Econ 201 Chapter 2

The value of money or income in terms of the quantity of goods the money can buy is called its: A) real value. B) marginal value C) nominal value D) implicit value

A) real value

O'Sullivania, a small country, produces two types of goods: computers and food. O'Sullivania's initial production possibilities frontier is denoted by the solid line in Figure 1.4. Suppose that O'Sullivania's population doubles. Which diagram shows the most likely change in the country's production possibilities frontier? A) A B) B C) C D) D

A. There are more human resources to produce both goods, so both intercepts shift out.

The opportunity cost of something is: A) the cost of the labor used to produce it. B) what you sacrifice to get it. C) the price charged for it. D) the search cost required to find it.

B This is a central concept in economics so make sure you understand it. I would like to learn to snowboard but I don't because I already know how to ski and a day falling snowboarding is a day of skiing lost. Since I don't get to ski as much as I would like I am unwilling to sacrifice a day of skiing to snowboard. The opportunity cost of learning how to snowboard is the lost opportunity to ski.

Suppose your bank pays you 4% interest per year on your savings account, so that $100 grows to $104 over a one-year period. If prices increase by 3% per year over that time, approximately how much do you gain by keeping $100 in the bank for a year? A) $0 B) $1 C) $3 D) $4

B) You only gain about $1 in real purchasing power.

A firm produces its product using both capital and labor. When it does not change its capital usage, but doubles its labor input, its output increases by less than 50%. Which of the following is the most likely explanation of this finding? A) the principle of opportunity cost B) the principle of diminishing returns C) the marginal principle D) the spillover principle

B.

If a society is at a point inside its production possibilities frontier it implies that: A) goods are produced with the optimal mixture of resources. B) more output could be produced using the same resources. C) technology is improving. D) all resources are used in production.

B.

The extra benefit resulting from a small increase in an activity is called the: A) opportunity cost. B) marginal benefit. C) marginal cost. D) diminishing returns of the activity.

B.

The principle of diminishing returns occurs: A) only in the long run. B) only in the short run. C) in both the short run and the long run. D) in either the short run or the long run, depending on the circumstances.

B.

Figure 2.1 presents a production possibilities curve for a country that can either produce highways or provide people with medical care in a given year. The opportunity cost of the third new highway built in a year is: A) 10,000 people provided with medical care. B) 50,000 people provided with medical care. C) 90,000 people provided with medical care. D) 450,000 people provided with medical care.

B. 50,000 fewer people will receive health care.

Mark quit his job as a salesman where he made $35,000 per year to start his own t-shirt making business. His business expenses are $6,000 per year on rent, $12,000 per year on supplies, and $4,000 per year on part time help. As for his personal expenses, his apartment costs him $4,800 per year and his personal bills are an extra $1,200 per year. What is Mark's opportunity cost of running the business? A) $63,000 B) $57,000 C) $41,000 D) $35,000

B. If Mark did not start new business, would not have spent $22K on new business, and would not have lost $35K by not doing salesman work, so opportunity cost is $57K.

The principle of diminishing returns implies that as one input increases while the other inputs are held fixed, output: A) increases at an increasing rate. B) increases at a decreasing rate. C) decreases at a decreasing rate. D) decreases at an increasing rate.

B. Only a relevant concept in the short run, as in long run all factors are variable. Also, the long run is different for different industries. An airline has a much longer long run because it is difficult for them to get now planes and increase their scale of production. The soup shack in front of PLC has a much smaller long run because they can buy another shack (actually I think it's a trailer) fairly quickly or sell the one they have.

Refer to Table 2.4. The principle of diminishing returns sets in with the addition of the ________ tank of fertilizer. A) second B) third C) fourth D) fifth

B. The first tank has a MP of 18, the second 20, the third, 5. So marginal product begins to diminish with the third tank. Notice that we don't necessarily assume that marginal product is everywhere decreasing but we do assume that it does eventually and forever thereafter. In practice economists usually assume that MP is everywhere decreasing. This is defendable because the region that we are interested in will have diminishing returns. That is firms are going to increase production if they are getting increasing marginal returns so the equilibrium, where they choose not to increase or decrease output, will most likely be a point where MP is decreasing

A group of people has formed a house cleaning and yard maintenance business. The number of houses or yards that they can clean or maintain in any given day is depicted in Table 2.1. As the group cleans more houses the opportunity cost of cleaning houses: A) falls. B) rises. C) stays the same. D) is the sum of the opportunity costs of cleaning all the houses prior to that one.

