Problem 1.

1 - Budget lines

Problem: Answer:

Suppose that Russ has budgeted $20 a month to buy candy bars,
music downloads, or some combination of each. If Russ buys
only candy bars he can obtain 40 bars a month; if he buys only
downloads, he can buy 20 a month.
a. What is the price of a candy bar?
b. What is the price of a music download?
c. What is the opportunity cost of a music download?
d. What is the opportunity cost of a candy bar?
e. Would the opportunity cost of each good change if
Russ decided to increase his monthly budget to $30 for
the two items?
a. The price of a candy bar is 50 cents. This is found by
dividing the $20 budget by the 40 bars he can obtain
per month. $.50 = $20/40.
b. The price of a music download is $1. This is found by
dividing the $20 budget by the 20 downloads he can
obtain per month. $1 = $20/20.
c. The opportunity cost of 1 more music download is the
number of candy bars given up to get it. That number
is 2. The purchase of 1 more music download at $1 per
download requires the sacrifice of 2 candy bars at 50
cent each. 2 = $1/$.50.
d. The opportunity cost of 1 more candy bar is ½ (= .5)
music downloads. .5 = $.50/$1.
e. No, the opportunity cost would not change because the
prices of the two goods have not changed. Russ simply
can either buy more candy bars and/or music
downloads than before. But the opportunity cost of
music downloads remains 2 candy bars; the
opportunity cost of candy bars remains ½ (= .5) music
downloads.

Problem: Answer:

Suppose that a nation's production possibilities can be a. The greatest amount of food is 16 units, achieved by
represented by the table below: producing at alternative E. At this point, all resources
are devoted to food production and none to clothing
production. Clothing production is zero.
b. At C, 8 units of food and 14 units of clothing are
being produced. By moving to alternative D, 4
Production Alternatives additional units of food are produced at the cost of 6
Products A B C D E units of clothing. Each of the next 4 units of food
Food 0 4 8 12 16 costs 6/4 = 1.5 units of clothing.
Clothing 20 18 14 8 0 c. Moving from alternative C to alternative B, the
economy gains 4 units of clothing at a cost of 4 units
of food. The opportunity cost of the next 1 unit of
clothing is then 4/4 = 1 unit of food.
d. Yes—Starting at alternative A, each successive
a. What is the maximum amount of food this economy
increase in food production requires a larger and
can produce? How much clothing can it produce at this
larger reduction in clothing. Specifically, the
point?
opportunity cost of each successive four units of food
b. If the economy is producing at alternative C, what is
cost 2 (=20–18), 4 (=18–14), 6 (=14–8), and 8 (=8–0)
the cost of one more unit of food?
units of clothing.
c. If the economy is producing at alternative C, what is
e. No—By producing efficiently, the table suggests that
the cost of one more unit of clothing?
the economy can produce 4 units of clothing and 18
d. Is this economy subject to the law of increasing
units of food (alternative B). This is 2 more clothing
opportunity costs? How can you tell?
than is currently being produced, suggesting the
e. Suppose the economy is currently producing 4 units of
economy is inefficient.
food and 16 units of clothing. Is this economy
producing efficiently?
Problem 4.1 - Elasticity of demand
Problem:
Suppose a firm sells 20,000 units when the price is
$16, but sells 30,000 units when the price falls to
$14.
a. Calculate the percentage change in the
quantity sold over this price range using the
midpoint formula.
b. Calculate the percentage change in the price
using the midpoint formula.
c. Find the price elasticity of demand over this
range of prices. State whether demand is
elastic or inelastic over this range.
d. Suppose the firm's elasticity of demand is
constant over a large range of prices. If the
price were to fall another 4%, what should
the firm predict will happen to its sales?
Problem:
Suppose a firm sells 70 units when the price is $6,
but sells 80 units when the price falls to $4.
a. Calculate the firm's revenue at each of the
prices.
b. Use the total-revenue test to determine
whether demand is elastic or inelastic over
this range.
c. Verify your previous answer by calculating
the elasticity of demand using the midpoint
formula.
Answer:
a. The midpoint formula uses the average of the
two quantities as the reference point for
computing the percentage change. In this
example, the percentage change is (30,000 –
20,000)/25,000 = 0.40, or 40%.
b. The percentage change is (16 – 14)/15 =
0.133, or 13.3%.
c. The price elasticity of demand is the ratio of
the percentage change in quantity to the
percentage change in price. In this example,
Ed = 40/13.3 = 3. Since Ed is bigger than one,
demand is elastic.
d. Since Ed = 3, which equals the ratio of the
percentage change in quantity to the
percentage change in price, this can be
rearranged to determine that the percentage
change in quantity is equal to the elasticity of
demand times the percentage change in price.
In this example, sales will increase by 12%.
12% = 3 x 4%.
Answer:
a. Revenue equals price times quantity sold. At
P = $6, revenue equals $420. $420 = $6 x 70.
At P = $4, revenue = $4 x 80 = $320.
b. Revenue falls when the price falls, suggesting
demand is inelastic over this range.
c. Ed = [(80 – 70)/75] / [(6 – 4)/5] = .133/.40
= .33, or 1/3. This is less than one, verifying
that demand is inelastic.
Problem 5.1 - Optimal amount of a public good

