14.01 - Principles of Microeconomics Prof.

Rothschild

Problem set 7
Problem set 7 is due on Friday, April 26th at 11:59 PM.

Problem 1: True/False/Explain (25 points)

1. (5 points) If properly labeled, this diagram would correctly illustrate the effects
of a rise in interest rates for a consumer for whom the income effect of the rise in
interest rates outweighs the substitution effects of the rise in the interest rates
(ci = consumption in period i).

2. (5 points) Suppose that interest rates are at 3 percent and a firm is considering
a project with an upfront cost, a revenue stream of k per year for 10 years, and
strictly positive NPV. If interest rates fall to 2 percent, the firm will still decide
to make the investment to start that project.

3. (5 points) Suppose the country requiring the least labor to make artisan pottery
is Japan (assume labor is the only input to make artisan pottery). Then Japan
should specialize in producing and exporting artisan pottery because it has the
comparative advantage in artisan pottery.

4. (5 points) Sheilah is working, consuming, and saving rationally for retirement.

A rise in real interest rates will definitely lead Sheilah to optimally decide to
save more for retirement and consume less today.

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14.01 - Principles of Microeconomics Prof. Rothschild

5. (5 points) Consider a firm that is considering two possible investment projects.

Project A has revenue stream RA (t), t = 0, 1, 2, 3... and cost stream CA (t),
t = 0, 1, 2, 3, .... Project B has revenue stream RB (t), t = 0, 1, 2, 3... and cost
stream CB (t), t = 0, 1, 2, 3, .... It is possible that project A will be a better
choice for low interest rates, project B will be a better choice for intermediate
interest rates, and project A will again be a better choice for high interest rates.

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14.01 - Principles of Microeconomics Prof. Rothschild

Problem 2: Production Possibilities Frontier (20 points)

Chuckie the farmer has a large square plot of land. We normalize the sides of the
square to 1 and use (x, y) ∈ [0, 1] × [0, 1] to denote the coordinates of a point in
that square plot. The local productivity of land at the coordinate (x, y) is c(x, y) if
planted in corn and s(x, y) if planted in soy. This question asks you to plot Chukie’s
Production Possibilities Frontier for various “productivity” functions c(·) and s(·).
For questions including graphing, please provide all relevant information necessary to
interpret the graph (labeled axes, intercepts, notable coordinates, general shape).

1. (4 points) Suppose first that all of Chuckie’s land is equally productive: c(x, y) =
5 and s(x, y) = 3 for all (x, y). Plot Chuckie’s PPF.

2. (8 points) Suppose instead that the left half of Chuckie’s land is differently
productive than the right half of Chuckie’s land:
( )
4 if x ≤ 0.5
c(x, y) =
6 if x > 0.5
( )
1 if x ≤ 0.5
s(x, y) =
5 if x > 0.5

Plot Chuckie’s PPF. (Hint: which land will Chuckie plant in soy “first”?)

3. (8 points) Suppose that the productivity of the land varies with its "longitude:"
1 2
c(x, y) = 25
4
x 4 and s(x, y) = 5x 3 . Plot Chuckie’s PPF. (A graphing tool is
useful here – but explain your reasoning and the thing you plotted clearly.)

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14.01 - Principles of Microeconomics Prof. Rothschild

Problem 3: International Trade (42 points)

Consider the production of wine and cheese in France and Spain. The table below
gives the number of necessary hours to produce each (labor is the only input):

France Spain
1 Kilo of Cheese 4 6
1 Bottle of Wine 6 12

For questions including graphing, please provide all relevant information necessary to
interpret the graph (labeled axes, intercepts, notable coordinates, general shape).

1. (4 points) For each good, which country has an absolute advantage?

2. (4 points) Suppose that, originally, there is no trade between countries, and all
markets are perfectly competitive. For each country, what is ratio of the price
of wine to the price of cheese?

3. (4 points) For each good, which country has a comparative advantage?

4. (6 points) Suppose that France and Spain are under autarky (no trade), and
they both have a total of 24 units of labor L. Draw the production possibility
frontier for each country for the number of goods they can produce in one day.
Draw your graph with cheese on the y-axis and wine on the x-axis.

5. (3 points) France and Spain decide to trade. Describe the pattern of trade, i.e.
which country exports which good.

6. (7 points) Draw the joint production possibility frontier.

7. (10 points) The countries agree to trade at a rate of 7/4 kilos of cheese for 1
bottle of wine. Draw the new consumption set for each country. Would each
country have an interest in trading at this rate?

8. (4 points) In the hopes of increasing the value of its exports, the government
of France would like to increase the rate at which it trades wine to 3 kilos of
cheese for 1 bottle of wine. How would this affect the degree of trade? Would
France be better off offering to trade at this rate or at the original rate of 7/4
kilos of cheese for 1 bottle of wine.

