Microeconomics Review Workbook

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Microeconomics Review Workbook

By

Mike Fladlien


For Hose,


Contents Production Possibilities 4 Perfect Competition 9 Monopoly 16 Elasticity 24 Production Costs 33 Externalities 40 Basic Macro Concepts 45 AD/AS 56 AS 62 LRS 66


Production Possibilities Name ___________________ Problem PPF1 (3) For the economy of Alpha, there are 71 units of unskilled labor used to make two goods, washers and dryers. Quantity 1 2 3 4 5 6 7 8 9 10 Labor Used 5 12 15 26 36 45 56 71 92 122 a. Draw the production possibilities curve for an economy with 71 labor units and label it PPC0. b. What’s the opportunity costs of the eight worker? _________ c. Suppose immigration from Mexico brings in 21 more workers. Draw the new curve to show the increase in labor and label it PPC1. d. Suppose technology changes so that productivity increases the 92 labor force to an equivalent of 122. Draw the new curve and label it PPC2.


Sample Problem 2 – Perfectly substitutable resources. Suppose that Lucy has baking flour, cake mix, and 2 eggs. With these inputs, she can either make 10 cupcakes or 10 muffins. These resources are perfect substitutes. Lucy’s production possibilities curve would be a constant cost, straight line, from 10 muffins to 10 cupcakes. This is shown graphically below.

Lucy has a constant cost of making cupcakes of one muffin. Suppose Lucy is making 1 cupcake and 4 muffins. If Lucy makes one ore cupcake or 2, then she can only make 3 muffins. Lucy has a constant cost of 1 muffin. Likewise, If Lucy decides to make muffins, she gives up one cupcake. If Lucy decides to make 5 cupcakes, then she gives up 5 muffins. What you give up is “opportunity cost”.

Problem PPF2 (0) Billy Bob can either sheer sheep or shuck corn equally well. In one hour, he can sheer 20 sheep or shuck 20 bushels of corn. Draw Billy Bob’s PPF below.

a. If Billy Bob just sheers sheep, how many sheep can he sheer? _______ b. If Billy Bob just shucks corn, how many bushels can be shuck? ________ c. What’s the opportunity cost of shucking one bushel of corn?_____ Sheering one sheep? _____

Sample Problem 3 – Increasing Opportunity Cost

In Buffoonia, guns can be transformed into butter. The PPF schedule and graph shows the transformation. Buffoonia must give up more and more guns to get additional tubs of butter. The cost of 5 tubs of butter is 2/5 guns. The costs increase to 3/5, 8/5, and 7/1.


Problem PPF3 (0) Willy Wonka can transform Wanks into Wongs as shown below. Answer the questions that follow:

a. What’s the opportunity cost of making the third Wang? b. Explain why the resources used in making Wonks and Wangs are not perfectly substitutable. c. Show how the opportunity cost increases as additional Wangs are produced.

Sample Problem 4 – Efficiency Efficiency is shown on the PPF as any point on the boundary. This is so because one would have to give up some of Good X to get more of Good Y. Think of an iPod that holds 100 songs. If the owner of the iPod had 50 Rap and 50 Classical songs, the owner

would have to give up one Rap song to make room for one more Classical song. On the other hand, if the owner only had 5 songs total, then she could add more of both songs. Only when something must be given up to get more of another are the resources efficient. The embedded graph shows an inefficient point inside the PPF. At 4 MP3 players and 2 cell phones, the user could have enjoy more of either good without opportunity cost.


Problem PPF4 (0) Johan Cabooci can produce oil or watercolor paintings according the PPF below. Answer the questions that follow.

a. Point F is not obtainable by Johan. What must happen for his PPF to shift outward? ________________________________ b. If Johan is at Point E, could he paint more watercolors without giving up any oil paintings? ______________ c. Johan’s girlfriend says that he should only paint oil paintings. Explain why you might disagree with her. ______________

Problem PPF5 (3) Mars can make 18 Guns and 6 Roses. Venus can make 6 Guns and 6 Roses. Currently Mars is making and consuming 9 Guns and 3 Roses. Venus is making and consuming 3 Guns and 3 Roses. Draw their respective PPFs, identify autarky, and find the comparative advantage of each country. Finally, assume that the two countries trade 2:1. Draw the new trading possibilities curve.


Solutions: PPF1

PPF2 20, 20, 1. PPF3 3 Wonks; each Wang costs more; 1 Wang costs ½ Wonk; 2 cost 1; 3 cost 3; ½ costs 5 PPF4 Increase in land, labor, and capital; Yes; He should not just paint watercolors. He gives up 5 oil paintings. PPF5


Perfect Competition Name __________________________ Sample 1 Lee Pullem pulls weeds in the perfectly competitive dandelion removal market. Since there are millions competing against him, Lee is a price taker. In this example, weed pullers can sell their services for $2 per yard.

Comp1 (0) Bill Booge sells Boogers in a perfectly competitive market. Use the Market to compute total revenue, marginal revenue, and average revenue and graph the demand curve.


Comp2 (0) Take the data contained in the graph for the market, and perform the following tasks: A. Determine the market price B. Compute the amount of profit being earned by the firm C. Compute the total revenue being earned by the firm. D. Determine the total cost being incurred by the firm. E. The long-run price.

A. __________ B. __________ C. __________ D. __________ E. __________

Comp3 (0) Loss Minimizing Take the data contained in the graph for the market, and perform the following tasks: A. Determine the market price B. Compute the amount of profit being earned by the firm C. Compute the total revenue being earned by the firm. D. Determine the total cost being incurred by the firm. E. The long-run price.

A. _____ B. _____ C. _____ D. _____ E. ______


Comp4 (0) Shut-down case Take the data contained in the graph for the market, and perform the following tasks: A. Determine the market price B. Compute the amount of profit being earned by the firm C. Compute the total revenue being earned by the firm. D. Determine the total cost being incurred by the firm. E. The long-run price.

A. ______ B. ______ C. ______ D. ______ E. ______

Comp5 (2) Assume that the table below is a true and accurate picture of a perfectly competitive firm in the Doodle market. The firm sells it output at $2 per Doodle at flea markets, yard sales, and to spammers. Complete the table. Q FC VC TC AVC ATC AFC MC TR π

0 4 0

1 4 2

2 4 2.5

3 4 4.75

4 4 10

5 4 17.5


Comp6 (1) Using the quantities from Comp5, graph TR, FC, VC, and TC. Use a yellow highlighter to shade the area of profit.

Comp7 (1) Using the quantities from Comp5, graph ATC, AVC, MC, and MR.


Comp8 (2) Now, look at your table from Comp5 and your graphs from Comp6 and Comp7. Explain on the yellow legal pad below why micro economists call this the “loss minimizing position.” (A few hints might aid you in your discovery. If the firm would shut down, how much would it lose in fixed costs? How much does the firm lose when it operates at profit max?) Next, postulate a rule for loss minimization.

