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Topic 1 The Scope of Economic Analysis
Question 1.1
“According to the definition of opportunity cost, the more alternatives that we
have given up in undertaking an action, the higher the opportunity cost.” Please
comment on this statement and explain your answers using examples.
Ans
Opportunity cost of an action refers to the value of the best alternative that must be given
up in order to undertake that action. That is, the highest-valued option forgone.
The statement in the question is uncertain and is determined by situation, because the
opportunity cost is the value of the best alternative forgone rather than the sum of all the
alternatives forgone. There are two possibilities. Firstly, if the value of one added option
is higher than that of original best alternative forgone, the opportunity cost increase. By
contrast, if each of the added options’ values is no more than that of original best
alternative forgone, the opportunity cost remains constant.
Example for the situation that the value of one added option is higher than that of original
best alternative forgone:
Suppose that you have $5,000 dollars at hand and you are considering spending this
money on (Listed in the priority of the action’s value for you)
Original buying list
Value
Added alternatives
value
1. Buy a notebook
10
1. Buy a mobile phone
9
2. Buy a professional camera
8
2. Buy a video game console
5
3. Buy a handbag
6
4. Trip to Taiwan
4
In this case, originally your opportunity cost, best alternative forgone, of buying a
notebook (valued highest as 10) is to buy a professional camera (valued 8). However, the
option of buying a mobile phone (valued 9) come up, whose value exceeds buying a
professional camera. Now, the best alternative forgone will be considered as buying a
mobile phone. Consequently, your opportunity cost of buying a notebook now is to buy a
mobile phone. In a word, the opportunity cost rises from 8 to 9, when we introduce in
alternative of buying a mobile phone in this situation.
Example for the situation that each of the added options’ values is no more than that of
original best alternative forgone:
Suppose that you still have $5,000 dollars at hand and you are considering spending this
money on (Listed in the priority of the action’s value for you)
Original buying list
1. Buy a notebook
2. Buy a professional camera
3. Buy a handbag
4. Trip to Taiwan
Value
10
8
6
4
Added alternatives
1. Buy a television
2. Buy a video game console
value
7
5
In this situation, the value of buying a professional camera (valued 8) which is the
original opportunity cost is higher than all of the added alternatives’ value (7 for buying a
television and 5 for buying a video game console). Consequently, the option of buying a
professional camera is still the best alternative forgone. Under this condition, although
the number of alternatives increases, however the opportunity cost remains constantly.
Question 1.2
Suppose you are considering whether to go to Paris with a group of classmates
during your summer holidays. The round trip airfare from Hong Kong to Paris is
$6000, but you can select to pay this airfare with a frequent-flyer coupon. All other
relevant costs for the vacation in Paris are $10,000. The most you would be willing
to pay for the Paris vacation is $19,000. This amount is your benefit of taking the
vacation in Paris. You only alternative use for you frequent-flyer coupon is your trip
to New York after summer holidays and this is a trip that you must make. The Hong
Kong-New York round-trip airfare is $8,000
a) Suppose you decide to use the frequent-flyer coupon for the Paris trip. What is
the opportunity cost of using this coupon? Briefly explain your calculation.
b) What are the economic costs and economic surplus of your trip to Paris if you
use the frequent-flyer coupon for the trip? Briefly explain your answer
c) Should you use the frequent-flyer coupon for the trip to Paris or use it for the
trip to New York? Briefly explain you answer.
ANS
Part 1.2 has revealed the definition of opportunity cost and principles of making
economic decisions and helps us apply them in specific cases. Sometimes people may
mistake economical costs for explicit cost and neglected the opportunity cost in daily life.
As for making decisions, there might be a possibility that people did not calculate the
entire cost or benefit but parts of them.
1.2 a
The opportunity cost of an action is the best alternative forgone to undertake that action.
The opportunity cost of using frequent-flyer coupon for the Paris is $8,000. In this case,
to use the coupon for the round trip airfare to Paris, the best alternative of using the
coupon to New York is given up. As a result, the opportunity cost in this situation is the
value of the round trip airfare to New York which is $8,000.
1.2 b
Economic cost takes into account all opportunity costs that include all the implicit costs
and explicit costs that are relevant to the activity under consideration, that is:
Economic cost = Implicit Cost + Explicit cost
Implicit cost is all the opportunity cost of taking a particular action. For this question, the
implicit cost is the opportunity cost of using the coupon for round trip to New York
whose value is $8,000
Explicit cost is all other relevant costs of taking an action, as opposed to implicit cost. For
this question, the explicit cost is the relevant costs for the vacation in Paris whose value is
$10,000
Economic surplus = Benefits of Taking The Action – Costs of Taking The Action
The economic costs of using the frequent-flyer coupon is:
The Economic costs
= Explicit Cost + Implicit Cost
= $10,000 + $8,000
= $18,000
So the economic costs of using coupon for trip to Paris is $18,000
As shown in the content of question, the economic benefit is the most you would be
willing to pay for the Paris vacation, while the economic costs have been obtained as
above. The economic surplus of using the frequent-flyer coupon is:
The Economic Surplus
= Economic Benefits – Economic Costs
=$19,000 – $18,000 = $1,000
1.2 c
No matter the coupon is used or not for the trip to Paris, the economic surplus to Paris is
always positive. In another word, the trip to Paris gains our economic surplus. Therefore,
we should take this trip. Meanwhile, the trip to New York is compulsory. Consequently,
both of the two trips should be taken.
It is indubitable that the total explicit costs of each vacation, the sum of relevant costs for
the vacation in Paris and in New York, are not affected by our choice. So, in the situation
of the question supposed, an action is considered right, when the total opportunity cost is
at its least. Furthermore, we should choose the alternative that minimizes our total
opportunity cost. If we use the coupon for the trip to Paris, the total opportunity cost is
the value of airfare to New York that is $8,000. If we use the coupon for the trip to New
York, the total opportunity cost is the value of airfare to Paris that is $6,000. As a
conclusion, using the coupon for New York trip should be taken as the choice.
Topic 2 The Price Mechanism: Demand, Supply
and Market
Question 2.1
Consider the following stock price information extracted from the
newspaper.
a)Noting how the closing price and quantity of each stock changed
between 19 July 2007 and 20 July 2007, state whether each stock has
experienced a decrease in demand, increase in demand, decrease in
supply or increase in supply, assuming there were changes in either the
demand or supply curves but not both.
b) Suppose on 20 July 2007 CLP closed at $53.70 instead of $53.85 (and all
other information remains unchanged), explain how you would conclude
about the shifts of its demand and supply curves between 19 and 20 July
2007.
Ans
2.1 a
The equilibrium price is the price where the quantity demanded is equivalent to the
quantity supplied.
The equilibrium quantity is the quantity bought and sold at the equilibrium price.
In order to illustrate the price mechanism in the case of stock market, we consider this
question into a free market model, in which, we suppose that the volume transacted of
each stock is exactly the equilibrium quantity and the closing price of each stock is the
equilibrium price.
CLP --- Diagram 2.1 (1), P10
When supply decreases, the price rises and the quantity falls. The supply curve shifts
leftward.
For CLP, there is an increase in closing price; however a decrease in volume transacted.
In another word, the equilibrium price increase, while the equilibrium quantity decrease.
Applying the theory mentioned above, there must be a decrease in supply. The Diagram
2.1 (1), P10 represents the changes in price and quantity, as well as the original and new
supply curves.
HSBC --- Diagram 2.1 (2), P10
When demand decreases, both the price and the quantity decrease. The demand curve
shifts leftward.
For HSBC, both the closing price and the volume transacted decrease. We can know that
decline occurs in both the equilibrium price and the equilibrium quantity. It satisfies the
condition of theory two. So, there is a decrease in demand. The changes in price and
quantity transacted, as well as the original an new demand curves are shown in the
diagram 2.1 (2), P10.
PCCW --- Diagram 2.1 (3), P10
When demand increases, both the price and the quantity increase. The demand curve
shifts rightward.
For PCCW, both the closing price and the volume transacted increase. So, both the
equilibrium price and equilibrium quantity rise. We can conclude easily that there is an
increase in demand. The diagram 2.1 (3), P10 represents the changes in price and
quantity, original and new demand curve as well.
Cathay Pacific --- Diagram 2.1 (4), P10
When supply increases, the price falls and the quantity increases. The supply curve shifts
rightward.
For Cathay Pacific, the closing price of the stock decrease, while volume transacted
increase. In another words, the equilibrium price decrease and the volume transacted
increase. Therefore, we can obtain the answer that there is an increase in supply. The
diagram 2.1 (4), P10 shows the changes in closing price and volume transacted, original
and new supply curves as well.
2.1 b --- Diagram 2.1 (5), P11
We have seen that a decrease in demand leads to a decrease both in price and quantity.
Meanwhile, a decrease in supply causes an increase in price and decrease in supply. We
can combine these two changes. Owing to either a decrease in demand or a decrease in
supply decrease the quantity, and consequently the equilibrium quantity decrease when
both demand and supply decrease. However, a decrease in demand leads to decrease in
price and a decrease in supply raises price. Therefore, it is uncertain whether the price
will rise or decline.
Using the same approach, we can conclude all the other possible conditions as follow.
When the demand and supply both increase, the quantity increases while the direction
of price change is uncertain.
