ECF5921 Week 2, Tutorial 1 (Mankiw: Chapters 1, 2 & 4)

Chapter 1 – Question 1

1. Describe some of the trade-offs faced by each of the following:

a. A family deciding whether to buy a new car
b. A member of Congress deciding how much to spend on national parks
c. A company president deciding whether to open a new factory
d. A professor deciding how much to prepare for class
e. A recent college graduate deciding whether to go to graduate school

Answers

1. a. A family deciding whether to buy a new car faces a trade-off between the cost of
the car and other things they might want to buy. For example, buying the car
might mean they must give up going on vacation for the next two years. Also, fuel
efficient cars are more expensive but regular cars require spending more on gas.
Smaller cars are less expensive, but bigger cars mean saving time by avoiding
multiple trips.

b. For a member of Congress deciding how much to spend on national parks, one
trade-off is between parks and other spending items or tax cuts. If more money
goes into the park system, that may mean less spending on national defense or on
transportation. Or instead of spending more money on the park system, taxes
could be reduced. Another tradeoff when deciding how much to spend on national
parks is spending a small amount on a lot of parks or a larger amount on a single
park.

c. When a company president decides whether to open a new factory, the decision is
based on whether the new factory will increase the firm’s profits compared to
other alternatives. For example, the company could upgrade existing equipment or
expand existing factories. The bottom line is: Which method of expanding
production will increase profit the most?

d. In deciding how much to prepare for class, a professor faces a trade-off between
the value of improving the quality of the lecture compared to other things she
could do with her time, such as working on additional research or enjoying some
leisure time.

e. In deciding whether to go to graduate school, the student faces a trade-off between

his possible earnings with a bachelor’s degree and the benefits of an increased
education (such as higher future earnings and greater knowledge). The student
also faces the trade-off between spending time with family or on leisure and
spending time studying. Also, the student may face the tradeoff between taking
out student loans and buying a home or car with a loan.

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Chapter 2 – Question 2

2. Imagine a society that produces military goods and consumer goods, which we’ll call
“guns” and “butter”.
a. Draw a production possibilities frontier for guns and butter. Using the concept of
opportunity cost, explain why it most likely has a bowed-out shape.
b. Show a point that it is impossible for the economy to achieve. Show a point that is
feasible but inefficient.
c. Imagine that the society has two political parties, called the Hawks (who want a
strong military) and the Doves (who want a smaller military). Show a point on your
production possibilities frontier that the Hawks might choose and a point that the
Doves might choose.
d. Imagine that an aggressive neighboring country reduces the size of its military. As a
result, both the Hawks and the Doves reduce their desired production of guns by the
same amount. Which party would get the bigger “peace dividend’, measured by the
increase in butter production? Explain.

Answer

2. a. Figure 6 shows a production possibilities frontier between guns and butter. It is

bowed out because of the law of increasing opportunity costs. As the economy moves
from producing many guns and a little butter (point H) to producing fewer guns and
more butter (point D), the opportunity cost of each additional unit of butter increases
because the resources best suited to producing guns are shifting toward the production
of butter. Thus, the number of guns given up to produce one more unit of butter is
increasing.

Figure 6

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 b. Point A is impossible for the economy to achieve; it is outside the production
possibilities frontier. Point B is feasible but inefficient because it is inside the
production possibilities frontier.

c. The Hawks might choose a point like H, with many guns and not much butter. The
Doves might choose a point like D, with a lot of butter and few guns.

d. If both Hawks and Doves reduced their desired quantity of guns by the same amount,
the Hawks would get a bigger peace dividend because the production possibilities
frontier is much flatter at point H than at point D. As a result, the reduction of a given
number of guns, starting at point H, leads to a much larger increase in the quantity of
butter produced than when starting at point D.
Chapter 4 – Questions 5 & 7

5. Over the past 30 years, technological advances have reduced the cost of computer chips.
How do you think this has affected the market for computers? For computer software? For
typewriters?

7. Ketchup is a complement (as well as a condiment) for hot dogs. If the price of hot dog
rises, what happens to the market for ketchup? For tomatoes? For tomato juice? For orange
juice?

Answer

Technological advances that reduce the cost of producing computer chips represent a
decline in an input price for producing a computer. The result is a shift to the right
in the supply of computers, as shown in Figure 19. The equilibrium price falls and
the equilibrium quantity rises, as the figure shows.

Figure 19

Because computer software is a complement to computers, the lower equilibrium

price of computers increases the demand for software. As Figure 20 shows, the result
is a rise in both the equilibrium price and quantity of software.

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 Figure 20

Because typewriters are substitutes for computers, the lower equilibrium price of
computers reduces the demand for typewriters. As Figure 21 shows, the result is a
decline in both the equilibrium price and quantity of typewriters.

Figure 21

7. Ketchup is a complement for hot dogs. Therefore, when the price of hot dogs rises, the
quantity demanded of hot dogs falls and this lowers the demand for ketchup. The end
result is that both the equilibrium price and quantity of ketchup fall. Because the quantity
of ketchup falls, the demand for tomatoes by ketchup producers falls, so the equilibrium
price and quantity of tomatoes fall. When the price of tomatoes falls, producers of tomato
juice face lower input prices, so the supply curve for tomato juice shifts out, causing the
price of tomato juice to fall and the quantity of tomato juice to rise. The fall in the price
of tomato juice causes people to substitute tomato juice for orange juice, so the demand

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for orange juice declines, causing the price and quantity of orange juice to fall. Now you
can see clearly why a rise in the price of hot dogs leads to a fall in the price of orange
juice!

