In-Class Exercise #1

1. Charlie is considering selling his guitar. Recently, he spent $150 to replace they keys on the guitar. At this point, he expects to sell the guitar for $2000. However, before he puts the guitar on consignment at a guitar shop, he notices that the top of the guitar is cracked. Now, in order to sell the guitar for $2000, he must repair the crack, which costs $500. The price at which he can sell the guitar without making further repairs is $1250. Should Charlie fix the guitar or not? The $150 Charlie spent to replace the keys is irrelevant. The key is to compare the marginal benefit and marginal cost of repairing the crack on the top of his guitar. The marginal cost of the fixing the crack is the $500. What is the marginal benefit? Compare the total benefit of fixing the crack, $2000, to the total benefit of NOT fixing the crack, $1250. The difference between these benefits is the marginal benefit, i.e. MB=$2000-$1250=$750. Because the MB>MC ($750>$500), Charlie should repair the crack. 2. Charlie is considering selling his guitar. Recently, he spent $150 to replace they keys on the guitar. At this point, he expects to sell the guitar for $2000. However, before he puts the guitar on consignment at a guitar shop, he notices that the top of the guitar is cracked. Now, in order to sell the guitar for $2000, he must repair the crack, which costs $500. The price at which he can sell the guitar without making further repairs is $1600. Should Charlie fix the guitar or not? The $150 Charlie spent to replace the keys is irrelevant. The key is to compare the marginal benefit and marginal cost of repairing the crack on the top of his guitar. The marginal cost of the fixing the crack is the $500. What is the marginal benefit? Compare the total benefit of fixing the crack, $2000, to the total benefit of NOT fixing the crack, $1600. The difference between these benefits is the marginal benefit, i.e. MB=$2000-$1600=$400. Because the MB<MC ($400<$500), Charlie should NOT repair the crack. 3. The company that you manage has invested $5 million in developing a new product, but the development is not quite finished. At a recent meeting, your salespeople report that the introduction of competing products has reduced the expected sales of your new product to $3 million. Similar to the last two problems, there is some irrelevant information in this problem. In particular, the $5 million that has already been spent doesnt help you make current and future decisions. a. If it would cost $1 million to finish developing and making the product, should you go ahead and do so?

Yes. Why? Again, you must ignore the $5 million that has already been spent. Given the new competition in the market, you are now trying to minimize your losses. The marginal benefit of completing the product is the $3 million in expected sales, while the marginal cost is the additional $1 million to complete the production of the product. Because the MB>MC, you should complete the project. Your total loss of finishing the project is -$3 million (profit = revenue - cost = $3 million - $6 million = -$3 million). But your total loss would be larger if you didnt finish it, which would be -$5 million. b. What is the most that you should pay to complete the development? You should be willing to spend up to $3 million to finish the project. This is where the MB=MC. If you spent $3 million to finish the project, your loss would be -$5 million, which is exactly what the loss would be of not finishing it. If the cost to complete the project is $3 million, you would be indifferent between finishing the project and NOT finishing the project. As a result, if the cost of finishing the project is less than $3 million, you would be better off finishing it. 4. Assume only two countries exist: Country A and Country B. Each of these countries produces two goods, x and y. If Country A devotes all of its resources to the production of x and y, it can produce 100 and 75 units of each, respectively. If Country B devotes all of its resources to the production of x and y, it can produce 90 and 120 units of each, respectively. a. Construct a table displaying the production possibilities for each country. Country A B X 100 90 Y 75 120

b. Draw the production possibilities frontier for both countries. Plot the data in (a) part by putting good Y on the y-axis and good X on the xaxis. Then connect the two points by drawing a linear line between the two points. Im not particularly good at drawing graphs in MS Word. If you are struggling with this part, stop by my office or see me after class, and Ill be happy to help. c. Which country has an absolute advantage in the production of goods x and y, respectively?

Country A has an absolute advantage in the production of good X, while Country B has an absolute advantage in the production of good Y. d. Calculate the opportunities costs of producing one more of each good (in terms of the other good) for both countries. The opportunity cost of producing an additional unit of good X for Country A is 3/4 Y, while the opportunity cost of producing an additional unit of good X for Country B is 4/3 Y. The opportunity cost of producing an additional unit of good Y for Country A is 4/3 X, while the opportunity cost of producing an additional unit of good Y for Country B is 3/4 X. e. Who has a comparative advantage in the production of goods x and y, respectively? The opportunity cost of producing good X is lowest for country A (i.e. they give up the least amount of Y). As such, country A should specialize in the production of good X. The opportunity cost of producing good Y is lowest for country B (i.e. they give up the least amount of X). As such, country B should specialize in the production of good Y.