OCR - A Lev - Econ - Ex - and - CS - Ans

Answers to Exercises and Case
studies
OCR A Level Economics (Fourth Edition)

Section 1 Microeconomics
Part 1 How competitive markets work

Chapter 1 The economic problem and opportunity cost
Exercise 1.1
The question of rational choice is important in economics. When economic agents take decisions
with a clear objective in mind, it becomes possible for us to explore how they are likely to
behave. However, it is also important to be aware of situations in which they may not appear to
act rationally.
In the case of consumers, the issue is whether they will always set out to maximise their utility.
You will be able to think of situations in which this may not happen. In your own day-to-day life,
there may be things that you choose to do, even if they don’t necessarily maximise your utility —
for example, you may give to charity.
Firms do not always set out to maximise profits but adopt a variety of strategies that seem to
contradict rational behaviour. We will be exploring some of these aspects of firms’ behaviour
later in the course.
As far as government is concerned, it is hard to see whether it always acts rationally, partly
because it has such a variety of different objectives that it is committed to achieving. These may
not always be mutually consistent.
Exercise 1.2
a Timber is a natural resource and therefore it is part of the factor land.
b The services of a window cleaner are an example of a human resource (labour).
c A combine harvester is an example of capital.
d A computer programmer who sets up a company to market her software is an example of
enterprise.
e A computer is capital.
Exercise 1.3
If English was Andrew’s next-best choice of subject, then the opportunity cost of choosing
French is that he is then unable to study English.
Exercise 1.4
a This is point C, where Amy picks no coconuts.
b Point E is beyond the production possibility curve (PPC), so cannot be reached.
c An example of such a point is B. Of course there are many other examples at points along the
PPC.
d This is point A, where Amy ignores the fish.
© Hodder & Stoughton Limited 2019 1

e In this situation Amy spends only part of her time fishing and gathering coconuts, and
therefore ends up at a point within her PPC, such as at D.

Case study 1.1
Plantains and tobacco
a The opportunity cost of a decision is defined as the value of the next-best alternative that could
have been chosen. In Jacob’s case, the decision is to produce more tobacco. He can only do
this by producing fewer plantains, so the opportunity cost is the plantains forgone in switching
the land to producing tobacco.
b Figure A1.1 shows a PPC for Jacob’s choice between plantains and tobacco. Notice that it is
drawn as a curve rather than a straight line to reflect the fact that some of the land may be
more suitable for one of the crops, so the opportunity cost of tobacco in terms of plantains
changes as more land is used for tobacco production.
Tobacco
PPC
A
Plantains
Figure A1.1 Plantains and tobacco
c i See point A on Figure A1.1.

ii Any point such as B that lies somewhere on the PPC shows a situation in which Jacob uses
some of his land for growing tobacco, and the rest for plantains.
iii If Jacob does not use all of his land, then he would be operating at a point somewhere
within the PPC, for example at C.
d The PPC itself shows the possible combinations of plantains and tobacco that Jacob could
choose to produce if he uses his resources efficiently. If he chooses a point inside the PPC, he
would be underusing some resources. However, he would not be able to choose a point that
was outside the PPC. If producing efficiently, he needs to be aware of the opportunity cost of
producing the crops. If he wants to grow more of one, he must produce less of the other.
Chapter 2 The allocation of resources, specialisiation and

trade
Exercise 2.1
Incentives are important in economics and may take various forms. This may come through the
prices at which products are sold, but there are other incentives that may be effective — these will
be analysed as your study of economics progresses.
a An increase in the price of alcohol could be an incentive for consumers to buy less alcohol.
This could be achieved by increasing the tax on alcoholic drinks. An alternative approach

would be to convince drinkers of the adverse health effects of drinking alcohol. This is
discussed in Chapter 10 in the book, in the context of taxes on tobacco.

b Pharmaceutical firms could be encouraged to produce more medical drugs if they could charge
a higher price, or perhaps if they received a subsidy that reduced their costs.
c A higher wage paid to plumbers would be an incentive for more people to train as plumbers.
Reducing the price of such training might also help.
d It is more difficult to see how changing a price could bring about an improvement in air
quality in cities, as there is no price charged for breathing air. However, if the problem arises
from pollution produced by firms, then charging firms for the pollution that they cause would
be an incentive for them to use cleaner production techniques.
e An incentive that could help to reduce the number of cars using the roads during peak hours
would be to charge drivers for using the roads during those hours.
Exercise 2.2
The relative merits of market and centrally planned economies primarily relate to the way in
which resources are allocated in a society. Central planners face the logistical nightmare of
directing the way in which resources are allocated to alternative uses in order to produce the
goods and services that match consumer needs and desires. A market system allows prices to
provide signals to producers and consumers that bring about an appropriate allocation, but future
chapters will explain how markets may not always bring about the ideal outcome. You could
benefit from exchanging ideas with your fellow students on the arguments in this context.
Case study 2.1

Singapore
a On the face of it, the Singapore government did seem to intervene quite a lot in the
development of the economy. This was a one-party state that exerted control over both the
media and wages. The government was active in providing housing and infrastructure for
business. This was certainly not an economy in which a free market dictated the allocation of
resources.
b However, there are also indications that markets were allowed to operate. Businesses were
given incentives to be enterprising and foreign investment was encouraged. It would seem that
the government provided a secure environment in which business could flourish and the
economy become highly competitive. Although not apparent in the passage, although wages
were controlled this was done in a way that enabled markets to work, in the sense that wage
levels were raised to reflect the high skill levels of workers, which in turn reflected investment
in education. Personal freedom was sacrificed in order to allow the economy to develop
rapidly.
Singapore used strong central planning to stimulate economic growth, but in a way that helped
markets to work, rather than trying to override them.

Part 2 The role of markets

Chapter 3 Demand
Exercise 3.1
a See Figure A3.1.
Figure A3.1 The demand for trinkets
b 20 trinkets would be sold if the price were at £65. You can read this from the graph you have
drawn.
c 50 trinkets would be demanded if the price were at £45.
Exercise 3.2
a A digital camera is likely to be a normal good, as we expect demand to increase as consumer
incomes increase.
b If the demand for magazines increases as consumer incomes increase, this is likely to be an
example of a normal good. On the other hand, if increasing incomes leads to a fall in demand
for magazines because more people rely on the internet instead of reading magazines, then a
magazine would become an example of an inferior good.
c Potatoes are a classic example of an inferior good because as consumer incomes increase, so
people tend to switch to other types of food. This may be especially the case for low-income
families, where potatoes may form a high portion of the diet, but an increase in incomes
enables the purchase of a wider range of foodstuffs.
d Again, it is difficult to say whether a bicycle is a normal or an inferior good, as this may
depend upon context. There may be situations in which rising consumer incomes lead to a fall
in the demand for bicycles, as consumers are able to afford motor bikes or cars. For example,
this has been seen in China, where rapidly rising incomes have led to a substantial shift from
bicycles to cars in recent years. On the other hand, in some developing countries, an increase
in incomes may enable more people to purchase bicycles. Remember that the distinction
between normal and inferior goods is wholly about how the demand will respond to a change
in consumer incomes.
e A bottle of fine wine is likely to be an example of a normal good, as demand will tend to
increase as incomes rise.
f On the other hand, a bottle of cheap wine may be an inferior good, if people with rising
incomes buy more expensive wines.

Exercise 3.3
In this exercise, there are three possible responses, represented by Figures A3.2, A3.3 and A3.4.

Price
D1 D0
Quantity
per period
Figure A3.2 A leftward shift of the demand curve
Price
D0 D1
Quantity
per period
Figure A3.3 A rightward shift of the demand curve
Price
D0
Quantity
per period
Figure A3.4 A movement along the demand curve

a If the campaign is successful, people will eat less chocolate, and the demand curve will shift to
the left — less will be demanded at any given price (see Figure A3.2).

b As the price of apples increases, some people may choose to buy oranges instead (in other
words, we would expect apples and oranges to be substitutes), so the demand curve for
oranges will shift to the right — more will be demanded at any given price (see Figure A3.3).
c A decrease in the price of oranges will induce a movement along the demand curve — more
oranges will be demanded but the demand curve does not shift (see Figure A3.4).
d Blu-ray discs and Blu-ray players are considered to be complements, so a decrease in the
price of Blu-ray players is likely to increase the demand for Blu-ray discs — the demand curve
shifts to the right (see Figure A3.3).
e In general, private transport is expected to be a normal good: as incomes rise, more people are
likely to have their own cars rather than relying on buses. Therefore, a rise in consumer
incomes will lead to a rise in the demand for private transport and the demand curve will shift
to the right (see Figure A3.3).
f In contrast, public transport tends to be regarded as an inferior good: demand falls as income
rises. Therefore, an increase in consumer incomes will lead to a shift of the demand curve to
the left (see Figure A3.2).
Exercise 3.4
a Given Table 3.2 (see page 40 of the book) and a market price of £14, only consumers A, B, C
and D would be prepared to buy the good.
b Consumer A would have been prepared to buy the good even if the price had been £20, so
enjoys a surplus of £6 if only £14 has to be paid.
c The total consumer surplus with the price at £14 would be £12 (as A has a surplus of £6, B of
£4 and C of £2).
d With the price at £16, the total consumer surplus would be only £6. Consumer A would get a
surplus of £4 and B would get £2. However, C would get no surplus and D would no longer be
prepared to buy the good.
Case study 3.1

Fast food
a In general, the demand for a good or service is said to depend on the price of the good or
service, the price of other goods, consumer incomes, preferences and the size of the market. In
this particular case, the campaign is likely to have affected people’s preferences, if people are
now more aware of the health dangers of fast food.
b The question here is whether fast food is a normal or an inferior good. If a rise in consumer
incomes allows people to switch to more tasty and more healthy food, then fast food would be
seen as an inferior good, so the demand curve for fast food would shift to the left.
c If McDonald’s found that its market share was being squeezed by competition from
companies serving healthier and more upmarket burgers, then one response from McDonald’s
would be to use its advertising to draw attention to the healthiness of its own products —
which is exactly what they have been doing.

Chapter 4 Supply

Exercise 4.1
Figure A4.1 The supply of trinkets
a See Figure A4.1

b If the price is £35, the quantity supplied will be 55.
c If the quantity supplied is 65, the price would be £45.
Exercise 4.2
In this exercise, there are three possible responses, represented by Figures A4.2, A4.3 and A4.4.
Figure A4.2 A rightward shift of the supply curve

Figure A4.3 A leftward shift of the supply curve
Figure A4.4 A movement along the supply curve
a The introduction of more efficient computer software would lead to an increase in supply —
that is, the supply curve would shift to the right, as in Figure A4.2.
b An increase in the tax paid on sales would result in a decrease in supply, as in Figure A4.3.
c A rise in the selling price of ice cream would lead to an extension of supply — a movement up
along the supply curve, as in Figure A4.4.
d If firms leave the market, the market supply curve will shift to the left, as in Figure A4.3.
Exercise 4.3
a If consumers are convinced of the benefits of organic vegetables, the demand curve will shift
to the right.
b If firms can produce bicycles using fewer numbers of inputs (e.g. of labour), the supply curve
will shift to the right.
c A severe frost in Brazil will shift the supply curve of coffee to the left.
d An increase in the rate of value added tax will shift the supply curve to the left.
e An increase in the real incomes of consumers will affect demand curves: for normal goods
the demand curve will shift to the right, whereas for inferior goods the shift is to the left.
f Assuming coffee and tea are substitutes, the demand for coffee will shift to the left and there
will be a movement along the demand curve for tea. Whether supply behaviour will also

change depends upon how prolonged the change in relative prices is, and whether it is possible
for coffee producers to switch their production to tea.

g Assuming that coffee and sugar are complements, a fall in the price of sugar will tend to lead
to an increase in the demand for coffee, so there will be a shift of the demand curve to the
right.
Case study 4.1

Champagne
a The millennium celebrations led to an increase in the demand for champagne, with the
demand curve shifting to the right. However, the increased availability of good-quality
sparkling wines from other regions would lead to a fall in the demand for champagne, as at
least some consumers would see these alternatives as being substitutes for champagne. The
rise in real consumer incomes over time would shift the demand curve for champagne to the
right.
b The supply side of the market has also seen change. Mechanisation of some parts of the
production process reduces the costs producers face and improves the efficiency of
production. This would mean that producers would be prepared to supply more champagne at
any given price, and the supply curve would shift to the right. Expanding the area in which
champagne could be produced would also shift the supply curve to the right, but this will not
happen for some years because of the time needed for vines to come to maturity.
Chapter 5 The interaction of markets

Exercise 5.1
The equilibrium price is Pc at the intersection of Demand and Supply (see page 52 of the book).
Exercise 5.2
a With the initial supply curve S0, consumer surplus is given by the area ACP0. A shift in the
supply curve to S1 brings a fall in consumer surplus, to ABP1.
b With the initial supply curve S0, producer surplus is given by the area P0CF. A shift in the
supply curve to S1 brings a fall in producer surplus, to P1BE.
c Both consumer surplus and producer surplus are lower after the decrease in supply. This
makes intuitive sense, given that production costs have risen. Both consumers and producers
lose out as a result. Notice that the extent to which the surpluses are affected depends upon the
shapes of demand and supply, as you could see by drawing some diagrams.
Exercise 5.3
a Before answering this question, you need to make an assumption about whether bus travel is a
normal good or an inferior good. Bus travel is often perceived to be an inferior good — in
other words, as consumer income rises, it is thought that the demand for bus travel falls. If this
is indeed the case, then Figure A5.1 illustrates the effect on equilibrium price and output. The
demand curve shifts from D0 to D1, equilibrium price falls from P0 to P1, and quantity also
falls, from Q0 to Q1. If you were to assume that bus travel was a normal good, demand would
have moved to the right, and equilibrium price and quantity would both have increased.

Figure A5.1 A change in the demand for bus travel
b The firm here faces an increase in its production costs, and will be prepared to supply less
output at any given price. The supply curve shifts to the left in Figure A5.2, equilibrium price
rises from P0 to P1 and quantity falls from Q0 to Q1.
Price
S1 S0
P1
P0
D0
Q1 Q0 Quantity
Figure A5.2 A change in the supply of paint
c This reverses the effects seen in the previous question. The new computers improve efficiency
and result in a reduction in the firm’s costs, so it is prepared to supply more at any given price,
and the supply curve shifts to the right (see Figure A5.3). The equilibrium price falls from P0
to P1 and quantity increases from Q0 to Q1.
Price
S0
S1
P0
P1
D0
Q0 Q1 Quantity
Figure A5.3 A change in the supply of accountant services

d The switch from chicken to pizza affects demand in the two markets, as shown in Figure A5.4.
In the market for chickens demand shifts to the left, from Dc0 to Dc1. The equilibrium price
falls from Pc0 to Pc1, and the quantity traded increases from Qc0 to Qc1. In the market for pizza

the reverse happens: demand increases from Db0 to Db1, equilibrium price increases from Pb0 to
Pb1, and quantity increases from Qb0 to Qb1.
Figure A5.4 An outbreak of chicken flu
Exercise 5.4
The price of oil is notoriously volatile, and can have effects that spread across many markets. You
might like to brainstorm this question with your fellow students to see how the effects might
spread.
Case study 5.1

A healthy diet?
a As consumers would be looking to buy more organic foodstuffs, the demand for non-organic
products would shift to the left, as shown in Figure A5.5. In the short run, the supply of non-
organic foodstuffs is likely to be relatively inelastic, as producers would not be able to react
quickly to the change in demand. We would expect to see a movement down along the supply
curve (a contraction of supply). The equilibrium price would fall from P0 to P1 and the
quantity traded would fall from Q0 to Q1.
Figure A5.5 The market for non-organic foodstuffs in the short run

b In the market for certified organic produce, we would expect to see the reverse effect, with
demand shifting to the right, as shown in Figure A5.6. Given the difficulty of attaining
certified organic status, supply in the short run is likely to be relatively inelastic, as producers

will not be able to expand production quickly. In this situation, we would expect to see a
relatively large increase in price from P0 to P1 with a relatively small rise in the quantity
traded from Q0 to Q1.
Figure A5.6 The market for certified organic foodstuffs in the short run
c If consumer preferences remain strongly in favour of organic produce, non-organic producers

are likely to reduce the acreage devoted to production, and some farmers may choose to leave
the market altogether. The supply curve will therefore tend to shift to the left. Figure A5.7
illustrates this. Whether the price recovers all the way to the original level is uncertain.
Figure A5.7 The market for non-organic foodstuffs in the long run
Some previously non-organic producers may go through the process of switching to organic
production in the longer run, and existing farmers may expand their production. This would
mean a rightward shift in supply, as shown in Figure A5.8. Notice that this is tantamount to
saying that supply becomes more elastic in the long run, as producers are able to adjust to
changing market conditions. I have therefore marked the long-run supply curve on Figure
A5.8: this is labelled SL.

Figure A5.8 The market for certified organic foodstuffs in the long run
Chapter 6 Elasticity
Exercise 6.1
a See Figure A6.1.
Figure A6.1 The demand for Pedro’s olive oil
b The elasticity is calculated as the percentage change in quantity demanded divided by the
percentage change in price. When the price rises from £8 to £10, the quantity demanded falls
from 40 to 20. The percentage change in quantity is therefore 100 x –20/40, and the
percentage change in price is 100 x 2/8. Therefore, the elasticity is –50/25 = –2.
c An increase in price from £6 to £8 (which is an increase of 33.3%) leads to a decrease in the
quantity demanded from 60 to 40 (which is –33.3%), so the elasticity is –1.
This is because we are starting at the mid-point of the demand curve, which is the point at
which we observe unit elasticity.
d An increase in price from £4 to £6 (which is an increase of 50%) leads to a decrease in the
quantity demanded from 80 to 60 (which is –25%), so the elasticity is –0.5.
This demonstrates the way in which the price elasticity of demand varies along a straight-line
demand curve, being elastic at relatively high prices and inelastic when price is relatively low.
Unit elasticity occurs at the mid-point.

