Take Home Assignment 1 (Fall 2020)

Course: Principles of Microeconomics

Instructor: Rabbia Tariq

Name of Student
Program (EM/BBA) ANSWER KEY
ERP Number

Deadline: Sunday, October 25, 2020 till 11:55 P.M.

Please follow the instructions carefully:

1. Write your answers in this Word file and upload it before the due date on LMS.
2. Write your name and ERP number in the given fields above.
3. Answer scripts can be uploaded on LMS any time before its deadline. Therefore, do not
wait for the last hour to avoid any unforeseen problems.
4. Assignment submission will be graded only if uploaded through LMS in word format within the
deadline. Therefore, do not send your submission through email or any other medium.
5. Explain your answers as required but avoid unnecessary details for each question.
6. If you are more comfortable in drawing graphs on paper, you can do that but paste the pictures
here in this file. Do not submit the pictures of graphs separately.
7. You can consult any book or material from internet but remember there is a difference between
consultancy and plagiarism.
8. Remember that PLAGIRISM is not only unethical but also a crime. Genuine work is not
only honorable but can also earn a better score.
9. You are always welcome to ask, consult and discuss your problems regarding assignment by
writing at rtariq@iba.edu.pk
10. Last but not least, deadline is final and no relaxation would be granted in any case. You
have enough time to accommodate unavoidable circumstances.

Q1 Q2 Q3 Q4 Q5 Total
Maximum
12 12 15 15 6 60
Marks

Marks
Obtained
Question#1: Finn and Edison are living on an island with no one around to buy anything. They are
stranded there unless a help reaches to them. They have some basic stuff for survival but the only
issue is of food. They are out of food supplies. The only options on the island are either to catch
fish or gather fruits. Finn has done fishing with his father when he was young so he can catch 5
fishes in 30 minutes. Edison on the other hand was finding it hard and can only catch 2 fishes in an
hour. They both also wanted to eat fruits and often look around in search of them. Finn can gather
20 apples in an hour while Edison can gather only 10 in an hour. (12 marks)

a) What is the Fin’s opportunity cost of catching fish? What is the opportunity cost of catching
fish for Edison?
b) What is the Fin’s opportunity cost of gathering apples? What is the opportunity cost of
gathering apples for Edison?

Fish Apples
Finn 10/hr 20/hr
Edison 2/hr 10/hr
Opportunity cost
Finn 1 fish = 2 Apples 1 Apple = 0.5 Fish
Edison 1 fish = 5 Apples 1 Apple = 0.2 Apples

c) Who has an absolute advantage in catching fish? Who has an absolute advantage in gathering
apples?

Finn has absolute advantage in both catching fish and gathering apples.

d) If they both work for 6 hours each day to get food, what maximum quantity of fish and
apples they both can have in a day individually?

Fish Apples
Finn 60 120
Edison 12 60

e) Illustrate PPF for Finn and Edison assuming constant opportunity costs.
 f) Would there be a mutually beneficial trade possible between Finn and Edison? If yes, what
should be the price and how much each should produce after trade?

Yes, mutually beneficial trade is possible between Finn and Edison.

Finn has comparative advantage in the catching fish and Edison has comparative advantage
in gathering apples. If Finn specializes in catching Fish and Edison specialize in gathering
apples, then trade their specialized good with each other, both can be better off.

The price of Fish will be set somewhere between 2 Apples and 5 Apples. Each should
produce such that both can be better off than before.

One possibility is that the price is set at 3 apples. (Assuming before trade consumption and
production)

Before Trade After Trade

(3 hrs spent on catching (Finn: 4 hrs catch Fish & 2 hrs gather Apples)
fish and 3 hrs on gathering (Edison: 6 hrs gather apples)
apples)
Production Consumption Production
Traded quantity Consumption
(1 Fish = 3 Apples)
Finn 30 Fish & 30 Fish & 60 40 Fish & -8 Fish & 32 Fish & 64
60 Apples Apples 40 Apples +24 Apples Apples
Edison 6 Fish & 6 Fish & 30 60 Apples +8 Fish & 8 Fish & 36
30 Apples Apples -24 Apples Apples
Question#2: Kiran and Amna live in IBA hostel. They own a small business in which they make
brownies and pasta and sell them to people on campus. As shown in the table on the following page,
Kiran can make 30 brownies per hour but only 6 bowls of pasta. Amna is a bit slower and can make
only 24 brownies or 4 bowls of pasta in an hour. (12 marks)

Output per hour

Brownies Bowls of pasta
Kiran 30 6
Amna 24 4

a) What is the opportunity cost of making one brownie for Kiran and Amna? Who has
comparative advantage in making brownies?
b) What is the opportunity cost of making one pasta bowl for Kiran and Amna? Who has
comparative advantage in making pasta?