When demand increases and supply decreases, the price rises and again the direction of
change in quantity is uncertain.
When demand decrease and supply increase, the price falls and the direction of quantity
change is uncertain.
For the supposed situation of CLP, there is a decrease in volume transacted and the
closing price remains constant. Therefore, we can figure out the only possible condition
from the four alternatives using exclusive method, which is the decrease both in demand
and supply. On the other hand, as a result of the price of the closing price is supposed
unchanged, the magnitudes that the supply curve shifts leftward equal what the
demand curve do. The diagram represent the change in this situation can be found in
diagram 2.1 (5), P11
Question 2.2
Country X mainly produces two types of agricultural products: rice and wheat. The
supply curves for rice and wheat are identical and both products are selling at the
same market price of $5 per kg and have the same equilibrium quantity transacted
of 1,000kg per day. We also know that the demand for wheat is more price elastic
than that of rice. Now suppose Country X has imposed a price ceiling of $4 per kg
on both products.
a) Which product will have a larger excess demand after the imposition of the
price ceiling?
b) Which product will have a higher black market price?
Ans
2.2 a
A price ceiling is a government-imposed limit on how high a price can be charged on a
product. It may differ from market price as shown in diagram 2.2 (1), P11
Price Elasticity measures the price responsiveness of change in Quantity demand to
change in Price. The higher the absolute value of elasticity, the higher the good elastic
will be.
% Qd
The price elasticity of demand =
% P
For the question, we can figure out from the definition of elasticity that the higher the
price elasticity of a particular good, the flatter the slope of the good curve will be. Owing
to the demand for wheat is more price elastic than that of rice, we can understand that the
demand curve of wheat flatter than that of rice. If price ceiling of $4 dollars are imposed
on both goods, the supply-demand diagram will be as shown in diagram 2.2 (2), P11 .
From the diagram mentioned above, the gap between Qd & Qs of wheat is larger. Then
the excess demand of wheat will be larger than that of rice after the imposition of price
ceiling.
To illustrate the solution stronger, let us consider an example. If price ceiling of $4
dollars are imposed on both good A and B, the supply-demand diagram is shown as
diagram 2.2 (3), P12.
Price Elasticity measures the price responsiveness of change in Quantity demand (Qd) to
Qd
change in Price (P). It can be calculated by
. %
This
(absolute) value is higher for a
% P
more elastic good.
According to the above supply-demand diagram and the equation mentioned, we can
calculate the Price elasticity of demand as follows:
Product
Decrease in Price
Increase in Qd(kg/day)
% change in Price
% change in Qd
Price Elasticity of demand
A
From $5 to $4
From 1000-1500
20%
50%
2.5
B
From $5-$4
From 1000-1100
20%
10%
0.5
The above calculation shows that A has higher price elasticity of demand than B. This
proves that the demand curve is flatter for a more elastic product. At the same time, a
larger excess demand after the imposition of the price ceiling will happen on the more
elastic products.
2.2 b
The black market is the market includes not only legally-prohibited commerce. It
emerges when Price is set above or below the equilibrium the market price, i.e. price
ceiling or price floor.
The black market price is a price above the price ceiling, at which people sell and buy
goods.
As price ceiling is set, there is a problem of excess demand. Some people are willing to
pay a higher price than the price ceiling price $4 so that the black market rises. At the
same time, some people will shift to buy the alternatives.
However, as there is higher availability of substitutes for goods of higher price elasticity
of demand, buyers can easily switch to substitutes when black market price increases.
Therefore wheat, which has a higher price elasticity of demand, will have less black
market activities emerge as wheat buyer will shift to other alternatives, instead of paying
a high black market price. In Contrast, as rice has lower price elasticity of demand,
buyers cannot switch to other substitutes easily. They can choose only to pay a higher
black market price for it. There will be less black market activities for wheat than rice so
that people will pay a higher price for rice. What is just as shown in the diagram 2.2 (4),
P12
Consequently, rice will have a higher black market price.
Diagram List
Diagram 2.1
Diagram 2.1 (1)
Diagram 2.1 (2)
Diagram 2.1 (3)
Diagram 2.1 (4)
Diagram 2.1 (5)
Diagram 2.1
Graph 2.2 (1)
Supply-demand diagram for Wheat(Left) and Rice(Right)
Diagram 2.2 (2)
Diagram 2.2 (3)
Diagram 2.2 (4)
Topic 3 – Elasticity of Demand
Question 3.1
The Eastern Harbour Tunnel increased the tolls by an average of 67% on 1 May 2006.According to
the government’s estimates, the higher tolls will eventually reduce the Eastern Harbour Tunnel and
the Cross Harbour Tunnel by 21% and 3 % respectively (while at the same time the tolls of these two
tunnels remained unchanged)
a) Based on the government’s estimates, describe the price elasticity of demand for the service of
the Eastern Harbour Tunnel and compare the closeness of substitution between the Eastern Harbour
Tunnel and the other two cross-harbour tunnels.
b) CITIC Pacific is a major shareholder of both the Eastern Harbour Tunnel and the Western Harbour
Tunnel. Therefore the profit of this company will rise and fall with the joint profit of the two tunnels,
other things being equal. Assume that the costs of operating the two tunnels will remain unchanged
despite the changes in the traffic flows of each of them. Based on your answer in (a), explain with
appropriate disgrams whether CITIC Pacific will gain or lose from the increase in tolls. [Note:
Although in reality the tunnels charge different types of vehicles different tolls, for simplicity, assume
in your analysis that each tunnel only charges a fixed amount of toll on all vehicles.]
ANS
A. Price elasticity of demand (|PED|) is a measure of the responsiveness of the
quantity demanded of a good to a change in its price, when all other factors remain
constant.
|PED| is calculated by using the following formula:
|PED| = Percentage change in quantity demanded ÷ Percentage change in price
= -17% ÷ +67% = 0.25
(We normally take the absolute value of |PED| as the negative value is invalid.)
In this case, the percentage change in quantity demanded (-17%) is less than the
percentage change in price (+67%). The price elasticity of demand is between zero
and one (Ed=0.25), that means the demand of Eastern Harbour Tunnel is inelastic.
Although the price is raised, this does not cause any great influence on total traffic
flow of the Eastern Harbour Tunnel. Most of the drivers are still willing to access the
Eastern Harbour Tunnel due to the necessity and convenience matter. However, this
will cause an increase of demand on its substitutes.
Regarding to the closeness of substitution, it states the closeness of substitutes for
a good or service, the more elastic is the demand for it. In this case, we compare
Eastern Harbour Tunnel together with other two tunnels by using cross elasticity of
demand. The definition of cross elasticity of demand states the responsiveness of
the demand for a good to the price of a substitute or complement, other influences
remain the same.
The cross elasticity of demand (|CED|) is calculated by using this formula:
|CED| = Percentage change in quantity demanded of X ÷
Percentage change in price of Y
For Western Harbour Tunnel(X) and Eastern Harbour Tunnel(Y),
|CED| = +21% / +67% = + 0.31
For Cross Harbour Tunnel(X) and Eastern Harbour Tunnel(Y),
|CED| = +3% / +67% = + 0.04
As we can see that, their elasticity are both positive, which means Cross Harbour
Tunnel and Western Harbour Tunnel are the substitutes of Eastern Harbour Tunnel.
However, the cross elasticity of demand for Western Harbour Tunnel and Eastern
Harbour Tunnel is slightly larger. Hence, this shows that Western Harbour Tunnel is
the closer substitute of Eastern Harbour Tunnel, compared with Cross Harbour
Tunnel.
B. For Eastern Harbour Tunnel, the decrease in quantity demanded (traffic flow) is
17% only (Q1→Q2), although the tolls have increased by 67% (P1→P2). The
percentage gained is greater than loss, thus the total revenue will increase. The
illustration is shown as Diagram 1 below:
Eastern Harbour Tunnel:
Diagram 1
↓Quantity demanded (-17%) X ↑Price (+67%)
=↑Total Revenue
4
For Western Harbour Tunnel, it is a substitute of Eastern Harbour Tunnel. When
the tolls of Eastern Harbour Tunnel increased, Western Harbour Tunnel has an
increase in demand (+21%) even its tolls remain unchanged. The demand curve
will shift from D1 to D2 and the quantity demanded will increase (Q1 to Q2). That
means the increase in demand of Western Harbour Tunnel generate revenue, as
the tolls remain unchanged. The diagram is presented below as Diagram 2:
Western Harbour Tunnel:
Diagram 2
We assume that the operating costs for both tunnels remained unchanged. When
the revenue for both tunnels increased and the total cost remains constant, the
total revenue of CITIC Pacific will be increased.
(↑Total Revenue + Total Cost (unchanged) =↑Total Revenue)
:: End of Question 3.1 ::
↑Quantity demanded (+21%) + Price (unchanged)
=↑Total Revenue
Question 3.2
Diagram 5
A. According to the condition of the question, cigarettes are more price elastic than
cigars. In above Diagrams 3 and 4, we can see that these two products have
different price elasticities. The demand curve of cigars is steeper than the demand
curve of the cigarettes.
If the government of country X want to impose a unit tax of $3 on a product, then
the suppliers will command a higher price at each level output supplied. It means
that there will be an upward shift in the supply curve. Therefore, in Diagram 5, the
supply curve will shift from S1 to S2.
