Assignment 1 - Principles of Macroeconomics

Kavyaa Kannan
2210110354
B.Sc (Research) Economics & Finance

Q1. a)
Country A

Guns 0 100 200 300 400 500

Bread 1000 900 750 550 300 0

The opportunity cost of something is what you give up to get it.

To get 400 guns, from an initial point of 200 guns, you give up 750 − 300 = 450 units of bread.

The opportunity cost thus changes by 450 units of bread when 400 guns are produced in the place of 200
guns in country A.

b) Opportunity cost of getting bread is lowest at the point where 400 guns and 300 units of bread are
produced. 100 guns are given up to get 300 additional units of bread.

1
Opportunity cost of bread at this point in terms of guns is 3
of a gun. One-third of a gun is given up for
every additional unit of bread produced at this point.

Q2.
Time taken to make pizza Time taken to brew root beer

Pat 2 hours 4 hours

Kris 4 hours 6 hours

a) Assuming there are 24 hours in a day, and Pat and Kris utilise all 24 hours of their day to make
pizza and brew root beer.

Pat’s production possibilities:

Hours spent making Quantity of pizza made Hours spent making Quantity of root beer
pizza root beer brewed (in gallons)

0 0 24 6
 8 4 16 4

12 6 12 3

16 8 8 2

24 12 0 0

Kris’s production possibilities:

Hours spent making Quantity of pizza made Hours spent making Quantity of root beer
pizza root beer brewed (in gallons)

0 0 24 4

8 2 16 23
2

12 3 12 2

16 4 8 13
1

24 6 0 0

Pat’s PPF - P1
Kris’ PPF - P2
 b) Since Pat takes lesser time than Kris in brewing root beer, Pat has the absolute advantage in
brewing root beer. Pat takes only 4 hours to brew root beer while Kris takes 6 hours to do the
same.

c)
Opportunity cost of making Opportunity cost of brewing root
pizza in terms of root beer beer in terms of pizza

Pat 1
gallon of root beer 2 pizzas
2

Kris 2
gallon of root beer 1.5 pizzas
3

Pat’s opportunity cost of producing root beer in terms of pizza is 2 pizzas

Kris’ opportunity cost of producing root beer in terms of pizza is 1.5 pizzas

d)

Pat Kris

Root Beer Pizza Root Beer Pizza

Without trade

production 3 units 6 units 2 units 3 units

With trade

production 1 units 10 units 4 units 0 units

trade (+) 2 units (-) 4 units (-) 2 units (+) 4 unit

consumption 3 units 6 units 2 units 4 units

Gains from trade (+) 0 units (+) 0 units (+) 0 unit (+) 1 unit

The first situation without trade is where both Kris and Pat spend an equal amount of their time in
producing root beer and pizza. Kris has a comparative advantage in producing root beer, and Pat
has a comparative advantage in pizza. So Kris dedicates all their time to produce root beer.

Since Pat has an absolute advantage in both goods, they produce both goods by allocating 4 hours
of time to produce beer and 20 hours to produce pizza.

Pat receives 2 units of beer in exchange for 4 units of pizza. In other words, Pat buys each unit of
beer for a price of 2 units of pizza. This price of pizza is equal to their opportunity cost of
producing a unit of beer. Similarly, Kris receives 4 units of pizza in exchange for 2 units of beer.
In other words, Kris buys each unit of pizza for a price of 0.5 units of beer. This price of pizza is
 lower than their opportunity cost for a unit of beer, Thus, Kris benefits from the deal because they
get to buy pizza at a good price.

This way, Kris can export root beer and Pat can export pizza to each other. There is a gain from
trade as they are able to consume more than they did before.

Q3.

a) Domestic price remains unchanged between the free trade situation and one where the
government pays a subsidy. The domestic price first increases to the world price W from the
pre-trade equilibrium. Let S be the value of the subsidy per unit of the good. The domestic price
does not increase after subsidy since the competitive world price will ensure that price remains
the same. If the price were to increase, consumers would prefer buying coffee beans from outside
the country.

b) There is an increase in production with the introduction of a subsidy. This is because producers
are getting paid more and hence, are willing to produce a higher quantity. When there is no
subsidy and the economy has opened itself to free trade, the quantity produced in the domestic
market is Qs1. If the subsidy is provided the the quantity produced in the domestic market
increases to Qs2.

c) With the introduction of a subsidy, the price remains unchanged for consumers as explained in a).
Since the price remains unchanged, the consumption and overall demand also remains at Qd1,
unchanged.
d) Since the subsidy incentivises producers to supply quantities far exceeding the domestic demand,
the amount of exports increase with the introduction of a subsidy. Prior to the introduction of the
subsidy, Qs1-Qd1 is the amount of exports. After the subsidy, this increases to Qs2-Qd1.

e) As the following table shows, consumer surplus is unaffected, producer surplus rises, government
revenue declines, and total surplus declines.
Pre-subsidy Post-subsidy Change

Consumer Surplus a+b a+b 0

Producer Surplus c+d+f b+c+d+e+f +(b+e)

Government Revenue 0 -(b+e+g) -(b+e+g)

Total Surplus a+b+c+d+f a+b+c+d+f-g -g