Answers To in Text Questions Sloman J 6e

Answers to in-text Questions in Economics (6th edition)
Chapter 1
Page Could production and consumption take place without money? If you think they could, give examples. 4 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.
Answers to questions in Economics (6th edition) by John Sloman
Page (Box 1.2) 1. Has the UK generally fared better or worse than the other three countries? 7 Generally worse until recent years. Unemployment was higher than in Germany and Japan, and also than in the USA from 1981 to 2000. In the last period, however, UK unemployment has been lower than in Germany. Inflation has generally been higher than in the other countries, although in the last period it has been lower than the US rate. In the 1960s and 70s, UK growth was lower than in the other three countries. In the last two periods, economic growth in the UK has been higher than that in Germany and Japan and only slightly lower than 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 for most of the time since 1961. The UKs deficit, however, has generally been less severe than the USAs, especially in the latest period.
(Box 1.2) 2. Was there a common pattern in the macroeconomic performance of each of the four countries over these 45 years? With inflation yes, but not with the other indicators. Unemployment has been rising throughout in Germany and Japan, whereas in the UK it has fallen in the last two periods. The USA has not followed a similar pattern to any of the other three countries, with unemployment lowest in the middle period (the period in the UK when unemployment was at its highest). Inflation was highest for all four countries in the second period. Since then each subsequent period has recorded lower inflation than the previous one. Growth rates in Germany and Japan have slowed, whereas rates in the UK and the USA have generally been maintained. UK and US current account deficits have deteriorated, with a dramatic worsening in the USA in the last period. German and Japanese current account surpluses have increased, with the exception of Germany in the penultimate period. Note that the figures given are merely the averages for each period. They do not indicate, therefore, the fluctuations that took place within the periods. For example the early 1980s and early 1990s were periods of low growth and high unemployment, whereas the late 1970s and late 1980s were periods of relatively high growth and high inflation and the late 1990s was also a period of relatively high growth.
(Threshold Concept 1) 1. Think of three things you did yesterday. What are the opportunity costs of each one? Obviously, this depends on the three things you choose. In the case of things you purchased, the opportunity cost is the next best thing you could have purchased with the money. In the case of other activities, the opportunity cost is the next best thing you could have done with the time. (Threshold Concept 1) 2. Assume that a supermarket has some fish that has reached its sell-by date. It was originally priced at 10, but yesterday was marked down to 5 for quick sale. It is now the end of the day and it still has not been sold. The supermarket is about to close and there is no-one in the store that wants fish. What is the opportunity cost for the store of throwing the fish away. It is simply the cost of disposing of it which may be zero, if its waste disposal is not charged per unit. The price it paid for the fish is irrelevant since it cannot recoup this cost.
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.
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).
Chapter 1
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(Threshold Concept 2) 1. Assume that a firm is selling 1000 units of a product at 20 each and that each unit on average costs 15 to produce. Assume also that to produce additional units will cost the firm 19 each and that the price will remain at 20. To produce additional products will therefore reduce the average profit per unit. Should the firm expand production? Explain? Yes. Additional units still earn extra profit of 1 each (i.e. 20 19). If the firm wants to increase profits, therefore, it should increase production, even though additional units earn only an extra 1 and not the average of 5 earned on previous units. We consider the concepts of marginal cost and marginal revenue in Chapter 5. (Threshold Concept 2) 2. Assume that a ferry has capacity for 500 passengers. Its operator predicts that it will typically have only 200 passengers on each of its mid-week sailings over the winter. Assume also that each sailing costs the company 10,000. This means that mid-week winter sailings cost the company an average of 10,000/200 = 50 per passenger. Currently tickets cost 60. Should the company consider selling stand-by tickets during the winter for (a) less than 60; (b) less than 50? (Clue: think about the marginal cost of taking additional passengers.) It should consider the additional cost of taking the extra passengers. This is likely to be close to zero, given that there is room for extra passengers and the ferry is sailing anyway. In considering how much to reduce the stand-by price below the current price of 60, the company must weigh up the extra passengers attracted by the lower price against the lower amount earned per stand-by passenger. If a 20 per cent cut in price, say, resulted in an increase in passengers of more than 20 per cent, then the ferry company would earn more as a result of that price cut. We will consider these calculations when we look at the concept of elasticity in section 2.4. These calculations assume that selling stand-by tickets does not affect the number of passengers on regular tickets. However, if cheap stand-by tickets reduce the number of people buying regular tickets, then the net gain in revenue will be less.
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(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.
(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.
(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.
Page 11 (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.
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?
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(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.
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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.
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.
Chapter 1
Page 14 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. 17
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.
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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.
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(Threshold Concept 3) 1. Give two other examples of perverse incentives. How could the incentives be improved? If the government caps the amount of money that local authorities can raise in council tax in order to encourage them to cut waste and reduce their bureaucracy, it might have the perverse effect of reducing the quality of services the local authority provides. If house prices rise in response to the excess of demand over supply, this may have the perverse effect of increasing demand, not choking it off. The reason is that people may see prices rising and rush to buy now before they rise any further. We examine this destabilising speculation in section 2.5. If the government, or firm or anyone else is offering incentives for people to do things, they need to think closely about the unintended consequences of these incentives and, if necessary, change the incentives so as to avoid them. In general it is best to tackle a problem as close to source as possible if these unintended consequences or side effects are to be minimised. (Threshold Concept 3) 2. Find out just what the learning objectives are of the economics course or module that you are studying. What positive incentives are there for you to meet these learning objectives? Identify any perverse incentives and how you would change them. Perverse incentives are likely to arise from assessment capturing only some of the learning objectives, with the result that others will be ignored by some students. Lecturers are encouraged to consider constructively aligning their courses. What this means is that teaching and study methods, class activities, reading and assessment should all match the learning objectives of the course or module.
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(Threshold Concept 4) 1. If there is a shortage of certain skilled workers in the economy, how will market forces lead to an elimination of the skills shortage? The shortage of skilled workers will drive up their wages relative to other workers, thereby choking off the excess demand firms will try to economise on these skilled workers, perhaps by using alternative techniques of production. The higher wages will encourage more people to train. It will also encourage skilled workers to move to the country from abroad. Over time, then, this will lead to increased supply. This will have a dampening effect on the wage rate, making the net rise smaller.
Answers to questions in Economics (6th edition) by John Sloman Page 22
(Threshold Concept 4) 2. If consumers want more of a product, it is always desirable that market forces result in more being produced? No. People may be unaware of the harmful consequences to themselves from the increased consumption of certain products. Also the consumption of certain products may have adverse consequences on other people (e.g. the effects of passive smoking, or the nuisance of litter). Similarly the production of certain goods may result in pollution.
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.
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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 surplus (Si > Di) Pi
Si until Di = Si Di
Goods Market Sg Pi Sg surplus (Sg > Dg) Pg Dg until Dg = Sg
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.
Chapter 1
Page 24 (Threshold Concept 5) 1. Would you ever swap things with friends if both of you did not gain? Explain your answer. In most cases you would not do so. The exceptions would be: where you thought you would gain at the time you made the swap, but afterwards find that the item you have obtained does not give you the benefit you thought it would. The problem here is one of imperfect knowledge at the time of the swap. where you were thinking more about the other person than yourself, and swapped something you know they really wanted from you for something you did not really want from them. The question here, however, is whether you can still be said to have gained because you made a sacrifice yourself for someone else. A similar question is whether you gain from giving to charity or giving someone a gift.

