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HL Paper 3 Quantitative Exercises

and Worked Solutions
taken from

Workbook for the New I.B. Economics

(2nd edition)
by Bryce McBride

Copyright 2013, Croecko Publishing

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or
transmitted in any form or by any means, electronic, mechanical, photocopying, recording or
otherwise, without the prior written permission of the publisher.

Croecko Publishing
650 Lacroix Bay Road, R.R. #1
Westmeath, Ontario
Canada K0J 2L0

For ordering and other information, please go to

www.brycemcbride.com and www.croecko.com or send an email to bryce@brycemcbride.com

ISBN 978-0-9868944-6-6
 2

Author’s Introduction

Since the fall I have been working on a new and improved edition of Workbook for the New I.B.
Economics featuring improved lessons and additional exercises presented with the aid of attractive
graphic design.

I expect to complete the entire revision later this spring (most likely in April, 2013) but have decided to
release these exercises and worked solutions earlier (without the benefit of graphic design) in order to
assist teachers and students facing the first examinations under the new syllabus coming up in May.

The questions are arranged in the order that the expectations they refer to appear in the syllabus.
Section one features questions arising from syllabus sections 1.1 and 1.3 (Markets and Government
Intervention), section two features questions arising from syllabus section 1.5 (Theory of the Firm),
section 3 features questions arising from syllabus section 2 (Macroeconomics) while section 4 features
questions arising from syllabus section 3 (International Economics).

I would like to thank Kathryn Peyton for her help in reviewing some of the questions and answers and
would encourage anyone finding anything questionable to email me with their concerns.

Thank you for your consideration and best wishes in the upcoming exams.

Bryce McBride
bryce@brycemcbride.com

Table of Contents

Additional HL Paper 3 Exercises – Section 1 Page 3

Additional HL Paper 3 Exercises – Section 2 Page 11

Additional HL Paper 3 Exercises – Section 3 Page 16

Additional HL Paper 3 Exercises – Section 4 Page 20

Section 1 Solutions Page 30

Section 2 Solutions Page 41

Section 3 Solutions Page 46

Section 4 Solutions Page 48

 3

Additional HL Paper 3 Exercises – Section 1

1. Given the demand function Qd = 100 – 2P and the supply function Qs = -50 + 4P:

a) Plot the functions on the grid below and label them. You may first like to calculate the
ordered pairs using a table of values as indicated below.

Price Qd = 100 – 2P Qs = -50 + 4P

b) Using algebra, find the equilibrium price and quantity implied by the intersection of the two
functions. Check that it agrees with what is suggested by your graph from part ‘a’.
 4

c) Using geometry (and remembering that the area of a triangle is calculated according to the
formula A = ½ b * h) calculate the consumer and producer surplus enjoyed at this equilibrium
point.

d) Using algebra, calculate the quantity demanded and the quantity supplied at a price of $20.
Would there be excess demand or excess supply at this price and of how many units?

e) Just by looking at the functions expressed algebraically, how can you tell how many units
people would want to buy at a price of zero? How can you tell at which price sellers will begin to
bring the good to market?

f) If buyers suddenly began buying many more additional units every time the price dropped by
$1, how would you expect the demand function to change? Conversely, if sellers suddenly
began supplying many more additional units every time the price rose by $1, how would you
expect the supply function to change? Explain your answers.
 5

2. Given the same linear demand and supply functions as were used in question 1:

a) Apply a $5 per unit specific indirect tax to the good and plot the resultant supply and demand
curves on the grid below:

b) Looking at the diagram, what has been the impact of the tax on the equilibrium market price
and quantity sold as compared to the situation without the tax looked at in question 1? Estimate
the new equilibrium price and quantity to the nearest whole unit.

c) Calculate the consumer and producer surplus associated with this new post-tax equilibrium
point as well as the revenue gained by the government through the imposition of the tax.
Comparing the sum of these three amounts to the sum of the consumer and producer surplus
associated with the equilibrium point in question 1 ‘c’ above, which is greater? What then has
been the impact of the tax on overall welfare?
 6

d) Calculate and compare consumer expenditure and producer revenue before the tax was
applied to consumer expenditure and producer revenue after the tax was applied. What was the
impact of the tax on each?

e) Comparing the initial equilibrium price from Q1 with the post-tax equilibrium price from part
‘b’ above, how much of the $5 tax has been borne by consumers? What portion therefore has
been borne by producers? Explain why the incidence of the tax is different for consumers and
producers (or, in other words, why the burden of the tax has been borne unevenly).

3. Given the same linear demand and supply functions as were used in question 1:

a) Apply a $5 per unit specific indirect subsidy to the good and plot the resultant supply and
demand curves on the grid below:
 7

b) Looking at the diagram, what has been the impact of the subsidy on the equilibrium market
price and quantity sold as compared to the initial situation looked at in question 1?

c) Calculate the consumer and producer surplus associated with this new post-subsidy
equilibrium point as well as the money spent by the government to pay for the subsidy.
Compare the sum of the consumer and producer surplus to the total welfare associated with the
equilibrium point in question 1 ‘c’. What has been the impact of the subsidy on overall welfare?

d) After making the necessary calculations, compare consumer expenditures and producer
revenues before the subsidy was applied to consumer expenditures and producer revenues
after the subsidy was applied. What is the impact of the subsidy on each?

e) Comparing the initial equilibrium price from Q1 with the post-subsidy equilibrium price from
part ‘b’ above, how much of the $5 subsidy has been transferred to consumers? What portion
therefore has been transferred to producers? Explain why the incidence of the subsidy is
different for consumers and producers (or, in other words, why the benefits of the subsidy have
been distributed unevenly).
 8

4. Given the demand function Qd = 200 – 30P and the supply function Qs = -50 + 20P:

a) Plot the functions on the grid below and label them. You may like to first calculate the
ordered pairs using a table of values as indicated below.

Price Qd = 200 – 30P Qs = -50 + 20P

b) Using algebra, find the equilibrium price and quantity implied by the intersection of the two
functions. Check that it agrees with what is suggested by your graph from part ‘a’.
 9

c) Using geometry (and remembering that the area of a triangle is calculated according to the
formula A = ½ b * h) calculate the consumer and producer surplus enjoyed at this equilibrium
point.

d) If the government were to impose a floor price of $6, would there be a shortage or surplus in
response and of how many units?

e) Compare producer revenue and consumer expenditure in this situation (the $6 price floor)
with producer revenue and consumer expenditure in the initial situation without the price floor.
Consider only the units that are actually sold by producers to consumers.

f) If the government were to commit to buying the surplus production at the price they have
mandated, how much would they have to spend?

g) If instead the government were to impose a price ceiling of $4, would there be a shortage or a
surplus in response and of how many units?
 10

h) Compare the producer revenue and consumer expenditure in this situation (the $4 price
ceiling) with the producer revenue and consumer expenditure in the initial situation without the
price ceiling. Consider only the units that are actually sold by producers to consumers.

i) Calculate the consumer and producer surplus enjoyed under the $4 price ceiling and compare
it to the consumer and producer surplus enjoyed in the initial situation set out in part ‘c’. Has
the price ceiling transferred some surplus from producers to consumers and if so, how much?
Has some welfare simply been lost? If so, explain your answer and calculate the extent of the
welfare loss. You may wish to use the grid below to draw the demand and supply functions and
the price ceiling to help you answer the question.
 11

Additional HL Paper 3 Exercises – Section 2

1. A monopolist can supply a product for $3 per unit (which is both his marginal and average cost)
while the demand curve for the product is Qd = 10 – P.

a) Complete the table below:

Price $10 $9 $8 $7 $6 $5 $4 $3 $2

Qd = 10 – P

Total Revenue

Marginal Revenue

Average Revenue

b) On the grid below, graph the monopolist’s marginal and average cost curves along with their
marginal and average revenue curves

c) Were the firm not a monopolist, the equilibrium point would be where the marginal cost
curve met the demand curve. Identify this point and label the resulting price and quantity Pc
and Qc.
 12

d) Calculate, using geometry, the producer and consumer surplus at this equilibrium point.

e) Now find the price and output that a profit-maximizing monopolist would choose and mark
them Pm and Cm (remember the profit maximizing rule – produce until MR = MC).

f) Calculate, using geometry, the producer and consumer surplus at the monopolist’s preferred
equilibrium point.

g) From using the calculations and from looking at the diagram, how much surplus was
transferred from consumers to the monopolist and how much was simply lost?

h) In order to limit the welfare loss due to monopoly, the government decides to regulate the
monopolist and mandates a fixed price of $4/unit for the product. Calculate the producer and
consumer surplus at this new price and calculate the extent of the welfare loss to determine
whether or not the fixed price would achieve the government’s aim.
 13

2. A farmer has a fixed amount of land and workers. However, he can vary the number of tractors
he uses. He finds that his total production of corn varies with the number of tractors he uses as
described by the table below:

Number of Tractors 0 1 2 3 4 5 6

Output of Corn (tonnes) 10 30 70 100 120 130 130

Marginal Product

Average Product

a) Calculate the marginal product of each additional tractor and record it in the table above. At
what point does the farmer begin suffering diminishing returns from using additional tractors?

b) Calculate the average product attributable to each tractor for each quantity of tractors and
record it in the table above.

c) If corn prices are $100/tonne and if tractors cost $2000 per season to own and operate, how
many tractors should the farmer use to maximize his returns? Explain your answer.

