Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

Solutions Manual Solution Manual For for Economics 11th Edition by Dean Garratt, John Answers_to_End_of_Chapter_Question Sloman, Jon Guest

Economics, 11th edition John Sloman Dean Garratt Jon Guest Chapter 1-26

Answers to End-of-Chapter Questions in Chapter 1 (11th edition) 1.

Imagine that a country can produce just two things: goods and services. Assume that over a given period it could produce any of the following combinations: Units of goods

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10

20

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50

60

70

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90

100

Units of services

80

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77

74

70

65

58

48

35

19

0

(a) Draw the country’s production possibility curve. (b) Assuming that the country is currently producing 40 units of goods and 70 units of services, what is the opportunity cost of producing another 10 units of goods? (c) Explain how the figures illustrate the principle of increasing opportunity cost. (d) Now assume that technical progress leads to a 10 per cent increase in the output of goods for any given amount of resources. Draw the new production possibility curve. How has the opportunity cost of producing extra units of services altered? (a) See the inner (blue) line in Diagram 1 below. (b) 5 units of services. Producing another 10 units of goods means producing a total of 50 units of goods. Thus, referring to the table, production of services has to be reduced from 70 units to 65 units: a sacrifice of 5 units of services. (c) Each additional 10 units of goods produced involves an increasing sacrifice of services. Thus increasing production of goods from 0 to 10, to 20, to 30, to 40, etc. involves a sacrifice of 1 (80– 79), then 2 (70–77), then 3 (77–74), then 4 (74–70), etc. units of services.

Similarly, increasing the production of services involves an increasing sacrifice of goods. This can be seen by starting at the right-hand end of the table and moving to the left. Smaller and smaller increases in services are obtained for each extra 10 units of goods sacrifice: in other words, for each extra units of services obtained, more and more goods must be sacrificed. (d) See the outer (red) line in Diagram 1 below (which is 10 per cent further to the right than the inner line). The opportunity cost of producing extra services has increased (by 10 per cent): in other words, each extra unit of services produced involves a sacrifice of 10 per cent more goods than previously.

Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

90 80

Units of Services

70 60 50 40 30 20 10 0 0

10

20

30

40

50

60

70

80

90

100

110

Units of goods

Diagram 1 Production possibility curve

2.

Imagine that you won millions of pounds on the National Lottery. Would your ‘economic problem’ be solved?

For most people it would certainly be eased! But it would not be solved. As the old saying goes, money can‟t buy everything. Many things would still be scarce. For example, you would still have only a finite amount of time to enjoy what the money could buy: there are only 24 hours in a day, and we do not live for ever. Even with millions of pounds, you may find that you can‟t buy everything you want; there will always be a smarter house, or a bigger yacht. In addition, more money means more choices. So you might have to spend more time and effort on your consumption decision than you currently do.

3.

Assume that in a household one parent currently works full time and the other stays at home to look after the family. How would you set about identifying and calculating the opportunity costs of the second parent now taking a full-time job? How would such calculations be relevant in deciding whether it is worth taking that job?

For the parent thinking of taking the job, the opportunity cost would include lost leisure time, and time spent with other family members (e.g. with the children) and the possible unpleasantness of the job.

For the family as a whole, the opportunity costs would include all the adverse effects on the family: such as stress, reduced time for each other, reduced time available for household tasks, increased burdens on the other family members.

Whether these will all be taken into account depends on how carefully the decision is made, and how much caring for the other family members is done by the parent thinking of taking the job.

Giving values to the opportunity costs is very difficult and it is unlikely that the process would be a mechanical one. Most families, trying to come to a „rational‟ decision, would simply attempt to use their judgement as to whether the extra income (plus any other benefits from the job) would be worth the sacrifices: a decision that could well turn out to be wrong, once the imagined sacrifices had become reality.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

4.

When you made the decision to study economics, was it a ‘rational’ decision (albeit based on the limited information you had available at the time)? What additional information would you like to have had in order to ensure that your decision was the right one?

You will have to answer this one for yourself! The amount of care taken by prospective students to find out about their courses and what they entail differs enormously from one student to another. Your decision would be a rational one if you did your best to weigh up the advantages and disadvantages of alternative courses, and chose the one that seemed to have the best balance of advantages over disadvantages.