Problem: Answer:

Three individuals' demand schedules for a good are a. For a private good, the total quantity
shown in the table below. Assume these are the only demanded is the sum of the quantities
individuals in the society. demanded by each of the three individuals at
a given price. At a price of $13, the total
Lynn Mark Pete quantity demanded is 3: 2 from Lynn, 0 from
P Qd P Qd P Qd Mark, and 1 from Pete. At a price of $11, the
$14 1 $14 0 $14 0 total quantity demanded is 4 + 1 + 3 = 8.
b. The optimal amount occurs where price and
13 2 13 0 13 1
marginal cost are equal. Since marginal cost
12 3 12 0 12 2
is $10, price must be $10. At this price, the
11 4 11 1 11 3 total quantity demanded is 5 + 2 + 4 = 11
10 5 10 2 10 4 units.
9 6 9 3 9 5 c. The marginal benefit of any particular unit is
8 7 8 4 8 6 the sum of the values placed on that unit by
7 8 7 5 7 7 each of the individuals. In this example, the
marginal benefit of the second unit is $35:
a. If this is a private good, what is the total $13 by Lynn, $10 by Mark, and $12 by Pete.
quantity demanded at a price of $13? What is The marginal benefit of the third unit is $12 +
the total quantity demanded at a price of $11? $9 + $11 = $32. The marginal benefit of the
b. Assuming this is a private good whose fourth unit is $11 + $8 + $10 = $29.
marginal cost is constant and equal to $10, d. Comparing marginal benefit to marginal cost,
determine the optimal quantity of the good. the third unit should be provided, as its
c. Now assume this is a public good. What is marginal benefit of $32 exceeds its marginal
the marginal benefit of the second unit of this cost of $30. However, the fourth unit should
good? What is the marginal benefit of the not be provided as its marginal benefit is less
third unit? The fourth unit? than its marginal cost: $29 < $30.
d. If the marginal cost is constant and equal to
$30, determine the optimal quantity of this
public good.
Problem 6.1 - Economic profit

Problem: Answer:

After working as a head chef for years, Jared gave up a. Jared's accounting profit is the difference
his $60,000 salary to open his own restaurant last between total sales revenue and his explicit
year. He withdrew $50,000 of his own savings that costs, or $80,000 in this example. $80,000 =
had been earning 4% interest and borrowed another $590,000 – $510,000.
$100,000 from the bank at a rate of 5%. As the b. Implicit costs include his foregone wages
restaurant space he was leasing had no separate ($60,000), the value of his entrepreneurial
office, Jared converted his basement apartment into skill ($10,000), foregone rent on the
office space. He had previously rented the apartment apartment ($3,600 = 12 x $300) plus the
to a student for $300/month. The following table foregone interest on his savings ($2,000 = .04
summarizes his operations for the past year. x $50,000). These total $75,600.
c. Jared's total economic cost, explicit plus
Total sales revenue $590,000 implicit, was $585,600 = $510,000 +
$75,600. His economic profit is the
Employee wages $120,000 difference between revenue and economic
cost, or $4,400 (= $590,000 – $585,600).
Materials $350,000
Interest on loan $5,000
Utilities $10,000
Rent $25,000
Total explicit costs $510,000

a. What is Jared's accounting profit?

b. Suppose Jared could have used his talents to
run a similar kind of business instead. If he
values his entrepreneurial skill at $10,000
annually, find Jared’s total implicit costs
c. What was Jared's economic profit last year?

