MAE101 Economic Principles Assignment, T2 2015
Department of Economics, School of Business
Word Limit (1500 words)
Basic Version
The due date for this written assignment is Monday 21 September 2015.
This basic version is worth 18 marks total. There are three other challenging
versions, each of which is worth 4 bonus marks. You only have to complete one (1)
assignment.
This version is worth 45 points, reweighted to 18 marks.
Submit your assignment via Cloud Deakin in the appropriate assignment dropbox by
11:59 p.m. on Monday 21 September 2015. Hard copies will NOT be accepted. Please
note the new, later, due date.
Extensions can only be granted by the Unit Chair (Dr Randy Silvers,
randolph.silvers@deakin.edu.au).
This is an individual assignment; the work that you submit must be your own.
Plagiarism will incur penalties.

1

Background
Currently, Australia and China are implementing a bilateral trade agreement that the
leaders of the two countries signed recently; known in the press as the ChinaAustralia Free Trade Agreement.1 For some background, see:
http://business.nab.com.au/wp-content/uploads/2014/11/china-australia-freetrade-agreement-highlights-november-2014-economic-report.pdf
and
http://dfat.gov.au/trade/agreements/chafta/Pages/australia-china-fta.aspx
As you have learned in MAE101, economics is about allocating scarce resources
among competing uses. One of the core principles is that voluntary trade benefits all
participants to the trade.
If this principle is so basic and intuitive, why then have governments resisted trade
between countries? In what ways do governments restrict trade? Why is trade between
countries different from trade within a country — such as, workers moving from one
state to another for employment, or goods being manufactured in one state and sold in
another?
In this assignment, you will use the economics that you have learned in MAE101 to
assess who gains and who loses when trade restrictions are relaxed.

1

2

This is separate from the TransPacific Partnership, which is a trade agreement that

Task 1: Opportunity Cost and Trade
(a)

Use an example from your own life in which two individuals (you can be one of
them) can produce two different “goods.”2
(i)

Describe the example. Who are the individuals, what can they produce,
what do they actually produce.

(ii)

Generate a table showing how much each individual can hypothetically
produce in a given period of time — define the period of time.3

(iii) On one graph, show the production possibilities frontiers for each
individual and the joint production possibilities.
(6 Points)
(b)

Using your example:
(i)

Define opportunity cost, absolute advantage, and comparative advantage.

(ii)

Derive the opportunity costs for both individuals, for both goods.

(iii) State who, if either, has the absolute advantage in each good; state who, if
either, has the comparative advantage in each good. Describe how both
individuals gain by trading.
(6 Points)
(c)

Notice that you have not expressed any costs in dollars. What is the “real cost”
of a good?
(2 Points)

2

Do not use examples referenced in the textbook, lectures, or videos. You may use
examples from your household, your studies, your work, and your extracurricular
activities — such as a sport team or video production.
3
You do not need to do research. Just generate reasonable numbers.
3

Task 2: Supply, Demand, and Changes in the Equilibrium
Choose an industry for which China currently has a tariff and that is affected by the
new trade agreement — see the first page after the title page of the NAB link. Assume
for parts (a) and (b) below that the market for your chosen industry is perfectly
competitive.
(a)

For the market you’ve chosen, draw two demand-and-supply graphs side-byside — one for Australia, one for China. Show the effects of the tariff in both
markets.
(2 Points)

(b)

Reproduce the graphs without the tariffs. On each graph, identify:
(i)

the old and new equilibrium price;

(ii)

the old and new equilibrium quantity;

(iii) the old and new amounts of exports or imports, as appropriate; and
(iv) the changes to consumers’ surplus and producers’ surplus.
Also, explain each effect. That is, explain the change to the price, quantity,
imports/exports, and consumers’ and producers’ surpluses in both markets.
(4 Points)
(c)

