Solution To Econ Subject Guide 2016

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Solution to econ subject guide (2016)
Principles of banking and finance (University of London)
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EC1002 Introduction to Economics
Block 1 – Answers
Activity SG1.1
a) Let us change the details of the problem in concept box 1.1. Suppose that there were no jobs in
the campus shop. The only job available, and this is the alternative to going to the beach with
your friends, is to work at the local fast food restaurant clearing tables, and washing dishes. This
job also pays £70, but because of its general unpleasantness you wouldn’t do it unless you were
paid at least £55. Should you go to the beach or work at the fast food restaurant?
Answer: In this case you should go to the beach. This is worth 60 minus explicit costs of 30 minus
opportunity costs of £15 (the net value of working in the restaurant). The benefits outweigh the
costs (explicit plus opportunity costs).
b) A high-end ladies fashion boutique purchases winter coats from a manufacturer at a price of
£300 per coat. During the winter the boutique will try to sell the coats at a price higher than £300
but may not be able to sell all of the coats. Since they are the latest fashion, no customers would
be interested in buying the coats next season. However, at the end of the winter, the
manufacturer will pay the boutique 20% of the original price for any unsold coats (and re-use the
expensive fabrics they are made from for the next year’s designs).
i. At the beginning of the year, before the boutique has purchased any coats, what is the
opportunity cost of these coats?
Answer: The value the store could have derived from spending £300 times the number of coats
on the next best alternative (e.g. another product to sell in their store, marketing or renovating
the store)
ii. After the boutique has purchased the coats, what is the opportunity cost associated with
selling a coat to a prospective customer? (You can assume the coat will be unsold at the end
of the winter if that customer doesn’t buy the coat).
Answer: The opportunity cost is the £60 the boutique could get back from the manufacturer since
that is their only alternative given the assumptions.
iii. Suppose towards the end of the winter the boutique still has a large inventory of unsold
coats. The boutique has set a retail price of £950 per coat. The marketing manager argues
that the boutique should cut the price to £199 to try to sell the remaining coats before they
become unfashionable at the end of the winter. However, the general manager disagrees,
arguing that would mean a loss of £101 on each coat. Which makes more economic sense
– the marketing manager’s suggestion or the general manager’s argument?
Answer: Since the company has already paid the £300 and cannot get this back, it is no longer
relevant to the decision making. Given that winter is nearly over and there are still a large number
of coats unsold, it is unlikely they can be sold for £950. The next best realistic alternative to selling
the coats at a discount is to sell them back to the manufacturer, but then they will only get £60
per coat. Compared to £60, £199 is a good option; hence the marketing manager’s suggestion
makes more economic sense.

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Activity SG1.2
In the box below, draw a production possibility frontier, clearly marking the regions of inefficient
production, efficient production and unattainable production.
Answer:
Output of
good A
Output of good B
Illustrate how the slope of the PPF represents opportunity cost.
Answer:
Moving from A to B involves a trade-off: (A0 – A1) units of good A must be sacrificed in order to
increase production of good B by (B1 – B0) units. Thus the opportunity cost of increasing
production of good B from B0 to B1 is (A0 – A1) units of good A.
Why is the frontier concave to the origin?
Answer: One reason why the PPF is concave to the origin is diminishing marginal returns to a
factor of production – as more of one input is added to the production of a certain good (while
the other remains fixed), the output added by those additional resources decreases.

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Activity SG1.3
a) Putting cakes on the horizontal axis and T-shirts on the vertical axis draw Jennifer and John’s
production possibility frontiers for a 10 hour working day.
Answer:
b) In what way do these PPFs differ from that drawn in Figure 1.4? Why?
Answer: They are straight lines because neither Jennifer nor John are subject to diminishing
marginal returns to extra hours per day spent on producing cakes or T-shirts.
c) Write down the equations of these production possibility frontiers, making T (T-shirts) a function
of C (cakes).
Answer:
Jennifer: T = 40 − 2C
1
John: T = 5 − 2C
d) What is the interpretation of the slope of these PPFs?

∆T
Answer: The slopes are ∆C
, which is the opportunity cost of cakes in terms of T-shirts. To increase
C by 1 (∆C=1) the output of T-shirts must fall (the slope is negative) by ∆T.
e) In your diagram what represents Jennifer’s absolute advantage in producing both goods? Answer:
Jennifer’s PPF lies outside John’s.
f) In your diagram what represents John’s comparative advantage in making cakes?
Answer: The fact that John’s PPF is flatter than Jennifer’s.

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Activity SG1.4
Suppose there are two countries (M and W) and two goods (shoes and hats). The table gives the labour
requirements to produce a unit of each output in each country.
Country M Country W
labour hrs/unit of output
Shoes 10 12
Hats 2 5
a) Which country has an absolute advantage in shoes? In hats?
Answer: Country M has the absolute advantage for both.
b) Which country has a comparative advantage in shoes? In hats?

Answer: Country W has the comparative advantage for shoes, and Country M for hats. Hint: to
work out the comparative advantage, calculate the opportunity cost of making each good for
both countries, then compare these. Whoever has the lowest opportunity cost has the
comparative advantage.
c) Assuming each country has 100 labour hours available, what will the total production of shoes
and hats be if each country specialises fully in the production of the good in which it has a
comparative advantage (presumably they could then engage in trade with each other) compared
to what they could produce in a situation with no trade if they spent half their available labour
on each good?
Answer: The total production is 8.3 pairs of shoes and 50 hats, compared to 5 + 4.2 = 9.2 shoes
and 25 + 10 = 35 hats.
Activity SG1.5
Classify the following statements as positive or normative:
 Inflation is more harmful than unemployment. Answer: N
 An increase in the minimum wage to £8 per hour would reduce employment by 0.5 percentage
points. Answer: P
 The government should raise the national minimum wage to £8 per hour to help reduce poverty
in society. Answer: N
 An increase in the price of crude oil on world markets will lead to an increase in cycling to work.
Answer: P
 A reduction in personal income tax will improve the incentives of unemployed people to find paid
employment. Answer: P
 Discounts on alcohol have increased the demand for alcohol among teenagers. Answer: P
 The retirement age should be raised to 70 to combat the effects of our ageing population.
Answer: N

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Activity SG1.6
Index numbers: work through the following example to help you understand how index numbers are
calculated: Say we want to calculate inflation (a Retail Price Index) for four specific goods. The index
for each good is set at 100 for the first year. Work out the percentage price change in each good (the
first one is filled in for you).
Product Price – year 1 Index – year 1 Price – year 2 Index – year 2

Bread 80p 100 120p 150
Cheese 260p 100 312p 120
Sausages 300p 100 390p 130
Toothpaste 100p 100 80p 80
TOTAL 400/4 480/4

Overall index 100 120
(Answers are in bold.)
The change in the overall index is the average rate of inflation. What was the rate of inflation for these
four products?
Inflation between year 1 and 2:
Answer: 20%
However, the products in the price index are not equally important and should not be given an equal
weighting in the calculation of the index. That is why Weighted Index Numbers are often used.
Of the four products above, which do you think represents the lowest proportion of a family’s total
spending? Which represents the highest?
If toothpaste represents a small proportion of each family’s total spending, then we should make the
price change for toothpaste have a much smaller overall effect on the price index. To do this we
WEIGHT each price change to give it more or less importance in the overall index.
This has been done in the table below – see if you can complete the last column:
Product Weights Price – Index – Weighted Price – Index – Weighted

year 1 year 1 index – year 2 year 2 index –
year 1 year 2
Bread 4 80p 100 400 120p 150 600
Cheese 2 260p 100 200 312p 120 240
Sausages 3 300p 100 300 390p 130 390
Toothpaste 1 100p 100 100 80p 80 80
TOTAL 10 1000/10 1310/10

Overall 100 131
index
(Answers are in bold.)
Inflation between year 1 and 2?
Answer: 31%

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This figure is considerably higher than the original inflation figure. This is because the products with
the highest weights went up in price the most. The effect of the falling price of toothpaste on the
overall index was reduced because this item had a very small weight. A weighted index gives a much
better estimate of inflation, since it reflects which items are most important to family’s expenditure.
Activity SG1.7
You got a job in the year 2012 with a salary of £25,000. In 2014, you receive a £3,000 increase in your
salary. CPI in 2014 with base year 2012 is 108. Calculate your real income in 2012 and 2014 as well as
the percentage changes in your nominal income and your real income.
Answer: Your real income in 2012: is £25,000; your real income in in 2014 is £25,925.93. The
percentage change in nominal income is 12% and the percentage change in real income is 3.7%.
Activity SG1.8
Use the following functions to draw diagrams in the boxes below.
Answer:
Q = 50 + 20P Q = 150 – 10P
Curve Curve
Slope = 20 Slope = -10

Intercept = 50 Intercept = 150

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Sample examination questions

Multiple-choice questions
1) Every summer New York City puts on free performances of Shakespeare in the Park. Tickets are
distributed on a first-come-first-served basis at 1PM on the day of the show, but people begin
lining up before dawn. Most of the people in the lines appear to be young students, but at the
performances most of the audience appears to be made up of older working adults (tickets can
be transferred, so the person picking up the tickets does not have to be the person watching the
performance). Which of the following concepts best explains this fact?
a) Ceteris paribus
b) Opportunity cost
c) Marginal analysis
d) Absolute advantage
Answer: (b)
2) The output produced by each person in 20 labour hours is given below for wine and cheese. Chose
the option with the correct statement below.
Wine Cheese
Samuel 6 4
Roberto 2 3
a) Samuel has an absolute advantage in both products and a comparative advantage in

cheese.
b) Roberto has an absolute advantage in both products and a comparative advantage in
cheese.
c) Roberto has an absolute advantage in Cheese and a comparative advantage in Wine,
whilst the opposite is true for Samuel.
d) Samuel has an absolute advantage in both products and a comparative advantage in wine.
e) Roberto has an absolute advantage in both products and a comparative advantage in wine.
Answer: (d)
Samuel can produce more wine than Roberto and more cheese than Roberto in 20 hours of labour, so
he has an absolute advantage in producing both products. Samuel’s opportunity cost of producing one
unit of wine is 2/3 units of cheese compared to Roberto’s opportunity cost of producing one unit of
wine which is 3/2 units of cheese – therefore Samuel has a comparative advantage in producing wine.
On the other hand, Roberto has a comparative advantage in producing cheese.
Long answer question

Use the production possibility frontier to illustrate the following concepts
i) scarcity
ii) opportunity cost
iii) productive efficiency
iv) diminishing marginal returns.

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Answer:
i) Scarcity is demonstrated by the fact that a PPF is a boundary demarcating the area of
possible production. Points beyond the curve (such as point F) are unattainable because
society possesses insufficient resources to produce this combination.
ii) The slope of the PPF represents opportunity cost because it illustrates what must be
sacrificed of one good to increase production of the other good.
iii) Points on the PPF are productive efficient since at these points it is not possible to increase
the production of one good without decreasing the production of the other good. Points
inside the curve represent an inefficient use of resources.
iv) The fact that the PPF is concave to the origin illustrates that there are diminishing marginal
returns to an input of production. For example, using the diagram below, let us assume
that production of good A is decreased by removing one worker and letting this person
produce good B instead. Removing one worker when production of good A at A0 decreases
the production of good A by (A0 – A1) units and letting this worker produce good B
increases production of good B by (B1 – B0) units. Removing an additional worker from the
production of good A decreases production by (A1 – A2) units, and adding this worker to
the production of good B increases production by only (B2 – B1) < (B1 – B0) units. This helps
to illustrate why diminishing marginal returns give the PPF a shape that is concave to the
origin.

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EC1002 Introduction to economics
Block 2 Answers
Activity SG2.1
Use the data in the following table to draw for yourself a demand curve, a supply curve, and the whole
market – where demand and supply interact. Be careful to put price on the vertical axis and quantity
on the horizontal axis. What are the equilibrium price and quantity?
Price of a Small Table (£) Quantity Demanded (thousands) Quantity Supplied (thousands)

0 90 0
10 75 15
20 60 30
30 45 45
40 30 60
50 15 75
60 0 90
(Note: Although these lines are straight, they are still called demand and supply curves.)
Answer:

Demand Curve Supply Curve Demand and Supply

Equilibrium price = £30
Equilibrium quantity = 45,000
Activity SG2.2
The direct demand function and direct supply function can be used to easily find the equilibrium
quantity and price. Use the following curves to find the equilibrium price and quantity for noodles: QD
= 30 – 3/4P
QS = 5 + 1/2P
Equilibrium Price = £20 Equilibrium quantity = 15
(Answers in bold.)
Activity SG2.3
Find the inverse demand and supply functions using the direct demand and supply functions in the
table below.
Demand / Supply Function Inverse Demand / Supply Function
Demand QD= 30 – ¾*P P = 40 – 4/3*QD
Supply QS= 5 + ½*P P = ‐10 + 2Q
(Answers in bold.)
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and make a graph of these in the following box:
Supply and Demand

Activity SG2.4
For each event in the following table, identify whether this relates to demand or supply, in what
direction the curve would shift, and the effect on price and quantity. If you draw a graph for each
example, you will also see the movement along the other curve, resulting in the new equilibrium price
and quantity. The first line has been completed for you.
The market for sushi
Event Which curve Direction? Effect on Effect on Movement along
shifts? Supply price? quantity? the other curve –
or demand? which direction?
The price of salmon Supply Left Higher Lower Demand, left
increases
Sushi becomes Demand right higher higher Supply, right
more popular in
Europe
The price of similar Demand right higher higher Supply, right
alternatives rises
Sushi sellers expect Supply left higher lower Demand, left
the price of sushi to
rise in the future
New evidence Demand left lower lower Supply, left
reveals sushi is not
as healthy people
had thought
New machines are Supply right lower higher Demand, right
invented which
make sushi
production more
efficient
(Answers in bold.)

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Activity SG2.5
Multiple choice questions
1. The only four consumers in a market have the following willingness to pay for a good:
Buyer Willingness to pay
Sally £15
Simon £25
Susan £35
Shaun £45

If there is only one unit of the good and if the buyers bid against each other for the right to
purchase it, then the consumer surplus will be
a) £0 or slightly less
b) £10 or slightly less
c) £30 or slightly less
d) £45 or slightly less.
NB: It may help to calculate the price first. Assume it is an open auction where each bidder calls
the price out aloud.
Answer: (b) £10 or slightly less.
(Explanation: The price is set in an open auction where the bidder calls the price aloud. Although
Shaun is willing to pay of £45, once the other consumers have revealed their willingness to pay,
Shaun must only make a bid of just over £35 to be the highest bidder and get the item. The
consumer surplus is the difference between the price he pays (just over £35) and his willingness
to pay (£45).)
2. Examine the diagram below:
£120
Supply Curve
£100
£80
£60 Equilibrium
£40
£20 Demand Curve
0 100 Quantity
Figure 2.1

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At the equilibrium price, the producer surplus is equal to:
e) a. £2,000
f) b. £4,000
g) c. £6,000
h) d. £10,000.

Answer: (a) £2,000.
(Explanation: (60 – 20)*100*1/2 = 2000.)

3. Here you see Anthony’s demand curve for football matches (you can treat the demand curve as
being approximately linear).

P
£8
£6
0 6 10 Q
Figure 2.2
When the price per match falls from £8 to £6, his welfare:
i) Rises by £16
j) Falls by £16
k) Rises by £12
l) Falls by £12.
Answer: (a) Rises by £16.
(Explanation: Calculating the change in welfare (consumer surplus) involves finding the sum of
the areas of rectangle A and triangle B: A = (8 – 6) x (6 – 0) = 12; B = [(8 – 6) x (10 – 6)]/2 = 4.
Hence, A+B = 16.)
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Activity SG2.6
Price floors and ceilings result in a loss of consumer and producer surplus, this is called a deadweight
loss. Can you calculate how much consumer and producer surplus is lost due to the price ceiling in the
diagram below? Has there also been a transfer of surplus between consumers and producers?
Loss of Producer and Consumer Surplus due to a Price Ceiling
Price
£120
£100
Supply Curve
£80
£60 Free Market Equilibrium
£40 Price Ceiling

Excess demand
Demand Curve
£20
0
50 100 Quantity
Figure 2.3
Answer:
Initial consumer surplus: 2000
Initial producer surplus: 2000
Initial total surplus = 4000
Consumer surplus with price ceiling: 2500
Producer surplus with price ceiling: 500
Total surplus with price ceiling: 3000
Deadweight loss: 1000
Transfer of surplus from producers to consumers: 500

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For each question, choose the correct response:
1. An increase in consumer incomes would result in
a) a decrease in demand for bread
b) a decrease in demand for diamonds
c) a decrease in demand for low‐quality cars
d) an increase in demand for inter‐city bus travel (compared to flying or taking the train).
2. An increase in the price of chilli would lead to
a) an increase in demand for Mexican food
b) a decrease in supply of Mexican food
c) an increase in the supply of Mexican food
d) a decrease in demand for other spices.
3. From the diagram below, the loss in consumer surplus due to the price floor is:
a) £50
b) £100
c) £150
d) £200.
Price
£50
Supply Curve
Excess supply
£40 Price Floor
£30 Free Market Equilibrium
£20
£10 Demand Curve
0
10 20 30 Quantity
Figure 2.4

4. Given the following inverse demand and supply curves:
P = 8 – QD/2
P = 2 + QS
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and assuming that price is fixed below the equilibrium price at £5, the loss in producer surplus
due to the price ceiling is:
a) £3.50
b) £4.50
c) £8
d) £9.
5. The demand curve for good A is given by
Q AD = a – bPA + cPB

a) Goods A and B are complements.
b) Goods A and B are substitutes.
c) Goods A and B are unrelated in consumption.
d) The demand curve for good A is upward sloping.
6. The demand curve for good A is given by
Q AD = a – bPA + cPB

a) The quantity of A purchased falls and the price of A falls.
b) The quantity of A purchased increases and the price of A increases.
c) The quantity of A purchased increases and the price of A falls.
d) The quantity of A purchased increases and the price of A stays the same.
7. Suppose that the price of Porto wine was £20 per litre in 2010 and £25 per litre in 2011. Ingrid
observes that Margaret’s consumption of wine rose from 1 litre per month in 2010 to 1.2 litres
per month in 2011.
Ingrid concludes that Margaret’s demand for Porto wine has to be upward sloping:
a) Ingrid is wrong: given the above information Margaret’s demand for Porto wine has to be
downward sloping.
b) Ingrid is right: given the above information Margaret’s demand for Porto wine has to be
upward sloping.
c) Ingrid is wrong: the above information is not enough to conclude that Margaret’s demand
for Porto is necessarily upward sloping.
Answers:
1. c. A decrease in demand for low‐quality cars
2. b. A decrease in supply of Mexican food
3. b. £100
4. a. £3.50
5. b. Goods A and B are substitutes
6. b. The quantity of A purchased increases and the price of A increases.
7. c. There is not enough information to answer this question.
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Suppose that the inverse demand and supply schedules for rental apartments in the city of Auckland
are as given by the following equations:
Demand: P = 2700 – 0.12QD
Supply: P = ‐300 + 0.12QS
a) What is the market equilibrium rental price per month and the market equilibrium number of
apartments demanded and supplied?
Answer: $1,200 ; 12,500 apartments
b) If the local government can enforce a rent‐control law that sets the maximum monthly rent at
$900, will there be a surplus or a shortage? Of how many units will this be? And how many units
will actually be rented each month?
Answer: Shortage of 5000 apartments, 10,000 units actually rented
c) Suppose that the government decides to implement a policy to keep out the poor. It declares
that the minimum rent that can be charged is $1500 per month. If the government can enforce
that price floor, will there be a surplus or a shortage? Of how many units will this be? And how
many units will actually be rented each month?
Answer: There will be a surplus of 5000 apartments; 10,000 apartments will actually be rented.
d) Suppose that the government wishes to decrease the market equilibrium monthly rent to $900
by increasing the supply of housing. Assuming that demand remains unchanged, find the new
equilibrium quantity and the new inverse supply curve.
Answer: 15,000 apartments; P = ‐900 + 0.12Qs’
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Block 3 Answers
Activity SG3.1
Consider your own buying habits. Rank the items below in terms of how responsive your demand for
these goods is to a change in their price:
Product Rank of responsiveness
A nice pair of trousers 2
Rice 4
Bananas 3
Medicine 5
Holidays abroad 1
Answer: This will depend on your own preferences. For the subject guide author, the ranking would
be as follows:
Product Rank of responsiveness
A nice pair of trousers 2
Rice 4
Bananas 3
Medicine 5
Holidays abroad 1
Activity SG3.2
Part A: Calculating an arc elasticity
Given the following information, calculate the elasticity of demand for the following goods, expressing
the elasticities as positive numbers.
Good A Good B Good C Good D
Initial Price and P0 = 4 P0 = 4 P0 = 5 P0 = 12
Quantity Q0 = 10 Q0 = 10 Q0 = 4 Q0 = 13
New Price and P1 = 5 P1 = 5 P1 = 2 P1 = 11
Quantity Q1 = 7 Q1 = 9 Q1 = 10 Q1 = 15
PED: value 1.588 0.474 1 1.643
PED: category elastic inelastic unit elastic elastic
(Answers in bold.)
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Part B: Calculating a point elasticity
PED = -1/s * (P/Q)

Slope = – 1/2
Answers:
At X, PED = 4
At Y, PED = 1
At Z, PED = 1/3
(Answers in bold.)
Activity SG3.3
Factor Example Effect on demand Good / Service
elasticity
Necessity People depend in this Demand is inelastic Life-saving medicine
Substitutes There are many similar Demand is elastic A chess game
products available
Definition Good defined very More elastic (because Wholemeal bread
narrowly there are more possible
substitutes)
Time-span Tastes change Demand becomes more iPhones
elastic
The share of Small items Demand is inelastic Salt
your budget
(Answers in bold.)
Activity SG3.4
Use the boxes below to draw demand curves appropriate to each heading.
Perfectly inelastic demand Perfectly elastic demand

ε= 0 ε=∞
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Activity SG3.5
Total spending is the same as the firm’s revenue. Use the data below to decide, if you were a manager,
whether or not to make the price change in the following cases (you can ignore costs for the purposes
of this activity and just assume that an increase in revenue is a good thing and a decrease in revenue
is bad). For each case, calculate the demand elasticity (using the arc method), decide whether or not
to make the change, and then check your answer by calculating total revenue before and after the
price change.
a) Increasing the price from £6 to £7 will lead to a fall in sales from 10,000 to 8,000.
b) Increasing the price from £8 to £10 will lead to a fall in sales from 15,000 to 12,500.
c) Decreasing the price from £20 to £18 will lead to an increase in sales from 6,000 to 8,000.
Answer:
a) Elasticity= -1.444; revenue 1 = £60,000; revenue 2 = £56,000 -> don’t change!
b) Elasticity = -0.8181; revenue 1 = £120,000; revenue 2 = £125,000 -> change!
c) Elasticity = -2.7143; revenue 1 = £120,000; revenue 2 = £144,000 -> change!
Activity SG3.6
Multiple-choice question
A Bordurian lawyer explains: ‘Smoking is a Bordurian tradition. If you had coffee, you had cigarettes;
if you had cigarettes, you had coffee.’ According to this statement, the cross-price elasticity of the
demand for coffee with respect to the price of cigarettes in Borduria is:
a) Positive
b) Negative
c) Zero
Answer: (b).
(Explanation: According to the lawyer coffee and cigarettes are complements, so the cross-
elasticity of demand is negative.)
Activity SG3.7
Classify the following goods, based on their (hypothetical) income elasticity
Good Income elasticity Type of good

Car 2.98 Normal good (Luxury)
Food 0.5 Normal good (Necessity)
Margarine -0.37 Inferior good
Vegetables 0.9 Normal good (Necessity)
Public Transportation -0.36 Inferior good
Books 1.44 Normal good (Luxury)
Would you expect income elasticities for given goods to be broadly similar in different countries? For
example, would you expect the income elasticity of demand for public transport to be similar in the
US and in Mali? Think about why or why not.
Answer: Public transport may be an inferior good in some countries and a luxury in others
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Activity SG3.8
For the following direct supply function, calculate and interpret the PES when Q = 10 and P = 2.5.
Direct Supply Function: QS = 5 + 2P
PES = = 2 x (2.5 / 10) = 0.5. Less than one -> inelastic. A 1% increase in the price will increase the
quantity supplied by less than 1%.
(Answer in bold.)
Activity SG3.9
Initially, the price of tennis racquets is £20. Demand is 30 and supply is 50. If the price falls by £5, the
quantity demanded rises to 40, the quantity supplied rises to 40, and the quantity demanded of white
cotton t-shirts rises from 70 to 100. Using the arc method, calculate the own-price demand elasticity
and the elasticity of supply for tennis racquets; and the cross-price demand elasticity for white cotton
t-shirts. Are white cotton t-shirts a complement or substitute to tennis racquets?
Own price elasticity = – 1 (unit elastic)
Cross-price elasticity = – 1.235
Elasticity of supply = 0.777 (inelastic)
Substitute or complement? Complement
(Answers in bold.)
Activity SG3.10
Let’s put Maths 4.4 into practice using a numerical example. If
QD = 30 – 4P
QS = -6 + 8P
t = 0.375
Calculate
i) the equilibrium quantities with and without the tax
ii) how much the price paid by consumers increases and the fall in consumer surplus
iii) how much the price received by suppliers decreases and the fall in producer surplus
iv) the tax revenue received by the government
v) the deadweight loss of the tax.
Answer:
i) Q = 18 without the tax; Q = 17 after the tax is introduced

ii) The price paid by consumers increases from $3 to $3.25. The CS is initially
(1/2)*(7.5 –3)*18 = 40.5. This falls to (1/2)*(7.5 – 3.25)*17 = 36.125.
iii) The price received by suppliers falls to 3.25 – 0.375 = 2.875. Producer surplus is
originally (1/2)*(3 – 0.75)*18 = 20.25. And it falls to (1/2)*(2.875 – 0.75)*17 =
18.0625.
iv) The tax revenue received by the government is 0.375*17 = 6.375.
v) The original welfare generated was 40.5 + 20.25 = 60.75. The welfare after the tax
is = 36.125 + 18.0625 + 6.375 = 60.5625. Hence the DWL is 0.1875.
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Activity SG3.11
Multiple choice question
Here you see the football fans’ demand curve d for televised football matches together with the
Football Association’s supply curve s for such matches. The market for televised matches clears
where the two curves cross, hence when 10 matches are televised for 6 euro each. Suppose now
that the Government introduces a tax of £4 per televised match. The figure shows that the number
of televised matches falls from 10 to 6. For these 6 matches fans pay £8 but the Football Association
(FA) earns only £4 as the difference goes into the government’s coffers.
Figure 3.3
As a result of the tax:
a) The welfare of fans increases and the welfare of the FA decreases

b) The welfare of fans decreases and the welfare of the FA increases
c) Both fans and the FA lose welfare but the government raises enough tax revenues to
compensate them
d) Both fans and the FA lose welfare and the government does not raise enough tax revenues
to compensate them
e) Both fans and the FA gain welfare
Answer: (d)
(Explanation: Calculating the change in welfare for fans (consumer surplus) involves finding the
sum of the areas of rectangle A and triangle B: A = (8-6) x (6 – 0) = 12; B = [(8 – 6) x (10 – 6)]/2 =
4. Hence, A + B = 16 is the fans’ welfare loss.
Calculating the change in welfare for the FA (producer surplus) involves finding the sum of the
areas of rectangle C and triangle D: C = (6 – 4) x (6 – 0) = 12; D = [(6 – 4) x (10 – 6)]/2 = 4. Hence,
C+D = 16 is the FA’s welfare loss.
Calculating the change in tax revenues involves finding the sum of the areas of rectangle A and
triangle C: A = (8 – 6) x (6 – 0) = 12; C = (6 – 4) x (6 – 0) = 12. Hence, A + C = 24 is the government’s
tax revenues.
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Accordingly, as both the fans and the FA lose 16, their joint loss is 36. Thus, as the government’s
revenues are only 24, these are not enough to compensate the fans’ and the FA’s losses.
Aggregate welfare is reduces by 36 – 24 = 12.)