3. An entrepreneur’s business exhibits the following total costs and total revenues:

Output Total Costs Marginal Costs Average Costs Total Revenue Marginal Revenue Average Revenue
0 10 0
1 15 12
2 19 22
3 22 30
4 24 36
5 25 40
6 27 42
7 30 42
8 34 40
9 39 36
10 45 30

a) From looking at the table, what are the entrepreneur’s fixed costs? Explain your answer
 14

b) Thus, what would be the entrepreneur’s total variable costs where output is 6? Explain your
answer.

c) Calculate and record in the table the entrepreneur’s marginal and average cost and marginal
and average revenue at each level of output.

d) Calculate the entrepreneur’s profits at each level of output. At which level of output are
profits highest?

e) From the evidence provided by the table, is the entrepreneur operating in a competitive
environment or is he operating as a monopolist? Explain your answer.

f) What would be the entrepreneur’s revenue-maximizing output?

g) At what output levels does the entrepreneur roughly break even?

h) On the grid that follows, record the entrepreneur’s marginal and average costs and revenues.
Mark in the profit-maximizing, revenue-maximizing and break-even points on the graph.
 15

4. A firm is operating in a competitive market and exhibits the following total costs:

Quantity Fixed Cost Variable Cost Total Cost Marginal Cost Avg. Var. Cost Avg. Total Cost
0 10
1 16
2 21

3 25
4 28
5 30
6 33

7 37
8 42
9 48

a) Complete the table above after calculating the relevant costs.

b) At which level of output are average total costs at a minimum? What is happening if the
market price of the firm’s output is exactly this amount? What is happening if the market price
of the firm’s output is greater than this amount?

c) At which level of output are average variable costs at a minimum? What is likely to happen if
the selling price of the firm’s output is below this minimum amount? What is likely to happen if
the selling price of the firm’s output is above the minimum of average variable cost but below
the minimum of average total cost?
 16

Additional HL Paper 3 Exercises – Section 3

1. The following are the accounts of national expenditure for 2012:

Consumption spending by households: $100 billion

Total investment spending by firms: $15 billion
Depreciation of firms’ existing capital stock: $3 billion
(ie spending needed to replace worn out machinery and equipment)
Government spending on goods and services $20 billion
Spending on Imports $30 billion
Receipts from Exports $31 billion

a) Calculate nominal GDP from the expenditure side for 2012.

b) If the nation’s population was 40 million, what is the nation’s nominal GDP per capita?

c) If the nation’s GDP deflator was set at ‘100’ in 2011 and was estimated to be 105 in 2012,
what was the nation’s real GDP in 2012, measured in constant 2011 dollars?

d) If the nation’s GDP in 2011, measured in 2011 dollars, was 126 billion, what was the rate of
real economic growth between 2011 and 2012? What was the nominal rate of economic growth
between the two years?

e) If the nation’s workers and firms operating abroad produced (and earned) $10 billion while
the workers and firms of other countries operating within the nation produced (and earned) $5
billion in 2012, what would be the nation’s nominal GNP/GNI for that year?
 17

2. As there are often unmet basic needs in poorer countries, their marginal propensity to consume
is often much higher than in richer countries. If we assume that the MPC in the nation of
Povertia is 0.96 while the MPC in the nation of Largesse is 0.7:

a) Calculate the Keynesian multiplier for both nations.

b) Using the multipliers from part ‘a’, calculate the effect on GDP of an additional $1000 of
government spending in each country. How much would GDP increase as a result of the increase
in government spending?

3. In Australia there were 11 500 000 people working and 650 000 people actively looking for work
in 2012. What was Australia’s unemployment rate that year?

4. Statisticians from the small island nation of Paradiso calculate that the average household in the
country spends one quarter of its income on housing, another quarter on food, and an eighth on
each of clothing, utilities, transportation and entertainment.

The statisticians then decided to select representative goods from each category and then
tracked the prices year by year, as shown in the table below:

Good Price in 2010 Price in 2011 Price in 2012

3 BR House Rent, per month $500 $515 $520

2 BR Apartment Rent, per month $350 $375 $385
Bread, one loaf $2 $2 $2
Bananas, kg $1 $0.8 $1
Milk, litre $1 $1.25 $1.25
Leather shoes, one pair $30 $25 $25
Woman’s cotton dress $30 $33 $35
Electricity, per kWh $0.10 $0.12 $0.13
Bus ticket $1 $1 $1.10
Gasoline, per litre $1.5 $1.35 $1.40
Cinema ticket $7 $7.50 $7.50
Dance hall admission $7 $7 $7

a) Construct a weighted price index for Paradiso using the data above. Give the index the value
‘100’ for the prices given for 2010. It is suggested that you follow certain steps when
constructing your index, such as:
 18

i) Determining which items go under which category

ii) Determining how to weight the different items in each category. As a default it is acceptable
to weight each item the same within each category. For instance, it would be fine to give
‘bread’, ‘bananas’ and ‘milk’ equal weight in the ‘food’ category (suggesting that I eat a loaf of
bread about as often as I eat a kg of bananas or drink a litre of milk). However, make sure that
‘food’ overall is one quarter of your overall index.

iii) Figuring out the adjustment numbers to make your prices fit the category weights. For
instance, for the food items, if I decide to give each item equal weight, I would want each of the
three items to count for 8.3 % of the index (as 8.33 * 3 = 25), as 25% is the weight of the food
category in the overall index.

To get the $2 price of bread to 8.3, you would need to multiply it by 4.15. To get the $1 price of
bananas or milk to 8.3, you would just need to multiply it by 8.3, as below:

(Price of Bread*adjustment #) + (Price of Bananas*adjustment #) + (Price of Milk*adjustment #)

= ($2 * 4.15) + ($1 * 8.3) + ($1 * 8.3) = 25

Feel free to use the guide below to calculate your index. At the end of it, you should have
something that looks like this:

(3 BR House Rent) * ______ + (2 BR Apartment Rent) * _______ + {should = 25}

(Bread Price) * ______ + (Banana Price) * ______ + (Milk Price) * ______ + {should =25}

(Price of Shoes) * ______ + (Price of Cotton Dress) * ______ + {should = 12.5}

(Electricity Price) * ______ + {should = 12.5}

(Bus Ticket Price) * ______ + (Price of a litre of gasoline) * ______ + {should = 12.5}

(Cinema Ticket Price ) * ______ + (Dance Hall Ticket Price) * ______ = 100 {should = 12.5}

The blanks (ie ‘___’) are the weights given to each item in your index. Keeping these weights the
same you will then be able to calculate new index numbers easily for 2011 and 2012 by simply
plugging in the changed prices for each item.
 19

b) Keeping the weights the same, what is the value of the price index for 2011 and 2012?

c) What then was the rate of inflation between 2011 and 2012?

