1 TEN PRINCIPLES OF ECONOMICS
Problems and Applications
1. a. A family deciding whether to buy a new car faces a tradeoff between the cost of the car
and other things they might want to buy. For example, buying the car might mean they
must give up going on vacation for the next two years. So the real cost of the car is the
family's opportunity cost in terms of what they must give up.
b. For a member of Parliament deciding whether to increase spending on national parks,
the tradeoff is between parks and other spending items or tax cuts. If more money goes
into the park system, that may mean less spending on national defense or on the police
force. Or, instead of spending more money on the park system, taxes could be reduced.
c. When a company president decides whether to open a new factory, the decision is based
on whether the new factory will increase the firm's profits compared to other
alternatives. For example, the company could upgrade existing equipment or expand
existing factories. The bottom line is: Which method of expanding production will
increase profit the most?
d. In deciding how much to prepare for class, a professor faces a tradeoff between the
value of improving the quality of the lecture compared to other things she could do with
her time, such as working on additional research.
2. When the benefits of something are psychological, such as going on a vacation, it isn't easy to
compare benefits to costs to determine if it's worth doing. But there are two ways to think about
the benefits. One is to compare the vacation with what you would do in its place. If you didn't
go on vacation, would you buy something like a new set of golf clubs? Then you can decide if
you'd rather have the new clubs or the vacation. A second way is to think about how much work
you had to do to earn the money to pay for the vacation; then you can decide if the
psychological benefits of the vacation were worth the psychological cost of working.
3. If you are thinking of going skiing instead of working at your part-time job, the cost of skiing
includes its monetary and time costs, which includes the opportunity cost of the wages you are
giving up by not working. If the choice is between skiing and going to the library to study, then
the cost of skiing is its monetary and time costs including the cost to you of getting a lower grade
in your course.
4. If you spend $100 now instead of saving it for a year and earning 5 percent interest, you are
giving up the opportunity to spend $105 a year from now. The idea that money has a time value
is the basis for the field of finance, the subfield of economics that has to do with prices of
financial instruments like stocks and bonds.
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5. The fact that you've already sunk $5 million isn't relevant to your decision anymore, since that
money is gone. What matters now is the chance to earn profits at the margin. If you spend
another $1 million and can generate sales of $3 million, you'll earn $2 million in marginal profit,
so you should do so. You are right to think that the project has lost a total of $3 million ($6
million in costs and only $3 million in revenue) and you shouldn't have started it. That's true, but
if you don't spend the additional $1 million, you won't have any sales and your losses will be $5
million. So what matters is not the total profit, but the profit you can earn at the margin. In
fact, you'd pay up to $3 million to complete development; any more than that, and you won't be
increasing profit at the margin.
6. Harry suggests looking at whether productivity would rise or fall. Productivity is certainly
important, since the more productive workers are, the lower the cost per gallon of potion. Ron
wants to look at average cost. But both Harry and Ron are missing the other side of the
equationrevenue. A firm wants to maximize its profits, so it needs to examine both costs and
revenues. Thus, Hermione is rightit’s best to examine whether the extra revenue would exceed
the extra costs. Hermione is the only one who is thinking at the margin.
7. a. The provision of welfare benefits lowers an individual’s incentive to save for retirement.
The benefits provide some level of income to the individual when he or she retires. This
means that the individual is not entirely dependent on savings to support consumption
through the years in retirement.
b. Since a person gets fewer after-tax welfare benefits the greater is his or her earnings,
there is an incentive not to work (or not work as much) after age 65. The more you
work, the lower your after-tax welfare benefits will be. Thus the taxation of welfare
benefits discourages work effort after age 65.
8. a. The loss of benefits means that someone who can't find a job will get no income at all,
so the distribution of income will become less equal. But the economy will be more
efficient, since welfare recipients have a greater incentive to find jobs.
b. The change in the law is one that increases efficiency but reduces equity. Chapter 1/Ten Principles of Economics ✦ 3
9. By specializing in each task, you and your roommate can finish the chores more quickly. If you
divided each task equal