Opportunity cost
Kiran 1 Brownie = 1/5 or 0.2 bowl of Pasta 1 bowl of pasta = 5 brownies
Amna 1 Brownie = 1/8 or 0.125 bowl of Pasta 1 bowl of pasta = 8 brownies

Amna has comparative advantage in making brownies and Kiran has comparative
advantage in making pasta.

c) Assume that both the girls work for 20 hours per week and they work on their own
independent of each other. Graph the possible combinations of brownies and pasta bowls
each can produce.

If works for 20hr/week Brownie Pasta

Kiran 600 120
Amna 480 80
 d) If Kiran devoted half of her time (10 out of 20 hours) to brownies and half of her time to
pasta, how many of each would she produce in a week? If Amna did the same, how many of
each would she produce? How many brownies and pasta bowls would be produced in total?

Production
(10 hrs spent on brownie and 10 hrs on pasta)
Kiran 300 brownies & 60 pasta bowls

Amna 240 brownies & 40 pasta bowls

In total, 540 brownies and 100 pasta bowls would be produced.

e) Suppose that Amna spent all 20 hours of her time in making brownies and Kiran spent 17
hours in making pasta and 3 hours in making brownies. How many of each item would be
produced?

Production
Kiran
600 brownies
(20 hr for brownie)
Amna
72 brownies & 12 pasta bowls
(3 hr brownie & 17 hr pasta)

In total, 672 brownies and 12 pasta bowls would be produced.

f) Suppose that Kiran and Amna can sell all their brownies for PKR10 each and all their pasta
bowls for PKR 50 each. If each of them worked 20 hours per week, how should they split
their time between brownies and pasta? What is their maximum joint revenue?

Kiran should produce pasta only and Amna should produce brownies only. This way they
would have maximum joint revenue.

Revenue
Kiran
PKR 6000
(20 hr for pasta)
Amna
PKR4800
(20 hr for brownie)

Total PKR 10800

The market price of 1 bowl of pasta is 5 brownies (50/10=5). If Kiran produces 1 less pasta
bowl, she would be able to bake 5 more brownies (according to her opportunity cost). That
does not make any difference to the total revenue. However, since Amna is baking brownies
only, if she bakes 8 less brownies, she would be able to cook one bowl of pasta. That costs
her more than the market price of pasta bowl. Therefore, the best way to split their time is
that Kiran cooks pasta only and Amna bakes brownies only.

Question#3: Illustrate the following with supply and demand curves: (15 marks)

a) With increased access to wireless technology and lighter weight, the demand for laptop
computers has increased substantially. Laptops have also become easier and cheaper to
produce as new technology has come online. Despite the shift of demand, prices have fallen.

Demand for laptops increased with the increased access to wireless technology and other
benefits of laptop. This shifts the demand curve from black to green line in the figure. There
will be shortage created, as a result prices would raise leading to new equilibrium at E2
(demand falls along the curve and supply increases along the curve). However, as new
technology has led to reduction in the cost of production for laptops, supply will also
increase. There will be a shift in supply curve from black to blue line in the figure. The
market will move from E2 to E3. The adjustment will take place as at P*, demand is greater
than supply; price falls until the market reaches to new equilibrium point E3. In such a case,
although demand has shifted, prices have fallen (from P1 to P2) in the market as supply has
also increased.
 b) Before economic reforms were implemented in the countries of Eastern Europe, regulation
held the price of bread substantially below equilibrium. When reforms were implemented,
prices were deregulated and the price of bread rose dramatically. As a result, the quantity of
bread demanded fell and the quantity of bread supplied rose sharply.