Comp9(0) Complete the table below. All of the data will look like Comp5 except total revenue. Assume more suppliers enter the market and the price falls to 50¢. Complete the total revenue and profit columns. Explain whether you think the firm should shut down or minimize losses? _________________________________________________ Q FC VC TC TR π

0 4 0 4

1 4 2 6

2 4 2.5 6.5

3 4 4.75 8.75

4 4 10 14

5 4 17.5 21.5


Solutions: Comp1

Comp2 A. $4 B. $6.3 C. $12 D. $5.7 E. $2 Comp3 A. $2 B. -$2.25 C. $3 D. $5.25 E. $3 Comp4 A. $ .50 B. Shut down and lose $4 in fixed costs. C. 0 D. $4 E. $3 Comp5 Q FC VC TC AVC ATC AFC MC TR π 0 4 0 4 0 - 4 1 4 2 6 2 6 4 2 2 - 4 2 4 2.5 6.5 1.25 3.25 2 .5 4 -2.5 3 4 4.75 8.75 1.58 2.9 1.33 2.5 6 -2.75 4 4 10 14 2.5 3.5 1 5.25 8 -4 5 4 17.5 21.5 3.5 4.3 .8 7.5 10 -11.5


Comp6

Comp7

Comp8 It’s called the loss minimizing position because some fixed costs are covered. By producing 2.5 units all variable costs are covered and some fixed costs. The rule is P > AVC to minimize losses. Comp9 Firm should shut down since P < AVC and the losses keep mounting.


Monopoly Name _____________________ Sample 1: Perfect Competition Five friends go to an auction and see an Elvis bobble head doll. The auctioneer has hundreds of the dolls and they all are exactly alike. Alice is willing to pay $5, Betty is willing to pay $4, Cathy is willing to pay $3, Dolly is willing to pay $2, and Edna is willing to pay $1 for the dolls. At a marginal cost of $2, how many will be sold, what will be the total profit, total cost, total revenue, consumer’s surplus, producer’s surplus, and price of each doll?

Four dolls will be sold at the price of $2 because that’s the resource allocative efficient price (P = MC). Total revenue will be $8 and total cost will be $8 for zero profit. Consumer’s surplus is $8 and producer’s surplus is $8.

Sample 2: Pure Monopoly If the same five friends go to an action in which the seller has a monopoly, What will be the price the dolls sell at, profit, total cost, total revenue, consumer’s and producer’s surplus?

Two dolls will be sold at $4 dollars. Total revenue will be $8 and total cost $4 for a $4 profit. Consumer’s surplus will be $2 and producer’s surplus will be $8.


Sample 3 Price Discriminating Monopoly

A price discriminating monopolist can sell the same product at different prices. In this case, Alice pays $5, Betty pays $4, Cathy Pays $3, and Dolly pays $2. Total revenue equals $14, total cost equals $8, profit equals $6, consumer’s surplus equals $0, and producer’s surplus equals $14.50. When a monopolist is able to discriminate, profits are maximized and all surplus is captured by the producer.

Problem MONO1 (0)

a. This is a single-price monopoly. What is another name for this type of monopoly? __________________ b. What price would this monopoly sell all of her output?________ c. What quantity would the monopolist sell? ___________ d. How much is total revenue at the monopoly price?____________ e. How much is total cost at the monopoly price?____________ f. How much profit does the monopolist earn?___________ g. What price ranges are inelastic?______________ h. At what price is the price elasticity of demand = 1?__________ i. At the monopoly price, how much is consumer’s surplus?__________

j. Shade the dead weight loss. k. What price would a perfect competitor charge?___________ l. What price would allow the firm to break even?__________ m. Why does the marginal revenue curve lie below the demand curve? _________ ______________________________________________________.


Problem MONO2 (0) A monopoly might own all of the resources used to make a good or have exclusive ownership of the resources. A monopoly might have a license, patent, copyright or legal right to be the sole producer of the good. A monopoly might be large enough that it is the only business capable of producing and selling the good at an affordable price. Some monopolies have cozy relationships tacitly act like a monopoly. In each case below, identify the source of the monopoly power. a. A liquor store that requires a license. ___________________ b. A railroad that owns all of the tracks for 500 miles around a hub. ______________ c. Larry Litiagator, the only licensed lawyer in a town of 500 people. _____________ d. The U. S. Postal Service. _____________________ e. Terri’s Tropical Fish, the largest outlet for tropical fish in the Midwest. _________ Problem MONO3 (3) Hornbuckle Carnival Rides has one ride, the Matterhorn. They have the patent on the ride. The ride which simulates a rollercoaster ride through the Himalayas is popular in rural towns in Iowa. Complete the table and graph the demand, marginal revenue, and marginal cost curves. Assume that marginal cost is a constant $9. After you graph the data, What is the profit maximizing output? a. _________ What is the profit maximizing price? b. _________ If this were a perfectly competitive firm, what output would be produced? c. ____________ How much profit would be made by a price discriminating monopolist? d. _____________


Problem MONO4 (0) Each of the following brothers are willing to pay the maximum price shown in the table for an iPod Shuffle. Apple’s cost of making the Shuffle includes $50 of fixed costs and a constant marginal cost of $10. Graph the five brothers’ demand, marginal revenue, and marginal cost curves. What is the profit maximizing output? a. __________ What is the profit maximizing price? b. __________ How much profit is made? c. ____________ If Apple can price discriminate, how many Shuffles will Apple sell? d. ________ How much profit will be earned by the price discriminating monopolist? e. _______

Buyer Maximum Price

Alex $50

Barry 40

Cisero 30

Donovan 20

Edward 10


Problem MONO5 (3) Punky’s Pies sells ice cream pies in a monopolized market. Data for her market is contained in the table below: Complete the table and graph the Demand, MR, and MC curves. Answer questions a, b, c, and d.

P Q TR MR TC MC ATC Profit 20 0 8 18 1 14 16 2 22 14 3 32 12 4 44 10 5 58 8 6 74 6 7 92 4 8 112 2 9 147

a. If Punky only cares about the maximum revenue she can earn, how many pies will maximize her total revenue? __________ b. How many pies are produced at the profit-maximizing output? _____ c. If Punky’s Pies were a perfectly competitive market, about how many pies would she make?______ d. What would be the long-run price if the market were perfectly competitive?_____


Problem MONO6(0) The iMAX is the only theater in the tiny town of Maxwell, a mining town in Rural Iowa. The demand for popcorn once inside the theater is given in the following demand schedule: Price per Drink $7.00 $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 Quantity 0 10 20 30 40 50 60 70 Graph the demand, marginal revenue, and marginal cost assuming that marginal cost is a constant $1.00. What will be the price of a drink at the iMax a. ___________. If the citizens of Maxwell force the theater to sell at the perfectly competitive price, how many drinks will be sold? b. _________ How much is total revenue at the profit-maximizing price? c. ________ How much is total cost at the profit-maximizing price? d. __________

What is the price elasticity of demand between $3.00 and $2.00? e. ___________ How much is the dead weight loss when the iMax sells popcorn at the profit-maximizing price? f. ____________ How much is consumer’s surplus at the profit-maximizing price? g. __________

Sample 4 – Natural Monopoly A natural monopoly is so big that it supplies the entire market. This market structure is characterized by high fixed costs that are spread out over a large range of output. Because of the high fixed costs, the firm is easily identified by a broad sweeping ATC curve and low variable costs. The low variable costs can be seen in the marginal cost curve which over this range of output is constant.