6
Due to the difference of elasticities between these two products, the quantity
demanded for cigarettes will decrease from Qd1 to Qd2 after imposing a unit tax of
$3, but the quantity demanded for cigars will only decrease from Qd1 to Qd3 in
Diagram 5.
In order to maximize the tax revenue of the government, we need to compare the
tax revenue of both products. Government’s tax revenue equals the per-unit tax
multiplied by the new quantity demanded. So, the tax revenue of cigarettes will be
Qd2 x $3, which is indicated the red area in Diagram 5. And the tax revenue of
cigars will be Qd3 x $3, which means the blue area in the same diagram.
After comparing the tax revenue of these two products, it is obvious that cigars
have more tax revenue than cigarettes. Thus, to maximize the tax revenue, the
government of country X should impose the unit tax on cigars instead of cigarettes.
B. In this part, the government of country X wants to maximize the reduction of
consumption through imposing a unit tax on one of the tobacco products. As
mentioned in part (a), owing to the difference of elasticities between cigars and
cigarettes, their quantity demanded will be changed differently after imposing a
unit tax. In Diagram 5 shown above, the quantity demanded for cigarettes will
decrease from Qd1 to Qd2, but the quantity demanded for cigars will only decrease
from Qd1 to Qd3. The decreasing magnitude of the quantity demanded of
cigarettes is larger than cigars, which means that imposing a unit tax will have
greater impact on cigarettes.
Therefore, in order to maximize the reduction of consumption of tobacco products,
the government of country X should impose the unit tax on cigarettes rather than
cigars.
Topic 4 – Production and Cost
Question 4.1
There is an increase in the demand of a firm's output. There are five methods for
the firm to increase the quantity supplied of their product. Which one of them is
quicker? Which one is slower? We shall rank them accordingly.
Options:
A. Begin a second production shift by hiring more workers
B. Build a second production line in the existing manufacturing plant
C. Buy more materials and increase the rate of production
D. Deplete product inventories
E. Build a second manufacturing plant
Before we rank the options, we need to set up the criteria of ranking first. There
are two main factors that we need to consider, namely the factors of production
involved and the types of change required.
For the factors of production, if less factors of production are required, the quicker
the option can be implemented. We need to consider different types of production,
namely fixed factors and variable factors. Fixed factors are the factors that will not
vary with the amount of output, and it cannot be changed in short run; Variable
factors are the factors that will vary with the amount of output. As fixed factors is
more difficult to change than variable factors, so for the options, the less fixed
factors are needed to be added the quicker the option can implemented.
For the types of change, it means that when you practice the option, the company
should be capable to deal with additional aspects, both internal and external ones.
To make a change internally is faster than making a change externally, as less
transaction costs are involved, such as information cost.
According to the above criteria, I will rank the options D > C > A > B > E. It means
that depleting product inventories is the fastest method while building a second
manufacturing plant is the determined as the slowest.
8
For depleting product inventories (D), it means decreasing the inventories stored
in the company. As it only lowers the stock level, thus no factors of production are
required to increase output.
For buying more materials and increase the rate of production (C), as we need to
increase the materials, so there is an increase in the variable factors. And also the
firm may need to deal with external parties, such as the material suppliers. Also, if
the firm want to increase the rate of production, they could implement such
through punishment, bonus and training, thus making alterations to internal
policies. This option is slower than the previous one as the firm has to put more
effort then the previous option (D).
For beginning a second production shift by hiring more workers (A), as we need to
increase the number of labour to increase output, so there are increase in the
variable factors. Hiring a worker is more difficult than simply increasing the
materials, as the firm is required to provide training to new staff and to spend
effort on manpower recruitment, such as interviews and to run aptitude tests.
Rearrangements of working shifts are also required. Thus this option is slower than
C and D.
For building a second production line in the existing manufacturing plant (B), the
firm has to increase the labour and machineries to increase the output, so both the
fixed factors and the variable factors has to be changed. As there are changes in
the fixed factors, this option is slower than other options that do not have to alter
their fixed factors. Moreover, in order to build a new production line, the firm has
to interview the new working force, to provide training, and to put effort in
comparing the price and quality of machinery required, as well as proposing a
change in working shifts and even the company structure. So it is slower than the
previous options A, C and D.
For building a second manufacturing plant (E), the firm may need to acquire more
materials, labours, machineries and also a new plant. So both the fixed factors and
the variable factors have to be changed. According to the criteria of the factors of
production, the more the fixed factors are added, the slower the option will be. In
this option, two fixed factors were added, so therefore this is slower than the
option of building a new production line in the existing plant (B). Nevertheless, the
firm is required to find constructors to build the new manufacturing plant, and to
hire labour and machinery, thus this option is the slowest one among all five.
Which option is long run? And which option is short run?
By definition, Short run is a time period in which some of the factors of production
cannot be varied and there is at least one fixed input. Long run means a time
period in which all factors of production can be varied, and there is no any fixed,
but only variable factors.
The following 4 options are in the short run, as they all have at least one fixed input:
Option
Fixed input(s)
A – Begin a second production shift by
hiring more workers
B - Build a second production line in the
existing manufacturing plant
C – Buy more materials and increase the
rate of production
D – Deplete Product Inventories
Plant and Machinery
Plant
Plant and Machinery
Plant and Machinery
There is only one option in long run - building a second manufacturing plant (E),
which is the slowest option. This option is in the long run as the machine and plant
has become variable factors, and there are no fixed factors anymore. Thus, this
option is defined as a long-run.
Question 4.2 –
A grocery store currently adopts the manual system for its daily operation, which is
to use manpower to enter the prices of items into the cashier by hand. The store is
currently considering to introduce an automated system, in which uses laser beam
readers and barcodes to assist the staff members.
Under the manual system, each staff member is able to enter 360 items into the
cashier per hour. It is estimated that the hourly sales rate is 3600 items, while the
total number of staff members being hired is 10. Their remuneration, which is on an
hourly basis, is $18. There are no fixed costs of using the manual system.
A. As Total Costs equals to Fixed Costs plus Variable Costs (TC=FC+VC), all costs
incurred in using the manual system are variable costs as there are no fixed costs
incurred in using the manual system.
Average Variable Costs = Total Variable Costs ÷ Quantity
= 10 staffs x $18 ÷ 3600 items = $ 0.05 per item
Average Total Cost = Average Fixed Costs + Average Variable Cost
= $0 + 10 staffs x $18 ÷ 3600 items = $ 0.05 per item
B. The grocery store will incur an operating cost if they introduce the automated
system. The hourly operating cost is $54, which is determined by spreading out the
total operating costs over the system’s expected life. This operating cost must be
paid whether the system is utilized or not – the cost will not change whether he sells
groceries or not. This operating cost is defined as a fixed cost; as such costs do not
change with the output level, which is the sales level in this example.
As the automated system will increase the output level of each staff member being
hired, less staff members will be required to handle the same sales level. Under the
automated system, one staff member is able to handle 600 items per hour.
Assuming that the sales level remains at 3600 items per hour, the total number of
staff required to operate the grocery store by using the automated system will be
3600 items divided by 600 items per hour, which is 6 staff members only.
The average variable costs is equal to the total variable costs divided by the quantity
sold per hour: = 6 staffs x $18 ÷ 3600 items = $ 0.03 per item
The average total cost is the sum of the average fixed cost and the average variable
costs: = ($54 ÷ 3600 items) + (6 staffs x $18 ÷ 3600 items) = $ 0.045 per item
C. We shall evaluate the owner’s choice of using the manual or the automated system
when the sales level is 3600 items per hour. We should use the Average Total Cost
(ATC) to judge which system is to be used. The system which bears a lower ATC
should be used as to minimize the operating costs of the grocery store.
As the ATC of using the manual system and the automated system is $0.05 and
$0.045 per item respectively, the ATC of using the automated system under the sales
level of 3600 items per hour is lower than that of using the manual system. Thus, we
can conclude that the owner of the grocery store should buy the automated system
if the estimated sales level is 3600.
D. If the estimated sales level will drop from 3600 items per hour to 1800 items per
hour, the ATC of using both systems will also change. As the workload for each staff
is reduced, less staff could be hired regardless the system being implemented.
The total number of staff required under the manual system is 1800 items ÷ 360
items per hour, which is 5 staff members. As for the automated system is 1800
items ÷ 600 items per hour, which is 3 staff members.
The ATC if using the two systems will change also if the sales level drops to 1800
items per hour. Under the manual system, the average total cost is simply the
average variable cost, which is 5 staffs x $18 ÷ 1800 items, which is $0.05 per item.
As for the automated system, the average total cost is the sum of the average fixed
costs and the average variable costs, which is $54 ÷ 1800 items + 3 staffs x $18 ÷
1800 items, which leads to a sum of $0.06 per item.
12
As the ATC of using the automated system is higher than the manual system, the
manual system should be adopted when the sales level is 1800 items. Thus, the
owner should change his decision of adopting the automated system, but to
continue using the current manual system. The following graph, Diagram 6, shows
the ATC curves associated with the two systems:
13
Q.4.3
David, a former PolyU graduate, was initially earning $300,000 a year from his job. After careful
consideration, David decided to quit his job and start his own business. His mother agreed to let
David use a unit that she owns in a commercial building as the office. While David only needs to pay
his mother a rent of $60,000 per year, the unit can actually command a market rent of $200,000 if it
is rented to outsiders. David borrows $1 million from the bank to purchase equipment ( which we
assume does not depreciate and can last forever). Total revenue during the first year is estimated to
be $2.2 million. Total labor costs for the first year are $1.2 million and other costs are $500,000.