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ECF5921 Week 3, Tutorial 2 (Mankiw: Chapters 5 & 7)

Chapter 5 – Questions 1, 3, 10 & 12

1. For each of the following pairs of good, which good would you expect to have more
elastic demand and why?
a. Required textbooks or mystery novels
b. Beethoven recordings or classical music recordings in general
c. Subway rides during the next six months or subway rides during the next five years
d. Root beer or water

3. Suppose the price elasticity of demand for heating oil is 0.2 in the short run and 0.7 in the
long run.
a. If the price of heating oil rises from $1.80 to $2.20 per gallon, what happens to the
quantity of heating oil demanded in the short run? In the long run? (Use the midpoint
method in your calculations.)
b. Why might this elasticity depend on the time horizon?

10. Consider public policy aimed at smoking.

a. Studies indicate that the price elasticity of demand for cigarettes is about 0.4. If a pack
of cigarettes currently costs $2 and the government wants to reduce smoking by 20
percent, by how much should it increase the price?
b. If the government permanently increases the price of cigarettes, will the policy have a
larger effect on smoking one year from now or five years from now?
c. Studies also find that teenagers have a higher price elasticity of demand than do
adults. Why might this be true?

12. Explain why the following might be true: A drought around the world raises the total
revenue that farmers receive from the sale of grain, but a drought only in Kansas reduces the
total revenue that Kansas farmers receive.

Answers

1. a. Mystery novels have more elastic demand than required textbooks because
mystery novels have close substitutes and are a luxury good, while required
textbooks are a necessity with no close substitutes. If the price of mystery
novels were to rise, readers could substitute other types of novels, or buy
fewer novels altogether. But if the price of required textbooks were to rise,
students would have little choice but to pay the higher price. Thus, the
quantity demanded of required textbooks is less responsive to price than the
quantity demanded of mystery novels.

b. Beethoven recordings have more elastic demand than classical music

recordings in general. Beethoven recordings are a narrower market than
classical music recordings, so it is easier to find close substitutes for them. If
the price of Beethoven recordings were to rise, people could substitute other
classical recordings, like Mozart. But if the price of all classical recordings
were to rise, substitution would be more difficult. (A transition from classical

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 music to rap is unlikely!) Thus, the quantity demanded of classical recordings
is less responsive to price than the quantity demanded of Beethoven
recordings.

c. Subway rides during the next five years have more elastic demand than
subway rides during the next six months. Goods have a more elastic demand
over longer time horizons. If the fare for a subway ride was to rise
temporarily, consumers could not switch to other forms of transportation
without great expense or great inconvenience. But if the fare for a subway ride
was to remain high for a long time, people would gradually switch to
alternative forms of transportation. As a result, the quantity demanded of
subway rides during the next six months will be less responsive to changes in
the price than the quantity demanded of subway rides during the next five
years.

d. Root beer has more elastic demand than water. Root beer is a luxury with
close substitutes, while water is a necessity with no close substitutes. If the
price of water were to rise, consumers have little choice but to pay the higher
price. But if the price of root beer were to rise, consumers could easily switch
to other sodas or beverages. So the quantity demanded of root beer is more
responsive to changes in price than the quantity demanded of water.

3. a. The percentage change in price is equal to (2.20 – 1.80)/2.00 x 100 = 20%. If

the price elasticity of demand is 0.2, quantity demanded will fall by 4% in the
short run [0.20 × 0.20]. If the price elasticity of demand is 0.7, quantity
demanded will fall by 14% in the long run [0.7 × 0.2].

b. Over time, consumers can make adjustments to their homes by purchasing

alternative heat sources such as natural gas or electric furnaces. Thus, they can
respond more easily to the change in the price of heating oil in the long run
than in the short run.

10. a. With a price elasticity of demand of 0.4, reducing the quantity demanded of
cigarettes by 20% requires a 50% increase in price, because 20/50 = 0.4. With
the price of cigarettes currently $2, this would require an increase in the price
to $3.33 a pack using the midpoint method (note that ($3.33 – $2)/$2.67 =
.50).

b. The policy will have a larger effect five years from now than it does one year
from now. The elasticity is larger in the long run, because it may take some
time for people to reduce their cigarette usage. The habit of smoking is hard to
break in the short run.

c. Because teenagers do not have as much income as adults, they are likely to
have a higher price elasticity of demand. Also, adults are more likely to be
addicted to cigarettes, making it more difficult to reduce their quantity
demanded in response to a higher price.

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 12. A worldwide drought could increase the total revenue of farmers if the price
elasticity of demand for grain is inelastic. The drought reduces the supply of grain,
but if demand is inelastic, the reduction of supply causes a large increase in price.
Total farm revenue would rise as a result. If there is only a drought in Kansas,
Kansas’ production is not a large enough proportion of the total farm product to
have much impact on the price. As a result, price does not change (or changes by
only a slight amount), while the output by Kansas farmers declines, thus reducing
their income.

