Homework 1 Economics 503 Foundations of Economic Analysis Practice Module 1 1. Luxury Goods We observe the income of the consumers of diamond rings increase by 10%. We observe that the equilibrium consumption of diamond rings goes up by 5%. Assume that nothing else happens to cause a change in the equilibrium in the diamond ring market. Explain why, we can infer that diamond rings are normal goods, but why we can’t say if they are income elastic luxury goods or income inelastic. Use at most 1 paragraph and 1 graph. 2. Energy Markets For reasons of safety, the Chinese government orders the closure of 75% of the coal mines currently operating in the PRC. Draw a graph of the effect of this on closure on the world coal market. Draw a graph of the effect of this on the world oil market. Explain your graphs in 1 paragraph or less. 3. Equilibrium: Algebra The demand for widgets is represented as QD = 100 – 8 P and the supply of widgets are given by QS = 40 + 4P. Calculate equilibrium price and quantity. Calculate the change in equilibrium price and quantity if a shift in the demand curve gives a demand schedule of QD = 124 – 8 P. 4. Supply Shift Below are short-term and long-term demand schedules for petroleum as well as a supply schedule. Assume that the supply schedule is the same in the long-term and the short-term. Calculate the equilibrium level of price and quantity for oil in the short and the long term within the range of $10 per barrel (Hint: the answer is the same for the short-term and the long-term). . Assume that a conflict in the Middle East permanently reduces the amount of oil that can be supplied at any price level. After the shock, only 94% of the previous level is supplied at any price level. Calculate the new supply schedules. Assuming the short-run and long-run demand curves are unchanged, calculate the new price of oil in the short-term and in the long-term (within a range of $10). QD P 60 70 80 90 100 110 120 130 140 150 Short-term Long-term 83,033.06 89,314.83 81,762.92 82,689.46 80,678.38 77,348.91 79,733.70 72,925.25 78,898.04 69,182.97 78,149.63 65,963.37 77,472.59 63,155.12 76,854.95 60,677.48 76,287.50 58,470.28 75,762.98 56,487.66 QS 80,059.86 81,303.55 82,396.49 83,372.72 84,255.78 85,062.66 85,806.03 86,495.60 87,138.99 87,742.26 5. Equilibrium: Tabular A market faces a demand function of the form Q D 28 .2 P and a supply function of the form Q S 10 .2 P . Use these functions to fill out a supply and a demand schedule. Identify the equilibrium price and quantity. P Quantity Quantity Demanded Supplied 20 25 30 35 40 45 50 6. Revenue and Elasticity Posit a simple demand curve for breakfast cereal of the form Q = 100 - 5P where Q is the quantity of breakfast cereal and P is the price per box. Calculate Q and Revenue (R) at each of the following price points. What is the price elasticity of demand as we move from price point to price point (use the mid point method)? What is the price point where revenue is largest? Explain why raising prices above that point does not increase revenues. Price Q R evenue Elasticity 5 6 7 8 9 10 11 12 13 14 15 ; Module 2 1. Real Hong Kong Box Office. It is 2004. You are analyzing the profitability of Hong Kong’s movie industry. You hear that Steven Chao’s Kung Fu Hustle is the top grossing Hong Kong film of all time. You are given a list of local gross box office receipts for a number of Hong Kong movies. 1. Kung Fu Hustle 2. Shaolin Soccer 3. First Strike 4. Rumble In The Bronx 5. Infernal Affairs 6. God of Gamblers Return 7. Justice My Foot 8. All's Well, End's Well 9. Thunderbolt 10. Mr. Nice Guy 11. Fight Back to School 12. All for the Winner 13. Drunken Master II 14. God of Cookery 15. God of Gambers II 16. Flirting Scholar 17. All's Well, End's Well 1997 Box Office Revenues HK$60,830,000 HK$60,770,000 HK$57,519,000 HK$56,911,000 HK$55,030,000 HK$52,540,000 HK$49,880,000 HK$48,990,000 HK$45,650,000 HK$45,420,000 HK$43,830,000 HK$41,330,000 HK$40,970,000 HK$40,860,000 HK$40,340,000 HK$40,170,000 HK$40,160,000 Year 2004 2001 1996 1995 2003 1993 1992 1992 1995 1997 1991 1990 1994 1997 1990 1993 1997 Year CPI 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 63.5 70.8 77.4 84.0 90.8 98.7 104.6 110.6 113.5 109.8 106.6 104.8 101.4 99.3 99.3 (Source: www.Asianboxoffice.com) Adjust these for inflation using the Hong Kong CPI. Convert all of these film grosses into 2004 dollars (i.e. use 2004 as the reference year) and rank the films by their grosses in 2004 dollars. 