Possible exam questions:

6. In 1981, when regulations were holding the price of natural gas below its free-market level,
then-Congressman Jack Kemp of New York said the following in an interview with The New
York Times: “We need to decontrol natural gas and get production of natural gas up to a higher
level so we can bring down the price.” Evaluate the congressman’s statement.

One part of the congressman’s statement was incorrect. Removing the price controls through
deregulation would lead to an increase in price. Such deregulation would also cause an increase
in the quantity supplied (movement along the existing supply curve) and eliminate the shortage
but it would do so at a higher price.
The other part of the congressman’s statement may be correct depending on the interpretation. If
we could get production of natural gas to increase – by any means other than an increase in price
– we would expect to see an increase in supply which would be depicted as a movement to an
entirely new supply curve like S1 depicted below. That would lead to a decrease in the
equilibrium price.

3. Some people who do not understand the optimal purchase rule argue that if a consumer buys
so much of a good that its price equals its marginal utility, the consumer could not possibly be
behaving optimally. Rather, they say, the consumer would be better off quitting while ahead or
buying a quantity such that marginal utility is much greater than price. What is wrong with this
argument? (Hint: What opportunity would the consumer then miss? Is it maximization of
marginal or total utility that serves the consumer’s interests?)

It is reasonable to assume that rational consumers are trying to get the most possible consumer’s
surplus for themselves, that is, the most total utility less expenditure—not the most possible
average utility per good or marginal utility. If a consumer quit buying when the marginal utility
was higher than the price, then he or she would be forgoing the opportunity to increase
consumer’s surplus: By buying one more unit, the consumer could accumulate more utility than
he or she would be giving up in terms of money forgone. This will continue to be true until so
much is bought that the marginal utility of the next good has fallen to a level equal to the price.

1.“It may be rational for the management of a firm not to try to maximize profits.” Discuss the
circumstances un-der which this statement may be true.

There are some non – profit firms that not try to maximize profits, such as a private hospital may
seek to maximize the number of services offers to patients. Some for – profit firms also do not
try to maximize profits, as they may pay attention to expand the size of their business, to the
community responsibility (for example: to keep the environment clean, to use sustainable
materials) or they may feel there are risks to maximize profits. So rational decision does not
mean to try to maximize profits. Each firm has their own goals.

2. If competitive firms earn zero economic profits, explain why anyone would invest money in
them. (Hint: What is the role of the opportunity cost of capital in economic profit?)
If a firm earns zero economic profits, money invested in it earns just as high a return as it would
in its best alternate use. Thus the investment is just as good as another investment.

6. A new entrant, Bargain Airways, cuts air fares between Eastwich and Westwich by 20 percent.
Biggie Airlines, which has been operating on this route, responds by cutting fares by 35 percent.
What does Biggie hope to achieve?

Biggie hope to compete with Bargain and attract more customers. If Biggie do nothing while
Bargain cut air fares, consumers will defenitely choose to buy tickets from Bargain. But now
when Biggie cut the fares more than Bargain, people will chooose to fly with Biggie. However,
this may cause losses for Biggie. Biggie may expect that Bargain will left that route one day as
they do not have enough cusomer to cover the cost of flying, thus Biggie can increase the ticket
fees. But if there are new competitors, Biggie would have to decrease the fares once again.

7. If air transportation were perfectly contestable, why would Biggie Airlines (see Discussion
Question 6) fail to achieve the ultimate goal of its price cut?

When Bargain notice that they do not have enough cusomer to cover the cost of flying as people
choose to fly with Biggie due to the low fares, they could leave this flying route and use their
money for another routes. Biggle will eventually raise the price after Bargain left, then Bargain
will come back to compete as the price is higher. So Biggie will never achieve the ultimate goal
of its price cut

3. Give some reasons why gross domestic product is not a suitable measure of the well-being of
the nation. (Have you noticed newspaper accounts in which journalists seem to use GDP for this
purpose?)

Gross domestic product is the total monetary or market value of all the finished goods and
services produced within a country's borders. Hence, it may be an indicator of a society’s
standard of living, but it is only a rough indicator because it does not directly account for leisure,
environmental quality, levels of health and education, activities conducted outside the market,
changes in inequality of income, increases in variety, increases in technology.

5. Show why each of the following complaints is based on a misunderstanding about inflation:
a. “Inflation must be stopped because it robs workers of their purchasing power.”