Suppose that either: (i) the demand for this industry’s product in Australia, or
(ii) the supply for this industry’s product in Australia, is more inelastic than
what you have drawn above. You may choose which comparison to make.
State which comparison you consider. Then, for each of the effects in (b),
explain whether the effect becomes larger, smaller, or there is no change to the
effect.
For example, if you choose option (i) and stated that the new price in
Australia is greater than the old price, then for this part, you should
state, and explain, either “the price rise becomes greater the more
inelastic the demand in Australia” or “the price rise becomes smaller
the more inelastic the demand in Australia” or “the price rise is
unaffected by the elasticity of demand in Australia.”
(4 Points)

(d)

List the three defining characteristics of a perfectly competitive market. For the
market you’ve chosen, state whether or not each condition applies. Do you think
that the market is perfectly competitive, monopolistically competitive,
oligopolistic or monopolistic? State your reasoning.
(3 Points)

4

Task 3: Cost Structure and Effects in Short and Long Run
Regardless of your answer to Task 2 (d) above, assume that the industry in Australia
is perfectly competitive.
(a)

Consider the current market, in which China imposes tariffs on Australian
goods, to be in long-run equilibrium. Graph a typical firm’s cost curves and
production decisions.
(2 Points)

(b)

Show on your graph and explain what happens in the short run to this typical
firm after the tariff is eliminated.
(2 Points)

(c)

Explain what will happen in the long run to the market and to this typical firm.
What is the long-run equilibrium price?
(3 Points)

(d)

Who gains and who loses in this market from the elimination of tariffs? Be sure
to consider consumers and producers in both countries, and distinguish between
the short run and the long run.
(3 Points)

5

Task 4:
In this task, you are to complete part (a); you then complete either part (b) OR part (c)
– this is your choice.
(a)

Professor Ricardo, a leading economist, was interviewed recently about the Free
Trade Agreement with Australia. Professor Ricardo stated that it didn’t really
matter what the specifics of the agreement were. Said Professor Ricardo, “what
is really important is to lower and preferably eliminate all of China’s tariffs so
that China can have a level playing field”. Explain what Professor Ricardo
meant by a level playing field.
(4 Points)

(b)

In both China and Australia, there has been some opposition to the Free Trade
Agreement. In Australia, for example, some have feared that this will destroy
jobs.
Some groups have lobbied their governments to modify the agreement or
even stop it. Lobbying involves the use of scare resources. Is this a
productive activity or a dead weight loss? Explain your reasoning.
(4 Points)

(c)

Regarding both working conditions and environmental pollution standards,
Australia imposes stronger restrictions on its domestic producers than China
does on its domestic producers. If China were to impose similarly stringent
restrictions on its domestic producers, what would happen to the cost (marginal
cost and average total cost) of a typical Chinese firm? What effect(s) would that
have on Chinese exports to Australia and on Chinese imports from Australia?
(4 Points)

MAE101 Economic Principles Assignment, T2 2015.