Problem MONO7 (0) In the problem below, answer the questions that follow:

The firm still maximizes profit where MR = MC. What is the price at the profit maximizing output? a. __________ If this firm were regulated at the socially optimal output, that is, resource allocative output, what would be the price and output? b. Price ________ Output_______ At the socially optimal output how much profit is the firm making? c. ________ d. Shade the area dead weight loss. Should this municipality be subsidized or taxed? e. _________

Solutions:


MONO1 a. Pure Monopoly b. $7 c. 3 d. $21 e. $12 f. $9 G. Below $5 H. $5 I. 4.5 J. Shade Triangle; 3,$7 – 3, $4 – 4.5, $5.5 k. $5.5 l. 5 m. The monopolist has to lower the price to sell the next item. MONO2 a. License b. Economies of Scale or Exclusive ownership of a resource c. License d. Legal right e. Possibly all. Answers can vary. MONO3 a. $14 b. 2.5 c. 5 d. $25 if you include the whole area of consumer’s surplus; $20 if you assume a stairstep and discrete quantity. MONO4 a. 3 b. $30 c. 60 in profit d. 5 e. $100 MONO5 a. 5 b. 2.5 c. About 4 d. 10.67 MONO6 a. $4 b. 30 c. 120 d. $30 e. .56 f. 45 g. 4.5 MONO7 a. 6 b. $1, about 5.5 c. -1 d. not shown. E. subsidized. Elasticity Name __________________


Sample 1: Dr. D. Kay wants to increase his revenue. He is thinking about raising his prices. He sees 4 patients per hour no matter what so he has a constant cost of $400 per hour. Dr. D Kay’s demand for his services is shown. He charges $150.00 per patient. If Dr. D. Kay is at point A, he is charging $600 per hour and seeing 8 patients in 2 hours. His total revenue is $1,200.00 for a profit of $400.00. What happens if Dr. D. Kay raises his price to $700.00 per hour? His total revenue

FALLS and so does his profit. His total revenue is $700.00 and his total cost is $400.00 for a profit of $300.00. Dr. Kay should not raise prices. What if Dr. D. Kay lowers his price to $500.00 per hour? The good doctor would increase his revenue to $1,500.00 but his profit would fall to $200. Dr. D. Kay should keep his price right where it is at $600.00. Dr. Kay could see more patients and perhaps do more good by working four hours. However, his

profits are maxed by working two hours. Does this explain why doctors aren’t open on weekends and Fridays? A good is elastic in the range of demand when total revenue increases when the price decreases or total revenue falls when the price increases.


Elas1 (0) Total Revenue Test In the table below, compute the total revenue by multiplying price and quantity for each price and quantity. Next, circle “E” if the price is elastic, “U” if the price is unit elastic, and “I” if the price is inelastic.

Sample 2. In AP Microeconomics, three factors influence how elastic the response is to an increase in price. They are 1) Time 2) Percentage of Budget Spent on the Good 3) The Number of Substitutes for the Good. For example, the need for air conditioning is more elastic in winter where the temperatures are below zero than in summer when the temperatures are above 100 degrees. Salt has few substitutes and is inexpensive. It is unlikely that consumers will change their demand for salt if salt increases in price. Salt is inelastic. Elas2 (0) Three Elements of Elasticity In the problems below, which factor of elasticity most probably describes the good’s elasticity. a. A heart patient’s demand for Aortacin, a medicine that keeps the heart beat rhythmic. _____________________ b. Plastic surgery for breast implants. _____________________ c. A caffeine addicts need for caffeine now. _____________________ d. The need for medical attention for a patient who lops his hand off sawing wood.


____________________ e. The price of a 20¢ can of peas goes up a penny. ____________________ f. The opera La Boheme ticket prices sell for $100 each, but all tickets sell out to a wealthy clientele. ____________________ g. Cable television increases its service cost by a $1, and hundreds start renting DVDs. ____________________ h. Gas prices are driven up to $4 a gallon, and millions start carpooling to work. ____________________ Elas3 (3) Billy Soundoff claims that oil companies are a monopoly because he observes profits of big oil going up when the price of crude oil goes up. He claims that Big Oil can raise

prices and therefore raise profits. Sketch a demand, marginal revenue, and marginal cost curve and use the concept of elasticity to show that a monopoly would never operate on the inelastic portion of the demand curve. Show that a monopoly only operates on the elastic portion and thus could not raise price without sacrificing profit.

Sample 3 The Mid Point Formula Economists rely on observation to explain behavior. To quantify a consumer’s response to a price change, the College Board uses a mid point formula to determine is demand is elastic, unit elastic, or inelastic. If the price of Hungry Harry Porkchops raises fro $6 to $7 and the quantity falls from 20 to 10, the price elasticity of demand, PED equals 4 2/3. The chops are very elastic. If the price of Ugly Ducklings increases from $2 to $3 and the quantity demanded

changes from 14 to 12, the PED equals .46. Ugly Ducklings are inelastic.


Elas4 (0) Use the midpoint formula to calculate the price elasticity of demand for points, AB, BC, CD, and DE. Calculate the price elasticity of demand at point A and E.

Sample 4 Cross Elasticity Goods that are consumed together are complementary goods. Chicken and beef are substitutes. When the price of peanut butter goes up, people buy less peanut butter and less jelly. The demand for jelly decreases. A good is a complementary good when the cross elasticity of demand is negative. A good is a sub when the cross elasticity is positive. Sally always has cream in her coffee. When the price of coffee increased 10%, Sally decreased her consumption of cream by 5%. Coffee and cream are complements for Sally. Juan is a socialite. For Juan espresso is a substitute latte. When the price of espresso increases 8%, Juan’s demand for latte increases 10%.

The general formula is given to the left. If the result of the change in demand for good A divided by the change in the price for good B is positive, the goods are subs. Otherwise, comp’s.

Elas5 (0) Complete the table using the Xed formula above. Good A Good B Xed Sub?

Comp? Shoes Socks Qd -8% $P +6%

Pens Pencils Qd +10% $P +12%

Corn Soybeans Qd +12% $P +16%

Books Kindle $P +3% Qd +9%


Review: The total revenue test. It’s easy to know if a good is elastic. Simple find total revenue at a price and quantity then raise the price. Calculate total revenue again. If total revenue falls, the price is elastic in that range. Sample 5 Income Elasticity When your income goes up, do you buy more or less of a good, say, hotdogs? If you buy more, the good is a normal good. If you buy less, the good is an inferior good. Juan’s boss just gave him a $1 and hour raise. As a result of this wage increase, Juan’s income goes up. Juan buys more downloads from the iTunes store. For Juan, downloads are a normal good. If, for example, Juan’s income increased 10% and his downloads increased 3%, Juan’s income elasticity is +.3 = 3%/10%. Since the result of this ratio is positive. Downloads are a normal good.