5. Gillian has two job offers to work in neighboring states. The stated salary for both positions is
$85 000. However, the income tax regimes are very different in each state, as described in the
table below:

State A State B
Income Level Tax Rate Income Level Tax Rate
Below $15 000 0 Below 10 000 0
15 001-25 000 10 10 001-30 000 20
25 001-35 000 20 30 001-50 000 40
35 001-45 000 30 50 001-70 000 50
45 001-55 000 40 Above 70 000 60
55 001-65 000 50
Above 65000 60

a) What would be Gillian’s marginal rate of income tax in each state?

b) How many dollars of tax would Gillian pay in each state?

c) What then is Gillian’s average rate of tax in each state?

d) Gillian’s brother Jake faces a similar choice to Gillian, except that he has been offered a salary
of $50 000. What would be his marginal rate of tax in each state? What would be his tax burden
and average rate of tax in each state?
 20

Additional HL Paper 3 Exercises – Section 4

1. Australia and Indonesia each produce 2 goods – fruit and minerals. At the moment, Indonesia
can produce one unit of minerals at an opportunity cost of two units of fruit while Australia can
produce one unit of minerals at an opportunity cost of just one unit of fruit. If Indonesia were to
devote a certain quantity of productive resources to the production of fruit it would be able to
produce 1200 units per year, while if Australia were to devote the same quantity of productive
resources to the production of fruit, they would only be able to produce 500 units per year.

a) On the grid below, draw the PPCs for Indonesia and Australia for fruit and minerals.

Minerals

Fruit

b) Which country enjoys an absolute advantage in the production of fruit and of minerals?
Explain your answer with reference to resource costs.

c) For which good does Indonesia enjoy a comparative advantage and for which good does
Australia enjoy a comparative advantage? Explain your answer with reference to opportunity
costs.
 21

c) If Indonesia and Australia did not trade, but instead simply devoted half of their productive
resources to the production of fruit and the other half to the production of minerals, how much
of each good could each produce?
Minerals Fruit
Indonesia

Australia

Total

d) Now, if Australia were to devote all of its resources to producing minerals, and if Indonesia
were to devote enough of its resources to producing minerals to keep the total mineral
production the same for the two countries as in part ‘c’, how much fruit could Indonesia
produce? Is this amount greater than the total fruit produced in part ‘c’? What does this answer
suggest about the gains to be had from trade based on comparative advantage?

2. The following diagram shows the French market for berets:

Price (dollars)

20
18
Domestic Supply
16 (Qs = -5000 + 2500 P)

14
12

10
8

4
2
Demand (Qd = 30 000 – 1000 P)
0
0 5 10 15 20 25 30 35 40 45 50 Quantity (‘000s)
 22

a) What is the equilibrium price and quantity in the absence of trade?

b) If France were to throw open the doors to free trade in berets, manufacturers in Vietnam and
other countries know they can supply an unlimited quantity of berets at a price of $6. What
would be the new equilibrium price and quantity sold of berets in France when foreign-made
berets are made available for sale? Change the diagram above to reflect the entry of foreign
manufacturers.

c) How have the revenues of French beret makers been affected by the entry of the imported
berets? Using the diagram, compare their revenues before and after the event. How much
revenue are the foreign manufacturers earning from French beret buyers?

d) How has consumer surplus been affected by the entry of the imports? Calculate the
consumer surplus enjoyed in the initial situation with the surplus enjoyed when $6 berets are
made available.

e) In order to stem the tide of foreign berets, the French government imposes a $2 tariff on
imported berets.
i) Show the impact of the tariff on the diagram above

ii) What is the new equilibrium price and quantity?

iii) How much revenue is the French government collecting from the tariff?

iv) How much additional revenue is being earned by French beret makers?

v) How much less revenue is being earned by foreign beret makers in the French
market?
 23

vi) What has been the impact of the tariff on consumer surplus as compared to the free-
trade case described in part ‘d’ above?

f) Faced with complaints from the public that the tariff is a government tax on berets, the
government eliminates the tariff in favour of an import quota of 7000 berets.

i) Show the impact of such a quota on the diagram below:

Price (dollars)

Supply
18

16
14

12

10
8

6
8

2
Demand
0
0 5 10 15 20 25 30 35 40 45 Quantity (‘000s)

ii) What would be the new equilibrium price and quantity after the imposition of the
import quota?

iii) With the quota in place, how many berets would French beret-makers be able to
sell? What has been the impact of the quota on their sales revenue as compared to the
free-trade case described in part ‘c’ above?
 24

iv) What has been the impact of the quota on the French revenues of foreign beret
makers? Why have their revenues not been reduced as much as was the case when the
tariff was imposed in part ‘e’ above?

v) What has been the quota’s impact on consumer surplus as compared to the free
trade case described in part ‘d’ above?

g) Rather improbably, consumer complaints about rising beret prices cause the government to
eliminate the quota and instead give a $2 per beret subsidy to French beret makers. As in part
‘b’, foreign manufacturers are once again welcome to sell as many berets in France as they wish.

i) Show the impact of such a subsidy on the diagram below:

Price ($)

Supply
18

16
14

12

10
8

4
2
Demand
0
0 5 10 15 20 25 30 35 40 45 50 Quantity (‘000s)

ii) What is the new equilibrium price and quantity after the subsidy is granted to French
beret makers?
 25

iii) With the subsidy in place, how many berets are French manufacturers able to sell?
What is their total revenue in this situation? Be sure to include both the revenue
earned from consumers and the revenue earned from the government in the form of
the subsidy.

iv) Why would consumers be happier with the subsidy than either the quota or the
tariff? Why would foreign producers prefer to face quotas than tariffs or subsidies? Use
revenue and surplus calculations to justify your answers.

3. After travelling to France from Morocco, Majid received his credit card bill and noticed that the
restaurant meal that had cost him 30 Euros was listed on his statement as costing 340 Dirham.
What does this suggest is the currency exchange rate of Euros in terms of Dirhams?

4. It has always been Julia’s dream to buy a Ural motorcycle from Russia. Searching online one day,
she noticed a recent model for sale for 350 000 Russian rubles. If the exchange rate of US dollars
in terms of rubles is 32, how much would her dream motorcycle cost in terms of USD?

5. While on holiday in Thailand, Lee Hong from Singapore noticed that while he had gotten 2500
Thai Baht last week per $100 SGD note, on his most recent trip to the money changer he had
received 2650 Baht per $100 SGD note.
a) Calculate the initial exchange rate for Thai Baht in terms of Singapore dollars.

b) Had the Thai Baht appreciated or depreciated during Lee Hong’s holiday? By what percentage
had it changed in value?
 26

6. If the demand and supply functions for the Philippine Peso are defined as Qd = 10000 – 3000P
and Qs = -5000 + 2000P, and where P is the price of the Philippines Peso in terms of US cents:

a) What is the equilibrium exchange rate of the Philippine Peso in terms of US cents? Determine
your answer through solving the system of equations. If you would like to check your answer by
constructing a supply and demand diagram, feel free to do so.

b) Given this exchange rate, what would be the exchange rate of US dollars in terms of
Philippine Pesos?

7. An oil-producing nation in West Africa has just published its balance of payments accounts for
2012:

Imports of Goods $50 billion

Exports of Goods $80 billion
Imports of Services $15 billion
Exports of Services $2 billion
Income from Foreign Sources $1 billion
Payments to Foreign Beneficiaries $8 billion
Current Transfers from Foreign Sources $1 billion
Current Transfers to Foreign Beneficiaries $5 billion

Debt Forgiveness and other Capital Transfers 0.5 billion

Direct Investment from Foreign Sources $3 billion
Direct Investment Abroad from Domestic Sources nil
Portfolio Investment from Foreign Sources nil
Portfolio Investment Abroad from Domestic Sources $6 billion
Change in Reserve Assets $3.5 billion

a) Calculate:
i) The balance of trade in goods

ii) The balance of trade in services, income and current transfers

iii) The overall current account balance

iv) The balance in the capital account

v) The balance in the financial account

 27

b) The presence of a large, multinational oil company (such as Shell or Exxon-Mobil) employing
some expatriate technicians and managers would likely affect which entries in the accounts?
Explain your answer.

8. A nation operating under a fixed exchange rate currency regime is suffering from a current
account deficit of $100 (imports are $1000 and exports are $900) and wishes to try to reduce
the deficit through devaluing its currency by 20%. Economists estimate that the PED for the
country’s imports is 0.6 while the PED for the country’s exports is 0.3.

a) Will the devaluation have its intended effect? Explain your answer with the help of a
calculation using the numbers above.

b) Again using calculations to support your answer, show you the devaluation would have a
different effect if the PED of imports and the PED of exports were both 0.8.

