Answers AllChaps

Answers to in-text Questions in Economics (5th
edition)
Chapter 1
Page
4 Could production and consumption take place without money? If you think they could, give examples.
Yes. People could produce things for their own consumption. For example, people could grow vegetables
in their garden or allotment; they could do their own painting and decorating. Alternatively people could
engage in barter: they could produce things and then swap them for goods that other people had produced.
Before reading on, how would you define scarcity? Must goods be at least temporarily unattainable to
be scarce?
See page 2 of text for a definition of scarcity. Goods need not be unattainable to be scarce. Because
peoples incomes are limited, they cannot have everything they want from shops, even though the shops are
stocked full. If all items in shops were free, the shelves would soon be emptied!
If we would all like more money, why does the government not print a lot more? Could it not thereby
solve the problem of scarcity at a stroke?
The problem of scarcity is one of a lack of production. Simply printing more money without producing
more goods and services will merely lead to inflation. To the extent that firms cannot meet the extra
demand (i.e. the extra consumer expenditure) by extra production, they will respond by putting up their
prices. Without extra production, consumers will end up unable to buy any more than previously.
(Box 1.1) What is it that makes each one of the above news items an economics item?
Each one of the items has something to do with production, consumption or exchange, and/or the money
incomes and expenditures involved.
Which of the following are macroeconomic issues, which are microeconomic ones and which could be
either depending on the context?
(a) Inflation.
(b) Low wages in certain service industries.
(c) The rate of exchange between the pound and the euro.
(d) Why the price of cabbages fluctuates more than that of cars.
(e) The rate of economic growth this year compared with last year.
(f) The decline of traditional manufacturing industries.
(a) Macro. It refers to a general rise in prices across the whole economy.
(b) Micro. It refers to specific industries
(c) Either. In a world context, it is a micro issue, since it refers to the price of one currency in terms of
one other. In a national context it is more of a macro issue, since it refers to the euro exchange rate at
which all UK goods are traded internationally. (This is certainly a less clearcut division that in (a)
and (b) above.)
(d) Micro. It refers to specific products.
(e) Macro. It refers to the general growth in output of the economy as a whole.
(f) Micro (macro in certain contexts). It is micro because it refers to specific industries. It could,
however, also help to explain the macroeconomic phenomena of high unemployment or balance of
payments problems.
Assume that you are looking for a job and are offered two. One is more unpleasant to do, but pays more.
How would you make a rational choice between the two jobs?
You should weigh up whether the extra pay (benefit) from the better paid job is worth the extra hardship
(cost) involved in doing it.
Answers to questions in Economics (5th edition) by John Sloman

Page
8 (Box 1.2) 1. Has the UK generally fared better or worse than the other three countries?
Generally worse until the early 1990s. Unemployment and inflation were higher than in the other three
countries. Growth was generally lower than in the USA and Japan, but higher than in Germany in the
second half of the 1980s.
Since 1993, the picture is more mixed. UK unemployment has been higher than in the USA and Japan,
but has been falling, whereas in Japan it has been rising. UK inflation, although generally higher than in
the other countries, has nevertheless been much lower than in the 1980s, and in 19935 was lower than in
Germany and the USA and in the last period lower than in the USA. UK growth has been higher than that
in Germany and Japan, and similar to that in the USA.
If current account deficits are regarded as undesirable, then both the USA and the UK have fared
significantly worse than Japan and somewhat worse than Germany throughout the period since 1978. Since
1993, the UKs deficit has been lower than that of the USA.
10
(Box 1.2) 2. Was there a common pattern in the macroeconomic performance of each of the four
countries over these 25 years?
Yes, but less clear-cut in recent periods.
Unemployment was higher in the early to mid-1980s and the early to mid-1990s. In the late 1990s,
however, unemployment was rising in Germany and Japan and falling in the UK and USA. Then in the
last period, it was rising in the USA and Japan and falling in Germany and the UK.
Inflation was higher in the first half of the period and between 1990 and 1992.
Growth was higher in the second half of the 1980s (although Germanys growth rate was highest from
1990 to 1992). In the late 1990s, the pattern was less clear cut, given very low growth in Japan and
relatively rapid growth in the USA. In the early 2000s, however, all four countries experienced a
decline in economic growth.
UK and US current account deficits and German and Japanese current account surpluses increased
until the late 1980s and then the trend reversed somewhat. In the last period, all four countries
experienced a worsening of their current account position (i.e. deficits increased and surpluses
declined).
How would the principle of weighing up marginal costs and benefits apply to a worker deciding how
much overtime to work in a given week?
The worker would consider whether the extra pay (the marginal benefit) is worth the extra effort and loss of
leisure (the marginal cost).
Would it ever be desirable to have total equality in an economy?

The objective of total equality may regarded as desirable in itself by many people. There are two problems
with this objective, however.
The first is in defining equality. If there were total equality of incomes then households with dependants
would have a lower income per head than households where everyone was working. In other words,
equality of incomes would not mean equality in terms of standards of living. If on the other hand, equality
were to be defined in terms of standards of living, then should the different needs of different people be
taken into account? Should people with special health or other needs have a higher income? Also, if
equality were to be defined in terms of standards of living, many people would regard it as unfair that
people should receive different incomes (according to the nature of their household) for doing the same
amount of work.
The second major problem concerns incentives. If all jobs were to be paid the same (or people were to
be paid according to the composition of their household), irrespective of peoples efforts or skills, then what
would be the incentive to train or to work harder?
(Box 1.3) What might prevent you from making the best decision?
Lack of knowledge. You will not know just how much benefit you will gain from the textbook until you
have read it, taken your exams or had your assignments marked! Another cause of making poor decisions is
the lack of care taken in making them.
Chapter 1
Page
10 (Box 1.3) 1. If there are several other things you could have done, is the opportunity cost the sum of all
of them?
No. It is the sacrifice of the next best alternative.
12
13
(Box 1.3) 2. What is the opportunity cost of spending an evening revising for an economics exam? What
would you need to know in order to make a sensible decision about what to do that evening?
The next best alternative might be revising for another exam, or it might be taking time off to relax or to go
out. To make a sensible decision, you need to consider these alternatives and whether they are better or
worse for you than studying for the economics exam. One major problem here is the lack of information.
You do not know just how much the extra study will improve your performance in the exam, because you do
not know in advance just how much you will learn and you do not know what is going to be on the exam
paper. Similarly you do not know this information for studying for other exams.
(Box 1.3) 1. Why is the cost of food not included?

Because you would buy food anyway. If, however, food were being provided free of charge by your parents
if you lived at home, but you had to pay for it if you went to university or college, then food would be an
opportunity cost to you.
(Box 1.3) 2. Make a list of the benefits of higher education.

The benefits to the individual include: increased future earnings; the direct benefits of being more educated;
the pleasure of the social contacts at university or college.
(Box 1.3) 3. Is the opportunity cost to the individual of attending higher education different from the
opportunity costs to society as a whole?
Yes. The opportunity cost to society as a whole would include the costs of providing tuition (staffing costs,
materials, capital costs, etc.), which could be greater than any fees the student may have to pay. On the
other hand, the benefits to society would include benefits beyond those received by the individual. For
example, they would include the extra profits employers would make by employing the individual with
those qualifications.
(Box 1.4) 1. There is a saying in economics, There is no such thing as a free lunch (hence the sub-title
for this box). What does this mean?
That there is always (or virtually always) an opportunity cost of anything we consume. Even if we do not
incur the cost ourselves (the lunch is free to us), someone will incur the cost (e.g. the institution providing
the lunch).
(Box 1.4) 2. Are any other (desirable) goods or services truly abundant?
Very few! Possibly various social interactions between people, but even here, the time to enjoy them is not
abundant.
1. What is the opportunity cost of the seventh million units of clothing?

3 million units of food. (Food production falls from 3 million units to zero.)
2. If the country moves upward along the curve and produces more food, does this also involve
increasing opportunity costs?
Yes. Ever increasing amounts of clothing have to be sacrificed for each extra unit of food produced.

Page
13 3. Under what circumstances would the production possibility curve be (a) a straight line; (b) bowed in
toward the origin? Are these circumstances ever likely?
(a) When there are constant opportunity costs. This will occur when resources are equally suited to
producing either good. This might possibly occur in our highly simplified world of just two goods. In
the real world it is unlikely.
(b) When there are decreasing opportunity costs. This will occur when increased specialisation in one
good allows the country to become more efficient in its production. It gains economies of scale
sufficient to offset having to use less suitable resources. We shall look at economies of scale in Chapter
5, sections 5.3 and 5.4. Economies of scale are common in the real world.
Will economic growth necessarily involve a parallel outward shift of the production possibility curve?
No. Technical progress, the discovery of raw materials, improved education and training, etc., may favour
one good rather than the other. In such cases the gap between the old and new curves would be widest
where they meet the axis of the good whose potential output had grown more.
15
Do you agree with the positions that the eight countries have been given in the spectrum diagram?
Explain why or why not.
Given that there is no clearly defined scale by which government intervention is measured, the precise
position of the countries along the spectrum is open to question.
17
Can you think of any examples where prices and wages do not adjust very rapidly to a shortage or
surplus? For what reasons might they not do so?
Many prices set by companies are adjusted relatively infrequently: it would be administratively too
costly to change them every time there was a change in demand. For example a mail order company,
where all the items in its catalogue have a printed price, would find it costly to adjust prices very
frequently, since that would involve printing a new catalogue, or at least a new price list.
Many wages are set annually by a process of collective bargaining. They are not adjusted in the
interim.
18
1. Why do the prices of fresh vegetables fall when they are in season? Could an individual farmer
prevent the price falling?
Because supply is at a high level. The increased supply creates a surplus which pushes down the price.
Individual farmers could not prevent the price falling. If they continued to charge the higher price,
consumers would simply buy from those farmers charging the lower price.
2. If you were the owner of a clothes shop, how would you set about deciding what prices to charge for
each garment at the end of season sale?
You would try to reduce the price of each item as little as was necessary to get rid of the remaining stock.
The problem for shop owners is that they do not have enough information about consumer demand to make
precise calculations here. Many shops try a fairly cautious approach first, and then, if that is not enough to
sell all the stock, they make further end of sale reductions later.
3. The number of owners of compact disc players has grown rapidly and hence the demand for compact
discs has also grown rapidly. Yet the prices of discs have fallen. Why?
The costs of manufacture have fallen with improvements in technology and mass-production
economies.
Competition from increased numbers of manufacturers has increased supply and driven prices down.
Budget-priced CDs of original analogue recordings cost less to produce (there are no new studio costs).
In the early 2000s, the advent of copying CD tracks from the Internet has reduced the demand for CDs.
This change in demand has further compounded the fall in price.
Chapter 1
Page
19 Summarise this last paragraph using symbols like those in Figure 1.7.
The price mechanism: the effect of the discovery of raw materials
Factor Market
Si
Si
Pi
surplus
(Si > Di)
until Di = Si
Di
Goods Market
Sg
Pi
Sg
Pg
surplus
(Sg > Dg)
until Dg = Sg
Dg
20
Are different factor markets similarly interdependent? Give examples.

Yes. A rise in the price of one factor (e.g. oil) will encourage producers to switch to alternatives (e.g. coal).
This will create a shortage of coal and drive up its price. This will encourage increased production of coal.
24
Which of the following are positive statements, which are normative statements and which could be
either depending on the context?
(a) Cutting the higher rates of income tax will redistribute incomes from the poor to the rich.
(b) It is wrong that inflation should be reduced if this means that there will be higher unemployment.
(c) It is wrong to state that putting up interest rates will reduce inflation.
(d) The government should raise interest rates in order to prevent the exchange rate falling.
(e) Current government policies should reduce unemployment.
(a) Positive. This is merely a statement about what would happen.
(b) Normative. The statement is making the value judgement that reducing inflation is a less desirable goal
than the avoidance of higher unemployment.
(c) Positive. Here the word wrong means incorrect not morally wrong. The statement is making a
claim that can be tested by looking at the facts. Do higher interest rates reduce inflation, or dont they?
(d) Both. The positive element is the claim that higher interest rates prevent the exchange rate falling. This
can be tested by an appeal to the facts. The normative element is the value judgement that the
government ought to prevent the exchange rate falling.
(e) Either. It depends what is meant. If the statement means that current government policies are likely to
reduce unemployment, the statement is positive. If, however, it means that the government ought to
direct its policies towards reducing unemployment, the statement is normative.
Chapter 2
Page
31 Assume that there are 200 consumers in the market. Of these, 100 have schedules like Traceys and 100
have schedules like Darrens. What would be the total market demand schedule for potatoes now?
Price
(pence per kg)
20
40
60
80
100
Total market demand

(kg)
4400
2600
1400
800
600
32 1. How much would be demanded at a price of 6p per kilogram?

Reading off from the graph: at a price of 6p per kg, total market demand is 600 000 tonnes per month (or a
little under).
2. Assuming that demand does not change from month to month, plot the annual market demand for
potatoes.
The amount demanded would be 12 times higher at each price. If the scale of the horizontal axis were
unaltered, the curve would shift way out to the right. A simple way of showing the new curve, therefore,
would be to compress the scale of the horizontal axis. (If each of the numbers on the axis were multiplied
by 12, the curve would remain in physically the same position.)
1. Draw Traceys and Darrens demand curves for potatoes on one diagram. Note that you will use the
same vertical scale as in Figure 2.1, but you will need a quite different horizontal scale.
This is shown in Diagram 2.1.
100
90
Price (pence per kg)
80
70
60
50
40
30
20
10
0
0
10
15
20
Quantity demanded (kg per month)
Diagram 2.1 Tracey's and Darren's demand for potatoes
25
30
Chapter 2
Page
32 2. At what price is their demand the same?
The two curves cross at a price of 10p per kg and at a demand of 10 kg per month.
3. What explanations could there be for the quite different shapes of their two demand curves?
One explanation could be that Tracey is quite happy to eat rice, pasta or bread instead of potatoes. Thus
when the price of potatoes goes up she switches to these other foods, and switches to potatoes when the
price of potatoes comes down. Darren, by contrast, may not see these other foods as close substitutes and
thus his demand for potatoes will be less price sensitive. (See section 2.4 on elasticity.)
Do all these six determinants of demand affect both an individuals demand and the market demand for a
product?
All except the distribution of income. The (national) distribution of income simply affects an individuals
income and thus is not a separate determinant from income.
1. Assume that in Table 2.1 the total market demand for potatoes increases by 20 per cent at each price
due, say, to substantial increases in the prices of bread and rice. Plot the old and the new demand
curves for potatoes. Is the new curve parallel to the old one?
See Diagram 2.2 below. As you can see, the curves are not parallel. A constant percentage increase in
quantity demanded gives a bigger and bigger absolute increase as quantity increases.
100
90
80
Price (pence per kg)
33
70
60
50
40
30
20
10
0
0
100
200
300
400
500
600
700
800
900
Quantity demanded (kg per month)
Diagram 2.2 Market demand for potatoes
2. The price of pork rises and yet it is observed that the sales of pork increase. Does this mean that the
demand curve for pork is upward sloping? Explain.
No not necessarily. For example, the price of substitutes such as beef, chicken or lamb may have risen by a
larger amount. In such cases the demand curve for pork will have shifted to the right. Thus although a rise
in the price of pork will cause a movement up along this new demand curve, more pork will nevertheless be
demanded because pork is now relatively cheaper than the alternatives.

Page
34 1. Complete the demand schedule in Table 2:2 up to a price of 50.
P
5
10
15
20
25
30
35
40
45
50
Qd
9000
8000
7000
6000
5000
4000
3000
2000
1000
0
2. What is it about equation (2) that makes the demand curve (a) downward sloping; (b) a straight line?
(a) The fact that the 200P term has a negative sign. This means that as P rises, so Qd falls.
(b) The fact that there is no P to a power term. The curve thus has a constant slope of 1/200
1. Referring to equation (3), if the term a has a value of 50 000 and the term b a value of 0.001,
construct a demand schedule with respect to total income (Y). Do this for incomes between 100 million
and 300 million at 50 million intervals.
Y (millions)
Qd
100
150
200
250
300
50 000
100 000
150 000
200 000
250 000
2. Now use this schedule to plot a demand curve with respect to income. Comment on its shape.
The curve will be an upward-sloping straight line, crossing the horizontal axis at 50 000. It would rise by
100 000 units for each 100 million rise in national income. (See Diagram 2.3).
300
Income ( millions)
250
200
150
100
50
0
0
50
100
150
200
Quantity demanded
Diagram 2.3 Market demand (with respect to income)

8
250
300
Chapter 2
Page
35 (Box 2.1) From this equation, calculate what would happen to the demand for lamb if:
(a) the price of lamb went up by 10p per kg (at 1985 prices).
(b) the price of beef went up by 10p per kg (at 1985 prices).
(c) personal disposable income per head went up by 100 per annum (at 1985 prices).
(a) The demand would go down by 1.12 grams per person per week (i.e. 10 0.112).
(b) The demand would go up by 1.25 grams per person per week (i.e. 10 0.125).
(c) The demand would go down by 1.98 grams per person per week (i.e. 100 0.0198).
(Box 2.1) 1. How does the introduction of the TIME term affect the relationship between the demand for
lamb and (a) the price of beef and (b) personal disposable income per head?
(a) The demand for lamb is less sensitive to a change in the price of beef than in the first equation.
(b) The demand for lamb is slightly more sensitive to a change in disposable income than in the first
equation and the relationship is now a positive one: i.e. when income rises, the demand for lamb rises..
(Box 2.1) 2. Is lamb a normal good or an inferior good?
An inferior good in the first equation and a normal good in the second. In the first equation, as personal
disposable income rises so the demand for lamb falls. In the second equation as personal disposable income
rises so the demand for lamb rises. The reason is that, by introducing the TIME term, we are now allowing
for the fall in demand for lamb over time as a result of a shift in tastes away from meat. In other words, the
second equation allows us to take this factor out of account when looking at the effect of a change in the
price of lamb on the demand for lamb.
(Box 2.1) Use the second equation to estimate the demand for lamb in 1994, 1996 and 2000. In which of
these three years was the estimation closest to the actual figure? Explain the divergences in the actual
figures from the figures derived from the equation.
Qd = 192.3 (0.530 301.6) + (0.0738 343.0) + (0.0261 8266) (7.352 29)
= 192.3 159.85 + 25.31 + 215.74 213.21
= 60.29 (grams per person per week)
1996: Qd = 192.3 (0.530 296.2) + (0.0738 325.6) + (0.0261 8607) (7.352 31)
= 192.3 156.99 + 24.03 + 224.64 227.91
2000: Qd = 192.3 (0.530 310.7) + (0.0738 320.1) + (0.0261 9604) (7.352 35)
= 192.3 164.67 + 23.62 + 250.66 257.32
The equation most closely predicted the actual consumption in 1994: actual consumption (54 grams pppw)
was 6 grams pppw less than predicted by the equation. In 1996 and 2000, consumption was approximately
10 grams pppw more than predicted. This can be explained by BSE, which caused a shift in demand from
beef to lamb in these later two years.
1994:
37
1. How much would be supplied at a price of 70p per kilo?

About 430 000 tonnes per month.
2. Draw a supply curve for farmer X. Are the axes drawn to the same scale as in Figure 2.4?
The supply curve for farmer X will merely plot the relevant two columns from Table 2.3. The vertical axis
can be drawn to the same scale as in Figure 2.4, but a different scale will have to be used for the horizontal
axis (e.g. tonnes rather than thousands of tonnes).
38
1. For what reasons might the supply of potatoes fall?

Examples include:
The cost of producing potatoes rises.
The profitability of alternative crops (e.g. carrots) rises.
A poor potato harvest.
Farmers expect the price of potatoes to rise (short-run supply falls).
Page
38 2. For what reasons might the supply of leather rise?
Examples include:
The cost of producing leather falls.
9
This question is concerned with the supply of oil for central heating. In each case consider whether there
is a movement along the supply curve (and in which direction) or a shift in it (left or right). (a) New oil
fields start up in production. (b) The demand for central heating rises. (c) The price of gas falls. (d) Oil
companies anticipate an upsurge in demand for central-heating oil. (e) The demand for petrol rises. (f)
New technology decreases the costs of oil refining. (g) All oil products become more expensive.
(a) Shift right. (b) Movement up along (as a result of a rise in price). (c) Movement down along (as a result
of a fall in price resulting from a fall in demand as people switch to gas-fire central heating). (d) Shift left
(if companies want to conserve their stocks in anticipation of a price rise). (e) Shift right (more of a good in
joint supply is produced). (f) Shift right. (g) Movement up along.
1. If P was originally measured in s, what would happen to the value of the d term if P were now
measured in pence?
It would now have a value of 10.
2. Draw the schedule (table) and graph for equation (8) for prices from 1 to 10. What is it in the
equation that determines the slope of the supply curve?
10
9
8
7
6
Price
39
The profitability of producing alternative products decreases.

The price of beef rises.
A long-running industrial dispute involving leather workers is resolved.
Producers expect the price of leather to fall (short-run supply increases).
5
4
3
2
1
0
0
Qs
1500
2500
3500
4500
5500
6500
7500
8500
9500
10
10500
2000
4000
6000
8000
10000
Quantity supplied
Diagram 2.4 Market supply
The graph is an upward sloping straight line crossing the horizontal axis at 500 units. The slope is given by
10
Chapter 2
the value of the d term: i.e. the slope is 1/1000 (for every 1 increase in price, quantity supplied increases
by 1000 units).
Explain why the P and j terms have a positive sign, whereas the a1 and a2 terms have a negative sign.
A rise in the price of the good (P) and a rise in the profitability of a good in joint supply (j) will cause
supply to increase, whereas a rise in the profitability of an alternative good (a) will cause supply to fall.
11

Page
40 Explain the process by which the price of houses would rise if there were a shortage.
People with houses to sell would ask a higher price than previous sellers of similar houses (probably with
the advice of an estate agent). Potential purchasers would be prepared to pay a higher price than previously
in order to obtain the type of house they wanted.
41
What would happen to price and quantity if the demand curve shifted to the left? Draw a diagram to
illustrate your answer.
Both price and quantity will fall. Imagine in Figure 2.7 that the original curve were D2 and that it shifted to
D1. Price would fall from Pe2 to Pe1 and quantity would fall from Qe2 to Qe1.
42
What will happen to the equilibrium price and quantity of butter in each of the following cases? You
should state whether demand or supply (or both) have shifted and in which direction. (In each case
assume ceteris paribus.)
(a) A rise in the price of margarine; (b) A rise in the demand for yoghurt; (c) A rise in the price of bread;
(d) A rise in the demand for bread; (e) An expected rise in the price of butter in the near future; (f) A tax
on butter production; (g) The invention of a new, but expensive, process for removing all cholesterol from
butter plus the passing of a law which states that all butter producers must use this process.
(a) Price rises, quantity rises (demand shifts to the right: butter and margarine are substitutes).
(b) Price falls, quantity rises (supply shifts to the right: butter and yoghurt are in joint supply).
(c) Price falls, quantity falls (demand shifts to the left: bread and butter are complementary goods).
(d) Price rises, quantity rises (demand shifts to the right: bread and butter are complementary goods).
(e) Price rises, quantity rises or falls depending on relative sizes of the shifts in demand and supply
(demand shifts to the right as people buy now before the price rises; supply shifts to the left as
producers hold back stocks until the price does rise).
(f) Price rises, quantity falls (supply shifts to the left).
(g) Price rises, quantity rises or falls depending on the relative size of the shifts in demand and supply
(demand shifts to the right as more health-conscious people start buying butter; supply shifts to the left
as a result of the increased cost of production).
43
(Box 2.2) 1. Draw supply and demand diagrams to illustrate what was happening to house prices (a) in
the second half of the 1980s; (b) in the early 1990s.
(a) Demand was rising rapidly. There was thus a continuing rightward shift in the demand curve for houses
and a resulting rise in the equilibrium price.
(b) Demand was falling. The leftward shift in the demand curve for houses led to a fall in the equilibrium
price.
(Box 2.2) 2. Are there any factors on the supply side that influence house prices?
Yes. Although they are less important than demand-side factors, they are, nevertheless important in
determining changes in house prices. The two most important are the expectations of the construction
industry. If house building firms are confident that demand will continue to rise, and with it house prices,
they are likely to start building more houses. The resulting increase in the supply of houses (after the time
taken to build them) will help to dampen the rise in prices.
The other major supply-side factor is the expectations of house owners. If people think that prices will
rise in the near future and are thinking of selling their house, they are likely to delay selling and wait until
prices have risen. This (temporary) reduction in supply will help to push up prices even further.
(Box 2.2) 3. Find out what has happened to house prices over the last three years. Attempt an
explanation of what has happened.
You can find details from the Web sites referred to in Box 2.2. Your explanation should focus on the
various factors listed in the box.
12
Chapter 2
Page
46 Why will the price elasticity of demand for a particular brand of a product (e.g. Texaco) be greater than
that for the product in general (e.g. petrol)? Is this difference the result of a difference in the size of the
income effect or the substitution effect?
The price elasticity of demand for a particular brand is more elastic than that for a product in general
because people can switch to an alternative brand if the price of one brand goes up. No such switching will
take place if the price of the product in general (i.e. all brands) goes up. Thus the difference in elasticity is
the result of a difference in the size of the substitution effect.
Will a general item of expenditure like food or clothing have a price-elastic or inelastic demand?
(Consider both the determinants we have considered so far.)
The income effect will be relatively large (making demand relatively elastic). The substitution effect will be
relatively small (making demand relatively inelastic). The actual elasticity will depend on the relative size
of these two effects.
Demand for oil might be relatively elastic over the longer term, and yet it could still be observed that
over time people consume more oil (or only very slightly less) despite rising oil prices. How can this
apparent contradiction be explained?
Because there has been a rightward shift in the demand curve for oil. This is likely to be the result of rising
incomes. Car ownership and use increase as incomes increase. Also tastes may have changed so that
people want to drive more. There may also have been a decline in substitute modes of transport such as rail
transport and buses. Finally, people may travel longer distances to work as a result of a general move to the
suburbs.
48
Assume that demand for a product is inelastic. Will consumer expenditure go on increasing as price
rises? Would there be any limit?
So long as demand remains inelastic with respect to price, then consumer expenditure will go on rising as
price rises. However, if the price is raised high enough, demand always will become elastic.
Can you think of any examples of goods which have a totally inelastic demand (a) at all prices; (b) over
a particular price range?
(a) No goods fit into this category, otherwise price could rise to infinity with no fall in demand but people
do not have infinite incomes!
(b) Over very small price ranges, the demand for goods with no close substitutes may be totally inelastic.
To illustrate these figures, draw the demand curve corresponding to the following table.
P ()
TE ()
2.50
400
1000
5.00
10.00
200
100
1000
1000
20.00
40.00
50
25
1000
1000
If the curve had an elasticity of 1 throughout its length, what would be the quantity demanded (a) at a
price of 1; (b) at a price of 10p; (c) if the good were free?
The curve will be a rectangular hyperbola: it will be a smooth curve, concave to the origin which never
crosses either axis. (See Figure 2.14 (c) in text.)
(a) 1000 units.
(b) 10 000 units.
(c) There would be an infinite demand!
13

Page
50 (Box 2.3) 1. Think of some advertisements which deliberately seek to make demand less elastic.
Those that strongly promote a brand, so that in the consumers mind there is no close substitute.
(Box 2.3) 2. Imagine that Sunshine sunflower margarine, a well-known brand, is advertised with the
slogan, It helps you live longer. What do you think would happen to the demand curve for a
supermarkets own brand of sunflower margarine? Consider both the direction of shift and the effect on
elasticity. Will the elasticity differ markedly at different prices? How will this affect the pricing policy
and sales of the supermarkets own brand?
It depends on the extent to which the consumer is led to believe that sunflower margarines generally help
you to live longer, in which case the demand for the supermarkets brand is likely to shift to the right and
become less elastic as consumers are less prepared to switch to non-sunflower margarines. If, however, the
consumer was led to believe that it was specifically Sunshine margarine that made you live longer, then
the demand for the supermarkets brand (and all others) will shift to the left.
Referring to Table 2.5, use the mid-point formula to calculate the price elasticity of demand between (a)
P = 6 and P = 4; (b) P = 4 and P = 2. What do you conclude about the elasticity of a straight-line
demand curve as you move down it?
Using the formula: (Q/mid Q) (P/mid P) gives the following answers:
(a) 10/25 2/5
= 10/25 5/2
= 50/50
= 1 (which is unit elastic)
(b) 10/35 2/3
= 10/35 3/2
= 30/70
= 0.43 (which is inelastic)
The elasticity decreases as you move down a straight-line demand curve.
51
(Box 2.4) 1. Estimate the price elasticity of demand between 8p and 10p and between 10p and 12p.
The mid-point formula (see pages 546 of the text) for price elasticity is Qd/average Qd P/average P.
Thus between 8p and 10p, price elasticity equals 2/5 2/9
= 9/5 = 1.8 (elastic)
And between 10p and 12p, price elasticity equals 1/3.5 2/11
= 11/7 = 1.57 (elastic)
(Box 2.4) 2. Was the 10p fare the best fare originally?
No. A profit of 400 000 360 000 = 40 000 was made. At a price of 8p, however, a higher profit of
480 000 360 000 = 120 000 could have been made.
(Box 2.4) 3. The company considers lowering the fare to 6p, and estimates that demand will be 8
million passenger miles. It will have to put on extra buses, however. How should it decide?
If it lowers the price to 6p, the revenue will rise to 510 000 (6p 8.5m). But putting on extra buses will
also increase costs. It will only, therefore, be worth lowering the price if the increase in revenue is greater
than the increase in costs. (See Chapter 5, section 5.6 of the text.)
52
(Box 2.5) Calculate the price elasticity of demand on the above demand curve at a price of (a) 5; (b) 2;
(c) 0.
Given that Qd = 60 15P + P
then
dQ/dP = 15 + 2P.
Thus using the formula, Pd = dQ/dP P/Q, the elasticity at the each of the above prices equals:
(a) (15 + (2 5)) (5/(60 (15 5) + 5))
= 5 5/10
= 2.5
14
Chapter 2
Page
(b) (15 + (2 2)) (2/(60 (15 2) + 2))
= 11 2/34
= 0.65
(c) (15 + (2 0)) (0/(60 (15 0) + 0))
= 15 0/60
53
=0
These questions still refer to Figure 2.18.

1. What is the price elasticity of demand at points l and k?
Given that Pd = dQ/dP P/Q,
and given that dQ/dP = 5, then:
at point l, (with P = 4 and Q = 30), Pd = 5 4/30 = 0.6
at point k, (with P = 2 and Q = 40), Pd = 5 2/40 = 0.25
2. What is the price elasticity of demand at the point (a) where the demand curve crosses the vertical
axis; (b) where it crosses the horizontal axis?
(a) Infinity:
(b) Zero:
(P/Q = 10/0 = )
(P/Q = 0/50 = 0)
3. As you move down a straight-line demand curve, what happens to elasticity? Why?
It decreases. P/Q gets less and less, but dQ/dP remains constant.
4. Calculate price elasticity of demand between points n and l using the arc method. Does this give the
same answer as by the point method? Would it if the demand curve were actually curved?
By the arc method: Q/average Q P/average P = 20/20 4/6 = 1.5
By the point method, at point m (midway between n and l): dQ/dP x P/Q = 5 x 6/20 = 1.5
Thus both methods give the same answer.
If the demand curve were actually curved, the answer would only be the same if the tangent to the point (in
the point method) were the same as the slope of the line (the chord) joining the two points of the curve (in
the arc method).
54
Given the following supply schedule:

P
10
10
20
30
40
P
Q
(a) Draw the supply curve.

(b) Using the arc method calculate price elasticity of supply (i) between P = 2 and P = 4;
(ii) between P = 8 and P = 10
(c) Using the point method calculate price elasticity of supply at P = 6.
(d) Does the elasticity of the supply curve increase or decrease as P and Q increase? Why?
(e) What would be the answer to (d) if the supply curve had been a straight line but intersecting the
horizontal axis to the right of the origin?
(a) The supply curve will be an upward sloping straight line crossing the vertical axis where P = 2.
(b) (i) Using the formula Q/average Q P/average P, gives:
10/5 2/3
=3
(ii) 10/35 2/9
= 1.29
(c) Using the formula dQ/dP P/Q, and given that dQ/dP = 5 (= 10/2), gives:
5 6/20
= 1.5
(d) The elasticity of supply decreases as P and Q increase. It starts at infinity where the supply curve
crosses the vertical axis (Q = 0 and thus P/Q = ).
(e) No. At the point where it crossed the horizontal axis, the elasticity of supply would be zero (P = 0 and
thus P/Q = 0). Thereafter, as P and Q increased, so would the elasticity of supply.
15

Page
55 Look ahead to Box 3.4 (page 73). It shows the income elasticity of demand for various foodstuffs.
Explain the difference in the figures for fresh fish, bread, and milk.
Milk can be regarded as an inferior good (which is defined a good whose demand decreases as consumer
incomes increase). Inferior goods therefore have a negative income elasticity. According to the figures.
Bread and fresh fish, on the other hand, have a positive income elasticity. This means that as income rises,
so more of these two products are purchased. (Note that the figures have been corrected to take into
account changes in food prices, but there are still dangers in using such figures. They assume that all the
other determinants of demand are constant. This may well not be true. For example, consumer tastes for
fresh fish may have increased, as it is associated with healthy eating. Likewise there may have been a shift
in consumer tastes away from milk as a drink and towards other soft drinks.)
Which are likely to have the highest cross elasticity of demand: two brands of coffee, or coffee and tea?
Two brands of coffee, because they are closer substitutes than coffee and tea.
58
In Figures 2.23 and 2.24, the initial change in price was caused by a shift in the demand curve. Redraw
these two diagrams to illustrate the situation where the initial change in price was caused by a shift in the
supply curve (as would be the case in the wheat market that we have just considered).
See Diagram 2.5.
59
Redraw Figures 2.25 and 2.26 assuming, as in the previous question, that the initial change in price was
caused by a shift in the supply curve.
See the two figures in Diagram 2.6 on the following page.
60
(Box 2.6) If speculators believed that the price of cocoa in six months was going to be below the sixmonth future price quoted today, how would they act?
They would make a future contract to sell cocoa in six months time at the future price quoted today (even
though they do not yet have any cocoa to sell!). They hope then to buy cocoa in six months time at the
lower (spot) price in order to supply it as agreed. In other words, they buy at the lower spot price and sell at
the higher future price. Their profit, after commission, is the difference in price.
16
Chapter 2
Page
61 Give some examples of decisions you have taken recently that were made under conditions of
uncertainty. With hindsight do you think you made the right decisions?
An example would be an item you purchased that you had never consumed before: maybe because you had
seen it advertised. You might then subsequently regret the purchase if it does not live up to your
expectations. Another example would be a part-time job. Only when you have started doing the job do you
find out how onerous it is to do.
17
Chapter 3
Page
64 Draw a supply and demand diagram with the price of labour (the wage rate) on the vertical axis and the
quantity of labour (the number of workers) on the horizontal axis. What will happen to employment if
the government raises wages from the equilibrium to some minimum wage above the equilibrium?
The diagram will look like Figure 3.1 in the text. Employment will fall to Qd workers. The supply of
workers will rise to Qs. There will thus be unemployment (a surplus of workers) of Qs minus Qd.
65
(Box 3.1) 1. How could housing supplied by the public sector be made to rectify some of the problems we
have identified above? (What would it do to the supply curve?)
It would shift the supply of rental accommodation to the right, and thereby reduce the free-market rent; or it
would reduce the shortage of accommodation in the case where rents are fixed below the equilibrium.
(Box 3.1) 2. If the government gives poor people rent allowances (i.e. grants), how will this affect the
level of rents in an uncontrolled market?
They will increase (the demand for rented accommodation will increase).
(Box 3.1) 3. The case for and against rent controls depends to a large extent on the long-run elasticity of
supply. Do you think it will be relatively elastic or inelastic? Give reasons.
Relatively elastic. Below a certain rent, it will not be worth the owners incurring the costs and time of
renting out the accommodation. The solution, therefore, to cheap affordable accommodation is to tackle the
supply directly: either by public housing or by subsidising or giving tax relief to the private sector.
66
(Box 3.2) 1. What would be the effect on black-market prices of a rise in the official price?
Other things being equal, there would probably be a fall in the black-market price. A rise in the official
price would cause an increase in the quantity supplied and a reduction in the quantity demanded and hence
less of a shortage. There would therefore be less demand for black-market products.
(Box 3.2) 2. Will a system of low official prices plus a black market be more equitable or less equitable
than a system of free markets?
More equitable if the supplies at official prices were distributed fairly (e.g. by some form of rationing). If,
however, supplies were allocated on a first-come, first-served basis, then on official markets there would
still be inequity between those who are lucky enough or queue long enough to get the product and those who
do not get it. Also, the rich will still be able to get the product on the black market!
Think of some examples where the price of a good or service is kept below the equilibrium (e.g. rent
controls). In each case consider the advantages and disadvantages of the policy.
Two examples are:
Rent controls. Advantages: makes cheap housing available to those who would otherwise have
difficulty in affording reasonable accommodation. Disadvantages: causes a reduction in the supply of
private rented accommodation; causes demand to exceed supply and thus some people will be unable to
find accommodation.
Tickets for a concert. Advantages: allows the price to be advertised in advance and guarantees a full
house; makes seats available to those who could not afford the free-market price. Disadvantages:
causes queuing or seats being only available to those booking well in advance.
18
Chapter 3
Page
68 Supply tends to be more elastic in the long run than in the short run. Assume that a tax is imposed on a
good that was previously untaxed. How will the incidence of this tax change as time passes? How will
the incidence be affected if demand too becomes more elastic over time?
As supply becomes more elastic, so output will fall and hence tax revenue will fall. At the same time price
will tend to rise and hence the incidence will shift from the producer to the consumer. The situation will
move from being more like case (3) to more like case (4) in Figure 3.5 in the text.
As demand becomes more elastic, so this too will lead to a fall in sales. This, however, will have the
opposite effect on the incidence of the tax: the burden will tend to shift from the consumer to the producer.
The situation will move from being more like case (1) to more like case (2) in Figure 3.5.
69
(Box 3.3) 1. If raising the tax rate on cigarettes both raises more revenue and reduces smoking, is there
any conflict between the health and revenue objectives of the government?
There may still be a dilemma in terms of the amount by which the tax rate should be raised. To raise the
maximum amount of revenue may require only a relatively modest increase in the tax rate. To obtain a
large reduction in smoking, however, may require a very large increase in the tax rate. Ultimately, if the tax
rate were to be so high as to stop people smoking altogether, there would be no tax revenue at all for the
government!
(Box 3.3) 2. You are a government minister; what arguments might you put forward in favour of
maximising the revenue from cigarette taxation?
That it is better than putting the taxes on more socially desirable activities. That there is the beneficial spinoff from reducing a harmful activity. (You would conveniently ignore the option of putting up taxes beyond
the point that maximises revenue and thus cutting down even more on smoking.)
(Box 3.3) 3. You are a doctor; why might you suggest that smoking should be severely restricted? What
methods would you advocate?
That the medical arguments concerning damage to health should take precedence over questions of raising
revenue. You would probably advocate using whatever method was most effective in reducing smoking.
This would probably include a series of measures from large increases in taxes, to banning advertising, to
education campaigns against smoking. You might even go so far as to advocate making smoking tobacco
illegal. The problem here, of course, would be in policing the law.
70
Schooling is free in state schools in most countries. If parents are given a choice of schools for their
children, there will be a shortage of places at popular schools (the analysis will be the same as in Figures
3.6, with the number of places in a given school measured on the horizontal axis). What methods could
be used for dealing with this shortage? What are their relative merits?
Some form of rationing (selection) will have to be applied. This could be done on the basis of ability. If the
objective is to have schools that cater for the full range of abilities, then this objective will not be met. If the
objective is to recruit the most able children, then selection by ability is consistent with this goal. An
alternative is to select by geographical location, with the students living nearer to the school being given
preference over those living further away. This is the system used by most state primary and comprehensive
schools. It could well disadvantage children with particular needs, however, for whom the school would be
particularly suitable. It can also lead to the development of ghetto schools in deprived areas, especially if
schools rely for part of their funding on parental contributions. Other methods include the sibling rule,
whereby children who have older brothers or sisters already at the school are given preference. This,
however, could lead to children living nearer the school being deprived of a place.
71
Under what circumstances would making a product illegal (a) cause as fall in its price; (b) cause the
quantity sold to fall to zero.
(a) Where the shift in demand was greater than the shift in supply (perhaps because of very law abiding
consumers, or where consumers faced harsher penalties than suppliers.
(b) Where the penalties were very harsh and the law was strictly enforced, and/or where people were very
law abiding.
19

Page
71 What are the arguments for and against making the sale of alcoholic drinks illegal? To what extent can
an economist help to resolve the issue?
Clearly this involves making normative judgements about how far people should be free to choose their own
lifestyle and how much the state has a responsibility for controlling peoples behaviour that adversely
affects other people (or themselves). Benefits of making alcoholic drinks illegal include: a reduction in road
accidents and other drink-related accidents; a reduction in drink-related illnesses (and a saving to the
nations health budget); a reduction in drink-related anti-social behaviour; more money available to children
and other family members in families where there are one or more drinkers. Disadvantages include:
curbing an activity that gives many people pleasure; limiting human freedom (freedom to choose what to do,
rather than freedom from having to suffer other peoples drunken behaviour); problems of enforcing the law;
encouraging the development of criminal activity and the development of an illegal drink underworld (as
occurred during the Prohibition in the USA); preventing responsible, moderate drinking (which can have
health benefits).
Economists can contribute to the debate by identifying the costs and benefits and measuring many of
them (such as the money saved on treating road casualties in drink-related accidents). They cannot,
however, make the final moral judgements, since the weighting that should be attached to the costs and
benefits is a normative issue.
72
Why is the supply curve drawn as a vertical straight line in Figure 3.8?
Because, in the short run, the supply of food is virtually fixed. Once a crop is grown and harvested, then it is
of a fixed amount. (In practice, the timing of releasing crops on to the market can vary, given that many
crops can be stored. This does allow some variation of supply with price.)
Why dont farmers benefit from a high income elasticity of demand for convenience foods?
Because most of the increased expenditure goes on value added in the processing, not on the basic food
content. Thus it is the food processors who get the benefit, not the farmers.
73
(Box 3.4) 1. The income elasticity of demand for milk is negative (an inferior good). What is the
implication of this for milk producers?
Milk producers would expect to earn less as time goes past, given that national income rises over time. Thus
if the incomes of individual milk producers are to be protected, production should be reduced (with some
dairy farmers switching to other foodstuffs or away from food production altogether).
(Box 3.4) 2. Why do pork and lamb have relatively high price elasticities of demand compared with the
other foodstuffs in the table? What are the implications of this for the relative stability or instability of the
prices of pork and lamb compared with other foodstuffs?
They have relatively high price elasticities of demand because they are relatively close substitutes for each
other and for other meats. Shifts in supply of a particular meat will have a relatively small effect on price.
This suggests that their prices would be more stable than those of other broader categories of foodstuff,
assuming similar variations in supply. If the supply of all meats are affected, however, there will be a
greater effect on the price of each of the meats, since the demand for meat as a whole (as opposed to a
particular type of meat) is relatively price inelastic.
If, however, we compare them with narrower categories of other foodstuffs (e.g. a particular type of
vegetable), which therefore themselves have more substitutes and hence have a higher price elasticity of
demand, then the prices of the meats might not expected to be more stable. If, however, particular crops
vary more in supply than the output of particular meats, then the price of meats would be more stable, even
if the price elasticity of demand were no different from that of particular crops.
74
Page
74
(Box 3.5) 1. Can you think of any other (non-farming) examples of the fallacy of composition?
Two examples are:
People standing to get a better view at a concert. When one person does this, then that person will get a
better view. When everyone does it, there is no gain. In fact, there is a net loss, because people would
presumably prefer to sit than stand!
If one person gets a pay increase 5 per cent above the current rate of inflation, he or she will be 5 per
cent better off (assuming no change in the rate of inflation). If everyone gets a pay increase 5 per cent
above the current rate of inflation, then that will drive the rate of inflation up. People will not be 5 per
20
Chapter 3
cent better off.
(Box 3.5) 2. Would the above arguments apply in the case of foodstuffs that can be imported as well as
being produced at home?
In the case of a foodstuff that can be imported, the demand curve for the domestically produced foodstuff
would be more elastic (given that the imports are a substitute). Thus a good domestic harvest may only
depress the price slightly, with consumers merely switching from the imported to home-grown food. Thus
producers would gain from a good harvest (their incomes would rise if elasticity was greater than one).
If, however, the good harvest were world-wide, so that total world supply of the product increased, then
the problem would still occur if the overall demand (for home-grown plus imported food) were inelastic.
75
The total amount paid in subsidies is greater in Figure 3.11 than in Figure 3.12. Will it always be the
case that for a given after-subsidy price to the farmer (Pg), a greater amount will be paid out in subsidies
if the country is self-sufficient in the foodstuff than if it has to import part of the total amount consumed?
(Assume that the demand curve is the same in both cases.)
Yes. The free-market domestic price will not be above the world price. If it were (temporarily), then the
foodstuff would be imported, pushing the price back down to the world price. Thus the height of the grey
rectangle in Figure 3.11, cannot be less than that in Figure 3.12. But the width of the grey rectangle in
Figure 3.11 must be greater than that in Figure 3.12 (given that part of the demand in Figure 3.12 is
supplied from imports). Thus the area of the rectangle in Figure 3.11 must be bigger than that in Figure
3.12. Thus more is paid out in subsidy in the case where the country is self-sufficient (assuming the demand
curve is the same).
76
What will be the amount paid out in Figure 3.14 if instead of the government buying the surpluses, export
subsidies were given to farmers so as to guarantee them a price (plus subsidy) of Pmin?
The same as when the government sells the surpluses on the world market, namely the rectangle edcf. With
a guaranteed price of Pmin from exporting, farmers will produce Qs2. The farmers will therefore only be
prepared to supply domestic consumers at that same price (otherwise it would be more profitable to export).
Thus domestic consumers buy Qd2. Thus Qs2 Qd2 is exported at a subsidy per unit of Pmin Pw.
Compare the relative merits of (a) quotas on output, (b) limits to the amount of land used for a particular
product and (c) farmers being required to take land out of food production.
All these methods will restrict supply and thus help to raise the free-market price and thereby eliminate (or
reduce) the need for having a minimum price above the equilibrium.
(a) Quotas have the advantage of being a direct limitation on output (as opposed to land) and will thus lead
to a more stable supply than with the other two methods. They could, however, prevent efficient farmers
expanding, unless farmers quotas could be sold to other farmers (as has happened with dairy quotas in
the EU).
(b) This can allow land to be reallocated to some alternative use (e.g. recreational, forestry or growing a
different crop). It could, however, lead to a lower reduction in output than planned because of less
productive land being taken out of use, rather than more productive land (although this could be seen as
an efficient use of land).
(c) This is similar to (b), but has the problem of being less focused. For example, if there is a surplus of
one particular crop, it does not make sense to prevent farmers producing other crops (which are not in
surplus) on their land. It could lead to a neglect of the land taken out of use (with problems of weeds,
etc.). On the other hand, it could help prevent the extinction of various natural species.
21

Page
78 Assume that the world price were above point Pe (but still below Pi). Draw a diagram to illustrate the
static costs in this case.
P
S
Pi
a
h
Pw
d
b
D
O
Diagram 3.1 Static costs of high fixed prices
See Diagram 3.1. With a world price at Pw, then without intervention, the country would be a net exporter
of an amount c b.
With an intervention price of Pi, the costs are as follows:
Consumers lose by having to pay a higher price: i.e. Pi rather than Pw
Farmers gain by receiving the higher price and thus earning larger profits.
Taxpayers lose by having to finance the purchase of the surplus. This is shown by the shaded area
adef. This loss to the taxpayer could be reduced, however, to adgh if the surplus (d a) were sold on
the world market at the world price of Pw.
80
Does the requirement to set aside 5 per cent of land reduce output by 5 per cent?
Probably not. Farmers may well attempt to increase output on their remaining land or attempt to set aside
the poorest quality land.
22
Chapter 4
Page
88 1. Do you ever purchase things irrationally? If so, what are they and why is your behaviour irrational?
A good example is things you purchase impulsively, when in fact you do have time to reflect on whether you
really want them. It is not a question of ignorance but a lack of care. Your behaviour is irrational because
the marginal benefit of a bit of extra care would exceed the marginal effort involved.
2. If you buy something in the shop on the corner when you know that the same item could have been
bought more cheaply two miles up the road in the supermarket, is your behaviour irrational? Explain.
Not necessarily. If you could not have anticipated wanting the item and if it would cost you time and effort
and maybe money (e.g. petrol) to go to the supermarket, then your behaviour is rational. Your behaviour a
few days previously would have be irrational, however, if, when making out your weekly shopping list for
the supermarket, a moments thought could have saved you having to make the subsequent trip to the shop
on the corner.
89
Are there any goods or services where consumers do not experience diminishing marginal utility?
Virtually none, if the time period is short enough. If, however, we are referring to a long time period, such
as a year, then initially as more of an item is consumed people may start getting more of a taste for it and
thus experience increasing marginal utility. But even with such items, eventually, as consumption increases,
diminishing marginal utility will be experienced.
90
If Darren were to consume more and more crisps would his total utility ever (a) fall to zero; (b) become
negative? Explain.
Yes, both. If he went on eating more and more, eventually he would feel more dissatisfied than if he had
never eaten any in the first place. He might actually be physically sick!
(Box 4.1) Complete this table to the level of consumption at which TU is at a maximum.
60Q
4Q2
TU
60
56
120
16
104
180
36
144
240
64
176
300
100
200
360
144
216
420
196
224
480
256
224
23

Page
90 (Box 4.1) Derive the MU function from the following TU function:
TU = 200Q 25Q + Q
From this MU function, draw up a table (like the one above) up to the level of Q where MU becomes
negative. Graph these figures.
180
MU = dTU/dQ = 200 50Q + 3Q

160
200
50Q
3Q2
MU
200
50
153
200
100
12
112
200
150
27
77
200
200
48
48
200
250
75
25
200
300
108
200
350
147
140
120
100
80
60
40
20
0
0
-20
92
Diagram 4.1 MU = 200 50Q + 3Q2
If a good were free, why would total consumer surplus equal total utility? What would be the level of
marginal utility?
Because there would be no expenditure. At the point of maximum consumer surplus, marginal utility would
be equal to zero, since if P = 0, and MU = P, then MU = 0.
Why do we get less consumer surplus from goods where our demand is relatively elastic?
Because we would not be prepared to pay such a high price for them. If price went up, we would more
readily switch to alternative products.
How would marginal utility and market demand be affected by a rise in the price of a complementary
good?
Marginal utility and market demand would
MU, P
fall (shift to the left). The rise in the price of
the complement would cause less of it to be
consumed. This would therefore reduce the
marginal utility of the other good. For
example, if the price of lettuce goes up and as
a result we consume less lettuce, the marginal
utility of mayonnaise will fall.
Pd
93
(Box 4.2) The diagram illustrates a persons

MU curves of water and diamonds. Assume
that diamonds are more expensive than
water. Show how the MU of diamonds will
be greater than the MU of water. Show also
how the TU of diamonds will be less than
the TU of water.
See Diagram 4.2 opposite.
Pw
MU water
MU diamonds
Qd
Qw
Quantity of water
Quantity
Diagram 4.2 MU of water and diamonds of diamonds
Page
95 (Box 4.3) Imagine that you are going out for the evening with a group of friends. How would you decide
where to go? Would this decision-making process be described as rational behaviour?
You would probably discuss it and try to reach a consensus view. The benefits to you (and to other group
24
Chapter 4
members) would probably be maximised in this way. Whether these benefits would be seen as purely
selfish on the part of the members of the group, or whether people have more genuinely unselfish
approach, will depend on the individuals involved.
97
Define risk and uncertainty.

