, macro).
(c)Fiscal policy can have a significant stimulative impact on a less than fully employed economy: (positive, normative); (micro, macro).
(d)Antitrust laws should be used vigorously to reduce monopoly power from its current level: (positive, normative); (micro, macro).
(e)The Fed should be instructed to increase the money supply at a fixed rate: (positive, normative); (micro, macro).
(f)A minimum wage increases unemployment among young and unskilled workers: (positive, normative); (micro, macro).
(g)The proportion of U.S. GNP devoted to national defense increased throughout the 1980s: (positive, normative); (micro, macro).
(h)National defense expenditures should be reduced from their present levels: (positive, normative); (micro, macro).
(i)Effluent (pollution) taxes, not direct regulations, should be used to control pollution: (positive, normative); (micro, macro).
(j)The distribution of income in the United States became more unequal during the 1980s: (positive, normative); (micro, macro).
1.2 Many universities, hospitals, and charities are chartered as nonprofit organizations. Would such firms be interested in maximizing profits? Would they still be interested in maintaining an efficient level of operation? Explain.
1.3 A key step in using the scientific method is the formulation of a hypothesis. Suppose that for ten years, a farmer observed that every morning his rooster crowed, and shortly thereafter, the sun rose. He formed the following hypothesis: “The rooster’s crowing causes the sun to rise!” Comment on the validity of the farmer’s hypothesis. How could you test this hypothesis?
1.4 For over fifty years, there was a strong, positive correlation between U.S. stock prices and women’s hemlines. In the late 1920s and the 1960s, for example, hemlines were high, and so were stock prices. On the other hand, when hemlines were low, so too were stock prices — as during the Great Depression of the 1930s. Some investors came to base their stock purchasing decisions on whether fashion designers planned to raise or lower hemlines. Was this a good model to use? Why or why not?
1.5 One of the most often used economic model is the simple supply-demand model. Would you agree that this model is characterized by both its explanatory power and its predictive ability? Give an example to support your answer. ______.
1.6 Distinguish between pure, perfect, and effective competition. ______.
1.7 In the United States, approximately two billion baseball cards are produced each year. Card collecting is a hobby for several million individuals. Many people have argued that the market for buying and selling baseball cards can be characterized as a perfectly competitive market. What are the characteristics of a perfectly competitive market? Does this characterization seem applicable to the market for baseball cards
1.8 What would happen to New York City’s taxicab industry if the barriers to entry were removed? What would probably happen to the price of a medallion?
1.9 An issue receiving much attention in the western United States is whether water should be allocated using free market institutions. Exactly who owns much of the West’s surface and ground water is in question, however, due to long-standing claims by native Americans (which are validated by a landmark 1908 U.S. Supreme Court decision, Winters vs. United States). A myriad of lawsuits involving water rights are pending in state and federal courts as tribes seek fulfillment of original U.S. government promises made to them to make their reservations “livable, viable, self-sustaining communities.” Does this legal uncertainty over the existence of Indian water rights hamper the development of a viable water rights market? What role do property rights play in allowing efficient market transactions to take place?
1.10 The countries of Eastern Europe and the (former) Soviet Union are in the process of sweeping economic reform. Replacing failed socialist economic system with market capitalist systems is proving to be a formidable task (to say the least). Does the issue of property rights assignments play an important role in facilitating this economic transformation? Discuss.
1.11 If the government were to pass a law forcing polluting firms to internalize negative externalities, do you think that pollution levels would drop to zero? Why or why not?
1.12 According to the Coase Theorem, direct bargaining between affected parties can lead to the internalization of an externality. Consider a trans-Atlantic airline flight from London to New York that carries smokers and nonsmokers. Suppose that the property rights (to the air inside the cabin) are assigned to the nonsmokers. What sort of agreement might be reached between the smokers and nonsmokers? How would the situation change if instead the property rights were assigned to the smokers? Would high transactions costs prohibit a Coase-type bargaining solution on this flight?
Chapter 2 Exercises 1
Chapter 2 The Economic Problem
2.1 Robinson Crusoe lives alone on an isolated island in the South Pacific. Only two items are available to eat: fish and coconuts. Does Crusoe have to face the three fundamental economic questions? ______. Does this island economy have to face the three questions after a second person, Friday, appears on the island? ______.
