Solution: Practice problems/questions (chapter 1)

A/ Problems
Problem 1
Kashan and Ray, two cities of the province of Isfahan of Persia, are under the threat of a looming
attack by the terrible sect of the much feared Hassan Sabbah: the Assassins.
Authorities in both cities decide to coordinate their efforts in order to repel the imminent assault.
In particular, they wish to optimize total production of the two main goods produced during war
time, swords and bread, so that they maximize their chances of victory.
As an eminent economist, you are invited to attend a meeting of Isfahan’s National Authority of
Strategic Analysis (NASA) headed by Isfahan’s Grand Vizier, Nizam el Molk.
The Grand Vizier briefs you about the two cities productive capacities (per worker per day):
Cities Swords Bread
Kashan 20 10
Ray 48 12
a) Draw the PPF of Kashan and that of Ray and place swords on the vertical axis and bread
on the horizontal one (in each case, highlight the vertical and horizontal intercepts)

S S
Kashan 48 Ray

20

B B
10 12

b) According to NASA experts, in case the Assassins would besiege the cities, it is
recommended to have an equal output of both goods in each city. This would in effect
maximize the defensive capacities of both cities. The mighty Nizam el Molk looks you
straight in the eye and asks you solemnly: "how, in this case, should the labor force
(which consists of 6000 workers in each city) in each city be allotted between the two
goods?"
1) Let us examine how the labor force should be allotted between the two sectors in Kashan. Let
x be the number of workers that will be allocated to the swords industry and y the workers that
will be allocated to the bread industry. We know two things:
x + y = 6000 (1) (total number of workers is 6000)
20x = 10y (2) (equal output in terms of both goods)
From (2) we know that x = (10/20)y = 0.5y. We can substitute 0.5y for x in (1) 
0.5y + y = 6000  1.5y = 6000  y = (6000/1.5) = 4000  x = 0.5(4000) = 2000.

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All in all, 4000 workers should be working in the bread industry and 2000 in the swords
industry.
2) Let us know examine the case of Ray. We will use the same notations:
x + y = 6000 (1)
48x = 12y (2)
From (2) → x = (12/48)y = 0.25y. Substituting 0.25y for x in (1) 0.25y + y = 6000 
y = (6000/1.25)  y = 4800  x = 0.25(4800) = 1200.
In Ray, 4800 workers should be working in the bread industry and 1200 in the swords industry.

c) Nizam el Molk approves what you just stated and asks the following: “What would be the
output in each city in terms of each good? And what would be the total output of each
good (in both cities)”?
In Kashan, total production of swords will be equal to 2000(20) = 40000; and total production of
bread to 4000(10) = 40000. In Ray, total production of swords will be equal to: 1200(48) =
57600; and total production of bread to 4800(12) = 57600
Total production of each good is equal to 40000+ 57600 = 97600
Swords Bread
Kashan 40 000 40 000
Ray 57 600 57 600
Total output 97 600 97 600

d) In case the Assassins decide to strike immediately, NASA experts recommend that each
city specializes completely in the production of one good. This strategy would indeed
optimize the offensive capacities of the cities. All eyes are on you and the Grand Vizier
moves toward you while asking anxiously “What should be the specialization of each
city”?
To know what should be the specialization of each city, we must first know the comparative
advantage of each city. To do so, we need to compute the opportunity cost of producing each
good in each city. Let us start by computing the opportunity cost of producing swords:
The opportunity cost of producing swords in Kashan: during a day, a worker in Kashan can
either produce 20 swords or 10 bread  to produce 1 sword, the worker must give up 0.5 bread.
The opportunity cost of producing swords in Ray: during a day, a worker in Ray can either
produce 48 swords or 12 bread  to produce 1 sword, the worker must give up 0.25 bread.
Thus, we can produce swords in Ray at a lower opportunity cost than in Kashan  Ray has a
CA in producing swords and should therefore specialize in the production of swords.

Let us now compute the opportunity cost of producing bread:

The opportunity cost of producing bread in Kashan: during a day, a worker in Kashan can either
produce 20 swords or 10 bread  to produce 1 bread, the worker must give up 2 swords.

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The opportunity cost of producing bread in Ray: during a day, a worker in Ray can either
produce 48 swords or 12 bread  to produce 1 bread, the worker must give up 4 breads.
Thus, we can produce bread in Kashan at a lower opportunity cost than in Ray  Kashan has a
CA in producing bread and should therefore specialize in the production of bread.

e) Nizam el Molk’s following question is: “In this case, what would be the total output in
terms of each good?”

