ECON 10020/20020 Principles of Macroeconomics Problem Set ...€¦ · ECON 10020/20020 Principles of Macroeconomics Problem Set 1 Solutions Dennis C. Plott University of Notre Dame

ECON 10020/20020

Principles of Macroeconomics

Problem Set 1

Solutions

Dennis C. Plott∗

University of Notre Dame

Department of Economics

February 3, 2015

∗Email: [email protected]

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Name: Dennis C. Plott

General Instructions

1. Due: Thursday 29th January 2015 by 3:15 p.m.

2. Read and follow all instructions/directions carefully.

3. An inability to follow instructions/directions may result in points being deducted.

4. All problems sets submitted must be stapled and handwritten.

5. Only problem sets submitted in person and/or in class will be accepted.

6. Answer all questions in blue or black ink only; i.e., no pencils or colored inks. The only exception: graphsmay be drawn in pencil. Note: use a guide of some sort (e.g. a ruler) for all graphs.

7. Write, mark, and draw your answers neatly and clearly. If your answer is illegible (i.e. difficult to read inthe least), then it will not be graded. It is your job to clearly communicate.

8. Label all graphs fully and completely; i.e., axes, intersections, curves, etc.

9. Support your answers as thoroughly as possible; i.e., graphically, conceptually, and mathematically. Note:this may not be feasible or necessary for all questions asked. State and define any concept utilized and listand name any equation used. In other words, show all of your work.

10. Be concise.

11. Do not use white out or similar products, but neatly cross/scratch out any mistakes.

12. Do not copy from another student.

13. Note: only use materials from this class, listed textbooks, and suggested resources to answer questions.The Google can be quite useful and tempting, but very often a question has been constructed in a veryspecific manner; i.e., using a certain set of assumptions. Another source may have a very similar problem,but with slightly different underlying assumptions that change the answer completely. This is typicallynot obvious and will likely leave you very confused.

14. Note: the problem sets are a relatively small portion of your final grade. They are intended to help prepareyou for the exams. If you are struggling with particular questions and/or topics, then you are made awareof what you need to study.

15. For the multiple choice questions, choose the “best” answer and mark the letter in the spaces provided atthe bottom of the page. Only clearly written letters in the allocated space will be graded.

Original Score (%)

Adjustment (%) 5

Actual Score (%)

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1. Scarcity can be eliminated through

(a) the use of market mechanisms.

(b) exploration that helps us find new resources.

(c) wise use of our resources.

(d) None of the above because scarcity cannot be eliminated. X D

2. Your roommate, a psychology major, said, “The problem with economics is that it assumes that consumersand firms always make the correct decision. But we know that everyone’s human, and we all makemistakes.” Do you agree with her comment?

(a) Yes, I agree with her. One cannot make predictions about economic behavior because in realitypeople make incorrect choices in many situations.

(b) I disagree with her. Economics does not study correct or incorrect behaviors, but rather it assumesthat economic agents behave rationally, meaning they make the best decisions given their knowledgeof the costs and benefits. X B

(c) Yes, I agree with her. Economic theory should allow for irrational behavior so that we can have morereliable predictions.

(d) I disagree with her. If we cannot assume that decisions are correct, then we will not be able toexamine the moral implications of these decisions.

3. In the first six months of 2003, branches of Commerce Bank in New York City were robbed 14 times. TheNew York City Police recommended steps the bank could take to deter robberies, including the installationof plastic barriers called “bandit barriers”. The police were surprised the bank did not take their advice.According to a deputy commissioner of police, “Commerce does very little of what we recommend. They’vetold our detectives they have no interest in ever putting in the barriers.” It would seem that Commercebank would have a strong incentive to install “bandit barriers” to deter robberies. Why wouldn’t they doit?

(a) The banks would rather delay installation of any theft deterring equipment in anticipation of newlower cost innovations in the security devices market.

(b) The banks must have weighed the cost of installing bandit barriers against the benefits and decidedthat they have “no interest in ever putting in the barriers.” X B

(c) The banks are concerned that “bandit barriers” would send the wrong message to customers – thatthe bank is unsafe.

(d) The banks probably resent any interference from the police department.

4. The reason that opportunity costs arise is that

(a) an economy relies on money to facilitate exchange of goods and services.

(b) resources are scarce. X B

(c) there are no alternative decisions that could be made.

(d) people have limited wants.

5. Which of the following is NOT a normative statement?

(a) People buy more of a good or service when its price falls. X A

(b) The distribution of income is fair.

(c) The government ought to provide health care to everyone.

(d) Corporations should be more socially responsible.

1. D 2. B 3. B 4. B 5. A

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6. Ben says that “An increase in the tax on beer will raise its price.” Holly argues that “Taxes should beincreased on beer because college students drink too much.” We can conclude that:

(a) Ben’s statement is normative, but Holly’s is positive.

(b) Holly’s statement is normative, but Ben’s is positive. X B

(c) Both statements are normative.