David pays $100,000 interest to the bank on the use of the loan. Is it a correct decision for David’s
family (which consists of David and his mother) to run this business? Please show your calculation.
ANS
David, a former PolyU graduate, was initially earning $300000 a year from his job. After
consideration, David decided to open his own business. In this report, all numerical data concerning
cost and benefits would be analyzed in terms of economics so that we could make a conclusion
whether David’s family would make a right choice.
Regarding the information given by question 4.3, David has two choices currently. The first choice
is that he would remain his initial job. Another one is that he would give up his current job and start
his own business. We would compare these two choices through economic principle – The
cost-benefit principle.
There is a rationale behind for using this economic principle. David could not choose both choices
due to the problem of scarcity. Scarcity is the initial constraint applied in all economic theory. Scarcity
is a universal phenomenon in which a relative concept is involved. Economics assumes we have
unlimited wants which can’t be satisfied by our limited resources on hand. For instance, we would
face time and money constraints in our daily life. If our resources are unlimited on our earth,
economics is redundant. Whether we face scarcity, we have to make choice. Cost is involved after we
have made a choice. Cost is the highest-valued option forgone. In David case, since he only faces two
choices, both of which are mutually exclusive, trade off (cost) is involved. We would compare these
two choices in terms of benefit and cost.
For staying his initial job, David and his family would earn $500000 benefit in total. Firstly, David
could earn his $300000 a year from his job. Besides this, David’s mother would also earn $200000
market rent by leasing her commercial building to outsiders. After summing up two benefits,
$500000 is calculated.
For opening his own business, David‘s family would get $400000 total benefit. At first, David would
be able to earn $340000 accounting profit from his business. The profit calculation is shown below:
Revenue:
$2.2 millions
Cost:

Total labor costs
$1.2millions

Other costs
$0.5millions

Interest to the bank on the use of the loan
$0.1millions

Rental payment
$0.06millions $1.86millions
Profits:
$0.34millions
Apart from accounting profit from his business, David’s mum could also earn $60000 rental
payment from his son a year. After summing up two benefits, $400000 is counted
In cost analysis for both choices, as only two choices are available to David, 2 alternatives have
become trade-off of each other. The cost of choosing one action would be the benefit arising from
another action, which is highest-valued alternative.
If David chooses to stay his initial job, his cost would be the benefits emerged from starting his own
business, which is $400000 as calculated before. In contrast, the cost for David choosing to start his
business would be the benefits arising from staying his initial job, which is $500000. The cost and
benefit comparison for both choices are shown below:
Benefit
Cost
Staying his initial job
$500000
$400000
Starting his business
$400000
$500000
According to the Cost-Benefit principle, an individual should take an action, if and only if, the extra
benefits from taking the action are at least as great as the extra costs.
For theory applied in David’s case, starting business would be a wrong decision for David’s family case
as the costs outweigh the extra benefits. According to economics definition, a net gain is the
difference between the benefits and costs. David‘s family would get a negative ($-100000) net gain if
David started his business. On the contrast, David‘s family would get positive ($ 100000) net gain
once David remained his initial job.
To conclude, David should stay his job in economics sense.
Q.5.2
A small town in Middle Earth has the following monthly demand and supply equations for rice per kg:
Demand: Qd=20-P
Supply:
Qs=-10+2P
where P is the price of rice per kg. The rice market in this small town belongs to perfect competition.
a) What are the equilibrium price and quantity in this market?
In equilibrium price, quantity demanded (Qd) must equal to quantity supplied (Qs).We can find the
answer with this equation.
Qd = Qs
20 – P = -10 + 2P
30=3P
P=10
∴Equilibrium price is $10
We find that equilibrium price is $10. Now sub this answer into both demand and
supply equations.
Qd = 20 -10
Qd = 10
Qs = -10 + 2P
Qs = -10 + 2(10)
Qs = -10 + 20
Qs = 10
We can see both quantity demanded and quantity supplies are 10.
∴Quantity in this market is 10KG.
The local government plans to assist the rice producers by increasing the price of rice.
It is studying the following two alternative schemes as a means of increasing price.
In the first scheme, the government offers to purchase, at a price of $15 per kg, any amount of
rice that is produced but not sold to consumers. The government then destroys all the rice purchased.
b) Under the first scheme, what is the amount of rice purchased by the government?
Revenue
market
form
P
20
Qd
Excess Supply
Qs
Total
amount
government paid
(20 – 5) x 15
=225
S
Price Floor
15
of
10
5
D
0
5
10
15
20
Q
Amount of rice purchase
by governmant
Qs –Qd
20 – 5 = 15
=15
In this scheme, government will set a price floor at $15. This price level is higher than equilibrium
price. Quantity supplied is equal to 20kg and quantity demanded is equal to 5kg. Excess Supply is
formed in this price level, it is 15kg.
According to the first scheme, government will purchase the amount of rice that is produced but not
sold to consumers. That means the total amount of excess supply. The amount of rice purchase by
government should be equal to 15kg.And the total amount of government paid is $15 x 15kg = $225.
c) Under the first scheme, what is the social surplus at market equilibrium?
Social surplus means Consumer Surplus + Producer Surplus.
In other words, social surplus is:
Total Use Value (TUV) – Total Exchange Value (TEV) + Total Revenue (TR) – Total Cost (TC)
P
20
a
abc
S
c
b
Consumer
Surplus
(5x5)/2
=12.5
Price Floor
f
15
10
cdf
Producer
Surplus
(10x20)/2
=100
d
5
D
e
0
5
Qd
g
10
15
20
Qs
Q
abfdc
Social
Surplus
12.5+100
=112.5
This diagram shows the condition of the first scheme.
The area of abe0 is total use value (TUV) of consumer, it is $87.5. And total exchange value (TEV)
should be the area of cbe0, it is $75. Consumer surplus should be equal to TUV – TEV. It should be
$12.5.
Total revenue (TR) of producer is the area of cfg0, it is $300. And the area of dfg0 is the total cost (TC)
of producer, it is $200. Producer surplus should be equal to TR – TC. It should be $100.
Social surplus means the total of consumer surplus and producer surplus. In this scheme, consumer
surplus is $12.5 and producer surplus is $100. Social surplus should be $112.5 (The area of abfdc)
In the second scheme, the government decides to purchase, at a price of $15 per kg, all the rice
produced. That is, the rice producers will only sell their rice to the government at a price of $15 per
kg. The government then puts all of the rice purchased on the market for resale to consumers at
whatever price consumers are willing to pay for that quantity
d) Under the second scheme, what price will the government receive when it resells all of its rice?
In the second scheme, there include two transactions. One is between rice producer and government
(Purchasing). Another is between government and consumer (Reselling).
Government pays $15 rice producer for each kg .
Qs = -10 + 2P
Qs = -10 + 2(15)
Qs = -10 + 30
Qs = 20
Quantity supplied will be equal to 20kg. Producer is willing and able to sell 20kg to government if
price is $15.
If government wants to resells all the rice, quantity demanded should be equal to 20kg.
Qd = 20 - P
20 = 20 – P
P=0
Government should resell in $0 per 1 kg and the quantity demanded will be same as quantity
supplied.
e) What is the social surplus associated with the second scheme?
P
20
S
a
b
abd0
15
10
c
abc
5
d
0
5
10
15
Total Revenue
(Paid
by
Government)
15x20
=300
Producer
Surplus
10x20/2
=100
Q
20
This diagram shows the transaction between rice producer and government. Total revenue (TR) of
producer is the area of abd0, it is $300. And the area of cbd0 is the total cost (TC) of producer, it is
$200. Producer surplus should be equal to TR – TC. It should be $100(abc).
P
e
20
15
de0
Consumer
Surplus
20X20/2
=200
10
D
5
d
0
5
10
15
Selling price
is ZERO
20
And this diagram shows the transaction between government and consumer. The area of de0 is total
use value (TUV) of consumer, it is $200. And there is no more total exchange value (TEV), it is because
the selling price of government to resell all the rice is zero. Consumer surplus should be equal to TUV
in this scheme. It should be $200.
Social surplus means consumer surplus plus producer surplus. In this scheme, social surplus should
be $300.
f) Which scheme will you recommend to this government? Briefly explain your answer.
We should compare the social welfare of these two schemes. The larger one is better. It is different
between social benefit and social cost.
In this case, we assume social surplus is the social benefit and total amount of government paid is the
social cost.
First Scheme
P
abfdc
20
a
S
c
b
f
Price Floor
15
bfeg
10
Social
Surplus
12.5+100
=112.5
Total
amount of
government
paid
15x15
=225
d
5
D
e
0
Social welfare
112.5 – 225
= -112.5
g
5
10
15
20
Qd
Q
Qs
In the first scheme, social surplus (social benefit) is the area of abfdc (according to part C). It is $112.5.
Total amount of government paid (social cost) is the area of bfeg. It is $225. Social welfare in the first
scheme should be $-112.5.
