PRINCIPLES OF ECONOMICS – END TERM -ANSWER

DOCUMENT

QUESTION 1

A1. Country B has an absolute advantage in oil production.

A2. Country A has an absolute advantage in growing corn.

A3. Country B has a comparative advantage in producing oil. (Since the opportunity cost of oil in
country b i.e., 0.25 is less that the opportunity cost of oil in country A i.e., 2.5 country B has
comparative advantage.)

A4. Country A has a comparative advantage in growing corn. (Since the opportunity cost of corn
in country A i.e.,0.4 is less than the opportunity cost of corn in country a i.e., 4 country A has
comparative advantage.

A5.

When 100% When 50% TRADE (3 CONSUMPTION

time is time is units of oil
invested invested for 1 unit
corn)
COUNTRY A OIL 20 10 +18 28 UNITS
CORN 50 25 -6 19 UNITS
COUNTRY OIL 40 20 -18 2 UNITS
CORN 10 5 +6 11 UNITS

Since country A purchases 18 units of oil from country B it should sell 6 units of corn to country B
which leaves country A with 28 units of oil and 19 units of corn. While country B will be left with
2 units of oil and 11 units of corn. This shows that only country A is benefitted from the trade.
QUESTION 2

a. Nominal GDP refers to the Gross domestic product of a country at its current market prices.
NOMINAL GDP = ∑ Pi Qi
i where pi is the price of good and qi is the quantity
of good i.

here we have 3 goods, substituting the values of prices and quantities in the formula we get
NOMINAL GDP of 2005 = 10(2000)+4(1000)+1000(1) = $25,000
Thus, nominal GDP of 2005 is $25,000.

NOMINAL GDP OF 2006 = 12(3000) +6(500) +1000(1)= $40,000

Thus, nominal GDP OF 2006 IS $40,000

The total percentage change of nominal GDP from 2005-2006 is 60%

B. Real GDP also known as GDP at constant prices is the gross domestic product of an economy at
base year prices.

Taking 2005 prices as the base year prices the real GDP of 2005 is $25,000.
The real GDP of year 2006 can be calculated by multiplying the quantities produced in 2005 with the
prices of goods in the base year i.e., 2005

REAL GDP OF 2006= 12(2000) +6(1000) +1000(1) = $31,000

Thus, the real GDP of 2006 Is $31,000.

The total percentage change of real GDP from 2005-2006 is 24%

C. Yes, the percentage change is nominal GDP (60%) is greater than the percentage change in real
GDP (24%). This is because the nominal GDP is an unadjusted measure, and it includes inflation. The
rise in prices in 2006 due its inflation will lead a greater percentage change in nominal GDP.
However, the real GPD is adjusted to inflation, and it is based on constant prices which leads to
lesser change in percentage change of real GDP comparatively.

D. The GDP deflator is an indicator that measures the inflation.

GDP DEFLATOR = NOMINAL GDP

────────────── × 100
REAL GDP

Thus,

GDP deflator in 2005 = 25000/25000 (100) = 100.

GDP deflator in 2006 = 40000/31000 (100) = 129.03

The rate of inflation measured by GDP deflator = {(129.03- 100)/ 100} ×100 = 29%

QUESTION 3

a. Budget constraint = w(24-T) Where w is the wage rate

T is the free time per day

Budget constraint after winning the lottery OF RS.5000 = w(24-T) + 5000

We need to note that at each level of free time, my total income (earnings plus the lottery
amount) is rs.5000 higher than before. So, the budget constraint is shifted upwards by Rs.5000—
the feasible set has expanded. The feasible frontier shifted parallelly upward.

b. INCOME EFFECT – Income effect refers to the change in demand for a good or a service due
to the additional income if there is no change in prices or opportunity cost.
SUBSTITUTION EFFECT- substitution effect refers to an effect that occurs only due to the
change in prices or change in opportunity costs at a new utility level.
Substitution effect describes the idea that when the price of a good rises the consumer
tends to substitute it with a cheaper alternative.

c. The additional income earned through lottery increases the choice of free time. However, if
the income effect comes to zero one might end up enjoying the same number of free hours
but will not reduce it. Since lottery is an unearned income, it would only have income effect.
Opportunity cost of free time is not increasing as the wage rate is not changing. Hence the
substitution effect does not apply for this case.
D. Before the change:

Non-wage income = 10 Wage = rs.20 per hour Total available time = 40 hours

After the change:

Non-wage income = 0 wage = 20rs.per hour total time available = 40 hours

In this graph C1 shows the feasible frontier before change.