If the good is inferior, than quantity demanded, Qd, will be negative. A negative income elasticity indicates that the good is inferior. A positive income elasticity indicates that the good is normal.

Elas6 (0) Income Qd Yed Normal?

Inferior? +Y 3% -10% Head Cheese +Y 6% +5% Breakfast Bars -Y 20% +12% Marconi +Y 50% +64% Diamonds -Y 35% +40% Ramen Noodles


Sample 6 Elasticity of Supply Supply can be elastic, inelastic, unit elastic, perfectly inelastic or perfectly elastic. You might have guessed that the formula is:

Suppose that red roses at Valentine’s Day increasing by 5% and the quantity supplied, QS, increases by 10%. Roses are elastic in this range.

Elas7 (0) In the graph below, calculate the price elasticity of supply from point A to B and A to C.

a. Price Elasticity of Supply AB. _______ b. Price Elasticity of Supply AC. _______

Elas8 (1) Explain why a Snickers Bar has more subs, and therefore more elastic, than candy bars. Elas9 (0) Draw a perfectly inelastic supply curve in red and a perfectly elastic supply curve in blue below.


Elas10 (0) List at least factors that influence the elasticity of supply. a. b. c.


Solutions Elas1

Elas2 a. Subs, time b, c, d time e. subs, f. % of budget g and h subs. Elas3 The monopolist produces where MR=MC which always results in a price on the elastic portion of the curve.

Elas4 AB 7 BC 1.67 CD 1.67 DE 1/7 Elas5 (Table)

Good A Good B Xed Sub? Comp?

Shoes Socks Qd -8% $P +6%

-8/6 Comp

Pens Pencils Qd +10% $P +12%

+10/+12 Sub

Corn Soybeans Qd +12% $P +16%

+12/+12 Sub

Books Kindle $P +3% Qd +9%

+3/+9 Sub


Elas6 Income Qd Yed Normal?

Inferior? +Y 3% -10% Head Cheese -3.3 Inferior +Y 6% +5% Breakfast Bars .83 Normal -Y 20% +12% Macrooni .6 Inferior +Y 50% +64% Diamonds 1.28 Normal -Y 35% +40% Ramen Noodles -1.14 Inferior Elas7 a. Price Elasticity of Supply AB. _.55__ b. Price Elasticity of Supply AC. _1.11_ Elas8 There are more subs for a specific candy bar like Snickers. There are no subs for candy bars. For example, you could sub a Baby Ruth, Reeses Peanutbutter Cup, or Milky Way for a Snickers. What would be a reasonable sub for the broad category “Candy Bars”? Elas9

Elas10 a. Time to change plant or facility b. Time to get resources c. Excess capacity

d. Ease of factor substitution e. Stocks of resources in the production process Elas10 The three factors influencing the elasticity of supply are: the price of the product from which the inputs are derived; the amount of time involving in changing supply; and the price of complementary inputs.


Production Costs Name _________________________ Sample 1 Production Function

The firm’s production function shows how output is related to labor inputs. As more labor is added to a fixed resource such as a machine, less is produced. This is important because labor is expensive. Costs rise exponentially. For the AP Exam, it’s important to know that total product increases at a decreasing rate.

Sample 2 Marginal and Average Products Marginal Product, MP, is found by taking the slope of the Total Product curve. Average Product, AP, is found by dividing Total Product by the quantity of labor. The table shows the calculations. When MP is above AP, AP is rising. When MP is below AP, AP is falling. The MP curve intersects the AP curve when AP is at the maximum. Can you give an intuitive reason why the two curves must intersect at the maximum AP curve? Economists like to talk about the Average Margin Rule to describe this relationship. If you equate AP to your GPA, then you know higher grades in your classes

rise your GPA and lower grades lower your GPA. Because diminishing marginal returns set in after the second worker, the marginal product pulls the AP curve down.


Costs1 (0) Use the data contained in the graph for Sample 1 to construct the MP and AP curves. Draw the MP is red and AP in brown.

Costs2 (0) Use the data contained in the graph for Sample 2 to construct the Total Product curve.

Sample 3 – Returns to Scale

Using two labor resources results in increasing returns to scale. After two units of labor are employed, diminishing marginal returns set in. The fifth worker adds negative returns.


Costs3 (0) On the graphs for Costs1 and Costs2, show increasing returns to scale and decreasing returns to scale. Sample 4 – Cost Curves How are the total product curve and marginal product curve related? When marginal product is at its peak, marginal cost is at the lowest point as the table shows. Labor TP FC VC TC MC MP 0 0 10 0 10 1 3 10 5 15 1.6 3 2222 9999 10101010 10101010 20202020 .834.834.834.834 6666 3 14 10 15 25 1 5 4 18 10 20 30 1.25 4 5 21 10 25 35 1.6 3 6 23 10 30 40 2.5 2 Sample 5 – AFC, AVC, and ATC The table data has been plotted on the graph to the left. The rapidly decreasing slope is due to spreading of fixed costs over a range of output.


Average Variable and Average Total Costs

Costs4 (0) Complete the table below. Labor TP MP AP FC VC TC AFC AVC ATC

0 0 8 0

1 6 8 5

2 14 8 10

3 24 8 15

4 32 8 20

5 38 8 25

6 42 8 30

7 44 8 35


Costs5 (0) Use the data from Costs4 to graph AVC and ATC.


Solutions Costs1(0) Although the solution does not resemble the example, MP and AP intersect at the apex. Diminishing marginal returns are pulling the average product curve down just as the theory predicts.

Costs2 (0) It’s important to note that the curve increases at a decreasing rate. Of interest to me is how labor combines

with capital to produce output. For some workers the capital might hinder their output while others can create a monument.

Costs3 (0) On both graphs, diminishing returns set in immediately. Costs4 (0) Labor TP MP AP FC VC TC AFC AVC ATC 0 0 8 0 8

1 6 6 6 8 5 13 1.33 .83 2.17

2 14 8 7 8 10 18 .57 .71 1.28

3 24 10 8 8 15 23 .33 .62 .95

4 32 12 8 8 20 28 .25 .625 .875

5 38 6 7.6 8 25 33 .21 .65 .86

6 42 4 7 8 30 38 .19 .71 .90

7 44 2 6.2 8 35 43 .18 .795 .977


Costs5 (0)

AVC and ATC

0

0.5

1

1.5

2

2.5

0 2 4 6 8

Quantity

Co

sts AVC

ATC


Externalities and Market Failure Name ______________________ Sample 1 – Positive Externalities Wanda and Willy like to make their house look like a winter wonderland during winter. They decorate their home with tasteful lights and reefs. Ralph Rider gets tremendous pleasure from his neighbor’s work but he incurs none of the cost. Economists say that Wanda and Willy’s displays “spillover” to Ralph. If there are many more neighbors like Ralph, society would benefit from more winter lights and reefs. Therefore, in the case of a positive externality, the good is “under produced”.