The sorts of information that might have helped you make the right decision include: talking to students who are already studying economics, reading about the subject, talking to teachers/student advisers, finding out about the sort of jobs you can do with an economics qualification. A problem for many students applying for courses is that they are already studying for exams (e.g. A-levels) and that the time spent researching courses is time that could have been spent studying: in other words, the opportunity cost of the research may be a poorer A-level result.

5.

In what way does specialisation reduce the problem of scarcity?

If people specialise in jobs in which they are relatively able, total production (and hence consumption) in the economy will be greater than if everyone tried to do a little of everything. Part of the reason is that people would be spending much of their time doing things in which they had little or no ability; part is that a lot of time would be wasted in moving from job to job; part is that concentrating on just one job allows people to develop skills. It is the same for countries: total world production and consumption can be higher if countries specialise in producing those goods at which they are relatively efficient and then trading with other countries (see the „law of comparative advantage‟ in section 24.1)

6.

Would redistributing incomes from the rich to the poor reduce the overall problem of scarcity?

Yes, to the extent that the gain to the poor is greater than the cost to the rich. Nevertheless, it is difficult to give a categorical answer to this question. It could be argued that £1 gained by a poor person is more valuable to them than £1 sacrificed by a rich person: the more money you have the less valuable to you is each additional £1. If this is so, there would be a net gain in human welfare by such as redistribution. The problem, however, is in comparing one person‟s happiness with another: happiness is not something that lends itself to measurement.

7.

Assume that fracking becomes common across the UK. The result is that supplies of shale gas and oil increase sharply. Trace through the effects of this on the market for oil, gas and the market for other fuels.

Take the case of shale oil first. The increase in the supply of oil will cause a surplus of oil at current prices. This will cause the price of oil to fall. This will then have a twin effect: it will increase the quantity demanded and it will also make it less profitable to use more expensive extraction methods, thereby decreasing the quantity supplied. The effect of the lower price, therefore, will be to eliminate the excess. Turning to shale gas, the same effect would be seen with a lower price driving down the price (and then supply) of gas produced by more traditional methods.

As both gas and oil become cheaper, so the demand for alternative fuels will fall (the amount depending on how easy and suitable it is to switch). In the short run it may not be easy to switch: vehicles and heating appliances are generally designed to run on a specific fuel. Over the long term,

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

however, more switching will take place. For example, gas power stations can be built, whereas prior to fracking they might not have been cost-effective.

Not only will the demand for alternative fuels fall, but also the demand for vehicles and appliances that use oil, or gas, will rise. For example, there could be a fall in demand for bicycles and a rise for gas-powered boilers.

As the demand for these other products changes, so there will be surpluses or shortages of them.

Other things being equal, prices will change, eliminating the surpluses and shortages. Of course this sort of analysis is being undertaken „ceteris paribus‟ (holding other things constant). If we consider economic growth and increasing demand from developing countries, we might not see falling gas and oil prices in practice. However, the increase in supply will mean prices would be lower than they otherwise would have been.

Note that the price of oil and gas may fall only slightly as there is a global market in oil, and to some extent gas. Although the increase in supply may be large relative to UK demand, it is small relative to global demand and thus is likely to have only a very limited effect on world prices. There could be a substantial effect on the UK‟s balance of payments, however, with increased exports (or reduced imports) of oil and gas. This, as we shall see in section 15.7, is likely to drive up the exchange rate and make imports cheaper.

8.

Give two examples of positive statements about the economy, and two examples of normative ones.

Now give two examples that are seemingly positive, but which have normative implications or undertones.

Positive: ▪ The rate of inflation is 4 per cent.

▪ The price of beef has fallen.

Normative: ▪ The rich ought to pay a higher rate of tax than the poor.

▪ Reducing unemployment is more important than reducing inflation.

Seemingly positive (with normative undertones): ▪ The rate of unemployment has fallen.

Many politicians will focus only on the „good news‟ or the „bad news‟ in order to persuade the electorate of how well or how badly the government has managed the economy.