(d) Both statements are positive.

7. I have lived in a house on the Mississippi River for many years and have never seen a flood. Therefore,there is no reason for anyone to buy flood insurance. This statement is an example of

(a) fallacy of composition. X A

(b) post hoc, ergo propter hoc fallacy.

(c) fallacy of inductive reasoning.

(d) ceteris paribus fallacy.

8. The economy was expanding during all of the years that I was a student, but as soon as I graduated, theeconomy contracted. Therefore, the labor market was waiting until I started looking for a job to contract.This statement is an example of

(a) ceteris paribus fallacy.

(b) post hoc, ergo propter hoc fallacy. X B

(c) fallacy of composition.

(d) fallacy of inductive reasoning.

9. You explain to your friend Haslina, who runs a catering service called “Meals in a Zip”, about an economictheory which asserts that consumers will purchase less of a product at higher prices than they will at lowerprices. She contends that the theory is incorrect because over the past two years she has raised the priceof her catered meals and yet has seen a brisk increase in sales. How would you respond to Josie?

(a) Josie is right; she has evidence to back her claim. The theory must be erroneous.

(b) I will explain to her that she is making the error of reverse causality: it is the increase in demandthat has enabled her to raise her prices.

(c) I will explain to her that there are some omitted variables that have contributed to an increase in hersales such as changes in income. X C

(d) Josie is making the mistake of assuming that correlation implies causation.

10. What is the “reverse causality” problem in determining cause and effect?

(a) It is a problem that occurs when one concludes that a change in variable X caused a change invariable Y when in actual fact, it is a change in variable Z that caused a change in variable Y.

(b) It is a problem that occurs when one observes that a change in variable X caused a change in variableY which caused a change in variable Z and concludes that a change in variable X caused a change invariable Z.

(c) It is a problem that occurs when one concludes that a change in variable X caused a change invariable Y when in actual fact, it is a change in variable Y that caused a change in variable X. X C

(d) It is a problem that arises when two variables are inter-connected so that a change in variable Xcauses a change in variable Y, and a change in variable Y causes a change in variable X.

6. B 7. A 8. B 9. C 10. C

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11. In constructing models, economists:

(a) make simplifying assumptions. X A

(b) include all available information.

(c) must use mathematical equations.

(d) attempt to duplicate the real world.

12. The safest way for an individual to leave a burning theater is to run for the nearest exit; it is thereforealso the best means of escape for a large audience. This assertion illustrates the:

(a) “after this, therefore because of this” fallacy.

(b) correlation fallacy.

(c) fallacy of composition. X C

(d) fallacy of limited decisions.

13. Paige was out jogging and despite being tired, decided to run one more mile. Based on her actions,economists would conclude that Paige:

(a) must be an avid runner.

(b) decided that the marginal benefit of running one more mile would outweigh the cost of the additionalmile. X B

(c) decided that the marginal cost of running one more mile would outweigh the benefit of the additionalmile.

(d) was not very tired, so the marginal cost of the extra mile was very low.

14. You own the Lord of the Rings DVD set. The opportunity cost of watching these DVDs for the secondtime

(a) is zero.

(b) is one-half the cost of the DVDs, as this is the second time you have watched it.

(c) is the value of the alternative use of the time you spend watching the DVDs. X C

(d) cannot be calculated.

15. All of the following questions or statements regarding medical school are positive except:

(a) How do changes in expected future incomes affect the decisions of medical students about whichspecialty to choose?

(b) Medical students who enter specialized fields make a larger contribution to society than do studentwho enter primary care. X B

(c) What role does tuition play in a student’s decision about whether to attend medical school?

(d) Have tuition increases had a large effect or a small effect on the number of applications to medicalschool?

11. A 12. C 13. B 14. C 15. B

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16. Health insurance should be provided to every citizen in a wealthy nation such as the United States. Thisstatement is best described as

(a) a positive statement.

(b) a normative statement. X B

(c) a marginal statement.

(d) an implication of an efficient market.

17. In economics, the term “capital” refers to

(a) the money in one’s pocket.

(b) buildings and equipment. X B

(c) mineral resources.

(d) consumer goods.

18. After you graduate, you have decided to accept a position working at the Bureau of Labor Statistics for$45,000.00 a year. The two other offers you received were working for Wal-Mart for $38,000 and workingfor Ernst and Young consulting for $42,000. Of these two offers, you would have preferred the job at Ernstand Young. What is the opportunity cost of accepting the position at the Bureau of Labor Statistics?

(a) the $45,000 you are paid for working at the Bureau of Labor Statistics

(b) the $42,000 you would have been paid working for Ernst and Young X B

(c) the $38,000 you would have been paid working for Wal-Mart

(d) the $42,000 you would have been paid working for Ernst and Young and the $38,000 you would havebeen paid working for Wal-Mart

19. You won a free ticket to see an Eric Clapton concert (which has no resale value). Bob Dylan is performingon the same night and is your next-best alternative activity. Tickets to see Dylan cost $40. On any givenday, you would be willing to pay up to $50 to see Dylan. Assume there are no other costs of seeing eitherperformer. Based on this information, what is the opportunity cost of seeing Eric Clapton?