2. Construct a CPI You are given some statistical accounts for the country of Fruitopia which produces two goods, Apples and Oranges. The accounts contain information on the price of apples and the price of oranges for the years 1995 to 2005. You are asked to calculate a CPI, nominal GDP, real GDP and the GDP deflator using 1995 as the base year. Note that there is no investment, government spending, exports or imports in Fruitopia so GDP is equal to consumption. 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Apples price quantity $1.00 100 $1.10 105 $1.21 110 $1.33 115 $1.46 120 $1.61 125 $1.77 125 $1.95 130 $2.14 135 $2.36 140 $2.59 145 Oranges price quantity $2.00 100 $2.40 105 $2.88 100 $3.46 100 $4.15 100 $4.98 95 $5.97 90 $7.17 90 $8.60 85 $10.32 80 $12.38 75 a. Calculate the CPI. The representative market basket for the Fruitopian consumer is 100 apples and 100 oranges. Calculate the cost of this market basket in 1995. The CPI in subsequent years is the price of this same market basket (100 apples and 100 oranges) relative to price of that basket in the base year (multiplied by 100). b. Calculate the nominal GDP which is the sum of the market value of apples (price × quantity) plus the market value of oranges in each period. c. Calculate real GDP which is the sum of the market value of apples calculated using the 1995 price (1 × quantity of apples) plus the value oranges calculated using the 1995 price (2 × quantity of oranges). d. Calculate the GDP deflator as the ratio of the nominal GDP to the real GDP. e. Calculate the average inflation rate over the period of 1996-2005 using both price measures. Which price index increases the most over time? Explain. Notice that the market basket has switched toward apples whose price has not risen sharply over time. CPI 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 CPI Inflation N/A Nominal GDP Real GDP GDP Deflator GDP Deflator Inflation N/A 3. Deflate Soccer Transfer Fees In European soccer leagues, teams will acquire players from other clubs by agreeing to pay a transfer fee. The below table shows the top 10 transfer fees paid by English Premier League sides along with the fee paid measured in British pounds and the year of the transfer. Use the accompanying table with the British CPI to convert all transfer fees to 2008 pounds. Who has the highest transfer fee in constant dollar terms? Player 1 Robinho 2 Dimitar Berbatov 3 Andriy Shevchenko 4 Rio Ferdinand: 5 Juan Sebastian Veron: 6 Michael Essien 7 Didier Drogba: 8 Wayne Rooney 9 Shaun Wright-Phillips 10 Fernando Torres: From: Real Madrid Tottenham AC Milan Leeds Lazio Lyon Marseille Everton Manchester City Atletico Madrid To Manchester City Manchester United Chelsea Manchester United Manchester United Chelsea Chelsea Manchester United Chelsea Liverpool British CPI 4. 2000 2001 2002 2003 2004 2005 2006 2007 2008 93.7 94.7 96.3 97.5 99.1 101.0 104.0 106.2 109.5 Fee £32.50m £30.75m £30m £29.1m £28.1m £24.43m £24m £23m £21m £20m Year 2008 2008 2006 2002 2001 2005 2004 2004 2005 2007 4. Cakeland GDP An economy called Cakeland produces three products at three separate products: cake mix, frosting, and birthday cakes. All of the cake mix and frosting are sold to the birthday cake company. The cake mix and frosting companies grow all the inputs they need to make their product; their only expense is wages. Define profits as the value of sales less wages and cost of inputs. The following charts outline the activities of each of these firms. Cost of Inputs Cake Mix 0 Frosting 0 Wages $30 $40 Sales $100 $70 a. Solve for GDP using the expenditure method Final Expenditure Cake Mix Frosting Birthday Cakes GDP b. Solve for GDP using the production method Value Added Cake Mix Frosting Birthday Cakes GDP c. Solve for GDP using the income method Income Wages Profit GDP Birthday Cake $100 Cake Mix $70 Frosting $150 $400 Module 3 1. Foreign Exchange Market. Diamonds are discovered in Australia. Foreigners want to buy these diamonds and need Australian dollars to do so. Assume that this discovery has no particular effect on Australian demand for foreign goods or assets. Draw two graphs of the Forex market: 1) Demonstrate the effect on the Australian dollar exchange rate if Australian monetary policy remains unchanged so the exchange rate is allowed to fluctuate; 2) Demonstrate the effect on the market if the Reserve Bank of Australia conducts monetary policy to keep the exchange rate from changing. 