(Threshold Concept 5) 2. Give one or two examples of involuntary (i.e. compulsory) economic interaction where one side gains but the other loses. Paying taxes; robbery; parking fines.
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(Threshold Concept 6) 1. If global warming affects all of us adversely, why in a purely market economy would individuals and firms continue with activities that contribute towards global warming? Partly out of ignorance of the effects, but mainly because people individually gain more from such activities than they lose. Although each time you use your car, or use electricity generated by fossil fuels, you are contributing to global warming, your individual contribution is minuscule. What is more, the amount you suffer personally from global warming is again minuscule compared with the total amount the whole population of the world suffers. Thus many people selfishly ignore the environmental costs of their actions. But when the majority of people do this, then the costs to all of us may be considerable, let alone the costs to wildlife and the planet generally.
(Threshold Concept 6) 2. In what ways do your own consumption patterns adversely affect other people? You may what to take a while to reflect on the costs to others of what you do yourself. Are you ever inconsiderate, and if so, in what ways? Do you ever chuck litter away? Do you ever drive without giving due care and attention to other road users, pedestrians or residents, or do you ever park inconsiderately? Do you ever play music in public places that others can hear?
(Threshold Concept 7) 1. How may welfare benefits be seen as a means of correcting market failures? Does the payment of such benefits create any problems for society? A market economy may lead to a very unequal society. To the extent that this is seen as a market failure, then benefits can help to correct it by redistributing income from richer to poorer people. The main problems from benefits are: They may discourage people from looking for work if this will result in them losing their benefits. They may be set at too low a level to make a significant difference to inequality. The higher taxes that must be paid to fund the benefits may act as a disincentive to taxpayers generally to work so much. This will reduce the level of the countrys production and income. These issues are examined in section 10.2.
(Threshold Concept 7) 2. Assume that the government sees litter as a market failure that requires government action. Give some examples of policies it could adopt to reduce litter. Having litter wardens who could fine people for dropping litter; increasing fines for dropping litter; having an anti-litter campaign on television or on posters; requiring schools to include litter awareness as part of citizenship education; requiring fast food outlets to provide adequate wastebins and encourage their use; putting a tax on plastic bags and packaging to encourage manufacturers, shops and consumers to find alternatives.
Page 29 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 35 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
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.) 36 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 80
Price (pence per kg)
70 60 50 40 30 20 10 0 0 5 10 15 20 25 30 Quantity demanded (kg per month)
Darrens demand
Traceys demand
Diagram 2.1 Tracey's and Darren's demand for potatoes
Page 36 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.) 37 (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. 1994: 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 = 56.07 (grams per person per week) 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 = 44.59 (grams per person per week) 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.
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Chapter 2
Page 37 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. Relate each of these six determinants to the demand for butter. Tastes: if it is heavily advertised, demand is likely to rise. If, on the other hand, there is a cholesterol scare, people may demand less for health reasons. Substitutes: if the price of margarine goes up, the demand for butter is likely to rise as people switch from one to the other. Complements: if the price of bread goes up, people will buy less bread and hence less butter to spread on it. Income: if peoples income rises, they may well turn to consuming butter rather than margarine or feel that they can afford to spread butter more thickly on their bread. Income distribution: if income is redistributed away from the poor, they may have to give up consuming butter and buy cheaper margarine instead, or simply buy less butter and use it more sparingly. Expectations: if it is announced in the news that butter prices are expected to rise in the near future, people are likely to buy more now and stock up their freezers while current prices last. 38 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)
70 60 50 40 30 20 10 0 0 100 200 300 400 500 600 700 800 900 Quantity demanded (kg per month)
New demand Old demand
Diagram 2.2 Market demand for potatoes
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Page 38 2. The price of cashew nuts rises and yet it is observed that the sales of cashew nuts increase. Does this mean that the demand curve for cashew nuts is upward sloping? Explain. No not necessarily. For example, the price of substitutes such as peanuts or other nibbles may have risen by a larger amount. In such cases the demand curve for cashew nuts will have shifted to the right. Thus although a rise in the price of cashew nuts will cause a movement up along this new demand curve, more cashew nuts will nevertheless be demanded because cashew nuts are now relatively cheaper than the alternatives. (Looking at the Maths) 1. Complete the demand schedule in Table 2:2 up to a price of 50. See the following table: P 5 10 15 20 25 30 35 40 45 50 Qd 9000 8000 7000 6000 5000 4000 3000 2000 1000 0
(Looking at the Maths) 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 (Looking at the Maths) 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. See the following table: Y (millions) 100 150 200 250 300 Qd 50 000 100 000 150 000 200 000 250 000
(Looking at the Maths) 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 on next page).
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Chapter 2
Demand
300 250
Income ( millions)
200 150 100 50 0 0 50 100 150 Quantity demanded 200 250 300
Diagram 2.3 Market demand (with respect to income)
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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).
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By referring to each of the above determinants of supply, identify what would cause (a) the supply of potatoes to fall and (b) the supply of leather to rise. (a) Fall in supply of potatoes: The cost of producing potatoes rises. The profitability of alternative crops (e.g. carrots) rises. A poor potato harvest. Farmers may find producing other crops more enjoyable. Farmers expect the price of potatoes to rise (short-run supply falls). Potato farmers may leave the industry. (b) Rise in supply of leather The cost of producing leather falls. The profitability of producing alternative products decreases. The profitability of rearing sheep falls. 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). An increase in leather imports. 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.
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Answers to questions in Economics (6th edition) by John Sloman Page 42 (Looking at the Maths) 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. (Looking at the Maths) 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
P 1 2 3 4 5 6 7 8 9 10
Qs 1500 2500 3500 4500 5500 6500 7500 8500 9500 10500
Price
Supply
8 7 6 5 4 3 2 1 0 0 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 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). (Looking at the Maths) 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.
43
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.
44
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.
14
Chapter 2
Page 45 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) (b) (c) (d) (e) Price rises, quantity rises (demand shifts to the right: butter and margarine are substitutes). Price falls, quantity rises (supply shifts to the right: butter and yoghurt are in joint supply). Price falls, quantity falls (demand shifts to the left: bread and butter are complementary goods). Price rises, quantity rises (demand shifts to the right: bread and butter are complementary goods). 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).
47
(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 and the late 1990s and early 2000s; (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 past three years. Attempt an explanation of what has happened. You can find details from websites B7 and 8, accessed from the Hotlinks section of the books website. Your explanation should focus on the various factors listed in the box.
50
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.
15
Page 50 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. 51 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. 52 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 ()
2.50 5.00 10.00 20.00 40.00 Q 400 200 100 50 25 TE () 1000 1000 1000 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 2.13(c) in text.) (a) 1000 units. (b) 10 000 units. (c) There would be an infinite demand! 53
(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.
16
Chapter 2
Page 53 (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. 54 (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.) Referring to Figure 2.15, 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. 56 (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
17
Answers to questions in Economics (6th edition) by John Sloman 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 = 0 (Looking at the Maths) These questions still refer to the diagram. 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)
56
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). 58 (Looking at the Maths) Given the following supply schedule:
P
2 0
4 10
6 20
8 30
10 40
(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.
18
Chapter 2 Page 59 (Threshold Concept 8) 1. What would you understand by the wage elasticity of demand for labour? How would the magnitude of this elasticity affect the working of the market for plumbers? It is the responsiveness of demand for labour to a change in the wage rate. Its formulae is: %QDL %W Where QDL is the quantity of labour demanded and W is the wage rate. The less the wage elasticity of demand for plumbers, the more the wage rate will change with any given change in the supply of, or demand for, plumbers. Thus a rise in house building would shift the demand curve for plumbers to the right. The less the wage elasticity of demand for plumbers, the larger will be the rise in the wage rates of plumbers. If high wage rates led to a large increase in the numbers training to be plumbers, then after a time the supply of plumbers will increase. With a wage inelastic demand for plumbers, this will lead to a significant fall in their wage rates. (Threshold Concept 8) 2. How is the concept of income elasticity of demand relevant in understanding how the structure of economies changes over the years. The higher the income elasticity of demand for a particular product, the more will industries that supply it expand over time as national income rises. Conversely, products with a low income elasticity of demand will suffer a relative decline. In cases where income elasticity of demand is negative, this decline will be absolute. 60 Look ahead to Box 3.4 (page 79). It shows the income elasticity of demand for various foodstuffs. Explain the difference in the figures for milk, bread and fresh fish. 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. 63 In Figures 2.21 and 2.22, 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(a) and (b) on the next page. Redraw Figures 2.23 and 2.24 assuming, as in the previous question, that the initial change in price was caused by a shift in the supply curve. See Diagram 2.5(c) and (d) on the next page.
64
19
P2
Exports
Good a
P1C1 Imports
C2 I2 I1
Good b
Diagram 2.5 Speculation: initial shift in the supply curve
65
(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.
66
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.
20
Chapter 3
Page 70 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. 71 (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. 72 (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.
21
Page 74 (Looking at the Maths) Assuming that the pre-tax equations were: QD = 120 10P and QS = 10 + 5P What is (a) the consumer share of the tax and (b) the producer share? First we find the pre-tax price. This is found by setting the two equations equal to each other: 120 10 P = 10 + 5P 15P = 110 P = 7.33 We now find post-tax price received by producers (P1) and the post-tax price paid by consumers (P1 + t). In the text we saw that:
P1 =
a c bt b+d 120 10 20 P1 = 10 + 5 =6
and that the market price is:
P1 + t = 8
Thus the producers share is: 7.33 6 = 1.33 and the consumers share is: 8 7.33 = 0.67 75 (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 spin-off 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.
22
Chapter 3
Page 75 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. 77 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. 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. 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. 79 (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). 23
Page 79 (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. 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. 80 (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 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. 82 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 green 24
Chapter 3 rectangle in Figure 3.11, cannot be less than that in Figure 3.12. But the width of the green 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). 82 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. 83 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. 86 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.
25
Chapter 4
Page 92 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. 93 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. 94 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.
Q 1 2 3 4 5 6 7 8
60Q 60 120 180 240 300 360 420 480
4Q2 4 16 36 64 100 144 196 256
= = = = = = = = =
TU 56 104 144 176 200 216 224 224
26
Chapter 4 Page 94 (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. MU = dTU/dQ = 200 50Q + 3Q
180 160
Q 1 2 3 4 5 6 7
200 200 200 200 200 200 200 200
50Q 50 100 150 200 250 300 350
+ + + + + + + +
3Q2 3 12 27 48 75 108 147
= = = = = = = =
MU 153 112 77
140 120 100 80 60
48 25 8 3
40 20
MU
0 -20 0 1 2 3 4 5 6 7
Diagram 4.1 MU = 200 50Q + 3Q2
96
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 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.
MU, P
Pd
97
(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 Qd
MU diamonds
Qw
MU water Quantity of water Quantity of diamonds
Diagram 4.2 MU of water and diamonds