To induce Wanda and Willy and other neighbors to put up more lights and reefs, the government can give energy credits or tax breaks that effectively lowers the cost. Perhaps the credits are $2. Since the cost is artificially lowered the MSC does not shift, but the quantity increases from 4 to 5. The MSB curve shifts to the right to restore equilibrium at point 2. Classic positive externalities include smoke alarms, flu shots, and education.

Sample 2 – Negative Externality Michael is a crystal meth addict who has to steal to support his habit. Furthermore, drug enforcement incarcerates Michael and the state suffers from the burden of rehabilitation and social medicine. Michael’s addiction has “spill over” costs that are imposed on family members, law enforcement officials, and social services. From society’s standpoint, crystal meth is over produced and represents a negative externality.

Economists recommend placing a Pigouvian Tax on the sale of meth, say $3. This corrective tax will shift the supply of meth to the left from point 1 to point 2 and increase the price. Now less is demanded. Since the distribution of meth is illegal, perhaps the tax comes in the form of a longer prison sentence or more community service. The socially optimal output is arrived at when MSB=MSC. Classic negative externalities are: pollution, noise, and flu.


Extern1 (0) Answer each question “True” or “False”. ____ 1. A negative externality has MSC > MPC. ____ 2. A positive externality is over produced. ____ 3. A Pigouvian Tax corrects a positive externality. ____ 4. When MSB is greater than MPB a negative externality exists. ____ 5. The socially optimal output occurs where MSC = MSB. Extern2 (0) Sally Greene has organized a girl group to clean up the city. Many citizens in Sally’s city wish that she could do more clean up especially along the river. Use the graph below to show the socially optimal equilibrium if Sally is given an incentive of $3 per hour of cleanup.

a. Is this a positive or negative externality? ____ b. Should the city subsidize or tax this externality to achieve the socially optimal output? ________ c. What are some of the spill over externalities that the city might experience? ______________

Extern3 (0)

Tiny Tim drives a compact car he calls the “bug”. When he drives up to a dangerous intersection, huge pick up trucks pull up along side of him and he can’t see on coming traffic. For Tim, this generates an externality. If there are hundreds like Tim and they lobby to tax big trucks, show the new equilibrium on the graph below if the city levies a tax of $3 per unit. a. Is the situation described a positive or negative externality? _________


Sample 3 – Moral Hazard and Adverse Selection A moral hazard occurs when one party can shift the cost of their actions onto another. A moral hazard happens after perverse incentives are misaligned. Adverse selection happens before another event. A classic moral hazard is the seat belt law which prompted drivers to drive faster. A classic adverse selection case is when someone buys life insurance after they are diagnosed with a life threatening illness. The difference between the two is in the time. In both cases the risk and costs have been shifted to another party who has asymmetrical information. Extern4 (0) In each case below, place “MH” if the event describes a moral hazard and “AS” if the event describes adverse selection. ____ 1. Banks make many sub-prime loans because the FDIC guarantees payment to bank in the event of default. ____2. Juan puts sells his car when Maheep offers him more than the car is worth even though the car has a bad ignition. ____3. Because condoms are distributed free at school, Larry engages in more sex than he would otherwise. ____4. Pete is always broke and keeps spending knowing that his mom will bail him out with a loan. ____5. Mike does not work to prepare lessons after he earns tenure at Dukes of Hazard Community College. ____6. ISU’s pet agricultural project on Ethanol is funded even if it is a failure. ____7. Mary does what she wants to do at work because her father is the owner. ____8. Scott, a heavy meth user, applies to work at Barry’s Bar and Grill since they don’t drug test. ____9. Jim gets a credit card offer in the mail and immediately activates the card even though he’s deeply in debt. ___10. Every student in Professor Hurt’s class gets at least a B in the class. Kathy is in Professor Hurt’s class and never studies. ___11. Iowa has a no-fault divorce law. Paris and Astro get married with the idea that they can easily divorce if they want to. Sample 4 – Free Rider A free rider is someone who gets all of the benefits without any of the cost. Free riders benefit when the good consumed is nonexcludable like national security.


Extern5 (0) Harry claims that if there were no government no private individual would have the incentive or the means to provide public education and national defense. Explain in 50 words or less if you agree or disagree with Harry. Extern6 (0) On the graph below, sketch the market for gasoline. Assume that exhaust exerts a cost on third-party individuals who are neither buyers nor sellers of gasoline. Label all curves.


Solutions Extern1 1. T 2. F 3. F 4. F 5. T Extern2 Positive, Subsidize, Cleaner and healthier town, equilibrium price is $5 and quantity is 7 Extern3 $4, negative Extern4 2, 8 and 9 are adverse selection. The rest are moral hazard. Extern5 Agree. There would be free riders if someone provided the good itself. There’s no incentive to produce when all of the benefits accrue to free riders. Extern6 Anything that looks like Sample 2.


Basic Concepts MACRO Name _______________________ Sample 1 – Unemployment Rate Let’s begin with the population. That is every man, woman, and child. Now we subtract those in the military, retired, and those under the age of 16. This is the Civilian Non-Institutionalized Population. Next, we subtract from CINP those who have given up looking for work or discouraged workers. We have now derived the Civilian Labor Force, LF. The labor force is composed of the unemployed plus the employed. The unemployment rate is found by dividing the number of unemployed by the labor force. The employment rate is found by dividing the number of employed by the labor force by the Civilian Non-Institutional Population. Finally, the Labor Force Participation Rate is found by dividing the Labor Force by the Civilian Non-Institutional Population. Basic1 (0) The data below is from the FRED data base hosted at the St. Louis Federal Reserve Bank. All data is in thousands, (000). This data can be directly obtained at: http://research.stlouisfed.org/fred2/categories/12. The series ID is at the top of each header. CNP160V CINP

CIF160V LF

CE160V Employment

UNEMPLOY Unemployment

Year

224837 148029 140245 7784 2005 227553 150201 143142 7059 2006 230650 153117 146032 7085 2007 232616 154048 146421 7628 2008 234739 154140 142221 11919 2009 236832 153170 138333 14837 2010 For each year in the table above compute the unemployment rate, employment rate, and the labor force participation rate. Unemployment

Rate Employment

Rate Labor Force

Participation Rate Year

2005 2006 2007 2008 2009 2010 Basic2 (0)


Graph the unemployment rate below using your calculation for Basic1.

