Eco 201 Name

Eco 201 Problem Set 1

Name_______________________________ 2 June 2009

Frank & Bernanke, Chapter 1

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 for 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?

The economic surplus from washing your dirty car is the benefit you receive from doing so ($6) minus your cost of doing the job ($3.50), or $2.50.

2. To earn extra money in the summer, you grow tomatoes and sell them at the farmers' market for 30 cents per pound. By adding compost to your garden, you can increase your yield as shown in the table below. If compost costs 50 cents per pound and your goal is to make as much money as possible, how many pounds of compost should you add?

Pounds Pounds

of

of

compost tomatoes

0

100

1

120

2

125

3

128

4

130

5

131

6

131.5

Marginal Cost ($) ---0.50 0.50 0.50 0.50 0.50 0.50

Marginal Benefit (pounds)

0 20 5 3 2 1 0.5

Marginal Benefit

($) --6.00 1.50 0.90 0.60 0.30 0.15

Net Benefits

0 5.50 6.50 6.90 7.00 6.80 6.45

Marginal Net

Benefits

--5.50 1.00 0.40 0.10 - 0.20 - 0.35

The benefit of adding a pound of compost is the extra revenue you'll get from the extra tomatoes that result. The cost of adding a pound of compost is 50 cents. By adding the fourth pound of compost you'll get 2 extra pounds of tomatoes, or 60 cents in extra revenue, which more than covers the 50-cent cost of the extra pound of compost. But adding the fifth pound of compost gives only 1 extra pound of tomatoes, so the corresponding revenue increase (30 cents) is less than the cost of the compost. You should add 4 pounds of compost and no more.

3. Residents of your city are charged a fixed weekly fee of $6 for garbage collection. They are allowed to put out as many cans as they wish. The average household disposes of three cans of garbage per week under this plan. Now suppose that your city changes to a "tag" system. Each can of refuse to be collected must have a tag affixed to it. The tags cost $2 each and are not reusable. What effect do you think the introduction of the tag system will have on the total quantity of garbage collected in your city? Explain briefly.

In the first case, the cost is $6/week no matter how many cans you put out, so the cost of disposing of an extra can of garbage is $0. Under the tag system, the cost of putting out an extra can is $2, regardless of the number of the cans. Since the relevant costs are higher under the tag system, we would expect this system to reduce the number of cans collected.

4. You are planning a 1000-mile trip to Kansas. Except for the matter of cost, you are

completely indifferent between driving and taking the bus. Bus fare is $260. The costs of

operating your car during a typical 10,000-mile driving year are as follows:

Insurance

$1000

0

Interest

2000

0

Fuel and Oil

1200 120

Tires

200

20

License and Registration

50

0

Maintenance

1100 110

Total

5550 250

Should you drive or take the bus? You should drive because it is $10 cheaper.

5. Al and Jane have rented a banquet hall to host a party in celebration of their wedding anniversary. Fifty people have already accepted their invitation. Given that many people, the caterers will charge $400 for food and $100 for drinks. The band will cost $300 for the evening, and the hall costs $200. Now Al and Jane are considering inviting 10 more people. By how much will these extra guests increase the cost of their party?

Marginal cost of inviting 10 more people is $100.

6. Down on Our Luck Studios has spent $100 million producing an awful film, A Depressing Story about a Miserable Person. If the studio releases the film, the most cost-effective marketing plan would cost an additional $5 million, bringing the total amount spent to $105 million. Box office sales under this plan are predicted to be $12 million, which would be split evenly between the theaters and the studio. Additional studio revenue from video and DVD sales would be about $2 million. Should the studio release the film? If no, briefly explain why not. If yes, explain how it could make sense to release a film that cost $105 million but earns only $12 million.

Yes, the studio should release the film. The $100 million in production costs are sunk. The total predicted revenue of $(12/2+ 2) = $8 million would exceed the $5 million in marketing costs by $3 million, meaning that the movie should be released. The question that shareholders in the studio will want answered, however, is why the movie was made in the first place. Was there a big drop in anticipated revenues due to some unforeseeable event? If not, then making the movie in the first place was really a bad decision.

7. A group has chartered a bus to New York City. The driver costs $100, the bus costs $500, and tolls will cost$75. The driver's fee is nonrefundable, but the bus may be canceled a week in advance at a charge of only $50. At $18 per ticket, how many people must buy tickets so that the trip will not be canceled?

Of the $675 in costs, $525 is recoverable if the trip is cancelled, and thus represents an

opportunity cost, while $150 is sunk. Thus, the marginal cost of going to New York City is $525. At $18 per ticket, you need thirty people to buy tickets to make it worthwhile going. With 30 people, the group is out ($675- 540) $135. If the group cancels the trip it is out $150.

8. Hatcher Thatcher Baxter III, a recent Wofford graduate, decided early this year to invest in a 2004 model $70,000 BMW sport coupe. He was able to trade in his 1994 Toyota Celica for $5,000. At the time, interest rates on auto loans were 8%, but Hatcher had the option of paying cash, having recently inherited a tidy sum from his grandfather (you guessed it, Hatcher Thatcher Baxter I). Hatcher could have earned 2% on his money if he had left it in a money market fund.

Calculate below the estimated opportunity cost per year to Hatcher of upgrading from the Toyota to the BMW:

Annual Interest Cost (Base this on Hatcher's best course of action.)

1,300

Annual Depreciation Cost (The resale value of the Toyota would have fallen by $1,000 this year, but the BMW will fall in value by $7,500 in this first year of ownership.)

6,500

Annual Registration with the DMV

150

(The Toyota would have cost $150, but the BMW will

cost $300.)

Annual Automobile Insurance

800

(The Toyota would have cost $800, but the BMW will

cost $1600 per year)

Annual Estimated Maintenance Expenses

400

(The Toyota would have cost $400, but the BMW will

cost $800.)

Annual Turtle Wax and Armor-All Expenses

50

(The Toyota would have cost $25, but the BMW will

cost $75)

Total Annual Estimated Opportunity Cost of Upgrading from Toyota to BMW

9,200

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