9. The prices of a country’s imports and exports are given in the table below:

Good Price in 2011 Price in 2012 Price in 2013

Oil (import) $100/barrel $120 $90

Bananas (import) $1/kg $1.10 0.90

Iron Ore (export) $100/tonne $90 $120

Machinery (export) $100/piece $100 $105

 28

a) Taking the figures from 2011 as representing the base year (with a value of ‘100’), and
assuming that oil comprises 3/4 of the value of the country’s imports (while bananas comprise
just one quarter) and that iron ore and machinery both make up half of the value of the
country’s exports, calculate the country’s terms of trade in 2012, by, in order:
i) Calculating the index of export prices

ii) Calculating the index of import prices

iii) Using these two figures to arrive at the country’s 2012 terms of trade

b) Again using the figures from 2011 to represent the base year, using a similar method to part
‘a’ calculate the country’s terms of trade in 2013.
i) Index of export prices

ii) Index of import prices

iii) 2013 terms of trade

c) In what year did the country’s terms of trade improve? In what year did they deteriorate?
 29

d) Can you assume that the country’s current account balance would have improved in the year
in which its terms of trade improved? Explain your answer with reference to the price elasticity
of demand for exports and imports and the following trade volume figures:

Good Volume traded, 2011 2012 2013

Oil 75 barrels 75 90

Bananas 2500 kg 2300 2800

Iron Ore 50 tonnes 60 40

Machinery 50 pieces 50 40

(note that in 2011 there is a balance in the trade in goods, as imports are 75 barrels *
$100/barrel plus 2500 kg * $1/kg = $10 000 and exports are 50 tonnes * $100/tonne plus 50
pieces * $100/piece = $10 000)
 30

Additional HL Paper 3 Exercises – Section 1 – Solutions

1. a) Price ($) Qd = 100 – 2P Qs = -50 + 4P

0 100 -50

10 80 -10

20 60 30

30 40 70

40 20 110

Price ($)

50

40 Supply

30

20

10

Demand
0 Quantity
0 10 20 30 40 50 60 70 80 90 100 110

b) Setting Qd = Qs and solving for P:

100 – 2P = -50 + 4P
150 = 6P
25 = P

Then substituting 25 for P in either (or both) equations and solving for Q:
Qd = 100 – 2P or Qs = -50 + 4P
Qd = 100 – 2(25) Qs = -50 + 100
Qd = 50 Qs = 50

Confirming that at the equilibrium price $25, the Qd and Qs are both 50 as suggested
by the graph.
 31

c) Looking at the graph, we are looking at a welfare triangle that looks like:

P=50

(50, 25)

P = 12.5

We can confirm the y-intercepts suggested by the graph algebraically as follows:

To find the y-intercept of the demand curve, find the price when the quantity is set to 0.

Qd = 100 – 2P
0 = 100 – 2P
2P = 100
P = 50

T o find the y-intercept of the supply curve, find the price when the quantity is set to 0.

Qs = -50 + 4P
0 = -50 + 4P
50 = 4P
12.5 = P

Thus, the consumer surplus is the area represented by the following triangle:

P = 50

P = 25 (50, 25)

A = ½ Base * Height
A = ½ (50) * 25
A = 625, so the consumer surplus is $625

Meanwhile, the producer surplus is the area represented by the following triangle:

P = 25 (50, 25)

P = 12.5

A = ½ Base * Height
A = ½ (50) * 12.5
A = 312.5, so the producer surplus is $312.50
 32

d) Find the quantity demanded and the quantity supplied at P = 20 by plugging 20 into both
equations and finding Q

Qd = 100 – 2P
Qd = 100 – 2 (20)
Qd = 60

Qs = -50 + 4P
Qs = -50 + 4 (20)
Qs = 30

As quantity demanded is 60 while quantity supplied is 30, there is an excess demand of 30 units
at a price of $20.

e) I can easily tell how many units people will want to buy at a price of zero, as that is told to me
by the fixed term in the demand function. For example, using the demand function Qd = 100 –
2P, I can easily see that at a price of zero, Qd = 100, as Qd = 100 – 2(0).

While it is not so easy to find the price at which sellers will begin to bring the good to market, as
that requires me to find the price when quantity is equal to zero, it is not difficult. Again using
our supply function, just set Q = 0 and solve for P, as in 0 = -50 + 4P
50 = 4P
12.5 = P

f) The demand function should get flatter, as the slope coefficient will have gotten larger. The
quantity demanded has become more responsive to changes in price. For instance, looking at
our demand function, if it were Qd = 100 – 4P, a drop in price of $1 would result in 4 more units
being demanded, not 2.

Similarly, the supply function would become flatter, as its slope coefficient would have also
gotten larger as the quantity supplied is now more responsive to changes in price. For instance,
looking at our supply function, if it were Qs = -50 + 8P, a price increase of $1 would bring 8 more
units to market instead of just 4.
 33

2. a) Price ($)

50
Supply with $5 tax

40
Supply

30

20

10

Demand
0 Quantity
0 10 20 30 40 50 60 70 80 90 100 110

b) The equilibrium market price appears to have risen to around $28 (from $25) while the
quantity sold has fallen to around 43 units (from 50).

To find the new equilibrium point algebraically, it would be necessary to first derive the new
(post-tax) supply curve. If the tax has shifted the supply curve up $5, and if the slope of the
supply curve is 4, then the translation of the curve $5 higher would suggest that the x-intercept
of the new curve would be 20 units further to the left. Thus, the post-tax supply curve function
would be Qs = -70 + 4P.

To find the new equilibrium point, simply set Qd = Qs and solve for P

-70 + 4P = 100 – 2P
6P = 170
P = 28.3

Which implies an equilibrium quantity of: Qd = 100 – 2P

Qd = 100 – 2(28.3)
Qd = 43.4

However, the answers that follow are calculated according to the equilibrium point (43, 28), as
my reading of the syllabus suggests that students will not be expected to derive new supply
curve functions resulting from the imposition of indirect, specific taxes.

c) The government has earned $5 on each of the 43 units sold, so $215.

 34

The consumer surplus is the area of the following triangle:

P = 50

P = 28 (43, 28)

So, as A = ½ Base * Height

A = ½ (43) * 22
A = 473 so the consumer surplus is $473.

The producer surplus is the area of the following triangle at right (remember that the $5 tax
comes between the price consumers pay ($28) and what producers receive ($23):

P = 23 (43, 23)

P = 12.5

So, as A = ½ Base * Height

A = ½ (43) * 10.5
A = 225.75 so the producer surplus is $225.75.

Comparing the sum of these three figures ($215 + $473 + $225.75 = $913.75) to the sum of
producer and consumer surplus before the tax was imposed ($625 + $312.50 = $937.50) we can
see that the sum from part ‘c’ is greater. Thus, we can conclude that the tax has led to a
decrease in overall welfare of roughly $23.75.

d) Before the tax was applied, consumer expenditures and producer revenues were both (50 *
$25) $1250. After the tax was applied, consumer expenditures were (43 * $28) $1204 while
producer revenue was (43 * $23) $989. The difference between the two numbers (1204 – 989)
was the tax collected by the government. In this case, the tax reduced both consumer
expenditure (a little bit) and producer revenue (significantly).

e) Well, as the initial price was $25, the fact that the price consumers pay rose to $28 while the
price received by producers fell to $23 would suggest that consumers ended up paying $3 of the
$5 tax while producers ended up paying the remaining $2. The reason the tax has been borne
unevenly is that the price elasticity of demand is less than the price elasticity of supply around
the old equilibrium price and quantity.

To calculate:
PED from (60, 20) to (40, 30) is: -(40 – 60)/60 = 0.33 = 0.66
(30-20)/20 0.5

PES from (30, 20) to (70, 30) is (70-30)/30 = 1.33 = 2.66

(30-20)/20 0.5
 35

The consumers end up paying more of the tax as their demand is less sensitive to price changes
than is producer supply. Whoever is less likely to change their behavior in response to a price
change will end up being hit with a greater price change whenever a tax is applied. Put more
simply, whoever is less likely to duck is more likely to get hit.

3. a)
Price ($)

50

Supply
40
Supply with $5 subsidy

30

20

10

Demand
0 Quantity
0 10 20 30 40 50 60 70 80 90 100 110

b) The subsidy has increased the equilibrium quantity from 50 to 56 while decreasing the
equilibrium price from $25 to $22.

c) The consumer surplus associated with the new post-subsidy equilibrium point can be
calculated by finding the area of the triangle under the demand curve from Q = 0 to Q = 56 from
P = $22 to P = $50:
A = ½ Base * Height
A = ½ (56) * 28
A = 784, so the consumer surplus is $784

The producer surplus associated with the same equilibrium point can be calculated by finding
the area of the triangle above the supply curve from Q = 0 to Q = 56 from P = $7.5 to P = $22:
A = ½ Base * Height
A = ½ (56) * 14.5
A = 406, so the producer surplus is $408

The initial producer and consumer surplus in question 1 were $625 and $312.50, so the subsidy
has clearly had a positive effect on both consumer and producer surplus, and hence overall
welfare. However, the subsidy did cost the government money, to the tune of $5 per unit for
each of the 56 units produced, or $280.
 36

d) After the subsidy was granted, consumers spent (56 * $22) $1232, while producers would
have received (56 * $27) $1512. Recall that while consumers only pay $22, the amount going to
the producers is that amount plus the amount of the subsidy. The difference between these two
numbers is the cost of the subsidy to government ($1512 – 1232 = $280).