And C2 shows feasible frontier after change.

QUESTION 4

a. Cement is a production good in building households. Which implies that rise in price of
cement will ultimately lead to rise in price of new houses. As the prices increase the supply
curve will shift leftward. Thus, leading to decrease in equilibrium quantity and increase in
equilibrium price.

here , s is the supply curve before rise in price.

S’ is the supply curve after rise in price
E’ is the equilibrium after rise in price.
D is demand curve.
 b. GDP= C+ I + G+NX(X-M)
Where
C- consumption, I – investment, G- Government spending
NX- net exports (exports- imports)
TATA buying the existing fleet of Air India for Rs. 100 million comes under investment.
Investing is the process of purchasing assets with the expectation that they will provide
income or appreciate in value over time. TATA will now invest more amount in refurbishing
and developing the air India which is also a part of investment. Thus, this transaction as a
whole will bring about an increase the GDP.

C. The percentage change in the amount demanded of a good or service divided by the percentage
change in the price is the price elasticity of demand. The slope of demand curve is the price elasticity
of demand. If change in demand is larger than change in price then the demand curve is said to be
elastic. When the change in demand is lesser than the change in price then the demand curve is said
to be inelastic.

In this case,

The quantity demanded decreased by 30% i.e., percentage change in quantity demanded= -30

The total expenditure on the good increased by 15% i.e., percentage change in price = 15

ELASTICITY OF DEMAND = percentage change in demand / percentage change in price

= -30 / 15 = -2 elasticity of demand is -2

Since the elastic of demand is less than 1 the demand curve is inelastic. That implies that quantity
changes slower than price.

d. Credit constrained households refer to those households whose request for credit
has been rejected by a financial institution. In an economy with more credit-
constrained households, the impact of a recession will be greater. Households with a
high credit constraint are unable to save and borrow money, so when faced with a
recession and their real income falls, consumption falls as well, resulting in a drop in
GDP and an economic downturn that may spiral downwards as consumers lack the
 purchasing power to increase consumer expenditure: thus, the recession will last
longer in this economy. While the impact of recession will be smaller in the economy
with less credit constrained households since they will be able to borrow money and
save, allowing them to maintain the same level of consumption.

5. Cigarette taxes are levied on all tobacco products by various levels of government, with
the ostensible objective of reducing tobacco use or at the very least raising funds for related

health complications.

Consumer surplus: customer surplus is generated when a consumer pay less for a
product or service than they are willing to pay. In this case consumer surplus falls as
consumer pays high price but purchases lesser cigarettes.

Producer surplus: The difference between the minimum amount a producer is willing to
supply goods for and the actual amount he receives when he makes the sale is known as
producer surplus. In this case producer produces lesser output and they receive lower net
price hence the producer surplus falls.

Total surplus: The sum of consumer surplus and producer surplus adds up to total surplus.
Since the producer surplus and consumer surplus both falls the total surplus falls.

Deadweight loss: A deadweight loss is generated when supply and demand are out of
equilibrium, creating a market inefficiency. Since smoking is an addictive habit and
the demand for cigarettes is inelastic. i.e., even large change is prices bring only
little change in quantity demanded. Deadweight loss of inelastic goods is lesser
since the change in quantity is lesser.

5b. Tax lowers the consumption of an unhealthy or bad good. According to a policy
maker the deadweight loss from taxing a good which is “unhealthy” is a positive or
good outcome for the society since it reduces the negative externalities. However, a
consumer might not be feeling the same. According to a consumer deadweight loss
is a negative outcome, since the prices rise making it difficult for them to purchase
the good. A consumer is bothered by the negative consequences of the tax and
does not care about the potential positive outcome that might result from the new
tax revenue.