Second Scheme
P
20
e
S
a
b
15
10
c
5
D
d
0
5
10
15
20
Producer Surplus
abc
10x20/2
=100
Consumer Surplus
de0
20X20/2
=200 = 300
Social surplus
Total amount of
government paid
15x30
Social welfare
=300
300 – 300
=0
In the second scheme, social surplus (social benefit) is the area of ed0 + abc (according to part E). It is
$300. Total amount of government paid (social cost) is the area of abd0. It is $300. Social welfare in
the first scheme should be 0.
We can see that, social welfare of first scheme is $-112.5 and second scheme’s is 0. Second scheme is
better. We recommend Second Scheme to this government.
Q.5.3
(a)
Table (i)
Output (in
thousand)
Short-run
AC ($)
Short-run
TC
($)
(Output x
AC)
(in
thousand)
Price ($)
Qd
(in
thousand)
Total
Revenue ($)
(P x Qd) (in
thousand)
Profit
($)
(TR-TC) (in
thousand)
1
13
13
22
1
22
9
2
10
20
21
2
42
22
3
9
27
20
3
60
33
4
12
48
19
4
76
26
5
16
80
18
5
90
10
6
20
120
17
6
102
-18
7
25
175
16
7
112
-63
To find out the profit maximizing output level, price and profit earned by Firm X if the firm is
operating in the small plant, total cost, total revenue and profit earned for different levels of output
have to be calculated first, where total cost = output x average cost, total revenue = price x quantity
demanded (Qd) and profit = total revenue – total cost. From Table (i), it shows that the largest profit
that the firm can earn is $33,000. Therefore, the profit maximizing output level is 3,000 and price is
$20 while the profit earned by the firm is $33,000.
(b)
Table (ii)
Outp
ut
(in
thou
sand
)
Price
($)
Short-run
AC
of
small
plant ($)
Short-run
AC
of
medium
plant ($)
Short-run
AC
of
large
plant ($)
Long-ru
n AC ($)
Long-run
TC ($) (in
thousand
)
Total
Revenue
($)
(in
thousand
)
Profit
($) (in
thous
and)
1
22
13
18
22
13
13
22
9
2
21
10
15
18
10
20
42
22
3
2
9
13
15
9
27
60
0
3
3
4
19
12
11
13
11
44
76
32
5
18
16
13
12
12
60
90
20
6
17
20
17
13
13
78
102
24
7
16
25
21
15
15
105
112
7
In long run, there are no variable factors. Therefore, the firm can change plant size (different levels
of capital and labour) and choose a plant size which minimizes cost.
To find out the
average cost for different output levels in long-run, the lowest average costs for different output
levels among the three short-run plants have to be found out. For instance, when the output level is
1,000, the average costs of small, medium and large plant in short-run are 13, 18 and 22 respectively.
Among the three, 13 is the lowest. Therefore, the average cost of small plant in short-run becomes
the average cost in long-run. After doing the same procedure for all other levels of outputs, long-run
average cost for different output levels can then be found out. By calculating long-run total cost, total
revenue and profit which is shown in Table (ii), the largest profit that the firm can earned is shown,
which is $33,000. The profit maximizing output level in long run is 4,000 and the price is $20. The
profit earned is $33,000.
(c)
Table (iii)
Output (in
thousand)
Price ($)
Total Revenue
($) (in thousand)
Short-run Total
cost ($) (in
thousand)
Short-run Profit
($) (in thousand)
1
29
29
13
16
2
28
56
20
36
3
27
81
27
54
4
26
104
48
56
5
25
125
80
45
6
24
144
120
24
7
23
161
175
-14
To find out the profit maximizing output level, price and profit earned by Firm X if the firm is
operating in the small plant, short-run total revenue, total cost and profit for different output levels in
small plants have to be calculated. To calculate new profit earned after increase in price, new total
revenue has to be calculated which total cost can be copied from part (a). From Table (iii), it is shown
that the profit maximizing output level in small plant is 4,000 and the price is $26. The profit earned
by the firm is $56,000.
Table (iv)
Output
thousand)
(in
Price ($)
Total Revenue
($) (in thousand)
Long-run Total
Cost ($) (in
thousand)
Long-run profit
($) (in thousand)
1
29
29
13
16
2
28
56
20
36
3
27
81
27
54
4
26
104
44
60
5
25
125
60
65
6
24
144
78
66
7
23
161
105
56
To find out profit maximizing output level, price and profit earned in long run, total revenue, total
cost and profit have to be calculated. By calculating total revenue after increase in price and copying
long-run total cost which has been calculated in part (b), profit for different output levels can be
calculated. From Table (iv), it is shown that the largest profit that Firm X can earned is $66,000.
Therefore, the profit maximizing output level is 6,000, price is $24 and profit earned by the firm is
$66,000.
The conclusion that we can draw from the above findings is that higher price allows the firm to be
more economic to expand the scale of production. It is related derived demand because the scale of
expansion depends on the market demand.
Question 5.4
a) Explain the essence of game theory and why it is only applied to oligopoly market but not prefect
competition and monopoly.
Ans. Game theory is a tool for studying strategic behavior－behavior that takes into account the
expected behavior of others and the recognition of mutual interdependence. Firms will consider their
rival’s possible action before making their own decision and this is the most important characteristic
of the oligopolistic market.
In addition, on the basis of the payoff matrix, we can predict the pricing behavior of firms in the
oligopolistic market. This analysis is also applicable to the firms’ decisions regarding advertising,
investment in R&D, etc.
Game theory is only applied to oligopoly market. In prefect competition, firms are free to enter or
exit from the industry. There are so many firms that they are not able to communicate and collude
among themselves. Also, there are perfect knowledge of the market. Consumers know well about the
price charged by sellers. They are not allowed to collude. Last but not least, each firms is the price
taker in the market, they must accept the market price set by the market. Because individual firm’s
output is too insignificant to affect market price. So there is no need to collude the others. In
monopoly market, there is only one seller. So, there is no need to make an agreement among the firms.
b) (i) ABC Ltd. is a small company composed of three persons: the owner Mr. Smart, and two
salesmen, Andy and Paul, In order to show his appreciation for the good effort of the two salesmen,
Mr. Smart has assigned a reward scheme as follows. He is going to offer Andy and Paul the following
choices: (a) give oneself $10,000 of bonus, and (b) give the other salesman $25,000 of bonus. Mr.
Smart tells Andy and Paul that they are only allowed to select either choice (a) or (b) but not both.
Ans. In this case, there are totally four possible outcomes. Both Andy and Paul may choose (a), or
both choose (b). Other situations are Andy chooses (a) and Paul chooses (b) and vice versa. There is
the payoff matrix that shows all the possible outcomes:
(ii) What is the best choice for Andy and Paul if they can communicate and collude before making
their choices? Explain.
Ans. The best choice of Paul and Andy is both of them have the same choice (b)－give the other
salesman $25,000 of bonus. In this way, both Paul and Andy can get $25,000 of bonus. And this is the
best choice benefit both Paul and Andy.
Although either one of them can get $35,000 if he chooses (a) and other choose (b), however in this
way, another one cannot get the bonus. That is not the best choice for Andy and Paul.
(iii) Suppose Andy and Paul have agreed to collude. Explain why their collusion is likely to fail.
Ans. After the collusion, each trust that the other will choose the choice (b). Under this state, he
believes he can get $25,000 if he follows the collusion or $35,000 if he does not follow the collusion
and choose (a). Both Andy and Paul tend to get $35,000 in order to maximize their own benefit. So,
both of them will not follow their collusion and choose (a). Then, their collusion will fail.
(iv) State and explain the Nash Equilibrium of the above game.
Ans. In Nash equilibrium, player A takes the best possible action given the action of player B and
player B takes the best possible action given the action of player A.
In this case, the Nash equilibrium occurs when Paul makes his best choice given Andy’s choice and
when Andy makes his best choice given Paul’s choice.
From Andy’s point of view, if Paul chooses to receive $10,000 bonus, his best action is to get the
same choice (a) as in this case, he can receive $10,000. However he cannot receive any bonus if he
chooses (b). If Paul choose to give the other salesman $25,000 bonus, Andy’s best action is still to get
the choice (a) as in this case, he can receive $35,000 rather than $25,000. So, Andy’s best action is to
choose to give himself $10,000 bonus.
From Paul’s point of view, if Andy chooses to receive $10,000 bonus, his best action is to get the
same choice (a) as in this case, he can receive $10,000. However he cannot receive any bonus if he
chooses (b). If Andy chooses to give the other salesman $25,000 bonus, Paul’s best action is still to get
the choice (a) as in this case, he can receive $35,000 rather than $25,000. So, Paul’s best action is to
choose to give himself $10,000 bonus.
Because each player’s best choice is to give oneself $10,000 bonus, this is the Nash equilibrium
of this game.
Question 6.1
a) Explain why the operation of Hong Kong Disneyland will generate positive
externality to the Hong Kong economy.
Ans. If Hong Kong Disneyland can operate in Hong Kong, it can attract more tourists to visit it. As
Disneyland is famous in the world, many tourists will visit Hong Kong to see whether the park is
interest or not. Furthermore, as a large theme park is built, it requires a large amount of talent people
and workers in operating the park. Thus it can create more employment.