B. This is a graphical illustration of the 'bowed outness' of the production possibility curve. If you clean no house and only do yard-work you can do 21 yards. In order to clean the first house you only give up 1 yard. The second house means you can't do 2 more yards. The third house means giving up 3 yards. So each increase in the number of houses you do causes an increasing amount of forgone yards. This might occur if certain people in the group were better at houses than yards and others were better at yards.

You borrow money to buy a house in 1999 at a fixed interest rate of 6.5%. By 2003, the inflation rate has risen to 8.5%. Considering only your mortgage, is inflation good news or bad news for you? A) Bad news, because inflation hurts everyone. B) Bad news, because it makes the real value of your mortgage payments increase. C) Good news, because it makes the real value of your mortgage payments decrease. D) Bad news, because it makes the nominal value of your mortgage payments increase.

C) This really hurt Savings and Loan institutions in the 1970s. S&Ls were traditionally in the practice of loaning people money long term to buy/build houses (like the Bailey S&L in 'It's a Wonderful Life'). Inflation had been pretty constant through much of the 1950s and 1960s so the S&Ls offered loans with fairly low fixed interest rates. When inflation jumped up during the '70s the S&Ls were receiving a lower real return on their loans while the homeowners were making a lower real payment on their debt. The opportunity cost of the mortgage payments are lower for the households because the payments result in less forgone purchases.

The face value of money or income is called its ________ value. A) real B) marginal C) nominal D) external

C) nominal

Suppose that you own a house. What is the opportunity cost of living in the house? A) There is no opportunity cost because you own the house. B) There is no opportunity cost unless you could set up a business in the house. C) The opportunity cost is the rent you could have received from a tenant if you didn't live there. D) The opportunity cost is the cost of your monthly mortgage payment plus bills

C.

Which of the points on Figure 1.1 is attainable and is a point where it is impossible for the society to produce more of both goods? A) E B) F C) G D) H

C.

The period of time over which one or more factors of production is fixed is the: A) long run. B) period of marginal costs C) short run D) none of the above

C. From comment on number 22. Also, fixed costs can be either sunk or not sunk. A sunk cost is not retrievable. For example, in order to open your own accounting firm you will need to rent or buy a facility to work in { this cost is fixed because it does not vary with the amount of output you produce. You would also need to go to school to become a CPA { even if you never use the degree you have to pay for it. The cost of the facility can be recovered by selling it (actually I suppose rent is a sunk cost also so renting represents a fixed and sunk cost, buying is a fixed but not sunk cost).

The saying that "There's no such thing as a free lunch" refers to the: A) marginal principle. B) spillover principle. C) principle of opportunity cost. D) reality principle.

C. Perhaps most famous economic "saying", illustrating scarcity and opportunity cost.

O'Sullivania, a small country, produces two types of goods: computers and food. O'Sullivania's initial production possibilities frontier is denoted by the solid line in Figure 1.4. Suppose that O'Sullivania's computer industry enjoys a technological innovation. Which diagram shows the most likely change in the production possibilities frontier? A) A B) B C) C D) D

C. The innovation is only for computers so only the intercept for computers shifts out. Notice that we could produce the same amount of computers and more food even though there was no technological improvement for food. This is because the real cost of producing computers, in terms of the amount of resources necessary, has decreased. The computers are produced more efficiently and so some resources are freed up to be devoted to food production. Actually one of the reasons we have had such tremendous growth over the past few centuries is because the intercept for food shifted out a lot. A few hundred years ago almost everyone lived and worked on a farm. As we became better able to produce food with technological advances like the combustion engine, we could devote less resources (our time) to food production and produce other things instead, like computers.

Refer to Table 2.4. The marginal product of the 2nd tank of fertilizer is: A) 45 truckloads of fruit. B) 37 truckloads of fruit. C) 20 truckloads of fruit. D) 5 truckloads of fruit.

C. The marginal product is the change in production from one unit increase in the input. When we go from one tank to two, we increase output from 63 to 83 truckloads, etc. So MP is 20 here.

