Economics 2037: Assignment 5
Economics 2037: Assignment 5
Due date: April 1, 2016
1. (a) A maintenance-free (m=M=0) machine costs $100 to purchase. It is projected that the machine will generate a return (marginal revenue product) of $35 in each of the following three years. After that the machine will be sold for scrap at a price of $20. If the interest rate facing the firm is 8% (.08) should the firm purchase this machine? Show your work.
(b) What is the yield (rate of return) on an investment in this machine? Show your work.
2. (a) An asset will pay you $10,000 next year and $20,000 in the following year. What is the
maximum that someone would pay for this asset if:
(i) the interest rate attainable on similar assets is 10%.
(ii) the interest rate on similar assets is 2%.
(b) What is the rate of return (yield) on theasset in (a) if its price is $23,000? What if the
price is $25,000? Show your calculations. Explain how price and rate of return are
related.
3. The price of a barrel of oil has fallen significantly in the past few years:
(a) Use the model of the demand for capital to explain the effect of this change on the amount of capital rented or leased in the oil industry. Provide a graph explaining the predicted effect.
(b) Explain the consequences of this change for demand for purchased capital in the oil industry. Provide the relevant equation as part of your answer.
4. Read Chapter 6 “Rotten Investments and Rotten Eggs” in Tim Harford’s The Undercover Economist and answer the following.
(a) Harford explains a scheme where as a marketing ploy an egg retailer offers to pay a million dollar jackpot to any customerwho buys a carton in which all eggs have double yolks. He claims that despite there being only a 1/1000 chance of any single egg having a double yolk this scheme could go wrong for the retailer. Explain why.
(b) Harford argues that something similar to his egg analogy contributed to the 2007-08 financial crisis in the United States. Explain how mortgage backed securities were somewhat like the egg cartons in (a). According to Harford why did these assets prove to be so dangerous?
(c) Harford suggests that the bailouts of financial firms that occurred during the crisis may have been sensible. Explain why.
(d) Harford mentions the efficient markets hypothesis. What does it suggest about the predictability of changes in asset prices? Explain why this might make sense.
5. (a) Bert and Ernie are the only two people in an exchange economy. Bert has an initial
endowment of 20 units of food and 15 units of clothing while Ernie has 10 units of food
and 20 units of clothing. Draw the Edgeworth box for this economy and indicate
the endowment point (put clothing on the horizontal axis and food on the vertical axis).
(b) Say that at the endowment point Bert’s marginal rate of substitution (MRS) is 1.5 food per
one clothing while Ernie’s marginal rate of substitution is 3 food per unit of clothing.
(i) Draw an indifference curve for Bert and an indifference curve for Ernie that goes
through the endowment point in (a) and is consistent with the information on each
person’s MRS.
(ii) If Bert and Ernie are allowed to trade who will buy food and who will buy clothing.
Explain.
(iii) Give a numerical example of a small trade (one sells 1 clothing to the other) that
would make both Bert and Ernie better off. In your Edgeworth box show the post-trade allocation and draw indifference curves through this point. Are Bert and Ernie better off after trade?
(c) Say that instead of bartering (as in (b)(iii)) Bert and Ernie can buy and sell at market
prices).
(i) Say that the price of food is $2 per unit and the price of clothing is $12 per
unit. (so the relative price is Pc/Pf=$12/$2=6). Draw the budget line that would go through the endowment point in (a). Would Bert want to buy or sell food at these prices? Explain and show a possible outcome for Bert at these prices. Be sure to indicate in your diagram how much food and clothing he would buy or sell.
(ii) The prices in (c)(i) could not possibly be a set of equilibrium prices. Why not?
(iii) Illustrate a budget line that could give an equilibrium outcome and show such an
equilibrium. How would the equilibrium relative price compare to that in (c)(i)? How would it compare to the MRS’s at the initial endowment point in (b). Explain.