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Page 99 (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 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. 101 (Threshold Concept 9) 1. What risks are involved in buying a house? That mortgage interest rates may go up; that the price of the house may not rise as rapidly as you thought; that the house may suffer from some structural defect that you had not known about at the time of purchase; that there may be some accident to the property; that the neighbours may be unpleasant in one way or another. In most of these cases, the problem is largely one of uncertainty rather than risk as the probability of the occurrence and magnitude of these events is not known. Insurance can help here. Insurance companies are likely to be able to assess risks much more accurately than you, and they can spread their risks over a large number of properties where, at least, they can assess the average risk. (Threshold Concept 9) 2. Give some examples of ways in which it is possible to buy better information. Your answer should suggest that there is profitable business to be made in supplying information. You could use an estate agent when selling a house, or an employment agency when finding a job. In both cases a charge is made, either to you or to the other party (i.e. the employer in the case of the job). The problem is whether you are always given accurate information. This is known as the principalagent problem and is Key Idea 22 on page 208. 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. 102 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.) 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.
28
Chapter 4
Page 102 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. 103 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. 104 (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. (Box 4.5) 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!). 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. 107 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.
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Page 107 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 107). 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. 108 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. 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. 110 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. 111 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).
30
Chapter 4
Page 113 (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. (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. 114 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 below. In each case the substitution effect is shown by a movement from point a to point b and the income effect is shown by a movement from point b to point c.
Good Y B1
Good Y
Substitution
B1a
a
B2
Income
a
b
I1
b
B2 B1a I1
I2
c
I2 Good X
Substitution
B1
Good X
Income
(a) Decrease in price of X Diagram 4.3
(b) Increase in price of Y
115 (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.
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Page 115 (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). 116 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).
32
Chapter 5
Page 121 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.
122 (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 5.1 and Figure 5.1 on page 123, 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. 124 (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.)
33
Answers to questions in Economics (6th edition) by John Sloman Page 125 (Box 5.3) A cricketer scores the following number of runs in five successive innings: Innings: Runs: 1 2 3 4 20 20 50 10 5 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 1 2 3 4 5 Total runs 20 40 90 100 100 Average runs 20 20 30 25 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 = 100/Qf + 32 + 10Qf Qf = 25 + 32 + 40 16 = 81 = 32 + 20Qf 3Qf = 32 + 80 48 = 64
Equation (2) APP
Equation (3) MPP
127 (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 50 to 52 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).
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Chapter 5 Page 129 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 (Q) (units) 0 1 2 3 4 5 6 7 () 12 12 12 12 12 12 12 12 TFC AFC (TFC/Q) () 12 6 4 3 2.4 2 1.7 () 0 10 16 21 28 40 60 91 TVC AVC (TVC/Q) () 10 8 7 7 8 10 13 TC (TFC + TVC) () 12 22 28 33 40 52 72 103 AC (TC/Q) () 10 22 6 14 5 11 7 10 12 10.4 20 12 31 14.7 MC (TC/Q) ()
130 (Box 5.6) 1. 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 5.4.) (Box 5.6) 2. 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.
35
Answers to questions in Economics (6th edition) by John Sloman Page 131 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. 133 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. 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. 134 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.
36
Chapter 5 Page 134 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). 136 (Box 5.7) Assume that the production function is given by: TPP =36K1/3L1/2R1/4 where R is the quantity of a particular raw material used. (a) Are there constant, increasing or decreasing returns to scale? (b) What is the marginal productivity of the raw material if K = 8, L = 16 and R = 81? (a) There are increasing returns to scale, since the power terms of the three factors (1/3, 1/2 and 1/4) add up to more than 1. (b) This can be found as follows:
MPPR = AK L R 1 36 3(81 / 3 )(161 / 2 )(81 3 / 4 ) 4 1 = 964 27 =8 =
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!). 137 Calculate the MRS moving up the curve in Figure 5.5 between each of the points: ed, dc, cb, and ba. 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. 138 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.
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Page 139 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. 140 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. 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. 141 Given the LRAC curve in Figure 5.11, what would the firms long-run total cost curve look like? Up to Q1, 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. Between Q1 and Q2, the long-run marginal cost curve would be horizontal and (equal to the LRAC curve) and thus the long-run total cost curve would be rising at a constant rate: i.e. it would be a straight line up from the origin. Above Q2, 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. 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. 142 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.
*
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Chapter 5
Page 143 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. 145 (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. 146 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. 149 Copy Figures 5.17 and 5.18 (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 (units) 3 4 5 6 7 8 9 P = AR () 8 7 6 5 4 3 2 TR () 24 4 28 2 30 0 30 2 28 4 24 6 18 MR ()
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.
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Page 150 1. Fill in the missing figures (without referring to Table 5.8 or 5.9).
Q (units) 0 1 2 3 4 5 6 7 P = AR () 9 8 7 6 5 4 3 2 TR () 0 8 8 6 14 4 18 2 20 0 20 2 18 4 14 56 8 36 6 16 42 6 25 5 9 18 3 18 4.5 6 5 1 14 4.3 4 2 0.5 12 6 2 4 1.3 10 10 2 2 1 MR () TC () 6 AC () 4 2 2 MC () T () 6 A ()
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. 151 From the information for a firm given in the table below, construct a table like Table 5.10.
Q P TC 0 12 2 1 11 6 2 10 9 3 9 12 4 8 16 5 7 21 6 6 28 7 5 38
Use your table to draw diagrams like Figures 5.19 and 5.21. 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 (units) 0 1 2 3 4 5 6 7 P = AR () 12 11 10 9 8 7 6 5 TR () 0 11 11 9 20 7 27 5 32 3 35 1 36 1 35 38 5.4 28 4.7 10 3 0.4 21 4.2 7 8 1.3 16 4.0 5 14 2.8 12 4.0 4 16 4.0 9 4.5 3 15 5.0 6 6.0 3 11 5.5 MR () TC () 2 AC () 4 5 5.0 MC () T () 2 A ()
The curves will be a similar shape to those in Figures 5.19 and 5.21. The peak of the T curve will be at Q = 4. This will be the output where MR and MC intersect. Page 40
Chapter 5 152 (Box 5.9) 1. How much is total fixed cost? 12 (the constant term in the TC equation) (Box 5.9) 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 5.9) 3. Plot TR, TC and T on a diagram like Figure 5.19. The curves will be a similar shape, with the T curve peaking at Q = 4 (Box 5.9) 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 (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 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.
(1)
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Chapter 6
Page 157 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. 158 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.] 159 (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 2firm or a 1-firm 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.
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Chapter 6
Page 159 (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. 160 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. 162 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. 164 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. 165 (Box 6.3) 1. Why may the Internet work better for replacement buys than for new purchases? With replacement buys, the consumer knows the product and can use the Internet to obtain them more cheaply. With first-time purchases purchased over the Internet, there is more risk that. It is not possible to see the items and possibly handle them, as would be the case in a shop. Returning goods that turn out not to be as expected may be time consuming.
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Answers to questions in Economics (6th edition) by John Sloman Page 165 (Box 6.3) 2. Give three examples of products that are particularly suitable for selling over the Internet and three that are not. Explain your answer. Particularly suitable: (i) tickets (coach, airline, concert, etc.); (ii) certain financial services, where the consumer understands the product; (iii) rare items that would otherwise require the consumer to travel a long distance to obtain them. In each of these cases, suppliers are likely to be in competition over the Internet, and hence help to drive the price lower. Having the items sent by post, or in the case of various financial services recorded electronically, saves the consumer time. Not particularly suitable: (i) fashion clothes; (ii) furniture; (iii) perishable foodstuffs. In each of these cases, consumers would probably rather choose their products from a shop, where they can inspect the items. In the case of clothes and perishable foodstuffs, there are clearly benefits of bringing the item home immediately from the shop rather than having to wait for it to be delivered. 166 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 rail 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. 168 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). (Looking at the Maths) What is the profit-maximising price if MC = MR = 12 and PD = 2? MC P= 1+ ( 1 ) P D 12 12 12 = = = = 24 1 1 1 + ( 2) 1 2 0.5 169 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 1901). 44
Chapter 6 Page 169 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. 171 (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. (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? 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. 172 (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. 174 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.
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Answers to questions in Economics (6th edition) by John Sloman Page 175 (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). (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.
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Chapter 7
Page 178 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. 179 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 longrun 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. (Box 7.1) 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 7.1) 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.
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Answers to questions in Economics (6th edition) by John Sloman Page 180 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). 181 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. 182 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. 183 (Box 7.2) 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 7.2) 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. 184 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. 185 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.
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Chapter 7 Page 186 (Box 7.3) 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. 187 (Box 7.3) 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) the early 2000s? 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 188: 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. 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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Answers to questions in Economics (6th edition) by John Sloman Page 188 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 188. 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. 193 (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) Give some 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. 194 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. 195 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. 196 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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Page 196 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. 197 (Box 7.5) 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 7.5) 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). 198 (Box 7.6) 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 7.6) 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 7.6) 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.
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Page 198 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 7.12. 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 7.12, 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. 200 (Box 7.7) 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 7.7) 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 7.7) 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. 201 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 7.14), 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 7.14). 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 7.14).
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Page 205 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. 207 (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. 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. 2. 3. 4. To increase sales. To seek promotion to a bigger store, head office or some other company. To ensure that staff work efficiently. 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. 208 (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. 210 (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. 211 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 5.21 on page 151 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 150.)
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Page 212 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. 213 See if you can identify two companies that are vertically integrated and what advantages they have from such integration.

