396 EXCHANGE (Ch.

Jl)

f would it choose the same amount in

For what value o a each
. ate is zero?'----- If a = .55, what Would
period if the interest r ung creatures would want to consume th
r have to be in order that yo e

same amount in each period?

f alee in period 1 equals the total cake earnings 0 f
(c} The total supply O c tures earn no cake in this period Th
all Id t since young crea · ere
o crea ures, d each earns J units of cake, so this total is N 1
are N1 old creatures 8Il . d 2 al th t l 1 .
Similarly, the total supply of cake in peno equ s e ota amount

earned by young creatures. This amount i..'.>---------- --

( d} At the equilibrium interest rate, the to_tal demand of c~e~tures for

period-! cake must equal total supply of penod-1 c~ke, and similarly the
demand for period-2 cake must equal supply. If the mterest rate is r, then

the demand for period-! cake by each old creature is - - - - and the

demand for period-! cake by each young creature is - - - - - - Since

there are N 1 old creatures 8Ild N2 young creatures, the total demand for

period-! cake at interest rater " " " - - - - - - - - - - - - - - -

(e) Using the results of the last section, write an equation that sets the
demand for period-1 cake equal to the supply. _ _ _ _ _ _ _ _ __

Write a general expression for the equilibrium value of r, given

N1, N2, I, and/*. _ _ _ _ __ Solve this equation for the special

case when N1 = N2 and / = /* and a= 11/21.,_ _ _ _ _ _ _ _ _,

(/) In the special case at the end of the last section, show that the in-
terest rate that equalizes supply and demand for period- I cake will also
equalize supply and demand for period-2 cake. (This illustrates Wal-
ras's law.)_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ __
chapter 33 t·- -

Production

Introduction. In this section we explore economywide production pos-

sibility sets. We pay special attention to the principle of comparative
advantage. . T?e princi~le is simply that efficiency suggests that people
should specialize according to their relative abilities in different activities
rather than absolute abilities.

Example: For simplicity, let us imagine an island with only two people
on it, both of them farmers. They do not trade with the outside world.
Farmer A has 100 acres and is able to grow two crops, wheat and hay.
Each acre of his land that he plants to wheat will give him 50 bushels
of wheat. Each acre of his land that he plants to hay will give him 2
tons of hay. Farmer B also has 100 acres, but his land is not so good.
Each acre of his land yields only 20 bushels of wheat and only 1 ton of
hay. Notice that, although Farmer A's land is better for both wheat and
hay, Farmer B's land has comparative advantage in the production of hay.
This is true because the ratio of tons of hay to bushels of wheat per acre
2/50 = .04 for Farmer A and 1/20 = .05 for Farmer B. Farmer A, on the
other hand, has comparative advantage in the production of wheat, since
the ratio of bushels of wheat to tons of hay is 50/2 = 25 for Farmer A
and 20/1 = 20 for Farmer B. The efficient way to arrange production is to
have Farmer A "specialize" in wheat and farmer B "specialize" in hay. If
Farmer A devotes all of his land to wheat and Farmer B devotes all of his
land to hay, then total wheat production will be 5,000 bushels and total
hay production will be 100 tons. Suppose that they decide to produce
only 4,000 bushels of wheat. Given that they are going to produce 4,000
bushels of wheat, the most hay they can possibly produce together will
be obtained if Farmer A devotes 80 acres to wheat and 20 acres to hay
while Farmer B devotes all of his land to hay. Suppose that they decide to
produce 6,000 bushels of wheat. Then they will get the most hay possible
given that they are producing 6,000 bushels of wheat if Farmer A puts
all of his land into wheat and Farmer B puts 50 acres into wheat and the
remaining 50 acres into hay.

33.1 (0) Tip and Spot finally got into college. Tip can write term
papers at the rate of 10 pages per hour and solve workbook problems at
the rate of 3 per hour. Spot can write term papers at the rate of 6 pages
per hour and solve workbook problems at the rate of 2 per hour. Which
of these two has comparative advantage in solving workbook problems?
 398 PRODUCTION (Ch. JJ)

ProbleIJlS

80 -
-
60 -
40
~

20
~

80 100 120
20 40 60
0 Pages

(a) Tip and Spot each work 6 hours a day. They decide to work together
and to produce a combination of term papers and workbook problems
that lies on their joint production possibility frontier. On the above graph
plot their joint production possibility frontier. If they produce less than
will write all of the term papers.
60 pages of term papers, then _ __
pages of term papers, then - - -
If they produce more than _ __
will
will continue to specialize in writing term papers and - - - -
also write some term papers.