▪ Company A pays much lower wages than company B. There may well be an implied criticism of company A or, from an employer‟s point of view, of company B.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

Answers to End-of-Chapter Questions in Chapter 2 (11th edition) The weekly demand and supply schedules for t-shirts (in millions) in a free market are as follows: Price (£)

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7

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1

Quantity demanded

6

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Quantity supplied

18

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4

(a) What are the equilibrium price and quantity? (b) Assume that changes in fashion cause the demand for t-shirts to rise by 4 million at each price.

What will be the new equilibrium price and quantity? Has equilibrium quantity risen as much as the rise in demand? Explain why or why not. (c) Now plot the data in the table and mark the equilibrium. Also plot the new data corresponding to (b). (a) Equilibrium is where quantity demanded equals quantity supplied: P = £5; Q = 12 million. (b) The schedules are shown in the following table: Price (£)

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2

1

Quantity demanded

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Quantity supplied

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Equilibrium price and quantity are now as follows: P = £6; Q = 14 million Demand has risen by 4 million but equilibrium quantity has only risen by 2 million (from 12 million to 14 million). The reason why quantity sold has risen by less than demand is that price has risen. This has choked off some of the extra demand (i.e. 2 of the 4 million). (c) See Diagram 2.1.

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S

8 7 6

Price (£)

1.

5 4 3 2 1

D1

D2

0 0

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Quantity (millions)

Diagram 2.1 Market for t-shirts (weekly)

5

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

2.

On separate demand and supply diagrams for bread, sketch the effects of the following: (a) a rise in the price of wheat; (b) a rise in the price of butter and margarine; (c) a rise in the price of rice, pasta and potatoes. In each case, state your assumptions. (a) The supply curve will shift to the left: the price of bread will rise and the quantity sold will fall.

Wheat is used to make flour, which is used to make bread. If wheat goes up in price, this will increase the cost of producing bread and hence shift the supply curve (upward) to the left. (b) The demand curve will shift to the left: the price of bread will fall and the quantity sold will fall.

Butter and margarine are complements for bread. If they go up in price, less „bread-and-butter‟ will be consumed. (c) The demand curve will shift to the right: the price of bread will rise and the quantity sold will rise.

Rice, pasta and potatoes are substitutes for bread. If they go up in price, less of them will be purchased and more bread will be purchased instead.

3.

For what reasons might the price of overseas holidays rise? In each case identify whether these are reasons affecting demand or supply (or both).

▪ ▪ ▪ ▪ ▪ ▪

4.

A rise in the price of air travel (supply).

A fall in the exchange rate, giving less foreign currency for the pound (supply – tour operators‟ costs abroad rise when measured in pounds).

The economy booms (demand – more people can afford to go on holiday; supply – inflation raises tour operators‟ costs).

The price of domestic holidays increases (demand – a rise in the price of a substitute).

Certain tour operators go out of business or cut down on the number of holidays on offer (supply).

Poor weather at home (demand – more people decide to take their holidays abroad).

If both demand and supply change, and if we know which direction they have shifted but not how much, why is it that we will be able to predict the direction in which either price or quantity will change, but not both? (Clue: consider the four possible combinations and sketch them if necessary: (a) D left, S left; (b) D right, S right; (c) D left, S right (d) D right, S left.)

D left, S left: quantity falls, price may rise or fall.

D right, S right: quantity rises, price may rise or fall.

D left, S right: price falls, quantity may rise or fall.

D right, S left: price rises, quantity may rise or fall.

5.

If you were the owner of a clothes shop, how would you set about deciding what prices to charge for each garment at the end-of-season sale?

If you were seeking simply to sell all the stock, you would have to reduce the price enough to ensure that all the items are sold. Clearly, your knowledge of the market is likely to be imperfect and thus you would have to make a guess as to the effect on demand of reductions in price. What you would be trying to estimate is the responsiveness of demand to the reduction in price. We use the concept of „elasticity‟ of demand to measure this responsiveness. We examine elasticity in the next chapter.

If you were seeking to maximise profits from the sale, then it is likely to be a bit more complicated as you would have to look at the effects on revenue of price reductions, and this again depends on elasticity. You may prefer to make only modest reductions in price and have some items unsold if the revenue you earn on the items you do sell is greater that the revenue you would get by

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

reducing prices further in order to ensure that all items are sold. Again, an estimate of elasticity here will help you make the right decision.

