PART 1. Gains from trade [36 points]
Suppose Amy and Penny are housemates and there are two chores that need to be completed: cooking
meals and laundry. Assume the hours needed to cook a meal or finish a basket of laundry are different
for Amy and Penny and are described in the table below.
1 MEAL 1 BASKET
AMY 1/4 2
PENNY 1 4
1.1. What is the maximum number of meals and laundry baskets that Penny can produce in 12 hours?
What is the maximum number of meals and laundry baskets that Amy can produce in 12 hours? (4
points)
1.2. Plot in a graph: Amy’s production possibility frontier. (4 points)
1.3. Plot in a graph: Penny’s production possibility frontier. (4 points)
1.4. What is Amy and Penny’s opportunity cost of producing one meal (in terms of baskets given up)?
What is their opportunity cost of producing one basket (in terms of meals given up)? (4 points)
1.5. Who has an absolute advantage in producing meals? Who has an absolute advantage in producing
laundry baskets? Explain your answer. (4 points)
1.6. Who has a comparative advantage in producing clean laundry baskets? Explain your answer. (4
points)
1.7 What is the price range (in terms of meals given up per laundry basket) at which: (1) trade would
occur between Amy and Penny, and (2) both Amy and Penny would be better off? (4 points)
1.8. Suppose each person has 12 hours for the two tasks in a week and suppose both Amy and Penny
each spend 8 hours on laundry and 4 hours on cooking. Assume also that they do not trade initially.
Suppose Amy then proposes to Penny that they specialize in what each one does relatively best and
trade at a price of 1 basket of laundry for 6 meals. Will trade occur at this price? If so, can you find a
production plan and proposed trade that would make both Penny and Amy better off relative to the initial
production plan without trade? Hint: For a production plan, you need to specify how each person divides their 12 hours between the two tasks. The final allocation with trade benefits Amy and Penny when it results in no fewer meals and no fewer baskets for either person. (8 points)
PART 2. The lumber market in Australia [46 points]
Suppose the demand and the supply for lumber (harvested wood processed in a sawmill) used for
construction in Australia are given by
QD =100 – 2P
QS = 1
2P
Assume also that the market is perfectly competitive.
2.1. Compute the equilibrium price P* and quantity Q *
. (4 points)
2.2. Plot on a graph: the demand curve, the supply curve, and the equilibrium price and quantity. (4
points)
2.3: Calculate the price elasticity of demand and price elasticity of supply at the equilibrium price and
quantity. (4 points)
2.4. Calculate the producer surplus and consumer surplus in the equilibrium and illustrate them in a
graph. (4 points)
2.5. Now suppose a pandemic hits and the government introduces a Homebuilder Scheme, which
provides up to a fixed amount of money towards building a home or renovating an existing one. As a
result, there is an increase in construction projects. Use a demand and supply graph to explain how
this affects the equilibrium price and quantity in the market. (4 points)
2.6. A number of factors now affect the market at once. First, the price of oil rises, increasing
transportation costs. Second, landowners who supply logs to sawmills decide to hold off on cutting trees
in response to the market conditions described in 2.5. Use a demand and supply graph to explain how
these two events affect the equilibrium price and quantity. Show changes relative to the equilibrium you
illustrated in 2.5. (4 points)
2.7. Steel is a substitute for lumber in construction. Now suppose the price for steel rises. Use a graph
of supply and demand to show what happens in equilibrium. Show changes relative to the original
equilibrium you found in 2.1. (4 points)
2.8. Now go back to the setup of 2.1 once more and suppose that instead of introducing the
Homebuilder scheme, the government introduces a subsidy of s=5 per unit of lumber transacted in the
market. Calculate the new equilibrium quantity and the price paid by consumers and received by
producers. (4 points).
2.9. Given the subsidy in 2.8, calculate and illustrate in a graph the consumer surplus, producer surplus
and subsidy expenditure. (6 points)
2.10. Calculate the dead weight loss caused by the subsidy in 2.8 and illustrate it in a graph. (4 points).
2.11. Who benefits more from the subsidy, consumers or producers? Why? (4 points).
3.1 Suppose the lumber market described in 2.1 was closed to the rest of the world. Now it opens to
trade and the world price of lumber is 20. Compute the equilibrium price, quantity supplied by
domestic producers, and quantity demanded by domestic consumers. (3 points)
3.2 Use a demand and supply graph to show how consumer surplus, producer surplus, and total
surplus change with international trade. (5 points)
3.3 Now suppose that Country A is a major exporter of lumber to Australia and in an effort to impose
sanctions on Country A, Australia imposes a tariff of t=10 on all lumber imported into Australia. Use a
graph of supply and demand to show how the tariff changes consumer, producer and total surplus. (6
points)
3.4 Calculate the equilibrium price, quantity produced and demanded domestically, tariff revenue, and deadweight loss. (4 points)