Oil companies, such as ExxonMobil, explore for oil and gas reserves, drill, transport, refine, process, distribute and sell to customers. Many companies in the coffee industry own plantations, coffee processing plants and distribution networks. Kraft, for example, buys, roasts and markets its coffee.
214 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. 215 (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.
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Page 217 (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. 219 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. 220 (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). 221 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. 223 (Box 8.7) 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 8.7) 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.
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Page 224 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. 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.
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Chapter 9
Page 228 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. 229 (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. 231 (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 2845). (a) Diagram (c) on page 285 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 285 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 231 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. 232 (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. (Box 9.3) 3. Is the outsourcing of call-centre work to India and example of telecommuting? It is similar to the extent that a service can by provided in the UK without workers having to travel to a UK office. In other respects it is not quite the same. It is more similar to workers abroad working for a UK manufacturer which will sell its products in the UK, only here the product is a service rather than a physical good. 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. 233 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. 234 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 9.6) 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).
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Page 235 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! 237 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 workers (1) 1 2 3 4 5 6 7 8 9 10 Wage rate () (2) 100 105 110 115 120 125 130 135 140 145 Total cost of labour () (3) 100 110 210 120 330 130 460 140 600 150 750 160 910 170 1080 180 1260 190 1450 130 150 170 190 210 230 240 240 230 Marginal cost of labour () (4) Marginal revenue product () (5)
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.
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Page 238 (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 oligopsonistically 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. (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). 239 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 240 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. 241 (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.
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Page 242 (Box 9.6) 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) 244 (Box 9.7) 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 9.7) 2. In Table (b), which of the occupations have a largely female workforce? Many of the lower-paid occupations, such as sales assistants, and assemblers and routine operatives. 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). 245 (Box 9.7) 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 saving 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 9.7) 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.
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Answers to questions in Economics (6th edition) by John Sloman Page 247 (Box 9.8) 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 9.8) 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 9.11(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). 249 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. 250 Under what circumstances would the market demand for renting a type of capital equipment be (a) elastic; (b) inelastic? (Clue: turn back to pages 2345 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). 251 (Box 9.19) 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.) 62
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Page 251 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 9.13(c), 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. 252 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 9.13. (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)). 253 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. 255 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.
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Page 257 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? 259 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. 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. 260 (Box 9.10) 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 9.10) 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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Page 251 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. 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.
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Page 266 In which country in Figure 10.3 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. 267 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 10.4 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 7225 on the limitations of official national income statistics.) 3. What would the ratio be if national income were absolutely equally distributed? 40% / 20% = 2 268 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. 270 List the reasons for each of the three factors above. (Re-read section 9.2 and Box 9.7 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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Page 271 (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. 272 (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 287): 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
275 (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 a rise in the minimum wage encourages employers to substitute machines for workers, will this necessarily lead to higher 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. 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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Page 276 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. 278 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 2756 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 376) on the underground economy), (vi) if levied at a single rate on all goods and services, (vii), (viii), (ix). (c) (vi), (vii), (ix). 279 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. 280 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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Page 281 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 287, 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 10.12, 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). 282 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. 283 (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).
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Page 283 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. 284 (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. 285 (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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Page 285 (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. 288 (Box 10.6) Economists sometimes refer to an unemployment trap. People are discouraged from taking work in the first place. Explain how such a trap arises. Does the working tax credit create an unemployment trap? What are the best ways of eliminating, or at least reducing, the unemployment trap? An unemployment trap occurs where workers are discouraged from taking (low-paid) employment because the wages they would gain from such jobs would be wholly or substantially offset by the unemployment benefits they would lose. The working tax credit helps to reduce the unemployment trap by allowing people who take work to retain some benefit. The unemployment trap is best eliminated, or at least reduced, by tapering off lost benefits more slowly. Such a system, however, would cost more to provide, or would provide less to the very poor and more to the slightly less poor.
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Page 292 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. 293 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. 294 (Threshold Concept 10) 1. If general equilibrium is achieved when all markets have responded to a change and its knock-on effects, and if such changes are constantly occurring, will general equilibrium actually be achieved? Does your answer have any implications for policy? No, it will not actually be achieved because many markets do not respond instantly to changes in demand or supply, and thus before markets can have fully adjusted to one change, others have already occurred. The policy implication is that markets cannot be relied on, even in the absence of monopoly, to reflect all changes in demand or supply. Nevertheless, market forces are still powerful drivers in affecting output, employment and prices (Threshold Concept 10) 2. If social efficiency is seen as desirable (a normative issue), should policy necessarily be geared to achieving this? Not necessarily if there is a conflict with other goals, such as equity. In such cases, policy-makers may seek compromise between the different goals. 295 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 304.) 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).
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Page 295 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 = MDUf for all firms and factor suppliers. In the absence of externalities in the factor market, MSBf = MRPf, and MDUf = MSCf. Thus: MSBf = MRPf = Pf = MDUf = MSCf i.e. MSBf = MSCf 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 MDUf (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 237.) 296 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 2. Labour supply MRPl (i.e. MSBl) MRPl > W employment of labour W
W W > MDUl (i.e. W > MSCl) supply of labour MDUl (movement up along MDUl and hence MSCl curve) .
These adjustments would continue until MSBl = MSCl. 3. Producer supply MRPl MC P > MC (i.e. P > MSC) production P
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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(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 P
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).
297 (Threshold Concept 11) 1. Why might consumers not always make efficient consumption decisions? Because of lack of knowledge about the product and the utility they will derive; because of lack of care when buying products; (Threshold Concept 11) 2. Explain the meaning of social efficiency using the concept of Pareto optimality. There is a socially efficient allocation of resources when all possible Pareto improvements have been made: in other words, where it is not possible to make anyone better off without making at least one person worse off and when the gainers do not make sufficient gains to enable full compensation to be paid to the losers and there still to be a net gain. In considering such gains and losses, we must count the full social benefits and costs and not just private ones. 298 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. 299 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.
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Chapter 11 Page 302 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. 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?
MSC
MC
P1 P2
MC
P0 P1 P2
AC = S (= MSC)
P0
MU
MR O
Q1 Q2 Q0
AR Q
O
Q2
MSB
Q1 Q0
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 75
Answers to questions in Economics (6th edition) by John Sloman (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 237).] 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. 302 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!). 303 (Box 11.1) 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. (Box 11.1) 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 nontoll roads. 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 276) 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.
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Page 305 Referring back to Figure 9.8 on page 237, 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). 306 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. 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) (i) or (ii) (e.g. Which magazine); (b) (iii) (by asking people currently doing the job) or (iv); (c) (iii) (by obtaining estimates); (d) (iii) (albeit imperfect, by inspecting other work that the different builders have done) or (iv); (e) as (d); (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.
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Page 306 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). 307 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. 308 (Box 11.2) 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. 309 (Box 11.2) 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 11.2) 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 308). 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).
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Chapter 11 Page 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).
309 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.
311 (Box 11.3) 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 11.3) 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). 312 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 79
Answers to questions in Economics (6th edition) by John Sloman 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). 312 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. 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. 313 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.
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Page 313 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. 314 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. 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. 317 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.
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Page 317 (Box 11.4) 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 11.4) 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. 318 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.
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Page 319 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 322).] 321 (Box 11.5) 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. 323 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. 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.
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Page 323 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). 325 (Box 11.6) 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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Page 328 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. 331 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 on page 310). 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. 333 Draw a diagram like Figure 12.32, only this time assume that the activity has the effect of reducing pollution, with the result that the MCpollution 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. 335 (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).
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Page 337 (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 CO2 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. 338 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. 339 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). 340 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. 341 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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Chapter 13 Page 341 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. 342 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 Extra total journey time for all cars as traffic increases by one more car (Marginal social time cost: in minutes) (4) = (3) 5 5 5 9 16 26 46 80 123 Additional time cost imposed on other road users by one more car (Marginal external time cost: in minutes) (5) = (4) (2) 0 0 0 3 8 15 30 56 88
(Cars entering road per minute) (1) 1 2 3 4 5 6 7 8 9
(Marginal private time (total time cost: in cost: in minutes) minutes) (2) 5 5 5 6 8 11 16 24 35 (3) 5 10 15 24 40 66 112 192 315
344 (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). 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). 345 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.)
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Page 346 (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. 347 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. 349 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! 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. 351 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. 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. 352 (Box 12.5) 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 88
Chapter 13 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 cooperation and co-ordinated action by the competition authorities of different countries. 353 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 anticompetitive practices. Only if anti-monopoly and restrictive practice legislation were perfectly effective would there be no case for merger policy. 354 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 page 351. 355 (Box 12.6) 1. What features of the market for EWs distort competition?