Finally, you should take costs into account. It may well be that as you have bought the garments already from your suppliers there are no additional costs to you whether or not you sell each item. If there are any additional costs, such as staff costs or handling costs, of either selling garments or disposing of unsold ones, then these would have to be offset against revenue. Balancing costs and revenues in order to maximise profits is considered in Chapter 6.

6.

Is there any truth in the saying that the price of a good is a reflection of its quality?

Yes (albeit not always). There are two reasons: (i) Goods of a better quality often cost more to produce – because better quality materials are used, or more time is taken in their manufacture. This will lead to a supply curve vertically higher than for inferior quality goods. (ii) Goods of better quality are in higher demand than inferior quality ones at any given price. The demand curve is therefore further to the right.

The combination of (i) and (ii) produces a higher equilibrium price.

Sometimes, however, consumer ignorance may lead to people being prepared to pay high prices for inferior quality goods.

7.

Assume that oil begins to run out and that extraction becomes more expensive. Trace through the effects of this on the market for oil and the market for other fuels.

As oil begins to run out and the costs of extraction rise, so the supply curve will shift (upwards) to the left. With a given demand curve, the price will rise.

Over time, as prices rise, so people and firms will increasingly try to find cheaper alternatives, such as households shifting from oil-fired central heating or electricity generating companies shifting away from oil-fired power stations. People will also try to cut down their consumption of oil by using it more efficiently or more sparingly. For example, people could switch to smaller, more fuel-efficient cars and invest more money in insulating their homes to save on energy. This can be illustrated by the demand curve being further to the left in the future (given a higher price) than at the present time.

Firms too will have an incentive to invest in energy-efficient technology. The effect of these reductions in demand will help to dampen the rise in price.

What we are talking about here is the responsiveness of demand to the higher price: i.e. its price elasticity. In the short run, there may be little people can do. In the long run, there may be many more opportunities for using less oil.

If reductions in demand for oil are achieved by switching to alternatives, such as solar panels or wind turbines, so the demand for these alternatives will rise. Other things being equal, the effect of this increase in demand for alternative energy sources will increase their price. If, however, there is increased investment in developing these energy sources, their costs may come down. In other words, the increased demand may be partially, wholly or more than wholly offset by a rise in supply. The new price will be where the new demand and supply curves intersect, which may be above or below the original price depending on the relative shifts in demand and supply curves.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

8.

Why are both the price elasticity of demand and the price elasticity of supply likely to be greater in the long run?

Demand: if the price of a good rises, then the longer the time period, the longer time consumers have to shop around and find alternative products that are close substitutes.

Supply: if the price of a good rises, more firms will be attracted into the industry and existing firms will be encouraged to expand. Both of these take time – to purchase more capital equipment, recruit more staff and build new factories.

9.

Which of the following will have positive signs and which will have negative ones? (a) price elasticity of demand; (b) income elasticity of demand (normal good); (c) income elasticity of demand (inferior good); (d) cross elasticity of demand (with respect to changes in price of a substitute good); (e) cross elasticity of demand (with respect to changes in price of a complementary good); (f) price elasticity of supply. (b), (d), (f): positive. (a), (c), (e): negative.

10.

What are the advantages and disadvantages of speculation from the point of view of (a) the consumer; (b) firms?

Generally, stabilising speculation will benefit both consumers and firms as it will create a more stable market environment in which it is easier to plan purchases, production or investment. Generally people prefer certainty to uncertainty. Destabilising speculation, on the other hand, by exaggerating the upswings and downswings in markets, will make it more difficult to plan – something that will be unpopular with consumers and producers alike.

Of course, to the extent that the consumers or producers are themselves taking part in the speculation, they will gain from it, whether it is stabilising or destabilising, provided that they predict correctly. For example, if you are thinking of buying a house and, correctly, predict that house prices will rise in the near future, then you will gain by buying now before they do.

Answers to End-of-Chapter Questions in Chapter 3 (11th edition)

1.