1. If demand for pork is given by: QD = 200 – 6P + 2Y, when the price of pork is £8, a rise in
consumers’ income from £100 to £150 leads to:
a) a fall in demand and an income elasticity of -0.14, pork is an inferior good
b) a rise in demand and an income elasticity of 0.14, pork is a normal good and a necessity
c) a rise in demand and an income elasticity of 7.08, pork is a luxury good
d) a fall in demand and an income elasticity of -7.08, pork is an inferior good.
Answer: (b).
(Explanation: The formula for calculating income elasticity of demand is: Percentage change in
quantity demanded of good X divided by the percentage change in real consumers’ income.)
2. Suppose that a firm currently charges a price of £100 per unit and at this price its total revenue
is £70,000. Suppose also that at this price demand is elastic. Now the firm raises its price by £2
per unit. Explaining your answer state which of the following quantities the firm might sell after
the price increase.
a) 300
b) 700
c) 900
d) 1200
Answer: (a)
(Explanation: Only this option represents a fall in quantity.)
3. In Côte d’Ivoire the own-price elasticity of demand for beef is 1.91. If the price of beef rises by
10 per cent, the quantity demanded of beef:
e) rises by more than 10 per cent
f) falls by less than 10 per cent
g) falls by more than 10 per cent
h) rises by less than 10 per cent
Answer: (c)
(Explanation: As the own-price elasticity of demand measures the percentage change in the
quantity demanded of a good when its price changes by 1 per cent, the quantity demanded for
beef will fall 1.91 per cent. Note that no unit of measurement (e.g. unit of weight) is required for
this calculation.)
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4. When price elasticity of demand is greater than unity (in absolute value):
a) revenue will increase with an increase in price

b) revenue will decrease with a fall in price
c) revenue will decrease with an increase in price
d) revenue will remain unchanged with any change in price.
Answer: (c)
(Explanation: Demand is elastic. The increase in price will lead to a relatively large fall in demand
for the product and a fall in revenue.)
5. An estimation of demand facing a particular firm produced the following information with
regard to the elasticities of the demand function for x:
Own price: -2; income: 1.5; cross price, y: 0.8; cross price z: 3.
Where x, y and z are goods and M is income. Therefore:
Select one:
a) If the price of x rose, your sales would fall but your total revenues would increase.
b) If the price of x fell, your sales would increase and so would your total revenues.
c) If the price of x fell, your sales would increase but your revenues would fall.
d) If the price of x rose, your sales would increase and so would your revenues.
Answer: (b)
(Explanation: The own price elasticity is -2 so it is elastic. A fall in price will lead to a relatively
large increase in quantity demanded and an increase in revenue.)
6. With reference to the same information as in question 5:
Select one:
a) Commodities x and z are complements while x and y are gross substitutes.
b) Commodities x and z are complements and so are x and y.
c) Commodities x and z are gross substitutes and so are x and y.
d) Commodities x and z are gross substitutes but x and y are complements.
Answer: (c)
(Explanation: The cross price elasticity of x and z is 3 – since it is positive, the two goods are
substitutes. The same applies for goods x and y where the cross-price elasticity is 0.8.)

1. a Discuss the meaning of elasticity and the various types. What determines the price elasticity
of demand for a certain good? Who is likely to find this information useful?
Answer:
Elasticity generally describes the responsiveness of quantity demanded to a change in price. It
can refer to a change in the price of the good itself (own-price elasticity) or a change in the price
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of a complement or substitute (cross-price elasticity). The change in quantity supplied in response

to a change in price is known as supply elasticity, whilst a change in demand in response to a
change in consumer income is known as the income elasticity of demand). The determinants of
price elasticity include the closeness of substitutes and how narrowly the good is defined.
Knowing the elasticity of demand is very useful for firms as it tells them whether to raise or lower
prices or keep them constant. It is also useful for governments when setting sales taxes.
b. Assume that the market demand for barley is given by:
𝑄 = 1900 − 4𝑃𝐵 + 0.1𝑀 + 2𝑃𝑊

Where Q is the quantity of barley demanded, PB is the price of barley, M is income (say per capita
income of consumers) and PW is the price of wheat. The prices of wheat and barley are each 200
(say £s per tonne) and M is 1000. The slopes for barley demand, wheat demand and income are
–4, 2 and 0.1 respectively. Calculate the own price elasticity of demand, the income elasticity of
demand and the cross price elasticity of the demand for barley with respect to the price of wheat.
Answer: Own price elasticity = –4*200/1600 = –0.5; cross-price elasticity = 2*200/1600 = 0.25;
income-elasticity = 0.1*200/1600 = 0.0125
c. Calculate and illustrate graphically the government revenue and the impact on welfare of a
specific tax of 37.5p per unit when QD = 30 – 4P and QS = –6 + 8P. How do the welfare
implications change if the tax is paid by consumers instead of suppliers?
Answer: See activity SG3.10 for DWL and tax. No change to welfare if consumers pay the tax
instead of producers.
2. Interpret the following elasticities for petrol
Demand elasticity: –0.39

Income elasticity: 1.2
Supply elasticity: 0.7
a) Do there appear to be good substitutes for petrol in the preferences of buyers?

Answer: No. Demand is price inelastic (elasticity = –.39). This price insensitivity suggests that
there are not good substitutes for petrol in the preferences of buyers.
b) Does petrol appear to be a luxury or a necessity in the preferences of buyers?

Answer: A luxury is a commodity with an income elasticity greater than one. Luxuries are such
that as income increases, the proportion of total expenditure spent on the commodity increases.
For petrol, the income elasticity = 1.2. As income increases, the proportion of total expenditure
spent on petrol increases. Hence, it is a luxury good (according to this data).
c) Do firms appear to have excess capacity in the petrol industry?

Answer: No. Supply is price inelastic (=.7). This means that as price increases, sellers are not able
to initiate large changes in the amount offered for sale to take advantage of the higher market
price. One reason for this may be that they do not have a lot of spare capacity.
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Block 4 Answers
Activity SG4.1
Linking the shape of the indifference curves to the assumptions regarding consumer tastes.
The various assumptions that lie behind indifference curves are reflected in certain aspects of the
shape of the curve. Match the assumption to the characteristic of the curve and explain why.
Diminishing marginal rate of Lines never cross
substitution
Consumers prefer more to Any bundle is on some
less (non‐satiation) indifference curve
Completeness Concave (ICs look like ‘smiles’
when seen from the origin)
Transitivity Downward sloping

(Answer: Shown above.)
Activity SG4.2
Draw a map of indifference curves, marking out bundles and comparing them to each other based
on the following story: Mark likes jeans and cowboy boots. He is indifferent between a bundle with 3
pairs of jeans and 2 pair of cowboy boots (Bundle A) and a bundle with 2 pairs of jeans and 4 pairs of
cowboy boots (bundle B). However, he would prefer to have a bundle with 4 pairs of jeans and 5
pairs of cowboy boots (bundle C). He is also indifferent between a bundle with 2 pairs of jeans and 1
pair of cowboy boots (bundle D) and a bundle of 1 pair of jeans and 3 pairs of cowboy boots (bundle
E), although these last two options are his least preferred options. How do you think he would feel
about a bundle with 3 pairs of jeans and 3 pairs of cowboy boots?
Remember:
 An indifference curve shows all the consumption bundles yielding a particular level of utility
 Any point on a higher indifference curve is preferred to any point on a lower indifference
curve

Indifference map
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Answer: See the indifference map above. Point F shows the combination of 3 pairs of jeans and 3 pairs
of cowboy boots. Since this is above the indifference curve u2 it is preferred to combinations A and B.
Since it below the indifference curve u3, Mark would prefer combination C.
Activity SG4.3
The slope depends only on the relative prices of the two goods. Draw budget constraints for the
following three price combinations, assuming a total income of £120.

A: PX = £12
PY = £20

B: PX = £10
PY = £20

C: PX = £12
PY = £15

(Answer: See the graph above.)
Activity SG4.4
Jeremy has £M and wants to buy some combination of books and shoes. Books cost PB each and shoes
cost PS per pair. Both of these goods are normal goods to him. Describe graphically and in equations
how he will decide on an optimal combination of the two goods which will maximise his total utility.
What is the intuition behind this?
Answer:
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Jeremy will choose a combination of books and shoes where his indifference curve is tangent to his
budget constraint. The budget constraint shows what is possible for him to buy given his income and
the prices of the goods, while his indifference curves show his preferences. The further from the origin
an indifference curve lies, the greater his overall utility from the combinations represented by this
curve. Choosing a point where the budget constraint is tangent to an indifference curve allows him to
maximise his utility given what is feasible for him. At this point, the slopes of the two lines are equal.
The slope of the budget constraint is given by the relative price: –PB / PS. The slope of his indifference
curve is given by the ratio of the marginal utilities from each good: –MUB/MUS. Therefore, when the
lines are tangent to each other and the slopes are equal, –MUB/MUS = –PB / PS. Rearranging this
expression gives: MUB/ PB = MUS / PS which has the intuitive explanation that the marginal utility
derived from the last pound spent on books is the same as the marginal utility of the last pound spent
on shoes. In the diagram, a point such as A fulfils this and offers him the optimal combination of shoes
and books. At this point, Jeremy will buy the quantity of books given by BooksA and the quantity of
shoes given by Shoes.
Activity SG4.5
Draw budget constraints and possible indifference curves for the following scenario:
Susan buys cabbages and carrots. Cabbages cost £1 per kilo and carrots cost £0.80 per kilo. Her income
falls from £20 to £16. Carrots are a normal good, but cabbages are an inferior good.
Answer:

Susan’s original optimal combination is given by point A. When her income falls her budget line shifts
inward toward the origin. Her optimal combination changes to a point such as point B. Moving from
point A to point B, her consumption of carrots has fallen but her consumption of cabbages has
increased.
Activity SG4.6
Page 98 contains a suggestion of two diagrams you should draw to check your understanding,
complete this in the boxes below:
Answer: Figure 5.13, except that the old and new budget lines are the other way around; the budget
line rotates around the x‐intercept since only the price of films has changed. If you are unclear about
this, it is recommended that you re‐do exercise SG4.3.

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Activity SG4.7
For a choice between Good X and Good Y, complete the graphs below, clearly indicating the income
and substitution effects in each case. You will find Figures 5.14 and 5.16 helpful for this activity, and
you might want to repeat it a few times on a separate sheet of paper until you are really comfortable
with these concepts. The following order is generally best:
1) Draw the original budget line and indifference curve.
2) Draw the new budget line.
3) Draw the hypothetical budget line parallel to the new budget line and tangent to the original
indifference curve. This gives you the substitution effect.
4) Draw the new indifference curve (where you place this depends on what type of good it is). This
gives you the income effect.

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Activity SG4.8
Derive the individual demand curve from the information in part A. Can you now explain why the
demand curve is downward sloping?
Figure 4.5
(Answer is the second graph.)
Activity SG4.9
Complete the fourth graph, showing the market demand curve. Why might the three consumers have
different demand curves?
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Explanation for the answer in the fourth graph: The three consumers appear to have different incomes
and different preferences regarding good X and good Y, as such their demand curves are all different.
Activity SG4.10
Draw the indifference curves for perfect complements together with a budget line. Now draw a new
budget line for a change in the price of one of the goods. Indicate the income and substitution effects
(if any) of the price change.
Answer:

Perfect complements

Explanation: In the case of perfect complements, there is no substitution effect, only an income effect,
when the price of one good changes.
Activity SG4.11
Barbara likes peanut butter and jam together on her sandwiches. However, Barbara is very particular
about the proportions of peanut butter and jam. Specifically, Barbara likes 2 scoops of jam with each
1 scoop of peanut butter. The cost of ‘scoops’ of peanut butter and jam are 50p and 20p, respectively.
Barbara has £9 each week to spend on peanut butter and jam. (You can assume that Barbara’s mother
provides the bread for the sandwiches.) If Barbara is maximising her utility subject to her budget
constraint, how many scoops of peanut butter and jam should she buy?
Answer: Notice that Barbara only enjoys these goods if they are in the exact ratio she prefers.
This means that peanut butter and jam are perfect complements for Barbara. Barbara wants to
consume at the ‘corner point’ of her L‐shaped indifference curve (least expensive point on any
given utility curve). Thus, she will consume twice as much jam as peanut butter. By consuming in
this ratio, she will spend 90p for each peanut butter/jam bundle. She has a total of £9 in income.
Thus, she can afford 10 bundles: £9.00/£0.90 = 10.
Since each bundle contains two scoops of jam, Barbara should buy 20 scoops of jam. Since each
bundle contains one scoop of peanut butter, Barbara should buy 10 scoops of peanut butter. At
10 = PB and 20 = J, Barbara is at the point where the corner of the L‐shaped indifference curve
just touches the budget constraint at that one point.
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Activity SG4.12
Suppose that a consumer considers coffee and tea to be perfect substitutes, but he requires two
cups of tea to give up one cup of coffee. This consumer’s budget constraint can be written as 3C + T
= 10 (where C is a cup of coffee and T is a cup of tea). What is this consumer’s optimal consumption
bundle?
Answer: Ten cups of tea and no coffee.

The budget constraint is shown by the bold line and the indifference curves are shown by the thinner
lines. The consumer maximises his utility by choosing the point of intersection between the budget
constraint and the highest indifference curve, which occurs at the corner solution of 10 cups of tea
and no coffee.
Activity SG4.13
Calculate the optimal quantity of each of two goods (x and y) and the consumers’ total utility given
px=1, py=2, M=80, and U(x,y) = xy, where MUx = y and MUy = x. How would you represent this
graphically?
Answer:

We have MRS(x,y) = MUx/MUy = y/x.
Using (MRS(x,y) = px/py) we have y/x = 1/2 → x = 2y
Substituting in (xpx+ ypy = M) we have x+2y =80 → 2x=80.
That is, x*= 40, y*= 20, and u* = x*y* = 800.

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1. The price of car transport is 30 cents per mile. The price of bus transport is 60 cents per mile. The
marginal utility of Mario’s last mile of car transportation is 80 utils, and the marginal utility of his
last mile of bus transportation is 150 utils. Hence:
a) Mario is currently maximising his utility.
b) Mario could increase his utility by decreasing his consumption of car transportation.
c) Mario could increase his utility by increasing his consumption of car transportation.
Answer: (c)
(Explanation: Mario is not maximising his utility. He is getting greater marginal utility from his last
cent spent on car transportation than from his last cent spent on bus transportation: 80/0.3 >
150/0.6. In other words, Mario’s MRS of car transportation for bus transportation is larger than
the price ratio of the former to the latter: 80/150 > 0.3/0.6. Therefore, Mario could increase his
utility by increasing his consumption of car transportation until the equilibrium condition MRSyx
= MUx/MUy = px/py is satisfied.)
2. If an agent has a utility function of the form u(x,y)=xy then:
a) S/he will be indifferent between (6,4) and (3,8).
b) S/he will prefer (6,4) over (5,5).
c) S/he will be indifferent between (6,4) and (5,5).
d) None of the above.
Answer: (a)
(Explanation: 6*4 = 24 and 3*8= 24 so the agent gets the same utility from both of these bundles
and is indifferent between them.)
3. The slope of the demand curve for an inferior good is steeper than that of a normal good because:
a) Income and substitution effects enhance each other.
b) Substitution effect for a normal good is greater than that of an inferior good.
c) Income effect of a normal good is smaller in magnitude (absolute value) than the income
effect of an inferior good.
d) Income and substitution effects offset each other.
Answer: (d)
4. Judith spends all her money buying wine and cheese. The marginal utility of the last bottle of
wine is 60, and the marginal utility of the last block of cheese is 30. The price of wine is £3, and
the price of cheese is £2. Judith:
a) is buying wine and cheese in the utility‐maximising amounts
b) should buy more wine and less cheese
c) should buy more cheese and less wine
d) is spending too much money on wine and cheese.
Answer: (b)
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Long response questions
1.a Susan buys bread rolls and cheese. One bread roll costs £1 and cheese costs £3 per 500g block.
Susan has £12 income to spend on bread and cheese.
i. Draw Susan’s budget constraint and a possible indifference curve. Explain the assumptions
behind the shape of the indifference curve you have drawn.
ii. If the price of bread falls to £0.80 per bread roll, how will this affect her purchases? Answer
in words and graphically, clearly indicating income and substitution effects of the price
change.
iii. If Susan only enjoys bread and cheese when she has 500g of cheese for every bread roll
that she eats, draw her indifference curves (on a new graph). How much bread and cheese
should she buy to maximise her utility? Assume Susan has £12, one bread roll costs £0.80
and cheese costs £3 per 500g block.
Answer:

The indifference curve is downward sloping because we assume both bread and cheese are
‘goods’ not ‘bads’, such that Susan prefers more of these to less (this is called non‐satiation). The
curve is concave to the origin because we assume that Susan experiences a diminishing marginal
rate of substitution between the two goods, such that when she has a small amount of cheese
she requires more bread to give up some of this, but when she has more cheese, she requires a
smaller amount of bread to give up some of this, and vice versa.

When the price of bread rolls falls, Susan’s budget line rotates outward. She can now buy a
maximum of 15 bread rolls rather than 12. Her consumption of bread will increase due to the
substitution effect (bread is now cheaper relative to cheese compared to what it was before) and
the income effect (the lower price means she can buy more of everything). These effects are
marked on the diagram. In terms of her consumption of cheese, the overall effect is ambiguous
– she may buy more or less. The income effect will lead to an increased demand for cheese, but
the substitution effect will lead to a decrease, because cheese is now more expensive relative to
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bread rolls compared to what it was before. The diagram shows a slight decrease in the demand
for cheese, but this will not necessarily be the case – it depends on which effect dominates.

We now assume that bread rolls and cheese are perfect complements in consumption. Susan’s
budget constraint is:
QB * 0.8 + QC * 3 = 12
Since Susan only enjoys her food when she has 1,500g block of cheese for every 1 bread roll,
QB = QC
Therefore, QC * 0.8 + QC * 3 = 12
3.8 * QC = 12
QC = 3 1/6
QB = 3 1/6
To maximise her utility, Susan should buy 3 1/6 bread rolls and 3 1/6 blocks of 500g of cheese.
More realistically, we can say she should buy 3 bread rolls and 3 blocks of cheese.
b) Now let’s assume that Susan grows 100 potatoes each year and all of her income comes from
selling them. She spends all of her income each year consuming potatoes and other goods. For
Susan, potatoes are a Giffen good, in that if her income is fixed in some way (i.e. ignoring the
fact that she sells potatoes and just fixing her income at some value) her consumption of
potatoes will rise when their price rises. The price of potatoes falls and she consumes more
potatoes. Taking into account the fact that her income actually comes from selling potatoes,
explain how the last statement can be consistent with those that precede it.
Answer: Giffen goods are always inferior goods because they have a negative income effect.
Because potatoes are a Giffen good for Susan, we would expect the quantity demanded to fall
when the price falls. However, the question states that the quantity demanded rises. The reason
for this is because Susan’s income derives from selling the potatoes. Since the quantity she sells
is fixed at 100, a fall in the price of potatoes signifies a fall in Susan’s income. For inferior goods,
the quantity demanded rises when income falls (negative income effect). In this case, the rise in
quantity Susan demands due to the fall in her income more than offsets the decrease due to the
fall in price.
2. I consume two goods, Ice Cream and Biscuits. I shop once a week, spending £100, at either
Sainsbury or Tesco (two well‐known supermarkets). Interestingly, I’ve noticed that the bundle I
purchase when I visit Tesco costs more at Sainsbury. Similarly, the bundle I purchase when I visit
Sainsbury costs more at Tesco. And yet, I find that I get the same utility from shopping at either
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store (i.e the Sainsbury shopping bundle gives me the same utility as the Tesco shopping
bundle). Explain how it is possible for all of these statements to be true. (Hint: draw a single
indifference curve and have me maximise utility given a £100 budget and different prices in the
two stores).
Answer:

On the diagram above, ice cream is more expensive at Sainsbury’s but biscuits are more expensive
at Tesco. Therefore when I go to Tesco I buy more ice cream and fewer biscuits than when I go to
Sainsbury’s and vice versa. If I bought the quantity of ice cream and biscuits that I buy when I go
to Tesco at Sainsbury’s, this would cost more than £100 (this point lies beyond the budget
constraint for Sainsbury’s) and vice versa. However, since I adjust the quantities of the two goods
depending on which store I am in, I can spend £100 in each store and derive the same utility from
each bundle. This can be seen because both bundles lie on the same utility curve – and thus give
me the same utility.
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Block 5 Answers
Activity SG5.1
What is the economic cost of studying for an undergraduate degree?
Answer: The economic cost includes direct costs and opportunity costs. The direct costs would be
tuition, fees and textbooks, while the opportunity cost is the lost wages that could have been earned
during the time spent studying for the degree.
Activity SG5.2
Describe how the phrase ‘too many cooks spoil the broth’ can demonstrate the law of diminishing
returns.
Answer: This idiom expresses the idea that too many people working together may be less effective
than just a few. As more cooks start to work together in one kitchen, their productivity falls. In time,
adding more cooks may even reduce the total output, as they start to get in each other’s way.
Activity SG5.3
Define the following terms and give a formula for (b) and (c):
a) total product
b) average product
c) marginal product.
Answer:
a) total product – the total amount produced during a period of time by all the inputs that the
firm is using at that time
b) average product – total product per unit of the variable input (labour): APL = Q/L
c) marginal product – the change in total product resulting from the use of one more (or one less)
unit of the variable input (labour): MPL = ΔQ/ΔL
(These definitions are from L&C, ‘Short-run variations in input’, pp.102. The definitions from
BVFD would be fine as well.)
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Activity SG5.4
Complete the following table:
Quantity of Total Product Average Marginal
Labour (L) (TP) Product (AP) Product (MP)
1 129 129 129
2 480 240 351
3 1053 351 573
4 1800 450 747
5 2625 525 825
6 3456 576 831
7 4116 588 660
8 4608 576 492
9 4968 552 360
10 5250 525 282
11 5445 495 195
12 5580 465 135
(Answers in bold.)
The point where marginal product reaches a maximum is called the point of diminishing marginal
returns. At what quantity of labour do diminishing marginal returns set in?
Answer: Diminishing marginal returns set in with the seventh unit of labour.
Graph the Total Product curve in the upper section and the Marginal and Average Product curves in
lower section of the box below.
Total Product (TP)

6000
5000
4000
3000
2000
1000
0
1 2 3 4 5 6 7 8 9 10 11 12
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900
800
700
600
500
400
300
200
100
0
1 2 3 4 5 6 7 8 9 10 11 12
Average Product (AP) Marginal Product (MP)
Activity SG5.5
Based on the production function: Q(L, K) = L0.5 * K0.5 , where Q is output, L is labour and K is capital, fill in
the blanks below and draw isoquants for the three output levels on a large graph on a separate piece of
paper, or using scatter plots in Excel. (NB: remember 𝑥 0.5 = √𝑥).
Output = 10 Output = 20 Output = 24
Labour Capital Labour Capital Labour Capital
1 100 - - 4 144
4 25 4 100 9 64
5 20 6.25 64 16 36
10 10 16 25 36 16
20 5 64 6.25 64 9
25 4 100 4 144 4
100 1 - - - -
(Answers are in the shaded areas.)
160
140
120
Output = 10
100
Labour
Output = 20
80
Output = 24
60
Isocost (C=100)
40 Isocost (C=150)
20 Isocost (C=50)
0
0 50 100 150 200
Capital
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On the isoquant reflecting an output level of 10 units – what is the MRTS between labour and capital
when labour changes from 4 to 5 units?
Answer: MRTS = ΔL/ΔK =-1/5
Activity SG5.6
If r = £2/hr and w = £12.50/hr, draw three isocost lines onto the diagram you created in Activity SG5.2 for
when cost is equal to £50; to £100; and to £150. What is the optimal (i.e. the least-cost or cost-minimising)
combination of labour and capital for an output level of 10? What is the cost?
Answer: C=£100, L= 4, K=25. The isocost line where cost = £100 is tangent to the isoquant where output
= 10 at K=25 and L=4. The isocost line where cost = £50 is unrealistic as the firm cannot produce 10 units
of output with only £50 to spend on inputs. The cost curve £150 is not efficient as the firm can produce
10 units at a lower cost.
160
140
120
Output = 10
100
Labour
Output = 20
80
Output = 24
60
Isocost (C=100)
40 Isocost (C=150)
20 Isocost (C=50)
0
0 50 100 150 200
Capital
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Activity SG5.7
Use the information below to draw isoquants and isocost lines and find four points on the firm’s total cost
curve.
Rental rate of capital = £2 per hour
Wage = £2 per hour
Cost levels: £12, £16, £20 and £24.
Output combinations:
Qx=25 Qx=50 Qx=75 Qx=100

Capital Labour Capital Labour Capital Labour Capital Labour
A 1 8 2 10 3 10 4 10
B 2 5 3 6 4 7 5 8
C 3 3 4 4 5 5 6 6
D 5 2 6 3 7 4 8 5
E 8 1 10 2 10 3 11 4
What is the slope of the isocost lines? What is the MRTS at the points where the isoquants are tangent to
the isocost lines? What does this imply about the firm’s total cost curve?1
Answer: Slope of isocost lines = –1. MRTS = –1, because the isoquants and isocost lines are tangent to
each other (i.e. they have the same slope). It would also be possible to find the slope of the isoquant using
calculus, but that is not a requirement here. Implication: The total cost curve is made up of the least-cost
ways of producing each output level.
Total Cost Curve