Risk: when an outcome may or may not occur, but its probability of occurring is known.
Uncertainty: when an outcome may or may not occur and its probability of occurring is not known.
Give some examples of gambling (or risk taking in general) where the odds are (a) unfavourable;
(b) fair; (c) favourable.
(a) Betting on the horses; firms launching a new product in a market that is already virtually saturated and
where the firm does not bother to advertise.
(b) Gambling on a private game of cards which is a game of pure chance; deciding which of two
alternative brands to buy when they both cost the same and you have no idea which you will like the
best.
(c) The buying and selling of shares on the stock exchange by dealers who are skilled in predicting share
price movements; not taking an umbrella when the forecast is that it will not rain (weather forecasts are
right more often than they are wrong!); an employer taking on a new manager who has excellent
references.
(Note that in the cases of (a) and (c) the actual odds may not be known, only that they are unfavourable or
favourable.)
98
Which gamble would you be more likely to accept, a 60:40 chance of gaining or losing 10 000, or a
40:60 chance of gaining or losing 1? Explain why.
Most people would probably prefer the 40:60 chance of gaining or losing 1. The reason is that, given the
diminishing marginal utility of income, the benefit of gaining 10 000 may be considerably less than the
costs of losing 10 000, and this may be more than enough to deter people, despite the fact that the chances
of winning are 60:40.
Do you think that this provides a moral argument for redistributing income from the rich to the poor?
Does it prove that income should be so redistributed?
Arguments like this are frequently used to justify redistributing income and form part of peoples moral
code. Most people would argue that the rich ought to pay more in taxes than the poor and that the poor
ought to receive more state benefits than the rich. The argument is frequently expressed in terms of a pound
being worth more to a poor person than a rich person. It does not prove that income should be so
redistributed, however, unless you argue (a) that the government ought to increase total utility in society and
(b) that it is possible to compare the utility gained by poor people with that lost by rich people something
that is virtually impossible to do.
99
(Box 4.5) What details does an insurance company require to know before it will insure a person to drive
a car?
Age; sex; occupation; accident record; number of years that a licence has been held; motoring convictions;
model and value of the car; age of the car; details of other drivers.
25

Page
99 (Box 4.4) How will the following reduce moral hazard?
(a) A no-claims bonus.
(b) You having to pay the first so many pounds of any claim.
(c) Offering lower premiums to those less likely to claim (e.g. lower house contents premiums for those
with burglar alarms).
In the case of (a) and (b) people will be more careful as they would incur a financial loss if the event they
were insured against occurred (loss of no-claims bonus; paying the first so much of the claim). In the case
of (c) it distinguishes people more accurately according to risk. It encourages people to move into the
category of those less likely to claim (but it does not make people more careful within a category: e.g. those
with burglar alarms may be less inclined to turn them on if they are well insured!).
If people are generally risk averse, why do so many people around the world take part in national
lotteries?
Because the cost of taking part is so little, that they do not regard it as a sacrifice. They also are likely to
take a hopeful view (i.e. not based on the true odds) on their chances of winning. What is more, the act of
taking part itself gives pleasure. Thus the behaviour can still be classed as rational: i.e. one where the
perceived marginal benefit of the gamble exceeds the marginal cost.
100 1. Why are insurance companies unwilling to provide insurance against losses arising from war or civil
insurrection?
Because the risks are not independent. If family A has its house bombed, it is more likely that family B will
too.
2. Name some other events where it would be impossible to obtain insurance.
Against losses on the stock market; against crop losses resulting from drought.
102 Although indifference curves will normally be bowed in toward the origin, on odd occasions they might
not be. Which of the diagrams correspond to which of the following?
(a) X and Y are left shoes and right shoes.
(b) X and Y are two brands of the same product, and the consumer cannot tell them apart.
(c) X is a good but Y is a bad like household refuse.
(a) Diagram (ii). An additional left shoe will give no extra utility without an additional right shoe to go
with it!
(b) Diagram (i). The consumer is prepared to go on giving up one unit of one brand provided that it is
replaced by one unit of the other brand.
(c) Diagram (iii). If consumers are to be persuaded to put up with more of the bad, they must have more
of the good to compensate.
103 Draw another two indifference curves on Figure 4.6, one outward from and one inward from the original
curve. Read off various combinations of pears and oranges along these two new curves and enter them
on a table like Table 4.2.
The curves would look like those in Figure 4.7 (on page 103). The curve further outward would represent a
higher level of utility. This would be obtained by consuming a larger quantity of pears for each quantity of
oranges consumed and a larger quantity of oranges for each quantity of pears (i.e. an increase in each of the
figures in Table 4.2). The curve further inward would represent a lower level of utility. This would be
experienced with fewer pears for each quantity of oranges and vice versa.
104 1. Assume that the budget remains at 30 and the price of X stays at 2, but that Y rises in price to 3.
Draw the new budget line.
The budget line will pivot inwards on point d (i.e. where it crosses the horizontal axis). It will now connect
10Y on the vertical axis with 15X on the horizontal.
26
Chapter 4
Page
104 2. What will happen to the budget line if the consumers income doubles and the price of both X and Y
double?
It will not move. Exactly the same quantities can be purchased as before. Money income has risen, but
real income has remained the same.
106 1. The incomeconsumption curve in Figure 4.13 is drawn as positively sloped at low levels of income.
Why?
Because for those on a low level of income the good is not yet in the category of an inferior good. Take the
case of inexpensive margarine. Those on very low incomes may economise on their use of it (along with all
other products), but as they earn a little more, so they can afford to spread it a little thicker or use it more
frequently (the incomeconsumption curve is positive). Only when their income rises more substantially do
they substitute better quality margarines or butter.
2. Show the effect of a rise in income on the demand for X and Y where this time Y is the inferior good
and X is the normal good. Is the incomeconsumption curve positively or negatively sloped?
The curve will slope upwards at first, but become less and less steep. It will then peak at the point where Y
becomes an inferior good, and will thereafter slope downwards (i.e. have a negative slope).
Illustrate on an indifference diagram the effects of the following:
(a) A rise in the price of good X (assuming no change in the price of Y).
(b) A fall in the price of good Y (assuming no change in the price of X).
(a) The budget line will pivot inwards (e.g. from B2 to B1 in Figure 4.14, causing a fall in consumption
from point k to point j).
(b) The budget line would pivot outward on the point where the budget line crosses the horizontal axis. It
is likely that the new tangency point with an indifference curve will represent an increase in the
consumption of both goods. Diagram 4.3 below can be used to illustrate this. Assume the budget line
pivots outwards from B2 to B1. The optimum consumption point will move from point c to a.
107 As quantity demanded increases from Q1 to Q2 in Figure 4.15 the expenditure on all other goods
decreases. (Point b is lower than point a.) This means, therefore, that the persons total expenditure on X
has correspondingly increased. What, then, can we say about the persons price elasticity of demand for
X between points a and b? What can we say about the price elasticity of demand between points b and c
and points c and d?
Between a and b the demand for X is price elastic: a fall in the price of X leads to an increase in
expenditure on it. Between b and c price elasticity is equal to (minus) one: a fall in the price of X leads to
no change in expenditure. Between c and d demand for X is price inelastic: a fall in price leads to a
reduction in expenditure on X (and hence an increase in expenditure on the total of all other goods).
Illustrate on two separate indifference diagrams the income and substitution effects of the following
(a) A decrease in the price of good X (and no change in the price of good Y).
(b) An increase in the price of good Y (and no change in the price of good X)
See Diagram 4.3 on the next page. In each case the substitution effect is shown by a movement from point
a to point b and the substitution effect is shown by a movement from point b to point c.
109 (Box 4.6) 1. If Judy earned more than Warren, show how much income she would redistribute to him if
(a) she cared somewhat for him; (b) she loved him as herself. Draw her indifference curve in each of
these two cases.
Assuming that their joint income remained the same as before (i.e. that Judy earned more but Warren earned
less), then, if each spent their own income entirely on themselves, they would consume at a point high up
along the line YTYT: e.g. at a point between f and eJ.
(a) If she cared somewhat for Warren, her optimum point would be somewhere like eJ. Her indifference
map would be north-west of Warrens, with the tangency point to her highest possible indifference
curve at eJ.
(b) If she loved him as herself, the optimum point would be at eE.
27
(b) Increase in price of Y
(a) Decrease in price of X

Diagram 4.3
Page
109 (Box 4.6) 2. In the case where they both love each other as themselves, will their two sets of
indifference curves be identical?
It depends on what precisely is meant by loving each other as themselves. Even if the optimum point for
both Warren and Judy were at eE, the slope of their indifference curves may be very different at points other
than along the line of equality OE. In other words they may gain a different individual utility from an
unequal distribution of income.
110 (Box 4.7) 1. Make a list of the characteristics of shoes. Which are objective and which are
subjective?
Objective: size, durability, colour, material. Subjective: brand image, the appearance (pleasurable or
unpleasurable), comfort.
(Box 4.7) 2. If two houses had identical characteristics, except that one was near a noisy airport and the
other in a quiet location, and if the market price of the first house was 80 000 and the second was
100 000, how would that help us to put a value on the characteristic of peace and quiet?
It would suggest that purchasers are prepared to pay an extra 20 000 for peace and quiet (see Chapter 11,
section 4, on costbenefit analysis).
111 Are there any Giffen goods that you consume? If not, could you conceive of any circumstances in which
one or more items of your expenditure would become Giffen goods?
It is unlikely that any of the goods you consume are Giffen goods. One possible exception may be goods
where you have a specific budget for two or more items, where one item is much cheaper: e.g. fruit bought
from a greengrocer. If, say, apples are initially much cheaper than bananas, you may be able to afford some
of each. Then you find that apples have gone up in price, but are still cheaper than bananas. What do you
do? By continuing to buy some of each fruit you may feel that you are not eating enough pieces of fruit to
keep you healthy and so you substitute apples for bananas, thereby purchasing more apples than before (but
probably less pieces of fruit than originally).
28
Chapter 5
Page
116 1. How will the length of the short run for the shipping company depend on the state of the shipbuilding
industry?
If the shipbuilding industry is in recession, the short run (and the long run) may be shorter. It will take less
time to acquire a new ship if there is no waiting list, or if there are already ships available to purchase (with
perhaps only minimal modifications necessary).
2. Up to roughly how long is the short run in the following cases?
(a) A mobile disco firm. (b) Electricity power generation. (c) A small grocery retailing business.
(d) Superstore Hypermarkets Ltd.
In each case specify your assumptions.
(a)
(b)
(c)
(d)
Two or three days: the time necessary to acquire new equipment or DJs.
Two or more years: the time taken to plan and build a new power station.
Several weeks: the time taken to acquire additional premises.
One or two years: the time taken to plan and build a new store.
117 (Box 5.1) 1. Why might it be possible for there to be a zero marginal productivity of labour on many
family farms in poor countries and yet for there to be just enough food for all the members of the family
to survive? (Illustrate using MPP and APP curves.)
Because the average physical product is sufficiently high to provide basic subsistence. In terms of Table
5.2 and Figure 5.2 on pages 122 and 125, if there were 7 family members working on the farm, the MPP
would be zero, but the APP would be 6 tonnes of wheat per year.
(Box 5.1) 2. The figures in the following table are based on the assumption that birth rates will fall faster
than death rates. Under what circumstances might these forecasts underestimate the rate of growth of
world population?
A faster decline in the death rate as a result of new advances in medicine allowing people to live longer. A
slower growth in living standards in developing countries causing people to continue choosing to have large
families so that they will have offspring to look after them in their old age.
119 (Box 5.2) How would you advise the baker as to whether he should (a) employ four assistants on a
Saturday; (b) extend his shop, thereby allowing more customers to be served on a Saturday?
(a) If maximising profit is the sole aim, then he should employ a fourth assistant if the extra revenue from
the extra customers that this assistant can serve is greater than the costs of employing the assistant.
(b) Only if the extra revenue from the extra customers will more than cover the costs of the extension plus
the extra staffing.
1. What is the significance of the slope of the line ac in the top part of Figure 5.1?
It gives the level of APP at point c. The reason is that the slope of a line from the origin to the TPP curve
gives TPP/Lb. Note that since the line from the origin to the TPP curve is steepest at point c, point c
represents the quantity of labour where APP is at a maximum (as the lower part of the diagram confirms).
2. Given that there is a fixed supply of land in the world, what implications can you draw from Figure 5.1
about the effects of an increase in world population for food output per head?
Other things being equal, diminishing returns would cause food output per head to decline (a declining
MPP and APP of labour). This, however, would be offset (partly, completely or more than completely) by
improvements in agricultural technology and by increased amounts of capital devoted to agriculture: this
would have the effect of shifting the APP curve upwards. (See Box 5.1.)
29

Page
120 (Box 5.3) A cricketer scores the following number of runs in five successive innings:
Innings: 1 2 3 4 5
Runs:
20 20 50 10 0
These can be seen as the marginal number of runs from each innings. Calculate the total and
average number of runs after each innings. Show how the average and marginal scores illustrate
the three rules above?
Innings
Total runs
Average runs
20
20
40
20
90
30
100
25
100
20
(Box 5.4) Check out some figures by substituting values of Qf into each of the three equations.
Take the case of Qf = 4.
Equation (1) TPP = 100 + 32Qf + 10Qf Qf
= 100 + 128 + 160 64
= 324
Equation (2) APP
= 100/Qf + 32 + 10Qf Qf
= 25 + 32 + 40 16
= 81
Equation (3) MPP
= 32 + 20Qf 3Qf
= 32 + 80 48
= 64
122 (Box 5.5) Why is the correct price to charge (for the unsold trees) the one at which the price elasticity of
demand equals 1? (Assume no disposal costs.)
Because, with a zero cost, the shop will want to maximise the revenue from the sale of the trees. Revenue
is maximised at the price where elasticity equals 1 (see pages 478 of the text).
The following are some costs incurred by a shoe manufacturer. Decide whether each one is a fixed cost
or a variable cost or has some element of both.
(a) The cost of leather. (b) The fee paid to an advertising agency. (c) Wear and tear on machinery. (d)
Business rates on the factory. (e) Electricity for heating and lighting. (f) Electricity for running the
machines. (g) Basic minimum wages agreed with the union. (h) Overtime pay. (i) Depreciation of
machines as a result purely of their age (irrespective of their condition).
(a) Variable. (b) Fixed (unless the fee negotiated depends on the success of the campaign). (c) Variable
(the more that is produced, the more the wear and tear). (d) Fixed. (e) Fixed if the factory will be heated
and lit to the same extent irrespective of output, but variable if the amount of heating and lighting depends
on the amount of the factory in operation, which in turn depends on output. (f) Variable. (g) Variable
(although the basic wage is fixed per worker, the cost will still be variable because the total cost will
increase with output if the number of workers is increased). (h) Variable. (i) Fixed (because it does not
depend on output).
30
Chapter 5
Page
124 Fill in the missing figures in the Table 5.3. (Note that the figures for MC come in the spaces between
each level of output.)
Output
TFC
(Q)
AFC
TVC
(TFC/Q)
AVC
TC
AC
MC
(TVC/Q)
(TFC + TVC)
(TC/Q)
(TC/Q)
()
(units)
()
()
()
()
()
()
12
12
10
12
12
10
10
22
22
12
16
28
14
12
21
33
11
6
5
7
4
12
28
40
10
12
12
2.4
40
52
10.4
12
60
10
72
12
20
31
7
12
1.7
91
13
103
14.7
125 (Box 5.6) Assume that a firm has 5 identical machines, each operating independently. Assume that with
all 5 machines operating normally, 100 units of output are produced each day. Below what level of
output will AVC and MC rise?
20 units. Below this level, the one remaining machine left in operation will begin to operate at a level below
its optimum. (Note that with 5 machines producing 100 units of output, minimum AVC could be achieved at
100, 80, 60, 40 and 20 units of output, but between these levels some machines may be working at less than
their optimum and some at more than their optimum. Thus if the optimum level for a machine is critical,
then the AVC curve may look wavy rather than the smooth line in Figure 5.14.)
(Box 5.6) Manufacturing firms like the one we have been describing will have other fixed costs (such as
rent and managerial overheads). Does the existence of these affect the argument that the AVC curve will
be flat bottomed?
In most cases, no. For example, in the case of rent or rates on land or on premises, not all the land or
premises have to be used, just because the rent covers it all. For example, a firm cutting its production in
half may prefer to use only half the factory. It all depends on the divisibility of the fixed factors. If they are
divisible, and thus only part of them need be used, then the AVC curve is more likely to be flat bottomed.
Similarly, managers could simply work less hard if output were to be cut. Thus the proportion of
managerial time or effort could remain the same per unit of output.
Why is the minimum point of the AVC curve at a lower level of output than the minimum point of the AC
curve?
Because between points y and z marginal cost is above AVC (and thus AVC must be past the minimum
point) but below AC (and thus AC cannot yet have reached the minimum point). Even though AVC is rising
beyond point y, the fall in AFC initially more than offsets the rise in AVC and thus AC still falls.
31

Page
126 Referring still to Table 5.4, are there diminishing or increasing marginal returns, and are there
decreasing or increasing returns to scale?
Diminishing marginal returns: the output figures in column 3 increase by a smaller and smaller amount as
input 2 increases.
Increasing returns to scale: the output figures in column 6 increase by a larger and larger amount with equal
proportional increases in both inputs.
127 1. Which of the economies of scale we have considered are due to increasing returns to scale and which
are due to other factors?
All except financial economies (and possibly the production of by-products) are due to increasing returns to
scale, since they all involve using less inputs per unit of output as the scale of production increases. In the
case of financial economies, it is not that less units of input are used, but that they may be obtained more
cheaply.
2. What economies of scale is a large department store likely to experience?
Specialised staff for each department (saving on training costs and providing a more efficient service for
customers); being able to reallocate space as demand shifts from one product to another and thereby
reducing the overall amount of space required; full use of large delivery lorries which would be able to
carry a range of different products; bulk purchasing discounts; reduced administrative overheads as a
proportion of total costs.
128 Why are firms likely to experience economies of scale up to a certain size and then diseconomies of scale
after some point beyond that?
Because economies of scale, given that most arise from increasing returns to scale, will be fully realised
after a certain level of output (see Box 5.7 on page136), whereas diseconomies of scale, given that they
largely arise from the managerial problems of running large organisations, are only likely to set in beyond a
certain level of output.
How is the opening up of trade and investment between eastern and western Europe likely to affect the
location of industries within Europe that have (a) substantial economies of scale; (b) little or no
economies of scale?
(a) Given that production will take place in only one or two plants, new plants will tend to be located near
to the centre of the new enlarged market (i.e. further to the east than before in the case of western
European companies).
(b) Plants will still tend to be scattered round Europe, given that the customers are scattered.
These effects will be the result of attempts to minimise transport costs and thus will be more significant the
higher are transport costs per kilometre.
1. Name some industries where external economies of scale are gained. What are the specific external
economies in each case?
Two examples are:
Financial services: pool of qualified and experienced labour, access to specialist software, one firm
providing specialist services to another.
Various parts of the engineering industry: pool of qualified and experienced labour, access to specialist
suppliers, possible joint research, specialised banking services.
2. Would you expect external economies to be associated with the concentration of an industry in a
particular region?
Yes. There may be a common transport and communications infrastructure that can be used; there is likely
to be a pool of trained and experienced labour in the area; joint demand may be high enough to allow
economies of scale to be experienced in the supply of some locally extracted raw material.
32
Chapter 5
Page
129 If factor X costs twice as much as factor Y (Px/Py = 2), what can be said about the relationship between
the MPPs of the two factors if the optimum combination of factors is used?
MPPx/MPPy = 2. The reason is that if MPPx/Px = MPPy/Py, then, by rearranging the terms of the equation,
MPPx/MPPy must equal Px/Py (= 2).
130 1. Could isoquants ever cross?
Not for a given state of technology, otherwise it would mean that at one side of the intersection the higher
output isoquant would be south-west of the lower output isoquant. This would mean that a higher output
could be achieved by using less of both factors of production!
2. Could they ever slope upward to the right? Explain your answers.
Yes. It would mean that one of the two factors had a negative marginal productivity that was greater than
the positive marginal productivity of the other: i.e. that MPPa/MPPb (or MPPb/MPPa) was negative (a
negative marginal rate of factor substitution).
This situation will occur when so much is used of one factor that diminishing returns have become so
great as to produce substantial negative marginal productivity: isoquants will bend back on themselves
beyond the points where they become vertical or horizontal. The firm, however, will not produce along this
portion of an isoquant, because the price ratio (Pa/Pb) will (virtually) never be negative: (but see Box 5.5 on
the price of Christmas trees on Christmas Eve, when it might be better for a shop to pay people to take them
away a negative price!).
131 Calculate the MRS moving up the curve in Figure 5.5 between each of the points: ed, dc, cb, and b
a. Does the MRS diminish moving in this direction?
When moving up the curve, MRS = L/K. Thus from points:
ed, MRS = 20/2 = 10
dc, MRS = 10/4 = 2.5
cb, MRS = 8/10 = 0.8
ba, MRS = 7/20 = 0.35
This illustrates that the MRS does diminish when moving up the curve.
1. What will happen to an isocost if the prices of both factors rise by the same percentage?
It will shift inwards parallel to the old isocost.
2. What will happen to the isocost of Figure 5.8 if the wage rate rises to 15 000?
It will pivot inwards round the point where it crosses the vertical axis. It will now cross the horizontal axis
at 20L. Its slope will now be 15 000/20 000: i.e. PL/PK.
132 Why are Christmas trees and fresh foods often sold cheaply on Christmas Eve?
With a vertical supply curve, price will be determined by demand. If demand is lower than anticipated, the
price will have to be reduced if the trees or fresh foods are to be sold.
133 1. Could the long run and the very long run ever be the same length of time?
Yes, if more advanced technology is already in existence but would require the purchase of new capital
equipment for it to be used.
2. What will the long-run and very long-run market supply curves for a product look like? How will the
shape of the long-run curve depend on returns to scale?
The long-run curve will be more elastic than the short-run curve. If there are increasing returns to scale, the
long-run supply curve will slope downwards (unless the effect is offset by external diseconomies of scale).
The very-long run curve is difficult to identify. It is likely to slope downwards if improvements in
technology result directly from a growth in the size of the industry. If, however, the advances in technology
are the result of factors independent of the size of the industry (e.g. scientific advance), this would be shown
by a vertical shift downwards of the long-run supply curve.
33

Page
133
3. In the very long run, new isoquants will have to be drawn as factor productivity changes. An increase
in productivity will shift the isoquants inwards towards the origin: less capital and labour will be required
to produce any given level of output. Will this be a parallel inward shift of the isoquants? Explain.
Possibly but not necessarily. It depends on whether the advance in technology increases the productivity of
both factors in the same proportion.
134 What would the firms long-run total cost curve look like in each of these three cases?
(a) The long-run marginal cost curve would be falling (and below the LRAC curve) and thus the long-run
total cost would be rising less and less steeply.
(b) The long-run marginal cost curve would be rising (and above the LRAC curve) and thus the long-run
total cost curve would be rising more and more steeply.
(c) The long-run marginal cost curve would be horizontal and (equal to the LRAC curve) and thus the longrun total cost curve would be rising at a constant rate: i.e. it would be a straight line up from the origin.
135 1. Explain the shape of the LRMC curve in diagram (d).
At first economies of scale cause the LRMC to fall. Then because of (marginal) diseconomies of scale,
additional units of production begin to cost more to produce than previous units: the LRMC begins to slope
upwards. But the LRAC is still falling because the LRMC is below it pulling it down. It is not until the
LRMC crosses the LRAC that the firm will experience a rising LRAC and hence average diseconomies of
scale.
2. What would the LRMC curve look like if the LRAC curve were flat bottomed as in Figure 5.12?
It would be below the LRAC between O and Q1, gradually getting closer to the LRAC. It would be the same
as LRAC between Q1 and Q2, and then rise above LRAC beyond Q2.
136 Will the envelope curve be tangential to the bottom of each of the short-run average cost curves?
Explain why it should or should not be.
No. At the tangency points the two curves must have the same slope. Thus if the envelope curve is
downward sloping, so too must the short-run average cost curve be downward sloping at the tangency point.
137 (Box 5.7) 1. Why might a firm operating with one plant achieve MEPS and yet not be large enough to
achieve MES? (Clue: are all economies of scale achieved at plant level?
There may be economies of scale to be gained that do not relate to plant size but rather to the size of the
organisation: for instance, marketing economies of scale and research and development economies of scale.
Despite operating with a minimum cost plant, the firm may still not be large enough to achieve these other
economies.
(Box 5.7) 2. Why might a firm producing bricks have an MES which is only 0.2 per cent of total EU
production and yet face little effective competition from other EU countries?
Because bricks, being heavy and having relatively low value, are costly to transport. The effective market
for bricks, therefore is a relatively local one.
138 What would the isoquant map look like if there were (a) continuously increasing returns to scale; (b)
continuously decreasing returns to scale?
(a) The isoquants would get progressively closer and closer together.
(b) The isoquants would get progressively further and further apart.
140 What would happen to the TR curve if the market price rose to 10? Try drawing it.
With a doubling in price from 5 to 10, the total revenue would double at each level of sales. The curve
would still be a straight line up from the origin, but twice as steep.
34
Chapter 5
Page
142 Copy Figures 5.18 and 5.19 (which are based on Table 5.8). Now assume that incomes have risen and
that as a result two more units per time period can be sold at each price. Draw a new table and plot the
resulting new AR, MR and TR curves on your diagrams. Are the new curves parallel to the old ones?
Explain.
The table will now be as follows:
Q
P = AR
TR
MR
(units)
3
()
8
()
24
()
28
30
30
28
24
18
4
2
0
2
4
6
The new AR curve will be 2 units to the right of the old one (and parallel to it). The new MR curve will be
1 unit to the right of the old one (and parallel to it). The new TR curve will be 2 higher than the old TR
curve for each unit of sales. Thus at a level of sales of 4 units, it is 4 x 2 = 8 above the old curve (i.e. 28
as opposed to 20). The TR curve has thus not shifted upwards parallel to the old curve, but has become
steeper with the peak now at Q = 5.5 as opposed to Q = 4.5 previously.
What can we say about the slope of the TR and TC curves at the maximum profit point? What does this
tell us about marginal revenue and marginal cost?
The slopes are the same. But given that the slope of the total curve gives the respective marginal, this
means that marginal revenue will be equal to marginal cost.
143 1. Fill in the missing figures (without referring to Table 5.8 or 5.9).
Q
P = AR
TR
MR
TC
AC
MC
(units)
0
()
9
()
0
()
()
6
()
()
10
10
14
12
18
14
4.3
20
18
4.5
20
25
1.3
0.5
18
42
18
36
4
7
2
6
0
5
2
4
2
2
4
3
A
()
8
6
T
()
6
16
14
56
35

Page
143 2. Why are the figures for MR and MC entered in the spaces between the lines in Table 5.10?
Because marginal revenue (or cost) is the extra revenue (or cost) from moving from one quantity to
another.
144 From the information for a firm given in the table below, construct a table like Table 5.10.
Q
Q
12
11
10
12
16
21
28
38
TC
Use your table to draw diagrams like Figures 5.20 and 5.22. Use these two diagrams to show the profitmaximising output and the level of maximum profit. Confirm your findings by reference to the table you
have constructed.
Q
P = AR
TR
MR
TC
AC
MC
(units)
0
()
12
()
0
()
()
2
()
()
11
11
6.0
11
10
9
20
4.5
27
12
4.0
32
16
4.0
35
21
4.2
15
5.0
16
4.0
14
2.8
1.3
0.4
36
28
4.7
1
7
5.5
1
6
11
3
5
5.0
5
4
5
3
7
3
A
()
9
2
T
()
2
10
35
38
5.4
The curves will be a similar shape to those in Figures 5.20 and 5.20. The peak of the T curve will be at Q
= 4. This will be the output where MR and MC intersect.
Will the size of normal profit vary with the general state of the economy?
Normal profit is the rate of profit that can be earned elsewhere (in industries involving a similar level of
risk).
When the economy is booming, profits will normally be higher than when the economy is in recession.
Thus the normal profit that must be earned in any one industry must be higher to prevent capital being
attracted to other industries.
145 (Box 5.8) 1. How much is total fixed cost?
12 (the constant term in the TC equation)
(Box 5.8) 2. Continue the table for Q = 8 and Q = 9.
Q = 8, TR = 320, TC = 332, T = 12
Q = 9, TR = 351, TC = 399, T = 48
(Box 5.8) 3. Plot TR, TC and T on a diagram like Figure 5.22.
The curves will be a similar shape, with the T curve peaking at Q = 4
36
Chapter 5
Page
145 (Box 5.8) Given the following equations:
TR = 72Q 2Q; TC = 10 + 12Q + 4Q
Calculate the maximum profit output and the amount of profit at that output using both methods.
(a) T = 72Q 2Q 10 12Q 4Q
= 10 + 60Q 6Q
dT/dQ = 60 12Q
Setting this equal to zero gives:
60 12Q = 0
12Q = 60
Q=5
(1)
(b) MR = dTR/dQ = 72 4Q
MC = dTC/dQ = 12 + 8Q
Setting MR equal to MC gives:
72 4Q = 12 + 8Q
12Q = 60
Q=5
To find the level of maximum profit, we must substitute Q = 5 into equation (1). This gives:
T = 10 + (60 5) (6 5)
= 10 + 300 150
= 140
37
Chapter 6
Page
149 Give one more example in each category.
Perfect competition: grains; foreign exchange.
Monopolistic competition: taxis; van hire.
Oligopoly: (homogeneous) white sugar; (differentiated) beer; banks.
Monopoly: National Grid Company (electricity transmission); local bus company on specific routes.
Would you expect builders and restaurateurs to have the same degree of control over price?
Other things being equal, restaurateurs are likely to produce a more differentiated product/service than
general builders (as opposed to specialist builders), and are thus likely to face a less elastic demand. This
gives them more control over price. Note, however, that the control over price depends on the degree of
competition a firm faces. If, therefore, there were only a few builders in a given town, but many
restaurants, the above arguments may not hold.
150 1. It is sometimes claimed that the market for various stocks and shares is perfectly competitive, or
nearly so. Take the case of the market for shares in a large company like Ford. Go through each of the 4
assumptions above and see if they apply in this case. (Dont be misled by assumption (1). The firm in
this case is not Ford itself.)
[Note that the market in this case is for Ford shares not for the products of Ford itself.]
Most aspects of the four assumptions of perfect competition apply.
a) There is a very large number of shareholders (although there are some large institutional shareholders.)
b) People are free to buy Ford shares.
c) All Ford ordinary shares are the same.
d) Buyers and sellers know the current share price, but they have imperfect knowledge of future share
prices. This gives rise to speculation in stocks and shares.
2. Is the market for gold perfectly competitive?
Nearly. It is similar to the market for Ford shares. There are many buyers and sellers of gold, who are thus
price takers, but who have imperfect knowledge of future gold prices. Also, countries with large gold stocks
(e.g. the USA) could influence the price by large-scale selling (or buying). [Note also that the price would
have to refer to a weighted average of the price in all major currencies to take account of exchange rate
fluctuations.]
151 (Box 6.1) What are the advantages and disadvantages of using a 5-firm concentration ratio rather than a
10-firm, 3-firm or even a 1-firm ratio?
The fewer the number of firms used in the ratio, the more useful it is for seeing just how powerful the largest
firms are. The problem with only including one or two firms in the ratio, however, is that it will not pick up
the significance of the medium-to-large firms. For example, if we look at the 3-firm ratio for two industries,
and if in both cases the three largest firms have a 50 per cent market share, but in one industry the next
largest three firms have 45 per cent of the market (a highly concentrated industry), but in the other industry
the next three largest firms have only 5 per cent of the market (an industry with many competing firms), the
3-firm ratio will not pick up this difference. Clearly, this problem is more acute when using a 2-firm or a 1firm ratio.
The more the firms used in the ratio, the more useful it is for seeing whether the industry is moderately
competitive or very competitive. It will not, however, show whether the industry is dominated by just one or
two firms. For example, the 10-firm ratio for two industries may be 90 per cent. But if in one case there
are 10 firms of roughly equal size, all with a market share of approximately 9 per cent, then this will be a
much more competitive industry than the other one, if that other one is dominated by one large firm which
has an 85 per cent market share.
A more complete picture would be given of an industry if more than one ratio were used: perhaps a 1firm, a 2-firm, a 5-firm and a 10-firm ratio.
38
Chapter 6
Page
157 (Box 6.1) Why are some industries like bread baking and brewing relatively concentrated, in that a few
firms produce a large proportion of total output (see Box 7.3 and Web case 7.5). and yet there are also
many small producers?
The large firms may produce a fairly standardised product for a national market, sold through large outlets
or large outlet chains. They have the advantage of economies of scale and can probably compete in terms of
price. The small firms, on the other hand, may be able to produce a more specialist product and/or serve a
particular local market. They may well compete more in terms of quality and variety than in terms of price.
152 1. Why do economists treat normal profit as a cost of production?
Because it is part of the opportunity cost of production. It is the profit sacrificed by not using the capital in
some alternative use.
2. What determines (a) the level and (b) the rate of normal profit for a particular firm?
It is easier to answer this in the reverse order.
(b) The rate of normal profit is the rate of profit on capital that could be earned by the owner in some
alternative industry (involving the same level of risks).
(a) The level of normal profit depends on the total amount of capital employed.
154 Will the industry supply be zero below a price of P5 in Figure 6.3?
Once the price dips below a firms AVC curve, it will stop production. But only if all firms have the same
AVC curve will the entire industry stop production. If some firms have a lower AVC curve than the firm
illustrated in Figure 6.3 (b), then industry supply will not be zero at P5.
Illustrate on a diagram similar to Figure 6.4 what would happen in the long-run if price were initially
below PL.
The industry supply curve would initially be to the right of Se and average revenue would be below ARL.
Firms would be making a loss. They would thus leave the industry. As they did so, the supply curve would
shift to the left until it reached Se. At that point, normal profits would be restored and firms would cease
leaving the industry.
155 1.
What other reasons can you think of why perfect competition is so rare?
Information on revenue and costs, especially future revenue and costs, is imperfect.
Producers usually produce differentiated products, one from another.
There are frequently barriers to the entry of new firms.
2. Why does the market for fresh vegetables approximate to perfect competition, whereas that for
aircraft does not?
There are limited economies of scale in the production of fresh vegetables and therefore there are many
producers. There are such substantial economies of scale in aircraft production, however, that the market is
only large enough for a very limited number of producers, each of which, therefore, will have considerable
market power.
157 (Box 6.3) What advantages might a large established retailer have over a new e-commerce rival to
suggest that the new e-commerce business is unlikely to have it all its own way?
Customers are familiar with its products and services and may trust their quality.
Consumers may prefer to be able to ask advice from a sales assistant.
It may have sufficient market strength to match any lower prices offered by the e-commerce firm.
It may have sufficient market strength to force down prices from its suppliers.
Consumers may prefer to see and/or touch the products on display to assess their quality.
Consumers may prefer the retail experience of going shopping.
39

Page
158 As an illustration of the difficulty in identifying monopolies, try to decide which of the following are
monopolies: British Telecom; your local evening newspaper; the village post office; a rival company;
Interflora; the London Underground; ice creams in the cinema; Guinness; food sold in a university
refectory; the board game Monopoly.
In some cases there is more obvious competition than in others. For example, with the growth of mobile
phones and cable television companies supplying phone services too, British Telecom has lost its monopoly
status for most customers. In other cases, such as ice creams in the cinema, village post offices and
university refectories, there is likely to be a local monopoly. In all cases, the closeness of substitutes will
very much depend on consumers perceptions.
160 Try this brain teaser. A monopoly would be expected to face an inelastic demand. And yet, if it produces
where MR = MC, MR must be positive, demand must therefore be elastic. Therefore the monopolist
must face an elastic demand! Can you solve this conundrum?
Demand is elastic at the point where MR = MC. The reason is that MC must be positive and therefore MR
must also be positive. But if MR is positive, demand must be elastic. Nevertheless, at any given price a
monopoly will face a less elastic demand curve than a firm producing the same good under monopolistic
competition or oligopoly. This enables it to raise price further before demand becomes elastic (and before
the point is reached where MR = MC).
1. On a diagram like Figure 6.9, by drawing in MR and MC curves, demonstrate that PL could be below
the short-run profit-maximising price.
You will also need to draw an AR curve. If you look at Figure 6.8, you can see that the profit-maximising
price will depend on the height of the MR and AR curves. With a high AR curve, the profit-maximising
position on this curve could well be above PL.
2. What does this analysis assume about the price elasticity of demand for the new entrant (a) above PL;
(b) below PL?
Above PL, demand will be relatively elastic because the existing firm will not put its price above PL. In
other words, if the new entrant raised its price above PL, it would lose a lot of sales to the existing firm.
Below PL, however, demand is likely to be much less elastic. If the new entrant did try to cut its price
below PL, hoping to survive long enough to capture a significant share of the market and gain economies of
scale, the existing firm would probably reduce its price too in order to drive the new entrant out of business;
the new entrant would not, therefore, gain many sales from the existing firm. The demand curve would thus
be kinked at the limit price set by the existing firm (see pages 1856).
161 If the shares in a monopoly (such as a water company) were very widely distributed among the
population, would the shareholders necessarily want the firm to use its monopoly power to make larger
profits?
If the water company raised its charges and thereby made a larger profit, shareholders would gain from
larger dividends, but as consumers of water would lose from having to pay the higher charges. Except in
the case of shareholders with only a few water shares, however, the gain is likely to outweigh the loss.
Nevertheless, with shares very widely distributed, the average net gain would be only very small, and the
wider the distribution, the more shareholders there would be who would suffer a net loss from the higher
charges.
163 (Box 6.4) 1. In what respects might Microsofts behaviour be deemed to be: (a) against the public
interest; (b) in the public interest?
(a) Prices are likely to be higher, given the lack of competition; there may be less product development,
because potential competitors fear Microsofts power to block their entry to the market, or drive them
from it if they do succeed in entering; less choice for consumers.
(b) By developing products that are in general use round the world, it is more convenient for businesses
and their employees, who do not have to learn different sets of programmes or have problems with
incompatibility of programmes; monopoly profits can lead to high levels of investment and product
development, which can help to reduce prices over the longer term.
Page
163 (Box 6.4) 2. Being locked in to a product or technology is a problem only if such a product can be
clearly shown to be inferior to an alternative. What difficulties might there be in establishing such a
case?
40
Chapter 6
If potential competitors have been prevented from developing superior products or technology, then those
products or technology are not available to be compared with the existing products or technology! You are
trying to compare an existing situation with a hypothetical one. Even if the competitors do have a product
on the market, its inferiority may be a practical one rather than an intrinsic one namely that it is
incompatible with the market leaders products or technology.
164 (Box 6.5) 1. How might you measure X inefficiency?
The proportion by which actual output falls short of that which it is estimated could be produced if all inputs
were fully and effectively used. Alternatively you could measure it in cost terms: i.e. the amount by which
average costs exceed the level at which all inputs were fully and effectively used.
(Box 6.5) 2. Another type of inefficiency is productive inefficiency. What do you think this is? (Clue: it
has to do with the proportions in which factors are used).
Productive inefficiency occurs when the cost of producing a particular level of output could be reduced by
combining the factors of production in different proportions.
166 In which of the following industries are exit costs likely to be low: (a) steel production; (b) market
gardening; (c) nuclear power generation; (d) specialist financial advisory services; (e) production of a
new drug; (f) mobile discos; (g) car ferry operators? Are these exit costs dependent on how narrowly
the industry is defined?
(a) High. The plant cannot be used for other purposes.
(b) Relatively low. The industry is not very capital intensive, and the various tools and equipment could be
sold or transferred to producing other crops.
(c) Very high. The plant cannot be used for other purposes and decommissioning costs are very high.
(d) Low. The capital costs are low and offices can be sold.
(e) Low to moderate. It is likely that a pharmaceutical company can relatively easily switch to producing
alternative drugs. Substantial exit costs are only likely to arise if the company is committed to a longterm research and development programme or if equipment is not transferable to producing alternative
drugs.
(f) Low to moderate. The exit costs again will depend on the second-hand value of the equipment.
(g) Relatively low if the ships can be transferred to other routes. Much higher if the company wishes to
move out of shipping entirely and if the market for second-hand ships is depressed.
167 Give some other examples of hit-and-run competition.
Ice cream vendors on a beach in a heat wave; a plastics company manufacturing a batch of cheap moulded
sledges in a snowy spell.
(Box 6.6) 1. Make a list of those factors that determine the contestability of a particular air route.
The number and severity of legal obstacles to the entry of new operators (the greater the obstacles, the
less contestable the market).
The amount of government regulation preventing anti-competitive practices by existing operators (the
greater the regulation, the more contestable the market).
The number of alternative routes that could be operated from the same airports (the more alternatives,
the less the exit costs from any one route).
The degree of control of facilities at hub airports by existing operators (the greater the control, the less
contestable the routes).
The more rapid the growth in passenger demand (the more contestable the market).
41

Page
167 (Box 6.6) 2. In the UK, train operators compete for franchises to run services on a particular route.
The franchises are normally for 7, 10, 12 or 15 years. The franchise specifies prices and minimum
levels of services (frequency, timing and quality). Would this be a good system to adopt in the airline
market over particular routes? How is the airline market similar to/different from the rail market in
this regard?
At the time of awarding the franchises there could be considerable competition from airlines and this would
be in the interests of passengers. Once the franchises had been awarded, however, it could limit the entry of
new carriers into the industry (such as low cost, no-frills airlines) and thus restrict possible competition.
Most train routes are close to natural monopolies (though not entirely, as more than one train operator can
use a particular line) and thus franchises are a particularly suitable way of making routes contestable. With
airlines, however, there is scope for several airlines flying from particular airports and, for many
destinations, for more than one airline to specific destinations from that airport. Nevertheless, take-off and
landing slots are limited, as are slots for trains on particular lines, and thus the markets are similar, even if
the airline industry is potentially more competitive.
42
Chapter 7
Page
170 Give some other examples of monopolistic competition. (Try looking through the Yellow Pages if you are
stuck.)
Examples include: taxis, car hire, pubs, hotels and restaurants, insurance agents, estate agents, child
minders, office equipment suppliers, double glazing installers, antique dealers, computer systems.
1. Why may a food shop charge higher prices than supermarkets for essential items and yet very similar
prices for delicatessen items?
Because the demand for such essential items from a local food shop is likely to be less price-elastic than the
demand for delicatessen items: if people run out of basic items, they will want to obtain them straight away
rather than waiting until they visit the supermarket. Also the supermarkets may obtain bulk discount from
their suppliers on basic items, but not on delicatessen items, where the turnover is much lower.
2. Which of these two items is a petrol station more likely to sell at a discount: (a) oil; (b) sweets? Why?
Oil (especially in large cans). The reason is that demand is more price elastic. People will be tempted to
buy now, rather than waiting, if they see a reasonable discount (or a free gift). In the case of sweets, these
are often an impulse buy and the price is very low anyway relative to the amount already spent on petrol. A
penny or two price reduction will probably make very little difference to sales.
171 1. Why does the LRMC curve cross the MRL curve directly below the tangency point of the LRAC and
ARL curves?
At the tangency point the slope of the long-run AC and long-run MC are the same, and thus the slope of the
long-run TC and long-run TR must be the same. But the slope of the long-run TC gives the long-run MC
and the slope of the long-run TR gives the long-run MR. Thus the long-run MC must equal the long-run
MR.
Another way of answering the question is to note that long-run profits are maximised where long-run
MR equals long-run MC (at QL). But at QL, long-run AR equals long-run AC, whilst at any other output
long-run AR is below long-run AC. Thus profits must be maximised at QL for this reason too.
2. Assuming that supernormal profits can be made in the short run, will there be any difference in the
long-run and short-run elasticity of demand? Explain.
Yes. The entry of new firms, attracted by the supernormal profits, will make the long-run demand for the
firm more elastic: there are now more alternatives for consumers to choose from.
172 (Box 7.2) 1. Was there totally free entry to this market?
Pretty well. Additional ice-cream vans could be sent to the by-pass from elsewhere. Also, there were no
sunk costs associated with selling in the traffic, since ice cream vans and the sellers could easily be diverted
to other areas if there were insufficient profits to be made. Thus both entry and exit were virtually costless.
The market was thus highly contestable.
(Box 7.2) 2. What forms of product differentiation were there?
The main one was location: where in the traffic queue the seller was standing. There were also some
differences between the ice creams of the different companies and differences in the manner of the sellers.
43