33.2 (0) Robinson Crusoe has decided that he will spend exactly 8 hours
a day gathering food. He can either spend this time gathering coconuts or
catching fish. He can catch 1 fish per hour and he can gather 2 coconuts
per ~our. On the graph below, show Robinson's production possibility
frontier between fish and coconuts per day. Write an equation for the line

segment that is Robinson's production possibility frontier,- -----

 Coconuts

12
--------
,t- -t- H H H W i-- .1

:--------
0 4 8 12 16
Fish

(a) Rob inso n's util ity function is

U(F ,C) = FC , where F is his dai ly
fish con sum ptio n and C is his daily
coconut consumption. On the gra ph
above, sketch the indifference curve
tha t gives Robinson a util ity of 4,
and also ske tch the indifference curv
e tha t gives him a utility of 8. How
ma ny fish will Robinson choose to
catch per day?_ _ __
How ma ny
coc onu ts will he collect? - - -
(Hint: Robinson will choose a bun dle
tha t maximizes his utility subject to
the constraint tha t the bun dle lies
in his pro duc tion possibility set. But
for this technology, his pro duc tion
pos sibi lity set looks jus t like a budget
set.)
(b) Sup pos e Robinson is not isolated
on an island in the Pacific, but is
reti red and lives nex t to a grocery
store where he can buy eith er fish
or coc onu ts. If fish cost $1 per fish
, how much wou ld coconuts hav e to
cos t in ord er tha t he would choose to
consume twice as many coc onu ts as
fish? _ _ _ _ Suppose tha t a soc
ial planner decided tha t he wan ted
Rob ins on to consume 4 fish and 8
coconuts per day. He cou ld do this
by set ting the pric e of fish equal to
$1, the price of coconuts equ al to
and giving Robinson a daily income
of $,_ __
.
( c) Bac k on his island, Robinson has .
,
-
little else to do, so he pre ten ds tha t
he is run nin g a competitive firm tha
t produces fish and coconuts. He
wo nde rs, "W hat wou ld the price hav
e to be to make me do jus t wh at I am
act ual ly doi ng? Let 's assume tha t1is
h a.re the numeraire and hav e a pric e
of $1. An d let' s pre ten d tha t I have
access to a competitive lab or ma rke
wh ere I can hire as much labor as t
I want at some given wage. The re
a con sta nt retu rns to scale technolo is
gy. An hou r's lab or pro duc es one fish
or 2 coc onu ts. At wages above $,_
_ __ per hour, I wo uld n't pro duc e
 400 PRODUCTION (Ch. 33)

any fish at iill, because it would cost me more than $1 to produce a fish.

At wage.s below$,_ _ _ per hour, I would want to produce infinitely

. 1 would make a profit on every one. So the only poss'bl
many fish smce .. 1 e
wage rate that would make me choose to produce a pos1t1ve finite amoun t
. $ per hour. Now what would the price of cocon t
of fish 1511 1--- .. b f Us
have to be to induce me to produce a pos1t1ve num er o coconuts. At
the wage rate J just found, the cost of producing _a _coconut is - - -
At this price and only at this price, would I be wilhng to produce a finite
positive number of coconuts."

33.3 (0) We continue the story of Robinson Crusoe_ from the previous
problem. One day, while walking along the beach, Robmson Crusoe saw a
canoe in the water. In the canoe was a native of a nearby island. The na-
tive told Robinson that on his island there were 100 people and that they
all lived on fish and coconuts. The native said that on his island, it takes
2 hours to catch a fish and 1 hour to find a coconut. The native said that
there was a competitive economy on his island and that fish were the nu-
meraire. The price of coconuts on the neighboring island must have been

___ _ The native offered to trade with Crusoe at these prices. "I will
trade you either fish for coconuts or coconuts for fish at the exchange rate

of _ _ _ coconuts for a fish," said he. "But you will have to give me
I fish as payment for rowing over to your island." Would Robinson gain

by trading with him?_ _ H so, would he buy fish and sell coconuts or
vice versa?_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ __

{a) Several days later, Robinson saw another canoe in the water on the
other side of his island. In this canoe was a native who came from a
different island. The native reported that on his island, one could catch
only I fish for every 4 hours of fishing and that it takes 1 hour to find
a coconut. This island also had a competitive economy. The native
offered to trade with Robinson at the same exchange rate that prevailed
on his own island, but said that he would have to have 2 fish in return
for rowing between the islands. H Robinson decides to trade with this
island, he chooses to produce only _ _ __
and will get his - - -
_from the other island. On the graph above, use black ink
to draw Robmson's production possibility frontier if he doesn't trade and
use blue ink to show the bundles he can afford if he chooses to trade
and specializes appropriately. Remember to take away 2 fish to pay the
'tJ
trader. .
 Coconuts

24
--------
N-t-t-+-l---1--LI

16 ,HH--+--1----1--L_J

0 8 16 24 32
Fish

(b) Write an equation for Crusoe's "budget line" if he specializes appr<>-

priately and trades with the second trader. If he does this, what bundle
will he choose to consume?______ _ Does he like this bundle

better than the bundle he would have if he didn't trade?_ _ _ _~

33.4 (0) The Isle of Veritas has made it illegal to trade with the outside
world. Only two commodities are consumed on this island, milk and
wheat. On the north side of the island are 40 farms. Each of these
farms can produce any combination of non-negative amounts of milk and
wheat that satisfies the equation m = 60- 6w. On the south side of the
island are 60 farms. Each of these farms can produce any combination
of non-negative amounts of milk and wheat that satisfies the equation
m = 40 - 2w. The economy is in competitive equilibrium and 1 unit of
wheat exchanges for 4 units of milk.

