Columbia University Department of Economics

UN1105 Principles of Economics

Problem Set 4

Due November 5th, in mailbox 5 by noon

1. The following question comes from Krugman and Wells, Economics (4th Ed.), Ch. 22, Q4.
The small economy of Pizzania produces three goods (bread, cheese, and pizza), each produced
by a separate company. The bread and cheese companies produce all the inputs they need
to make bread and cheese, respectively. The pizza company uses the bread and cheese from
the other companies to make its pizzas. All three companies employ labor to help produce
their goods, and the difference between the value of the goods sold and the sum of labor and
input costs is the firm’s profit. The accompanying table summarizes the activities of the three
companies when all the bread and cheese produced are sold to the pizza company as inputs
in the production of pizzas.

Bread company Cheese company Pizza company

Cost of inputs $0 $0 $50 (bread), $35 (cheese)
Wages $15 $20 $75
Value of Output $50 $35 $200

Do each of the following, showing your work for each:

(a) Calculate GDP as the value added in production. Solution: ($50 − $0) + ($35 − $0) +
($200 − $50 − $35) = $200.
(b) Calculate GDP as the spending on final goods and services. Solution: $200 (final value
of pizza).
(c) Calculate GDP as factor income. Solution: 15 + 20 + 75 = $110 in wages. ($50 − $15) +
($35 − $20) + ($200 − $75 − $50 − $35) = $90 in profits. $110 + $90 = $200.
2. The following question comes from Krugman and Wells, Economics (4th Ed.), Ch. 22, Q6.
Which of the following transactions will be included in GDP for the United States?
(a) Coca-Cola builds a new bottling plant in the United States.
(b) Delta sells one of its existing airplanes to Korean Air.
(c) Ms. Moneybags buys an existing share of Disney stock.
(d) A California winery produces a bottle of Chardonnay and sells it to a customer in Mon-
treal.
(e) An American buys a bottle of French perfume in Tulsa.

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 (f) A book publisher produces too many copies of a new book; the books don’t sell this year,
so the publisher adds the surplus books to inventories.
Solution: A, D and F are included in GDP.
3. The following question comes from Krugman and Wells, Economics (4th Ed.), Ch 22, Q8.
Eastland College is concerned about the rising price of textbooks that students must purchase.
To better identify the increase in the price of textbooks, the dean asks you, the Economics
Department’s star student, to create an index of textbook prices. The average student pur-
chases three English, two math, and four economics textbooks per year. The prices of these
books are given in the following table.

2012 2013 2014

English textbook $100 $110 $114
Math textbook $140 $144 $148
Economics textbook $160 $180 $200

(a) What is the percent change in the price of an English textbook from 2012 to 2014?
Solution: 14%
(b) What is the percent change in the price of a math textbook from 2012 to 2014? Solution:
5.7%
(c) What is the percent change in the price of an economics textbook from 2012 to 2014?
Solution: 25%
(d) Using 2013 as a base year, create a price index for these books for all years.
Solution:
2012 2013 2014
Cost of Market Basket $1220 $1338 $1438
Index 91.1 100 107.5

(e) What is the percentage change in the price index from 2012 to 2014? Solution: 18%

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4. The following question comes from Krugman and Wells, Economics (4th Ed.), Ch 22, Q9.
The consumer price index, or CPI, measures the cost of living for a typical urban household
by multiplying the price for each category of expenditure (housing, food, and so on) times
a measure of the importance of that expenditure in the average consumer’s market basket
and summing over all categories. However, using data from the consumer price index, we
can see that changes in the cost of living for different types of consumers can vary a great
deal. Let’s compare the cost of living for a hypothetical retired person and a hypothetical
college student. Let’s assume that the market basket of a retired person is allocated in the
following way: 10% on housing, 15% on food, 5% on transportation, 60% on medical care,
0% on education, and 10% on recreation. The college student’s market basket is allocated as
follows: 5% on housing, 15% on food, 20% on transportation, 0% on medical care, 40% on
education, and 20% on recreation. The accompanying table shows the March 2014 CPI for
each of the relevant categories.

CPI March 2014

Housing 228.7
Food 239.7
Transportation 219.3
Medical care 436.5
Education 229.1
Recreation 115.7

Calculate the overall CPI for the retired person and for the college student by multiplying the
CPI for each of the categories by the relative importance of that category to the individual
and then summing each of the categories. The overall CPI for all items in March 2014 was
235.6. How do your calculations for a CPI for the retired person and the college student
compare to the overall CPI?
Solution: CPI for the retired person is 343.26. CPI for the college student is 206.03. These
are respectively higher and lower than the overall CPI.

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5. The following question comes from Krugman and Wells, Economics (4th Ed.), Ch 22, Q11.
The following table provides the annual real GDP (in billions of 2009 dollars) and nominal
GDP (in billions of dollars) for the United States.

2009 2010 2011 2012 2013

Real GDP (billions of 2009 dollars) 14,417.9 14,779.4 15,052.4 15,470.7 15,761.3
Nominal GDP (billions of dollars) 14,417.9 14,958.3 15,533.8 16,244.6 16,799.7

(a) Calculate the GDP deflator for each year.

(b) Use the GDP deflator to calculate the inflation rate for all years except 2009.
Solution:

2009 2010 2011 2012 2013

Real GDP (billions of 2009 dollars) 14,417.9 14,779.4 15,052.4 15,470.7 15,761.3
Nominal GDP (billions of dollars) 14,417.9 14,958.3 15,533.8 16,244.6 16,799.7
GDP Deflator 100 101.2 103.2 105.0 106.6
Inflation - 1.2% 2.0% 1.7% %1.5

6. The following question comes from Krugman and Wells, Economics (4th Ed.), Ch 23, Q3.
In each of the following situations, what type of unemployment is Melanie facing?
(a) After completing a complex programming project, Melanie is laid off. Her prospects for
a new job requiring similar skills are good, and she has signed up with a programmer
placement service. She has passed up offers for low-paying jobs. Solution: Frictional.
(b) When Melanie and her co-workers refused to accept paycuts, her employer outsourced
their programming tasks to workers in another country. This phenomenon is occurring
throughout the programming industry. Solution: Structural.
(c) Due to the current slump, Melanie has been laid off from her programming job. Her
employer promises to rehire her when business picks up. Solution: Cyclical.
7. The following question comes from Krugman and Wells, Economics (4th Ed.), Ch 23, Q9.
In the following examples, is inflation creating winners and losers at no net cost to the economy
or is inflation imposing a net cost on the economy? If a net cost is being imposed, which type
of cost is involved?
(a) When inflation is expected to be high, workers get paid more frequently and make more
trips to the bank. Solution: Net shoe-leather costs.
(b) Lanwei is reimbursed by her company for her work-related travel expenses. Sometimes,
however, the company takes a long time to reimburse her. So when inflation is high, she
is less willing to travel for her job. Solution: Net unit-of-account costs.
(c) Hector Homeowner has a mortgage with a fixed nominal 6% interest rate that he took out
five years ago. Over the years, the inflation rate has crept up unexpectedly to its present
level of 7%. Solution: No net cost - Hector’s gains are the mortgage company’s losses.
(d) In response to unexpectedly high inflation, the manager of Cozy Cottages of Cape Cod
must reprint and resent expensive color brochures correcting the price of rentals this
season. Solution: Net menu costs.