Chapter 7 – Question 1 & 5

1. Melissa buy an iPhone for $120 and gets consumer surplus of $80.
a. What is her willingness to pay?
b. If she bought the iPhone on sale for $90, what would her consumer surplus have
been?
c. If the price of an iPhone were $250, what would her consumer surplus have been?

5. Ernie owns a water pump. Because pumping large amounts of water is harder than
pumping small amounts, the cost of producing a bottle of water rises as he pumps more. Here
is the cost he incurs to produce each bottle of water:

Cost of first bottle: $1

Cost of second bottle: $3
Cost of third bottle: $5
Cost of fourth bottle: $7

a. From this information, derive Ernie’s supply schedule. Graph his supply curve for bottled
water.
b. If the price of a bottle of water is $4, how many bottles does Ernie produce and sell? How
much producer surplus does Ernie get from these sales? Show Ernie’s producer surplus in
your graph.
c. If the price rises to $6, how does quantity supplied change? How does Ernie’s producer
surplus change? Show these changes in your graph.

Answer

1. a. Consumer surplus is equal to willingness to pay minus the price paid.

Therefore, Melissa’s willingness to pay must be $200 ($120 + $80).

b. Her consumer surplus at a price of $90 would be $200 − $90 = $110.

c. If the price of an iPhone was $250, Melissa would not have purchased one
because the price is greater than her willingness to pay. Therefore, she would
receive no consumer surplus.

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5. a. Ernie’s supply schedule for water is:

Price Quantity Supplied

More than $7 4
$5 to $7 3
$3 to $5 2
$1 to $3 1
Less than $1 0

Ernie’s supply curve is shown in Figure 10.

Figure 10

b. When the price of each bottle of water is $4, Ernie sells two bottles of water.
His producer surplus is shown as area A in the figure. He receives $4 for his
first bottle of water, but it costs only $1 to produce, so Ernie has producer
surplus of $3. He also receives $4 for his second bottle of water, which costs
$3 to produce, so he has producer surplus of $1. Thus Ernie’s total producer
surplus is $3 + $1 = $4, which is the area of A in the figure.

c. When the price of each bottle of water rises from $4 to $6, Ernie sells three
bottles of water, an increase of one. His producer surplus consists of both
areas A and B in the figure, an increase by the amount of area B. He gets
producer surplus of $5 from the first bottle ($6 price minus $1 cost), $3 from
the second bottle ($6 price minus $3 cost), and $1 from the third bottle ($6
price minus $5 price), for a total producer surplus of $9. Thus producer
surplus rises by $5 (which is the size of area B) when the price of each bottle
of water rises from $4 to $6.

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ECF5921 Week 4, Tutorial 3 (Mankiw: Chapter 15)

Chapter 15 – Questions 1, 8 & 10

1. What components of GDP (if any) would each of the following transactions affect?
Explain.
a. A family buys a new refrigerator.
b. Aunt Jane buys a new house.
c. Ford sells a Mustang from its inventory.
d. You buy a pizza.
e. California repaves Highway 101.
f. Your parents buy a bottle of French wine.
g. Honda expands its factory in Marysville, Ohio.

8. A farmer grows wheat, which she sells to a miller for $100. The miller turns the wheat into
flour, which she sells to a baker for $150. The baker turns the wheat into bread, which she
sells to consumers for $180. Consumers eat the bread.
a. What is GDP in this economy? Explain.
b. Value added is defined as the value of a producer’s output minus the value of the
intermediate goods that the producer buys to make the output. Assuming there are no
intermediate goods beyond those described above, calculate the value added of each
of the three producers.
c. What is the total value added of the three producers in this economy? How does it
compare to the economy’s GDP? Does this example suggest another way of
calculating GDP?

10. The participation of women in the U.S. labor force has risen dramatically since 1970.
a. How do you think this rise affected GDP?
b. Now imagine a measure of well-being that includes time spent working in the home
and taking leisure. How would the change in this measure of well-being compare to
the change in GDP?
c. Can you think of other aspects of well-being that are associated with the rise in
women’s labor-force participation? Would it be practical to construct a measure of
well-being that includes these aspects?

Answers

1. a. Consumption increases because a refrigerator is a good purchased by a

household.
b. Investment increases because a house is an investment good.
c. Consumption increases because a car is a good purchased by a household, but
investment decreases because the car in Ford’s inventory had been counted as
an investment good until it was sold.
d. Consumption increases because pizza is a good purchased by a household.
e. Government purchases increase because the government spent money to
provide a good to the public.
f. Consumption increases because the bottle is a good purchased by a household,
but net exports decrease because the bottle was imported.
g. Investment increases because new structures and equipment were built.

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8. a. GDP is the market value of the final good sold, $180.

b. Value added for the farmer: $100.

Value added for the miller: $150 – $100 = $50.
Value added for the baker: $180 – $150 = $30.

c. Together, the value added for the three producers is $100 + $50 + $30 = $180.
This is the value of GDP. This example suggests that GDP could be calculated
as the sum of the value added by all producers.