The other industries in Hong Kong, such as hotel and restaurants, may get a ‘boost ’from the
above reasons, which means that the operation can attract more foreign tourists. Because of this, these
several industries will expand and they can absorb more workers and talent people, the opportunities
of employment in Hong Kong will increased gradually. Furthermore, as there is underproduction with
social benefit bigger than private benefit, positive externality in Hong Kong can be generated in
operating the Disneyland in Hong Kong.
b) (i) Suppose that if the Walt Disney Company has to take care of all the infrastructural constructions
including land reclamation, it will not be able to make any profit by operating the theme park in Hong
Kong. Explain and illustrate such a case where it will make a loss.
Ans. When the Walt Disney Company will make a loss in operating the theme park in Hong Kong, the
average cost curve of it will always lie above the demand curve, so that the maximum price will
always lower than the average cost. As the total revenue generate by the Walt Disney Company is
smaller than the total cost, it will make an economic loss. This is shown in graph (a).
Graph (a)
b) (ii) The Walt Disney Company will operate a theme park in Hong Kong only if it can make profit.
Therefore the Hong Kong government completed the land reclamation and building the preliminary
infrastructure work that will support the entire Hong Kong Disneyland Resort. Explain with a graph
the case where Hong Kong Disneyland can make a profit when it does not have to bear there
construction costs.
Ans. For this case, as average cost decrease, the average curve of Hong Kong Disneyland will shift
downward, as the cost require to complete the land reclamation and building the preliminary
infrastructure work are fixed cost only, it will not change although the number of visitors increase. The
MC curve and thus the profit-maximizing point remain unchanged. As the total revenue generated by
the Walt Company is larger than the total cost, it can make an economic profit as the average cost
curve shift downward. This is shown in graph (b).
Graph (b)
c) Explain the rationale for the Hong Kong government to subsidize the Hong Kong Disneyland by
undertaking the infrastructural constructions.
Ans. For this question, consider the case when the Hong Kong government do not subsidize for the
Hong Kong Disneyland. From 6.1(b)(i), it will make an economic loss in operating the theme park,
then it will not invest in doing this project. As a result, the Hong Kong Disneyland will not be built.
The external benefit cannot be gotten. Since the net gain to society is greater than the cost of the
subsidy, the government should subsidize the Hong Kong Disneyland by undertaking the
infrastructural constructions.
Question 6.2
a) Explain with a graph why the market will fail to allocate resources efficiently for the production
of this drug.
P
Graph (a)
MC
D
PM
Ec
PC
A
MR
QM
D
Q
QC
P
B
PM
MC
D
A
Eso
Pso
Ec
PC
so
A
MSB
MR
QM
Graph (b)
D
Q
QC
Qso
Ans. The pharmaceutical company has successfully developed a drug that can cure aids and has a
patent for the drug. It means that the company is the single producer of the drug and only the company
can produce the drug in the market. Therefore, the company is monopoly of the market. Moreover, the
drug can help prevent the spreading of AIDS, thus, there is positive externality in consumption for the
whole society. Due to the positive externality, the marginal social benefit (MSB) is larger than the
marginal benefit (MB) .The marginal benefit curve is equal to the demand curve and it is also the
same as the marginal Private benefit (MPB).
Furthermore, production is carried out by a monopoly, the monopoly’s equilibrium will be the
profit-maximizing point of marginal revenue equals to marginal cost (MR=MC). In the graph (a),
point A will be the wealth-maximizing output at Qm and the price will be in the Pm . In the monopoly
without any positive externality, the company will have the triangle area of deadweight loss ADEc in
graph (a).
Since there is positive externality in the consumption, therefore, the marginal social
benefit(MSB) will not be the same as demand curve. This is because the pharmaceutical obly
concerned about their own benefit, thus, the company will only consider the quantity (Qso)and
price(Pso) at the MPB which is the same as the demand curve in graph(b).When the company
produces in Qso and Pso, the under production will occure. The company will under produc in
quantity and get the under price as its equilibrium. Then, the deadweight loss will be the triangle area
of ABEso in the graph (b) which is lager than the ADEso in the graph (a). It means that the company
get the larger deadweight in the positive externality consumptions than in the monopoly, therefore, the
company fail to allocate resource efficiently for the production of the drug.
b) Suppose the governmwnt knows the situation of this company. What do you suggest tto the
government to deal with the misallocation problem?
P
Graph (c)
MC
MC-subsidy
PM
Pso
Eso
Ec
A
MSB
Egovt
MR
QM
Qso
D
Q
Ans. The government can provide a subsidy to the pharmaceutical company. Providing the subsidy,
the government will reduce the cost for the company. The marginal cost (MC) curve will shift to the
right to MC-subsudy. Then the company will produce at Qso which is the socially optimum output and
receive the socially optimum price Pso. The society will pay for the drug at Pso in the market. Then
the allocation will be efficiently.
Question 6.3
Three households live by a small polluted pond. If the pond water is treated, the water quality will
improve sufficiently so that these households can use the water for gardening, entertainment, etc. If
one of these households treats the water, the resulted improvement in water quality will be enjoyed by
all three households.
The table (a) gives the marginal benefit (MB, where the subscript indicates the household) each
household can derive from an improvement in the water quality (larger number indicates higher level
of quality). It also shows the marginal cost (MC) of the required treatment. (All MBs and MC are in
dollar value)
Table (a)
a) Explain which level of water quality is optimal for this community (of three households).
Ans. The treatment of the pond water is a public good to all three households. The marginal social
benefit (MSB) is the vertical sum of the individual MBs. The social optimal level of water quality is
achieved at level 4, where MSB = ΣMB = MC = 22. This is shown in the table (b).
Table (b)
b) Assume that these three households are enemies (perhaps because they blame one another for
polluting the pond) and never communicate with one another, will the optimal level of water quality
be reached? Why or why not? What can you conclude about the resource allocation in such a case?
Ans. The treatment of the pond water is considered to be a public good. As the given information, no
one will have the incentive to treat the water. The optimal level of water will not be reached. And even
the best outcome, where household 1 treats the water, the water quality will not be higher than level 2.
This is because his MB < MC for water quality levels higher than 2. This water quality level is below
the social optimal water quality level of 4. This is shown in table (c).
Table (c)
For household 2 and 3, they will not treat the water as their respective MBs are lower than the MC for
all water levels. This is shown in table (d).
Table (d)
In conclusion, there is under-allocation of resources to water treatment in such a case. There is
under-production of water quality and it is a case of inefficient resource allocation.
7.1 Peter operates a garage which provides customers with car repairing services.
In March 2006 he bought a 5-year old second hand car from his customer at a
price of $20000. He paid his worker $5000 to repair and clean up the engine, and
then successfully sold the car to another customer for $28000 in June 2006.
Discuss how the 2006 GDP and its components were affected under the three
different approaches of GDP accounting.
ANS:
In GDP accounting, there are three approaches to calculate the contribution to
2006’s GDP of these transactions, which are expenditure approach, income
approach and output approach.
For expenditure approach, GDP consists of four components:
C + I + G + NX
Where
C is consumption expenditure,
I is investment expenditure,
G is government expenditure and
NX is net exports.
By definition of GDP, sales of second-hand item should not be included. The
$20,000 of buying second-hand car by Peter in March 2006 should not be
included in any components of GDP. Since there is no component for business
consumption, the $5,000 of paying the worker to repair and clean should not be
included too. Finally, only the transaction that another customer bought the car
from Peter will be included in 2006 GDP because only this transaction involved
production (i.e. the renewal). The amount will be the value of the renewed car
minus the cost of the second-hand car, i.e. $28,000 - $20,000 = $8,000. And the
amount will be included in the component of consumption expenditure as it is a
household consumption by the customer. Therefore, by expenditure approach,
GDP of 2006 will be increased by $8,000.
For income approach, GDP is calculated by following formula:
Wages + Rent + Interest + Profit + Depreciation + Tax – Subsidy
Again, by definition of GDP, sales of second-hand item, which is the $20,000 of
buying cat by Peter in this question, should not be included. For the income
received by the worker who cleaned and repaired will be included in the
component of wages which is the income of labour. And, for Peter, he earned a
profit in the whole event, i.e. $28,000 - $20,000 - $5,000 = $3,000. This profit will
be counted in the component of profit which is the income of entrepreneur.
Therefore, by income approach, GDP of 2006 will be increased by $8,000 ($3,000
+ $5,000) too.
For output approach, GDP can be calculated by adding up the contribution to
final output. In this question, the only final output is the renewed car which is
cleaned and repaired by worker. The transaction of buying the car by Peter in
March 2006 is excluded because this is not the final output and also this is a sale
of second-hand item. The contribution of the renewed car can be calculated by
the value of the car minus the cost of the car. The value of the car is the price of
selling the car, which is $28,000. The cost of the renewed involves the cost of
buying the car which is $20,000. Therefore, by output approach, GDP of 2006 will
be increased by $8,000 ($28,000 - $20,000) too.
In conclusion, it can be seen that no matter which approach is used, the GDP of
2006 will also be increased by $8,000.
7.2 a) Explain whether each of the following statement is true or false:
(i) Jim bought a new car in August 2004 and then sold it to John in June 2007. As
a result, the value of the car would be included in 2007 GDP only, since that was
the year of the last sale.
ANS:
This statement is totally wrong because a second-hand transaction should be
excluded in calculating the current GDP. According to the question, Jim bought
the new car in 2004, the value of the car has already been included in the GDP of
the year of production. If we include the value of the car in 2007 GDP,
double-counting of this transaction will occur.
