Introduction to Economics
Introduction to Economics ECON 1
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Dr. Janiya Bernier
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This 10 page Class Notes was uploaded by Dr. Janiya Bernier on Thursday October 22, 2015. The Class Notes belongs to ECON 1 at University of California - Berkeley taught by M. Olney in Fall. Since its upload, it has received 8 views. For similar materials see /class/226703/econ-1-university-of-california-berkeley in Economcs at University of California - Berkeley.
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Date Created: 10/22/15
Department of Economics Spring 2011 University of California Berkele Economics 1 Problem Set 1 Suggested Solutions Page 1 of 10 PR T 1 Suggested Solutions 1 3 points total For each of the events described below sketch a supply and demand graph that illustrates the event Be sure to properly label all curves and relevant points in your graph In the area to the left of your graph explain why you think your graph is correct In that area also answer the questions asked a Gasoline Strong growth in India China and the Middle East has increased worldwide demand for gas What is the effect on the price of gasoline On the quantity of gasoline sold The question asks about the worldwide supply and demand for gasoline Thefirst step is establishing some equilibrium E at P1 and Q The strong growth in India China and the Middle East increased those countries demandfor gasoline which in turn increased market demand Remember that the demand curve shows how much ofa good will be purchased at any given price When there is an increase in demand the demand curve itselfshifts to the right which indicates that consumers will purchase more gas at any given price as opposed to an increase in quantity demanded where there would be movement along the demand curve Remember changes in the price ofa product affect the quantity demanded whereas changes in any otherfactor affect demand The result is the equilibrium quantity and equilibrium price both increase The graph showing the market equilibrium before and after the shift illustrates why this is the case The demand curve shifts to the right changing the equilibrium pointfrom E to E increasing the equilibrium price from P1 to P2 and increasing the equilibrium quantityfrom 21 to 22 Note that the supply curve has not moved it is only the quantity supplied that rises Because the question does not specify otherwise we assume that everything a ecting the supply curve has stayed the same and nothing has happened to shift the supply curve Price of Gas Q1 Q2 Quantity of Gas b Fresh fruit Walmart the nation39s largest grocery retailer by far vows to reduce the costs of growing picking and transporting fresh fruit Because it39s now cheaper families add more fresh fruit to their daily diets What is the effect on the retail price of fresh fruit On the quantity of fresh fruit sold For all supplydemand questions like this we assume that all other things 7 asidefrom what is specified in Department of Economics Spring 2011 University of California Berkele Economics 1 Problem Set 1 Suggested Solutions Page 2 of 10 the question stay the same that is we make the llceteris paribus assumption When the cost of production decreases the supply curve shifts to the right This shift means that the seller IIalmart is willing to sell more quantity at the original price which is equivalent to providing the same quantity at a lowerprice Lowered cost ofinputs means Walmart can sell thefruit ata lower price The question states llBecause it s now cheaper which isyour clue that the change in buyer behavior is a movement along the demand curve and not a shift of the demand curve In response to a drop in price the quantity demanded increases Price of Fruit S1 S2 E i H gt P2 E D1 Q1 Q2 Quantity of Fruit gt Houses in Richmond Tighter lending standards make it more dif cult for many families to borrow money to buy a house At the same time thousands of houses taken by banks through foreclosure are offered for sale What happens to the price of houses in Richmond To the quantity sold of houses in Richmond r H Ifwe start at the beginning of the mortgage meltdown with high prices P1 and a high quantity ofhomes being sold Q1 we have an equilibrium ofE While some ofthese events occur relatively simultaneously let s break it up into two partsfor clarity First let s look at the demand side of the market Loans and houses are complements When lending standards are tighter so borrowing is more dif cult you can think of that as an increase in the price ofa loan for the typical borrower Demand for houses the complement good