Tutorial 2 Practice Questions Key Concepts in Economics

Tutorial 2 Practice Questions: “Key Concepts in Economics” 1. Explain the concept of opportunity cost arising from the central economic problem of scarce resources and unlimited wants. What is the opportunity cost of seeing a movie? What is the marginal benefit of seeing a movie (assume that you are seeing it with a friend). How would the marginal benefit change if you are seeing a second movie with a different friend? 2. Using the same amount of resources, Australia and New Zealand can both produce apples and oranges as shown in the following table, measured in thousands of tonnes. Apples 12 3 0 Australia Oranges 0 3 4 Apples 6 3 0 New Zealand Oranges 0 3 6 2a. Draw the PPF for each country. Are the opportunity costs increasing or constant? Explain your reasoning. 2b. Who has the comparative advantage of producing apples? Who has the comparative advantage of producing oranges? 2c. Does either country have an absolute advantage of producing both goods? Explain. 2d. Suppose that both countries are currently produce 3000 tonnes of apples and 3000 tonnes of oranges. Show that both can be better off if they specialise in producing one good and then engage in trade. 3. You have exams in economics and chemistry coming up and five hours available for studying. The table shows the trade-offs you face in allocating the time you will spend in studying each subject. Choice A B C D E F Hours Spent Studying Economics Chemistry 5 0 4 1 3 2 2 3 1 4 0 5 Mid term score Economics Chemistry 95 70 93 78 90 84 86 88 81 90 75 91 3a. Draw the production possibility frontier graph. Make sure you label the axis and the values. 3b. Label the points representing choice C and D. If you are at choice C what is the opportunity cost of increasing your chemistry score? 3c. Under what circumstances would point A be a sensible choice? 3d. Is the above an example of increasing or constant opportunity costs? Explain 4. What are the two main categories of participants in the markets? Which participants are of greatest importance in determining what goods and services are produced? Multiple Choice Questions 5. The Coffee Nook, a small cafe near campus, sells cappuccinos for $2.50 and Russian tea cakes for $1.00 each. What is the opportunity cost of buying a Russian tea cake? A) 2 1/2 cappuccinos B) 2/5 of a cappuccino C) $2.50 D) $1.00 6. Arlene quits her $125 000-a-year job to take care of her ailing parents. What is the opportunity cost of her decision? A) Zero, since she will no longer be earning a salary. B) It depends on the 'going rate' for home-care providers. C) At least $125 000. D) The value she attributes to the satisfaction she receives from taking care of her parents. 7. Economists reason that the optimal decision is to continue any activity up to the point where the A) marginal benefit is zero. B) marginal benefit is greater than the marginal cost. C) marginal cost is zero. D) marginal benefit equals the marginal cost. 8. The principle of opportunity cost is that A) in a market economy, taking advantage of profitable opportunities involves some money cost. B) the economic cost of using a factor of production is the alternative use of that factor that is given up. C) taking advantage of investment opportunities involves costs. D) the cost of production varies depending on the opportunity for technological application. 9. Refer to Figure above. What is the opportunity cost of producing 1 bolt of cotton in Indonesia? A) 3/8 of a kilogram of cashews B) 5/8 of a kilogram of cashews C) 2 2/3 kilograms of cashews D) 120 kilograms of cashews 10. Which of the following statements is true about scarcity? A) Scarcity refers to the situation in which unlimited wants exceed limited resources. B) Scarcity is not a problem for the wealthy. C) Scarcity is only a problem when a country has too large a population. D) Scarcity arises when there is a wide disparity in income distribution. 11. Economists reason that the optimal decision is to continue any activity up to the point where the A) marginal benefit is zero. B) marginal benefit is greater than the marginal cost. C) marginal cost is zero. D) marginal benefit equals the marginal cost. 12. Holding all other personal characteristics—such as age, gender and income—constant, economists would expect that A) people with health insurance will be less likely to be overweight than people without health insurance. B) people with health insurance will be more likely to be overweight than people without health insurance. C) people with health insurance will be equally likely to be overweight as people without health insurance. D) there is no correlation between having health insurance and being overweight. 13. Bella can produce either a combination of 60 silk roses and 80 silk leaves or a combination of 70 silk roses and 55 silk leaves. If she now produces 60 silk roses and 80 silk leaves, what is the opportunity cost of producing an additional 10 silk roses? A) 2.5 silk leaves B) 10 silk leaves C) 25 silk leaves D) 55 silk leaves 14. Refer to Figure above. A movement from X to Y A) could be due to a change in consumers' tastes and preferences. B) is the result of advancements in food production technology only, with no change in the technology for plastic production. C) is the result of advancements in plastic production technology only, with no change in food production technology. D) could occur because of an influx of immigrant labour. 