Exercise 6.2
a An increase in the quantity demanded from 150 to 165 is an increase of 10%, so the income

elasticity of demand (YED) is 10/5 = +2. This is an elastic normal good.
b YED is –0.5. This is an inelastic inferior good.
c YED is +0.4. This is an inelastic normal good.
d YED is –4. This is an elastic inferior good.
e If the quantity demanded does not change, the YED is zero: there is no relationship between
income and quantity demanded.
Exercise 6.3
a If the quantity demanded of a good increases from 200 to 260 following a 15% increase in the
price of another good, the cross elasticity of demand (XED) is calculated as the percentage
change in quantity demanded (30% in this case) divided by the percentage change in the price
of the other good. In this case the XED is +2, so the two goods are (elastic) substitutes.
b The XED is –1.5: the goods are (elastic) complements.
c The XED is +0.8: the goods are (inelastic) substitutes.
d The XED is –0.4: the goods are (inelastic) complements.
e If the quantity demanded does not change, the XED is zero: the goods are unrelated (neither
substitutes nor complements).
Exercise 6.4
a If the quantity supplied increases from 500 to 800 (60%) following an increase in price of
20%, the price elasticity of supply (PES) is +3: supply is price-elastic.
b The PES is +0.5: supply is price inelastic.
c The PES is 0: supply is perfectly inelastic.
Exercise 6.5
First of all, notice that your company is making a loss, so you need to take some action. The first
piece of information you look at is the PED, where you see that you face elastic demand, with the
price elasticity being –1.58. So if you were to increase your fares by 10% (and if your company
faced the same elasticity as the average for the market), you would expect to see a fall in demand
of 15.8%, and a fall in revenues. On the other hand, if you were to reduce your fares by 10%,
revenue would increase following a 15.8% increase in demand.
However, you need to be aware of market conditions. The economy is heading into a recession,
and you are faced with a YED that is strongly negative (–2.43). In other words, bus travel is an
inferior good. This is good news for you as it means that, as incomes fall in the recession, more
people will use the buses, and you will enjoy an increase in demand.
Whether the cross-price elasticity will be helpful to you depends on what is happening in the
market for rail travel. If you happen to know that rail fares are about to increase, then again this is
good news for you, as bus travel is a strong substitute for rail travel. For a 10% increase in train
fares, there will be a 22.1% increase in the demand for bus travel.
These elasticities therefore help you to make a reasoned decision on pricing, depending on what
is happening in the economy as a whole, and in the markets for close substitutes, such as rail
travel. The PES is less helpful to you. It tells you how you would respond to a change in price —
but you probably know that anyway.

Case study 6.1
Rice

a The demand for rice is likely to be price inelastic.
b In the passage, we read that rice is a staple food, and a part of the daily diet of many people in
Southeast Asia. This suggests that the demand for rice is likely to be inelastic. Another way of
interpreting the fact that a commodity is a staple food is to say that there are no substitutes that
people find acceptable for it: they perceive rice to be a necessity. This being the case, demand
is likely to be highly inelastic. An increase in the price of rice will not have a substantial effect
on demand, as people will continue to demand it. This is further supported in the passage,
which describes how some households have reduced their consumption of other commodities
such as meat in order to be able to maintain their consumption of rice.
c Will government intervention to control the price be effective? A full answer to this question
takes us into Chapter 10, which will explain how the price of a good comes to be set in a
market when the government decides to intervene. However, you may well have begun to
anticipate this discussion. If there is not enough rice to go round, then no action by the
government to control the price can reach the heart of the problem. Indeed, we may view price
as one way of trying to ration a limited amount of a commodity. If the quantity of the
commodity is limited, then some form of rationing is needed. If not price, then some other
way is needed.
Case study 6.2

Bicycles
a One important reason for the change in the pattern of traffic between cars and bicycles in
China over the period described is likely to have been the increase in real incomes of
households. With higher incomes, more households may be able to afford to buy cars, rather
than relying on bicycles or public transport. It is also possible that cars have become more
available in China as part of the economy’s transformation to a more diversified structure.
However, the passage does not tell us about this.
b It is quite possible that the income elasticity of demand for bicycles in China could be negative
— at least in the urban areas. In other words, bicycles could be an example of an inferior
good, whereby as incomes rise, more people demand cars, and therefore reduce their demand
for bicycles.
c On the other hand, the income elasticity of demand for cars is likely to be positive, and
perhaps strongly so. Here we have an example of a normal good, possibly even a luxury good
(a good for which the income elasticity of demand is greater than 1).
Case study 6.3

Fish
a Once the fishermen have returned from their fishing, the supply of fish is fixed, so supply is
likely to be perfectly inelastic on that day. Fish cannot have been stored from the previous day,
as this is not possible. The supply curve is vertical.
b If there is a record catch of fish, the supply will be far to the right. With demand unaffected,
the result will be that price will be much lower. You can see this in Figure A6.2.

Price
Sn Sr

Pn
Pr
Quantity of fish
Figure A6.2 The market for fish
Here, Sn represents supply on a ‘normal’ day and D represents the demand curve. The
equilibrium price is Pn. When there is a record catch, supply is to the right at Sr, and with
demand unchanged the equilibrium price falls to Pr.
c On the next day, it is possible that some fishermen will be so discouraged by the fall in the
price of fish that they will not think it worthwhile to go out fishing. If this is the case, they
may choose to do something else the next day, and this will mean the supply curve is likely to
be further to the left. Another way of interpreting this is that the long-run supply curve is more
elastic than that in the short run.
d A technological advance that reduces the cost of catching fish (e.g. in terms of the opportunity
cost of other activities) will shift the supply curve to the right.
e One way of looking at this change is that the size of the market has increased, as fish can now
be sold to the neighbouring island as well as ‘at home’. This would be seen as a shift of the
demand curve, which (ceteris paribus) would result in a higher equilibrium price. In the longer
term, this may lead more islanders to engage in fishing, therefore shifting the supply curve
also.
Chapter 7 Prices, resource allocation and concept of the

margin
Exercise 7.1
a It is somewhat difficult for me to comment on this question, as I do not know you, nor do I
know about the decisions that you take in your daily life. However, how about the following?
Your alarm clock wakes you on one of those cold, dark winter mornings. If you don’t get up
you will have to rush your breakfast, or be late for college. You could decide by weighing up
the benefits of taking a few moments extra in the warmth of your bed against the costs of a
rushed breakfast or being late for college. In this case you would be balancing the marginal
benefit of a few moments in bed against the marginal cost of missing breakfast or being late.
Of course, you may not actually think of the decision in those exact terms, but it is one way of
analysing that decision. Or you are having dinner at a restaurant. Extra chips or dessert?
b/c Again, I don’t know how you take your decisions. Would you freely choose to do
something if there is an alternative that you would enjoy more?
Exercise 7.2
a Point B is productively inefficient, as it lies inside the frontier. By employing resources more
effectively, more of each product could be produced.

b Points A and C both represent points of productive efficiency, as both lie on the frontier.
c This is trickier: in order to identify a point of allocative efficiency we need information about

consumer preferences. Either A or C could be such points, but we do not have enough
information to be sure.
d Point D is outside the frontier, and therefore cannot be reached given existing resources. The
only way to reach it would be to expand the productive capacity of the economy. This could
occur if there was an improvement in technology, or an increase in the amount of labour,
capital or other inputs available in the economy.
Case study 7.1

Jewellery
The first paragraph indicates that the market starts off in equilibrium, with the jewellery sellers
just making enough profit to remain in business. This can be seen in Figure A7.1, where D0
represents the original demand curve and S0 is the supply curve.
Price
S0
S1
P1
P0
D1
D0
Q0 Q1 Q2 Quantity
of jewellery
Figure A7.1 The market for jewellery
The equilibrium price is P0 and the quantity traded is given by Q0. The publicity given to the
jewellery results in a rightward shift of the demand curve to D1, and the equilibrium price rises to
P1. The jewellery makers find that they are selling more jewellery — namely the amount Q1.
There has been a movement along the supply curve. However, this situation does not last long, as
new jewellery sellers join the market, shifting the supply curve to S1. The equilibrium price falls
back to the original level P0, but with higher quantity traded of Q2. There has now been a
movement along the demand curve, and the market has settled down again.
Chapter 8 Market failure and externalities

Exercise 8.1
The answers to this exercise are discussed in the main text.
Exercise 8.2
I cannot predict the examples that you will have identified. Externalities are common in everyday
life, as there are many costs and benefits that are not explicitly reflected in market prices,
affecting either production or consumption. Aspects of pollution, traffic congestion and the
dropping of litter all tend to have negative effects. Positive externalities are perhaps less common,
but I expect you came up with some. Perhaps your town has some striking buildings or statues
from which you get pleasure, or perhaps your neighbour has a well-kept garden.

Exercise 8.3
a In this numerical example, marginal social benefit is equal to marginal private cost when the

quantity produced is 50,000 per week. This is the quantity that would be produced in an
unregulated market.
b At this level of output, marginal social cost is 90, whereas marginal private cost is 48, so the
difference is 42.
c Marginal social benefit is equal to marginal social cost when production is at 40,000 per week.
This is the best market situation for society as a whole.
d In order to induce firms to supply this quantity of output, firms would need to face marginal
costs of 60, but marginal private cost is 32. A tax would need to bridge the difference, so
would need to be set at 28.
Exercise 8.4
This is an example of a facility that could easily produce a NIMBY (Not-In-My-Back-Yard)
syndrome. Waste disposal is one of those essential requirements of life, but everyone would
prefer that the facilities for waste disposal were sited away from their own house.
Landfill as a form of waste disposal has been especially contentious, as it may have long-term
costs for society in terms of permanently damaging the land. Nonetheless, society generates vast
amounts of waste that have to be disposed of in some way. Recycling can help to reduce the size
of the problem, but even with higher levels of recycling there will remain the problem of
disposing of waste that cannot be recycled. Landfill is one way of doing this. If the necessity for
this is accepted, then sites have to be chosen, and it may sometimes be that these sites have to be
located in the vicinity of residential areas. There will then be local costs for residents, in terms of
traffic to and from the site, the possible air pollution (smell) and perhaps an effect on house
prices. These costs are borne by the local residents, and from their perspective they face high
private costs from a new landfill site. The benefits — in terms of waste disposal — accrue to
society more generally, so that there is a divergence between private and social costs. Most
people suffering the costs of this would object under these circumstances.
Exercise 8.5
● Externality A arises because marginal private benefit is greater than marginal social benefit.
This is a negative consumption externality, resulting in too much of the good being produced.
● Externality B arises because marginal private cost is greater than marginal social cost. This is a
positive production externality, resulting in too little of the good being produced.
● Externality C arises because marginal private benefit is lower than marginal social benefit. This
is a positive consumption externality, resulting in too little of the good being produced.
● Externality D arises because marginal social cost is greater than marginal private cost. This is a
negative production externality, resulting in too much of the good being produced.
Case study 8.1

Healthcare: public or private?
a Market failure is a situation in which the free market mechanism does not lead to an optimal
allocation of resources. This occurs when there is a divergence between marginal social
benefit and marginal social cost, or between marginal private benefit and marginal social
benefit. Economic decision-makers will take their decisions on the basis of the private costs
and benefits, and therefore may fail to take adequate account of the costs and benefits to
society, therefore producing a sub-optimal allocation of resources.
b The argument presented in the passage is couched in terms of a divergence between the
benefits from vaccination received by an individual and those that may accrue to society at

large. An individual faces a risk of infection from a disease, but may regard the probability of
infection as being relatively low. However, the benefits for society from a widespread
vaccination programme are much higher, as it lowers the chance of there being an epidemic.

One way of interpreting this is to see the vaccination programme as being associated with a
consumption externality. The possible effects can be seen in Figure A8.1, where in a private
market, individuals choose to be vaccinated up to Qmkt where marginal private benefit (MPB)
is equal to marginal cost (MC). The optimal point for society is at Q*, where marginal social
benefit (MSB) is equal to marginal cost.
The shaded area indicates the deadweight cost on society if the market is left to its own
devices.
Costs/
benefits
MC
MSB
MPB
Qmkt Q* Quantity of
vaccinations
Figure A8.1 A consumption externality
Case study 8.2

Plastic oceans
a Plastic pollution caused by litter reaching the ocean is partly about responsible waste disposal,
but a key part of the problem is the use of cheap plastic material in packaging (especially in a
single-use situation). To the extent that this results from firms’ use of plastics instead of more
expensive alternatives, we can view this as an example of a negative production externality, in
the sense that the marginal private cost (MPC) incurred by forms does not take into account
the negative effects on society. In other words, MPC is lower than marginal social cost (MSC).
The effect is shown in Figure A8.2.
MSC
MPC
P*
Costs, benefits
P1
D(MSB)
Q* Q1
Quantity per period
Figure A8.2 A production externality

In a free market, producers will choose to produce at Q1, where MPC = D (MSB). However,
from society’s point of view, it would be better off at Q*, where MSC = MSB. The shaded
area shows the welfare cost imposed on society resulting from over-production.

b Given that the problem is occurring on a global scale, it is not enough for one country to take
action in isolation. Coordinating action across countries is a major challenge to be overcome.
Chapter 9 Market failure: information failure and public

goods
Exercise 9.1
A problem that arises in this situation is information asymmetry — unless Ethel is a roofing
expert. Suppose that Frank knows more about the building trade, and about market conditions,
than Ethel, who may not be in a position to judge whether Frank’s assessment of the situation is
accurate. Frank may therefore be able to charge a price that is above the value of the work — or
even to convince Ethel that unnecessary work is essential. This is a form of market failure. A
solution is to address the cause of the market failure, by providing a way in which Ethel can
check whether Frank is a reputable builder, and whether he is presenting the facts accurately and
truly. For example, there could be a register of reliable local builders prepared to do work for the
elderly — such registers do exist. This is one way of trying to address the problem of information
asymmetry.
Exercise 9.2
This is another example of a market failure involving information asymmetry. The position here
is that pharmaceutical firms have better information about the products they sell than do potential
consumers — as is inevitable. Firms are naturally reluctant to publish results of trials that may
damage the public’s perceptions of the quality of their products, or they may argue that most
consumers do not have the training required to understand the nature of statistical evidence.
However, a failure to disclose information may lead to market failure if people are making
decisions to buy on the basis of misperceptions of product quality.
Exercise 9.3
I leave you to think about this and discuss it with your friends. Think about the characteristics of a
merit good. Why should the government treat museums as merit goods? Do the arguments apply
equally to all museums? Discuss the features of some museums that you have visited.
Exercise 9.4
a A National Park, such as the North York Moors or the Peak District, would be a good example
of a public good. It is not possible to exclude people from entering a National Park, as
operationally there are too many entry points. In addition, one person’s consumption of the
views does not reduce the amount of view available for other consumers, so a National Park is
also non-rivalrous. However, if too many tourists use the park, then the non-rivalry might
begin to be diluted. It is not rejectable for motorists that need to travel across a National Park,
assuming they do not take a long detour to avoid it.
b A playground may be non-rivalrous to some extent, in the sense that in general one child’s
play does not prevent other children from also playing — subject to capacity constraints.
However, in principle a playground could charge for entry, so could be excludable. It is
rejectable.

c A theatre performance is non-rivalrous, as your consumption of a play does not prevent the
person sitting next to you from also enjoying the performance. However, people without
tickets can be excluded from consuming the play. It is rejectable.

d An apple is a private good, having neither of the characteristics of a public good. You can be
excluded from eating it if it is mine, and you cannot consume it after I have already done so.
You don’t need to buy apples if you do not like them, so it is rejectable.
e One person’s ‘consumption’ of a TV programme does not prevent anyone else from
consuming it too, so a TV programme is non-rivalrous. When TV channels were all open-
access, TV programmes were also non-excludable. However, the advent of new technology
makes it possible for people to be excluded from consuming some channels.
f A firework display is non-rivalrous, but people can be excluded to some extent — they may
watch it from afar, but they could be charged for the best locations.
g Law and order in general may be regarded as having elements of a public good, as all
people in a community can ‘consume’ the police protection that is provided without affecting
the amount that can be consumed by others, and cannot be excluded from it. In general, law
and order is non-rejectable. At an individual level, police protection may become a private
good — for example, the individual protection given to a key witness in a criminal case. Such
bodyguard activities are different in nature from the services provided at community level.
h Again, a lecture is non-rivalrous, but it is possible to exclude people from attending it. It is
rejectable.
i Clearly, it is possible to prevent people from obtaining a Blu-ray recording, although there are
non-rivalrous aspects in the sense that the recording could be watched many times over by
different people. It is rejectable.
j Citizens of a country cannot opt out of their country’s national defence — short of emigrating.
Furthermore, one citizen’s ‘consumption’ of defence does not diminish the amount available
for others, so it is non-rivalrous and non-rejectable.
Case study 9.1

Asymmetric information
a When individuals who have been granted a loan then decide to take more risk with their
project, this is moral hazard.
b If those who apply for loans are inherently less reliable or more likely to take risks, then this is
adverse selection.
c If reliable and low risk borrowers choose not to borrow at the high rates of interest, then the
only borrowers will be those likely to default. This could kill the market as banks will no
longer be prepared to lend.
Case study 9.2

A common problem
In the case of common land, a natural tendency would be for the land to be over-used. Villagers
cannot be excluded from using the land for grazing, but over-use would lead to degradation of the
land. This is what has happened in some developing countries, where land has been overworked
and there has been widespread deforestation. A similar argument could be applied to fisheries
where there is no regulation or quotas. This has become known as the ‘Tragedy of the Commons’.