Page
172 Why will additional advertising lead to smaller and smaller increases in sales?
Because fewer and fewer additional people will see each extra advert (i.e. many of the people will have
seen the adverts already and thus there will be little additional effect on their demand).
173 Does this imply that if, say, half of the petrol stations were closed down, the consumer would benefit?
(Clue: what would happen to the demand curves of the remaining stations?)
No. Demand would become less elastic and the lack of competition may enable remaining petrol stations to
make supernormal profits in the long run as well as the short run. The consumer would only benefit from a
reduced number of firms if there was still sufficient competition to allow profits to be kept at a normal level,
and if cost conditions changed so that the LRAC now continued sloping downward for longer (so that the
point of tangency is at a higher output): this would require changes in technology such as new computerised
systems which allow one cashier to handle a larger number of customers.
Which would you rather have: five restaurants to choose from, each with very different menus and each
having spare tables so that you could always guarantee getting one; or just two restaurants, charging a
bit less but with less choice and where you have to book quite a long time in advance?
Many people would choose the first, but clearly it is a question of personal preference.
175 How will advertising affect the cartels MC and AR curves? How will this affect the profit-maximising
output? Is there any problem here for the cartel in fixing the price?
If the advertising increases total cartel sales, the cartels AR curve will shift to the right and possibly
become less elastic. The MC curve will only shift if the advertising varies with output. Given that the
amount that member firms will advertise is not known and, even if it were, the effects of any amount of
advertising on AR is also not known, so it is impossible for the cartel to identify the profit-maximising price
with any degree of precision.
If this fair solution were adopted, what effect would it have on the industry MC curve in Figure 7.3?
It would be likely to shift it upwards, given that additional output would not merely come from the most
efficient producers, but rather from all producers in proportion to their market share. Also, over time, by
protecting companies market share in this way, there would be less competition to adopt new more efficient
techniques.
176 (Box 7.3) 1. What are the barriers to entry in (a) brewing; (b) opening new pubs?
(a) Costs of plant for producing on a large scale; brand loyalty; advertising by the established firms;
difficulty in finding outlets for the beer, given that most pubs are tied to a brewery and are required to
sell only one guest beer; pressure from large breweries on pubs to stock their guest beers.
(b) Market is already saturated in most areas; high cost of purchasing premises and fitting them out; fear of
unfair competition from existing pubs, most of which are tied to the large breweries.
(Box 7.3) 2. Do small independent brewers have any market advantages?
Yes. Beer, being heavy and bulky relative to value, is quite expensive to transport. Local brewers, by
being near to their outlets are likely to have lower transport costs. On the demand side, there is often
considerable loyalty for local ales.
177 Draw a pair of diagrams like those in Figure 7.4. Illustrate what would happen if there were a rise in
market demand and no rise in the costs of either the leader or the followers. Would there be an equal
percentage increase in the output of both leader and followers?
The Dmarket curve would shift to the right. This would cause the Dleader curve also to shift to the right (now
intersecting the vertical axis at the price where the Sall other firms curve crosses the new Dmarket curve). There
would be a corresponding rightward shift in the leaders MR curve, which would cause the leader to
increase output to where the new MR curve intersects with its MC curve, and to raise price to the point on
its demand curve vertically above the new MR/MC intersection.
Whether there would be an equal percentage increase in the output of both leader and followers
depends on the shapes of the various curves and the initial market share of each.
44
Chapter 7
Page
178 (Box 7.4) Illustrate what was happening here on a demand and supply diagram. Remember that
demand is highly inelastic and was increasing over time.
The initial demand and supply curves intersect at a price of $3 per barrel. The actions of OPEC in 1973/4
can be shown by a shift in the supply curve to the left, which, given the inelastic nature of the demand
curve, causes price to rise substantially to over $12 per barrel. Then during the mid to late 1970s, the
demand curve shifts to the right (demand was increasing over time), which combined with a slight
movement back to the right of the supply curve, allowed sales (Q) to resume their pre 1973 level while
price still remained above the $12 per barrel level.
179 (Box 7.4) 1. What conditions facilitate the formation of a cartel? Which of these conditions were to be
found in the oil market in (a) the early 1970s; (b) the mid-1980s; (c) 2000?
For the conditions that facilitate the formation of a cartel, see the list of factors favouring collusion on page
180. Taking the points in order as they appear on page 180:
There are relatively few oil producing countries (but more in the 1980s than in the 1970s).
The OPEC members meet openly to discuss pricing and quotas (in all three periods)
Production methods are relatively similar, although costs vary according to the accessibility of the oil.
The (final) product is very similar and there is an international price for each type of crude.
Saudi Arabia is the dominant member of OPEC: its dominance over the world market, however, waned
from the mid-1980s as non-OPEC production increased and there was a world glut of oil. With a
growing world economy in the late 1990s, Saudi Arabias influence grew again.
Entry barriers, however, have not been significant. This has allowed several non-OPEC members (e.g.
Mexico, Norway and the UK) to break into the market.
The market is relatively stable in the short run (given the price and income inelasticity of demand).
There has been a problem, however, of a decline in demand over the longer term.
Governments round the world have been relatively powerless to curb OPECs collusion, although from
time to time (e.g. during the Gulf War) the USA has released oil from its huge stock piles to prevent
excessive price increases.
(Box 7.4) 2. Could OPEC have done anything to prevent the long-term decline in real oil prices since
1981?
Very little, given that the supply of substitutes (both oil and non-oil) for OPEC oil have increased
substantially. Perhaps, with hindsight, if OPEC had not raised prices so much in 1973/74 and 1979 there
would have been less incentive to develop substitutes and to break the power of the cartel.
(Box 7.4) 3. Many oil analysts are predicting a rapid decline in world oil output in 10 to 20 years as
world reserves are depleted. What effect is this likely to have on OPECs behaviour?
The fall in output will drive up prices. Provided that OPEC can prevent its members from pumping oil more
rapidly to take advantage of the rising price, OPECs power could increase. It could demonstrate to its
members the rising trend in oil prices and attempt to persuade them of the benefit of reducing production
even further. It could sell this policy to the world as one of being prudent with dwindling oil stocks.
180 If a firm has a typically shaped average cost curve and sets prices 10 per cent above average cost, what
will its supply curve look like?
It will be vertically above the AC curve by 10 per cent: i.e. it will get further apart from the AC curve, the
higher the AC curve is.
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180 In which of the following industries is collusion likely to occur: bricks, beer, margarine, cement, crisps,
washing powder, blank audio or video cassettes, carpets?
In all cases collusion is quite likely: check out the factors favouring collusion on page 180. In some cases it
is more likely than others: for example, in the case of cement, where there is little product differentiation
and a limited number of producers, collusion is more likely than in the case of carpets, where there is much
more product differentiation.
183 (Box 7.5) 1. Why is this a dominant strategy game?
Because, whatever assumption is made about the others behaviour, each prisoner is likely to confess (and
end up in position D).
(Box 7.5) 2. How would Nigels choice of strategy be affected if he had instead been involved in a joint
crime with Jeremy, Pauline, Diana and Dave, and they had all been caught?
The more people there were involved in the crime, the greater would be the likelihood of one of them
confessing and therefore the greater the temptation for Nigel to confess.
(Box 7.5) 3. Can you think of any other non-economic examples of the prisoners dilemma?
Children in a class previously agreeing not to do homework for a test, but parents keeping them apart so that
they can persuade their children to do their homework, telling them, The other children will also be doing
theirs and you will not want to be shown up by doing badly compared with them.
Assume that there are two major oil companies operating filling stations in an area. The first promises
to match the others prices. The other promises always to sell at 1p per litre cheaper than the first.
Describe the likely sequence of events in this game and the likely eventual outcome. Could the
promise of the second company be seen as credible?
Prices would be driven down, and hence profits reduced, until one of the companies could no longer stick
to its promise either the first accepting that its price will be 1p above the second, or the second
accepting the same price as the first. Alternatively both companies simultaneously may decide to
abandon their policy and collude to raise prices. This may involve a secret meeting between them, or
simply letting it be known that they would be willing to raise prices, providing that the other company
did the same.
The promise of the second company could be seen as credible if it had lower costs or greater
financial backing than the first company. In such circumstances, the first company may be forced to give
up its policy first. If they have similar costs and financial strength, then the threat is not credible.
184 Give an example of decisions that two firms could make in sequence, each one affecting the others next
decision.
Two supermarket chains are thinking of expanding into the small metro stores segment of the market in a
particular city that does not have any such stores. There is room in the market for only one in each of three
suburbs, with the third having little prospect of making a profit in the short run. The first mover may
succeed in gaining planning permission for the most profitable of the three. This will give the second an
advantage in gaining planning permission in the second most profitable, given than the local authorities will
want to maintain as much competition as possible. Both will have to consider, however, what they do about
the third, which is only marginally profitable, but could help to develop the image of their other metro store
in the city. They will also have to consider whether if the other company opened the third store this would
deny them an opportunity of ever having a second metro store in the city: a store which could be profitable
at some point in the future.
186 Which of the following are examples of effective countervailing power?
(a) Tour operators purchasing seats on charter flights.
(b) A large office hiring a photocopier from Rank Xerox.
(c) Marks and Spencer buying clothes from a garment manufacturer.
(d) A small village store (but the only one for miles around) buying food from a wholesaler.
(a) and (c) are examples of effective countervailing power, because the individual purchasing firms are
large relative to the total market for the product.
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Chapter 7
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187 1. Could annoyance to the public ever rebound as a direct cost to the firm?
Yes. The government may be persuaded to tax advertising; local authorities may levy charges on companies
for bill-boards. Also, on the demand side, consumers may be put off buying the product.
2. Choose two products which are extensively advertised. Make out a case for and a case against these
particular advertisements.
Check the particular products and the nature of the adverts against the list of points made on page 190.
Which of the following markets do you think are contestable?
(a) credit cards; (b) brewing; (c) petrol retailing; (d) insurance services; (e) compact discs?
The least contestable are credit cards and brewing, where the existing companies have considerable control
over the market. Petrol retailing and insurance services (especially at the retail level) are relatively
contestable because the barriers to entry are low. Exist costs are also relatively low (assuming that petrol
stations can be sold easily). New producers of compact discs (the recording companies as opposed to the
manufacturers of the basic discs on which recordings are made) face moderately high entry barriers in terms
of recording contracts, economies of scale and influence over outlets, but there have been examples of new
companies setting up, especially in more specialist parts of the market.
189 (Box 7.6) 1. Look at each of the above questions. In each case decide whether price discrimination is
being practised. If it is, is it sensible for train operators to do so? Is it discriminating between people
with different price elasticities of demand?
Price discrimination occurs when the same product or service (with the same marginal cost) is sold at
different prices to different customers. Thus charging a different price for first and standard class, for seat
reservation, for travel on different times of day, or on different days of the week, or at different times of the
year are not examples of price discrimination, since (a) the service is different and (b) the marginal cost is
not the same. On the other hand, charging a different price for children, students, old people, people
travelling on single rather than return tickets and on day, saver or period return tickets are examples of
price discrimination since they allow travel on the same seat on the same train to different classes of people.
(Box 7.6) 2. Are these various forms of price discrimination in the travellers interest?
If the lower-price fares are making travel possible for people who could otherwise not afford it, then clearly
they are benefiting. For the people paying the higher-priced fares, then there are advantages and
disadvantages. Clearly, they will not like paying more than they would in the absence of price
discrimination, but given that at peak times some lines are operating to full capacity, the higher price may be
necessary to prevent queuing or grossly overcrowded trains (though note, as explained in the answer to the
last question, charging higher prices at peak times to everyone is strictly speaking not a form of price
discrimination).
Explain why, if the firm can practise first-degree price discrimination by selling every unit at the
maximum price each consumer is prepared to pay, its revenue from selling 200 units will be the sum of
both the shaded areas in Figure 7.11.
Because the demand curve shows the maximum price consumers are prepared to pay for each additional
unit purchased. Thus reading from left to right along Figure 7.11, the first unit can be sold at the price
corresponding to Q = 1 on the demand curve; the second unit can be sold at the price corresponding to Q = 2
on the demand curve without affecting the price at which the first unit was sold, and so on for each unit.
Thus in each case, the marginal revenue (not the average revenue) is given by the demand curve. When all
these marginal revenues are added up (up to 200 units), this will give the area under the demand curve (both
shaded areas), and being the sum of the marginal revenues, it must equal the total revenue from selling 200
units.
47

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190 (Box 7.7) 1. If, over time, consumers are encouraged to switch their consumption to off-peak periods,
what will happen to peak and off-peak prices?
The difference between the prices will narrow. The peak demand curve has shifted to the left (and possibly
become more elastic, assuming that people could easily shift back to peak times if the peak price came
down).
(Box 7.8) 2. To what extent is peak-load pricing in the interests of consumers?
It may help to keep the average price down, if it spreads the use of fixed factors more evenly. It may also
help to ease congestion (e.g. on trains) at peak times for those who have no alternative but to use the service
at that time. Peak users may prefer a higher priced journey to a more congested journey or having to queue,
and possibly running the risk of not getting the service (e.g. not getting on the train or bus because it is full).
(Box 7.8) 3. Is total consumption likely to be higher or lower with a system of peak and off-peak prices
as opposed to a uniform price at all times?
Higher, since some people would only be prepared to buy the product at off-peak prices.
191 How would profit-maximising output and price be determined under third-degree price discrimination if
there were three separate markets? Draw a diagram to illustrate your answer.
The overall MR curve would be found by drawing a separate MR curve for each of the three markets (as
was done for the two markets in Figure 7.13), and then adding them horizontally. The profit-maximising
output would be found where this total MR curve crossed the MC curve (as in diagram (c) of Figure 7.13).
The output in each of the three individual markets would then be found by reading down from the respective
MR curve at the level of MR established in the overall market. The price in each market would then be
found by reading up to the demand curve (as in diagrams (a) and (b) in Figure 7.13).
192 (Box 7.8) 1. Which type of price discrimination is the cinema pursuing: first, second or third degree?
Would it be possible for the cinema to pursue either of the other two types?
Third-degree price discrimination. It groups cinema goers into two types: adults and children.
It could not practise first-degree discrimination: it would not be possible to negotiate a separate ticket price
with each customer! It could possibly practise a form of second-degree price discrimination, however, if it
gave tokens to people each time they purchased a ticket and then sold tickets at reduced prices to people
with tokens.
(Box 7.8) 2. If all cinema seats could be sold to adults in the evenings at the end of the week, but only a
few on Mondays and Tuesdays, what price discrimination policy would you recommend to the cinema in
order for it to maximise its weekly revenue?
Offer reduced-price tickets to children in the evenings as well as in the afternoon for the first part of the
week, but not for the end of the week.
(Box 7.8) 3. Would the cinema make more profit if it could charge adults a different price in the
afternoon and the evenings?
Possibly. The danger for the cinema, however, is that adults who would have gone to the cinema anyway
may now choose to go in the afternoon, thereby losing the cinema revenue. Ideally the cinema would like to
discriminate in such a way as to encourage people to go in the afternoon at a reduced price who would not
have gone at all (whether in the afternoon or the evening) if they had to pay the higher price. One such
group may be senior citizens and people on social security. Many cinemas, therefore, find it profitable to
sell concessionary seats in the afternoon but not the evening.
48
Chapter 8
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195 What cost concepts are there other than those based on opportunity cost? Would the use of these
concepts be likely to lead to an output greater or less than the profit-maximising one?
Historical costs and replacement costs. Given that these will generally be higher than opportunity costs in
the case of equipment already owned by the firm, the firm is likely to produce less than the profit
maximising output by using these other cost concepts.
197 (Box 8.1) What advantages might a consumer gain from a large M- or H-form company?
Individual divisions or parts of the organisation may be more responsive to consumer wishes and better
serve particular segments of the market.
198 Make a list of six possible aims a manager of a high street department store might have. Identify some
conflicts that might arise between these aims?
Six possible examples are:
1. To increase sales.
2. To seek promotion to a bigger store, head office or some other company.
3. To ensure that staff work efficiently.
4. To ensure that this seasons stocks are all sold by the end of the season (without having to make
massive reductions at sale time).
5. To stock as full a range of products as possible.
6. To have an easy life.
Conflicts could arise between (4) and (5), and between (6) and virtually any of the others.
(Box 8.2) 1. When are increased profits in the managers personal interest?
When they lead to an increased salary, to promotion, to greater prestige with colleagues and contacts
outside the firm, to greater personal satisfaction, to a greater sense of job security, etc.
(Box 8.2) 2. Do you carefully allocate your time between study and leisure? If not, why not?
You will have to answer this for yourself! If you dont allocate your time carefully, the reason may be that
you dont like planning your time too much and prefer to take each day or hour as it comes; or it could be
that you have learnt by experience what allocation best suits you and thus do not need to do detailed
planning.
201 (Box 8.3) 1. Why might it be difficult to refute a theory of long-run profit maximisation?
Because a firm could always claim that it was seeking to maximise profits by its various activities, even if
in practice they turn out not to have been very successful. Also, a firm will be unable to predict the precise
effects of its actions on costs and revenues, especially given that it will be unable to predict the long-term
responses of its rivals and their effects (see page 200).
(Box 8.3) 2. If a theory cannot in principle be refuted, is it a useful theory?
No, not very except that it may give useful pointers as to the types of effects that could be expected, were
the theory to be true. It could thus alert people to what could occur.
Draw a diagram with MC and MR curves. Mark the output (a) at which profits are maximised; (b) at
which sales revenue is maximised.
(a) Profits are maximised where MC = MR.
(b) Sales revenue is maximised where MR = 0.
Thus in Figure 5.22 on page 144 of the text, profits are maximised where Q = 3, and sales revenue is
maximised between Q = 4 and Q = 5. (This can be confirmed from Table 5.10 on page 143.)
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Page
202 Since advertising increases a firms costs, will prices necessarily be lower with sales revenue
maximisation than with profit maximisation?
No. If advertising could go on increasing total revenue substantially beyond the profit-maximising level of
advertising, (and hence go on shifting the demand curve to the right), the effect could be to give a higher
price.
204 Which of the three types of merger (horizontal, vertical and conglomerate) are most likely to lead to (a)
reductions in average costs; (b) increased market power?
(a) Horizontal: there is probably greater scope for rationalisation of production in fewer plants or for each
plant to concentrate on a smaller range of products. Note that there is some scope for this with vertical
mergers too (and possibly, to a limited extent, with conglomerate mergers).
(b) Horizontal: this directly reduces the number of producers of the particular product(s).
1. Which of the above theories overlap and in what way?
The motives given in the text are:
1) growth, 2) economies of scale, 3) monopoly power, 4) increased market valuation, 5) reduction in
uncertainty, 6) opportunities that arise, 7) to resist takeovers, 8) defending another firm from an unwanted
predator, 9) asset stripping, 10) empire building, 11) broadening the geographical base.
(1) overlaps with (2), (3), (4), (5) and (10), depending on just why firms want to grow; (3) overlaps with
(2), (5), (7), (10) and possibly (11), depending on the extent to which these others will increase monopoly
power; (6) overlaps with all the others, depending on motives at the time.
2. Why, do you think, is it difficult to find adequate empirical support for any of them?
Because motives are often complex and ill-defined, and because the decision makers may hide their
motives. Also, given that the motives may well overlap, it is difficult to separate them.
205 (Box 8.4) 1. Why may a business favour borrowing, as a means of financing growth, over other sources
of finance?
It may be easier to raise finance through borrowing. Also, if the alternatives are a new issue of shares or
financing growth from retained profit, then both could result in lower profits for existing shareholders and a
lower share price, since the first would reduce the profits for distribution to shareholders and the second
would create more shares to divide the profits between. Also, if a rapid growth in profits is expected, the
cost of financing growth through borrowing would be constant (unless interest rates rose), whereas the cost
of issuing extra shares would be a rapidly growing amount distributed to these new shares (and hence less
to existing shareholders).
(Box 8.4) 2. What are the strengths and weaknesses of diversification as a business growth strategy?
A major advantage is that the firm becomes less reliant on one product and hence less vulnerable if the
market for that product fluctuates. It is a way, therefore, of spreading risks. It is also advantageous to the
firm if the market for its existing products is growing slowly or declining and if it is difficult to gain a bigger
share of the market (either because of aggressive competition from rivals or because it already has a large
market share). There may also be some economies of scale (albeit probably not as great as with the other
two types of merger). For example, there could be marketing, warehousing, distribution and financial
economies.
Disadvantages arise largely from a lack of focus and a lack of detailed understanding of the markets
into which it expands. Also some of the acquired companies may be less profitable.
207 (Box 8.5) Are the motives for merger likely to be different in a recession from in a period of rapid
economic growth?
In a period of rapid economic growth the motives for merger include: the desire to expand to take advantage
of the growth in demand; to defend market share against other firms similarly trying to expand; to take
advantage of the relative ease in financing the merger.
In a recession, firms are more cautious about expanding. The main opportunity for mergers in these
circumstances occurs when a company is in financial difficulties and a predator company takes it over. It is
more difficult to raise finance to fund mergers in a recession.
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Chapter 8
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207 How will competition between growth-maximising firms benefit the consumer?
The firms may compete in terms of price or product specification in order to gain a bigger share of the
market. Also the competition for corporate control (i.e. the potential competition for the control of
companies, by, say, rival take-over bids) will encourage firms to be efficient, both to help stave off predators
and to help them in their bids to take over other companies.
209 (Box 8.6) Are customers interests best served by profit-maximising firms, answerable primarily to
shareholders, or by firms where various stakeholder groups are represented in decision taking?
The answer depends on (a) the amount of competition faced by firms and (b) the degree to which
customers (as opposed to other stakeholders) interests are represented in any decision making. Generally,
the more competitive the market, the more will profit-maximising firms be forced to take customers
interests into account, in terms of both quality and price. In other words, competition is a good means of
protecting consumers interests. With monopolists and powerful oligopolists, customers may be in a better
position to exert pressure on the firm if they have some formal representation (e.g. consumers councils for
gas and electricity), but their interests may well conflict with the interests of others, such as workers (where
higher pay may result in higher prices) or environmentalists (who may want to restrict consumption) or
suppliers (who may want to receive higher prices, which again could lead to higher prices).
211 Will this type of behaviour tend to lead to profit maximisation?
Only if they are trying to outdo their rivals in terms of profit.
Are satisficing firms more likely to suffer from X inefficiency (see Box 6.5) than firms which seek to
maximise profit or sales revenue?
Probably. They will be less anxious to increase labour productivity than maximising firms, and thus may
continue with inefficient practices.
213 (Box 8.8) 1. Which of the following is more likely to be consistent with the aim of maximising profits:
pricing on the basis of (a) cost per unit plus a variable percentage mark-up; (b) cost per unit plus a fixed
percentage mark-up.
Providing that the size of the mark-up is adjustable according to market conditions, either approach could
lead to maximum profit. (b) is easier to implement, but (a) allows the firm to focus on the size of total profit
(which is the object of profit maximisation) rather than on profit per unit.
(Box 8.8) 2. Explain the differences in the importance attached to the different factors leading to price
increases from those leading to price reductions.
The weighting suggests that firms react more to threats than opportunities. Thus a price reduction by rivals
(a threat) is given a 36 per cent weighting, whereas a price increase by rivals (an opportunity to raise
prices) is given only a 16 per cent weighting. An increase in material costs (a threat to profits) is given a 64
per cent weighting, whereas a decrease in material costs (an opportunity for price cuts) is given only a 28
per cent weighting. A fall in demand (a threat) is given a 22 per cent weighting, whereas a rise in demand
(an opportunity) is given only a 15 per cent weighting). It is similar with the last three factors in the lists.
214 1. If the firm adjusts the size of its mark-up according to changes in demand and the actions of
competitors, could its actions approximate to setting price and output where MC = MR?
Yes. If demand conditions or the actions of competitors cause the firm to adjust its price in the belief that it
would be profitable to do so, then the firm is effectively saying that the marginal revenue (gained) of the
price change exceeds the marginal cost (incurred) (or the marginal revenue lost is less than the marginal cost
saved). If the firm is a profit satisficer, however, then any price adjustment in response to demand changes
or the actions of competitors may be to protect this satisfactory level of profit, rather than to gain maximum
profit.
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Page
214 2. Some firms set their prices by adding a mark-up to average variable cost (the mark-up would be
larger to include an element to cover fixed cost). Why might this make pricing easier for the firm? (See
Box 5.6.)
Because AVC is often relatively constant over fairly large ranges of output. Also, it is changes in AVC that
will affect the profit-maximising output, not changes in AFC (changes in AFC do not affect MC), and thus
basing the mark-up on AVC means that prices will only be changed when it is profitable.
52
Chapter 9
Page
216 Which of the above assumptions do you think would be correct in each of the following cases?
(a) Supermarket checkout operators
(b) Agricultural workers.
(c) Crane operators.
(d) Economics teachers.
(e) Call centre workers
The four assumptions are: (i) Everyone is a wage taker; (ii) There is freedom of entry; (iii) There is perfect
knowledge; (iv) Factors are homogeneous. They apply to the above cases as follows: (in some cases you
may want to challenge my answers, since the answers themselves depend on the assumptions you make!)
(a) (i) approximately, (ii), (iii) approximately, (iv) approximately.
(b) (ii)
(c) (iv) approximately.
(d) (ii) assuming that the teachers are qualified, (iii) approximately.
(e) (i) approximately, (ii), (iii) approximately, (iv) approximately.
217 (Box 9.1) Assume that it is agreed by everyone that it is morally wrong to treat labour as a mere factor
of production, with no rights over the goods produced. Does this make the neo-classical theory wrong?
It depends what is meant by wrong. If the word means factually incorrect then the theory could still
make accurate predictions about the incomes of the various factors, and it could still look at the implications
for employment of various policies pursued by firms policies such as profit maximisation. If the word
means morally wrong, however, then the neo-classical analysis could be regarded as guilty of demeaning
workers. On the other hand, many using neo-classical analysis do so to demonstrate the inequalities (and
hence, for them, the injustices) of the free market. Just because you study the workings of the capitalist
system, it does not follow that you are lending moral support to it.
219 (Box 9.2) 1. Using the analysis developed in Chapter 4, try to show the size of the income and
substitution effects when moving from point x to point y and from point y to point z.
(a) Movement from point x to point y:
Draw a line parallel to B2 but tangential to I1. Call the point of tangency of this line to I1, point x. The
substitution effect is the movement from x to x. The income effect is the movement from x to y.
(b) Movement from point y to point z:
Draw a line parallel to B3 but tangential to I2. Call the point of tangency of this line to I2, point y. The
substitution effect is the movement from y to y. The income effect is the movement from y to z.
Note that, when moving from point x to point z, the negative substitution effect (giving up leisure
because it is more expensive in terms of lost income) is exactly offset by the positive income effect
(taking more leisure because the higher income makes you feel that you can afford to do so).
(Box 9.2) 2. Illustrate on an indifference diagram the effect on the hours a person works of (a) a cut in
the rate of income tax; (b) an increase in child benefit (assuming the person has children).
See Box 10.5 (pages 2767).
(a) Diagram (c) on page 277 shows the effect of a cut in the rate of income tax.
(b) The effect of an increase in child benefit is shown by a parallel shift outward of the budget line (like
that in diagram (d) on page 277 to the left of point u. There is an income effect, leading to less hours
worked, but no substitution effect, because that marginal rate of tax is unchanged.
For example, if child benefit were made sufficiently generous, some parents would now no longer
feel the need to go out to work full time, and would prefer to stay at home full time or part time to look
after their children.
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Page
219 Which way will the supply curve shift if the wage rates in alternative jobs rise?
To the left. Workers will tend to move away from this job to the higher-paid alternatives.
220 1. Assume that there is a growing demand for computer programmers. As a result more people train to
become programmers. Does this represent a rightward shift in the supply curve of programmers, or
merely the supply curve becoming more elastic in the long run, or both? Explain.
It represents a rightward shift in the short-run supply curve. It can be seen as a movement up along a longrun supply curve (which is more elastic than the short-run curves, given that it allows for the time taken to
train).
2. Which is likely to be more elastic, the supply of coal miners or the supply of shop assistants? Explain.
Shop assistants: it is a less skilled occupation and thus it is easier to switch from other occupations if the
wage becomes more attractive.
(Box 9.3) 1. What effects are such developments likely to have on (a) trade union membership; (b) trade
union power?
They are likely to lead to a fall in trade union membership, given that it is difficult to build up a spirit of
worker solidarity if workers are dispersed. To the extent that this happens, trade union power is likely to
diminish. If a union, however, has a careful recruitment drive which focuses of the benefits of union
membership for workers who might feel isolated at home, then this could help to offset any fall in
membership.
Then there is the effect of an increasing use of temporary sub-contracted workers, working from home.
Unions are less able to cater for such workers, particularly if they are classed as self-employed.
(Box 9.3) 2. How is a growth in telecommuting likely to affect relative house prices between capital cities
and the regions?
As with salaries, the differences in house prices will tend to narrow. As there is less need for people to
travel into cities to work, so the demand for city houses will tend to fall and the demand for houses out of
cities will tend to rise.
221 Why is the MCL curve horizontal?
The firm in a perfectly competitive labour market is a wage taker. The cost of employing one more
worker (MCL), therefore, will simply be the market wage. It will not vary with the number of workers
employed.
222 What will determine the elasticity of this curve?
It will depend partly on the shape of the MRP curve. This will be steeper, the more rapidly diminishing
returns occur.
It will also depend on how much a fall in wages (e.g. from W1 to W2 in Figure 9.9) which causes
industry employment and hence output to increase will depress industry price and hence shift the MRP to
the left. This in turn will depend on the elasticity of demand for the industrys product. The less elastic the
demand for the product, the more its price will fall as industry supply increases, and hence the more will the
MRP curve shift to the left in Figure 9.6, and hence the less elastic will be the demand for labour (the green
line in Figure 9.6).
223 For each of the following jobs, check through the above list of determinants (excluding the last), and try
to decide whether demand would be relatively elastic or inelastic: firefighters; typists; carpenters; bus
drivers; Punch and Judy operators; farm workers; car workers.
Elasticity of demand for labour will tend to be greater:
(i) the greater the price elasticity of demand for the good; (ii) the easier it is to substitute labour for other
factors and vice versa; (iii) the greater the elasticity of supply of complementary factors; (iv) the greater the
elasticity of supply of substitute factors; (v) the greater the wage cost as a proportion of total costs.
The elasticity of demand for the particular occupations given in the question will depend on the relative
strength of these factors. I would estimate that the balance of these determinants would make demand more
elastic in the cases of bus conductors, Punch and Judy operators, farm workers and car workers than in the
other cases. You may well disagree, however, depending on the assumptions you make!
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Chapter 9
225 1. The following table shows data for a monopsonist employer. Fill in the missing figures for columns (3)
and (4). How many workers should the firm employ if it wishes to maximise profits?
Number of
Wage rate
Total cost of
Marginal cost
Marginal revenue
workers
()
labour ()
of labour ()
product ()
(1)
1
(2)
100
(3)
100
(4)
(5)
110
230
105
210
120
240
110
330
130
240
115
460
140
230
120
600
150
210
125
750
160
190
130
910
170
170
135
1080
180
150
140
1260
190
130
10
145
1450
The figures have been filled in in the above table. The firm should employ workers up to the point where
MCL = MRPL: it should employ 7 or 8 workers.
2. Will a monopsony typically be a monopoly? Try to think of some examples of monopsonists that are
not monopolists, and monopolists that are not monopsonists.
Typically firms which have market power in the goods market will also have market power in the labour
market.
But this is not necessarily so. For example a firm may sell its product nationally in competition with
other firms and yet be a major local employer, and thus have considerable monopsony power in the local
labour market. For example, a textile factory, which is the major local employer, may be a virtual
monopsonist for many types of labour and yet sell its products in a highly competitive national or
international market.
Conversely a firm may be a unique supplier of its product, and yet may demand labour in competition
with many other employers. For example, a factory producing specialist component parts, for which it has a
monopoly, may employ secretaries in competition with hundreds of other local employers.
226 (Box 9.4) 1. Why did competition between employers not force up wages and improve working
conditions?
Partly because there was little local competition; partly because employers could collude oligopsonist-ically
to keep wages down; partly because the elasticity of demand for labour was relatively high, especially in
labour-intensive industries where labour costs were a relatively high proportion of total costs; and partly
because the supply of labour was so high that the competition between workers for jobs kept wages down.
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226 (Box 9.4) 2. Were the workers making a rational economic decision when they chose to work in such
factories?
Often they had no alternative. There were no other jobs they could do that paid better, and they had to feed
and clothe themselves and their families.
Which of the following unions find themselves in a weak bargaining position for the above reasons?
(a) The seafarers part of the rail and maritime union (RMT)
(b) The shopworkers union (USDAW).
(c) The National Union of Mineworkers.
(d) The farmworkers union (part of the Transport and General Workers Union).
The power of all of them has been weakened in recent years by the development of labour displacing
technologies, by a decline in the proportion of the total workforce that are members and by government
legislation to reduce unions ability to take industrial action. Of the above four cases, the unions are
probably weakest in the cases of (b) and (d), where the membership is more scattered, and where it is
difficult to get collective action (much of which would be illegal secondary action anyway).
227 If the negotiated wage rate were somewhere between W1 and W2, what would happen to employment?
It would increase. It would be at the level where the horizontal line from the negotiated wage crossed the
MRPL curve, which would be to the right of Q1
229 (Box 9.5) What factors, other than those identified above, could account for the decline in union
membership in recent years?
The ending of closed shops; the belief by some workers that unions are not very effective in securing wage
increases or better conditions; the resistance of new companies to granting union recognition; the political
propaganda (especially during the Conservative governments of 197997) against unions as being the cause
of economic and political problems; workers increasingly feeling that they cannot afford union
subscriptions; the growing respectability of not being a union member.
Recall the various strategies that rival oligopolists can adopt. What parallels there are in union and
management strategies?
The two sides may decide to collude. In this case they may agree that industrial peace is in both sides
interest: the management gives higher wages in return for uninterrupted production; the union accepts a
slightly lower wage than it wants in return for avoiding disputes that are costly to the members. Maybe the
collusion between management and unions will extend to competing more effectively with other
companies by introducing new products, more efficient techniques, new working practices, etc. Again, both
sides will gain from the increased profits and wages.
Alternatively war may break out, with the union believing that a dispute is in its interests, with
management believing that it is in its interests to resist the unions claims.
231 (Box 9.6) What are the advantages and disadvantages of Japanese work practices from the point of view
of the worker?
Advantages: they may increase company profits (MRPL rises), and thereby allow the company to pay higher
wages; workers may get more job satisfaction; by insisting on greater worker flexibility, there may be more
variety for the worker; the satisfaction from identifying with a team, and setting and meeting team goals;
greater job security from the flexible work practices.
Disadvantages: possibly greater stress from having to meet targets and be flexible; TQM puts people under
pressure with less opportunity to relax, possibly having to work unsociable hours; people may feel
alienated from the team, especially if there are particularly dominant members of the team.
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232 1. When you finish studying and start looking for a job (assuming you havent already got one), what
factors will you take into account when deciding whether to accept a job offer or to continue looking?
How will the level of unemployment affect your decision?
Current salary; prospects for promotion; your expectations of what you could earn, given your
qualifications; interest or challenge of the job; working conditions; fringe benefits; how long you have been
currently looking; your current financial commitments and thus the degree of urgency to find a job. The
higher the level of unemployment, the more readily you will probably be to accept a job that is offered to
you, fearing that you may not get a better offer, or may have to wait a very long time before you do.
2. In what ways could the government reduce the problem of imperfect information?
By providing better job information to employees and better information on the labour market to employers.
This could be done through existing agencies, like job centres, or by the establishment of new agencies. It
could give tax incentives to companies to advertise their jobs more widely.
233 (Box 9.7) Do any of the following contradict marginal productivity theory:
(a) wage scales related to length of service (incremental scales);
(b) nationally negotiated wage rates;
(c) discrimination;
(d) firms taking the lead from other firms in determining this years pay increase?
Even if marginal productivity theory were not relevant in these cases, the theory would still be accurate in
the sense that if firms wanted to maximise profits then they should employ workers to the point where MCL
= MRPL.
But do any of the above four cases necessarily contradict marginal productivity theory?
(a) No, not necessarily. A system of incremental scales may be consistent with a profit-maximisation
strategy. The employer can pay less to new recruits and yet still attract them to the firm because of the
prospects of higher pay in the years to come. The firm can go on recruiting new staff to the point where
their MRP was equal to their addition to costs (based on the agreed scale).
(b) No, not necessarily. Firms may find it convenient (in terms of the costs of negotiating and the
avoidance of disputes) to pay nationally agreed wage rates. They then could employ workers up to the
point where their MRP was equal to this wage rate (which, given that the firm was a wage taker
would be equal to the MCL).
(c) Yes. Discrimination would lead to firms employing those workers against whom they were
discriminating below the level where their MRP was equal to their MCL (see pages 2338 of the text).
(d) No, not necessarily. (See answer to (b) above)
234 (Box 9.8) 1. If we were to look at weekly rather than hourly pay and included the effects of overtime,
what do you think would happen to the pay differentials in Table (a)?
They would widen. A higher percentage of women than men work part time and a lower percentage do
overtime work. Thus women, on average, do fewer hours of paid employment per week than men.
(Box 9.8) 2. In Table (b), which of the occupations have a largely female workforce?
Many of the lower-paid occupations, such as sales assistants, computer operators and assemblers and
lineworkers. There are exceptions, however, such as nurses (although, of course, nurses are relatively
poorly paid compared with other occupations with a similar amount of training).
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235 (Box 9.8) 1. If employers were forced to give genuinely equal pay for equal work, how would this affect
the employment of women and men? What would determine the magnitude of these effects?
The wages of women would rise relative to those of men. This would lead to firms employing relatively
more men and fewer women, since there would no longer be any savings in wages for firms by employing
women. The effects could be lessened (but not eliminated) if there was accompanying legislation that
ensured the enforcement of equal opportunities.
The magnitude of these effects on employment would be greater: (a) the more that relative wages
changed (the effects may be relatively small if the main cause of the differentials was that women were
doing the types of jobs that were low paid, in which case differences between average male and female
earnings would remain); (b) the more easily firms could substitute men for women (e.g. the higher the level
of unemployment of men); (c) the more easily firms could replace female workers by machines.
(Box 9.8) 2. What measures could a government introduce to increase the number of women getting
higher-paid jobs?
Examples include: improving educational opportunities for girls and women (e.g. by increasing Access
provision to higher education for mature students); improving state provision of child care and nurseries;
legislation to encourage or enforce the provision of work-based crche facilities; tougher equal
opportunities legislation; operating positive discrimination (or at least insisting on genuine equal
opportunities) in government jobs.
237 (Box 9.9) 1. Is a flexible firm more or less likely to employ workers up to the point where their
MRP = MCL?
More likely. By being able to switch workers from task to task and, by the use of temporary workers, being
able to vary the amount of labour employed, the firm can more easily employ the profit-maximising number
of workers in each category.
(Box 9.9) 2. How is the advent of flexible firms likely to alter the gender balance of employment and
unemployment.
Given that a higher proportion of women than men seek part-time employment and are prepared to accept
temporary contracts, it is likely to increase the employment of women relative to men.
What effect will the discrimination by the firm have on the wages and employment of black workers in
other firms in the area if (a) these other firms discriminate against black workers; (b) they do not
discriminate?
(a) These firms will also employ black workers along a curve like the MRPBx in Figure 9.12(a). The
effect of discrimination by the first firm will be to shift the MCB and ACB curves downwards to the right
as the supply of black workers increases to other firms. The bigger the first firm, the bigger these
shifts. The shifts in these curves will have the effect of reducing wages in the other firms to the point on
the new lower ACB curve vertically below the point where the new lower MCB curve crosses their
MRPx curve. Employment of black workers will be higher, since the MCB and ACB curves are to the
right of the ones that existed before the first firms practised discrimination.
(b) In the case of firms that do not discriminate, it is simply the MC and AC curves that will have shifted to
the right. These MC and AC curves will be more elastic that those for the discriminating firm as they will
include both black and white workers (the firm not discriminating between them). Thus wages will fall only
slightly; total employment will rise, but the employment of black workers by these firms will rise by more
than this total, since the lower wage will encourage some white workers to leave and take up employment
elsewhere (possibly in the firms that do discriminate: depending, of course, on the ethical position of the
white workers).
239 When we were looking at wage rates, were we talking about the price of labour or the price of labour
services? Is this distinction between the price of a factor and the price of factor services a useful one in
the case of labour? Was it in Roman times?
The price of labour services. The distinction is not useful, given that workers themselves are not sold. The
distinction was useful in Roman times where some workers were paid wages while others were sold as
slaves.
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240 Under what circumstances would the market demand for renting a type of capital equipment be
(a) elastic; (b) inelastic? (Clue: turn back to page 222 and see what determines the elasticity of demand
for labour.)
It would be more elastic: (i) the greater the price elasticity of demand for the good; (ii) the easier it is to
substitute other factors for the equipment; (iii) the greater the elasticity of supply of factors that are used as
complements to the equipment; (iv) the greater the elasticity of supply of factors that are substitutes for the
equipment; (v) the greater the cost of hiring the equipment as a proportion of total costs of production;
(vi) the longer the time period (to enable alternative production methods to be used).
241 (Box 9.10) Which of the following are stocks and which are flows?
(a) Unemployment.
(b) Redundancies.
(c) Profits.
(d) A firms stock market valuation.
(e) The value of property after a period of inflation.
Stocks: (a), (d) and (e). They are measurements at a point in time.
Flows: (b) and (c). They are measurements over a period of time. (Note that (e) would only be a flow if it
were measuring the rise in the value of property over a period of time.)
Assume now that the firm has monopoly power in hiring out equipment, and thus faces a downwardsloping demand curve. Draw in two such demand curves on a diagram like Figure 9.17, one crossing the
MC curve in the horizontal section, and one in the vertical section. How much will the firm supply in
each case and at what price? (You will need to draw in MR curves too.) Is the MC curve still the supply
curve?
The firm will hire out that quantity where the MR curve intersects with the MC curve. If the MR intersects
with MC in its vertical section, it will hire out Qmax. If it intersects with MC in the horizontal section, it will
hire out less than Qmax. The rental charged will be found from the point on the demand curve vertically
above the MR and MC intersection.
The MC is no longer the supply curve (in the horizontal section). There is no unique supply curve to
the left of Qmax. The amount supplied at a given price depends not only on the MC curve, but also on the
shape of the AR and MR curves, and on the vertical distance between them.
242 If supply is totally inelastic, what determines the rental value of capital equipment in the short run?
The demand. All earnings will be economic rent.
What will happen to the demand for capital services and the equilibrium rental if the price of some other
factor, say labour, changes? Assume that wage rates fall. Trace through the effects on a three-section
diagram like that of Figure 9.14. (Clue: a fall in wages will have two significant effects: it will reduce
costs and hence the price of the product, so that more will be sold; and it will make labour cheaper
relative to capital. How will these two things affect the demand for capital?)
If labour is a substitute for capital, then as the lower wage encourages more labour to be used, so the
demand for capital services will tend to fall. But with more output being produced, the demand for capital
services will tend to rise. The net effect, therefore, may be an increase or a decrease in demand: the smaller
the substitution effect, the more likely it is that the demand will rise. If this is so, the demand (MRPK) curve
in diagram (a) will shift to the right. The market demand curve in diagram (b) will also shift to the right,
causing the equilibrium rental to rise. There will be a movement up along the supply curve in diagram (b)
as individual suppliers of capital respond to the increased price and supply more (diagram (c)).
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243 What is the present value of a machine that lasts three years, earns 100 in year 1, 200 in year 2 and
200 in year 3, and then has a scrap value of 100? Assume that the rate of discount is 5 per cent. If the
machine costs 500, is the investment worthwhile? Would it be worthwhile if the rate of discount were 10
per cent?
Using the formula on page 250 gives:
PV = 100/1.05 + 200/(1.05) + 300/(1.05)
= 95.24 + 181.41 + 259.15
= 535.80
Thus given that the machine costs 500, the investment is profitable at a discount rate of 5 per cent.
If the rate of discount is 10 per cent, then the present value this time is given by:
PV = 100/1.1 + 200/(1.1) + 300/(1.1)
= 90.91 + 165.29 + 225.40
= 481.59
With a 10 per cent discount rate, therefore, the investment would not be profitable.
245 Can a perfectly competitive firm earn a supernormal rate of return on capital if it continuously
innovates?
Yes. The long run never comes. By the time other firms have copied the innovations, this firm has gone
ahead with a new innovation, and thus continues to earn supernormal profits.
248 Would the stock market be more efficient if insider dealing were made legal?
Yes. There would be a move towards strong efficiency. There would still be two problems, however. The
first is that strong efficiency would not be fully achieved if the insider information was limited to a few
people and therefore the share prices lagged the information, or if the people with the information did not
act on it immediately. The second would the question of fairness. Is it morally right for people with insider
information to profit thereby and at the expense of those without the information?
249 What other factors will determine the MPP of land for industry?
Proximity to markets, raw materials and other plants; its geological structure and physical relief.
250 1. We defined the factor of production land to include raw materials. Does the analysis of rent that we
have just been looking at apply to raw materials?
No. Raw materials are sold, not rented out. The analysis on page 250 is more relevant here.
2. The supply of land in a particular area may be totally inelastic, but the supply of land in that area for a
specific purpose (e.g. growing wheat) will be upward sloping: the higher the price of wheat and thus the
higher the rent that wheat producers are prepared to pay, the more will be made available for wheat
production. Using the concept of transfer earnings, what will determine the elasticity of supply of land
for any particular purpose?
It will depend on the ease that land can be transferred from one use to another. Assume that the demand for
wheat goes down and thus the demand for land for growing wheat also goes down. As the demand curve for
this land shifts to the left, with a resulting fall in its rental value for growing wheat, so it will be transferred
to growing other crops as soon as the earnings from these other crops matches that from wheat. The greater
the transfer earnings, and hence the greater the elasticity of supply, the less will the rental value fall.
1. What price would the same piece of land sell for if it still earned 1000 rent per year, but if the rate of
interest were now 5 per cent?
According to the formula, its market price would be:
1000/0.05 = 20 000.
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250 2. What does this tell us about the relationship between the price of an asset (like land) and the rate of
interest?
The higher the rate of interest, the lower the market price of the asset. The asset would have to be cheaper
(i.e. yield a higher rate of return) to persuade the purchaser to sacrifice the alternative of earning the market
rate of interest.
251 (Box 9.11) 1. Will the market provide incentives for firms to research into energy-conserving techniques,
if energy prices at present are not high enough to make the use of such techniques profitable?
It will provide some incentive. Even though energy-conserving techniques might not be profitable at present
prices, the continuing depletion of resources and the resulting higher energy prices will probably make such
techniques profitable in the future. Firms could borrow now to finance the research and then use the future
profits to repay the loans. Then there is the point that if a firm does not fund such research, its rivals may
discover new profitable energy-saving techniques first: techniques which are denied to the first firm because
of patents.
There is a major weaknesses with this argument, however. It is concerned with risk and uncertainty.
The discovery of new energy sources or new energy-saving techniques by other firms could mean that
energy prices do not rise sufficiently in the future to yield a profit on the research. Firms, fearing this, may
be reluctant to borrow the money to fund the research. Also there is the risk that interest rates may rise in
the future, thus increasing the cost of the borrowing. Finally, there is the uncertainty over the results of the
research. There is no guarantee that the research will lead to the discovery of the desired amount of energy
saving.
(Box 9.11) 2. How will the existence of monopoly power in the supply of resources influence their rate of
depletion?
By leading to higher prices, it will reduce the rate of depletion (and encourage the search for alternative
sources of supply and the development of resource-saving techniques and products).
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257 In which country in Figure 10.4 would you expect to find the highest proportion of poor people?
Describe how income is distributed in the two cases.
Country A. The curve rises less quickly at first. This means that, for the poorest sectors of the population, a
larger percentage of the population shares a smaller percentage of national income in country A than in
country B. On the other hand, in country A, income is more equally distributed at the top end. This means
that, the richest sector of the population in country A earns a smaller percentage of national income than in
country B.
1. Why, do you think, are the ratios for developing countries lower than those for developed countries?
Because income is generally less equally distributed in developing countries. Many live in abject poverty,
whereas there are a few (e.g. senior government officials, industrialists and certain professionals) with
incomes similar to those earned by wealthier people in advanced countries.
2. Make a list of reasons why the ratios in Figure 10.5 may not give an accurate account of relative levels
of inequality between countries?
The degree of inequality may not be as great as the figures suggest because many of the poorest are in the
subsistence sector, where they produce their own food and make their own clothing and shelter. These items
may not be fully recorded in the official statistics. On the other hand, the rich in developing countries may
not declare a large proportion of their income in order to avoid paying income taxes. (See pages 7447 on
the limitations of official national income statistics.)
3. What would the ratio be if national income were absolutely equally distributed?
40% / 20% = 2
259 If fringe benefits (such as long holidays, company cars, free clothing/uniforms, travel allowances and
health insurance) were included, do you think the level of inequality would increase or decrease?
Explain why.
The measured level of inequality would probably increase. The reason is that most of these benefits are
received proportionately more by those on higher incomes. In some cases the benefits are a way of
rewarding people without the rewards being liable to tax.
264 List the reasons for each of the three factors above. (Re- read section 9.2 and Box 9.8 if you need help).
Examples of reasons for each include:
1) Women are paid less than men in the same occupations.
Discrimination by employers.
Breaks in careers: therefore women may achieve less promotion or be lower up an incremental
scale than men.
2) Women tend to be employed in lower-paid occupations than men.
The occupations are often more labour-intensive and therefore have a lower marginal product of
labour.
Many of the occupations are not represented by unions.
Women are often less mobile geographically (for social/family reasons) and therefore may have to
settle for whatever job is available in the locality.
Custom and practice. Womens jobs are often low paid irrespective of questions of productivity.
3) Women do much less overtime than men.
Family commitments.
Less overtime available in the occupations done mainly by women.
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262 (Box 10.1) 1. If we were to measure poverty today and in the 1800s in absolute terms in which would
there be the greater number of poor?
The 1800s.
(Box 10.1) 2. If we measure poverty in relative terms, must a society inevitably have a problem of
poverty, however rich it is?
Probably. The richer a society becomes, the higher will be societys expectations about minimum
acceptable living standards. Unless there were a totally comprehensive and generous system of social
welfare, some people will almost certainly fall below this minimum.
263 (Box 10.2) Suggest a range of direct policies that the government could use in order to reduce
inequality and poverty within the UK.
There could be an increase in benefits targeted at the poor. These include cash benefits, such as income
support, working tax credit and housing benefit, and in benefits in kind, such as free milk and school meals.
(See Web case 10.5 for an examination of the system of benefits in the UK.) The threshold for paying taxes
could be increased, with reductions in the starting rate of tax. A problem, however, with tax reductions is
that they only benefit the working poor, not the unemployed and non-working dependants. A problem with
both tax cuts and targeted benefits is that of the poverty trap (see page 278): people may be discouraged
from working or from working extra hours by the fear of losing benefits or incurring extra taxes. The
government could increase the minimum wage. The danger here is of creating unemployment or of reducing
the hours available for some people to work.
Which of the above causes are reflected in differences in the marginal revenue product of factors?
Differences in ability
Differences in attitude (if it affects peoples productivity)
Differences in qualifications
Differences in the demand for goods
265 (Box 10.3) 1. If an increase in wage rates for the low paid leads to their being more motivated, how
would this affect the marginal revenue product and the demand for such workers? What implications
does your answer have for the effect on employment in such cases?
Their MRP would increase and hence the demand for them would increase. Thus it is possible that minimum
wage rates could lead to an increase in employment (or, at least, no decrease).
(Box 10.3) 2. If minimum wages encourage employers to substitute machines for labour, will this
necessarily lead to lower long-term unemployment in (a) that industry and (b) the economy in general?
(a) No. It may encourage the firm to invest more in the latest technology, which in the long run may give it
a competitive advantage over its rivals and therefore gain a larger share of the market. Thus reducing
the number of workers per unit of output may be more than compensated for by a greater number of
units sold.
(b) No. If the government were to invest more in training, thereby increasing the marginal revenue product
of workers, firms would find it profitable to employ workers at a higher rate of pay. Also, if firms
invest more in modern technology, this could give a boost to the economy, leading to a growth in output
and firms in general taking on more labour.
267 Is it horizontally equitable for smokers and drinkers to pay more tax than non-smokers and
non-drinkers?
It is horizontally equitable within each category. All smokers are treated equally and so are all drinkers of a
given type of alcoholic beverage. It is not horizontally equitable, however, in the broader context of taxing
people the same who are earning the same level of income, or who are spending the same total amount.
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267 1. Does the benefit principle conflict with either vertical or horizontal equity?
It conflicts with vertical equity, because poorer people often rely most heavily on government expenditure,
either in the form of cash benefits or in terms of education, health, state retirement homes, etc. Clearly it
would be regarded as wrong to tax such people more than richer people!
2. Would this be a good principle to apply in the case of health care?
No. As explained in the answer to the last question, there would be a conflict with vertical equity.
How can the market distortions argument be used to justify putting excise duties on specific goods such
as petrol, alcohol and tobacco? Is this the only reason why excise duties are put on these particular
products?
In each of these cases, the consumers impose costs on society (external costs see Chapter 11, section
11.2). For example, car users cause accidents, pollution and congestion for other motorists and pedestrians.
A tax on such goods, by raising their price, will restrict consumption. In theory, the tax could be levied at a
rate which covered these external costs.
This, however, is probably not the main reason for the use of excise duties. The goods concerned
generally have a relatively inelastic demand and are purchased in large quantities. They therefore provide a
convenient source of tax revenue for the government.
270 To what extent do (a) income tax, (b) VAT and (c) a poll tax meet the various requirements for a good tax
system on pages 2668 above?
The requirements are: (i) horizontal equity, (ii) vertical equity, (iii) equitable between recipients of benefits,
(iv) cheap to collect, (v) difficult to evade, (vi) non-distortionary, (vii) convenient to the taxpayer,
(viii) convenient to the government, (ix) minimal disincentive effects.
The types of tax given above meet these requirements as follows:
(a) (i), (ii), (iv), (v) for those whose tax is deducted at source, (vi), (vii), (viii).
(b) (i), (iv) but less so than single-stage indirect taxes, (v) except in the case of various services (e.g.
cowboy car repairers see Box 13.2 (page 383) on the underground economy), (vi) if levied at a
single rate on all goods and services, (vii), (viii), (ix).
(c) (vi), (vii), (ix).
271 1. If a person earning 5000 per year pays 500 in a given tax and a person earning 10 000 per year
pays 800, is the tax progressive or regressive?
Regressive. The person with the higher income pays a lower average rate of tax (8 per cent rather than 10
per cent).
2. A proportional tax will leave the distribution of income unaffected. Why should this be so, given that a
rich person will pay a larger absolute amount than a poor person?
An example will illustrate why. Assume that before tax one person earns 20 000 and the other earns 10
000: the first persons income is twice that of the second. Now assume that a 50 per cent income tax is
imposed on every pound (a proportional tax). The first person now has a disposable (after tax) income of
10 000, and the second of 5000. The distribution is unaffected: the first persons income is still twice that
of the second.
272 Why may a steeply progressive income tax which is designed to achieve greater vertical equity lead to a
reduction in horizontal equity?
Because, if evasion increases, some people on high incomes will pay less tax than others on the same
income.
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272 1. Do poor people gain more from a cut in income tax with an elastic or an inelastic supply of labour? Is
the supply of unskilled workers likely to be elastic or inelastic?
With a cut in tax, the supply of labour will increase: the supply curve will shift vertically downwards by the
amount of the tax cut. This will have the effect of reducing the pre-tax wage, thus reducing somewhat the
gain to workers. This reduction in the pre-tax wage will be less, the lower is the elasticity of supply of
labour. Thus workers gain more from a cut in income tax with an inelastic supply of labour.
The overall supply of unskilled workers is likely to be relatively inelastic, unless there is a significant
poverty trap which will be eliminated or significantly reduced by a cut in tax rates. (As we shall see on
page 286, the poverty trap is where poor people are discouraged from working or getting a better paid job
because any extra income they earn will be largely taken away in taxes and lost benefits.)
2. Draw two diagrams like Figure 10.14, one with a steep demand curve and one with a shallow
demand curve. How does the elasticity of demand affect the incidence of the income tax?
Area A (the workers share of the tax) will be bigger relative to area B (the employers share of the tax), the
more elastic is the demand for labour. The reason is that with an elastic demand for labour, the vertical shift
upwards of the supply curve will cause only a relatively small increase in the pre-tax wage rate (the
employers share).
274 (Box 10.4) 1. What is the elasticity of supply of output with respect to changes in tax rates at a tax rate of
t1? What is it below t1? What is it above t1?
At t1 it is negative. A rise in the average tax rate will cause a sufficient fall in output to maintain tax
revenues constant.
Below t1 it is either positive, zero or negative. A rise in the average tax rate could cause output to
increase (a positive elasticity of supply), stay the same (a zero elasticity of supply) or even fall (a negative
elasticity of supply) provided that this would not be sufficient to prevent a rise in tax revenues.
Above t1 it is negative. The rise in the average tax rate causes a fall in output sufficient to cause a fall
in tax revenues.
(Box 10.4) 2. If the substitution effect of a tax cut outweighs the income effect, does this necessarily mean
that the economy is to the right of point t1?
No. Although people would work more (or harder), the extra incomes may be insufficient to offset the cut in
the tax rate: tax revenue may still fall (making the economy to the left of t1).
1. Who is likely to work harder as a result of a cut in income tax rates, a rich person or a poor person?
Why? Would your answer be different if personal allowances were zero?
A poor person. There would be little income effect to offset the substitution effect. With a rich person,
however, a cut in income tax rates would lead to a substantial windfall income. The income effect is
therefore likely to be large and may outweigh the substitution effect (causing the rich person to work less).
In the case of very poor people, however, who are below the tax threshold, a cut in income tax will
have no effect at all. If personal allowances were zero, however, this would not apply. The substitution
effect would outweigh the income effect.
2. How will tax cuts affect the willingness of married women to return to employment after having
brought up a family?
The size of the income effect will depend on her partners income: if it were substantial, a tax cut may
remove the family pressure on her for a return to work. The substitution effect will encourage her to return
to work (unless the work earned too little to be eligible for tax, in which case there would be no substitution
effect). Both effects will be smaller if a major reason for returning to work is not so much the money, but
rather the desire to return to a work-place environment.
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275 1. Go through each of the above types of tax change and consider the effects of a tax cut.
(a) Reducing the higher rates of tax:
The substitution effect will be higher when rates are cut from a very high level (causing people to feel
that it is now worth working when it was not before). The income effect will only be small for those
near the higher rate tax threshold: the net effect will probably be to encourage them to work more. The
income effect, however, will be substantial for those on very high incomes: the net effect will probably
be to encourage them to work less. There will be no effects at all on those not paying higher rates
(except, maybe, those hoping to gain promotion).
(b) Reducing the basic rate of tax:
The income effect will be large for those well above the tax threshold, probably causing a net
disincentive effect. The income effect will be small for those just above the tax threshold, resulting in a
net incentive effect. For those below the threshold there will be no effect (unless by working more or
harder, they now rise above the threshold).
(c) Increasing tax allowances:
There will be no substitution effect, since marginal tax rates are not altered (except for those now
brought below the threshold, whose marginal rate has thus been reduced to zero). There will be an
income effect, however, There will thus be a disincentive effect.
2. What tax changes (whether up or down) will have a positive incentive effect and also redistribute
incomes more equally?
Reducing the marginal tax rate for those on low incomes. Reducing the threshold at which higher rates of
tax start.
276 (Box 10.5) Why is the budget line straight? What would it look like if overtime were paid at higher rates
per hour? What will the budget line look like for a person with higher qualifications?
It assumes a constant wage rate per hour.
If overtime were paid at a higher rate, then as you move back up the budget line, it would be a straight
line up to the point where overtime is paid (e.g. 8 hours per day worked and the corresponding number of
leisure hours), and then would become a steeper straight line, reflecting the higher overtime rate of pay.
For a person with higher qualifications, the wage rate would be higher, and thus the budget line would
be steeper.
(Box 10.5) Redraw diagram (b), but this time do it in such a way that the income effect outweighs the
substitution effect.
In this case the indifference map would be such that point b is to the left of point a: In other words, the tax
acts as an incentive: people take less time in leisure (i.e. work more) as a result of the imposition of income
tax.
277 (Box 10.5) Try drawing two or three diagrams like diagram (c), with the tangency point at different
points along the budget line to the left of q. You will find that the further to the left you move, the less
likely is the substitution effect to outweigh the income effect; i.e. the more likely are people to work less
when given a tax cut.
Try doing this and you will see that this is so: the reason is that the indifference curves become steeper the
further to the left that you move. The steeper they are, the more likely it is that the tangency point with the
higher budget line (the lower tax budget line) will be to the right of the tangency point with the lower
budget line: point s to the right of point r. The explanation for this is that the richer a person is, the lower
will be the marginal utility of their income, and hence the more they would like to take the benefit of a tax
cut in the form of additional leisure, rather than additional consumption.
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277 (Box 10.5) Will people actually on the old tax threshold, (i.e. those whose indifference curve/budget line
tangency point is at t) work more or less? Try drawing it.
They will work more. The reason is that for them the marginal rate of tax has been cut from the old rate to
zero: i.e. before the raising of the threshold, any extra they earned would be taxed; now they are below the
threshold and hence any extra they earn is not taxed at all (until they reach the new threshold). The new
tangency point will be to the left of point t, quite probably at the new kink in the budget line (point u).
(Box 10.5) All the above analysis assumes that taxes will not affect peoples gross wage rates. If part of
the incidence of taxes is borne by the employer, after-tax wages will be affected less. There will therefore
be a smaller shift in the budget line. How will this affect the argument for tax cuts?
It will reduce the argument. If tax cuts are given as an incentive for people to work harder, and in fact they
result in a cut in gross wages with only a small increase in take home pay, they will only have a small
stimulus effect.
279 (Box 10.6) Draw up a similar table to the one above, only this time assume that the basic benefit is
6000. Assume that the marginal tax rate is 20 per cent up to 10 000 and 40 per cent from 10 000 to
20 000. To what extent would this particular system help to tackle the problem of (a) equity; (b) cost of
provision; (c) incentives?
Earnings
Tax on earnings
Benefit
Tax minus benefit
Net income
()
()
()
()
()
6000
6000
2 000
4 000
800
6000
5200
5 000
8 000
1600
6000
4400
8 000
12 000
2800
6000
3200
11 000
16 000
4400
6000
1600
14 000
20 000
6000
6000
20 000
(a) The system would be more progressive, with a higher basic benefit and with people on higher incomes
paying higher marginal rates of taxation.
(b) It would be much more costly to provide, with only people earning over 20 000 paying positive net
income taxes. This would go some way to reducing the equity advantages, since a much bigger burden
would now fall on indirect taxes.
(c) There would be minimal disincentive effects for those with incomes below 10 000. The disincentive
effects would be more substantial for those with incomes over 10 000.
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283 Do you agree that, if some people gain and if no one loses, then this will be an improvement in the wellbeing of society? Would it be possible for there to be an improvement in the well-being of society without
there being a Pareto improvement?
Assuming that there really is a gain and that no-one loses at all in any way whatsoever, then most people
would probably agree that there has been an improvement in the well-being of society. It is virtually true by
definition.
There is a major problem in reality, however, that people are unlikely to agree as to what constitutes a
gain or no loss. For example, if a person has a substantial increase in income, he or she at the time may
regard this as a gain. However, other people may claim that it made the person more miserable and selfish,
and the person may end up being less happy not more. The question here is whether people are the best
judge as to whether they are actually gaining or losing.
Then there is the question of distributive justice. If the rich get richer and the poor stay the same, then
could this be said to be an improvement in the well-being of society, even if the poor feel themselves to be
no worse off (which is unlikely if the poor see the rich getting richer!)?
Most people would argue that it is possible to have an improvement in the well-being of society without
a Pareto improvement. Any redistributive policy (e.g. taxing people to help pay for health and education,
health and social security) will involve gainers and losers, and thus, by definition, no Pareto improvement,
and yet most people would argue that such policies are desirable. The problem comes in getting people to
agree on how much redistribution is desirable, and, clearly, the political left and right would fundamentally
disagree here.
285 Assume that the price of the good falls. How will an efficient level of consumption be restored?
The fall in the price will cause MU to be above P. Consumers will buy more. But as they do so, the MU
will fall (diminishing marginal utility) until P = MU: until the efficient level of consumption has been
restored.
286 1. If monopoly power existed in an industry, would production be above or below the socially efficient
level (assuming no externalities)? Which would be greater, MSB or P?
Below. (See Figure 11.7 on page 295.) A firm with monopoly power produces at Q1, where MR = MC. But
this is below the socially efficient level of output (Q2) where P = MC.
MSB will still equal P. Consumption still takes place along the demand curve, which gives MSB
(assuming no consumption externalities).
2. Assuming perfect competition and no externalities, social efficiency will also be achieved in factor
markets. Demonstrate that this will be where:
MSBf = MRPf = Pf = MDUf = MSCf
(where MRP is the marginal product of a factor, MDU is the marginal disutility of supplying it and f is
any factor see section 9.1).
The MRPf is the marginal benefit to the employer from employing a factor. Profits will be maximised
where MRP = Pf.
The MDUf is the marginal cost to the factor supplier from supplying a factor. The factor suppliers
surplus will be maximised where Pf = MDUf.
Under perfect competition, since MRPf = Pf for each producer, and Pf = MDUf for each factor supplier,
then, since the market price for the factor (Pf) is the same for all firms and factor suppliers, then MRPf =
MDU f for all firms and factor suppliers.
In the absence of externalities in the factor market, MSBf = MRPf, and MDU f = MSCf. Thus:
MSBf = MRPf = Pf = MDU f = MSCf
i.e. MSBf = MSCf
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286 3. Why will marginal social benefit not equal marginal social costs in the labour market if there exists (a)
union monopoly power and/or (b) firms with monopsony power?
(a) Because the factor price (the wage rate) will be above the MR of supplying labour (given that the union
faces a downward-sloping demand for labour). It will be unlikely, therefore, that the union will seek to
equate Pf (= W) with the MDU f (the marginal cost of supplying labour) of its members. [Note that the
analysis is the same here as with monopoly in the goods market. The price of a good is above the MR,
and thus, by equating MR and MC, a firm does not equate price with MC.]
(b) Because the factor price (its average cost) will not be equal to its marginal cost. (See Figure 9.8 on
page 225.)
287 Trace through the effects in both factor and goods markets of the following:
(a) An increase in the productivity of a particular type of labour.
(b) An increase in the supply of a particular factor.
Show in each case how initially social efficiency will be destroyed and then how market adjustments will
restore social efficiency.
The following charts illustrate the effects:
(a)
1. Labour demand
MRPl (i.e. MSBl)
MRPl > W
employment of labour
2. Labour supply
W W > MDUl (i.e. W > MSCl) supply of labour
along MDU l and hence MSCl curve) .
These adjustments would continue until MSBl = MSCl.
3. Producer supply
MRPl
MC
P > MC (i.e. P > MSC)
production
MDUl (movement up
4. Consumer demand
P MU > P consumption MU (movement down along MU and hence
MSB curve)
These adjustments would continue until MSB = MSC (in goods markets).
(b)
1. Factor supply
Sf (i.e. MSCf) Sf > Df
Pf
2. Factor demand
Pf MRPf > Pf employment of factor (movement down along MRPf and hence
MSBf curve)
These adjustments would continue until MSBf = MSCf.
3. Producer supply
Pf
MC
P > MC (i.e. P > MSC)
production
4. Consumer demand
P MU > P consumption MU (movement down along MU and hence
MSB curve)
These adjustments would continue until MSB = MSC (in goods markets).
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288 If MUX/MUY were greater than PX/PY, how would consumers behave? What would bring consumption
back to equilibrium where MUX/MUY = PX/PY?
Consumers would buy relatively more of X and relatively less of Y. But as they did this, MUX/MUY would
fall (because of diminishing marginal utility) until MUX/MUY = PX/PY.
If MCX/MCY were greater than PX/PY how would firms behave? What would bring production back into
equilibrium where MCX/MCY = PX/PY?
Firms would produce relatively more of good Y and relatively less of good X. But as they did this,
MCX/MCY would fall (because of the law of diminishing returns and hence increasing marginal costs as
production increases) until MCX/MCY = PX/PY.
289 If production were at a point on the production possibility curve below point S, describe the process
whereby market forces would return the economy to point S.
At a point on the curve below point S:
MRT > MRS
i.e. MRT PX/PY MRS
i.e. MCX/MCY PX/PY MUX/MUY
Thus relatively more of Y will be produced and relatively less of X.
There will thus be a movement up along the production possibility curve until point S is reached: until
MCX/MCY = PX/PY = MUX/MUY
i.e. until MRT = MRS.
292 Is it likely that the MSB curve will be parallel to the MU curve? Explain your reasoning.
No. It is likely that the marginal external costs of consumption will increase as more is consumed, and thus
the curves will get further apart (making the MSB curve steeper than the MU = MB curve). For example,
the marginal pollution costs of cars gets progressively greater as more and more cars come onto the roads
and the environment becomes less and less able to absorb the additional quantities of pollutants.
1. Give other examples of each of the four types of externality.
(a) External costs of production (MSC > MC)
The pollution of rivers and streams by slurry and nitrate run-off from farms; road congestion near a
factory.
(b) External benefits of production (MSC < MC)
Beneficial spin-offs from the development of new products (for example, the various space programmes
in the USA, the USSR and Europe have contributed to advances in medicine, materials technology,
etc.); where the opening of a new environmentally friendly factory results in less output from factories
that pollute.
(c) External costs of consumption (MSB < MB)
The effect of CFC aerosols on the ozone layer; the unpleasant sight of satellite dishes.
(d) External benefits of consumption (MSB > MB)
People decorating the outside of their houses or making their gardens look attractive benefits
neighbours and passers-by; people insulating their houses reduces fuel consumption and the pollution
associated with it.
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292 2. Redraw Figures 11.4(a) and 11.5(a), only this time assume that the producer (in the first diagram) or
the consumer (in the second) has economic power and is thus not a price taker. How does the existence
of power affect the relationship between the private and the social optimum positions?
Diagram 11.1 External costs in production
Diagram 11.2 External costs in consumption
The firm in Diagram 11.1 has market power and thus faces a downward-sloping demand curve and
marginal revenue curve. It produces Q1 at a price of P1. (If the industry had been under perfect
competition, it would have produced Q0 at a price of P0.) The effect of monopoly power is to thus to reduce
output. With external costs in production, the optimum output will be at Q2 at a price of P2, where MSB =
MSC. This is below the perfectly competitive output (Q0), but may be above, below or the same as the
monopoly output (Q1). The way it is drawn in Diagram 11.1, it is the same as Q1. Thus in this case the
socially disadvantageous effects of external costs and monopoly power tend to cancel each other out!
The consumer in Diagram 11.2 has monopsony power and thus faces an upward-sloping supply curve
(average cost of consumption) and a marginal cost of consumption curve (MC) which is above it and
steeper. [This is the same analysis as in the case of a firm with monopsony power (see Figure 9.8 on page
225).] Consumption will be at Q1 at a price of P1. This is below the perfectly competitive level of Q0, P0.
With external costs of consumption, the optimum consumption will be at Q2 at a price of P2, where MSB =
MSC. This is below the perfectly competitive level of consumption (Q0), but may be above, below or the
same as the monopsony level of consumption (Q1). Thus, as in the above case, the socially disadvantageous
effects of external costs and monopsony power tend to cancel each other out.
Had there been external benefits rather than external costs in either case, the socially disadvantageous
effects of this and the market power would have reinforced each other. They would both have led to
production or consumption below the socially optimum level.
293 (Box 11.2) 1. The police charge football clubs for policing inside football matches. Do you think this is a
good idea?
In this case the benefits of the policing are largely confined to those attending the match. Although it is still
a public good in the sense that the benefits to individual consumers cannot be separated, it could be
regarded as fair that only those benefiting ought to pay. This is achieved by charging the club, which then
passes it on to the consumer in terms of higher entrance fees.
The method could be criticised, however, if the policing is seen to benefit the wider community by
leading to the apprehension of people who would commit crimes outside the ground at some other time.
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293 (Box 11.2) 2. Some roads could be regarded as a public good, but some could be provided by the market.
Which types of road could be provided by the market? Why? Would it be a good idea?
Roads where there are relatively few access points and where therefore it would be practical to charge tolls.
Charges could be regarded as a useful means of restricting use of the roads in question, or, by charging more
at peak times, of encouraging people to travel at off-peak times. Such as system, however, could be
regarded as unfair by those using the toll roads, and might merely divert congestion onto the non-toll roads.
Which of the following have the property of non-rivalry: (a) a can of drink; (b) public transport; (c) a
commercial radio broadcast; (d) the sight of flowers in a public park?
(a) No. (b) No (passengers take up seats). (c) Yes. (d) Yes (unless I get in your way!).
294 1. Give some other examples of public goods. Does the provider of these goods (the government or local
authority) charge for their use. If so is the method of charging based on the amount of the good people
use? Is it a good method of charging? Could you suggest a better method?
Two examples are: national defence; urban roads. In both cases the user is not directly charged. The
funding comes from taxation. In the case of roads, part of the funding comes from road users generally (in
the form of taxes on petrol and road fund licences) and part from general or local taxation. Only in the case
of petrol tax is the charging related to the amount that people use the public good. It encourages people to
use the roads less, and thus takes into account the marginal cost (i.e. repairs and maintenance) of road
provision. In this sense, however, roads are not a pure public good because using them does create a small
amount of wear and tear on them (although a significant portion of road maintenance costs are due simply to
deterioration through time).
If the marginal cost of provision is zero (as is the case with a pure public good) then charging people
according to how much they use it will not cause an efficient allocation of resources: with a zero marginal
cost, the price should be zero. Charging people according to how much they use it, however, could be
regarded as fair according to the benefit principle (see page 296) but not according to the principle of
vertical equity.
2. Name some goods or services provided by the government or local authorities that are not public
goods.
Education, health, libraries, state retirement homes.
295 Referring back to Figure 9.8 on page 225, and assuming that the MRPL curve represents the marginal
social benefit from the employment of a factor, and that the price of the factor represents its marginal
social cost (i.e. assuming no externalities), show that a monopsony will employ less than the Pareto
optimal amount of factors.
The monopsonist will employ Q1 of the factor. The Pareto optimal employment of the factor, however, is Q2
where MSB (i.e. MRP) = MSC (i.e. factor price = ACfactor).
296 Why will Pareto optimality not be achieved in markets where there are substantial economies of scale in
production?
Because such markets are incompatible with perfect competition. Once a firm gets large enough to
experience the full economies of scale, it would also be large enough to charge prices above MC and hence
to produce an output below the Pareto optimal level.
(Box 11.3) Does this argument also apply to food and other basic goods?
To some extent, but the problem is more acute in the case of health care. The expenditure on food is
relatively constant per week, and therefore can more easily be budgeted for. For those unable to afford an
adequate diet, cash benefits (such as family credit) could be argued to be better than the provision of free
food as a means of tackling the problem. In the case of health care, because many people only require
occasional treatment, but when they do, it can be very expensive, and because the needs of people differ so
hugely, a fixed cash benefit per week related to income would be quite inappropriate, unless it had to be
spent on some type of health insurance.
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297 (Box 11.3) 1. If health care is provided free, the demand is likely to be high. How is this high demand
dealt with? Is this a good way of dealing with it?
It is dealt with by a system of queuing. Emergency cases are usually dealt with immediately, or at least very
quickly, but non-emergency cases may have to wait weeks, months or even years for treatment.
Many people would argue that for reasons of equity, and the special nature of health, it is better to solve
the problem of waiting lists by diverting more resources into health care, rather than by using a system of
charging people. Except where there are initially idle resources or inefficiencies, this approach will result in
a lower provision of other publicly provided goods or services, or higher taxes.
(Box 11.3) 2. Go through each of the market failings identified in this box. In each case consider what
alternative policies are open to a government to tackle them. What are the advantages and
disadvantages of these alternatives?
People may not be able to afford treatment.
Cash benefits (for advantages and disadvantages see answer to question in this box on page 296).
Free health care for those below a certain income.
Advantages: less costly to taxpayers.
Disadvantages: people just above threshold may have difficulty in affording treatment; given the
problems of externalities and patient ignorance, the consumption of health care may be below
the social optimum.
Medical insurance (see discussion in the text).
Difficulty for people in predicting their future medical needs.
Medical insurance: (see discussion in the text).
Externalities.
Subsidies for treatments where there are substantial external benefits.
Advantages: less costly than comprehensive free health care, encourages the authorities to focus on
the whole question of externalities
Disadvantages: difficult to measure externalities, administratively complex.
Patient ignorance.
Health education.
Advantages: can encourage people to detect early symptoms, can encourage people to take
preventative measures.
Disadvantages: few (except if it makes people believe that they are better at diagnosis than they
really are!)
Oligopoly.
Encouraging competition by attacking restrictive practices, by devolving budgets, etc.
Advantages: competition may reduce prices and improve quality.
Disadvantages: quality of provision may suffer in an attempt to cut the price of treatment, difficult
for the consumer to make rational decisions given patient ignorance (see discussion in text).
1. Assume that you wanted the following information. In which cases could you (i) buy perfect
information, (ii) buy imperfect information, (iii) be able to obtain information without paying for it, (iv)
not be able to obtain information?
(a) Which washing machine is the most reliable?
(b) Which of two jobs that are vacant is the most satisfying?
(c) Which builder will repair my roof most cheaply?
(d) Which builder will make the best job of repairing my roof?
(e) Which builder is best value for money?
(f) How big a mortgage would it be wise for me to take out?
(g) What course of higher education should I follow?
(h) What brand of washing powder washes whiter?
In which cases are there non-monetary costs to you of finding out the information? How can you know
whether the information you acquire is accurate or not?
(a)
(b)
(c)
(d)
(e)
(i) or (ii) (e.g. Which magazine);

