BUSS1040

Tutorial 2 Week 2

Exercises to be covered in the tutorial

1. (Concept: Production Possibility Curve) A great example of trade-offs comes from the life of a full-
time student. Such students can be imagined as having only two uses of their time—studying and
socializing—and two outputs from those uses—knowledge acquired and social satisfaction. If a
student is efficient, he or she cannot increase the amount of knowledge acquired at university without
giving up social satisfaction.

(a) Provide a definition and draw the production possibility frontier.

(b) Show a point in which the student is not producing efficiently (point x). Why does this
inefficiency occur in x?
(c) Show a point that is unattainable given the current state of “technology” (point z). Why is z
unattainable?
(d) Show a point where the student is producing efficiently (point y). Why is y efficient?
(e) What is the opportunity cost of an extra unit of knowledge? What is the OC of another unit of
social satisfaction? Illustrate this by linking it to movements along the PPF.
(f) This production possibility frontier can shift out along each axis. A speed-reading course
moves the curve out along the axis for knowledge acquisition, allowing the student to obtain
both more knowledge and more social satisfaction (because some time that can be saved from
studying can be shifted to socializing).
List one other example of a technical improvement that shifts the frontier out along the
learning axis, and one that shifts it out along the social satisfaction axis. Illustrate this in the
diagram by drawing a new production possibility curve.

2. Billy can produce either good x (cake) or good y (donuts). In one hour he can produce 4 units of
cake. Alternatively, in one hour he can produce 2 donuts. Sally can produce either 6 units of cake or 2
donuts in an hour.

(a) What is absolute advantage? Who has absolute advantage in producing cake and which party
has absolute advantage of producing donuts?

(b) What is comparative advantage? Which party has the comparative advantage in producing
cake, and which party in making donuts?

(c) If each party has 10 hours in which they can work, draw the production possibilities frontier
for each party. What does the slope of each production possibilities frontier represent?

(d) What is the maximum price that Billy is willing to pay for a unit of cake? What is the minimum
price that Sally would be willing to sell a unit of cake for a donut?

(e) What is the minimum price that Billy would be willing to sell a donut for? What is the
maximum price that Sally would be willing to pay for a donut?

(f) Will Billy and Sally trade? If yes, at what prices?

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3. Discussion question

(Concept: Opportunity cost) At a party recently one of my colleagues mentioned that his 14-year-old
daughter was babysitting for her 6- and 3-year-old siblings so that her parents could be at the party. I
asked how much they were paying the teenager, and he answered that she was being paid nothing. He
noted, however, that if his wife and he wanted the daughter to babysit, but she was called by someone
else to babysit for pay, they would match the market rate that she would have received outside the
house. My colleague is paying the girl her opportunity cost. When she has an alternative babysitting
job that pays, she receives a rate of pay at home equal to her opportunity cost—what she was offered
for babysitting elsewhere. When she has no alternative job, she is again paid the opportunity cost of
her time—which is then zero! (Only an economist would do something like this) (from “Economics is
Everywhere” by Daniel Hamermesh)

(a) If you were in the daughter’s position, would you settle for what you would be paid elsewhere?
Are there economic reasons why you might be willing to settle for less than others would pay for
your babysitting services?
(b) Are there economic reasons why you would want to insist on—and get—your parents to pay
more than others would pay for your babysitting services?

4. (Concept: Opportunity cost) Pablo and Lisa give up their current jobs to set up their own
consultancy firm. Each earns $60,000 per year in their current jobs. To set up the business, they must
hire an office space for which they pay $20,000 per year. They also need to hire a research assistant
for their business. The salary cost of the assistant is $50,000 per year. If they decide not to start the
consultancy firm, they would instead deposit the cash in a bank account at an interest rate of 3%. In
the first year of operation Pablo and Lisa expect to earn a revenue of $200,000. What is the economic
cost (i.e. total opportunity cost) of setting up & running the consultancy for one year?

5. (Concept: Correlation and Causation) Give an example of two variables that move together, but that
are otherwise unrelated. Relate your answer to correlation and causation.

Additional exercises

6. (Concept: Growth) Australia can produce two goods – coffee and TVs. Consider two ways in which
the Australian economy can grow: through an increase in population, and through technological
progress. Illustrate both of these changes on a PPF. What is the advantage of the second type of
growth over the former?

7. (Concept: Opportunity cost) The School of Economics needs to find a new building for their School.
They have two options: they could locate the school in an existing building the University owns in
Newtown. Alternatively, the University could build a new building on a suitable site of land in
Parramatta. Some of the University’s administrators suggest that the first option is preferable,
because it does not involve constructing a new building. Assess this decision and compare the two
options. Can you say which one is better? Relate your answer to the concept of the opportunity cost.

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8. (Concept: Comparative Advantage) There are two countries: Australia and the Rest of the World.
Each of the countries can produce either good A or good B. Australia is more productive with respect
to both goods (meaning Australia can produce more of any good with a given amount of resources).
Which statement is not true?

(a) Australia has an absolute advantage in producing both goods.

(b) Only the country that does not have the absolute advantage can benefit from trade.
(c) Comparative advantage determines the patterns of production between the countries.
(d) The opportunity cost of producing good A is good B.

9. (Concept: Opportunity Cost, Absolute and Comparative Advantage) Robinson Crusoe can gather 10
coconuts or catch 1 fish per hour. His friend Friday can gather 30 coconuts or catch 2 fish per hour.

What is Crusoe’s opportunity cost of catching 1 fish?

What is Friday’s opportunity cost of catching 1 fish?
Who has an absolute advantage in catching fish?
Who has a comparative advantage in catching fish?

10. Bob can produce either good x or good y. In one hour he can produce 4 units of good x. Alternatively he
can produce 2 units of good y in that hour. Suzie can produce either 6 units of good x in an hour or 2 units of
good y in an hour.

a. What is absolute advantage? Who has the absolute advantage in producing x and which party has the
absolute advantage of producing good y?
b. What is comparative advantage? Which party has the comparative advantage of producing good x and
good y?
c. If each party has 10 hours in which they can work, draw the production possibilities frontier for each
party. What does the slope of each production possibilities frontier represent?
d. What is the maximum price that Bob is willing to pay for a unit of good x? What is the minimum price
that Suzie would be willing to sell a unit of good x for? What is the minimum price that Bob would be
willing to sell a unit of good y for? What is the maximum price that Suzie would be willing to pay for a unit
of good y?

11. Now reinterpret question 10 with Bob and Suzie: rather than both parties producing goods x and y,
instead consider the situation in which Bob and Suzie undertake tasks x and y at a workplace. Which party
should do task x? Which party should perform task y? What is different about this case than if we are
considering two goods (or services) being traded in the market?