2. Stock Market Liberalization Consider an economy that operates a floating exchange rate. The government announces that next year, they will liberalize their stock market which will make investing in that economy more attractive in the future. Describe the effect of this announcement on the Forex market this year. 3. Currency Board During much of the 1990’s, the South American country of Argentina implemented a currency board system similar to Hong Kong with the Argentine peso being fixed 1-to-1 with the US dollar. In January 2002, the Central Bank of Argentina abandoned the currency peg. Below are interest rates for the US dollar and money market interest rates for the Argentine Peso from 1995 to 2001. 1996 1997 1998 1999 2000 2001 Peso US Dollar Interest Interest Rate Rate 6.23 5.14 6.63 5.2 6.81 4.9 6.99 4.77 8.15 6 24.9 3.48 Calculate the expected exchange rate depreciation in every year (assuming that interest parity is true). Module 4 1. Loanable Funds Market Some economists argue that the savings behavior is not very responsive to the interest rate. Other economists argue that savings is strongly affected by the interest rate. Use the loanable funds framework for a large, closed economy. Compare the effect of expansionary fiscal policy (i.e. an increase in government deficits) on the interest rate and investment in A) an economy in which the supply of loanable funds (S) was inelastic with respect to the interest rate; with the effect in B) an economy in which the supply of loanable funds is very elastic. Draw a graph of each theory to show under which theory there is a bigger impact on investment and under which theory there is a bigger impact on the interest rate. Module 5 1. Using aggregate demand, short-run aggregate supply and long-run aggregate supply curves, explain the process by which each of the following economic events will move the economy from one long-run macroeconomic equilibrium to another. Illustrate with diagrams. In each case, what are the short-run and longrun effects on the aggregate price level and aggregate output? a. There is a decrease in households’ wealth due to a decline in the stock market. b. There is an increase in the wealth of households in the economy of a foreign trading partner. 2. In 2005, a hurricane hit New Orleans, Louisiana, an important transportation and oil refining center in the USA, one of Hong Kong’s key for the petrochemical industry in that country. a. Consider the impact of the recent hurricanes that devastated that city as a temporary supply shock for the USA. Discuss briefly, using one graph, the outcomes that we would have been likely to see in terms of goods markets in the USA as a result of this negative business cycle shock. Analysts are also worried that the natural disaster might have had a negative impact on consumer confidence. Discuss briefly, using one graph, the differences in outcomes that we would observe if this demand side effect were stronger from the outcomes that we would observe if the supply side effects were dominant Module 6 1. The Liquidity Crisis and the Taylor Rule in Hong Kong. You are given the following Table listing the output gap, the CPI and the overnight HIBOR Rate in Hong Kong. 2007Q4 2008Q1 2008Q2 2008Q3 2008Q4 2009Q1 2009Q2 2009Q3 Output Gap CPI Inflation xxx 107.4 xxx 0.049219808 108.2 0.029795 0.0299929 110.1 0.013160519 107.7 -0.013435423 109.6 -0.063140353 109.5 -0.037229897 109.2 -0.040702363 108.2 Interest Rate Under Taylor Rule xxx Actual Interest Rate xxx 0.00781 0.00875 0.024375 0.00225 0.00375 0.0013 0.0013 a. For each quarter, construct the inflation rate on an annual basis. This is obtained just P Pt 1 by constructing the % growth rate of the price that occurs in a given quarter t Pt 1 and then multiplying the result by 4. An example is constructed in the Table for the 1st Quarter of 2008. b. Construct a hypothetical interest rate for HK with the Taylor rule using the CPI inflation. CPI data and an assumption of an inflation target of 2%. c. Compare the interest rate with that observed in HK. Note that the interest rate has been below 1% in every quarter except the 2008Q3. Has the interest rate been higher or lower in HK than that suggested by the Taylor rule? 2. Does the BOJ have a Taylor Rule? The following table shows numbers for Japan’s inflation rate, output gap, and the uncollateralized call money interest rate for the years 1990 to 2000. 