ECON 1001 AB Introduction to Economics I Dr. Ka-fu WONG First week of tutorial sessions KKL 925 Clifford CHAN KKL 1109

Covered and to be covered Covered last week Dr. Wong covered up to #63 of kf001.ppt You should have at least read up to Chapter 1 Thinking like an economist. If not, please press hard on it. Don’t pile all the readings until exam period! Start reading chapter 2 and 3 To be covered in tutorial sessions this week Problems in chapter 1: #1, #3, #5, #7 and #9 You are advised to work on the even ones as well

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 #3, Chapter 1 Residents of your city are charged a fixed weekly fee of $6 for garbage collection. They are allowed to put out as many cans as they wish. The average household disposes of three cans of garbage per week under this plan. Now suppose that your city changes to a “tag” system. Each can of refuse to be collected must have a tag affixed to it. The tags cost $2 each and are not reusable. What effect do you think the introduction of the tag system will have on the total quantity of garbage collected in your city? Explain briefly.

Solution to problem #3 (1) Initially the city has imposed a lump-sum fee of $6 per week for garbage collection No garbage = $6 1 can of garbage = $6 2 cans of garbage =$6… Extra cost of an additional can of garbage =$0 Now the city imposes a pay-as-you-go fee for garbage collection called “tag system.” No garbage =$0 1 can of garbage =$2 2 cans of garbage =$4… Extra cost of an additional tag (can of garbage) =$2

Solution to problem #3 (2) The initial plan is more favourable to residents who have so much garbage The current plan is more favourable to residents who have less garbage Initial plan (lump-sum) Current Plan (Pay-as-you-go) 2 cans = $62 cans = $4 3 cans = $6 4 cans = $64 cans = $8 5 cans = $65 cans = $10 6 cans = $66 cans = $12

Solution to problem #3 (3) Suppose now the pay-as-you-go plan is effective, residents who discharge less garbage are favoured All residents are now induced to reducing their garbage so as to avoid the marginal cost of disposal of $2 for which it was initially zero The total quantity of garbage collected will decrease The new garbage disposal system functions well in reducing amount of garbage which in turn produces a positive impact on the environment

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) This problem is very similar to Example 1.13 that Dr. Wong covered in class last week 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 100% return, as the mushrooms double in weight in one year By investing $200 in mushrooms, Tom can potentially come out with a return of $200 after a year Thus, Dick should pay Tom an interest at least $200 after a year

Solution to problem #5 (3) An interest of $200 is just enough to compensate for Tom’s loss of investment opportunity in mushrooms If Dick pays Tom an interest of $200, Tom is indifferent between investing in mushrooms and lending the money to Dick, as the payoff ($200) is the same for both options What if Dick pays Tom an interest more than $200? Tom will gain more by lending the money to Dick What if Dick pays Tom an interest less than $200? 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 $200, say $100, Tom is sending Dick a gift equivalent to $100 (= ).

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.” – Dr. Wong, 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

Problem #9, Chapter 1 For each long-distance call anywhere in the continental United States, a new phone service will charge users 30 cents per minute for the first 2 minutes and 2 cents per minute for additional minutes in each call. Tom’s current phone service charges 10 cents per minute for all calls, and his calls are never shorter than 7 minutes. If Tom’s dorm switches to the new phone service, what will happen to the average length of his calls?

Solution to problem #9 (1) At a length of seven minutes, both service plans charge exactly the same amount - $0.70 for seven minutes If Tom talks beyond 7 minutes, Under the current service plan, the marginal cost is $0.10 per minute Under the new service plan, the marginal cost is only $0.02 per minute Since Tom never talks on phone shorter than seven minutes, he will be benefited from a new lower marginal cost under the new service plan

Solution to problem #9 (2) Suppose the new service plan is now effective. Will Tom change his behaviour? A lower marginal cost will encourage Tom to talk longer under the new phone service plan.

Done!!! If you have any questions or concerns with exercise, you are always welcomed to come to my office KKL 1109 during my office hours posted on the course website Or reach me through

The end Thanks for coming! See you next week!