Answers To The Questions in IB Econ Skills and Practice

Foundations
Exercise 1 (page 8)
1 Rational 6 Unattainable
2 Utility 7 Inefficient
3 Profits 8 On
4 Opportunity cost 9 Positive
5 Bowed-in 10 Normative
Exercise 2 (page 8)
1 False The word ‘ought’ makes this statement a value
judgment, an opinion
2 True Increased output can be achieved on the diagram
without having to decrease the level of output of
other good(s)
3 True Combinations of output inside the PPF imply the
existence of unemployed resources i.e. of waste
4 False Resources and thus the goods and services that
can be produced in a ‘rich’ country are still limited
compared to the unlimited wants that are assumed
to exist
5 True If resources are not specialized then they can be
switched around to produce additional units of
either good without the opportunity cost of doing so
increasing; if the opportunity cost is constant then
the PPF is linear.
Exercise 3 (page 8)
None of these situations is sustainable
© Oxford University Press 2012: this may be reproduced for class use solely for the purchaser’s institute
1
Section 1.1 Exercise 4 (page 12)
a Qd = 100 – 2P
Exercise 2 (page 11) To find the P intercept, set Qd = 0
0 = 100 – 2P g 2P = 100 g P = 50
1 a) Holidays abroad are a normal good/ service To find the Q intercept, set P = 0
so that an increase in income levels will tend Qd= 100
to increase the demand for holidays abroad
b) Airline tickets and holidays abroad are b Qd = 60 − 4P
complements so that an increase in the price To find the P intercept, set Qd = 0
of airline tickets will tend to decrease the 0 = 60 – 4P g 4P = 60 g P = 15
demand for holidays abroad To find the Q intercept, set P = 0
c) Holidays abroad and at home are substitutes Qd = 60
so if domestic hotels offer discounts the
demand for holidays abroad will tend to c Qd = 5000 − 25P
decrease To find the P intercept, set Qd = 0
0 = 5000 – 25P g 25P = 5000 g P = 200
2 a) No effect, as a change in price leads to a To find the Q intercept, set P = 0
change in the quantity demanded and not Qd = 5000
in demand; a movement along the existing
demand curve will result and not a shift of
the demand curve
Exercise 5 (page 12)
b) Helmets and bicycles are complements so if Qd = 320 – 8P Qd = 140 – 7P Qd = 40 – 2P
for some reason helmets become much more P Qd Qd Qd
expensive then the demand for bicycles will 0 320 140 40
tend to decrease
1 312 133 38
c) Demand for bicycles could increase as people
2 304 126 36
will try to decrease pollution by switching to
bicycles, but it could also decrease as it could 3 296 119 34
become very difficult to ride your bicycle 10 240 70 20
exposed to heavy pollution 20 160 0 0
40 0 - -
3 a) Demand for coffee could increase as more
people will start drinking coffee
Exercise 6 (page 7)
b) Coffee and sugar for many are complements
so a sharp increase in the price of sugar may To plot these linear demand functions on graph
decrease the demand for coffee paper, you need to find the vertical (P) intercept and
c) Coffee and tea are considered by many as the horizontal (Q) intercept and then connect the 2
substitutes so a decrease in the price of tea may points. The intercepts are:
lead to a decrease in the demand for coffee
1 Qd = 100 − 2P g if Qd = 0 then P = 50 and if
P = 0 then Qd = 100
1 Quantity 6 Decrease 11 Increase P = 0 then Qd = 200
demanded
2 Movement 7 Inferior 12 Right P = 0 then Qd = 700
along
3 Increase 8 Left 13 Decrease
P = 0 then Qd = 140
4 Right 9 Decrease 14 Shift
5 Substitutes 10 Complements 15 Movement
along
2
Exercise 7 (page 16) Exercise 10 (page 20)
1 a) Market supply of meat will decrease and 1 An increase in the cost of natural fertilizers will
the supply curve will shift to the left as the increase production costs of organically grown
higher price of cereals used to feed cattle will aubergines (eggplants) decreasing their supply
increase the cost of producing meat and shifting the supply curve to the left. As a
b) A subsidy is a payment by the government result the market price is expected to increase
to meat producers (typically on a per unit while the equilibrium quantity is expected to
basis) that will lower their cost of producing decrease.
meat and will thus increase supply of meat 2 An unusually hot summer is expected to
and shift the supply curve to the right increase the demand for air conditioners shifting
c) A switch of consumers away from meat the demand curve to the right. As a result, the
consumption will affect (decrease) the price of air conditioners is expected to probably
demand for meat and not the supply of rise with more air conditioners bought and sold
meat. On a diagram, the supply curve will that summer.
not shift but remain constant. 3 An increase in average individual incomes is
2 a) An increase in the price of corn will change expected to increase the demand for restaurant
(increase) the quantity supplied of corn dining as restaurant dining is a normal good
but will not affect the supply of corn. The (service). The demand curve will thus shift to
supply curve will thus not shift but remain the right and, as a result, it is expected that the
constant. There will only be a movement price of a typical restaurant meal will increase.
along the same supply curve. Equilibrium quantity will also increase as dining
b) Since many farmers could choose to devote out will become more frequent and more people
their land to either wheat production or will also choose to do so.
corn production, an increase in the price of 4 If better training permits egg packaging workers
wheat will make wheat production more to pack more eggs in filler trays per hour then
lucrative relative to corn production. As a it is as if production costs (wage costs) decrease
result, more land will be devoted to wheat for such firms. Supply of eggs is expected to
production and less to corn. The supply of increase shifting the supply curve to the right.
corn may thus decrease and the supply curve Eggs will probably become cheaper with more
shift to the left. eggs produced and consumed per period of time.
c) If the price of fertilizers increases then the 5 In this case we have two effects on the market
cost of producing corn will increase as for Alaskan king crabs, one affecting demand
fertilizers are an input in the production and one affecting supply. As a result, either
process. Higher production costs tend to the direction of change of the equilibrium price
decrease supply so the supply of corn will or the direction of change of the equilibrium
shift to the left. quantity will be indeterminate without knowing
3 a) An indirect tax imposed on cod producers how much each side of the market was affected.
can be thought of as an increase in their More specifically, publication of medical
production costs. As a result the supply of reports confirming suspected health benefits
cod will tend to decrease shifting the supply from the consumption of king crabs will tend
curve to the left. to increase demand and thus equilibrium price
b) If the fishing fleet adopts more advanced and quantity. An increase though in the wages
fishing technology then production costs will of trawler men will increase wage costs of
decrease, increasing the supply of cod and these businesses decreasing supply, which will
shifting the supply curve to the right. also tend to increase equilibrium price but to
c) If the industry expects the government to decrease equilibrium quantity. It follows that
impose severe fishing quotas next year then these concurrent developments will tend to
it is very likely that fishermen will try to fish raise the price of king crabs but the effect on
as much as possible this year, increasing the the equilibrium quantity cannot be determined
supply of cod and shifting the supply curve without more information.
to the right. 6 Again, we have two effects on the market, one
affecting demand and one affecting supply. As
a result, either the direction of change of the
3
equilibrium price or the direction of change of Step 4 Q* = 980 – 90 3 6
the equilibrium quantity will be indeterminate Q* = 980 – 540
without knowing how much each side of the Q* = 440
market was affected. More specifically, an Step 5 Double checking:
increase in the number of firms will tend to Q* = 200 + 40 3 6
increase supply which will decrease the price Q* = 200 + 240
of DVD rentals and increase the equilibrium Q* = 440
quantity. A decrease though in the price of Answer: the equilibrium quantity of peaches is
renting movies on demand over the internet will 440 thousands of kilograms per month
tend to decrease the demand for DVD rentals so
that their equilibrium price will tend to decrease 2
but their equilibrium quantity will also decrease. Step 1 Qd = 10 – 2P
It follows that rental prices will certainly have Qs = 2P
the tendency to fall, but whether equilibrium Qd = Qs
quantity will increase or decrease cannot be Step 2 10 – 2P = 2P
determined without more information. Step 3 10 = 4P
P = 10/4
Exercise 11 (page 21) P* = 2.5
Answer: the equilibrium price of racing bicycles is
Since prices of swimsuits are significantly lower 2.5 thousand dollars per bike
despite the fact that supply has decreased it means Step 4 Q* = 10 – 2 3 2.5
that demand must have decreased even more. This Q* = 10 - 5
is probably the result of the fact that on the one Q* = 5
hand few consumers think of buying swimsuits in Step 5 Double checking:
the fall as the season is over, and on the other hand Q* = 2 3 2.5
many consumers are eager to see the new designs Q* = 5
and styles and prefer to wait than buy now. Answer: the equilibrium quantity of racing
bicycles is 5 thousand bicycles per year.
Exercise 12 (page 21) 3
The first statement is perfectly sensible: use of Step 1 Qd = 2000 – 40P
improved technology by firms will increase supply Qs = 400
of the product leading to a fall in its price. The Qd = Qs
error is in the next sentence: as the price decreases Step 2 2000 – 40P = 400
there will be a movement along and not a shift Step 3 2000 – 400 = 40P
of the demand curve. Remember that within our 1600 = 40P
demand and supply analytical framework, a change P = 1600/40
in price leads to a movement along and not a shift P* = 40
of either curve. Answer: the equilibrium price of olives is 40 euros
per 10 kilogram bag
Exercise 13 (page 23) Step 4 Q* = 2000 – 40 3 40
Q* = 2000 - 1600
1 Q* = 400
Step 1 Qd = 980 – 90P Step 5 The answer makes sense as supply is vertical at
Qs = 200 + 40P Q = 400
Qd = Qs Answer: the equilibrium quantity of olives is 400
Step 2 980 – 90P = 200 + 40P thousand 10-kilogram bags
Step 3 780 = 130P
P = 780/130
P* = 6
Answer: the equilibrium price of peaches is 6
dollars per kilogram
4
4 Exercise 15 (page 24)
Step 1 Qd = 440 – 10P
1 Qd = 10 – 2P
Qs = 100 + 7P
Qd = Qs Qs = 2P
Initial equilibrium price = 2.5
Step 2 440 – 10P = 100 + 7P
Initial equilibrium quantity = 5
Step 3 440 – 100 = 7P + 10P
If P = 1 then Qd = 8 and Qs = 2 so since Qd >
340 = 17P
Qs there is excess demand (ED) = 6 units
P = 340/17
P* = 20 If P = 3 then Qd = 4 and Qs = 6 so since Qs >
Answer: the equilibrium price of T-shirts is 20 Qd there is excess supply (ES) = 2 units
dollars per T-shirt
Step 4 Q* = 440 – 10 3 20 2 Qd = 2000 – 40P
Q* = 440 - 200 Qs = 400 (supply is vertical)
Q* = 240 Initial equilibrium price = 40
Step 5 Double checking: Initial equilibrium quantity = 400
Q* = 100 + 7 3 20 If P = 38 then Qd = 480 and Qs = 400 so since
Q* = 100 + 140 Qd > Qs there is excess demand (ED) = 80 units
Q* = 240 If P = 42 then Qd = 320 and Qs = 400 so since
Answer: the equilibrium quantity of T-shirts is 240 Qs > Qd there is excess supply (ES) = 80 units
thousand of T-shirts per year
3 Qd = 440 – 10P
Exercise 14 (page 23) Qs = 100 + 7P
Initial equilibrium price = 20
To plot the above you need to find for each demand Initial equilibrium quantity = 240
curve the vertical (P) and horizontal (Q) intercepts If P = 18 then Qd = 260 and Qs = 226 so since
and connect the 2 points. For each supply curve Qd > Qs there is excess demand (ED) = 34 units
you need to find the value of Q if P = 0 and the If P = 22 then Qd = 220 and Qs = 254 so since
value of Q for any other convenient price (or, more Qs > Qd there is excess supply (ES) = 34 units
generally, any 2 points).
In general, if the market is free but the price is
1 Demand intercepts: below the equilibrium price, then excess demand
If P = 0 then Q = 980 will result. Whereas if the price is above the market
If Q = 0 then P = 10.89 clearing level then excess supply will result.
Supply intercepts:
If P = 0 then Q = 200
If P = 5 then Q = 400
2 Demand intercepts: Qd = 1000 – 10P
If P = 0 then Q = 10 Qs = 200 + 30P
If Q = 0 then P = 5 Finding the original equilibrium price and output:
Supply intercepts: 1000 – 10P = 200 + 30P
If P = 0 then Q = 0 1000 – 200 = 30P + 10P
If P = 5 then Q = 10 800 = 40P
3 Demand intercepts: P = 800/40
If P = 0 then Q = 2000 P = 20
If Q = 0 then P = 50 Q = 1000 – 10 3 20
Supply intercepts: Q = 1000 – 200
(here supply is vertical at Q = 400) Q = 800
4 Demand intercepts: or
If P = 0 then Q = 440 Q = 200 + 30 3 20
If Q = 0 then P = 44 Q = 200 + 600
Supply intercepts: Q = 800
If P = 0 then Q = 100
If P = 10 then Q = 170
5
1 To find the change in P and Q we must first At the initial equilibrium price (20) there was excess
find the new equilibrium price and output. If supply equal to distance HF, the 200 (million) units
demand decreases by 200 (million) units at each by which demand for bracelets fell. But, as a result
price, the new demand will be: of the excess supply the market price of bracelets
Qd = 1000 – 10P – 200, or started to fall. This induced a movement along the
Qd = 800 – 10P demand curve (from H to H’): quantity demanded
Equating the new demand with the unchanged started to increase. At the new, lower equilibrium
supply we get: price (15) the quantity consumers bought (and
800 – 10P = 200 + 30P firms sold) was consequently only 150 (million)
800 – 200 = 30P +10P units less (at 650 million bracelets) than the original
600 = 40P equilibrium quantity.
P = 600/40
P = 15, and Exercise 17 (page 26)
Q = 800 – 10 3 15
Q = 800 – 150 The basic idea is that the market supply will
Q = 650 decrease (shift left) as a result of the tax-induced
So: increased costs of production. At the original price
P1 = 20 there will thus be excess demand pushing price up
P2 = 15 and decreasing output and consumption of fruit
ΔP = P2 – P1 = 15 – 20 = –5 thus equilibrium juice. Oranges are an input in the production of
price has decreased by 5 cents. This should fruit juice so fewer oranges will be allocated in
have been expected since demand decreased and (used by) the fruit juice industry. Overall demand
shifted to the left. for oranges could thus decrease, but this is not
Q1 = 800 necessary if households start buying fresh oranges
Q2 = 650 to make their own juice.
ΔQ = Q2 – Q1 = 650 – 800 = –150, thus
equilibrium quantity has decreased by 150 Exercise 18 (page 26)
(million) bracelets. This should have been
1 It depends whether and to what extent firms will
expected since demand decreased and shifted to
be able to respond to the increased demand and
the left.
price. Will it be ‘easy’ for firms to adjust their
production level? This is related to the idea of
2
price elasticity of supply, a concept that will be
P/unit examined later. If firms can easily adjust, output
S then quantity supplied will increase by more
than if adjusting output is very costly.
2 It could be that the factors of production
necessary to produce a good are very specialized
and cannot be transferred away from other uses.
H F 3 Consider labor: it may suffer from occupational
20
and/or geographical immobility. Workers
H’
may not have the necessary skills to become
15 employed elsewhere. Or, they may not be able
to relocate to where jobs exist because they may
not be able to sell their house or there may be
no housing or good schools available for their
D1
children in the new location.
D2
0 650 800
Q/period
6
The social surplus enjoyed is the sum of the
consumer and the producer surplus. Consumer
surplus if Q’ units are consumed at a price P’ is
equal to area(HP’E), whereas producer surplus
is equal to area(FEP’). It follows that social (or
community) surplus is area(FEH).