(Correction on the graph: the label on x-axis should be quantity of bread instead of quantity
demanded)

Since the price was kept below the equilibrium, there would be shortage in the market.
Before reforms, there would be excess demand as price is low for buyers so they’ll be willing
to buy more while suppliers would be finding it difficult to cover their costs. When the
regulation was lifted, the price is no more bound to be at P* (from the above figure). When
market forces of demand and supply are allowed to work freely, the price started to rise as
there was shortage in the market. The increase in price caused fall in demand (along the
curve movement) and increase in supply (along the curve movement). The quantity of bread
demanded fell and quantity of bread supplied rose sharply till the equilibrium point is
reached.

c) When the corona virus hit Pakistan in February, people rushed to the markets to get masks
and sanitizers but they were unable to get them even at a higher price. There was shortage in
the market and suppliers were unable to fulfill the sudden increase in demand.
As the corona virus caused increase in demand for masks and sanitizers, the demand curve
shifted towards right. The supply of these products was inelastic in the short run. The
market came to point A where there was shortage in the market. The increased price also
could not lead to higher supply as supply was irresponsive to the changes in prices. The
result was price hike for these products.

Question#4: The following statements contain common errors. Identify and explain each error
using the demand-supply graph. (15 marks)

a) The price of tomatoes increases which increases supply in the market. The market demand
curve for tomatoes shift back as a result of increase in price bringing prices back to the
original level.

When price of tomatoes increases the supply increases but the increase is shown by along
the curve movement on the supply curve. The market demand responds by decrease in
quantity demanded as a result of price increase. This is again the movement along the curve
and not any shift in demand curve as stated in the statement. If initially the market was in
equilibrium, the increase in price (to P1) will result is surplus in the market. This will push
prices down unless the market reaches back to the equilibrium point. We are assuming that
there was equilibrium before the price change and market forces are free to operate.
 b) The demand for warm clothes is observed to increase during the month of December in
Karachi. This means the price for warm clothes would fall.

The demand for warm clothes increases which means that there will be a shift in demand
curve for warm clothes. This will create shortage in the market as at the same price demand
is now greater than supply. In this situation, price increases rather than falls as mentioned
in the statement. There will be increase in price which would cause supply to increase
(along the curve) and quantity demanded to decrease (along the curve). The supply and
demand will change unless the new equilibrium point is reached. Following figure shows
the graphical representation of this change.
 c) The lockdown has caused shutdown of many local fast food outlets. Assuming that the
market for fast food is competitive, there will be increase in demand for fast food leading to
higher prices.

The lockdown has caused many restaurants to close their business. This would imply that
supply of their services fall. This would lead to a leftward shift in supply curve. There would
not be any increase in demand as even if we consider change in demand, it would fall rather
than rise due to lockdown restrictions.

1. When only supply shifts leftward, there will be shortage created, resulting in
higher price.
2. When demand also shifts leftwards, there will be ambiguous result. Net effect
on price will depend on the magnitude of relative shift in demand curve.

Following figure shows both the cases.

In the second figure, if demand shift is less than supply shift (demand shifted till green
line), the price would increase. If the demand shift to red line which means that shift in
demand is greater than supply shift, the price would fall (to P3). Lastly, if demand shift is
equal to supply shift, there will be no change in price and price would remain at P1
(equilibrium is shown by point 1 in the graph).
Question#5: Consider the following events: Scientists reveal that consumption of oranges
decreases the risk of diabetes and at the same time, farmers use a new fertilizer that makes orange
trees more productive. Illustrate and explain what effect these changes have on the equilibrium price
and quantity of oranges. (6 marks)

First event where people get to know about the benefit of oranges in decreasing the risk of
diabetes, the demand curve would be affected. There will be increase in demand and the
demand curve would shift to right. In the second event, where there is increase in
productivity, supply curve will be affected. Farmers will now be able to grow more oranges
and sell more at the same price. There would be increase in supply and supply curve would
shift rightward. The following graph shows the shifts.

If the initial equilibrium is E where price is P1, there are three possibilities;

1. The shift in demand curve is greater than the shift in supply curve. The new
equilibrium after the adjustment of market forces would be at point 2 where the new
price is higher than before and quantity is also higher than before.
2. The shift in demand curve is equal to the shift in supply curve. The new equilibrium
would be at point 1 where price is unchanged but quantity is greater than before.
3. The shift in demand curve is less than the shift in supply curve. The new equilibrium
would be at point 3 where price is lower than before but quantity is higher than
before.
We can conclude that the impact of given events on price is ambiguous. The price may
increase, decrease or remain unchanged depending on the relative magnitude of shift in
demand curve and supply curve. However, the quantity of oranges would increase
unambiguously.