(a) On the diagram below, use black ink to draw the production possibility
set for a typical farmer from the north side of the island. Given the
equilibrium prices, will this farmer specialize in milk, specialize in wheat,

or produce both goods? _ _ _ _ _ _ _ ~se blue ink to draw_ the

budget that he faces in his role as a consumer 1f he makes the optimal
choice of what to produce.
 402 PRODUCTION (Ch. 33)

''
•'
. Milk

80

60

40

20

0 20 40 60 80
Wheat

(b) On the diagram below, use black ink to ~aw the pr~duction possibility
set for a typical farmer from the south side of the ISiand. Given the
equilibrium prices, will this farmer specialize in milk, specialize in wheat,
or produce both goods? _ _ _ _ _ _ _ _ Use blue ink to draw the
budget that he faces in his role as a consumer if he makes the optimal
choice of what to produce.

Mille

0 20 40 60 80
Wheat

• I

(c) Suppose that peaceful Viking traders discover Veritas and offer to.
exchange either wheat for milk or milk for wheat at an exchange rate of
1 unit of wheat for 3 units of milk. If the Isle of Veritas allows free trade
with the Vikings, then this will be the new price ratio on the island. At,
this price ratio, would either type of farmer change his output?---
right choice of what to produce. On
all~=
(d) On the first of the two graphs above
for north~rn farmers if free trade is
the
red.
and th
seco nd of the two grap
th ers if free trade is allowed
red ink to draw e budget for southern farm produce.
t to
and the farmers make the right choice of wha

(e} The council of elders of Veritas will

meet to vote on whether to
north endof the islan d
accept the Viking offer. The elders from the
end get 60 votes. Assum-
get 40 votes and the eld~rs from the south
of his end of the island,
ing that everyone votes m the selfish interest
how will the northerners vote?_ _ _ __ How will the sout hern - I I

can make a definite answ er l

ers vo te? __ __ _ How is it that you
I
hing abou t the farm ers's I
to the last two questions without knowing anyt l

_ _ _ _ _ _ _ _ __
cons ump tion preferences?_ _ _ _ _ _ _

anges at the rate of 1 unit

(!) Sup pose that instead of offering to make exch
offered to trad e at the pric e
of whe at for 3 unit s of milk, the Vikings had
versa. Would eith er type
of 1 unit of whe at for 1 unit of milk and vice
_ _ _ _ _ _ _ _ __
of farm er chan ge his outp ut? _ _ _ _ _ _
kind of
Use pencil to sketch the budg et line for each
production decision. How will
farm er at thes e prices if he makes the right
the nort hern ers vote now?_ _ _ __ How will the sout hern ers vote

__ __ _ Exp lain why it

no w? __ __ __ __ __ __ __
I

tions has to be "it dep end s."

is that you r answer to one of the last two ques

s of Cha pter 2. The y hav e a

33.5 (0) Rec all our friends the Mungoan
Blue Mon ey and Red Mon ey.
stra nge two -cur renc y syst em consisting of
ng, a blue -mo ney pric e and
Orig inal ly, ther e were two prices for everythi
are 1 bcu per unit of amb rosi a
a red- mon ey price. The blue-money prices
money pric es are 2 rcu' s per
and 1 bcu per unit of bub ble gum. The red-
ble gum.
unit of amb rosi a and 4 rcu' s per unit of bub

inco me of 24. If it has to

(a) Har old has a blue income of 9 and a red
its bud get set in the gra ph
pay in both curr enci es for any purc hase , draw
a few mon ths ago .)
belo w. (Hin t: You answ ered this ques tion
 404 PRODUCTION (Ch. 33)

Bubble gum

20
-
15 -
~

10

10 15 20
0 5
Ambrosia

(b} The free Choice party campaigns on a platform that M~ngoans should
be allowed to purchase goods at either the blue-money pnce or the red-
money price, whichever they prefer. We ":ant _to const ruct Harol d's bud-
get set if this reform is instituted. To b_egm with, how muc~ bubbl e gum
could Harold consume if it spent all of its blue money and its red money
_
on bubble gum?·_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

y
(c) How much ambrosia could it consume if it spent all of its blue mone
_,
and all of its red money on ambrosia?_ _ _ _ _ _ _ _ _ _ _ _

( d) H Harold were spending all of its money of both colors on bubbl e gum
and it decided to purchase a little bit of ambrosia, which curren cy would
it use?__ __ __ __ __ __ __ __ __ __ __ _
_

(e) How much ambrosia could it buy before it ran out of that color mone y?

that
(/) What would be the slope of this budget line before it ran out of
--
kind of money?_ _ _ _ _ _ _ _ _ _ _ _ _ _ _~--' ---'-

sia
(g) H Harold were spending all of its mone y of both colors on ambro
ncy
and it decided to purchase a little bit of bubble gum, which curre
__
would it use?_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
(h) How much bubble gum could it buy before it ran
x:noney?_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ __

(i} What would be the slope of this budget line before it ran out of that
kind of money? _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ __

CJ Use your answers to the above questions to draw Harold's budget

set
i~ the above graph if it could purchase bubble gum and ambrosia using
either currency.