Usually, it is being thought by the people that inflation robs the purchasing power of the workers
because at higher inflation people need to pay more to get the same amount of goods and
services.
When a inflation occurs, everything charges more. Prices of goods and services increase,
however workers’ salaries and wages also rise. So their purchasing power does not be robbed.

b. “Inflation makes it impossible for working people to afford many of the things they were
hoping to buy.”

Working people often cannot buy many of the things they were hoping to buy, but
inflation does not make this problem more difficult unless wages rise more slowly
than prices.

c. “Inflation must be stopped today, for if we do not stop it, it will surely accelerate to ruinously
high rates and lead to disaster.”

Neither economic theory nor historical experience confirms the view that creeping
inflation necessarily accelerates to hyperinflation. There can be many different causes
of creeping inflation, but the only plausible cause of hyperinflation is a rapid increase
in the money supply.

3. Chapter 23 pointed out that, because faster capital formation comes at a cost (reduced current
consumption), it is possible for a country to invest too much. Suppose the government of some
country decides that its businesses are investing too much. What steps might it take to slow the
pace of capital formation?

There are 3 steps in capital formation: creation of savings, mobilization of savings and
investment of savings. To slow the pace of capital formation, on the first stage, the government
could lower taxations so that people would spend more instead of saving money, which increase
production and requires more money used for it. On the second stage, government could

2.Explain why economic growth might be higher in a country with well-established property
rights and a stable political system compared with a country where property rights are uncertain
and the government is unstable.

A stable political system and well-established property rights provide the foundation for firms to
make long-term capital investments. Firms will not make long-term investments such as
factories, if there is a risk that the government will collapse or decide to nationalize the industry
and confiscate the factory.

5. What is a consumption function, and why is it a useful device for government economists
planning a tax cut?

A consumption function shows the aggregate consumer expenditures to be expected at different

levels of disposable income. Since a tax reduction results in an increase in disposable income,
economists can use the consumption function to predict the initial change in spending that will
follow a tax cut.

6. Explain why permanent tax cuts are likely to lead to bigger increases in consumer spending
than temporary tax cuts do.

People tend to base their consumption expenditures not just on their current income, but also on
the level of income that they expect in the future. A temporary tax cut raises today's disposable
income but not expected future income, so consumers are not likely to change their expenditures
as much as they would if they expected a permanent increase in disposable income.
5. Each year during the Christmas shopping season, consumers and stores increase their holdings
of cash. Explain how this development could lead to a multiple contraction of the money supply.
(As a matter of fact, the authorities prevent this contraction from occurring by methods explained
in the next chapter.)

Less demand deposits to facilitate their shopping. Decrease the money supply because banks lose
reserves, thereby affecting their ability to create money.

6. Excess reserves make a bank less vulnerable to runs. Why, then, don’t bankers like to hold
excess reserves? What circumstances might persuade them that it would be advisable to hold
excess reserves?

Banks hold excess reserves to make themselves less vulnerable to runs. When a bank has excess
reserves, it can lend them out to other banks, or it can keep them on its own balance sheet. If a
bank feels that it is in danger of being run, it may decide to hold excess reserves in order to
prevent depositors from withdrawing their money.

3. Explain why the quantity of bank reserves supplied normally is higher and the quantity of
bank reserves demanded normally is lower at higher interest rates.

At a higher interest rate, there is more demand for bank reserves because people want to keep
more money in reserve in case of an unexpected expense or a sudden increase in their credit
score. This demand for reserves causes the banks to increase their supply of reserves.

8. The year 2007 closed with the unemployment rate around 5 percent, real GDP barely growing,
inflation above 2 percent and apparently rising a bit, and the federal budget showing a large
deficit.

a. Give one or more arguments for engaging in expansionary monetary or fiscal policies under
these circumstances.
Expansionary monetary policy leads to lower interest rates, and these lower interest rates
encourage more investment spending, which has multiplier effects on aggregate demand.
b. Give one or more arguments for engaging in contractionary monetary or fiscal policies under
these circumstances.

4. Explain how a collapse in house prices might lead to a recession.

When house prices decrease, people tend to spend their money on buying properties instead of
investing. That will lead to a stagnation in production as there is not enough money. That is
when recession occurs.

5. Explain how a collapse of the economy’s credit-granting mechanisms might lead to a

recession.
A collapse of the economy’s credit-granting mechanisms will lead to a lack of financial
resources for production, hence cause a recession.