Not enough knowledge on the part of consumers about alternatives to the EW being offered by the retailer and what constitutes value for money. Lack of transparency in the pricing of EWs. Lack of information about the benefits of the EW. A lack of alternatives at the point of sale. This gives the retailer considerable market power in the sale of EWs. The market for EWs being too closely linked to the market for the products. People are more concerned about the product and its price and specifications than about the EW. Being pressurised by the sales assistant to rush the decision. The principalagent problem that the sales assistants (as agents) are assumed by customers to be offering impartial advice when really they are more concerned to sell the EW and get a commission on the sale.
(Box 12.6) 2. To what extent will the ruling by the government make the market for EWs competitive? It will help to address the problem of imperfect information on the part of the consumer, but will not prevent the possibility of consumers being pressurised to buy an EW and being poorly advised by sales assistants. After all, people rarely read all the small print or other details of a supplementary product such as an EW when they are more concerned with the main product they are buying. 357 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.
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Page 358 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. 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. 359 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. 361 (Box 12.7) 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.
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Page 370 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. 372 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.
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Page 374 (Threshold Concept 12) When comparing two countries GDP growth rates, does it matter is we use nominal figures, provided we use them for both countries? Yes it does, since the two countries are unlikely to have the same inflation rate. The figures will overstate the GDP growth rate of the country with the higher inflation relative to that of the other country. 375 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. 375 (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, France, Italy, Spain, Greece, Portugal the Czech Republic and Poland. For example, the USA had a GDP per head that was 27.3 per cent higher than the EU average, but when the PPS figures are used, its GDP was 42.5 per cent higher than the EU average. In other words the actual exchange rate, on which the simple GDP figure was based, understates the purchasing power of the USAs GDP. 376 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. (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. Page 92
Chapter 13 376 (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). 377 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. 379 (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. 380 Figure 13.3 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. 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). 381 (Threshold Concept 13) 1. If people believe that the economy is about to go into recession (i.e. that real GDP will fall), how may their actions aggravate the problem? Firms may cut down on investment (an injection) and consumers may try to save more in order to prepare for possible cuts in overtime or even for unemployment. The effect is to reduce injections and hence reduce aggregate demand, thereby aggravating the fall in national income. (Threshold Concept 13) 2. Why will some people suffer more from others from a recession? Because some people will lose their jobs while others will not; some people will face cuts in incomes while others will not; firms selling luxury goods will find sales falling, while those selling basic everyday goods are likely to find sales holding up.
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Page 383 (Box 13.4) Under what circumstances would sustainable output (i.e. a zero output gap) move further away from the potential output ceiling shown in Figure 13.3? 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. 385 (Threshold Concept 14) 1. Give some examples of supply-side policy. Policies to increase incentives to invest in research and development (e.g. tax breaks or subsidies); increased spending on education and training and on improvements in transport infrastructure; reduced bureaucracy and red tape. (Threshold Concept 14) 2. If there is an increase in aggregate supply, will this result in an increase in potential growth? Not necessarily. There would need to be a faster increase in aggregate supply than previously if the potential rate of economic growth is to increase. 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. 387 (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. 389 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. 391 (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 94
Chapter 13 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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Page 397 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. 398 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. 400 (Box 14.1) 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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Page 402 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. 403 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. 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. 409 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.
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Page 412 (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. 413 (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. 415 (Box 14.5) Assume that these is a trade-off between unemployment and inflation, traced out by a Phillips curve. What would cause a leftward shift in this curve? A lower rate of unemployment for any given rate of inflation. This could be the result of policies to reduce equilibrium unemployment, for example policies to provide better job information so as to reduce frictional unemployment, or regional policy so as to reduce regional unemployment. It could also be the result of policies to reduce cost-push inflation (which, if successful, would shift the curve downwards). Such policies might include legislation to curb the power of trade unions, or competition policy to reduce the ability of monopolies or oligopolies to use their power to raise prices. 416 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. 418 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. 419 With reference to the above, provide an assessment of the UK balance of payments in each of the three years illustrated in Table 14.6. In 1997, the current account deficit was a modest 0.9 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 98
Chapter 14 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 exceeded 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 2004, there had been a substantial deterioration in the trade in goods account (to 57.9 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 14.7). There had, however, been a modest increase in the surplus on the balance on trade in services account since 1997. There were also substantial net income inflows, both of which helped to reduce the current account deficit, which nevertheless still stood at a deficit of 25.7 billion. The net investment flows in both directions had increased substantially since 1997, but the overall effect was a deterioration in the investment balance to 56.5 billion. A substantial increase in short-term financial inflows, however, (thanks to relatively high UK interest rates) outweighed the deficit on the investment part of the account and resulted in a financial account surplus of 27.0 billion. Page 420 How did the pound fare compared with the dollar, the lira and the yen from 1980 to 2005? 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 (until it ceased to circulate in 2001). There were, however, fluctuations around this trend. There was, for example, an appreciation against the dollar between 1994 and 1998 and between 2002 and 2005, and against the yen between 1994 and 1998 and between 2000 and 2005. 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 4212 of the text. 422 (Box 14.6) 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.
423 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.)
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Page 425 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. 426 1. Was there any five-year period when all four indicators were better than in the previous five years? 19948 2. Which macroeconomic problem(s) has/have generally been less severe since 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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Page 432 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. 433 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. 434 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. 435 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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Page 437 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. 438 (Box 15.2) 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). 441 Demonstrate this argument on an aggregate demand and supply diagram. See Figure 15.8 in the text (page 441). 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. 442 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). 444 Give some examples of supply-side policies that would help to reduce the natural rate of unemployment. Policies that reduce structural, frictional and technological unemployment. Examples include improving information on jobs, increased expenditure on training and vocational education, and re-locating government departments or offices to areas of high unemployment. 448 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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Page 454 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.) 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). 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. The mpc will increase, because the poor have a higher mpc than the rich. The consumption function will shift upwards and become steeper.
(b)
(c) (d)
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. 455 Go through each of the determinants of consumption that were listed in the previous section and consider how they will affect saving. Are there any determinants of consumption in that list which will not cause savings to rise if consumption is caused to fall?
Determinant Income (rise) Assets held (increase in) Taxation (fall) Cost of credit (lower interest rates) Expectations (that prices will rise) Redistribution of income (becomes more equal) Tastes and attitudes (people want to consume more) The average age of durables (increases) Consumption rise rise rise rise rise rise rise rise Saving rise fall rise fall fall fall fall 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.
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Page 456 (Box 16.1) Try using this equation to derive the figures in Table 16.1. 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.) (Box 16.1) First of all try constructing a table like Table 16.1 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
0 10 20 30 40 50 60 70 80 90 100 110 20 20 20 20 20 20 20 20 20 20 20 20 20 + + + + + + + + + + + + + 0.9Y 0 9 18 27 36 45 54 63 72 81 90 99 0.001Y2 0.0 0.1 0.4 0.9 1.6 2.5 3.6 4.9 6.4 8.1 10.0 12.1 = = = = = = = = = = = = = C 20.0 28.9 37.6 46.1 54.4 62.5 70.4 78.1 85.6 92.9 100.0 106.9
The curve gets gradually less and less steep because the negative term (0.001Y) becomes relatively larger and larger as Y increases. (Box 16.1) 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 16.1) 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. 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.
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Page 457 (Box 16.2) 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. 458 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 . 461 (Box 16.3) 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 16.3) 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. 463 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. (Threshold Concept 15) 1. How might cumulative causation work at the level of an individual firm that is losing market share? Stops might stop stocking its products or spare parts; suppliers may start charging higher prices to cover the fact that delivery loads are smaller; the firm may have less spare funds to devote to advertising; it may start losing key staff who are worried about their jobs. In other words, the decline in market share may result in further declines. (Threshold Concept 15) 2. Are there any market forces that work against cumulative causation? For instance, how might markets help to arrest the decline of a depressed region in the economy and slow down the expansion of a booming region? Market forces do generally work against cumulative causation. If demand for a product falls, the resulting fall in price will help to arrest the fall in demand; if demand rises, the resulting rise in price will serve to dampen the rise in demand. In other words, there is movement to an equilibrium. Taking the example in the question, if a region of the economy is depressed, wages are likely to fall in that region. This will attract firms to invest there to take advantage of the lower labour costs. By contrast, wages will rise in the booming regions, encouraging employers to move out of those regions.
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Page 464 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 16.1. The flatter the W line (the lower the mpw), the bigger the rise in Y for any given rise in J. 465 Why is the withdrawals multiplier strictly speaking a negative figure?
W, J W1
W2 W3 J1 J0
O Y0 Y1 Y2 Y3
Diagram 16.1 How the multiplier depends Because a rise in withdrawals causes a fall on the slope of the W curve in national income; and a fall in withdrawals causes a rise in national income. Thus in the 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.
466 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. 467 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 85 (m) 100 15 Ydis S = C (m) 85 5 80
C TE M = Cd (m) 80 10 12.5 57.5
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Page 467 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 saving will mean less total consumption, including less expenditure on imports.
(Box 16.5) 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. 470 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 Multiplier = 1/mpw (a) (b) (c) = 18bn = 22bn = 40bn
= 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 19, section 1 on the size of the tax multiplier).
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. 471 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. 472 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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Page 474 (Box 16.6) 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. Growth slows down after 2000 Q2, but the growth in investment only falls after 2000 Q4. Growth rises from 2003 Q1, but the growth in investment only begins to rise from 2003Q4. 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 16.6) 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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Page 480 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 Threshold Concept 12 on page 374) in order to compare the values of goods at different points in time.
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. 481 Which of the above are examples of economies of scale? 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. 485 (Box 17.2) 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. 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. 486 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! Page 109
Answers to questions in Economics (6th edition) by John Sloman 488 (Box 17.3) 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 104). 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 17.3) 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. 1. Would it be possible for an economy to function without a central bank? No. The functions listed on pages 4868 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 19, pages 5501.] 489 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. 491 (Box 17.4) 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. (Box 17.4) 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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Page 492 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) 493 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. 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. 494 (Box 17.5) 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 17.5) 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). 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).
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Page 495 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). 498 (Box 17.6) 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). 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! 499 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. 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. 500 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.
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Page 502 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 17.4: 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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Page 505 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 507 Figure 18.4 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 18.4 509 (Box 18.1) 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. 510 (Box 18.2) Why might it be difficult to establish the direction of causality from the evidence?