(ii) Peter and Paul, who are both full-time students, used to work on their own cars.
Now Peter decides to hire Paul to repair the car radio, and in turn, Paul hires
Peter to keep his car clean. As a result of these new arrangements, GDP rises.
ANS:
This statement is also incorrect. On the grounds that Peter and Paul hire each
other for repairing the car radio and keeping his car clean, all these activities are
not reported for tax purpose despite the fact that these transactions are legal.
Thus, it will not be included in GDP and GDP will not rise.
b) If a Canadian tourist drinks German beer in a restaurant in New York City, how
will the U.S. GDP be affected?
ANS:
Gross Domestic Product (GDP) is the market value of the final goods and
services produced within a given period by factors of production in the economy.
We assume that the restaurant in New York City buys the German beer at
US$100 and then sell it to the Canadian tourist at US$150. According to the
expenditure approach in GDP accounting, GDP = Consumption Expenditure (C) +
Investment Expenditure (I) + Government Expenditure (G) + Exports (X) – Imports
(M). The US$100 should be treated as an import (M) of U.S. and the US$150
should be treated as an export (X) of U.S. Therefore, the U.S. GDP will be
increased by US$50 after this transaction.
7.3 Explain how the following activities should be treated in the GDP accounting:
a) Hong Kong Electric Company issues new shares of stock and uses the
proceeds to finance the construction of a power plant .Hong Kong Electric
Company issues new shares of stock and uses the proceeds to finance the
construction of a power plant.
ANS:
Gross Domestic Product (GDP) is the market value of the final goods and
services produced within a given period by factors of production in the economy.
According to the expenditure approach in GDP accounting, GDP =
Consumption Expenditure (C) + Investment Expenditure (I) + Government
Expenditure (G) + Exports (X) – Imports (M). The expenditure on buying new
shares of stock issued by Hong Kong Electric Company should not be included in
the GDP. This is because there is no corresponding production of any goods and
services when Hong Kong Electric Company issues new shares of stock.
However, the use of proceeds to finance the construction of a power plant is an
investment (I) which should be included in the GDP.
If the expenditure on buying new shares of stock issued by Hong Kong Electric
Company is also included in the GDP, then there will be a double counting in the
GDP.
b) Company A successfully launches a takeover of Company B, in which it
purchases all the assets of Company B. During the takeover Company A hires an
investment bank for financial advice.
ANS:
Gross Domestic Product (GDP) is the market value of the final goods and
services produced within a given period by factors of production in the economy.
According to the expenditure approach in GDP accounting, GDP =
Consumption Expenditure (C) + Investment Expenditure (I) + Government
Expenditure (G) + Exports (X) – Imports (M). The expenditure on purchasing all
the assets of Company B during the takeover by Company A should not be
included in the GDP. This is because when Company A buys the assets from
Company B, Company B sells the assets to Company A, there is simply a change
of ownership without corresponding production of any goods and services.
However, the expenditure on hiring an investment bank for financial advice by
Company A is an investment expenditure (I) which should be included in the GDP.
c) The government pays out social welfare to the poor.
ANS:
Gross Domestic Product (GDP) is the market value of the final goods and
services produced within a given period by factors of production in the economy.
According to the income approach, national income = wages + rent + interest +
profit. The social welfare paid by the government to the poor should not be
included in the GDP. This is because the social welfare paid by the government to
the poor is a transfer payment, it is not the income generated in the production of
goods and services by the poor. There is no corresponding production when the
social welfare is received by the poor.
d) Peter wins $50,000 from Mark Six, and uses half of these dividends to treat his
friends a dinner.
ANS:
Gross Domestic Product (GDP) is the market value of the final goods and
services produced within a given period by factors of production in the economy.
According to the income approach, national income = wages + rent + interest +
profit. The $50000 won by Peter from Mark Six should not be included in the GDP.
This is because the $50000 won by Peter from Mark Six is a transfer payment, it
is not the income generated in the production of goods and services by Peter.
There is no corresponding production when the social welfare is received by
Peter.
However, according to the expenditure approach in GDP accounting, GDP =
Consumption Expenditure (C) + Investment Expenditure (I) + Government
Expenditure (G) + Exports (X) – Imports (M). The half of the dividends ($25000)
spent on the dinner with friends by Peter is a consumption expenditure (C) which
should be included in the GDP.
8.1 Suppose you are the government’s chief economist of country X and after
careful investigation you discover the following economic data apply to your
country:
Autonomous consumption = $200 billion
Marginal propensity to consume (MPC) = 0.8
Autonomous investment = $20 billion
Autonomous government spending = $100 billion
Lump sum tax = $50 billion
Proportional tax rate = 0.1
Autonomous exports = $100 billion
Marginal propensity to import (MPM) = 0.12
You also know that the output of country X is currently at its equilibrium level.
a) Suppose the full employment output of country X is $1,000 billion, what is the
current level of output gap?
ANS:
At equilibrium, aggregate expenditures (AE) = C+I+G+X-M =National income
(Y)
Y  C  I G  X M
Y  C  cYd  I  G  X  mY
Y  C  cY  T  tY   I  G  X  mY
Y  200  0.8Y  (50  0.1Y )  20  100  100  0.12Y
Y  420  0.8Y  40  0.08Y  0.12Y
Y  380  0.6Y
Y  380 / 0.4Y
Y  950
Therefore, the equilibrium income is $950 billion. Considering that the full
employment output of country X is $1,000 billion, the current level of output gap is
$(950-1000) =$-50 billion.
b) Explain whether your government is incurring budget deficit or enjoying budget
surplus.
ANS:
Considering that government tax revenue minus government expenditures is
equal to budget deficit or budget surplus, we have to calculate the value of
government tax revenue and government expenditure. For the government tax
revenue, it is equal to T+tY=50+0.1(950) =$145 billion. For the government
expenditure, it is equal to $100 billion. Thus, government tax revenue minus
government expenditure $(145-100) is equal to $45 billion. The government is
enjoying budget surplus.
c) What is the value of net exports for country X?
ANS:
As the exports minus imports is equal to the net exports, we have to calculate
the value of exports and import. For the exports, it is $100 billion. For the imports,
it is m(Y)=$0.12(950)=$114 billion. Thus, exports minus import $(100-114) is
equal to $-14 billion. The value of net exports for country X is negative.
d) Suppose you know that autonomous investment will be changed by $10 billion
when interest rate is changed by 1%, explain the direction and magnitude of
changes in interest rate for country X in order to reach full employment at
equilibrium.
ANS:
Given that autonomous investment will be changed by $10 billion, interest rate
is changed by 1%. With a view of acquiring the direction and magnitude of
changes in interest rate for country X, we have to find out how much expenditure
should be increased. Due to the multiplier effect, an increase in expenditure will
not be the same as the increase in equilibrium income. As for the output gap ($50
billion) divided by the expenditure multiplier (2.5) equals 20 billion, which is the
value of expenditure needed to increase in a bid to reach full employment output
level. Thus, the interest rate should be decreased by 2% in order to increase $20
billion of autonomous investment for reaching full employment at equilibrium.
e) Suppose the people in country X prefer to purchase more foreign goods such
that there is an increase in marginal propensity to import, explain how such
change in preference affects the multiplier effect.
ANS:
Given that people in country X prefer to purchase more foreign goods such that
there is an increase
in marginal propensity to import. Provided that the
1
1

c

ct

expenditure multiplier is m
, there is an increase in
marginal propensity to import. The value of the expenditure multiplier will
decrease and the multiplier effect will be smaller. In other words, when the
withdrawal of the economy increases, more capital is out-flowing, thus affecting
the equilibrium output level.
8.2 Determination of National Product
The manager of Company A is considering constructing a tolled highway between two cities. Under
the BOT scheme, Company A will build (B) the highway, operate (O) if for five years and then transfer
(T) the highway to the government. The information of the cost and benefit of Company A is given
below.
The building cost, to be incurred immediately, is 2.8 billion dollars.
The construction will take one year to complete. In each of the following five years, the operation of
the highway will generate a net income (after deducting all operating costs) of 0.75 billion dollars. For
simplicity, assume that Company A receives all the annual net income at the end of each year.
a) Calculate the net present value (NPV) of this project at discount rates of 6% and 8%. Explain
whether Company A will invest in the project in each case.
ANS:
Present value is the value on a given date of a future payment or series of future payments,
discounted to reflect the time value of money and other factors such as investment risk
Net present value (NPV) is the investment of the present value of the future income stream minus
the present value of the cost
If...
It means...
Then...
NPV > the investment would
the project may be accepted
0
add value to the firm
the investment would
NPV <
subtract value from the project should be rejected
0
the firm
We should be indifferent in the decision whether to accept or reject
the investment would
NPV =
the project. This project adds no monetary value. Decision should
neither gain nor lose
0
be based on other criteria, e.g. strategic positioning or other factors
value for the firm
not explicitly included in the calculation.
An investment project is worthwhile only if it can operate non-negative NPV.
The larger the NPV, the more worthwhile the investment is.
Because building of highway is proceeding in the first year, so no income will be made. To the NPV
value, the time of the cash flow will start from the second year.
