GBEA IE Workshop 1: Chapter 2 Questions & Answers
Mock EXAM Economics as part of the course Global Business
& Economic Analysis, September-October 2022 plus ANSWERS
This mock exam consists of open-ended questions.
The closed book exam via Remindo on November 04 between 11:30-13:30 will
consist of 25 open questions without MC-questions.
Make sure you use the time during the exam (two hours)
as efficient as possible so that all questions are answered!
There will also be a few questions about Chapter 2 in the exam on November
04.
Question 1 – Chapter 6
a) Explain what is the difference between the short run and the long run production theory, as discussed in
Sloman Chapter 6.
Short run: at least one factor of production is fixed.
Long run: all factors of production are variable.
b) Clearly mark in the graph below at what point diminishing returns set in? (2 points)
c) List and explain two different reasons why companies can experience economies of scale.
Specialisation and division of labor; indivisibilities; container principle; greater efficiency of large machines; byproducts; multi-stage production; organisational economies; spreading overheads; financial economies;
economies of scope. Explanation Sloman p.162-153.
Question 2 – Chapter 7
a) Explain what will happen in the long run with profits gained in the short-run in a market structure of perfect
competition?
In the short-run equilibrium, the firm is able to make supernormal profit. In the long-run equilibrium,
supernormal profit disappears because new producers will enter the market, supply shifts to the right, and only
normal profit is made.
b) Indicate in the diagram below the equilibrium price and quantity of both the perfect competition and the
monopoly.
See the diagram. P1 and Q1 (P2 and Q2) are the equilibrium price and quantity of the monopoly (perfect
competition).
c) Explain what is a perfectly contestable market? Provide one example of a contestable market.
A market where is free and costless entry and exit. A catering company running a canteen in a factory. See
Sloman p. 211-215.
Question 3 – Chapter 8
The resulting equilibrium of models that explain non-collusive oligopoly is known as a Nash equilibrium.
a) What is meant by a Nash equilibrium?
The position resulting from everyone making their optimal decision based on their assumptions about their
rivals’ decisions. Without collusion, there is no incentive for any firm to move from their position.
There are three broad types of price discrimination: first, second and third degree price discrimination.
b) What is the difference between first and second degree price discrimination?
First-degree price discrimination: Where a firm charges each consumer for each unit the maximum price which
that consumer is willing to pay for that unit.
Second-degree price discrimination: Where a firm charges a consumer so much for the first so many units
purchased, a different price for the next so many units purchased, and so on.
c)Give three conditions necessary for third degree price discrimination to operate?
2
The firm must have market power; there must be no opportunity to resell the product for a higher price; demand
elasticity must differ in each market.
Question 4 – Chapter 9
One means of achieving growth is through the formation of strategic alliances with other firms. There are many
types of strategic alliances between businesses, covering a wide range of collaborative arrangements. Two of
these are a joint venture, and a consortium.
Explain the difference between a joint venture and a consortium.
Consortium is cooperation for a specific project (limited in time), joint venture has no predetermined time limit
..(two or more firms set up and jointly own a new independent firm.
Question 5 – Chapter 12
a)Explain what is meant by the term Pareto improvement.
Answer: changes in production or consumption can make at least one person better off without making anyone
worse off.
b)Explain what is meant by the term Common Resources.
Answer: resources that are not owned by a particular individual, but are available free of charge for everybody.
Question 6 – Chapter 13
a)Give two reasons why the market fails to achieve a socially efficient use of the environment.
Answer: because large parts of the environment are a common resource, because production or consumption
often generates environmental externalities, because of ignorance of the environmental effects of our actions,
and because of a lack of concern for future generations.
With tradable permits each firm is given a permit to produce a given level of pollution. If less than the permitted
amount is produced, the firm is given a credit. This can then be sold to another firm, allowing it to exceed its
original limit.
b)Give a disadvantage of using tradable permits.
Answer: It can lead to pollution being concentrated in certain areas and can reduce the pressure on firms to find
cleaner methods of production.
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Question 7 – Chapter 18
One of the causes of the global financial crisis is the phenomenon of securitisation of assets, which involves a
financial institution is selling some of its assets to financial investors, often other financial institutions.
How might securitisation of assets be beneficial to banks and the real economy?
Future cash flows are turned into marketable securities, such as bonds. The sellers get cash immediately and can
use it to fund loans to customers. Hence, securitisation facilitates the provision of credit.
Question 8 – Chapter 25
Explain what are the differences between nominal and real exchange rates.
Nominal exchange rate is simply the rate at which one currency exchanges for another. The real exchange rate is
the exchange rate index adjusted for changes in the prices of imports (measured in foreign currencies) and
exports (measured in domestic prices) – in other words, adjusted for the terms of trade. If a country’s prices rise
(fall) relative to those of its trading partners, its real exchange rate will rise (fall) relative to the nominal
exchange rate.
1.
What are the most important determinants of the demand curve? How they possibly could cause a
rise in demand?
Tastes; number and price of substitute goods; number and price of complementary goods; income;
distribution of income and expectations.
2.
What are the most important determinants of the supply curve? How they possibly could cause a
rise in supply?
Costs of production; profitability of alternative products (substitutes in supply); profitability of goods in joint
supply; nature and other random shocks; aims of producers; expectations of producers.
3.
What is the meaning of the price elasticity of demand? What does the sign of this elasticity tell us?