Case study 9.3
Paying for lighthouses

a A lighthouse can be seen as a classic example of a public good because it has all the key
characteristics. It is non-excludable, non-rivalrous and non-rejectable.
b Relying on general taxation would be seen as inequitable, as the majority of taxpayers would
not make use of the lighthouse service.
c In its favour, the Light Dues system attempts to ensure that vessels that benefit from the
lighthouse service are the ones that pay for it. However, some have argued that exempting
smaller vessels from having to pay the dues is unfair, given that smaller vessels may depend
upon the lighthouses more heavily than larger and more modern ships with sophisticated GPS
systems. Therefore, the smaller vessels may be able to free-ride.
Chapter 10 Government intervention and government failure

Exercise 10.1
I will not try to influence your discussions at this point: after all, you are in the final chapter of
Part 2 of the course.
Exercise 10.2
First consider the market for rented accommodation in the short run, as depicted in Figure A10.1.
Figure A10.1 The short-run impact of rent controls on the market for rented accommodation
In a free market, the equilibrium rent would be R*, but if the government imposes a rent control
such that landlords cannot set a rent above Rmax, some landlords will not be prepared to supply
accommodation, so there is a movement down along the supply curve (a contraction of supply),
with quantity supplied falling from Q* to QS. At the same time, the demand for rented
accommodation will rise, so there is also a move down along the demand curve. There is now a
severe shortage of rented accommodation with demand (QD) greatly exceeding supply (QS).
Notice that I have drawn supply as being relatively inelastic, as it may not be possible to vary the
supply very much in the short run, given that tenants have existing contracts. Demand may be
more sensitive — perhaps some young adults living at home may wish to move out, or some
homeless people may be able to afford the new lower rents. The problem is that the supply does
not match the demand at the lower rent.
In the longer run, the position becomes even worse because landlords can withdraw more
properties from the rental market. This is shown in Figure A10.2.

Figure A10.2 The long-run impact of rent controls on the market for rented accommodation
In the long run, supply shifts to the left, and with the rent still held at R*¸the shortage becomes
larger, as more potential tenants cannot find accommodation.
How about the market for owner-occupied dwellings?
Figure A10.3 The short-run impact of rent controls on the market for owner-occupied
accommodation
The initial equilibrium is with a price of P0 and quantity Q0. In the short run, there will be some
people who had been in rented accommodation who now wish to become owner-occupiers, so the
demand curve will shift to the right, from D0 to D1. Supply is likely to be relative inelastic in the
short run, so price increases by a relatively large amount, from P0 to P1, whereas quantity
increases only from Q0 to Q1.
In the longer-run, as landlords release houses and flats that were previously rented, the supply of
housing will increase, as shown in Figure A10.4.

Figure A10.4 The long-run impact of rent controls on the market for owner-occupied
accommodation
Supply shifts to the right from S0 to S1. Price eases a little, falling to P2, with quantity increasing
to Q2 in the new equilibrium. Whether price falls to its original level depends upon the extent to
which the curves move, but with the rent controls still in place, the shortage of housing overall
remains, so there may be pressure on the government to find a way of encouraging the provision
of more affordable housing.
Exercise 10.3
Assuming that prices are generally in equilibrium, volatility in prices from one year to the next
must emanate either from volatility in demand conditions or from volatility in supply.
One source of variation in the level of demand over time is the business cycle, by which the level
of economic activity tends to fluctuate through time according to a regular cycle of boom and
recession. On the supply side, volatility may result from changes in supply conditions. Volatility
may be especially likely in markets for agricultural commodities, where the level of supply is
closely related to the weather conditions in a particular period. A glut year resulting from
favourable weather conditions may force prices down, especially for perishable products. On the
other hand, a poor harvest may push prices up. Notice that within the global economy, the prices
prevailing in international markets may reflect market conditions in the economies of the major
producers. A frost in Brazil may be great news for smaller producers of coffee in other countries.
The impact of volatility of supply or demand is relatively high in agricultural markets, where
demand and supply tend to be relatively inelastic.
Buffer stock schemes are one method under which producers may try to stabilise prices from year
to year. Such schemes operate by buying up surplus stock in bumper years and selling it off when
supplies are low. These measures can be effective so long as the majority of producers are
included in the scheme, and so long as the target price is set at an appropriate level. Too high a
price will mean that stocks accumulate, as more stock will be bought to maintain the price than
will be sold. The storage and administrative costs can then become very high.
Case study 10.1

A bittersweet tax?
a The analysis of the incidence of a tax suggests that the cost of paying the levy will be shared
between producers and consumers, with the share being influenced by the elasticities of
demand and supply.

b The relevant market failure arises from increasing concerns about the problems of obesity,
especially among the young. Obesity raises the chances of diabetes. The sugar content of
many soft drinks was seen to be a major part of the problem, as the recommended daily sugar

intake could be exceeded by drinking a standard 330ml can of cola. In terms of market failure,
it could be argued that there is an information failure, such that individuals do not realise the
risks they are taking by consuming so many sugary drinks. Or it could be argued that
consumers do not fully take into account the social costs of treating diabetes. A teenager
interviewed on the day the levy came into effect said that she would continue to consume
sugary drinks because she felt she was ‘addicted’ to them. If this were true, it would suggest a
parallel with tobacco, and the taxes that have proved insufficient to discourage smoking.
c The reduction in the estimated revenue has several causes. Part of the explanation may be that
some manufacturers had acted to reduce the sugar content of their products in order to avoid
the levy. To the extent that this happened, the levy could be viewed as achieving its intention
— to reduce the amount of sugar being consumed. If the reduction arises because consumers
are expected to be more price-sensitive than at first thought, this could also mean that the levy
was expected to be effective — unless, of course, they are switching to other products that are
exempt from the levy, such as smoothies. Notice that in itself the reduced expected revenue is
not an issue, as revenue raising was not the prime reason for introducing the levy.

Part 3 Business objectives

Chapter 11 Costs, economies of scale, revenue and profit
Exercise 11.1
As I do not know where you live, I cannot comment in detail on how you will have responded to
this question. However, I can make some educated guesses.
Of course, it is possible that there is a large-scale enterprise located in your town or city. Perhaps
there is a car factory or a chemical plant operated by a multinational corporation that operates on
a global scale. Notice that such large manufacturing enterprises do tend to concentrate their
production in certain locations. As the discussion proceeds, you will realise that this is because of
the costs they face, which means that production on a relative large scale is more efficient than in
small establishments.
Even if there are no large manufacturing firms in your vicinity, there will be firms that do operate
on a national (or global scale). For example, there may be local branches of banks, accountants,
supermarkets and so on — not to mention the rail network, National Express buses and the Post
Office. You may also have branches of McDonald’s or Burger King.
There will also be smaller-scale local economic enterprises that may serve much smaller
geographic markets. This is likely to include hairdressers, bakeries, restaurants, gymnasiums or
taxi firms that are not part of a national chain.
As a further exercise, you might like to think about the characteristics that these small-scale
enterprises have in common that might prevent them growing into global businesses.
Exercise 11.2
a Short-run total cost (STC) is STFC + STVC = 300 + 140 = 440
Short-run average total cost (SATC) is STC/output = 440/40 = 11
Short-run average variable cost (SAVC) is 140/40 = 3.5
Short-run average fixed cost (SAFC) is 300/40 = 7.5
b STC = 300 + 200 = 500
SATC = 500/50 = 10
SAVC = 200 / 50 = 4
SAFC= 300 / 50 = 6
SMC = (change in STC)/change in output = (500 – 440)/(50 – 40) = 6
c If STC = 660 and STVC = 300, then STVC = 660 – 300 = 360
Exercise 11.3
a As a firm becomes established in a market, and learns the best way of utilising its factors of
production, it becomes able to produce at lower average cost for any given level of output.
This learning-by-doing effect would cause a movement downwards of the long-run average
cost curve.
b If a firm observes that average cost falls as it expands its scale of production, it is moving
along its cost curve.
c Similarly, as a firm grows and encounters diseconomies of scale because of the difficulties of
managing a larger enterprise, it is moving along its long-run average cost curve.

d If average cost falls for any given level of output — perhaps because of the adoption of new
computers — this is a movement of the long-run average cost curve.

Exercise 11.4
Different firms face different market conditions and technical characteristics. You need to think
about these characteristics of firms and whether the possible causes of economies of scale would
be relevant to them.
Exercise 11.5
a The calculations may be found in Table A11.1. Average cost is column (2) divided by column
(1). Marginal cost is the change in total cost as output increases. (Strictly speaking, marginal
cost is the change in cost divided by the change in output, but in this example the change in
output is 1.)
Table A11.1 Output and long-run cost
(1) Output (’000 (2) Total cost (3) Average cost (4) Marginal cost
units/week) (£’000) (£’000) (£’000)
0 0
32
1 32 32.0
16
2 48 24.0
34
3 82 27.3
58
4 140 35.0
88
5 228 45.6
124
6 352 58.7
b See Figure A11.1.
Figure A11.1 Average and marginal cost
c Long-run average cost is at a minimum at output level 2 (thousand) units.

d This is also 2 (thousand) units — since marginal cost always equals average cost at the
minimum point of average cost.
e Up to 2 (thousand) units — this is the range over which average cost falls as output rises.
f Above 2 (thousand) units, as long-run average cost now rises as output rises.

Exercise 11.6
a To calculate the level of profit at any output level, you need first to calculate total cost and

total revenue. Total cost (TC) is average cost (AC) multiplied by the quantity sold, and total
revenue (TR) is the price (i.e. average revenue) also multiplied by quantity sold. Profit is then
TR – TC. Table A11.2 shows the calculations.
Table A11.2 A firm’s revenue, costs and profit
Price (£) Quantity Average Total Total cost Profit

(AR) sold cost (£) revenue (TC)
(AC) (TR)
35 200 24 7,000 4,800 2,200
30 300 18 9,000 5,400 3,600
25 400 18 10,000 7,200 2,800
20 500 20 10,000 10,000 0
15 600 25 9,000 15,000 –6,000
b The firm makes abnormal profit at quantities 200, 300 and 400.
c The firm makes normal profit at quantity 500.
d The firm makes a loss at quantity 600.
Case study 11.1

Economies and diseconomies of scale
a Table A11.3 shows long-run average cost at each level of output. Figure A11.2 plots these on
a graph.
Table A11.3 Long-run average cost for a firm
Output Total cost Long-run average cost

100 6,000 60
200 8,000 40
300 9,000 30
400 10,000 25
500 15,000 30
600 24,000 40
700 42,000 60

Figure A11.2 Long-run average cost
b The minimum efficient scale is at 400 units, which is the point at which the LAC curve stops
falling (in this case, it is at the minimum point of LAC).
c The firm experiences economies of scale up to the minimum efficient scale (400 units).
d The firm experiences diseconomies of scale when it produces output beyond the minimum
efficient scale (above 400 units).
e The pattern here is that the firm experiences economies of scale at relatively low levels of
output. This could be due to any of the factors that can cause LAC to fall as output increases.
However, once the firm goes beyond the minimum efficient scale, LAC begins to rise again, so
the firm experiences diseconomies of scale. You need to discuss which factors can lead to the
curve taking on this shape.
Chapter 12 Objectives of business

Exercise 12.1
a To maximise profits the firm must choose output such that MR = MC. When price is at P1 this
is at output C. At P2 profits are maximised at B, and at P3, A is the level of output at which MR
= MC.
b At output level C, with price at P1, average revenue is above average cost, so the firm makes
supernormal profits (profits above the opportunity cost of capital). At output level B, with
price at P2, the firm finds that average revenue equals average cost, so it makes only normal
profit. At output level A, with price at P3, the firm finds that average revenue is below average
variable cost — the firm is therefore making such a loss that it is better off closing down and
leaving the market, even in the short run.
Exercise 12.2
a In this case, the owners of the firm are the principals and the managers act as the agents,
running the firm on behalf of the owners.
b Here the department store is the principal, and the employees undertake work on the store’s
behalf. John Lewis has tried to address this by making its employees ‘partners’ in the
company.
c The customers are now the principals and the department store is the agent, providing retail
services to its customers.
d The consumers of electricity are the principals, and the electricity supplier is the agent,
supplying electricity. Notice that it may be difficult to establish effective ways in which the
supplier can be held to account if it fails to deliver effective services, as coordinated action
may be problematic.
e Here the dentist is the agent, and the patients the principals.

Exercise 12.3
I do not know which large firms you looked at, but I would be surprised if any of them failed to

itemise a range of activities in which they engage to demonstrate their commitment to corporate
social responsibility.
Case study 12.1

Coke vs Pepsi in India
a The approach adopted by the firms seems to be aimed more at maximising the volume of sales
rather than profits.
b The strategy seemed to be to maximise sales volumes in order to maximise their market
shares. This was seen to be costly in the short run, in the sense that profit margins were being
squeezed. However, the managers of the firms seemed to see this as necessary in order to
boost sales.
c By cutting price to such a low level, it was crucial to be able to minimise costs. The firms used
a number of ways to try to achieve this. One way was to reduce the weight of the bottles in
order to reduce transport costs. Using cheap methods of transport in the rural areas also helped
to reduce costs. Reducing the size of bottles for sale was expected to lead to an increase in
demand from poor consumers by putting the cola within reach of those on low incomes.
d It is difficult to evaluate the impact of PepsiCo’s record on corporate social responsibility, but
it is likely to have an impact on its reputation. This may have helped to counter the bad
publicity resulting from the pesticide scare mentioned in the case study, which seems to have
affected its market position.
e The passage does not say anything specific about the firms’ long-term objectives. However,
one possibility is that each firm hopes to gain a dominant market position that would then
enable it to increase its profits in the longer term. It does seem that the market was recovering
from a difficult period but was growing rapidly. The firms may therefore have seen it as being
important to gain a high market share in this growing market — or at least, not to get left
behind the other firm, and therefore find themselves squeezed out of the market when things
quietened down later.

Part 4 Market structures

Chapter 13 Market structure: perfect competition
Exercise 13.1
a Where there is a fairly large number of firms in a market selling differentiated products, the
most likely model of market structure is monopolistic competition. Fast-food outlets in a city
centre offering various styles of cuisine would be one example of this.
b An island’s only airport is a monopoly. An example is on the Scilly Isles.
c A large number of farmers producing parsnips at a common price are best described as perfect
competition.
d Where there is a market with just a few sellers (in this case producing commercial vans), there
is a state of oligopoly.
Exercise 13.2
a With the price at 40, the firm would maximise profit at output where MR = MC: namely at
output 500 (remember that in perfect competition price equals marginal revenue because the
firm is a price taker). Supernormal profit per unit would be AR – AC = 40 – 30 = 10.
b With the price at 25, the firm would maximise profit at output 400. Supernormal profit per unit
would be AR – AC = 25 – 25 = 0.
c With the price at 20, the firm would attempt to maximise profit at output 200. The firm would
make a per unit loss of AR – AC = 20 – 40 = –20.
Each of these points represents a point on the firm’s supply curve, which tracks the marginal cost
curve.
Exercise 13.3
Consider Figure A13.1.
Figure A13.1 Adjustment to long-run equilibrium under perfect competition
Suppose that market demand (in the right-hand panel) is initially at D0 and price is at P*. S0
represents the short-run supply curve, compiled from the sum of the short-run marginal cost
curves of all the firms in the industry. The typical firm is shown in the left-hand panel, and at P*
the firm maximises profits by setting marginal cost equal to marginal revenue, producing q*
output and breaking even, i.e. just making normal profits. This is just sufficient to encourage the
firm to remain in the market.

Now suppose there is a decrease in market demand, so in the right-hand panel the demand curve
shifts to D1, leading to a fall in the market price. In the short run firms respond to this by reducing
output, sliding along their short-run marginal cost curves. (I have not marked this on the left-hand

panel, as it would get too messy.) Price in the short run therefore falls to a new equilibrium at P1.
Firms are now making losses, and some will exit from the market. As firms leave the market the
industry supply curve moves to the left, and the process will continue until it has reached S1, at
which point the price will have risen back to P* and the market will be back in long-run
equilibrium, with the remaining firms just making normal profits.
In other words, the short-run adjustment occurs by existing firms reducing their individual output
levels. Adjustment in the long run occurs by firms leaving the market.
Case study 13.1

Competition online
a Before internet comparison sites, some dealers were able to charge prices above the minimum
at which a good could be bought in the market. A key reason that allowed this was that search
was costly for a potential buyer, so not every individual could keep looking until they found
the lowest possible price.
b If all traders have perfect information, then no trader is able to exert undue pressure to
influence the price of a good or service. Firms are price takers, and consumer can buy at the
going market price without fear of being exploited.
c There are several reasons why prices may vary between suppliers. For some goods where the
price is relatively low (such as salt, or onions), it is simply not worth it for buyers to check
relative prices — in other words, buyers may choose not to collect information. In addition,
some customers may prefer to buy from a particular seller. Some people prefer to do all their
shopping at a supermarket because of the convenience, others may prefer to visit their local
greengrocer (where these still exist…). Some people may believe that they will get better
after-sales service by buying from an actual shop rather than going online. It may be that in
practice a good may not be homogeneous between sellers.
Chapter 14 Market structure: monopoly

Exercise 14.1
a See Table A14.1. (Remember that price is the same as average revenue, so total revenue is
column (1) x column (2). Marginal revenue is the change in total revenue from one level of
output to the next. This is divided by the change in output — which in this case is 1.)
Table A14.1 Marginal revenue for a monopoly
(1) Demand (’000 (2) Price (£’000) (3) Total revenue (4) Marginal
units/week) (£’000) revenue (£’000)
0 80 0
70
1 70 70
50
2 60 120
30
3 50 150
10
4 40 160
–10
5 30 150
–30
6 20 120
–50
7 10 70

b Remember that when you plot MR the points need to be located half way between the output
levels.