30
25
20
15
10
0
0 20 40 60 80 100 120
1
The shape of this cost curve (a straight line) is simplistic – we will examine more realistic total cost curves later,
where the shape will reflect increasing, constant and then decreasing returns to scale. These concepts are
discussed in chapter 7, to be covered in the following block.
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Activity SG5.8
A firm Sam’s Lamps has the production function Q(L, K) = L*K. Given labour of 5 and capital of 7, are they
producing efficiently by producing 12 units? What level of production is the productive efficient level?
What reasons might there be for not producing efficiently?
Answer: With labour of 5 and capital of 7, they are not producing efficiently by producing 12 units. The
productive efficient level of production is 35. Possible reasons include: workers are shirking; managers
have imperfect information on best practice; there is some kind of strategic reason (e.g. if firms with poor
production performance get support from the government via grants).
Now suppose that Sam’s Lamps has decided to produce 100 lamps and the price of labour is £5 per unit
and the price of capital is also £5 per unit. The firm decides to employ 50 units of capital and 10 units of
labour. Is this efficient? Hint: with this production function the marginal product of labour is equal to K
and the marginal product of capital is equal to L.
Answer: No, it is not efficient. The firm should use 10 units of each input.
Activity SG5.9
To produce a subject guide, one author and one computer are perfect complements in production. One
author and two computers would not be more productive. Two authors is more productive – but
(probably) only if they each have a computer. What would be the shape of the isoquants in this case?
Answer: Fixed proportions – perpendicular lines.
Now imagine that there is a machine that does exactly the same thing as a human in regards to the
production of a certain good. Labour and capital will be perfect substitutes in production in this case.
What would be the shape of the isoquants if the inputs are labour and this type of machine?
Answer: perfect substitutes – straight lines.
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Activity SG5.10
If the firm faces the demand curve: P=25-2Q,
a) fill in the blanks in the table below
b) draw the marginal cost and marginal revenue curves
c) find the profit maximising output level for this firm. How much profit is the firm earning at that point?
Assume output must be in integers.
Total Total Marginal Marginal
Output Price Profit
Revenue Cost Revenue Cost
0 25 0 8 0 8 -8
1 23 23 23 23 15 0
2 21 42 34 19 11 8
3 19 57 42 15 8 15
4 17 68 49 11 7 19
5 15 75 55 7 6 20
6 13 78 65 3 10 13
7 11 77 78 -1 13 -1
8 9 72 93 -5 15 -21
9 7 63 110 -9 17 -47
10 5 50 130 -13 20 -80
150
100
Total Revenue
50
Total Cost
Marginal Revenue
Marginal Cost
0
0 2 4 6 8 10 12 Profit
-50
-100
Answer: The profit maximising level of output for this firm is 5 units. At this level, marginal cost and
marginal revenue are (almost) equal. Profit is maximised at £20.
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1. Labour Productivity at Shakespeare’s Pies:
Number of
Workers 0 1 2 3 4 5 6
Output of Pies
0 10 26 36 44 49 52
Note: Pies are sold competitively at £3 each. Labour is the only variable input and costs £14 per
worker. Capital costs are £80. These are short run and long run costs and productivities (i.e. there is
no possibility of using different production techniques or combinations in the long run).
Using the information above, which describes the number of pies produced as a function of the
number of workers at Shakespeare’s Pies, and focusing just on the decision to hire workers (ignoring
the shut-down condition and just trying to pick the best number of workers), Shakespeare’s Pies
maximises its profit if it hires:
a) 1 worker
b) 3 workers
c) 5 workers
d) 6 workers.
Answer: (c)
2. Anita owns a grocery shop. These are her annual revenues and costs:
Revenues £250,000
Supplies £25,000
Electricity and heating £6,000
Employees’ salaries £75,000
In addition to the above, Anita pays herself a salary of £80,000. If she closed her shop she could rent
out the land and building for £100,000. Due to her experience at running her own shop the local
supermarket would offer her a job and pay her £95,000.
a) Anita’s revenue exceeds her economic costs so she should continue running her business
b) Anita’s economic costs exceed her accounting costs so she should shut down her business
c) Anita’s economic costs exceed her revenue so she should shut down her business
d) Anita’s salary is less than what the supermarket would pay so she should shut down her
business.
Answer: (c)
(Explanation: Her accounting costs: £186,000; her economic costs: £301,000. Revenue: £250,000.
Anita should shut down the shop. Anita should compare her revenue with her economic costs – since
her economic costs are lower than her revenue, she should shut down the business.
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3. Chose the statement which is false:
When long run costs for a firm are at a minimum
a) The ratio MPL/MPK = wage / rental

b) MPL = MPK
c) The extra output we get from the last dollar spent on an input must be the same for all inputs.
d) the firm’s production is economically efficient.
Answer: (b)
Long response question

1. a What is an isoquant?
b Why does an isoquant get flatter as you move towards the right?
c Draw an isoquant and an isocost line which have a point of tangency and indicate the productive
efficient level of output. How will this change if the wage level rises? Clearly indicate output and
substitution effects.
d Use the following information to derive the total cost curve for Ice Cream Inc. (indicating three
points on the curve will be sufficient):
Production function: Q (K,L) = K*L
Rental rate of capital = £15 per hour
Wage = £15 per hour
Answer:
a) An isoquant is a line depicting all possible combinations of inputs that result in the
production of a given level of output.
b) An isoquant gets flatter due to a diminishing marginal rate of technical substitution (MRTS).
c) See 5 below.
d)
10
9
8
7 Q=1
6 Q=4
5 Q=9
4 C=30
3 C=60
2 C=90
1
0
0 2 4 6 8 10
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TC
100
90
80
70
60
50
40
30
20
10
0
0 2 4 6 8 10
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2.
a) Fill in the blanks in the table below
Q P TC TR MR MC π
0 5 5 0 – – –5
1 5 10 5 5 5 –5
2 5 13 10 5 3 –3
3 5 14 15 5 1 1
4 5 16 20 5 2 4
5 5 19 25 5 3 6
6 5 23 30 5 4 7
7 5 28 35 5 5 7
8 5 34 40 5 6 6
Explain the difference between economists and accountants definitions of profit. What assumption is
required such that the profit levels you calculated in the table above represent economic profit?
Answer: Profit is defined as revenue minus cost. In the case of economic profits, costs include the
opportunity cost of the inputs used to make the output, whereas the costs used to calculate
accounting profits only include the actual payments made. For the profit levels in the table below to
represent economic profit, the assumption is that the costs include the opportunity costs of all
resources used in production.
b) What is the profit maximising level of output? What can you say about the relationship between
marginal cost and marginal revenue at this point?
Answer: The maximum profit that can be attained (in this example) is £7. This occurs when the
quantity of output is 6 or 7 units. At 7 units of output, MR = MC.
c) Draw a graph of a generic marginal cost schedule and a generic marginal revenue schedule (not
based on the figures above) and indicate the profit maximising level of output.
Answer: The profit maximising level of output occurs where the MC and MR lines cross (i.e. at Q*).
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d) Demonstrate graphically how a fall in the price of the raw materials will affect the profit
maximising level of output.
Answer: A fall in the price of the raw materials will cause the MC curve to shift downwards. The
profit maximising level of output will therefore increase.
e) Demonstrate graphically how a fall in demand will affect the profit maximising level of output
Answer: A fall in demand will cause the MR curve to shift downwards. The profit maximising level
of output will therefore decrease.
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Block 6 Answers
Activity SG6.1
This section introduces various cost curves – practice these in the boxes below as indicated.
Answer: See Figures 7.3, 7.4 and 7.5.
Activity SG6.2
Why does the SMC curve cut the SAVC and SATC curves at their minimum points? Provide an intuitive
answer.
Answer: Where marginal cost is less than average cost, the average cost curve is falling. Where
marginal cost is greater than average cost, the average cost curve is rising. Thus, the marginal cost
curve must cross the average cost curve at the point where the average cost curve changes direction
(i.e. its minimum point). This applies to average variable cost as well as average total cost.
Activity SG 6.3
Find the short run fixed cost, variable cost, marginal cost, average fixed cost, average variable cost and
average total cost for the short run total cost function STC = M + aQ2, for which the first derivative is
2aQ.
 short run fixed cost: M
 variable cost: aQ2
 marginal cost: 2aQ
 average fixed cost: M/Q
 average variable cost : aQ
 average total cost: M/Q+aQ
(Answers in bold.)
Activity SG6.4
How does the switch in technique in the final sub-section of section 7.5 relate to the analysis of a
change in factor prices using isocost lines and isoquants? (See Figure 7.A4.)
Answer: Each of the techniques is a point on an isoquant. A change in relative factor prices means a
point on a different isoquant will be tangent to the new isocost line. This represents a change in
technique). In this section in the text, Tables 7.7 and 7.8 refer to points on a single isoquant (Q=100)
– this is oversimplifying what would really happen. In fact, the change in factor prices would result in
a move to a different isoquant.
Activity SG6.5
Draw the long run cost curves in the boxes below as marked.
Answer: See Figures 7.A3 and 7.9.

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Activity SG6.6
Increasing returns to scale can be expressed as saying that a certain increase in inputs leads to a more
than proportional increase in output. Equivalently, it can also be expressed by saying that a certain
increase in output requires a less than proportional increase in inputs. Use this idea and the following
isoquant map to derive a production function (with a composite input on the horizontal axis),
assuming that the level of output represented by each successive isoquant increases by an equal
amount each time.
Activity SG6.7
Draw six short-run average cost curves, each with a single point of tangency to a long-run average cost
curve showing increasing, constant and then decreasing returns to scale. Answer: See Figure 7.12
(Answer on the right-hand side.)

1. Labour Productivity at Shakespeare’s Pies:
Number of
Workers 0 1 2 3 4 5 6
Output of Pies
0 10 26 36 44 49 52
Note: Pies are sold competitively at £3 each. Labour is the only variable input and costs £14 per worker.
Capital costs are £80. These are short run and long run costs and productivities, i.e. there is no
possibility of using different production techniques or combinations in the long run.
Refer to the information above which describes the number of pies produced as a function of the
number of workers at Shakespeare’s Pies and the note, which highlights that capital costs (fixed costs)
are £80 in the short and the long run. Assuming wages and prices don’t change, Shakespeare’s Pies
should:
a) Shut down immediately
b) Stay open in the short run but shut down in the long run
c) Stay open in the short run and the long run

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d) Shut down in the short run but reopen in the long run.
Answer: (b)
Number
Output
of Price TR MR FC TC MC π
of Pies
Workers
0 0 3 0 80 80 -80
1 10 3 30 30 80 94 14 -64
2 26 3 78 48 80 108 14 -30
3 36 3 108 30 80 122 14 -14
4 44 3 132 24 80 136 14 -4
5 49 3 147 15 80 150 14 -3
6 52 3 156 9 80 164 14 -8
Shakespeare’s Pies is making a loss and there is no reason why this should change in the future,
hence in the long run they should shut down. However, in the short run, while they are still
incurring capital costs, the firm can more than cover its variable costs and contribute to its fixed
costs by remaining in business. Therefore they should continue to produce in the short-run but
shut down in the long-run.
2. If short-run average total cost equals short-run marginal cost, then

a) Short-run average total cost is at a minimum.
b) Short-run marginal cost is at a minimum.
c) Both (a) and (b) above.
d) Neither (a) nor (b) above.
Answer: (a)
3. Which of the following statements best summarises the law of diminishing marginal returns?
a) In the short run, as more labour is hired, output diminishes.
b) In the short run, as more labour is hired, output increases at a diminishing rate.
c) In the short run, the amount of labour a firm will hire diminishes as output increases.
d) As more labour is hired, the length of time that defines the short run diminishes.
Answer: (b)
4. Let the production function be q=ALaKb where q is output, L is labour and K is capital. The
function exhibits increasing returns to scale if
a) a + b = 1
b) a + b > 1
c) a + b < 1
d) Cannot be determined with the information given.
Answer: (b)

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5. Suppose the short-run total cost of producing T-shirts can be represented as STC = 50 + 2q
where q is the level of output. The average and marginal costs of the 5th t-shirt are:
a) 50 and 2
b) 12 and 2
c) 50 and 10
d) 12 and 10
Answer: (b)

1. The isocost line is the graph of factor inputs such that their total combined cost is equal to a
given constant. Suppose a firm uses two factor inputs, labour (L) and capital (K). Per day, the
wage rate for labour is £15 while renting units of capital costs £60.
a) Depict on a graph the isocost line for a firm spending C* = £3,000 on factor inputs. Put on
this graph a typical isoquant for output level, say Q*, to illustrate the optimal input levels L*
and K* at cost C*
Answer:
The isocost line cuts the y-axis at 50 (£30,000/60 = 50) and the x-axis at 200 (£30,000/15 =
200). The isoquant is downward sloping and concave to the origin. The point of tangency
between the isocost line and the isoquant occurs at the optimal level of capital and labour
(K*, L*).
b) The government introduces a minimum wage for labour at £20. With capital fixed at K* in
the short run, show graphically and describe how much it would cost the firm to continue to
produce Q*
Answer: With the minimum wage of £20, the isocost curve is now steeper and the firm could buy
less labour if it only spent £30,000 in total as it was doing before the introduction of the minimum
wage. If the firm wants to maintain its production level at Q*, however, it will now have to spend
more. The cost and quantity of capital do not change in the short-run. The isoquant has not

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changed so the ratio of labour and capital will remain the same. Therefore the cost increases from
60K*+15L* to 60K*+20L*.
c) Taking the minimum wage as given, show graphically and describe how the optimal factor
input mix to produce Q* changes in the long run. How does the eventual production cost
compare to that in the short run and that before the minimum wage?
Answer: In the long run, capital can also vary. The optimal input mix (the isocost that is tangent
to Q*) involves more capital and less labour than before the introduction of the minimum wage.
The production cost is higher than before the introduction of the minimum wage, but lower than
it was straight afterwards before capital could adjust to the change.

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2)
a) Bob Smith manages a branch office of a large financial-services firm. He uses computers
(capital, K) and people (labour, L) to produce consulting advice Q, according to the
production function: Q=K * L.
Employing people costs the wage rate w = 1 while renting computers costs the rental rate r.
Suppose computers cost twice what people do, i.e., r=2w=2. For now the number of
̅.
computers in the branch is fixed at K = 𝐾
i. How much labour does Mr Smith employ if he needs to produce output Q? Show that
̅ + Q/𝐾
total cost is C(Q) = 2𝐾 ̅
Answer:
̅*L
Q = K*L = 𝐾
L=Q/𝐾 ̅
TC = wL + rK
̅ ) + 2*𝐾
= 1*(Q / 𝐾 ̅
̅ + Q/𝐾
= 2𝐾 ̅
ii. ̅ , derive average and
Given that the first derivative of the total cost function above is 1/𝐾
marginal cost. How do average and marginal cost vary with output?
Answer:
Average cost: AC = TC / Q
= (2𝐾̅ + Q/𝐾̅) / Q
= 2𝐾̅ / Q + 1/𝐾
̅
Marginal cost: MC = 1/𝐾 ̅
Average cost declines with output but marginal cost is constant.
iii. Corporate headquarters has just authorised Mr Smith to upgrade the branch office by
varying the quantity of computers. What is the optimal (cost-minimising) mix of capital
and labour? Using the production function given above, the marginal product of labour
is equal to K and the marginal product of capital is equal to L.
Answer:
First let us depict this graphically with capital on the vertical axis and labour on the horizontal
axis

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At the cost-minimising mix of capital and labour, the slope of the isoquant is equal to the slope
of the isocost line. The slope of the isoquant is the marginal rate of technical substitution. The
slope of the isocost line is the ratio of the factor prices of capital and labour.
Slope of isoquant = -MPK/MPL = -L/K

Slope of isocost line = -r/w = -2/1 = -2
As such, L/K = 2
L = 2K
Mr Smith should use two workers for every computer.
b) In the diagram below choose levels of output for the three unlabelled isoquants such that
from a to b there are increasing returns to scale, from b to c constant returns to scale and
from c to d decreasing returns to scale.
Q2 =3, Q3=6, Q4=9

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Block 7 Answers
Activity SG7.1
For the forex market (foreign exchange – e.g. selling US dollars), note down how and to what extent
each of the four assumptions above are met.
1) Many firms, each negligible in size relative to the entire industry.

2) All firms produce homogenous goods.
3) Perfect information regarding prices and available alternatives.
4) Free entry and exit.
Answer:
1) To some extent: traders have access to many different buyers and sellers. However,
central banks are large players in the market and sometimes make very large trades
relative to the market size.
2) Yes: one $US or GBP is the same as any other.
3) There is a very fast flow of information, so it is easy to compare prices.
4) Yes.
Activity SG7.2
Draw the short-run cost curves of a perfectly competitive firm and indicate prices at which they … and
the quantities they will produce at each of these prices:
i) make supernormal or economic profits
ii) will not produce in the short-run
iii) just cover all their costs.
Answer:

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Activity SG7.3
Reproduce Figure 8.4 from the textbook, except to show exit, not entry.
Answer:
At the original price P1, price is below long-run average costs and the firms in the market are making
losses. This will lead some firms to leave the market, shifting the market supply curve to the left to S2.
Exit will stop once the price is equal to the firms’ minimum LRAC curves (i.e. at P2).
Activity SG7.4
Suppose all firms in a perfectly competitive market are initially in both short-run and long-run
equilibrium. Then a lump-sum tax (i.e. a tax that is unrelated to a firm’s output) is introduced.
a) What impact will this have on each firm in the short-run?
b) What impact will this have on market price in the long-run? (Explain your answer.)
c) What impact will this have on each firm’s output in the long-run?
d) What impact will this have on the number of firms in the industry in the long-run?
Draw diagrams to illustrate the effects of the lump-sum tax on an individual firm and the whole
industry in the short-run and in the long-run.
Answer:
a) In the short-run, the lump sum tax represents an increase in the fixed cost of each firm. As
neither MC nor MR are affected, the firm’s output decision is unchanged. As firms were
originally just covering opportunity costs (they were in long-run equilibrium) they will now be
making losses. Firms leave the industry.
b) The lump sum tax has increased the LRAC of each firm, but not has not affected MC.
Minimum AC is higher, so the long-run industry price is higher.
c) With a higher price, each firm produces a greater quantity, but the higher price means total
output demanded in the industry will fall.
d) There will be fewer firms in the industry in the long-run.

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The diagram for the firm in the short-run has a single SMC curve, as this is not affected by a
lump sum tax, while the SATC curve shifts upwards. The average tax per item will be very large
when there is a low level of production and very small when there is a large total output. For
this reason, the two SATC curves are further apart on the left and come progressively closer
together. There is no change in equilibrium market price or quantity since the supply curve does
not shift in the short-run. Since the price remains stable, each firm produces the same quantity
as they did before, but are now making losses, which will lead to exit from the market in the
long term. As firms exit in the long-run, this will cause the supply curve to shift to the left,
leading to an increase in price. Each of the remaining firms will respond to this price increase by
producing more than they did before. The amount of tax paid by each firm in the short-run and
the long-run is shown by the grey boxes. In the long-run, the price increases by more than the
average per unit tax.

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Activity SG7.5
Reproduce both graphs in Figure 8.8, but for an increase in demand, rather than an increase in costs.
(The textbook also suggests this activity and already provides the industry side.)
Answer:
The individual firm faces a horizontal demand curve. When there is a shift in market demand from DD
to D’D’, price increases from P0 to P’ and the demand curve faced by the firm shifts upwards (also from
D to D’). The firm chooses the output quantity where P = MC such that quantity increases from Q0 to
Q’. At this point, firms are making supernormal profits, represented by the grey box. (NB: the height
of this box is the distance from P’ down to where the dotted line crosses the SATC curve.) The
increased production of each firm in the market leads to an outward shift of the market supply curve
from SRSS to SRSS’. The long-run market supply curve is given by LRSS. This is flatter than the short-
run curves, both because firms can adjust all inputs in the long-run so their individual supply curves
are flatter, and also because of entry to the market due to the incentive provided by supernormal
profits. This diagram shows a rising LRSS curve, which implies that the expansion of the market has
resulted in higher input prices. The impact of this on the individual firm is shown by the fact that the
SATC’ curve lies above the SATC curve. The long-run equilibrium is at price P” and quantity Q” at which
point firms are just covering all their costs and are no longer making supernormal profits.

1) Identify the truthfulness of the following statements for a competitive profit maximising firm in
the short-run:
I. The firm never produces where P<AVC.
II. The firm never produces where TR<TC.
a. Both I and II are true.
b. Both I and II are false.
c. I is true; II is false.
d. I is false; II is true.
Answer: (c)

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2) An increase in the cost of capital will have the following effect on a perfectly competitive market:
a) Short-run average and marginal costs will increase which would lead to a fall in output and
an increase in prices. In the long-run, firms will leave and prices will rise further.
b) Short-run average and marginal costs will not change but there will be a fall in output and
an increase in price. In the long-run, firms will leave and prices will rise further.
c) Short-run average costs will increase but there will be no change in output or price. In the
long-run, firms will leave and price will rise.
d) Short-run marginal cost will decrease which would lead to an increase in output and a
decrease in prices. In the long-run, firms will enter and prices will become stable.
Answer: (a)
Long-response question
1(a)
i. Define the concept of market structure and list the fundamental assumptions of the perfect
competition model.
Answer:
Market structure refers to the economic environment in which buyers and sellers in an industry
operate. It is generally defined according to four characteristics: the size and number of buyers
and sellers, the extent of substitutability of different sellers’ products, the extent to which buyers
are informed about prices, available alternatives and the conditions of entry/exit.
The model of perfect competition rests on the follow assumptions:
1) many firms, each negligible in size relative to the entire industry

2) all firms produce homogenous goods
3) perfect information regarding prices and available alternatives
4) free entry and exit.
From these assumptions, the key implication is that the individual firms in this market face a
horizontal demand curve. All act as price-takers, with no ability to influence the market price.
ii. Provide a graphical representation of equilibrium in the perfect competition model in the
long-run, distinguishing between what holds for the firm and what holds for the market.
Carefully describe the various components of your graphical representation.
Answer:

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The market is represented by a downward sloping demand curve and an upward sloping supply
curve. The individual firm faces a horizontal demand curve, because if the firm raises its price
even a little above the market price, it will lose all its customers to other firms. The demand curve
corresponds to the firm’s marginal revenue curve. The diagram also includes two cost curves –
the long-run marginal cost curve, and the long-run average cost curve. The long-run marginal
cost curve is flatter than the short-run marginal cost curve because in the long-run the firm can
adjust all its inputs. In the long-run firms will produce at the lowest point on their long-run
average cost curve and there will be no entry or exit. (It is not necessary to draw the average cost
curve for the long-run because in the long-run, if the price is below the average cost curve, the
firm will leave the industry.)
iii. Use graphs to illustrate how a decrease in costs changes the long-run equilibrium of a
competitive market. Carefully describe the various components of your graphical
representation.
Answer:
The market is represented by a downward-sloping demand curve, upward sloping short-run

supply curves and horizontal long-run supply curves (the long-run curves are assumed to be
horizontal for simplicity). The firm’s cost curves are represented, including the short-run marginal
and average total cost curves and the long-run average cost curve (short-run average variable
cost curves are not included for simplicity). The short-run marginal cost curve cuts the short-run

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average total cost curve at its lowest point. The decrease in costs is represented by a downward
shift in both short-run cost curves from SMC0 and SATC0 to SMC1 and SATC1.
The original market equilibrium occurs at quantity Q0 and price P0 where the initial demand and
supply curves intersect. The short-run supply curve shifts down by the amount of the fall in costs
when each firm’s costs fall (because the supply curve is the sum of the marginal cost curves of all
firms in the industry), shifting from SRSS0 to SRSS1. However, the price only falls to P1 not P2 since
demand is not perfectly inelastic. The new market supply curve SRSS1 intersects the demand
curve at quantity Q1, and price P1.
At the price P1, firms are making supernormal profits. This is represented by the grey box in the
diagram for the individual firm. Because firms are making supernormal profits, there is an
incentive for other firms to enter the market. Entry of new firms will lead to a further rightward
shift of the short-run market supply curve to SRSS2. The SRSS2 curve intersects the market
demand curve at the price P2 and the quantity Q2. At the price P2, firms are no longer making
supernormal profits. This represents a new long-run equilibrium with the LRSS1 curve intersecting
the demand curve at price P2 and quantity Q2.
The position of the LAC1 curve in this diagram of the individual firm is based on the assumption
that the new SATC curve touches the lowest point of the LAC1 curve. This does not necessarily
have to be the case. If it were not so, firms would increase their plant sizes until they were
producing at the lowest point on the LAC1 curve. This would result in a further rightward and
downward shift of the market SRSS curve and a lower LRSS curve.
b) In a perfectly competitive industry all firms have the Total Cost function TC = 4+q2, where q is
output of the individual firm. The market (industry) demand is given by Q = 120 – P where P is
price and Q is industry output. The figure shows the individual firm’s AC and MC.
i. Suppose that initially the price is 8. How much output does each firm produce? In the short-
run, with the number of firms fixed, how many firms are there in the industry?
ii. Could this be a long-run equilibrium? Explain why or why not.
iii. What is the long-run equilibrium number of firms in this industry?

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Answer:
i. Each firm produces four units, and there are 28 firms in the industry.
ii. No, it could not. Abnormal profits are being made and new firms would enter the industry
and drive down the price until P=4.
iii. The long-run equilibrium number of firms in this industry is 58.

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Block 8 Answers
Activity SG8.1
As part of your studies of microeconomics, it is important for you to be able to draw the cost and
revenue curves for a typical monopolist.
a) Reproduce Figure 8.11, making note of the key points (the point where the MC and MR curves
cross, the price level the monopolist chooses, and the average cost at this quantity) and
highlighting the monopolist’s profit.
b) Illustrate a rise in costs (as described in the section ‘comparative statics for a monopolist’).
c) Illustrate an increase in demand (as described in the section ‘comparative statics for a
monopolist’).
Answer:
a)
b)

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c)
Activity SG8.2
A monopolist faces an (inverse) demand curve given by P=100-2Q. Marginal cost is constant and equal
to 16. Profit maximisation is achieved when price is equal to:
a) 45
b) 21
c) 58
d) 82
e) 16
Answer: (c)
The demand curve is given by P = 100 – 2Q so the MR curve is given by MR = 100-4Q. Equating
MC and MR gives 16 = 100 – 4Q, Q = 21. When Q=21, P=100-2*21 = 58. Therefore the profit
maximising price for this monopolist is £58.

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Activity SG8.3
Consider two monopolists in two industries. One is the sole postal service operating in a country.
The other is the sole producer of a certain type of cheese (no-one else has the technology to
produce this cheese). Which of these do you think faces a more elastic demand schedule? Draw a
rough sketch of the demand, marginal revenue and cost curves for each industry and examine the
gap between the point where MC=MR and the price chosen by each monopolist. Which firm has
greater market power?
Answer:
The cheese producer faces a much more elastic demand curve and as such has less market power;
it would have a lower Lerner Index.
Activity SG8.4
Define first, second and third degree price discrimination. For first degree price discrimination, draw
graphs illustrating producer and consumer surplus compared to a competitive industry and to a non-
discriminating monopolist.
Answer:
First degree – also known as perfect price discrimination, everyone gets charged a different price
based on their willingness to pay.
Second degree – also known as quantity discrimination, people who buy different quantities are
charged different prices (e.g. there is a discount for buying in bulk).
Third degree – different prices are charged to different groups based on a certain characteristic
(e.g. adults and children, students and non-students).
For the graph, see Figure 8.16 in the textbook. The perfectly discriminating monopolist produces
at point C which is the same as the competitive equilibrium. The consumer surplus that existed
under perfect competition is now captured entirely by the monopolist. There is no deadweight
loss. The non-discriminating monopolist produces output Q1 and charges price P1 (some previous
consumer surplus is now captured as monopoly profit – this is the rectangle P2P1AX where X is
the intersection of the left-most vertical dotted line and the lower horizontal dotted line; there
is also some deadweight loss, represented by the triangle XCB).