Comparing these figures to the initial consumer expenditure/producer revenue of ($25 * 50)
$1250, we can see that the subsidy has resulted in a slight reduction in consumer expenditure
and a significant increase in producer revenue.

e) Comparing the initial equilibrium price of $25 with the post-subsidy equilibrium price of $22,
we can see that $3 of the $5 subsidy has been transferred to consumers, whereas producers are
only gaining $2 (recall that while the price is $22, producers are receiving $22 + $5 = $27).

Consumers are enjoying a greater portion of the subsidy than producers due to consumers and
producers having different responses to a change in price, as measured by PED and PES. As we
saw in our answer to question 2 e), the price elasticity of demand around the initial equilibrium
point is only 0.66 while the price elasticity of supply is 2.66.

What this means is that producers are more likely to increase output in response to a price
increase than consumers are likely to increase purchases in response to a price drop. So, when
faced with a subsidy, which has the effect of increasing the price paid to producers even while
reducing the price paid by consumers, producers are more likely to increase output than
consumers are to increase purchases. This being the case, the subsidy in this instance lowers
consumer prices more than it increases producer prices.

4. Price ($)
11

10

9
8
Supply
7

6
5

4
3 Demand

0 Quantity
0 10 20 30 40 50 60 70 80 90 100 110
 37

Price Qd = 200 – 30P Qs = -50 + 20 P

0 200 -50

1 170 -30

2 140 -10

3 110 10

4 80 30

5 50 50

6 20 70

b) Setting Qd = Qs and then solving for P:

200 – 30P = -50 + 20 P

250 = 50P
5 = P

Substituting this value for P in either (or both) equations to find Q:

Qd = 200 – 30P Qs = -50 + 20P

Qd = 200 – 30 (5) Qs = -50 + 20 (5)
Qd = 50 Qs = 50

Thus showing that at a price of $5, Qd = Qs at 50 units, which is in agreement with the graph.

c) The consumer surplus can be described by the area of the triangle below the demand curve
from its y-intercept to the equilibrium point. While I know the equilibrium point, I need to find
the y-intercept, or the price at which the quantity demanded is zero.

Qd = 200 – 30P
0 = 200 – 30P
30P = 200
P = 200/30 or 6.66

Thus, the consumer surplus can be calculated as the area of the following triangle:
P = 6.66

P=5 (50, 5)
 38

A = ½ Base * Height
A = ½ (50) * 1.66
A = 41.66 so the consumer surplus is $41.66

The producer surplus can be described by the area of the triangle above the supply curve from
its y-intercept to the equilibrium point. To find the y-intercept of the supply curve I need to find
the price at which the quantity supplied is zero.

Qs = -50 + 20P
0 = -50 + 20P
50 = 20P
50/20 = P, or in other words, P = $2.5

Thus, the producer surplus can be calculated as the area of the following triangle:

P=5 (50, 5)

P = 2.5

A = ½ Base * Height
A = ½ (50) * 2.5
A = 62.5 so the producer surplus is $62.50

d) If the government were to impose a price floor of $6, we can calculate the Qd and Qs as
follows:

Qd = 200 – 30P Qs = -50 + 20P

Qd = 200 – 30 (6) Qs = -50 + 20 (6)
Qd = 20 Qs = 70

Thus, as Qs is greater than Qd, there would be a surplus of 50 units.

e) In the initial situation, producer revenue and consumer expenditure would both be (50 units
at $5 each) $250. However, after the price floor has been put into place, while suppliers want to
sell 70 units, only 20 will actually change hands. Thus, producer revenue/consumer expenditure
will fall to (20 units at $6 each) $120.

f) If the government were committed to buying the additional 50 units at the floor price, they
would have to spend (50 units at $6 each) $300.

g) if the government were to impose a price ceiling of $4, we can see from looking at the table
of values in part ‘a’ that there would be a shortage of 50 units as at that price the Qd is 80 units
while the Qs is just 30 units.
 39

h) With a $4 price ceiling, while consumers would like to buy 80 units, only 30 will be supplied by
producers, so as a result total consumer expenditure and producer revenue will fall to (30 units
at $4 each) $120.

i) Price ($)

9
8 Supply

6
5

3 Demand
2

0 Quantity
0 10 20 30 40 50 60 70 80 90 100 110

With a $4 price ceiling, the consumer surplus can be represented by the irregular area under the
demand curve from the vertical axis until Q = 30. I will decompose it into two regular shapes as
follows:

A triangle: P = 6.66

P = 5.66 (30, 5.66)

And the rectangle below:

P = 5.66 (30, 5.66)

P=4 (30, 4)

The areas of each shape are: A = ½ Base * Height and A = Length * Width
A = ½ (30) * 1 A = 30 * 1.66
A = 15 A = 49.8

So the total consumer surplus is (15 + 49.8) $64.8

The producer surplus is simpler to figure out, being just the area of the triangle above the supply
curve from the vertical axis until Q = 30, as shown below:
P=4 (30, 4)

P = 2.5
 40

A = ½ Base * Height
A = ½ (30) * (1.5)
A = 22.5 so the producer surplus is $22.50

Thus, the overall welfare (producer and consumer surplus) in this situation is (64.8 + 22.5) $87.3

Looking at the results from part ‘c’, where the consumer surplus was $41.66 and the producer
surplus was $62.50 we can see that some producer surplus has been transferred to consumers
as a result of the price ceiling. However, clearly some welfare has been lost as well, as total
welfare before was $104.16 before the price ceiling was put in place but just $87.30 afterwards.

Looking at the graph we can try to measure the area of the welfare loss (the triangle from Q =
30 right towards the old equilibrium at (50,5) and see if it gives us a figure similar to the loss
arrived at by subtracting $87.30 from $104.16 (ie $16.86).

The welfare loss can be represented by the triangle described below:

(30, 5.66)
(50, 5)

(30, 4)

Taking the vertical side as the base, we can calculate the area as follows:

A = ½ Base * Height
A = ½ (1.66) * 20
A = 16.6, or $16.60 which is quite close to the amount calculated above ($16.86)
 41

Additional HL Paper 3 Exercises – Section 2 - Solutions

1. a)

Price $10 $9 $8 $7 $6 $5 $4 $3 $2

Qd = 10 – P 0 1 2 3 4 5 6 7 8

Total Revenue 0 9 16 21 24 25 24 21 16

Marginal Revenue - 9 7 5 3 1 -1 -3 -5

Average Revenue - 9 8 7 6 5 4 3 2

b)

Price ($)
11

10
9

8
7

Pm 6

5
4

Pc 3 MC = AC
2

1
MR AR
0
0 1 2 3 4 5 6 7 8 9 10
Qm Qc

c) Pc = $3 and Qc = 7 units on the graph above

d) There is no producer surplus as all output is at lowest average and marginal cost. Consumer
surplus is the area of the triangle from $3 to $10 from output 0 to output 7, calculated as:
A = ½ Base * Height
A = ½ (7) * 7
A = 24.50, so the consumer surplus is $24.50
 42

e) The profit maximizing monopolist would choose to produce 4 units and charge $6, as shown
on the graph.

f) The producer surplus would be the rectangle from output 0 to 4 and from price $3 to $6,
calculated as: A=l*w
A = 4 *3
A = 12, so the producer surplus is $12

Consumer surplus can be calculated by taking the area of the triangle from output 0 to 4 and
between the price $6 and $10, as follows:
A = ½ Base * Height
A = ½ (4) * 4
A = 8, so the consumer surplus is $8

g) $12 of surplus was transferred from consumers to producers and, as initially consumer
surplus was $24.50, clearly $4.50 was simply lost. We can confirm this loss by calculating the
area of the welfare loss triangle, which is the triangle beneath the AR curve between output 4
and 7 from $3 to $6 as follows:
A = ½ Base * Height
A = ½ (3) * 3
A = 4.5, so the welfare loss is confirmed as being $4.50

h) If the government mandates a price of $4 per unit, the new equilibrium price and quantity
would be $4 and 6. The demand curve would still exist but the monopolist would no longer be
aware of it or able to use it to calculate marginal revenue as under the fixed price, his marginal
revenue (and hence average revenue) is $4 for every unit sold.