It explains the responsiveness of quantity demanded to a change in price. When the sign of the elasticity is
larger (smaller) than one (in absolute terms), the demand curve is price elastic (inelastic) (see p.56-57
Sloman).
4.
In the market for a particular phone, when the price of the phone is €500, total consumer
expenditure is €400,000. When the price falls to €450, total consumer expenditure increases to
€450,000.
Calculate the price elasticity of demand (PεD) by using the ARC or ‘midpoint’ elasticity method. Show all
calculations leading to your answer.
Qold = €400,000/€500 = 800
Qnew = €450,000/ €450 = 1,000
200/900
5.
/ -50/475 = 0.222/-0.105 = - 2.11
(a)
What is the formula for the income elasticity of demand?
Qd / mid Qd  Y / mid Y
(where Y is income)
5.
(b)
What can be measured with the use of the income elasticity of demand?
4
Degree of necessity of a good: normal (basic or luxury) good or inferieur good. (see p.66-67)
6.
What can be measured with the use of the cross price elasticity?
Degree of substitution or complementarity of a good (see p.67)
GBEA IE Workshop 1: Q&A Ch.6
Background to Supply
1.
(a) Complete the following table of costs for a firm. (Note: enter the figures in the MC column
between outputs of 0 and 1, 1 and 2, 2 and 3, etc.)
Output
TC (£)
AC (£)
0
55
–
1
85
85
2
110
55
3
130
43.3
4
160
40
5
210
42
6
280
46.7
7
370
52.9
8
480
60
9
610
67.8
10
760
76
MC (£)
30
25
20
30
50
70
90
110
130
150
(b) How much is total fixed cost at:
(i)
an output of 0? .................................................................................................... £55.00
(ii) an output of 6? ......................................................................................................£55.00
(c) How much is average fixed cost at:
(i)
an output of 5? ......................................................................................................£11.00
(ii) an output of 10? ......................................................................................................£5.50
(d) How much is total variable cost at an output of 5? .....................................................£155.00
5
(e) How much is average variable cost at an output of 10? ................................................£70.50
6
(a) Referring to the data from question 1, draw the firm’s average and marginal cost curves on
the following diagram. (Remember to plot MC mid-way between the quantity figures.)
MC
140
120
100
Costs (£)
2.
AC
80
60
AR = P = MR
40
20
X
0
0
1
2
3
4
5
6
7
8
9
10
Output
(b) Mark on the diagram the output at which diminishing returns set in.
See point x, where MC begins to rise
(c) Assume that the firm is a price taker and faces a market price of £60 per unit.
Draw the firm’s AR and MR curves on the above diagram. ............................... See diagram
(d) How much will it produce in order to maximise profit? ................ 5 units, where MC = MR
(e) Shade in the amount of profit it makes. .............................................................. See diagram
(f)
Calculate how much profit this is. ..................................... TR – TC = (5  £60) – (5  £42)
= £300 – £210 = £90
7
3. The following is a list of various types of economies of scale:
(i) The firm can benefit from the specialisation and division of labour.
(ii) It can overcome the problem of indivisibilities.
(iii) It can obtain inputs at a lower price.
(iv) Large containers/machines have a greater capacity relative to their surface area.
(v) The firm may be able to obtain finance at lower cost.
(vi) It becomes economical to sell by-products.
(vii) Production can take place in integrated plants.
(viii) Risks can be spread with a larger number of products or plants.
Match each of the following examples for a particular firm to one of these types of economy of scale.
(a) Delivery vans can carry full loads to single destinations. ..........................................................(ii)
(b) It can more easily make a public issue of shares.
(c) It can diversify into other markets.
................................................................... (v)
..................................................................................... (viii)
(d) Workers spend less time having to train for a wide variety of different tasks, and
less time moving from task to task.
........................................................................................ (i)
(e) It negotiates bulk discount with a supplier of raw materials.
...............................................(iii)
(f) It uses large warehouses to store its raw materials and finished goods.
.............................. (iv)
(g) A clothing manufacturer does a deal to supply a soft toy manufacturer with offcuts
for stuffing toys.
.................................................................................................................. (vi)
(h) Conveyor belts transfer the product through several stages of the manufacturing
process. ..................................................................................................................................... (vii)
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4. There are two methods of showing the profit-maximising position for a firm. The first uses total
revenue and total cost curves.
The figure below shows the total cost and revenue curves for a firm on the same diagram.
TC
60
Costs and revenue (£).
50
e
d
a
40
TR
30
b
c
20
10
TΠ
0
0
10
20
30
40
50
60
70
80
90
Quantity
(a) At what output is the firm’s profit maximised? .......... 40 (where the two curves are furthest apart)
(b) How much profit is made at this output? .......................................................£7 (the size of the gap)
(c) Draw the total profit TΠ curve over the range of output where positive profit is made. The curve
should plot the size of the gap, crossing the horizontal axis at outputs of 21 and 56 and
reaching a peak of £7 at an output of 40.
(d) How much is total fixed cost? .............£10 (the point where the TC curve crosses the vertical axis)
(e) At what output is the price elasticity of demand equal to 1? 67 (the peak of the TR curve: where
MR  0)
(f) At what outputs does the firm break even? .................................. 21 and 56 (where total profit  0)
GBEA IE week 2: Q&A Ch.7
9
Profit Maximising
under Perfect
Competition and Monopoly
1.
It is usual to divide markets into four categories. In ascending order of competitiveness these
are (fill in the missing three):
Monopoly, Oligopoly, Monopolistic competition and Perfect competition
2. In which of the four categories would you place each of the following? (It is possible in some
cases that part of the industry could be in one category and part in another: if so name both.)