Consumer surplus will decrease by area(PFHP’)

Producer surplus will increase by area(PFHP’)

The first statement refers to a movement along a
supply curve, while the second statement refers to
a shift of the supply curve. Remember when the
price of the good changes then we have a movement
along a supply curve, while if any other factor
changes (such as input prices, level of technology,
factor productivity, prices of goods jointly produced
or produced with the same inputs etc.) we have a
shift of the supply curve.
7
Section 1.2 Now we can use the PED measure to calculate
the %ΔQ:
%ΔQ = PED 3 %ΔP − 0.4 3 0.05 = −0.02
So quantity demanded decreased by 2%.
1 Schweppes lemonade has many more and closer
substitutes compared to carbonated beverages.
Since we know that the original quantity Q1 was
Remember, the narrower a product is defined,
300 units, we can now calculate the new lower
the more price elastic demand will be.
quantity Q2:
2 Carbonated beverages are considered a product
Q2 = Q1 − 0.02Q1 = 0.98Q1 = 0.98 3 300 = 294
group and as such have few close substitutes. If
the price of all products in this group increase
So quantity demanded decreased to 294 units
for some reason (say because of an indirect tax)
following the price increase.
then quantity demanded will not be greatly
affected as juice or beer or milk are not very
DTR = TR2 − TR1 = (9.45 3 294) − (9.00 3 300) =
close substitutes.
2778.3 − 2700 = 78.3
Exercise 2 (page 33) Weekly revenues from unagi increased by $78.3.

1 A price elasticity of demand equal to −0.04
means that a 10% increase in the price of oil This makes sense as demand is price inelastic, so the
will, in the short run, lead to a 0.4% decrease increase in price leads to a proportionately smaller
in the quantity demanded. A price elasticity decrease in quantity demanded.
of demand equal to −0.35 means that a 10%
increase in the price of oil will, in the long Exercise 4 (page 33)
run, lead to a 3.5% decrease in the quantity
Write down what you know:
demanded.
P1 = €8.50
2 In the short run, price elasticities of demand
P2 = $9.35
are typically lower as consumers need time to
Q1 = 550
make adjustments. The longer the time period,
ΔTR = −935
the more adjustments are possible and thus the
more price elastic demand will tend to be. %Q
We also know that: PED =
%P
and that TR = P 3 Q
Exercise 3 (page 33) 9.35
Write down what you know: %DP = − 1 = 0.1, or +10%
8.50
P1 = $9.00
P2 = $9.45 TR1 = P1 3 Q1 = 8.50 3 550 = 4675 units
Q1 = 300 DTR = TR2 − TR1 so TR2 = 4675 − 935 = 3740
PED = −0.4 TR2 3740
%Q
We also know that: PED = Q2 = = = 400
%P P2 9.35
and that TR = P 3 Q
400
Since we have the two prices we can easily calculate %DQ = − 1 = −0.2727
550
their percentage change:
−0.2727
9.45 PED = = −2.73
( − 1) = (1.05 − 1) = 0.05 or +5%, 0.1
9.00
X X2
as %DX = =( − 1) It makes sense for demand to be price elastic as
X1 X1
revenues decreased following the price increase.
So price increased by 0.05 or 5%.
8
Exercise 5 (page 33) Honey-glazed and chocolate-frosted are 2 different
types of doughnuts, whereas doughnuts and bagels
Write down what you know: may be in competitive consumption but doughnuts
P1 = $7.00 are sweet whereas bagels are typically not sweet.
TR1 = $294
DP = −0.70
Find Q1: Using the XED measure:
TR1 294 %DQ(A) %DQ(A)
Q1 = = = 42 0.2 = g 0.2 = g %DQ(A)
P1 7 %DP (B) 0.06
Find P2: = 0.2 3 0.06 = 0.012
P2 = P1 − 0.70 = 7.00 − 0.70 = 6.30
So the quantity of Arborio rice will increase by
Find %DP: 1.2% following an increase in the price of Basmati.
P2 6.30 Given that the initial quantity was 1500 packages
%DP = −1= − 1 = −0.1 = −10% (and not 800 as erroneously written in the book),
P1 7.00
the new quantity will be:
Find %DQ: Q2(A) = Q1(A) + 0.012 Q1(A) = 1.012 Q1(A)
Q2 63 = 1.012 3 1500 = 1518 packages of Arborio rice.
%DQ = −1= − 1 = 0.5 = +50%
Q1 42
Find PED:
Denoting Cape Cod potato chips with the letter ‘C’
%DQ 0.5
PED = = = −5 and Al’s Delicious popcorn with the letter ‘A’ the
%DP −0.1 measure for XED can be written as:
Find TR2: %DQ(A)
TR2 = P2 3 Q2 = 6.30 3 63 = 396.3 XED =
%DP (C)
Find %DTR: 28500
%DQ(A) = − 1 = 1.14 − 1 = 0.14
25000
TR2 396.9
%DTR = −1= − 1 = 0.35 2.60
TR1 294 %DP(C) = − 1 = 0.0833
2.40
So total revenues increased by 35% following the 0.14
price decrease. This makes sense as demand was Thus, XED = = 1.68
0.083
found to be price elastic.
This is positive which was expected as the two types
of potato chips are substitutes, and it implies that
Exercise 6 (page 35) a 10% increase in the price of Cape Cod chips is
Remembering that a negative XED implies expected to lead to a 16.8% increase in the quantity
complements permits the manager to assign the of Al’s Delicious chips.
−0.50 figure to doughnuts and lattes (they are
consumed jointly). The remaining figures are Exercise 9 (page 38)
positive which means that the goods involved are
substitutes. Remembering that the higher the value 1 Goods at Wal-Mart and public transportation
the closer the relationship, a sensible match is the carry a negative YED so they are considered
following: inferior.
2 It would probably be higher as luxury dining
would be more responsive to an increase (or,
+1.10 Honey-glazed and chocolate-frosted doughnuts
decrease) in incomes.
+1.00 Doughnuts and muffins
3 During bad times (when incomes drop) demand
+0.20 Doughnuts and bagels for public transport will increase so demand for
taxi services will probably decrease. If people
9
take the bus or use the underground more they Exercise 10 (page 40)
will be less likely to use taxis.
4 Revenues from the sale of inferior products will Substituting the values given into the measure for
rise in bad times as their demand will increase. PES we arrive at:
x
5 Revenues of the goods with the highest positive 1.4 = = 0.112, or an 11.2% increase in the
0.08
YED values will suffer the most as demand
quantity supplied.
for these will decrease the most. This includes
automobile sales as well as furniture sales and
restaurant meals. Exercise 11 (page 40)
6 Electricity is predominantly required to power Find the percentage change in quantity supplied:
household appliances. Many appliances 5775
(refrigerators, TV sets, DVD players etc) in − 1 = 0.05
5500
advanced countries have already been purchased
by most households at relatively low levels of Find the percentage change in price:
income and do not consume much power. Even 0.75
poor families have a refrigerator, a TV set, a − 1 = 0.25
0.60
DVD player or even an air-conditioner or a
fan. Upgrading to better appliances will not Substitute the values above into the measure for
change too much the power requirements of a PES:
household. But as incomes rise further, demand
0.05
for water may rise faster because of better = 0.2
personal hygiene (daily showers/ baths), more 0.25
plants, gardens and yards to water, cars to wash
and swimming pools or jacuzzi’s to fill. PES is equal to 0.2, i.e. supply is price inelastic.
7 Acyclical industries are industries producing
goods with an absolutely low income elasticity
of demand. Electricity in this list is thus the
most acyclical industry as YED=0.2 meaning
that a 10% change in income would induce only
a 2% change in demand for electricity.
8 The YED for furniture in the US according to
the data provided is equal to 1.48.
%DQ
The measure of YED is: = .
%DY
Substituting the values YED and the percentage
increase in income we arrive at:
X
1.48 = = 6.1%
0.041
9 The main reason that governments tax gasoline
relates mostly to its low price income elasticity
of demand. In addition, gasoline may be taxed
because driving creates pollution so the goal
could be to decrease driving. The low YED
(income inelastic demand) informs policy
makers that it is a ‘day-to-day’ good so demand
is not very much affected by good times or bad
times.
10
Section 1.3
P
St
Exercise 1 (page 48) 30 S
1 120 – 4P = 2P – 30 26
P = $25 25
Q = 20 (20,000 units)
23
2 120 – 4Pc = 2(Pc − 3) – 30 18