will decrease because some people cannot get a loan even ifthey want one The demand curve shifts to the leftfrom D1 to D2 This decrease in demand will lead to a decrease in the price and a decrease in the quantity ofhomes sold at the new equilibrium E Second let s look at the supply side of the market As foreclosures start to increase the banks will take Department of Economics Spring 2011 University of California Berkele Economics 1 Problem Set 1 Suggested Solutions Page 3 of 10 2 ownership ofthe ho uses theyforeclose upon and will then put them back on the market to resell them This will cause an increase in the supply ofhomes availablefor sale and the supply curve shifts to the rightfrom 1 to 2 The price ofhouses will drop even more to P3 However we do not know what happens to the quantity of ho uses sold The decline in demandfor houses puts downward pressure on the quantity of ho uses sold the increase in the supply of houses puts upward pressure on the quantity ofhouses sold Thus lacking more information on the relative sizes ofthe changes in demand and supply ofho uses the net effect on the quantity ofho uses sold is ambiguo us If as shown below the decrease in demand is larger than the increase in supply the equilibrium quantity decreases If the decrease in demand is smaller than the increase in supply the equilibrium quantity increases If the changes in demand and supply are the same size the equilibrium quantity remains the same Your graph may look different than this graph it depends upon the relative sizes ofthe changesyou drew in demand and supply Pn39ce of Housing 2 points total To understand the economy39s current woes we need some shared basic knowledge You will need to use the internet to find answers to some of these questions Cite your source a What is a FICO score List three 3 things someone could do that would increase their FICO score The FICO score represents an individual39s credit rating and helps creditors determine an applicant39s credit worthiness and decide whether or not to approve a loan FICO scores typically rangefrom 300 to 850 with a higher score translating into lower interest rates There are fi ve key factors used to calculate a borro wer39s creditscore 1 Forms of credit used 2 NewCredit 3 Length of credit history Department of Economics Spring 2011 University of California Berkele Economics 1 Problem Set 1 Suggested Solutions Page 4 of 10 4 Balance owed 5 Payment history Looking at each ofthese vefactors in turn ways to increase a FICO score are 1 Forms of credit used Using creditfor only a short time not opening a lot ofnew accounts too quickly and not closing unused credit cards as a shortterm strategy could raise yo ur F C 0 score 2 NewCredit Applyfor and open new credit accounts only as needed Opening acco untsfor the purpose of providing a better credit picture won 39t raise yo ur FICO score and in so me instances may even lo weryo ur score 3 Length ofcredit history The impact ofpast credit problems onyo ur FICO scorefades as time passes and as recentgood payment patterns show up onyo ur credit report A good FICO score weighs any credit problems against the positive information thatsaysyou39re managing your credit well 4 Balance owed Pay offdebt rather than move it aroundfrom one credit card to another The most effective way to increase a FICO score in this area is by paying down total revolving credit card debt managing credit cards responsibly and keeping balances well under the credit limit In general having credit cards and installment loans and making timelypayments will raise your FICO score 5 Payment history Paying bills on time have an impact on FICO score Delinquentpayments even ifonly afew days late and collections can have a major negative impact on your FICO score The more months you are on time whenyou payyour bills after one or more times ofbeing late the moreyo ur FICO score should increase Sources http wwwmyficocomz Defaultaspx I I httD WWW nu w lur rnm mortgage olnccnrvncn b What is a mortgage What is an adjustable rate home mortgage A mortgage is a loan secured by real property A ho meb uyer or builder can obtain nancing a loan either to purchase or secure against the propertyfrom afinancial institution such as a bank either directly or indirectly through intermediaries An Adjustable Rate Mortgage ARM is a mortgage product with an interest rate that is adjusted based on market factors As a result the mortgage paymentcan increase or decrease over the life of the mortgage For example a oneyearARM with a 30year term would have an interest rate thatvaries eachyear The lender will add a margin eg 2 75 points to a pegged lo wrisk interest rate eg a oneyear