Figure A14.1 Revenue of a monopolist
c See Figure A14.2.
Figure A14.2 Total revenue
d Total revenue is at a maximum at output level 4 (thousand).

e Marginal revenue is zero at output level 4 (thousand). (It is no coincidence that MR is zero at
the maximum point of TR: this is a mathematical property of these curves.)
f Unit own-price elasticity of demand is also at the point where TR is at a maximum and MR is
zero, i.e. at output level 4 (thousand).
g Revenue is maximised at the point where MR = 0. A profit-maximising monopolist will
always choose output such that MR = MC, and since MC will always be positive this will be to
the left of the MR = 0 point. Therefore, the profit-maximising monopolist will always produce
less output than a revenue maximiser.
h As demand is price elastic to the left of the MR = 0 point, the monopolist will chose to produce
in the elastic range of the demand curve.
Exercise 14.2
Whether the firm is able to maximise profits as a monopolist depends on a number of factors. For
example, although the firm has a monopoly to operate trains on the route, this does not
necessarily mean that there are no substitutes for the firm’s product. The firm may need to take
into account competition from bus companies, or be aware that individuals may choose to travel
by car if the fares charged are perceived as being too high. Furthermore, if the monopoly were
seen to be exploiting its market position to make excessive supernormal profits, there is always
the possibility that the franchise would be withdrawn. However, in recent years the problem
facing rail franchise companies has been rather different, as some have made substantial losses
and have had to be rescued by government intervention.

Exercise 14.3
In tackling this question, remember that the key conditions for price discrimination to be possible

are for different consumers (or groups of consumers) to have different price elasticities of
demand, and a situation in which the market can be segmented, i.e. where the product cannot be
resold — if that were possible, we would expect a process of arbitrage to take place, and price
discrimination could not be sustained.
a Hairdressing is certainly a product that cannot be resold. But would there be different
elasticities of demand? One possibility is that pensioners and/or students might be prepared to
visit hairdressers at off-peak times of the day, so that hairdressers could offer discounts to such
groups.
b Peak and off-peak rail travel is a common example of price discrimination, reflecting the fact
that the product cannot be resold, and that commuters display more price-inelastic demand
than travellers who are free to travel at any time of day.
c Sellers of apples are unlikely to be able to practise price discrimination, as apples can readily
be resold, and there may be no identifiable groups of consumers displaying differing price
elasticities of demand.
d In the case of air tickets, price discrimination can occur in a number of ways. One possibility
would be to charge higher prices for travellers who book late, as these are more likely to be
business travellers who need to attend business meetings, whereas holiday passengers may
plan further ahead. Similarly, you might interpret business class (or first class) fares as an
example of price discrimination, where again there may be a difference in the elasticity of
demand between business travellers (who may have their tickets paid for by their companies)
and other travellers. (The situation is less transparent than some of the other examples, as the
quality of service provided is also different.)
e In the case of newspapers, the possibilities for price discrimination may again be limited,
although some firms do offer discounts to students. This may be with the aim of encouraging a
habit of reading a particular newspaper that may persist in post-student life.
f Plastic surgery is certainly a product that cannot be resold, and there may be widely differing
sensitivities to price among consumers. It may even be that surgeons can negotiate individual
prices with individual clients, thereby creating first-degree price discrimination.
g Beer is another good for which there may only be limited opportunities for price
discrimination — although, again, there may be student discounts in student union bars, where
there is the possibility of excluding non-students.
Case study 14.1

Of cabbages and rings
a It seems clear that the market for cabbages is close to perfect competition, whereas the market
for diamond rings is a monopoly.
b Remember the assumptions of perfect competition:
1 Firms aim to maximise profits.
2 There are many participants (both buyers and sellers).
3 The product is homogeneous.
4 There are no barriers to entry to or exit from the market.
5 There is perfect knowledge of market conditions.
6 There are no externalities.
If you re-read the first paragraph you should find that most of them appear, albeit not in the
same words, therefore leading to the conclusion that Ted Greens operates under conditions
approaching perfect competition.

In contrast, Edward de Vere has some control over price, faces few substitutes and is able to
increase profits by restricting output and raising price. He does not have to worry about
competition from other firms as he is the only seller of diamond rings. This market meets the

conditions specified for the market to be regarded as a monopoly.
c The last sentence of the first paragraph indicates that there are some years in which Ted
Greens ‘barely covers his costs’. If this situation were to arise persistently, then Ted would
probably give up and decide to grow some other crop. One of the characteristics of some
commodity markets is that supply does tend to fluctuate from season to season, as growing
conditions vary with the weather. This means that firms have to take decisions on the basis of
expected price, as they cannot predict the weather with any degree of certainty, and by the
time the cabbages are ready for market it is too late to switch production by growing
something else. As cabbages cannot be stored indefinitely without loss of quality, supply is
highly inelastic at harvest time. This is one way in which this market may not meet all of the
conditions of the model of perfect competition. Specifically, freedom of exit may not be a
valid assumption in the very short run.
d In a perfectly competitive market, the prospects for increasing profitability are limited. Ted
might try to go organic, and therefore attempt to convince potential buyers that he has a
premium cabbage crop for sale. This would be taking the market away from being perfectly
competitive. The notion of product differentiation (which is what this would be) is introduced
in Chapter 15.
e The change can be seen in Figure A14.3.
£
MC
AC
P1
P0
MR1
D0 D1
MR0
Q0 Q1 Output
Figure A14.3 A monopoly faces an increase in demand
Initially demand is at D0 and the corresponding marginal revenue curve is at MR0. The
monopolist (Edward) maximises profit by choosing the level of output at which marginal
revenue is equal to marginal cost, which is at Q0. Price will be set at P0. If demand increases to
D1, the new profit-maximising output is at Q1, and the price charged will increase to P1.
f The appearance of a rival firm on the scene is going to move the market away from being a
pure monopoly. Edward will no longer be able to maintain his practice of restricting output
and raising price, but will have to take decisions based on the strength of the new rival. This
may introduce a strategic element into the firm’s decision-making, as the actions and reactions
of the rival firm will need to be taken into account. This creates an oligopoly situation, which
is discussed in Chapter 15.

Chapter 15 Monopolistic competition, oligopoly and
contestable markets

Exercise 15.1
a Profits are maximised where MR = MC, at output N.
b Price A.
c At output N and price A supernormal profits are given by the area ABEC (that is, the difference
between AR and AC, multiplied by the output level).
d As the firm is making supernormal profits and there are no barriers to entry under
monopolistic competition, this must be a short-run equilibrium.
e The lure of supernormal profits will attract new firms into the market. As more firms enter, the
firm shown in the figure will find that its demand curve shifts to the left, as some of its
customers shift to buying the new firms’ products. Furthermore, as there are now more
substitutes for the firm’s product, the demand curve will become more price elastic. This will
continue until the typical firm in the market is no longer making supernormal profits — which
occurs when the demand curve is just at a tangent to the average cost curve at the output level
at which MR = MC. Once this point is reached, there is no further incentive for entry.
f AC is at a minimum at output level R, and this is the point at which productive efficiency is
reached. The market will not reach this position under monopolistic competition.
Exercise 15.2
a Where there are a large number of firms in a market selling differentiated products, the most
likely model of market structure is monopolistic competition.
b A sole supplier of postal services is a monopoly.
c A large number of farmers producing cauliflowers at a common price is best described as
perfect competition.
d Where there is a market with just a few sellers (in this case banks), there is a state of
oligopoly.
e A sole supplier of rail transport may be a monopoly provider of rail transport, but yet may face
competition from suppliers of other forms of transport such as coach or air travel.
Exercise 15.3
There are several issues that you will need to discuss here. In general, consumers tend to benefit
in the short run during the period of a price war, as they are able to purchase goods or services at
a low price. Even here, whether they benefit or not may depend upon whether firms reduce the
quality of their products in order to conduct the price war. However, the crunch comes in the
longer term. If the firm that initiated the price war is successful in forcing its rivals out of
business, then it is likely to raise prices in the longer term in order to increase its profits. Of
course, this would also apply if one of the other firms in the market wins the war. Over the long
term, consumers probably do not benefit — and may even be worse off.
Exercise 15.4
In tackling this exercise, it is important to bear in mind the key characteristics of a contestable
market, and then judge the extent to which the various markets have exhibited change in those
characteristics in recent years. These key characteristics are that there are no barriers to entry or
exit, and no sunk costs.

a Looking back in time, optometrists had a monopoly in the supply of glasses until the market
was deregulated in the 1980s as part of Margaret Thatcher’s drive for privatisation and
deregulation. This allowed market entry, as dispensing opticians could now sell glasses, not to

mention supermarkets and chemists such as Boots. This seemed to improve the intensity of
competition within the market, but it cannot be viewed as a contestable market because of the
continued existence of economies of scale, and the relatively high fixed costs of setting up in
business as an optician. The market has therefore not remained competitive, and today is
relatively concentrated, with Specsavers being the largest player in the market.
b When it comes to travel agents, superficially, the market looks to be highly competitive, with
many high street travel agency offices operating. However, it is not only the number of offices
that is important but also the number of firms in the market, and the distribution of the
business between them. The Association of British Travel Agents (ABTA) is an organisation
that acts as a trade association for tour operators and travel agents in the UK. Some large
companies such as Thomson or Thomas Cook have a significant market share.
However, it seems clear that the market is becoming more contestable. The growing ability of
consumers to bypass the local travel agent by making their own bookings online suggests that
the travel market is highly contestable. It is now possible for a potential holidaymaker to find
their flights, hotel accommodation, car rentals or hotel transfers from their PCs or mobile
devices. This can be done either by booking direct with airlines and hotels or by using one of
the growing number of online firms, such as Expedia, the world’s largest online travel agent.
The travel agents have therefore had to respond to these new online entrants to their market.
They have done so partly by themselves going online, and developing their own websites and
online sales. They have also responded by looking for niche markets, offering specialist advice
on long-haul holidays, adventure trips or skiing packages.
The intensity of this competition is likely to be beneficial for consumers in terms of the prices
that can be obtained for package holidays. Inevitably, there may also be dangers. For example,
it may be that online purchase of the separate components of a holiday is more risky than
buying from a travel agent backed by the code of conduct now issued by ABTA. Or it may be
that the online companies themselves will go through a process of merger, acquisition and
increasing concentration that may lead at some point to market power. In 2014, high street
travel agents accounted for only 10% of UK holidays and 20% of holidays abroad according
to ABTA.
c Financial services — such as retail banking — also went through a process of deregulation,
allowing entry from new firms. For example, Tesco started to provide financial services such
as travel insurance and even mortgages, many former building societies such as Abbey
National demutualised and became retail Banks, and a number of online banks have also
launched into the market. This seems to suggest that some segments of this market at least are
contestable, although the high street remains dominated by a few big players. The credit
crunch of 2008 was in part due to excessive lending by the banking sector — so perhaps in
this case, the deregulation went too far.
d The postal service is another market that for some 350 years was a monopoly protected by the
state. The Royal Mail was established in 1516 by Henry VIII. However, from January 2006
the market was liberalised, and any licensed operator was able to deliver mail to business and
residential customers. The market was not perfectly contestable, as licensees had to pay an
application fee of £1,000 and an annual fee of £1,000. There were other legal requirements
that had to be fulfilled. New measures introduced in January 2008 reduced the application fee
to £50, abolished the annual fee and removed some of the restrictions on licensees, which was
intended to encourage more small and medium-sized enterprises into the market. This suggests
that this market has become more contestable. However, the extent to which competition will
increase may vary in different segments of the market. Delivering mail to an isolated croft in

the Scottish Islands is not going to be as attractive as delivering mail to businesses in a
metropolitan area such as London. The Royal Mail continues to have an obligation to make
deliveries across the entire UK. It was privatised in 2013.

e Aircraft manufacture is an example of a market that cannot be contestable. The barriers to
entry are substantial and the fixed costs of joining the market are enormous. Indeed, the
surprise is that there are still two firms (Boeing and Airbus) operating in the market for
commercial aircraft. Indeed, it is probable that without some form of state assistance, one or
other of these giants would have exited the market.
Case study 15.1

Competition in oligopolistic markets
a Joint profits would be highest if the firms both set a high price, acting as if they were a joint
monopoly. This could be achieved if each firm had trust in its rival to believe that it would not
try to set a lower price and therefore come to dominate the market.
b It does not seem very likely that this outcome will be reached. The temptation to set a lower
price and sweep up the market is great, given the profits that would result. Each firm will see
that the other firm faces this temptation, and will therefore want to guard against it happening.
The likelihood is therefore that both firms will go for a low price, accepting that they will
make lower profits in this situation.
c The issue is whether all of the restaurants would be able to agree to work together in setting
their prices. It would only need one of them to depart from the agreement to trigger a price
war. It could also depend upon whether the restaurants are producing similar types of food, or
whether they are able to differentiate themselves. In practice the competition seems to be quite
fierce.

Part 5 The labour market

Chapter 16 The demand for labour
Exercise 16.1
a See column three in Table A16.1. The marginal physical product of labour is calculated as the
change in output as labour input increases. Therefore the change between 1 and 2 units of
labour is 15 – 7 = 8 units of output. Notice that in the table this is located halfway between 1
and 2.
Table A16.1 Marginal physical and marginal revenue product of labour
Labour Output Marginal Marginal

input per (goods per physical revenue
period period) product product
0 0
7 35
1 7
8 40
2 15
7 35
3 22
5 25
4 27
2 10
5 29
b See column four in Table A16.1. The marginal revenue product of labour is the additional
revenue that the firm receives from selling the additional output that is produced by hiring an
additional unit of labour. In this case, the firm is operating in a perfectly competitive market,
and receives the same price for each unit of output sold. Marginal revenue is therefore
constant at £5, so column four is simply column three multiplied by 5.
c In Figure A16.1 the profit-maximising level of labour input is where the wage equals the
MRPL, which is at 3 units of labour.
£ 45
40
35
Wage
30
25
20
15
MRPL
10
5
0
1 2 3 4 5 6
Units of labour
Figure A16.1 The marginal revenue product of labour

d See Table A16.2.

Table A16.2 Total revenue, total cost and profit
Labour input Output Total revenue Total cost Profit

1 7 35 40 –5
2 15 75 70 5
3 22 110 100 10
4 27 135 130 5
5 29 145 160 –15
Exercise 16.2
a A fall in the selling price of a firm’s product reduces the marginal revenue product. Figure
A16.2 shows that the MRPL shifts from MRPL0 to MRPL1, and with the wage (the marginal
cost of labour) unchanged, the amount of labour employed falls from L0 to L1.
MCL
W*
MRPL0
MRPL1
L1 L0 Quantity
of labour
Figure A16.2 A fall in the selling price of a firm’s product
b The adoption of improved work practices that improve labour productivity increases the
marginal physical product, which in turn affects the marginal revenue product of labour. This
time the MRP curve shifts to the right. In Figure A16.3, there is a move from MRPL0 to
MRPL1, and with the wage (the marginal cost of labour unchanged), the amount of labour
employed rises from L0 to L1.
£
MCL
W*
MRPL1
MRPL0
L0 L1 Quantity
of labour
Figure A16.3 An increase in labour productivity

c An increase in the wage raises the marginal cost of labour to the firm, as shown in Figure
A16.4, where the wage increases from W0 to W1. The effect is that there is a move along the
MRPL, with the amount of labour employed falling from L0 to L1.

£
MCL1
W1
MCL0
W0
MRPL
L1 L0 Quantity
of labour
Figure A16.4 An increase in the wage rate
d To the extent that an increase in demand for the firm’s product leads to a rise in the selling
price of the product, there will be a rightward shift of the MRPL, similar to the situation that
was shown in part b of this question.
Chapter 17 The supply of labour

Exercise 17.1
There are three possible options that apply in this exercise.
Figure A17.1 shows an increase in labour supply (i.e. a shift in the curve to the right).
Figure A17.1 An increase in labour supply

Figure A17.2 shows a decrease in labour supply (i.e. a shift in the curve to the left).

Figure A17.2 An decrease in labour supply
Figure A17.3 shows a movement along the labour supply curve.
Figure A17.3 A movement along the labour supply curve
a An increase in the number of engineering graduates is an increase in supply (Figure A17.1).

b If the wage rate rise there will be an extension of supply (a movement up along the labour
supply curve), as shown in Figure A17.3.
c An increase in the wage paid to web designers will induce some computer programmers to
switch, so there will be a decrease in labour supply of computer programmers, as in Figure
A17.2.
d If qualifications are tightened, there will be a decrease in labour supply (Figure A17.2).

e An improvement in non-pecuniary benefits will encourage an increase in labour supply
(Figure A17.1).

f An epidemic that causes a decrease in the size of the working population results in a decrease
in labour supply (Figure A17.2). This is what happened across much of sub-Saharan Africa in
the HIV/AIDS epidemic.
Chapter 18 The interaction of labour markets

Exercise 18.1
If a firm experiences a fall in the selling price of its product, this reduces the marginal revenue
product of labour, so the demand curve for labour will shift to the left. This is shown in Figure
A18.1. Demand shifts from Dl0 to DL1, and the result is that there is a fall in the equilibrium wage
rate and a fall in the quantity of labour employed.
Figure A18.1 A fall in the selling price of a firm’s product
Exercise 18.2
a The demand for labour is given by the marginal revenue product of labour curve (MRPL).
Under perfect competition, the average cost of labour curve ACL represents the supply curve
of labour, so equilibrium is where supply equals demand, with the wage rate at OC, and the
quantity of labour employed OJ.
b As a monopsony, the employer is the sole buyer of this sort of labour, and will employ labour
up to the point where the marginal cost of labour equals the marginal revenue product.
Because the firm is a monopsony, its marginal cost of labour is higher than the average cost.
In other words, as it hires more labour, it must offer higher wages not only to the additional
workers that it hires, but to its existing labour force as well. It therefore hires OH workers, at a
wage of OF.
c The area OFGH is the wage bill — the wage paid multiplied by the quantity of labour.
d This generates a surplus to the firm given by the area FABG.