15. Economists assume that rational behaviour is useful in explaining the choices people make A) because irrational people do not make economic choices. B) even though people may not behave rationally all the time. C) because individuals act rationally all the time in all circumstances. D) even though people rarely, if ever, behave in a rational manner. Model Answers Question 1 As resources are in limited supply and wants are unlimited, choices must be made by people and society about how to use their resources to best fulfil their wants. When analysing the decision between choices, the concept of opportunity cost is used. Opportunity shows the highest-valued alternative that must be given up to engage in an activity. Consideration of opportunity cost provides the information needed to make informed decisions between choices. The opportunity cost of seeing a movie includes the monetary cost of admission plus the time cost of going to the theatre and attending the show. The time cost depends on what else you might do with that time. For example, if the next best alternative is staying home and watching TV, the time cost may be small (e.g., an old sitcom), or large (e.g., a live broadcast of your favourite sport). If the next best alternative is working an extra three hours at your job, the time cost includes the money you could have earned. The marginal benefit will be the enjoyment of seeing the movie and the enjoyment from seeing and being with the friend. If you were to see a second movie then it is likely that, assuming both movies were your choice, that you would see you favourite movie first and your second favourite next. Therefore, the second movie will not be as enjoyable and the marginal benefit will be lower. You could also apply the same logic to the marginal benefit of spending time with your friends. The first movie would be spend with the friend that gives you the greatest marginal benefit. Maybe you have not seen this person for a long time? Maybe they are just a closer friend. Either way the marginal benefit from the second movie is likely to be less than the first in most situations. Question 2a Australia New Zealand Apples Apples Oranges Oranges The opportunity costs for both Australia and New Zealand are constant because the PPF is a straight line not bow shaped. Question 2b New Zealand has the comparative advantage in producing oranges. If New Zealand is currently producing 6000 tonnes of oranges and zero apples, and wishes to produce 3000 apples, then it must give up 3000 tonnes of oranges. As opportunity costs are constant the opportunity cost of producing one tonne of oranges is one tonne of apples. As an exercise show that the opportunity cost is the same if New Zealand is currently producing 3000 tonnes of oranges and 3000 tonnes apples, and wishes to produce 6000 tonnes of apples opportunity. Using the same logic you can now show that, for Australia, the opportunity cost of producing 1 tonne of oranges is giving up 3 tonnes of apples. Australia has the comparative advantage in producing apples. In Australia, the opportunity cost of producing 1 tonne of apples is giving up only 1/3 of a tonne of oranges, whereas for New Zealand the opportunity cost is giving up 1 tonne of oranges to produce 1 tonne of apples. Question 2c Absolute advantage is the ability of an individual, firm or country to produce more of a good or service than competitors using the same amount of resources. In this case neither country has an absolute advantage in making both goods. Australia has the absolute advantage in producing apples (Australia can produce 12 tonnes vs New Zealand 6 tonnes), and New Zealand has the absolute advantage in producing oranges (Australia can produce 4 tonnes vs New Zealand 6 tonnes). Question 2d The theory tells us that if both countries specialise in the good in which they have a comparative advantage and then trade with the other, they can both be better off. To show that this theory is correct for this case we need to find at least one situation in which both countries are better off specialising and then trading. Let’s use the case in which each trades half of what it makes for half of what the other makes. Australia will specialise by producing 12 000 tonnes of apples and New Zealand will specialise by producing 6000 tonnes of oranges. Since each gets half of the other’s production, Australia will keep 6000 tonnes of Apples and give 6,000 tonnes to New Zealand. Similarly New Zealand with keep 3000 tonnes and give 3000 tonnes to Australia. The before and after specialisation and trade is shoen below. Apples Oranges Australia Before trade After trade 3000 6000 3000 3000 New Zealand Before trade After trade 3000 6000 3000 3000 This shows they are better off than before trading, since they end up with the same amount of oranges, but twice as many apples. Others trades will make them better off as well. Question 3a Question 3b The opportunity cost of increasing your chemistry score by 4 points in moving from Choice C to Choice D is the 4 point decline in your economics score. Question 3c Choice A might be sensible if the marginal benefits of doing well on the chemistry exam are low relative to the marginal benefits from doing well on the economics exam – for example, the chemistry exam is only a small portion of your grade, but the economics exam is a large portion of your grade; or if you are majoring in economics and don’t care much about chemistry. Question 3d The opportunity costs of increasing your grade in either subject is subject to diminishing returns making the PPF bow shaped. This is because it is much harder to increase your mark from say 90 to 95% than from say 50 to 55%. As a result you need to spend a lot more time (resources) in the first case compared to the second case. Question 4 The two main categories of market participants are households and firms. Households as consumers are the most important in determining what goods and services are produced. If they don’t want to buy something, there is no reason for the firms to make it. Multiple Choice Answers 5 Answer: B 6 Answer: C 7 Answer: D 8 Answer: B 9 Answer: A 10 Answer: A 11 Answer: D 12 Answer: B 13 Answer: C 14 Answer: D 15 Answer: B