Assume that the (weekly) market demand and supply of tomatoes are given by the following figures: Price (£ per kilo)

4.00

3.50

3.00

2.50

2.00

1.50

1.00

Qd (000 kilos)

30

35

40

45

50

55

60

Qs (000 kilos)

80

68

62

55

50

45

38

(a) What are the equilibrium price and quantity? (b) What will be the effect of the government fixing a minimum price of (i) £3 per kilo; (ii) £1.50 per kilo? (c) Suppose that the government paid tomato producers a subsidy of £1 per kilo. (i) Give the new supply schedule. (ii) What will be the new equilibrium price? (iii) How much will this cost the

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

government? (d) Alternatively, suppose that the government guaranteed tomato producers a price of £2.50 per kilo. (i) How many tomatoes would it have to buy in order to ensure that all the tomatoes produced were sold? (ii) How much would this cost the government? (e) Alternatively, suppose it bought all the tomatoes produced at £2.50. (i) At what single price would it have to sell them in order to dispose of the lot? (ii) What would be the net cost of this action? (a) Equilibrium is where quantity demanded equals quantity supplied, where: P = £2.00 per kilo; Q = 50 000 kilos (b) (i) There will be a surplus of 22 000 kilos (i.e. 62 000 – 40 000) (ii) No effect. The equilibrium price of £2.00 is above the minimum. (c) (i) With the £1.00 subsidy, producers will supply at each price the amount that they were previously willing to supply for £1 more. The schedules will now be as follows: Price (£ per kilo)

4.00

3.50

3.00

2.50

2.00

1.50

1.00

Qd (000 kilos)

30

35

40

45

50

55

60

80

68

62

55

50

Qs (000 kilos)

(ii) The new equilibrium price will be £1.50 (where quantity demanded and the new quantity supplied are equal). (iii) The cost will be £1  55 000 = £55 000. (d) (i) At a price of £2.50, (original) supply exceeds demand by 10 000 kilos. The government would therefore have to buy this amount in order to ensure that all the tomatoes produced were sold. (ii) £2.50  10 000 = £25 000 (e) (i) It would have purchased 55 000. To dispose of all these, price would have to fall to £1.50. (ii) The cost of this course of action would be (£2.50 – £1.50)  55 000 = £55 000

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

2.

Think of two things that are provided free of charge. In each case, identify whether and in what form a shortage might occur. In what ways are/could these shortages be dealt with? Are they the best solution to the shortages?

The state provides various goods and services free at the point of use (albeit at a cost to the taxpayer).

Two examples are: (i) Primary and secondary education If education were not provided free at the point of use, parents would have to pay for this from current income, from savings or by borrowing. In a society with income inequality, it is likely that some would not be able to afford schooling, many would not be able to borrow enough, while others might not choose to spend money on this. Education is key to economic growth, making workers more productive and so pushing out the production possibility curve. (See pages 14–16 in Economics (11th edition).) Since some parents might not make the „correct‟ decision with regard to school attendance and some might not be willing or able to pay for it, many countries make education compulsory and free at the point of use. The UK government commits to providing sufficient school places, so that overall rationing is not required. There will however be rationing of places in particularly popular schools, where demand exceeds the number of places available.

This may have the impact of increasing property prices for houses that are in the catchment areas of the most popular schools. (ii) Health care from general practitioners People may have to wait to see their doctor. Rationing takes place though this process of waiting: either people have to wait in the doctor‟s surgery or are not given an immediate appointment.

Because people have to wait, this reduces the number of people seeing their doctor, either because they are better by the time that their appointment is due, or because they would rather suffer the symptoms than have to wait. The shortage could alternatively be dealt with by increasing the number of doctors (in which case the benefits from more immediate treatment would have to weighed against the extra cost to the taxpayer), or by charging for people to visit their doctor. This latter solution, however, would be hard for poor people, and might discourage people from getting treatment (which in turn could lead to the spread of infectious diseases).

3.

Discuss the relative merits of the different methods used by the All England Club to allocate tickets for Wimbledon each year.

Tickets are allocated for Wimbledon in a number of different ways. The following are the most common: Random ballot with the people who have their name drawn at random still having to pay the face value of the tickets: There are three different ballots that people can enter: −

The public ballot where tickets are allocated by a randomly computerised selection process.

Anyone can enter the ballot by applying between 1 September and 31 December.

−

The LTA British Tennis Membership ballot. Everyone who is a member of LTA British Tennis, but not a member of an affiliated club, is automatically entered into this ballot.