(iii) (by asking people currently doing the job) or (iv);
(iii) (by obtaining estimates);
(iii) (albeit imperfect, by inspecting other work that the different builders have done) or (iv);
as (d);
73

(f) (iii);
(g) (iii);
(h) (i) or (ii) (as in (a)) or (iii) by experimenting.
All could involve the non-monetary costs of the time involved in finding out.
If the information is purely factual (as in (c) above), and you can trust the source of your information,
there is no problem. If you cannot trust the source, or if the information is subjective (such as other peoples
experiences in (b) above), then you will only have imperfect information of the costs and/or benefits until
you actually experience them.
2. Make a list of pieces of information a firm might want to know, and consider whether it could buy the
information and how reliable that information might be.
Some examples include:
The position and elasticity of the demand curve:
Market research can provide some information, but it is very unreliable, especially in an
oligopolistic environment, where the actions of rivals is unpredictable.
Next years wages bill:
The information cannot be purchased, but it could use its own past experiences to predict (albeit
imperfectly) the outcome of wage negotiations.
The costs of alternative inputs:
This information is probably available free from suppliers.
Ways of saving taxes:
Employing accountants can help the firm save money here.
298 Give examples of how the government intervenes to protect the interests of dependants from bad
economic decisions taken on their behalf.
Insistence that children attend school; employing social workers to check that dependants are not being
neglected; free school milk (in the past).
How do merit goods differ from public goods?
They could be provided by the market (albeit with too little consumed). The problem of non-excludability
does not apply.
Summarise the economic policies of the major political parties. (If it is near an election you could refer
to their manifestos.) How far can an economist go in assessing these policies?
You will need to look at the current policies.
Economists in their role as economists cannot challenge fundamental normative issues such as
whether it is desirable to have a much more substantial redistribution of income from the rich to the poor.
They can, however, examine whether the factual claims of the parties are correct, and whether the policies
they advocate will bring the effects they claim.
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299 Give some examples of how correcting problems in one part of the economy will create problems
elsewhere.
Two examples are:
A local authority reduces street parking in the centre of a town in order to reduce congestion on the
streets, but succeeds in encouraging commuters and shoppers to park outside the town centre in
residential areas, thus reducing the quality of life for those living in those areas.
The government taxes the consumption of electricity in order to encourage people to become more fuel
efficient and thus to reduce power station emissions. Some people respond by switching to burning
coal, with the result that emissions from this source increase.
301 (Box 11.4) 1. How far can an economist contribute to this normative debate over the desirability of an
excise tax?
An economist can identify costs and benefits. As far as measuring them is concerned, private financial
costs and benefits can be measured, if the demand and supply curves can be predicted. External costs and
benefits are much more difficult to measure (see section 11.4 on costbenefit analysis). Also there is the
question of distribution. How can the gains to person A be compared to the costs to person B? This requires
inter-personal comparisons of utility: something that is notoriously difficult to do, and fraught with ethical
and philosophical problems.
(Box 11.4) 2. What is the excess burden of a lump-sum tax? (For a clue, see Figure 11.11.)
None. A lump-sum tax, because it is a fixed cost and thus does not affect marginal cost (only average
cost), will not affect output. Any reduction in profit to the producer (producer surplus) is exactly matched
by an increase in tax revenue (government surplus).
302 Would could we say about the necessary subsidy if the MR curve crossed the horizontal axis to the left of
point b?
It would have to be bigger than marginal cost.
1. Why is it easier to use taxes and subsidies to tackle the problem of car exhaust pollution than to tackle
the problem of peak-time traffic congestion in cities?
Because with car exhaust pollution, a single tax can apply to all motorists: e.g. so many pence per litre of
petrol. This encourages people to drive less and to buy cars with high fuel economy. With peak-time
congestion in cities, however, if people were not to be discouraged from using cars at other times,
differential taxes would have to be used: e.g. meters fitted to cars that would be triggered by roadside
devices at peak times, (such schemes are being tried in many cities throughout the world: see page 368).
Subsidies for public transport are easier to administer, but would probably have to be combined with a
system of bus lanes and other anti-car measures in order to encourage sufficient people to switch to public
transport (unless the subsidies were very large).
2. If the precise environmental costs of CFCs in fridges (becoming a pollutant when old fridges are
broken up) were known, would the tax solution be a suitable remedy for the problem?
It depends how high the environmental costs were. If they were very high, then the tax would have to be so
high that virtually no-one would buy fridges that used CFCs. In which case it might be simpler to ban the
use of CFCs in fridges, thus avoiding the costs of administering the tax.
303 If the sufferers had no property rights, show how it would still be in their interests to bribe the firm to
produce the socially efficient level of output.
So long as the cost of the bribe is less than the value of the reduction in suffering, the sufferer will gain by
paying the bribe: there is a Pareto improvement. When the marginal suffering has been reduced to the level
of the bribe, no more will be paid. The social optimum will have been reached.
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303 1. To what extent could property rights (either public or private) be successfully extended and invoked to
curb the problem of industrial pollution (a) of the atmosphere; (b) of rivers; (c) by the dumping of toxic
waste; (d) by the erection of ugly buildings; (e) by the creation of high levels of noise?
(a) This would be very difficult given that large numbers of people are affected by the pollution. One
possible answer would be to legislate such that if specific health problems could be traced to
atmospheric pollution, then those affected would have rights to sue.
(b) If tracts of the river were privately owned, then as relatively few owners would be involved, it would be
relatively easy to pursue polluters through the courts, provided they could be clearly identified (i.e. it
would be easier to pursue factories for specific toxic emissions than individuals for dumping litter).
(c) Again if the dumpers could be identified and the dumping were on private ground, then the owners
could use the courts to prevent it. The problem here is that the owners may be quite happy to charge the
company for dumping, not caring about the effects on other people of polluting, say, the water table.
(d) This is more difficult, given that the ugly buildings are on land owned by owners of the buildings! The
law would have to give people the right to sue for visual pollution. This could be difficult to prove, as it
involves aesthetic judgements.
(e) There would have to be laws prohibiting banning noise above a certain level within the hearing of
residents. Then it would be a relatively simple case of the affected residents demonstrating to the
satisfaction of the courts that a noise offence had been committed. It would be easier if the summons
could be brought by an environmental inspectorate.
It should be clear from these answers that the boundaries between legal controls and exercising property
rights are rather blurred. The ability of people to exercise property rights depends on the laws of property.
2. What protection do private property rights in the real world give to sufferers of noise (a) from
neighbours; (b) from traffic; (c) from transistor radios at the seaside?
(a) The noisy neighbours can be reported to the police/environmental health officers, who have powers to
order the neighbours to be quieter.
(b) Very little if any protection is given, unless your property is damaged by a road accident.
(c) None.
304 How suitable are legal restrictions in the following cases?
(a) Ensuring adequate vehicle safety (e.g. that tyres have sufficient tread or that the vehicle is
roadworthy).
(b) Reducing traffic congestion.
(c) Preventing the abuse of monopoly power.
(d) Ensuring that mergers are in the public interest.
(e) Ensuring that firms charge a price equal to marginal cost.
(a) Very suitable, provided that periodic tests and possibly spot checks are carried out.
(b) Good in certain cases: e.g. one-way systems, banning lorries of a certain size from city centres during
certain parts of the day, bus lanes.
(c) Not very, given that the main problem is excessive profits, which would be difficult to define legally
and relatively easy to evade even if they were defined. Various types of unsafe or shoddy goods (which
are possibly more likely to be produced by firms not facing competition) could be made illegal,
however.
(d) Good. The law could give the government or some other body the right to ban any merger it considered
not to be in the public interest. (See Chapter 12, section 12.3.)
(e) Not. It would require an army of inspectors to identify marginal costs, or to check that a firms reported
marginal costs were what it claimed. The scope for evasion and ambiguity would be immense.
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304 What other forms of intervention are likely to be necessary to back up the work of regulatory bodies?
Clear laws to which the regulatory body can appeal; an inspectorate to ensure that decisions of the
regulatory body were being adhered to.
305 Information may not be provided by the private sector if it can be used by those who do not pay: if it is a
public good (service). Do all the examples above come in the category of public goods? Give some
other examples of information which is a public good. (Clue: do not confuse a public good with
something merely provided by the government, which could also be provided by the private sector.)
The provision of job centres.

No. Private employment agencies provide information on jobs to job hunters and on applicants to
employers seeking additional staff.
The provision of consumer information.
No. Companies provide extensive information (although not impartial) on their products.
Consumers organisations provide information which is sold to consumers (e.g. in Which
magazine).
The provision of government statistics on prices, etc.
Partly. It would be difficult to exclude non-payers from general information on the state of the
economy. Nevertheless, The Statistical Office does sell statistical information in various journals
(such as the Annual Abstract of Statistics and Economic Trends), which are mainly bought by
libraries.
An example of information that is nearer to being a public good, is information that is simple enough not to
require being presented as a set of tables or as a report. It can be told from one person to another: as such it
would be difficult to enforce copyright. An example would be the current rate of inflation or the size of the
balance of trade deficit or surplus.
307 What price should be used when there is such a distortion?
The price that would result without that specific distortion: the price that would occur if the level of price
distortion were the same as for similar items in other parts of the economy. This is the second-best rule.
308 (Box 11.5) 1. Can you think of any other ways of getting a more rational evaluation of human life?
Would the persons age make any difference?
Economists have been wrestling with this problem for years. Part of the difficulty is that people value
different peoples lives differently. Most of us care more about those close to us, and thus would be
prepared to spend more time, money and effort to help save or prolong the lives of our loved ones than the
lives of strangers. Yet some people have many close family and friends, while others have few, but most of
us would probably not want to claim that the lives of those with few family and friends are worth less than
those with many. Perhaps the most rational evaluation is still to value life at a flat rate of some arbitrary
amount, which reflects roughly the decisions that are actually made. Whether some weighting for age is
adopted (with young peoples lives being given a higher valuation than old peoples) is again highly
controversial. You could take a basic figure for a years life and then multiply it by the average life
expectancy of someone of the age of the person in question. Naturally, many older people might reject this
method of evaluation!
(Box 11.5) 2. If you had to decide whether more money from a hospitals budget were to be spent on hip
replacements (which do not save lives, but do dramatically improve the quality of the patients life), or on
heart transplants (which do save lives, but which are expensive), how would you set about making a
rational decision?
Attempt to measure the costs and benefits of each and allocate money to each in the proportion where the
MB ratio of the two was equal to the MC ratio. If the MB ratio of hip replacements to heart transplants was
greater than the MC ratio, then, according to the analysis of section 11.1, money ought to be diverted from
heart transplants to hip replacements, until the two ratios became equal.
Marginal costs are relatively easy to measure. Hospitals have such data. Marginal benefits are another
matter! It is very difficult to compare the benefits of the patients in the two cases. Again, it would involve
the relatively arbitrary evaluation of life and the quality of life.
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309 How would you attempt to value time that you yourself save (a) getting to work; (b) going on holiday; (c)
going out in the evening?
The approach is to ask what is the opportunity cost to you of that time. What else could you have done with
the time and what, as a result, would you have been prepared to pay to save time. Thus in the case of (b), if
you have a long holiday and the travel is seen as an enjoyable part of it, then there may be no time cost to
you, or it may even be seen as a benefit; whereas if you only have a week off work and want to get to the
sun as quickly as possible, then you will want to minimise travel time and thus may be prepared to pay quite
a lot more to fly rather than go over land.
How would you evaluate (a) the external effects of building a reservoir in an area of outstanding natural
beauty; (b) the external effects of acid rain pollution from a power station?
In both cases it is difficult to give a precise valuation.
In the case of (a), you could try to estimate the amount people would be prepared to pay to visit the area
before the reservoir was built and the amount people would be prepared to pay to enjoy the benefits of the
reservoir (e.g. for fishing and sailing). But this ignores the psychic costs of building the reservoir to those
who were not visitors to the area at all, but who might get very upset by the thought of areas of wilderness
being destroyed.
In the case of (b), you could attempt to identify the commercial damage done to the forestry and fishing
industries, but this ignores the possibly massive costs to the general population of seeing their beloved
forests destroyed and their lakes and rivers polluted.
310 Imagine that a public project yields a return of 13 per cent (after taking into account all social costs and
benefits), whereas a 15 per cent private return could typically be earned in the private sector. How
would you justify diverting resources from the private sector to this project?
If it could be argued that this particular project yielded longer-term benefits, and that the market rate of
discount is too high in the sense that it gives undue weight to present benefits and costs over future benefits
and costs than is socially desirable, then there would be some justification. The justification for a lower
social rate of discount is that the market only reflects the wishes of the current generation, whereas
governments ought to take a longer-term perspective.
An alternative justification may be in terms of the distribution of costs and benefits. If the project was
an effective means of targeting help to the poor (say a new hospital in an area where there is a lot of
poverty) then the government may want to apply a lower rate of discount. [Distribution can also be taken
into account by giving different weightings to costs and benefits (see page 311).]
311 (Box 11.6) Assume that a project has an initial construction cost of 10 000, takes a year to come into
operation and then has a life of 3 years. Assume that it yields 5000 per year in each of these 3 years. Is
the NPV positive at (a) a 10 per cent discount rate; (b) a 15 per cent discount rate?
(a) NPV = 10 000 + 5000/1.1 + 5000/1.21 + 5000/1.331
= 10 000 + 4545 + 4132 + 3757
= +2434
The NPV is therefore positive at a 10 per cent discount rate.
(b) NPV = 10 000 + 5000/1.15 + 5000/1.3225 + 5000/1.5209
= 10 000 + 4348 + 3781 + 3288
= +1417
The NPV is therefore still positive at a 15 per cent discount rate.
313 (Box 11.7) Why is this type of costbenefit analysis simpler to conduct that ones assessing the
desirability of a new road or airport?
There are specific scenarios, with very precise assumptions. The main purpose was not to demonstrate the
positive NPV (which depends on the assumptions about the value of the environmental benefits of reducing
emissions), but to compare the relative advantages of the alternative scenarios.
With a CBA of a new road or airport, there have to be assumptions, not only about the environmental
impact, but about the value of time saved or additional time incurred by travellers, about the value of lives
saved or lost and about the costs to local people disturbed by the road or airport. Thus the measurement of
externalities is likely to be more problematic than in the case of lowering the sulphur content of road fuel.
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314 What are the possible arguments in favour of fixing prices (a) below and (b) above the equilibrium? Are
there any means of achieving the same social goals without fixing prices?
Fixing prices
(a)
(i) to enable those on low incomes to be able to afford the good.
(ii) to prevent firms with market power from exploiting their position.
(iii) to help in the fight against inflation.
(b)
(i) to protect the incomes of producers (e.g. farmers).
(ii) to increase profits and thereby encourage investment.
(iii) (in the case of wages) to protect workers incomes.
(iv) to create a surplus in times of glut which can be stored in preparation for possible future
shortages.
Alternatives to fixing prices
(a)
(i) cash benefits and benefits in kind; subsidising the good.
(ii) anti-monopoly legislation; lump-sum taxes.
(iii) fiscal, monetary and supply-side policies (see macro half of the book).
(b)
(i) subsidies and tax relief.
(ii) subsidies and tax relief.
(iii) benefits and progressive taxation.
(iv) state acting as purchaser or seller on the open market.
315 Go through the above arguments and give a reply to the criticisms made of government intervention.
In each case the main reply is that the problems are essentially costs of government intervention. But this
does not mean that these costs outweigh the benefits of intervention. Even if they accept these costs, the
advocates of intervention would argue that the net benefits of an interventionist approach still exceed those
of a laissez-faire approach.
An economist can test these claims to the extent of examining whether the predicted effects of
intervention are as claimed. To the extent, however, that they are based on a different moral position from
that taken by the advocates of laissez-faire, they cannot be tested, other than to examine whether the moral
position taken is logically consistent.
Are there any features of free-market capitalism which would discourage innovation?
The fear that inventions and innovations will be copied by other firms and that sales will therefore not
increase sufficiently; the fear that competition will break out too quickly (thus bringing down prices and
profits) to make it worthwhile investing in research and development; the risks that the product will not be
as popular as was hoped, and that therefore the costs of development will not be recouped; the fear that the
development costs will escalate once a programme of research and development has been embarked on; the
difficulties in persuading banks to lend money for pure research (because of the risks entailed).
317 (Box 11.8) Do the arguments of Mises and Hayek necessarily infer that a free market is the most
desirable alternative to centrally planned socialism?
No. They merely imply that an economic system based primarily on the market is superior to a system of
central planning. The arguments do not rule out a role for government in correcting market signals where
they are distorted (e.g. by externalities).
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321 Are there any conflicts between using the environment as productive resource and as a dump?
Given that using the environment as a dump can damage the environment as a productive resource,
protecting the value of the environment as a productive resource will reduce its availability as a dump.
Would the adoption of cleaner methods of production represent a shift or a movement along the curve in
Figure 12.2?
If less waste was produced, then it would represent a movement back down along the curve. If, however, the
waste was less damaging to the environment (i.e. cleaner waste), then this would represent a shift
downwards of the curve. In practice, cleaner production methods will probably represent a mixture of the
two effects.
324 Look through the categories of possible market failings in section 11.2. Are there any others, in addition
to the four we have just identified, that will result in a socially inefficient use of the environment?
If firms have market power, they may be in a stronger position to resist pressure from employees, consumers
or the government to introduce cleaner technology or greener products. Some of the large multinationals
have a poor record in terms of meeting safety or environmental standards, especially in developing
countries. On the other hand, to the extent that market power leads to lower output (and higher prices) this
could result in less pollution than in a more competitive market (see Figure 11.10).
Sometimes people may underconsume green products, not simply because the external benefits, by
definition, are not experienced by the consumer (a problem of externalities), but because people may not do
what is in their own interests. Thus the government might want to encourage people to use their cars less,
not only because of the benefits to other people, but because of the direct health benefits to car owners if
they drove less and walked or cycled more. Thus bicycles could be seen as a merit good.
Firms may be slow to respond to green taxes or subsidies. There is a problem of factor immobility,
especially in the short run.
327 (Box 12.1) Is it a good idea to use the revenue from green taxes to subsidise green alternatives (e.g.
using petrol taxes for subsidising rail transport)?
In terms of strict social efficiency criteria, the answer is no, unless the tax and subsidy were being used as a
joint policy to correct one and the same externality: e.g. a charge being imposed on a firm which was then
used to clean up the pollution that it had created. In all other cases, charging creators of negative
externalities in one part of a country to finance subsidies for activities elsewhere that create positive
externalities could be argued to be unfair. Why should the motorist in town A subsidise rail transport
between towns B and C? The problem here is that there are redistributive effects as well as allocative ones.
To correct for an externality without having any redistributive side-effects, subsidies should be paid from
general taxation.
The counter-argument that is often used is that it is desirable to redistribute income away from the
general category of polluters to the general category of green-minded people. There is also the very strong
argument that governments, always short of finance, will be more willing to subsidise green activities if they
can identify a specific source of new finance (e.g. taxing carbon emissions).
328 Draw a diagram like Figure 12.3, only this time assume that the activity has the effect of reducing
pollution, with the result that the MC pollution curve lies below the horizontal axis, sloping downwards.
Identify the socially optimal level of the activity. What would be the level of subsidy required to achieve
this level of activity?
The socially optimal level of the activity would still be at the output where the MB MC curve crossed the
MCpollution curve (this time, below the horizontal axis). The optimal subsidy would be the vertical distance
between this intersection point and the horizontal axis. This level of subsidy would have the effect of
shifting the MB MC curve upwards so that it crossed the horizontal axis at the optimal level of output. In
other words, profit would now be maximised at the socially optimal level of output.
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330 What determines the size of the administrative costs of a system of tradable permits? For what reasons
might green taxes be cheaper to administer than a system of tradable permits?
The more specific and detailed the permits are, as they may need to be if ambient-based or social-impact
standards are used, rather than simple technology-based standards, the more costly such a system will be to
set up, operate and monitor. Green taxes are likely to be cheaper to administer because they need be less
specific to individual producers, with flexibility achieved through the effect that taxes have of providing a
continuous pressure on firms to cut pollution: the more pollution is cut, the lower will the firms tax bill be.
Some taxes (e.g. on CO2 emissions) could apply across a whole range of industries, and this too could cut
down the average cost per of revenue of administering them.
331 (Box 12.2) Explain who are likely to be the winners and losers as a result of the recent talks on carbon
dioxide emissions. Use the concepts of game theory to illustrate your argument.
US business and possibly US consumers would be better off by not having to incur the costs associated with
making CO2 reductions. The rest of the world would be losers to the extent that higher US emissions would
contribute to global warming and climate change. Some US citizens may lose from the direct impact of
climate change (either drought or flood).
The negotiations over CO2 reductions are an example of the prisoners dilemma (see pages 3312). If
governments and their negotiators are concerned purely with their own national interests, then they have to
weigh the costs of their own CO2 reduction against the benefits of global reductions. The less a country
(such as the USA) cuts emissions itself and the more other countries cut their emissions, the greater will the
countrys net gain be. In other words, it will want to get away with the minimum amount of CO 2 reduction
itself. When all countries think like this, however, global emission reductions are likely to be small. Only
when agreements are seen to be fair to all countries (and that in itself is very difficult to achieve, given that
fairness is very much in the eyes of the beholder!), and when effective monitoring and enforcement
methods are in place, will agreements for substantial reductions in emissions be likely to be reached.
332 How does an international negotiation game differ from the prisoners dilemma game?
representatives can talk to each other, and will be encouraged to reach agreements by the international
body or bodies brokering the negotiations. Then there is the question of enforcement. If an agreement is
reached, part of the agreement will probably be the setting up of a system of monitoring and enforcing the
agreement. This will give countries more confidence in reaching agreements in the first place. The
prisoners in their cells, however, will be less likely to have any prior collusive agreement that is binding
(unless via some system of reprisals for grassers).
334 Are there any costs associated with motoring that would not be included as marginal costs? Explain.
Yes. Costs that do not vary with the amount that a car is used, such as: the annual road fund licence,
insurance premiums and that element of depreciation that is purely due to age rather than wear and tear.
What does this evidence suggest was the figure for the price elasticity of demand for petrol in London?
Expressed in percentage terms, price elasticity of demand = % Qd % P.
Using this formula with the figures in the text gives a value for the price elasticity of demand for petrol in
London of 4/200 = 0.02, which is highly inelastic.
Is the cross-price elasticity of demand for road space with respect to the price of cars likely to be high or
low?
Relatively low. There are two reasons for this.
If the price of cars goes up, many people will switch to a cheaper car, or make their existing car last
longer, rather than doing without a car altogether.
Households that would otherwise have owned two cars, and now make do with just one, are likely to
use that car more intensively.
For both reasons, therefore, a rise in the price of cars may only lead to a small reduction in the number of
miles motored.
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335 Go through each of the determinants we have identified so far and show how the respective elasticity of
demand makes the problem of traffic congestion a difficult one to tackle.
In the case of price elasticity and cross-price elasticities of demand, the elasticity is low. Thus an increase
in the cost of motoring or a reduction in the price of alternatives, is likely to lead to only a small reduction in
the amount of car journeys.
In the case of the income elasticity of demand, the elasticity is high. Thus as peoples incomes grow,
the demand for motoring increases rapidly. As we have seen, car traffic is forecasted to carry on growing at
a fast rate.
336 Complete Table 12.4 up to 9 cars per minute, assuming that the journey time increases to 24 minutes for
the eighth car and 35 minutes for the ninth car.
Time taken to travel between two points along a given road
Traffic density
Journey time per car
Total journey time

for all cars
Extra total journey time

as traffic increases by
one more car
Additional time cost

imposed on other road
users by one more car
(Cars entering
road per minute)
(Marginal private time