10. a. The increased labor-force participation of women has increased GDP in the
United States, because it means more people are working and production has
increased.

b. If our measure of well-being included time spent working in the home and
taking leisure, it would not rise as much as GDP, because the rise in women's
labor-force participation has reduced time spent working in the home and
taking leisure.

c. Other aspects of well-being that are associated with the rise in women's
increased labor-force participation include increased self-esteem and prestige
for women in the workforce, especially at managerial levels, but decreased
quality time spent with children, whose parents have less time to spend with
them. Such aspects would be quite difficult to measure.

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ECF5921 Week 5, Tutorial 4 (Mankiw: Chapter 23)

Chapter 23 – Questions 1, 8, 9 & 10

1. Suppose the economy is in a long-run equilibrium.

a. Draw a diagram to illustrate the state of the economy. Be sure to show aggregate
demand, short-run aggregate supply, and long-run aggregate supply.
b. Now suppose that a stock market crash causes aggregate demand to fall. Use your
diagram to show what happens to output and the price level in the short run. What
happens to the unemployment rate?
c. Use the sticky-wage theory of aggregate supply to explain what will happen to output
and the price level in the long run (assuming there is no change in policy). What role
does the expected price level play in this adjustment? Be sure to illustrate your
analysis in a graph.

8. Explain whether each of the following events shifts the short-run aggregate-supply curve,
the aggregate-demand curve, both, or neither. For each event that does shift a curve, draw a
diagram to illustrate the effect on the economy.
a. Households decide to save a larger share of their income.
b. Florida orange groves suffer a prolonged period of below-freezing temperatures.
c. Increased job opportunities overseas cause many people to leave the country.

9. For each of the following events, explain the short-run and long-run effects on output and
the price level, assuming policymakers take no action.
a. The stock market declines sharply, reducing consumers’ wealth.
b. The federal government increases spending on national defense.
c. A technological improvement raises productivity.
d. A recession overseas causes foreigners to buy fewer U.S. goods.

10. Suppose firms become very optimistic about future business conditions and invest heavily
in new capital equipment.
a. Draw an aggregate-demand/aggregate-supply diagram to show the short-run effect of
this optimism on the economy. Label the new levels of prices and real output. Explain
in words why the aggregate quantity of output supplied changes.
b. Now use the diagram from part (a) to show the new long-run equilibrium of the
economy. (For now, assume there is no change in the long-run aggregate-supply
curve.) Explain in words why the aggregate quantity of output demanded changes
between the short run and the long run.
c. How might the investment boom affect the long-run aggregate-supply curve? Explain.

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Answers

Price Long-Run Aggregate

Level Supply
AS1

AS2

AD1

AD2

Output

Figure 6

1. a. The current state of the economy is shown in Figure 6. The aggregate-demand

curve (AD 1 ) and short-run aggregate-supply curve (AS 1 ) intersect at the same
point on the long-run aggregate-supply curve.

b. A stock market crash leads to a leftward shift of aggregate demand (to AD 2 ).

The equilibrium level of output and the price level will fall. Because the
quantity of output is less than the natural level of output, the unemployment
rate will rise above the natural rate of unemployment.

c. If nominal wages are unchanged as the price level falls, firms will be forced to
cut back on employment and production. Over time as expectations adjust, the
short-run aggregate-supply curve will shift to the right (to AS 2 ), moving the
economy back to the natural level of output.

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8. a. If households decide to save a larger share of their income, they must spend
less on consumer goods, so the aggregate-demand curve shifts to the left, as
shown in Figure 10. The equilibrium changes from point A to point B, so the
price level declines and output declines.

b. If Florida orange groves suffer a prolonged period of below-freezing

temperatures, the orange harvest will be reduced. This decline in the natural
level of output is represented in Figure 11 by a shift to the left in both the
short-run and long-run aggregate-supply curves. The equilibrium changes
from point A to point B, so the price level rises and output declines.

Figure 11

Figure 12

c. If increased job opportunities cause people to leave the country, the long-run
and short-run aggregate-supply curves will shift to the left because there are
fewer people producing output. The aggregate-demand curve will also shift to
the left because there are fewer people consuming goods and services. The
result is a decline in the quantity of output, as Figure 12 shows. Whether the

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 price level rises or declines depends on the relative sizes of the shifts in the
aggregate-demand curve and the aggregate-supply curves.

9. a. When the stock market declines sharply, wealth declines, so the aggregate-
demand curve shifts to the left, as shown in Figure 13. In the short run, the
economy moves from point A to point B, as output declines and the price level
declines. In the long run, the short-run aggregate-supply curve shifts to the
right to restore equilibrium at point C, with unchanged output and a lower
price level compared to point A.

Figure 13

Figure 14

b. When the federal government increases spending on national defense, the rise
in government purchases shifts the aggregate-demand curve to the right, as
shown in Figure 14. In the short run, the economy moves from point A to
point B, as output and the price level rise. In the long run, the short-run

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 aggregate-supply curve shifts to the left to restore equilibrium at point C, with
unchanged output and a higher price level compared to point A.

Figure 15

c. When a technological improvement raises productivity, the long-run and

short-run aggregate-supply curves shift to the right, as shown in Figure 15.
The economy moves from point A to point B, as output rises and the price
level declines.

