EC 101.

01&05 Problem Session: Chapter 8 Fall 2021

Solutions

1. Explain the impact, if any, of each of the following on the PPC.

a. Brazil’s population suffers from water shortages even though the country has about a fifth of the
water reserves of the world.

b. China’s one-child policy was planned to reduce the country’s population and limit the demand for
natural resources.

c. Niger was among the top ten countries in the world with the highest fertility rates in 2016.

Answer:

a. The water shortages mean a reduced availability of natural resources for various reasons, which
shifts the PPC outwards.

b. The Chinese plan reduces the availability of labor in the economy, which means that the PPC will
shift inward. However, if we discuss the limited demand for natural resources, this means that the
stock increases, which shifts the PPC outwards.

c. A rise in population means an outward shift of the PPC curve.

2. The infant industry argument relies on the idea that in industries with economies of scale, it is
important for the government to protect newborn companies in their development. What are the
implications of such an economic policy in the short run and long run?

Answer: In the short run, this policy would help the company to gain experience and adapt its production
to the technologies and innovation levels available on the market. It will not be forced to compete directly
with other companies and could stay on the market until its production becomes stable and the products or
services are known by the consumers.

In the long run, the company could become weak and dependent on the governmental support. It will not
withstand the competition from other companies in the field because it would not be able to develop its
comparative advantage and maintain it in the market.

3. Suppose a school has 150 first-year and 100 second-year students to work in its greenhouse for
practical training. A first-year student can clean either 2 pots or 2 planters; a second-year student can
clean either 3 pots or 1 planter.

a. Who has a comparative advantage in cleaning pots? In cleaning planters?

b. Suppose the school selects 60 first-years and 60 second-years to clean the pots. How many
planters will the remaining students clean?

c. Why should you have anticipated the answer to part b.?

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 d. Now assume that the school selects 40 first-years and 40 second-years to clean the pots. How
many planters will the remaining students clean?

Answer:

a. In case of freshmen, the opportunity cost of cleaning pots is 2/2 = 1 and the opportunity cost of
cleaning planters is 2/2 = 1. In case of sophomores, the opportunity cost of cleaning pots is 3/1 =
3 and the opportunity cost of cleaning planters is 1/3 = 0.33. This means that freshmen have a
comparative advantage in cleaning the pots (1 < 3) and the sophomores have a comparative
advantage in cleaning planters (0.33 < 1).

b. If the school uses 60 freshmen and 60 sophomores to clean the pots, then 90 freshmen and 40
sophomores will be available to clean the planters. In this case, (90 × 2) + (40 × 1) = 220 planters.

c. You should have anticipated this result because you showed in (a) that the easterners have a
comparative advantage in the production of defense.

d. If the school selects 40 first-years and 40 second-years to clean the pots then 110 first-years and
60 second-years will remain. In this case, the number of planters will be (110  2) + (60  1) =
280 planters.

4. The remote island nations of Nearway and Farway produce fish and coconuts and have recently
decided to trade with one another. Use the table to answer the following questions:
Coconuts Fish
Nearway Farway Nearway Farway
Optimal Production without Trade 200 300 100 200
Specialization: Optimal Production with Trade 600 500
Traded Goods 250 250
Post-Trade Allocation
Gains for Trade
a. Calculate the opportunity costs of producing fish and coconuts in Nearway and Farway, and then
determine who has an absolute advantage and comparative advantage in the production of each
good.

b. Using what you learned in part (a), fill in the blanks in the table above.

c. Which nation received the better deal in this trade? Explain using the exchange rate range.

d. Would Nearway and Farway ever trade 60 coconuts for 20 fish? Why or why not?