(1) assignment.
This version is worth 41 points, reweighted to 22 marks.
Submit your assignment via Cloud Deakin in the appropriate assignment dropbox by
11:59 p.m. on Monday 21 September 2015. Hard copies will NOT be accepted. Please
note the new, later, due date.
Extensions can only be granted by the Unit Chair (Dr Randy Silvers,
randolph.silvers@deakin.edu.au).
This is an individual assignment; the work that you submit must be your own.
Plagiarism will incur penalties.
2
Background
For most of the goods and services that we have considered, markets operate with few
restrictions – we have studied the consequences of price controls and taxes and tariffs,
but those restrictions affect the prices that consumers pay and the prices that firms
receive, not who can or cannot be a consumer or producer.
Consider the markets for drugs:
(i) Some drugs, such as aspirin, ibuprofen, and antacids, are over-thecounter
– anybody can purchase them and the only restriction on their
production is much the same as that on most other products, namely
that its contents be listed and the product not be defective.
(ii) Other drugs, such as codeine and penicillin, require a prescription.
Anybody can purchase them provided that they have a note, signed by
a professional, who has passed a series of tests to demonstrate
competency and ethical behavior as an authority. Moreover, the
quantities purchased are limited by the note. As with the first category,
any firm can produce these pharmaceuticals, subject to the similar
regulations – there may be tougher standards in first obtaining
approval, such as demonstrating that the drug be both safe and
effective, and documenting potential side effects, in order to warn.
(iii) The last category of drugs, such as heroin and cocaine, are illegal. No
consumer can legally purchase the drugs, no firm can legally produce
them, and no professional is authorized to issue a note that allows the
purchase or production of the drug.
In this version, you will study why these three categories of drugs exist and how
making a drug illegal does not eliminate the market; rather, it becomes part of the socalled
“black market.” You will also learn about some of the ramifications of different
policies, such as the restrictions that create the second and third categories.
Useful references:
• the article for discussion in seminar week 6 (It’s Time to End the War on
Drugs);
• the Aplia problem set that was due 16 August, News Analysis — Optimal
Decision Making: A Parking Dilemma;
• the following 50-minute podcast for which there is also a transcript
available at the link:
http://thedianerehmshow.org/shows/2015-07-28/efforts-to-curb-thenations-
deadly-heroin-epidemic
3
Task 1: Voluntary Exchange and the Risk of Addiction
(a) Consider the first two markets described in the Background. Suppose that the
production in both markets is perfectly competitive. For each, derive the
equilibrium price, quantity, and consumers’ surplus.
(i) In the over-the-counter market, assume for simplicity that the market
supply is Qs = 40 + P and the demand is given by Qd = 184 – 8P.
(ii) In the prescription drug market, assume for simplicity that the market
supply is Qs = 10 + P/2 and demand is given by Qd = 100 – 2P.
(6 Points)
Unlike with the over-the-counter drugs, both prescription drugs and illicit drugs can
become addictive. A consumer does not know the probability that he will become
addicted until after he has consumed the drug.
Now, consider the third market, that for illicit drugs. We can think then of the
individual having an initial willingness to pay for an illicit drug (WTPo) and
subsequently, either an experienced willingness to pay (WTPe) or an addicted
willingness to pay (WTPa). Let the probability of becoming addicted be denoted by
padd — and thus, the probability of not becoming addicted and being able to continue
using the drug with experience is 1 – padd.
(b) Assume for simplicity that the current market price is $25. For a particular
consumer, let WTPo = 40, WTPe = 60, and WTPa = -$140 < 0.
(i) Interpret each WTP.
(ii) Show that if the probability of becoming addicted is 0.1 (padd = 0.1),
then the individual will choose to consume the drug.
(iii) Show that if the probability of becoming addicted is 0.4 (padd = 0.4),
then the individual will choose to not consume the drug.
(7 Points)
(c) One of the core principles of economics is that voluntary transactions make
those economic agents that transact better off. Discuss this in light of what you
have just shown above.
(3 Points)
(d) Some goods in each category have similar characteristics to goods in other
categories. In the U.S., the government has cracked down on prescription
painkillers, tightening the supply. Refer to the podcast. Show the effects of a