Figure 16

d. When a recession overseas causes foreigners to buy fewer U.S. goods, net
exports decline, so the aggregate-demand curve shifts to the left, as shown in
Figure 16. In the short run, the economy moves from point A to point B, as
output declines and the price level declines. In the long run, the short-run
aggregate-supply curve shifts to the right to restore equilibrium at point C,
with unchanged output and a lower price level compared to point A.

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10. a. If firms become optimistic about future business conditions and increase
investment, the result is shown in Figure 17. The economy begins at point A
with aggregate-demand curve AD 1 and short-run aggregate-supply curve AS 1 .
The equilibrium has price level P 1 and output level Y 1 . Increased optimism
leads to greater investment, so the aggregate-demand curve shifts to AD 2 .
Now the economy is at point B, with price level P 2 and output level Y 2 . The
aggregate quantity of output supplied rises because the price level has risen
and people have misperceptions about the price level, wages are sticky, or
prices are sticky, all of which cause output supplied to increase.

Figure 17

b. Over time, as the misperceptions of the price level disappear, wages adjust, or
prices adjust, the short-run aggregate-supply curve shifts to the left to AS 2 and
the economy gets to equilibrium at point C, with price level P 3 and output
level Y 1 . The quantity of output demanded declines as the price level rises.

c. The investment boom might increase the long-run aggregate-supply curve

because higher investment today means a larger capital stock in the future,
thus higher productivity and output.

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ECF5921 Week 6, Tutorial 5 (Carbaugh: Chapter 2)

Chapter 2 – Questions 5, 6 & 12

5. How does the comparative-cost concept relate to a nation’s production possibilities

schedule? Illustrate how differently shaped production possibilities schedules give rise to
different opportunity costs.

6. What is meant by constant opportunity costs and increasing opportunity costs? Under what
conditions will a country experience constant or increasing costs?

12. The maximum amount of steel or aluminum that Canada and France can produce if they
use all the factors of production at their disposal with the best technology available to them is
shown (hypothetically) in Table 2.8.

Table 2.8
Steel and Aluminum Production

Canada France
Steel (tons) 500 1200
Aluminum (tons) 1500 800

Assume that production occurs under constant cost conditions. On graph paper, draw the
production possibilities schedules for Canada and France; locate aluminum on the horizontal
axis and steel on the vertical axis of each country’s graph. In the absence of trade, assume
that Canada produces and consumes 600 tons of aluminum and 300 tons of steel and that
France produces and consumes 400 tons of aluminum and 600 tons of steel. Denote these
autarky points on each nation’s production possibilities schedule.

a. Determine the MRT of steel into aluminum for each nation. According to the
principle of comparative advantage, should the two nations specialize? If so, which
product should each country produce? Will the extent of specialization be complete or
partial? Denote each nation’s specialization point on its production possibilities
schedule. Compared to the output of steel and aluminum that occurs in the absence of
trade, does specialization yield increases in output? If so, by how much?
b. Within what limits will the terms of trade lie if specialization and trade occur?
Suppose Canada and France agreed to a terms of trade ratio of 1:1 (1 ton of steel = 1
ton of aluminum). Draw the terms of trade line in the diagram of each nation.
Assuming 500 tons of steel are traded for 500 tons of aluminum, are Canadian
consumers better off as the result of trade? If so, by how much? How about French
consumers?
c. Describe the trade triangles for Canada and France.

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Answers

5. The principle of comparative advantage can be explained in opportunity cost, which

indicates the amount of one product that must be sacrificed in order to release enough
resources to be able to produce one more unit of another product. The slope of the
production possibilities curve (i.e., the marginal rate of transformation) indicates this rate
of sacrifice. A nation facing a straight-line production possibilities curve produces under
conditions of constant costs, while production under increasing costs refers to a
bowed-out (i.e., concave) production possibilities curve.

6. Constant opportunity costs refer to a situation where the cost of each additional unit of
one product in terms of another product remains the same. Constant costs occur when
resources are completely adaptable to alternative uses. Under increasing cost conditions,
a nation must sacrifice more and more of one product to produce each additional unit of
another product. Increasing costs occur when resources are not completely adaptable to
alternative uses.

12.
a. Canada's MRT of steel into aluminum equals 1/3 ton of steel per ton of aluminum while
France's MRT of steel into aluminum equals 1 ½ tons of steel per ton of aluminum. Canada
specializes in the production of aluminum while France specializes in the production of
steel. Complete specialization occurs in each country. The production gains from trade
for the two countries total 500 tons of aluminum and 300 tons of steel.

b. Lower limit, 1 ton of aluminum = 1/3 ton of steel; upper limit, 1 ton of aluminum = 1 ½
tons of steel. The consumption gains from trade for Canada consist of 400 tons of aluminum
and 200 tons of steel; the consumption gains from trade for France consist of 100 tons of
aluminum and 100 tons of steel.

c. Canada's trade triangle is bounded by 500 tons of aluminum (export), 500 tons of steel
(import), and a terms of trade equal to 1 ton of aluminum per ton of steel. France's trade
triangle is bounded by 500 tons of steel (export), 500 tons of aluminum (import), and a
terms of trade equal to 1 ton of steel per ton of aluminum.

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ECF5921 Week 8, Tutorial 7 (Carbaugh: Chapter 3)

Chapter 3 – Questions 2, 4, 9 & 13

2. Explain how the international movement of products and factor inputs promotes an
equalization of the factor prices among nations.