Pc = $26
Pp = (Pc − 3)= $23 15
Q'= 16 (16,000 units)
3 $1.00 or 1/3 of the tax is paid by consumers
4 $2.00 or 2/3 of the tax is paid by producers
D
5 3 3 16,000 = $48,000
–36 –30 16 20 120 Q
6 Pre-tax TR = 25 3 20,000 = $500,000

Post-tax TR = 23 3 16,000 = $368,000
Total revenues collected decreased by $132,000 5 3 20
10 Pre-tax CS = = $50,000
2
7 Pre-tax expenditures: 25 3 20,000 = $500,000 (remember that Q is in thousands)
Post-tax expenditures = 26 3 16,000 = $416,000
4 3 16
Total consumer expenditures following the Post-tax CS = = $32,000
imposition of the tax decreased by $84,000 2
Change in CS: CS decreased by $18,000
8 %ΔQ = –0.2 (decreased by 20%) 10 3 20
%ΔP = 0.04 (increased by 4%) Pre-tax PS = = $100,000
2
PED = –5 8 3 16
This makes sense since demand must be elastic Post-tax PS = = $54,000
2
for consumer expenditures to decrease following
Change in PS: PS decreased by $36,000
a price increase.
Pre-tax social surplus = $150,000

9 Remember, to find the intercepts of the demand
Post-tax social surplus = $96,000
and supply functions you enter zero for the
Welfare of market participants decreased by
price and then you enter zero for the quantity.
$54,000
Remember also to use the new post-tax supply
But, tax revenues collected were $48,000 which
function to find the intercepts of the new supply
in principle could have be spent on schools so
curve.
welfare decreased only by $6,000
Thus:
You should find the same answer if you
(P,Q) for demand: (30, 120)
calculate the area of the welfare loss triangle
(P,Q) for initial supply (15, –30)
334
(P,Q) for post-tax supply (18, –36) = = 6, i.e.$6,000
2
11
Exercise 2 (page 48) 9 P
1 100 – 5P = 5P
P = £10.00 20 St
Q = 50 (or, 50,000,000 units) S
2 100 – 5Pc = 5(Pc − 2)

Pc = £11.00
Pp = (Pc − 2) = £9.00
Q' = 45 (i.e. 45,000,000 units) 11
10
3 £1.00 on consumer or ½ of the tax is paid by
9
consumers
4 £1.00 on consumer or ½ of the tax is paid by

producers
(it thus seems that PED = 1 as PES is equal to 1: D
the supply curve goes through the origin) Q
–10 45 50 100
5 2 3 45,000,000 = £90,000,000
10 3 50
10 Pre-tax CS = = £250,000,000
6 Pre-tax TR = 10 3 50,000,000 = £500,000,000 2
Post-tax TR = 9 3 45,000,000 = £405,000,000 (remember that Q is in millions)
Change in TR = TR decreased by £95,000,000 9 3 45
Post-tax CS = = £202,500,000
2
7 Pre-tax consumer expenditures:
10 3 50,000,000 = £500,000,000 Change in CS: CS decreased by £47,500,000
Post-tax consumer expenditures: 10 3 50
11 3 45,000,000 = £495,000,000 Pre-tax PS = = £250,000,000
2
Change in consumer expenditures: 9 3 45
a (slight) decrease by 5,000,000 Post-tax PS = = £202,500,000
2
8 %ΔQ = –0.1 (decreased by 10%) Change in PS: PS decreased by £47,500,000
%ΔP = 0.1 (increased by 10%)
PED = –1 or unitary elastic Pre-tax social surplus = £500,000,000
This seems to be the result expected as the Post-tax social surplus = £405,000,000
incidence of the tax is split: given that PES is 1 Welfare of market participants decreased by
(the supply curve is linear and goes through the £95,000,000
origin) price elasticity of demand should also But, tax revenues collected were £90,000,000
be 1. But it seems to conflict with the finding which in principle could have be spent
that consumer expenditures did not remain the on schools so welfare only decreased by
same. This is only the result of the fact that £5,000,000
the constant expenditure result along a linear You should find the same answer if you
demand requires that the change in price is very calculate the area of the welfare loss triangle
small, say a 1% or smaller change. For those 535
with minimal calculus background the point = = 5, i.e. £5,000,000
2
elasticity of demand at the equilibrium price is
–1 as: Exercise 3 (page 53)
dQP 10
PED = =−53= =−1 Pre-subsidy equilibrium:
dPQ 50 1200 – 100P = 100P
P=6
Q = 600
12
1 1200 − 100Pc = 100(Pc + 2) 600 + 700
Pc = 5 9 ΔCS = 3 1 = 650
2
Q' 700 600 + 700
PP = 7 ΔPS = 3 1 = 650
2
2 1/2 or 50% So, market participants gained 1300 but since

subsidy cost the government (and eventually
3 1/2 or 50%; we should thus expect PED to taxpayers) 1400 there was a welfare loss equal to
equal PES and, since PES is 1, that PED = –1 100 (as determined earlier by calculating in (4) the
(remember: the supply function is linear and area of the little triangle).
goes through the origin)
2 3 100 Exercise 4 (page 53)
4 2 3 700 = 1400 and = = 100
2 Pre-subsidy equilibrium:
200 – P = 50 + P
5 TR1 = 6 3 600 = 3600
P = 75
TR2 = 7 3 700 = 4900
Q = 125
ΔTR = 4900 – 3600 = 1300
1 200 − Pc = 50 + (Pc +10)
6 TE1 = 6 3 600 = 3600
Pc = 70
TE2 = 5 3 700 = 3500
Q' = 130
ΔTE = 3500 – 3600 = –100
PP = Pc + 10 = 80
7 %ΔP = –16.67%
2 1/2 or 50%
%ΔQ = +16.67%
PED = −1
3 1/2 or 50%
We would thus expect that consumer
expenditures in (6) above should not have
4 10 3 130 = 1300
changed. The small change in expenditures
found is the result of the fact that constant 10 3 5
= 25
consumer expenditures (or constant total 2
revenues) along a linear demand require that the
5 TR1 = 75 3 125 = 9375
change in price is very small, say a 1% or even
TR2 = 80 3 130 = 10400
smaller.
ΔTR = 10400 – 9375 = 1025
8 Demand intercepts: if P = 0 then Q = 1200;
6 TE1 = 75 3 125 = 9375
if Q = 0 then P = 12
TE2 = 70 3 130 = 9100
For initial supply: if P = 0 then Q = 0;
ΔTE = 9100 – 9375 = –275
let P = 6 then Q = 600
Post subsidy supply: if P = 0 then Q = 200;
7 %ΔP = –6.67% (or, 0.0667)
if P = 5 then Q = 700
%ΔQ = 4% (or, 0.04)
P PED = –0.06
12
8 Demand intercepts: if P = 0 then Q = 200;
S if Q = 0 then P = 200
Ss For initial supply: if P = 0 then Q = 0;
if Q = 0 then P = –50
7
Post subsidy supply: if P = 0 then Q = 60;
6 if Q = 0 then P = –60
5
0 200 600 700 1200 Q
13
P 6 True: the same price control will lead to a
200 greater surplus or shortage the more price
elastic demand and supply are around the initial
equilibrium price
7 False: it deteriorates as landlords do not have
S
the incentive to maintain them and try to cut
Ss their costs
80 8 True: a minimum wage, at least in a competitive
75
70 labor market, will create some unemployment
9 True: as price will not ration the tickets
anymore, club members will most probably
0 50 60 125 130 200 Q be in an advantageous position (‘sellers’
–50 preferences)
–60 10 True: they typically aim at assisting
disadvantaged producers and households
125 + 130 respectively
9 ΔCS = 3 5 = 637.5 11 False: a price ceiling set above the equilibrium
2
price is ‘non-binding’ i.e. ineffective
125 + 130
ΔPS = 3 5 = 637.5 12 False: there will be no effect as a maximum
2 price set above the market price will be ‘non-
Thus, market participants gained 1275. But, binding’ i.e. ineffective
since the subsidy cost 1300, a welfare loss equal
to 25 resulted.
1 4800 – 35P = 160 +5P
P = €116
1 Floor 7 Collapse 13 Overallocation Q = 740 i.e. 740,000
2 Above 8 Demand 14 Allocative
3 Supplied 9 Taxpayers 15 Producers 2 Qd = 4800 – 35 3 100Qd = 1,300, i.e. 1,300,000
4 Demanded 10 Agricultural 16 Consumers Qs = 160 + 5 3 100
Qs = 660, i.e. 660,000
5 Surplus 11 Farmers 17 Less
Shortage 1,300,000 – 660,000 = 640,000 units
6 Surplus 12 Much 18 Higher
3 Sketching the functions is always helpful:
P
1 True: they sell more at a higher price so their
total revenues are higher S
2 False: some (the lucky ones that end up with the
Ss
good in their market basket) are better off but
some are worse off as a shortage exists
3 False: too much of the good is produced and a
welfare loss results
220
4 False: there may be an element of fairness
involved (as allocation does not depend on
116
income), but since some lucky individuals would maxP
be willing to sell the good at a price that some 100
unlucky ones would be willing to pay, there