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Activity SG8.5
Suppose that all consumers in the market have an inverse demand curve given by P = 50 − 0.25Q.
Suppose also the firm charges its customers £25 per unit. If it decides to use a two-part tariff pricing
strategy what is the maximum that it could charge each customer as a fixed entry fee?
Answer:
This question requires us to calculate the consumer surplus when P = 25. This can be seen on the
diagram below:
When the firm charges £25 per unit, the consumer will purchase 100 units. Their consumer
surplus would generally be £1,250 – the shaded area in the diagram above. If the firm employs a
two-part tariff pricing strategy to capture this consumer surplus, the most they can charge as a
fixed entry fee is £1,250.

1. A monopolist maximises profits when:
Select one:
a) Average revenue equals average cost.
b) Average revenue equals marginal cost.
c) Marginal revenue equals average cost.
d) Marginal revenue equals marginal cost.
Answer: (d)
2. With full (perfect) price discrimination, equilibrium output of the monopolist is:
Select one:
a) The same as in a non-discriminating monopolist.
b) Less than in a non-discriminating monopolist.
c) The same as perfect competition.
d) The same as in monopolistic competition.
Answer: (c)

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3. A monopolist faces two consumer groups: old and young. The inverse demand of old clients for
the output of the monopolist is Po = 100 – 2Qo. This implies that MRo=100-4Qo. The inverse
demand of young clients for the output of the monopolist is Py = 80 – Qy. This implies that
MRy= 80-2Qy .The marginal cost of supplying any type of client is MC = 10. If the monopolist
can price discriminate between the two groups (i.e., charge a different uniform price to each
group), what price will old and young clients be charged?
a) Po = £45; Py = £55
b) Po = £55; Py = £45
c) Po = £50; Py = £50
d) Po = £40; Py = £60
Answer: (b)
Calculate the price elasticity of demand for each group for the prices you have chosen. εo =
−1.22, εy = −1.29. Older clients have more inelastic demand, so they will be charged a higher
price. When the party with less elastic demand is charged a higher price, the marginal
revenues from the two groups can be equated so MR1 = MC = MR2.
1 a)
i. List the fundamental assumptions of the monopoly model and provide a graphical
representation of equilibrium in this model. Carefully describe the various components of
your graphical representation.
Answer:
The model of monopoly rests on the follow assumptions:
1. There is only one firm.

2. There are large barriers to entry and exit.
The monopolist faces a downward-sloping demand curve. The marginal revenue curve has the
same intercept as the demand curve but is twice as steep. The marginal cost curve passes
through the minimum point of the average cost curve. The firm choses the level of production
where the marginal cost curve cuts the marginal revenue curve. The price is then set at the

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point on the demand curve which corresponds to this quantity of output. The monopolist
makes a positive profit (greater than just normal profit). The monopolist’s profit is equal to
the quantity produced multiplied by (the price minus the average cost at that quantity).
ii. Define and discuss the concept of ‘deadweight loss’ of monopoly using your graphical
representation of the monopoly model.
Answer:
Total welfare under the monopolist model is less than total welfare under the perfectly
competitive model. The difference is known as deadweight loss. Deadweight loss is
represented by the yellow triangle in the diagram below.
Under perfect competition, total welfare is consumer surplus (triangle ADF) plus producer
surplus (triangle GDF).
Under monopoly, total welfare is consumer surplus (triangle ABC) plus producer surplus (area
GHCB). The area BCED has changed from consumer surplus to monopoly profit.
The difference is the triangle CHF. That represents the deadweight loss.

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iii. Provide a graphical representation of a monopolist that engages in third degree price
discrimination, dividing its customers into a group with a high elasticity of demand and a group
with a low elasticity of demand. Demonstrate how the monopolist sets its prices to achieve
profit maximisation in this situation.
Answer:
The monopolist’s marginal cost is the same, regardless of the group it is supplying. For each
group, it matches this marginal cost with the relevant marginal revenue schedule such that
MC = MR for both groups. This determines the quantity it supplies to each group. The price
charged to each group is determined using the relevant demand schedules.
b. A monopolist faces a demand curve P = 210 – 4Q. The firm faces a constant marginal cost
MC = 10.
i. Calculate the profit-maximising monopoly quantity and price.
ii. Suppose that all firms in a perfectly competitive equilibrium had a constant marginal cost
MC = 10. Find the long-run perfectly competitive industry price and quantity.
iii. Compare consumer surplus under monopoly versus perfect competition. Hint: you may
find it useful to draw a diagram.
iv. What is the deadweight loss due to monopoly? Is this the same as the difference between
the two consumer surpluses you calculated in iii?
Answer:
i. For this demand curve MR=210-8Q. Using this, we can find Q=25, P=110.
ii. P=10 (MC), Q=50.
iii. CSPC=5000, CSM=1250.
iv. 1,250. No, it is less because the reduction in CS is partially offset by profits earned by
the monopolist.

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Block 9 Answers
Activity SG9.1
1. Calculate the four-firm concentration ratio of an industry with the following distribution of
sales: 40%, 10%, 10%, 10%, 8%, 8%, 6% 4% 2% 1% 1%.
a) 100%
b) 80%
c) 70%
d) 40%
Answer: (c)
Activity SG9.2
Figure 9.2 shows the short-run and long-run equilibria for a firm in a monopolistically competitive
market. Remember that the demand curves DD and DD/ (and the associated MR curves) refer to a
single firm in the market. The market demand curve, of course, lies further to the right. Make sure you
understand this figure by reproducing it below, highlighting:
i. the short-run monopoly profits
ii. the tangency of the DD’ curve and the AC curve in long run equilibrium.
Answer:
See Figure 9.2. You could practise drawing this several times to help you understand and
remember the set-up.
Activity SG9.3
The high-output/low-output game is based on a famous game called the ‘Prisoner’s dilemma’. McGraw Hill
has a nice interactive version of this which you can access at
http://highered.mheducation.com/sites/007243404x/student_view0/chapter9/interactive_ activities.html#
(though the question appears to be slightly misworded). The prisoner’s dilemma is described below. Read
through the scenario and decide what you would do if you were one of the prisoners.
You and your partner were just arrested for the burglary you pulled off last night, and are being
interrogated separately in different rooms. The officer says to you ‘Well, looks like you’ve got some
decisions to make here. You can confess to the burglary or you can continue to deny any role in it. Your
problem is that the consequence for you depends on what your partner does. If he confesses and you
don’t, we’ll throw the book at you and give him immunity. You get 10 years in jail and he goes free. Of
course, the reverse would be true if you confess and he doesn’t. If you both confess, you’d both get a
lighter sentence, 5 years. If you both insist on denying the charges, we should have enough evidence to
get you both for 1 year for sure.’
Now answer the following questions:

a) What does the payoff matrix for this game look like? (Base this on Figure 9.5.) It is conventional
to make the payoff for the player on the left-hand side of the payoff matrix, the ‘row player’
the first entry in each cell and the payoffs for the player at the top of the matrix, the ‘column
player’ second.
b) Does either player have a dominant strategy?

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c) Does this strategy result in the best joint outcome for the prisoners?
d) Does this strategy result in the best outcome for the police?
Answer:
a)
Your partner (prisoner 2)
Confess Deny
You (prisoner 1) Confess (5, 5) (0, 10)
Deny (10, 0) (1, 1)
a) Prisoner 1: if prisoner 2 confesses, it is better for prisoner 1 to confess (5<10). If prisoner

2 denies, it is better for prisoner 1 to confess (0<1). Thus confessing is a dominant
strategy for prisoner 1. By symmetry, the same is true for prisoner 2.
b) If both confess, they each receive five years in jail, or 10 years in total. This is not the best
joint outcome, as they could both have achieved only one year in jail, or two years total,
if they had both denied any involvement in the crime.
c) The police would probably be satisfied with this outcome, since both criminals end up in
jail. This point is included to remind you that in games where two companies are playing
against each other, they may not achieve the optimal joint outcome, but this may in fact
be better for another party (i.e. the consumers).
Activity SG9.4
Consider a market for a homogeneous product with demand given by Q = 37.5 –P/4. There are two
firms, each with a constant marginal cost equal to 40.
a) Determine output and price under a Cournot equilibrium.
b) Compute the deadweight loss as a percentage of the deadweight loss under a non-
discriminating monopolist.
Answer:
a) Duopolist A’s total revenue is given by
TRA = qAp(Q)
= qA[150 – 4(qA+qB)]
= 150qA – 4qA2 –4qAqB
(using calculus: MRA = 150 – 8qA – 4qB ).
Alternatively, using the method above:
Q = 37.5-P/4
P = 150 – 4Q
P = 150 -4QA – 4QB
Therefore MRA = 150 – 8qA – 4qB)
MCA = 40
Setting MRA = MCA,
150 – 8qA – 4qB = 40
2qA+qB = 27.5
By symmetry, qA = qB = 9.17. Total industry output is 18.33
Q = 37.5 –P/4

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P = 150 – 4Q
= 76.66.
b) The total revenue of the monopolist is given by:

TRM = QM [150 – 4QM]
(using calculus: MRM = 150 – 8QM ).
Alternatively, using the method above:
QM = 37.5-P/4
P = 150 – 4QM
Therefore MRM = 150 – 8QM)
MCM =40
Setting MRM = MCM,
150 – 8QM = 40
QM = 13.75
PM = 150 – 4Q
= 95
This shows that the monopoly output is lower than the Cournot duopoly output and the monopoly
price is higher than the Cournot duopoly price.
Under perfect competition, the price would be given by P = MC, therefore PC = 40.
QC = 37.5 – PC/4
QC = 27.5
Total social welfare is producer surplus plus consumer surplus. There is no producer surplus since
there is a constant marginal cost. Consumer surplus is given by price when quantity is zero minus the
market price, multiplied by the industry output and divided by two (since it is the triangle under the
demand curve). When quantity is zero, price is 150. Therefore:
CSC = (150 – 40)*27.5 / 2
= 1512.5
Under duopoly, welfare is given by the profits of the two firms, plus the consumer surplus:
πA = P*qA - TCA
= 76.66*9.17-40*9.17
=336.17
CS = (150 – 76.66)*9.17 *2 / 2
=672.53
Total welfare = 1344.87
DWLD = 1512.5 – 1344.87
= 167.63
Under monopoly,
πM = PM*qM – TCM
= 95*13.75 – 13.75*40
= 756.25
CSM = (150 – 95)*13.75 / 2

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= 378.125
Total Welfare = 1134.38
DWLM = 1512.5 – 1134.38
= 378.12
Duopoly deadweight loss as a percentage of monopoly deadweight loss is therefore:

EL = 167.63 / 378.12
= 44.3%
Activity SG9.5
Which model of strategic duopoly interaction (Cournot or Bertrand) would you think provides a better
approximation to each of the following industries, and why?
i) Oil refining
ii) Insurance.
Answer:
The Cournot model, where firms compete on outputs, seem more relevant for the oil-refining
industry, where capacity constraints seem relatively more important. The Bertrand model
(competition on prices) seems more relevant for insurance, as this is less affected by capacity
constraints.
Activity SG9.6
Suppose there are two firms with the same constant average and marginal cost, AC = MC = 5, facing
the market demand curve Q1 + Q2 = 53 - P. Firm 1 is a Stackelberg leader and makes its output
decision before Firm 2 (a Cournot follower).
a) Find the reaction curves that tell each firm how much to produce in terms of the output of its
competitor and use these to calculate how much each firm will produce and the profits it will
make, as well as the market price and the total market profit.
Answer:
In this situation, Firm 1 is the Stackelberg leader and Firm 2 is the Cournot follower. Under the
Cournot assumption, Firm 2 treats the output of Firm 1 as a constant in its maximisation of profits.
Therefore, Firm 2 chooses Q2 to maximise 2 with Q1 being treated as a constant.
The demand curve is Q1 + Q2 = 53 – P
Which equals P = 53 - Q1 - Q2
Therefore MR2 = 53 - Q1 - 2Q2
MC = 5
Setting MC and MR equal for Firm 2 gives:
53 - Q1 - 2Q2 = 5
2Q2 =48 - Q1
Q2 =24 - Q1/2

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This equation is the reaction function for Firm 2, which generates the profit-maximising level of
output, given the constant output of Firm 1.
Firm 1, the Stackelberg leader, will choose its output, Q1, to maximise its profits, subject
to the reaction function of Firm 2.
Substituting for Q2 in the demand function gives:
𝑄
P =53 – Q1 – (24- 21)
P = (106 – 2Q1 -48 + Q1)/2
P = 29 – Q1/2
Thus the MR for Firm 1 is given by:
MR1 = 29 – Q1
MC = 5
Setting MC and MR equal for Firm 2 gives:

29-Q1 = 5
Q1 = 24
Substituting Q1 = 24 into Firm 2’s reaction function gives Q2:
Q2 =24 – 24/2 = 12
Substitute Q1 and Q2 into the demand equation to find the price:
P = 53 – 24 – 12 = $17.
Profits for each firm are equal to total revenue minus total costs, or
1 = (17)(24) – (5)(24) = $288 and
2 = (17)(12) – (5)(12) = $144.

Total industry profit, T = 1 + 2 = $288 + $144 = $432.
(If you are interested to calculate the outcome of a Cournot duopoly and compare it to
this outcome, you will find that under the Stackelberg model, total output has increased
from 32 to 36, price has fallen from $21 to $17, and total profits have fallen from $512
to $432. Profits for Firm 1 have risen from $256 to $288, while the profits of Firm 2 have
declined sharply from $256 to $144.)
b) If each firm believes that it is the Stackelberg leader, while the other firm is the Cournot follower,
how much will each firm produce, and what will its profit be?
Answer:
They both will initially produce 24 units, so total output will be 48 units. The market price will be
driven to $5, equal to marginal cost. It is impossible to specify exactly where the new equilibrium
point will be, because no point is stable when both firms are trying to be the Stackelberg leader.

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c) In the Stackelberg model, the firm that sets output first has an advantage. Explain why.
Answer:
The Stackelberg leader gains the advantage because the second firm must accept the leader’s
large output as given and produce a smaller output for itself. If the second firm decided to
produce a larger quantity, this would reduce price and profit. The first firm knows that the second
firm will have no choice but to produce a smaller output in order to maximise profit, and thus,
the first firm is able to capture a larger share of industry profits.

1. Refer to the box below. Two bus companies offer a daily service running from London to
Nottingham. Each company can decide to leave early or leave late. Their buses are somewhat
different, so the payoffs are not symmetric. From the payoff matrix, we can see that:
a) neither company has a dominant strategy
b) only bus company A has a dominant strategy
c) only bus company B has a dominant strategy
d) both companies have a dominant strategy.
Answer:
Explanation: If company A leaves early, it is better for bus B to leave early. If company A leaves
late, it is better for company B to leave late. Therefore company B does not have a dominant
strategy, since their best response depends on what company A decides.
If company B leaves early, it is better for company A to leave early. If company B leaves late, it is
better for company A to leave early. Therefore company A has a dominant strategy – it is always
better for them to leave early, no matter what company B does.
The answer to the question is (b) – only company A has a dominant strategy. The outcome of the
game is that company A will leave early and company B will leave early too. Company A will get a
payoff of £1,000 and company B will get a payoff of £900.

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2. Which market structure is characterised by a long-run equilibrium where price is equal to

average cost but is greater than marginal cost and marginal revenue?
a) perfect competition
b) monopolistic competition
c) oligopoly
d) monopoly.
Answer: (b)
3. The demand curve faced by a monopolistically competitive firm is
a) elastic
b) unit elastic
c) inelastic
d) perfectly inelastic.
Answer: (a)
4. If an imperfectly competitive firm is producing a level of output where marginal cost is equal to
marginal revenue, marginal revenue is below average variable cost, and price is equal to
average total cost, then the firm:
a) should shut down
b) should decrease output, but should not shut down
c) should increase output
d) none of the above is correct
Answer: (d)

1. a Duopoly: There are two firms in a market, both have a linear cost function C(q) = 2q. The market
inverse demand function is given by P(Q) = 9 – Q.
i. What is the Cournot equilibrium output for each firm? What price will they charge? How
much profit will they each earn?
ii. Assume Firm 1 is the Stackelberg leader and Firm 2 follows afterwards. What is the
Stackelberg equilibrium output for each firm? What price will they charge? How much profit
will they each earn?
iii. Compare the price, total market output and profits for the two firms under Cournot and
Stackelberg duopoly. Which market structure does Firm 1 prefer? Firm2?
iv. Which market structure do consumers prefer? Why?
Answer:
i. q = 2.33. Price = 4.33; profit = 5.44
ii. Leader: q = 7/2, profit = 49/8 = 6.125. Follower: q = 7/4, profit = 49/16 = 3.0625. Market
P = 3.75
iii. Firm 1 prefers Stackelberg; firm 2 prefers Cournot
iv. The consumer prefers Stackelberg since this has the higher output and the lower price,
which gives them the highest consumer surplus of the two models.

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b) Contestable markets:
i. What is a contestable market?
ii. How is globalisation relevant for the analysis of contestable markets
iii. For the payoff matrix given below, draw a decision tree and find and explain the outcome
of the game (the payoff to the incumbent is listed first in each cell)
Potential entrant
In Out
Incumbent Accept 15, 10 50, 0
Fight -10, -20 50, 0
Answer:
i. A contestable market has no barriers to entry or exit.
ii. Globalisation makes it more likely that a firm can enter, especially foreign firms.
This increases the relevancy of the concept of contestable markets.
iii. The decision tree is given below. We use backwards induction, and start at the
second step – if the incumbent fights they receive –10 and if they accept they
receive 15. Therefore they will accept. Knowing this, the entrant chooses between
coming in, where they will receive 10 and staying out, where they will receive 0.
Therefore they will enter the market. The outcome of the game is that the entrant
will enter and the incumbent will accept.
2. a Monopolistic competition:
i. What are the particular characteristics of monopolistic competition as a market structure?
Answer: The particular characteristics of monopolistic competition are:
a. A large number of quite small firms
i. limited opportunities for economies of scale
ii. no strategic interaction between firms
b. Differentiated products
i. individual firms have some market power to determine their own price and
influence their market share (firms do not face a horizontal demand curve)
c. Freedom of entry and exit
d. New firms entering the market take customers from all existing firms.

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ii. Draw a short-run equilibrium for monopolistic competition where the firms are making
losses, and show how exit results in a new, long-run equilibrium.
Answer:
At the initial short-run equilibrium, price is P0 and quantity is Q0. At this quantity, price is below
average costs and the firm is making losses. This will lead some firms to exit the market,
increasing demand for the products of the remaining firms. The demand curve faced by the
remaining firms will shift outwards from D0 to D1. The demand curve D1 is tangent to the AC
curve. Firms choose their level of production such that MC=MR and produce at Q1, where price
is equal to average cost and firms are just breaking even. There will be no further entry at this
point: it is a long-run equilibrium.
iii. Is this outcome efficient?
Answer:
As can be seen in the example above, the long-run equilibrium point is not on the minimum
of the LAC curve as it would be under perfect competition – this implies inefficiency, as firms
are operating with extra capacity, on the downward-sloping section of their average cost
curves. Any point on the LAC curve is by definition productive efficient. Producing on the
downward-sloping part of the AC curve implies a loss of allocative efficiency, as price will be
higher than marginal cost (since the LMC curve passes through the lowest point of the LAC
curve). Because the price is set higher than the marginal cost, consumer surplus is lower than
it would be if prices were set equal to marginal cost at the lowest part of the firm’s AC curve.
However, people are willing to pay to have differentiated products. For example, people
wouldn’t be happy if there was only one type of restaurant to go to, even if this made prices
lower. An optimal outcome would be achieved where the number of differentiated products
was increased until the marginal gain in consumer’s satisfaction from an increase in diversity
was equal to the loss from having to produce each existing product at a higher cost. Market
forces would not necessarily lead to this outcome. Thus it is unclear whether or not the long-
run equilibrium of a monopolistically competitive industry is allocative efficient.
b) Concentration ratios:
In the United States, the four-firm concentration ratio for beer increased from 22 to 95 between
1950 and 2000. Explain what this means and describe possible reasons for why this occurred.

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Answer:
This means that in 1950, the four largest firms in the American beer industry had a combined
market share of 22%, while in 2000, the four largest firms had a combined market share of 95%.
Although the market appears to have had many firms in the 1950s (when it was probably best
described as a monopolistically competitive market), by 2000 it had clearly become an oligopoly
– dominated by just four large firms.
A brief description of the consensus opinion of why this occurred is described in Adams (2006)1
and summarised below:
During this period, technological progress enabled the automation of brewing and
the acceleration of packaging. This progress increased the advantages of large-
scale production, which led a few national brewers growing strongly while most
regional and local brewers disappeared. The success of these large-scale
producers was also a result of advantages gained through television advertising.
Once their large sunk investments in television advertising had created substantial
advantages for these first-movers, it became very difficult for other firms to enter
and move in the market.
While you are not expected to be aware of these historical developments, certain aspects which
you could have hypothesised about from the theory you have learned thus far include changes in
the production process (technological progress) leading to increasing returns to scale – this
would mean that originally many firms could operate in the market, but once technological
change made it cheaper to produce large quantities, the minimum efficient scale increased. Thus
firms that adopted new technologies and invested in larger plants may have gained cost
advantages which allowed them to undercut smaller players and drive them out of the market.
Furthermore, you could discuss the role of advertising in increasing market power and creating
barriers to entry. When a concentration ratio increases so dramatically, it is also very likely that
there were a lot of mergers and takeovers in the industry. This would also be a valid theory –
although it wasn’t necessarily a key factor in this case.
1
Adams, W. J. ‘Markets: beer in Germany and the United States’, The Journal of Economic
Perspectives 20(1) 2006, pp.189–205.
10

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Answers Block 10
Activity SG10.1
Use budget constraints and indifference curves to demonstrate the effect on the demand for labour
of a fall in the wage rate – clearly indicate both substitution and output effects and accompany your
graph with a written explanation.
Answer:
The firm starts at point A where there is a tangency between the original isocost line and the isoquant
I1. A fall in the wage tilts the isocost line upwards: the intercept on the vertical axis is higher since it is
now possible to buy more labour than before when the whole cost is composed of wages. Drawing a
line parallel to the new isocost line but tangent to the original isoquant gives us the pure substitution
effect. This can be seen by the distance between A and A’. There is a fall in the demand for capital
(which is now relatively more expensive) and an increase in the demand for labour (which is now
relatively cheaper). The output effect can be seen by moving from A’ to B on the new isoquant I2 which
is parallel to the new isocost line. The output effect is positive for both capital and labour since the
profit-maximising level of output is now higher. Thus there is an unambiguous increase in the demand
for labour due to the substitution effect and also the output effect.
Activity SG10.2
Multiple choice question: Choose the correct response.
A fall in the wage rate will:
a) Increase the demand for capital but the effect on the demand for labour is uncertain.
b) Increase the demand for labour but the effect on the demand for capital is uncertain.
c) Decrease the demand for capital but the effect on the demand for labour is uncertain.
d) Decrease the demand for labour but the effect on the demand for capital is uncertain.
Answer: (b)

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Explanation: In the diagram above, the increase in the demand for labour is unambiguous. The
diagram above shows a decrease in the demand for capital – this occurs because the substitution
effect is greater than the outout effect. This is not always the case – there is no reason a priori
why one effect should always dominate, therefore the effect on the demand for capital is
uncertain.
Activity SG10.3
Imagine you are the manager of a small firm which makes and sells donuts and you need to decide
how many workers to employ. Use the information below to make your decision. A donut sells for
£1.50. All workers work an 8 hour shift and the wage rate given is the hourly rate. The market for
donuts is perfectly competitive. Explain the reasoning behind your decision.
Workers Output per hour MPL MVPL(£) Wage rate (£)

1 20 20 30 £7
2 30 10 15 £7
3 37 7 10.5 £7
4 42 5 7.5 £7
5 44 2 3 £7
(Answers in bold.)
Explanation: The MPL is calculated using the output per hour. The MVPL is the MPL x £1.50. I would
choose to employ four workers for my firm because at this level of employment, the MVPL is just
above the wage rate. If I employed five workers, I would lose money on this last worker as they
would cost me £7 per hour in wages but only produce £3 worth of value per hour.

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Activity SG10.4
Draw a large diagram showing a budget constraint and indifference curve for three different wage
levels, such that it can be used to derive a backwards-bending labour supply curve. For each of the
two increases in the wage level, clearly indicate the income and substitution effects, noting which is
larger in each case. (You may need to refer back to Figure 5.14 in Chapter 5 to remember how income
and substitution effects can be distinguished graphically.)
Answer:
For the first increase in wage, the substitution effect dominates. For the second increase in wage, the
income effect dominates. When the income effect dominates the substitution effect at high wage
levels, this leads to a backwards-bending labour supply curve, as per the diagram below.

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Activity SG10.5
Match the factor which increases participation to the description of the graphical representation of
this factor in Figure 10.5.
Shorter distance AC
Shorter distance BC
Flatter indifference curves
Steeper budget constraint line
Answer:
Higher real hourly wage rate Shorter distance AC

Lower fixed costs of working Shorter distance BC
Lower non-labour income Flatter indifference curves
Changes in tastes in favour of more Steeper budget constraint line
work and less leisure

1. The labour supply curve:
a) Is always upward sloping
b) Is always downward sloping
c) Slopes upwards when the substitution effect dominates
d) Slopes upwards when the income effect dominates
Answer: (c)
2. Which of the following could explain a decrease in the demand for labor in a particular job?
a) additional training that increases the productivity of each unit of labor in this market
b) an increase in the amount of risk associated with this job
c) a decrease in the amount of risk associated with this job
d) a decrease in the productivity of each unit of labor in this market
Answer: (d)
3. A profit maximising firm will employ labour up to the point where:
a) Marginal revenue = marginal product
b) Marginal cost = marginal product
c) Marginal revenue product = average cost of labour
d) Marginal revenue product = marginal cost of labour
Answer: (d)

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4. A monopsony occurs if there is:

a) A major employer of labour in a market
b) A highly unionized workforce
c) A major provider of employees
d) A single seller of products in a market
Answer: (a)
5. Compared to a monopolist, a perfectly competitive firm’s demand for labour is
a) less responsive to a change in the wage rate
b) more responsive to a change in the wage rate
c) equally responsive to a change in the wage rate
d) the demand for labour does not depend on the wage rate for either firm
Answer: (b)
Explanation: The derived demand for labour, is more responsive to wage changes the more
elastic is the demand for output.