(a) Restaurants in large town ............................................................. Monopolistic competition
(b) Banks....................................................................................................................... Oligopoly
(c) Smart phone operating industries ........................................................................... Oligopoly
(d) Producers of potatoes ......................................................Perfect competition (or close to it)
(e) Water supply .......................................................................................................... Monopoly
(f)
Local buses ........................................................................................ Monopoly or oligopoly
(g) The market for foreign currency .....................................Perfect competition (or close to it)
(h) City company collecting garbage ........................................................................... Monopoly
3. To which of the above four categories do the following characteristics apply? (There can be more
than one market category in each case.)
(a) Firms face a downward sloping demand curve. Monopoly, oligopoly, monopolistic competition
(b) New firms can relatively without problems enter the industry. Perfect
competition,
monopolistic competition
(c) Firms produce a homogeneous product. Perfect competition, some oligopolies, monopoly
(d) Firms are price takers. ........................................................................... Perfect competition
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4.
The following diagram shows the cost curves of a firm under perfect competition.
(a) How much will the firm produce in order to maximise profits at a price
of £8 per unit?
................... 35 units
(b) What will be its average cost of production at this output? ..................................................... £6
(c) How much (supernormal) profit will it make? ...................................................... £2  35 = £70
(d) How much will the firm produce in order to maximise profits at a price
of £5 per unit?
........................... 25 units
(e) How much (supernormal) profit will it make? ......................................................................... £0
(f)
How much will the firm produce in order to maximise profits at a price
of £4 per unit?
........................... 20 units
(g) What will be its profit position now? ................................................A loss of £1.50  20 = £30
(h) Below what price would the firm shut down in the short run? ............. £3.50 (where P = AVC)
(i)
Below what price would the firm shut down in the long run? ...................... £5 (where P = AC)
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5. A monopolist is faced with the following cost and revenue curves:
(a) What is the maximum-profit output?
£
...............200 units (where MC = MR)
80
MC
(b) What is the maximum-profit price?
£60 (given by AR curve at 200 units)
70
(c) What is the total revenue at this price
and output?
60
....................... £12 000 (i.e. £60  200)
50
AC
(d) What is the total cost at this price and
output?
40
................. £6000 (i.e. £30 (AC)  200)
30
(e) What is the level of profit at this price
and output?
20
AR
............................ £6000 (i.e. TR – TC)
(f)
10
If the monopolist were ordered to
produce 300 units, what would be the
market price?
0
0
..................... £50 (given by AR curve)
-10
(g) How much profit would now be
made?
-20
100
200
300
400
.......................... £4500 (i.e. £15  300)
(h)
500
MR
Quantity
If the monopolist were faced with the
same demand, but average costs were constant at £60 per unit, what output would
maximise profit?
...................................................................... 100 units (where AC = MC = MR = £60)
(i)
What would be the price now? ......................................... £70 (given by AR curve at 100 units)
(j)
How much profit would now be made? £10  100 = £1000
(k) Assume now that the monopolist decides not to maximise profits, but instead sets a price
of £40. How much will now be sold?
400 units (given by AR curve)
(l)
What is the marginal revenue at this output? 0
(m) What does the answer to (l) indicate about total revenue at a price of £40? Maximised
(n) What is the price elasticity of demand at a price of £40? (You do not need to do a
calculation to work this out: think about the relationship between MR and TR) –1 (this is
the case where TR is maximised).
6.
A perfectly contestable market is defined as one where entry and exit costs are zero.
12
600
7. Classify each of the following markets as highly contestable, moderately contestable, slightly
contestable or non-contestable. If it depends on the circumstances, explain in what way.
(a) satellite broadcasting: highly / moderately / slightly / non
(b) hospital cleaning services: highly / moderately / slightly / non
(Highly, if the cleaning is put out to periodic tender. Non, if the hospital employs its
own cleaners or if an outside firm has a permanent contract).
(c) banking on a university/college campus: highly / moderately / slightly / non
(Moderately if the banks are invited to tender periodically for a site licence. Non if a
single bank is given a permanent site licence.)
(d) parcels delivery: highly / moderately / slightly / non
(e) bus service to the area where you live: highly / moderately / slightly / non
(unless prohibited by law or unless an existing service is heavily subsidised)
GBEA IE week 3: Q&A Ch. 8
Imperfect Competition
13
1.
The following diagram illustrates a firm under monopolistic competition.
MC
Price
AC
P6
P5
P
P3 4
P2
P1
MR
0
Q1
Q2
Q3 Q4 Q5
AR
Quantity
(a) Does the diagram represent the short-run or long-run position? Short-run
(b) Is P3 the long-run equilibrium price? Explain. No. The long-run equilibrium price is where
the (downward-sloping) AR curve is tangential to the AC curve.
(c) What are the profit maximising output and price? P6 , Q2 (the output where MR = MC)
(d) On the diagram, shade in the amount of profit made at the maximum-profit output. .......... See
diagram.
2.
Which of the following are characteristics of oligopoly? From the list below select those which
distinguish a monopolistically competitive industry, a perfectly competitive industry or an
oligopolistic industry.
(a) There are no barriers to the entry of new firms into the market.................. Perfect competition
(b) Firms in the industry produce differentiated products. .................... Monopolistic competition
(c) The industry is characterised by a mass of sellers, each with a small market share. ....... Perfect
competition
(d) There are just a few firms that dominate the industry. ................................................ Oligopoly
(e) A downward sloping demand curve means the firm has some control over the product's price.