A recession often is accompanied by high unemployment. In what year, would you opine the recession began? _______ The natural rate of unemployment is 5%. In what year was the economy operating at its natural rate of unemployment? _____ Sample 2 – Inflation Rate

The inflation rate is simply the change in the Consumer Price Index, CPI, from year to year. For example, if the CPI this year is 112 and the CPI last year was 110, the inflation rate is 1.8%. A healthy inflation rate is 2%. Basic3 (0) The data below is from the FRED data base hosted at the St. Louis Federal Reserve Bank. The data series is found at http://research.stlouisfed.org/fred2/graph/?id=CPIAUCSL. Specifically, the series is CPIAUCSL, the Consumer Price Index All Urban Consumers All Items. Complete the table by calculating the inflation rate. Year CPI Inflation Rate 2005 191.6 2006 199.2 2007 203.4 2008 212.23 2009 211.96 2010 217.6 Basic4 (0)


Graph the inflation rate you calculated in Basic3. Use the graph below. a. When the economy was at its natural rate, what was the inflation rate? __________

b. When the unemployment rate was 9.7%, what was the inflation rate? _________ c. When the unemployment was 4.7%, what was the inflation rate? ___________ d. In periods of high unemployment, what do you predict the inflation rate to be, (high or low)? ___________ Basic5 (0) Carls Badd loves country and western

music. He swears that there’s a relationship between the number of sad love ballads and the state of the economy. For the years 2005, 2006, 2007, 2008, 2009, and 2010, Carls has kept track of the sad songs played on his favorite station, KWBOOHOO in Ames, Iowa. The table below has his results. Calculate the rate of change in sad songs. Does Carls Badd theory hold true? Year Sad Songs Change in Sad Songs 2005 832 2006 800 2007 784 2008 800 2009 840 2010 889 Sample 3 Changing the base


Suppose that the CPI for 5 years for the country of Omega is contained in the table below. Year CPI 1 100 2 110 3 120 4 130 5 140 To make year 3 the base year, divide 120/120 and multiply by 100. Next divide, 120 by 120 and multiply by 100, divide 140 by 120 and multiply. To find year index, divide 110 by 120 and multiply by 100. Repeat for year 1. The new index is: Year CPI 1 83 2 91 3 100 4 108 5 117 Basic6 (0) Calculate the inflation rate from year 1 to 5 in each table above. Does the selection of the base year make a difference in the inflation rate? ________ Sample 4 -- Deflator in Action The table below combines many basic concepts. Real GDP can be calculated by taking current year output at base year prices or dividing nominal GDP by a price index. The GDP Deflator is found by dividing nominal GDP by real GDP. Assume that a cheeseburger is the only good made. See if you can discover how the data interacts with each other to construct a picture of the economy. Real GDP (AP Way) is found by dividing nominal GDP by the price index. In year 1, the price index equals 1 ($50/$50), in year 2, the price index equals 1.2 ($12/$10). Year Price Quantity NGDP RGDP GDP Deflator RGDP

(AP Way) 1 $10 5 $50 $50 1 $50 2 $12 6 $72 $60 1.2 $60 3 $14 8 $112 $80 1.4 $80 4 $13 7 5 $14 9 Basic7 (0)


Complete the table in Sample 4 for years 4 and 5. Basic8 (0) Using the same data as Sample 4, change the base year to year 3. Recalculate the table. Year Price Quantity NGDP RGDP GDP Deflator RGDP

(AP Way) 1 $10 5 2 $12 6 3 $14 8 4 $13 7 5 $14 9 Basic9 (1) The data below is from the FRED data base hosted at the St. Louis Federal Reserve Bank. Calculate the real GDP for each year. (NGDP figures are in billions.) (GDPDEF) GDP Deflator

(GDPA) NGDP

Year Real GDP

88 10286 2001 89 10642 2002 91 11142 2003 91 11868 2004 93 12638 2005 95 13398 2006 98 14078 2007 102 14441 2008 105 14256 2009 Sample 5 – Real Interest Rates The real interest rate is computed by taking the nominal interest rate minus the expected rate of inflation. If the nominal interest rate is 10% and the expected rate of inflation is 7%, then the real interest rate is 3%. Basic10 (0) Complete the table below using Sample 5 as an example.


Real Interest Rate, r Nominal Interest Rate, i Expected Rate of Inflation, πe 8 2 5 10 3 4 3 2 Basic 11 (0) The table below has had the quantities changed. The intent of this exercise is show how assumptions made as to the typical quantities consumed by the average consumer, changes the CPI. Complete the table with the new quantities. How does the GDP Deflator, nominal GDP, and real GDP change? Year Price Quantity NGDP RGDP GDP Deflator RGDP

(AP Way) 1 $10 8 2 $12 5 3 $14 7 4 $13 9 5 $14 10 Basic 12 (0) The CPI assumes that the quantities do not change from period to period.

Microeconomics predicts that a higher price of a good, say cheeseburgers, will lead to a substitution of a cheaper product such as soybean burgers. Some economists assert that the CPI does not take into account the substitution effect and

overstates the CPI. In the space below, explain what those economists mean when they say the CPI is overstated.


Basic 13 (3) You are given the following data. Calculate the CPI for Year 1, 2, and 3.

Year 1 Year 2 Year 3 Item $P Q Expenditure $P Expenditure $P Expenditure A 3 8 3.2

5 3.1

5

B 6 20 6.5 6.75

C 5 6 4.5 4.5 Totals Index


Solutions Basic1 Unemployment

Rate Employment

Rate Labor Force

Participation Rate Year

5.25% 62.3% 65% 2005 4.69% 62.9% 66% 2006 4.62% 63.3% 66% 2007 4.95% 63.3% 66% 2008 5.1% 60.5% 65% 2009 9.6% 58.4% 64% 2010

Basic 2

Basic 3 Year CPI Inflation Rate 2005 191.6 --------------- 2006 199.2 3.9% 2007 203.4 2.1% 2008 212.23 4.3% 2009 211.96 0% 2010 217.6 2.8%


Inflation Rate

-1.00%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

2005 2006 2007 2008 2009 2010 2011

Year

Infl

atio

n R

ate

Inflation Rate

Basic 4

a. 2009 b. 9.6% c. 7.5% D. Inverse relationship between unemployment and inflation. Data weakly confirms this.

Basic 5 Year Sad Songs Change in Sad Songs 2005 832 2006 800 -3.8% 2007 784 -2% 2008 800 2% 2009 840 5% 2010 889 5.8% Sad songs seem to be related to the state of the economy. Basic 6 The inflation rate is still 40%. The choice of base doesn’t change the inflation rate but changes the index. Basic 7 Year Price Quantity NGDP RGDP GDP Deflator RGDP

(AP Way) 1 $10 5 $50 $50 1 $50 2 $12 6 $72 $60 1.2 $60 3 $14 8 $112 $80 1.4 $80 4 $13 7 $91 $70 1.3 $70 5 $14 9 $126 $90 1.4 $90


Basic 8 Year Price Quantity NGDP RGDP GDP Deflator RGDP

(AP Way) 1 $10 5 $50 $70 71.4 $70 2 $12 6 $72 $84 85 $84 3 $14 8 $112 $112 100 $112 4 $13 7 $91 $98 92 $98 5 $14 9 $126 $126 100 $126 Basic 9 (GDPDEF) GDP Deflator

(GDPA) NGDP (billions)

Year Real GDP

88 10286 2001 11688 89 10642 2002 11957 91 11142 2003 12243 91 11868 2004 13041 93 12638 2005 13589 95 13398 2006 14103 98 14078 2007 14365 102 14441 2008 14157 105 14256 2009 13577 Basic 10 Real Interest Rate, r Nominal Interest Rate, i Expected Rate of Inflation, πe 6 8 2 5 10 5 3 7 4 1 3 2 Basic 11 Year Price Quantity NGDP RGDP GDP Deflator RGDP