Treasury bill interest rate Sources t answersusa ov s stem selfservicecontrollerCONFIGURATION1000ampPARTITION ID1ampCMDVIE W ARTICLEampARTICLE ID10096ampUSERTYPE1ampLANGUAGEenampCOUNTRYUS httD umvurr i lqnnkrnm in39 w uinnrese 39 quotIncmrvhtm c What is home equity What is a home equity line of credit HELOC Home equity is the current market value ofa home minus the outstanding mortgage balance It is essentially the amount ofownership that has been built up by the holder ofthe mortgage through payments and Department of Economics Spring 2011 University of California Berkele Economics 1 Problem Set 1 Suggested Solutions Page 5 of 10 appreciation A HELOC is a unique kind of second mortgage where the interest rate adjusts typically monthly There is a drawperiod during which the HELOC behaves like a credit card where the securityfor the note isyour home You can pay it off pull more moneyout or make partial use ofthe total available money at any point Once the draw period ends the mortgage behaves like an adjustable rate mortgage that is amortized over a certain number ofyears The monthlypaymentis typically based on a percentage ofhow muchyou have borrowed rather than a setamortization schedule Sources http wwwinvestorwordscom 5 605 homeequityhtml httn ummrquot 39 I unccnrv tmh httD I 39 39 cnm 1 39k 139 Wiew d Use an online mortgage calculator to determine the answers to these questions I In 2006 a homeowner borrowed 400000 on a 525 mortgage to buy a house The terms were 45 percent for the rst 5 years interest only I In 2011 after 5 years the interest rate resets to 8 percent and the homeowner must begin repaying the principal What is the initial monthly payment What is the new monthly payment after 5 years What is the increase in percentage terms in the monthly payment Generally in the United States interest on mortgages is compounded monthly and homeowners pay monthly as well This means that the interest is calculated and added to the amount owed each mont For thefirstfiveyears you are paying interest only The monthly interest rate is 0 04512 or 0375 The interest each month is 40000004512 1500 The initial payment is therefore 1500 a monthfor the first 5 years After 5years you still owe 400000 becauseyou have notpaid any ofthe principal Now the new annual interest rate is 8 You are required to pay offthe loan in 25years andyou will be paying the same amount each month How do we calculate this You canfind a derivation andformula here httpenwikipediaorgwikizFixed rate mortgage oryou can simply use an online mortgage calculator There are many such calculators All will give the same answers We used 1 I f httpwww bankrc39t 39 a a w a I This is equivalent to a llfixed rate mortgage with a term of25years a principal of400000 and an interest rate of8 We nd that the payment is 308726 1 month which is an increase of10582 in monthly pay You can calculate this as 308726 15001500 10582 This sort ofdo ubling ofmonthly payments is onefactor thatgot a lot ofhomeowners in nancial trouble They could afford to pay 1500 a month but their incomes just couldn t support paying 3087 a month Other homeowners did have enough income when they took out the loan to pay the higher monthly amount but when the recession hit in 2007 they lost theirjob or lost income and couldn t keep up with the payments When someone doesn t pay their mortgage the bank has the right to foreclose upon the loan and take back ownership ofthe property 3 1 point total For each statement is it a positive or a normative statement Brie y explain why Department of Economics Spring 2011 University ofCalifornia Berkeley Economics 1 Problem Set 1 Suggested Solutions Page 6 of10 Recall that positive economics attempts to quotunderstand behavior and the operation ofeconomic systems without making judgments about whether the outcomes are good or bad It strives to describe what exists and h it works In contrast normative economics looks at the quotoutcomes of economic behavior and asks whether they ood or bad and whether they can be made better Normative economics involves judgments and prescriptionsfor courses ofaction Case Fair and Oster p 10 a The earthquake in Haiti destroyed much of Haiti s infrastructure which should lower economic growth in Haiti 39 39 positive 39 iaeaso 39 l quot quot what will 1 pp 39 h l quot There nr quot0 i Idnm quott made to whether it is good or quotbadquot in The developed world should provide aid to Haiti to help it rehuild its infrastructure This is a normative statement because it is stating what should or shouldn t be done based on judgments the author made that are notpart ofbasic positive economic reasoning 4 1 points total A country can