If each city specializes completely in the production of the good in which it has a CA 
Total production of swords will be: 48(6000) = 288 000; and total production of bread: 10(6000)
= 60000

As a sign of gratitude for your much appreciated opinion, you are awarded a golden
sword to defend your city in the approaching battle. Good luck!
Problem 2
Assume that consumers in Felixpolis buy only two goods: bread (a necessity) and cake (a
luxury). Anna Karenina has an income of 1000 Kopeks per year. The price of a loaf of
bread is 5 Kopeks, and the price of a cake is 10 Kopeks.
Note: each time you have to sketch a new budget constraint, indicate the maximum
amount of bread and cake that she can consume on the corresponding axes.

(a) Sketch Anna’s budget constraint (label it AA).

Bread
400
DD

200

AA

AB AC

83 100 200 400 Cake

(b) If Anna were relatively poor in Felixpolis, where on the budget constraint might
you expect her choice to lie?
Assuming that Anno would spend her entire income, she would purchase a combination
with a large amount of bread (the necessity good) relatively to cake

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 (c) Suppose that a tax of 20% is placed on luxury goods. Assume that the tax is paid
by the consumer. Sketch the new budget constraint facing Anna (label it AB) and
explain.
If the tax is paid by consumers  the price of cakes will increase by 20%  it
will become 12 Kopecks ((0.2 × 10) + 10). The budget constraint will rotate
inward: if Anna spends her entire income on cakes, she will be able to consume
83 cakes instead of the previous 100.

(d) Ignore c. Suppose that the price of a cake were to fall from 10 Kopeks to 5
Kopeks. Sketch Anna’s new budget constraint (label it AC). What happens to the
size of Anna’s opportunity set on the diagram in (a) above?
If the price of a piece of cakes drops to 5  Anna’s budget constraint will rotate
outward because she will be able to buy more cakes in case she spends her entire
income on cakes. In fact, she will be able to buy 200 cakes. Her opportunity set
will expand: as the price of cakes decreases, she will be able to buy more of all
available goods.

(e) Suppose that Anna’s income increases from 1000 Kopeks to 2000 Kopeks. Sketch
the new budget constraint (label it DD) and explain. (the prices are those of (d)
above).

If Anna’s income increases  her budget constraint will shift to the right. She
will be operating on a new budget constraint: if she spends her entire income on
bread, she will be able to consume more bread than previously (400 units); and if
she spends her entire income on cakes, she will also be able to increase her
consumption of cakes (400 units).
B/ Questions
B.1/Multiple choice questions
1. Beethoven Jr. buys only two goods: violins and pianos. This month he has $500 in a
savings account that he plans to spend. Violins cost $5 each and pianos cost $10 each.
Beethoven Jr. can buy a maximum of            violins and a maximum of            pianos.
(a) 100; 0
(b) 100; 100
(c) 0; 50
(d) 100; 50
Simply compute the ratio of the income to the price of each instrument to get the
maximum amount of each one of the latter that Beethoven Jr. can buy: to get the
maximum amount of violins he can get if he spends all his income on violins:
500/5 = 100; and to get the maximum amount of pianos (assuming he is spending
his entire income): 500/10 = 50

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2. Draw Beethoven Jr.’s budget constraint in the space below. Place “Violins” on the
horizontal axis and “Pianos” on the vertical axis. Write in the maximum value for violins
and for pianos at the appropriate places.

Pianos

50

Violins
100

3. The slope of Beethoven Jr.’s budget constraint is

(a) –2.
(b) –1/2.
(c) 1/2.
(d) 2.

The slope of the budget constraint is equal to ∆Y/∆X, where in this case Pianos are
represented on the Y axis and Violins on the X axis  the slope of Beethoven
Jr.’s budget constraint is therefore equal to the ratio: ∆P/∆V: from the graph: (50 -
0)/(0-100) =-50/100 = -1/2
This can also be obtained from the equation of the budget line:
Beethoven Jr.’s budget constraint is illustrated by the equation: 500 = P V × (number of
violins: V) + PP × (number of pianos: P)  replacing PV by 5 and PP by 10:
500 = 5V + 10P => 10P = 500 – 5V  P = 500/10 – 5/10V => P = 50 - (½)V 
(∆P/∆V) = -1/2
Notice that the slope of the budget constraint is equal to minus the ratio of the price of
violins to the price of pianos.

B.2/Question (the 1 million-dollar question):

A large scale survey of consumer food purchases revealed that, on average, retired people spend
less money for the same basket of food than working people do. Can you explain this fact? (Hint:
this has nothing to do with differences in income levels. Use the concept of opportunity cost.)
Purchasing a basket of food takes two basic ingredients: money and time. For individuals who
work, the opportunity cost of shopping in terms of time is high. For retired individuals, the
opportunity cost of time shopping is lower. A lower opportunity cost of time spent on shopping
means that retired people will spend more time for shopping and bargaining/searching for the
least costly items  retired individuals are likely to pay less for the same bundle of goods than
individuals who work.