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EC Problems and Applications #1
Terms in this set (10)
Suppose an economic theory sets up a model that implies that, other things being equal, an increase in interest rates will reduce the growth of national production. How can you test the validity of the theory?
Answer: The model would assume that increases in interest rates decrease the net gain from borrowing. Less borrowing means less spending, which will reduce the gain possible from producing more goods. As this occurs, national production would fall. To test this hypothesis, that increases in interest rates decrease national production, you'd have to find support for it based on observation of the relationship between changes in production and changes in interest rates, other things being equal.
An economic model to explain sales of cars establishes a relationship between the price of cars and the quantity buyers are willing to purchase. A hypothesis developed from the model postulates that, whenever the price of cars goes up, the quantity buyers will buy goes down. During the year, consumer income increases as the price of cars goes up. The quantity of cars sold also increases. Does this invalidate the theory establishing the relationship between the price of cars and the quantity consumers are willing and able to purchase?
Answer: The "other things being equal" qualifier isn't being met when car prices and income change together. Income as well as prices of cars affect the amount purchased. Because other things aren't equal, the observation doesn't refute the theory.
1. In what ways do economic theories and models abstract from reality? Why are unrealistic models useful?
Answer: Economic models concentrate on the relationships of cause and effect among only a few variables, while taking other variables as given. The models abstract from reality by only considering certain aspects of relationships between variables, ignoring all the details and complexity of the real world. Models with unrealistic assumptions must be evaluated on the basis of their ability to explain economic phenomena. If the model predicts well, it will be useful.
1. Give an example of a behavioral assumption in an economic model. What is the purpose of using behavioral assumptions in economic models?
Answer: A common behavioral assumption is that owners of business firms seek to maximize profits. Behavioral assumptions establish cause and effect relationships among economic variables.
1. In what sense can a criminal be regarded as engaging in rational behavior?
Answer: If a criminal weighs the marginal benefit of actions for achieving an objective (no matter how weird the objective) against the marginal cost, the person is rational.
1. A person makes decisions by habit. This person considers neither the benefits nor the costs of his or her actions. Can the person be considered rational?
Answer: A person who makes decisions by habit isn't rational unless he adjusts his habits to changes in marginal benefits or marginal costs.
1. Suppose the marginal benefit to you of acquiring another suit this year is $200. If the price of suits is $250, and you're rational, will you buy one?
Answer: The marginal benefit of the suit falls short of its marginal cost, which is its price. If you're rational, you won't buy another suit this year.
You currently choose to buy two DVDs of new releases per month with your income. The current price is $29.99. Other things being equal, explain why a drop in the price to $25.99 next month is likely to increase the quantity you'll buy.
Answer: A drop in the price of DVDs to $25.99 reduces the marginal cost. You'll buy more until the marginal benefit falls to equal the now lower marginal cost.
1. The following table shows how the marginal benefit of shoes of given quality varies with the number Jill purchases each year. As shown, the price of shoes is $29.99 per pair.
Pairs Purchased(per year)
Assuming Jill is rational and the price of shoes accurately reflects the marginal cost to her, how many pairs of shoes will Jill buy per year?
Suppose the price of shoes increases to $39.99 per year. Assuming nothing else changes, how many pairs will Jill now buy?
a. Jill will buy 3 pairs per year. If she were to purchase a fourth pair, the marginal benefit will fall below the marginal cost when the price is $29.99.
b. If the price increases to $39.99, Jill will reduce purchases to only two pairs per year, because the marginal cost of the third pair now exceeds the marginal benefit of $30.
1. Suppose the marginal benefit of a pair of shoes for Joe is exactly double the marginal benefit indicated for Jill in the previous example. If the price of shoes for Joe is also $29.99, and Joe is rational, how many pairs of shoes per year will Joe buy?
Answer: Joe will buy 4 pairs of shoes per year. At that level of purchase, the marginal benefit is $40, which exceeds the $29.99 price. If Joe were to buy 5 pairs per year, the marginal benefit would fall to $20, which is below the $29.99 marginal cost of the fifth pair.
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