2.2 In the late 1980s, the unemployment rate in Spain was reported to be as high as 20 percent. Can the overall production level in this nation be considered efficient? Does your answer change if the unemployment rate was to fall substantially, say, to 4 percent?
2.3 The distribution of an economy’s output in a purely communist society would probably be governed according to the rule: “from each according to ability — to each according to need.” What type of income distribution would result from this philosophy? Can you modify this phrase to apply to a strictly capitalist society?
2.4 A tiny, island nation in the Caribbean produces only fish and sea turtles. The resources of this nation include a labor force of 100 people who work an average of 160 hours per month and a capital stock of 20 boats. Laborers with boats are capable of producing either type of good. Some combinations of the two goods that can be produced are shown below:
Turtles per monthFish per month (tons)
1,0000
90015
80029
70042
60054
50065
40075
30084
20092
10099
0105
(a)Graph the production possibilities curve (PPC) for this island economy on the following figure.
(b)If 800 turtles per month are currently being caught, what is the maximum amount of fish that can be caught? If 84 tons of fish are currently being caught, what is the maximum number of turtles that can be caught?
(c)If 300 turtles per month are currently being caught, what is the opportunity cost of catching an additional 100 turtles?
(d)If 99 tons of fish are currently being caught each month, what is the opportunity cost of catching one more ton of fish? (You will have to estimate.)
(e)Does the law of increasing opportunity cost hold for this island economy? Explain.
(f)If the island economy is currently producing 200 turtles and 75 tons of fish per month, what do you think is happening in this economy? Show this point (label it point E) in relation to the PPC on your graph.
(g)What would be needed in order for the island economy to be able to produce 300 turtles and 100 tons of fish per month? Show this point (label it point F) in relation to the PPC on your graph.
2.5 The tiny nation of Freon, situated high in the Himalayas, uses all of its resources to produce sweaters and Sno-Cones. Some of the combinations of sweaters and Sno-Cones that can be produced, given an efficient level of production, are shown in the graph below:
(a)What is the opportunity cost of the first thousand Sno-Cones produced (that is, moving from point F to point E on the PPC)? ______.
(b)What is the opportunity cost of the third thousand Sno-Cones produced (moving from point D to point C)? ______.
(c)Is production in the land of Freon consistent with the law of increasing cost? Explain. ______.
(d)Does this seem like a realistic situation? What does it imply about the type of resources that Freon would first apply to sweater production (assuming that Freon was initially operating at point A)? ______.
2.6 Consider a production possibilities curve (PPC) given by the equation Y = 100 – X2, where X and Y represent the only two goods produced in a certain economy:
(a)Fill in the table, and then graph this production possibilities curve below:
X:012345678910
Y:10099
(b)The negative of the slope of the PPC is called the marginal rate of transformation (MRT). When: X = 1, MRT = ______; X = 4, MRT = ______; X = 8, MRT = ______.
(c)As you move down the PPC (as X increases), what happens to the opportunity cost of producing more X? ______.
2.7 Two men live on a small, isolated island in the South Pacific: Robinson Crusoe and his trusted friend, Friday. By working for one hour, Robinson Crusoe can either catch 2 fish or collect 6 coconuts. Friday, in one hour, can either catch 1 fish or collect 5 coconuts. Both men work 8 hours each day.
(a)On the following diagram, graph the PPCs for Robinson Crusoe and Friday. Assume that each PPC is linear (a straight line). What does this assumption imply about the opportunity cost, or trade-off, between fish and coconuts for each person?
(b)Currently, Robinson Crusoe likes to divide his work time so that he can catch 12 fish (which takes 6 hours) and collect 12 coconuts (which uses up his remaining 2 work hours). Friday spends half of his work day fishing and the remainder collecting coconuts. On the PPCs you’ve drawn, show the point marking each person’s current daily consumption bundle.
(c)Who has the absolute advantage in fishing? ______Who has the absolute advantage in collecting coconuts? ______
(d)Robinson Crusoe can catch one more fish if he is willing to give up ______coconuts. If Friday wants to catch one more fish, however, he must give up ______coconuts. Who has the comparative advantage in fishing? ______Who has the comparative advantage in collecting coconuts? ______
(e)Robinson Crusoe should specialize by producing ______and trade them to Friday.