Problem: Answer:

The following table summarizes the short-run a.

relationship between a firm's total labor input and its
total output. Labor Total Marginal Average
Input Product Product Product
Labor Total Marginal Average 0 0
Input Product Product Product 1 20 20 20
0 0 2 46 26 23
1 20 3 75 29 25
2 46 4 102 27 25.5
3 75 5 125 23 25
4 102 6 138 13 23
5 125 7 140 2 20
6 138
7 140
8 136
a. Fill in the columns labeled "Marginal
Product" and "Average Product."
b. Over what range of labor input does the firm
experience increasing marginal returns?
Diminishing marginal returns? Negative
marginal returns?
c. Comparing marginal product to average
product, under what circumstances will
average product rise? Under what
circumstances will average product fall?
Problem:
Suppose a firm is currently producing 10 units. It is
spending $100 on fixed costs, $40 on variable costs.
At an output level of 10 units, what is the firm's
current:
a. Total cost?
b. Average fixed cost?
c. Average variable cost?
d. Average total cost?
e. If the total cost of producing 11 units is $147,
what is the marginal cost of the eleventh
unit?
f. Is average total cost rising or falling? How do
you know?
g. Is average variable cost rising or falling?
How do you know?
8 136 -4 17
b.
c. Increasing marginal returns corresponds to an
increasing marginal product of labor.
Marginal product increases through the
addition of the third worker. Diminishing
returns begins with the addition of the fourth
worker, while negative returns appears with
the addition of the eighth worker.
d. Average product will rise provided marginal
product exceeds average product and fall if
marginal product is below average product.
Answer:
a. Total cost (TC) is the sum of total fixed cost
and total variable cost. TC = $100 + $40 =
$140.
b. Average fixed cost (AFC) is the amount of
fixed cost divided by the number of units
produced. AFC = $100/10 = $10.
c. Average variable cost (AVC) is the total
amount of variable cost divided by the
number of units produced. AVC = $40/10 =
$4.
d. Average total cost can be found one of two
ways. It is the ratio of total cost to total
output: ($100 + $40)/10 = $14. It is also the
sum of average fixed cost and average
variable cost = $10 + $4 = $14.
e. Marginal cost is the increase in total cost
associated with the next unit. From part a.,
the total cost of 10 units is $140. Since the
cost of 11 units is $147, the marginal cost of
the eleventh unit is $7 = $147 – $140.
f. Average total cost is falling. This is because
marginal cost ($7) is less than average total
cost ($14). When the cost of the next
(marginal) one is below the average, the
average must fall.
g. Average variable cost is rising. This is
because marginal cost ($7) is more than
average variable cost ($4). When the cost of
the next (marginal) one is above the average,
the average must rise.
Problem 7.1 - Profit maximization: MR = MC approach

Problem: Answer:

Suppose a competitive firm's cost information is as a. Marginal revenue is equal to price, or $9.10
shown in the table below. Its total fixed cost is $9.00. in this instance.
b. The firm will expand production as long as
Average MR exceeds MC and price exceeds average
Marginal Variable Average variable cost. It produces 8 units to maximize
Output Cost Cost Total Cost profits.
0 c. Per-unit profit is equal to average revenue, or
1 $ 8.00 $8.00 $17.00 price, minus average total cost. Per-unit
profit = $9.10 – $8.13 = $.97.
2 7.00 7.50 12.00
d. Total profit is equal to per unit profit ($.97)
3 6.00 7.00 10.00
times the number sold (8). Profit = $7.76.
4 5.00 6.50 8.75 e. MR = price = $7.10. Comparing to MC, the
5 6.00 6.40 8.20 firm produces 6 units. The firm's per unit loss
6 7.00 6.50 8.00 is $7.10 – $8.00 = –$.90. Since this is
7 8.00 6.71 8.00 negative, check to see if price exceeds
8 9.00 7.00 8.13 average variable cost. At 6 units of output,
9 10.00 7.33 8.33 AVC = $6.50, which is indeed less than
10 11.00 7.70 8.60 price, so the firm should produce 6 rather
than shut down. The firm's total loss is $.90 x
6 = $5.40. The firm would lose an amount
a. Suppose the firm sells its output at a price of
equal to its fixed cost ($9.00) if it were to
$9.10. What is the firm's marginal revenue
shut down.
(MR)?
f. Marginal revenue is $6.10. This is lower than
b. Compare MR to marginal cost (MC) to
the lowest possible value of average variable
determine the firm’s profit maximizing (loss-
cost, so the firm should shut down, losing an
minimizing) output level. Be sure to check
amount equal to its fixed cost, or $9.00.
whether or not the firm should shut down.
c. What is the firm's per-unit profit (loss) at this
output level?
d. What is the firm's total profit (loss) at this
output level?
e. Repeat parts a. through d. assuming the price
has fallen to $7.10.
f. Repeat again assuming the price has fallen to
$6.10

Problem: Answer:

A competitive firm's short-run cost information is a. At prices below $6.40, the price is less than
shown in the table below. minimum average variable cost, so the firm
shuts down, producing zero. For other prices,
Average the firm produces at the output corresponding
Marginal Variable Average to MR = MC. The table is completed below:
Output Cost Cost Total Cost
0 Quantity
1 $ 8.00 $8.00 $17.00 Quantity Supplied,
2 7.00 7.50 12.00 Supplied, 2000 Quantity
3 6.00 7.00 10.00 Price This Firm Firms Demanded
4 5.00 6.50 8.75 $5.25 0 0 20,000
5 6.00 6.40 8.20 $6.25 0 0 18,000
6 7.00 6.50 8.00 $7.25 6 12,000 16,000
7 8.00 6.71 8.00 $8.25 7 14,000 14,000
8 9.00 7.00 8.13 $9.25 8 16,000 12,000
9 10.00 7.33 8.33 $10.25 9 18,000 10,000
10 11.00 7.70 8.60
b. Each value in the third column is 2000 times
the value in the second column: total quantity
a. If the market price is $5.25, how much will
supplied in the market is equal to the number
this firm produce? Enter in the second
of firms multiplied by the amount produced
column of the table below. Repeat for the
by the typical firm.
remaining prices shown in the table.
c. Equilibrium quantity is 14,000 units, where
market quantity demanded equals quantity
Quantity supplied.
Quantity Supplied, d. Equilibrium price is $8.25, corresponding to
Supplied, 2000 Quantity the equilibrium quantity.
Price This Firm Firms Demanded
e. At a market price of $8.25, the typical firm
$5.25 20,000 produces 7 units. Its revenue is $8.25 x 7 =
$6.25 18,000 $57.75. Its total cost is $56, equal to its
$7.25 16,000 output times its average total cost: $56 = 7 x
$8.25 14,000 $8. Its profit is the difference between total
$9.25 12,000 revenue and total cost: profit = $57.75 – $56
$10.25 10,000 = $1.75. Alternatively, its profit is equal to
output times the difference between price and
b. Fill in the next column to determine the average total cost: 7 x ($8.25 – $8.00) =
market supply in this industry, assuming $1.75
there are 2000 identical firms in the industry.

Further suppose that the market demand

schedule for this industry is given by the last
column in the table.

c. What is the equilibrium quantity in this

market?
d. What is the equilibrium price in this market?
e. What are the resulting output, revenue, cost,
and profit of the typical firm?
Problem 8.1 - Monopoly price and output

Problem: Answer:

Suppose a monopoly's demand schedule is given by a. Total revenue is the product of output and
the first two columns of the following table. Its total price. For example, if the firm wishes to sell
cost of production is given in the next column. two units, it sets a price of $18 and its total
revenue is 2 x $18 = $36. The completed
Total Total table is shown below.
Output Price Cost Revenue MC MR
0 $24 $10 Total Total
1 21 14 Output Price Cost Revenue MC MR
2 18 20 0 $24 $10 $0
3 15 28 1 21 14 21 $ 4 $21
4 12 38 2 18 20 36 6 15
5 9 50 3 15 28 45 89
4 12 38 48 10 3
a. Fill in the Total Revenue column by 5 9 50 45 12 –3
computing the firm's total revenue associated
with each output level.
b. By comparing total cost and total revenue, b. At one unit of output, profit is the difference
find the output level that maximizes the between total revenue and total cost: $21 –
firm's profit. $14 = $7. As output is increased from 2 to 5,
c. What price should the firm set to achieve profit becomes $16, $17, $10, and –$5. Profit
maximum profit? is greatest at an output level of 3 units.
d. Complete the final two columns to verify that c. According to the demand schedule, price
the same conclusions are reached using the must be set at $15 to sell three units.
MR = MC rule. d. Comparing MR to MC, output should be
expanded to produce the third unit, but not the
fourth. The marginal revenue of the fourth
unit is $7 less than its marginal cost, and will
cause profit to decrease.

Problem: Answer:

Suppose a price-discriminating monopoly has a. The completed table is shown below.

segregated its market into two submarkets and can
prevent resale between the two. Assume that its Total
marginal cost is constant and equal to its average Output Price Revenue MR
total cost of $8. The firm's demand schedule for the 0 $24 $0
first group is given by the first two columns of the 1 22 22 $22
following table.
2 20 40 18
3 18 54 14
Total
4 16 64 10
Output Price Revenue MR
5 14 70 6
0 $24
6 12 72 2
1 22
7 10 70 –2
2 20
3 18 8 8 64 –6
4 16
5 14 b. Using the MR = MC rule, profit is
6 12 maximized at 4 units of output, implying a
7 10 price of $16.
8 8 c. The completed table is shown below.

a. Find the firm's total revenue schedule for this Total

submarket, entering the data into the table Output Price Revenue MR
where indicated. Use these data to determine 0 $33 $0
the marginal revenue schedule in this 1 30 30 $ 30
submarket. 2 27 54 24
b. What output level and price will maximize 3 24 72 18
the firm's profit in this submarket? 4 21 84 12
c. The firm's demand schedule for the second 5 18 90 6
group is given by the first two columns of the 6 15 90 0
following table.
7 12 84 –6
8 9 72 –12
Total
Output Price Revenue MR
d. Comparing MR and MC, maximum profits
0 $33
are achieved by selling 4 units in this
1 30 submarket as well, but at a price of $21 as
2 27 shown in the demand schedule.
3 24 e. Since the price is higher in the second
4 21 submarket, demand is more elastic in the first
5 18 submarket.
6 15 f. The firm earns revenue of 4x$16 = $64 in the
7 12 first submarket and revenue of 4x$21 = $84
8 9 in the second. Its total revenue is then $64 +
$84 = $148. Its total cost is 8x$8 = $64, so its
total economic profit is $148 – $64 = $84.
d. Find the firm's total and marginal revenue
schedules in this second submarket. What
output level and price will maximize the
firm's profit in this submarket?
e. Based on these prices, which submarket has
the more elastic demand?
f. What is this firm's total economic profit?
Problem 10.1 - Labor demand

Problem: Answer:

Suppose a firm's short-run total product schedule is a. Marginal product is the addition to total
given in the table below. It sells its output in a output associated with the next worker. Total
competitive market for $1.50 each. output rises from 0 to 8 with the addition of
the first worker, so the marginal product is 8.
Marginal b. Marginal revenue product is the increase in
Total Marginal Revenue total revenue associated with the next worker.
Labor Product Product Product For a competitive firm, this is product price
0 0 times marginal product. The marginal
1 8 revenue product of the first worker is $1.50 x
8 = $12.
2 18
c. To determine the profit-maximizing level of
3 29
employment, it is necessary to find marginal
4 39 revenue product and compare it to the wage
5 47 rate. The completed table is below:
6 52
7 53 Marginal
8 53 Total Marginal Revenue
Labor Product Product Product
a. What is the marginal product of the first 0 0
worker? 1 8 8 $12.00
b. What is the marginal revenue product of the 2 18 10 15.00
first worker? 3 29 11 16.50
c. Suppose the wage is $7. How many workers
4 39 10 15.00
will this firm hire?
5 47 8 12.00
d. If the wage rises to $9, how will the firm
adjust its employment? 6 52 5 7.50
e. Alternatively, suppose the firm sells its 7 53 1 1.50
output according to the following demand 8 53 0 0.00
schedule:
d. Maximum profits are obtained by hiring only
Marginal those workers whose marginal revenue
Total Product Total Revenue products exceed the wage. In this example, 6
Labor Product Price Revenue Product workers are hired.
0 0 ---- e. The 6th worker is no longer profitable.
1 8 $3.50 Reducing employment by 1 worker would
save $9 in wages and "costs" the firm only
2 18 2.80
$7.50 in lost revenue. Maximum profits are
3 29 2.30 obtained with 5 workers.
4 39 1.90 f. The completed table is shown below: Total
5 47 1.65 revenue is product price times total product
6 52 1.50 and marginal revenue product is the change
7 53 1.40 in total revenue from hiring an additional
worker.
f. Fill in the remaining two columns of the
table. How many workers will be hired at a Marginal
wage of $7? Total Product Total Revenue
Labor Product Price Revenue Product
 0 0 ---- ---- ----
1 8 $3.50 $28.00 $28.00
2 18 2.80 50.40 22.40
3 29 2.30 66.70 16.30
4 39 1.90 74.10 7.40
5 47 1.65 77.55 3.45
6 52 1.50 78.00 .45
7 53 1.40 74.20 –3.80

g. Comparing MRP to the wage, the firm

maximizes profits by hiring 4 workers.

Problem: Answer:

Suppose a firm hiring from a competitive labor a. It will hire 5 workers. The marginal revenue
market has the marginal revenue product schedule as product of the sixth worker ($12) is less than
given in the first two columns of the table below: his or her wage rate ($16). Therefore, hiring
the sixth worker will reduce profits.
Marginal Total Marginal b. Total labor cost is found as the wage rate
Revenue Wage Labor Labor times the number of workers. The total labor
Labor Product Rate Cost Cost cost of one worker is $6, while two workers
0 $0 cost $8 x 2 = $16. The marginal labor cost of
1 20 $6 the second worker is the change in total labor
cost, or $10: $16 – $6 = $10.
2 24 8
c. Three workers cost $10 x 3 = $30. The
3 28 10
marginal labor cost is the difference between
4 24 12 this cost and the cost of hiring just 2: $30 – 16
5 18 14 = $14. The complete table is below. All
6 12 16 numbers in the fourth column are the product
7 6 18 of the wage rate and the corresponding
number of workers; marginal labor cost is the
a. If this firm can hire labor competitively at a difference in successive total wage costs.
wage of $16, how many workers will it hire?
Marginal Total Marginal
Alternatively, suppose the firm has Revenue Wage Labor Labor
monopsony power such that it must pay $6 to Labor Product Rate Cost Cost
hire the first worker and must increase the 0 $0 $0
wage rate by $2 to attract each successive 1 20 $6 6 $6
worker, as shown in the third column of the 2 24 8 16 10
table above. 3 28 10 30 14
4 24 12 48 18
b. What is the total labor cost of hiring one
worker? Of two workers? What is the 5 18 14 70 22
marginal labor cost of the second worker? 6 12 16 96 26
c. What is the total labor cost of hiring three 7 6 18 126 30
workers? What is the marginal labor cost of
the third worker? Fill in the remainder of the d. The firm expands employment until the
final two columns. marginal revenue product no longer exceeds
d. What level of employment maximizes this
firm's profit?
e. What wage rate will the firm pay to attract
the profit-maximizing number of workers?
Compare this outcome with that in part a.
the marginal labor cost. It hires the fourth
worker ($24 > $18), but not the fifth ($14 <
$22).
e. Note that the wage paid to attract the sixth
worker is $16, the same as for the competitive
firm hiring the profit-maximizing amount of
labor. For the monopsony, only four workers
are demanded. To attract exactly four
workers, this firm pays the corresponding
wage rate, or $12. Relative to an otherwise
identical competitive firm, a monopsony hires
fewer workers at a lower wage rate.
Problem 11.1 - Lorenz curve
Problem:
Suppose society consists of 5 households whose
incomes are $8,000, $12,000, $20,000, $40,000, and
$80,000.
a. What is the total income in this society?
b. What percentage of total income is earned by
the poorest quintile?
c. What percentage of total income is earned by
the richest quintile?
d. What percentages of total income are
received by the second, third, and fourth
quintiles?
e. Construct a Lorenz curve for this five-
household economy.
Answer:
a. Total income in the society is $8,000 +
$12,000, $20,000 + $40,000 + $80,000 =
$160,000.
b. In this example with only one household, the
poorest quintile consists only of the lowest-
income household, that earning $8,000. As a
percentage of total income, this is 5%:
8,000/160,000 = .05, or 5%.
c. The richest quintile consists only of the
highest-income household, that earning
$80,000. This is half, or 50%, of the total
income of $160,000.
d. Second quintile: $12,000/$160,000 = 7.5%
Third quintile: $20,000/$160,000 = 12.5%
Fourth quintile: $40,000/$160,000 = 25%
e. The Lorenz curve plots the percentage of
total income against the cumulative
percentage of households. The values are
below:
Households Income
0% 0%
20% 5%
40% 12.5%
60% 25%
80% 50%
100% 100%
f. Each value in the Income column is
constructed by accumulating the quintile
shares. For example, the poorest 60% of
households are comprised of the bottom three
households whose shares are 5%, 7.5%, and
12.5%, for a cumulative total of 25%.
Problem 12.1 - Gains from specialization