−

The club ballot. All LTA affiliated tennis clubs are allocated a number of tickets. Each club runs a ballot for these tickets, which its members, who are also members of the All England Club, can enter.

One advantage of running a ballot is that many members of the public believe it is a fair way of allocating the tickets. The organisers may be very sensitive to the fans‟ perception of how fairly they are treated when trying to purchase tickets. Another advantage of making the winners pay is that only those people who value going to Wimbledon more highly than the price of the tickets will enter the ballot. However, a number of people who are lucky enough to purchase tickets via

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

the ballot will value the tickets less than other fans who have not been so lucky. This will lead to an allocatively inefficient outcome if resale is prohibited. Having ballots for people who are members of tennis clubs may also make it more likely that the tickets are allocated to those who value them most highly.

Purchased on-line. The authorised ticketing website for Wimbledon is Ticketmaster. Some tickets are released for sale on this website at 9.00am for play the following day. They typically sell out in a few minutes, with many fans left frustrated. This suggests that they are priced well below the marketclearing level. Once again, only people who value going to Wimbledon more highly than the price will try to purchase them online. They also have to go through the hassle of sitting at their computer at 9.00am and constantly hitting the refresh button. However, given excess demand, there is still an element of luck involved: i.e. does a fan happen to hit the refresh button at the exact moment to gain access to the website? Given this random element to the allocation process, tickets will be sold to some fans who value going to Wimbledon less than others.

Tickets can also be purchased from secondary ticketing websites such as Stubhub, Seatwave, GetMein and Viagogo (see Box 3.3 for more details). However, the Wimbledon website states that “All tickets are strictly non-transferable and must neither be sold nor advertised or offered for sale whether on the internet, in newspapers or elsewhere. Any such tickets which are transferred, advertised or offered for sale will be void.” Making the tickets non-transferable creates allocative inefficiency as it stops people from selling the tickets and using the money to buy goods/services they value more highly or would give them more pleasure than attending Wimbledon. We explore questions of allocative efficiency and inefficiency in later chapter, especially Chapter 12.

First come, first served: i.e. queuing outside the ticket office. Many people join the queue the day before play and camp out overnight to make sure they can purchase the tickets. Until recently, they queued on the pavement leading to the entry gates, but now the process is more organised with people camping in Wimbledon park. Only one ticket can be purchased per person queuing and payment is by cash only.

Once again, it can be argued that only people who value going to Wimbledon the most highly would be willing to camp outside overnight in order to purchase the tickets: i.e. willingness to queue is closely correlated with willingness to pay. However, willingness to queue will also depend on the opportunity cost of someone‟s time. A person who would love to go to Wimbledon but has a very high opportunity cost of their time (e.g. a person with childcare commitments) might not be prepared to queue for a long time, whereas a person who values going to Wimbledon less highly but has a lower opportunity cost of their time (e.g. a student on holiday) might be prepared to queue. Another drawback is the opportunity cost of the time of the thousands of people who do queue each year. What other productive activities could they have carried out in the time spent queuing.

The organisers could simply increase the price of tickets until the market cleared where the quantity demanded equals the quantity supplied. This would eliminate (a) the queues and (b) the frustrated fans willing to pay the cost of a ticket but unable to purchase one. However many fans might perceive this system to be very unfair.

4.

If the government increases the tax on a litre of petrol by 5p, what will determine the amount by which the price of petrol will go up as a result of this tax increase?

The price elasticity of demand for and supply of petrol. The more elastic the demand and the less elastic the supply, the less will price rise: i.e. the more of the tax that must be absorbed by the producers/suppliers (see Figure 3.6 in the text).

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

5.

Illustrate on four separate diagrams (as in Figure 3.6) the effect of different elasticities of demand and supply on the incidence of a subsidy.

See Diagrams 3.1 and 3.2.