Exercise 18.3
I cannot know how you will respond to this question, as I don’t know when you will be tackling

it. If I were tackling it now, I would discover strike action on the trains, with unions protesting at
the removal of guards from train services, but also some pay claims, such as hospital cleaners.
Exercise 18.4
a The effects of immigration are shown in Figure A18.2. The increased number of people means
an increase in labour supply from S1 to S2, and a fall in the equilibrium wage from W1 to W2.
£ S1
S2
W1
W2
Demand
L1 L2 Quantity
of labour
Figure A18.2 The effect of immigration
b A reduction in the rate of the Jobseeker’s Allowance has a similar effect, in that when the
Jobseeker’s Allowance is low, the opportunity cost of unemployment is high, and more people
will be prepared to accept jobs — which can be seen as a rightward shift in labour supply.
c An improvement in technology that raises labour productivity will increase the marginal
productivity of labour, causing a rightward shift in the demand for labour curve. This is shown
in Figure A18.3, where demand increases from D1 to D2, the equilibrium wage increases from
W1 to W2, and the quantity of labour demanded also rises, from L1 to L2.
£
Supply
W2
W1
D1 D2
L1 L2 Quantity
of labour
Figure A18.3 The effect of an improvement in labour productivity

d A new health and safety regulation raises firms’ labour costs. In Figure A18.4, the effect is to
move labour supply, by the cost of the regulations (assumed to be C). The firm will therefore
employ fewer workers (L2 instead of L1), and offer a lower wage (W2 instead of W1). As it is

the firm that incurs the additional cost, the supply curve S still shows the amount of labour that
workers are prepared to supply at any wage, which is why the new equilibrium wage is W2.
£
S+C
S
W1
W2
Demand
L2 L1 Quantity
of labour
Figure A18.4 The effect of health and safety regulation
e As people are retired, the size of the working population falls, reducing labour supply. This is
shown in Figure A18.5. Here the supply curve moves from S1 to S2, the equilibrium wage
increases from W1 to W2, and the amount of labour employed falls, from L1 to L2.
£ S2
S1
W2
W1
Demand
L2 L1 Quantity
of labour
Figure A18.5 A fall in labour supply
Case study 18.1

Valuing professional footballers
a The marginal revenue product of a player is the additional revenue received by the club that
signs him.
b By saying that team revenues tend to be win-elastic, the author is arguing that the revenues
received by a club are sensitive to whether the team wins. Wins bring extra revenue.

c This phrase refers to the fact that top players can bring revenue to the club through their
activities off as well as on the field. David Beckham is a prime example because of his high
profile off the pitch.

d The most skilled footballers are in inelastic supply because of their innate talent and ability.
This coupled with the high MRP helps to explain why they should command high wages.
Notice that there may be many difficulties in trying to estimate the MRP in practice. For example,
there may be externality effects, where one player may perform better in partnership with another.
This makes it difficult to isolate the incremental impact of a player on overall team performance.

Section 2 Macroeconomics

Part 6 Aggregate demand and aggregate supply
Chapter 19 The circular flow of income and aggregate
demand
Exercise 19.1
a The overall level of prices in an economy is an example of a macroeconomic phenomenon.
b The price of ice cream is microeconomic in nature.
c The overall rate of unemployment in the UK is a macroeconomic variable.
d The unemployment rate among catering workers in Aberdeen is microeconomic in character.
e The average wage paid to construction workers in Southampton is also a microeconomic
phenomenon.
Exercise 19.2
a Aggregate demand is C + I + G + X – M
which is 75 + 30 + 25 + 50 – 55 = 125.
b The trade balance is given by exports minus imports, which is 50 – 55 = –5.
Exercise 19.3
a True.
b True.
c False. A fall in the average/overall price level in an economy is likely to be associated with
changes in the pattern of demand: the demand for some goods and services will increase but
for others it may stay the same or fall.
d False. Although government expenditure is indeed regarded as autonomous, it does not affect
the shape of the aggregate demand curve, but its position.
e True, given that interest rates tend to be relatively low when prices are relatively low (see page
274 of the book).
f False. Consumption expenditure tends to be the largest component by quite a long way.
Case study 19.1

Investment and the financial crisis
a In the lead-up to the financial crisis, which began to take effect in 2008, investment had been
between 17 and 17.5% of GDP. However, as the crisis unfolded, investment fell, reaching just
over 15% of GDP by 2009. This reflected the turmoil in financial markets, with the banks
struggling to carry on their business and reluctant to lend. Even firms that wanted to borrow
for investment found it difficult to obtain loans. After 2009, investment began to recover, but
slowly. By 2017 investment was still below 17%.

b Interest rates hit an all-time low during and after the crisis. We would normally expect this to
boost investment, as low interest rates mean a low cost of borrowing. However, investment
also depends upon the willingness of banks to lend, and on the view that firms take about the

future direction of the economy. With all the uncertainty that came with the crisis, firms are
likely to have formed weak expectations about the future prospects for the economy, so may
have been reluctant to invest. One thing you will see as you proceed with your study of
macroeconomics is that we are always looking to explain real-world events — but there are
rarely single or simple explanations. The truth is a combination of different influences.
Chapter 20 Aggregate supply and the interaction of

aggregate demand and supply
Exercise 20.1
a The discovery of a new source of a raw material that reduces its price will lower costs and
enable firms to supply more output at any given price, so the SRAS curve will shift to the
right.
b An increase in the exchange rate (ceteris paribus) has a major impact on aggregate demand, by
reducing the competitiveness of domestic exports. However, there may also be a supply-side
effect, because an appreciation of the exchange rate reduces the domestic price of imports, so
firms that rely on imported intermediate goods may find that their costs have decreased,
encouraging them to supply more output at any given price.
c An increase in wage rates (i.e. in labour costs) means that firms will be prepared to supply less
output at any given price, so the SRAS curve would shift to the left.
d A fall in oil prices reduces firms’ costs, so they are prepared to supply more output at any
given price, and the SRAS curve shifts to the right.
Exercise 20.2
a A fall in the exchange rate that affects the prices of imported inputs would raise the costs
faced by firms, so in the short run, aggregate supply will shift to the left. Whether the shift will
also affect the long-run aggregate supply curve is less clear, as the fall in the exchange rate
may be only temporary, depending on what caused it. It is likely that the exchange rate will
readjust in the long run.
b An increase in the rate of immigration allows the workforce to expand, and should shift the
long-run aggregate supply curve to the right, as there has been an increase in the potential
capacity of the economy.
c An increase in the price of oil would shift the short-run aggregate supply curve to the left, as it
increases the costs firms face. The price of oil has shown fluctuations over the years, so it may
well be that the increase will not be long-lasting.
d A reduction in corporation tax improves the profitability of firms, so a rightward shift in
aggregate supply would be expected. If this is a permanent change, then long-run aggregate
supply would be affected.
e The introduction of new and improved computers reduces costs faced by firms and raises
productivity, expanding the long-run ability of the economy to produce. Long-run aggregate
supply shifts to the right.

Exercise 20.3
a A technological advance that improves the efficiency of capital raises the productive capacity

of the economy and shifts the aggregate supply curve to the right, as in Figure A20.1a, where
aggregate supply moves from LRAS0 to LRAS1. Initially the equilibrium general price level
was P0 and real output was Y0. After the supply shift the general price level falls to P1 and real
output (GDP) rises to Y1. Figure A20.1b shows that the effects are very similar if the starting
position of the economy is in the more elastic part of aggregate supply. Don’t forget that the
elasticity of aggregate demand is also important in determining the outcome.
Figure A20.1a A supply shock
Figure A20.1b A supply shock revisited
b If a financial crisis reduces the demand for exports, the impact is on aggregate demand. Figure
A20.2a illustrates the effects. Aggregate demand shifts from AD0 to AD1. The result is a large
fall in the general price level, from P0 to P1, but no change in real GDP. When the starting
position of the economy is further to the left, as in Figure A20.2b, the effect is felt in output as
well as in in prices, as the aggregate supply curve is more elastic.

Figure A20.2a A shift in aggregate demand
Figure A20.2b A shift in aggregate demand again
c If firms increase their investment spending because they are more optimistic about future
demand for their goods, the aggregate demand curve shifts to the right, as in Figure A20.3.
Figure A20.3 A rightward shift in aggregate demand

When aggregate demand moves from AD0 to AD1, the general price level rises from P0 to P1,
but real GDP remains at Y0. The effect here is only on price than on output because the
economy starts at full capacity. If, as in the previous question, the initial equilibrium had been

further to the left — in the elastic section of the aggregate supply curve — the effect on output
would have been apparent. Notice that if the increase in investment spending leads to an
increase in productive capacity, then the long-run effect is a shift of the LRAS curve as well.
d If the introduction of new health and safety legislation increases the costs faced by firms, this
will induce them to supply less output at any given price level, and the aggregate supply curve
will shift to the left, as in Figure A20.4. Following a shift of aggregate supply from LRAS0 to
LRAS1, the general price level rises from P0 to P1 and real output falls from Y0 to Y1. Again,
starting the economy off further to the left makes little difference to the result.
Figure A20.4 A negative supply shock
Notice that the starting position is more important for a demand change than for a supply
shock, as the key issue determining whether it is the general price level or the level of real
output that is affected is the elasticity of the aggregate supply curve, i.e. a move along the
supply curve following a demand shock.
Case study 20.1

The importance of expectations
a The passage describes a number of different factors affecting the economy at the time. For one
thing, oil prices were being pushed to all-time high levels, and other world commodity prices
were also being pushed up because of various pressures, in particular those arising from the
rapid growth of China’s economy. One effect of these changes was to increase the costs faced
by firms in the UK. This would be expected to mean that firms would be prepared to supply
less output at any given price level. If this is the case, the result would be a leftward shift of
the LRAS curve. This is shown in Figure A20.5 as a shift from LRAS0 to LRAS1.

Figure A20.5 Changes in AD and LRAS
However, there were also things happening to affect the position of aggregate demand. These
are set out in the second paragraph. Business confidence was reported to be low, and people
were expecting a recession to affect the economy. In addition, house prices were falling.
b As for the impact of Brexit, this may depend on decisions and events that are happening even
as you are reading this and thinking about the question, which makes it hard for me to
comment.
Chapter 21 The multiplier and the accelerator

Exercise 21.1
If households save 20% of additional income and spend 10% on imports, with a marginal tax rate
of 10%, the marginal propensity to withdraw is 0.2 + 0.1 + 0.1 = 0.4, so the multiplier is 1/mpw =
1/0.4 = 2.5.
If the marginal tax rate increases to 20%, the mpw is now 0.5, and the multiplier is 2.
Therefore, an increase in the marginal tax rate reduces the size of the multiplier.
Exercise 21.2
a Saving by households is a leakage — an increase in saving triggers a negative multiplier
effect.
b Expenditure by central government is an injection — an increase triggers a positive multiplier
effect.
c Spending by a country’s residents on imported goods and services is a leakage — an increase
triggers a negative multiplier effect.
d Expenditure by firms on investment is an injection — an increase triggers a positive
multiplier effect.
e Spending by overseas residents on home-produced goods and services is an injection — an
increase triggers a positive multiplier effect.
f Income tax payments are a leakage — an increase triggers a negative multiplier effect.

Exercise 21.3
a Figure A21.1 illustrates the situation.

Figure A21.1 A negative output gap
The economy starts in equilibrium with aggregate demand at AD0. Real GDP in this
equilibrium is below full employment, and the output gap is Y0 – YFE. A further decrease in
aggregate demand to AD1 takes the economy further from full employment GDP, and the
output gap widens to Y1 – YFE. Under Keynesian assumptions, the economy can remain in this
position.
b Under neoclassical assumptions, the story would be different, because the LRAS curve would
be vertical at the full employment level of real GDP, and the economy would be expected to
adjust back to YFE.
Figure A21.2 shows how this would work. If the economy were operating with a negative
output gap at the beginning of the process, it would have to be temporarily showing real GDP
below full employment. In the figure this could have been at Y0, at the intersection of AD0 and
the short-run aggregate supply curve SRAS0. The decrease in aggregate demand from AD0 to
AD1 would move the economy to a new temporary equilibrium along SRAS0 with real GDP at
Y1 and price level P1. However, firms would react to the lower price level, which would reduce
their costs, and the SRAS curve would shift to the right to SRAS1, where full employment real
GDP (YFE) is restored with a price level P2.

Figure A21.2 A negative output gap with a neoclassical LRAS curve

Part 7 Economic policy objectives

Chapter 22 Economic growth
Exercise 22.1
a An increase in the rate of change of potential output is genuine economic growth, and would
be represented by an outward movement of the PPC, or a rightward shift of the aggregate
supply curve.
b A fall in the unemployment rate is a move towards the PPC, so is only short-run economic
growth. It is remedying a former inefficiency in the labour market.
c Improved work practices that increase labour productivity are regarded as long-run economic
growth, as this entails an outward movement of the PPC, or a rightward shift of the long-run
aggregate supply curve.
d An increase in the proportion of the population joining the labour force is the equivalent of an
increase in the size of the labour force, and represents an increase in the productive capacity of
the economy, i.e. a rightward shift of the long-run aggregate supply curve. Therefore, it is
long-run economic growth.
e An increase in the utilisation of capital is a movement towards the PPC, as it does not entail
an increase in the potential productive capacity of the economy — in other words, it is simply
removing a productive inefficiency. Just as a reduction in unemployment means better use of
existing labour input, so an increase in capacity utilisation entails the better use of existing
capital. This is short-run economic growth.
f A rightward shift of the long-run aggregate supply curve is an increase in potential productive
capacity — and is exactly what is meant by long-run economic growth.
Exercise 22.2
See Table A22.1.
Table A22.1 The growth of real GDP in the UK
Year Real GDP Growth rate of real GDP

(% p.a.)
2005 1,676 —
2006 1,717 2.45
2007 1,758 2.39
2008 1,749 −0.51
2009 1,676 −4.17
2010 1,704 1.67
2011 1,729 1.47
2012 1,755 1.50
2013 1,791 2.05
2014 1,845 3.02
2015 1,889 2.38
2016 1,925 1.91
2017 1,960 1.82

Growth was at its highest from 2013 to 2014, when real GDP grew by 3.02%. It was at its lowest
between 2008 and 2009, when real GDP fell by 4.17%.

Exercise 22.3
No doubt you will have discussed a range of potential benefits and costs associated with
economic growth. Economic growth enables an increase in the standard of living of the
inhabitants of a country, but this needs to be balanced against the potential costs, for example in
terms of the need to ensure sustainability. It is also important to be able to explore whether the
population as a whole is benefiting from economic growth, or whether the benefits are largely
going to a wealthy elite.
Case study 22.1

China’s economic growth
a Central planning has been seen as a costly and inefficient way of allocating resources, which
has often resulted in large production and allocative inefficiency. By allowing market forces to
influence the allocation of resources, some of these inefficiencies are likely to be squeezed out
of the system, therefore allowing resources to be more effectively used, and leading to a
rightward shift of the aggregate supply curve.
b The problem with cross-border externalities is in negotiating an acceptable form of
cooperation between the parties. China’s relations with its neighbours have not always been
friendly, as there is a history of tension and conflict between them. However, China has
acknowledged that there is an issue with air pollution, both within its own cities and in relation
to its neighbours. Joint discussions have taken place between the three countries, and China
has committed itself to taking action.
c This is a highly contentious issue, with no ready solution. Rising car ownership may
contribute to rising carbon dioxide emissions, which may then contribute towards climate
change and global warming. However, from China’s perspective, they are a relatively young
economy with relatively low average incomes and a high poverty rate. Why should they not be
able to benefit from rising incomes when countries that developed in earlier periods were able
to grow with less concern for the environment? China can also point to the fact that the
lifestyles enjoyed by people in the already developed countries also contribute to global
warming, but Americans continue to drive gas-guzzling cars. There is no easy answer to this.
Chapter 23 Development
Exercise 23.1
A first point to notice in the table is that both countries have similar levels of GNI per capita,
although Country A’s is marginally higher. However, on all of the other indicators, Country B
performs significantly better, especially in relation to the poverty headcount, but also in adult
literacy, life expectancy and infant mortality.
This very clearly indicates the danger of relying only on GNI per capita as an indicator of relative
living standards in the two countries.
In part, these differences may reflect differing emphasis given to policy objectives in the two
countries. It could be, for example, that country B has devoted more of its resources to health and
education, rather than to achieving economic growth. Or it may be that the HIV/AIDS epidemic
has had a devastating impact on the standard of living in Country A. We cannot really tell from
these data alone.
If you were exploring these countries in more depth, it would also be helpful to have some idea of
how incomes are generated, by finding out about the balance of different economic activities in

the two economies. Furthermore, you would want to find out why poverty is so prevalent in
Country A, given its GNI per capita level.