(AP Way) 1 $10 8 $80 $80 100 $80 2 $12 5 $60 $50 120 $50 3 $14 7 $98 $70 140 $70 4 $13 9 $117 $90 130 $90 5 $14 10 $140 $100 140 $100


Basic 12 Economists mean that the CPI reports that inflation is higher than it actually is. Since consumers will buyer the cheaper product, inflation doesn’t hurt the consumer as much as the index suggests. Basic 13

Year 1 Year 2 Year 3 Item $P Q Expenditure $P Expenditure $P Expenditure

A 3 8 24 3.25

26 3.15

25.2

B 6 20 120 6.5 130 6.75

135

C 5 6 30 4.5 27 4.5 27 Totals 174 183 187.2 Index 100 105 108


Aggregate Demand/Supply Name _____________________________ Sample 1—Real Balances One reason why aggregate demand slopes downward and to the right is the Real Balances Effect. When the price level declines, your savings becomes worth more and your buying power is boosted. For the macro economy, the real balances effect can be illustrated as shown.

To interpret, suppose that Harriet has $5,000 in cash, and $10,000 in non monetary assets (car, computer, and Android). What is the value of her real balances when the price level is 120? Simply add her assets together, $15,000, and divide by the price level and multiply by 100. The value of her assets when the price level is 120 is $12,500. The value of her real balances when the price level is 100 is $15,000. As the price level falls, Harriet’s buying power increases causing her quantity demanded to increase from Q1 to

Q2. When the price level increases, her buying power decreases and the quantity demanded falls. Notice that this is a movement along the curve since the only variable that is changing is the price level. AD1 (0) Assume that Harriet has $15,000 in cash and assets. Compute Harriet’s real balances for each price level in the table below. Price Level Real Balance 80 90 100 110 AD2(0) Suppose the price level changes from 123 to 125. What is the inflation rate? _________ Sample 2 – Interest Rate Effect What is not spent is saved. So when the price level falls, the consumer buys a fixed market basket and save the rest. The supply of savings increases and interest rates fall. The lower interest rates induce more business investment and household consumption of durable goods. The quantity demanded of real GDP increases.


Suppose that when the price level is 120 the interest rate is 8% . This means that for every $100 dollars a consumer or business borrows, they will pay back $8. If HNI borrows $10 million to finance capital restructuring, they will pay in interest $800,000. If the price level drops to 100 and consumers save more, HNI will only pay $600,000 in interest. This interest rate effect also works in reverse. AD3 (0) How much interest would HNI have to repay if they wanted to borrow $10 million and the interest rate was 4%? _____________ Sample 3 – Foreign Purchases Effect When the price level is higher in Alpha than the price level in Beta, it’s cheaper for Alpha consumers to buy from Beta. It’s like buying at Walmart* a pair of shoes for $10 instead of buying the shoes at Shoe Carnival for $20. So Alpha citizens buy less domestic goods

and the quantity demanded decreases. In the example, the price level for Alpha increases from A to B. Alpha and Beta consumers find it cheaper to buy from Beta so the quantity demanded falls from Q3 to Q2.


AD4 (0) Explain how the foreign purchases effect would work if the price level in Alpha decreased.

Sample 4 – Aggregate Demand Shifts When the price level changes, the economy moves along the aggregate demand curve for three reasons. In other words, the quantity of aggregate demand changes as the price

level changes. But the AD curve can shift because of exogenous variables. Anything that changes spending shifts the AD curve. So any change in C, I, G, or Nx shifts the curve. A change in personal taxes and expectations of future prices will shift the curve. When people feel wealthier, they spend more. So if the value of their assets or their income changes, AD shifts. One example will explain. Suppose the economy is at point B. If consumers spend more, business increase their investment, or the government increases its spending, the AD will shift to the right to point D. The same shift would

have happened if personal income taxes were reduced, consumers felt that prices were going to be higher in the future, or stock market assets were increasing. If the USD were depreciating, the AD would shift from AD to AD1.


AD5 (0) Event PL (U or D) AD (U or D) Real GDP (U or D) 1. Personal income taxes decrease 2. Consumer confidence spurs increased

spending

3. Housing values skyrockets 4. Businesses become pessimistic about the

future

5. The USD rapidly appreciates because of higher domestic interest rates

6. Government slashes military spending 7. iPods become the rage around the world.

Domestic exports increase

8. The money supply increases along with consumption

9. The government pursues contractionary Fiscal Policy

10. A lower reserve ratio spurs more lending to business. Investment increases

11. U. S. goods suddenly become attractive to foreigners

12. Businesses become optimistic about future sales

13. Foreign income increases 14. Business taxes increases. Businesses

expect lower profits

15. Consumer spending on durables declines 16. USD appreciates relative to foreign

currencies

17. Personal income taxes decline 18. Wealth increases because of higher stock

market values


Solutions AD1 Price Level Real Balance 80 18750 90 16666.67 100 15000 110 13636.37 AD2 The inflation rate is 1.62% AD3 The interest is: $400,000 AD4 The USD would appreciate as more US goods would be demanded by foreigners. Net exports would increase. AD would shift to the right. Event PL (U or D) AD (U or D) Real GDP (U or D) 1. Personal income taxes decrease Up U Right Up 2. Consumer confidence spurs increased

spending Up U Right Up

3. Housing values skyrockets Up U Right Up 4. Businesses become pessimistic about the

future

5. The USD rapidly appreciates because of higher domestic interest rates

Up U Right Up

6. Government slashes military spending Down D Left Down 7. iPods become the rage around the world.

Domestic exports increase Up U Right Up

8. The money supply increases along with consumption

Up U Right Up

9. The government pursues contractionary Fiscal Policy

Down D Left Down

10. A lower reserve ratio spurs more lending to business. Investment increases

Up U Right Up

11. U. S. goods suddenly become attractive to foreigners

Up U Right Up

12. Businesses become optimistic about future sales

Up U Right Up

13. Foreign income increases Up U Right Up 14. Business taxes increases. Businesses Down D Left Down


expect lower profits 15. Consumer spending on durables declines Down D Left Down 16. USD appreciates relative to foreign

currencies Up U Right Up

17. Personal income taxes decline Up U Right Up 18. Wealth increases because of higher stock

market values Up U Right Up


Aggregate Supply Name ______________________ Sample 1 – Slope of AS Curve When employees enter into long-term contracts that last for years, changes in the price level leave the employee sometimes better off and sometimes worse. Suppose Juan signs a contract to roof houses at $100,000 a year. During the time Juan signs the contract to the duration, the price level rises fro 150 to 175. Juan’s real earning power declines from $66,667 to $57,143. Since Juan has signed a contract, his wages are “sticky” as he’s unable to renegotiate a higher wage in response to a higher price level. However, some roofers who do not have contracts can raise their prices so that their earnings keep up with inflation. Sticky wages are a reason why the aggregate supply curve slopes upward. Likewise, restaurant owners who print expensive menus cannot change their prices in response to rising prices because of the cost of reprinting menus. Economists refer to “sticky” prices to describe the restaurant’s response. Yet, some restaurants can change their prices. Sticky prices are a reason why the aggregate supply curve slopes upward.