4. The factor-endowment theory demonstrates how trade affects the distribution of income
within trading partners. Explain.

9. Distinguish between intra-industry trade and inter-industry trade. What are some major
determinants of intra-industry trade?

13. Table 3.6 illustrates the supply and demand schedules for calculators in Sweden and
Norway. On graph paper, draw the supply and demand schedules of each country.
a. In the absence of trade, what are the equilibrium price and quantity of calculators
produced in Sweden and Norway? Which country has the comparative advantage in
calculators?
b. Assume there are no transportation costs. With trade, what price brings about balance
in exports and imports? How many calculators are traded at this price? How many
calculators are produced and consumed in each country with trade?
c. Suppose the cost of transporting each calculator from Sweden to Norway is $5. With
trade, what is the impact of the transportation cost on the price of calculators in
Sweden and Norway? How many calculators will each country produce, consume,
and trade?
d. In general, what can be concluded about the impact of transportation costs on the
price of the traded product in each trading nation? The extent of specialization? The
volume of trade?

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Answers

2. The factor endowment theory suggests that a capital-abundant nation enjoys relatively
cheap capital. It thus specializes in and exports a capital-intensive good. This leads to
increased demand for capital, which forces up the price of capital and thus the price of
the capital-intensive good. The opposite occurs in the capital-scarce country. The basis
for further specialization and trade ceases when the capital prices and product prices in
each nation equate.

4. The Heckscher-Ohlin theory reasons that exports of products embodying large amounts
of relatively cheap, abundant factors makes those factors less abundant domestically.
This leads to higher prices and thus an increased share of national income for these
factors.

9. Inter-industry trade refers to the exchange between nations of products of different

industries. Intra-industry trade refers to two-way trade in a similar product. Among the
determinants of intra-industry trade are: (a) overlapping demand segments in trading
countries, (b) the extent to which domestic producers ignore "minority" consumer tastes,
and (c) economies of scale associated with differentiated goods.

13. a. Sweden--P = $15, Q = 600; Norway--P = $30, Q = 600. Sweden has the comparative
advantage in calculators.
b. P = $22.50 and 600 calculators are traded at that price. Sweden--Qs = 900, Qd =
300; Norway--Qs = 300, Qd = 900.
c. Sweden--P = $20; Norway--P = $25. Sweden--Qs = 800, Qd = 400, Exports= 400;
Norway--Qs = 400, Qd = 800, Imports = 400.
d. Prices do not equalize. Less specialization occurs. A smaller trade volume occurs.

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ECF5921 Week 9, Tutorial 8 (Carbaugh: Chapter 4)

Chapter 4 – Questions 5, 6, 12 & 15

5. Distinguish between consumer surplus and producer surplus. How do these concepts relate
to a country’s economic welfare?

6. When a nation imposes a tariff on the importation of a commodity, economic inefficiencies

develop that detract from the national welfare. Explain.

12. Suppose that the production of $1 million worth of steel in Canada requires $100, 000
worth of taconite. Canada’s nominal tariff rates for importing these goods are 20 percent for
steel and 10 percent for taconite. Given this information, calculate the effective rate of
protection for Canada’s steel industry.

15. Assume the nation of Australia is “small” and thus unable to influence world price. Its
demand and supply schedules for TV sets are shown in Table 4.11. Using graph paper, plot
the demand and supply schedules on the same graph.

Table 4.11
Demand and Supply: TV Sets (Australia)

Price of TVS Quantity Demanded Quantity Supplied

$500 0 50
400 10 40
300 20 30
200 30 20
100 40 10
0 50 0

a. Determine the Australia’s market equilibrium for TV sets.

(1) What are the equilibrium price and quantity?
(2) Calculate the value of Australian consumer surplus and producer surplus.
b. Under free-trade conditions, suppose Australia imports TV sets at a price of $100
each. Determine the free-trade equilibrium, and illustrate graphically.
(1) How many TV sets will be produced, consumed, and imported?
(2) Calculate the dollar value of Australian consumer surplus and producer surplus.
c. To protect its producers from foreign competition, suppose the Australian government
levies a specific tariff of $100 on imported TV sets.
(1) Determine and show graphically the effects of the tariff on the price of TV sets in
Australia, the quantity of TV sets supplied by Australian producers, the quantity
of TV sets demanded by Australian consumers, and the volume of trade.
(2) Calculate the reduction in Australian consumer surplus due to the tariff induced
increase in the price of TV sets.
(3) Calculate the value of the tariff’s consumption, protective, redistributive, and
revenue effects.
(4) What is the amount of deadweight welfare loss imposed on the Australian
economy by the tariff?

1
Answers

5. Consumer surplus (producer surplus) refers to the difference between the amount
actually paid by the buyer (received by the producer) and the maximum (minimum) that
the buyer (producer) would have been willing to pay (receive) for the product. By
influencing market prices, trade restrictions influence consumer and producer surplus.