Exercise 23.2
I don’t know which country you chose to look at, but I chose to look at South Africa. The data
show that GNI per capita is out of line with other indicators, especially health-related measures.
Exercise 23.3
Picking the country with the highest GNI per capita looks fairly straightforward, as Country C
shows lower life expectancy, low flows of foreign direct investment, high levels of
unemployment, HIV/AIDS and infant mortality. The other two countries are perhaps more
closely aligned on the indicators shown, and you may have found it more difficult to choose
which would have the lowest GNI per capita. However, did you get things right? A point made in
the textbook is that there is considerable diversity among countries in terms of the configuration
of characteristics they display. It was also emphasised that GNI per capita does not always
provide a true picture of the relative living standards across countries. In the table, Country A is
Madagascar with the lowest GNI per capita at PPP$1,440. Country B (Kenya) had more than
double Madagascar’s GNI per capita, at PPP$3,130. Country C (Swaziland) has by far the highest
GNI per capita, at PPP$7,980, showing how misleading the GNI per capita level can be. Clues
that might have given Country C away are the relatively low dependence on agriculture, and the
very high prevalence of HIV/AIDS, which has a knock-on effect on other indicators.
Case study 23.1

Wildlife tourism
a A danger with introducing tourism into an area is that the construction of roads and other
infrastructure may cause damage to wildlife habitats, and the intrusion of tourists may
interfere with the lives of the animals that they come to see. The more tourists that visit, the
greater this danger may become. Interfering with local ecosystems may even cause the demise
of some species of fauna or flora, therefore affecting biodiversity.
b Visiting tourists are likely to bring their own lifestyles and consumption habits, which could
mean that local people see them as (inappropriate) role models. Tensions could arise because
of the income differences between the visitors and the local population. The promotion of
tourism also carries an opportunity cost, in that funds used to provide infrastructure could have
been used for other development projects.
c Local communities may benefit in many ways from tourist activity. They can take advantage
of improvements to roads and other aspects of the infrastructure. The tourists may provide a
market for goods and services provided by people in the local community, and there may be
multiplier effects that flow from this.
d It is tempting to think that less developed countries (LDCs) that are heavily reliant on
agriculture or other primary goods need to industrialise in order to achieve economic growth
and human development. However, there are potential benefits from developing service sector
activities that have the potential for earning foreign exchange, which can contribute to the
growth process.

Chapter 24 Employment

Exercise 24.1
Remember that the working population is made up of three groups: those in employment, the
unemployed and the economically inactive. We can therefore calculate the number of
unemployed as the population minus the employed and the economically inactive. For Greece in
late 2017, this is 6,885 – 3,706 – 2,193 = 986 (thousands).
The percentage unemployment rate is calculated as the number unemployed as a percentage of
the labour force (i.e. those employed plus the unemployed). So, the unemployment rate in this
example is 100*986/(3,706 + 986) = 21%.
This sounds really high, but Greece in 2017 was still recovering from a deep recession.
Exercise 24.2
a If unemployment arises as a result of the decline of the manufacturing sector and the
expansion of financial services, this is regarded as structural unemployment. Manufacturing
and financial services require quite different skills, and former factory workers cannot become
international bankers without some considerable retraining. In other words, this is
unemployment that arises from changes in the structure of economic activity within an
economy. It is involuntary unemployment.
b When a worker leaves one job to search for a better one, this is frictional unemployment,
and is part of the proper working of the labour market. This is voluntary unemployment.
c Unemployment that occurs in the trough of the economic cycle is cyclical unemployment.
d If the real wage is held above the labour market equilibrium there is excess supply of labour,
and therefore unemployment. The root cause is the sluggishness of the labour market in
reaching equilibrium — or it may be caused by trade union action holding wages above the
market equilibrium level. In some circumstances the imposition of minimum wage legislation
can have a similar effect in some segments of the labour market. This sort of unemployment is
involuntary, as workers would like to take jobs at the going wage rate but cannot find
employment.
e This is seasonal unemployment.
f If unemployment arises from a slow adjustment to a fall in aggregate demand, this may be
regarded as demand-deficient unemployment. It should fade away once wages adjust to the
equilibrium level.
g When low-paid jobs offer less than a worker can obtain in unemployment benefit, the worker
may choose to remain unemployed. This is voluntary unemployment, and arises where
benefit levels are over-generous relative to wages. Changes in the eligibility requirements for
unemployment benefit have attempted to eliminate this sort of unemployment.
Exercise 24.3
I cannot comment on your answer here, as I do not know when you will be accessing the data.
Case study 24.1

The cost of unemployment
a In evaluating the costs of unemployment from society’s perspective, you need to balance the
negative effects (such as lost output or civil unrest) against the positives (such as the need to
have a flexible labour market).

b Again, the issues for discussion will need to cover the distinctions between short and long
periods of unemployment, and the voluntary/involuntary aspects of unemployment. There is
also the need to find a balance between protecting the vulnerable by providing benefits, and

the need to give appropriate incentives for people to work and contribute to society.
Chapter 25 Inflation
Exercise 25.1
a Table A25.1 shows index numbers based on March 2015 for each of the variables.
Table A25.1 Index numbers (March 2015 = 100)
Average petrol Average

price, South East supermarket
Oil price region petrol price
Date ($ per barrel) (£ per litre) (£ per litre)
March 2015 100.0 100.0 100.0
March 2016 64.5 92.2 91.3
March 2017 84.0 107.7 101.5
March 2018 107.0 107.9 106.3
Comparing the price of petrol in the South East region with the oil price, it is apparent that the
correlation between the two series is not strong. The oil price fell substantially (by 35.5%)
between March 2015 and March 2016, but petrol prices in the South East fell by only 7.8%.
By March 2017, oil prices had recovered somewhat, being only15% below the March 2015
level, but the petrol price in the South East was now 7.7% above the 2015 level. In March
2018, the differences compared with March 2015 were much less marked.
b Table A25.2 shows index numbers comparing the price of petrol in the South East with the
average supermarket price.
Table A25.2 Index of petrol prices in the South East compared with the average supermarket
price
Date Petrol price in the South East

(Index, average supermarket price
=100)
March 2015 101.7
March 2016 102.8
March 2017 107.9
March 2018 103.3
These index numbers show that petrol prices in the South East were higher than the average
supermarket price in each of the years, although the extent of the difference varied from year
to year, being at its highest in March 2017.
Exercise 25.2
a Table A25.3 shows inflation rates for each country from 2007 to 2016.

Table A25.3 Inflation (rate of change of CPI, % p.a.), 2007–16
Year UK USA Brazil

2007 2.35 0.74 3.62
2008 3.61 1.68 5.70
2009 2.11 1.76 4.85
2010 3.31 1.63 5.04
2011 4.50 3.20 6.60
2012 2.78 2.03 5.44
2013 2.61 1.42 6.23
2014 1.45 1.69 6.28
2015 0.00 0.00 9.06
2016 0.72 1.38 8.74
b See Figure A25.1.
Figure A25.1 Inflation in the UK, USA and Brazil, 2007–16
c Between 2006 and 2016, the percentage change in prices over the period was 26.0 in the UK,
16.6 in the USA and 81.5 in Brazil.
d All three countries demonstrate some variation in the inflation rate over this period — indeed,
both the UK and the USA experienced zero inflation in 2015. The USA showed a bit more
stability (less volatility) than the other two countries. However, Brazil clearly experienced the
strongest rise in prices over the whole period, and showed much higher inflation throughout.
The USA had the lowest overall increase in prices between 2006 and 2016.
Exercise 25.3
Deflation occurred in 2009, when prices fell by 0.5%. Disinflation occurred in 2008, when
inflation fell from 4.3% to 4.0%, and in 2009 when inflation fell from 4.0% to –0.5%. Inflation
took place in all years except 2009.
Exercise 25.4
If inflation rises to 15% per annum next year but incomes rise by the same percentage, then,
strictly speaking, the real purchasing power of income will not have changed, so why should
anyone be worse off?

One reason is that the costs of undertaking transactions have risen. Firms find that to keep pace
with changing prices they have to alter their prices more often — these are the menu costs of
inflation. In addition, people will tend to leave their money in the bank for longer than previously,

as there is a cost in holding money balances. They will therefore have to visit the bank or
cashpoint more often — these are the shoe-leather costs of inflation. These costs reduce the
efficiency with which markets are working, so there is some cost imposed on society as a result.
It is also possible that some people will lose out — say, if their incomes are not inflation-
protected. For example, pensioners or others on fixed incomes may find that their incomes do not
rise by the 15% needed for them to keep up with the rising cost of living. Therefore, there may be
redistribution costs of inflation.
More important is the case when high inflation also means less predictable inflation. If firms
become more pessimistic about the future, and revise downwards their expectations of future
demand, they may be less prepared to undertake the productive investment that would increase
the productive capacity of the economy. This may damage the rate of economic growth that can
be achieved within the economy. Many commentators regard this as the most serious cost of high
inflation.
Case study 25.1

The UK economy in mid-2008
Figure 25.5 (see page 356 of the book) shows inflation in the UK up to 2008, measured by the
rate of change of the consumer price index (CPI). Remember that the government has set a target
for inflation of 2% per annum, and if the inflation rate strays beyond one percentage point (in
either direction), the Bank of England has to write an open letter to the chancellor of the
exchequer explaining why it happened, and how it will be tackled. The first such letter had to be
written in March 2007, when inflation briefly rose above the 3% critical figure. The situation in
May 2008 seemed more severe, as inflation moved well above 3%, as you can see in the figure.
To what extent was this a major concern? From one perspective, it could be argued that the rise in
inflation partly reflected events occurring in the global economy — substantial increases in the
price of oil and rising food prices. It was a question of judgement as to whether these changes
would be long-lived, or just a temporary blip. On the other hand, in the domestic economy, house
prices were falling, following the so-called ‘credit crunch’, and expectations about the future were
looking gloomy.
Furthermore, Figure 25.6 (see page 356 of the book) shows an alternative view of the economy.
This shows the unemployment rate, and the data do not seem to show any major cause for
concern.
In order to come to a full judgement about the economy’s performance, it is important to have
information about other aspects of the domestic and global economy, as it may be dangerous to
jump to conclusions on the basis of just two indicators. And, of course, the Bank of England’s
Monetary Policy Committee has regular discussions about the various aspects of the economy. It
is this extra commentary on the economy that informs the formation of policy.

Chapter 26 The balance of payments

Exercise 26.1
Table A26.1 The UK balance of payments, 2015 (£ billion at current prices)
Current account
Trade in goods –118.6
Trade in services +86.3
Investment income –42.8
Compensation of –0.1
employees
Current transfers –22.8
Current account –98.0
balance
Capital account
Capital transfers –2.0
Capital account –2.0
balance
Financial account
Net direct +76.1
investment
Transactions in –21.1
reserve assets
Total net portfolio +139.0
investment
Other transactions –103.1
in financial assets
Financial account +90.9
balance
Errors and omissions +9.2
Overall balance of payments 0
Note: The overall balance of payments actually sums to 0.1, because of a rounding error.
Case study 26.1

The UK balance of trade
a The significance of having the trade balance measured in current prices is that the data do not
take into account the effect of changing prices. As prices have risen during this period, the
data shown in the graph overstate the extent to which the deficit has increased, as part of the
increase is due to the higher prices.
b The changing economic structure is important. As manufacturing activity has declined and
service sector activity has increased, it is natural that the trade in goods should have declined,
whereas services have offset this effect.
c It is important to remember that the trade in goods is just one component in the overall balance
of payments, albeit an important one. Of more concern to the authorities is the overall picture.
You can get some feel for this by looking back at Figure 26.2 (see page 360 of the book),

which shows how the overall deficit on the current account is balanced by the surplus on the
financial account.

Chapter 27 Exchange rates
Exercise 27.1
I cannot offer helpful comments here, as I do not know when you will be undertaking the
exercise.
Exercise 27.2
a The sterling price if the firm buys in the USA is £100,000.
b The firm is likely to buy in the USA, as the UK price is higher at £125,000.
c However, if the exchange rate is devalued to £1 = $2, the US price is now £150,000, although
the dollar price is unchanged.
d The firm will now buy in the UK, as the devaluation has made British goods more
competitive.
e With the improvement in competitiveness of British goods in international markets, we would
expect to see an increase in the demand for exports, and a fall in demand for imports
accompanied by an increase in the domestic demand for goods that are import-competing. The
key question is whether British firms will be able to respond to these changes, or whether the
effect will be to put pressure on domestic prices. In other words, the short-run elasticity of
supply of British goods is crucial in determining the impact of devaluation on the current
account of the balance of payments. It is possible that there will be a J-curve effect, whereby
the current account improves only after a time lag.
Exercise 27.3
The three statements capture the key arguments that have been advanced in examining whether
fixed or floating exchange rates are recommended for a country.
A floating exchange rate system is fairly robust in the face of external shocks, enabling
adjustment to take place through movements in the exchange rate, rather than through output and
employment. Fixed exchange rates force governments to intervene to support the currency in
response to an external shock, which can lead to increasing unemployment and slower growth.
On the other hand, with a fixed exchange rate system, there is more certainty about future trading
conditions — unless there is a devaluation, of course. Some countries in the euro area have
struggled in the crisis and subsequent recession because they were unable to adopt independent
policies — being a member of the euro area means that monetary policy is set by the European
Central Bank, leaving little scope for manoeuvre by individual nations. The monetary policy
stance that is appropriate for Germany may not suit Greece.
You should discuss these issues with your fellow students, and come to a view about the
questions.
Case study 27.1

Balancing the balance of payments
a From China’s point of view, there are some clear benefits, as mentioned in the passage — the
low exchange rate means that China’s exports remain highly competitive, and makes China an
attractive destination for foreign direct investment. However, there are some risks attached to
this strategy. China had been growing very rapidly and needed to export to find a market for
its expanding production. If the economy were to slow down, this could prove costly for the

domestic economy. Furthermore, the high dependence on exports had meant that domestic
consumption had taken a relatively small share of GDP, so not all of China’s population had
been benefiting from the growth.

Some commentators have therefore argued that China should have allowed its exchange rate
to appreciate partly to enable the economy to grow at a steadier pace, and partly to enable
more domestic consumption. Another possible risk is that by accumulating so many US
government securities, China becomes vulnerable to an adverse movement in the value of the
US dollar, which could reduce the value of China’s holdings. In the period since 2006, China
has allowed its currency to appreciate — but only relatively slowly.
b From the USA’s point of view, China’s actions allowed the USA to run a large and persistent
current account deficit. Furthermore, with China demanding US Treasury Bills, interest rates
in the USA had been relatively low, which facilitated a consumer boom based on borrowing.
However, there has been intense lobbying from within the USA from people who argue that
cheap imports from China have led to a loss of jobs in the USA. This is a contentious issue, as
in general economists have argued that there are potential gains to be made from international
trade.
c An indirect effect of the strategy was that US interest rates were lower than they would
otherwise have been. This may have contributed to high consumer spending and the housing
boom, which built into a bubble that was bound to burst at some point.
d The actions of President Trump illustrate the legacy. He has accused China of adopting
policies that have affected jobs in the USA. In response, he imposed tariffs on a wide range of
goods imported from China, later extending these to Europe, provoking further response.
Chapter 28 Trends in macroeconomic indicators

Exercise 28.1
It is not possible for me to comment on your response to this question, as I do not know when you
will be carrying out the exercise.
Exercise 28.2
I cannot comment on this exercise, as I do not know when you are undertaking it, nor which
countries you have chosen to discuss.
Case study 28.1

The UK’s productivity puzzle
a Productivity is a measure of the efficiency of production. If productivity is low in one country
compared to another, then production costs will tend to be higher, so relative prices will also
be higher. Ceteris paribus, international competitiveness will be lower as a result. Low
productivity may also be reflected in poor quality and design, rather than just in price —
again, this will affect competitiveness.
b One argument put forward for the way in which productivity fell below trend after the
recession is that firms acted in just this way, keeping workers in employment even when
output was falling. This then has a dampening effect on productivity measures. One rationale
for this would be that rehiring costs could be high. However, this does not provide a full
explanation for the very slow recovery of productivity levels when output began to increase
again.

c This is a big question, and only time will tell whether problems will arise. If the UK is
successful in building new trading relationships, then it could be that there will be new trading
partners from which to learn.

d The development of human capital is likely to be key to achieving productivity growth.
Education and training is an important factor in allowing new best practice techniques of
production and new technology to bring efficiency gains.
Chapter 29 Income distribution and welfare

Exercise 29.1
Table A29.1 shows the ratios of top decile to bottom decile and top quintile to bottom quintile,
together with the results for the UK and Norway, for comparison purposes.
Table A29.1 Decile and quintile ratios
Country Ratio of top decile to Ratio of top quintile to

poorest decile poorest quintile
South Africa 57.0 27.6
Belarus 5.8 3.9
UK 8.5 5.3
Norway 5.8 3.8
These calculations seem to suggest that South Africa is characterised by much higher inequality
than any of the countries considered so far. The ratios of top decile (quintile) to bottom decile
(quintile) for South Africa are far larger than for the other countries, reflecting the fact that the
richer households in South Africa receive a far greater percentage of household income — and
the poor a far smaller share. In contrast, Belarus shows a more equitable distribution than the
other countries.
These results are confirmed by the Lorenz curves shown in Figure A29.1, with those for the UK
and Brazil drawn for comparison. This shows that the Lorenz curve for South Africa is much
further from the equality line, and the one for Belarus is much closer. You might like to compare
this figure with Figure 29.1 (see page 398 of the book). In that figure, Brazil was included as an
example of a country with substantial inequality.
Figure A29.1 Lorenz curves

I hope you noticed that when you drew the Lorenz curves for South Africa and Belarus, you had
to be careful with the arithmetic at the bottom end of the distribution. In order to compile the data
for the Lorenz curve you need to calculate the cumulative percentages. However, the ‘lowest

decile’ is part of the ‘lowest quintile’ — so for South Africa you should have plotted the sequence
of points shown in Table A29.2.
Table A29.2 Coordinates for the Lorenz curve for South Africa
Cumulative % of households Cumulative % of household income

0 0
10 0.9
20 2.5
40 7.2 (2.5 + 4.7)
60 15.2 (7.2 + 8.0)
80 31.1 (15.2 + 15.9)
90 68.8 (31.1 + 48.7)
100 100
Exercise 29.2
a If the prime concern is to reach the most needy, the funds would be channelled to group 2,
bringing the income of individuals in this group up from $250 to $300 per person.
b The best way of raising the incomes of people to the poverty line is to channel the funds to
group 1, raising their incomes from $450 to $500 and thereby halving the number of people
living below the poverty line.
c The strategy that has the biggest impact on the poverty line has the effect of neglecting the
most needy in society. If the objective is to help those most in need, setting the target in terms
of the poverty line causes policy to be misdirected, as the poverty line ignores the intensity of
poverty.
A similar sort of argument has come into play at national level, where there is a choice to be
made in directing overseas assistance. The question here is whether to direct aid at the
countries most in need of assistance, or to direct it to the countries best equipped to make use
of the funds.
Exercise 29.3
The UK has been committed to devoting 0.7% of GDP to overseas assistance since 1974, but it is
only relatively recently that it has actually achieved the target. Given the funding problems with
the NHS, education and student loans (to mention a few), there has been pressure on many
spending items, and in 2018 a proposal was put forward to alter the definition of the items that
constitute aid, which would have made it easier to reach the committed target. I am sure that your
discussion will have explored the question of how to reconcile different commitments and how to
balance domestic and external commitment, but I will not try to influence the outcome of your
discussions.