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 i. ii. iii. iv. Output Actual Gap Inflation Interest Rate 3.30% 3.02% 7.56% 4.09% 3.22% 7.48% 2.50% 1.70% 4.82% 0.51% 1.26% 3.18% -0.87% 0.69% 2.41% -1.20% -0.12% 1.15% 2.14% 0.13% 0.48% 2.32% 1.75% 0.52% -1.48% 0.67% 0.44% -2.46% -0.33% 0.06% -2.57% -0.71% 0.12% Calculate the inflation gap (i.e. the difference between inflation and target inflation) in each period if Japan had used a target inflation rate of 2% in each year. What is the average inflation gap during the period 1990-1995 (inclusive) and for 1996-2000? Calculate the interest target, iTGT, for every period if the Bank of Japan had used a Taylor rule as specified in class. Compare this with the actual interest rate. Does the Bank of Japan adjust the target interest rate to domestic inflation and output? Some have argued that the BOJ was not aggressive enough in cutting interest rates in the early 1990’s to get the economy out of the slump. What was the average interest rate during the period 1992-1997? What was the average interest rate suggested by a Fed-style Taylor rule. Which was larger? What difficulties did the Bank of Japan have in implementing the Taylor rule in 1999 and 2000? Module 7 1. Costs of Running a Factory You examine the production of an auto-parts factory which uses labor, materials and capital machinery referred to as a die press to produce goods. To start producing any goods, the factory has sunk set-up costs of $25,000 per year. Up to 300 die presses can be installed in the factory in increments of 50. The costs of owning and using a die press (including depreciation and financing costs) in a given year are $5,000 per press. Therefore, fixed costs are $25,000 plus $5000 times the number of die presses used. Die presses are varied in increments of 50. In addition, producing goods requires some variable inputs including materials, energy, and labor. Producing each good requires material and energy costs of $20 per unit. For various reasons, production can only be done in batches of 10,000 units. The following Table 1 reports the variable labor costs of producing different levels of output at different levels of die-press usage. Table 1. Variable Labor Costs at the Auto Parts Factory Production Level 10000 20000 30000 40000 50000 60000 70000 80000 90000 100000 50 $121,904.74 $501,327.80 $1,146,431.10 $2,061,688.19 $3,250,269.77 $4,714,646.67 $6,456,848.58 $8,478,600.52 $10,781,403.97 $13,366,589.17 # of Die Presses 100 150 $60,113.22 $39,751.81 $247,212.94 $163,477.55 $565,323.92 $373,838.72 $1,016,652.16 $672,294.10 $1,602,761.17 $1,059,877.64 $2,324,869.37 $1,537,395.02 $3,183,977.62 $2,105,508.13 $4,180,936.56 $2,764,779.45 $5,316,486.60 $3,515,698.63 $6,591,283.69 $4,358,699.41 200 $29,642.81 $121,904.74 $278,770.47 $501,327.80 $790,347.74 $1,146,431.10 $1,570,071.43 $2,061,688.19 $2,621,646.48 $3,250,269.77 250 $23,608.65 $97,089.53 $222,023.30 $399,276.34 $629,462.71 $913,060.90 $1,250,464.01 $1,642,006.11 $2,087,977.98 $2,588,637.25 300 $19,602.27 $80,613.45 $184,345.99 $331,519.22 $522,642.99 $758,114.63 $1,038,260.49 $1,363,357.96 $1,733,648.48 $2,149,345.96 A. Short-run The factory has set up 100 die presses. Fill in the Table 2 cost chart for the firm in the short term. Calculate the marginal cost for each level of production as the cost of producing one more batch (i.e. the cost of producing another 10,000). B. Long-run Now assume that the factory managers can vary the number of die presses. Calculate the average total cost function for each level of production for each # of die presses. For each quantity of die-presses, calculate the minimum average cost. For each level of production, calculate the minimum average cost and the number of die presses that would generate the lowest average total cost. Draw a diagram of those minimum points. Over what range is the firm operating according to increasing returns to scale? Over what range is the firm operating over decreasing returns to scale? What is the minimum efficient scale (i.e. what scale of production will result in the lowest overall level average total cost when we can vary energy, workers, and # of die presses)? At what number of die-presses is that minimum achieved?