1)
a) Describe, in words and using graphs, the impact of a change of hourly wage on a person’s
labour supply decision, regarding both hours of work and their participation decision.
Answer: The graphs from Maths 10.2 as well as Figure 10.5 are required.
b) Alisha earns £20 per hour for up to 8 hours of work per day and is paid £25 for every hour in
excess of this. She receives £20 per day from the government in child benefit (regardless of
whether or not she works) and pays £8 per hour for childcare for each hour she works. If she
works, she pays £5 per day for an all-day bus ticket. Graph Alisha’s budget line, for an 18-
hour day.
Answer:

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Explanation: £20 per day in child benefit is non-labour income – even if Alisha consumes 18
hours of leisure she still receives this amount. If she works, she incurs a fixed cost of working
of £5 (the bus ticket). That is why the slanted line starts at £15 (from right to left). For the first
8 hours of work, Alisha earns £20 per hour. She pays £8 per hour for childcare and thus
receives £12 per hour net. £12 x 8 hours = £96. Adding this to the £15 figure: £96 + £15 = £111.
After 8 hours of work, Alisha starts getting paid overtime and earns £25 per hour. Minus
childcare she thus receives £17 per hour net. £17 per hour x 10 hours = £170. Adding this we
get £111 + £170 = £281. The total possible earnings for Alisha, if she were to consume no
leisure, is equal to £281; this is the intercept of the budget constraint with the y-axis.
c) Discuss some reasons why labour markets may not clear, illustrating with diagrams as much
as possible.
Answer: Some reasons why labour markets may not clear include: minimum wage laws, trade
union power, scale economies which create entry barriers for new firms, insiders and
outsiders, and efficiency wages. You should include diagrams for minimum wage law and trade
unions as per Figures 10.9 and 10.11 in the textbook. Although not shown in the textbook, you
could also include diagrams showing how higher wages from insider power or the payment of
efficiency wages can also lead to involuntary unemployment (these would essentially look the
same as Figure 10.9).

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Block 11 Answers
Activity SG11.1
Coffee and tea are substitutes. The demand for each depends on its own price as well as the price of
its substitute. Supply and demand curves are given as follows:
Coffee demand: 𝑄𝐶𝐷 = 60 − 6𝑃𝐶 + 4𝑃𝑇
Coffee supply: 𝑄𝐶𝑆 = 3𝑃𝐶
Tea demand: 𝑄𝑇𝐷 = 20 − 2𝑃𝑇 + 𝑃𝐶
Tea supply: 𝑄𝑇𝑆 = 2𝑃𝑇
where PC is the price of coffee, PT the price of tea.
a) Find the equilibrium prices and quantities for coffee and tea. Hint: both markets must be
simultaneously in equilibrium.
b) Suppose that there is a major failure in the coffee crop, leading to a large reduction in
supply. Use supply and demand diagrams to trace out the effect in both markets. In the new
equilibrium what happens to the equilibrium price and quantity of tea?
Answer:
a) PC=10, QC=30, PT=7.5, QT=15
b)
Explanation: The failure in the coffee crop leads to a fall in supply, and the supply curve for
coffee rotates upwards to the left, leading to a large increase in the price of coffee. This in
turn increases the demand for tea (which is a substitute for coffee), leading the demand curve
for tea to shift to the right. This leads to an increase in the price of tea. The increase in the
price of tea leads to a small increase in the demand for coffee, such that the demand curve
for coffee shifts out slightly to the right.

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Activity SG11.2
Household A and B of an exchange economy with two goods x and y have the utility functions UA(xA,
yA) = (xA)(yA), and UB(xB, yB) = (xB)(yB). Household A has the initial endowment (xA0, yA0)=(10,16) and
Household B has (xA0, yA0)=(25,12).
a) Illustrate the initial endowment in an Edgeworth Box.
b) Assuming that this point is not on the contract curve, draw possible indifference curves for
the two households and indicate the area where trade could result in an improvement for
both households. (You can draw standard indifference curves without reference to the
utility functions given above.)
𝑦
c) Given the utility functions above, the MRS of Household A is 𝑀𝑅𝑆𝐴 = 𝑥𝐴 and the MRS of
𝐴
𝑦
household B is 𝑀𝑅𝑆𝐵 = 𝑥𝐵 . Use this information to find the Pareto optimal point when the
𝐵
price of x is £0.80 and the price of y is £1.00 (i.e. the relative price is £0.80). Clearly state
which household sells which quantity of which good and the final Pareto-optimal allocation.
d) Calculate the utility of the two households at the initial endowment and at the new optimal
point.
e) Draw your solution onto your graph along with the budget constraint and the new utility
curves at this point. Also draw the contract curve on your diagram.
Answer: (a), (b) and (e):
f) the relative price is £0.80. The MRS of both agents is therefore also 0.8.
𝑦 𝑦 4
Therefore 𝑥𝐴 = 𝑥𝐵 = 5 .
𝐴 𝐵
The other requirement is that supply must equal demand. Whatever quantity of x is given up
by Household A must be the same quantity of x that is bought by Household B, and vice versa
for good y. Students should use the diagram and their own calculations to find the following
optimal allocation: Household A: (xA1, yA1)=(15,12); Household B: (xB1, yB1)=(20,16). As such,
Household A has bought five units of good x and sold four units of good y. Household B has
𝑦𝐴 4
sold five units of good x and bought four units of good y. 𝑀𝑅𝑆𝐴 = = . Similarly, 𝑀𝑅𝑆𝐵 =
𝑥𝐴 5
𝑦𝐵 4
= .
𝑥𝐵 5

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g) (d) Household A’s utility has increased from (10*16=)160 to (15*12=)180 while household
B’s utility has increased from (25*12=)300 to (20*16=)320.
Activity SG11.3
Here is a game-theoretic treatment of the common property problem. Suppose both England and
Norway fish in the North Sea. Both countries know that their fish supplies are being depleted and
that this depletion could be slowed down if they both cut their fishing fleets in half. The matrix
below shows the payoff for both countries (England’s payoff is first entry in each cell) with
unchanged and halved fleets. Will they agree between them to reduce their fleets? (Hint: what is the
Nash Equilibrium?) Should they?
Norway
10 boats 5 boats
10 boats 300, 300 550, 250

England
5 boats 250, 550 500, 500
Answer: Both England and Norway have a dominant strategy of using 10 boats (300>250 and
550>500), so they will both continue to use 10 boats and the fish supplies will continue to be
depleted. The overall optimal outcome would have been for both to cut their fleets to 5 boats, in
which case the total payoff would have been 1,000 rather than 600. This shows there can be an
important role for regulation or, if possible, making binding contracts.
Activity SG11.4
Using the equations below, find the level of production which will occur without regulation and the
socially optimal level of production, and calculate the social cost of the externality. Graph your
answers and shade in the area representing the social loss of inefficient production.
Example 1: Grating, unpleasant music
Demand: DD = £40 – 0.3*Q
Marginal private cost: MPC = £10
Marginal social cost: MSC = £10 + 0.1*Q
Example 2: Beautiful, pleasant music
Marginal private benefit: MPB= £20 – 0.2*Q
Marginal social benefit: MSB = £24 – 0.2*Q
Marginal cost: MPC= MSC = £4 + 0.2*Q
Answer:
Example 1: unregulated production = 100, socially optimal production = 75, social loss of inefficient
production = (1/2*(100-75)*(20-10)) = £125
Example 2: unregulated production = 40, socially optimal production = 50, social loss of inefficient
production = (1/2*(50-40)*(14-12)) = £10

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1. Suppose that Bill, Jill, and Al constitute the entire market for consumers of national defence.
Each individual has an identical demand curve for national defence, which can be expressed as
P = 50 – Q. Suppose that the marginal cost for national defence can be expressed as MC = £30.
What is the optimal quantity of national defence?
a) 150 units
b) 60 units
c) 40 units
d) 20 units.
Draw a diagram showing the analysis.
Answer: (c)
Explanation: The individual demand curves are P = 50 – Q and there are three consumers in the
market. The total market demand curve (adding the three individual curves vertically) is P = 150
– 3Q. Equating this to MC gives 30 = 150 – 3Q, so Q = 40 in equilibrium.

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2. The equations below describe a negative production externality:

Demand: DD = £80 – 0.6*Q
Marginal private cost: MPC = £20
Marginal social cost: MSC = £20 + 0.2*Q
The social cost of this externality is equal to
a) 750
b) 3000
c) 2250
d) 250
Answer: (d)
Explanation: Unregulated production = 100, socially optimal production = 75, social cost of
inefficient production = (1/2*(100-75)*(40-20)) = £250.
3. Two goods, x and y, are complements. What will be the effect on the prices of x and y of a
substantial increase in the supply of x?
a) the price of x rises and the price of y rises
b) the price of x falls and the price of y falls
c) the price of x rises and the price of y falls
d) the price of x falls and the price of y rises
Answer: (d)

1. This question concerns a two good economy (food and clothing) where there are two agents
(Bill and Ernie) who can trade with each other.
a. Bill has an initial endowment consisting of 10 units of food and 10 units of clothing. Ernie
has an initial endowment of 10 units of food and 20 units of clothing. Draw an Edgeworth
Box for these consumers.
Answer: The box should be 20 units high by 30 units wide, assuming that you put food on the
vertical axis and clothing on the horizontal. Let’s assume that you decide to put Bill’s origin at the
bottom left and Ernie’s origin at the top right. Mark amounts of food and clothing on the axes so
that Bill measures increasing amounts of food in an upward direction and increasing amounts of
clothing in a rightward direction. Ernie will then measure increasing amounts of food in a
downward direction and increasing amounts of clothing in a leftward direction.
b. Bill regards food and clothing as perfect one-for-one substitutes, while Ernie regards them as
perfect complements but in a ratio of 3 units of clothing for 2 units of food.
i. On your diagram, indicate the area which represents the set of allocations that are
Pareto-preferred or Pareto superior to the original endowment given above
Answer: Perfect one-for-one substitutes means that Bill’s indifference curves are straight lines
joining equal amounts of food and clothing along the axes. One indifference curve is a straight
line joining the point representing 20 units of food and no clothing to the point representing 20
units of clothing and no food – this means that Bill gets equal amounts of utility from 20 units of
food or 20 units of clothing or any linear combination of these two. In contrast, Ernie’s

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indifference curves are L-shaped (upside-down L-shaped since his origin is in the northeast corner
of the Edgeworth Box). The vertex of the L always has an allocation of food and clothing to Ernie
in the ratio of 3 units of clothing to 2 units of food. Any other ratio involves either excess clothing
or excess food, in the sense that Ernie gets no additional utility from the excess food which is
above a ratio of 2 to 3, and no additional utility from the excess clothing which is above a ratio of
3 to 2.
Any point on the lens formed by the two indifference curves that pass through the initial
endowment will be Pareto superior (except for the one exception of the allocation at the extreme
opposite end of the lens). The area of allocations that are Pareto superior to the initial
endowment is thus given by the grey triangle in the diagram below.
ii. Find the Pareto-optimal allocation
Answer: The initial endowment gives Ernie 10 units of food and 20 units of clothing. This
implies that Ernie has 5 units of excess clothing at this initial endowment. He is therefore
willing to trade away clothing in exchange for food. On the other hand, Bill gets equal
utility from a unit of food or a unit of clothing (they are perfect substitutes). So, for
instance, if Ernie were to trade 2 units of clothing and get 2 units of food in return, he
would be better off and Bill would be no worse off, so this would be a Pareto superior
move. In fact, this allocation would be Pareto optimal since Ernie’s allocation cannot be
further improved without making Bill worse off.
The Pareto optimal allocation thus occurs where Bill has 8 units of food and 12 units of clothing
and Ernie has 12 units of food and 18 units of clothing. At this point, the indifference curves
of the two agents are tangent to each other.
iii. What price ratio would allow this Pareto-optimal trade to take place?
Answer: A competitive price ratio of 1-1 (i.e. PF/PC = 1).

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Block 12 Answers
Activity SG12.1
Good Excludable / Rival / Type of good

non-excludable? non-rival?
Air
Bacon
Coal
House
Private park
Publicly broadcast radio
Satellite
Timber
Answer:
Good Excludable / Rival / Type of good

non-excludable? non-rival?
Air Non-excludable Non-rival Public good
Bacon Excludable Rival Private good
Coal Non-excludable Rival Common property
House Excludable Rival Private good
Private park Excludable Non-rival Club good
Publicly broadcast radio Non-excludable Non-rival Public good
Satellite Excludable Non-rival Club good
Timber Non-excludable Rival Common property
Activity SG12.2
Planting a tree improves the environment: trees improve soil quality and water retention in the soil,
and transform greenhouse gases into oxygen. Assume that the value of this environmental
improvement to society is £10 per tree for the expected lifetime of the tree. The following equation
provides a hypothetical private (excluding the value of the externality) demand schedule for trees to
be planted:
Q = 32 – 0.8*P where Q refers to the quantity of trees demanded in thousands.
a) Assume that the marginal cost of producing a tree for planting is constant at £20. Draw a
diagram that shows the market equilibrium quantity and price for trees to be planted.
b) What type of externality is generated by planting a tree? On your diagram, indicate the
optimal number of trees planted. How does this differ from the market outcome?
c) On your diagram, indicate the optimal Pigouvian tax/subsidy (as the case may be). Explain how
this moves the market to the optimal outcome.

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Answer:
a) The market equilibrium quantity is 16,000 trees (point A in the diagram below), at an
equilibrium price of £20.
b) Planting a tree generates a positive externality. For this reason, the market equilibrium
quantity is inefficiently low. The MSB curve corresponds to the demand curve, D, shifted up
by the amount of the marginal external benefit of £10. The intersection of the MSB curve and
the MC curve (point B) shows the optimal quantity of production to be 24,000 trees.
c) The optimal policy in this case is to adopt a Pigouvian subsidy of £10 per tree. This lowers the
price to consumers from £20 per tree to £10, leading them to purchase and plant the optimal
quantity of 24,000 trees (point c in the diagram below).

1) The Tiebout model of local government emphasises
a) Internalising externalities
b) The ‘user pays’ principle for public goods
c) Competition between jurisdictions
d) Log-rolling.
Answer: (c)
2) Common property is
a) Rival and excludable
b) Non-rival and excludable
c) Rival and non-excludable
d) Non-rival and non-excludable.
Answer: (c)
3) The relationship between tax rates and tax revenue is expressed by

a) the fiscal stance
b) the Laffer curve
c) tax incidence

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d) the Lorenz Curve.

Answer: (b)
4) Private negotiations along the lines suggested by the Coase Theorem are best suited to resolve
conflicts that affect
a) a large number of widely dispersed households
b) only a small number of individuals
c) only those who create positive externalities
d) only those who create negative externalities
5) One drawback to the use of taxes to reduce pollution is that

a) it is not easy to arrive at the exact size of tax to be imposed
b) taxing polluters is inherently unfair
c) the tax is easy to avoid
d) new technologies will be developed to cut down on pollution.
Answer: (a)
6) A public good differs from a private good in that it

a) fails to satisfy individual needs
b) creates benefits that are not exclusive
c) creates benefits that are consumed only by government
d) is more costly because it is produced by government.
Answer: (b)

1. Pigouvian taxes
a. An artist produces metal sculptures using a noisy production process. Let’s say the
demand curve (showing the marginal social benefit) can be expressed by the
function
MSB: P = 80 – 2Q where Q is the number of sculptures
The artist’s marginal private cost of producing sculptures is given by
MPC: P = 2Q
while the marginal social cost is higher, since other people also experience negative
effects due to the noisy production process
MSC: P = 6Q.
Given these equations, find
i. the free market equilibrium (price and quantity)
ii. the socially optimal price and quantity
iii. the Pigouvian tax that should be charged on the artist so that the
social optimal quantity of sculptures is produced
iv. the revenue this tax will raise.

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Answer:
You are supplied with the MSB, MPC and MSC equations. To calculate the free market equilibrium,
the socially optimal output and the Pigouvian tax:
1) Find the free market equilibrium by setting the MSB = to the MPC. Solve for Quantity. (Q1)
2) Find the equilibrium price by plugging the quantity found in step one into either the MPC or MPB
formulas. (P1)
3) Find the socially efficient level of output by repeating steps 1 and 2 using the MSB and MSC
formulas. (Q2 & P2)
4) Plug in Q2 into the MPC formula; this gives you the price the sellers get to keep after the tax. (P3)
5) The difference between P2 and P3 is the amount of the tax.
6) The tax revenue is this amount multiplied by Q2.
1) MPB = MPC
80 – 2Q = 2Q
Q1 = 80/4 = 20
2) P1 = 2Q = 40
(Check: P1 = 80 – 2Q = 80 – 40 = 40)
3) MPB = MSC
80 – 2Q = 6Q
Q2 = 10
P2 = 6Q = 60
(Check: P2 = 80 – 2Q = 80 – 20 = 60)
4) MPC: P = 2Q
P3 = 2*10 = 20
5) Pigouvian tax: P2 – P3 = 60 – 20 = 40
6) Tax revenue: 40*10 = 400.
Therefore
i. The free market equilibrium occurs where P = 40 and Q = 20.
ii. The socially optimal price and quantity are P = 60 and Q = 10.
iii. A Pigouvian tax of £40 should be charged.
iv. This will generate £400 in revenue for the government.

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b) Many dairy farmers in California are adopting a new technology that allows them to
produce their own electricity from methane gas captured from animal wastes. (One cow
can produce up to 2 kilowatts a day.) This practice reduces the amount of methane gas
released into the atmosphere. In addition to reducing their own utility bills, the farmers are
allowed to sell any electricity they produce at favourable rates.
i. Explain how the ability to earn money from capturing and transforming methane gas
behaves like a Pigouvian tax on methane gas pollution and can lead dairy farmers to
emit the efficient amount of methane gas pollution.
Answer:
Without the new technology, dairy farmers will release methane gas until the marginal
social benefit of emissions is zero (because there is no cost them themselves of releasing
the gas). With the new technology, there is now an opportunity cost to the farmer from
releasing methane gas because there now exists a profitable alternative – turning it into
electricity. The financial reward forgone if a farmer emits the methane gas acts like a
Pigouvian tax on emissions. If the financial reward is set at the right level – equal to the
marginal social cost of a unit of methane gas pollution – it will lead dairy farmers to emit
the efficient amount of methane gas pollution. You could use rough sketches such as the
ones below to illustrate these ideas.
ii. Suppose some dairy farmers have lower costs of transforming methane into
electricity than others. Explain how this system leads to an efficient allocation of
emissions reduction among farmers.
Answer:
Farmers who have a lower cost of capturing methane will generate more profit from
transformation of their methane than farmers who have a higher cost. So farmers with
lower costs will transform more units of methane gas into electricity than will farmers
with higher costs. As a result, emissions reduction will be allocated efficiently among
dairy farmers.

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Block 13 Answers
Activity SG13.1
Do you know the long term trend of growth, unemployment and inflation for your own country? If
you live outside the UK/US/EU/China it would be useful to attempt to replicate Table 15.1 for your
own country. This will help to provide you with some empirical context for your study of
macroeconomics and also show you how your own country relates to the places that the textbook has
selected. You can use the following websites to do some research:
 https://stats.oecd.org/
 http://data.worldbank.org/
 www.imf.org/external/datamapper
 http://www.worldeconomics.com/
Answer: Student’s own research.
Activity SG13.2
Which of these three do you think is easiest to measure? What kind of data would you use if you were
to try to measure economic activity in these three ways?
Information on the data used for each of these measures can be found on the following two websites:
http://www.ons.gov.uk/ons/rel/elmr/explaining-economic-statistics/understanding-gdp-and-how-it-
is-measured/sty-understanding-gdp.html
http://www.economist.com/blogs/economist-explains/2014/03/economist-explains-26
Activity SG13.3
Fill in the blanks in the table below (based on Table 15.4).
(1) Good (2) Seller (3) Buyer (4) (5) Value (6) Spending (7) Household
Transaction Added on Final Goods Earnings
Value
Wood Timber Stamp £100
producer manufacturer
Wood Timber Paper £800
producer Manufacturer
Stamps Stamp Paper £300
manufacturer manufacturer
Special Paper Households £1,200
paper with manufacturer
stamped
design
Total
Transactions
GDP

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Answer:
(1) Good (2) Seller (3) Buyer (4) (5) Value (6) Spending (7) Household
Transaction Added on Final Goods Earnings
Value
Wood Timber Stamp £100 100 – 100
producer manufacturer
Wood Timber Paper £800 800 – 800
producer Manufacturer
Stamps Stamp Paper £300 200 300 200
manufacturer manufacturer
Special Paper Households £1,200 400 1,200 400
paper with manufacturer
stamped
design
Total 2,400
Transactions
GDP 1,500 1,500 1,500
Activity SG13.4
Short answer questions
1. Which components of GDP would each of the following transactions affect:

a. Your family buys a new TV.
b. All motorways are repaved.
c. You buy a bottle of Italian wine.
d. Renault opens a new factory in England.
Answer:
a. Consumption.
b. Government spending.
c. Import.
d. Investment by a foreign firm (not included directly in UK GDP).
2. Why, in the absence of government and foreign sectors, are saving and investment always
equal? How does this change when the government and foreign sectors are introduced?
Answer:
In the absence of government and foreign sectors Y = C + I, where Y denotes GDP, which is
also equal to the value of household incomes. Since household incomes can either be
consumed or saved, saving by definition is unspent income, so Y = C + S.
Y=C+S=C+I
It follows that I = S.
Investment, government spending (G) and exports (X) are all injections to the circular flow
that do not originate from households. Conversely, household spending leaks out, directly or
indirectly, through saving, net taxes (NT) and imports (Z), only the remaining spending flows
back to domestic firms and round again as household incomes. Since total leakages are always
equal to total injections S + NT + Z = I + G + X. With three sectors – households, firms and

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government – if one sector is running a surplus, this must correspond to the aggregate deficit
of the other two sectors.
3. The level of wealth can be measured by looking either at the Gross National Product or at the
Gross Domestic Product. Suppose that the government wants to maximise total income of
British citizens: which of the two concepts should it look at? Would you change your answer
if the aim is that of maximising the total amount of economic activity occurring in the UK?
Answer:
 GDP can be defined as: ‘an estimated value of the total worth of a country’s production
and services, within its boundary, by its nationals and foreigners, calculated over the
course on one year’.
 GNP can be defined as: ‘an estimated value of the total worth of production and services,
on its land or on foreign land, by citizens of a country, calculated over the course on one
year’.
 As such, GNP is more relevant for measuring the total income of British citizens, while
GDP is more relevant for measuring the total amount of economic activity occurring in
the UK.
4. Leakages and injections – complete the following table.
Item Leakage or Injection? Amount (£m)

Savings 30
80
Taxes 40
Government spending 20
Imports 25
Exports
Answer:
Item Leakage or Injection? Amount (£m)

Savings Leakage 30
Investment Injection 80
Taxes Leakage 40
Government spending Injection 20
Imports Leakage 25
Exports Injection –5

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Activity SG13.5
Re-draw the five sector model yourself in the box provided, making sure you understand the meaning
behind each of the flows.
Answer:
Activity SG13.6
Complete the exercises below to check your understanding.
1. Say the price level rises 10% from an index of 1 to an index of 1.1 and nominal GDP rises
from $4 trillion to $4.6 trillion. What is nominal GDP in the second period? What is real GDP
in the second period?
Answer:
A real value is a nominal value adjusted for inflation. So, nominal GDP in the second period is
$4.6 trillion, but real GDP is $4.6 trillion divided by the price index, 1.1, or $4.18 trillion.
2. The table below shows nominal GDP for two country A and country B. Which economy
experienced higher growth in real GDP per capita between 1960 and 2010?
1960 2010 % change
Nominal GDP (current 20 2000
£bn)
GDP deflator (2010=100) 8 100
Country A Population (bn) 1 5

£bn)
GDP deflator (2010=100) 1 100
Country B Population (bn) 3 5

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Answer:
1960 2010 % change

£bn)
GDP deflator (2010=100) 8 100
Country A Population (bn) 1 5
Real GDP 250 2000
Real GDP per capita 250 400 60%
£bn)
GDP deflator (2010=100) 1 100
Country B Population (bn) 3 5
Real GDP 6000 5000
Real GDP per capita 2000 1000 –50%
Explanation:
Real GDP = Nominal GDP/(Deflator divided by 100)
Country B’s real GDP per capital actually declined over this period. Therefore country A experienced
faster growth in real GDP per capita over this period.
Activity SG13.7
From the chapter as a whole, what are the advantages and limitations of GDP as a measure of
wellbeing in an economy?
Answer:
See case 15.1, case 15.2, section 15.5 ‘A comprehensive measure of GDP’, and section 15.6
‘International comparisons’.

1. Assume that a firm buys all the parts that it puts into an automobile for $10,000, pays its
workers $10,000 to fabricate the automobile, and sells the automobile for $22,000. In this
case, the value added by the automobile company is:
a) $2,000
b) $12,000
c) $20,000
d) $22,000
Answer: (b)

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2. Assume that total output consists of 4 apples and 6 oranges and that apples cost $1 each
and oranges cost $0.50 each. In this case, the value of GDP is
a) 10 pieces of fruit
b) $7
c) $8
d) $10
Answer: (b)
3. Which of the following is correct within the context of national accounting used in this
chapter?
a) (S – I) = (T – G) + (X – Z)
b) (S – I) + (T – G) + (X – Z) = 0
c) (S – I) (T – G) = (X – Z)
d) (S – I) + (X – Z) = (T – G)
Answer: (c)
4. Assume GDP is 6,000, personal disposable income is 5,100, the government budget deficit is
200, consumption is 3,800 and the trade deficit is 100.
a) Saving (S) = 1300, Investment (I) = 1300, Government spending (G) = 1000
b) Saving (S) = 100, Investment (I) = 100, Government spending (G) = 200
c) Saving (S) = 200, Investment (I) = 100, Government spending (G) = 200
d) Saving (S) = 1300, Investment (I) = 1200, Government spending (G) = 1100
Answer: (d).
Explanation: Saving (S) = 1300 (disposable income minus consumption); investment (I): I
= S + (T – G) + (Z – X)=1300 – 200 + 100 = 1,200. We can now use Y = C + I + G + NX to
calculate G = 1100.
5. The leakages and injections approach implies that the government surplus is equal to
a) Private saving less private investment plus net exports.
b) Private investment less private saving plus net exports.
c) Private investment plus private saving plus net exports.
d) None of the above.
Answer: (b)
6. Fill in the blanks in the table.

Year Nominal GDP (£b) Real GDP (£b) GDP deflator
2010 90 120
2011 125 125
Answer:
Year Nominal GDP (£b) Real GDP (£b) GDP deflator

2010 108 90 120
2011 125 100 125
Real GDP = Nominal GDP/(Deflator divided by 100).