............................................................................................................ Monopolistic competition
(f)
In the long run only normal profits will be earned. ..................................... Perfect competition
(g) The firms face price inelastic downward sloping demand curves. ............................. Oligopoly
(h) Advertising plays a key role in bringing the product to the attention of the consumer.
Monopolistic competition
(i)
3.
Producers tend to take into account the actions and reactions of other firms. ............ Oligopoly
The following diagrams illustrate an industry under oligopoly consisting of 10 equal-sized firms
and a particular firm in that industry. Each of the firms produces an identical product.
14
£
£
40
40
MC
35
35
30
30
25
25
20
20
15
15
MC
AR
10
AR
5
10
MR
5
MR
0
0
0
50
100
150
200
250
300
350 Q 0
The Industry
5
10
15
20
25
30
An individual firm
(a) Assuming that the firms form a cartel, what price will the cartel choose if it wishes to
maximise overall profits for the cartel? £25 (where MC = MR)
(b) What total output must the cartel produce in order to maintain this price? 100
(c) To what output will an individual firm be restricted if this price is to be maintained
(assume all firms are permitted to produce the same level of output)? .............................. 10
(d) If the other firms stick to this output, how much would an individual firm be tempted to
produce if it wished to maximise its own profit at the agreed price? 20 (where MC = price
(= MR))
(e) If it undercut the cartel price, what price and output would maximise its profit assuming
that the other members did not retaliate? ............................ £23; 15 units (where MC = MR)
15
35 Q
4. The following table shows the annual profits of two pork pie manufacturers. At present they both
charge €3.00 for a large pork pie. Their annual profits are shown in box A. The other boxes show the
effects on their profits of one or the other firm or both firms reducing their price to €2.50.
Allmeat's price
€3.00
A
€3.00 €4m each
Porkyfill's
price
C
€2.50 €7m for Porkyfill
€2m for Allmeat
€2.50
B
€1m for Porkyfill
€6m for Allmeat
D
€3m each
(a) What is a dominant strategy game? Where the firm’s optimal strategy remains the same,
irrespective of what it assumes its rivals are going to do.
(b) According to dominant strategy game, which price should Allmeat charge if it is pursuing a
highest profit? €2.50
(c) What is the Nash equilibrium in this game? D €3m each
(d) What is a trigger strategy in game theory? Once a firm observes that its rival has broken
some agreed behaviour it will never co-operate with them ever again.
(e) Assume now that the ‘game’ between Porkyfill and Allmeat has been played for some time
with the result that they both learn a ‘lesson’ from it. What are they likely to do? Tacitly
agree to stick to the higher price.
5.
A firm may practice price discrimination. This is where it sells the same product (costing the same
to produce) at different prices in different markets or to different customers. To practice price
discrimination a firm must be a price setter, and be able to distinguish between markets displaying
differing price elasticity of demand. The markets must be segmented to prevent arbitrage. There are
three types of price discrimination:
(i) First-degree price discrimination.
(ii) Second-degree price discrimination.
(iii) Third-degree price discrimination.
Match each of the three types to the following definitions:
(a) A firm charges a consumer so much for the first so many units purchased, a different
price for the next so many units purchased and so on.
(b) A firm divides consumers into different groups and charges a different price to
consumers in different groups, but the same price to all the consumers within a group.
(c) A firm charges each consumer for each unit the maximum price which that consumer
is willing to pay for that unit
16
ii
iii
i
6. Joe’s Pizza Place discovers that it can sell 70 pizzas at £6 each during the ‘happy hour’ time of
5pm to 7pm and 30 pizzas at £9 each after 7pm in the evening. Profit maximisation occurs
where MR (in both markets) = MC = £5.
(a) Complete the following diagram showing equilibrium price and output in the ‘happy hour’
and ‘after-7pm’ markets. Show the relationship between elasticity of demand and pricing on
your diagram. See diagram.
Profit-maximising output for Joe’s Pizza Plac
5
O
O
(a) After 7pm
O
(b) ‘Happy hour’:
5pm to 7pm
100
(c) Combi
Markets (a)
(b)
What is the total revenue from both markets? ................................... £420 + £270 = £690
(c)
What sort of pricing is Joe’s Pizza Place using? Third-degree price discrimination
Answers chapter 9 The behaviour of firms
Alternative Theories of the Firm
1.
Firms may want to maximise profits, but lack the information to do so.
(a) If firms do not use marginal cost and marginal revenue concepts, they will not be able to
arrive at their profit maximising output................................................................. True / False
17
(b) If a firm uses accountants’ cost concepts that are not based on opportunity cost, then it will
only be by chance if it ends up maximising profits. .............................................. True / False
2.
A fundamental criticism of the traditional theory of the firm is that the decision makers in the
firm may not even aim to maximise profits in the first place.
On which ONE of the following is this criticism based?
A. Many shareholders do not want to maximise profits.
B. Owners of firms are not ‘rational’.
C. Shareholders are not the decision makers and have different interests from them.
D. Managers prefer to maximise profits because this is usually in their own interest.
E. Shareholders are really utility maximisers.
3.
The divorce between the ownership and control of a firm is likely to be greater if there are
(a) a few large shareholders / many small shareholders.
(b) It is also likely to be greater in partnerships / private limited companies / public limited
companies.
