1.1.

Penny:

Meal-12 (12 hours  1 hour per meal)

Basket-3 (12 hours  4 hours per meal)

Amy:

Meal-48 (12 hours  1/4 hour per meal)

Basket-6 (12 hours  2 hours per meal)

1.2.
1.3.

1.4. Opportunity cost of producing one meal (in terms of baskets given up):

Number of baskets sacrificed ÷ Number of meals gained (given that they use all 12 hours to
produce meals)

Amy-6 ÷ 48= 1/8 basket

Penny-3 ÷ 12= 1/4 basket

Opportunity cost of producing one basket (in terms of meals given up):

Number of meals sacrificed ÷ Number of baskets gained (given that they use all 12 hours to
produce baskets)

Amy-48 ÷ 6= 8 baskets
Penny-12 ÷ 3= 4 baskets
1.5. Amy has an absolute advantage in producing meals and baskets. This is because she
takes lesser time to cook a meal and finish a basket (1/4 hour and 2 hours respectively)
compared to Penny (1 hour and 4 hours respectively).

1.6. Penny has a comparative advantage in producing laundry baskets. This is because she
must forego fewer meals (4 meals) for each basket she produces than Amy (8 meals) (i.e.,
she has a lower opportunity cost of producing 1 basket in terms of meals).

1.7. A mutually beneficial exchange is established at a price ranging from 4 to 8 meals per
basket. Amy wants to sell meals and buy baskets whereas Penny wants to sell baskets and
buy meals, in this price range. Each party can buy a service that is lower than their
opportunity cost, hence benefitting from specialization according to comparative advantage
and trade.

1.8. Trade will occur at the proposed price because it lies between the range of 4 and 8 as
explained in part 1.7. For each party to mutually benefit from the trade at this price, Amy
must spend 6 hours in cooking and 6 hours in producing baskets. Whereas, Penny, must
spend 0 hours in cooking and 12 hours in producing baskets. The table below elaborates on
this proposed plan in relation to their pre-trade production and consumption:

Without trade With trade

Production and Production Trade Consumption Gains
consumption from
trade
Amy 16 meals 24 meals Sells 6 meals 18 meals 2 meals

4 baskets 3 baskets Buys 1 4 baskets 0 basket

basket
Penny 4 meals 0 meals Buys 6 meals 6 meals 2 meals

2 baskets 3 baskets Sells 1 basket 2 baskets 0 basket

Overall, the proposed trade offers each party a combination of meals and baskets that
would be impossible in the absence of trade. Both individuals benefit from trade as shown
in the graphs below, as they produce at a point on their PPC (A) but consume beyond the
PPC (B) (since they obtain 2 extra meals as from before trade).
2.1.

100-2P=1/2P
2.5P=100
P*=$40
Q*(derived from supply curve)=Qs=1/2(40)=20

2.2.
2.3. D=|-2 x 40/20|=|-2 x 2|=|-4|=4
S=1/2 x 40/20=1

2.4. C.S=1/2 x 20 x 10=$100

P.S=1/2 x 20 x 40=$400

2.5

2.5. Since lumber is used in construction, the number of buyers in the lumber market
increases as the construction projects increase. This results in demand for lumber increasing
(as Qd increases at all prices), causing the demand curve to shift right (arrow 1). Hence, the
equilibrium price and quantity increase from P* to P** and Q* to Q** respectively.
2.6. Increased transportation prices (raising production costs) and decreased raw material
supplies reduces supply of lumber (as Qs decreases at all prices), causing the supply curve to
shift left (arrow 2). Overall, a decrease in supply raises equilibrium price while decreasing
equilibrium quantity. Since the price impact is the same for both 2.5 and 2.6, the equilibrium
price rises from P* to P**. Yet, depending on the relative size of the shifts in the demand
and supply curves, as well as their elasticities, the equilibrium quantity may increase or
decrease. In the graph below, since the size of the supply curve shift relative to demand is
greater, the equilibrium quantity decreases from Q* to Q**.
2.7. As the price of steel rises the quantity demanded falls, and there is a shift along the
demand curve (arrow 1).
This leads to an increase in demand for lumber (arrow 1) causing the equilibrium price and
quantity to increase from P* to P** and Q* to Q** respectively.

2.8. When a subsidy is introduced demand equation changes to- Qd=100-2(P-5). The
equilibrium price after subsidy (P**) is the price received by producers (Ps):

100-2(P-5)=1/2P
100-2P+10=1/2P
2.5P=110
P**=Ps=$44

Q**(equilibrium quantity after subsidy, derived from supply curve)=Qs=1/2(44)=22

Pd (price paid by consumers) is calculated by subtracting subsidy/unit from new equilibrium

price (P**=Ps) for 22 units:

Pd=44-5=$39
2.9. C.S. (blue triangle)=1/2 x 22 x 11=$121
P.S. (green triangle)=1/2 x 22 x 44=$484
Subsidy expenditure (shaded orange rectangle)=22 x 5= $110

2.10 DWL (orange triangle)=1/2 x 5 x 2=$5

2.11. Producers receive a price of $44, representing a $4 gain over the original equilibrium
price ($40). The benefit to consumers is a $1 decrease in price paid after subsidy ($39) from
the original ($40). So, producers obtain a larger share of the subsidy (pink shaded region
highlighting rise in P.S) than consumers (green shaded region highlighting increase in C.S),
and hence benefit more from it. This is because supply is less elastic than demand (the
incidence of subsidies is higher on the less elastic side of the market).

3.1.
Pw-Equilibrium price after market opens to world trade.
Qs-Quantity supplied domestically.
Qd-Quantity demanded domestically.

3.2.

Before trade After trade Net change

C.S A A+B+D+E +B+D+E
P.S B+C C -B
Total surplus A+B+C A+B+C+D+E D+E

Hence, welfare gain from trade is D+E.

3.3.

No tariff With tariff Net change

C.S A+B+C+D+E+G A+D -B-C-E-G
P.S F B+F +B
Tariff revenue None +C +C
Total surplus A+B+C+D+E+F+G A+B+C+D+F -E-G

Hence, total surplus falls by E+G. These two triangles represent the DWL.

3.4 Equilibrium price= World price (before tariff)+tariff/unit=20+10=$30

Quantity supplied domestically=1/2(30)=15
Quantity demanded domestically=100-2(30)=40
Tariff revenue=Tariff/unit x (m2)=10 x (40-15)=$250
DWL (E+G)=(1/2 x 5 x 10)+(1/2 x 20 x 10)=$125