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7. Intermediate goods are excluded from GDP because

a) they represent goods that have never been purchased so they cannot be counted.
b) their inclusion would understate GDP
c) their inclusion would involve double counting
d) the premise of the question is incorrect because intermediate goods are directly
included in calculating GDP.
Answer: (c)
8. Which of the following is NOT a final good?
a) a purse sold to a foreign visitor
b) a new computer sold to an LSE student
c) a hot dog sold to a spectator at a Chicago Bears football game
d) a new car sold to Rent-A-Car for use in their fleet of rental cars
Answer: (d)
9. If nominal GDP rises we can say that
a) production has fallen and prices have risen.
b) production has risen and prices remain constant.
c) production has risen or prices have risen or both have risen.
d) prices have risen and production remains constant
Answer: (c)
10. Goods that go into inventory and are not sold during the current period are
a) counted as intermediate goods and so are not included in current period GDP.
b) counted in current GDP only if the firm that produced them sells them to another
firm.
c) included in current period GDP as inventory investment.
d) included in current period GDP as consumption.
Answer: (c)

1. The graph below shows the per capita annual GDP growth rate for Pakistan and the USA
between 2000 and 2014.
GDP per capita growth rate
Source: www.google.com/publicdata/explore?ds=d5bncppjof8f9_

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a) What are the key features of the trend path for each country?
Answer:
For Pakistan, per capita GDP grew strongly in the early 2000s, peaking at just under 6% p.a. in
2005. There was then a period of decline and the growth rate fell to just below zero in 2008
and again in 2010 at the end of the global economic crisis. Since 2010, Pakistan has seen an
increase in growth rates year by year. The latest available figures from 2014 show per capita
growth of just under 4% p.a.
(Though this is not examinable, interested students may like to read more about Pakistan’s
growth here:
 http://www.worldbank.org/en/news/feature/2014/04/09/pakistan-dvelopment-
update-economy-gradually-improving
 http://www.economist.com/news/asia/21596554-slowly-lights-may-be-coming-
again-urdu-rate-growth
For the USA, the most obvious feature is the sharp drop in growth from 2007 to 2009 and then
the rapid recovery. Since 2010, growth has been fairly stable at between 1% and 2% p.a. The
sharp drop from 2007-–2009 is clearly the recession caused by the financial crisis.
b) Why is it important to compare per capita growth rates when countries have different
rates of population growth? How might this apply to the case of Pakistan and the USA?
Answer:
Pakistan has much faster population growth than the USA. If we examined annual change in
GDP without taking this into account, it would look like Pakistan was growing even faster than
the USA, but this may not reflect any real improvement in living standards in Pakistan unless
the growth in GDP was outstripping population growth.
c) Although Pakistan shows a faster growth rate for many of the years in the graph above,
the level of per capita GDP is much lower, as can be seen below. Briefly discuss how the
magnitude of each component of GDP is likely to differ for countries at different stages of
development.
Answer:
Y = C + I + G + NX. The key components of GDP are consumption, investment, government
spending and net exports – all of these components are likely be much smaller in a developing
country compared to a much richer industrialised country. Consumption will be much lower
because incomes are lower and people have less to spend. Investment may be lower due to
lower business confidence or because the industrial sector is smaller. Government spending
may make up a smaller or larger percentage of GDP but the magnitude is likely to be much
smaller due to lower tax revenues. Exports and imports will be smaller if the country is less
open to international markets. What is important in this answer is to show understanding of
the different components of GDP and make sure that your ideas are related to magnitude
rather than growth rates.

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2. This graph shows per capital GDP in constant 2005 international $.
GDP per capita, PPP (constant 2005 international $)
Source: www.google.com/publicdata/explore?ds=d5bncppjof8f9_
a) Why is it important to examine real rather than nominal GDP? (NB: The graph uses Purchasing
Power Parity figures (PPP) to reflect the cost of living in each country, but you can ignore this
for now since it is not covered until Block 20. Just focus your answer on ‘constant’ dollars to
address the difference between real and nominal GDP.)
Answer:
See section 15.5: ‘nominal and real GDP’. Real GDP provides a more accurate picture of the actual
quantity of extra goods produced by the economy as a whole without this being influenced by
changes in the level of prices.
b) What are some advantages and limitations of GDP as a measure of wellbeing?

Answer:
See case 15.1, case 15.2, section 15.5 ‘a comprehensive measure of GDP’, and section 15.6
‘international comparisons’.

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Block 14 Answers
Activity SG14.1
Draw the consumption function in the box below. What does the intercept mean? What does the
slope indicate?
Answer:
The intercept indicates the amount that people would consume when current income is zero (e.g.
consumption that is required for survival) and would mean that savings is negative. The slope indicates
the marginal propensity to consume, which means how much out of every pound is used for
consumption rather than being saved.
Interpret the following identities:

Y≡C+S interpretation: income can only be consumed or saved. As such,
consumption plus savings is equal to income by definition.
MPC + MPS ≡ 1 interpretation: The proportion of the last dollar which is consumed plus the
proportion of the last dollar which is saved must necessarily sum to one since income can only be
consumed or saved.
(Answers in bold.)
Now draw the aggregate demand schedule for a closed economy with no government (Figure 16.5). If
you were to include a line for investment, how would this look? Why?
Answer:
Investment: The line for investment would be a horizontal straight line, since investment is
independent of income in this model.
Activity SG14.2
Using the following savings and investment functions, calculate the equilibrium level of output Y and
the level of planned saving and planned investment. Graph these in the second box below.
Savings and Investment Functions (numerical example)

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Activity SG14.3
Given, C = 10 + 0.5Y, calculate the equilibrium output when I = 20.
Now check that Y = AD = C + I in equilibrium.
Answer:
Equilibrium demand is autonomous demand [A+I] multiplied by the multiplier [1/(1 – c)].
Y* = (A + I)/(1 – c)
= (10 + 20)/(1 – 0.5)
= 60
C = 10 + 0.5*60 = 40
I = 20
Y =C + I = 60
Activity SG 14.4
Draw the aggregate demand schedule with and without the government sector given the following
parameters:
C = 200 + 0.6YD I = 300
G = 200 t = 0.3
Answer:
Aggregate demand (numerical example)
What is the change in equilibrium output?
Answer:
Y* = (200 + 300)/(1 – 0.6) = 1250

Y*’ = (200 + 300+ 200)/(1 – (c(1 – t)) = 1207

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Activity SG14.5
1) One of the important underlying tenets of the balanced budget multiplier model is that
a) for any increase in taxes, households will finance some of their increased tax liability
out of savings
b) a change in taxes by the government causes households to change the composition
of stock of wealth and will not affect aggregate demand
c) a change in fiscal policy changes aggregate demand and this causes a multiple
change in aggregate income and output
d) any increase in government spending and taxes will have essentially no effect on
aggregate employment and income.
Answer: (a)
Explanation: Consumption expenditure falls by less than the change in taxes because
money which would have been saved by households becomes an injection.
2) A £1 increase in government spending will have a larger impact upon national income than a
£1 cut in taxes since
a) the government prints the pound it spends.
b) not all of a tax cut is spent.
c) when taxes are cut, so too is government spending.
d) taxes are an injection into the system.
Answer: (b)
Explanation:This at the heart of the balanced budget multiplier effect.
Activity SG14.6
1) The structural budget shows what the budget would be if _________ is at ___________.
a) actual spending; planned spending
b) actual tax revenue; forecast tax revenue
c) forecast consumers' expenditure; actual consumers' expenditure
d) output; potential output
Answer: (d)
Explanation: That is, what would the budget look like when the economy is at potential
output.
2) The inflation-adjusted budget

a) uses real interest rates to calculate government spending
b) uses real GDP to calculate the deficit-to-GDP ratio
c) uses the tax rate minus the inflation rate to calculate tax revenues
d) shows what the budget will be if output is at potential output.
Answer: (a)
Explanation: The inflation-adjusted budget uses real not nominal interest rates to
calculate government spending on debt interest.

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Activity SG14.7
Which of these are automatic stabilisers and which are discretionary fiscal policies?
a) Unemployment benefits
b) A high savings rate
c) Increasing the income tax rate
d) VAT
e) Decreasing government spending
f) New education opportunity grants for low-income families
Answer:
a) AS
b) AS
c) DFP
d) AS
e) DFP
f) DPF
Activity SG14.8
Complete the following table
Answer: Summary of section 17.6.
Activity SG14.9
Using the following parameters:
C = 100+ 0.4Y I = 300
G = 200 t = 0.2
X = 300 z = 0.4
Draw the aggregate demand schedule for the following economies
a) A closed economy with no government
b) A closed economy with government
c) An open economy with government.
In each case – What is the size of the multiplier? What is the equilibrium level of income? What is the
budget deficit or surplus and the trade balance?
Aggregate demand (numerical example)

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Answer:
Multiplier Equilibrium Budget deficit or Trade balance
income surplus
a) 1.667 £667 0 0
b) 1.471 £882 23.53 0
c) 0.926 £833 23.53 -33.33
(See the Excel spreadsheet for calculations.)
Read Maths 17.1.

The full multiplier, taking into account all leakages savings, taxation and imports, is lower than in the
simple, two-sector model, at 1/[1 – c(1 – t)+z].
Activity SG14.10
Show that this is equivalent to the version on p.406, given as: 1/[t + s(1 – t) + z].
Answer:
See page 393. This is based on the fact that c = (1 – s)
1/[1 – c(1 – t)+z] = 1/[1 – c+ct+z]
= 1/[s+(1 – s)t+z]
= 1/[s+t – st+z]
=1/[t+s(1 – t)+z]

1) Responsible fiscal policy involves:
a) Running a balanced budget at all times.
b) Having a debt less than 60% of GDP.
c) Running a budget surplus at all times.
d) Running a deficit some of the time.
Answer: (d)
Explanation: Fiscal policy is a stabilisation tool. When the economy is depressed, the
government can influence income through a fiscal expansion, running a deficit. On the other
hand, when the economy is overheated, the government can reduce spending and run a
fiscal surplus. Therefore it is not optimal to run a balanced budget all the times.
2) Suppose the consumption function is C=100+0.95YD. If the tax rate changes from t=0 to t=30%,
then the increase in government spending that leaves equilibrium income unaffected is
a) 570
b) 2000
c) 2570
d) 0
Answer: (a)

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3) Which of the following statements is false?

a) Actual saving is always equal to actual investment.
b) Planned saving is always equal to planned investment.
c) Firms adjust their inventories which ensures that saving and investment are equal.
d) Consumers must sometimes adjust their savings patterns so that saving and investment
are equal.
Answer: (b)
4) Potential output is
a) The maximum an economy could conceivably make.
b) The output when every market in the economy is in long run equilibrium.
c) The amount of production a country is striving for through technological innovation.
d) The output when there are no unemployed workers.
Answer: (b)

1
a) How might a fall of 5 in investment demand cause a fall of 50 in equilibrium output?
Answer: This is due to the multiplier effect. The multiplier is the ratio of the change in equilibrium
output to the change in autonomous spending that caused the change. When investment falls,
output exceeds aggregate demand, which will increase inventories, and then lead to a cut in output.
This in turn leads to a fall in income, which causes a fall in consumption demand. The lowered
output still exceeds aggregate demand, and again inventories pile up, and again firms respond by
cutting output. This goes on until aggregate demand again equals output. The multiplier tells us how
much output changes after a shift in aggregate demand. The multiplier exceeds 1 because a change
in autonomous demand sets off further changes in consumption demand. The size of the multiplier
depends on the marginal propensity to consume.
b) Given the following information about an open economy with government, draw the AD
function and find the equilibrium level of income.
C = 100 + 0.7YD I = 200 G = 150 t=0.2 X = 100 z=0.2
Answer: Equilibrium income: 859
c) Now suppose that there is an upturn in the global economy leading to an increase in
business confidence (so aggregate investment rises to 250); an increase in overseas
incomes (so exports rise to 200) and an increase in the marginal propensity to import
(such that z increases to 0.3). On the diagram, show the new AD function and find the
new equilibrium income level.
Answer:
C = 100 + 0.7YD I = 250 G = 150 t=0.2 X = 200 z=0.3
Equilibrium income: 946

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Block 15 Answers
Activity SG15.1
Based on Maths 18.1, use the following information to calculate the money multiplier, the bank
deposit multiplier, and the money supply (broad money).
Deposits = £1000
Banks hold cash reserves of 5% of deposits
The private sector holds cash in circulation of 3% of deposits
Answer: Money multiplier = 12.875; bank deposit multiplier = 51.5; money supply = £1,030.
Activity SG15.2
Based on the model above, use the following information to calculate the money multiplier, the bank
deposit multiplier, and the money supply (broad money).
Cash held by the public = £600
Banks reserves = £900
Banks hold cash reserves of 5% of deposits
The private sector holds cash in circulation of 3.333% of deposits
Answer: Money multiplier =12.4; bank deposit multiplier =20.667; money supply = £18,600.
Activity SG15.3
Figure 18.2 and Table 18.3 in the textbook provide a good summary of the various factors behind the
demand for money. Draw the MB and MC curves for the demand for money in an economy, and use
these to answer the following question:
What will happen to the demand for money in the following cases, assuming all other factors remain
constant?
 Real incomes fall (say, because of a recession)
 There is a general rise in prices
 Interest rates fall
Answer:

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1) All of the following are examples of financial intermediaries except:
a) commercial banks
b) stock exchanges
c) pension funds
d) insurance companies.
Answer: (b)
Explanation: The stock exchange is not an intermediary, it is the platform where the exchanges
happen.
2) A credit crunch reduces aggregate demand by:

a) increasing the exchange rate
b) increasing interest rates
c) reducing consumption and investment spending
d) reducing the money supply.
Answer: (c)
Explanation: A credit crunch is a decrease in lending to consumers and firms. It reduces the
aggregate demand because, with less lending, there is less consumption and investment.
3) To the extent that mortgage defaults contributed to the financial crisis of 2008–2009, blame for
these actions lies with:
a) homebuyers who borrowed more than they could afford to repay.
b) mortgage brokers who encouraged households to borrow excessively.
c) financial intermediaries who held large positions in mortgage-related assets
d) all of the above.
Answer: (d)
Explanation: Until 2008 homebuyers borrowed massively. Sometimes even more than 100 per
cent of the value of their collateral (price of the house).
Mortgage brokers encouraged this kind of lending, as they were able to make good profits.
As this type of lending was profitable, financial intermediaries held large positions in mortgage
related assets.
When house prices fell, the value of collateral dropped. Many households were not able to repay
their debts. Mortgage brokers and financial intermediaries had to write-down their assets,
causing fears of insolvency.

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4) A bank with assets worth less than liabilities is said to be _____, while a bank without adequate
funds immediately available to make promised payments is said to be _____.
a) inflated; inverted
b) inverted; inflated
c) insolvent; illiquid
d) illiquid; insolvent.
Answer: (c)
Explanation: A bank is insolvent when the value of its assets is lower than the value of its
liabilities. If instead the value of assets is equal to liabilities, but some of the assets are not in
liquid form and therefore the bank is not able to satisfy some of the required payments, then the
bank is called illiquid.
5) An increase in the demand for money could be caused by

a) an increase in the general level of prices
b) an increase in incomes
c) an increase in interest rates
d) an increase in synchronisation between payments and receipts.
Answer: (b)
Explanation: An increase in real incomes increases both the transactions motive and the
precautionary motive for holding money. Part (a) would have no effect and parts (c) and (d)
would lead to a decrease in the demand for money.
6) Given a fixed money supply, more competition in banking could lead to

a) An increase in the interest rate paid on bonds
b) A decrease in the interest rate paid on bonds
c) No change in the interest rate paid on bonds
d) A decrease in the interest rate paid on bank deposits
Answer: (a)
Explanation: Increased competition between banks increases the interest rate paid on bank
deposits, leading to an upwards shift in the LL curve, with more money demanded at each
interest rate (on bonds). Given a fixed money supply, the interest rate paid on bonds must
increase to maintain equilibrium in the money market.

A farmer’s harvest will be worth £200 if she can borrow £100 worth of fertiliser. The fertiliser needs
to be applied now and harvest will take place in six months’ time. There are N savers in the
economy, each endowed with £1. Each agent faces a p% chance that there will be an emergency
such as they will absolutely need their £1 three months from now.
a) Explain why a financial intermediary is needed in this situation
Answer: On the one hand, the farmer needs to borrow in order to finance its investment: the
cost of the fertiliser has to be paid now but the investment will pay out in six months’ time. As
the farmer does not have any endowment, the only way to finance the investment is through
borrowing.
On the other hand, savers have an endowment that they need in the future only with a
probability p%.

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A financial intermediary can:

 collect money from the savers, providing an interest rate
 finance the farmer’s investment, making a profit (the difference between the
interest rate received by the farmer and the interest rate paid to savers).
b) What is the minimum value of N such that a financial intermediary can solve the problem of
getting money from savers to borrowers? (Hint: it depends on p)
Answer: The financial intermediary has to hold some liquid assets, so as to be able to cover the
needs of the agents that will face an emergency (occurring with probability p). As this
emergency occurs with probability p, the financial intermediary has to hold p*N*1 in liquid
assets. It also needs to finance 100$ to the farmer. This means it must receive at least
N*1=100+p*N*1 solving N=100/(1-p)
c) On the basis of this example, can you see what economists mean when they say banks are
engaged in maturity transformation?
Answer: Maturity transformation means that the bank receives short-term debt (from savers)
and transform it into long-term asset (loan to the farmer).
d) Now for something a bit harder. Instead of p being a fixed number, suppose that p can turn
out to be small (with 90% probability) or large (with 10% probability).Can you see a bank
run developing in this case?
Answer: In the case p is subject to uncertainty, the bank holds liquid the fraction of resource
that on average is sufficient to cover the withdrawal needs of the savers.
Here is the problem: if after hree months the realised p is p_high, savers will ask to the bank an
amount of money equal to= p_high*N*1$. However, the bank held liquid only the quantity
0.9*p_small*N*1$+0.1*p_high*N*1$, which is lower than p_high*N*1$.
In this case the bank is not able to cover the liquidity needs of all its savers. There is a bank run,
as savers run to the bank hoping to the able to be among the few who are given money the
bank has.
e) What could the role of a central bank be in this case?
Answer: The role of the central bank is to prevent a bank run to happen. In case the bank’s
liquidity is insufficient, the central bank can intervene, lending to the suffering bank the
necessary liquidity in order to satisfy savers liquidity needs. When the central bank steps in,
there is no reason for a bank run, as savers realise there won’t be any liquidity shortage.

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Block 16 Answers
Activity SG16.1
Given the following information, provide a graphical derivation of the IS curve. The multiplier is equal
to three. When interest rates are equal to 5%, autonomous demand is 200. When the interest rate
rises to 8%, investment falls from 100 to 80.
Answer:
Activity SG16.2
Given the following information, provide a graphical derivation of the LM curve. There is a fixed supply
of money. When output is at 600, the money market is in equilibrium when interest rates are equal to
5%; when output rises to 800, the interest rate rises to 8% to restore equilibrium in the money market.
Answer:

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Activity SG16.3
Answer the five questions in the boxes below:
IS-curve: LM-curve:
combinations of interest rates and income that combinations of interest rates and income that
lead to equilibrium in the goods market lead to equilibrium in the money market
Lower interest rates increase consumption The quantity of money demanded rises with
demand (Why?) the level of output (Why?)
Transmission mechanisms were discussed in Because people have to undertake more
the previous block (e.g. through making transactions and there is a greater need for
consumer credit cheaper). precautionary balances (Chapter 18).
Lower interest rates increase investment Higher interest rates lead to a fall in money
demand (Why?) demand (Why?)
Transmission mechanisms were discussed in This represents an increase in the opportunity
the previous block (e.g. through making more cost of holding money, hence people will
investment projects satisfy a present value switch from holding money to holding bonds.
opportunity cost evaluation).
(This approach assumes that whatever is Higher output induces a higher interest rate to
demanded will be supplied. Supply side keep money demand in line with money supply
economics will be covered in Chapter 28.) (Who determines this?)
The central bank fixes the money supply
(according to the traditional central bank
approach where there is a money supply
target). Competitive market forces ensure the
interest rate moves to restore equilibrium.
(Answers in bold.)
Activity SG16.4
Using the IS-LM framework, draw a fiscal expansion and a monetary expansion in the boxes below.
What are the effects on output and interest rates?
Answer:

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Explanation:
Fiscal expansion: interest rates rise and output rises.
Monetary expansion: interest rates fall and output rises.
Activity SG16.5
The figure below summarises this section, showing how changes in money demand (other than those
caused by changes in interest rates and output) cause the LM curve to shift. Complete the empty boxes
in the second row.
Activity SG16.6
1. a) Find the interest rate and level of output at which both goods and money markets are in
equilibrium, given the following equations:
Y = 80 – 4r (IS curve)
M = 360 (money supply)
M = 10Y – 4r (money demand)
Answer:
LM curve: Y = 36+ 2/5r; r=10%; Y = 40
b) How would this change if there is expansionary fiscal policy and autonomous demand in
the IS schedule increases to 102?
Answer:
r = 15%, Y = 42
2. Find the interest rate and level of output at which both goods and money markets are in
equilibrium, given the following information:
C = 100 + 0.7(Y – T)
I = 100 – 0.2r

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G = 150
T = 50
M=310
M = 0.3Y – 0.2r
Answer:
r=12.5%, Y = 1041.667
Activity SG16.7
Describe the policy mix you would adopt in the following situations, assuming you are in a position of
power over both fiscal and monetary policy, and provide an explanation of the reasoning behind your
decision.
a) A very deep recession.
b) There is a need to build a solid foundation for long-term growth, but there is currently a
temporary bubble in the economy.
c) The country is heavily engaged in a war which is being fought outside the country.
Answer:
a) Easy fiscal policy, easy monetary policy.
b) A tight monetary policy will be more effective in combating a temporary bubble because there
is less of a time lag. There is a need to build a foundation for long-term growth but it is
important not to crowd out private investment. However, the economy must not be driven
into recession either and therefore the aim could be for a neutral fiscal policy.
c) A war is likely to cause a large strain on the country’s finances, leading to easy fiscal policy
which may need to be controlled by a tight monetary policy.
Activity SG16.8
Use IS-LM curves to represent these three options graphically.
a) an expansionary fiscal policy financed via an increase in taxes: this will not cause an increase
in the money supply so fiscal policy and monetary policy will be independent. It does cause a
decrease in consumption but not by as much as a tax increase as people are likely to reduce
savings as well as consumption. Interest rates will increase and output will increase, though
probably less than it will in (b).
b) an expansionary fiscal policy financed via borrowing (selling bonds to the public): this doesn’t
affect money supply as the money the public uses to buy bonds is reinjected into the economy.
Fiscal and monetary policy will be independent in this case. Crowding out will occur due to
the increase in interest rates. Output will most likely increase more than in (a), depending on
how much crowding out of investment and consumption occurs.
c) an expansionary fiscal policy financed via printing money (selling bonds to the central bank):
this will lead to an increase in the money supply and can be highly inflationary if the
government has large debts (for more on this, see Chapter 20). Output will rise and there will
be no crowding out. The effect on the interest rate is unclear.

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Answer:

1) Suppose an economy is in short-run equilibrium at the intersection of the IS and LM curves.
The central bank decreases the money supply. What will happen to the equilibrium interest
rate and equilibrium output?
a) the interest rate will rise and output will fall
b) the interest rate will fall and output will rise
c) the interest rate will fall and output will fall
d) the interest rate will rise and output will rise.
Answer: (a)
2) The LM curve will shift down when the:
a) nominal money supply declines
b) price level rises
c) expected inflation declines
d) real money demand declines.
Answer: (d)
3) An increase in money demand causes the real interest rate to _____ and output to _____ in
the short run, before prices adjust to restore equilibrium.
a) rise; fall
b) fall; fall
c) fall; rise
d) rise; fall.
Answer: (a)

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1) Explain why each of the following is either true or false and discuss the effectiveness of
monetary and fiscal policy to affect income in each case. (In parts a, b and c, monetary policy
means controlling the money supply; in d, it means setting the interest rate.)
a) If neither consumption nor investment depend on the interest rate, the IS curve is
vertical.
b) If money demand does not depend on the interest rate, the LM curve is horizontal.
c) If money demand does not depend on income, the LM curve is horizontal.
d) If the government fixes the interest rate rather than the money supply, the LM curve
is vertical.
Answer:
a) True. Fiscal policy is effective (there is no crowding out). Monetary policy cannot
affect income.
b) False. It is vertical. Monetary policy is effective, but fiscal policy ineffective.
c) True. Both monetary and fiscal policy can affect Y.
d) False. It is horizontal. Fiscal policy is effective (there is no crowding out) and
monetary policy is effective as long as consumption or investment is sensitive to the
interest rate.
2) Assuming constant prices (no inflation) and that the central bank pursues a money supply
target,
a) derive the IS-LM framework graphically, and
b) use it to show what will happen if:

i. There is an expansionary fiscal policy financed by borrowing.
ii. There is a contractionary monetary policy.
iii. Both of these policies are in effect at the same time.
Answer:
a) Use Figures 16.1, 16.2, 16.3 and 16.4. These graphs must be accompanied by a written
explanation as they are in the block.
b)
i.
This doesn’t affect money supply as the money the public uses to buy bonds is reinjected
into the economy. Fiscal and monetary policy will be independent in this case. Crowding
out will occur due to the increase in interest rates. Output will most likely increase more
than an expansionary fiscal policy financed by an increase in taxes, depending on how
much crowding out of investment and consumption occurs.

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ii.
A contractionary monetary policy (reduction in the money supply) is shown by a leftward

shift in the LM curve. This increases interest rates and leads to a fall in output.
Governments may use the reason that the economy is ‘overheating’ to bring the level of
output back to a more suitable level.
iii.
Since these two policies will work against each other, it is not clear which will dominate
and what the effects on output will be. There will definitely be an increase in the interest
rate, however, as both policies lead to higher interest rates. This policy mix implies a high
share of government spending and a low share of private consumption and investment in
total output.

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Block 17 Answers
Activity SG17.1
Use the framework of Concept 21.1 to trace out the effects of a looser monetary policy on the AD
schedule.
Answer:
A looser monetary policy shifts the ii schedule downwards to ii’. This results in an outward shift in the
AD curve to AD’. The original AD curve can be found by tracing out the paths A-B-C-D and E-F-G-H. The
new curve AD’ can be found by tracing out the paths A-P-Q-R and E-S-T-U. This shows that a looser
monetary policy (a lower interest rate at each possible inflation rate) results in higher output at a given
rate of inflation (or higher inflation at a given rate of output).
45°
Hint: Do not start by trying to draw all four curves. Draw the IS curve, the ii schedule and the 45° line.
Then trace out the lines from a point on the IS curve to find the first point on the AD curve. Choose a
second point on the IS curve and use this to find the second point on the AD curve. Once you have
two points, you can draw the initial AD curve. Then shift the ii schedule, and repeat the process to find
the second AD curve.
Activity SG17.2
Beginning at point C in Figure 21.5, where would the economy end up if there was an adverse supply
shock shifting the AS curve from AS1 to AS0 and the central bank did not react?
Answer:
The economy would end up with a higher level of inflation, represented by the intersection between
the curves AS0 and AD1).

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Activity SG17.3
Select the appropriate response below in regards to the following two statements:
i. Central banks can offset temporary demand shocks but in doing so they will face a trade-off
between stabilising output or inflation.
ii. Central banks can offset temporary supply shocks without facing any trade-off between
stabilising output or inflation.
a) I is true and II is false.
b) II is true and I is false.
c) I and II are both true.
d) I and II are both false.
Answer: (d)
Activity SG17.4
Identify the following shocks (demand or supply, permanent or temporary, positive or negative) and
use AD-AS curves to demonstrate their short-run and long-run effects on output and inflation. Clarify
the appropriate monetary policy response and its effects on output and inflation.
i) A technological breakthrough significantly enhances productivity.
Answer:
A positive permanent supply shock increases potential output (the long-run AS curve shifts right),
leading to higher output at a lower rate of inflation. If the central bank accommodates this to
maintain the target inflation rate, loosening monetary policy (i.e. shifting the AD curve to the
right), the final outcome would be a higher level of output at the original inflation rate.
ii) A major trading partner suffers a deep recession.