(f)Would 1 fish for 1 coconut be an acceptable exchange rate (terms of trade)? Why, or why not? Would 1 fish for 8 coconuts be acceptable? What would be acceptable? ______.
(g)On your graph, show how each person can move outside his PPC through trade.
2.8 The law of comparative advantage also applies to nations. Below you see portions of the PPCs for two nations (the United States and Saudi Arabia) that both produce oil and wheat. Currently, the U.S. economy is operating at point A and the Saudi economy is at point C. The Americans would like to have more oil (moving to a point like B), however, while the Saudis would like to have more wheat (moving to a point like D).
(a)In the range over which the U.S. economy is currently operating, one more unit of wheat costs ______unit(s) of oil. In Saudi Arabia, one more unit of wheat costs ______unit(s) of oil. Therefore,______has a comparative advantage in wheat production, and ______has a comparative advantage in oil production.
(b)An acceptable terms-of-trade for these two nations would be one unit of wheat for ______units of oil. If the U.S. is initially at point A, and is willing to trade 4 units of wheat to Saudi Arabia, the U.S. can obtain ______units of oil in return. Indicate on your graph the point that represents the final consumption bundle for the U.S. Do the same for Saudi Arabia, assuming that they receive 4 units of wheat from the U.S. in return for their oil.
(c)Do both countries benefit from this trade? Why or why not?
2.9 The figure below shows a production-possibilities curve for a region in northern Norway. The region produces only two goods: natural gas and fish.
(a)What does point A represent? ______.
(b)What does point B represent? ______.
(c)Suppose that new and better natural gas production techniques are developed. On the graph, illustrate what will happen to the PPC. Explain why. Will both intercepts on the graph change? Why or why not?
2.10 The production-possibilities curve is used to demonstrate the concepts of scarcity and opportunity cost. It can also demonstrate the concept of economic growth. On the next figure you see the PPC for two countries, Extravaganza and Thriftland, that are initially identical in terms of population, resource endowments, and technology. However, Extravaganza is producing relatively more consumer goods at point A and Thriftland is producing relatively more capital goods at point B. What do you think the PPC curves for these countries will look like in twenty years? Show them on the graph, and explain why they are different.
2.11 Economies that devote more of their current production to capital (investment) goods (and therefore less to consumer goods) should, other things being equal, exhibit higher rates of growth. The following scatter plot compares investment rates (the portion of national output devoted to capital goods) and growth rates for eight countries, both capitalist and communist. Examine the scatter plot, and then answer these questions:
(a)Does the actual economic growth of nations support this assertion? ______.
(b)Is there a positive correlation between investment rates and growth rates? ______.
(c)Notice that the countries do not fall neatly on a straight line. France and Canada, for example, have the same growth rate but different investment rates. What might this imply?
2.12 In a market economy, prices serve as signals, helping to allocate resources to their highest valued uses, and in essence, helping to make the What to Produce and How to Produce decisions. In a command economy, these decisions are made by a central planning authority. How difficult would it be to organize all of the economic activity of a large nation, such as the (former) Soviet Union?
2.13 Louie Staphopoulos loves his job. He sells hot dogs (with “relish”) from a cart in the Wall Street area of New York City. On a sunny day, Louie sells the following numbers of hot dogs, sodas, knishes, and sausages (his prices and costs per unit are also shown below):
ItemNumber SoldPriceCost
Hot dog125 $1.00 $0.36
Soda75 $0.60 $0.33
Knish20 $0.75 $0.33
Sausage10 $1.00 $0.40
Louie pays $40 per day for ice, $3 for propane, $13 for rent, and $2 for insurance. His cart cost $4,500, and will have to be replaced after about 1,000 days of use. He bought the cart with his life savings, which he always insisted on keeping in his mattress, because he did not trust banks.
(a)What are Mr. Staphopoulos’ total sales on a sunny day? ______.
(b)What is his daily total cost, including depreciation? (Use straight-line depreciation; that is, just spread the cost of the cart over its 1,000-day useful life.) ______.