P

P

S

S

P2 + sub

S (with subsidy)

S (with subsidy) P2 + sub P1

P1 P2

D P2

D O

Q1Q2

Q

O

(a) Inelastic demand

Q1

Q2

Q

(b) Elastic demand

Diagram 3.1 Effect of elasticity of demand on the incidence of a subsidy

P

S

P

S (with subsidy)

P2 + sub

S P2 +

P1 P2

sub

S (with subsidy)

P1 P2

D O

Q1Q2

O

Q

(a) Inelastic supply

Q1

Q2

(b) Elastic supply

Diagram 3.2 Effect of elasticity of supply on the incidence of a subsidy

In each diagram the producer‟s share is P2 + sub – P1 (the rise in the price including the subsidy). The consumer‟s share is P1 – P2 (the fall in the actual price). The more elastic is demand and the less elastic is supply, the greater will be the producers‟ gain from the subsidy (in terms of a higher price-plussubsidy) and the smaller will be the consumers‟ gain (in terms of a lower actual price).

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

6.

The UK government introduced the Soft Drinks Industry Levy in April 2018. Explain how this tax works and discuss its impact on both soft drinks companies and consumer behaviour.

The tax has been set at 18p per litre for drinks with 5 to 8 grams of sugar per 100ml and 24p per litre for drinks with more than 8 grams per 100ml. Pure fruit juices and milk-based drinks are exempt from the levy as well as drinks supplied by small producers. The impact on consumer behaviour will depend on (a) how much of the tax is passed onto the consumer in the form of higher prices, (b) how sensitive consumers are to any price changes that do occur: in particular, to what extent consumers will switch to buying drinks with a much lower sugar content.

As was discussed in the chapter, the extent to which taxes are passed on to consumers in the form of higher prices depends on the price elasticity of demand and supply. It also depends on the degree of competition in the market. One study estimated an own-price elasticity of demand of –0.81 for sugar-sweetened drinks. This suggests that the tax could have a quite a strong impact on consumer behaviour. However this elasticity figure is for all sugar sweetened drinks, whereas fruit juices and milk-based drinks are exempt from the levy. Therefore customers may respond to the levy by switching away from the sugary drinks that are taxed to the ones that are not taxed.

The marginal rate of tax on sugar content is also zero within each tax bracket. For example, a drink with 10g/100ml would be taxed at the same rate as one with 20g/100ml: i.e. at 24p per litre. This reduces the incentives for the consumer to switch to drinks with a lower sugar content within this band and for producers to reduce the sugar content of their drinks. The IFS has suggested that the tax should be set at a constant rate per sugar content to give stronger incentives – for example at 2p per gram of sugar in each 100ml of the drink.

7.

Why are agricultural prices subject to greater fluctuations than those of manufactured products?

▪ ▪ ▪ ▪

8.

Because supply fluctuates with the weather and other natural conditions.

Because demand is relatively price inelastic.

Because short-run supply is relatively price inelastic.

Because there is a time lag between planned supply and actual supply. If there is initially a high price, then more of the product will be grown. Only later will this come to market, and prices will then fall. At that stage, farmers might plan to grow less for the next season. But when this reduced supply comes to the market, the price will rise again.

Compare the relative benefits of subsidies and high minimum prices to (a) the consumer; (b) the producer. (a) The consumer ▪ Subsidies lead to lower prices than do high minimum prices.

▪ Prices will be more stable with a system of high minimum prices than with subsidies.

▪ The costs to the taxpayer may or may not be greater with subsidies, depending on the price elasticity of demand (see Case Study 3.7 on the Student Website) and the costs of storing surpluses under the high minimum price system. (b) The farmer It depends on how the subsidies are applied. If they provide the same amount of support to all producers as do high minimum prices, then there is little difference in the benefits. Subsidies can more easily be used to support particular sections of an industry or sector. For example, higher subsidies can be given for small producer or producers in particular parts of the country. Subsidies thus have the advantage of greater flexibility. On the other hand, if subsidies are of a fixed amount per unit, then the price will fluctuate with demand and supply. High minimum prices remove this uncertainty for producers and make it easier for them to plan. th

Answers to End-of-Chapter Questions in Chapter 4 (11 edition) 14

Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

1.

Imagine that you had £10 per month to allocate between two goods, A and B. Imagine that good A cost £2 per unit and good B cost £1 per unit. Imagine also that the utilities of the two goods are those set out in the table. (Note that the two goods are not substitutes for each other, so that the consumption of one does not affect the utility gained from the other.)