cost: in minutes
(total time cost: in

minutes)
(Marginal social time

cost: in minutes)
(Marginal external time

cost: in minutes)
(1)
(2)
(3)
(4) = (3)
(5) = (4) (2)
10
15
24
40
16
11
66
26
15
16
112
46
30
24
192
80
56
35
315
123
88
337 What other types of transport could be directly provided by the government or a local authority?
Light rail systems, underground railways, bicycles (for borrowing: some cities have tried this).
338 (Box 12.3) Compare the relative advantages and disadvantages of these measures with those of charging
people to come into the zones.
Advantages of the Athenian system: directly reduces traffic; relatively cheap to administer; hard to evade
(providing it is policed).
Disadvantages of the Athenian system: does not distinguish between essential and casual users, in other
words it takes no account of the strength of an individual motorists demand; a charge is more flexible (it
can be varied according to time of day and level of pollution); encourages people to own two cars (one with
an even-numbered plate and one with an odd-numbered plate).
339 (Box 12.4) Explain how, by varying the charge debited from the smart card according to the time of day
or level of congestion, a socially optimal level of road use can be achieved.
The higher the level of congestion, the higher is the marginal external cost of motoring, and thus the higher
must be the charge if the charge is to equal the full marginal social cost. What this means is that if the
charge increases with the level of congestion, there is an incentive for people to reschedule their journeys to
non-peak times.
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340 Would a tax on car tyres be a good way of restricting car usage?
It is directly related to car usage and thus in theory could be used to reduce congestion. Nevertheless it is a
bad measure for three reasons.
Safety. Even if policing of tyre tread limits were stepped up, there would still be the temptation for
people to drive with unsafe tyres.
Expenditure on tyres is a relatively small part of motoring costs. Thus the tax would have to be very
high indeed to have much impact on congestion (and then this would increase the temptation to drive
with unsafe tyres).
If the purpose is solely to reduce congestion, it will have the side effect of discouraging motoring on
uncongested roads too. (In this respect it is like taxes on petrol.)
341 Which is preferable: general subsidies for public transport, or cheap fare policies for specific groups
(such as children, students and pensioners)?
It depends on the objectives. If the objective is to reduce congestion and pollution, then general subsidies
are better, since they would encourage people with cars to use public transport. If, however, the objective is
to help increase the mobility of those on low incomes, then cheap fare policies are better, since they are
targeted at those in need.
342 Try to formulate a definition of the public interest.
It is difficult to be uncontroversial here! In recent years the government has tended to define the public
interest in terms of whether firms are behaving competitively. You may prefer to define it in terms of ends
rather than mere behaviour: for example, whether the prices are kept at a reasonable level above costs
(however you choose to define reasonable). Then you may want to consider whether the firms level and
quality of investment is sufficiently high. Also you will probably want to take external costs and benefits
into account: for example, whether the firm is paying adequate attention to the environment. Finally you
may want to take into account questions of distribution and social justice: for example, whether the firm is
treating its workforce sufficiently well. As you can see, defining the public interest is a highly normative
issue!
343 What are the possible disadvantages of vertical mergers?
It can lead to increased control of the market. For example, if a component manufacturer merged with an
assembler of a product (e.g. radios), then the company might refuse to purchase components from other
manufacturers.
345 To what extent is Article 82 consistent with both these points of view?
To the extent that Article 82 concentrates on anti-competitive behaviour, as opposed to simple market
share, firms could be large within an EU context, and still not violate Article 86. Then there is the sheer
size of the EU market: EU firms which are large enough to compete effectively on a world scale, could still
face considerable competition from both EU and non EU firms.
347 (Box 12.5) 1. Identify the main barriers to entry in the supermarket and banking sectors.
Both industries have considerable economies of scale, in terms of centralised organisation, integration of
operations and considerable purchasing power to drive down the prices charged by suppliers (especially in
the supermarket sector). In addition, supermarkets often occupy prime sites and with planning restrictions
equivalent sites may not be available to competitors. Banks benefit from the inertia of customers who are
often unwilling to change bank.
(Box 12.5) 2. In what forms of tacit collusion are firms in the three sectors likely to engage.
The main one would be that of observing each others prices/charges and not starting a price war. At certain
times, one of the firms may take the lead in changing prices, with the other firms following suit.
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348 What problems are likely to arise in identifying which firms practices are anti-competitive? Should the
OFT take firms assurances into account when deciding whether to grant an exemption?
The main difficulty arises in establishing the extent to which competition would have occurred without the
agreement. Nevertheless, given that the OFT now has much greater powers of investigation and access to
firms documents, it is easier to establish the extent to which firms are intending to restrict competition by
engaging in one or more of the practices identified in the Act. There is still the problem, however, of
establishing the extent to which secret collusion is taking place.
The OFT would probably be wise to accept firms assurances only if a system of monitoring future
behaviour were established to ensure that firms adhered to their assurances.
349 (Box 12.6) Why might global cartels be harder to identify and eradicate than cartels located solely
within the domestic economy? What problems dos this raise for competition policy?
Firms operating in several countries tend to have more complex organisations. This tends to make their cost
structure harder to ascertain and hence makes it difficult to determine whether they are charging excessive
prices. Thus one of the tell-tale signs of collusion (high prices) may be hard to spot. Also, global cartels
have more ways of combining in their mutual interest. For example, they can divide up global markets,
agreeing not to compete in each others key markets. This too is hard to spot by the authorities, since the
absence of a particular multinational in a particular market in a particular country could have an innocent
explanation such as the company not wanting to over-reach itself. Also, if meetings between
representatives of the companies take place in different countries at different times, the meetings may be less
apparent to the authorities. Finally, there may be difficulties in achieving global co-operation and coordinated action by the competition authorities of different countries.
350 If anti-monopoly legislation is effective enough, is there ever any need to prevent mergers from going
ahead?
The more effective is anti-monopoly legislation, the less is the need for a specific merger policy.
Nevertheless, it is probably useful to prevent any mergers that pose considerable dangers to competition, in
order to prevent the later disruption of having to conduct investigations and terminate any anti-competitive
practices. Only if anti-monopoly and restrictive practice legislation were perfectly effective would there be
no case for merger policy.
351 If two or more firms were charging similar prices, what types of evidence would you look for to prove
that this was collusion rather than coincidence?
Profit margins would be a major piece of evidence. If profit margins were typical of those in other
industries, then similar prices between the firms could have been established through a process of
competition. After all, in perfect competition, prices will be identical! If profit margins suggest large
supernormal profits are being made, then some form of collusion is probable, but whereas this could be the
deliberate getting together of firms (openly or secretly) to rig prices, it could be merely a form of perfectly
legal price leadership, where one firm takes the lead from another and is reluctant to start a price war. In
order to establish whether the collusion contravened the Competition Act, it would be necessary to see
whether the firms were engaging in any of the practices specified on pages 3467.
355 To what extent can the problems with privatisation be seen as arguments in favour of nationalisation?
Whereas most of the problems could be addressed if the industries were nationalised and were run
efficiently and in the public interest, this begs the question of whether nationalised industries would be
efficiently run, given that competition would probably be very limited. Many of the problems of
privatisation could be overcome through increased competition, and this has been the approach of both
Conservative and Labour governments in the 1990s. The next section, Ownership and the Public Interest,
addresses some of these issues.
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356 1. In the case of buses, subsidies are often paid by local authorities to support various loss- making
routes. Is this the best way of supporting these services?
Either this or the local authority running the buses itself. In either case the support would come from
taxation (local and central) rather than involving a cross subsidy, and is therefore fairer.
Which of these alternatives is preferable depends in part on your political views: whether you prefer
public ownership or subsidised private ownership. But it also depends on cost. There are two arguments to
bear in mind here. On the one hand direct local authority provision may involve higher costs if the authority
is only providing a few (loss-making) services and thus does not gain the full potential economies of scale,
or is inefficient due to a lack of competition. On the other hand the private operator may be a monopoly and
thus again be inefficient. It is more likely, however, that the monopoly would be contestable (see section
6.4) and thus the company would have to be relatively efficient if it was to continue getting the local
authority business.
2. In the case of postal services, profitable parts of the service cross- subsidise the unprofitable parts.
Should this continue if the industry were privatised?
On grounds of fairness, it could be argued that the practice should continue of having the same postage rates
for both rural and urban postal services, the argument being that those living in rural areas should not
suddenly be penalised by having to pay higher postage rates. If, however, it is regarded as desirable that
such people should be subsidised, it would be fairer to do so from general taxation rather than from users of
urban postal services.
If the object, however, is to provide an allocatively efficient service it would be better to let price reflect
marginal cost for each part of the service. Thus long-distance rates should be higher than local rates, just as
international rates are higher than national ones, and heavier letters and parcels are charged more than
lighter ones. The only problem here is the cost of operating a system of multiple tariffs. At least the current
system allows stamps to be sold at many outlets with people knowing what value stamp to place on a letter.
If stamps were to continue to be sold widely, postage rates would have to remain simple: for example, just
two national rates: a local rate (e.g. within the same post code area) and a rate for all other destinations
within the country.
357 If the regulator imposed such rules, would they cause the firm to make a loss if it faced a downwardsloping LRMSC curve? (Clues: Where would the LRAC curve be relative to the LRMC curve? What
would be the effect of externalities and the addition of the Z factor on the price?)
Without the addition of a Z factor, and in the absence of externalities, the imposing of a P = LRMSC rule
would cause the firm to make a loss if it faced a downward-sloping LRMSC curve. The reason is that the
LRAC curve will be above the LRMC curve (= LRMSC curve, given no externalities). Thus price will be
below LRAC and the firm would make a loss.
If, however, the Z factor were positive, and/or if there existed external costs, the LRMSC + Z curve
would be above the LRMC curve, and thus might be above the LRAC curve too. In this case the firm could
make a profit.
Why might it equally result in average cost pricing?
The X factor could be the amount that the regulator expects average costs to decrease as a result of
efficiency gains. The firms could well have been using a cost-plus method of pricing, where cost was
average cost onto which was added a mark-up for profit. This practice could easily continue.
358 (Box 12.7) Look through each of the parts of the industries in the final column and consider in what
forms competition is likely to occur, and why, therefore, it is felt unnecessary for there to be price
regulation. (For the electricity industry see Box 12.8.)
Telecoms
Payphone calls: some competition, but largely only one company (BT). Mercury decided in 1995 to get
rid of its pay phones.
Telephones and other equipment: several companies.
Mobile phones: several companies.
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Price of gas to industrial and commercial companies, and from 1998 domestic customers too: several
companies using TransCo pipelines.
Connections: several local gas engineers.
Appliance sales: several manufacturers and retail outlets.
Electricity
Generation: the large companies (such as NPower), and several smaller companies.
Supply to customers consuming over a certain megawattage, and to all customers from 1998: the
regional distribution companies, the national generators (see Box 12.8) and other companies (such as
British Gas).
Electrical contracting and appliances: several companies.
Water
Bulk supplies to other users: regional water companies.
Water infrastructure charges: little or no competition.
Railways
Very little competition from within the industry, except for the size of the subsidy at time of granting the
franchise: some competition from buses (but several of the train operating companies have been sold to
bus operating companies, such as Stagecoach and FirstBus).
362 (Box 12.8) Does vertical integration matter if consumers still have a choice of suppliers and if
generators are still competing with each other?
Vertical integration is normally less damaging to competition than horizontal integration. Nevertheless, the
economies of scale of the integrated companies may allow them to undercut smaller competitors and thereby
drive them out of the market. This, in the longer run, could lead to higher prices.
364 To what extent would the use of bonuses that were graduated according to the amount of output have
solved this problem?
It would certainly have helped, but it could have aggravated the problem of poor quality output (as workers
cut corners in order to increase output). This problem in turn would have been helped if sub-standard output
was rejected by quality-control inspectors. Indeed, in the late 1980s, under the perestroika reforms, quality
control inspectors (Gospriomka inspectors) were appointed for most major factories. Another major
problem, however, was that the equipment was often very poor and materials were in short supply or
delivered late, and thus graduated bonuses would have had only a minor effect on the quantity and quality of
output.
365 Under which headings has most progress been made? Why has more progress be made under these
headings than the others?
Privatisation (especially small-scale) and trade liberalisation. These are relatively easy to implement. It is
has proved much more difficult, however, to achieve internal reorganisation of factories, given that there are
often vested interests which resist change. Price liberalisation too has had to be limited. The prices of many
basic products are often controlled or subsidised, otherwise they could become unaffordable by poor people,
especially given the huge widening of the gap between the incomes of rich and poor. Competition policy too
has still a long way to go, given the inheritance of an industrial structure that was highly monopolistic.
367 (Box 12.9) 1. How are Russian consumers likely to be affected by the use of barter by Russian
businesses?
To the extent that it allows production to take place that would otherwise not, the consumer will gain. But
barter is inefficient, and costs are likely to be substantially higher than with a competitive market. It is at
best, therefore, only a stop gap while more efficient and effective supply channels are developed.
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367 (Box 12.9) 2. Why might the various ways of reducing reliance on barter make the situation within the
Russian economy worse in the short run?
Increasing competition, corporate restructuring and bankruptcies all create losers in the short run, as people
lose their jobs and incur the stress of adapting to change. The gap between rich and poor is thus likely to
widen further, at least in the short run (which could be several years).
368 For what reasons might inequality in the transition economies lessen in the future?
As business infrastructure and business opportunities expand, and the number of competitors (both national
and international) in various industries grows, so the resulting competition is likely to erode the massive
supernormal profits and economic rent earned by firms and individuals. A lot will depend on the actions of
governments, however. If the poor and unemployed are to be given a chance to improve their lot, the
education, training, health and welfare systems cannot be neglected. But that depends on ensuring that
taxes are paid so that the various programmes can be funded.
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377 Would this argument still hold if prices rose?
Money incomes would remain unchanged, but fewer goods could be purchased with it. Thus real incomes
and output would fall. To keep output and real incomes the same (given that prices were rising), then either
money would have to circulate faster, or extra money would have to be injected into the flow.
379 Are the following net injections, net withdrawals or neither? If there is uncertainty, explain your
assumptions.
(a) Firms are forced to take a cut in profits in order to give a pay rise.
(b) Firms spend money on research.
(c) The government increases personal tax allowances.
(d) The general public invests more money in banks and building societies.
(e) UK investors earn higher dividends on overseas investments.
(f) The government purchases US military aircraft.
(g) People draw on their savings to finance holidays abroad.
(h) People draw on their savings to finance holidays in the UK.
(i) The government runs a budget deficit (spends more than it receives in tax revenues) and finances it
by borrowing from the general public.
(j) The government runs a budget deficit and finances it by printing more money.
(a) Neither, there is merely a redistribution of factor payments on the left-hand side of the inner flow. (The
only exception to this would be if a smaller proportion of wages were saved than of profits. In this case
there would be a net reduction in withdrawals.)
(b) Increase in injections (investment).
(c) Decrease in withdrawals (taxes).
(d) Increase in withdrawals (saving). Note that investing in building societies is really savings not
investment.
(e) Fall in withdrawals (a reduction in net outflow abroad from the household sector).
(f) Neither. The inner flow is unaffected. If, however, this were financed from higher taxes, it would
result in an increase in withdrawals.
(g) Neither. The inner flow is unaffected. The consumption of domestically produced goods and services
remains the same.
(h) Decrease in withdrawals (saving).
(i) Neither. An increase in government expenditure (or decrease in taxes, or both) is offset by an increase
in saving (i.e. people buying government securities).
(j) Net injections. An increase in government expenditure (or decrease in taxes, or both) is not offset by
changes elsewhere. Extra money is printed to finance the net injection.
What effect will there be on the four objectives of an initial excess of withdrawals over injections?
If withdrawals exceed injections, national income will fall. Other things being equal, this will have the
following effects on the four objectives:
Growth will be negative.
Unemployment will rise.
Inflation will fall.
The current account of the balance of payments will tend to improve. The deficit will be reduced, or
eliminated, or be transformed into a surplus. If it was already in surplus, the surplus will increase.
381 By what would we need to divide GDP in order to get a measure of labour productivity per hour?
The total number of hours worked in the year throughout the country.
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382 (Box 13.1) Referring to the figures in the table, which countries actual exchange rates would seem to
understate the purchasing power of their currency?
In terms of the 1998 EU average, countries whose GDP per head is less than their GDP (PPS) per head: i.e.
USA, Belgium, Ireland, Italy, Spain, Greece and Portugal.
For example, the USA had a GDP per head that was 40.3 per cent higher than the EU average, but
when the PPS figures are used, its GDP was 50.0 per cent higher than the EU average. In other words the
actual exchange rate, on which the simple GDP figure were based, understates the purchasing power of the
USAs GDP.
If we were trying to get a true measure of national production, which of the following activities would
you include: (a) washing-up; (b) planting flowers in the garden; (c) playing an educational game with
children in the family; (d) playing any game with children in the family; (e) cooking your own supper; (f)
cooking the supper for the whole family; (g) reading a novel for pleasure; (h) reading a textbook as part
of studying; (i) studying holiday brochures? Is there a measurement problem if you get pleasure from the
do-it-yourself activity itself as well as from its outcome?
The difficulty stems from separating production from consumption. In the paid-employment sector of the
economy, the distinction is clear. With production, money flows from firms to households (as wages, etc.),
and with consumption, money flows from households to firms. Many activities in the home, however, have
both a production and consumption element. Although they all lead to a benefit when complete (e.g.
washing-up leads to clean dishes), several, if not all, could give pleasure while they are actually being
performed. If so, should two lots of benefits be recorded (or even three)? Playing an educational game with
children can give pleasure to the children, future benefits to the children from the educational element, and
pleasure to the parents. Then there is the cost element. Should this be deducted? It is not deducted for
marketed output. In other words, the final value of goods and services sold is what is included, not the
value minus the cost of producing them: costs such as the disutility (effort, boredom, etc.) experienced by
workers.
Ideally, a true measure of national welfare, as opposed to national production, should be only a net
measure (i.e. benefits from consumption, minus costs of production). If this principle was used to measure
welfare in the household, then all pleasurable activities should be included with a positive sign (including
things such as reading a novel for pleasure) and anything causing displeasure should be recorded with a
negative sign. Most of the above activities would have elements of both benefits and costs. However, when
marketed national production is recorded, costs are ignored, and so for comparative purposes, household
production should be recorded on the same basis, and only the benefits recorded.
All the above items bring pleasure, either directly (such as reading a novel) or indirectly (such as doing
the washing-up), and in this sense they should all be included, but whether activities that give direct
pleasure should count as production or merely as consumption, is a question of definition.
383 (Box 13.2) 1. Is the size of the underground economy likely to increase or decrease as the level of
unemployment rises?
It could rise or fall depending on which of two effects is the larger. On the one hand, if a certain proportion
of unemployed people claim benefit and work in the underground economy, then, with a higher official level
of unemployed, the size of the underground economy is likely to be bigger. On the other hand, if the
economy is in recession, it is likely that the size of the underground economy will shrink along with the rest
of the economy.
(Box 13.2) 2. If the amount of cash used in the economy falls, does this mean that the size of the
underground economy must have fallen?
No. It could mean that the amount of cash used in the remainder of the economy has fallen, for example,
with increased use of credit cards or debit cards).
Name some external benefits that are not included in GDP statistics?
Three examples are: the pleasure people get from seeing other peoples attractive houses and gardens,
aesthetically pleasing architecture, improved health from a better diet.
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385 (Box 13.3) 1. Is a constrained optimisation approach a practical solution to the possible costs of
economic growth?
Yes. But there still remains the question of what level of constraints should be applied. For example, does
the government apply rigorous environmental standards or more lax ones? This is where there is a role for
some variant of costbenefit analysis (see Chapter 11, section 11.4): to identify and measure the costs of
economic growth.
(Box 13.3) 2. Are worries about the consequences of economic growth a luxury that only rich countries
can afford?
This is a very cynical way of looking at the issue. The point is that the marginal benefit of increased output
in a poor country is likely to be much higher than in a rich country (given the diminishing marginal utility of
income). Thus if a costbenefit study were done of specific growth policies, the benefits would probably
enter with a higher value per unit in a poor country than in a rich country. This does not mean that the cost
should be ignored. It is just that people may be prepared to make bigger sacrifices for increased output in
poor countries than in rich countries.
We must be careful with these arguments, however. They could be used to justify policies that are
highly damaging to the environment by governments which have little long-term interest in the welfare of
the people, or by firms which are unconcerned about the environmental consequences of their activities.
The point is that costs should still be taken into account: it is just that the benefits should possibly be given
a higher weighting.
387 Figure 13.4 shows a decline in actual output in recessions. Redraw the diagram, only this time show a
mere slowing down of growth in phase 4.
The curve would still slope upwards during phase 4, but its slope would be less than in the other phases. Its
slope would also be less than that of the potential output curve, with the result that the gap between actual
and potential output would widen.
388 If the average percentage (as opposed to the average level) of potential output that was unutilised
remained constant, would the trend line have the same slope as the potential output line?
No, it would be less steep. The ratio of the vertical distance between the trend output line and the potential
output line to the vertical distance between horizontal axis and the potential output line would have to
remain constant (assuming that the vertical axis starts at zero).
1. At what phases of the business cycle are points w, x and y in Figure 13.5?
w: phase 4, the recession.
x: phase 1, the upturn (growth is becoming positive again)
y: phase 2, the expansion (growth is at its most rapid).
Note that the bottom, the steepest point and the peak of this curve (Figure 13.5) do not correspond to the
bottom, the steepest point and the peak of the curve in Figure 13.4.
2. How long was the average duration of the cycle from peak to peak between 1950 and 2002?
6.25 years approximately (although it was slightly less than 5 years up to 1970 and more than 5 years after
1970, rising to 7 years after 1988).
389 (Box 13.5) Can growth go on for ever, given that certain resources are finite in supply?
Yes, provided that technical progress continues to allow output be produced with declining amounts of
resources.
392 For what reasons might the productivity of land increase over time?
Because of the increase in quantity and quality of complementary factors. Thus a hectare of land yields
more agricultural output today than 100 years ago because of the increased mechanisation of agriculture
and the increased amount of chemicals used.
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394 If a retailer buys a product from a wholesaler for 80 and sells it to a consumer for 100, then the 20 of
value that has been added will go partly in wages, partly in rent and partly in profits. Thus 20 of
income has been generated at the retail stage. But the good actually contributes a total of 100 to GDP.
Where then is the remaining 80 worth of income recorded?
At the wholesale stage and earlier. Each stage adds value value that is partly in wages, partly in rent, etc.
When the values added at all the stages are summed, this gives the final value of the good.
397 (Box 13.6) Make out a case against using ISEW. How would an advocate of the use of ISEW reply to
your points?
There are three major criticisms of ISEW. The first concerns its use as a substitute for GDP. GDP is not
meant to be a true measure of living standards, both now and sustainable into the future. Instead it is
primarily a measure of output that involves exchange, an important measure when attempting to understand
the relationship between aggregate demand (as expressed through exchange relationships) and aggregate
supply. The second criticism concerns the selection of items that should be included. Any list could be
criticised for including too many or too few items. For example, it could be argued that various forms of
public expenditure should be included (other than on health and education, which are already included). On
the other hand, various forms of services of household labour are not clearly production. They could be
seen as a form of consumption. For example, does time spent gardening constitute work or pleasure? We
would not include watching television or sitting relaxing as production, so should be include gardening or
any other hobbies as production which generates pleasure when consumed or merely as pure consumption?
Similarly, do relationships between people constitute the provision of services or is it rather mere joint
consumption? The third and perhaps the most serious criticism concerns measurement. How, for example,
should the depletion of non-renewable resources or long-term environmental damage be measured? Such
measurement entails various value judgements about the relationship between present and future costs. In
fact, the value placed on all non-marketed items is likely to be highly controversial (more so than marketed
items, where corrections for market distortions could relatively easily be made).
An advocate of ISEW would reply that ISEW, as its name says, is meant to be a measure of sustainable
economic welfare, and not a measure of marketed output and is thus doing something different from the
conventional use of GDP. If GDP is used, not for its original purpose, but as a measure of welfare, then
ISEW is superior. As far as the selection of items and their measurement is concerned, there will be
inevitably be disagreement, because people have different values. But here the advocate of ISEW would
reply with the last two sentences of the box.
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402 How does the ILO/OECD definition differ from the economists definition? What is the significance of
the phrase available for work at current wages in the economists definition?
There are two differences. The first concerns the word actively. People may genuinely want work and be
available, but because they have been out of work for a long time they have become dispirited and are
thus not actively seeking work. They would not be included in the ILO/OECD measure, but many
economists would consider that they should nevertheless be counted as unemployed.
The second difference is that the economists definition would normally include the phrase available
for work at current wage rates to highlight the fact that any change in wage rates would make a difference
to the number available for work. A person currently without work, but not seeking work at current wage
rates, and hence not counted as unemployed, may choose to look for work if real wage rates rose, and then
would be counted as unemployed. The point here is that the labour force (and hence the number available
for work) varies with the average wage rate (see curve N in Figures 14.4 and 14.5). The ILO/OECD
definition assumes that we are talking about current wage rates and hence leaving the phrase out makes no
difference to the measured unemployment level or rate.
404 1. If the number unemployed exceeded the total annual outflow, what could we conclude about the
average duration of unemployment?
That it would be greater than a year.
2. Make a list of the various inflows to and outflows from employment from and to (a) unemployment; (b)
outside the workforce.
Inflows to employment:
(a) From unemployment:
The two items in the bottom left corner of Figure 14.2.
(b) Outside the workforce:
School/college leavers.
Immigrants.
Returners to the labour force: e.g. parents after raising children.
Outflows from employment:
(a) To unemployment:
The three items in the top left corner of Figure 14.2.
(b) To outside the workforce:
People who retire.
People who are made redundant, who are sacked or who resign, and choose not to look for a
new job.
People who temporarily leave their jobs: e.g. to raise a family, or to attend further or higher
education
People who emigrate.
People who die.
405 Why have the costs to the government of unemployment benefits not been included as a cost to the
economy?
Because unemployment benefit is merely a transfer of money: from the taxpayer to the unemployed. The
monetary cost to the taxpayer is exactly offset by the benefit to the unemployed.
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407 If the higher consumer expenditure and higher wages subsequently led to higher prices, what would
happen to: (a) real wages; (b) unemployment (assuming no further response from unions)?
(a) Real wages would fall back again: the wage rate would fall back towards We in Figure 14.3.
(b) The lower real wages would cause consumer demand to fall (assuming that profit earners spend a lower
proportion their profits than do wage earners of their wages) and thus shift ADL back to the left again.
But unemployment would fall, because firms could afford to employ more workers at the now lower
real wage.
In other words, there is a movement back towards the original position in Figure 14.3 of We.
How would you show this last problem in a diagram like Figure 14.3?
The ADL curve will shift to the left. Thus, if wages were reduced to We in Figure 14.3, this would no longer
be the equilibrium. There would still be a problem of some disequilibrium unemployment. Wages would
thus have to fall below We to clear the market and eliminate disequilibrium unemployment.
408 If this analysis is correct, namely that a reduction in wages will reduce the aggregate demand for goods,
what assumption must we make about the relative proportions of wages and profits that are spent (given
that a reduction in real wage rates will lead to a corresponding increase in rates of profit)?
That the proportion of profits that is spent is smaller than the proportion of wages that is spent. Thus a
redistribution from wages to profits will reduce total expenditure.
On a diagram similar to that of Figure 14.6, illustrate how a growth in labour supply can cause
disequilibrium unemployment.
The ASL curve will shift to the right. If wages are inflexible downwards, this will cause an excess supply of
labour at the given wage rate.
409 Why are Wo and Wa curves rather than straight lines?
The Wo curve starts at a relatively low level, as firms are initially optimistic about finding appropriately
qualified workers without having to pay very much. But then as time goes past, firms will have to offer
more if they are still unsuccessful in recruiting. But the extra they are prepared to pay will level off as they
reach the maximum wage they can afford. The Wo line therefore does not continue to rise at a constant rate.
The Wa curve starts at a relatively high level, as workers first coming onto the labour market may be
optimistic about getting a high wage. But then as time goes past and they still have not got a job, so they
will be prepared to accept a lower wage. But this will level out as a minimum is reached which would only
just make it worthwhile doing a job rather than remaining on benefits. The Wa line therefore does not
continue to fall at a constant rate.
410 (Box 14.1) 1. In what areas of the economy are jobs growing most rapidly? Is this due to a lack of
technological innovation in these areas?
In the service sector. It is partly due to a lack of displacement of labour by machines, but also due to a rapid
rate of growth in demand. (Note that in some parts of the service sector, there has been a displacement of
labour as a result of the information technology revolution.)
(Box 14.1) 2. Why have rural areas generally seen a smaller decline in high-tech employment than
urban areas, and in some cases have seen an increase?
Because high-tech firms increasingly are choosing to locate in low-cost out-of-town sites. Given that
transport costs are generally only a small proportion of the total costs of these firms, it is not important for
them to be located near to their market. (See also Box 9.3 on page 220.)
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416 1. Do you personally gain or lose from inflation? Why?
You will have to answer this for yourself! Whether you gain or lose will depend on (a) whether your
income tends to go ahead of, or fall behind inflation; (b) whether you are a net borrower or saver, and
whether the rate of interest is above or below the rate of inflation (if it is below, then the real rate of interest
is negative and thus borrowers will gain and savers will lose); (c) just how inconvenient you find it to
update your information on prices so that you can decide whether items are good value for money. If you
are in receipt of a student grant, you are probably a loser, given that grants have not risen to compensate for
inflation.
2. Make a list of those who are most likely to gain and those who are most likely to lose from inflation.
Gainers: powerful companies; members of powerful unions; property owners (if property is rising in value
more rapidly than prices generally).
Losers: those on incomes fixed in money terms (e.g. savers living on interest on their capital: the real value
of their capital will be being eroded by inflation); workers with no bargaining power; people on state
benefits, where these benefits do not rise in line with prices; students.
419 (Box 14.3) If consumer demand rises and firms respond by raising prices, is this necessarily an example
of demand-pull inflation? Could there be such a thing as demand-pull illusion? (Clue: why might
consumer demand have risen?)
If the rise in consumer demand were the result of higher wages resulting from trade union or other wagepush pressure, then the rise in demand will be a symptom of these cost-push pressures. To refer to the
outcome as demand-pull inflation would be wrong. It would be a case of demand-pull illusion. In
practice, most inflationary episodes have both demand-pull and cost-push elements.
420 (Box 14.4) How is the policy of targeting inflation likely to affect the expected rate of inflation?
It is likely to make it approximately equal to the target rate, assuming that people believe that the authorities
(e.g. the Bank of England in the UK) will be successful in keeping inflation at approximately its target
level. The more successful the authorities are in keeping to the target, the more will peoples expectations
help to guarantee that this success will continue. If, however, people believe that the authorities will not be
able to keep inflation down to the target rate, then the expected rate will be above the target rate, making it
more difficult for the authorities to meet the target.
423 (Box 14.5) Under what circumstances would sustainable output (i.e. a zero output gap) move further
away from the potential output ceiling shown in Figure 13.4?
If the level of equilibrium unemployment in the economy rose. This could be the result of more rapid
technological change, or more rapid changes in the pattern of consumer demand, or a fall in labour mobility.
It could also be caused by a decline in the adaptability of capital or in the adequacy of the nations
infrastructure to cope with changes in demand.
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427 Why is the US current balance approximately a mirror image of the Japanese current balance?
Because the USA and Japan have a high proportion of their trade with each other. Many US imports are
Japanese exports and many Japanese imports are US exports. Thus a Japanese trade surplus is quite likely
to correspond to a US trade deficit. Similarly, many of the income flows into and out of each country are
from the other. Thus Japanese investments in the US lead to income flowing from the US (a debit on the US
current account) to Japan (a credit on the Japanese current account). Clearly, however, the current accounts
are only an approximate mirror image of each other, given each countrys trade with other countries.
429 1. Why may inflows of short-term deposits create a problem?
Because they may be very rapidly withdrawn again and thus can contribute to instability of the exchange
rate. To prevent sudden outflows of deposits (arising, say, from a fear by depositors that the exchange rate
is about to fall) governments may be forced to raise interest rates: something they may otherwise prefer not
to do.
2. Where would interest payments on short-term foreign deposits in UK banks be entered on the balance
of payments account?
As a debit on the investment income part of the current account. Payments of interest, profits and dividends
are all elements in this part of the balance of payments account.
430 With reference to the above, provide an assessment of the UK balance of payments in each of the three
years illustrated in Table 15.1.
The current account was in large deficit in 1989. This was the result largely of the poor performance on the
trade in goods part of the account, where there was a deficit of 24.7 billion. In part, this can be explained
by the boom that took place in the UK economy in the late 1980s, which had the effect of sucking in large
quantities of imports. It also reflected the slow growth of UK manufacturing exports. On the financial
account, the boom in the late 1980s led to an increase in UK investment abroad (and hence a deficit on item
6 in the balance of payments). This could be seen as advantageous, however, to the extent that it increased
future investment income earnings for the UK when these investments yielded a profit. To balance these
deficits, there was a substantial drawing on reserves and a very large inflow of short-term finance, attracted
by relatively high interest rates in the UK. This, however, could be seen as undesirable because the interest
earned on these deposits would then be a debit on the investment income part of the current account. What
is more, the deposits could be rapidly withdrawn and were thus potentially destabilising.
In 1997, the current account deficit was a modest 1.7 billion, but there was, nevertheless, quite a large
balance on trade in goods deficit, albeit offset by a trade in services surplus. With the recession of the early
1990s and the consequent slowing down in the growth of imports, the trade in goods deficit had been
reduced but never quite eliminated. Then with the recovery in the mid 1990s, the trade in goods account
went further into deficit, not helped in 1997 by a high exchange rate for sterling. The deficit on the trade in
goods account was offset by a surplus on the trade in services account and net income flows (the returns on
the high levels of overseas investment by the UK). On the financial account, UK investment abroad
continued to exceed foreign investment in the UK, helping to maintain the surplus on the net income flows
part of the current account. The deficit on the investment part of the financial account was largely offset by
a large short-term inflow of finance, attracted by relatively high UK interest rates.
By 2001, there had been a substantial deterioration in the trade in goods account (to 33.0 billion),
accounted for by the rapid growth in imports into a booming UK economy, but only a modest increase in
exports, given the high exchange rate (see Table 15.2). There were substantial net income inflows, however,
which helped to reduce the current account deficit. The investment part of the financial account was similar
to 1997, but increased short-term inflows (thanks to relatively high UK interest rates) gave a substantial
financial account surplus.
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431 How did the pound fare compared with the dollar, the lira and the yen from 1980 to 2001? What
conclusions can be drawn about the relative movements of these three currencies?
Taking the period as a whole, the pound depreciated against the US dollar and substantially against the
Japanese yen, but appreciated against the Italian lira. There were, however, fluctuations around this trend.
There was, for example, an appreciation against the dollar between 1993 and 1998 and against the yen
between 1995 and 1998.
The movements mean that over the period as a whole there was a decrease in demand for the pound
relative to the dollar and yen, but an increase in demand for the pound relative to the lira. This in turn
would suggest, other things being equal, that the rate of inflation was higher in the UK than in Japan and the
USA but lower than in Italy. There are, however, other possible explanations for currency demand and
supply shifts: these are examined on pages 4323 of the text.
432 (Box 15.1) What are the current and previous total weights of the EU countries? Comment.
Old weight was 0.6204. New weight is 0.6996. This reflects the growth of the UKs trade with the EU as
a proportion of the UKs total trade.
433 (Box 15.2) Assume that an American firm wants to import Scotch whisky from the UK. Describe how
foreign exchange dealers will respond.
The firm will want to purchase pounds with dollars. It will thus ask banks foreign exchange departments
for a $/ quote. The dealers will thus be put in competition with each other, trying to offer the lowest $
price for pounds in order to obtain the business. But they must be careful not to offer so low a $ price that
they will be unable to buy the necessary pounds at an even lower $ price from UK importers wanting
dollars.
Go through each of the above reasons for shifts in the demand for and supply of sterling and consider
what would cause an appreciation of the pound.
A rise in UK interest rates relative to those abroad.
A lower rate of inflation in the UK than abroad.
A fall in UK incomes relative to those abroad.
Better investment prospects in the UK than abroad.
Speculators believe that the rate of exchange will appreciate.
UK goods become more competitive (in terms of quality, etc.) than imported goods.
435 What problems might arise if the government were to adopt this third method of maintaining a fixed
exchange rate?
It could invite retaliation from other countries, whereby they imposed restrictions on UK exports to them.
By reducing the total amount of international trade, it would reduce the benefits that flow from it. (For a
discussion of the benefits of trade and of the advantages and disadvantages of trade restrictions, see Chapter
23, sections 23.1 and 23.2.)
436 What is likely to happen to the exchange rate during phase 2 if the government (a) seeks to maintain a
stable rate of interest; (b) raises the rate of interest to dampen the growth in aggregate demand?
(a) In phase 2 interest rates will tend to rise. If the government attempts to keep interest rates constant, the
exchange rates will tend to depreciate.
(b) The higher interest rate will encourage short-term capital inflows and help to prevent the exchange rate
depreciating. If the interest rate is raised sufficiently, the exchange rate will actually appreciate.
437 1. Was there any five-year period when all four indicators were better than in the previous five years?
19948
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437 2. Which macroeconomic problem(s) has/have generally been less severe since in the early 1990s than in
the 1980s?
Inflation and, since the mid-1990s, unemployment.
3. Why could the world as a whole not experience a problem of a current account balance of payments
deficit?
Because every import to one country is an export from another, and every outflow of investment income or
transfer of money from one country is an inflow to another. Thus when all the current account deficits and
current account surpluses of all the countries of the world are added up, they must all cancel each other out.
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442 Why are real wages likely to be more flexible downwards than money wages?
Money wages are unlikely to fall. The reason is that price inflation is virtually always positive. Thus if
money wages were to fall, there would have to be a bigger fall in real wages. For example if inflation were
10 per cent and firms wanted to cut money wages by 5 per cent, this would mean cutting real wages by 15
per cent: something they would find it hard to get away with.
Real wages, on the other hand frequently do fall. Because wage agreements are usually made in
money terms, it only needs inflation to go ahead of money wage increases, and real wages will fall.
Another reason why money wages are less flexible downwards has to do with money illusion. People
will resist a cut in money wages, seeing this as a clear cut in their living standard. If, however, a money
wage increase is given a bit below the rate of inflation (i.e. a real wage cut), many workers will perceive
this as an increase and will be more inclined to accept it. And indeed, because pay increases normally occur
annually, any money rise (even if below the annual rate of inflation) will be a temporary real rise for a few
months, until inflation overtakes it.
443 Would it be possible for a short-run AS curve to be horizontal (as in diagram (b)) at all levels of output?
No. Given that some factors are fixed in supply in the short run, there will inevitably be a limit to output.
As that limit is approached, the AS curve will slope upwards until it becomes vertical at that limit.
444 If firms believe the aggregate supply curve to be relatively elastic, what effect will this belief have on the
outcome of an increase in aggregate demand?
Firms will respond to the increase in aggregate demand by increasing their output and investment. There
are two main reasons. The first is that they will expect output elsewhere to increase and that they will
therefore be able to obtain supplies. The second is that, if they believe that the rise in aggregate demand is
not going to cause inflation to increase significantly, they will not expect the government to start deflating
the economy and thus dampening demand again. They will therefore expect their increased sales to
continue.
445 Assuming that rates of interest are initially above the equilibrium and that one particular financial
institution chooses not to reduce its rate of interest, what will happen? What will be the elasticity of
supply of loanable funds to an individual institution?
As other institutions reduce theirs, so savers will switch their deposits to this institution and new borrowers
will go elsewhere. The net effect is that this institution will have a huge glut of deposits (on which it is
paying interest) that it is unable to lend out. It will thus make a large loss. The institution will thus be
forced to lower its interest rate in line with the other institutions.
The elasticity of supply will be infinite (if the market for loanable funds is perfect) or at any rate highly
elastic (if it is not perfect).
What would have happened if countries in deficit had not responded to an outflow of gold by reducing
total expenditure?
They would run out of gold.
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448 Assuming that Y rises each year as a result of increases in productivity, can money supply rise without
causing inflation? Would this destroy the validity of the quantity theory?
Yes. If V does not change, then for every one per cent that output (Y) rises, so M can also rise by one per
cent without causing the price level (P) to rise.
This does not destroy the validity of the quantity theory. Although the theory states that changes in
money supply will not cause changes in output, it still allows for changes in output occurring independently
of changes in money supply, in which case there can be an accommodating rise in the money supply
without it being inflationary.
450 (Box 16.3) Could resource crowding out take place at less than full employment?
Yes. Increased government expenditure on certain projects could divert key workers and other resources
that were in short supply away from the private sector, even though there was a surplus of other resources.
The problem is that labour and other resources are not homogeneous and not perfectly mobile. The point
still remains, however, that the amount of resource crowding out that occurs, for any given increase in
government expenditure, will be less, the greater the degree of slack in the economy (i.e. the further away
the economy is from full employment).
452 Demonstrate this argument on an aggregate demand and supply diagram.
See Figure 16.8 in the text (page 453). If the economy is initially at Y1 (i.e. there is a lot of slack in the
economy), a rise in money supply that results in an increase in aggregate demand from AD1 to AD2 will lead
to a rise in output (from Y1 to Y2) with little increase in the level of prices.
454 What would be the classical economists criticisms of this argument?
That the increases in money supply would simply lead to higher prices in the private sector, and that the
public works would thus still lead to crowding out - both financial and resource crowding out. Given that
the cause of the problem, to classical economists, was the rigidities in markets, the solution was to free-up
markets: to encourage workers to accept lower wages, and producers to charge lower prices.
Might the AS curve shift to the right in the meantime? If it did how would this influence the effects of the
rises in aggregate demand?
Yp (and hence AS) will shift to the right over time as potential growth takes place (new resources discovered
and new technologies invented). Also the rise in aggregate demand and in output may lead to increased
investment and hence a bigger capital stock: this too will shift Yp and AS to the right.
The rightward shift of Yp and AS will allow the rise in aggregate demand to lead to a bigger increase
actual output (Y) and a smaller increase in the price level (if any at all).
457 What effects, according to monetarists, would successful supply-side policies have on the Phillips curve?
If the supply-side policies reduced the natural level of unemployment by improving the working of the
labour market (e.g. by improving information on jobs), then the (vertical) Phillips curve would shift to the
left. If, however, the supply-side policies merely affected output, the Phillips curve would be unaffected.
462 Two economists disagree over the best way of tackling the problem of unemployment. For what types of
reasons might they disagree? Are these reasons positive or normative?
They may disagree over what has caused unemployment. This could be either a disagreement over facts or
a disagreement over the way in which these factors operate on unemployment (i.e. a disagreement over the
correct model of unemployment). Alternatively they may disagree over the effects on unemployment of
particular policies. In each of these cases the disagreement is a positive one.
On the other hand they may disagree over the degree of priority that should be given to tackling
unemployment, given that it might be at the expense of some other economic goal (like reducing inflation).
In such cases the disagreements are (at least in part) normative.
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468 It is possible that as people get richer they will spend a smaller and smaller fraction of each rise in
income (and save a larger fraction). Why might this be so? What effect will it have on the shape of the
consumption function?
It is likely that the rich will feel that they can afford to save a larger proportion of their income than the
poor. The consumption function will slope upwards, but get less and less steep, the slope being given by the
mpc.
What effect will the following have on the mpc:
(a)
a rise in the rate of income tax;
(b)
the economy begins to recover from recession;
(c)
people anticipate that the rate of inflation is about to rise;
(d)
the government redistributes income from the rich to the poor?
In each case sketch what would happen to the consumption function.
(a)
The mpc will fall. The curve swings downwards, becoming less steep. (Remember that we are
relating consumption to gross income. For any given gross income, a rise in taxes will cause a fall
in disposable income and hence a fall in consumption.)
(b)
A simple rise in national income caused by the recovery from recession will, other things being
equal, lead to a movement along the short-run consumption function. This will therefore lead to a
possible fall in the short-run mpc. If, however, people anticipate further rises in income, they may
increase their short-run mpc. There will be an upward shift in the short-run consumption function
and a movement along the (steeper) long-run consumption function (which has a higher mpc).
(c)
The mpc will rise as people spend a larger fraction of any rise in income. Thus the (short-run)
consumption function shifts upwards and becomes steeper.
(d)
The mpc will increase, because the poor have a higher mpc than the rich. The consumption
function will shift upwards and become steeper.
Which is likely to show the greater variation from one person to another at any given level of income: the
short-run mpc or the long-run mpc?
The short-run mpc. The reason is that some people will react very quickly to a rise in income and will go
out on a spending spree, whereas others may prefer to save the rise in income. It also depends on how
transitory people expect the rise to be.
469 (Box 17.1) Try using this equation to derive the figures in Table 17.1.
Given C = 10 + 0.8Y, then when:
Y = 0, C = 10 + 0 = 10
Y = 10, C = 10 + 8 = 18
Y = 20, C = 10 + 16 = 26
Y = 30, C = 10 + 24 = 34
Y = 40, C = 10 + 32 = 42
and so on. (All figures are in billions.)
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469 (Box 17.1) First of all try constructing a table like Table 17.1 and then graph the consumption function
that it gives. What is it about equation (3) that gives the graph its particular shape?
Given C = 20 + 0.9Y 0.001Y, the following table can be derived:
Y
20
+ 0.9Y
0.001Y2
20
0.0
20.0
10
20
0.1
28.9
20
20
18
0.4
37.6
30
20
27
0.9
46.1
40
20
36
1.6
54.4
50
20
45
2.5
62.5
60
20
54
3.6
70.4
70
20
63
4.9
78.1
80
20
72
6.4
85.6
90
20
81
8.1
92.9
100
20
90
10.0
100.0
110
20
99
12.1
106.9
The curve gets gradually less and less steep because the negative term (0.001Y) becomes relatively larger
and larger as Y increases.
(Box 17.1) 1. What are the values of mpc at incomes of (a) 20 and (b) 100?
(a) When Y = 20, mpc = 0.9 (0.002 20) = 0.86
(b) When Y = 100, mpc = 0.9 (0.002 100) = 0.7
(Box 17.1) 2. What happens to the value of mpc as national income increases? Is this what you would
expect by examining the shape of the consumption function?
The mpc falls. Given the negative term (0.002Y), the higher the value of Y, the lower the value of the
mpc.
470 (Box 17.2) Comparing the saving ratios in France and New Zealand, what do the differences imply for
the balance between government expenditure and taxation if both countries want to achieve similar rates
of investment and want to maintain a balance between imports and exports?
Given that in equilibrium withdrawals must equal injections, then, if imports are to equal exports, the
remaining withdrawals (saving plus taxes) must equal the remaining injections (investment plus government
expenditure). Thus for a given level of investment, the lower is the level of saving, the higher must be the
level of taxes or the lower must be the level of government expenditure. Given that New Zealand has a
much lower saving ratio than France, it must therefore have a much higher ratio of taxes to government
expenditure for any given rate of investment. This is the case.
Put another way, France for many years has had a higher budget deficit as a percentage of national
income than has New Zealand (which in many years has had a budget surplus). France has been able to
sustain this because of its higher saving ratio.
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471 Go through each of the determinants of consumption that were listed in the previous section and consider
how they will affect savings. Are there any determinants of consumption in that list which will not cause
savings to rise if consumption is caused to fall?
Determinant
Consumption
Saving
Income (rise)
rise
rise
Assets held (increase in)
rise
fall
Taxation (fall)
rise
rise
Cost of credit (lower interest rates)
rise
fall
Expectations (that prices will rise)
rise
fall
Redistribution of income (becomes more equal)
rise
fall
Tastes and attitudes (people want to consume more)
rise
fall
The average age of durables (increases)
rise
fall
Thus there are two determinants of consumption (namely income and taxation, which will not cause saving
to rise if consumption is caused to fall.
471 If a country imports a whole range of goods whose average income elasticity of demand is the same as
for home produced goods, what will the import function look like?
It will be a similar shape to the consumption function, but below it and with a gentler slope.
473 (Box 17.3) 1. How is the existence of surveys of business confidence likely to affect firms expectations
and actions?
They will amplify changes in expectations. If businesspeople are gloomy and plan to reduce investment, a
pessimistic report on business expectations will only confirm their gloom and may cause them to reduce
investment even further. Similarly an optimistic report may cause firms to increase investment.
(Box 17.3) 2. Why, if the growth in output slows down (but is still positive), is investment likely to fall (i.e.
be negative)? If you look at table (a) you will see that this happened in 1991 and 1992.
Because firms will require a smaller increase in capital. They will thus buy fewer extra machines and other
equipment: i.e. investment will fall.
If the slope of the Cd function is what is the slope of the W function?
One quarter. The slope of the Cd function gives the mpcd and the slope of the W function gives the mpw.
But since the mpcd + mpw = 1, then if the mpcd is , the mpw must be .
476 Why do a b = e f, and c d = g h?
The gap e f shows the amount that E (i.e. Cd + J) exceeds Y (i.e. Cd + W). This must therefore also be the
amount that J exceeds W, which is given by the gap a b. Similarly the gap g h shows the amount that Y
(i.e. Cd + W) exceeds E (i.e. Cd + J), which must also be the amount, therefore, by which W exceeds J,
which is given by the gap c d.
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477 Try this simple test of the above argument.
Draw a series of W lines of different slopes all
crossing the J line at the same point. Now
draw a second J line above the first. Mark the
original equilibrium and all the new ones
corresponding to each of the W lines. It
should be quite obvious that the flatter the W
line the more will Y have increased.
See Diagram 17.1. The flatter the W line (the
lower the mpw), the bigger the rise in Y for any
given rise in J.
Why is the withdrawals multiplier strictly
speaking a negative figure?
Because a rise in withdrawals causes a fall in
national income; and a fall in withdrawals
Diagram 17.1 How the multiplier depends
causes a rise in national income. Thus in the
on the slope of the W curve
withdrawals multiplier formula Y/W, one of
the two terms (Y or W) will be positive and
the other will be negative. This means that Y/W must be negative.
478 1. What determines the slope of the E function?
The E function is parallel with the Cd function (assuming that the J curve is a horizontal straight line).
Thus the slope of the E function is given by the mpcd.
2. How does the slope of the E function affect the size of the multiplier? (Try drawing diagrams with E
functions of different slopes and see what happens when they shift.)
The steeper the slope of the E function (and hence the bigger the mpcd) the bigger will be the multiplier (=
1/(1 mpcd)). For example, if the slope were , the multiplier would be 1/(1 ) = 4. Whereas, if the
slope were 9/10, the multiplier would be 1/(1 9/10) = 10.
479 Assume that the rate of income tax is 15 per cent, the rate of expenditure tax is 12 per cent, the mps is
1/20, the mpm is 1/8 and the mpc (from disposable income) is 16/17. What is the mpcd? Construct a
table like Table 16.3 assuming again that national income rises by 100 million.
Substituting the above figures in the formula: mpcd = mpc(1 tE)(1 tY) mpm, gives:
mpcd = (16/17)(1 1/8)(1 3/20) 1/8
= (16/17)(7/8)(17/20) 1/8
= (16/17)(119/160) 1/8
= 7/10 1/8
= 23/40 or 0.575
Y TY = Ydis
(m) 100 15
85
Ydis S = C
(m) 85
5
80
C TE M = Cd
(m) 80
10
12.5
57.5
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Page
479 Give some other examples of changes in one injection or withdrawal that can affect others.
A rise in government expenditure on infrastructure projects may encourage firms to invest, or, on the
other hand, may replace private investment.
A rise in taxation will reduce savings and imports as well as consumption of domestic goods and
services.
A depreciation of the exchange rate will lead to increased exports (an injection) and decreased imports
(a withdrawal). This could encourage increased investment in the domestic economy.
Higher savings will mean less total consumption, including less expenditure on imports.
(Box 17.5) Is an increase in saving ever desirable?
Yes.
If there is a problem of excess demand, an increase in savings will reduce inflationary pressures.
If investment increases over time, an increase in savings will allow these increases to be financed
without problems of rising interest rates or inflation, problems which would have the effect of curtailing
the investment.
482 The present level of a countrys exports is 12 billion; investment is 2 billion; government expenditure is
4 billion; total consumer spending (not Cd) is 36 billion; imports are 12 billion and expenditure taxes
are 2 billion. The economy is currently in equilibrium. It is estimated that an income of 50 billion is
necessary to generate full employment. The mps is 0.1, the mpt is 0.05 and the mpm is 0.1
(a) Is there an inflationary or deflationary gap in this situation?
(b) What is the size of the gap? (Dont confuse this with the difference between Ye and Yf.)
(c) What would be the appropriate government policies to close this gap?
J = 12bn + 2bn + 4bn
Cd = 36bn 12bn 2bn
E (= Cd + J) = 18 + 22
= 18bn
= 22bn
= 40bn
Multiplier = 1/mpw
(a)
(b)
(c)
= 1/(0.1 + 0.05 + 0.1)