4.
Firms must still make enough profits to survive. But this does not make them profit maximisers.
Instead they are ‘profit satisficers’.
5.
If a firm under perfect competition had an aim other than profit maximisation, would this make
any difference to the output it would choose to produce?
(a) In the short run? .............................................................................................................. Yes / No
(b) In the long run?............................................................................................................... Yes / No
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6.
The problem of managers not pursing the same goals as shareholders is an example of the
principal–agent problem. Because of asymmetric information and different goals, agents may not
always carry out the wishes of their principals.
(a) Asymmetric information refers to the fact that either principals or agents have superior
knowledge and can, therefore, act against the interests of the other party. Normally the party
with superior knowledge is the principal / agent.
In the following cases, which are the principals and which are the agents?
(b) Estate agents and house buyers:
estate agents ................................. agents
(c) Shareholders and managers:
shareholders ................................. principals
(d) House builders and architects:
house builders .............................. principals
(e) Employers and workers:
employers ..................................... principals
(f) Shops and their customers:
shops ................................................... agents
7.
house buyers ......................... principals
managers ................................. .. agents
architects ................................... agents
workers ...................................... agents
customers ..............................principals
The traditional theory of the firm assumes that firms are short-run profit maximisers. An
alternative assumption is that firms seek to maximise long-run profits.
In what way might each of the following lead to smaller short-run profits but larger long-run
profits?
(a) A large-scale advertising campaign. Marginal advertising costs exceeding marginal
revenue from advertising in the short run; but marginal revenue increasing in the long
run as demand steadily grows with the product becoming more established
(b) Opening up a new production line. Initial high set-up costs and initial ‘teething’ costs,
costs that would fall in the long run. Also if demand is growing and it takes time to open
a new production line, the opening of the line may lead to excess capacity in the short
run, but not in the long run.
(c) Investing in research and development. Revenue from new or improved products only
occurs in the future after the research and development has taken place. Costs occur
from the outset.
(d) Launching a takeover bid for a rival company. There may be high administrative and
public relations costs associated with the bid. If successful, the acquisition of the new
company is likely to lead to bigger profits (sheer size of output; economies of scale;
increased monopoly power).
(e) Installing expensive filter equipment to reduce atmospheric pollution from the factory’s
chimneys. Costs of the filter equipment with little immediate return. In the long run
consumers may prefer the firm’s ‘greener’ image and the firm may avoid governmentimposed restrictions that might turn out to be more expensive in the long run.
8.
A major problem with the theory of long-run profit maximisation is that it is virtually impossible
to test. Explain why. Because a firm could always, in hindsight, use it to justify virtually any
decisions, no matter how unprofitable they eventually turn out to be.
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9.
It is also virtually impossible in advance to identify a long-run profit-maximising price and
output. Which of the following are reasons for this?
(a) Cost and revenue curves are likely to shift unpredictably as a result of the policy
pursued. ......................................................................................................................... Yes / No
(b) Cost and revenue curves are likely to shift as a result of unpredictable external
factors. . .......................................................................................................................... Yes / No
(c) The firm is likely to experience economies of scale. .................................................. Yes / No
(d) Some policies may affect both demand and costs. ........................................................ Yes / No
(e) Different managers are likely to make different judgements about the best way
of achieving long-run maximum profits. . .......................................................................... Yes / No
10. The diagram below shows a firm’s short-run cost and revenue curves. (It operates under
monopoly or imperfect competition.) The level of output it produces will depend on its aims. For
each of the following four aims, identify the firm’s output.
A firm’s short-run cost and revenue curves
£
MC
AC
AVC
AR  D
MR
O
Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9
Q
(a) Profit maximisation ................................................................................. Q3; where MC = MR
(b) Sales maximisation (must earn at least normal profits)
Q7; the maximum level of sales consistent with AR being not less than AC
(c) Sales maximisation (must cover all variable costs)
Q9; the maximum level of sales consistent with AR being not less than AVC
(d) Sales revenue maximisation (must earn at least normal profits) Q8; the point where MR = 0
and where, therefore, TR is at a maximum. (Note that in this diagram, the sales revenuemaximising point leads to abnormal losses because the average revenue curve is below
the average cost curve at Q8.)
GBEA – Ch.12-13
Answers
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Market Failures and
1. The following are problems that prevent markets from providing a socially optimal allocation of
resources:
(i)
(ii)
(iii)
(iv)
(v)
Externalities
Monopoly/oligopoly power
Ignorance and uncertainty
Public goods and services
Merit goods
Match each of the above categories of problem to the following examples of failures of the free
market. In each case assume that everything has to be provided by private enterprise: that there is
no government provision or intervention whatsoever. Note that there may be more than one
example of each category of problem. Note also that each of the following cases may be an example
of more than one category of problem.
(a) There is an inadequate provision of street lighting because it is impossible
for companies to charge all people benefiting from it.
(iv)
(b) Advertising allows firms to sell people goods that they do not really want.
(iii)
(c) A firm tips toxic waste into a river because it can do so at no cost to itself.
(i)
(d) People may not know what is in their best interests and thus may underconsume
certain goods or services (such as education).
(v)
(e) Firms’ marginal revenue is not equal to the price of the good and thus they do
not equate MC and price.
(ii)
(f)
2.
Firms provide an inadequate amount of training because they are afraid that
other firms will simply come along and ‘poach’ the labour they have trained.