produce two types of output food and agricultural implements amp machinery raw a production possihilities frontier at the right with food F on the vertical axis and agricultural implements amp machinery M on the horizontal axis Lahelyour curve PPF Mark a point A on the graph that corresponds to an economy using its resources e ficiently and producing mostlyfood and Very little agricultural implements amp machinery Mark a different point B on the graph that corresponds to an eco using its resources me iciently and producing mostly agricultural implements amp machinery and Very littlefood Food Machines in The economy is initially at a point like A on your graph The government of this country implements an effective policy that encourages farmers to purchase more agricultural implements Department of Economics Spring 2011 University of California Berkele Economics 1 Problem Set 1 Suggested Solutions Page 7 of 10 and machinery What effect will this policy have on the economy Illustrate the effects of the policy on your graph Ifthe government is able to implement an effective policy farmers will increase their demandfor machinery you can think of this as a shift in preferences induced by government policy marketing advertising cajoling whatever In response to the increase in demand the economy would shift resources to producing more machinery More resources allocated to machinery production means fewer resources allocated to food production less food can be produced The economy would produce less food and more machines This is illustrated bya movementalong the PPF to A A plow or tractor can be used to producefood but can t be used to produce other plows or tractors Thatis the increase in agricultural machinery increases the resources available for production of food but doesn t change the quantity or productivity ofresources available to produce machines This is shown as an asvmmetric shift in the PPF More food can be produced with the available resources but the maximum quantity ofmachines that can be produced is unchanged PPF illustrates Food hlachines In the long run the economy can produce morefood ifit has more machines a pointsuch asA r H Should governments encourage their country39s farmers to purchase more agricultural implements and machinery or should the government seek outside international aid that could provide farmers with that machinery Does your answer depend on whether the country is relatively rich or relatively poor Explain your answers This is a normative question Any time you are asked a normative question you mustfirst state what the goal is that we are trying to achieve Whether the government should encourage the farmers to purchase domestically produced machinery or not depends in part on the goal In order to get more production ofmachines resources are reallocated awayfrom food production So ifthe Department of Economics Spring 2011 University of California Berkele Economics 1 Problem Set 1 Suggested Solutions Page 8 of 10 machines are produced domestically there has to be a period where lessfood is produced in order to produce more machinery As shown in lecture on February 7 one consequence of this reallocation ofresources would be an increase in the price offood If the government s goal is to avoid increased prices offood then seeking international aid would allow an increase in ability to producefood without the intermediate rise infoodprices On a more dire basisfor a verypoor country that is able to producejust enoughfood tofeed its people lessfood may mean that some people will starve Again ifthe goal is to avoid starvation the government could seek outside aid that could supply the machinery Again in this case there could be an increase infood production that would not have to come at the expense ofa short term shortage offood For a relatively rich country such as the United States a reallocation of resources away from food toward machine production would be unlikely to lead to food riots or starvation Ifthe goal is to letmarketforces move the economy to the most efficient outcome then encouraging farmers to purchase the machinery rather than seeking outside aid would be chosen As an aside it s rather hard to even imagine thatany other country would even offer aid to a country as rich as the United States in order to enable itsfarmers to buy machinery 5 Taylor and Morgan are a couple who are about to adopt a baby They are trying to decide who should be the stayat home parent They are both able to work producing consumption units CUquot and they are both able to care for the baby and the home producing homemaking units HUquot In one week Taylor can produce 5000 consumption units or 