=4
Deflationary gap. If the economy is in equilibrium, then Y = E. Thus Ye = 40bn. But full
employment is achieved at an income of 50bn. There is thus a deflationary gap.
2.5bn. This is the amount that must be injected (given a multiplier of 4) in order to increase
national income by 10bn from the current 40bn to the full-employment level of 50bn.
Increase government expenditure by 2.5bn (or reduce taxes by 3.33bn: see Chapter 20, section 1
on the size of the tax multiplier).
483 How does the above argument about firms responses to a rise in demand relate to the shape of their
marginal cost curves?
The steeper are firms marginal cost curves, the more they will respond to a rise in demand by increasing
prices and thus the steeper will be the AS curve.
484 If money supply did increase sufficiently for the E line to remain at E2 what would be the position of the
new AD curve?
It would cross the AS curve at Ye2.
485 How is it that the cost of an investment to a firm will exceed the value of the output that the investment
will yield? Surely that would make the investment unprofitable? (Clue: the increase in output refers to
output over a specific time period, usually a year.)
Machines last many years. Thus even though they may cost more than the value of their annual output,
they will cost less than the value of their lifetimes output.
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487 (Box 17.6) 1. Can you identify any time lags in the graph? Why might there be time lags?
Growth in GDP stops falling in 1980 Q2, but growth in investment only stops falling in 1981 Q1.
Growth in GDP begins to fall in 1983 Q4, but growth in investment only begins to fall in 1984 Q2.
Growth in GDP begins to fall in 1988 Q1, but growth in investment only begins to fall in 1988 Q2.
There is no time lag, however, between the growth in GDP beginning to rise in 1991 Q3 and growth in
investment beginning to rise: this was investment led growth.
Similarly there was no time lag with the fall in growth and fall in investment after 1994 Q3 and
1997 Q4.
There was, however, a small time lag between the rise in growth in GDP in 1999 Q1 and the rise in
investment growth in 1999 Q2.
In the final two years in the graph, there is a time lag apparent. Growth slows down after 2000 Q1, but
the growth in investment only falls after 2000 Q3
Time lags can exist because it takes time for businesses to plan their investments. Also, firms may wait
before adjusting their investment plans until they are clear on the direction in which the economy is moving.
(Box 17.6) 2. Why does investment in construction and producer goods industries tend to fluctuate more
than investment in retailing and the service industries?
Because demand for the output of these industries (which are investment goods industries) fluctuates much
more as a result of the accelerator effect.
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493 (Box 18.2) 1. Would it matter if it was easy to forge a 10 note but cost 15 to do so?
No. It would not be profitable for forgers to produce such notes.
(Box 18.2) 2. How well do each of the following meet the seven requirements listed above? Grain,
strawberries, strawberry jam, gold, diamonds, luncheon vouchers, ICI share certificates, a savings
account requiring one months notice of withdrawal, notes and coin?
Acceptability: most are not currently acceptable as a medium of exchange, with the possible exception
of gold under certain circumstances. Most, however, could be acceptable, if society chose.
Strawberries would be a clear exception! Clearly the degree of acceptability would depend on the
extent to which the item met the other six requirements.
Durability: gold, diamonds, notes and coin and a savings account have almost perfect durability;
luncheon vouchers and share certificates have moderately high durability; grain and strawberry jam
have moderate durability; strawberries clearly have very low durability (unless frozen).
Convenience: notes and coin (except for large amounts and the risks of robbery), luncheon vouchers
and share certificates would be very convenient; gold and diamonds would be moderately convenient
for large transactions; again, strawberries would be very inconvenient.
Divisibility: notes and coin (assuming different denominations) and also a savings account score
highest here (assuming that any amount can be withdrawn or transferred); share certificates and
luncheon vouchers also score highly (especially if they come in different denominations); gold and
diamonds are divisible down to moderately low levels; strawberries are also good in this respect (mind
you, its about the only one!); strawberry jam would be quite good, if it came in small-sized jars as well
as normal-sized ones; grain is virtually perfectly divisible.
Uniformity: notes and coin and the paper assets are the best in this respect; the others are only suitable
here if there is a means of identifying quality.
Hard for individuals to produce themselves. In the case of the commodities, there would be no problem
here providing that their value as money was no higher than their market value as a commodity. As far
as the other assets are concerned, notes and coin are good (assuming they are hard to forge); a savings
account would also be good, providing it was not possible for people to get unauthorised access to the
account; the suitability of share certificates and luncheon vouchers would depend on how easy they
were to forge.
Stability of value: notes and coin and a savings account are as good as the currency in which they is
denominated; luncheon vouchers could be good, but only if their supply were tightly controlled; share
certificates are bad, given that share prices fluctuate with the fortunes of the company; diamonds and
gold are good, as their supply is relatively constant; grain and especially strawberries are bad, given
that their supply fluctuates with the harvest; strawberry jam is not very good either, given that its cost
of production also fluctuates with the price of strawberries.
Why may money prices give a poor indication of the value of goods and services?
Money prices may be distorted by monopoly power.
They ignore externalities.
Simply adding up the money incomes of individuals in order to get a measure of their total incomes
ignores questions of the distribution of income.
The value of money is eroded over time by inflation. Thus nominal prices would have to be converted
to real prices (see page 461 of the text) in order to compare the values of goods at different points in
time.
494 In terms of the broad definition of money would a deposit account pass book count as money?
No. The passbook itself is not money. It is merely a means of giving access to the money. The money itself
is the deposit.
Page
495 Which of the above are examples of economies of scale?
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Chapter 18
Expert advice can be given by larger institutions which can employ specialist personnel. The same applies
to expertise in channelling funds: larger institutions can acquire a greater expertise by having a number of
different departments. In both these cases, however, the economies of scale may be exhausted relatively
quickly. Small financial institutions could always buy specialist information.
In the case of maturity transformation and risk transformation, however, there may be more substantial
economies of scale to be gained. Larger institutions can spread risks more widely and can operate with a
bigger maturity gap.
499 (Box 18.3) Is it possible to argue that secondary marketing allows a lower safe average liquidity ratio?
(Clue: The answer has to do with risk transformation.)
Yes, to some extent. Secondary marketing allows risks to be spread across the whole banking system. This
is fine as long as the risks are independent. There is a problem, however, when risks are not independent.
For example the risks of bankruptcy of businesses are not totally independent, because the general risks of
bankruptcy increase during times of recession. The banks therefore still have to maintain sufficient
collective liquidity to meet such eventualities.
500 1. If a bank buys a 500 000 Treasury bill at the start of its 91-day life for 480 000, at roughly what
price could it sell it to another financial institution after 45 days Why is it not possible to predict that
precise price when the bill is first purchased?
Approximately 490 000. The bank makes approximately 10 000 for the 45 days it has held the bill, and
the financial institution which then buys it from the bank makes approximately 10 000 for the remaining
46 days. The precise price of the bill after 45 days is not possible to predict, however, since the price will
reflect interest rates at that point in time: i.e. the bill must give a comparable return for the purchaser to
other assets (of equivalent liquidity) which the purchaser could have bought instead.
2. Suppose there were a sudden surge in demand for cash from the general public, would the existence of
inter-bank market loans help to meet the demand in any way?
It could allow cash to be redirected from institutions which had a relative abundance of cash to those with a
relative shortage. It could not result, however, in an increase in the overall level of cash.
Why are government bonds which still have 11 months to run regarded as liquid, whereas overdrafts
granted for a few weeks are not?
Because bonds with eleven months to run can be sold today on the stock exchange at a price not very
different from their face value, whereas overdrafts cannot be redeemed immediately, or even necessarily
within the agreed time span!
502 1. Would it be possible for an economy to function without a central bank?
No. The functions listed on pages 5012 have to be carried out in a modern money-based economy.
2. What effect would a substantial increase in the sale of government bonds and Treasury bills have on
interest rates?
It would drive them up. In order to sell the extra bills, the government would have to accept a lower
discount price (a higher rate of discount). In order to sell the extra bonds, governments would have to offer
them at a higher rate of interest, or at a lower price for a given interest payment (which amounts to a rise in
the interest rate). These higher rates of interest on government securities would have a knock-on effect on
other rates of interest. [These issues are examined in Chapter 20, pages 5645.]
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503 (Box 18.4) 1. Are there any circumstances where diversification could lead to increased risks?
This could occur if the risks in the different parts of the banks business were not independent of each other
(see page 100). The problem here would be if the risks appeared to be independent and then turned out not
to be so. For example, if a bank decided to diversify into insurance, it might find that a national problem,
such as a recession and, perhaps, falling prices, led to (a) people wanting to hold a larger proportion of their
assets in cash and hence a liquidity problem for the bank, but also to (b) more insurance claims as the
recession led to more crime, ill health and suicides. There is also the danger that a highly diversified
organisation is less focused and hence more subject to bad decision making. Finally, a more diversified
organisation may be willing to take more risks because it believes (rightly or wrongly) that any loss that
could, as a result, occur in one part of the organisation can be covered by profits in another part.
(Box 18.4) 2. To what extent are the lower costs associated with Internet banking attributable to
economies of scale?
Most of the cost savings are the result of needing a lower staffing per transaction: in other words, a
reduction in variable costs (a shift downwards of the AVC curve: see page 124). To the extent that banks
with successful Internet banking facilities have gained a larger share of the market, however, there are
clearly economies of scale from the increased size of the organisation. There is greater scope for such
economies with Internet banking than with conventional branch-based banking, since the computing costs of
Internet banking are to a large extent fixed costs, with average costs declining more rapidly as business
increases than with conventional banking.
Why should Bank of England intervention to influence rates of interest in the discount market also
influence rates of interest in the parallel markets?
Because market forces will ensure that interest rates in the two markets will move together: otherwise
deposits would flow to the higher interest rate market and loans would be sought in the lower interest rate
market. The higher interest rate market would thus have a glut of funds and the lower interest rate market
would have a shortage of funds. These shortages and surpluses would act to eliminate the interest rate
differential.
506 (Box 18.5) 1. Why is cash in banks and building societies included in the UKs M0 measure but not in the
other two measures?
Because in the other measures it is already included in bank deposits. To count it as a separate item apart
from bank deposits would be a case of double counting.
If banks choose to operate a 20 per cent liquidity ratio and receive extra cash deposits of 10 million:
(a) How much credit will ultimately be created?
(b) By how much will total deposits have expanded?
(c) What is the size of the bank multiplier?
(a) 40m
(b) 50m
(c) 5 (= 1/0.2)
507 (Box 18.5) 2. What are the benefits of including these additional items in the broad measure of money
supply?
Because, although not quite as liquid as cash, they are nevertheless highly liquid and thus their inclusion
gives a broader overall picture of the liquidity position between financial institutions. They can,
nevertheless give a false impression of the overall liquidity position of euro economy, since much of the
liquidity is simply short-term claims of one banking institution on another.
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507 How will an increased mobility of savings and other capital between institutions affect this argument?
This will make interest rates more similar (after taking into account differences in liquidity and the terms of
accounts), as deposits flow from low to high interest rate accounts and borrowers switch from high to low
interest rate sources. But as interest rates become more similar, so a general surplus of credit on offer will
drive down interest rates generally. Individual institutions will be less worried about lowering their rate,
and driving depositors away to other institutions, if these other institutions are all lowering their rates too.
508 Is the following statement true: The greater the number of types of assets that are counted as being
liquid, the smaller will be the bank multiplier?
Yes. The more assets it counts as liquid for purposes of deciding how much credit to grant, the bigger will
be its liquidity ratio and therefore the smaller will be the bank multiplier. On the other hand, any rise in the
total amount of broad liquidity is likely to be much larger than a rise in cash, and thus, although the
multiplier is smaller, a larger figure is being multiplied, with the result that the total amount of credit
expansion may be much the same as by basing it on cash alone.
(Box 18.6) 1. If c were 0.1 and r were 0.01, by how much would M4 expand if the monetary base rose by
1 million?
Putting the figures into the formula:
m = (1 + c) / (r + c)
gives
m = (1 + 0.1) / (0.01 + 0.1)
= 1.1 / 0.11
= 10
Therefore, if the monetary base (M0) rose by 1 million, the money supply (M4) would rise by 10 million.
(Box 18.6) 2. M4 includes wholesale as well as retail deposits. Given that firms will wish to keep only a
very small fraction of a rise in wholesale deposits in cash (if any at all), how will a change in the balance
of wholesale and retail deposits affect the value of c and hence of the money multiplier?
The higher the proportion of new deposits that are wholesale (as opposed to retail), the smaller will be the
proportion of new deposits that will be held as cash outside banks and hence the lower will be the value of
c. The lower the value of c in the formula m = (1 + c) / (r + c), the higher will be the value of the money
multiplier (m).
509 What effects do debit cards and cash machines (ATMs) have on (a) banks prudent liquidity ratios;
(b) the size of the bank multiplier?
Debit cards: (a) Reduce it (there is less need for cash); (b) Increase it (the liquidity ratio is smaller).
Cash machines: (a) Increase it (there is a greater need for cash); (b) Reduce it (the cash ratio is larger).
If the government borrows but does not spend the proceeds, what effect will this have on the money supply
if it borrows from (a) the banking sector; (b) the non-bank private sector?
(a) Little or no effect, if it simply replaces one liquid asset by another; but reduce it, if it involves reducing
the liquidity of the banking sector (e.g. by the sale of bonds).
(b) Reduce it. The liquidity of the banking sector will be reduced (when people pay for the securities with
cash withdrawn from the banks, or cheques drawn on the banks).
512 Will students in receipt of a grant or an allowance who are paid once per term have a high or a low
transactions demand for money relative to their income?
High, to the extent that they succeed in living off their grant or allowance. In such cases, their current
account balances may be relatively large compared with their annual income (given that they are only paid
three times a year). If, on the other hand, their grant or allowance is spent very rapidly, and then they have
to seek a loan, their transactions balances may be low relative to their income!
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513 (Box 18.7) Under what circumstances are cheques more efficient than cash and vice versa? Would you
get the same answer from everyone involved in transactions: individuals, firms and banks?
Cheques are more efficient than cash for large transactions, or when there is a danger of theft of the cash.
Cheques are less efficient than cash for small transactions: these have a low value relative to the cost of
processing a cheque; also cash transactions are quicker than transactions by cheque.
The above points apply generally, but sometimes, what may be in the interests of one party to a
transaction may not be in the interests of the other(s). For example, a shop may prefer to receive cash on
occasions where it is more convenient for a customer to write out a cheque (because that saves a visit to the
bank or cash machine).
Buying something like a car is at the other end of the spectrum from holding cash. A car is highly
illiquid, but yields a high return to the owner. In what form is this return?
The utility per period of time from using it.
514 Would the demand for securities be low if their price was high, but was expected to go on rising?
No. The demand would be high. People would want to hold the securities, so that they could benefit from
the anticipated capital gain.
515 Which way is the L2 curve likely to shift in the following cases?
(a) The balance of trade moves into deficit.
(b) People anticipate that foreign interest rates are likely to rise relative to domestic ones.
(c) The domestic rate of inflation falls below that of other major trading countries.
(d) People believe that the pound is about to depreciate.
(a) To the left. A deficit on the balance of trade will cause the exchange rate to depreciate. People,
anticipating this, will want to hold smaller sterling balances.
(b) To the left. People will want to switch to holding the other currencies where interest rates are expected
to rise.
(c) To the right. People will expect an appreciation of sterling as the lower inflation causes the balance of
payments to move into surplus. They will therefore want to hold larger sterling balances.
(d) To the left.
516 Trace through the effects on the foreign exchange market of a fall in the money supply.
The shortage of money balances will lead to a reduction in the purchase of foreign assets and hence a
reduction in the supply of the domestic currency on the foreign exchange market.
The fall in money supply can be represented on Figure 18.6: the Ms curve will shift to the left. This will
cause a rise in the rate of interest.
The higher rate of interest will lead to a reduction in the supply of the domestic currency on the foreign
exchange market as people prefer to keep their deposits within the country and earn the higher rate of
interest. This effect will reinforce the first effect.
The higher rate of interest will also increase the demand for the domestic currency on the foreign
exchange market as people abroad deposit more in this country to take advantage of the higher interest
rate.
The increased demand for and reduced supply of the domestic currency will cause the exchange rate to
appreciate. This effect will be reinforced by speculation.
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519 If V is constant, will (a) a 10 million rise in M give a 10 million rise in MV; (b) a 10 per cent rise in M
give a 10 per cent rise in MV ? (Test your answer by fitting some numbers to the terms.)
(a) No (unless V = 1)
(b) Yes
If both V and Y are constant, will (a) a 10 million rise in M lead to a 10 million rise in P; (b) a 10 per
cent rise in M lead to a 10 per cent rise in P? (Again, try fitting some numbers to the terms.)
(a) No (unless V = Y: which it never would)
(b) Yes
521 Figure 19.4 shows a steep investment demand curve. If the rate of interest rises from r1 to r2, there is only
a small fall in investment from I1 to I2. Now draw a much more elastic I curve passing through point a.
Assume that this is the true I curve. Show how the rate of interest could still rise to r2 and investment still
only fall to I2 if this curve were to shift.
This could happen if the I curve shifted to the right. The new curve could still pass through the point r2, I2,
even though it was more elastic than the I curve illustrated in Figure 19.4
523 (Box 19.1) Can the government choose both the exchange rate and the money supply if it is prepared to
use the reserves to support the exchange rate?
Probably, but only for a short time. If the government reduces interest rates to avoid a recession, but at the
same time is unwilling to let the exchange rate depreciate, then it can indeed use its reserves to support the
currency. If speculators believe that the government can succeed in supporting the exchange rate, then the
government may well succeed. The government will be helped in this, if it is supported by other central
banks. Thus it was easier for the UK to support a disequilibrium exchange rate when it was a member of
the exchange rate mechanism of the European Monetary System than it was before joining, because there
was joint support from the member countries to support currencies that were being pushed to the floor of
their agreed exchange rate band.
If, however, the government attempts to keep the exchange rate above its equilibrium level over the
long term, without correcting the underlying balance of payments problem, then it is likely that the country
could be forced to devalue: speculation will become too great. Thus, even within the ERM, a country could
be forced to devalue, despite support from other countries. This was precisely what happened to the UK
and Italy in September 1992. Speculation against the pound and the lira became so great that their
exchange rates could not longer be maintained. The two countries left the ERM and their exchange rates
depreciated.
If importers and exporters believe that the exchange rate has bottomed out, what will they do?
Importers and exporters will stop speculating that the currency will fall. Importers will thus cease stocking
up, and will cut back on imports, waiting for the exchange rate to rise. Exporters will start selling more, to
take advantage of the low exchange rate. The combined effect, therefore, could be a substantial boost to
aggregate demand.
524 Do you think that this is an accurate description of how people behave when they acquire extra money?
For some people, yes. Many people, however, are more likely to adjust their spending in line with changes
in income (which of course will also tend to affect their money balances).
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525 Redraw the three diagrams of Figure 19.1 with a steeper L curve. Show how an increase in money
supply will have a larger effect on national income.
In Figure 19.1(a), with a steeper L curve, the shift in the M curve will cause a larger change in r. In Figure
19.1(b), the larger change in r will cause a bigger change in the level of investment (i.e. a bigger horizontal
movement along the I curve). Thus in Figure 19.1(c) there will be a bigger vertical shift in the J line and
hence a bigger multiplied change in national income.
(Box 19.2) How would a monetarist answer the five Keynesian criticisms given above?
1. Not all the measures of money supply have moved together.
Monetarists would argue that it is clearly important to be consistent in which measure of the money
supply is used for analysis. It is also important to look at the movements over the range of measures
(to avoid the problem of Goodharts law when only one measure is targeted).
2. The time lag with monetary policy could be very long.
Monetarists do not claim that monetary policy can be used to fine tune the economy. It is simply
important to maintain a stable growth in the money supply in line with long-term growth in output.
3. Monetary and fiscal policy can work together.
Monetarists would argue that it is the monetary effects of fiscal policy that cause aggregate demand to
change. Pure fiscal policy will be ineffective, leading merely to crowding out.
4. The marginal velocity of circulation varies.
Monetarists would accept the marginal velocity of circulation will fluctuate in the short term, but that
there is still a strong correlation between monetary growth and inflation over the longer term.
5. Changes in aggregate demand cause changes in money supply and not vice versa.
Monetarists would argue that if governments respond to a rise in aggregate demand by allowing money
supply to increase, then that is their choice to expand money supply. If they had chosen not to and had
pursued a policy of higher interest rates, then money supply would have thereby been controlled and
aggregate demand would soon have fallen back again.
527 Assume that the government cuts its expenditure and thereby runs a public-sector surplus.
(a) What will this do initially to equilibrium national income?
(b) What will it do to the demand for money and initially to interest rates?
(c) Under what circumstances will it lead to (i) a decrease in money supply; (ii) no change in money
supply?
(d) What effect will (i) and (ii) have on the rate of interest compared with its original level?
(a) Injections will fall. In Figure 19.7(a), the J line would shift downwards, causing a multiplied fall in
national income.
(b) This will cause a reduced transactions demand for money. In Figure 19.7(b) the L curve will shift to
the left, causing a fall in interest rates.
(c) If the reduced PSNCR from the reduced government expenditure causes a reduction in government
borrowing from the banking sector in such a way as to cause a reduction in banks liquidity, there will
be a multiple contraction of credit. If, however, the government simply reduces the total number of
outstanding bonds, then money supply will be little affected.
(d) If money supply is reduced, then interest rates will fall less than in (b) above.
(Box 19.3) We have argued that the short-term inflow of finance following a rise in the rate of interest
will drive up the exchange rate. Are there any effects of expansionary fiscal policy on the demand for
imports (and hence on the current account) which will go some way to offsetting this?
The higher demand from an expansionary fiscal policy will lead to increased imports. The resulting
deterioration in the current account will tend to depress the exchange rate, and thus go some way to
offsetting the upward pressure on the exchange rate from the improvement in the financial account resulting
from the higher interest rates.
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531 In a complete model where there were three injections (I, G and X), and three withdrawals (S, T and M),
what else would determine the shape of the JW curve?
The responsiveness of imports to changes in interest rates:
The more responsive the demand for imports, the more imports will rise as interest rates fall, and
therefore the smaller will be the vertical shift downward of the W curve in Figure 20.14, and hence the
less the multiplied rise in national income, and hence the less elastic the JW curve in the lower part of
the diagram.
The marginal propensity to import (mpm) and the marginal tax propensity (mpt):
The higher these are, the bigger will be the multiplier effect on national income of any rise in injections
and fall in withdrawals, and the more elastic therefore will be the JW curve.
In a complete JW model, what else would cause the JW curve (a) to shift to the right: (b) to shift to the
left?
(a) A rise in government expenditure or exports, or a fall in taxes or imports.
(b) A fall in government expenditure or exports, or a rise in taxes or imports.
532 Draw a diagram like Figure 19.11, only with just one L curve. Assume that the current level of national
income is at Y1. Now assume that the supply of money decreases. Show the effect on (a) the rate of
interest; (b) the position of the LM curve.
Referring to Figure 19.11, and assuming that L is the only L curve, the decrease in the supply of money is
illustrated by a leftward shift in the Ms curve, causing the equilibrium rate of interest (for any given level of
national income in the right-hand side of the diagram) to rise. The LM curve will thus shift upwards.
533 Assume that national income is initially at Y2 in Figure 19.12. Describe the process whereby equilibrium
in both markets will be achieved.
At Y2 the money market equilibrium is shown by reading up from Y2 to the LM curve. But at this rate of
interest the desired level of savings and investment would generate a national income given by the IS curve,
found by reading across to this curve from this high rate of interest (i.e. a level of Y below Ye). Thus
national income will fall. But as it falls, there will be a movement back down the LM curve (since the fall
in national income generates a lower demand for money). As interest rates fall back, so the equilibrium
national income will stop falling until equilibrium is reached in both markets at re and Ye.
535 (Box 19.5) Going back to point a, show how an expansionary monetary policy (combined with a
contractionary fiscal policy) would allow a higher level of environmentally sustainable national income.
The expansionary monetary policy would shift the LM curve to the right. A contractionary fiscal would
shift the IS curve to the left. The two curves can now intersect further down the EE curve (provided the
fiscal change is of the right amount): i.e. at a higher level of environmentally sustainable national income.
(Box 19.5) 1. What will determine the slope of the EE curve?
The greater the growth in environmental damage resulting from a rise in national income, the steeper will be
the curve. The cleaner capital-intensive techniques are relative to labour-intensive techniques, the
shallower will be the curve.
(Box 19.5) 2. Draw an ISLMEE diagram with the EE curve shallower than the IS curve. Now
illustrate the effect of an expansionary fiscal policy. Given this fiscal expansion, illustrate by a shift in
the LM curve the monetary policy that would be necessary to restore sustainability. Is national income
higher or lower than it was originally?
The IS curve will shift to the right, but this time, to restore equilibrium along the EE curve, the LM curve
would have to shift to the right, through an expansionary monetary policy. Equilibrium would be at a
higher level of national income and a lower interest rate.
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535 On a diagram similar to Figure 19.12, trace through the effects of (a) a fall in investment and (b) a fall
in the money supply. On what does the size of the fall in national income depend?
(a) The IS curve will shift to the left. There will be a resulting fall in the rate of interest and a fall in
national income. The fall in national income will be greater, (i) the flatter the LM curve i.e. the less
the rate of interest has to fall to bring equilibrium in the money market; (ii) the steeper the IS curve
i.e. the less will any fall in the rate of interest help to boost investment again (after its initial fall).
(b) The LM curve will shift to the left. There will be a resulting rise in the rate of interest and fall in
national income. The fall in national income will be greater,(i) the flatter the IS curve i.e. the more
investment is reduced by the rise in interest rates; (ii) the steeper the LM curve i.e. the more
interest rates will have to rise (and hence the more investment and national income will fall) in order
to restore equilibrium in the money market..
536 1. Trace through the effects of a fall in the price level to show how a further point on the AD curve can
be derived.
Starting at point a in the lower diagram, if price falls to a lower level (call it P3), then the demand for
money balances will fall. In the top diagram, the LM curve will shift below LM1. Equilibrium will be at a
level of national income greater than Y1 (call it Y3). Plotting the intersection of P3 and Y3 in the lower
diagram will give another point on the AD curve: this time lower down and to the right of a.
2. Explain what could cause a downward shift in the LM curve and how this would affect the AD curve.
The LM curve would shift downwards if either of the following occurred: (a) an increase in the supply of
money; (b) a fall in the demand for money, other than as a result of a rise in interest rates (this could
occur, for example, if people relied more on credit and less on cash).
The effect of the downward shift in the LM curve is a fall in the real rate of interest and a rise in
national income (see the top diagram in Figure 19.14). The rise in national income causes an increase in
aggregate demand at any given price level: i.e. the AD curve shifts to the right. (Whether the price level
will rise and hence nominal interest rates, will depend on the shape of the AS curve.)
539 Using a graph similar to Figure 19.16, trace through the effect of a reduction in aggregate demand.
ASI
Rate of inflation (P)
Ptarget
P2
a
b
ADI1
ADI2
O
Y3 Y2
Y1
National income
Diagram 19.1 Effect of a reduction in aggregate demand
In the above diagram, the reduction in aggregate demand is shown by a leftward shift in the ADI curve to
ADI2. Assume that Y1 is the sustainable level of national income. If inflation remained at its target level,
national income would initially fall to Y3 (point c). But as firms responded by reducing price increases
below the rate of inflation, equilibrium is reached at point b. The movement along curve ADI2 from point
c to point b is the result of lower interest rates imposed by the central bank in response to inflation falling
below the target level. But point b is below the target rate of inflation. The central bank will thus lower
the target rate of interest to shift the ADI curve back to ADI1, bringing equilibrium back to point a.
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539 1. Trace through the effect of an adverse supply shock, such as a rise in oil prices.
ASI2
ASI1
Rate of inflation (P)
P2
Ptarget
ADI
Y2
Y1
National income
Diagram 19.2 The effect of a temporary fall in aggregate supply
In the above diagram, the adverse supply shock is illustrated by a leftward shift in the ASI curve from
ASI1 to ASI2. Inflation rises above its target level. The central bank thus raises the rate of interest. The
effect is illustrated by a movement along curve ADI from point a to point b. National income falls to Y2.
Since this is only a temporary fall in aggregate supply, the central bank will not raise the target rate of
interest. The ADI curve will not shift. When the aggregate supply shock peters out and the ASI curve
shifts back to ASI1 again, equilibrium will return to point a with inflation at its target rate.
2. What determines the amount that national income fluctuates when there is a temporary shift in the
ASI curve?
The shape of the ADI curve. This depends on the policy of the central bank. The more it is concerned to
maintain its target rate of inflation, the more it will change interest rates in response to any deviation of
the actual rate of inflation from its target and the flatter will be the ADI curve and hence the bigger will
be any change in national income resulting from a shift in the ASI curve. The more it is concerned to
prevent fluctuations in national income, however, the less it will change interest rates in response to shifts
in the ASI curve and hence the steeper will be the ADI curve and hence the more stable will national
income be.
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546 Draw an injections and withdrawals diagram, with a fairly shallow W curve. Mark the equilibrium
level of national income. Now draw a second steeper W curve passing through the same point. This
second W curve would correspond to the case where tax rates were higher. Assuming now that there
has been an increase in injections, draw a second J line above the first. Mark the new equilibrium
level of national income with each of the two W curves. You can see that national income rises less
with the steeper W curve. The higher tax rates are having a dampening effect on the multiplier.
See the following diagram:
W, J
Weconomy 2
Weconomy 1
J2
J1
O
Y0
Y2
Y1
Y
Economies with different marginal rates of taxation
547 (Box 20.1) What effects will government investment expenditure have on public-sector debt (a) in the
short run; (b) in the long run?
(a) Increase. Unless financed by extra taxation, an increase in government expenditure (for whatever
purpose) will lead to an increase in public-sector debt.
(b) Possibly decrease. If the investment leads to extra output and income, then the extra tax revenue from
the extra incomes and expenditure could more than offset the cost of the investment, thereby leading to
a fall in public-sector debt.
548 Show the effect of an increase in government expenditure by using (a) the injections and withdrawals
diagram; (b) the income/expenditure diagram (see Figures 17.8 and 17.10 on pages 477 and 478).
In Figure 17.8, the rise in government expenditure will shift the J line upwards (since government
expenditure is an injection). In Figure 17.19, the rise in government expenditure will shift the E line
upwards. In both diagrams there will be a multiplied rise in national income from Ye1 to Ye2.
Why will the multiplier effect of government transfer payments such as child benefit, pensions and social
security be less than the full multiplier effect given by government expenditure on goods and services.
Will this transfer payments multiplier be the same as the tax multiplier? (Clue: will the recipients of
such benefits have the same mpcd as the average person?)
The transfer payments multiplier will be smaller than the government expenditure multiplier, because part
of transfer payments is not spent on domestic goods: some is saved, some goes in taxes and some is spent on
imports.
The transfer payments multiplier, however, will probably be larger than the tax multiplier. The reason
is that the marginal propensity to save from transfer payments will probably be lower than from incomes.
This is because transfer payments are paid proportionately more to poorer people, who have a low mps.
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550 (Box 20.2) If cuts in interest rates are not successful in causing significant increases in investment,
how can they lead to economic recovery? What, in these circumstances, determines the magnitude of
the recovery?
They can lead to recovery if they cause consumers to borrow more. The increased spending causes a
multiplied rise in national income. The magnitude of the recovery depends on (a) the amount of extra
consumer spending; (b) the size of the multiplier; (c) whether there is any subsequent increase in investment
(through the accelerator effect).
551 How do peoples expectations influence the outcome?
Peoples expectations will reinforce whatever it is they expect. If firms expect a rise in government
expenditure to lead to higher interest rates, a reduction in private-sector investment and hence no expansion
of the economy, they will reduce their investment plans, thus bringing about the effect (i.e. economic
stagnation) that they had anticipated.
Do theories of the long-run and short-run consumption functions help us to understand consumer
reactions to a change in taxes?
If consumption is less responsive to changes in disposable income in the short run than in the long run, then
tax changes will have less effect on consumption (and hence a smaller multiplier effect) in the short run than
in the long run.
552 Give some examples of these random shocks.
Changes in international (and hence national) interest rates; a war in the Middle East and hence a sudden
rise in oil prices; a crisis in Asia or in the US economy, which pushes the world into recession; an
unpredictable rise in industrial disputes; a political crisis at home.
553 (Box 20.3) If tax cuts are largely saved, should an expansionary fiscal policy be confined to increases in
government spending?
Under these conditions, increases in government spending, provided they are direct expenditure on outputgenerating activities, will be more effective than tax cuts in stimulating a recovery.
555 (Box 20.4) 1. Could you drive the car at a steady speed if you knew that all the hills were the same length
and height and if there were a constant 30-second delay on the pedals?
Yes. You would simply push on the accelerator (or brake) 30 seconds before you wanted the effect to occur.
You would do this so that the car would end up braking as you went down hill and accelerating as you went
up hill.
The lesson for fiscal policy is that if forecasting is correct, if you know the precise effects of any fiscal
measures, and if there are no random shocks, then fiscal policy can stabilise the economy.
(Box 20.4) 2. What would a fixed throttle approach to fiscal policy involve?
It could either involve setting targets for the PSNCR or budget deficit (or surplus), which would be stuck to,
irrespective of what happened to the economy. The problem with this is that it would remove any automatic
stabilising effects of fiscal policy.
An alternative is to set targets for the PSNCR or budget deficit (or surplus) that vary with the level of
unemployment, or some other measure of the degree of slack in the economy. Thus the greater the slack, the
bigger would be the target deficit. This would then build in an automatic stabilising element. The more the
economy expanded, and slack was taken up, the more the deficit would be reduced (or surplus increased),
thereby dampening the growth in aggregate demand.
How could long-term monetary growth come about if the government persistently ran a public-sector
surplus (a negative PSNCR)?
See the flow-of-funds equation on pages 50910 of the text for the sources of monetary growth. If the
PSNCR is negative, then this will have a downward effect on money supply, but this may be offset by a
growth from the other sources: e.g. the government buying back debt; banks creating more credit.
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558 (Box 20.5) Give some every-day examples of Goodharts Law.
Using waist measurements as an indicator of a persons fatness. By wearing a corset, this will pull in
the waist, but it will not make the person any lighter! Controlling the waist through a corset makes the
waist measurement a poor indicator of the persons true fatness. [This was the problem with the form
of monetary control used in the 1970s known as the corset: this involved the government setting limits
to bank deposits. But financial institutions got round it by encouraging the expansion of accounts not
covered by the regulations.]
Using exam marks alone as an indicator of a students overall academic ability. The student will swot
up for exams, which will then be a poor indicator of overall ability, and instead will be an indicator of
(a) the persons ability to do exams in that subject and (b) the amount of revision done.
559 If banks operated a rigid 5 per cent cash ratio and the government reduced the supply of cash by 1
million, how much must credit contract? What is the money multiplier?
Assuming that this resulted in 1 million less cash being held in the banking system (i.e. that the proportion
of cash in circulation did not fall), then credit must contract by 19 million, giving an overall reduction in
money supply of 20 million (of which the 1 million cash is 5 per cent). The money multiplier is therefore
20 (i.e. 1/5%).
560 1. Explain how open-market operations could be used to increase the money supply.
The central bank could buy back bonds from the banking system before they reached maturity. The banks
balances in the central bank would be credited, allowing the banks to create more credit.
2. Why would it be difficult for a central bank to predict the precise effect on money supply of openmarket operations?
(a) Banks may vary their liquidity ratio.
(b) It is difficult to predict how much the holding of Treasury bills by the banks will vary, and how much
the banks will take this into account when deciding how much credit to grant.
(Box 20.6) Assume that the Bank of England wants to reduce interest rates. Trace through the process
during the day by which it achieves this.
The Monetary Policy Committee will announce a reduction in the rate of interest. The Bank of England will
then conduct open market operations to back this up. This will entail making more liquidity available to
banks through gilt repos. Assuming that the reduction in the rate of interest was announced the previous
day, then early in the morning the Bank of England will forecast the days shortage of liquidity in the
banking system (at the new lower interest rate) and will offer assistance to banks through repos and
rediscounting in order to meet the shortfall. By making additional assistance available at further points
during the day, the Bank can adjust liquidity as necessary to maintain the rate of interest at the new level.
561 (Box 20.7) In what ways is the Feds operation of monetary policy (a) similar to and (b) different from
the Bank of Englands?
(a) The Fed, like the Bank of England, uses open market operations to influence the money supply and
thereby to make the announced discount rate the equilibrium rate. If the discount rate is raised (just as
when the Monetary Policy Committee of the bank of England raises the rate of interest) then open
market sales of bands and Treasury bills are used to back this up.
(b) Unlike the Bank of England, however, the Fed also from time to time alters the minimum reserve ratio
as a means of influencing bank lending (see last paragraph of the box).
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561 If the Bank of England issues 1 million of extra bonds and buys back 1 million of Treasury bills, will
there automatically be a reduction in credit by a set multiple of 1 million?
No. It depends on the proportion of the 1 million of bills that were held by the banks (since only by
reducing these will there be a reduction in banks liquidity). It also depends on banks willingness to vary
their liquidity ratio. Finally, it depends on banks use of repo and rediscounting facilities available through
the Bank of England (if these are used by the banks as a means of maintaining short-run liquidity, there is
less pressure on them to reduce credit). (See page 567.)
563 (Box 20.8) What are the arguments for and against publishing the minutes of the meetings of the ECBs
Governing Council and Executive Board?
For: The greater transparency and publicity would help to show how focused the ECB was on keeping the
rate of inflation down to the target. It could help to reduce inflationary expectations. It could help to inform
public debate on the direction and efficacy of monetary policy.
Against: Any disagreements could be seen as a weakness and could undermine public and international
confidence in monetary policy and the strength of the euro. It might limit frank debate by the members of
the Council and make the Council more cautious. Secrecy goes against the principles of democratic
accountability.
567 1. Trace through the effects of a squeeze on the monetary base from an initial reduction in cash, to banks
liquidity being restored by the rediscounting of bills. Will this restoration of liquidity by the Bank of
England totally nullify the initial effect of reducing the supply of cash? (Clue: what is likely to happen to
the rate of interest?)
Banks, short of cash, will, in the last resort, acquire money from the Bank of England through gilt repos or
the rediscounting of bills. But the Bank of England will only do this at a penal rate, thereby driving up
interest rates (to its announced level, assuming that it has raised the rate of interest) and thereby reducing
the demand for money, and hence the quantity of credit supplied.
2. Given the difficulties of monetary base control, would you expect M0 and broader measures of the
money supply, such as M4, to rise and fall by the same percentage as each other? Explain.
No. Even if M0 is controlled, if the demand for credit is still high, banks may be prepared to reduce their
cash ratio and allow credit to expand, and with it M4. To reduce their risks of a lower cash ratio, they may
try to encourage customers to switch to time accounts (by increasing the interest rate differential).
568 Is credit rationing easier to implement if banks operate as a cartel or if they are highly competitive?
It is easier if they operate as a cartel. See the last part of Web case 20.6.
569 (Box 20.9) 1. Give some other examples of the impossibility of using one policy instrument to achieve
two policy objectives simultaneously.
Two examples are:
Using changes in personal allowances (on income tax) to boost aggregate demand and to increase
incentives to work. To boost aggregate demand the allowances would have to be raised (thereby
reducing the amount of tax paid). But this will reduce incentives (except for those actually on the
threshold), since there will be an income effect but no substitution effect.
Using the exchange rate both to reduce inflation and to improve the balance of trade. An improvement
in the balance of trade would require a depreciation of the exchange rate, whereas a reduction in
inflation would require an appreciation of the exchange rate (to reduce import prices and thereby
compete down the prices of import substitutes, and to reduce the domestic currency price of exports and
thus put downward pressure on costs in export industries).
(Box 20.9) 2. If the central bank wanted to achieve a lower rate of inflation and also a higher exchange
rate, could it under these circumstances rely simply on the one instrument of interest rates?
A higher interest rate would help both to reduce inflation and push up the exchange rate. The problem is
that the desired magnitude of these effects may require a different sized increase in interest rates. If this
were the case, then again relying on one instrument alone would not be sufficient.
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570 Why does an unstable demand for money make it difficult to control the supply of money?
Because the supply of money depends in part on the demand for money.
571 According to Keynesians, which will have a bigger effect on national income and employment:
(unforeseen) fluctuations in investment or (unforeseen) fluctuations in the money supply?
Fluctuations in investment. These will shift the IS curve, which as Figure 20.9 illustrates, will have a bigger
effect on Y than shifts in the LM curve (caused by fluctuations in the money supply).
575 Would a floating exchange rate have imposed no constraint at all on expansionist policies?
Only from the higher inflation that would have resulted from a depreciating exchange rate.
Answer these points from a monetarist perspective.
Monetarists agreed with the point about flexibility of the exchange rate: this would have made adjustment
more automatic. But they argued that this would make the case for a firm control of the money supply even
more imperative. Monetarists rejected the cost-push explanation of inflation and thus argued that prices and
incomes policies would be at best useless and at worst positively damaging to the supply side of the
economy, by preventing market signals from working.
Monetarists attributed the relative stability of the 1950s and 60s, not to discretionary fiscal policy, but
to the relatively stable monetary environment.
Improved forecasting would be largely irrelevant, given the relative impotence of fiscal policy. It is
better, claimed the monetarists, to stick to monetary rules (see section 20.7).
576 Go through each of the above causes of the stagflation of the 1970s and early 1980s and consider
whether there would have been any policies that the government could realistically have adopted to deal
with each one.
The approach to monetary control:
A tighter monetary policy (say by a greater use of open market operations, or by a more modest
loosening of statutory reserve requirements) would have helped prevent the huge increase in money
supply that fuelled the inflation of the mid-1970s.
Highly reflationary budgets in 1972 and 1973:
A more modest expansion would have helped avoid the later inflationary problems.
The adoption of floating exchange rate:
This need not have created the problem it did if the government had pursued more cautious monetary
and fiscal policies.
Oil prices:
There was little here that governments could do, given the monopoly power of OPEC.
Domestically generated cost-push pressures:
If unemployment is not to rise significantly (from deflationary demand-side policies) the solution to
cost-push pressures must be found in supply-side policies (see Chapter 22), such as industrial policies.
The problem is that policies to improve the supply side of the economy tend to take a time to work.
Increased import penetration and a decline in the UKs share of world exports:
Again, apart from depreciation to retain price competitiveness, the solution to a lack of competitiveness
is to be found in supply-side policies, such as industrial policies (see Chapter 22, section 22.4).
Technological change:
This problem could be eased by improved education and training, and improved job information, so as
to increase labour mobility.
Expectations of inflation:
Clearly, if inflation had not been allowed to rise to such high levels in the first place, expectations
would not have been fuelled to such an extent.
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578 In what way was the stopgo policy of the late 1980s different from the stopgo policies pursued during
the 1950s and 1960s?
The main instrument of this stopgo policy was the rate of interest rather than the Budget.
Will targeting the exchange rate help to reduce inflation? Does it depend on the rate of inflation in the
countries to whose currencies the pound is fixed?
It will help to reduce inflation, if the rate of inflation is lower abroad than at home. The main pressure will
be on the export and import substitute sectors, which will have to reduce their rate of cost increases in order
to remain competitive.
If inflation is higher abroad, then targeting the exchange rate will not reduce domestic inflation:
instead, it will probably increase it. The balance of payments surpluses that will arise from the initial lower
inflation will have the effect of increasing money supply and hence fuelling inflation.
580 If tax increases are phased in as the economy recovers from recession, how will this affect the
magnitude and timing of the recovery?
It would have a similar effect to automatic fiscal stabilisers. It would reduce the rate of growth of aggregate
demand and thus dampen and slow down the recovery. The hope of the government was that this would
make the recovery more sustainable and would create confidence in the financial community that the budget
deficit would be significantly reduced over the longer term. As the budget deficit fell, so the hope was that
this would allow interest rates to fall. The danger, of course, was that the tax increases might totally halt the
fragile recovery.
At lot depended on confidence. The more that investors believed that the policy would help to make the
recovery more sustainable, the more they would invest and, therefore, the more sustained the recovery
would be. On the other hand, if investors believed that the tax increases would kill off the recovery, the less
they would invest, and therefore the more likely the recovery would peter out.
581 1. From 1998 to 2001 the exchange rate of sterling was very high (see Table 15.2 on page 431). This was
largely the result of the MPC keeping interest rates above those in other countries in order to try to keep
inflation down to its 2 per cent target. What are the arguments for and against a discretionary rise in
the inflation target in such circumstances?
It should allow interest rates to be kept at a lower level, thereby preventing or limiting the appreciation of
the exchange rate. The problem concerns confidence. If people believe that the target rate of inflation is not
a firm target, this could raise the expected rate of inflation and thereby push up actual inflation for any given
interest rate. In the extreme case, it could entail interest rates being raised as much to keep inflation to the
higher target as they would have been raised to keep it to the original lower target!
2. Why do ever more rapid financial flows across the world that are unpredictable and uncertain make
Keynesian discretionary fiscal (and monetary policy) less suitable?
Because the interest-rate and exchange-rate effects of fiscal policy changes will cause crowding out (see
Box 19.3 on page 527). Also, the unpredictability of international financial flows makes the effects of fiscal
(and monetary policy) changes less predictable.
582 Would it be desirable for all countries to stick to the same targets?
No. Targets should differ if there are differences in the underlying growth in productivity or in cost-push
pressures. A country with a higher growth in productivity should have a higher target growth in money
supply, for example, if inflation rates are to be kept the same.
If there are shifts in the demand and supply of traded goods, then countries with the same inflation rate
may find their balance of trade is destroyed. In this case, it may be desirable for the country moving into
persistent surplus to have a faster target growth in both money supply and inflation, so as to eliminate the
surplus.
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583 (Box 20.10) Why may there be problems in targeting (a) both inflation and money supply; (b) both
inflation and the exchange rate?
(a) It depends on how consistent the two targets are. If the target for the growth in the money supply is too
lax, then inflation may rise above its target. If, however, the target for the growth in the money supply is
periodically adjusted to make it consistent with the target rate of inflation, then the problem largely
disappears. It is simply then a question of whether the two targets can actually be achieved.
(b) There is much more problem in targeting both the rate of inflation and the rate of exchange. The major,
if not the only, instrument for achieving either target is the rate of interest. If the exchange rate were
above its target and the inflation rate were above its target, then to meet the exchange rate target would
require a cut in the rate of interest, whereas to meet the inflation target would require a rise in the rate
of interest The two are clearly incompatible.
585 (Box 20.11) If people believe that the central bank will be successful in keeping inflation on target,
does it matter which of the above two rules is used? Explain.
In either case, if expected inflation is at the target rate, then, given that the expected rate of inflation is a
major determinant of actual inflation, it will be easier for the central bank to keep inflation on target.
Nevertheless, there are some differences between the two rules in terms of what the central bank will do,
even if people believe that the inflation target will be met.
In the case of the Taylor rule, the course of the business cycle or some random shock may cause
national income to diverge from its sustainable level. In this case, the central bank will alter interest
rates, with the effect of moving inflation off target. Also, inflation may currently be off-target, despite
peoples expectations, because of some supply-side or demand-side shock. In this case, again interest
rates will have to be adjusted.
In the case of the Bank of England rule, forecast inflation takes into account not only peoples future
beliefs about inflation, but also any likely changes to aggregate demand or supply that could affect
inflation. These may be different from the current changes to demand or supply taken into account by the
Taylor rule.
586 Under what circumstances would adherence to money supply targets lead to (a) more stable interest
rates; (b) less stable interest rates than pursuing discretionary demand management policy?
(a) If, in the absence of intervention, the demand for money were stable, and if discretionary fiscal policy
involved having to make substantial changes to aggregate demand and hence to the transactions
demand for money, or if discretionary monetary policy involved changing interest rates to achieve
changes in aggregate demand.
(b) If the demand for money, in the absence of intervention, was unstable (and hence a constant money
supply would entail large changes in interest rates), and if discretionary policy had the effect of
expanding aggregate demand when interest rates were falling (thus helping to arrest the fall) and
reducing aggregate demand (or its rate of growth) when interest rates were rising (thus helping to arrest
the rise).
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589 1. In the extreme Keynesian model, is there any point in supply-side policies?
Yes. Successful supply-side policies, by increasing potential output, will shift the vertical portion of the AS
curve to the right. As a result, expansionary demand management policies could now increase output to a
higher level than before.
2. In the new classical model, is there any point in using supply-side policies as a weapon against
inflation?
No. Demand-side policy must be used to control inflation (which for a monetarist means monetary policy).
Supply-side policy will be the policy to use to reduce unemployment. If successful, it will shift the
(vertical) AS curve to the right, and shift the (vertical) Phillips curve to the left by reducing the equilibrium
level of unemployment. [These issues are explored throughout this chapter.]
590 Under what circumstances would this interdependence of firms give a vertical long-run AS curve?
When costs rise by the same percentage as the increase in demand. This will occur at full employment
(which under classical assumptions of perfectly flexible wages and prices will be the case anyway). At full
employment, a rise in aggregate demand could not allow an increase in total output in the economy. An
individual firm could only expand its output by attracting labour and other resources away from other firms.
But when all firms try to do this, the effect will be for wages and prices to rise by the same percentage as
the increase in demand, leaving real aggregate demand unaffected. Aggregate supply will not have
changed. The long-run curve is vertical.
The same effect could occur at less than full employment if individual firms decided to raise their prices
in response to an increase in demand rather than increasing output, even if they had the spare capacity to do
so. Firms may not be rational profit maximisers.
591 1. Will the shape of the long-run AS curve here depend on just how the long run is defined?
If the long run is defined so as to include the possibility of technological change (strictly speaking this
would be defined as the very long run: see page 132 of the text), then if this technological change is the
result of investment, which in turn had resulted from the increased aggregate demand, the (very) long-run
aggregate supply curve will be relatively elastic.
2. If a shift in the aggregate demand curve from AD to AD1 in Figure 21.5 causes a movement from point
a to point d in the long run, would a shift in aggregate demand from AD1 to AD cause a movement from
point d back to point a in the long run?
Yes, if there were disinvestment as the result of the fall in aggregate demand, and if there had been no
technological progress as a result of the previous shift from AD to AD1. If, however, earlier investment had
led to new more productive plant and machinery being used, then a fall in aggregate demand will lead to the
older, less efficient plant and machinery being scrapped. The result will be that the eventual equilibrium
will be below point a.
592 Assume that there is a fall in aggregate demand (for goods). Trace through the short-run and long-run
effect on employment.
Prices fall. This causes the real wage to rise above We in Figure 21.6. At this real wage rate there is a
deficiency of demand for labour. In the short run there will be an increase in unemployment. In the long
run the deficiency of demand will drive down the money wage rate until the real wage rate has returned to
We.
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594 (Box 21.1) Give some examples of single shocks and continuing changes on the demand side. Does the
existence of multiplier and accelerator effects make the distinction between single shocks and continuing
effects more difficult to make on the demand side than on the supply side?
Examples of single shocks include government expenditure on a specific project, a surge in consumer
spending in anticipation of a rise in taxes and a temporary movement in the exchange rate (a depreciation
causing a rise in aggregate demand through increased exports and decreased imports, and an appreciation
causing a fall in aggregate demand). Examples of continuing changes include a sustained increase in
consumer or business confidence, which builds over time, and changes in interest rates that then remain for
a period of time.
The multiplier and accelerator will amplify single shocks on the demand side and the process will last
for several months. Aggregate demand will not go on and on rising, however, unless there are continuing
changes on the demand side, which then continue to be amplified by the multiplier and accelerator. Thus the
effects are somewhat less clear cut than with changes on the supply side, but it is still possible to distinguish
between single shocks on the demand side and continuing changes (even if the single shocks do cause
multiplier and accelerator effects).
If point g is vertically above point a does this mean that the long-run AS curve is vertical? Are there any
circumstances where point g might be to the left of point a?
If point g is vertically above point a, it does not necessarily follow that the long-run AS curve is vertical. It
would only follow if the upward shifts in the (short-run) AS curves had been entirely due to the increased
aggregate demand feeding through into higher costs.
If the AS curves had shifted upwards partly as a result of cost-push pressures (i.e. cost pressures
independent of aggregate demand), then point g could still be vertically above point a (i.e. if the long-run
AS curve were upward sloping and had shifted upwards). With an upward-sloping long-run AS curve, if
there had been no such cost-push pressures, g would be to the right of a.
Alternatively, if cost-push pressures had been great enough, point g could be to the left of point a.
597 Construct a table like Table 21.1, only this time assume
that the government wishes to reduce unemployment to 5
per cent. Assume that every year from year 1 onwards
the government is prepared to expand aggregate demand
by whatever it takes to do this. If this expansion of
demand gives f(1/U) = 7 per cent, fill in the table for the
first six years. Do you think that after a couple of years
people might begin to base their expectations differently?
After a couple of years, people will realise that inflation is
continuing to rise. They will therefore expect this years
inflation to be higher than last years, not the same.
Rising inflation
P e
21
14
28
21
35
28
42
35
14
Year
f(1/U)
598 (Box 21.2) Under what circumstances will term a in equation (4) be large relative to terms b, c, etc?
The more quickly expectations adjust, and hence the greater the weighting attached to last years inflation
compared with previous years.
What will determine the speed at which inflation accelerates?
The amount by which unemployment is kept below the natural level (a process which is determined by the
level of excess demand). The more that unemployment is kept below the natural level, the higher will be the
value of f(1/U), and thus the more will inflation accelerate. (Compare the table above where f(1/U) = 7,
with Table 21.1 in the text, where f(1/U) = 4.)
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598 Construct a table like Table 21.1, only this time assume
that in year 1 the economy is in recession with high
unemployment, but also high inflation due to high
inflationary expectations (which have resulted from past
excess demand). Assume that in year 1, P = 30 per
cent, f(1/U) = 6 per cent an Pe = 36 per cent. Continue
the table for as many years as it takes for inflation to be
squeezed out of the economy (assuming that the
government keeps aggregate demand at a low enough
level to maintain f(1/U) = 6 per cent throughout).
See table opposite
125
Falling Inflation
Year
f(1/U)
P e
30
36
24
30
18
24
12
18
12
599 Under what circumstances would a Phillips loop (a) be tall and thin; (b) short and wide?
(a) When the government pursues mild reflationary or deflationary policies for a long time. The mild
policies will involve only a small divergence of unemployment from the natural level (and hence the
loop will be thin). The persistence of reflationary policies will cause inflation to go on rising for a long
time (and hence the loop will be tall).
(b) When the government pursues strongly reflationary policies followed by strongly deflationary policies,
but for only a short time. The strong policies will cause a large divergence of unemployment from the
natural level (and hence the loop will be wide). The short length of the policies will cause the loop to
be short.
600 (Box 21.3) 1. Why might a government sometimes get it wrong and find itself at the wrong part of the
Phillips loop at the time of an election?
Because it has imperfect information on (a) current expectations and trends in unemployment and inflation;
(b) the time lags before the policys full effect on aggregate demand is felt; (c) just how expectations will be
affected by its policies.
(Box 21.3) 2. Which electoral system would most favour a government being re-elected: the US fixed
term system with presidents being elected every four years, or the UK system where the government can
choose to hold an election any time within five years of the last one?
The UK system. This gives a government more flexibility to ensure that the economy is at the politically
best point of the trade cycle at the time of the election.
603 Show these effects of an increase in aggregate demand from both the adaptive expectations and rational
expectations points of view, only this time show the effects on Phillips curves.
Refer to Figure 21.12 on page 596. Let us assume that the effect of the increase in aggregate demand is
eventually to raise inflation from 0 to 4 per cent.
In the adaptive expectations model, there will initially be a move from point a to b. Then as price
expectations increase towards 4 per cent, so the short-run Phillips curve will shift upwards towards curve II:
the economy will move towards point c. The short-run curve is downward sloping; the long-run curve is
vertical (through points a and c).
In the rational expectations model, although curve I still represents the relationship between inflation
and unemployment if expectations are of zero inflation, the moment the economy moves away from point a
expectations will adjust. Assuming that expectations are correct, the economy will move immediately to
point c. Thus in the rational expectations model, not only the long-run but also the short-run curve is
vertical through point a.
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604 (Box 21.5) Under what circumstances might weather forecasters have a tendency to err on the side of
pessimism or optimism? If you knew this tendency, how would this affect your decisions about picnics,
hanging out the washing or watering the garden?
If they are more likely to be criticised for failing to forecast bad news than for failing to forecast good news,
they are likely to give pessimistic forecasts. Thus during a wet Summer, when everyone is longing to go on
picnics, the weather forecasters may be cautious about forecasting a fine day in case it does rain, and then
there would be a lot of cross picnickers. Another example is when they see a storm coming. They are likely
to err on the side of overestimating possible wind strengths to prevent people complaining afterwards that
they had not been adequately warned.
Thus you may be justified in assuming it will be dry for your picnic or hanging out your washing, even
if the forecast is that there is a chance of a shower, but you may be wise to water the garden. On the other
hand, if there has been a drought, and the forecasters, seeing a rain-bearing front approaching the country
warn that some parts of the country may nevertheless remain dry, you may be justified in not watering
your garden. The assumption here is that the weather forecasters have understated the chance of rain,
because they do not want to incur the wrath of gardeners and farmers who would be disappointed to have
had their hopes dashed if rain amounts turn out to be small or non-existent.
605 Should the government therefore simply give up as far as curing unemployment is concerned?
Unless the government believes that it can go on fooling people, it might as well give up using demand-side
policies to try to reduce unemployment below the natural level (see Box 21.6). This does not mean,
however, that there is no way to reduce unemployment. It can use supply-side policies to reduce the natural
level of unemployment and shift the vertical Phillips curve to the left.
1. If the government announced that it would, come what may, reduce the growth of money supply to zero
next year, what (according to new classical economists) would happen? How might their answer be
criticised?
Provided people believed that the government actually would reduce the growth in money supply to zero,
and that as a result of this and also of increased output, the level of prices would fall, then people would
expect a negative inflation. The result would be that prices would fall, provided they were not sticky
downwards.
Even if people did believe that the government would reduce money supply growth to zero, (money)
wages and prices may be sticky downwards, and as a result prices may not fall.
2. For what reasons would a new classical economist support the policy of the Bank of England
publishing its inflation forecasts and the minutes of the deliberations of the Monetary Policy Committee?
Because it reduces unanticipated changes in aggregate demand and thus reduces deviations of
unemployment and output from the natural level. The increased confidence will then strengthen the supply
side of the economy as the greater certainty encourages more investment and hence an increase in potential
and actual output.
606 (Box 21.6) Does this parable support the adaptive or the rational expectations hypothesis?
Both. It supports the adaptive expectations hypothesis to the extent that people adapt their forecasts
according to the amount by which they under- or over-predicted inflation. If the government keeps on
boosting aggregate demand, people will see the resulting upward trend in inflation and will adapt their
expectations to it.
It supports the rational expectations hypothesis to the extent that people refine the model on which
they base their forecasts. If their initial model is to believe what the government says, and that a rise in
aggregate demand will have little effect on inflation, then they are likely to change their model, when they
see that the government had fooled them.
(Note that when we talk about adaptive expectations, we are talking about the expectations being
adapted, not the theories on which they are based. Adapting theories is an example of rational
expectations.)
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606 Assume that there are two shocks. The first causes aggregate supply to shift to the left. The second,
occurring several months later, has the opposite effect on aggregate supply. Show that if both these
effects persist over a period of time, but gradually fade away, the economy will experience a recession
which will bottom out and be followed in smooth succession by a recovery.
A fall (leftward shift) in aggregate supply in the new classical model will reduce output and hence cause a
recession. If the shock pushing the AS curve to the left persists for a period of time, then the recession will
deepen as aggregate supply falls, but less and less quickly as the effect fades away. If the second shock has
a rightward pushing effect on the AS curve, then, as the first effect fades away, the second effect will
become relatively stronger. Output will begin to rise again and gather pace as the first effect disappears.
Whether output will continue falling initially after the appearance of the second effect depends on the
relative size of the two effects at that particular stage.
608 1. What effect will these developments have had on (a) the Phillips curve; (b) the aggregate supply
curve?
(a) It will have shifted to the right.
(b) It will have shifted to the right less quickly than if labour had been more mobile.
2. What policy implications follow from these arguments?
Interventionist supply-side policies are required, such as regional policy or industrial policy (e.g.
government encouragement of training or research and development). [Interventionist supply-side policies
are examined in Chapter 22 sections 22.4 and 22.5.]
609 Would it in theory be possible for this long-run Phillips curve to be horizontal or even upward sloping
over part of its length?
Yes, if the effects described in the two bullet points an the bottom of page 609 are strong enough to
completely offset the upward pressure on costs from the increased aggregate demand.
610 Why is it important in the Keynesian analysis for there to be a steady expansion of demand?
To create a climate of confidence and certainty so as to encourage investment.
611 1. If constant criticism of governments in the media makes people highly cynical about any governments
ability to manage the economy, what effect will this have on the performance of the economy?
It will become less manageable! It may become less stable and as a result investment and growth may be
lower and inflation higher. The worse people believe the long-term economic prospects are for the country,
the more pessimistic they are likely to become, and thus the worse is likely to be the actual performance of
the economy.
2. Suppose that, as part of the national curriculum, everyone in the country had to study economics up to
the age of 16. Suppose also that the reporting of economic news by the media became more thorough
(and interesting!). What effects would these developments have on the governments ability to manage
the economy? How would your answer differ if you were a Keynesian from if you were a new classicist?
Peoples predictions would become more accurate (at least thats what teachers of economics would
probably hope!). Thus the government would be less able to fool people. In the new classical world there
would be less shifting of the short-run vertical Phillips curve. The government would find it even more
useless to try to reduce unemployment by demand-side policy. On the other hand a tight monetary policy
would be more likely to reduce inflation very rapidly.
In the Keynesian world, correctly executed demand management policy would be seen to be so. This
would create a climate of confidence which would help to encourage stable growth and investment. On the
other hand, poorly executed government policy would again be seen to be so. This could cause a crisis of
confidence, a fall in investment and a rise in unemployment and/or inflation.
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616 What would be the rate of economic growth if 20 per cent of national income were saved and invested
and the marginal efficiency of capital were 2/5?
Given the formula: g = i MEC, the rate of economic growth will be:
20% 2/5
= 8%
617 If there were a gradual increase in the saving rate over time, would this lead to sustained economic
growth?
Yes, but the rate of economic growth would gradually slow down, given that the Y curve gets less and less
steep. If, however, the extra saving were invested in research and development, with the result that the Y
curve shifted upwards, this would allow a higher output to result from the extra saving and hence a faster
rate of economic growth as saving increased over time.
If this is true, why do people not increase their rate of saving?
Because people generally have a preference for spending their money sooner rather than later. Saving
entails sacrificing present consumption for future consumption, and the cost of waiting has to be offset
against any increased consumption (from earning interest) in the future.
618 1. If there were a higher participation rate and GDP per capita rose, would output per worker also have
risen?
Not necessarily. GDP per capita will still rise if a greater proportion of the population work and there is the
same output per worker.
2. If people worked longer hours and, as a result, GDP per capita rose, how would you assess whether
the country was better off?
The country would be better off if the benefits from the extra consumption exceeded the costs of working
more. Calculating such costs and benefits is fraught with difficulties, however. For example, just because
people do work longer hours, it cannot be assumed that for them the benefits outweigh the costs: the may
have little choice over the number of hours worked, and even if they did, they may not realise the full costs
to them (in terms of lost leisure opportunities, diminished family and social interactions and possibly poorer
health). Also, some of the costs and benefits are external to the people working the longer hours (e.g. costs
and benefits to other family members), and thus may well not be fully taken into account.
619 (Box 22.1) Identify some policies that a government could pursue to stimulate productivity growth
through each of the above means.
Giving firms grants and/or tax relief for investment; reducing delays in hearing planning applications.
Putting more public money into education, training, R & D and infrastructure; better auditing to ensure
that such money is used efficiently.
Reducing barriers to trade and outlawing various anti-competitive practices (see Chapter 12, section 3).
Many of the supply-side policies that are considered in sections 3, 4 and 5 of the current chapter are
designed to increase productivity.
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619 (Box 22.1) In the November 1998 pre- Budget Report it was stated that US consumers pay less than
those in the UK for a significant range of products. For example, figures from the OECD show, adjusting
for movements in exchange rates, British prices are higher than in the US by an average of: 58 per cent
for furniture and carpets; 54 per cent for hotels and restaurants; 29 per cent for cars. Can productivity
differences explain price differences?
Prices depend on both demand and costs. Thus price differences between two countries may be partly a
reflection of cost differences, which in turn are largely a reflection of differences in productivity (see the
figure in this box), but they may also reflect differences in market power. For example, higher car prices in
the UK than in many other countries have been attributed to the market power of manufacturers and their
retail dealers (see Box 12.5 on page 346).
621 Why do Keynesians argue that, even in the long run, demand-side policies will be still be required if
faster growth in aggregate supply is to be achieved?
A faster growth in aggregate supply will require higher investment (especially in new technology and other
productivity-increasing areas). A stable economy with an avoidance of recessions will encourage higher
investment. Also, when increases in aggregate supply do occur, they will still need to be matched by
increases in aggregate demand if a deflationary gap is not to be opened up.
622 Does this mean that Keynesians would advocate using supply-side policies only at times of full
employment?
No. There is a case for using supply-side policies all the time to try to increase potential output in the
economy, and at the same time to use demand-side policies to ensure that potential output is translated into
actual output.
624 Why might a recovering economy (and hence a fall in government expenditure on social security
benefits) make the government feel even more concerned to make discretionary cuts in government
expenditure?
To prevent money supply and the economy from expanding too rapidly. The automatic stabilising effects of
the cuts in social security benefits and the rise in tax revenues may be insufficient.
625 What would happen to the ASL curve and the level of unemployment if unemployment benefits were
increased?
If the gap between benefits and wage rates narrowed, workers would be less inclined to take jobs offered.
The ASL curve would be likely to move to the left and equilibrium unemployment would increase.
Does this mean, therefore, that there were no positive incentive effects from the Conservative
governments tax measures?
It depends on the relative size of the income and substitution effects of the tax changes, which, as Chapter
10 explained (see pages 2735 and Box 10.5), will vary according to the type of tax change.
It also depends on the degree of money illusion. If people are given an income tax cut, this might act as
an incentive, even if VAT has gone up so as to keep the amount they can purchase the same as before. They
may believe that they are better off because their take home pay has gone up in money terms (even though
in real terms there is no change in their income).
626 Is the number of working days lost through disputes a good indication of (a) union power; (b) union
militancy?
It is a moderately good indicator. It is not perfect, however, because (a) there are other ways in which
unions can take industrial action that do not involve days lost, and (b) days lost are also a reflection of
employers power and militancy (in resisting union demands or in forcing through measures unpopular with
the workforce).
Also there is a problem of separating power and militancy. Power may be better measured by the
percentage of the workforce unionised, the state of union finances, government legislation, etc.
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627 Would a cut in benefits affect the Wo curve? If so, with what effect?
The curve may start at a lower point on the vertical axis (but rise to the same level eventually). The reason
is that, employers, now hopeful of finding suitable workers at a lower wage, reduce the wages they offer. If
unsuccessful, however, they will eventually be prepared to offer the same as before, since this is governed
by the firms demand and cost conditions.
628 (Box 22.3) 1. Under what circumstances would it be wise for a bus company to put up fares when faced
by falling numbers of passengers? Would deregulation make any difference to this decision?
It would not normally make sense to put up fares in these circumstances. If the company is a profit
maximiser, then a shift in the demand curve to the left will lead to the maximum (albeit lower) profit now
being achieved at a lower price. (Try drawing it.) If, however, it was not a profit maximiser, but instead
was concerned to provide a public service at a price that would allow it merely to achieve some minimum
level of profit, and if demand were price inelastic, then raising its price might be necessary to restore this
minimum profit (see Box 2.4 on page 51).
If after deregulation companies were in genuine competition with each other (and mot merely
colluding), then, facing a more elastic demand, they would be even less likely to raise prices, but more
likely to be forced to close down.
(Box 22.3) 2. Does the introduction of mini-buses affect the case for or against deregulation?
By reducing fixed costs per bus, they have made certain routes viable that were not before.
Mini-buses reduce the minimum efficient scale of operation (i.e. the minimum efficient numbers of
passengers). They therefore reduce the probability of any one route being a natural monopoly and thus on
many routes they would encourage competition if the market were deregulated. They therefore increase the
case for deregulation.
Even where routes would remain natural monopolies, the market is likely to become more contestable
(see Chapter 6, section 6.4) because of the reduced costs of operating a fleet of mini-buses. This again
strengthens the argument for deregulation.
629 If supply-side measures led to a shake out of labour and a resulting reduction in overstaffing, but also to
a rightward shift in the Phillips curve, would you judge the policy as a success?
Clearly there are costs and benefits. The benefits are an increase in efficiency and an increase in potential
output in the economy. The costs are the increase in unemployment and the wastes associated with it. An
important question is whether the government (or the market) can eventually reduce the equilibrium level of
unemployment again, and thereby shift the Phillips curve back to the left. This could be done, for example,
by policies of retraining and improved information on job opportunities.
631 (Box 22.4) 1. Governments and educationalists generally regard it as desirable that trainees acquire
transferable skills. Why may many employers disagree?
Employers will probably want their trainees to acquire skills that allow them to be used flexibly within the
organisation, but will not want such skills to make them a target for other employers. Clearly, in many
instances it is impossible to meet both objectives simultaneously. The better the skills acquired, the greater
will be the workers chances of gaining a good job elsewhere.
(Box 22.4) 2. There are externalities (benefits) when employers provide training. What externalities are
there from the undergoing of training by the individual? Do they imply that individuals will choose to
receive more or less than the socially optimal amount of training?
Let us assume that the individual has the choice whether or not to be trained (or at least knows when
accepting the job that it includes training). To the extent that training benefits people other than the trainee,
there will be external benefits. Such benefits might include, for example, the worker sharing newly
acquired skills with colleagues. In such circumstances, the individual will choose to have less than the
optimal amount of training. (Note that this is a separate issue from the amount of training provided. This
depends on the private costs and benefits to the employer.)
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632 How would the radical right reply to these arguments?
They would argue that external benefits from investment and training are relatively small and can best be
internalised by tax concessions rather than by direct government provision.
They would claim that problems of monopoly are relatively small or even virtually non-existent
because many markets, although monopolistic or oligopolistic are nevertheless highly contestable,
especially given the open nature of the UK economy. Where such problems do exist, then they are best
overcome by policies to encourage competition (such as deregulation). Imperfections in the capital market
are again relatively small given the deregulation that has already taken place, and given increasing
international competition.
As far as bailing out lame ducks because of the external costs of job losses, radical right economists
would argue that the social costs would be much higher of constantly coming to the rescue of inefficient
firms. It would simply encourage them to remain inefficient and would destroy jobs for the future because
of a lack of competitiveness.
633 What instruments might a government use to persuade firms to abide by a national plan? What are
their advantages and disadvantages?
Incentives such as tax concessions, subsidies, government contracts, the provision of free information on
market conditions, etc. Penalties such as the withdrawal of government contracts, fines, the denial of
planning permission.
Incentives would create less resentment amongst industrialists than penalties. More market-orientated
instruments, such as tax concessions, would be less distortionary than instruments such as the denial of
planning permission. The government is essentially trying to secure a partnership with industry, and thus it
has to be careful that incentives and penalties do not alienate industry and destroy a co-operative spirit.
(Box 22.5) 1. In what senses could these new policies be described as (a) non-interventionist; (b)
interventionist?
They are non-interventionist to the extent that they involve market liberalisation (e.g. by reducing the power
of trade unions and developing more flexible labour markets: see Box 9.9 on page 236). They are also
generally less targeted at specific industries. They are interventionist to the extent that they concentrate on
improving infrastructure and state education.
(Box 22.5) 2. Does globalisation, and in particular the global perspective of multinational corporations,
make industrial policy in the form of selective subsidies and tax relief more or less likely?
It tends to make it more likely to the extent that countries compete with each other to attract multinational
investment. This is a problem recognised by international bodies, such as the World Trade Organisation (see
Chapter 23, section 2), which seeks to achieve international agreements to ban countries using unfair
trading practices. It tends to make it less likely to the extent that countries focus on improving their overall
competitiveness by pursuing market liberalisation policies and policies to improve infrastructure.
635 (Box 22.6) Are these reforms consistent with a third way philosophy?
Yes. They focus on giving people incentives to help themselves. The idea is to reduce the degree of
dependence of people on the state while providing routes for people to progress out of poverty (i.e. by
reducing various forms of poverty trap).
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636 Provide a critique of these arguments.
Taking each of the arguments in turn:
Subsidies, tax concessions, etc., need only be granted when firms do agree to new investment. They
need not be granted to firms which merely continue with old inefficient practices, who could thus still
be faced with the rigours of the market.
There need be no guarantee to rescue lame ducks. Very few lame ducks were in fact rescued in the
1960s and 1970s.
To argue that government aid might be used for extravagant projects does not necessarily imply that the
government should not give aid. A closer scrutiny of requests for government aid would be an
alternative answer to this problem.
The point is whether market opportunities have been sufficiently good to warrant non-intervention. If
there is a low potential return on investment, government aid may indeed be warranted. The problem of
poor market opportunities could be made worse by a non-interventionist approach, especially at a
macroeconomic level, where an over-reliance on monetarist policies could lead to severe short-term
fluctuations in interest rates and a resulting lack of business confidence.
Low investment could have been the result of too little intervention not too much. It could also have
been due to the particular type of intervention: i.e. too much support for ailing industries and not
enough support for industries with growth potential.
Even if reducing the tax burden did increase investment (and there is little evidence to suggest this),
there would still be the problem of the failure of the market to provide an optimum distribution of
investment at a micro level, given the substantial external costs and benefits involved (e.g. from
research and development and from training).
638 1. Think of some other pro-market solutions to the regional problem.
Two examples are:
Reductions in planning restrictions in the less prosperous areas.
Adjusting unemployment and social security benefits to an areas cost of living. Thus if the cost of
living were lower in the less prosperous regions, there would be a reduction in unemployment and
social security benefits in those regions. This would shift the Wa curve downwards in Figure 22.15
(page 627), and reduce the regions level of equilibrium unemployment.
2. Do workers in the less prosperous areas benefit from pro-market solutions?
Those currently in work lose from lower wages. Those out of work lose if their benefits are reduced. There
are gains, however, for those who now find a job, especially capital is relatively mobile into the area and
therefore there has not been a need to have a significant cut in wage rates.
If a Japanese car manufacturer were attracted into an unemployment blackspot and opened up a highly
capital-intensive robot-line car assembly plant, in what other local industries might employment be
stimulated?
Construction industry (during initial construction phase) and firms supplying services such as transport,
cleaning and building maintenance, Provided the company did employ some local residents, then their
expenditure will help to stimulate the local economy (shops, transport, entertainment, etc.). Clearly, though,
there will be less effect here than with a more labour-intensive factory.
639 1. If you were the government, how would you set about deciding the rate of subsidy to pay a firm
thinking of moving to a less prosperous area?
If the purpose were to provide jobs, then the government should estimate the costs of providing additional
jobs, and raise the subsidy to such a level where the marginal cost of providing one more job was felt to be
worth the benefit of so doing. The problem, of course, is in estimating the number of jobs that will result,
both directly and indirectly through multiplier effects, and also the difficulty in estimating the marginal
social benefit of providing extra jobs. This will involve value judgements about the personal benefits to the
workers involved. There is also the problem of ensuring that the subsidies are used as efficiently as
possible, and not simply used to subsidise capital-intensive industries that provide few jobs.
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639 2. Should firms already located in less prosperous areas be paid a subsidy?
If the sole purpose is to provide employment, then the answer is no, unless there is a danger of a firm
closing down or making workers redundant if it is not paid a subsidy (which might well be the case if a firm
were in direct competition with one of the new firms moving into the area).
641 (Box 22.7) 1. With 12 countries using the euro, how is the common currency likely to affect the
distribution of income among the EU countries?
With a common currency, the individual EU-11 countries are like regions of a large country. The extent to
which inequalities will persist depends to a large extent on the degree of flexibility of prices and wage rates
and the mobility of labour and capital. If prices and wage rates are relatively inflexible and labour and
capital are relatively immobile, then, without the devaluation option, countries which are less competitive
and have a lower stock of capital will find that they are unable to attract investment: inequality will widen.
With flexible prices and wage rates and with a relatively high mobility of labour and capital, however, a
single currency will encourage greater equality via the attraction of investment to regions where wage rates
are relatively low.
(Box 22.7) 2. What obstacles lie in the way of a growing convergence in output per head in the EU
countries?
Immobility of labour (and, to a lesser extent, capital); differences in infrastructure; transport costs, given
differences in the distance from the centre of gravity of markets; a limited budget for regional policy.
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648 Why does the USA not specialise as much as General Motors or Texaco? Why does the UK not
specialise as much as ICI? Is the answer to these questions similar to the answer to the questions, Why
does the USA not specialise as much as Luxembourg?, and Why does ICI or Unilever not specialise as
much as the local butcher?
There are two elements to the answer. One concerns costs, one concerns demand and revenue.
In terms of costs, as a firm or country specialises and increases production, so the opportunity costs of
production are likely to fall at first, due to economies of scale, and then rise as resources become
increasingly scarce. The butchers shop may not have reached the point of rising long-run opportunity
costs. Also it is too small to push up the price of inputs as it increases its production. It is a price taker. ICI
and Texaco, however, probably will have reached the point of rising opportunity costs. Countries certainly
would have if they specialised in only one product. Thus the larger the organisation or country, the more
diversified they are likely to be.
Turning to the demand side: the butchers shop supplies a relatively small market and faces a relatively
elastic demand. It is therefore likely to find that complete specialisation in just one type of product is
unlikely to lead to market saturation and a highly depressed price. Large companies, however, may find that
complete specialisation in one product restricts their ability to expand. The market simply is not big
enough. Countries would certainly find this. The USA could hardly just produce one product! The world
market would be no where near big enough for it. The general point is that overspecialisation would push
the price of the product down and reduce profits.
649 (Box 23.1) If Pat took two minutes to milk the sheep and Tarquin took six, how could it ever be more
efficient for Tarquin to do it?
Because Tarquin might take more than three times longer than Pat to do other jobs, and thus Tarquin would
have a comparative advantage in milking the sheep.
Draw up a similar table to Table 23.1, only this time assume that the figures are: LDC 6 wheat or 2 cloth;
DC 8 wheat or 20 cloth. What are the opportunity cost ratios now?
The opportunity cost of wheat in terms of cloth is 2/6 in the LDC and 20/8 in the DC (i.e. 7.5 times higher
in the DC).
The opportunity cost of cloth in terms of wheat is 6/2 in the LDC and 8/20 in the DC (i.e. 7.5 times higher
in the LDC).
650 (Box 23.2) In Ricardos example, what is the opportunity cost of wine in terms of cloth in (a) Portugal;
(b) England? (Assume that the only costs are labour costs.)
(a) 90/90 = 1; (b) 120/100 = 1.2
1. Show how each country could gain from trade if the LDC could produce (before trade) 3 wheat for 1
cloth and the developed country could produce (before trade) 2 wheat for 5 cloth, and if the exchange
ratio (with trade) was 1 wheat for 2 cloth. Would they both still gain if the exchange ratio was (a) 1
wheat for 1 cloth; (b) 1 wheat for 3 cloth?
The LDC still gains by exporting wheat and importing cloth. At an exchange ratio of 1:2, it now only has to
give up 1 kilo of wheat to obtain 2 metres of cloth, whereas without trade it would have to give up 3 kilos of
wheat to obtain just 1 metre of cloth. The developed country still gains by importing wheat and exporting
cloth. At an exchange ratio of 1:2, it can now import 1 kilo of wheat for only 2 metres of cloth, whereas
without trade it would have to give up 5 metres of cloth for 2 of wheat (i.e. 2 of cloth for 1 of wheat).
(a) Yes. (This ratio is between their two pre-trade ratios.)
(b) No. The LDC would gain, but the DC would lose. It would now have to give 3 metres of cloth for 1
kilo of wheat, whereas before trade it only had to give 2 metres of cloth for 1 kilo of wheat. Thus the
developed country would choose not to trade at this ratio.
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650 2. In question 1, which country gained the most from a trade exchange ratio of 1 wheat for 2 cloth?
The LDC. The opportunity cost of its import (cloth) has fallen much more than that of the developed
country.
652 (Box 23.3) Under what circumstances would a gain in revenues by exporting firms not lead to an
increase in wage rates?
When there is such surplus labour (e.g. through high unemployment or the firms being legally required to
pay minimum wages) that an increase in demand for labour will not bid up the wage rate. At least,
however, unemployment will probably fall, unless new workers flood in from the countryside to take
advantage of new jobs created in the towns.
1. If the opportunity cost ratio of wheat for cloth is 1/2 in the LDC, why is the slope of the production
possibility curve 2/1? Is the slope of the production possibility curve always the reciprocal of the
opportunity cost ratio.
Because if the cost of a unit of wheat is only unit of cloth, then 2 units of wheat can be produced for
every one unit of cloth. The slope of the production possibility curve is thus always the reciprocal of the
opportunity cost ratio of the good measured on the vertical axis.
2. Show (graphically) that, if the (pre-trade) opportunity cost ratios of the two countries were the same,
there would be no gain from trade assuming that the production possibility curves were straight lines
and did not shift as a result of trade.
The two blue lines in Figure 23.1 (a) and (b) respectively, would have the same slope. Given that the slope
of the lines after trade will shift until they are the same in both countries, the lines will not shift, since they
already have the same slope. Thus consumption cannot take place beyond the production possibility curve.
653 1. If 4x exchange for 3m what are the terms of trade?
3/4
2. If the terms of trade are 3, how many units of the imported good could I buy for the money earned by
the sale of 1 unit of the exported good? What is the exchange ratio?
If Px/Pm = 3/1, then 3 units of imports can be purchased with the money earned by the sale of 1 unit of the
exports. The exchange ratio is 1x:3m.
654 Draw a similar diagram to Figure 23.2 showing how the price of an individual good imported into
country A is determined.
The diagrams would be the same as Figure 23.2, only the left-hand diagram would represent the rest of the
world and the right-hand one would represent country A.
Why will exporters probably welcome a deterioration in the terms of trade?
Because a fall in the price of exports relative to imports would probably be the result of a depreciation in
the exchange rate. This would mean that exporters could now reduce the foreign exchange price of their
exports and hence sell more, without reducing their price in domestic currency. They would therefore end
up earning more. (These issues are explored in the next chapter, section 24.1.)
655 1. If production was at point a in Figure 23.3, describe the process whereby equilibrium at point P1C1
would be restored under perfect competition.
At any point on the curve below point P1C1, such as point a:
MRT > MRS
i.e. MRT Px/Pm MRS
i.e. MCx/MCm Px/Pm MUx/MUm
Thus relatively more of m will be produced and relatively less of x.
There will thus be a movement up along the production possibility curve until point P1C1 is reached: until
MCx/MCm = Px/Pm = MUx/MUm
i.e. until MRT = MRS.
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655 2. Why would production be unlikely to take place at P1C1 if competition were not perfect?
Because price would not equal marginal cost, and thus MCx/MCm would not equal Px/Pm.
1. Draw a similar diagram to Figure 23.4, only this time assume that the two goods are good a measured
on the vertical axis and good b measured on the horizontal axis. Assume that the country has a
comparative advantage in good a. (Note that the world price ratio this time will be shallower than the
domestic pre-trade price ratio.) Mark the level of exports of a and imports of b.
See Diagram 23.1.
Exports
Good a
P2
P1C1
C2
Imports
I2
I1
Good b
Diagram 23.1 Exports of good a and imports of good b
2. Is it possible to gain from trade if competition is not perfect?