Case study 29.1
Inequality and economic growth

a The key causes of inequality include:
● inequality in the distribution of assets, including land or mineral resources
● inequality in the distribution of wages
● a rural-urban divide
● differences in skill levels between individuals
● differing access to education etc.
b Wealth confers economic power of those in possession of it. Ownership of assets such as land,
mineral resources, property or financial assets generates income, which entrenches the
position of the wealthy in the income distribution as well.
c Inequality in income and/or wealth can engender feelings of unfairness, which can turn into
distrust of those in authority, and civil unrest. The Brexit referendum vote partly reflected this
sense of unfairness and distrust of remote politicians. The period that followed was not the
most stable political environment that the UK has experienced…
d The question asks you to outline things in your own words, so I will refrain from doing it for
you!

Part 8 Implementing policy

Chapter 30 Fiscal policy
Exercise 30.1
Find out about the stance of the various political parties by checking out the manifestos produced
for the most recent general election. In particular, see what is said about the attitudes towards
taxation and public spending.
Exercise 30.2
In Figure A30.1a, the economy begins in equilibrium at the full employment level of real output
YFE, and with the aggregate demand curve at AD0. An expansionary fiscal policy moves the
aggregate demand curve to the right, to AD1, and the price level rises to P1.
You can see that in this situation fiscal policy cannot affect the equilibrium level of real output,
but merely pushes up the general level of prices in the economy.
Figure A30.1a The use of fiscal policy (1)
Figure A30.1b The use of fiscal policy (2)

By contrast, in Figure A30.1b, the economy begins in equilibrium with aggregate demand at AD0,
and with real output below the full employment level. Price is at P0. If fiscal policy is used in this
situation, it moves the aggregate demand curve to the right to AD1, and the new equilibrium

position, while still below full employment, has resulted in higher real output, which has
increased from Y0 to Y1. The general level of prices has also increased, from P0 to P1. However,
fiscal policy has now had some effect on real output, and has taken the economy closer to full
employment.
Notice that this analysis implies that the government must be very careful when framing fiscal
policy, and needs to know how close the economy is to full employment before using it in an
active manner. Policy-makers also need to be aware that fiscal policy measures do not take effect
instantaneously, so the policy must be designed to have an impact on the problems that the
economy will face in the future. The danger is that by the time the policy takes effect it will no
longer be necessary — or appropriate.
Exercise 30.3
Table A30.3 Average and marginal tax rates
Income (£) Tax paid (£) Average tax rate Marginal tax rate
(%) (%)
1,000 100 10 —
2,000 300 15 20
3,000 600 20 30
4,000 1,000 15 40
Case study 30.1

The HS2 project and the macroeconomy
a In the short run, the expenditure by government constitutes an increase in aggregate demand, so
the AD curve would shift to the right, as shown in Figure A30.2. The extent of the shift would
depend not only on the direct expenditures, but also would reflect multiplier effects. For
example, as part of the construction, workers would be hired who in turn would spend their
income, therefore resulting in a second round of spending, benefiting local shops and other
businesses.
Figure A30.2 An increase in aggregate demand in the short run

b In the long run, the benefits from the project should increase the productive capacity of the
economy through the cost savings of faster travel and the easing of capacity on other routes.

Figure A30.3 An increase in aggregate supply in the long run
Figure A30.3 shows the effect of an increase in aggregate supply from LRAS0 to LRAS1. The
full employment level of output rises from YFE0 to YFE1 and there is downward pressure on the
overall price level.
Chapter 31 Monetary policy

Exercise 31.1
The rate of interest affects aggregate demand through a number of channels. An increase in the
rate of interest affects investment by raising the cost to firms of borrowing — or the opportunity
cost of using internal funds for investment. Similarly, it affects consumers in their decision to
allocate income to either spending or expenditure. A higher rate of interest raises the cost of
borrowing funds, which may affect expenditure on consumer durables or on housing. The
increase may also raise the attractiveness of saving by raising the rate of return on saving. These
channels lead to a fall in aggregate demand. In addition, there may be indirect effects via the
exchange rate. If an increase in the rate of interest attracts funds from abroad, this will put upward
pressure on the exchange rate. An increase in the exchange rate then reduces the international
competitiveness of UK goods and services, so imports are likely to rise and exports will fall.
Again, the effect is to reduce aggregate demand.
Exercise 31.2
I cannot know when you are tackling this question, so I cannot help very much. It may be that the
Monetary Policy Committee (MPC) considered that the economy did not need intervention, so it
may have left bank rate unchanged. If the MPC considered that the inflation rate was accelerating,
it may have increased bank rate to reduce the pressure on aggregate demand and prices. Or it may
have been concerned about impending recession, and therefore decided to reduce interest rates to
encourage aggregate demand to increase.

Exercise 31.3
The fundamental aim of adopting a rules-based approach to fiscal and monetary policy is to

influence the expectations of economic agents.
In the case of fiscal policy, the adoption of a rule is designed to be a pre-commitment by the
government to exercise fiscal discipline. For example, this may assure voters that the incumbent
government will not manipulate government expenditure to curry favour in advance of an
election, perhaps by stimulating aggregate demand to bring about a reduction in unemployment at
the expense of higher inflation in the longer term.
In the case of monetary policy, setting an inflation target, and then delegating responsibility for
achieving the target to the central bank, again reduces uncertainty about the future so that
economic agents can form their expectations in the secure knowledge that inflation will not get
out of hand.
Case study 31.1

The Monetary Policy Committee
a The main channel of the monetary transmission mechanism is that a change in bank rate leads
to a change in other interest rates in the economy, which in turn affects aggregate demand via
both investment and consumption effects. These effects are reinforced indirectly through
movements in the exchange rate.
b The MPC may allow inflation to move beyond its target range in the light of factors that are
affecting the level of activity in the economy. For example, it might allow inflation to rise if
there was imminent threat of a recession setting in, or if it regarded the rise in prices as being a
temporary phenomenon that would drop away without intervention.
c The MPC influenced aggregate demand when bank rate was at a very low level by using
quantitative easing — effectively by increasing the availability of credit in the economy.
d Hopefully the discussion on the Bank of England website will have helped you to tackle this
question.
Chapter 32 Supply-side policy

Exercise 32.1
Under neoclassical assumptions, the LRAS curve is vertical at the full employment level, as
shown in Figure A32.1. If there is an increase in LRAS, the equilibrium full employment level
increases from YFE0 to YFE1, and if aggregate demand remains unchanged, the overall price level
falls from P0 to P1.

Figure A32.1 An increase in LRAS under neoclassical assumptions
Under Keynesian assumptions, if the initial equilibrium is below full employment, the effect is
different, as shown in Figure A32.2. Initially, equilibrium is at Y0 with a price level at P0. The
rightward shift in the LRAS curve results in a higher equilibrium real GDP at Y1 and a lower
overall price level at P1. Notice that the equilibrium level of real GDP remains below the (new)
full employment level after the change.
Figure A32.2 An increase in LRAS under Keynesian assumptions
Exercise 32.2
The key issue for debate here is how to balance the future benefits of improving the road network
against the present benefits of improving the NHS. People need healthcare in the present, but
improving the road network would help to keep British firms competitive by reducing transport
costs in the future.

Exercise 32.3
a An increase in government expenditure is primarily an example of fiscal policy. By increasing

expenditure, the government can influence the position of the aggregate demand curve.
However, if such a policy is introduced when the economy is already at full employment, the
only effect of rising government expenditure will be to increase the overall price level in the
economy. Some types of expenditure could also be part of supply-side policy, for example if
there is spending on retraining of workers.
b A decrease in the rate of unemployment benefit (ceteris paribus) will encourage higher labour
force participation, as some workers who previously have chosen to live on benefit will find
work more attractive. This constitutes a supply-side policy, as it directly affects aggregate
supply — with more workers in the labour force, the productive capacity of the economy is
increased. The effects can be seen in Figure A32.3: an increase in productive capacity
associated with a rightward shift of the aggregate supply curve from LRAS0 to LRAS1 leads to
an increase in real output from YFE0 to YFE1, and a fall in the general price level, from P0 to P1.
Figure A32.3 A shift in aggregate supply
c A fall in the rate of interest is an example of monetary policy. A fall in the interest rate is
seen as a fall in the cost of borrowing, and can be expected to encourage higher spending by
households and higher investment by firms. In the short run, this means a movement of the
aggregate demand curve to the right, and an increase in equilibrium real output and the general
price level. The extent to which the effect is felt in output and prices will depend upon whether
or not the economy begins at full employment. In the long run, a higher level of investment by
firms will lead to an increase in productive capacity, and a rightward shift of the aggregate
supply curve.
d Legislation to limit the power of trade unions is a supply-side policy, which improves the
flexibility of the labour market and therefore increases the productive capacity of the
economy, shifting aggregate supply to the right.
e Encouraging more students to attend university is a supply-side policy. The expectation is that
in the long run, students with a university degree will be more productive in the labour force,
thereby raising the productive capacity of the economy and shifting aggregate supply to the
right.
f Retraining in the form of adult education improves the flexibility of the labour market and
helps to reduce structural unemployment. It is therefore a supply-side policy, which will

increase the productive capacity of the economy and shift aggregate supply to the right. The
provision of such retraining also entails government expenditure, so there would be a side
effect on aggregate demand.

g A reduction in the highest rate of income tax may be seen as an example of fiscal policy, to
the extent that it increases salaries of high-income earners and leads to an increase in
consumption — and therefore in aggregate demand. However, the impact of this may be
limited, as high earners tend to have a relatively high propensity to save. More important may
be the incentive effects of reducing marginal tax rates to high-income earners. If the change
encourages a higher level of labour input, it raises the productive capacity of the economy and
shifts aggregate supply to the right. In this case, the measure is an example of a supply-side
policy.
h Measures to break up a concentrated market are intended to reduce the extent to which firms
abuse their monopoly power in a market by restricting output and raising price in order to
maximise profits. If successful, this will improve allocative efficiency in the economy, raising
the productive capacity and shifting aggregate supply to the right. It can therefore also be
regarded as an example of a supply-side policy.
i The bank rate is the interest rate used as a policy instrument by the Bank of England. An
increase in the bank rate is therefore an example of monetary policy, and will have the effect
of reducing aggregate demand. In other words, this is answer (c) in reverse.
Case study 32.1

Macroeconomic policy instruments
Monetary policy operates in the UK through the MPC — the Monetary Policy Committee of the
Bank of England, which was given independent power to use monetary policy to hit the
government’s inflation target in 1997. In essence, the Bank operates by manipulating the bank
rate, therefore influencing interest rates in the economy, which in turn affects aggregate demand
by influencing investment and consumption expenditure. There are also indirect effects that work
through the exchange rate. Maintaining macroeconomic stability is seen as fundamental for the
economy, as this provides a stable environment within which economic growth can be achieved.
A key argument here is that stability in the macroeconomy encourages investment by firms,
which then raises the productive capacity of the economy.
Fiscal policy operates through the government’s spending and taxation, which together determine
the government’s budget. It is thought that too active a government will be potentially damaging
by crowding out the private sector. Where the private sector is more efficient (productively) than
the public sector, this would damage the long-run economic growth prospects for the economy.
Hence, the need to maintain a balance between the private and public sectors. A balance between
present and future generations is also sought. The idea here is that government borrowing (which
has to be paid back by future generations) should be restricted to acts of investment that will
benefit that future generation. Present consumption should be financed by the present generation.
Supply-side policies use microeconomic incentives to affect the productive capacity of the
economy, therefore promoting economic growth directly.
It is not possible to say that one type of policy is more important than the others. They each set
out to achieve a different set of objectives, all of which are important to the modern economy.
The important thing is to keep an appropriate balance between them in order that the economy
follows the best possible path into the future.

Chapter 33 The Phillips curve and policy conflicts

Exercise 33.1
Let’s look at each country in turn, starting with France. Figure A33.1 shows the scatter plot of
inflation against unemployment. Notice that I have restricted the x-axis to show only the range of
unemployment above 7% to make it easier to discern the patterns. When you come to look at the
graphs for Italy and Germany, you will see that the range I have plotted is slightly different in
each case, reflecting the variation in unemployment rates between the three countries.
Figure A33.1 Inflation and unemployment in France, 2006–17
When looking at the graph, it is important to remember that the financial crisis affected all of the
countries in 2008–9, so we might expect to see some shift in the relationship as the economies
adjusted to new conditions. This is clear in the graph for France, where the relationship appears to
shift between 2009 and 2010 (as it did in the case of the UK (see Figure 33.3, page 453 of the
book). However, there is a generally negative relationship between these variables between 2006
and 2009 and between 2010 and 2017. Notice that the pattern differs from that shown for the UK,
where unemployment fell more strongly after 2013.
I will look at Italy next, shown in Figure A33.2.
Figure A33.2 Inflation and unemployment in Italy, 2006–17

In some ways the graph for Italy shows some similarity to that for France, in that there is a
negative relationship between inflation and unemployment between 2006 and 2009, which could
be said to resemble a Phillips curve. There is then a shift in the relationship, but a longer

transition, so that the relationship does not seem to settle until about 2012, and there seems to
have been a much larger increase in unemployment. This reflects the way that the crisis affected
the Italian economy.
Finally, let’s look at Germany, shown in Figure A33.3.
Figure A33.3 Inflation and unemployment in Germany, 2006–17
The pattern here is quite different. The pre-crisis period from 2006 to 2008 shows a clear negative
pattern, but inflation fell abruptly in 2009 without much change in the rate of unemployment.
Inflation then accelerated between 2009 and 2011, with unemployment falling, but between 2011
and 2015 both unemployment and inflation fell, before the negative relationship seemed to be re-
established in the last years shown. Notice that the UK also showed a negative relationship in
these last three years.
Exercise 33.2
A key argument in support of granting independence to the Bank of England in the use of
monetary policy to meet an inflation target is that this raises the credibility of policy. The
government can no longer court popularity in the run-up to an election by exploiting the Phillips
curve relationship, gaining lower unemployment in the short run at the expense of inflation in the
longer term.
If economic agents believe that the inflation target will be met, their expectations will adjust more
rapidly to a changing economic environment, so in theory the economy should return to
equilibrium more rapidly after an external shock. This could also help to explain why the Phillips
curve may have become flatter in recent years.
Case study 33.1

Macroeconomic policy conflicts
a It seems quite a challenge to be faced with all these competing demands, but there are strong
arguments in favour of each of them, so we can regard all of them as valid objectives.
The problem is there are conflicts that arise between many of the various objectives, as has
been explained in the chapter. These arise because of trade-offs in the macroeconomy. For
example, given the Phillips curve relationship, the simultaneous achievement of low inflation
and low unemployment may not always be feasible. Depending on the policy context, high
economic growth may not be compatible with a low deficit on the current account of the

balance of payments. High economic growth may not be consistent with the maintenance of
high environmental quality. This has been seen in China in recent years, where the pursuit of
economic growth has led to increasing problems with environmental pollution.

