Economics Model Answers Twelve

Introductory

1. Receiving $100 next year is not the same as receiving $100 today because of the _________________.

time value of money

2. “Free enterprise does not cause interest rates. Impatience does!” Explain both views.

Free enterprise explains interest rates as someone will not allow someone else to use his money unless he obtains something in return. The interest rate is the "price" for use of someone's money, just as goods and services have their own prices in free enterprise.

Impatience explains interest rates as the emotional desire to have something "right now" causes them to pay more than they would if they were patient and simply waited until they saved the money themselves.

Intermediate

3. I agree to pay you $1,000 in one year, if you pay me ______ today. The interest rate is 5%. Fill in the blank, showing your work.

If the interest rate is 5%, then money today is worth 5% more in a year, or 1.05 times its value today. Hence 1.05 times the money received today must equal $1000 for a year from now. In other words, the loan times 1.05 must equal $1000. Doing the math, the loan = $1000/1.05 = $952.38.

4. Elizabeth owns a clothing store. She can spend $100,000 today to increase her inventory of fancy clothes, which would increase her profits by $104,000 in one year without any further benefit. Interest rates are 5%. Should she make the investment?

Elizabeth would do better to invest her money at the 5% interest rate. By doing so she would end up with $105,000 rather than $104,000. (Chris J.)

5. If total utility is maximized, then (a) average utility is minimized (b) average utility is maximized (c) marginal utility is maximized (d) marginal utility is zero

Answer and explain.

The correct answer is (d), because total utility is maximized when no additional utility can be obtained. That is when marginal utility is zero. Average utility, the answer chosen by many students, may be maximized long before total utility is maximized, due to the Law of Diminishing Marginal Utility.

6. All of the following are fixed costs for starting a new school EXCEPT: (a) textbooks (b) electricity (c) rent (d) landscaping Answer and explain.

Only (a) is dependent on the amount of students, so the answer is (a).

7. During hurricane season a town’s power plant was completely destroyed. People wanted to buy kerosene to run their emergency generators. But the price of kerosene doubled! What is the effect of the price increase? Should a new law force the price of kerosene down by half?

Due to the Law of Demand, the increased price will reduce demand for the kerosene. But the demand for kerosene will be inelastic. Thus the most significant effect of the price increase will be to increase the profit and economic rent of the kerosene supplier. Because the price increase represents an increase in economic rent due to the crisis, price controls probably would not decrease supply in the short run, and might be desirable. In the long run, however, price controls could lead to shortages. (thanks to Chris J.)

Honors

8. Explain what “economic rent” is in your own words, using your own example.

Economic rent is supplier surplus. Just as consumer surplus represents the amount by which the utility of a good or service exceeds the cost, economic rent is the amount by which the price of a good or service exceeds the price at which it would be sold for zero economic profit to the supplier. By this definition nearly every good or service has some economic rent. Gold has economic rent because it is rare and highly valued, while food at the local supermarket has a small amount of economic rent because of its convenience. (Chris J.)

9. Explain which of these earn economic rent, and how much: Katrina earns $500 for playing her violin at events, but would play for free. Philip collects $800 for renting his basement, which equals the electricity, property, interest and costs of his time collecting the rent. Victoria, because of her special talent, earns $30,000 a year growing soybeans when others like her only make $20,000 with similar land.

Katrina makes $500 economic rent. Since she is willing to play for free, it can be inferred that the sum of her costs and utility is zero. Phillip does not earn economic rent, because his revenue does not exceed his costs. Victoria does earn economic rent. Definition two from the lecture states that economic rent is the amount that a payment exceeds the supply cost. If Victoria makes an accounting profit of $30,000 a year, her economic rent is that profit minus the opportunity cost of her most profitable alternative employment. Assuming that her most profitable alternative is to use the land after the method of those around her, who make $20,000, her economic rent is $10,000. (Chris J.)

10. Explain Jesus’ parable about the talents, using general principles learned during this course.

Jesus entrusted more to the servants who had been faithful with a little. This illustrates the principle of increasing returns to scale- when the first two servants demonstrated that they had put made profitable use of the inputs they were entrusted with, the master allowed them to continue their work with more inputs available, i.e., on a larger scale. When the master saw that the servant with the one talent had failed to make use of the inputs he was entrusted with, he recognized this as an inefficient allocation of resources which represented an opportunity cost for him. So he took the talent from the inefficient servant and entrusted it to the servant who had best demonstrated his ability to use it efficiently. (Chris J.)