At discount rate of 6%,
NPV=0.180
At discount rate of 8%
NPV=-0.0273
Therefore, from the net present value and sign of the NPV, we can conclude that Company A will
invest in the project at discount rate of 6%.
b) Suppose the manager thinks that given the financial condition of Company A the appropriate
discount rate should be 8% for the highway project. At the same time, this project brings
considerable external benefits to the society. Assume the government has perfect information. It
knows the costs and benefits of Company A and that the present value of all the net external
benefits is 0.8 billion dollars. If Company A is the only firms that possess the technical ability to
build the project, explain whether the government should subsidize Company A such that the
applied discount rate for Company A lowers down to 6%.
ANS:
Without the external benefit:
From (a)
At discount rate of 6%
NPV=0.180
At discount rate of 8%
NPV=-0.0273
Because the manager thinks the appropriate discount rate is 8%, at this discount rate, NPV is smaller
than zero. Company A will not invest in the project.
So government will not receive the highway from Company A as the government is beneficial from
the highway project.
Now, there is 0.8 billion dollars of net external benefits, therefore the NPV value is changed
At discount rate of 6%
NPV=0.180 + 0.8 = 0.980
At discount rate of 8%:
NPV= -0.0273 + 0.8 = 0.7727
From the result, both NPV is larger than zero for discount rate of 6% and 8%. However, However,
Company A will not consider the extra benefit as it only concerns about the profitability of the
project. So it will only invest in the project at discount rate of 6%. So the government should
subsidize Company A such that the applied discount rate for Company A lowers down to 6%
9.1 Fiscal Policy
Suppose in country X the current GDP falls below the full employment GDP by $40 billion and the
government is incurring a budget deficit of $60 billion. The tax revenue of government consists of
both lump sum tax and proportional tax. The current amount of lump sum tax is $10 billion and the
proportional tax rate is 25%. The marginal propensity to consume (MPC) of country X equals 0.8. The
government plans to stimulate GDP by increasing the government spending and lump sum tax by the
same amount.
a) Calculate the amount of increase in government spending that is required in order to achieve full
employment.
ANS:
As the question stated that the current GDP is lower than the full employment GDP with $ 40 billion.
Therefore, it is suitable to use the Government Spending Multipler and Lump sum tax Multipler in
order to calculate the amount of increase in government spending(G) and lump sum tax(T0) which
reach the increase of GDP of $40 billion.
Government Spending Multipler:
Lump sum tax Multipler:
So, change in GDP is equal to change in Lump sum tax plus change in government spending. Also,
change in government spending equal change in lump sum tax as government stimulates GDP by
increasing the government spending and lump sum tax by the same amount.
Using the resulted answer 0.5 to find the change in government spending and lump sum tax to reach
a change in $40 billion of GDP :
So, the Government Spending (also lump sum tax) increased $80 billions in order to achieve full
employment GDP.
b) Based on your answer in part a), calculate the resulting government budget deficit (i.e., tax
revenue minus government spending)
ANS:
In original fiscal policy, there is $60 billion budget deficit:
-60 = Tax revenue- Government Spending.
(A)
In new fiscal policy, we can get the new budget deficit by substitution of (A) and
increase of both government spending and lump sum tax with $80 billions. Also,
increase in GDP of $40 billion.
New budget deficit = $50 billion
9.2 Fiscal Policy
a) To tackle recession and unemployment with expansionary fiscal policy, a government can adjust
either the tax or the government expenditure. Suppose fiscal deficit is not a concern and all taxes are
lump sum tax.
i)Why is government expenditure a more powerful policy instrument than tax?
ANS:
When there is recession and unemployment , the government can increase government expenditure
to stimulate the output level through multiplier effect or reduce the tax to remove the output gap.
If government expenditure (G) increase by $100M , aggregate expenditure (AE) will increase by
$100M.
As AE = C+ I + G + X – M
C = Private consumption
I = investment
G = government expenditure
X = export
M = import
If lump sum tax reduce by $100M , aggregate expenditure will increase by $100M x mpc.
As AE = C + I + G + X – M
C = a + b Yd
, a = autonomous expenditure
b = mpc ( marginal propensity to consume out of disposable
income )
Yd = total income – tax
bYd= induce expenditure
C = a + b ( Y –T )
C = a + bY – bT
( bT = mpc x $100M )
As mpc is always less than 1 , government expenditure has a more powerful effect than lump sum
tax.
$100M > $100M x mpc
Government spending multiplier : 1 / 1-b ( 1- t ) + m
Lump sum tax multiplier : -b / 1- b ( 1-t ) + m
( b <1 )
ii ) Why is government expenditure a less popular fiscal policy instrument than tax?
ANS:
Firstly, increase in G will make the size of government become larger , which is not welcome by
people. Secondly , private expenditure through tax cut is more efficient than government
expenditure because a tax cut can stimulate the economy directly and not need to use an extra
amount of money to implement the policy. Last, It is more flexible as it is more convenience for the
government to just lower the interest rate rather the think of how to spend more on government
expenditure.
b)
Suppose the government adopts debt financing for its expansionary fiscal policy. Explain why it
will lead to crowding-out effect.
ANS:
Debt financing means when government increase government expenditure or reduce tax, it may face
a deficit . The government finance it by issuing bonds . Bond holders can receive interest from the
government . The interest rate is usually high to attract people to buy bonds.
It will discourage private investment , as interest rate and investment is inversely related .
People buy bonds rather than invest, which cause the crowding out effect .
c) “The larger is the interest elasticity of investment expenditure, the less effective is an
expansionary fiscal policy.” Evaluate this statement with reference to the crowding out effect.
ANS:
Investment and interest rate is inversely related .
Because
Equilibrium
bond price
I
=
(1+r)
:
I2
+
(1+r)2
In
+ ....
+
(1+r)n
P
+
(1+r)n
When r increases, equilibrium bond price will decrease. People expect the bond price will rise in the
future , so they will buy bond rather than invest. So investment is inversely related with interest rate.
Larger interest elasticity of investment expenditure means
Percentage change in investment is larger than percentage change in interest rate
With same percentage increase in interest rate
decrease in investment with larger e is larger than decrease in investment with smaller e
( e = interest elasticity of investment expenditure )
As AE = C + I + G + X – M
Increase in AE with larger e will be smaller than increase in AE with smaller e
So the larger the interest elasticity of investment expenditure , the expansionary fiscal policy is less
effective.
Problem Set 10.1 Money and Banking
a) A 10-year bond has a principal of $10,000 and a coupon rate of 8%. The bond will mature in four
years’ time. Therefore its holder will get the coupon interest at the end of each of the coming four
years and the principal four years from now. What is the market price of this bond if the market
interest rate is (i)6%; (ii)8%; (iii)10%?
ANS:
For Part a, it requires the calculation of equilibrium bond price.
It is the equation of calculating the equilibrium bond price:
Where:
I
P
=
=
coupon interest received from the bond
principal of the bond
n
r
=
=
length of maturity of the bond
market interest rate
The coupon interest received from the bond is
=$ 10,000 x 8%
=$ 800
For part (i), the equilibrium bond price under 6% is
=$ (754.7+720.0+671.7+633.7+7920.9)
=$10701
The Equilibrium bond price in 6% market interest rate is $10701
For part (ii), the equilibrium bond price under 8% is
=$740.7+685.9+635.1+588.0+7,350.3
=$10,000
The Equilibrium bond price in 8% market interest rate is $10,000
For part (iii), the equilibrium bond price under 10% is
=$727.3+661.2+601.1+546.4+6,830.1
=$9,366.1
The Equilibrium bond price in 10% market interest rate is $9,366.1
Here are findings from the above calculation. Equilibrium bond price and interest rate are inversely
related. A higher interest rate will result in lower equilibrium bond price. The relationship
between coupon rate and the interest rate also affect the initial principal and the equilibrium bond
price. There are 3 possibilities arise from this findings.
If the market interest rate is lower than the coupon rate, then the equilibrium bond price will be
higher than the initial principal.
If the market interest rate is the same as the coupon rate, then the equilibrium bond price will be the
same as the initial principal.
If the market interest rate is higher than the coupon rate, then the bond price will be lower than the
initial principal.
The reasons underlying is listed below.
The market interest rate is the opportunity cost of holding the money. A higher market interest rate
(exceeds the coupon rate) will attract more people to invest in other investing opportunities, such as
saving deposit, which can give a higher return when compared to the bond, the less attractiveness of
bond implies a lower bond price and vice versa.
b) Using the concept of the “speculative” motive for money demand, explain why the quantity of
money demanded falls when interest rate rises.
ANS:
Speculative demand for money is money demand due to speculation about possible changes in the
bond price. It is about the people hold more(less) money in order to avoid losses (capture gains)
from holding stocks or bonds that are expected to fall (rise) in value.
There are two kinds of interest rates, subjective rate of interest and normal rate of interest.
Subjective rate of interest is the people expectation of the interest rate and it is unobservable.
While the normal rate of interest is the market interest rate it is observable.
If the market rate of interest rises and market rate of interest is exceed subjective rate of interest.
People will expect that there will be a drop of interest rate in the near future. (Until the subjective
rate of interest equal to the normal rate of interest) The equilibrium bond price will rise by a drop
of interest. Therefore, the people believe a positive return will be earned from holding bonds and
they will convert their cash into bonds, the demand for money will be dropped. Hence, the quantity
of money demanded and the interest rate is inversely related.