(i)
Give two examples of each of the following:
(a) External costs of production. Global warming; unsightly factories; radiation of a nuclear
power plant
(b) External benefits of production. Research and development benefits to others; forestry
(benefits to atmosphere); solar panels
(c) External costs of consumption. Litter; nuisance to others from mobile phones on trains;
alcohol intake
(d) External benefits of consumption. Benefits to others from medicines curing infectious
diseases; benefits to others from people painting the outside of their houses
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3.
Assume that a firm produces organic waste that has the effect of increasing the fertility of
neighbouring farmland and thus reducing the farmers’ costs. It is impractical, however, to sell
the waste to the farmers. The following table shows the firm’s private marginal costs and these
external benefits to farmers from the firm’s production.
Output
(units)
Price
(£)
Marginal (private)
costs (£)
Marginal external
benefit (£)
Marginal social
cost (£)
1
20
16
6
10
2
20
15
5
10
3
20
15
4
11
4
20
16
3
13
5
20
17
2
15
6
20
18
2
16
7
20
20
2
18
8
20
22
2
20
9
20
24
2
22
10
20
27
1
26
(a) Assuming no government intervention, how much will the firm produce to maximise
profits? 7 units (where P (= MR) = MC (private))
(b) Fill in the column for marginal social cost. See table
.
(c) What is the socially optimum level of output? 8 units (where P = MSC)
(d) What subsidy per unit would the government have to pay the firm to encourage it to
produce this level of output?£2 (= marginal external benefit)
(e) What would it cost the government? £2  8 = £16
(f)
If new farming technology doubled the benefit of the waste to the farmers, what will now
be the socially optimum level of the firm’s output?
9 units (where P = MSC = £20)
4. Distinguish between publicly provided goods (impure public goods), pure public goods and merit
goods.
Publicly provided goods are merely goods that the government or some other public agency
provides, whether or not they could be provided by the market.
Public goods are the much narrower category of goods that the market would fail to provide
because of their characteristics of non-rivalry and non-excludability. Thus a local government
might provide both street lighting and public libraries: they are both publicly provided goods,
but only street lighting is a public good.
A merit good is either publicly provided or subsidised. It is a good that the government wants
to encourage consumtion and that people would otherwise underconsume (e.g. health care). It
is not normally a public good, however, because it would be provided by the market: it is just
that people would consume too little of it.
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5. Provide an example of a common resource. fish in the rivers, forest fruits, etc.
6.
Which of the following are examples of pure public goods (or services)? (Note that we are not
merely referring to goods or services that just happen to be provided by the public sector.)
(a) Museums ................................................................................................................................. No
(b) Cross-country rail services ...................................................................................................... No
(c) Roads in town ................... Yes (unless an electronic road pricing scheme becomes practical)
(d) Highways and Motorways .............................................................. No (tolls could be charged)
(e) National defence .................................................................................................................... Yes
(f)
Health care .............................................................................................................................. No
(g) Community policing .............................................................................................................. Yes
(h) Street drains ............................................................................................................................ Yes
(i)
7.
Secondary education ............................................................................................................... No
Assume there are just two consumers of a pure public good, Suarez and Ronaldo. Their individual
demand curves are illustrated in the diagram below – DS and DR. The market demand curve is
given the line abc, (the individual demand curves need to be vertically added).
(a) Illustrate the socially efficient quantity (output) that should be produced).
The socially efficient quantity is Q3: the output where MSC = MSB
(b) Will the socially efficient quantity be produced in a private market if Suarez and Ronaldo act
in perfectly rational and selfish manner?
No. Once the good is produced both Ronaldo and Suarez can consume the good whether they
have paid for it or not. Therefore they both have an incentive to free-ride – enjoy the benefits
of consuming the good without paying for it. If nobody pays, then a firm cannot generate any
revenue and make a profit and so will not produce the good.
8.
Diagram 1 and 2 show an industry which was previously perfectly competitive, but is now
organised as a monopoly. Cost and revenue curves are assumed to be the same in both
situations.
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Diagram 2
Diagram 1
Answer the following questions using Diagram 1
(a) What is the perfectly competitive price and output? P2, Q2
(b) What is the monopoly price and output? P3, Q1
(c) What areas represent consumers’ surplus in the perfectly competitive situation?
1+2+3+4+5
(d) What areas represent consumers’ surplus after the industry has become a monopoly? 1+2
(e) What areas represent the loss in consumers’ surplus after the industry has
become
a
monopoly? 3+4+5
(f) What areas represent producers’ surplus in the perfectly competitive situation?6+7+8+9
(g) What areas represent producer’s surplus after the industry has become a monopoly?
3+4+6+7+9
(h) What areas represent the gain in producer’s surplus after the industry has
monopoly?3+4–8
(i) What areas represent total deadweight welfare loss under monopoly?5+8
become
a
Answer the following questions using Diagram 2:
(a) At which price and output the company maximises profit? D and Q1
(b) What area represents the maximum profit? DBbd
(c) The government introduces a lump-sum tax to compensate for the enviromental cost.
Which area represents now the maximum profit of the monopolist? DCcd
9. Explain briefly. What are the conflicts between using the environment as a productive resource
and as an amenity to be enjoyed?
There is a trade-off between the use of the environment and the use as an amenity to be enjoyed. The
use of the environment as a productive resource reduces its amenity value. For example mining
certain areas will lead to growing quarries that are ugly, dangerous and unpleasant for living.