would be a possibility of (Pareto) improvement
(i.e. for both parties in the transaction to be
D
better off) so a random allocation is not efficient
0 660 740 1300 Q
(Pareto optimal)
5 False: a maximum price does not lead to a
surplus but to a shortage
14
We need to find at which price firms would be 4 Since the higher price leads to a decrease in
willing to offer 1,300 (thousand) units, so we consumer expenditures, demand should be price
enter 1,300 into the supply function: elastic.
1300 = 160 + 5P
P = 228 euros 5 P1 = 100
To maintain the market price at the €100 ceiling P2 = 120
level, a subsidy equal to 228 – 100 = €128 euros Q1 = 400
per unit must be granted. Q2 = 330
To double-check we solve the system again: %ΔP = +0.2, %ΔQ = –0.2, so PED = –1
Qd = 4800 – 35P This ‘unexpected’ result is because the arc PED
Q's = 160 + 5(P + 128) we calculate is along a ‘large’ change in price. If
4800 – 35P = 160 + 5P + 640 though we had calculated the arc elasticity using
4800 – 800 = 40P the ‘mid-point’ formula (NB: not expected in
P = 100 our syllabus) we would get:
Q = 1300 DQ − 80
(Q1 + Q2)/2 720/2 −176000
Exercise 10 (page 59) = = = −1.22
DP 20 14400
1 800 – 4P = 200 + 2P (P1 + P2)/2 220/2
P = 100 i.e. price elastic, as expected
Q = 400
6 TR1 = BRL 40,000,000
2 Qd at P = 120: TR2 = 120 3 440 = 52,800 or BRL 52,800,000
Qd = 800 – 4 3 120 ΔTR = 52800 – 40000 – 12800 or an increase
Qd = 320 by BRL 12,800,000
Qs at P = 120: 7 (440 – 320) 3 120 = 120 3 120 = 14400

Qs = 200 + 2 3 120 or BRL 14,400,000
Qs = 440
Surplus = 440 – 320 = 120 or 120,000 units 8 Inspecting the graph we realize that by entering
the quantity offered into the demand function,
3 Sketching the functions is always helpful: we can find the price at which consumers would
P be willing to purchase whatever (the 440,000
S units) was produced:
440 = 800 – 4P
P = 90
P
S
MinP Ss
120
100
MinP
120
100
90
D
0 320 400 440 Q
TE1 = 100 3 400 = 40,000 or BRL 40,000,000

TE2 = 120 3 320 = 38,400 or BRL 38,400,000 D
ΔTE = 38,400 – 40,000 = –16,000 or a decrease of 0 320 400 440 Q
BRL 1,600,000
15
So, for the price producers earn per unit to be Exercise 3 (page 62)
120 and consumers to be paying 90, a subsidy
of BRL 30 per unit must be granted. 1 more 6 third 11 Pollution 16 Emissions
Double checking by solving the system again 2 optimal 7 under- 12 cap 17 Positive
with a BRL 30 subsidy: allocation
Qd = 800 – 4P 3 (social) 8 Pigovian 13 Trade 18 legislation
Qs = 200 + 2(P + 30) cost
P = 90 4 last 9 Cost 14 Regulation 19 education
5 positive 10 Polluter 15 Output
9 The BRL 30 subsidy would cost the government
30 3 440 = 13200 or BRL 13,200,000 while the
minimum price costs BRL 14,400,000. So the
subsidy would cost the taxpayer less. 1 True: Enjoying (consuming) these flowers is
non-excludable and non-rival
2 True: decisions are based on the (smaller)
Section 1.4 private benefits and not the social benefits
involved
3 False: it is excludable (but it can still be non-
Exercise 1 (page 62) rival)
1 Positive production externality; MSC < MPC; 4 True: if you do not pay for the ticket you cannot
underproduction and under-allocation; the watch the game at the stadium and if you watch
external benefit would decrease if banks asked it, I can watch it too (up to the capacity of
employees to sign binding employment contracts Camp Nou)
2 Negative consumption externality; 5 True: if one can benefit from a good or service
MSB < MPB; overconsumption and over- without having to pay for it then this person is a
allocation; prohibiting smoking inside buildings free rider
3 Positive consumption externality; MSB > MPB;
underconsumption and under-allocation;
subsidized interest rates
Exercise 7(page 63)
4 Negative production externality; MSC > MPC; 1 Marginal 5 Private
overproduction and over-allocation; create a cost
market for pollution issuing tradable permits 2 Congestion 6 Advertising
3 Free-rider 7 Excludable
Exercise 2 (page 62) 4 Decreases 8 Rival
1 True: since either producers or consumers ignore
the external costs their activity create Exercise 9 (page 66)
2 False: since either producers or consumers 1 Area(1+2+4)
ignore the external benefits their activity create
3 True: if the externality is somehow internalized 2 Area(3+5)
the socially optimal level of output is produced
/ consumed (although consumers will typically 3 Area(1+2+3+4+5)
pay part of the pollution costs)
4 True: the main advantage of such schemes is 4 Area(1)
that they create a market for pollution and thus
rely on the price/ market mechanism 5 It decreased by area(2+4)
6 Area(2+3)
7 It increased by area(2) and lost the smaller

area(5)
16
8 Area (2) was transferred from consumers to the
producer and represents the redistribution of
income that monopoly power is responsible for.
9 Social (or community) surplus decreased as a

result of the monopoly by area(4+5). This area
represents the resulting welfare (or deadweight)
loss.
10 Units (QmQc) should have been produced from

society’s point of view as each unit is worth to
society more than what it would cost society to
produce. Consumers value each of these units
more than what it would cost (i.e. more than
what would have to be sacrificed) to produce
each. Drawing a vertical line from any level of
output between unit Qm and unit Qc reveals
that the price they were willing to pay exceeds
the marginal cost of production (as the supply
curve is nothing but the marginal cost).

1 True: Insurance companies would not be able to
sort out individuals with lower health risks to
offer them cheaper rates and they may thus drop
out of the market leaving only high risks to be
insured.
2 True: The reasoning is similar to the one above.
3 True: This explains why only past season

collections are offered at a discount but never
the new items.
4 False: This behavior is referred to as ‘signaling’.
17
Section 1.5
1
Output (Q), or Average
Labor, or Marginal Product
Total Product Product
Number of Workers (L) MP(L)
TP(L) AP(L)
0 0 - -
1 120 120 120
2 300 150 180 (300 – 120)
3 500 (300 + 200) 500/3 = 166.67 200
4 640 160 (640/4) 140
5 675 (5 3 135) 135 35 (675 – 640)
6 675 (675 + 0) 675/6 = 112.5 0
2 Diminishing returns set in with the 4th worker as his/her marginal product is less than that of the 3rd
worker (140 < 200).

Cost item Amount Type of cost
Ground meat €1.23/kg Variable (more ground meat is needed to produce more burgers)
Insurance €600/month Fixed (its level is independent of the number of burgers produced)
Delivery personnel €5.00/hour Variable (assuming that an increase in output implies an increase in
deliveries)
Electricity $0.20/kwh Variable (assuming that producing more burgers requires more
power)
Store Manager $28,000/year Fixed (her compensation is independent of the level of output)
Potatoes €0.60/kg Variable (assuming that each order of burgers has fries on the side)
Hamburger buns €0.05/bun Variable (as each hamburger requires a hamburger bun)
Lettuce €0.30/head Variable (as each hamburger requires lettuce)
Property taxes €1,800/year Fixed (its level is independent of the number of burgers produced)
Grill assistants €4.90/hour Could be considered variable as the more burgers produced, the
more assistants are needed, or fixed if their number remains
constant per period.

Q FC VC TC ATC AFC AVC
0 500 - 500 - - -
1 500 20 520 520/1 500/1 20/1
2 500 100 600 300 500/2 100/2
3 500 400 900 900/3 500/3 133.33
4 500 1100 1600 1600/4 500/4 1100/4
18
Exercise 5 (page 74) 8 80 640 10 80
9 70 630 -10 70
Capital (K) Labor (L) Output (Q)
Number of Number of Number of units 10 60 600 -30 60
machines workers of the good
6 12 200 Exercise 11 (page 76)
6 13 220
If up to 49 books are sold then total revenues will
6 14 235 be 49 3 20 = €980.00
12 24 600 If the buyer decides to buy 50 copies then the new
12 25 660 price charged will be 5% less.
12 26 710 New discount price: (P – 0.5P) = 0.95P = 0.95 3 20
= €19.00
1 If the firm was characterized by a constant So, total revenues collected from the sale of 50
returns to scale technology, doubling all inputs copies will be: 50 3 19 = €950.00
should double output (or, a 1% increase in all The marginal revenue from the 50th copy is the
inputs should increase output by 1%). Since extra revenues from the last unit sold, or
with 6 machines and 12 workers output is 200, MR(50th) = ΔTR/ΔQ = (950 – 980)/1 = –30 euros
and with 12 machines and 24 workers (double
the machines and double the workers) output Exercise 12 (page 78)
is 600 (triple), the firm experiences increasing
returns to scale. It will bother operating as it will still be making
2 Yes, it does: money. It will be making the minimum it requires
Given capital at 6 machines, the marginal to remain in that line of business which is as much
product of the 13th worker is 20 units but of as it would have made in its next best alternative
the 14th worker it is 15 units: MP decreased; with the same risk. This amount of money is
given capital at 12 machines the marginal referred to as normal profits and is an element of
product of the 25th worker is 60 units but the total production costs of the firm.
of the 26th worker it is 50 units: MP again Assume, for example, that a firm could make $5
decreased. million in its next best alternative with the same
risk; this amount is referred to as normal profit
and is included in its total costs. If then it collected
Exercise 9 (page 75) revenues equal to $140 million and it incurred
Not necessarily as economies of scale may be costs equal to $140 million (in which amount
exhausted at very low levels of output. This the $5 million normal profit is included) then the
is, for example, the case with exquisite dining firm is making zero economic profits but it has no
establishments or more generally with many service incentive to leave the industry as it is making $5
sector firms where personal service is important million, as much as it would make in its next best
and minimal capital is required to operate so that alternative (it is making normal profits).
technical economies are not present. If its total revenues were $143 million then it
would be making $3 million supernormal profits
as it would be pocketing $8 million, i.e. $3 million
Exercise 10 (page 76) over and above the $5 million normal profit it
Q P TR MR AR requires.
0 160 0 - - If, on the other hand, its total revenues were
1 150 150 150 150 $138 million, it would be making an economic loss
2 140 280 130 140 equal to $2 million even though it would be making
$3 million. This $3 million is not enough to keep it
3 130 390 110 130
operating as it could make $5 million in its
4 120 480 90 90
next best alternative with the same risk.
5 110 550 70 110 In the long run, it would exit the industry.
6 100 600 50 100
7 90 630 30 90
cont.
19
1 Investing 5 Sacrifices
2 Financial 6 Opportunity cost
3 Normal 7 Supernormal
4 15%