Both sticky prices and sticky wages are often used to describe the slope of the aggregate supply curve. The AS curve slopes upward and to the right because of sticky wages and sticky prices. Sellers routinely believe that they have marked up prices to keep up with inflation, but economists generally agree that the producer has underestimated the inflation rate. The producer produces more as she thinks that she’s keeping up

with inflation. Thus, as the price level increases, some producers make more because they underestimate the inflation rate. Producer misperceptions are another reason why the aggregate supply curve slopes upward. Workers often mistake a raise in their nominal wages with a raise in their real wage rate. Say that Harry gets a 2% wage increase, but the inflation rate is 5%. Harry’s real wage is 3% lower, but because he misperceives his wage increase as a increase in his real earnings, Harry works more. Worker misperceptions are another reason the aggregate supply curve slopes upward. Sample 2 -- A Horizontal Aggregate Supply Curve One interpretation of price rigidity is that the AS curve is flat. A flat AS curve infers that prices are sticky and inflexible downward. I interpret the horizontal AS curve to mean

that there are many idle resources. Since resources are idle, they come into production at little opportunity cost so the price of these resources do not increase. Still, one can interpret the flat AS curve to mean that in the short run firms simply


meet demand because they are unsure if the demand increase reflects consumer preferences for their product or a rise in the price levels. Sample 3 AS Shifts The AS curve captures the relationship between the price level and real GDP. Changes in technology, cost of resources, and supply shocks can shift the curve. For example, an

increase in wages paid to labor will shift the AS curve to the left. If labor becomes more productive, the AS curve will shift to the right. In AP Macroeconomics, an adverse supply shock comes from a rise in oil. A positive supply shock might be the technology of the Internet. In the graph, AS shifts to the right when resources become cheaper, or a new technology improves productivity of labor, or there is a positive supply shock.

AS1 (0) List the reasons why the AS curve slopes upward and to the right. Explain why each reason contributes to the slope.

AS2 (0)

On the graph, show a beneficial supply shock.


AS3 (0)

On the graph, show the effects of a decrease in wage rates.

AS4 (0)

On the graph, show an increase in the price level.

AS5 (0) In the short run, what is the impact on the price level, real GDP, and employment in each case. Assume an upward sloping AS curve. Event PL RGDP UnRate A Wages decrease B Marginal Product of Labor Increases C Oil price rise dramatically D A decline in productivity E Positive supply shock F Non labor inputs increase AS6 (0) Calculate Juan’s real wage rate at each of the price levels in the table. Price Level Nominal Wage Real Wage a 112 $10 b 116 $10 c 125 $10


Solutions AS1 See Samples AS2 A new AS curve should be drawn to the right of the original AS3 A new AS curve should be drawn to the right of the original AS 4 The students should show a movement along the curve AS5 Event PL RGDP UnRate A Wages decrease Down Up Down B Marginal Product of Labor Increases Down Up Down C Oil price rise dramatically Up Down Up D A decline in productivity Up Down Up E Positive supply shock Down Up Down F Non labor inputs increase Up Down Up AS6 Price Level Nominal Wage Real Wage a 112 $10 $8.93 b 116 $10 $8.62 c 125 $10 $8.00


Long Run Supply Macro Name ___________________________ Sample 1 – Theory There’s a tendency for a body to come to a rest. When nothing is changing, the body is at

rest or in equilibrium. In Macroeconomics, when the labor market is in equilibrium, nothing is changing, then the economy is in long-run equilibrium. The graph below shows the change in the unemployment rate and the GDP growth (%) from 1990 to 2010. (FRED series UNRATE and GDP1 annual data.) Notice that when the unemployment rate is zero, the economy is growing at about 3.5%.

At a natural growth rate of 3.5%, real GDP was $12,000 billion in 2005-2006. If the economy was growing at less than 3.5%, unemployment is increasing. At growth rates greater than 3.5%, unemployment is decreasing. When the economy is at a growth rate greater of less than 3.5%, the economy must not be at the natural rate of unemployment. Sample 2 – The Natural Rate of Employment A body is in equilibrium when it is at rest. When GDP is changing at 3.5%, then the labor market should be in equilibrium since labor is used to make GDP. Using the FRED

data base, series UNRATE and GDP1), graphed this relationship. This graph shows that when approximately 6.2% of the labor force is actively seeking employment, GDP is growing at the natural rate.


Sample 3 – Long Run Supply In macroeconomics, long run supply is shown as a vertical line at the natural growth rate of GDP. This vertical line captures the essence of a body at rest and a reference point. If

short-run equilibrium is anywhere but on this line, the labor market must be adjusting. Think of the long run like Goldilocks and the three bears. In a recessionary gap, the porridge is too cold, in an inflationary gap, the porridge is too hot, and in the long run, the porridge is just right. LRS1 (0) In Alpha, AD intersects SRAS at 5 billion in real GDP. In Alpha, the long run supply is 7 billion. Is Alpha’s economy in a recessionary gap, inflationary gap, or in long run equilibrium (circle one). LRS2 (0) In Alpha, the natural rate of unemployment is 5%. Currently, the unemployment rate is 7%. In Alpha GDP growth is less than, greater than, or equal to (Circle one) the natural GDP growth rate. LRS3 (0) In classical economics, wages and prices adjust to bring the economy into long-run equilibrium. Show this adjustment on the graph below.


LR4 (0) In classical economics, wages and prices adjust to bring the economy into long-run equilibrium. Show this adjustment on the graph below.

AS5 (0) Use Fiscal Policy to move the economy into long run in each case below.


LR6 (0) In the graph below, show an increase in consumer confidence that increases AD by 1 billion at every level. a. In terms of real GDP, what is the new SR equilibrium? b. Is the unemployment rate above or below the natural rate? c. If the economy is left alone and the classical economists are right, show the new long run equilibrium on the graph. LR7 (0) In the graph below, show how an increase in real balances changes the AD curve if AD increases by 1 billion at every level. a. What is the effect on aggregate output? Explain why a change in AD was only inflationary.

LR8 (0) When the quantity of factors of production used to create goods increases, so does the economy’s ability to increase long run supply. The economy’s productive capacity is captured in the production possibilities curve. Using the graphs below, show how an increase in technology would move the PPF and LRS.


LR8 (0) On the graph below, move AD so that the economy is in long run but not experiencing inflation. Explain what happens when there are further increases in AD.


Solutions LRS1 recessionary gap LRS2 less than LRS3

LRS4

LRS5

AD would increase to 82.5. Workers would ask for a raise as the labor market is below its natural rate. When wages increase, the SRAS shifts to the left so that 82 billion in real GDP is produced but at a higher price level or P1. In the long run the only change is an increase in the price level.


LRS6

LRS7 When any of the factors of production increases, the PPF shifts to the right and so does the LRS curve.

LRS8

LRS8


Documents

Microeconomics Review Workbook