Yes. Production would not initially take place at the Pareto optimum position P1C1, but it is quite likely that
trade would lead to a consumption on a higher indifference curve, and that therefore there would be some
gain: a Pareto improvement.
656 Would it be possible for a country with a comparative disadvantage in a given product at pre-trade levels
of output to obtain a comparative advantage in it by specialising in its production and exporting it?
Yes, if the country has potential economies of scale in producing that good (which it had not yet exploited).
Specialisation could then reduce the opportunity costs of that good below that of the same good in other
137

countries. (This assumes that the other country does not have potential economies of scale in that good or
does not exploit them if it does.)
658 (Box 23.5) Should the world community welcome the use of tariffs and other forms of protection by the
rich countries against imports of goods from developing countries that have little regard for the
environment?
There is no simple answer to this question. In terms of social efficiency, trade should take place as long as
the marginal social benefit was greater than the marginal social cost (where environmental benefits and
costs are included in marginal social benefits and costs). The problem with this approach is in identifying
and measuring such benefits and costs. Then there is the problem of whether a social efficiency approach
towards sustainability is the appropriate one (see page 322). Then there is the issue of the response by the
developing countries to the protection. Will they respond by introducing cleaner technology? This may
prove difficult to predict.
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658 How would you set about judging whether an industry had a genuine case for infant/senile industry
protection?
Whether it can be demonstrated that, with appropriate investment, costs can be reduced sufficiently to make
the industry internationally competitive.
659 Does the consumer in the importing country gain or lose from dumping?
In the short run the consumer will gain from cheaper products. In the long run the consumer could lose if
domestic producers were driven out of business, which then gave the foreign producer a monopoly. At that
point, it is likely that prices would go up above the pre-dumping levels.
In what ways may free trade have harmful cultural effects on developing countries?
The products and the lifestyles which they foster could be seen as alien to the values of society. For
example, many developing countries have complained about the cocacolonisation of their economies,
whereby traditional values are being overcome by Western materialist values.
1. How much would be the total tax revenue for the government?
(P2 P3) OQ2
2. Will the individual producers gain from the export tax?
The producers as a group will lose. They will be selling less at a lower price (Q2 at P3 rather than Q1 at P1),
but only at a relatively moderate reduction in costs. Their revenue falls by the area P1aQ1Q2bP3, but their
costs only fall by the area baQ1Q2. There is thus a net loss to producers of area P1abP3. It is the
government (or at least the recipients of increased government expenditure or reduced taxes elsewhere) that
will gain.
660 (Box 23.6) See if you can devise a similar proof to show that the optimal import tariff, where a country
has monopsony power, is 1/Ps (where Ps is the price elasticity of supply of the import).
In Figure 23.6 the optimum tariff rate is:
(P3 P2) P2
(1)
i.e. (MC P) P
(2)
Price elasticity of supply is given by

Ps = dQ P
(3)
dP Q
Marginal cost is given by:
MC = dTC = d(AC.Q)
(4)
dQ
dQ
In the example of a country buying imports, the average cost of so doing is the price (AC = P). Marginal
cost is thus given by:
MC = dTC = d(P.Q)
(5)
dQ
dQ
From the rules of calculus:
d(P.Q) = dP.Q + dQ.P
(6)
dQ
dQ
MC P = (dP.Q + dQ.P) P
dQ
&
P
=
P
MC P
(dP.Q + dQ.P) P
dQ
=
P
1
dP.Q + dQ.P
dQ
(7)
(8)
(9)
139

Again from the rules of calculus:
= dQ.P + dQ.P 1
dP.Q dQ.P
= dQ.P + 1 1
dP.Q
(10)
(11)
= dQ.P = Ps
dP.Q
(12)
from equations (2) and (12)