6. A tariff detracts from the nation's welfare via its consumption effect and protective effect.

12. Effective tariff rate equals 21 percent.

15. a. P = $250; Q = 25. Consumer surplus = $3125; producer surplus = $3125.

b. Qs = 10, Qd = 40, Imports = 30. Consumer surplus = $8000; producer surplus =
$500.
c. P = $200, Qs = 20, Qd = 30, Imports = 10. $3500. Consumption effect = $500,
protective effect = $500, redistribution effect = $1500, revenue effect = $1000.
Deadweight welfare loss = $1000.

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3
ECF5921 Week 10, Tutorial 9 (Carbaugh: Chapter 5)

Chapter 5 – Questions 1, 2, 6 & 16

1. In the past two decades, NTBs have gained in importance as protectionist devices. What
are the major NTBs?

2. How does the revenue effect of an import quota differ from that of a tariff?

6. Which is a more restrictive trade barrier – an import tariff or an equivalent import quota?

16. Table 5.5 illustrates the demand and supply schedules for television sets in Venezuela, a
“small” nation that is unable to affect world prices. On graph paper, sketch Venezuela’s
demand and supply schedules of television sets.

Table 5.5
Venezuela Supply of and Demand for Television Sets

Price per TV set Quantity Demanded Quantity Supplied

$100 900 0
200 700 200
300 500 400
400 300 600
500 100 800

a. Suppose Venezuela imports TV sets at a price of $150 each. Under free trade, how
many sets does Venezuela produce, consume, and import? Determine Venezuela’s
consumer surplus and producer surplus.
b. Assume that Venezuela imposes a quota that limits imports to 300 TV sets. Determine
the quota induced price increase and the resulting decrease in consumer surplus.
Calculate the quota’s redistributive, consumption, protective, and revenue effects.
Assuming that Venezuelan import companies organize as buyers and bargain
favorably with competitive foreign exporters, what is the overall welfare loss to
Venezuela as a result of the quota? Suppose that foreign exporters organize as a
monopoly seller. What is the overall welfare loss to Venezuela as a result of the
quota?
c. Suppose that, instead of a quota, Venezuela grants its import-competing producers a
subsidy of $100 per TV set. In your diagram, draw the subsidy-adjusted supply
schedule for Venezuelan producers. Does the subsidy result in a rise in the price of
TV sets above the free trade level? Determine Venezuela’s production, consumption,
and imports of TV sets under the subsidy. What is the total cost of the subsidy to the
Venezuelan government? Of this amount, how much is transferred to Venezuelan
producers in the form of producer surplus, and how much is absorbed by higher
production costs due to inefficient domestic production? Determine the overall
welfare loss to Venezuela under the subsidy.

1
Answers

1. Nontariff trade barriers include import quotas, voluntary export agreements, subsidies,
buy-national policies, product and safety standards, and content requirements.

2. The revenue effect of a tariff is captured by the government, while a quota's revenue
tends to be captured by domestic or foreign firms.

6. Since import quotas directly limit the number of goods that can enter the home nation,
they tend to be more restrictive than import tariffs which may be circumvented by foreign
producers absorbing the tariff as a lower selling price. During periods of rising domestic
demand, quotas hold down imports more effectively than tariffs.

16. a. Qs = 100, Qd = 800, Imports = 700. Consumer surplus = $160,000, producer

surplus = $2500.
b. Price rises by $100 and consumer surplus falls by $70,000. Redistribution effect =
$20,000, consumption effect = $10,000, protective effect = $10,000, revenue effect
= $30,000. Overall welfare loss = $50,000.
c. Price remains at the free trade level. Qs = 300, Qd = 800, imports = 500. Total cost
of subsidy = $30,000 of which $20,000 is absorbed by producer surplus and $10,000
is absorbed by higher domestic production costs. Overall welfare loss = $10,000.

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 Venezuela TV Sets

600

500

400
Price of TV sets

300
Demand
Supply

200

100

0
0 100 200 300 400 500 600 700 800 900 1000
Quantity of TV sets

3
ECF5921 Week 11, Tutorial 10 (Carbaugh: Chapters 10 & 11)

Chapter 10 – Questions 9 &10

9. Indicate whether each of the following items represents a debit or a credit on the U.S.
balance-of-payments:
a. A U.S. importer purchases a shipload of French wine.
b. A Japanese automobile firm builds an assembly plant in Kentucky.
c. A British manufacturer exports machinery to Taiwan on U.S. vessel.
d. A U.S. college student spends a year studying in Switzerland.
e. American charities donate food to people in drought plagued Africa.
f. Japanese investors collect interest income on their holdings of U.S. government
securities.
g. A German resident sends money to her relatives in the United States.
h. Lloyds of London sells an insurance policy to a U.S. business firm.
i. A Swiss resident receives dividends on her IBM stock.

10. Table 10.8 summarizes hypothetical transactions, in billions of U.S. dollars, that took
place during a given year.

Table 10.8
International Transactions of the United States (billions of dollars)

Travel and transportation receipts, net 25

Merchandise imports 450
Unilateral transfers, net -20
Allocation of SDRs 15
Receipts on U.S. investments abroad 20
Statistical discrepancy 40
Compensation of employees -5
Changes in U.S. assets abroad, net -150
Merchandise exports 375
Other services, net 35
Payments on foreign investments in the -10
United States

a. Calculate the U.S. merchandise trade, services, goods and services, income, unilateral
transfers, and current account balances.
b. Which of these balances pertains to the net foreign investment position of the United
States? How would you describe the position?