Answer:
A temporary negative demand shock would shift the AD curve to the left, leading to a lower
inflation rate and an output level below the level of potential output. This in turn will lead to a
downward shift in the SAS curve from SAS0 to SAS1 (because inflation is lower than was expected),
eventually resulting in an equilibrium at the intersection of AS0 and AD1, at the level of potential

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output and at a lower inflation rate than previously. However, the government could respond by
boosting demand back to the original level – this would require a loosening of monetary policy
and would restore equilibrium at E0.
iii) A country realises that its stocks of minerals is significantly lower than what it had
previously estimated.
Answer:
A permanent negative supply shock will lead to a lower output and higher rate of inflation, and is
represented by a leftward shift in the AS curve. Initially, the SAS curve will shift left, say to SAS1
and the economy will move from Y0 to Y1 and from π0 to π1. If the government does not act, the
SAS curve will continue to shift left and the economy will end up at point EA. However, the
government can tighten monetary policy to maintain the target inflation rate, shifting the AD
curve leftward to AD1. In this case, the economy will end up at EB, with the original rate of inflation
but a lower output level.
iv) The price of a key input into production rises for some time.
Answer:
A temporary negative supply shock shifts the short-run aggregate supply curve upward from SAS0
to SAS1, moving the economy to point E1, with inflation π1 and output Y1. If the monetary policy

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remains unchanged, the SAS curve will shift back down and to the right in the long run, eventually
returning to SAS0 and the economy moves back to E0. On the other hand, if the government
responds to the shift in the SAS curve by tightening monetary policy, this shifts the AD curve to
the left to AD1 and the economy moves to point E2, where the target inflation rate is maintained.
With output below the potential level, at Y2, the short-run aggregate supply curve will shift back
to AS0 and to keep inflation at the target rate, the autonomous tightening of monetary policy is
reversed, shifting the AD curve back to AD0 and the economy back to E0.
Activity SG17.5
Search online to find some predictions or analysis relating to the expected (or announced) actions of
a major central bank (e.g. the Bank of England, US Federal Reserve, European Central Bank). How well
do they fit with the theory described in these sections (flexible inflation targeting and the Taylor rule)?
Answer: Students’ own research.

1) According to the sticky-wage model of economic fluctuations, when inflation is lower than
expected, workers get a (i) _______ real wage than expected and (ii) _______ workers are
hired than expected. (Indicate which words go on the blanks labelled (i) and (ii).)
a) (i) lower, (ii) more
b) (i) lower, (ii) fewer
c) (i) higher, (ii) more
d) (i) higher, (ii) fewer
Answer: (d)
2) In the classical model, the economy is in long-run equilibrium where the equilibrium inflation
rate is equal to the target inflation rate. The economy suffers an adverse supply shock (such
as a permanent increase in the price of raw materials). In the new equilibrium
a) Equilibrium inflation is below the target inflation rate and the government needs to
loosen monetary policy to achieve its target.
b) Equilibrium inflation is above the target inflation rate and the government needs to
tighten monetary policy to achieve its target.

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c) Equilibrium inflation is below the target inflation rate and the government needs to
tighten monetary policy to achieve its target.
d) Equilibrium inflation is above the target inflation rate and the government needs to
loosen monetary policy to achieve its target.
Answer: (b)
3) Beginning in long-run equilibrium with the central bank’s inflation target being met, which of
the following statements is false?
a) The economy experiences a permanent adverse supply shock (such as an increase in oil
prices). If the central bank wishes to maintain the pre-shock inflation target monetary
policy will have to be tightened.
Answer:
True. With the existing policy inflation will increase and so will real interest rates as the
economy moves back up the AD schedule to bring AS and AD back into balance. There will
be no shift in the ii curve. Therefore the bank has to tighten monetary policy (shift up ii
curve) in order to lower the AD curve so the original inflation target can be met.
b) With a permament positive supply shock it is possible for the economy to have lower
inflation and lower real interest rates without the central bank changing its monetary
policy.
Answer:
True. This is a movement down the existing AD curve. Output increases, inflation falls and
real interest rates fall.
c) If the central bank fails to offset the effects of an adverse temporary supply shock (a
temporary increase in the prices of raw materials for example) this will initially lead to
higher inflation and real interest rates and lower ouptut and employment. Over time
however, all these effects will be reversed without central bank intervention.
Answer:
True. SAS shifts leftwards, taking the economy back up the unchanged AD curve, but in
the medium term, lower output and employment will moderate inflation and wage
growth and restore the economy to its original position.
d) If the central bank loosens monetary policy it can largely offset the output effects of a
temporary adverse supply shock while continuing to meet its pre-shock inflation target.
Answer:
False. Looser monetary policy shifts AD outwards and offsets the fall in output, but only
at the cost of higher inflation. It would have to accept higher inflation

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1. a) The classical school of economic thought assumes a vertical short-run aggregate supply
curve while the Keynesian school assumes an upward-sloping short-run aggregate supply
curve. Explain what lies behind this difference.
Answer:
The Keynesian school assumes that wages and prices are sticky in the short-run. This means
they do not adjust immediately, markets do not immediately clear and output can be below
potential. This leads to an upward-sloping, short-run aggregate supply curve based on the
assumption that in the short run, firms are stuck with a given rate of growth of nominal wages
inherited from previous wage negotiations. Prices change more easily than wages. Both
suppliers and demanders of labour will have negotiated the rate of growth of money wages
on the basis of their inflation expectations (i.e. they will have implicitly been negotiating over
real wages). If the rate of change of nominal wages is fixed by wage agreements but inflation
deviates from the rate assumed by the parties to such agreements, then the real wages will
differ from those implicitly agreed by the negotiating parties. Now suppose that for given
expectations about the growth of money wages and prices, the rate of inflation is higher than
expected. Firms get higher prices for their product and real wages are lower than expected
because prices are rising faster than was expected when nominal wage growth was
negotiated. So production becomes more profitable and firms increase output. Similarly, if
inflation is lower than expected, the prices at which firms sell their output is lower than they
were counting on and real wages are greater than expected. Output falls, unemployment
increases. Thus there is a positive relationship between inflation and aggregate supply in the
short run, assuming sticky wages.
On the other hand, the classical school assumes that prices and wages are fully flexible, even
in the short run. For example, suppose inflation increased – in the classical model, it is
assumed that nominal wage growth would match the new, higher rate of inflation so that real
wages would be unaffected and there would be no forces acting to change aggregate output.
The vertical aggregate supply curve shows that in the long-run there is no relationship
between inflation and the level of output. The level of output is the full employment
equilibrium level and, in the long run, can co-exist with inflation at any level. Resources are
fully employed since price and wage flexibility ensures that all markets, including the labour
market, are in equilibrium, with no shortages or surpluses.
b) Suppose an economy in long-run equilibrium experiences a sharp rise in oil prices. Use a
diagram to demonstrate the short-run and long-run effects on output and inflation and explain
the mechanisms behind each movement. Clarify the appropriate monetary policy response
and its effects on output and inflation.
Answer:
This is a temporary negative supply shock which shifts the short-run aggregate supply curve
upward from SAS0 to SAS1, moving the economy to point E1, with inflation π1 and output Y1. If
the monetary policy remains unchanged, the SAS curve will shift back down and to the right
in the long run, eventually returning to SAS0 and the economy moves back to E0. On the other
hand, if the government responds to the shift in the SAS curve by tightening monetary policy,

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this shifts the AD curve to the left to AD1 and the economy moves to point E2, where the target
inflation rate is maintained. With output below the potential level, at Y2, the short-run
aggregate supply curve will shift back to AS0 and to keep inflation at the target rate, the
autonomous tightening of monetary policy is reversed, shifting the AD curve back to AD0 and
the economy back to E0.
c) Suppose that the economy is in long-run equilibrium in the classical model, with output determined
by the availability of inputs, technology, efficiency, etc. However, the equilibrium inflation rate
exceeds the government’s target inflation rate. Describe the appropriate policy action for the central
bank to take in these circumstances and trace through the effects of the policy in terms of the
aggregate supply and demand curves.
Answer:
In terms of the AS and AD diagram, policy has to engineer a fall in the AD curve so that it crosses the
vertical AS at a lower equilibrium rate of inflation. To do this the central bank has to tighten
monetary policy. The ii curve shifts upwards; at any given inflation rate real interest rates are higher,
thus at any given interest rate, AD is lower (due to the higher interest rate reducing investment and
any other elements of AD sensitive to interest rates). The AD curve shifts downwards, lowering the
equilibrium inflation rate.

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2. Taylor rule – The graph below shows the US Federal Funds Rate (the baseline interest rate)
and the Taylor Rule Estimate, from 1995 to 2013.
a) What is the Taylor rule?
Answer:
The Taylor rule is a monetary policy rule that expresses the relationship between the interest
rate set by the central bank and deviations in output and inflation from their target long-term
equilibrium levels.
The formula for the Taylor Rule is given by :
i-i* = a(π-π*)+b(Y-Y*)
where i is the real interest rate, π is the inflation rate, Y is real outputand a and b are constants
b) For the first half of the time period shown, the Taylor rule provides a good estimate of the
actual Fed Funds rate. Explain why this might be the case
Answer:
The Taylor rule tends to provide a good empirical description of the behaviour of most major
banks. It is not a rule in the sense that central banks are obliged to follow it. Central banks
have discretion as to how they set interest rates and committees involved in these decisions
take many factors and a lot of data about the economy into account. However, the two main
aims of most central banks are low and stable inflation, and low unemployment. Since these
are the key variables in the Taylor rule equation, it is not surprising that there is substantial
alignment between what the Taylor rule suggests and what central banks actually do. One
exception to this is that the Taylor rule often indicates there should be an increase in interest
rates before rates are actually raised. This is mainly due to the fact that central banks tend to
be very cautious about raising interest rates too early and choking off a recovery that is just
getting started.

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c) Explain the section of the graph where the green colour indicates a substantial shortfall.
Answer:
The section where the green colour indicates a substantial shortfall between the Taylor rule
estimate and the Fed Funds rate is the period of the financial crisis where output and
employment fell so dramatically that the Taylor rule estimate fell below zero. The lower
bound for the Fed Funds is zero. When the Fed Funds rate fells to (nearly) zero, monetary
policy loses its effectiveness. This is what is meant by a liquidity trap (as discussed in Block 14).
Although the central bank creates additional liquidity this falls into a trap: the extra money is
willingly held as part of wealth portfolios at zero interest and has no effect on output, which is
demand constrained by the IS curve. In other words, the interest rate has lost its power of
linking the monetary and goods sectors of the economy; monetary policy has lost its ability to
stimulate investment and other components of aggregate demand which depend on the rate
of interest. During the financial crisis, once central banks had lowered the baseline interest
rates as far as they could go, many resorted to less conventional forms of monetary policy,
notably quantitative easing. This graph shows that by the end of 2013, the Taylor rule was
again predicting/prescribing a positive Fed Funds rate.

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Block 18 Answers
Activity SG18.1
What does this section tell you about the velocity of money during a hyperinflation? Assume that
output is constant and the money supply is rising rapidly (for example, because a government is
printing large amounts of money to cover its debts), and use the equation of exchange to describe the
change in the price level.
Answer:
(MV = PY –> M↑ * V↑ = P↑↑ * Ybar)
The rate of growth of the price level will be extremely rapid (which is the definition of a hyperinflation).
The brief notation above says that since Y is constant, the fact that both M and V are increasing will
lead to a very large increase in P. The brief notation above says that since Y is constant, the fact that
both M and V are increasing will lead to a very large increase in P.
Activity SG18.2
Use your own words to explain seigniorage and the inflation tax.
Answer:
Students’ own words. (Note: these concepts are covered on pp.499 and 500 of BVFD.)
Activity SG18.3
Based on Figure 22.6, use the LRAS and the long-run Phillips curve, together with the short-run curves,
to depict what will happen to output, unemployment and the inflation rate when there is:
a) a negative shock to aggregate demand in the context of a credible, constant inflation target
b) an expectation that the inflation rate will rise and that the central bank will not be able to
contain this
c) the productivity of the labour force increases permanently (for example due to changes in the
county’s education and training systems)
d) a temporary adverse supply shock that is not fully accommodated.
Answer:

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Demand shocks cause a movement along the SAS curve and the short-run Phillips curve.
Expectations that inflation will rise cause the PC and SAS curve to shift upwards. Higher
inflationary expectations are represented by a higher PC. The SAS curve will shift upwards
because higher inflationary expectations will lead workers to negotiate for higher nominal
wages.

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A permanent positive supply shock would increase potential output and shift the long-run
aggregate supply curve to the right. Because the permanent supply shock will result in lower
prices, there will be an immediate fall in inflation and so the short-run aggregate supply curve
will shift downwards and to the right.
Note: a permanent supply shock will cause both the long-run and short-run Phillips curves to
shift. Whether or not there is an increase, decrease or no change in inflation (in the case of an
increase in productivity) depends on whether nominal wage growth or productivity is growing
faster. The diagram above indicates that nominal wage growth and productivity are growing at
the same rate. If productivity is growing faster than nominal wages, there will be disinflation
(i.e. the short-run SAS curve will shift further to the right and the PC will shift further to the left
than is shown in the diagram above).
The temporary adverse supply shock will shift the PC and SAS curve upwards. If interest rates
are raised to prevent inflation rising as far as π’, output will fall and unemployment will increase,
resulting in stagflation, with both unemployment and inflation higher at A’ than at A.
Activity SG18.4
You can use the following website to find inflation figures for your country and see how these changed
during the financial crisis. Was there deflation in your country between 2007 and 2009?
http://databank.worldbank.org/data
Answer:
Students’ own research.
1) If the quantity theory of money is true, inflation will be less than the growth of the money
supply if:
a) The growth of output is positive and/or the growth of velocity is positive.
b) The growth of output is positive and/or the growth of velocity is negative.
c) The growth of output is negative and/or the growth of velocity is positive.
d) The growth of output is negative and/or the growth of velocity is negative.
Answer: (b)

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2) In the case of unanticipated inflation

a) creditors are hurt by lending but debtors gain by borrowing.
b) The elderly (mostly savers) are advantaged but the young (mostly borrowers) are
disadvantaged.
c) Workers gain because their real wages are higher than expected.
d) Institutional arrangements such as tax brackets and VAT rates will be fully adjusted.
Answer: (a)
3) Which of the following statements is true?
a) Inflation that is higher than expected inflation shifts the short-run Phillips curve upwards.
b) Higher expected inflation shifts the short-run Phillips curve upwards.
c) Higher expected inflation shifts the long-run Phillips curve rightwards.
d) Higher expected inflation shifts the long-run Phillips curve leftwards.
Answer: (b)
4) Which of the following statements is false?
a) A positive demand shock leads to a leftward movement along the short-run Phillips curve.
b) A positive demand shock leads to a rightward movement along the short-run Phillips
curve.
c) A positive demand shock leads to no change in the position of the short-run Phillips curve.
d) A positive demand shock leads to no change in the position of the long-run Phillips curve.
Answer: (a)
5) Real revenue from the inflation tax:
a) always rises as the inflation rate rises
b) always falls as the inflation rate rises
c) depends on the size of the government’s real deficit
d) depends on the multiple of the inflation rate and the quantity of real cash.
Answer: (d)
a) What do the short-run and long-run Phillips curves represent? Draw a diagram with a short-run
Phillips curve and a long-run Phillips curve and explain why they have the shape they do.
b) Draw diagrams (explaining your answers in words at the same time) to depict what will happen
to output, unemployment and the inflation rate when there is:
i. a short-term boom in consumption
ii. a fall in the price of oil that is fully accommodated by monetary policy
iii. a new, very tough and inflation-hating central bank governor appointed in a period of high
inflation
iv. a fall in the natural rate of unemployment.
c) Certain types of inflation can have very serious implications. Discuss the implications of
i. negative inflation
ii. hyperinflations.
Answer:

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a) The short-run Phillips curve is downwards sloping, representing a trade-off between

unemployment and inflation in the short-run. This can be explained intuitively as follows:
In the short-run, when inflation increases, unemployment decreases. For example, inflation
is usually demand-pull inflation, which occurs when aggregate demand increases. The
quantity supplied by firms needs to increase to meet the increase in aggregate demand; to
increase quantity supplied, firms must hire more workers, hence unemployment falls. Higher
prices make firms supply more output and demand more workers.
Alternatively, when unemployment rises, inflation falls. This could be because, as
unemployment rises, people can no longer afford to buy as many goods and services. Thus
firms must lower their prices to attract customers and inflation falls.
Students could also discuss the influence of actual inflation differing from expected inflation.
The long-run PC is a vertical line at equilibrium unemployment. It demonstrates that in the
long-run, there is no trade-off between inflation and unemployment and long-run
unemployment is compatible with any level of inflation.
b) Since this question asks about output as well as unemployment and inflation, students must
draw the SAS curve as well as the PC.
i. This is a temporary positive demand shock, which leads to a movement along the SAS
curve and along the PC. Inflation and output will increase and unemployment will
decrease initially. In time, unless inflation expectations change, the economy will
move back to its long-run equilibrium point at A.

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ii. This is a temporary, positive supply shock. Since the shock is fully accommodated by
monetary policy, the economy will remain at A’ and not move back to the original
equilibrium. At the new equilibrium A’, output and unemployment are the same as
before, but inflation is lower.
iii. This will lead to a fall in inflation expectations, shifting down the short-run PC.

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iv. This is a permanent, positive supply shock. The long-run PC shifts to the left and the
long-run AS curve shifts to the right. There is higher output and lower
unemployment. The short-run PC and SAS curves will also shift. Depending on the
magnitude of the shifts in the long-run and short-run curves, inflation may be
higher, lower or the same as before the change in long-run unemployment.
c) See case 22.1 on deflation and the later part of section 22.2 on hyperinflations.

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Block 19 Answers
Activity SG 19.1
Try to find out what the trend has been in the country where you live.
Activity SG19.2
What is the unemployment rate in a country with a working-age population of 1,000, a labour force
participation rate of 80% and 100 unemployed people?
Answer: 12.5%.
Activity SG19.3
Why do you suppose the incidence of long-term unemployment is so low in Korea?
Answer:
In 2014, South Korea had the lowest long-term unemployment rate in the OECD. This partly reflects
South Korea’s historically low rates of unemployment since the 1960s, together with relatively good
current labour market conditions as well as low income support for unemployed people, which
encourages a higher than average rate of people re-entering employment. However, Korea also has a
high rate of unemployed people leaving the labour force and becoming inactive. This is likely to
strongly inhibit future working prospects for these people. These factors combined to result in a
remarkably low long-term unemployment rate.
Activity SG19.4
Match the concept of unemployment with its definition in the schematic below.
(Answer in red.)

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Activity SG19.5
In a country with a working age population equal to 25, aggregate labour demand and labour supply
in an economy are summarised by the following equations:
Labour demand: ND = 24 – W
Labour supply: NS = 3 + 2W
a) Determine the equilibrium level of employment and wages as well as the unemployment and
inactivity rates in equilibrium.
b) Determine the unemployment and inactivity rates if the government imposed a minimum wage
of £9.
Answer:
a) Employment = 17, wage = 7; unemployment rate = 0; inactivity rate = 8/25 = 32%
b) A minimum wage of £9 results in 15 employed, 6 unemployed, 4 inactive. Labour force =
15+ 6 = 21. Unemployment rate = 6/21 = 29%; inactivity rate = 4/25 = 16%.
Activity SG19.6
Use the (LD, AJ, LF) framework to illustrate the effects of the following supply-side factors on
unemployment:
a) a rise in the use of online employment websites for job search decreases skill mismatch
b) a fall in unemployment benefit, decreasing the replacement rate
c) a fall in trade union power
d) an increase in marginal tax rates.
Answer:
a) the opposite of 23.7
b) the opposite of 23.8 or the same as 23.10 (although this should include a leftward shift in
the LF curve)
c) rightward shift in the AJ curve, reducing unemployment
d) Use Figure 23.9 to work out this answer. The tax wedge is increased, the after-tax wage
falls, the gross wage rises and equilibrium unemployment increases.

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Activity SG19.7
Based on the equations in Maths 23.1, let a = 10, b = 0.2, c = 0.3, e = 30, f = 1 and t = 10.
a) Draw a graph this initial setup with two labour demand curves – with and without the tax.
Answer:
b) Calculate equilibrium unemployment.
Answer: 6.
c) How does equilibrium unemployment change when the tax is reduced to 5? Draw this line
onto your diagram as well.
Answer: 5.

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d) Imagine c was in fact equal to 0.8 – now calculate equilibrium unemployment when t is equal
to 10 and when t is equal to 5.
Answer:
When t = 10, u* = 2; when t = 5, u* = 0. The change in the tax rate now makes a much greater
difference to the unemployment rate, since people are more sensitive to changes in the wage
rate).

1) Which of the following in not true?
a) The unemployment rate is counter-cyclical.
b) The average unemployment rate differs substantially across countries.
c) The sign of a well-functioning economy is that there is no unemployment.
d) In an advanced economy, the unemployment rate can exceed 20%.
Answer: (c)
2) The conflict of interest between different groups of workers results in insiders wanting
___________, while outsiders want ________.
a) more hirings, high wages
b) high wages, more hirings
c) high wages, fewer hirings
d) fewer hirings, high wages.
Answer: (b)
3) If the fraction of employed workers who lose their jobs each month (the rate of job separation)
is 0.01 and the fraction of the unemployed who find a job each month is 0.09 (the rate of job
findings), then the natural rate of unemployment is:
a) 1 per cent (0.01)
b) 9 per cent (0.09)
c) 10 per cent (0.10)
d) About 11 per cent (actually, 1/9)
Answer: (c)

a) Suppose that at the beginning of the month, the number employed, E, equals 180 million; the
number not in the labour force, N, equals 50 million; and the number unemployed, U, equals 20
million. During the course of the month, the flows indicated below occurred:
4.0 million - moved from employment into unemployment (EU)
1.5 million - moved from employment to not being in the labour force (EN)
2.2 million - moved from unemployment into employment (UE)
2.7 million - unemployed people dropped out of the labour force (UN)

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0.3 million - moved from not being in the labour force directly into employment (NE)
1.8 million –moved from not being in the labour force directly into unemployment (NU)
i. Assuming that the population has not grown, calculate the unemployment and labour force
participation rates at the beginning and end of the month.
ii. Excluding movements into and out of the labour force, calculate the rate of job loss (j), and
the rate or hiring (h)
b) Use an appropriate graphical framework to illustrate the effects of the following supply-side factors
on unemployment
i. An increase in marginal tax rates
ii. A fall in unemployment benefit, decreasing the replacement rate
Answer:
a) (Note: the millions terms have been dropped for ease of calculation.)
i. Initial unemployment rate = 100 * U/(U+E)
= 100 * 20 / (180+20)
= 10%
Initial labour force participation rate = 100 * (U+E) / (U+E+N)
= 100 * (180+20)/ (180+20+50)
=80%
New number unemployed = 20 + 4.0 -2.2 – 2.7 + 1.8

= 20.9
New number employed = 180 – 4 –1.5 +2.2 +0.3
= 177
New number not in the labour force = 50 +1.5+2.7 – 0.3 – 1.8
= 52.1
New unemployment rate = 100 * 20.9/(20.9+177)

= 10.6%
New labour force participation rate = 100 * (20.9+177)/(20.9+177+52.1)
= 79.2%
ii. Rate of job loss = (4.0)/(180)
= 2.2%
Rate of hiring = (2.2)/(20)
= 11.0%
b)
i. Increase in marginal tax rates from AB to EF. Initially job acceptances are at B, the
workers response to the take-home wage W3, employment is N1 and unemployment
is BC. An increase in marginal tax rates decreases the take-home wage to W4. At this
wage level, job acceptances are at point F, employment is at N2 and unemployment
is given by FG.

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ii. Initially, the job acceptance schedule is AJ and equilibrium unemployment is the
distance AB. A fall in unemployment benefit raises the cost of searching for a better
job offer. Job acceptances shift to AJ’. It is also possible that some people will leave
the labour force if they no longer consider the low unemployment benefit a
sufficient incentive to remain in the labour force and continue actively searching for
work. This would lead to a shift in the LF curve to LF’, and unemployment would fall
from AB to CD.
2) The graph below shows percentage change in GDP against percentage change in the unemployment
rate for Australia from the 1980s to 2012. (GDI refers to Gross Domestic Income, which is GDP adjusted
for terms of trade: you can ignore this).
a) Describe the movement of GDP growth relative to change in the unemployment rate,
differentiating between periods of time which seem different to each other
b) Explain why this might occur. What does this say about unemployment in Australia in recent
decades?

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Source: http://markthegraph.blogspot.com/2012/10/gdp-gdi-and-okun.html
Answer:
a. Until 1995: large movements in the opposite direction to each other; from the mid-
1990s until the financial crisis: both series are much flatter, as there is not as much
evidence of demand deficient unemployment
One exception in the early 2000s: there was a sharp drop in GDP growth and then a
recovery, at the same time as a small spike in unemployment which then fell again as
the economy recovered. This may be related to the bursting of the dot.com bubble
which occurred at this time, resulting in a downturn in economic activity in many
developed economies.
Financial crisis: there was a spike in unemployment as GDP dropped substantially
and then a fall in unemployment as GDP recovered followed by another small rise in
unemployment as growth slowed once again. However, these changes are much
smaller than the fluctuations of the early 1990s.
You might be interested to see that the general impression that can be gained from
the simple graph above is supported by much more sophisticated analysis carried
out by the Reserve Bank of Australia (the Australian central bank), involving
estimates of the NAIRU as well as an analysis of the components of unemployment.
Although the authors of the report emphasise that it is difficult to draw strong
conclusions from the available data, a summary of their findings is provided below
(their discussion focuses on spare capacity in the labour market which is equivalent
to our focus on demand deficient unemployment):
The 1990s saw significant spare capacity in the labour market. The unemployment
rate was above several estimates of the NAIRU, particularly early in the decade. At
the same time, the components of unemployment that are more indicative of spare
capacity were also relatively high. Both of these approaches provide evidence of
spare capacity, which is consistent with the relatively moderate domestic
inflationary pressures and slow growth in labour costs seen over much of the

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decade. However, given the earlier experience of relatively high inflation, inflation
expectations declined only gradually.
(Stevens, 2003)
The extent of spare capacity gradually moderated over the 1990s, and for much of
the 2000s there was general evidence of labour market tightness. The
unemployment rate fell below most estimates of the NAIRU, although not by enough
to be considered statistically significant. At the same time, other indicators of cyclical
unemployment were at low levels relative to their history. Consistent with this
evidence of a tight labour market, the period ended with a rise in domestic wage and
inflationary pressures.
(Lowe, 2011)
Since the global financial crisis, there appears to have been a degree of spare
capacity in the labour market. However, this has been substantially less than was the
case over much of the 1990s. The unemployment rate has recently been a little
above several central estimates of the NAIRU (again these recent NAIRU estimates
should be viewed with particular caution given their sensitivity to new information).
At the same time, the more cyclical components of unemployment have also risen,
accounting for most of the increase in the aggregate unemployment rate. This is
consistent with evidence of subdued domestic inflationary pressures, including a
slowing in wages growth and non-tradables inflation.
(Jacobs and Williams, 2014; Kent 2014)
Source: Ballantyne, A., D. de Voss and D. Jacobs. ‘Unemployment and spare capacity
in the labour market’, RBA Bulletin 2014, pp.7–20.
b. Unemployment may rise in periods of falling GDP because of demand-deficient

unemployment. When there is insufficient aggregate demand in the economy, firms
tend to lay off workers and reduce new hirings. Demand-deficient unemployment is
also known as Keynesian or cyclical unemployment and the cycles in GDP and
unemployment can be clearly seen in the graph above. Since the graph above shows
change in the unemployment rate rather than the actual rate of unemployment, the
amount of voluntary employment in the economy (e.g. structural and frictional
unemployment) is more difficult to see. What is clear is that involuntary or demand-
deficient unemployment has been a significant feature of the Australian economy,
with clear increases during the economic downturns of the early 1990s, early 2000s
and the recent financial crisis.

