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1 Econ Holmes Fall 9 Some Additional Practice Questions to Get Ready for Midterm Question Let s put Econland in the world economy. Suppose the world price of widgets is $. Suppose Econland is small relative to the world market so that its trade policy has no effect on the world price. The domestic demand and supply for widgets is given in Graph below. (a) Suppose there is a total ban on widget imports. (This is like setting an import quota equal to.) The equilibrium widget price in Econland is then. 9 7 $ F I H G A B E C S D 7 9 Quantity Graph : Change in total Econland Surplus from a ban on Widget Imports (b) What are the two reasons total Econland surplus declines with the import ban compared to free trade? With free trade, at a world price of, domestic consumption equals and domestic production equals. The trade ban does two things: ) It causes domestic consumption to decrease from to. This reduces surplus in Econland because consumption is too low. The price to Econland is the $ world price. At Q=, the marginal benefit of one more unit equals $ (we get this from the demand curve) and this is greater than the $ marginal cost. ) The ban causes domestic production to increase from to. This reduces surplus in Econland because producing units from to in Econland costs more than the $ per unit cost of imports. Domestic production is inefficiently large.

2 (c) The loss in total Econland surplus from the import ban relative to the free market is -9. Illustrate the loss in Econland total surplus in Graph. Label the two parts of the loss in total Econland surplus corresponding to the two reasons given in part (b). With free trade: PS is the area GAF. This is. CS is the area ICG. This equals. So Total Surplus equals + =. When trade is impossible: PS is the area FHB. This is. CS is the area IBH. This is.. So TS =. +. =. So the change in total surplus from the import ban equals ΔTS = = -9 This equals (minus) the area ABC in the graph. We can think of this has having two parts, ABC = ABE + BCE. The (minus) ABE is the loss from inefficient production. The units being produced domestically in this range all cost more then $ to produce. If the goods are imported, Econland only has to pay $. The (minus) BCE is the loss from inefficient consumption.

3 Question. Pam consumes pizza and soda. She has an income of $. The price of pizza is p pizza = $ and the price of soda is p soda = $. Her indifference curves are illustrated in Graph below BC BC s o d a A B S Pizza BC U Graph : Pam s Indifference Curves (a) Illustrate Pam s budget constraint in the figure and label it BC. Provide an interpretation of the slope of the budget constraint. The slope equals. This is the opportunity cost of one more pizza in terms of soda given up. (b) Illustrate Pam s optimal consumption bundle in Graph, by labeling it point A. At the optimal consumption bundle, Pam consumes pizzas and sodas. (c) The marginal rate of substitution at point A equals sodas for one pizza. (d) Suppose the price of pizza falls to p pizza = $. Illustrate the new budget constraint and label it BC. Label Pam s new optimal consumption bundle point B. At the new lower price of Pizza, Pam consumes pizzas and sodas.

4 Question (e) Breakdown the movement from A to B from the price change into a substitution effect (a movement from point A to an appropriate point S) and an income effect. Do this by illustrating in Graph a budget constraint with the new slope (the new opportunity cost) but just touches the original indifference curve. Label this BC. Label the optimal consumption choice at BC as point S. (d) The substitution effect of the price change increases demand for pizza by income effect increases demand by units. units and the Hint: The tricky part here is figuring out the substitution effect. Understanding the total effect should be straightforward. The fall in the price of pizza shifts the budget constraint from BC to BC and the optimal consumption bundle goes from A to B. Notice that at the new budget constraint BC, the slope equals one. Pizza and Soda have the same price, so the opportunity cost of one more pizza equals one soda. To figure out the substitution effect, we use the new slope, but stay on the original indifference curve. The line BC has the new slope (equal to -) and just touches the original indifference curve. The point where this happens is the point S (with pizza and sodas). On account of the substitution effect, Pam increases consumption of pizza from to slices, a change of. When we add in the income effect, consumption rises to slices. So the income effect increases demand by =.

5 Question. Dwight works hours a day. He can make apples in an hour or oranges in an hour. Jim also works hours a day. Jim can make apples in an hour or oranges in an hour. (a) Illustrate Dwight s and Jim s production possibility frontiers (ppf) in the graphs below. (Dwight on the left, Jim on the right). Label the ppf curves. (b) Circle the correct answer: Who has an absolute advantage in making apples? Dwight or Jim? Jim (c) Suppose trade is impossible so each is in autarky. So for each, production equals consumption. Determine the utility maximizing choice for Dwight and label it point A. At this choice, Dwight produces and consumes apples and oranges. Determine the utility maximizing choice for Jim and label it point X. At this choice Jim produces and consumes apples and oranges. (d) The opportunity cost for Jim to produce one apple is orange (be sure to specify units). (e) Explain why there are no gains from trade here based on comparative advantage. Both Jim and Dwight have the same opportunity cost: one apple costs one orange. So there are no gains from trade. (f) True or False (circle one) There are no gains from trade here based on increasing returns. True O r a n g e s A U U U Apples O r a n g e s Apples X U U U Dwight Jim

6 Question Each widget firm has the cost structure illustrated in the figure on the left below. Industry demand is illustrated on the right. Please use the lines in the graph paper to determine the numbers you need to do the problem. $ ATCmin MC ATC AVC 7 9 q $ S LR D Q Cost Structure of Firm Industry Level Variables (a) The fixed cost equals. To see this, note AFC = ATC-AVC. AT Q =, ATC=, AVC=, so AFC=. Fixed Cost = q AFC = =. (b) Draw in the long-run supply curve on the right-hand side graph and label it S LR. (c) Fill in the table below describing long-run equilibrium in this industry: Variable Definition P LR Long-run Industry Price Long-Run Equilibrium Value Q LR q LR N LR Long-run Industry Quantity Long-run output per firm Long-run number of firms