So, taking this new equilibrium point, we can see that the consumer surplus is now represented
by the triangle from Q = 0 to Q = 6 and from P = 4 to P = 10, which can be calculated as follows:
A = ½ Base * Height
A = ½ (6) * 6
A = 18, so the consumer surplus is now $18

Producer surplus is represented by the area of the rectangle from Q = 0 to Q = 6 between P = 3

and P = 4, and can be calculated as follows:
A=l*w
A = 6 * 1, so the producer surplus is now $6

Thus, total welfare is now $24, suggesting that the welfare loss has been reduced to $0.50. If
you calculate the area of the welfare loss triangle you can confirm this result.
 43

2. A farmer has a fixed amount of land and workers. However, he can vary the number of tractors
he uses. He finds that his total production of corn varies with the number of tractors he uses as
described by the table below:

Number of Tractors 0 1 2 3 4 5 6

Output of Corn (tonnes) 10 30 70 100 120 130 130

Marginal Product - 20 40 30 20 10 0

Average Product - 30 35 33.5 30 26 21.6

a) See table above. He begins to suffer diminishing returns from the 3rd tractor onwards, as his
marginal product falls from 40 tonnes with the second tractor to just 30 tonnes with the third
tractor.

b) See table above.

c) The farmer should use 4 tractors to maximize his returns. The marginal revenue from his 4th
tractor is equal to 20 tonnes * $100/tonne = $2000. The marginal cost of the 4th tractor is also
$2000. However, the 2nd and 3rd tractors yield more revenue than they cost. The 5th and
subsequent tractors, meanwhile, yield less revenue than they cost.

3. An entrepreneur’s business exhibits the following total costs and total revenues:

Output Total Costs Marginal Costs Average Costs Total Revenue Marginal Revenue Avg. Rev. Profit
0 10 - - 0 - - -10
1 15 5 15 12 12 12 -3
2 19 4 9.5 22 10 11 3
3 22 3 7.3 30 8 10 8
4 24 2 6 36 6 9 12
5 25 1 5 40 4 8 15
6 27 2 4.5 42 2 7 15
7 30 3 4.3 42 0 6 12
8 34 4 4.25 40 -2 5 6
9 39 5 4.3 36 -4 4 -3
10 45 6 4.5 30 -6 3 -15

a) The entrepreneur’s fixed costs are $10, as these are his costs when output is equal to zero,
indicating that these costs do not vary according to output.

b) Total variable costs when output is 6 are $17. Total costs are $27 at this output level.
Subtracting fixed costs of $10 from $27 gives us $17.

c) See table above.

d) See table above. His profits are highest ($15) when output is 5 or 6.
 44

e) The entrepreneur is operating as a monopolist, as he faces a downward sloping marginal

revenue curve, which implies that he or she knows the demand curve for the product and is not
therefore a price-taker.

f) The entrepreneur’s revenue-maximizing output is 6 or 7, where total revenue is $42.

g) The entrepreneur roughly breaks even at two points – the first point is at an output level
between 1 (loss of $3) and 2 (profit of $2) and the second point is at an output level between 8
(profit of $6) and 9 (loss of $3).

h)

Price ($)

16
14 Break-Even Points where AR = AC

12
10

6 Marginal Cost
4 Average Cost
Average Revenue
2

0
-2

-4
Marginal Revenue
-6 Quantity
0 1 2 3 4 5 6 7 8 9 10 11
Revenue Maximizing Point where MR = 0; (Q = 7)

Profit Maximizing Point where MR = MC; (Q = 6, P = $7)

Note that the profit maximizing point is where MR = MC, and that the break-even points occur
where AR = AC. The revenue maximizing point is where MR = 0, as so long as MR is positive,
producing more units will increase total revenue.
 45

4. a)

Quantity Fixed Cost Variable Cost Total Cost Marginal Cost Avg. Var. Cost Avg. Total Cost
0 10 0 10 - - -
1 10 6 16 6 6 16
2 10 11 21 5 5.5 10.5

3 10 15 25 4 5 8.33
4 10 18 28 3 4.5 7
5 10 20 30 2 4 6

6 10 23 33 3 3.83 5.5
7 10 27 37 4 3.85 5.29
8 10 32 42 5 4 5.25
9 10 38 48 6 4.2 5.33

b) Average total costs are at a minimum of $5.25 at an output of 8 units. If the market price of
the firm’s output is also $5.25 and if the firm produces 8 units the firm will be breaking even
(neither earning profits nor incurring losses). As well, what is suggested by a situation where the
market price of a good is equal to the minimum average cost to produce the good is that the
firm is operating in a perfectly competitive industry, as firms operating in perfectly competitive
industries are productively efficient and produce at lowest average cost. If the market price is
above $5.25 the firm will potentially be making profits, so long as they produce where the
market price is above average revenue. In a perfectly competitive market, a price above $5.25
would only be a short-term phenomenon as the profits earned at higher prices would attract
new entrants to the industry which would in turn depress prices back towards $5.25. If the price
remains above $5.25 consistently, the firm is not operating in a perfectly competitive industry.

c) Average variable costs are at a minimum of $3.83 at an output of 6. If the selling price of the
firm’s output is below $3.83 the firm is likely to shut down as every unit produced will result in
additional losses. If the selling price of the firm’s output is between $3.83 and $5.25 the firm will
likely stay in business but operate at a loss, as while the firm will lose money at such a price, if it
shut down and had to pay its fixed costs without any revenue its losses would be even greater.

For instance, if the price were $5, and if the firm were to sell 7 units, the firm would earn $35.
This suggests a loss of $2 as the total cost to produce 7 units is $37. This loss of $2 is less than
the loss that would be incurred if the firm were to shut down and still be responsible for its fixed
costs of $10.

Even if the price were $4, the same situation would apply. The revenues earned of $28 from 7
units are only $9 less than the $37 it cost to produce the goods, again less than the $10 loss that
would be incurred were the firm to shut down and cease production.
 46

Additional HL Paper 3 Exercises – Section 3 – Solutions

1. a) Y = C + I + G + (X-M)
Y = 100 + 15 + 20 + (31-30)
Y = 136 billion dollars

b) 136 Billion / 40 Million = 3400, so nominal GDP per capita is $3400

c) 136 = 105 solving for x, x = 129 523 800 000, or around $129.5 billion
x 100

d) Real GDP growth, like any percent change problem, is calculated by: (new – old) * 100
old
(129 523 800 000 - 126 000 000 000) * 100 = 2.79666
126 000 000 000

So real GDP growth was around 2.8% between 2011 and 2012

For nominal GDP growth, do a similar calculation:

(136 billion – 126 billion) * 100 = 7.9365

126 billion

So nominal GDP growth was around 7.9% between 2011 and 2012

e) Nominal GNP in 2012 = 136 billion + 10 billion – 5 billion = $ 141 billion

2. a) The Keynesian multiplier = 1/1-MPC, so for Povertia, it is:

1/1-0.96 = 1/0.04 = 25

while for Largesse it is:

1/1-0.7 = 1/0.3 = 3.333

b) Using the Keynesian multiplier, we can see that an additional $1000 of government spending
would result in an increase in GDP of ($1000 * 25 = ) $25000 in Povertia and ($1000 * 3.333 =)
$3333 in Largesse.