Problem: Answer:

The production possibilities tables for Malaysia and a. In Malaysia, 5 more units of clothing can be
the United States are shown in the tables below. produced by giving up 3 units of grain. The
Before specialization and trade, Malaysia's optimal opportunity cost of clothing is then 3/5 = 0.6
product mix is given by alternative C while optimal units of grain. The opportunity cost of grain
production in the U.S. is alternative J. is 5/3 = 1.67 units of clothing.
b. In the U.S., 8 additional units of clothing can
Malaysia Production Possibilities be produced by giving up 10 units of grain.
Product A B C D E The opportunity cost of clothing is then 10/8
Clothing 20 15 10 5 0 = 1.25 units of grain. The opportunity cost of
grain is 8/10 = 0.8 units of clothing.
Grain 0 3 6 9 12
c. Malaysia has a lower opportunity cost of
clothing while the U.S. has a lower
U.S. Production Possibilities opportunity cost of grain. Malaysia should
Product G H I J K specialize in clothing and the U.S. in grain.
Clothing 32 24 16 8 0 d. Prior to specialization, the two countries'
Grain 0 10 20 30 40 combined clothing production was 18 (10 in
Malaysia and 8 in the U.S.). Total grain
a. What is Malaysia's marginal opportunity cost production was 36 (6 + 30). With complete
of clothing? Of grain? specialization, Malaysia will produce 20
b. What is the U.S. marginal opportunity cost of units of clothing (a gain of 2 over the
clothing? Of grain? previous combined total) and the U.S. 40
c. Should these two countries specialize? If so, units of grain (a gain of 4 units.)
in what products should they specialize? e. The terms of trade can vary anywhere
d. What is the total gain in production that could between the pre-trade opportunity cost
be achieved through specialization? ratios. That is, anywhere between 1 unit of
e. What are the limits on the terms of trade clothing for 0.6 units of grain and 1 unit of
between the two nations? clothing for 1.25 units of grain.
f. Following specialization, suppose Malaysia f. Following trade, Malaysia would have 10
exports 10 units of clothing to the U.S. in units of clothing (production of 20 minus
exchange for 10 units of grain. What are the exports of 10) and 10 units of grain.
gains from trade for each country? Compared to its pre-trade choice at C, it has
gained 4 units of grain. The U.S. would
obtain 10 units of clothing and retain 30
units of grain (production of 40 minus its
exports of 10.) This is a gain of 2 units of
clothing compared to its pre-trade position.