Because there may be unpredictable time lags involved with both fiscal and monetary policy, which makes it very difficult to separate cause and effect. Because there are many contributing factors to changes in aggregate demand and it is not always clear the extent to which individual factors are causing it to change. Because an expansion of bank lending may be both the cause and the effect of an increase in aggregate demand.
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Page 511 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). Redraw the three diagrams of Figure 18.1 with a steeper L curve. Show how an increase in money supply will have a larger effect on national income. In Figure 18.1(a), with a steeper L curve, the shift in the M curve will cause a larger change in r. In Figure 18.1(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 18.1(c) there will be a bigger vertical shift in the J line and hence a bigger multiplied change in national income. 512 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 18.7(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 18.7(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. 513 (Box 18.3) 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. 517 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 18.10, 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.
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Answers to questions in Economics (6th edition) by John Sloman Page 518 Draw a diagram like Figure 18.11, 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 18.11, 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. 519 Assume that national income is initially at Y2 in Figure 18.12. 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. 521 (Box 18.4) 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 18.4) 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 18.4) 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. 522 On a diagram similar to Figure 18.12, 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.
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Page 522 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 18.14). 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.) 525 Using a graph similar to Figure 18.16, trace through the 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.
ASI
Rate of inflation (P)
Ptarget P2
c b
ADI1 ADI2
O Y3 Y2 Y1 National income Diagram 18.1 Effect of a reduction in aggregate demand
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Answers to questions in Economics (6th edition) by John Sloman Page 526 1. Trace through the effect of an adverse supply shock, such as a rise in oil prices.
ASI2
ASI1
Rate of inflation (P)
Ptarget
P2
b a
ADI
Y2
Y1
National income Diagram 18.2 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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Page 531 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
Y Economies with different marginal rates of taxation
Y0
Y2
Y1
532 (Box 19.1) Which is likely to give a bigger boost to aggregate demand: tax cuts of a given amount targeted to (a) the rich, or (b) the poor? The poor. They have a larger marginal propensity to consume. 533 Show the effect of an increase in government expenditure by using (a) the injections and withdrawals diagram; (b) the income/expenditure diagram (see Figures 16.8 and 16.10 on pages 464 and 465). In Figure 16.8, the rise in government expenditure will shift the J line upwards (since government expenditure is an injection). In Figure 16.10, 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. 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.
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Page 535 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. 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. 537 (Box 19.2) 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. 538 (Box 19.3) 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 19.3) 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. 541 (Box 19.4) 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. 543 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 page 495 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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Chapter 19 Page 544 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%). 545 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 open-market 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 19.5) 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. 546 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 54950.) 547 (Box 19.6) 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). 549 (Box 19.7) 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.
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Page 549 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). 552 (Box 19.8) 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.
553 (Box 19.9) 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 19.9) 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. 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. 556 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 19.9 illustrates, will have a bigger effect on Y than shifts in the LM curve (caused by fluctuations in the money supply).
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Page 558 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. 559 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 19.7). 560 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 22.3). 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.
562 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.
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Page 562 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. 563 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. 564 1. From 1998 to 2001 the exchange rate of sterling was very high (see Table 14.7 on page 420). 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 18.3 on page 513). Also, the unpredictability of international financial flows makes the effects of fiscal (and monetary policy) changes less predictable. 566 (Box 19.10) 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.
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Page 566 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. 569 (Box 19.11) 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. 570 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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Page 574 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.] 575 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. 576 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 139 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 20.5 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. 577 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 20.6. 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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Chapter 20 Page 579 (Box 20.1) 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. 580 (Box 20.2) If cost-push pressures reduce the sustainable level of national income (e.g. from Y1 to Y3 in the diagram), why do demand-pull pressures not increase the sustainable level of real national income (e.g. from Y1 to Y2 in the diagram)? Because demand-pull pressures affect demand not potential output (i.e. sustainable real national income). The only exception is where an increase in aggregate demand leads to an increase in investment and this leads to an increase in capacity and hence an increase in potential output. 583 Construct a table like Table 20.1, 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. 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 20.1 in the text, where f(1/U) = 4.)
Rising inflation
Year 1 2 3 4 5 6
7 14 21 28 35 42
= = = = = = =
f(1/U) 7 7 7 7 7 7
+ + + + + + +
e 0 7 14 21 28 35
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Answers to questions in Economics (6th edition) by John Sloman Page 584 (Box 20.3) 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. Construct a table like Table 20.1, 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, = 30 per cent, f(1/U) = 6 per cent an e = 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
Falling Inflation
Year 1 2 3 4 5 6
30 24 18 12 6 0
= = = = = = =
f(1/U) 6 6 6 6 6 6
+ + + + + + +
e 36 30 24 18 12 6
585 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. (Box 20.4) 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 20.4) 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. 589 (Box 20.6) 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. 128
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Page 589 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 20.12 on page 582. 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. 590 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 demandside policies to try to reduce unemployment below the natural level (see Box 20.7). 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. 591 (Box 20.6) 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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Page 592 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. 593 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 22.3 and 22.4.] 594 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 in column 1 of page 594 are strong enough to completely offset the upward pressure on costs from the increased aggregate demand. 595 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. 596 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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Page 601 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% 603 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. 604 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. 607 (Box 21.1) 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 2, 3 and 4 of Chapter 22 are designed to increase productivity.
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Page 607 (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 Web Case 7.5).
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Page 610 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. 611 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. 612 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. 614 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 2823 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). 615 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. 616 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.
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Answers to questions in Economics (6th edition) by John Sloman Page 617 (Box 22.2) Do a news Web search for PFI projects and identify the issues currently surrounding the success or otherwise of PFI. The issues are likely to concern the efficiency and quality of the private provision of public services (an example of the principalagent problem: see Key Idea 22 on page 208). They are also likely to concern the long-term effects on public finances. 618 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. 620 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. 621 (Box 22.3) 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 22.3) 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.) 622 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.
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Chapter 22 Page 623 (Box 22.4) 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 9.8 on page 246). 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 22.4) 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. 624 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). 626 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 22.7 (page 615), 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.
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Page 626 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. 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. 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). 629 (Box 22.5) 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 EU12 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 22.5) 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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Page 636 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. 637 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). 638 (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. 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. 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.
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Page 639 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. 640 (Box 23.2) 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. 641 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. 642 Draw a similar diagram to Figure 23.4 showing how the price of an individual good imported into country A is determined. The diagrams would be the same as Figure 23.4, 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.) 643 1. If production was at point a in Figure 23.5, 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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Page 643 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. 644 1. Draw a similar diagram to Figure 23.6, 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.
P2
Exports
Good a
P1C1 Imports
C2 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. 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 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.) 646 (Box 23.3) 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 330). 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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Page 646 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. 647 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. (Box 23.4) 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. 648 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. 649 (Box 23.5) 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 23.8 the optimum tariff rate is: (P3 P2) P2 i.e. (MC P) P Price elasticity of supply is given by Ps = dQ P dP Q Marginal cost is given by: MC = dTC = d(AC.Q) dQ dQ (4) (3) (1) (2)
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:
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Chapter 23 MC = dTC = d(P.Q) dQ dQ From the rules of calculus: d(P.Q) = dP.Q + dQ.P dQ dQ MC P = (dP.Q + dQ.P) P dQ & P = MC P = P (dP.Q + dQ.P) P dQ (6) (7) (8) (5)
P 1 dP.Q + dQ.P dQ
(9)
Again from the rules of calculus: = dQ.P + dQ.P 1 dP.Q dQ.P = dQ.P + 1 1 dP.Q = dQ.P = Ps dP.Q from equations (2) and (12) MC P = optimum tariff rate = 1 P Ps 650 (Box 23.6) 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 23.2. 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. 651 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. (10) (11) (12)
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Page 651 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. 652 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. Can US action to protect its steel industry from foreign competition be justified in terms of the interests of the USA as a whole (as opposed to the steel industry in particular)? 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. In other words, the losses to US consumers from higher steel prices would more than offset the gains to those in the steel industry. 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. 653 (Box 23.7) 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. 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.