1 Information 6 Growth 11 Profits
2 Objective 7 Management 12 Share
3 Stakeholders 8 Economies 13 Corporate social
4 Targets 9 Risk
5 Satisficing 10 Pricing

Output Rate Variable Costs Total Costs Marginal Costs Total Revenues Marginal Revenue Profit
1 1200 2200 1200 1400 1400 -800
2 2200 3200 1000 2800 1400 -400
3 3000 4000 800 4200 1400 200
4 3600 4600 600 5600 1400 1000
5 4400 5400 800 7000 1400 1600
6 5400 6400 1000 8400 1400 2000
7 6600 7600 1200 9800 1400 2200
8 8000 9000 1400 11200 1400 2200
9 9600 10600 1600 12600 1400 2000
10 11400 12400 1800 14000 1400 1600
11 13400 14400 2000 15400 1400 1000
1 Q = 8 units
2 See table above
3 To find the shut-down price in the short run we need the AVC figures:
Output Rate Variable Costs Average Variable Costs

1 1200 1200.00
2 2200 1100.00
3 3000 1000.00
4 3600 900.00
5 4400 880.00
6 5400 900.00
7 6600 942.86
8 8000 1000.00
The minimum AVC is Rp880.0
9 9600 1066.67
so the firm will shut-down
10 11400 1140.00
in the short run at any price
11 13400 1218.18 below Rp880.00
20
4
Output Variable Total Marginal Total Marginal
Profit
Rate Costs Costs Costs Revenues Revenue
1 1200 6200 1200 1400 1400 -4800
2 2200 7200 1000 2800 1400 -4400
3 3000 8000 800 4200 1400 -3800
4 3600 8600 600 5600 1400 -3000
5 4400 9400 800 7000 1400 -2400
6 5400 10400 1000 8400 1400 -2000
7 6600 11600 1200 9800 1400 -1800
8 8000 13000 1400 11200 1400 -1800
9 9600 14600 1600 12600 1400 -2000
10 11400 16400 1800 14000 1400 -2400
11 13400 18400 2000 15400 1400 -3000
Total costs will increase by 4000 (the difference between the new and the original fixed costs); marginal
costs will not be affected as fixed costs do not change when output changes; revenue figures will be
unaffected; since MC and MR are unaffected the optimal output choice remains the same; lastly, AVC will
also be unaffected.
5
Output Variable Total Marginal Total Marginal
Profit
Rate Costs Costs Costs Revenues Revenue
1 1200 6200 1200 1800 1800 -4400
2 2200 7200 1000 3600 1800 -3600
3 3000 8000 800 5400 1800 -2600
4 3600 8600 600 7200 1800 -1400
5 4400 9400 800 9000 1800 -400
6 5400 10400 1000 10800 1800 400
7 6600 11600 1200 12600 1800 1000
8 8000 13000 1400 14400 1800 1400
9 9600 14600 1600 16200 1800 1600
10 11400 16400 1800 18000 1800 1600
11 13400 18400 2000 19800 1800 1400
Exercise 18 (page 88) 2 The profit maximizing level of output is at 35

(35000) units as at this level of output
1 No: Price and MR are not equal MR = MC (= 210)
2 No: MR is not equal to MC; MR is greater 3 Assume that price is in dollars. Since AR at 35
signifying that the firm should increase its units is equal to $360 while ATC at 35 units is
output rate $460, it is making minimum losses equal to
3 TR = P 3 Q = 1.50 3 1000 = €1500.00 35 3 $100 = $3500, or $3,500,000.
4 TC = ATC 3 Q = 1.80 3 1000 = €1800.00 4 The revenue maximizing level of output is at 55
5 No, it is making a loss as TC > TR by €300.00 (55000) units as at this level MR = 0 (MR cuts
6 No, as P > AVC the horizontal axis)
5 The maximum total revenues earned are
Exercise 21 (page 92) 55 3 240 = 13200, or $13,200,000
6 Since it is making losses it should consider
1 No, as it is facing a negatively sloped demand
shutting down. If it is in the long run it should
curve
decide to shut down. If it is in the short run
21
then its decision will depend on its fixed costs. Exercise 24 (page 93)
If price (average revenue) is less than its average
variable costs it does not pay to continue The problem that will arise is that the firm will
producing so it should shut down. On the be making losses, so either it would have to be
diagram though there is no information on its subsidized or nationalized. This is because MC
average variable costs. must be less than AC as AC decreases (being a
natural monopoly). But the regulator forces the P
to equal MC (for the allocatively efficient level of
Exercise 22 (page 93) output to be produced) then P (= AR) will be also
1 No: Price is not equal to marginal revenue less than AC so losses will result.
(P > MR: 60 > –30)
2 Yes: Price which, as always equal to average Exercise 27 (page 93)
revenue, is greater than average costs: 60 > 45
3 No: MR (–30) is not equal to MC (60) We know that if an average decreases then the
4 It should decrease output as MC > MR marginal must be less than the average: your
5 No, as it is not producing with minimum average in a course is continuously decreasing
average costs; if AC was minimum then MC only if your grade in each ‘extra’ test is below your
would equal AC average to that point.
6 Yes: for allocative efficiency to exist, price must
equal marginal cost (60 = 60) Also (HL & SL calculus)
7 Since MC > AC it means that AC is rising so A linear demand is given by: P = a – bQ (having
if it decreases output, unit (average) costs will solved for P)
decrease Total revenues are given by P 3 Q, or substituting
8 Since MR is negative (–30) it should decrease the right hand side of the demand function for P:
output to maximize revenues as revenue TR (Q) = (a − bQ)Q
maximization occurs at that output rate at TR (Q) = aQ − bQ2
which MR = 0 Marginal revenue is the slope of total revenue i.e.
9 Breaking even requires that at the chosen output the first derivative of the TR function:
rate Q: dTR
AR (= P) = AC. It should increase output as at MR = = a − 2bQ
dQ
the current level of output, AC is rising and
P(= AR) > AC. By increasing output, price will Closer inspection of the above MR function and
fall and AC will rise so that they eventually comparison with the demand curve reveals that is
become equal. also linear, it has the same vertical (price) intercept
10 and double the slope.
P

MC 1 False: it is elastic below the current price; more
AC
correctly, it is more price elastic below than
above the current price
60
2 False: the behavioral assumption behind the
45 kinked demand curve model is the opposite;
rivals will join in a price cut but will not join in
a price rise
D, AR
3 True: each member would like others to abide
0
Q' Q by the agreement while it sells more and thus
collects even more profits; if all members increase
their output then the agreed price will collapse
–30
MR 4 False: interdependence is the key characteristic
in oligopolistic markets
At Q', P(= 60 = AR) = MC(= 60) > AC(= 45) 5 True: in a cartel, members maximize joint profits
> MR(= –30) as if they were a single monopoly firm
22
Section 2.1
Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Nominal
136,281 146,428 156,615 172,431 185,266 194,819 209,919 225,539 235,679 233,046
GDP
Price
100 103.12 103.4 103.92 102.95 102.81 103.12 103.06 103.2 101.2
Index
To calculate real GDP of a year you need to divide nominal GDP by the price index for the year and multiply the result by 100.
185266
So, for example, for 2004: 3 100 = 179957.3
102.95
136,281 141,997.7 151,465.2 165,926.7 179,957.3 189,494.2 203,567.7 218,842.4 228,371.1 230,282.6
Exercise 4 (page 105) 3 The marginal propensity to withdraw is 0.45

1 1
Note that the vertical axis is nothing but the annual Since k = MPW it follows that k = 0.45 = 2.22
growth rate of the economy, so:
1 False: growth is accelerating 4 The marginal propensity to consume in a closed
2 False: an economy is in recession if it registers economy without government is 0.85
negative growth rates 1 1
3 False: it is higher as the growth rate registered is Since k = MPW it follows that k = 0.85 = 1.18
positive
4 True: the growth rate is negative so real GDP
contracted (decreased)
5 False: growth at time t3 was slower than at time 1 Vertical 5 Short run aggregate supply
period t2 but it was still positive so real GDP 2 Equilibrium 6 Full employment
increased (albeit at a slower rate) 3 Temporary 7 Inflationary
6 True: growth again was positive 4 Money or nominal

To calculate the value of the multiplier:
1 Since $20 are taken away as taxes from every
DY extra $100 earned, the MRT is 0.20.
➞ Remember that k = , where DJ is the change
DJ DT

(Remember that MRT = DY )
in any injection: J = (X, I G) and that
1 The MPW is equal to the sum of the MPS and
k = MPW , where MPW = (MPS + MPM + MRT)
the MPM and the MRT or,
MPW = (0.11 + 0.19 + 0.20) = 0.50
1 Income has increased by $120 billion following
an increase in private sector investment by $50 1 1
The multiplier k is thus MPW = 0.50 = 2
billion 120
ΔY = 120, ΔI = 50 so k = 50 = 2.4
2 Income decreases by $20 billion when the

government cuts its spending from $62.5 billion
to $54.5 billion
ΔY = −20
ΔG = G2 − G1 = 54.5 − 62.5 = −8
−20
So k = −8 = 2.5
23
Given that ΔY = kΔG it follows that Exercise 10 (page 115)
850 The change in national income is equal to:
850 = 2 3 DG or, DG = 2 = 425
DY = Y2 − Y1 = 1.104 − 0.860 = 0.244 trillion
Thus if the government increases spending by or 244 billion
$425 million then, given a multiplier equal to
2, national income will rise by $850 million The multiplier k is equal to:
DY 244
closing the recessionary gap. k = DG = 122 = 2
2 The change in national income ΔY is: The multiplier k is equal to:

DY = Y2 − Y1 = 1.66 − 1.56 = $0.1 trillion, or
2
$100 billion k = MPW g
Given that DY = kDG it follows that
and, solving for MPW:
100
100 = 3.2 3 DG or, DG = 3.2 = $31.25 billion. 1 1
MPW = k g MPW = 2 = 0.5
The government, within the simple Keynesian
If there are no taxes then in a closed economy
framework, should thus increase its
the only withdrawal are savings so the marginal
expenditures by $31.25 billion to achieve the
propensity to consume is:
desired increase of national income.
MPC = (1 − MPS) g MPC = (1 − 0.5) = 0.5
3 Calculate 1.6% of 680:
0.016 3 680 = $10.88 billion. Exercise 1 (page 118)
This is the income gap that needs to be closed. 1 False: It is well known and accepted that
some unemployment is inevitable. This
Ye = Yf − 10.88 g Ye = 680 − 10.88 = 669.12. unemployment is referred to as normal or
This is the equilibrium level of national income. natural unemployment.
2 False: Structural unemployment is of a long
Given that DY = kDG it follows that term nature as it tends to persist way beyond an
10.88 = 2.8 3 DG or, economy entering recovery. It is a result of the
constantly changing structure of an economy
10.88 and of any built-in labor market rigidities.
DG = 2.8 = $3.89 billion.
3 True: People are constantly searching for better
jobs so there are always individuals caught in
Exercise 9 (page 115) between jobs.
1 The MPW = 0.25 + 0.15 = 0.40 so the multiplier 4 True: For example, the existence of discouraged
k is equal to workers will lead to underestimation of true
unemployment, whereas some individuals may
1
k = 0.4 = 2.5 claim to be unemployed even though they do
have some kind of job for fear of losing their
DY = k 3 DJ g DY = 2.5 3 12 = $30 billion unemployment or other benefits.
5 False: The PPF is drawn on the assumption that
2 The MPW = 0.24 + 0.12 + 0.14 = 0.5 so the an economy fully utilizes its scarce labor and
multiplier k is equal to other resources so a decrease in unemployment
would only move an economy from some point
1
k = 0.5 = 2 inside its PPF to another point in the north east.
6 False: The long run aggregate supply curve of an
DY = k 3 DJ g DY = 2 3 6 = $12 billion economy is vertical at the full employment level
of national income at which normal or natural
3 If the multiplier is estimated at 1.7 and the exists. The existence of cyclical unemployment
government initiates an increase of $350 billion implies the existence of a recessionary gap so
DY = k 3 DJ g DY = 1.7 3 350 = $595 billion that equilibrium (actual) income is to the left of
full employment income. A decrease in cyclical
24
would thus only move the economy closer to goods (such as price scanning devices and tractors)
its full employment level of income without but also semi-finished and intermediate goods
shifting its LRAS curve. The LRAS curve will (such as flour and steel) as well as raw or crude
shift to the right if the productive capacity of materials (such as coal and crude oil). It thus
the economy grows or if the natural rate of picks up and signals price changes that the typical
unemployment decreases. consumer will face before these changes actually
7 True: As mentioned above, the long run materialize. For this reason it is considered a
aggregate supply curve of an economy is vertical leading indicator of consumer inflation.
at the full employment level of national income 6 False: The value of money (i.e. what a unit of
at which normal or natural exists. Natural money can buy) is inversely proportional to the
unemployment consists of structural and (average) price level; if prices rise by 10% then
frictional unemployment so if these decrease the Yuan or the Peso or the Euro can buy 10%
then the natural (normal) rate of unemployment fewer goods than before.
decreases and the LRAS will shift to the right. 7 True: Deflation refers to a decrease in the prices
of goods and services, so the exports of a country
Exercise 2 (page 118) suffering from deflation will gain a competitive
advantage in foreign markets. If export revenues
1 frictional 8 increases 15 taxes increase then aggregate demand will increase
2 short 9 recession 16 interest rates helping the country exit the deflationary spiral.
3 information 10 labor 17 consumption 8 True: An adverse supply-shock, such as a
4 seasonal 11 money 18 durable sustained increase in the price of energy, will
5 aggregate 12 sticky 19 investment lead to higher prices (cost-push inflation)
demand expenditure and lower economic activity, i.e. higher
unemployment. It follows that for each level
6 deficient 13 higher
of inflation the economy will suffer higher
7 cyclical 14 government
unemployment pushing the short run Phillips
spending
curve outwards.
9 True and false: According to the monetarist
Exercise 7 (page 122) perspective it is only because of workers being
1 False: Lowering interest rates is easy monetary temporarily fooled (‘money illusion’) that
policy; borrowing by households to purchase expansionary demand-side policies can lower
cars and by firms to purchase capital goods such unemployment below its natural rate; according
as machines becomes cheaper so consumption to the Keynesian perspective, aggregate supply
and investment expenditures will probably can be thought of consisting of 3 sections;
increase, increasing aggregate demand and thus the rising section implies the existence of
inflationary pressures. bottlenecks in production so that output can be
2 True: Assuming fixed interest rate loans, the rising (and unemployment can be decreasing)
borrower will be paying back less in real terms (it while the price level is also increasing.
will be worth less as it will be able to buy less). 10 True: If policymakers are credible when they
3 True: Expectations of inflation create inflation as announce a policy initiative aiming at lowering
firms and workers with pricing power will increase inflation then expectations of inflation will
their prices and wages to keep ahead of the game adjust downwards immediately as neither
in anticipation of the higher overall price level. firms nor workers will fear that their real
4 False: The greater the recessionary gap the more revenues or wages will fall in the process. In the
unemployed resources exist and the flatter the extreme case where expectations are rational
short run aggregate supply curve will be. Any (and the SRPC is also vertical) the decrease in
increase in AD can be accommodated without inflation will lead to no temporary increase
resource prices (e.g. wages) increasing as there is in unemployment. Thus, the more credible
plenty of slack in the economy. policymakers are, the steeper the SRPC will be.
5 False: The PPI is the better predictor of future
inflation as it includes the prices that producers
receive for goods (services are not included) at all
stages in the production process not just finished
25
First, calculate how much it would cost the typical 1 degradation 8 capital intensive
consumer to purchase the same basket each year. 2 natural resources 9 worsening
The price of each product in each year is multiplied 3 sustainable 10 GDP
by the quantity purchased in the base year (here
4 distribution of income 11 GNP
2009):
5 inflation 12 imports
6 unemployment 13 exports
3 Cost of
Year pi = p1q1 + p2q2 + p3q3 7 appropriate
1 basket
2009 $6.50 3 5 + $0.99 3 12 + $2.50 3 20 = $94.38
2010 $6.60 3 5 + $1.05 3 12 + $2.55 3 20 = $96.60 Exercise 12 (page 124)
2011 $6.403 5 + 1.00 3 12 + $2.40 3 20 = $92.00 To calculate the growth rate of a country we use
real GDP. We thus have to first calculate real
To construct a weighted price index for any year t, GDP from the data. Real GDP can be calculated
you need to divide the cost of the basket in year t by by dividing nominal (or money GDP, or GDP at
the cost of the basket in the base period (here 2010) current prices) with the GDP deflator for the year
and multiply by 100. and multiply the result by 100.
Formula: Year Nominal GDP GDP Deflator Real GDP