(a) $0

(b) $10 X B

(c) $40

(d) $50

When you go to the Clapton concert, you forgo the $50 of benefits you would have received from going tothe Dylan concert. You also forgo the $40 of costs that you would have incurred by going to the Dylanconcert. An avoided benefit is a cost, and an avoided cost is a benefit. Thus, the opportunity cost ofseeing Clapton, the value you forgo by not going to the Dylan concert, is $10; i.e., the net benefit forgone.

20. The Latin phrase ceteris paribus means that when a relationship between two variables is being studied,

(a) both are treated as unpredictable.

(b) neither of those two variables is allowed to change.

(c) all other variables are held fixed. X C

(d) we recognize that some factors are unknown.

16. B 17. B 18. B 19. B 20. C

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21. Child labor has been prevalent in the news of late: Kailash Satyarthi became co-winner of the 2014 NobelPeace Prize, in part, for his efforts against child labor1; a Human Rights Watch report was publishedabout child workers on U.S. tobacco farms2; and child labor on West African cocoa farms was reportedand discussed by several media outlets, for example, Reuters3. Economic theory suggests family size andchild labor are related. True or False: A farmer with a lot of children will find it less costly to harvest hiscrops than a farmer with no children since he can put his children to work without pay.

False; remember opportunity costs. Suppose the going wage for child labor on farms is $5 per hour. Thenthe farmer without children must pay $5 to employ someone else’s children. The farmer with childrencould earn $5 an hour by hiring his children out–by using them on his own farm, he forgoes $5 an hour.Both therefore face the same costs.

Students tended to make a few common mistakes. One is that some argue the farmer with childrenhas higher cost because of the cost of education, food, housing, etc. Because these costs must be borneregardless of whether the children help, they are not relevant.

A second common incorrect answer is to argue that the farmer with children has lower costs becausehe makes no cash payments for their labor. If this were true, the farmer with children might indeed bewealthier at the end of the year. But who is wealthier is not the issue, the question is who has highercosts of harvesting. The costs for both are the same.

22. In the early 1980s Indonesia began phasing in a ban on the export of tropical hardwood logs, underpressure from environmental groups anxious to save the rainforests. The ban is a success on its own terms;Indonesia has not exported hardwood logs for decades. Unfortunately, the rainforest is being cut downfaster than it would be without the export ban. The reason is that the export ban reduces the domesticvalue of the hardwood forests. As a result, people consider the forests as a nuisance in the way of economicdevelopment; it is more profitable to cut or burn the trees down and farm the remaining land than toharvest the trees responsibly. This situation is worsened by the fact that the export ban makes logs cheapfor the domestic production of plywood and furniture, which are then exported from Indonesia in greatervolumes. In short, the trade policy has backfired. What general economic concept did the environmentalorganizations and Indonesian policy makers neglect? Explain.

This question was previously asked on an exam. Most students discussed secondary effects (i.e., unintendedconsequences of economic actions that may develop slowly over time as people react to events) as theirprimary answer and supported this by discussing opportunity costs (i.e., the highest valued alternativethat we forgo when we make a choice) and/or incentives (i.e., a reward that encourages an action or apenalty that discourages an action) to elaborate how secondary effects may be avoided.

1http://www.nobelprize.org/nobel_prizes/peace/laureates/2014/satyarthi-facts.html2http://www.hrw.org/news/2014/05/14/us-child-workers-danger-tobacco-farms3http://af.reuters.com/article/ghanaNews/idAFL1N0U11NK20141217

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23. A recent article in The Economist4 discusses hours worked and productivity. The article quotes JohnHicks, co-recipient of the 1972 Nobel Prize in Economics, as saying “probably it has never entered theheads of most employers . . . that hours could be shortened and output maintained.” True or False: JohnHicks’ quote is consistent with the concept of diminishing marginal returns.

True. The law of diminishing (marginal) returns states that as successive increments of a variable resourceare added to a fixed resource, the marginal product of the variable resource will eventually decrease. Fortrue/false questions, one method to justify answering false is to provide a counterexample. Although thesame technique may support an answer of true, this will not give full credit. In this particular case, thekey word is “consistent”; i.e., a rare case of demonstrating with an example justifies answering true. Forexample, in the table below, output is maintained between the 6th and 7th hours worked while diminishingmarginal returns are present. This can also be demonstrated graphically. Note: the question referenceshours worked, not the number of workers.

Hours Worked Output MPL =∆Output

∆Labor

0 0 –1 10 102 18 83 25 74 30 55 33 36 34 17 34 0

4The Economist “Working Hours: Proof that You Should Get a Life” 9 December 2014

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