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Page 656 Under which of the following circumstances is there likely to be a net gain from trade diversion? (Refer to Figure 23.11.) (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. 657 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. 659 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. 660 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. 661 (Box 23.8) 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.
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Answers to questions in Economics (6th edition) by John Sloman Page 662 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). 663 (Box 23.9) 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. 664 (Box 23.10) 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. (Box 23.10) 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.
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Page 665 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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Page 670 Assume that there is both internal and narrow external balance. Now assume that as a result of inflation being below target, the central bank cuts interest rates. Into which of the four quadrants in Figure 24.2 will the economy move? Quadrant 2. The cuts in interest rates will lead to a domestic boom. Lower interest rates will also lead to an outflow of finance and hence a financial account deficit. This will result in a depreciation of the exchange rate, which will boost exports and curb imports, resulting in a current account surplus to match the financial (plus capital) account surplus. 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. 672 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. 674 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.
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Page 676 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. 679 Trace through the short-run and long-run internal and external effects (under a fixed exchange rate) of (a) an fall in domestic saving; (b) a rise in the demand for exports. (a) A fall in saving means a higher level of aggregate demand, resulting in inflation. Internal balance is destroyed. The higher aggregate demand will result in a rise in imports and a current account deficit. The higher aggregate demand, however, will put upward pressure on interest rates and result in a financial account surplus, which will probably be larger than the current account deficit. To prevent the exchange rate from rising, the central bank must not allow interest rates to rise by much. This will result in an unsustainable boom with inflation rising (and going above the target level if there is one). In the long run, internal balance will be restored. The higher inflation will reduce real aggregate demand, and real income will return to the sustainable level. External balance, however, is unlikely to be restored at least in the narrow sense. The higher inflation worsens the current account deficit. Nevertheless, the rise in imports and fall in exports helps to dampen aggregate demand which helps to dampen the rise in inflation. This reduces the deterioration in the current account but not enough to restore external balance in the narrow sense. (b) A rise in the demand for exports will cause the current account to move into surplus. It will also destroy internal balance by pushing income above the sustainable level. 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. To prevent this happening, the central bank must allow money supply to rise. Indeed, it will have to make interest rates slightly lower than before so that the current account surplus is matched by a financial account deficit. But this will put further upward pressure on national income, thereby creating a bigger internal imbalance. In the long run the upward pressure on inflation will increase the real exchange rate and thereby help to reduce the current account surplus. The higher inflation will reduce real national income and hence restore internal balance. 680 (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. 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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Page 681 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. 682 To what extent do Keynesians and new classicists agree about the role of fixed exchange rates? They are both critical, as pages 6812 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. 683 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). 684 Describe the exchange-rate path if there were a single shock that caused interest rates to fall. What determines the magnitude and speed of changes in the exchange rate in such a scenario? There is a financial outflow and an immediate depreciation of the exchange rate (assuming that the cut in interest rates had not already been anticipated). But as the lower interest rate boosts aggregate demand and the current account deteriorates, so there will be pressure on the central bank to raise interest rates again. The anticipation of this will cause the exchange rate to appreciate. How quickly this will happen depends on how quickly the economy responds to the initial cut in interest rates and how soon people believe the central bank will raise interest rates again. 685 (Box 24.3) 1. If the Chinese yuan is undervalued by 59 per cent in PPP terms against the US dollar, and the Icelandic krna overvalued by 118 per cent, what implications does this have for the interpretation of Chinese, Icelandic and US GDP statistics? The GDP figures understate the purchasing value of Chinese national income by 59 per cent relative to US national income, and overstate the purchasing value of Icelandic national income by 118 per cent relative to US national income. In other words, at the exchange rates in question, Chinese national income seems 59 per cent lower relative US national income than it really is in purchasing terms, and Icelandic national income seems 118 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.
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Page 685 (Box 24.3) 3. At the time the table was complied, the Big Mac PPP rate for the Japanese yen was $1 = 81.7. What was the market exchange rate. The yen, according to the table, was 23 per cent undervalued against the US dollar. This means that the market exchange rate was 23 per cent lower than the PPP rate. This means that the market rate was 81.7 1.23 to the dollar. In other words, $1 = 100.5. 687 (Box 24.4) Find out what has happened to the euro/dollar exchange rate over the past 12 months. Explain why the rate has moved the way it has. You explanation will need to include what has happened to growth rates and interest rates and what peoples expectations are about future growth rates and interest rates. Draw a similar diagram to Figure 24.9 showing how an appreciation of the exchange rate would similarly be reduced by stabilising speculation. The diagram would look like Figure 24.9, only with S1 and S2, D1 and D2, and r1 and r2 reversed. 688 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. 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 24.12 on page 693 of the text and see what happened to the exchange rate over the five year period from 1980 to 1985!) 689 (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. 690 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).
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Page 691 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. 692 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. 692 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 7067). 694 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 19.6 on page 559 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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Chapter 24 Page 694 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 694 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. 695 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. 698 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 24.15, the BP curve will be horizontal, and Y3 Y1 will be the full horizontal distance between IS2 and IS1. 699 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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Page 699 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 24.15. (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. 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. 700 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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Page 703 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.
704 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. 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. 705 (Box 25.1) Examine the merits for the Chinese of (a) floating the yuan freely; (b) pegging it to a tradeweighted basket of currencies (a policy it adopted in mid-2005) A free float would allow automatic adjustment, but could lead to instability of the exchange rate. Pegging it to a trade-weighted basket of currencies would help to confine fluctuations in the yuan to fluctuations in the rates between other currencies and thus would not be so disruptive for Chinese importers and exporters. Some uncertainty, however, is inevitable given the considerable fluctuations between the US dollar, euro and Japanese yen. Thus Chinese exporters to the US would gain relative to those to the eurozone if the dollar appreciated relative to the euro. 706 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.
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Page 706 Referring to Table 25.1, is there any evidence that there was any greater convergence between the G7 countries in the period 20015 than in the period 19962000? There was generally greater divergence, but not with all indicators. Thus there was greater convergence in terms of economic growth, unemployment and short-term interest rates. 707 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. 708 (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 1915.) 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. 709 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. 712 How might multiplier effects (the principle of cumulative causation) lead to prosperous regions becoming more prosperous and less prosperous regions falling even further behind? See the section on regional multiplier effects on page 625. 713 (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. 714 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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Chapter 25 Page 714 2. Is greater factor mobility likely to increase or decrease the problem of cumulative causation associated with regional multipliers? (See page 625.) 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. 717 (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. 718 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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Page 721 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. 722 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).) 723 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. 724 (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). 726 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 640, gives the answer to this question. 727 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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Page 728 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.] 729 (Box 26.2) Could a case be made out for a flexible tax on oil imports to ensure that it was always profitable to produce alcohol? Yes, if over the long term it was considered socially desirable to produce alcohol but, thanks to fluctuating oil prices, it was not profitable when oil prices were temporarily low. 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. 730 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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Page 730 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). 733 (Box 26.3) 1. In what ways does a booming Chinese economy benefit the rest of the world? It creates a rapid growth in demand for rest-of-the-world exports to China. It also creates greater opportunities for inward investment to China. The competition from China may also act as a spur to efficiency to other countries. (Box 26.3) 2. Why may the Chinese be reluctant to adopt a freely floating exchange rate? Because it makes their economy more subject to short-term speculation, given the huge size of international financial flows into and out of China. Pegging the yuan to a trade-weighted basket, as it has been since mid-2005, provides a degree of stability to help exporters and importers plan, while recognising the relative importance of its exchange rate with the currencies of its various trading partners. 734 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. 736 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. 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.
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Page 737 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.
K
739 (Box 26.4) 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 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 26.4) 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 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.
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Page 740 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. 742 (Box 26.5) One solution proposed to help solve Argentinas weak financial position was that it should have abandoned the peso altogether as its unit of currency and replaced 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. 743 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. 744 (Box 26.6) 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-fornature swaps in Box 26.7 on page 746.
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Page 746 (Box 26.7) 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. 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.
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Appendix 1
Page A:2 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).
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.
A:3 What was the level of unemployment mid-way between quarter 2 and quarter 3 2004? About 1.41 million.
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) on one of the vertical axes. If you glance at page 558 of the text, you will see an example of this (Figure 19.11).
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 Figure (a) in Box 8.5 on page 216 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. A:5 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.
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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 consumer prices 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 2000 was 1.4 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.
A:7 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) (73.6 72.1)/72.1 100 = 2.08% (b) (100 101.4)/101.4 100 = 1.38%
If the CPI went up from 150 to 162 over 12 months, what would be the rate of inflation? Using the formula (CPIt CPIt1)/CPIt1 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.
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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)
165