MC P = optimum tariff rate = 1
P
P s
661 (Box 23.7) Go through each of these four arguments and provide a reply to the criticisms of them.
Imports should be reduced since they lower the standard of living. The money goes abroad rather
than into the domestic economy. Imports are not always matched by exports (see Chapter 24). If
imports exceed exports, then the resulting trade deficit has to be matched by a surplus elsewhere on the
balance of payments account, which might bring problems (e.g. short-term financial inflows leading to
exchange-rate volatility). A rise in imports, being a withdrawal from the circular flow of income, will
tend to reduce income unless matched by a corresponding rise in exports. Sometimes imports may
influence consumer tastes, and this may be seen as undesirable. For example, imports of soft drinks
into poorer developing countries has been criticised for distorting tastes.
Protection is needed from cheap foreign labour. See Box 23.3.
Protection reduces unemployment. The greater competition from free trade will provide a
permanently less certain market for domestic producers and possibly a permanently higher rate of
structural unemployment, given the greater rate of entry and exit of firms from markets.
Dumping is always a bad thing, and thus a country should restrict subsidised imports. The gain to
consumers may be short-lived, and if more efficient domestic firms have been driven from the market,
there will be a long-term net welfare loss to the country.
If economics is the study of choices of how to use scarce resources, can these other objectives be
legitimately described as non-economic?
In this sense they clearly are economic objectives. That is why I used inverted commas for the words noneconomic in the title.
662 In this model, where the country is a price taker and faces a horizontal supply curve (the small country
assumption), is any of the cost of the tariff borne by the overseas suppliers?
The whole of the tariff is passed on in higher prices to the consumer. The overseas suppliers still receive a
price of Pw after the tariff has been paid. Thus none of the per unit cost of the tariff is borne by the overseas
suppliers. There will, nevertheless, be a loss in sales for them from Q2 Q1 to Q4 Q3.
What would be the first-best solution to the problem of an infant industry not being able to compete with
imports?
If the problem is a lack of domestic infrastructure, then the first-best policy is for the government to provide
the infrastructure. If the problem is a lack of finance for the firms to expand (due to imperfections in the
capital market), then the first-best solution is for the government to remove imperfections in the capital
market, or to lend money directly to the firm. In other words, the first-best solution is to get to the heart of
the problem: to tackle imperfections at source.
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663 What determines the size of this world multiplier effect?
The size of the world multiplier will be the inverse of the marginal propensity to withdraw from the world
economy (into savings, taxes and imports from the UK). The bigger the world multiplier and the bigger the
worlds marginal propensity to import from the UK, the more will UK exports fall for a given fall in UK
imports (i.e. injections into the world economy).
Of course, all this assumes ceteris paribus. In practice there will be constant changes to world
injections and withdrawals, of which exports to the UK are a minute proportion. Thus any multiplier effects
from changes in exports to the UK (brought about by UK protectionism) are likely to be swamped by
changes in injections and withdrawals from other causes.
(Box 23.8) Airbus, a consortium based in four European countries, has received massive support from
the four governments, in order to enable it to compete with Boeing, which until the rise of Airbus had
dominated the world market for aircraft. To what extent are (a) air travellers; (b) citizens of the four
countries likely to gain or lose from this protection?
(a) To the extent that the resulting competition reduces the costs of aircraft and hence air fares, the traveller
will gain.
(b) Whether citizens of the EU as a whole gain depends on whether the costs of the support (including
external costs), as are recouped in the benefits of lower fares to travellers, profits to Airbus Industries
and external benefits (such as spillover research benefits to other industries). Of course, the costs and
benefits will not be equally distributed to EU citizens and thus there will be redistributive effects of the
policy, effects which may be considered to be desirable or undesirable.
665 (Box 23.9) 1. Can he US action to protect its steel industry be justified on economic grounds?
In terms of economic efficiency, then probably not, unless the protection was temporary while the industry
was given the opportunity to invest to allow it to realise a potential comparative advantage (assuming that
an imperfect capital market failed to lend it the requisite funds). But given that the industry almost certainly
does not have a potential comparative advantage, there would be no efficiency gains: rather, there would be
net loss in efficiency.
The main argument, then, would have to be in terms of distributive justice: that giving the industry
protection helps save US jobs and the livelihoods of people working in the industry. From a US perspective,
there is some justification here. In world terms, however, the gain to US jobs could well be at the expense of
jobs elsewhere, causing a net loss, as production was diverted from lower-cost producers in other countries
to higher-cost producers in the USA.
(Box 23.9) 2. What alternative economic strategy might the US government have adopted to improve the
competitiveness of steel producers?
Encouraging investment in new efficient plants by giving tax breaks or grants. Again, unless these plants
had a comparative advantage, this would still be regarded as unfair protection. Even if they did have a
potential comparative advantage, any such support would have to be purely temporary to be justified on
efficiency grounds.
666
(Box 23.10) Outline the advantages and drawbacks of adopting a free-trade strategy for developing
countries. How might the Doha Development Agenda go some way to reducing these drawbacks?
There are two main advantages:
The developing countries can gain from specialisation in goods in which they have a comparative
advantage. Other things being equal, this increases national income in these countries.
It can encourage inward investment into these countries.
The disadvantages are as follows::
Developed countries may continue to protect their industries. This makes free trade a risky strategy for
developing countries, which might find the market for key exports suddenly cut off.
Freely allowing imports into developing countries may mean that developed countries dump surplus
products on them (especially agricultural surpluses), with damaging consequences for producers within
the developing countries.
It may encourage developing countries to use low-cost, dirty technology, with adverse environmental
consequences.
Multinational investment in developing countries, encouraged by an open trade policy, may lead to
culturally damaging influences (the culture of McDonalds and Coca-Cola) and political control over
the developing countries.
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To the extent that the Doha Development Agenda focuses on sustainable development, fair access for
developing countries to the markets of rich countries and maintaining justifiable protection by the
developing countries for specific sectors, then some of these drawbacks will be reduced. How much they
will be reduced, however, depends on the terms of any agreement and how rigorously they are enforced.
669 Under which of the following circumstances is there likely to be a net gain from trade diversion? (Refer
to Figure 23.9.) (a) A small difference between the EU price and the New Zealand pre-tariff price and a
large difference between the EU price and the New Zealand price with the tariff, or vice versa. (b)
Elastic or inelastic UK demand and supply curves. (c) The UK demand and supply curves close together
or far apart.
(a) A small difference between the EU price and the New Zealand pre-tariff price. The smaller the
difference the bigger will areas 2 + 4 be relative to area 5. Diverting trade from New Zealand only
leads to a slight increase in costs relative to the benefit of the reduction in tariff payments.
(b) Elastic. The more elastic the demand and supply curves, the bigger will be areas 2 and 4 (and the
smaller will be area 5, if the greater elasticity results in the demand and supply curves being closer
together at price P1).
(c) The UK demand and supply curves close together. The closer they are, the smaller will be the level of
imports, and thus the smaller will be area 5.
670 How would you set about assessing whether or not a country had made a net dynamic gain by joining a
customs union? What sort of evidence would you look for?
It is very difficult to make an assessment. You would need to take each argument and attempt some
quantification in the two circumstances of (i) having joined and (ii) not having joined. This will necessarily
involve making some fairly gross assumptions about what would have happened in the hypothetical case of
it not having joined. The sort of evidence you could look for would be (a) the countrys performance before
joining and how its performance changed after joining, (b) other factors that could have caused changes in
its performance, (c) the experience of other countries which faced similar problems but had not joined a
customs union.
672 What would be the economic effects of (a) different rates of VAT, (b) different rates of personal income
tax and (c) different rates of company taxation between member states if in all other respects there were
no barriers to trade or factor movements?
(a) Consumers would buy items in those countries that charged the lower rates of VAT. This would push up
the prices in these countries and thus have the effect of equalising the tax-inclusive prices between
member countries. This effect will be greater with expensive items (such as a car), where it would be
worthwhile for the consumer to incur the costs of travelling to another country to purchase it.
(b) Workers would move to countries with lower income taxes, thus depressing gross wage rates there and
equalising after-tax wages. This effect would be greater, the greater is the mobility of labour between
member countries.
(c) Capital would move to countries with lower rates of company tax, thus depressing the rate of profit in
the low tax countries and equalising the after-tax rate of profit. This effect will be greater, the greater is
the mobility of capital between member countries.
In these last two cases, there will be an opposite effect caused by the multiplier. Workers or capital moving
into a country will generate incomes there and hence increase the demand for factors and push up wages
and profits.
673 Would the adoption of improved working conditions necessarily lead to higher labour costs per unit of
output?
No. They could lead to an increase in labour productivity which more than offset the cost of the improved
working conditions.
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674 (Box 23.11) How did the Cassis de Dijon ruling affected the balance of power in the Community between
(a) individual states and the whole Community; (b) governments and the courts?
(a) It reduced the power of individual states to regulate, given that firms or individuals can appeal to more
favourable regulations in other member countries.
(b) It strengthened the power of the European Court of Justice over individual member countries
governments.
675 Has the problem of adverse regional multiplier effects been made better or worse by the adoption of a
single European currency? (This issue is explored in section 25.3.) (Clue: without a single currency,
how would the devaluation of the drachma (the former Greek currency) have affected a depressed Greek
economy?)
Worse. A depressed economy is not able to devalue and thereby boost output and employment through the
resulting increase in exports and reduction in imports.
Is trade diversion more likely or less likely in the following cases?
(a) European producers gain monopoly power in world trade.
(b) Modern developments in technology and communications reduce the differences in production costs
associated with different locations.
(c) The development of the internal market produces substantial economies of scale in many industries.
(a) It depends on why they have gained monopoly power. If it is due to their protected home market and
their ability therefore to drive competitors out of business, then trade diversion is more likely. They are
likely to become high cost producers. If, however, their monopoly power has resulted from economies
of scale, increased investment and efficiency and lower costs generally, then trade diversion is less
likely. Trade will probably be moving to lower cost producers.
(b) Less likely. If production cost differences diminish between EU and non-EU producers, there is less
likelihood of trade being diverted to a higher cost internal producer.
(c) Less likely. Costs are likely to fall more in the EU than outside, and thus there is less chance of trade
being diverted to a higher cost internal producer.
Why may the newer members of the Union have possibly the most to gain from the single market, but
also the most to lose?
Because their economies are less harmonised with the other member economies, and because there are more
internal barriers, partly as a result of transitional arrangements. There is more chance, therefore, of both
trade creation and trade diversion. Also there is likely to be more change in their economies. The more
change there is, the more will there be gainers and losers (new industries growing up, and old industries
declining, with a resulting loss of jobs).
676 (Box 23.12) In what ways would competition be unfair if VAT rates differed widely between member
states?
It would give an unfair price advantage to producers in these countries. This would be a particular problem
for relatively expensive items, where it would be worthwhile consumers incurring the cost of travelling to
the countries charging lower rates of VAT.
Since customs restrictions were lifted in 1993 on imports of alcoholic drinks into the UK from other EU
countries (for personal consumption), many people take ferries over to France to stock up on wine and beer
in order to avoid the higher rates of excise duty in the UK. Off-licences in the UK, especially those near the
Channel ports, lose money as a result.
677 (Box 23.13) 1. What value are scoreboards for Member States and the European Commission?
Individual countries can compare their progress against others and see whether they need to take action to
speed up transposition. It is useful for the European Commission in identifying countries on which
pressure needs to be applied and whether the EU as a whole is making good progress.
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677
(Box 23.13) 2. Why do you think that it is so important that legislation, such as that governing the
Internal Market, is in place in all Member States at the same time?
Because individual countries could benefit at the expense of others if this were not so. This could also have
damaging political consequences, making future agreements harder to achieve.
If there have been clear benefits from the single market programme, why do individual member
governments still try to erect barriers, such as new technical standards
Because barriers sometimes enable them to gain at the expense of other member countries, or because
barriers benefit some individual pressure group (like sheep farmers, or the car industry).
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682 Imagine that there is an inflationary gap, but a balance of payments equilibrium. Describe what will
happen if the government raises interest rates in order to close the inflationary gap. Assume first that
there is a fixed exchange rate and then that there is a floating exchange rate.
Fixed exchange rate: The higher interest rates will reduce aggregate demand and thus help to close the
inflationary gap. The higher interest rates, however, will lead to an increase in the demand for and a
decrease in the supply of sterling: the financial account will move into surplus, and external balance will be
destroyed. The reduction in inflation will also have the effect of increasing exports and reducing imports,
thereby also improving the current account. (As we shall see in section 24.2 and Box 24.2, the effect does
not end here. The balance of payments surplus will increase the money supply, which will push interest
rates back down again, thus preventing internal balance from being achieved.)
Floating exchange rates: As under a fixed exchange rate, the higher interest rates will reduce aggregate
demand and thus help to close the inflationary gap. The higher interest rates will lead to an increase in the
demand for and a decrease in the supply of sterling: the financial account will move into surplus, and
external balance will be destroyed. The exchange rate will thus appreciate, thereby restoring external
balance. The effect of the appreciation will be also to reduce the demand for exports (an injection) and
increase the demand for imports (a withdrawal). This will help to reinforce the effect of higher interest rates
in dampening aggregate demand and restoring internal equilibrium. (The effects of monetary policy under
floating exchange rates are explored in Box 24.5.)
From the above it can be seen that monetary policy has a bigger effect on the domestic economy under
floating than under fixed exchange rates.
What adverse internal effects may follow from (a) a depreciation of the exchange rate; (b) an
appreciation of the exchange rate?
(a) It may fuel inflation by increasing the price of imported goods and reducing the need for export
industries to restrain cost increases.
(b) It may damage export industries and domestic import-competing industries, which would now find it
more difficult remain competitive.
684 Describe the open market operations necessary to sterilise the monetary effects of a balance of payments
surplus. Would this in turn have any effect on the current or financial accounts of the balance of
payments?
The balance of payments surplus would lead to an increase in the money supply. To sterilise this the
authorities would have to sell securities on the open market. The resulting higher interest rates would tend
to lead to a continuing surplus on the financial and current accounts and hence a continuing need to sterilise
the resulting increase in the money supply.
Under what circumstances would (a) contractionary and (b) expansionary policies cause no conflict
between internal and external objectives?
(a) When there was an inflationary gap and a balance of payments deficit.
(b) When there was a deflationary gap and a balance of payments surplus.
686 How would raising interest rates in this way affect the balance between the current and financial
accounts of the balance of payments?
It will have a bigger effect on the financial account. Thus if the financial account had been in deficit
(caused by the large scale selling of pounds), it will move back towards balance. The current account will
tend to deteriorate, however, as a result of the higher exchange rate, although this will be to some extent
offset by the reduction in aggregate demand (and hence demand for imports) caused by the higher interest
rates.
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689 Making first new classical, and then Keynesian assumptions, trace through the effects (under a fixed
exchange rate) of (a) an increase in domestic saving; (b) a rise in the demand for exports.
New classical
(a) A rise in saving will mean a lower level of aggregate demand. This will cause wage rates and prices to
fall, and thus cause imports to fall and exports to rise. There will be a current account surplus. At the
same time, the increased saving plus a lower transactions demand for money will put downward
pressure on interest rates. There will be an outflow of finance and a financial account deficit. Given a
high international mobility of finance, the financial account deficit is likely to exceed the current
account surplus. This will lead to a contraction in the money supply and hence ease the downward
pressure on interest rates (or even allow them to rise again), thus reducing the size of the financial
account deficit, or at least allowing a growing current account surplus to catch up the financial
account deficit. Overall balance has been restored.
(b) A rise in the demand for exports will cause the current account to move into surplus. At the same time,
the resulting rise in aggregate demand will increase the transactions demand for money and put upward
pressure on interest rates, causing an inflow of finance and hence a financial account surplus too.
Money supply will thus rise. But this will then put downward pressure on interest rates, thereby
boosting aggregate demand and hence the demand for imports, and also stemming the inflow of finance.
The net effect will be an erosion of the current and financial account surpluses until overall balance has
been restored. The current account will come back into balance because of flexible prices and wage
rates: prices and wage rates will go on rising until the current account surplus has been eliminated.
Keynesian
(a) A rise in savings will cause a multiplied fall in national income and a reduction in the rate of inflation.
This will cause a fall in imports and a rise in exports and hence a surplus on the current account. This
will lead to a rise in the money supply as the Bank of England sells pounds, but this will be more than
offset by an endogenous fall in money supply caused by the reduction in aggregate demand. This will
allow the current account surplus to persist. The reduction in money supply will prevent downward
pressure on interest rates. There will therefore be no financial account deficit to match the current
account surplus. Overall external imbalance will persist.
(b) A rise in the demand for exports will cause the current account to move into surplus. The rise in
exports (being an injection) will also cause a multiplied rise in national income. This will increase the
demand for imports and will thus reduce the current account surplus somewhat (but not completely,
given that the rise in exports is partly matched by a rise in other withdrawals too). The effect on the
financial account will be relatively small. The current account surplus will reduce the money supply
but the rise in aggregate demand will cause an endogenous rise in the money supply. The net effect on
interest rates, and hence the financial account, will depend on which of these two effects is the greater.
690 (Box 24.2) Suppose that under a managed floating system the government is worried about high inflation
and wants to keep the exchange rate up in order to prevent import prices rising. To tackle the problem of
inflation it raises interest rates. (Similar policies have been pursued in recent years.) What will happen
to the current and financial accounts of the balance of payments?
The high interest rates will cause a surplus on the financial account. The higher exchange rate will cause a
deficit on the current account.
691 When the UK joined the ERM in 1990, it was hoped that this would make speculation pointless. As it
turned out, speculation forced the UK to leave the ERM in 1992. Can you reconcile this with the
argument that fixed rates discourage speculation?
As long as speculators believe that the fixed rate can be maintained, there is no point in speculation. Thus
when the UK first joined, there was little speculation. But later, when there was a clear tension between the
German desire to keep interest rates high and the UK desire to reduce interest rates in order to help lift the
economy out of recession, speculators began to believe that rates might have to be realigned. The more they
became convinced of this, the more the speculative pressures mounted.
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692 Why will excessive international liquidity lead to international inflation?
Because countries can use the extra reserves to finance the purchase of extra imports. The extra liquidity is
thus equivalent of an increase in world money supply. If this grows faster than world trade, then there
will be a problem of excess demand and demand-pull inflation.
To what extent do Keynesians and new classicists agree about the role of fixed exchange rates?
They are both critical, as pages 6912 make clear. They both argue that monetary policy is relatively
ineffective under fixed exchange rates, and that overall imbalance on the balance of payments may persist.
693 If this is the case, need firms worry about losing competitiveness in world markets if domestic inflation is
higher than world inflation?
No, providing their goods are not going up in price any faster than the rate of inflation. A depreciating
exchange rate will ensure that the relative price of domestic and foreign goods is unaffected by the higher
domestic rate of inflation. (But as we shall now see, under certain conditions the purchasing power parity
theory will not hold.)
Will there be any cost to the UK economy from a decline in the demand for exports resulting from a
world recession?
Yes. The depreciation in the exchange rate will reduce the demand for imports (unless the world recession
causes the foreign currency price of imports to fall by the same percentage that the exchange rate
depreciates). A reduction in imports will mean that the exchange rate does not have to fall so far and thus
the level of exports will not be fully maintained. There is thus a cost to the export sector. This effect will be
partly or even wholly offset, however, by the boost to aggregate demand (and hence a further reduction in
the exchange rate) caused by the fall in imports (a withdrawal).
694 (Box 24.3) 1. If the Malaysian ringgit is undervalued by 47 per cent in PPP terms against the US dollar,
and the Swiss franc overvalued by 53 per cent, what implications does this have for the interpretation of
Malaysian, Swiss and US GDP statistics?
The GDP figures understate the purchasing value of Malaysian national income by 47 per cent relative to
US national income, and overstate the purchasing value of Swiss national income by 53 per cent relative to
US national income. In other words, at the exchange rates in question, Malaysian national income seems
47 per cent lower relative US national income than it really is in purchasing terms, and Swiss national
income seems 53 per cent higher relative to US national income than it really is in purchasing terms.
(Box 24.3) 2. Why do developing countries currencies tend to be undervalued relative to those of
developed countries?
Because the exchange rates faced by developing countries reflect the demand and supply of traded goods
only. Frequently developing countries face high prices of imports and low prices of exports, given (a) that
they have little power in international trade; (b) multinational companies, which buy their exports and
supply their imports, do have power to skew prices in the companies own favour. Non-traded goods in
developing countries (whose consumption affects living standards but does not affect exchange rates) tend
to be lower priced relative to imports than they are in developed countries.
696 Draw a similar diagram to Figure 24.6 showing how an appreciation of the exchange rate would
similarly be reduced by stabilising speculation.
The diagram would look like Figure 24.6, only with S1 and S2, D1 and D2, and r1 and r2 reversed.
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Page
697 (Box 24.4) If, in 1995, the Japanese yen was already above its purchasing-power parity rate, and was
therefore likely to depreciate over the longer term, why did speculators still continue to buy yen?
Similarly, why did people sell euros in 1999?
Because speculators believed that the yen would appreciate in the short term. This was based on the belief
that Japanese interest rates would rise relative to US interest rates. Similarly, people believed that the euro
would depreciate in the short term, as the ECB kept euro interest rates below those in the USA and as
investment prospects appeared more favourable in the USA..
698 If speculators on average gain from their speculation, who loses?
People buying or selling internationally traded goods who are not themselves speculating. For example, if
speculation drives the exchange rate below what it would otherwise have been, then purchasers of imports
will be paying a higher price than they otherwise would.
699 (Box 24.5) Compare the relative effectiveness of fiscal and monetary policies as means of expanding
aggregate demand under a system of floating exchange rates.
Monetary policy would be relatively effective. An expansion of the money supply will reduce interest rates.
This will increase aggregate demand directly; lead to a depreciation in the exchange rate, which will
increase exports and reduce imports, thereby further stimulating aggregate demand; cause initial exchange
rate overshooting, reinforcing the boost to demand from increased exports and reduced imports.
Fiscal policy will be relatively ineffective. A cut in taxes and/or an increase in government expenditure
will increase the transactions demand for money and thus increase interest rates. The exchange rate will
appreciate. This will have the effect of dampening the rise in aggregate demand.
Why would banks not be prepared to offer a forward exchange rate to a firm for, say, five years time?
It would involve too much risk. The longer the time period the greater the scope for movements in the
exchange rate and the more unpredictable they become. (Look forward to Figure 24.9 on page 704 of the
text and see what happened to the exchange rate over the five year period from 1980 to 1985!)
701 Under this system how would you expect countries to respond to a balance of payments surplus? Would
a revaluation benefit such countries?
In the short run a country would sell its domestic currency on the foreign exchange market, thus preventing
the exchange rate rising above the one per cent band. The reserves it accumulated from this could be used
to pay back loans to the IMF. If the surplus persisted, the country would be expected to pursue reflationary
policies. If the surplus was large and fundamental, then a revaluation would be expected.
The revaluation would benefit the country by improving the terms of trade. Less exports would need to
be sold to buy a given amount of imports. The export industries, however, would be less pleased: their
exports would now be less competitive. Also firms competing with imports would not be pleased either: the
imports would now be cheaper. Also many countries liked to run a balance of payments surplus and not
revalue, because it allowed them to build up their reserves, which would make it easier for them to defend
the exchange rate at some future point if their balance of payments moved into deficit (something it was less
likely to do if they did not revalue in the first place).
Would this uncertainty have a similar or a different effect on exporting companies and companies using
imported inputs?
It would have a similar effect in that in both cases the uncertainty might make the companies reluctant to
invest. It would have a different effect, however, on their short-term trading decisions. Importers would be
keen to buy as much as possible now, just in case the currency would be devalued. Exporters, on the other
hand, would want to hold back selling their exports as long as possible, hoping for the devaluation. These
actions of importers and exporters would worsen the deficit and thus hasten the devaluation.
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702 Why would the adjustable peg system have been less suitable in the world of the mid-1970s than it was
back in the 1950s?
Because the world economy was in much more of a state of turmoil than in the previous two decades. The
amount of adjustment required was therefore much greater. Under an adjustable peg system, pegged
exchange rates would much more rapidly have become disequilibrium rates. This would have necessitated
more severe stopgo policies and/or more frequent devaluations/revaluations, with the disruption that such
adjustments entail. What is more, with much of the increased oil revenues of OPEC being placed on shortterm deposit in Western banks, the size of short-term financial flows had increased substantially and this
worsened the problem of currency instability.
703 (Box 24.6) Why do high international financial mobility and an absence of exchange controls severely
limit a countrys ability to choose its interest rate?
Because if its interest rate were lower than international rates, there would be a massive outflow of finance
if international finance were highly mobile and there were an absence of exchange controls. The resulting
fall in the money supply would push the interest rate up to the international level. Similarly if its interest
rate were higher than international rates, the resulting massive inflow of finance would increase the money
supply and drive its interest rate down to the international level. These effects are stronger if the country is
attempting to peg its exchange rate.
704 Would any of these problems be lessened by the world returning to an adjustable peg system? If so, what
sort of adjustable peg system would you recommend?
No. All these problems would have existed with an adjustable peg. Predicting the appropriate rate at which
the currency should be pegged would have been a problem. Speculative financial movements would still
have been a problem as long as speculators believed that there was a possibility of devaluation or
revaluation. There would still have been a conflict with internal policy given that interest rates would have
been used to maintain a pegged rate. There could still have been competitive pressures to raise interest
rates. Just how bad these problems would have been would have depended on (a) the determination of
countries to defend the pegged rate, and (b) the amount of support given by the IMF, or central banks
collectively, to maintain pegged rates.
A return to an adjustable peg system is best when the required adjustments are easily made, without
building up large deficits or surpluses, and most importantly, when countries pursue consistent policies:
when their economies are harmonised (see pages 7189).
705 1. Were there any advantages of the high exchange rate?
Two major claims in support of the policy have been:
It put downward pressure on inflation.
It forced many firms to be more efficient, or to go bankrupt. Therefore those firms that survived the
recession were more efficient and better able to compete internationally.
2. Would there have been a danger of inflation rising if deflationary policies had not been used, even
though there was a rise in potential income caused by North Sea oil?
As Table 20.6 on page 576 showed, inflation in 1980 had already risen to 18 per cent. If deflationary
policies had not been used, it would have been much harder to have reduced inflationary expectations, even
if there had been no problem of excess demand. Expectations could have even led to an acceleration in
inflation if it had been thought that the government was not serious about controlling inflation.
An alternative to the severe deflationary policies of the government would have been for a much milder
constraint on the growth in aggregate demand. Thus may have led to some increase in unemployment, and
would have probably meant a slower reduction in inflation, but the recession would have shallower. At the
same time the government could have diverted oil revenues into improving the supply side of the economy
(e.g. improving infrastructure), which would have also helped to reduce inflation over the longer term.
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706 1. Why would the pound not have gone on falling indefinitely?
Because the more it fell, the more would exports increase and imports fall. The current account would
improve. Speculators, knowing this, would realise that the rate was getting further and further below the
long-term equilibrium rate, and thus would believe that the rate was eventually bound to rise again. The
moment that speculators became convinced that the bottom had been reached, or was about to be reached,
they would buy pounds and sell foreign currency. This would then push the exchange rate back up again.
2. Could the UK have done anything to prevent the massive fall in the dollar/pound exchange rate from
$2.40 in 1981 to only just above $1.00 in early 1985?
Very little on its own. As this section on page 720 has shown, most of the causes of the decline of the pound
were external to the UK. The final plunge from around $1.25 in November 1984 to $1.05 in February
1985, could possibly have been prevented, however, or at least reduced, if the government had not cut
interest rates in November 1984 at a time when the pound was already falling (see Web case 24.3).
Possibly if the government had been more interventionist, both on the foreign exchange market and
through using interest rates to control the exchange rate, it could have persuaded speculators that it meant
business and could have prevented some of the decline. Many commentators, however, believe that the
task would have been too big for the UK authorities on their own, and that the resulting failure to prevent
the fall would have simply given the message to speculators that the government really was powerless.
speculation even worse.
To what extent was there a conflict after 1988 between using interest rates to affect the rate of inflation
and using them to maintain a given exchange rate? Explain under what circumstances there was and
was not a conflict.
Using high interest rates to reduce inflation had the effect of keeping the exchange rate up. Initially after
1988, the resulting rate of exchange was felt by many economists to be too high, and thus it could be
claimed that there was some conflict between internal and external objectives. But then with the downward
pressure on the exchange rate from the growing current account deficit and the potential for speculation, the
government wanted to maintain a high interest rates both to put downward pressure on inflation and to
prevent an excessive depreciation of the pound. There was no longer a conflict between internal and
external objectives.
709 What will be the effect of an expansionary fiscal policy on interest rates and national income if there is a
perfectly elastic supply of international finance?
There will be no effect on interest rates. Instead, the money supply will expand fully (from an inflow of
finance) to match the rise in aggregate demand, thus giving the full effect on national income with no
crowding out. In Figure 24.12, the BP curve will be horizontal, and Y3 Y1 will be the full horizontal
distance between IS2 and IS1.
710 1. Why does this conclusion remain the same if the BP curve is steeper than the LM curve?
The increased money supply would drive down interest rates just the same, and there would still be a
resulting balance of payments deficit (only larger this time). This would still cause the money supply to fall
again and equilibrium to be restored back at the original point.
2. Trace through the effects of a fall in exports (thereby shifting the BP curve)
The BP curve will shift upwards to the left, illustrating that a higher rate of interest would now be necessary
at any given level of national income to achieve a balance of payments equilibrium. Reduced exports, being
an injection into the circular flow, will shift the IS curve to the left, showing that there will be a lower level
of national income associated with any given rate of interest. The leftward shift in the IS curve will cause a
reduction in the rate of interest, which combined with the balance of payments deficit will reduce the money
supply. The LM curve will shift to the left until a new equilibrium is reached where all three curves once
more intersect.
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710 3. Show what will happen if there is (a) a rise in business confidence and a resulting increase in
investment; (b) a rise in the demand for money balances (say for precautionary purposes).
(a) The IS curve will shift to the right. The effect is the same as with an expansionary fiscal policy
illustrated in Figure 24.12.
(b) A rise in the demand for money will shift the LM curve to the left. The effect will be the same as with a
contractionary monetary policy in question 2 above.
711 Under what circumstances would an expansionary fiscal policy have no effect at all on national income?
(i) The flatter the BP curve, the bigger will be the balance of payments surplus resulting from the expansion
in aggregate demand, and the more the exchange rate will appreciate, and hence the more aggregate demand
will be reduced again. (ii) The greater the price elasticity of demand for imports and exports, the more the
appreciation will reduce aggregate demand again. The bigger these two effects, the more likely it is that
fiscal policy will have no effect on national income under floating exchange rates.
What will determine the size of the shift in the BP curve in each case?
The amount that the LM curve shifts to the right as a result of the monetary policy, and the amount that the
IS curve shifts to the right as a result of the resulting depreciation. The bigger the shift in the LM curve and
the smaller the shift in the IS curve, the bigger will be the necessary shift in the BP curve to restore
equilibrium.
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714 Assume that the US economy expands. What will determine the size of the multiplier effect on other
countries?
The size of US marginal propensity to import. The bigger it is, the bigger the rise in imports for any
given expansion in US income.
The size of the multiplier in other countries. The bigger it is, the bigger will be the rise in their income
as a result of a rise in exports to the USA.
For any one country, the effect will be bigger, the larger the proportion of the increased US imports that
come from that country.
Are exports likely to continue growing faster than GDP indefinitely? What will determine the outcome?
Yes, so long as a growing proportion of countries GDP comes from exports. If international trade barriers
continue to be eroded, if consumers continue to have a growing demand for imports of goods and services
(e.g. foreign holidays) and if firms continue to expand the proportion of their purchases of capital, raw
materials, components and semi-finished products that they obtain from abroad, so the exports are likely to
continue growing faster than GDP. The growth may well level off over the years, however, as comparative
advantage becomes more fully exploited and as services (such as entertainment) account for a larger and
larger proportion of GDP.
715 What will be the effect on the UK economy if the European Central Bank cuts interest rates?
There will an outflow of funds from the euro-zone and the euro will probably depreciate. Funds will flow to
the UK and sterling will probably appreciate. UK exports will become less competitive and there will
probably be a rise in imports. UK aggregate demand will fall. This will put downward pressure on
inflation. (To some extent the downward pressure on aggregate demand in the UK will be offset by a rise in
aggregate demand in the euro-zone and hence a boost to the UK economy via the international trade
multiplier.)
The net result of a forecast of lower inflation in the UK and a worsening balance of trade may
encourage the Monetary Policy Committee to lower the rate of interest. If this happened, it could neutralise
the balance of payments effect of the ECBs interest rate cut. In fact, if rates of interest in the UK fell by
the same amount as in the euro-zone, the UKs balance of trade would probably improve, as sterling
depreciates against the dollar, the yen and other currencies other than the euro.
717 (Box 25.1) 1. Why did the contagion spread to countries outside south-east Asia?
Having witnessed the power of speculative flows to undermine relatively strong countries of south-east
Asia, speculators turned their attention to other economies perceived as having weaknesses. The
speculation against these economies then considerably worsened their position, causing their currencies and
stock markets to fall dramatically. The speculation was worsened by the perceived inability (or
unwillingness) of institutions such as the IMF to provide rapid support for these economies.
(Box 25.1) 2. What policy measures could the south-east Asian countries have adopted before the crisis
to prevent it occurring?
Tighter controls over their banking and financial systems, with better regulation and monitoring by the
authorities and higher minimum reserve requirements; greater exchange rate flexibility; more rigorous
attempts to reduce government debt over a long period of time (so as to avoid the shock of sudden
deflation); controls over the financing of corporate debt (so as to reduce the levels of corporate debt held
overseas).
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718 Give some examples of beggar-my-neighbour policies.
Increasing tariffs or other forms of trade protection in order to improve the balance of payments, in fact any
policy to support domestic industry at the expense of imports; devaluation, or deflationary fiscal policy, so
as to gain an international competitive advantage.
Referring to Table 25.1, is there any evidence that there was any greater convergence between the G7
countries in 2001 than in 1991?
There were still wide differences between the countries, although not quite as wide as in 1991. Divergences
in interest rates and rates of economic growth had narrowed somewhat and there had been a general fall in
inflation and in government borrowing requirements and a greater convergence in their levels. Also, despite
some differences between the size of output gaps, their narrowing suggested that countries business cycles
were coming more into line. On most measures, however, Japan was considerably out of line with the other
six countries.
719 If total convergence were achieved, would harmonisation of policies follow automatically?
Not unless (a) convergence could be expected to continue and (b) countries agreed on their macroeconomic
priorities.
720 (Box 25.2) To what extent can international negotiations over economic policy be seen as a game of
strategy? Are there any parallels between the behaviour of countries and the behaviour of oligopolists?
(See the section on game theory in Chapter 7, pages 1815.)
There is a collective gain to countries from agreement over harmonisation and the greater international
macroeconomic stability that would result. Each individual country, nevertheless, would have to agree to
take decisions which might be directly against its short-term national interests. Each country may therefore
be tempted to break the agreement.
Clearly there is a parallel with oligopoly. Collusion is in the collective interests of oligopolists, but
each will be tempted to cheat.
The greater the number of countries/oligopolists in an agreement, and the more divergent their
individual economic circumstances, the greater the likelihood of one country/oligopoly breaking the
agreement, and the less the commitment, therefore, of countries/oligopolists in general to the agreement.
722 Under what circumstances may a currency bloc like the ERM (a) help to prevent speculation;
(b) aggravate the problem of speculation?
(a) By its persuading speculators that the combined strength of the countries reserves and their combined
monetary policies would guarantee that rates of exchange could be maintained within their bands.
Under these circumstances speculation would be pointless.
(b) If exchange rates were being maintained at clearly disequilibrium levels. The longer devaluation or
revaluation were put off, and the more inevitable speculators believed the devaluation or revaluation
would eventually be, the more would speculation take place.
725 1. By what means would a depressed country in an Economic Union with a single currency be able to
recover? Would the market provide a satisfactory solution to its problems or would (Union) government
intervention be necessary, and if so, what form could that intervention take?
The market solution would be for the lower demand for its products and the resulting higher unemployment
to push its rate of inflation below the average in the Union, so that its exports and domestic import
substitutes became more competitive. This may be difficult if it has a higher rate of cost-push inflation, and
considerable unemployment could result before market forces drove inflation down sufficiently. The
government, or the Union as a whole, could help by diverting resources into supply-side measures in the
country, such as building infrastructure.
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725 2. Is greater factor mobility likely to increase or decrease the problem of cumulative causation
associated with regional multipliers? (See page 650.)
Labour mobility would increase it. As workers were attracted to areas of the Union where wages were high
and jobs were plentiful, so the areas they left would become depressed regions and would suffer a multiplied
decline in income and a resulting further rise in unemployment.
Capital mobility could help to reduce the problem. As the text argues, capital might be attracted to
areas where labour costs are low: i.e. the depressed regions. On the other hand, with the demand for capital
likely to be high in the more prosperous regions, capital is likely to be attracted to these areas, further
widening the divide between the richer and poorer parts of the Union.
726 (Box 25.3) Why is a single currency area likely to move towards becoming an optimal currency area
over time?
Because convergence of the individual economies within the currency area is likely to increase as common
laws and policies are adopted, as labour and capital mobility increase and as any remaining trade barriers
are reduced.
729 (Box 25.4) George Soros, multi-millionaire currency speculator, has referred to global capital markets
as being like a wrecking ball rather than a pendulum, suggesting that such markets are becoming so
volatile that they are damaging to all concerned, including speculators. What might lead Soros to such
an observation?
Because financial movements are so vast that they are largely beyond the control of governments or
international agencies. Once the sentiment of currency traders and speculators is affected in a particular
direction (e.g. losing confidence in a particular economy, such as Argentina in late 2001/early 2002)
currency movements can become large and very damaging. Such short-term movements may bear little
relation to long-term fundamentals.
730 1. Would the Williamson system allow countries to follow a totally independent monetary policy?
Not totally independent, but much more so than under a system where realignments were less frequent and
where bands were narrower. The country would still be somewhat constrained in the amount that it was
free to vary interest rates for short-term purposes.
2. If the euro were in a crawling peg against the dollar, what implications would this have for the ECB in
sticking to its inflation target of no more than 2 per cent?
If the euro were badly out of line with the dollar, perhaps because the euro-zone was at a different phase of
the business cycle from the USA, then a crawling peg might not allow sufficiently rapid adjustment of the
euro/dollar exchange rate, in which case, changes in euro-zone interest rates might be necessary to maintain
the exchange rate within the band. If interest rates were used to target the exchange rate, this might mean
temporarily abandoning the goal of keeping inflation at or below 2 per cent. Such circumstances would
probably be quite rare, however, since fundamental misalignments of exchange rates are unlikely to occur,
given that the exchange rate can continually crawl towards equilibrium. Also there would be a band
within which short-term fluctuations could occur.
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733 What other items might be included as basic needs?
It depends on what people regard as basic and needs. Thus some people might regard access to
transport, or to books and live performances of the arts as basic needs, whereas others might regard them as
luxuries.
734 Would it be possible with this basic needs approach to say (a) that one country was more developed than
another; (b) that one country was developing faster than another?
Not in any precise sense. Unless there was a single unit in which all the various needs could be measured,
it would not be possible to say which of two countries were more developed or were developing faster, if
one country was better off (or improving faster) in terms of one need and the other in terms of another. You
could still, of course, make separate judgements about each need. Thus country A could be more developed
than country B in terms of, say, doctors per head, but less developed in terms of literacy rates.
You could probably state that in general country A seems to be better off (or developing faster) than
country B, but you could not state how much better off. (See Box 26.1 for a discussion of another method
of measuring development: the United Nations Development Programmes human development index
(HDI).)
735 How would a redistribution of income to the powerful be likely to affect GNY?
It would tend to lead to a reduction in real output, as those with monopoly power use their power to restrict
output and drive up prices. GNY, however, as measured will not necessarily decline, given that the money
value of goods produced will not have declined.
736 (Box 26.1) 1. For what reasons are HDI and per-capita GDP rankings likely to diverge?
When the other two elements of HDI education and like expectancy diverge from per capita income in
the rank order. One of the main reasons for this divergence is inequality. Thus a country with a high GDP
per capita, but which is very unequally distributed, may have a large proportion of the population which is
poor, with relatively little access to education and with a relatively low life expectancy.
(Box 26.1) 2. Why do Qatar and Saudi Arabia have such a large negative figure in the final column of
the table?
Income is very unequally distributed in these two countries (see answer to question 1 in this box).
738 1. What effect will trade have on the price of capital in developing and developed countries?
It will tend to increase the price of capital in developed countries and reduce it in developing countries
(again an example of the process of factor price equalisation).
2. It is sometimes claimed that trade with developing countries is unjust because it leads to the
importation of goods produced at pitifully low wages. How can the HeckscherOhlin theory be used to
refute this claim? Is there any validity in the claim?
Box 23.3 on page 652, gives the answer to this question.
739 Why does this argument make GNY a better indicator of development than GDP? (See the appendix to
Chapter 13.)
GNY includes net income from abroad. If there is a net outflow of profits, then GNY will be smaller than
GDP.
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740 If a disastrous harvest of rice were confined to a particular country, would (a) the world price and (b) its
own domestic price of rice fluctuate significantly? What would happen to the countrys export earnings
and the earnings of individual farmers?
(a) The world price would not rise significantly as a result of its poor harvest. In the extreme case of a
small country facing a perfectly elastic demand for its rice exports, the world price would be unaffected
by its bad harvest.
(b) If rice were a significant proportion of its total exports, the fall in rice production, and hence sales,
would cause the current account to deteriorate and the exchange rate to depreciate (assuming a flexible
exchange rate). This would increase the domestic currency price of its rice exports.
The countrys dollar earnings would fall. Individual farmers earnings would also fall, unless, the rise
in price from the depreciation were sufficient to offset the fall in output and sales (which is unlikely unless
rice exports constitute a major portion of total exports). [Note that we are assuming here that if there is a
poor rice harvest, rice can be imported at the world price, and thus the only way in which price can rise is
through a depreciation.]
741 (Box 26.2) Could a case be made out for taxing oil imports sufficiently to make it still profitable to
produce alcohol?
Yes, if (a) there was a likelihood that oil prices would go up again; (b) there was a chronic balance of
payments problem and if the savings in foreign exchange from substituting alcohol for imported oil were
used for investment in infrastructure or in infant industries.
If a country specialises in a good in which it has a comparative disadvantage where will it be producing
with respect to its production possibility curve?
It could still produce on its production possibility curve, but because of an unfavourable terms of trade
would consume less than if it had specialised in a good in which it had a comparative advantage.
742 Why is an overvalued exchange rate likely to encourage the use of capital-intensive technology?
Because it reduces the price of imported capital equipment (assuming that such equipment, given a policy of
tariff escalation, has low or zero tariffs imposed on it). Also the policy of protection allows the government
to maintain both a high exchange rate and relatively low interest rates. Low interest rates encourage the
use of capital-intensive technology.
To demonstrate this last point, work out the effective rate of protection in the following three cases:
(a) Free-trade finished good price = 100, free-trade cost of imported inputs = 40.
(b) Free-trade finished good price = 100; free-trade cost of imported inputs = 80.
(c) Free-trade finished good price = 100; free-trade cost of imported inputs = 100.
In each case assume that a 50 per cent tariff is imposed on the finished good and a 10 per cent tariff on
the imported inputs.
(a) V = 100 40 = 60
V* = 150 44 = 106
(V* V) / V 100 = 76%
(b) V = 100 80 = 20
V* = 150 88 = 62
(V* V) / V 100 = 210%
(c) V = 100 100 = 0
V* = 150 110 = 40
(V* V) / V 100 = %
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742 Under what circumstances could the effective rate of protection be negative?
(a) When there is negative value added (V): i.e. the inputs cost more to import than the finished product.
This can occur if there is considerable tariff escalation, so that the after tariff price of imported inputs
becomes less than the finished good. It becomes profitable for domestic producers to produce the
product, but it costs the country more foreign exchange than if it had simply imported the finished
product!
(b) When there is a higher tariff on the imported inputs than on the finished good, so that V* is less than V
and hence (V* V) is negative.
Note that (a) is more likely than (b).
744 (Box 26.3) 1. Would the use of import controls help or hinder a policy of export-orientated
industrialisation?
In the early stages of industrialisation they may help a country build up its infant industries industries that
later could become export orientated. If protection is maintained for too long, or is too distorting, however,
such industries could well remain inefficient and find it difficult to compete internationally.
(Box 26.3) 2. What are the arguments for and against attempting to manage the exchange rate of a
secondary-outward looking economy?
Provided that the current exchange rate represents a fundamental long-term equilibrium rate and that there
are no excessive short-term problems within the economy that could cause a loss of international
confidence, then managing the exchange rate could make the rate more stable. Most developing countries
are too small, however, and have too limited reserves or access to loans from the IMF or other international
institutions or countries to be able to support a rate that is perceived by speculators to be other than an
equilibrium rate. In other words, managing the exchange rate can only work, provided that not much
management is required! Trying to maintain an exchange rate that is perceived by speculators as
unsustainable will simply end in speculation driving the exchange rate down (as happened to the Thai baht
in 1997).
Will the adoption of labour-intensive techniques necessarily lead to a more equal distribution of income?
Not if the amount of investment varies significantly from one sector of the economy to another. If it did,
then those working in sectors with new efficient labour-intensive technology would gain, while the poor, the
dispossessed, and those working in old inefficient industries would not. Income distribution could become
less equal.
Consider the arguments from the perspective of an advanced country for and against protecting its
industries from imports of manufactures from developing countries.
Consumers will lose from such protection, because they will be denied access to developing countries
products at such low prices. Workers and employers in the industries threatened by cheaper imports from
developing countries will gain from the protection. Nevertheless there will be a net welfare loss to the
country. A better solution to the problem of those in the industries threatened by the imports might for the
government to help in the redeployment of labour.
747 If a modern capital-intensive technique has a higher capital/labour ratio and a lower capital/output ratio
than a traditional labour-intensive one, what can we say about its labour/output ratio relative to the
traditional technique?
It will be much lower. If the modern capital-intensive technique involves using less labour per unit of
capital, and less capital per unit of output, then it will involve a lot less labour per unit of output.
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748 What is the difference between mechanical efficiency and economic efficiency?
Mechanical efficiency is where there is a low energy loss from a machine. For example, if a machine has
an 80 per cent mechanical efficiency, this means for every 100 units of energy used to power the machine, it
produces 80 units of energy output. In the context of the internal efficiency of a firm, economic efficiency
involves producing a given output with the least costly combination of factors.
Why may governments of developing countries be less strict than developed countries in controlling
pollution?
Reasons include:
Given the much lower average levels of income, there is a higher level of marginal utility from
increased output relative to the marginal pollution costs.
There is often less political pressure on governments to reduce pollution.
Possible greater ignorance of the full extent of the harmful effects of the pollution.
What difficulties is a government likely to encounter in encouraging the use of labour-intensive
technology?
Difficulties include:
Bias of firms towards using capital-intensive technologies which they see as modern.
Lack of efficient labour-intensive techniques available (due to a lack of research and development).
Multinationals preference for using techniques with which they are familiar. Such techniques, having
been developed in advanced countries, are likely to be capital intensive.
Labour-intensive technology may require a higher level of skills from the operatives.
749 What would be the effect on the levels of migration and urban unemployment of the creation of jobs in
the towns?
Urban employment would rise with the additional jobs. But if each job created in the towns encourages
more than one person to migrate from the countryside, the level of urban unemployment will also increase.
1. Is there any potential conflict between the goals of maximising economic growth and maximising
either (a) the level of employment or (b) the rate of growth of employment?
(a) Maximising growth may involve using more capital-intensive techniques, because they create a greater
surplus for reinvestment. But the adoption of more capital-intensive techniques will reduce the level of
employment.
(b) There is less likely to be a conflict here. If capital-intensive techniques lead to a faster growth in
output, they will tend to lead to a faster growth in employment, albeit from a lower level. (This
conclusion will not follow, however, if there is a continuous switching to more capital-intensive
techniques as profits are reinvested.)
2. What is the relationship between unemployment and (a) poverty; (b) inequality?
(a) The greater the unemployment, the greater will tend to be the level of poverty, given that in most
developing countries there is little or no state financial support for the unemployed.
(b) The greater the unemployment, the greater will tend to be the level of inequality. Society will become
increasingly polarised into those with and those without jobs.
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751 (Box 26.5) If there were three techniques available, what would the isoquant look like? Would it make
any difference to the conclusions of this model?
The isoquant would have four straight-line
K
sections. One vertical; then two downwardsloping sections, the higher one steeper than
the other; then a horizontal section. This is
illustrated in Diagram 26.1 opposite. Each of
the three corners of the isoquant would be at
the capital/labour ratio of one of the three
techniques.
An isoquant like this would make no
difference to the conclusions of the model. A
capital-intensity bias could still lead to a more
capital-intensive technique being chosen from
the three available, than that warranted by
questions of cost alone.
Diagram 26.1 A kinked isoquant
(Box 26.5) If more jobs were created in the

towns, how, in the ruralurban migration model, would this affect (a) the level of urban unemployment;
(b) the rate of urban unemployment?
If more jobs were created in the towns, Lm would rise. This would cause Wue to rise.
(a) If Wue rises, more people will migrate and thus the level of urban unemployment will rise.
(b) If the urban wage (Wu), the rural wage (Wr) and the cost of migration () are unaltered, then migration
will take place until Wu.Lm/Lu has returned to its original level, with Lm/Lu the same as before. Thus
although the level of unemployment has risen, the rate of unemployment has stayed the same.
What common ground is there between structuralist and monetarist explanations of inflation and lack of
growth in developing countries?
Structuralist economists generally accept that high inflation is accompanied by high rates of growth in the
money supply, even though they see monetary growth as a symptom of the problem rather than its basic
cause.
Both structuralists and monetarists accept the importance of supply-side policies to relieve bottlenecks,
increase growth and reduce unemployment. Monetarists, however, generally see the means of achieving
this to be a liberating of market forces, whereas structuralists generally advocate interventionist policies.
754 (Box 26.6) One solution proposed to help solve Argentinas weak financial position is that it should
abandon the peso as its unit of currency and replace it with the US dollar. What advantages and
drawbacks might such a solution have for the Argentine economy both in the short and the long term?
The advantages are that there would be much greater currency stability and a more stable macroeconomic
environment, with inflation more under control. In the short-term this would help to restore confidence in
the economy and encourage people to save. In the longer term it would encourage inward investment and
trade. The disadvantage is that interest rates would be determined in the USA, and they might not be
suitable for the Argentine economy at any given time: in other words, Argentina would lose control over
monetary policy. The arguments here are similar to those concerning whether the UK should adopt the euro.
The main difference is that the UK would have considerable input into eurozone macroeconomic policy,
whereas Argentina would have no input into US macroeconomic policy.
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755 What are the relative advantages and disadvantages to a developing country of rescheduling its debts
compared with simply defaulting on them (either temporarily or permanently)?
Default is a high-risk strategy. The benefits are an immediate wiping out of debt. The potential costs are
great, however. Its assets in foreign institutions may be confiscated, as too may its ships and merchandise
in transit. Once having defaulted, it will be virtually impossible to raise future loans to rebuild the
economy. The threat of default, however, especially if made by several debtor countries acting together,
could force creditor institutions to offer lower interest rates or more generous rescheduling programmes, or
even to write off a certain portion of the debt.
757 (Box 26.7) 1. If reductions in developing countries debt are in the environmental interests of the whole
world, then why have developed countries not gone much further in reducing or cancelling the debts
owed to them?
Because it would not be in the private interests of the banks concerned. Even in the case of official
government loans, individual developed countries may be reluctant to cancel debts on their own, feeling
that it is not their specific responsibility.
(Box 26.7) 2. Would it be possible to devise a scheme of debt repayments that would both be acceptable
to debtor and creditor countries and not damage the environment?
A longer period to pay would reduce the pressure on developing countries to exploit their environment.
Also direct financial help to developing countries to protect the environment would be in the global interest
and could also help to reduce developing countries debt burden. See the section on debt-for-nature swaps
in Box 26.8 on page 758.
767 (Box 26.8) Would the objections of developing countries to debt-equity swaps be largely overcome if
foreign ownership was restricted to less than 50 per cent in any company? If such restrictions were
imposed, would this be likely to affect the price at which debt were swapped for equity?
To some extent, yes. Developing countries would be able to retain the controlling interest in their
companies within their borders. There would still be foreign influence in the running of the companies,
however, but this may not be wholly unwelcome with the expertise that advanced countries can bring.
Restricting ownership to less than 50 per cent would reduce the benefits to the developed-country banks
or companies. They would therefore be unwilling to pay such a high price for equity than if they had been
able to acquire a controlling share.
759 Imagine that you are an ambassador of a developing country at an international conference. What
would you try to persuade the rich countries to do in order to help you and other poor countries
overcome the debt problem? How would you set about persuading them that it was in their own interests
to help you?
You could try to persuade them to reschedule your debts and to grant new loans on more concessionary
terms. This would be in their interests if it enabled you to give a firmer guarantee that the loans would be
repaid.
You might also try to encourage them to sign trade deals with you or companies in your country, in
order to improve your balance of payments. This would again be in their interests in that it would enable
you more easily to service any loans they had made to you.
You might also try to persuade them to reduce interest rates, both to make it easier for your country to
service its debts, and to give a boost to world demand and hence to the demand for your exports. You could
try to show them that a growing world economy was in everyones interests.
160
Appendix 1
Page
A:1 What else is the diagram telling us?
That below a certain level of income the person spends nothing at all on entertainment.
That even if the persons income dropped to zero, some food would still be purchased (presumably by
borrowing or begging the money).
That as income rises the proportion spent on food falls.
That as income rises the proportion spent on entertainment rises.
That although as income rises, a smaller amount is spent out of each pound on food, the rate at which
this amount falls gradually gets less (the curve changes slope less rapidly).
That although as income rises, a larger amount is spent out of each pound on entertainment, the rate at
which this amount rises gradually gets less (the curve changes slope less rapidly).
A:2 The table in Box 1.2 shows time-series data for four different variables for four different countries.
Would there have been any advantage in giving the figures for each separate year? Would there have
been any disadvantage?
Advantages: more detailed information; peaks and troughs can be more precisely identified in terms of
both timing and magnitude; might identify trends within the three-year periods.
Disadvantages: more information to take in; may make long-term trends harder to identify; may give undue
weight to short-term aberrations.
What was the level of unemployment mid-way between quarter 1 and quarter 2 2000?
About 1.66 million.
A:3 How would it be possible to show three different lines on the same diagram?
You could simply use three different vertical scales one for each line. You could actually show the units
of two (or even all three) up the left-hand (vertical) axis. If you glance at page 574 of the text, you will see
an example of this (Figure 20.11).
A:4 Could bar charts or pie charts be used for representing time-series data?
Bar charts are frequently used for this purpose. If you look at the figure in Box 8.5 on page 207 of the text,
you will see an example.
Pie charts are not so suitable for this purpose, unless we want to see how something has been divided
up over a period of time. For example, we may want to represent how a persons annual income is spent
over the course of the year and divide the pie into twelve segments, each one representing the proportion of
annual income spent in that month. The twelve segments could be represented in chronological order going
clockwise round the pie.
1. If the vertical scale for Figure A1.2 ran from 0 to 5 million, how would this alter your impression of the
degree to which unemployment had changed?
Unemployment would seem to have been more stable over the period. The fall in unemployment over the
period would seem to be smaller. (Of course, there would be no real difference at all.)
2. What are the advantages and disadvantages of presenting data graphically with the axes starting from
zero?
You can get a clearer impression of the percentage rate of change of a variable. On the other hand, if the
values of the variable in question start from a high level (e.g. unemployment fluctuating between 2.2 and
2.6 million), then to have the axis running from, say, 2.0 to 3.0 millions, will show up the fluctuations more
dramatically. It is like putting a magnifying glass on the information.
161

Page
A:6 1. If a bank paid its depositors 3 per cent interest and inflation was 5 per cent, what would be the real
rate of interest?
2 per cent. The real value of your deposits would be falling by 2 per cent per year.
2. Has your real income gone up or down this last year?
Look at the percentage increase in your nominal income, and then deduct the rate of inflation. (Note that
not all goods and services go up in price at the same rate, and thus the headline rate of inflation, based on
the retail price index (see page A:7 of the text), may not fairly reflect the increases in costs you personally
have faced.)
Does this mean that the value of manufacturing output in 2001 was 2.7 per cent higher in money terms?
No. If prices have risen (as they invariably do), the value of output in money terms will rise more than the
volume of output.
What was the growth rate in manufacturing output from (a) 1982 to 1983; (b) 2000 to 2001?
Using the formula (It It1)/It1 100, gives:
(a) (75.5 75.8)/75.8 100 = 0.40%
(b) (102.7 105.1)/105.1 100 = 2.28%
A:7 If the RPI went up from 150 to 162 over 12 months, what would be the rate of inflation?
Using the formula (RPIt RPIt1)/RPIt1 100, gives:
(162 150)/150 100 = 8%
A:9 On a diagram like Figure A1.8 draw the graphs for the following equations:
y = 3 + 4x
y = 15 3x
In the first case, the graph would cross the vertical (y) axis at 3. It would be upward sloping and have a
slope of 4: i.e. as you move up the line, for every one unit you move along the horizontal axis you would
move 4 units up the vertical.
In the second case, the graph would cross the vertical axis at 15. It would be downward sloping and have a
slope of 3: i.e. as you move down the line, for every one unit you move along the horizontal axis you
would move 3 units down the vertical.
Note that both graphs are a straight line. This is because there is no x squared term (or any other x term to a
power greater than 1).
What shaped graph would you get from the equations:

y = 6 + 3x + 2x
y = 10 4x + x
(If you cannot work out the answer, construct a table like Table A1.9 and then plot the figures on a
graph.)
In the first case, the graph will be a curve crossing the vertical axis at 6. As the value of x increases above
0 and the x term grows more and more rapidly, the curve will slope upwards more and more steeply.
In the second case, the graph will be a curve crossing the vertical axis at 10. As the value of x increases
above 0, initially the curve will slope downwards because the 4x term will be dominant; but then the curve
will slope upwards again as the x term begins to dominate.
162
Appendix 1
Page
A:10 What would be the marginal cost equation if the total cost equation were:
C = 15 + 20Q 5Q + Q
What would be the marginal cost at an output of 8?
To find the marginal cost equation you differentiate the total cost equation:
i.e. marginal cost = dC/dQ = 20 10Q + 3Q.
Thus when Q = 8, MC = 20 80 + 192 = 132.
What is the meaning of a negative profit?

A loss. (When the total cost of producing a given number of units of output exceeds the total revenue
earned by selling them.)
A:11 (Box A1.1) If the opposition were indeed to claim that a fall in unemployment was bad news, what would
have to be the value of dN/dt: positive or negative?
Positive. If the dN/dt term is negative (i.e. unemployment is falling) but the dN/dt term is positive, this
means that the rate of fall in unemployment is slowing down: signs, the opposition would say, that the
improvement is beginning to come to an end: bad news! (Looking at Table A1.1 and Figure A1.2, the
opposition may well have claimed this in 2000 Q3 or 2001 Q1.)
A:12 Given the following equation for a firms average cost (AC) i.e. the cost per unit of output (Q):
AC = 60 16Q + 2Q
(a) At what output is AC at a minimum?
(b) Use the second derivative test to prove that this is a minimum not a maximum.
(a) AC is at a minimum where dAC/dQ = 0
i.e. where 16 + 4Q = 0
i.e. where Q = 4
(b) This is a minimum rather than a maximum because the second derivative is positive.
(dAC/dQ = 4)
163

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Answers to in-text Questions in Economics (5th

Answers to questions in Economics (5th edition) by John Sloman

Would it ever be desirable to have total equality in an economy?

(Box 1.3) 1. Why is the cost of food not included?

(Box 1.3) 2. Make a list of the benefits of higher education.

1. What is the opportunity cost of the seventh million units of clothing?

Answers to questions in Economics (5th edition) by John Sloman

Are different factor markets similarly interdependent? Give examples.

Total market demand

32 1. How much would be demanded at a price of 6p per kilogram?

Price (pence per kg)

Quantity demanded (kg per month)

Diagram 2.1 Tracey's and Darren's demand for potatoes

Quantity demanded (kg per month)

Diagram 2.2 Market demand for potatoes

Answers to questions in Economics (5th edition) by John Sloman

Diagram 2.3 Market demand (with respect to income)

1. How much would be supplied at a price of 70p per kilo?

1. For what reasons might the supply of potatoes fall?

Answers to questions in Economics (5th edition) by John Sloman

The profitability of producing alternative products decreases.

Diagram 2.4 Market supply

Answers to questions in Economics (5th edition) by John Sloman

Answers to questions in Economics (5th edition) by John Sloman

These questions still refer to Figure 2.18.

Given the following supply schedule:

(a) Draw the supply curve.

Answers to questions in Economics (5th edition) by John Sloman

Answers to questions in Economics (5th edition) by John Sloman

Answers to questions in Economics (5th edition) by John Sloman

Diagram 3.1 Static costs of high fixed prices

Answers to questions in Economics (5th edition) by John Sloman

MU = dTU/dQ = 200 50Q + 3Q

Diagram 4.1 MU = 200 50Q + 3Q2

(Box 4.2) The diagram illustrates a persons

Define risk and uncertainty.

Answers to questions in Economics (5th edition) by John Sloman

Answers to questions in Economics (5th edition) by John Sloman

(b) Increase in price of Y

(a) Decrease in price of X

Answers to questions in Economics (5th edition) by John Sloman

Equation (3) MPP

Answers to questions in Economics (5th edition) by John Sloman

Answers to questions in Economics (5th edition) by John Sloman

Answers to questions in Economics (5th edition) by John Sloman

Answers to questions in Economics (5th edition) by John Sloman

Answers to questions in Economics (5th edition) by John Sloman

Answers to questions in Economics (5th edition) by John Sloman

Answers to questions in Economics (5th edition) by John Sloman

Answers to questions in Economics (5th edition) by John Sloman

Answers to questions in Economics (5th edition) by John Sloman

Answers to questions in Economics (5th edition) by John Sloman

Answers to questions in Economics (5th edition) by John Sloman

Answers to questions in Economics (5th edition) by John Sloman

Answers to questions in Economics (5th edition) by John Sloman

Answers to questions in Economics (5th edition) by John Sloman

Answers to questions in Economics (5th edition) by John Sloman

Answers to questions in Economics (5th edition) by John Sloman

Tax minus benefit

P > MC (i.e. P > MSC)

P > MC (i.e. P > MSC)

Answers to questions in Economics (5th edition) by John Sloman

Diagram 11.1 External costs in production

Diagram 11.2 External costs in consumption