3. a) (650 000/ 11 500 000) * 100 = 5.65, so the unemployment rate in Australia was 5.65%

4. a) i), ii) and iii)are suggested by the question. If the blanks were filled in with the
appropriate weights as suggested the final result for 2010 would look as follows:
(3 BR House Rent) * _0.025_ + (2 BR Apartment Rent) * _0.0357_ + {should = 25}
(Bread Price) * _4.15_ + (Banana Price) * _8.3_ + (Milk Price) * _8.3_ + {should =25}
(Price of Shoes) * _0.208_ + (Price of Cotton Dress) * _0.208_ + {should = 12.5}
(Electricity Price) * _125_ + {should = 12.5}
(Bus Ticket Price) * _6.25_ + (Price of a litre of gasoline) * _4.166_ + {should = 12.5}
(Cinema Ticket Price ) * _0.892_ + (Dance Hall Ticket Price) * _0.892_ = 100 {should = 12.5}
 47

b) 2011:
($515) * 0.025 + ($375) * 0.0357 +
($2) * 4.15 + ($0.8) * 8.3 + ($1.25) * 8.3 +
($25) * 0.208 + ($33) * 0.208 +
($0.12) * 125 +
($1) * 6.25 + ($1.35) * 4.166 +
($7.5) * 0.892 + ($7) * 0.892
= 103.448

2012:
($520) * 0.025 + ($385) * 0.357 +
($2) * 4.15 + ($1) * 8.3 + ($1.25) * 8.3 +
($25) * 0.208 + ($35) * 0.208 +
($0.13) * 125 +
($1.10) * 6.25 + ($1.40) * 4.166 +
($7.5) * 0.892 + ($7) * 0.892
= 108.084

c) The rate of inflation can be calculated like any percent change {ie (new – old)/old}

Price Index Number 2012 – Price Index Number 2011 * 100

Price Index Number 2011

108.084 – 103.448 * 100 = 4.48, so the rate of inflation was 4.48%

103.448

5. a) State A – 60%; State B – 60%

b) Tier State A State B

Rate * Income Tier = Tax Rate * Income Tier = Tax
1 0 * 15000 = $0 0 * 10000 = $0
2 0.1 * 10000 = $1000 0.2 * 20000 = $4000
3 0.2 * 10000 = $2000 0.4 * 20000 = $8000
4 0.3 * 10000 = $3000 0.5 * 20000 = $10000
5 0.4 * 10000 = $4000 0.6 * 15000 = $9000
6 0.5 * 10000 = $5000
7 0.6 * 20000 = $12000

Totals: $85000 $27000 $85000 $31000

c) Gillian’s average tax rate in State A would be (27000/85000) 31.7% while her average tax
rate in State B would be (31000/85000) 36.4%.

d) i) Jake would face a 40% marginal tax rate in both states

ii) Jake would have to pay $8000 tax ($0 + $1000 + $2000 + $3000 + $2000) in State A
and $12000 tax ($4000 + $8000) in State B.
iii) Jake’s average tax rates are (8000/50000) 16% in State A and (12000/50000) 24% in
State B.
 48

Additional HL Paper 3 Exercises – Section 4 – Solutions

1. a) Minerals
600

Australia
500
Indonesia

400

300

200

100

0
Fruit
0 100 200 300 400 500 600 700 800 900 1000 1100 1200

b) Indonesia enjoys an absolute advantage in the production of both goods as with the same
quantity of productive resources they can produce both more fruit (1200 to 500) and more
minerals (600 to 500) than Australia.

c) Australia enjoys a comparative advantage in the production of minerals, as the opportunity

cost of an extra unit of minerals is just 1 unit of fruit in Australia, as opposed to 2 units of fruit in
Indonesia

Conversely, Indonesia enjoys a comparative advantage in the production of fruit, as the

opportunity cost of an extra unit of fruit is just 0.5 units of minerals, as opposed to 1 unit of
minerals in Australia.

d) Without trade, Indonesia would produce 300 units of minerals AND 600 units of fruit,
and Australia would produce 250 units of minerals AND 250 units of fruit,
making a total production of 550 units of minerals and 850 units of fruit

e) If Australia were to devote all of its productive resources to producing minerals, it would
produce 500 units. In order to increase total production to 550 units of minerals (the amount
arrived at in part ‘d’ above), Indonesia would only have to produce 50 units. Looking at the
graph above, that would require Indonesia to operate at the point (1100, 50) on their PPC.
 49

Overall production with trade then would be 550 units of minerals and 1100 units of fruit. This is
an improvement of 250 units of fruit (1100 – 850) over the no-trade case, suggesting that trade
based upon comparative advantage does offer significant gains to the parties involved.

2. a) P = $10, Q = 20 000

Feel free to confirm the result from your graph algebraically, as follows:

-5000 + 2500 P = 30 000 – 1000 P

3500 P = 35 000
P = 10

Substituting P=10 into either the demand or supply function will give Q = 20 000

b) See Diagram – the new equilibrium price would be $6 and the quantity sold would be 24 000.

Price ($)

20

18
Domestic Supply
16 (Qs = -5000 + 2500 P)
14

12
10

World Price+Tariff=8 WS (with tariff)

} $2 Tariff
World Price = 6 World Supply
4

2
Demand (Qd = 30000 – 1000 P)
0 Quantity (‘000s)
0 5 10 15 20 25 30 35 40 45 50

Feel free to use algebra to confirm that at a price of $6, the quantity demanded of berets will be
24 000 as follows: Qd = 30 000 – 1000 P
Qd = 30 000 – 1000 (6)
Qd = 24 000

c) Before the entry of imported berets, French beret makers earned $10 * 20 000 berets, or a
total of $200 000. After the imports are permitted, they only earn $6 * 10 000, or $60 000.
Foreign beret-makers, meanwhile, are selling (24 000 – 10 000) 14 000 berets in France for $6
each, giving them earnings of $84 000.
 50

d) First, find the y-intercept of the demand function by finding the value of P where Q = 0
Qd = 30 000 – 1000 P
0 = 30 000 – 1000 P
1000 P = 30 000
P = 30

Then, the initial consumer surplus is the area of the triangle below the demand curve and above
the line P = 10 from Q = 0 to Q = 20 000

A = ½ Base * Height
A = ½ 20 000 * (30 – 10)
A = 200 000, so initially the consumer surplus was $200 000.

The consumer surplus under free trade is the area of the triangle below the demand curve and
above the line P = 6 from Q = 0 to Q = 24 000

A = ½ Base * Height
A = ½ 24 000 * (30 – 6)
A = 288 000, so consumer surplus under free trade is $288 000.

Clearly free trade in berets has increased consumer surplus.

e) i)See diagram above from part ‘b’

ii)The new equilibrium price and quantity is P = 8 and Q = 22 000. Feel free to confirm
this by plugging in a price of $8 into the demand function and solving for Qd.

iii) Under the tariff, domestic producers are now able to sell 15 000 units, leaving 7000
units to be imported (22 000 – 15 000). As the government is collecting $2 from each
imported beret, the government is then collecting a total of $14 000.

iv) French beret makers were only earning $60 000 before (see part ‘c’ above), but are
now selling 15 000 berets at $8 each, making a total of $120 000. This is $60 000 more
than was the case under free trade.

v) While foreign beret makers were earning $84 000 under free trade(see part ‘c’
above), they are now selling just 7000 berets and are still receiving just $6 per beret as
the extra $2 tariff goes to the French government. So, their overall revenues have fallen
to $42 000, which is $42 000 less than was the case under free trade.

vi) The tariff has reduced consumer surplus. While under free trade consumer surplus
was $288 000 (see part ‘d’ above) it is now represented by the area beneath the
demand curve and above the line P=8 from Q = 0 to Q = 22 000.

A = ½ Base * Height
A = ½ 22 000 * 22
A = 242 000, so consumer surplus has fallen to $242 000 from $288 000 due to
the imposition of the tariff.
 51

f) i) See diagram below:

Price ($)

20

18
Domestic Supply
16
14
Domestic Supply after Quota Qty used up
12

10
8

World Price = 6 World Supply

4

2
Demand
0 Quantity (‘000s)
0 5 10 15 20 25 30 35 40 45 50

Quota of 7000 units (from 10 000 to 17 000 units)

ii) The new equilibrium price and quantity are $8 and 22 000. You can confirm this result
using algebra if you like. The quota has the effect of shifting the original supply curve
over 7000 units to the right at prices above $6. Thus, the initial supply curve
Qs = -5000 + 2500 P becomes Qs = 2000 + 2500 P

Solving for the equilibrium point of this new supply function and the original demand
function as follows: 2000 + 2500 P = 30 000 – 1000 P
3500 P = 28 000
P=8
Qs = 2000 + 2500 P
Qs = 2000 + 2500 (8)
Qs = 22 000

Confirms that the equilibrium point is (22 000, 8).

iii) As total sales are 22 000 and as only 7000 imports are allowed with the quota, French
manufacturers can be seen to have sold 15 000 berets (those from Q = 0 to Q = 10 and
those from Q = 17 to Q = 22). Their revenue is much healthier under the quota regime
than under free trade – under quotas they earn (15 000 * $8) $120 000, which is double
the $60 000 in revenue earned under free trade.