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Answers to in-text Questions in Economics (6th edition)

Answers to questions in Economics (6th edition) by John Sloman

Answers to questions in Economics (6th edition) by John Sloman

Answers to questions in Economics (6th edition) by John Sloman Page 22

Factor Market Si surplus (Si > Di) Pi

Goods Market Sg Pi Sg surplus (Sg > Dg) Pg Dg until Dg = Sg

Answers to questions in Economics (6th edition) by John Sloman

Price (pence per kg)

70 60 50 40 30 20 10 0 0 5 10 15 20 25 30 Quantity demanded (kg per month)

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

Answers to questions in Economics (6th edition) by John Sloman

New demand Old demand

Diagram 2.2 Market demand for potatoes

Answers to questions in Economics (6th edition) by John Sloman

Diagram 2.3 Market demand (with respect to income)

Diagram 2.4 Market supply

Answers to questions in Economics (6th edition) by John Sloman

Answers to questions in Economics (6th edition) by John Sloman

Diagram 2.5 Speculation: initial shift in the supply curve

Answers to questions in Economics (6th edition) by John Sloman

and that the market price is:

Answers to questions in Economics (6th edition) by John Sloman

60Q 60 120 180 240 300 360 420 480

4Q2 4 16 36 64 100 144 196 256

TU 56 104 144 176 200 216 224 224

200 200 200 200 200 200 200 200

50Q 50 100 150 200 250 300 350

3Q2 3 12 27 48 75 108 147

140 120 100 80 60

Diagram 4.1 MU = 200 50Q + 3Q2

MU water Quantity of water Quantity of diamonds

Diagram 4.2 MU of water and diamonds

Answers to questions in Economics (6th edition) by John Sloman

Answers to questions in Economics (6th edition) by John Sloman

(a) Decrease in price of X Diagram 4.3

(b) Increase in price of Y

Answers to questions in Economics (6th edition) by John Sloman

Equation (2) APP

Equation (3) MPP

Answers to questions in Economics (6th edition) by John Sloman

Answers to questions in Economics (6th edition) by John Sloman

Answers to questions in Economics (6th edition) by John Sloman

Answers to questions in Economics (6th edition) by John Sloman

Answers to questions in Economics (6th edition) by John Sloman

Answers to questions in Economics (6th edition) by John Sloman

Answers to questions in Economics (6th edition) by John Sloman

Answers to questions in Economics (6th edition) by John Sloman

Answers to questions in Economics (6th edition) by John Sloman

Answers to questions in Economics (6th edition) by John Sloman

P MU > P consumption MU (movement down along MU and hence MSB curve)

Answers to questions in Economics (6th edition) by John Sloman

(b) 1. Factor supply Sf (i.e. MSCf) Sf > Df Pf

P MU > P consumption MU (movement down along MU and hence MSB curve)

Diagram 11.1 External costs in production

Diagram 11.2 External costs in consumption

Answers to questions in Economics (6th edition) by John Sloman

Answers to questions in Economics (6th edition) by John Sloman

Answers to questions in Economics (6th edition) by John Sloman

Answers to questions in Economics (6th edition) by John Sloman

(Cars entering road per minute) (1) 1 2 3 4 5 6 7 8 9

Answers to questions in Economics (6th edition) by John Sloman

Answers to questions in Economics (6th edition) by John Sloman

Answers to questions in Economics (6th edition) by John Sloman