An overarching issue is that resources are scarce (which of course is the fundamental
economic problem). Given high levels of national debt, there will not be sufficient funds to
meet all the competing demands for government expenditure.
No doubt you can identify other potential conflicts that can arise here.
b Can there be a policy package that could deliver on all of these objectives? Probably not. What
is needed is to set priorities that are acceptable to as many people as possible, and to create a
long-term strategy that will eventually allow targets to be achieved. Trying to do this while
coping with the uncertainties of Brexit makes this an even greater challenge…

Part 9 The global context

Chapter 34 International trade
Exercise 34.1
It is not easy for me to comment here, as I don’t know what you found at the shops — or which
sort of shop you visited! However, I would guess that you would find food products from a range
of different countries, perhaps tomatoes from Spain or asparagus from Peru. If you were in a
department store, I would expect you to find goods from China, from countries in Europe and
perhaps from the United States as well. The UK is an open economy, and imports goods from
many different countries.
Exercise 34.2
a See Table A34.1
Table A34.1 Inter- and intra-regional trade patterns
Region Share of total Share of total % of exports % of imports

exports (%) imports (%) within region within
region
North 14.1 18.6 50.5 38.3
America
South and 3.3 3.3 22.7 22.2
Central
America
Europe 38.0 37.7 69.7 70.4
CIS 2.7 2.1 18.5 24.2
Africa 2.2 3.1 20.1 14.2
Middle East 3.8 4.2 14.6 13.3
Asia 33.8 29.0 52.4 61.2
The export shares are calculated from the data in Table 34.1 (see page 465 of the book) by
expressing each row total as a percentage of the world total. For example, North America’s
total exports sum to $2,187bn, which represents 100 × 2,187/15,494 = 14.1% of total world
exports. The import shares are similarly calculated from the columns. The shares within region
are calculated as the diagonal (bold) entries relative to the row (column) totals in that table.
In terms of population, there are more people living in Africa than in Europe — and yet Africa
constitutes only about 2.6% of total world trade, while Europe accounts for about 37.8%. In
part this may reflect the extreme differences in average incomes between the two regions. It is
also significant that a high proportion of the trade in North America and Europe is within the
respective regions — in other words, the trade is between countries in North America and
within Europe, whereas this proportion is much smaller in Africa. In addition, it is important
to remember that trade within Europe has been consciously encouraged through increasing
integration in the EU — especially the Single Market measures, which have reduced the
transaction costs of trade within the region.
b I cannot help you with this, as I cannot tell what will have surprised you…

Case study 34.1
Trade: who benefits?

The main gainers from international trade have been the emerging countries (that benefited from
export-led growth) and the developed countries (that are able to specialise and profit from trade).
The large firms that engage in exporting activity also gain from international trade. Developing
countries have not benefited so much, as they have not been able to make substantial inroads into
global markets, and are hampered by a dependence on primary production.
As for Brexit, I do not know what you will have observed.
Chapter 35 Globalisation
Exercise 35.1
a If Here produces 200 scooters, it can produce 400 coats, and if There produces 100 scooters, it
can produce 300 coats, so total coat production is 400 + 300 = 700.
b The number of scooters produced is the same as before: 300. However, the production of coats
is now 800. The net result is that total world output has increased. This illustrates the potential
gains from trade, as both countries could be made better off than in the no trade position. A
separate question is how those gains will be distributed between Here and There.
Exercise 35.2
The interpretation of the terms of trade rests on its definition as the ratio of export prices to
import prices. Let’s start with United Arab Emirates (UAE), where the terms of trade index
increased to 192.6 in 2015 compared with the base year of 2000. This suggests that the price of
UAE’s exports relative to the price of its imports increased by 92.6 per cent between 2000 and
2015. This reflects the fact that UAE is an oil exporter, and the price of oil increased substantially
between these dates. Sierra Leone was in a very different situation, seeing its export prices fall
(relative to import prices) by 55.9 per cent. Bolivia’s terms of trade changed hardly at all over this
period.
Exercise 35.3
The arguments for and against globalisation have been rehearsed in the book. Now it is time for
you to decide where you stand. Try to base your views on objective economic reasoning, and do
not be distracted by the subjective factors that abound surrounding this topic. In particular, you
need to consider the trade-off between the flow of benefits in good times and the contagion that
may occur in times of crisis.
Exercise 35.4
Your discussion here will depend upon what is happening. Perhaps the trade war has escalated
and world trade is in decline. Or perhaps the World Trade Organization has intervened. Or
perhaps things have reverted to normal.
Case study 35.1

FDI and developing countries
There are many points for discussion here. In thinking about the question you may find it helpful
to begin by listing the possible advantages that a developing country would hope to achieve from
attracting a multinational corporation (MNC). These might include capital & technology,
employment tax revenue, etc. Think also about the nature of MNCs: their characteristics and
objectives. And be careful: MNCs are likely to be looking to maximise global after-tax profits,

they are not humanitarian institutions looking to provide development assistance to low-income
countries. In light of these characteristics, think about how significant will be the gains under
each possible advantage. You may find that you begin to wonder whether MNCs really do offer

significant benefits to developing countries. However, you should also be aware that some
countries, such as the ‘tiger’ economies, China and others, have gained from FDI, and many other
countries are keen to attract more MNCs. How do you think that a developing country could
strengthen its bargaining position?
Chapter 36 Trade policies and negotiations

Exercise 36.1
If a tariff has been in place and is removed by the authorities, there will be an impact on
consumers, producers and the government. The impact puts into reverse the effects that were
identified for the imposition of a tariff, so:
a Consumers will benefit from a lower price of the good, and will gain consumer surplus.
b Producers will lose the additional produce surplus that they had enjoyed while being protected
from foreign competition.
c The government will lose out because of the tariff revenues that they previously received.
Notice that this could be a painful adjustment for producers and the government. The producers
are likely to put pressure on the government to resist the removal of protection. The government
will find that they are losing revenue, but may be under pressure to provide assistance to workers
who lose their jobs in the previously protected sector.
Exercise 36.2
The clear story told by Figure 28.3 (see page 383 of the book) is that the share of manufacturing
employment in the UK fell substantially over the period between 1997 and 2017, whereas service
sectors expanded significantly. This fall in the relative position of the manufacturing industry is
known as a process of deindustrialisation.
When it first became apparent that this was happening, some commentators argued that this
would be bad for the country, because an industrial base was essential for economic prosperity.
However, if the UK’s comparative advantage lies in the service sector, then there is no obvious
reason why this should not be exploited. The service base of the economy can provide a solid
foundation for the economy.
Exercise 36.3
It is difficult for me to comment on this, as I don’t know when you will be tackling the exercise.
Hopefully, the UK is coping well with the process…
Case study 36.1

The European Union
a The key benefits that were expected from the establishment of the EU were in terms of
transactions costs, economies of scale and intensified competition. You should be able to
explain why these benefits were expected, and why they are difficult to observe.
b With a single currency, the implementation of monetary policy is in the hands of the European
Central Bank (ECB), and member countries have to accept the interest rate set by the ECB.
When countries as diverse as Germany and Greece face significantly different circumstances,
it is unlikely that a single interest rate will be appropriate for both. Given Germany’s stronger

position in the EU, it is likely that Greece will be the country to suffer — which is what has
happened.

c As the EU expanded, the possibilities for trade creation will have expanded — but the dangers
of trade diversion are also present.
Case study 36.2

Tariff retaliation
a The best joint position for the two countries would be where both imposed no tariffs. Each
country would gain 100, a total of 200.
b The worst possible state would be where both countries imposed a high tariff. Each country
would then gain 40, a total of 80.
c If Country B imposes no tariff, Country A maximises its gain by imposing a medium tariff,
therefore making 125, with Country B making only 50.
d With Country A imposing a medium tariff, Country B will respond by setting a high tariff,
which maximises its gain.
e Once Country B has imposed a high tariff, Country A’s optimum strategy is also to set a high
tariff, so that each country gains 40.
f What has happened here is that once one country has imposed a tariff, the ensuing tariff war
escalates until both countries impose high tariffs, therefore producing the worst possible joint
outcome for the two countries. This is the nature of tariff wars, and could so easily happen
when the trading partners of the USA begin to retaliate with their own tariffs.

Part 10 The financial sector

Chapter 37 Money and interest rates
Exercise 37.1
In the equation, M represents the money supply. A classical economist would assume that this
was exogenous — that is, it is set by the monetary authorities.
V is the velocity of circulation — the speed at which money circulates in the economy. Under
classical assumptions, this would be constant through time.
P is the aggregate price level. In the classical model this is determined by the other variables.
Y is level of real income, which in the classical world would be at its steady state level, so would
not vary.
Taking these assumptions together, any change in money supply would be reflected in the price
level, as neither V nor Y would vary.
In a modern economy, the money supply is not fully exogenous (determined by the monetary
authorities), as the banking system can create credit. Furthermore, the quantity of money and
credit in the economy cannot be precisely measured or monitored, because of the wide range of
assets that are ‘near-money’.
Keynesians would argue that the velocity of circulation may be unstable, as the expectations of
economic agents can vary and affect the position of the demand for money.
Keynesians would also argue that the level of real income can also vary over time, and that the
macroeconomy could settle at an equilibrium below the full employment level (natural rate of
output). However, the neoclassical economists would argue that the economy will return rapidly
to equilibrium at the natural rate.
Exercise 37.2
When considering a monetary expansion with a Keynesian LRAS curve, the position of the
original equilibrium is crucial. If the economy begins at full employment, i.e. in the vertical
section of the Keynesian LRAS curve, then there is no difference from the Monetarist situation:
the rightward shift in the AD curve just leads to an increase in the price level, and real output is
unaffected.
Figure A37.1 shows that the situation may be different if the economy begins in an equilibrium
position that is below full employment. Suppose that the economy begins in equilibrium with the
aggregate demand curve AD0 intersecting the upward sloping section of aggregate supply. Real
output is at Y0 and the price level is P0. A monetary expansion shifts aggregate demand to AD1,
and the new equilibrium is with price level P1 and real output at Y1. Although the monetary
expansion has led to an increase in the price level, real output has also increased. The extent to
which the impact is felt on the price level rather than real output depends crucially upon the slope
of the AS curve. The flatter is AS, the stronger is the effect on real output and the weaker the
effect on the price level.

Figure A37.1 An increase in money supply with a Keynesian LRAS curve
Exercise 37.3
The effect on the interest rate of an increase in money supply is shown in Figure A37.2. When
money supply increases from MS0 to MS1, the equilibrium rate of interest falls from r0 to r1.
Interest
rate MS0 MS1
r0
r1
MD
M0 M1 Money
holdings
Figure A37.2 The effect of an increase in money supply
Case study 37.1

Loanable funds and government intervention
Consider Figure A37.3. The equilibrium in this market for loanable funds occurs with the rate of
interest at r*, at which point the amount of investment that firms wish to undertake is just
matched by the amount of funds that savers are prepared to supply.

Rate of
interest

Savings
r*
r0 Investment
S0 S=I I0 Quantity of
loanable funds
Figure A37.3 The market for loanable funds
Suppose that the government is keen to encourage investment, and realises that firms would be
prepared to undertake more investment if the cost of borrowing were lower — say, at r0. This
seems at first glance to be a potentially valid policy, because if the interest rate were to be set at
r0, firms would indeed be prepared to invest up to I0. But will it work? No. The problem is that
when the interest rate is so low, savers are only prepared to supply loanable funds up to S0, so that
is the maximum amount that firms will be able to obtain for investment. The effect is therefore
that there will be less investment with interest rates held at r0 than if the market had been allowed
to find its own equilibrium position. The policy has had the opposite effect than was intended.
The impact could be even worse than this, depending on how the available funds are allocated to
borrowers. In the market equilibrium position, only projects with a rate of return of r* or above
would obtain funding. However, in a rationed (disequilibrium) market, it cannot be guaranteed
that only the most productive projects will be funded, so the average efficiency of the investment
that is undertaken could also be low. Indeed, one real possibility is that relatively rich individuals
in the economy will be able to borrow funds in order to finance their purchases of consumer
goods.
Chapter 38 The financial sector

Exercise 38.1
In tackling this question, you need to consider the benefits and costs of accepting alternative
forms of flows of financial capital, as each of them offer benefits but also may have a downside.
The key flows are foreign direct investment, overseas assistance and borrowing on international
markets.
Exercise 38.2
Market failure in rural credit markets has been a problem for many less developed countries.
People in the rural areas may need to undertake small-scale borrowing, but may not have access
to the formal financial institutions such as banks. This is partly because the commercial banks do
not find it profitable to establish branch banks in rural areas, and even if they did they would find
it difficult to distinguish between low and high-risk borrowers. This is because there is
information asymmetry, with the banks having less knowledge about potential borrowers. The
lack of sound property rights may mean that potential borrowers are not able to provide collateral
against loans. The result is that an informal financial sector grows up to cater for rural markets.
Local moneylenders have better information about borrowers than the formal institutions, but

may also have local monopoly power. This may lead to large differentials in interest rates
between the formal and informal sectors.

Microfinance schemes have been developed to try to overcome these problems, with success in
some countries.
Exercise 38.3
In order to promote economic growth and human development, it is imperative that funds can be
channelled to productive uses. This requires financial markets. In thinking about this question you
need to identify the impediments that may prevent the efficient and effective use of resources.
Case study 38.1

Access to finance
a Developing countries face many challenges in mobilising savings, not least the fact that so
many people must survive on very low incomes. Furthermore, even if people were able to
save, if they do not have access to formal financial institutions, they are unable to allow
potential borrowers to mobilise their savings. In this respect, financial markets fail to act as a
channel by which investors can borrow available savings.
b The lack of secure property rights inhibits borrowing. A poor household or small enterprise
that cannot prove it has property rights over the land it owns is unable to provide collateral
that would allow a bank to provide funds for investment. The formal financial institutions do
not have the local knowledge about potential borrowers, so are reluctant to lend without some
form of collateral or credit rating.
c Improving the supply of rural credit is a major challenge for many developing countries.
Extending the coverage of the banking system is one possible approach, but difficult to
implement, although one option is to allow banks to set up new branches in profitable
locations only if they also open new branches in less accessible places (India tried this
approach with some success). Building a system of secure property rights is even more
difficult. Microfinance has proved successful in some areas, but banks with a less credible
reputation than Grameen have struggled to survive without subsidies from non-governmental
organisations or from government.
Chapter 39 The central bank and financial regulation

Exercise 39.1
In the UK, the Bank of England was given responsibility to meet the government’s inflation
target in 1997. A key advantage was seen to be an improvement in the credibility of monetary
policy. An independent central bank will maintain focus on achieving the target, and will not be
subject to political pressure — or political temptation to sacrifice low inflation in order to achieve
growth or to curry favour with the public before an election. For the next decade, this policy was
perceived to be effective, with inflation remaining within its target range for all but a small
number of months. It is not entirely clear that this success can be entirely attributed to the
inflation targeting regime. After all, most developed countries were experiencing similar stability
in this period, and not all of them were using inflation targeting. The financial crisis underlined
the importance of tempering concern with maintaining low inflation with an awareness of other
economic indicators. When commodity prices accelerated in the late 2000s, the inflation rate in
the UK moved above its target range, but the Bank decided not to counter this by raising interest
rates, otherwise the recession would have been much deeper and probably more prolonged. These
are some of the issues you will need to discuss in response to this question.

Exercise 39.2
With surplus liquidity in the economy, there will tend to be downward pressure in interest rates,

as financial institutions are keen to lend the surplus funds. The central bank can counter this
tendency by selling securities in the open market, therefore soaking up the excess liquidity.
Exercise 39.3
I don’t know when you will be accessing these websites, so I cannot comment on what you will
have found.
Case study 39.1

The bailout of Greece in 2010
The problem of sovereign default can be viewed from different angles. In particular, the
international financial community may take a very different approach than the government of a
country that is in difficulties.

OCR - A Lev - Econ - Ex - and - CS - Ans

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

OCR - A Lev - Econ - Ex - and - CS - Ans

Uploaded by

Copyright:

Available Formats

Answers to Exercises and Case

OCR A Level Economics (Fourth Edition)

Part 1 How competitive markets work

© Hodder & Stoughton Limited 2019 1

OCR A Level Economics (Fourth Edition)

c i See point A on Figure A1.1.

Chapter 2 The allocation of resources, specialisiation and

© Hodder & Stoughton Limited 2019 2

OCR A Level Economics (Fourth Edition)

Case study 2.1

© Hodder & Stoughton Limited 2019 3

OCR A Level Economics (Fourth Edition)

Figure A3.1 The demand for trinkets

© Hodder & Stoughton Limited 2019 4

OCR A Level Economics (Fourth Edition)

Figure A3.2 A leftward shift of the demand curve

Figure A3.3 A rightward shift of the demand curve

Figure A3.4 A movement along the demand curve

© Hodder & Stoughton Limited 2019 5

OCR A Level Economics (Fourth Edition)

Case study 3.1

© Hodder & Stoughton Limited 2019 6

OCR A Level Economics (Fourth Edition)

Figure A4.1 The supply of trinkets

a See Figure A4.1

Figure A4.2 A rightward shift of the supply curve

© Hodder & Stoughton Limited 2019 7

Figure A4.4 A movement along the supply curve

© Hodder & Stoughton Limited 2019 8

OCR A Level Economics (Fourth Edition)

Case study 4.1

Chapter 5 The interaction of markets

© Hodder & Stoughton Limited 2019 9

Figure A5.2 A change in the supply of paint

Figure A5.3 A change in the supply of accountant services

© Hodder & Stoughton Limited 2019 10

OCR A Level Economics (Fourth Edition)

Figure A5.4 An outbreak of chicken flu

Case study 5.1

© Hodder & Stoughton Limited 2019 11

OCR A Level Economics (Fourth Edition)

c If consumer preferences remain strongly in favour of organic produce, non-organic producers

© Hodder & Stoughton Limited 2019 12

Figure A6.1 The demand for Pedro’s olive oil

© Hodder & Stoughton Limited 2019 13

OCR A Level Economics (Fourth Edition)

© Hodder & Stoughton Limited 2019 14

OCR A Level Economics (Fourth Edition)

Case study 6.2

Case study 6.3

© Hodder & Stoughton Limited 2019 15

OCR A Level Economics (Fourth Edition)

Figure A6.2 The market for fish

Chapter 7 Prices, resource allocation and concept of the

© Hodder & Stoughton Limited 2019 16

OCR A Level Economics (Fourth Edition)

Case study 7.1

Figure A7.1 The market for jewellery

Chapter 8 Market failure and externalities

© Hodder & Stoughton Limited 2019 17

OCR A Level Economics (Fourth Edition)

Case study 8.1

© Hodder & Stoughton Limited 2019 18