A production possibilities curve is bowed out because: A) society has fixed amounts of productive resources. B) the curve is negatively sloped. C) resources are not perfectly adaptable to different uses. D) it becomes less and less costly to produce each additional unit of output.

C. This is pretty important point. Note that a PPC is not a straight line, i.e., perfectly adaptable resources. Some resources are more suited to producing some goods.

Suppose prices increase by 5% per year. What nominal percentage return on your savings account would you require to get a 2% real return? A) 0% B) 2% C) 5% D) 7%

D) 7%

According to Figure 1.3, the economy produces only satellites (and no fighter jets) at point: A) R B) S C) T D) V

D.

An unemployed individual decides to spend the day fishing. The opportunity cost of fishing is equal to: A) the cost of bait and any other monetary expenses. B) zero, because the person doesn't have a job. C) the cost of bait, any other monetary expenses, and the value of the individual's wages while he was working. D) the cost of bait, any other monetary expenses, and the value of the best alternative use of the individual's time.

D.

O'Sullivania, a small country, produces two types of goods: computers and food. O'Sullivania's initial production possibilities frontier is denoted by the solid line in Figure 1.4. Suppose that O'Sullivania's computer industry enjoys a technological innovation while its agricultural community faces a significant drought. Which diagram shows the most likely change in the production possibilities frontier? A) A B) B C) C D) None of the above is correct.

D.

The production possibilities frontier may shift if the: A) amount of natural resources available increases. B) amount of physical capital available increases. C) level of technology increases. D) All of the above could shift the production possibilities curve.

D.

Which of the following would shift a production possibilities curve inward? A) improved access to transportation B) a decrease in the rate of inflation C) an increase in the number of people graduating from college D) a drought that caused crop failures

D.

Julianne runs a business and needs to decide how many hours to stay open. Table 2.2 illustrates her marginal costs of staying open for each additional hour. Suppose that Julianne's marginal benefit of staying open per hour is $28. If she is following the marginal principle, how many hours should Julianne stay open? A) 1 hour B) 3 hours C) 6 hours D) 7 hours

D. Choose where MB = MC.

Which of the points on Figure 1.1 is unattainable? A) E B) F C) G D) H

D. Points D, F, and G are attainable; only G is efficient, i.e., on the frontier.

Joe runs a business and needs to decide how many hours to stay open. Figure 2.2 illustrates his marginal benefit of staying open for each additional hour. Suppose that we observe Joe staying open 3 hours per day. If he is following the marginal principle, what must his marginal cost be? A) $24 B) $32 C) $40 D) $48

D. The rule is produce up to the point, but not beyond it, where MB = MC. Imagine that this were not true, imagine Joe only stayed open 2 hours, then his MB would be 56 which is higher than MC. If MB > MC then he would benefit from staying open longer because he's getting a greater benefit for his time than it is costing him. If MB < MC as it would be if Joe stayed open 5 hours, then it is costing him more to stay open for those last two hours than he gained. It may seem funny that joe would choose the hours where MB = MC because the last hour actually did not increase Joe's profits, i.e. it cost him exactly what he gained. The reason for the equality is that time is continuous, or perfectly divisible. That is Joe could stay open a half hour longer, or 15 minutes longer, or one minute longer, etc... In that case the profit maximizing number of hours would be where MB = MC. In the case where output is not perfectly divisible you should choose the output closest to MC but not exceeding it. DO NOT CONFUSE MARGINAL COSTS/BENEFITS WITH TOTAL COSTS/BENEFITS! If MB = MC profits could be positive, negative or zero.

According to Figure 1.3, the best possible point of production for this economy is: A) R B) S C) W D) Cannot be determined based on the information provided.

D. This is sort of a trick question. It is important to point out that, while all of the points on the curve are efficient, they are not all desirable. The classic example of a production possibilities curve uses guns and butter as goods. If we were to produce all guns we could be efficient but we would have nothing to eat. I often hear people argue for a certain production mix in an economy simply because it is most efficient. In reality we must also take into consideration society's preferences. In fact a point on the curve could be less desirable than a point inside (an inefficient point) depending on society's preferences. The ideal point, however, would be on the curve and still be consistent with preferences. In order to find the socially optimal point we need to formally model society's preferences, which is harder than modeling production possibilities both mathematically and theoretically.