Three managers of the Magic Potion Company are discussing a

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1. Three managers of the Magic Potion Company are discussing a possible increase in
production. Each suggests a way to make this decision:
a. Harry: We should examine whether our company’s productivity – gallons of potion
per worker – will rise or fall.
b. Ron: We should examine whether our average cost – cost per worker – would rise or
fall.
c. Hermione: We should examine whether the extra revenue from selling the
additional potion would be greater or smaller than the extra costs.
2. Your roommate is a better cook than you are, but you can clean more quickly than your
roommate can. If your roommate did all of the cooking and you did all of the cleaning, would
your chores take you more or less time than if you dividend each task evenly? Give a similar
example of how specialization and trade can make two countries both better off.
3. You win $100 in a basketball pool (a lottery). You have a choice between spending the
money now or putting it away for a year in a bank account that pays 5 percent interest.
What is the opportunity cost of spending the $100 now?
4. A recent U.S. bill reforming the government’s antipoverty programs limited many welfare
recipients to only two years of benefits. How does this change affect the incentives for
working? How might this change represent a trade-off between equity and efficiency?
5. Draw a circular-flow diagram. Identify the parts of the model that correspond to the flow of
goods and services and the flow of dollars for each of the following:
a. Households provide firms with labour at the cost of 15$ an hour
b. Firms sell households pizza at the price of 6$ each.
c. Firms rent land at the cost of 500$ a month.
d. Households buy earrings at the price of 15$ each.
6. Imagine a society that produces military goods and consumer goods, which will call “guns”
and “butter”.
a. Draw a production possibilities frontier for guns and butter. Explain why it most
likely has a bowed-out shape.
b. Show a point that 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 and the Doves.
The Hawks want a strong military, and therefore they want to produce a lot of guns
and not much butter. The Doves want a small military, and therefore want to
produce less guns and more butter than Hawks. Show a point on your production
possibilities frontier that the Hawks might choose and a point that the Doves might
choose.
1. Harry suggests looking at whether productivity would rise or fall. Productivity is certainly
important, since the more productive workers are, the lower the cost per gallon of potion. Ron
wants to look at average cost. But both Harry and Ron are missing the other side of the
equation – revenue. A firm wants to maximize its profits, so it needs to examine both costs
and revenues. Thus, Hermione is right – it is best to examine whether the extra revenue
would exceed the extra costs. Hermione is the only one who is thinking at the margin.
2. By specializing in each task, you and your roommate can finish the chores more quickly. If
you divided each task equally, it would take you more time to cook than it would take your
roommate, and it would take him more time to clean than it would take you. By specializing,
you reduce the total time spent on chores. Similarly, countries can specialize and trade,
making both better off. For example, suppose it takes Spanish workers less time to make
clothes than French workers, and French workers can make wine more efficiently than
Spanish workers. Then Spain and France can both benefit if Spanish workers produce all the
clothes and French workers produce all the wine, and they exchange wine for clothes.
3. If you spend $100 now instead of saving it for a year and earning 5 percent interest, you are
giving up the opportunity to spend $105 a year from now.
4. a. When welfare recipients have their benefits cut off after two years, they have a greater
incentive to find jobs than if their benefits were to last forever.
b. The loss of benefits means that someone who cannot find a job will get no income at all, so
the distribution of income will become less equal. But the economy will be more efficient,
because welfare recipients have a greater incentive to find jobs. Thus, the change in the law
is one that increases efficiency but reduces equity.
5. Please see figure below:
6. Please see graph below:
a. The graph shows a production possibilities frontier between guns and butter. It is bowed out
because the opportunity cost of butter depends on how much butter and how many guns the
economy is producing. When the economy is producing a lot of butter, workers and machines
best suited to making guns are being used to make butter, so each unit of guns given up
yields a small increase in the production of butter. Thus, the frontier is steep and the
opportunity cost of producing butter is high. When the economy is producing a lot of guns,
workers and machines best suited to making butter are being used to make guns, so each
unit of guns given up yields a large increase in the production of butter. Thus, the frontier is
very flat and the opportunity cost of producing butter is low.
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.
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