Transcript ECON 1001 AB Introduction to Economics I Dr. Ka

Chapter 1
Thinking Like an Economist
Q. 1, 5, 7
Q. 3, 9 Please see under “Answers” from the tutorial
weekly schedule
Problem #1, Chapter 1
• The most you would be willing to pay for
having a freshly washed car before going out
on a date is $6. The smallest amount of which
you would be willing to wash someone else’s
car is $3.50. You are going out this evening,
and your car is dirty. How much economic
surplus would you receive from washing it?
Solution to problem #1 (1)
• In Economics, we always assume rationality
• For example, you will pay $3500 for a new mobile phone because you
think the new mobile phone is worth at least $3500 or the new phone
will potentially bring you happiness or enjoyment that is worth at least
$3500
• The first line says the most you would be willing to pay for a car wash is
$6
– $6 is actually your benefit of having a washed car
– You pay $6 for a car wash because you think the service is worth $6;
you wont pay $6 for a type of service that you think is only worth $5
Solution to problem #1 (2)
• The question also says the smallest amount for which
you would be willing to wash a car for someone is $3.5
– $3.5 is actually your cost for performing a car wash for someone
else
– $3.5 is just right at compensating for the value of your effort
and time spent on the car wash
– You would be happy if someone pays you more than $3.5 for a
car wash; however, you would not be willing to perform a car
wash if someone pays you less than $3.5 as the price does not
cover the value of your alternate activity such as an afternoon
tea or an afternoon nap
Solution to problem #1 (3)
• Cost-benefit principle
– An action should be taken, if and only if, the extra benefits from
taking the action are at least as great as the extra costs
• Benefit of performing a car wash = $6
• Cost of performing a car wash = $3.5
• Net benefit (economic surplus) is the difference between
benefit and cost
– NB= B-C
– Economic surplus = $6- $3.5 = $2.5
Problem #5, Chapter 1
• Tom is a mushroom farmer. He invests all his spare cash
in additional mushrooms, which grow on otherwise
useless land behind his barn. The mushrooms double in
weight during their first year, after which time they are
harvested and sold at a constant price per pound. Tom’s
friend Dick asks Tom for a loan of $200, which he
promises to repay after 1 year. How much interest will
Dick have to pay Tom in order for Tom to recover his
opportunity cost of making the loan? Explain briefly.
Solution to problem #5 (1)
• Suppose Tom now has some spare money
available to lend to Dick
• But such lending generates an opportunity
cost
– By lending Dick the money, Tom scarifies the right
of using the money to invest in growing
mushrooms
Solution to problem #5 (2)
• If Tom does not lend the money to Dick, Tom
can invest $200 in growing mushrooms which
in turn will earn a 200% return, as the
mushrooms double in weight in one year
• By investing $200 in mushrooms, Tom can
potentially come out with a return of $400
after a year
• Thus, Dick should pay Tom an interest at least
$400 after a year
Solution to problem #5 (3)
• An interest of $400 is just enough to compensate for Tom’s loss of
investment opportunity in mushrooms
• If Dick pays Tom an interest of $400, Tom is indifferent between
investing in mushrooms and lending the money to Dick, as the payoff
($400) is the same for both options
• What if Dick pays Tom an interest more than $400? Tom will gain more
by lending the money to Dick
• What if Dick pays Tom an interest less than $400? Tom will loss by
lending the money to Dick as a better option actually available.
• If Tom lends money to Dick at an interest less than $400, say $300, Tom
is giving Dick a gift equivalent to $100 (=400-300).
Problem #7, Chapter 1
• Martha and Sarah have the same preferences and
incomes. Just as Martha arrived at the theater to see a
play, she discovered that she had lost the $10 ticket she
had purchased earlier. Sarah just arrived at the theater
planning to buy a ticket to see the same play when she
discovered that she had lost a $10 bill from her wallet. If
both Martha and Sarah are rational and both still have
enough money to pay for a ticket, is one of them likely
than the other to go ahead and see the play anyway?
Solution to problem #7 (1)
• Martha and Sarah should make the same move
• They both share some similarities
– Same preference
– Same income
– Same sunk cost
• An identical preference refers to an identical benefit from
watching the movie
– Enjoy the movie at a same level
– Get the same level of benefit from watching the movie
• Equal income
– Face the same income/ financial constraint
– Both have enough money to buy a movie ticket
Solution to problem #7 (2)
• Same sunk cost
– “Costs that have already been incurred and which cannot be
recovered to any significant degree.” – Glossary of Economic Terms
• For Martha
– The money ($10) that paid for the lost ticket is a sunk cost
• Incurred and unrecoverable- does not affect her decision about
buying another ticket
• For Sarah
– The $10 bill lost is a sunk cost
• Incurred and unrecoverable- does not affect her decision about
buying a ticket
Solution to problem #7 (3)
• In fact, sunk costs should never be included in the
decision making process
• Given that both Martha and Sarah face the same
ticket price, same financial constraint and same
benefit from watching the movie, they should go
ahead with the movie if:
Benefit from watching the movie > Cost of watching movie
• See- Cost-benefit analysis applied to all questions
involve Economics