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10. Assume that there are several chemical firms in an industry, each one producing different levels
of an effluent, whose damage to the environment depends on the location of the firm. Compare the
relative merits of using green taxes, tradable permits and controls as means of achieving the
socially optimum levels of effluent from these firms.
Green taxes. Green taxes have the major advantage of providing a continuous incentive for
reducing pollution. The more that effluents are reduced, the lower the tax bill for firms producing
the effluent. Assuming that the external costs of the effluent can be measured, then green taxes are a
socially efficient way of tackling the problem. If they cannot be measured, then there is the danger
that green taxes may be set at too low a level (perhaps by the government not wishing to upset
producers or consumers).
Tradable permits allow for the fact that firms often have a much better knowledge of their costs
than governments, and, by trading in these permits, firms are able to achieve a given level of
pollution reduction at minimum cost. The danger is that they could be seen as underwriting
pollution and not providing an incentive for firms to reduce pollution below their permitted level.
They may be used more as an instrument of reallocating rather than reducing pollution! Then there
is the issue of the distribution of the permits. If it is based on a grandfathering principle, then it
could be seen as unfair to newcomers, which might be more efficient, and less polluting per unit of
output. If it is not, then existing firms are likely to claim that it is unfair on them, given that they have
established a share of the market.
Controls are generally relatively simple to operate, but rather unsophisticated, given that they are
effectively giving permission to pollute up to a certain level. They could be made more efficient if
they were ambient based or social-impact based, but then they would be more costly to devise and
administer.
GBEA IE Workshop 6: Q&A Ch.18
Banking, Money and Interest Rates
1.
What are the main functions of a central bank?
Controls the issue of notes and coins (legal tender); Controls the money supply by either direct or indirect
means; Control over non-bank financial intermediaries (credit institutions); Effectively use instruments or tools
of monetary policy; Lender-of-last resort (LOLR); Government’s banker and Official agent to government in
dealing with gold and FX reserves.
2.
Give the most important functions of money? What is meant by narrow and broad money? Does broad money
fulfil all the functions of money?
Medium of exchange; unit of account (means of evaluation); store of value and standard of deferred payment.
Narrow money is cash (in circulation). Broad definitions of money include cash plus other highly liquid assets,
such as money in bank accounts (i.e. items that can be readily converted into cash).
Broad money fulfils all the functions of money, albeit somewhat imperfectly. Like cash, however, its stability of
value and hence its use as a means of storing wealth and evaluating assets depends on the rate of inflation.
Unlike cash, however, parts of broad money are in the form of interest-bearing deposits, and therefore provide
the holder with a better means of storing wealth. These accounts, however, are not generally instantly
accessible via cards or cheques and are therefore inferior as a medium of exchange.
3.
What enables banks safely to engage in both maturity transformation and risk transformation?
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The fact that they are able to spread their risks over a very large number of customers.
They spread their risks.
4.
The following items are some definitions about the supply of money:
Monetary base = ‘high-powered money’ consists of cash (notes and coin) in circulation
outside the central bank.
Broad money = cash in circulation plus retail and wholesale bank deposits (e.g. sight deposits
and short-term time and savings deposits)
Money multiplier = the number of times greater the expansion of money supply is than the
expansion of the monetary base that caused it.
Imagine that the banking system receives additional deposits of $50 million and that all the
individual commercial banks wish to retain their current liquidity or reserve ratio of 10%
(ceteris paribus).
a.
Calculate what will be the relationship between broad money and the monetary base if banks are
operating with a reserve or liquidity ratio of 10% (ceteris paribus).
M/B = 1/L = 1/0.10 = 10:1.
b.
Calculate the money multiplier.
Money multiplier is 10.
5.
Imagine that the banking system receives additional deposits of £100 million and that all the individual banks
wish to retain their current liquidity ratio of 20 per cent.
(a)
How much will banks choose to lend out initially?
(b)
What will happen to banks’ liabilities when the money that is lent out is spent and the
recipients of it deposit it in their bank accounts?
(c) How much of these latest deposits will be lent out by the banks?
(d) By how much will total deposits (liabilities) eventually have risen, assuming that none of the
additional liquidity is held outside the banking sector?
(e) How much of these are matched by (i) liquid assets; (ii) illiquid assets?
(f) What is the size of the bank deposits multiplier?
(g) If one-half of any additional liquidity is held outside the banking sector, by how much less will
deposits have risen compared with (d) above?
£80 million (retaining £20 million as reserves). In other words, banks retain one-fifth and lend
out the remaining four-fifths.
(b) Increase by a further £80 million.
(c) £64 million (i.e. four-fifths of £80 million).
(d) £500 million (given a bank multiplier of 5 = 1/L = 1/1/5).
(e) (i) £100 million; (ii) £400 million.
(f) 5
(g)
£250, since initial new deposits (and hence extra liquid assets) in the banking sector will have
only been £50 million.
(a)
6.
Since the start of sub-prime credit crisis in 2007 interest rates had been cut at an unprecedented rate.
Gradually during global financial crisis the central banks were reaching the end of the road for interest rate
cuts in 2009. After running out of options the central banks started to increase money supply directly, a
process known as quantitative easing which does have some dangers.
a.
Briefly describe the meaning and result of quantitative easing.
A deliberate attempt by the central bank to increase the money supply by buying large quantities of securities
through open-market operations. These securities could securitised mortgage and other private-sector debt or
government bonds. The result was that considerable quantities of new money were injected into the system.
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This also had the effect of reducing interest rates on the assets purchased by the Fed, thereby stimulating
aggregated demand.
b.