government crackdown on the market for heroin in a demand-and-supply
graph.
(3 Points)
4
Task 2: Risk of Incarceration, Taxes, Production Costs, and Entry
(a) For those drugs in the third category, any consumer and any producer risks
being caught and incarcerated.
(i) Consider a consumer who is experienced but not addicted to such a
drug. Let his WTPe = 60. If the consumer is caught and incarcerated,
then he gets 0. Let his willingness to pay for alcohol, which is licit, be
54. Show that if the probability of being caught and incarcerated is 0.1,
then the consumer is indifferent between consuming the illicit drug
which entails the risk of being caught and incarcerated, or consuming
alcohol.
(ii) Consider producers. Previously, when the drugs were illicit, each
producer had certain explicit and implicit costs of production; suppose
that these are constant and equal to 20. A producer would sell six units
at a price of 28 each. Suppose that the probability that a producer is
caught and incarcerated is 0.25. Determine the amount of loss that a
producer would regard incarceration to be equivalent to, that would
make this producer indifferent between becoming a producer and not.
(iii) Each producer attempted to maintain a monopoly over its territory,
often by threatening potential entrants with physical harm — after all,
since the drug is illicit, the producer cannot avail itself of the judicial
system to enforce their monopoly or contracts/agreements. Suppose
that a local monopolist faces a demand given by Qd = 20 – P and has a
constant marginal cost equal to 4. Graph this local monopolist’s
demand, marginal revenue, and marginal cost. On your graph, identify
the monopolist’s profit-maximizing quantity and price, then shade the
areas that represent consumers’ surplus, deadweight loss, and profit.
(6 Points)
Return to Task 1 (b) and suppose that the government decides to legalize the illicit
drugs and impose a tax of $10. Let Qd = 100 – 2P and Qs = 10 + P/2.
(b) Derive the new equilibrium — the price that consumers pay, the price that
firms receive, and the quantity. What is the share of tax burden that consumers
bear and how is that share related to the elasticity of demand versus the
elasticity of supply?
.
(4 Points)
(c) Because the drug is now licit, explain why demand would change and write a
demand that is consistent with your explanation — for example, if you think
that demand would increase and become more elastic, then modify Qd = 100 –
2P to an equation that shows greater demand and is more elastic (at least at the
equilibrium).
Repeat for supply — explain why supply would change and write a supply that
is consistent with your explanation.
(4 Points)
5
Task 3: Government’s Choices
(a) Listen to the podcast, particularly the question and response by Marc Fisher
from 1:44 – 3:40 (starting at 10:07:50 in the transcript). Consider his statement
that the Mexican cartels switched from marijuana to poppy/heroin production
after marijuana became legalized in some states in the U.S.
(i) Use a supply-and-demand graph to show the effects of this crackdown
for Mexican drug cartels.
(ii) Do you agree with the statement that the legalization of marijuana in
some states impelled the Mexican drug cartels to switch to
poppy/heroin production, or do you think that they would have started
producing anyway because the demand for heroin increased? Explain.
(4 Points)
In articles for discussion in the seminars, you have discussed policies to reduce
children’s tobacco consumption and the various benefits and costs of ending the war
on drugs. Many politicians and social scientists compare illicit drugs to alcohol and
tobacco, two products that are licit and taxed despite each being addictive and
physically harmful. Certainly, there is uncertainty about the benefits and costs that
would result if currently illicit drugs such as heroin were made licit and taxed.
(b) Suppose that as a government leader, you believe that making heroin licit
would result in either per annum net benefits of $1 million or a net loss of $3
million, with probabilities 0.9 and 0.1, respectively.
If after one year, you learn that:
• the result is good (net benefits of $1 million), then you maintain the
licit status into the future, yielding net benefits each year into the future
— suppose that this stream has a current value of $5 million; or
• the result is adverse (net loss of $3 million), then you would like to
reverse the policy and make heroin illicit again. However, reversing
this policy has become difficult and would entail a cost that has a
current value of $10 million; thereafter, heroin would be illicit,
yielding no net benefits or costs compared to the current situation.
(i) Would it be prudent to legalize heroin or maintain its illicit status?
(ii) Relate this to alcohol and tobacco.
(4 Points)

