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3. What are five questions that an economic system must answer?
An economic system must answer five questions: 1) What quantities of various goods and services will be produced in an economy? A successful economic system must provide answers that satisfy a large part of the population. 2) How will the goods and services be produced? There are different methods by which goods and services can be produced. An economic system must determine which methods will be used. 3) For whom will the goods and services be produced? This is a difficult question to answer. On the one hand, people must be rewarded for their production so there is an incentive to increase production. On the other hand, compassion or justice requires that those who cannot produce an adequate amount be taken care of in some way. 4) Will people be fully employed so that the economy produces at its capacity? Periods of high unemployment and/or rapid inflation disrupt an economic system. Unemployment translates into lost output for the economy. Rapid inflation makes it more difficult for the economy to operate because relative prices function provide less information to economic actors. 5) Will the economy grow, and if so how fast? Continued economic growth is important if more of people's unlimited desires are to be met.
5. Define comparative advantage. Suppose Hugh can produce either 3 short stories per week or 6 gallons of orange juice. Liz can produce either 2 short stories per week or 2 gallons of orange juice.
a. Which person has an absolute advantage in producing short stories? in orange juice?
b. Which person has a comparative advantage in short stories? in orange juice?
c. Is there a basis for specialization and trade between Hugh and Liz? Explain in detail why or why not.
Comparative advantage means that an individual can produce a good at a lower opportunity cost than another individual. An absolute advantage means that, given time and resources, an individual can produce more of product than another individual.
a. In the example above, Hugh can produce more short stories and more orangejuice than Liz. He has the absolute advantage in the production of both goods.
b. In the example above, Hugh's opportunity cost of producing 1 short story is 2 gallons of orange juice. Liz's opportunity cost of producing 1 short story is 1 gallon of orange juice. Thus, Liz has the comparative advantage in the production of short stories. Hugh's opportunity cost of producing 1 gallon of juice is 1/2 short story. Liz's opportunity cost of producing 1 gallon of juice is 1 short story. Hugh has the comparative advantage in the production of orange juice.
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c. There is a basis for specialization and trade between Hugh and Liz. Liz should specialize in producing stories and trade stories to Hugh for orange juice. Hugh should specialize in producing orange juice and trade juice to Liz in return for stories. Suppose Hugh and Liz settle on trading 1 story for 11/2 units of juice. If Liz trades away a story, she will get 11/2 gallons of juice. Typically, if she gave up 1 story, she would get only 1 juice in return. She is made better off by the trade. If Hugh gives up 11/2 gallons of juice he gets 1 story. Typically, Hugh would have to give up 2 stories to get 1 juice. He is made better off by the trade. By specializing in those goods for which they have the comparative advantage and trading for the other good, both individuals can obtain the other good at a lower opportunity cost.
9. Explain how price acts as a signal for consumers and producers. Explain how it actsas a motivator.
The price system informs both consumers and producers about underlying changes in the market. For example, a price increase tells both consumers and producers that a good is now valued more highly. For consumers, this means that the good will be more costly to buy. For producers, this means that the good will be more profitable to produce. This information then motivates consumers and producers to act.
Because the good is more costly, consumers will be willing to purchase less of it than they did previously. Because the good is more profitable to produce, producers will be willing to supply more of it than they did previously.
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