Answers

9. a-debit; b-credit; c-credit; d-debit; e-debit; f-debit; g-credit; h-debit; i-debit.

10. a. Merchandise trade balance, $75 billion deficit. Services balance, $60 billion
surplus. Goods and services balance, $15 billion deficit. Investment income
balance, $5 billion surplus. Unilateral transfers balance, $20 billion deficit.
Current account balance, $30 billion deficit.

1
 b. Current account. The current account deficit implies that the United States is a
net-demander of funds from the rest of the world.

Chapter 11 – Questions 9 & 11

9. If the exchange rate changes from $1.70 = £1 to $1.68 = £1, what does this mean for the
dollar? For the pound? What if the exchange rate changes from $1.70 = £1 to $1.72 = £1?

10. Table 11.11 shows supply and demand schedules for the British pound. Assume that
exchange rates are flexible.

Table 11.11
Supply and Demand of British Pounds

Quantity of Pounds Dollars per Pound Quantity of Pounds

Supplied Demanded
50 $2.50 10
40 2.00 20
30 1.50 30
20 1.00 40
10 0.50 50

a. The equilibrium exchange rate equals __________. At this exchange rate, how many
pounds will be purchased, and at what cost in terms of dollars?
b. Suppose the exchange rate is $2 per pound. At this exchange rate, there is an excess
(supply/demand) of pounds. This imbalance causes (an increase/a decrease) in the
dollar price of the pound, which leads to (a/an) ________ in the quantity of pounds
supplied and (a/an) __________ in the quantity of pounds demanded.
c. Suppose the exchange rate is $1 per pound. At this exchange rate, there is an excess
(supply/demand) for pounds. This imbalance causes (an increase/a decrease) in the
dollar price of the pound that leads to (a/an) ________ in the quantity of pounds
supplied and (a/an) _______ in the quantity of pounds demanded.

Answers

9. The dollar appreciates against the pound; the pound depreciates against the dollar. The
dollar depreciates against the pound; the pound appreciates against the dollar.

11. a. $1.50 per pound. 30 pounds are purchased at a cost of $45.

b. Excess supply, 20 pounds. Dollar price of the pound decreases, decrease,
increase.
c. Excess demand, 20 pounds. Dollar price of the pound increases, increase,
decrease.

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ECF5921 Week 12, Tutorial 11 (Carbaugh: Chapters 12 & 14)

Chapter 12 – Questions 2, 3 &10

2. Why are international investors especially concerned about the real interest rate as
opposed to the nominal rate?

3. What predictions does the Purchasing-Power-Parity theory make concerning the impact
of domestic inflation on the home country’s exchange rate? What are some limitations of
the Purchasing-Power-Parity?

10. Assuming market determined exchange rates, use supply and demand schedules for
pounds to analyze the effect on the exchange rate (dollars per pound) between the U.S.
dollar and the UK pound under each of the following circumstances:
a. Voter polls suggest that the UK’s conservative government will be replaced by
radicals who pledge to nationalize all foreign owned assets.
b. Both the UK and U.S. economies slide into recession, but the UK recession is less
severe than the U.S. recession.
c. The Federal Reserve adopts a tight monetary policy that dramatically increases U.S.
interest rates.
d. Britain’s oil production in the North Sea decreases, and exports to the United States
fall.
e. The United States unilaterally reduces tariffs on UK products.
f. Britain encounters severe inflation, while price stability exists in the United States.
g. Fears of terrorism reduce U.S. tourism in the United Kingdom.
h. The British government invites U.S. firms to invest in British oil fields.
i. The rate of productivity growth in Britain decreases sharply.
j. An economic boom occurs in the United Kingdom that induces the UK consumers to
purchase more U.S. made autos, trucks, and computers.
k. Ten-percent inflation occurs in both the United Kingdom and the United States.

Answers

2. The nominal interest rate refers to the interest rate, unadjusted for inflation. The real
interest rate equals the nominal interest rate minus the inflation rate. International
investors are especially concerned about the real interest rate.

3. The purchasing-power-parity theory predicts that a country's currency will depreciate by

an amount equal to the excess of domestic inflation over foreign inflation. The theory
also predicts that a country's exchange rate will appreciate by an amount equal to the
excess of foreign inflation over domestic inflation. The theory does not consider the
impact of international capital movements, and it suffers from the choice of an
appropriate price index used in price calculations.

10. Supply of Demand for Exchange rate

pounds pounds ($ per pound)

a. -------- decrease decrease

b. decrease increase increase
c. increase decrease decrease

1
d. -------- decrease decrease
e. -------- increase increase
f. increase decrease decrease
g. -------- decrease decrease
h. -------- increase increase
i. increase decrease decrease
j. increase -------- decrease
k. -------- -------- --------

Chapter 14 – Question 2

2. Three major approaches to analyzing the economic impact of currency depreciation are
(a) the elasticities approach, (b) the absorption approach and (c) the monetary approach.
Distinguish among the three.

Answers

2. Currency devaluation affects a country's trade balance via its impact on relative prices
(elasticities approach), spending behavior (absorption approach), and the purchasing
power of money balances (monetary approach).