MAE101 Economic Principles Assignment, T2 2015.

(1) assignment.
This version is worth 41 points, reweighted to 22 marks.
Submit your assignment via Cloud Deakin in the appropriate assignment dropbox by
11:59 p.m. on Monday 21 September 2015. Hard copies will NOT be accepted. Please
note the new, later, due date.
Extensions can only be granted by the Unit Chair (Dr Randy Silvers,
randolph.silvers@deakin.edu.au).
This is an individual assignment; the work that you submit must be your own.
Plagiarism will incur penalties.
2
Background
For most of the goods and services that we have considered, markets operate with few
restrictions – we have studied the consequences of price controls and taxes and tariffs,
but those restrictions affect the prices that consumers pay and the prices that firms
receive, not who can or cannot be a consumer or producer.
Consider the markets for drugs:
(i) Some drugs, such as aspirin, ibuprofen, and antacids, are over-thecounter
– anybody can purchase them and the only restriction on their
production is much the same as that on most other products, namely
that its contents be listed and the product not be defective.
(ii) Other drugs, such as codeine and penicillin, require a prescription.
Anybody can purchase them provided that they have a note, signed by
a professional, who has passed a series of tests to demonstrate
competency and ethical behavior as an authority. Moreover, the
quantities purchased are limited by the note. As with the first category,
any firm can produce these pharmaceuticals, subject to the similar
regulations – there may be tougher standards in first obtaining
approval, such as demonstrating that the drug be both safe and
effective, and documenting potential side effects, in order to warn.
(iii) The last category of drugs, such as heroin and cocaine, are illegal. No
consumer can legally purchase the drugs, no firm can legally produce
them, and no professional is authorized to issue a note that allows the
purchase or production of the drug.
In this version, you will study why these three categories of drugs exist and how
making a drug illegal does not eliminate the market; rather, it becomes part of the socalled
“black market.” You will also learn about some of the ramifications of different
policies, such as the restrictions that create the second and third categories.
Useful references:
• the article for discussion in seminar week 6 (It’s Time to End the War on
Drugs);
• the Aplia problem set that was due 16 August, News Analysis — Optimal
Decision Making: A Parking Dilemma;
• the following 50-minute podcast for which there is also a transcript
available at the link:
http://thedianerehmshow.org/shows/2015-07-28/efforts-to-curb-thenations-
deadly-heroin-epidemic
3
Task 1: Voluntary Exchange and the Risk of Addiction
(a) Consider the first two markets described in the Background. Suppose that the
production in both markets is perfectly competitive. For each, derive the
equilibrium price, quantity, and consumers’ surplus.
(i) In the over-the-counter market, assume for simplicity that the market
supply is Qs = 40 + P and the demand is given by Qd = 184 – 8P.
(ii) In the prescription drug market, assume for simplicity that the market
supply is Qs = 10 + P/2 and demand is given by Qd = 100 – 2P.
(6 Points)
Unlike with the over-the-counter drugs, both prescription drugs and illicit drugs can
become addictive. A consumer does not know the probability that he will become
addicted until after he has consumed the drug.
Now, consider the third market, that for illicit drugs. We can think then of the
individual having an initial willingness to pay for an illicit drug (WTPo) and
subsequently, either an experienced willingness to pay (WTPe) or an addicted
willingness to pay (WTPa). Let the probability of becoming addicted be denoted by
padd — and thus, the probability of not becoming addicted and being able to continue
using the drug with experience is 1 – padd.
(b) Assume for simplicity that the current market price is $25. For a particular
consumer, let WTPo = 40, WTPe = 60, and WTPa = -$140 < 0.
(i) Interpret each WTP.
(ii) Show that if the probability of becoming addicted is 0.1 (padd = 0.1),
then the individual will choose to consume the drug.
(iii) Show that if the probability of becoming addicted is 0.4 (padd = 0.4),
then the individual will choose to not consume the drug.
(7 Points)
(c) One of the core principles of economics is that voluntary transactions make
those economic agents that transact better off. Discuss this in light of what you
have just shown above.
(3 Points)
(d) Some goods in each category have similar characteristics to goods in other
categories. In the U.S., the government has cracked down on prescription
painkillers, tightening the supply. Refer to the podcast. Show the effects of a