Give two dangers of this approach of quantitative easing.
In the short run little credit creation may take place. People need to have the confidence to borrow (M might be
largely offset by V); If this policy is conducted for too long, the growth in money supply may then prove to be
excessive, resulting in inflation rising above the target level.
7.
Why might the relationship between the demand for money and the rate of interest be an unstable one?
Because the demand for money depends on other things too: for example, expectations about changes in
interest rates, exchange rates and the rate of inflation.
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8.
The Basel I definition of capital is made up of two elements: Tier 1 (‘core capital’) and Tier (‘supplemental
capital’). Bank total capital is the sum between Tier 1 and 2 (‘capital base’).
a.
Give an example of Tier 1-capital and Tier 2-capital.
Tier 1: ordinary paid-up share capital/common stock; disclosed reserves.
Tier 2: undisclosed reserves; asset revaluation reserves; general provisions/general loan loss reserves; hybrid
(debt/equity) capital instruments; subordinated term debt.
As a response on the global financial crisis the new Basel III accord (BIS III) for banks is phased
in 2019 and includes several new elements such as:
 Higher Tier 1 capital requirements;
 Risk weightings for exposure to certain securitized assets;
 Leverage ratios;
 Liquidity ratios;
 Capital conservation buffer;
 Counter-cyclical capital buffer;
 Global Systemically Important Financial Institution Surcharge
b.
Which of these new BIS III-elements address the macro-prudential supervision (overlay) to tackle
financial system-wide risks?
Risk weightings for exposure to certain securitized assets; Global Systemically Important Financial Institution
Surcharge
c.
How the leverage ratio is measured?
Measured by equity/assets
GBEA Week 7 Answers
Balance of Payments and
Exchange Rates
The following diagram shows a demand curve and supply curve of sterling against the euro.
1.40
S2 S1
1.30
€/ £
1.
1.20
1.10
D2
D1
1.00
0.90
Q of sterling
(a) Who is demanding sterling in the diagram and for what purpose?
Overseas residents for the purpose of buying UK exports and investing in the UK
(b) Who is supplying sterling in the diagram and for what purpose?
UK residents for the purpose of buying imports or investing abroad
(c) Mark the equilibrium exchange rate. €1.10 (See diagram)
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(d) Now illustrate what happens when there is an increased demand for sterling and a
decreased supply. See diagram
(e) Has the exchange rate appreciated or depreciated? Appreciated
2.
Assume that there is a free-floating exchange rate. Will the following cause the exchange rate to
appreciate or depreciate? In each case you should consider whether there is a shift in the demand
or supply curves of sterling (or both) and which way the curve(s) shift(s).
(a) Imports increase.
Demand curve: no shift
Supply curve shifts right
Exchange rate depreciates
(b) UK interest rates rise relative to those abroad.
Demand curve shifts right
Supply curve shifts left
Exchange rate appreciates
(c) The UK experiences a lower rate of inflation than other
countries (assuming no change in interest rates).
(d) Speculators believe that the rate of exchange will fall.
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Demand curve shifts right
Supply curve shifts left
Exchange rate appreciates
Demand curve shifts left
Supply curve shifts right
Exchange rate depreciates
3.
Assume that the government wishes to pursue a deflationary policy.
(a) What will happen to the exchange rate if it uses deflationary monetary policy?
Appreciate (because of higher interest rates)
(b) What effect will this exchange rate movement have on aggregate demand?
Decrease it (exports will fall (an injection) and imports will rise (a withdrawal))
(c) What will happen to the exchange rate if it uses deflationary fiscal policy?
Depreciate (because the lower demand for money will reduce interest rates)
(d) What effect will this exchange rate movement have on aggregate demand?
Increase it (exports will rise and imports will fall)
4.
The use of interest rates as the main instrument for stabilising the exchange rate can often led to
conflicts with internal policy objectives. In which of the following cases is there a clear conflict
between internal and external policy objectives, if interest rate changes are the only policy
instrument available to the government or central bank for achieving both sets of objectives?
(a) The government (or central bank) wants to prevent an appreciation of the exchange rate and
to reduce demand-deficient unemployment.
No
(b) The government (or central bank) wants to help domestic exporters and to reduce the rate of
inflation.
Yes
(c) The government (or central bank) wants to reduce the price of imports and to curb the rate of
growth in the money supply.
No
(d) The government (or central bank) wants to prevent a depreciation of the exchange rate and to
stimulate investment.
Yes
(e) The government (or central bank) wants to halt a rise in the exchange rate and to reduce the
rate of growth of the money supply.
Yes
(f) The government (or central bank) wants to reverse a recent fall in the exchange rate and to
reduce its unpopularity with home owners.
Yes
5.
Which of the following are likely to contribute to the volatility of exchange rates between the
major currencies?
(a)
(b)
(c)
(d)
(e)
(f)
(g)
A growth in the size of short-term financial flows relative to current account flows
Yes
The abolition of exchange controls
Yes
A harmonisation of international macroeconomic policies
No
The adoption of money supply targets by individual countries
Yes
The adoption of exchange rate targets by individual countries
No
The adoption of inflation targets by individual countries
No
A growing belief that speculation against exchange rate movements is likely to be stabilising
No
(h) A growing belief that speculation against exchange rate movements is likely to be
destabilising
Yes
(i) A growing ease of international transfers of fund
Yes
(j) Countries’ business cycles becoming more synchronised with each other.
No
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