cost of basket in year t Price
Year 345.12
cost of basket in base year (here 2009) 3 100 Index 2007 345.12 94.8 3 100 = 364.05
94.8
94.38 363.88
2009 3 100 = 100 100 2008 363.88 98.4 3 100 = 369.80
94.38 94.8
96.60 393.51
2010 3 100 = 102.35 102.35 2009 393.51 100.0 3 100 = 393.51
94.38 100
92.00
2011 3 100 = 97.48 97.48 420.39
94.38 2010 420.39 103.4 3 100 = 406.57
103.4
The inflation rate of a year is defined as the 431.5
2011 431.50 105.6 3 100 = 408.62
percentage change in the average price level 105.6
(expressed as a price index like the CPI). So:
The growth rate g of a year is the percentage change
inflation rate of period t = %D(CPI) = of real GDP with respect to the previous year
price index at (t) − price index at (t − 1) Denoting the growth rate in year t as g t and real
3 100 GDP of year t as yt :
price index at (t − 1)
(yt – yt – 1)
Year Inflation rate gt = , so:
yt – 1
2010 -
Nominal GDP Real Growth
Year
102.35 – 100 GDP Deflator GDP Rate
2011 3 100 = 2.35%
100 2007 345.12 94.8 364.05
97.48 – 102.35 2008 363.88 98.4 369.80 +1.58%
2012 3 100 = –4.76%
102.35 2009 393.51 100.0 393.51 +6.41%
2010 420.39 103.4 406.57 +3.32%
Note that this economy suffered from deflation in 2011 431.50 105.6 408.62 +0.50%
2012 as the average price level decreased and thus
the rate of inflation was a negative value. Economic activity in Oz did not decrease in 2010 as
it registered a lower but still positive growth rate.
As long as the growth rate is positive, an economy
continues to grow.
26
Exercise 13 (page 128) tax rate and reveals that the marginal rate is
higher than the average rate which implies that
1 g the ATR is rising (as expected).
2 f
3 b 4 Since 20% of their spending on goods and
4 c services will represent indirect taxes we need to
5 d multiply each individual’s spending by 0.20:
6 h
7 a Annual Spending
Indirect tax bill
on Goods and Services
8 e
Sara €15,000 0.20 3 15000 = 3000
Rebekah €30,000 0.20 3 30000 = 6000
Exercise 16 (page 128) Sanjeet €40,000 0.20 3 40000 = 8000
1
Income Tax Sara Rebekah Sanjeet 5
Bracket Rate (Y=€32,000) (Y=€48,000) Amount Proportion of income
(Y=€16,000) Income
spent on representing indirect
level
0-€5,000 0% 0.00 0.00 0.00 indirect taxes paid (column 2 /
(1)
€5,001- taxes (2) column1)
5% 500 500 500
€15,000
€15001 - Sara €16,000 €3000 3000
15% 150 2250 2250 = 0.1875 or 18.75%
€30,000 16000
€30,001 -
30% -- 600 5400
€50,000 Rebekah €32,000 €6000 6000
= 0.1875 or 18.75%
€50,000 + 40% -- -- -- 32000
Tax owed: Tax owed: Tax owed:
650 3350 8150 Sanjeet €48,000 €8000 8000
= 0.1666 or 16.67%
48000
2 The average tax rate is defined as
tax paid
3 100. Exercise 1 (page 133)
income (or tax base)
1 d
Entering the numbers we arrive at:
2 c
3 e
MTR
4 a
Average Tax (rate on the
Taxpayer So: 5 b
Rate last dollar
earned)
Sara 0.04 or 4% 0.15 or 15% MTR > ATR Exercise 2 (page 133)
Rebekah 0.11 or 11% 0.30 or 30% MTR > ATR
1 True: Lower interest rates (easy or loose
Sanjeet 0.17 or 17% 0.30 or 30% MTR > ATR monetary policy) may not succeed in increasing
household expenditures on durables or
3 A tax is a progressive tax if the average tax investment expenditures of firms as these
rate rises. Inspecting the ATR column above expenditures also depend on other variables
reveals that the Average Tax Rate is rising besides the cost of borrowing money (i.e.
which means that higher income individuals pay interest rates). If, because of the recession and
proportionately more. Sanjeet paid 17% of her the rising unemployment, I am afraid that I too
income in income tax whereas Rebekah paid could lose my job then lower interest rates will
11% of hers and Sara only 4% of hers. The last not induce me to buy a new car. Low consumer
column compares the marginal with the average confidence may deter consumers from spending
27
on ‘big ticket’ items in a recession. Firms will require a ‘big buyer’ (the state) to achieve and
also be hesitant to expand if they fear that the maintain low unit costs of production.
recession will be deep or drag for a long time. 4 False: Demand side policies are thought of as
2 True: Within the Keynesian framework easy short run stabilization (countercyclical) policies.
monetary may prove totally ineffective if the Supply-side policies are long term policies and
economy has fallen into a ‘liquidity trap’. If as such are not concerned with any short run
(nominal) interest rates are close to zero they fluctuations of output around its long run trend.
cannot be lowered any further (nominal interest 5 True: Both privatizations and deregulation have
rates cannot be negative). decreased and increased unemployment; for
3 True: The central bank can easily increase example, privatizing a state owned firm may
interest rates after decreasing them (and vice lead to a more efficient structure emerging with
versa) whereas if the government has adopted redundancies and thus fewer employees.
a fiscal stimulus plan spending, say, millions on
building new bridges, and a few months later it Exercise 3 (page 136)
is realized that this extra government spending
may prove inflationary, it is not possible to 1 incentive 7 normal 13 tax breaks
reverse the policy and leave the bridges half- 2 opposite 8 aggregate 14 subsidies
finished. demand
4 False: Countercyclical monetary policy involves 3 opportunity 9 budget 15 minimum
increasing interest rates in the upswing, as cost deficit wage
inflationary pressures may arise, and lowering 4 work 10 income 16 income
interest rates in the downswing of the business distribution inequality
cycle as (cyclical) unemployment increases. 5 disposable 11 Imports 17 misallocation
income
Exercise 4 (page 133) 6 leisure 12 industrial
policies
1 smaller 7 large
2 ambiguous 8 low cost
3 decrease 9 guarantee
4 interest 10 bank panics
rates
5 inflation rate 11 moral
hazard
6 growth and 12 large
employment

1 True: The positive spillover effects from general
R&D programs are typically substantial and
require government funding, whereas in the case
of product specific research (i.e. how to make
the picture of a Sony TV better) the company
will typically reap all the benefits.
2 True: Liberalizing trade (i.e. decreasing trade
barriers) increases the number of substitutes
available to the residents of a country. If more
substitutes exist then price elasticity of demand
increases which implies less monopoly power
for the domestic firm(s).
3 True: These industries typically are thought to
require an initial ‘big push’ to kick-start them or
28
Section 3.1 Remember that if you draw/sketch the PPF curves
properly, the country with the flatter PPF has the
Exercise 1 (page 139) comparative advantage in the production of the
good represented on the horizontal axis.
1 producers 7
technology 13 unemployed
2 raw 8
transfer and 14 retrained
diffusion Exercise 5 (page 144)
3 intermediate 9 domestic 15 role of the 1 $8.00 per unit (32 – 24)
markets government 2 280,000 units per year (400,000 – 120,000)
4 lower 10 economies 16 adjustment 3 $6,720,000 per year (or $24 3 280,000)
of scale 4 $2,880,000 per year (or $24 3 120,000)
5 inputs 11 less 5 $9,600,000 per year (or $24 3 400,000)
efficient 6 100,000 units per year (300,000 – 200,000)
6 capital 12 shut down 180,000 fewer units (100,000 – 280,000)
7 Import spending after the tariff:
$2,400,000 per year ($24 x 100,000)
Exercise 3 (page 139) Import expenditures decreased by $4,320,000
Remembering that the opportunity cost of per year (2,400,000 – 6,720,000)
producing a units of good X is given by the slope 8 $9,600,000 per year ($32 3 300,000)
DY 9 Foreign exporters collected: $2,400,000 per year
of the PPF, i.e. by the ratio we can calculate the
DX Domestic producers collected:
necessary opportunity costs: $6,400,000 per year ($32 x 200,000)
– 400 1 The state: $800,000 ($8 x 100,000)
OC(good X)/Pink = Y=– Y Sum: $9,600,000 per year
2000 5
80,000 3 8
– 250 1 10 Area of triangle (2) = = $320,000
OC(good X)/Black = Y=– Y 2
1500 6
(300,000 + 400,000)
It follows that country Black (the blue PPF below) 11 Area(1+2+3+4) = 38
has a comparative advantage in the production of 2
good X because it can produce a unit of X by = 2,800,000
1
sacrificing only th of a unit of good Y, whereas
6
country Pink needs to sacrifice more of Y,
1
specifically th of a unit of Y.
5
Units of
good Y
400
250
1500 2000 Units of

good X
29
Quota diagram 1 True: Export will lose their competitiveness
P/unit (small country case)
(Mexican pesos) and tend to decrease, decreasing the demand
Sd
for the currency in foreign exchange markets;
S ’ = (Sd + Quota) imported goods and services will become more
attractive to domestic consumers and tend to
a b
increase, increasing the supply of the currency in
foreign exchange markets; if demand decreases
and supply increases then the price, in this case
16
1 2 3 4 Sw the exchange rate, will tend to decrease, i.e.
12
depreciate.
A B C 2 True: Easy monetary policy in the US implies
D that US interest rates are decreasing, i.e. the rate
0 84 105 330 354 Q/year of return on fixed income assets denominated in
(mil. of units) dollars will decrease. Holders of dollar deposits
1 (330 – 105) = 225 million units and US bonds will seek other more profitable
2 (354 – 84) 3 12 = 3.24 billion Pesos (financial) investments: Brazilian fixed income
3 (84 3 12) = 1.002 billion Pesos assets (deposits in Real and Brazilian bonds) will
4 (354 3 12) = 4.248 billion Pesos seem (amongst such assets in other emerging
5 Original volume of imports = (354 – 84) markets) more attractive so some of these hot
= 270 million units monies will be channeled there; as supply of US
Quota = 225 million units dollars increases and demand for the Brazilian
Change in volume of imports = (225 – 270) currency increases, the US dollar will tend to
i.e. a decrease of 45 million units depreciate as the Real appreciates.
6 Post-quota expenditures on imports = 3 True: Excess demand in any competitive market
225 3 16 = 3.6 billion Pesos will push up the price (here, the exchange rate),
Pre-quota expenditures on imports = unless there is Central Bank intervention to
3.24 billion Pesos prevent this increase by selling the currency in
Change in import expenditures = the foreign exchange market at the same time
3.6 – 3.24 = 0.36 billion more (which would be the case in a fixed exchange
This is a case where the volume of imports rate system and could be the case in a managed
has decreased but import expenditures have exchange rate system).
increased as a result of the quota. 4 False: If there is pressure for the currency to
7 (330 3 16) = 5.28 billion Pesos devaluate, defending it requires buying the
8 (16 – 12) 3 225 = 900 million Pesos currency (selling foreign exchange reserves) and/
These are typically earned by the foreigners (the or increasing interest rates to render domestic
exporting firms or their government). It could be fixed income assets (deposits and bonds) more
that the domestic government auctions-off these attractive to foreign investors and thus induce
permits and thus collects these rents itself. capital inflows.
5 True: An appreciation implies that the foreign
(330 + 354)
9 3 4 = 1.368 billion Pesos price of exports rises rendering them less
2 competitive abroad; exporters have an incentive
(105 – 84) 3 4
10 Area of triangle (2) = to cut waste/costs (i.e. attempt to become more
2 efficient) so that their foreign price increases by
= 42 million Pesos less (or perhaps, not at all). Symmetrically, the
appreciation renders imports less expensive in
(354 – 330) 3 4
11 Area of triangle (4) = the domestic market and thus more attractive to
2 domestic consumers. Import competing firms
= 48 million Pesos thus have the same incentive: they will try to cut
any waste so that they can lower their price and
maintain their market share.
30
1 devaluation 8 competitiveness 15 unemployment To calculate the price of this IB Economics textbook
2 flexible 9 widening 16 reserves in the currency of each country, we need to multiply
3 depreciating 10 monetary 17 opportunity the dollar (USD) price of the textbook with the
cost number of units of each of these currencies, say,
4 certainty 11 interest 18 managed CLP
Chilean Pesos, to the dollar ( ):
5 price 12 deficits 19 periodic USD
6 attractiveness 13 fiscal CLP
(USD 3 ) so that the USD cancel out in this
7 inflation 14 decreases USD
multiplication and the result is in Chilian Pesos.
1 Qd = 701.24 – 18e Currency Units Price in
Symbol
Qs = 618.64 + 4e Unit per USD local currency
701.24 – 18e = 618.64 + 4e
701.24 – 618.64 = 4e + 18e CLP Chile Pesos 469.95
USD33.59 3 CLP469.95/USD
82.6 = 22e CLP 15785.62
82.6 DKK Denmark 5.667
e= g e = 3.76 DKK 190.3545
22 Kroner
So £1.00 = $3.76 EUR Euro 0.76 EUR 25.5284
HKD Hong Kong 7.78
HKD 261.3302
2 Q = 701.24 – 18 3 3.76 = 633.56 Dollar
Q = 633.56 billion Pounds per day INR India Rupee 45.213 INR 1518.705
KES Kenya 80.649
KES 2709
(Note: the supply of Pounds was originally Shilling
618.64 + 52e in which case: MYR Malaysia 3.097
MYR 104.0282
701.24 – 18e = 618.64 + 52e Ringgit
701.24 – 618.64 = 52e + 18e NZD New 1.335
82.6 = 70e Zealand NZD 44.84265
82.6 Dollar
e= = 1.18 RUB Russia 30.456
70 RUB 1023.017
Ruble
i.e. £1.00 = $1.18 with 680 billion pounds SGD Singapore 1.298
traded daily) SGD 43.59982
Dollar
SEK Swedish 6.832
SEK 229.4869
Exercise 5 (page 153) Kronor
CHF Switzerland 0.958
1 Qd = 919.76 – 16e CHF 32.17922
Franc
Qs = 837.56 + 4e
GBP UK Pound 0.648 GBP 21.76632
919.76 – 16e = 837.56 + 4e
919.76 – 837.56 = 4e + 16e
83.2 = 20e
83.2
e= g e = 4.11
20
So: CLP1.00 = COP4.11 in December 2010
2 Determine the volume of CLP’s traded per day:

919.76 – (16 3 4.11) = 854
Thus, 854 million CLP’s were traded per month.
31
Units per UK pound (GBP) GBP per unit of local currency
% change (1) % change (2)
Dec. 29, 2005 Dec. 29, 2010 Dec. 29, 2005 Dec. 29, 2010
Australian dollar
2.359 1.518 –35.65 0.42391 0.65876 55.40
AUD
Canadian dollar
2.011 1.536 –23.62 0.49727 0.65104 30.92
CAD
China Yuan
13.932 10.188 –26.87 0.07178 0.09815 36.75
Renminbi CNY
Euro EUR 1.457 1.171 –19.63 0.68634 0.85397 24.42
Japanese Yen JPY 203.499 126.374 –37.90 0.00491 0.00791 61.03
New Zealand dollar 2.530 2.019 –20.20 0.39526 0.49529 25.31
Norway kroner NOK 11.686 9.151 –21.69 0.08557 0.10928 27.70
Singapore dollar
2.874 1.993 –30.65 0.34795 0.50176 44.20
SGD
Swiss Franc CHF 2.269 1.465 –35.43 0.44072 0.68259 54.88
US dollar USD 1.726 1.539 –10.83 0.57937 0.64977 12.15
Mexico Peso MXN 18.469 19.011 2.93 0.05414 0.05260 –2.85
South Korea Won
1,747.79 1,759.992 0.70 0.00057 0.00057 –0.69
KRW
Note: In column (1) a plus (+) sign indicates that domestic price level automatically rises and cost-
the British currency appreciates between 2005 push inflationary risks arise) sacrificing the price
and 2010, while a minus (-) sign indicates that the stability objective.
Pound depreciated. 4 False: Money flows into the UK so it is an
invisible export.
Exercise 1 (page 158) 5 False: Money is flowing into China so it is a
credit item for China’s financial account.
1 True: To offset currency weakness requires 6 True: As money is flowing into Brazil it is a
that the central bank buys the currency in the credit item and it is recorded in the current
foreign exchange market using foreign exchange account (investment income inflow).
reserves. Its foreign exchange reserves will thus 7 True: This is the Marshall-Lerner condition
dwindle. which states that for a devaluation (sharp
2 True: The deficit must somehow be financed. depreciation) to correct a current account
Either the central bank will finance it using its deficit, it is not necessary that both the price
dollar (foreign exchange) reserves or it may elasticity of demand for exports and for imports
be forced to officially borrow from abroad. is greater than one, but that just their sum
Alternatively it may try to induce increased exceeds unity.
inflow of foreign exchange by increasing 8 False: It will trace an inverse J-curve as initially
domestic interest rates, rendering domestic fixed (after exports become pricier and imports
income assets (bonds, deposits) more attractive cheaper domestically) the surplus will increase,
to foreign investors. but once elasticities rise and their sum exceeds
3 True: Borrowing to finance such deficits cannot unity the surplus will start to decrease.
continue indefinitely so at some point the 10 True: The resulting lower income decreases the
country must adjust. It must either contract as absorption of imports as imports are a positive
lower income will shrink import demand (but function of national income.
this means that the growth objective as well
as the employment objective are sacrificed),
or it may need to devalue or induce a sharp
depreciation of the currency (in which case the
32
1 widening 13 undervalued 25 narrow 1 True: If the country is an oil exporter then the
2 deficit 14 competitive 26 unity TOT improves and, since export revenues will
3 rising 15 inflation 27 Marshall- increase, the BOT also improves (in the sense
Lerner that a deficit shrinks and a surplus widens); if
it is an importer then the TOT worsens and as
4 supply 16 interest rates 28 short run
import expenditures increase the BOT worsens
5 demand 17 inflows 29 J-curve
(as a deficit widens and a surplus decreases).
effect
2 False: The TOT will improve but what happens
6 foreign 18 growth 30 worsens
to the BOT depends on the PED of exports and
exchange
imports. In the long run, when the sum of the
7 downward 19 unemployment 31 informational
two exceeds unity then a surplus will tend to
8 export driven 20 reducing 32 habits shrink.
9 surplus 21 imports 33 contracts 3 True (assuming significant concentration of
10 appreciate 22 domestic exports/imports: If the country is an exporter
11 manage 23 cheaper of the commodity then the TOT movement is
12 selling 24 price favorable and, since the volume of exports will
elasticities also rise as a result of the shift to the right of
the demand, the trade balance will improve as
export revenues will necessarily increase. If it is
Exercise 3 (page 159) an importer then there will be an unfavorable
1 c movement of the TOT and, since the volume of
2 g imports has also risen (remember there was an
increase in the demand for the commodity so
3 e
an equal amount is imported as exported), the
4 b trade balance will worsen.
5 f 4 True: As the price of the commodity increases
6 a the TOT of exporters improve while the TOT
7 d of importers worsen. Since demand is assumed
inelastic, the value of exports (which is the same
as the value of imports) rises so the balance of
Exercise 4 (page 160) trade improves and worsens respectively.
X1 –3775 5 True: In these two cases, prices and volumes of
trade move in opposite directions so the trade
X2 –48577
value is dependent on price elasticities.
X3 –1720
X4 –54072
X5 54476
X6 54187 1 balance 7 increase
13 importers 19 Marshall-
of trade Lerner
X7 –115
2 goods 8 volume 14 opposite 20 absolute
3 services 9 worsen 15 elasticity 21 exceeds
Exercise 1 (page 163) of unity
demand
1 trading 5 outweighed 4 cause 10 deteriorate 16 Inelastic
block
5 boom 11 supply 17 same
2 trade 6 trade
6 improve 12 exporters 18 decrease
creation diversion
3 trade 7 member
4 Positive 8 nonmember
33
Index of Volume
PAX PBM
Year %ΔP %ΔX export TOT of exports
(as an index) (as an index) revenues (units of A)
2004 80 - 98.53 - 59.50 81.19 118.33 mil
2005 93.33 16.67 99.10 32.99 78.77 94.18 134.29 mil
2006 97.78 4.76 99.59 14.89 90.50 98.18 147.27 mil
2007 100 2.27 100 10.49 100 100 159.11 mil
2008 109.33 9.33 100.49 11.17 111.17 108.80 161.79 mil
2009 111.56 2.03 100.74 8.54 120.67 110.74 172.11 mil
1 To find the price as an index number, divide it 6 The easiest way with a calculator is to divide the
by the price in the base year and multiply by value for each year by the value in the previous
100. So, the price of exports in 2008 would be: year, subtract 1 and multiply by 100. So to
24.60 calculate the percentage change in the price of
3 100 = 109.33 good A between 2008 and 2007 (using either
22.50
the dollar prices or the indices):
24.6
2 The TOT is the ratio of the average price of 122.5
2
– 1 3 100 = 9.33%
exports over the average price of imports
109.33
expressed as index numbers multiplied by 100. Or, 1
100
2
– 1 3 100 = 9.33%
So, for 2008:
For the export revenues, do the same thing:
109.33
3 100 = 108.7968 = 108.80 3.98
100.49 1 3.58
2
– 1 3 100 = 11.17%
3 The TOT have been continuously improving
(favorable movement) meaning that a greater 7 Either the volume of exports decreased by
volume of imports is attainable by a unit of proportionately less (price elasticity of demand
Cymmeria exports. for exports less than one; this would be the case
4 The procedure is the same: divide each year’s if the increased export prices were the result of a
figure with the base year figure and multiply by currency appreciation), or the higher price was a
100. So, for 2008: result of greater demand for the commodity (for
Cymmeria’s exports). Here, since the volume of
3.98
3 100 = 111.17 exports has also been increasing, we can exclude
3.58 the first explanation.
5 Divide the revenues by the price (you will get
billions so multiply by 1000 to convert to
millions). So, for 2008:
3.98
= 0.161788 = 161.79 million
24.6
34

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Foundations

Exercise 20 (page 29)

Exercise 21 (page 29)

Exercise 22 (page 29)

Exercise 2 (page 33) Weekly revenues from unagi increased by $78.3.

2 120 – 4Pc = 2(Pc − 3) – 30 18

3 $1.00 or 1/3 of the tax is paid by consumers

4 $2.00 or 2/3 of the tax is paid by producers

6 Pre-tax TR = 25 3 20,000 = $500,000

Pre-tax social surplus = $150,000

2 100 – 5Pc = 5(Pc − 2)

4 £1.00 on consumer or ½ of the tax is paid by

2 1/2 or 50% So, market participants gained 1300 but since

0 200 600 700 1200 Q

unlucky ones would be willing to pay, there

Qs at P = 120: 7 (440 – 320) 3 120 = 120 3 120 = 14400

0 320 400 440 Q

TE1 = 100 3 400 = 40,000 or BRL 40,000,000

7 It increased by area(2) and lost the smaller

9 Social (or community) surplus decreased as a

10 Units (QmQc) should have been produced from

Exercise 10 (page 67)

2 True: The reasoning is similar to the one above.

3 True: This explains why only past season

4 False: This behavior is referred to as ‘signaling’.

Exercise 3 (page 72)

Exercise 4 (page 72)

Exercise 14 (page 80)

Exercise 17 (page 87)

Output Rate Variable Costs Average Variable Costs

Exercise 18 (page 88) 2 The profit maximizing level of output is at 35

Exercise 31 (page 99)

Exercise 4 (page 105) 3 The marginal propensity to withdraw is 0.45

Exercise 6 (page 114) Exercise 8 (page 115)

2 Income decreases by $20 billion when the

2 The change in national income ΔY is: The multiplier k is equal to:

Formula: Year Nominal GDP GDP Deflator Real GDP

Exercise 1 (page 136)

1500 2000 Units of

2 Determine the volume of CLP’s traded per day:

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