government crackdown on the market for heroin in a demand-and-supply
graph.
(3 Points)
4
Task 2: Risk of Incarceration, Taxes, Production Costs, and Entry
(a) For those drugs in the third category, any consumer and any producer risks
being caught and incarcerated.
(i) Consider a consumer who is experienced but not addicted to such a
drug. Let his WTPe = 60. If the consumer is caught and incarcerated,
then he gets 0. Let his willingness to pay for alcohol, which is licit, be
54. Show that if the probability of being caught and incarcerated is 0.1,
then the consumer is indifferent between consuming the illicit drug
which entails the risk of being caught and incarcerated, or consuming
alcohol.
(ii) Consider producers. Previously, when the drugs were illicit, each
producer had certain explicit and implicit costs of production; suppose
that these are constant and equal to 20. A producer would sell six units
at a price of 28 each. Suppose that the probability that a producer is
caught and incarcerated is 0.25. Determine the amount of loss that a
producer would regard incarceration to be equivalent to, that would
make this producer indifferent between becoming a producer and not.
(iii) Each producer attempted to maintain a monopoly over its territory,
often by threatening potential entrants with physical harm — after all,
since the drug is illicit, the producer cannot avail itself of the judicial
system to enforce their monopoly or contracts/agreements. Suppose
that a local monopolist faces a demand given by Qd = 20 – P and has a
constant marginal cost equal to 4. Graph this local monopolist’s
demand, marginal revenue, and marginal cost. On your graph, identify
the monopolist’s profit-maximizing quantity and price, then shade the
areas that represent consumers’ surplus, deadweight loss, and profit.
(6 Points)
Return to Task 1 (b) and suppose that the government decides to legalize the illicit
drugs and impose a tax of $10. Let Qd = 100 – 2P and Qs = 10 + P/2.
(b) Derive the new equilibrium — the price that consumers pay, the price that
firms receive, and the quantity. What is the share of tax burden that consumers
bear and how is that share related to the elasticity of demand versus the
elasticity of supply?
.
(4 Points)
(c) Because the drug is now licit, explain why demand would change and write a
demand that is consistent with your explanation — for example, if you think
that demand would increase and become more elastic, then modify Qd = 100 –
2P to an equation that shows greater demand and is more elastic (at least at the
equilibrium).
Repeat for supply — explain why supply would change and write a supply that
is consistent with your explanation.
(4 Points)
5
Task 3: Government’s Choices
(a) Listen to the podcast, particularly the question and response by Marc Fisher
from 1:44 – 3:40 (starting at 10:07:50 in the transcript). Consider his statement
that the Mexican cartels switched from marijuana to poppy/heroin production
after marijuana became legalized in some states in the U.S.
(i) Use a supply-and-demand graph to show the effects of this crackdown
for Mexican drug cartels.
(ii) Do you agree with the statement that the legalization of marijuana in
some states impelled the Mexican drug cartels to switch to
poppy/heroin production, or do you think that they would have started
producing anyway because the demand for heroin increased? Explain.
(4 Points)
In articles for discussion in the seminars, you have discussed policies to reduce
children’s tobacco consumption and the various benefits and costs of ending the war
on drugs. Many politicians and social scientists compare illicit drugs to alcohol and
tobacco, two products that are licit and taxed despite each being addictive and
physically harmful. Certainly, there is uncertainty about the benefits and costs that
would result if currently illicit drugs such as heroin were made licit and taxed.
(b) Suppose that as a government leader, you believe that making heroin licit
would result in either per annum net benefits of $1 million or a net loss of $3
million, with probabilities 0.9 and 0.1, respectively.
If after one year, you learn that:
• the result is good (net benefits of $1 million), then you maintain the
licit status into the future, yielding net benefits each year into the future
— suppose that this stream has a current value of $5 million; or
• the result is adverse (net loss of $3 million), then you would like to
reverse the policy and make heroin illicit again. However, reversing
this policy has become difficult and would entail a cost that has a
current value of $10 million; thereafter, heroin would be illicit,
yielding no net benefits or costs compared to the current situation.
(i) Would it be prudent to legalize heroin or maintain its illicit status?
(ii) Relate this to alcohol and tobacco.
(4 Points)