iv) The revenues of foreign beret makers in France rise to (7000 * $8) $56 000 under the
quota regime, which is higher than the $42 000 earned under the tariff regime. Their
 52

revenues are higher under the quota than under the tariff as with the quota they are
able to take advantage of the higher prices that have resulted from the imposition of
the quota, and collect the full $8 per beret from French consumers. By contrast, under
the tariff, the additional $2 in the final price charged to consumers goes to the French
government.

v) As the equilibrium price and quantity are the same under the quota as under the
tariff, so too is the consumer surplus. The consumer surplus under the tariff or the
quota, at $242, is less than the $288 of consumer surplus under free trade.

g) i) See diagram below

Price ($)

20

18 Domestic Supply
16
Domestic Supply (after subsidy)
14
12 Subsidy

10

8
World Price = 6 World Supply

4
2
Demand
0 Quantity (‘000s)
0 5 10 15 20 25 30 35 40 45 50

ii) The equilibrium price and quantity would be the same with a subsidy to domestic
producers as it would be under free trade: P = $6 and Q = 24 000. The subsidy allows
more domestic production to be available at the world price of $6.

iii) French manufacturers are now able to sell 15 000 berets at the world price, $6. Their
revenue from these sales would be a total of $120 000 - $90 000 from consumers (who
are buying 15 000 berets at $6 each) and $30 000 from the government due to the
subsidy (15 000 * $2).

iv) Consumers would be happiest with the subsidy as it gives them the most welfare –
with the subsidy they maintain their free-trade level of consumer surplus of $288 000.
Foreign producers, meanwhile, would prefer quotas as their revenues are higher under
quotas (7000 * $8 = $56 000) than they are under subsidies (9000 * $6 = $54 000) or
tariffs (7000 * $6 = $42 000).
 53

3. Dh/Eur = 340/30 = x/1

x = (340 * 1)/30
x = 11.3
Therefore the exchange rate is 1 Euro for 11.3 Dh

4. USD/Ruble = 1/32 = x/350 000

x = (1 * 350 000)/32
x = 10 937.50
Therefore the cost of the motorcycle in USD is $10 937.50

5. a) THB/SGD = 2500/100 = 1/x

x = (1 * 100)/2500
x = 0.04
Therefore the exchange rate is one Thai Baht for 0.04 Singapore dollars, or 4 Singapore cents

b) It has depreciated as now he receives more Baht for each Singapore dollar

The percentage change is calculated like any other percentage change: (New – Old/Old) * 100
(2650 – 2500) * 100 = 150 * 100 = 6, so the Baht depreciated by 6% against the SGD
2500 2500

6. a) To solve, set Qd = Qs and solve for P

10 000 – 3000 P = -5 000 + 2000 P
15 000 = 5000 P
3 = P, so therefore the exchange value of a Peso is 3 US cents

b) If one Peso is worth 3 US cents, then we can find the value of a USD by setting up the
following equivalency:

USD/Peso = 0.03/1 = 1/x

x = (1 * 1)/0.3
x = 33.33
Therefore the exchange value of 1 USD is 33.33 Philippines Pesos

7. a) i) 80 – 30 = + $30 billion
ii) -13 – 7 – 4 = - $24 billion
iii) + 30 – 24 = + $6 billion
iv) + $0.5 billion
v) 3 – 6 = - $3 billion

b) Imports of services would likely be higher as often local subsidiaries employ the financial and
marketing services of the head office.
Direct investment from foreign sources would likely be higher as the multinational would
regularly invest capital from its home country in local operations.
Current transfers to foreign beneficiaries would likely be higher as the foreign workers and
professionals working for the multinational would send remittances to their home countries.
 54

8. a) To check using the Marshall-Lerner condition:

PED (IM) + PED (X) = 0.6 + 0.3 = 0.9; As 0.9 is less than 1, a devaluation will not correct the
balance of payments deficit and in fact will likely make it worse.

To demonstrate that the Marshall-Lerner condition holds, look at the effect of the devaluation
on exports:
The price of exports falls 20% in terms of foreign currencies.
The PED of exports is 0.3.
Therefore export volumes rise by 6% (as PED = % change in qnty/% change in price; 0.3=6/20).
From the point of view of the exporting country, export receipts therefore rise by 6%, as the
receipts are in their own currency.
Therefore, export receipts rise to $900 * 1.06 = $954

To look at the effect on imports:

A 20% devaluation has the effect of pushing up import prices by 25%. For instance, if the
currency had once been worth one unit of foreign currency (ie it had been valued at par), a
devaluation of 20% would push the value of the currency down to 0.8 foreign currency units.
This being the case, it would then take 1.25 of your currency units to purchase one foreign
currency unit.
The PED of imports is 0.6.
Therefore import volumes fall by 15% (as PED = % change in qnty/% change in price; 0.6=15/25).
So, import volumes fall to (0.85 * $1000) $850 worth measured in old, strong currency units,
but ($850 * 1.25) $1062.50 measured in new, devalued currency units.

Taking these two figures together, we can see that the current account deficit has indeed gotten
worse, going from $100 initially to (1062.50 – 954) $108.50, as suggested by the Marshall-Lerner
condition.

b) In this case the current account deficit should be improved by the depreciation as the
Marshall Lerner condition holds – the PED(IM) + PED (EX) = 0.8 + 0.8 = 1.6

Checking the export side:

Export volumes should rise by 16%, as their price will fall by 20% in terms of foreign currency
and as the PED of exports is 0.8 (recall the PED calculation: 0.8 = x/20; x = 16)
Therefore export receipts will also rise by 16% to (900 * 1.16) $1044

Checking the import side:

As the prices of imports will rise by 25%, and as the PED of imports is 0.8, import volumes will
fall by 20%. So, measured in terms of old, strong currency units, imports will fall to $800.
However, in terms of new, depreciated currency units, the import bill will be (800 * 1.25) $1000.

Taking imports and exports together, we can see that the old $100 current account deficit has
been turned into a $44 current account surplus. As our M-L result suggested, the devaluation
did improve the current account balance.
 55

9. a) i) (90 + 100)/2 = 95

ii) (3 * 120) + (100 * 1.10) = (360 + 110)/4 = 117.5

4

Explanatory note – as iron ore prices and machinery prices both started at $100, and as they
both make up half of the value of country’s exports, a simple average is sufficient to determine
the export price index value for 2012. However, for imports the picture is more complicated.
First, you should adjust for the different initial prices for oil and bananas. As oil prices are 100
times banana prices, multiplying banana prices by 100 will make the values for oil and bananas
comparable. Next, though, as oil accounts for ¾ of imports to bananas ¼, it is necessary to
multiply the oil price by 3 and the banana price by 1, and then divide the sum by 4 to accurately
reflect the weight of each.

iii) 95/117.5 = 80.8 is the country’s 2012 terms of trade

b) i) (120 + 105)/2 = 225/2 = 112.5

ii) (3 * 90) + (100 * 0.9) = (270 + 90)/4 = 90

4

iii) 112.5/90 = 1.25

c) The country’s terms of trade improved in 2013 and deteriorated in 2012.

d) No, you can’t assume that a country’s current account balance would improve as a result of
an improvement in the terms of trade. Taking the figures given for 2013:

Imports: 90 barrels of oil * $90/Barrel + 2800 kg of bananas * $0.9/kg = $8100 + $2520 = $10620

Exports: 40 t iron ore * $120/t + 40 units of machinery * $105/unit = $4800 + $4200 = $ 9000

Exports – Imports = - $1620, a current account deficit of $1620.

This result can be explained by looking at the PED of the goods. Better export prices led to steep
falls in export volumes compared to the figures from 2011. For example, the PED of iron ore
between 2011 and 2013 is –(-20/+20) = 1, while the PED of machinery is – (20/+5) = 4. The very
high PED of machinery tells us that an increase in prices will result in a fall in export volumes
that more than offsets the improvement in the terms of trade, leading to lower overall revenue.

Looking at imports, a similar story emerges. The PED of oil in the example is – (20/-10) = 2, while
the PED of bananas is – (12/-10) = 1.2. Both of these figures are elastic, which means that
decreases in price are met with proportionally larger increases in quantity demanded, resulting
in higher overall expenditure.

Taken together, the improvement in the terms of trade led to a deterioration in the country’s
current account balance due to the consistently high price elasticity of demand for both the
country’s imports and exports.