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Block 20 Answers
Activity SG20.1
You are in Exchange International value of the What does it mean? (i.e.
rate domestic currency, or how much of one currency
domestic price of foreign can you buy for the other?)
exchange?
UK $US1.571/£
Germany 1.244€/£
Malaysia $US0.286/MR
UK £0.804/€
Answer:
You are in Exchange International value of the What does it mean? (i.e.
rate domestic currency, or how much of one currency
domestic price of foreign can you buy for the other?)
exchange?
UK $US1.571/£ International value of the domestic
£1 buys $US1.571;
currency $1US buys £0.637
Germany 1.244€/£ £1 buys 1.244€;
Domestic price of foreign exchange
1€ buys 0.804£
Malaysia $US0.286/MR International value of the domestic 1MR buys 0.286$US;
currency $US1 buys 3.496MR
UK £0.804/€ Domestic price of foreign exchange 1€ buys 0.804£;
£1 buys 1.244€
Activity SG20.2
Assume that the UK is the domestic country (the central bank is the Bank of England) and that the
exchange rate ($/£) is fixed. Supply the correct combination to fill the gaps in the following sentence.
If, at the fixed exchange rate the pound (£) is ……………… the Bank of England must ……….. pounds and
its dollar ($) reserves will ……..
a) overvalued buy rise
b) Overvalued sell rise
c) undervalued buy rise
d) overvalued buy fall

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Answer: (d)
Explanation: When the pound is overvalued, the government buys pounds, increasing demand for
them such that the fundamental value of the currency rises to be in line with the fixed exchange
rate. Since it buys pounds and sells dollars, its dollar reserves will fall.
Activity SG20.3
Complete the following multiple choice questions, providing a reason for your answer.
1) The value of a country’s exports is listed in its balance of payments account as a(an)
a) credit
b) debit
c) payment
d) investment.
Answer: (a)
Explanation: An export is considered a credit because exported goods and services bring money
into a country.
2) In the balance of payments, a net inflow of capital shows up as a
a) surplus in the capital account
b) deficit in the capital account
c) surplus in the current account
d) deficit in the current account
Answer: (a)
Explanation: Capital in this sense means financial capital. When more money enters a country
than leaves it, there is a surplus in the capital account.

1) If the price of a Big Mac is £2 in London and $2 in New York, and the exchange rate is $2/£ then
according to purchasing power theory:
a) the £ should appreciate, i.e. more $ should trade for a £.
b) The £ should depreciate, i.e. less $ should trade for a £.
c) The £ should appreciate, i.e. less $ should trade for a £.
d) The £ should depreciate, i.e. more $ should trade for a £.
Answer: (b)
Explanation: The exchange rate should change from $2/£ to $1/ £ (i.e. less $ should trade for a
£). This is a depreciation of the pound.

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2) In an economy with a fixed exchange rate policy, when both capital and current accounts are in
surplus:
a) The balance of payments will be balanced through a decrease in foreign exchange reserves
and there will be an increase in the supply of domestic currency.
b) The balance of payments will be balanced through an increase in foreign exchange reserves
and there will be an increase in the supply of domestic currency.
c) The balance of payments will be balanced through an increase in foreign exchange reserves
and there will be a decrease in the supply of domestic currency.
d) The balance of payments will be balanced through a decrease in foreign exchange reserves
and there will be a decrease in the supply of domestic currency.
Answer: (d)
3) Assuming there is perfect capital mobility, according to the interest parity condition, an increase
in the domestic inflation rate relative to other countries would lead to:
a) an increase in competitiveness
b) a decrease in the exchange rate
c) a surplus on the current account
d) none of the above.
Answer: (b)
Explanation: An increase in the domestic inflation rate implies a fall in the real interest rate,
therefore a country with low interest rates in the short-run must have a currency that is
expected to appreciate, and hence it drops to a point from which it is expected to rise.

1. a Draw a graph of the supply and demand for the foreign exchange market, expressed in
terms of pesos per dollar. Show the equilibrium price at 5 pesos per dollar. Suppose the
demand for dollars increases so that the new exchange rate is 7 pesos per dollar. Has the
peso appreciated or depreciated? Which currency has strengthened? Is this good or bad for
the United States? For Mexico?
Answer:

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The peso has depreciated because it requires more pesos to buy one dollar. A
depreciation of the peso means that the dollar has strengthened relative to the peso.
One dollar buys more pesos — 7 rather than 5. Whether this is good or bad depends
entirely on who you are. If you are a Mexican exporter to the United States, this is good
because the prices of your exports have fallen in dollars. If you are a consumer in the
United States, this is good because Mexican goods are cheaper. However, it is bad for
Mexican importers of US goods who must pay more in pesos for a given amount of
American goods.
b) True or false: If a Mexican businessperson exports goods and services to the United States,
this will show up in the balance of payments of both countries; however, the money spent
by an American on holiday in Mexico only shows up in the balance of payments of Mexico.
Answer: False. Both types of transactions have the same effect on the current account
balance of each country, as both represent an export for Mexico and an import for the
United States.
c) Suppose the following data represent Mexico’s international transactions measured in

millions of pesos.
Merchandise exports 15 Merchandise imports 10

Change in foreign assets in Mexico 12 Change in assets abroad 8
Exports of services 7 Imports of services 5
Income receipts on investment 5 Income payments on investment 10
Unilateral transfers 6
i. What is Mexico’s trade balance?

ii. What is its balance on current account?
iii. What is its balance on capital account?
iv. What kind of exchange rate regime is Mexico operating?
Answer:
i. Mexico’s balance of trade in goods and services is equal to (15+7) – (10+5) = 7.
Mexico has a trade surplus.
ii. Mexico’s balance on current account is equal to (merchandise exports + exports of
services + income from investments) – (merchandise imports + imports of services
+ income payments on investments + unilateral transfers) = (15 + 7 + 5) – (10 + 5 +
10 + 6) = 27 – 31 = –4. Mexico has a current account deficit.
iii. Mexico’s balance on capital account is the difference between changes in foreign
assets in Mexico and changes in Mexican assets in foreign countries = 12 – 8 = 4.
This surplus on the capital account exactly offsets the deficit on the current
account.
iv. Since the current and capital accounts offset each other exactly without any official
financing, this indicates that Mexico is operating a flexible exchange rate regime.

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Block 21 Answers
Activity SG21.1
Assuming fixed exchange rates and perfect capital mobility, use the IS-LM-BP framework to
demonstrate the effects of an increase in demand for exports on output and interest rates.
Answer:
With perfect capital mobility, the interest rate must remain at the same level to prevent an inflow of
capital and a currency appreciation. The BP curve is horizontal. The IS curve shifts right (since the
exchange rate is fixed, we can assume this would be because of an increase in foreign incomes –
although foreign income is often assumed to be constant in these models). Output will increase
substantially from Y0 to Y1. The LM curve shifts outward to restore internal and external balance at
point B.
Activity SG21.2
What policy measures should accompany a devaluation of a pegged exchange rate to ensure optimal
results?
Answer:
Fiscal policy should be tightened so that the increased demand for exports is offset by a fall in domestic
absorption, such that the devaluation does not lead to increases in domestic prices and wages but
rather a sustained period of improved competitiveness. Monetary policy cannot be used for domestic
policy goals since its only function is to support the exchange rate.
Under what circumstances is a devaluation likely to have the most positive impact on the economy?
Answer:
Devaluation can be an appropriate response to a real shock that requires a change in the equilibrium
exchange rate, such as a permanent fall in export demand. In this case, devaluation can speed up

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adjustment that could otherwise take several years. Thus the most appropriate circumstances for this
policy would be large and sustained shocks to the trade balance.
Activity SG21.3
The following graph shows the exchange rate between GBP and EUR – what might explain the
sudden drop just after 9am on 28 April?
Source: http://www.foremostcurrencygroup.co.uk/a-volatile-period-for-sterling/
Answer:
Freely floating exchange rates react a lot to new information. This graph seems to indicate that some
new information became available at 9am which influenced traders’ perceptions of future inflation or
growth in one of the two countries, affecting their expectations regarding future interest rates. This
graph shows depreciation in the pound against the euro. Anything that would make an increase in UK
interest rates would more than likely lead to increased demand for pounds and to an appreciation in
the exchange rate. It is therefore likely that whatever news was announced was something that makes
an increase in interest rates less likely.
You are, of course, not expected to know this. For your interest, on the date in question, there was an
announcement regarding the GDP figures for the UK for Q1 of 2015. The markets had been expecting
growth of at least 0.5% but the announced growth was only 0.3%. Slower than expected growth made
it very unlikely that the Bank of England would raise interest rates in the near future.

1. Suppose we have flexible exchange rates and the current account is +50. Then the capital
account:
a) is –50
b) depends on the level of sterilisation
c) depends on the balance of payments
d) depends on the amount of foreign exchange reserve accumulation.
Answer: (a)

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2. A number of countries in Europe have adopted a single currency, the Euro. One potential
drawback of a single currency for these countries is:
a) Fiscal expansions are no longer effective.
b) They no longer have control over interest rates.
c) Their exchange rates will now be more volatile, therefore reducing trade.
d) Capital account deficits will increase.
Answer: (b)
3. If we consider a situation of expansionary monetary policy under flexible exchange rates, the
monetary expansion will lead to _____ of the home currency and thus will be _____ effective in
increasing national income than under fixed exchange rates
a) an appreciation; more
b) an appreciation; less
c) a depreciation; more
d) a depreciation; less
Answer: (c)
4. Under flexible exchange rates:
a) fiscal policy is most effective in influencing national income when capital is perfectly
immobile internationally and least effective when the capital is perfectly mobile
b) monetary policy is more effective in influencing national income when capital is perfectly
immobile internationally than when capital is perfectly mobile
c) both fiscal and monetary policy are completely ineffective in influencing national income
when capital is perfectly immobile internationally
d) fiscal policy has no effect on national income, regardless of assumptions regarding the
degree of international mobility of capital.
Answer: (a)
5. With perfect capital mobility and other things being equal, an exogenous increase in demand
for a country's exports will lead to _____ increase in the country's national income under fixed
exchange rates than under flexible exchange rates.
a) a greater
b) a smaller
c) the same
d) a greater, a smaller or the same-impossible to determine without more information
Answer: (a)

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6. In the following diagram, with fixed exchange rates, the economy is in domestic equilibrium
at income level _____, and there is _____.
a) Y1; a balance of payments surplus

b) Y2; a balance of payments deficit
c) Y2; a balance of payments surplus
d) Y3; equilibrium in the balance of payments
Answer: (c)

1) In an open economy with a fixed exchange rate and perfect capital mobility, a mortgage crisis
leads to a fall in consumer spending.
a) How does the economy come back to internal and external balance if the government
does not intervene? Explain the process in words and illustrate graphically.
b) What would be the impact of an expansionary monetary policy? Explain in words and
illustrate graphically.
c) What would be the impact of an expansionary fiscal policy? Explain in words and
illustrate graphically.
d) Now assume the exchange rate is flexible, what would be the most effective macro policy
for the government to employ? Explain in words and illustrate graphically.
Answers
a) Look at the shifts in the AD curve as shown on p.569. A domestic slump reduces domestic
inflation. This leads to a depreciation in the real exchange rate (assuming the nominal
exchange rate is constant). This raises competitiveness and net exports. The fall in domestic
absorption is offset by the increase in exports, restoring the internal balance. Current
account surpluses raise the country’s net foreign assets and increase wealth. This increases
consumption demand and domestic absorption, leading to an increase in prices, which
reduces competitiveness at the fixed exchange rate and causes a fall in exports. Eventually,
both internal and external balance are restored.
b) IS-LM-BP analysis: monetary policy has no effect because the central bank has to cancel it
out immediately by changing the money supply to protect the exchange rate.

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c) IS-LM-BP analysis: fiscal policy is effective. The initial fall in consumer spending shifts the IS
curve to the left. Expansionary fiscal policy shifts it back to the right to restore equilibrium.
d) Under flexible ER, monetary policy is the most effective policy response. The fall in consumer
spending shifts the IS curve to the left. Expansionary monetary policy shifts the LM curve to
the right. This restores output at a lower interest rate than originally.
2) China’s economy has been experiencing an investment and export boom that has pulled the
unemployment rate well below the NAIRU. The country also has a substantial current account
surplus as well as a significant capital account surplus, a fixed exchange rate and relative capital
immobility. The People’s Bank of China (PBOC), China’s central bank, always sterilises any foreign
exchange market intervention that it undertakes. The Chinese government is worried about over-
investment in many industries and rising inflation.
a) One alternative (Scenario #1) for dealing with these concerns is to have the PBOC use
monetary policy to stabilise the economy at potential output. Based only on this
information, and making sure to provide an explanation, use a standard IS –LM – BP model
diagram to show:
i. China’s initial economic situation, and
ii. What happens to equilibrium income, interest rates, and the balance of payments if
the PBOC uses monetary policy to stabilize the economy at potential output.
Answer:
i.
China is initially at internal equilibrium at Y0 and R0 where Y0 > Y* because the

unemployment rate is below the NAIRU. In addition, because China has a current
account surplus and a capital account surplus it has a balance of payment surplus.
Thus, internal equilibrium lies above the BP line. Further, because China has relative
capital immobility, the BP line is steeper than the LM curve.
With a balance of payments surplus, the demand for China’s currency exceeds the
supply in the foreign exchange market and the currency wants to appreciate. In
order to maintain its fixed exchange rate and to sterilise its foreign exchange market
intervention, the PBOC will have to absorb the extra foreign currency coming into
the country – which will increase its foreign exchange reserves – by increasing the
domestic money supply. Simultaneously, the PBOC will engage in an open market

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sale of government securities to absorb the increase in the domestic money supply
from its foreign exchange market intervention. This will leave the domestic money
supply unchanged (i.e. the foreign exchange market intervention has been sterilised
and there is no change in the LM curve).
ii.
In order to return the economy to potential output, the PBOC will have to engage in
a contractionary monetary policy. This will reduce the money supply and shift the
LM curve to the left from LM0 to LM1. The money supply will now be less than the
demand for money (at the original income and interest rate levels), causing interest
rates to rise from R0 to R1. Higher interest rates will reduce interest-sensitive
spending and equilibrium income will fall from Y0 to Y1. The economy is now back at
potential output with higher interest rates. Monetary policy will be effective despite
the fact that China has a fixed exchange rate system because capital is relatively
immobile.
The balance of payments surplus has increased because both the current account
and the capital account have increased. The current account has increased because
of lower imports due to lower equilibrium income. The capital account has increased
because of higher interest rates. Because the balance of payments surplus has
increased, the magnitudes of the PBOC’s foreign exchange market intervention and
the domestic open market sales of government securities needed to sterilise it have
increased as well.
b) Re-draw your initial diagram. A second alternative (Scenario #2) for dealing with over-
investment and rising inflation is for the government to let the exchange rate float freely,
assuming that this would return the economy to potential output. Based only on this
information, and making sure to provide an explanation, use a second standard IS – LM – BP
model diagram to accurately and clearly show:
i. China’s initial economic situation, and what happens to equilibrium, interest rates, and
the balance of payments if the Chinese government allows that exchange rate to
become completely flexible.

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If the Chinese government allows the exchange rate to become completely flexible, the
currency will appreciate because of the balance of payments surplus. As the currency
appreciates, exports will become more expensive in the rest of the world and will decline
while imports will become less expensive in China and will increase. Thus, net exports
decline, the IS curve shifts to the left from IS0 to IS1 and the BP curve shifts to the left from
BP0 to BP1.
Because net exports decline, equilibrium income will drop by a multiplied amount. Lower
income will reduce the demand for money. As the demand for money falls below the
fixed supply of money, interest rates will decline from R0 to R1, interest-sensitive spending
will increase, and the decline in equilibrium income will be limited to Y1 from Y0. The
economy is now back at potential output with lower interest rates.
The balance of payments surplus has completely disappeared at Y1 and R1. The higher
exchange rate and lower equilibrium income have reduced the current account surplus
while lower interest rates have reduced the capital account surplus. The current account
plus the capital account now sum to zero. Unless both accounts are zero, one will be in
surplus while the other is in deficit (of the same order of magnitude).
c) For each of the following variables, identify whether it is higher, lower, the same, or
indeterminate in Scenario #1 (monetary policy) when compared to Scenario #2 (flexible
exchange rate).
i. equilibrium income
Answer: The same. Under both scenarios, equilibrium income is now at the level of
potential income.
ii. interest rates
Answer: Higher. Interest rates rose under scenario #1 and fell under scenario #2, so they
are higher under scenario #1.

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iii. investment
Answer: Lower: Under scenario #1, investment declined because of the rise in interest
rates from R0 to R1, while under scenario #2, investment increased because of the fall in
interest rates from R0 to R1. Thus investment is lower under scenario #1.
iv. net exports
Answer: Higher. Under scenario #1, net exports increased because the decline in
equilibrium income from Y0 to Y1 has reduced imports, while under scenario #2, net
exports decreased because of an appreciation of the currency following the change to a
completely flexible exchange rate. Thus net exports are higher under scenario #1.
v. the exchange rate
Answer: Lower. The exchange rate remained fixed under scenario #1 whilst it
appreciated substantially under scenario #2, thus it is lower under scenario #1.
vi. the balance of payments.
Answer: Under scenario #1, the balance of payments surplus increased while under
scenario #2, the balance of payments surplus has completely disappeared. It is thus
higher under scenario #1.

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Block 22 Answers
Activity SG22.1
Draw a quick sketch showing an upward sloping smooth line for trend output and a wavy line showing
actual output – mark the phases of the business cycle on the actual output curve.
Answer:
Activity SG22.2
The table below is based on Maths 27.1 and includes consumption as a further element of the system.
Use the formulas provided for each column, assuming a = 5/4 and c = 2/3, to complete the table (do
calculations to the nearest whole number): Assume that Y = 0 prior to period 1 (hint: this makes
investment = 38 in period 2). This example shows how the multiplier-accelerator interaction can
produce cycles. In other respects, the actual numbers are somewhat unrealistic. Think about why this
is.

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Answer:
Pse insert here the Excel spreadsheet as well as the scatter diagram of output over time.
Period Autonomous Induced Induced Income Business Cycle Phase

(1) Consumption Consumption Investment /Output
(2) (3) (4) (5) =
(2+3+4)
A=30 cY-1, I = a (Y-1 - Y -2), Y=C+I

c=2/3 a=5/4
1 30 0 0 30 Expansion
2 30 20 38 88
3 30 58 72 160
4 30 107 91 228
5 30 152 84 266 Boom
6 30 177 48 256 Contraction
7 30 170 -13 187
8 30 125 -86 69
9 30 46 -147 -71
10 30 -48 -176 -193 Recession
11 30 -129 -152 -251 Slump
12 30 -167 -72 -210 Recovery / Expansion
13 30 -140 52 -58
14 30 -39 189 181
15 30 121 299 449
16 30 299 335 665
17 30 443 270 743 Boom
18 30 495 98 623 Contraction
19 30 415 -150 295
20 30 197 -410 -183
Income /Output (5) = (2+3+4)

800
600
400
200
0
-200 0 5 10 15 20 25
-400
The actual numbers are somewhat unrealistic because income/output assumes negative values which
are difficult to interpret. Also, cycles are of ever-increasing magnitude which contradicts real world
experience.

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Activity SG22.3
In your own words, briefly summarise the discussion of how fluctuations in stockbuilding and
competitiveness can lead to business cycles.
Answer:
A key point to make is that in a recovery, firms must increase their output more slowly than the rate
of increase in aggregate demand, in order to restore the equilibrium level of stockholding. The story
about competitiveness depends on the country having a fixed exchange rate.
Activity SG22.4
Answer the following multiple choice questions on real business cycles:
1) Real business cycles are cycles in:
a) Potential output
b) Actual output
c) Real output
d) International trade
Answer: (a)
2) Real business cycle theorists argue that _________ can explain short and long-term fluctuations in
output.
a) imperfect labour markets

b) rational expectations
c) intertemporal decisions of households, firms and governments
d) variations in mood, caused for example by the weather.
Answer: (c)
3) Real business cycle theories suggest that ___________ to correct departures from the optimal
growth path
a) there is a role for fiscal policy

b) there is a role for monetary policy
c) there is a role for supply-side policies
d) there is no case for stabilising output over the business cycle.
Answer: (d)
Explanation: Supply-side policies are not aimed at correcting departures from the long-run growth
path. In the next chapter we will see that such policies are designed to change the long-run growth
path itself.

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Activity SG22.5
To help you work through this material, summarise it by filling out the table. Then check your
responses by comparing it to the summary table the authors have created (Table 27.2).
Answer:
Once you have filled in the table, you should check it against to the summary table (Table 27.2) in the
textbook.

1) The accelerator assumes:
a) the marginal propensity to consume is constant

b) the economy is at full employment
c) there is a constant relationship between net investment and the rate of change of output
d) the rate of growth of output continues in increase over time.
Answer: (c)
2) Investment depends mainly on:
a) past levels of income

b) future expected profits
c) present national income levels
d) historic data.
Answer: (b)
3) If an increase in investment leads to a bigger increase in national income, this is the:
a) accelerator
b) aggregate demand
c) real business cycle
d) multiplier.
Answer: (d)
4) The impossibility of negative gross investment provides a _________ to fluctuations in _______
a) ceiling; stockbuilding
b) Ceiling; capital prices
c) floor; output
d) Floor; the capital-output ratio
Answer: (c)

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a) The diagram below shows the world GDP growth rate from 1980 to 2015 – label the diagram
to show the different phases of a business cycle. (This will be quite approximate – what is
important is to show the key phases.)
GDP growth rate (world)
Answer: Labels have been inserted into the diagram above.

b) Describe at least two possible reasons for the pattern of actual output you have depicted.
Answer:
You could discuss the following topics: political business cycles, multiplier-accelerator
model, the role of ceilings and floors, fluctuations in stockbuilding, competitiveness and
fixed exchange rates, spillover from other countries (international business cycles).
c) Potential output is often depicted as a smooth, gently rising line. However, it does not
necessarily need to increase smoothly over time. What might explain fluctuations in
potential output?
Answer:
Students should use the real business cycle theory to explain fluctuations in potential
output.

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Block 23 Answers
Activity SG23.1
Do some research to find out if the current government in your country is pursuing active supply-side
policies and provide some examples of these.
Activity SG23.2
In a model without technical progress, use a graph to demonstrate how an increase in the rate of
population growth can lead to changes in the long-run level of per capita output. Will this affect the
long-run per capita growth rate?
Answer:
The level of per capital output will fall as the (δ+n)k line becomes steeper and cuts the sy curve at a
lower point. The long-run growth rate of output and also labour are n (or n’), so per capita output
growth is zero at the steady state (long-run equilibrium). If n increases, the rate of growth of labour
and the rate of growth of output both increase, and there is no change in the per capita growth rate.

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Activity SG23.3
Multiple choice question
Convergence implies that:
a) Rich nations will grow faster than poor nations.
b) The rich will get richer and the poor will get poorer.
c) The rich will get poorer and the poor will get richer.
d) Poor nations will grow faster than rich nations.
Answer: (d)

1)
The figure above represents an economy with unchanging technology. Assume that output only has
two uses: consumption and investment. According to this diagram, in the steady state, consumption
per worker is represented by:
a) the length of the segment D-k2
b) the length of the segment D-E
c) the length of the segment F-k3
d) the length of the segment F-G
Answer: (b)

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2) According to the Solow model, in an economy with a population growth rate of n, a depreciation
rate of 𝛿, and where the rate of technical progress is t, in the steady state of this model, output per
unit of labour will
a) grow at the rate t
b) grow at the rate n+ t
c) grow at the rate n + t- 𝛿
d) grow at the rate n + t + 𝛿
Answer: (a)
3) ‘Capital widening’ refers to that part of investment needed to:
a) increase the per capita capital-labour ratio
b) replace capital that has depreciated
c) equip new units of labour at the same capital-labour ratio
d) do all of the above.
Answer: (c)
4) Real GDP tends to understate income in developing economies by
a) underestimating saving
b) ignoring government deficit spending
c) omitting non-market transactions
d) all of the above.
Answer: (c)

Starting with two production functions, show the difference between the key assumptions of the
Solow model with technical progress and Romer’s model of endogenous growth. What is the long-run
growth rate of per worker output implied by each model and what are the implications of this for
government?
Answer:
Use the contents of this block to answer this question. You should use equations but may also find it
useful to reproduce the models graphically.

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Solution to econ subject guide (2016)

Principles of banking and finance (University of London)

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EC1002 Introduction to Economics

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EC1002 Introduction to Economics

Illustrate how the slope of the PPF represents opportunity cost.

Why is the frontier concave to the origin?

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EC1002 Introduction to Economics

d) What is the interpretation of the slope of these PPFs?

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EC1002 Introduction to Economics

b) Which country has a comparative advantage in shoes? In hats?

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EC1002 Introduction to Economics

Product Price – year 1 Index – year 1 Price – year 2 Index – year 2

TOTAL 400/4 480/4

(Answers are in bold.)

Inflation between year 1 and 2:

Product Weights Price – Index – Weighted Price – Index – Weighted

TOTAL 10 1000/10 1310/10

(Answers are in bold.)

Inflation between year 1 and 2?

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EC1002 Introduction to Economics

Q = 50 + 20P Q = 150 – 10P

Slope = 20 Slope = -10

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EC1002 Introduction to Economics

Sample examination questions

a) Samuel has an absolute advantage in both products and a comparative advantage in

Long answer question

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EC1002 Introduction to Economics

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Price of a Small Table (£) Quantity Demanded (thousands) Quantity Supplied (thousands)

£20 Demand Curve

£60 Free Market Equilibrium

£40 Price Ceiling

£30 Free Market Equilibrium

£10 Demand Curve

EC1002 Introduction to economics

EC1002 Introduction to economics

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PED = -1/s * (P/Q)

Perfectly inelastic demand Perfectly elastic demand

EC1002 Introduction to economics

Good Income elasticity Type of good

EC1002 Introduction to economics

i) Q = 18 without the tax; Q = 17 after the tax is introduced

EC1002 Introduction to economics

As a result of the tax:

a) The welfare of fans increases and the welfare of the FA decreases

EC1002 Introduction to economics

Sample examination questions

EC1002 Introduction to economics

a) revenue will increase with an increase in price

6. With reference to the same information as in question 5:

Long answer question

EC1002 Introduction to economics