2000 homemaking units or amix of the two I In one week Morgan can produce 3000 consumption units g 3000 homemaking units g a mix of the two I For both Taylor and Morgan their individual trade offs between CU and HU are constant regardless of how they allocate their time Currently Taylor is producing 2500 consumption units M 1000 homemaking units per week while Morgan is producing 1500 consumption units M 1500 homemaking units per week a Fill in the table at the right showing the opportunity costs for Taylor and for Morgan Show your work here or in the table Opp Cost of1 Opp Cost of1 Homemaki g unitl HU Z consumption unitl CU Z Morgan 3000 30001 CU 3000430001 HU Taylor 5000 200025 CU 20004500004HU Calculation Example Morgan 5 HU opportunity cost amount of units of CU Morgan can produce amount ofunits ofHU Morgan can produce b Who has the absolute advantage in the production of HU Absolute advantage is when one economyperson can produce some output withfewer resources than another Equivalently absolute advantage is when one economyperson can produce more output with the same amount of resources than can the other economyperson In our case Morgan has the absolute advantage in the production ofHU Morgan can produce 3000 HU per week whereas Taylor can produce only2000 HUper week Who has the absolute advantage in the production of CU Department of Economics Spring 2011 University of California Berkele Economics 1 Problem Set 1 Suggested Solutions Page 9 of 10 Taylor has the absolute advantage in the production ofCU Taylor can produce 5000 CU a week whereas Morgan can produce only3000 CU per week c Who has the comparative advantage in the production of HU Comparative advantage in this setting is when one person can produce the output with lower opportunity cost than can the other person Morgan has the comparative advantage producing HU because Morgan only needs to give up producing 1 consumption unit CU when producing 1 homemaking unit HU whereas Taylor has to give up producing 25 CU to produce 1 HU Who has the comparative advantage in the production of CU Taylor has the comparative advantage in producing CU because Taylor only needs to give up producing 04 HU when producing 1 CU whereas Morgan has to give up producing 1 HU to produce 1 CU d Morgan and Taylor decide who will work and who will be the stayathome parent What do they decide In one week how many homemaking units and how many consumption units will they produce in total What are the gains from trade that is compared with the initial total production how many additional HU and additional CU will Morgan and Taylor collectively produce when they completely specialize and then trade In terms ofproductive efficiency Morgan will stay athome and Taylor willgo to work Each will eXploithisher comparative advantage and specialize in producing only one ofgoods Originally they produced together 4000 CU units 2500 CUfrom Taylor and 1500 CUfrom Morgan 2500 HU units 1000 HUfrom Taylor and 1500 CUfrom Morgan Morgan will produce homemaking units and Tavlor willproduce consumption units In total they willproduce 3000 homemaking units and 5000 consumption units The gains from trade are CU units 30002500500 CU HU units 500040001000 HU e Unexpectedly Morgan is offered a new job Morgan can now produce 7500 consumption units g 3000 homemaking units g a mix of the two Should Morgan and Taylor continue to specialize and trade or should each of them produce a mix of consumption units and homemaking units Explain Opp Cost of1 Opp Cost of1 Homemaking unit quotHUquot consunlEtion unit quotCUquot Morgan 7500 300025 3000 750004 Taylor 5000 200025 2000 500004 The fo ur necessary conditions for specialization and trade are 1 Information about each other 2 Different opportunity costs 3 Relatively cheap transportation costs Department of Economics Spring 2011 University of California Berkele Economics 1 Problem Set 1 Suggested Solutions Page 10 of 10 4 A legal way to trade In this scenario they both have the same 0 ortuni cost and therefore specialization and trade will not increase the total amount ofhomemaking units and consumption units that they can produce There are no gainsfrom trade when the opportunity costs are the same Morgan and Taylor may decide to specialize and trade or they may decide theyshould both workpart time andparentpart time sharing responsibilityfor producing homemaking units and consumption units Their decision about what to do won t be based on llwhat decision will maximize our total 39 39 39 and r 39 units h aquot quoth r decision specialize and trade or each produce a miX willyield the same total ofHUamp CU
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