Answer:

a. Consider the opportunity cost of fish in Nearway. We know that Nearway could produce either (i)
200 coconuts and 100 fish, or (ii) 0 coconuts and 500 fish. So in Nearway increasing fish
production by 500 – 100 = 400 means that coconut production falls by 200. This is equivalent to
saying that increasing fish production by 1 means that coconut production falls by 200 / 400 = .5,
and so the opportunity cost of fish in Nearway is .5

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Now consider the opportunity cost of fish in Farway. We know that Farway could produce either
(i) 300 coconuts and 200 fish, or (ii) 600 coconuts and 0 fish. So in Farway increasing fish
production by 200 would mean that coconut production would fall by 600 – 300 = 300. This is
equivalent to saying that increasing fish production by 1 means that coconut production falls
300 / 200 = 1.5, and so the opportunity cost of fish in Farway is 1.5

Similar calculations would show that the opportunity cost of coconuts is 2 in Nearway and .67 in
Farway. The following table shows the opportunity costs of producing fish and coconuts in the
two countries:

Opportunity cost

Fish Coconut

.5
Nearway coconuts 2.0 fish

1.5
Farway coconuts 0.67 fish

Nearway’s opportunity cost of fish is less than Farway’s opportunity cost of fish (.5 < 1.5) and
therefore Nearway has a comparative advantage in fish. Farway’s opportunity cost of coconuts is
less than Nearway’s opportunity cost of coconuts (.67 < 2.0) and therefore Farway has a
comparative advantage in coconuts.

b. We found in the first part of this problem that Nearway has a comparative advantage in the
production of fish and that Farway has a comparative advantage in the production of
coconuts. Suppose Farway produced 600 coconuts and Nearway produced 500 fish as
shown in the table. Farway trades 250 coconuts for 250 fish with Nearway. This means that
after the trade Farway consumes 600 – 250 = 350 coconuts and 250 fish, while Nearway
consumes 250 coconuts and 500 – 250 = 250 fish. The last row in the table shows the gains
from trade. After trading with Farway, Nearway consumed 50 more coconuts and 150 more
fish than it had before specialization and trade. After trading with Nearway, Farway
consumed 50 more coconuts and 50 more fish than it had before specialization and trade.

Coconuts Fish

Nearway Farway Nearway Farway

Optimal Production without

200 300 100 200
Trade

Specialization: Optimal
0 600 500 0
Production with Trade

Traded Goods 250 -250 -250 250

Post-Trade Allocation 250 350 250 250

Gains for Trade 50 50 150 50

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 c. Nearway and Farway are trading one coconut for one fish. The terms of trade lie between
Nearway and Farway’s opportunity costs.

.5 coconuts per fish ≤ terms of trade ≤ 1.5 coconuts per fish

0.67 fish per coconut ≤ terms of trade ≤ 2.0 fish per coconut

Since the terms of trade of 1 fish per coconut is closer to Farway’s opportunity cost of coconuts,
Nearway received much of the benefit from trade.

d. Nearway and Farway would never trade 60 coconuts for 20 fish. If they did, the terms of trade
would be 3 coconuts per fish. Trade can occur only if the terms of trade are between the two
countries’ opportunity costs; the opportunity cost of fish is less than 3 coconuts in both Nearway
and Farway.

5. Suppose domestic demand is QD=16-P and domestic supply is QS=P. The world price is $2 and the
import tariff is $3 per unit. First, make a sketch, then find the following values. Each will be areas in your
sketch.
a. Consumer surplus.

b. Producer surplus.

c. Government revenue.

d. Deadweight loss of the tariff.

Answers:

First, the world price plus the tariff will be $2 + $3 = $5. The quantity supplied domestically will thus be
5 and the quantity demanded domestically will be 16 - 5 = 11 (instead of 2 and 14, respectively. Based on
these numbers the relevant areas are either triangles (area is one half base times height) or rectangles (area
is base times height).

a. (1/2)*(11-0)*($16-$5) = $60.50
b. (1/2)*(5-0)*($5-$0) = $12.50
c. (11-5)*($5-$2) = $18.00
d. Two triangles with area (1/2)*(3)*($3) = $4.50, or $9.00 total.

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