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14.01 - Principles of Microeconomics Prof. Rothschild

Question 4: To get a PhD or not? (52 points)

In the country of Nerdonia, everyone lives forever and there are two possible careers
after you finish college. You can either do a PhD and then work as a professor or get
a job as an actuary immediately after college. You make this career choice in t = 0,
the year you graduate college. If you decide to get a PhD, you will earn $0 per year
for years t = 1 to t = 5 while in grad school, followed by $12 per year from year 6
until the end of time. If you decide to get a job as an actuary, you will earn $10 per
year from t = 1 until the end of time.

1. (8 points) Say that you can borrow or save any amount at an interest rate of
r, i.e. if you save $1 this year, you will get back $(1 + r) next year, and if
you borrow $1 this year, you will owe $(1 + r) next year. If your decision is
purely financial, over what range of r will you choose to get a PhD? What is
the intuition for why you would choose the PhD when r is higher or lower?

Now assume that instead of living forever, each citizen of Nerdonia lives for just three
periods. At t = 0, you still face a choice between getting a PhD and becoming a
professor vs working as an actuary. If you get a PhD, you earn nothing at t = 1 and
earn $12 at t = 2. If you work as an actuary, you earn $10 at t = 1 and nothing at
t = 2. However, now you don’t just care about the financial payoffs from each career.
You also get some enjoyment a from being in the PhD, where the value for a varies
across individuals. If you work as an actuary, your utility function is therefore given
by:
U (c1 , c2 ) = ln(c1 ) + ln(c2 )

while if you get a PhD, it is given by:

U (c1 , c2 ) = a + ln(c1 ) + ln(c2 )

2. (4 points) Again, you can borrow or save any amount at interest rate r. What
will be your intertemporal budget constraint if you decide to get a PhD? What
is your budget constraint if you decide to be an actuary?

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14.01 - Principles of Microeconomics Prof. Rothschild

3. (7 points) Find expressions for c1 , c2 , and either savings or borrowing separately

in the cases that you get a PhD or work as an actuary. How do actuaries’ savings
and PhD students’ borrowing depend on r? Please explain intuitively.

4. (5 points) Say that the actuaries’ savings are the only supply of capital in
Nerdonia, and the PhD students’ borrowing is the only demand for capital.
There are 50 people in the country, and in equilibrium 24 of them decide at
t = 0 to be actuaries, while 26 decide to get PhDs and become professors. (Note
that this choice will depend on their values for a and on correctly forecasting
the equilibrium interest rate r. We’ll come back to this choice later.) What is
r in equilibrium?

5. (5 points) Given equilibrium r, write an expression for the threshold value of a

over which people choose to get a PhD and below which they choose to work
as actuaries. An expression involving natural logs and fractions is fine.

6. (9 points) Now say that Nerdonia opens to the world capital market, where
there is a perfectly elastic supply of capital at interest rate r = 0.5. Assume
that all residents of Nerdonia have already made their career choice and cannot
switch jobs.

(a) Draw a graph showing domestic supply and demand for capital, as well as
the world supply curve for capital. (The graph does not need to be scaled
properly.)
(b) How much capital do Nerdonia’s actuaries save?
(c) How much capital do Nerdonia’s PhD students borrow?
(d) How much capital does Nerdonia export or import?
(e) Which domestic group is made better off by opening Nerdonia’s capital
market to trade?

7. (8 points) After opening Nerdonia to the world capital market, the government
is displeased that PhD students are facing such high interest rates. Thus, they
decide to pay 10 cents of the interest that PhD students owe on each dollar
they borrow, whether borrowed from domestic or international lenders. In other
words, PhD students now face an interest rate of rp = 0.4, while actuaries can
still lend at ra = 0.5.

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14.01 - Principles of Microeconomics Prof. Rothschild

(a) Reproduce your graph of the market, adding the new effective capital
supply curve that PhD students face, and label all surplus-relevant areas
with letters.
(b) Using these letters, what is surplus to PhD students (PS), actuaries (AS),
and the government (GS) before and after the government introduces this
subsidy?
(c) Treating PS + AS + GS as total surplus, what is the deadweight loss
from offering this government subsidy to PhD students? Why does this
deadweight loss arise?

8. (5 points) Say the government does not actually implement this subsidy to
domestic borrowers, so both PhD students and actuaries again face a world
interest rate of 0.5. Now say that citizens of Nerdonia have the opportunity
to switch careers at t = 0 after learning that Nerdonia is opening to the
international capital market. Draw a new graph of Nerdonia’s capital market.
What happens to imports or exports of capital? (Don’t worry about numerical
answers; intuition is sufficient.)