Chapter 1Thinking 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