The utility gained by a person from various quantities of two goods: A and B Good A Units per month 0 1 2 3 4 5

Good B

MU (utils)

TU (utils)

– 11.0 8.0 6.0 4.5 3.0

0.0 11.0 19.0 25.0 29.5 32.5

Units per month 0 1 2 3 4 5 6 7 8 9 10

MU (utils)

TU (utils)

– 8.0 7.0 6.5 5.0 4.5 4.0 3.5 3.0 2.6 2.3

0.0 8.0 15.0 21.5 26.5 31.0 35.0 38.5 41.5 44.1 46.4

(a) What would be the marginal utility ratio (MUa/MUb) for the following combinations of the two goods: (i) 1A, 8B; (ii) 2A, 6B; (iii) 3A, 4B; (iv) 4A, 2B? (Each combination would cost £10.) (b) Show that where the marginal utility ratio (MUA/MUB) equals the price ratio (PA/PB) total utility is maximised. (c) If the two goods were substitutes for each other why would it not be possible to construct a table like the one given here? (a) (i) 11/3; (ii) 8/4; (iii) 6/5; (iv) 9/14. (b) PA/PB = 2/1. MUA/MUB = 2/1 when consumption is 2A and 6B. With this combination, total utility is maximised (54 utils). (c) Because the consumption of one good would affect the utility of the other.

2.

Is it reasonable to assume that people seek to equate the marginal utility/price ratios of the goods that they purchase, if (a) they have never heard of ‘utility’, let alone ‘marginal utility’; (b) marginal utility cannot be measured in any absolute way?

Yes. Even though people may have never heard of marginal utility, when they seek to get „value for money‟ from their purchases they are, in effect, weighing up the benefit they expect to get from each item against the price they are having to pay. Even though marginal utility cannot be measured in an absolute way, people still have a pretty good idea of whether an item is worth to them the price they are having to pay. They do not have to estimate how much utility they expect to get from that item, but merely whether it is worth spending their money on it, rather than spending it on something else. For example, if a can of drink costs 30p, you will buy it if it is worth at least 30p to you at that point in time. You do not have to estimate whether it is worth 36p, or 47p, or whatever.

In economic theory it is assumed that people act „as if‟ they were equating marginal utility/price ratios. It does not claim to describe the way that people actually make decision which will be far more informal.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

3.

Consider situations where you might consider swapping items with someone. Why are such situations relatively rare? Can you think of circumstances in which this might be more common?

When they have something that you want and you have something that they want, and when you get a better deal that way than selling your item second hand and then using the money to buy the other item (or something else). Swapping may have the additional advantage of being fun, especially if done with friends.

Such situations are rare because it is unlikely that two people both have things that the other wants more than they do, unless they are unwanted gifts, or items they have grown tired of, or items they wish they had not bought. With these exceptions, assuming that people had spend their money wisely in the first place, they would have already got their optimum combination of goods and would not want to swap.

The most common circumstances for swapping are with second-hand items where there is no market.

4.

Explain why the price of a good is no reflection of the total value that consumers put on it.

Price is a reflection of marginal utility: i.e. the utility of the last unit of it purchased in any given period of time. But, given that marginal utility diminishes at very different rates for different goods (you grow tired of some things much more quickly than others), then you will have gained much more total utility from previous units of some goods than of others. Box 4.2 (page 111) discusses this issue.

*5.

Sketch a person’s indifference map for two goods X and Y. Mark the optimum consumption point. Now illustrate the following (you might need to draw a separate diagram for each): (a) A rise in the price of good X, but no change in the price of good Y. (b) A shift in the person’s tastes from good Y to good X. (c) A fall in the person’s income and a fall in the price of good Y, with the result that the consumption of Y remains constant (but that of X falls).

In each case assume that units of good X are measured on the horizontal axis and that units of good Y are measured on the vertical axis. (a) In Figure 4.13 (page 122) the budget line will pivot inwards from B2 to B1, causing a fall in consumption from point k to point j. (b) The indifference curves will become steeper (crossing the original ones): for any given level of utility, the person would need to consume a greater additional amount of Y than before for each unit of X sacrificed.

Good Y

b

QY

a

I1 B2

B1

I2 (c) See Diagram 4.1. If the price of QX2 QX1 Y falls, the budget line becomes Good X steeper. If income falls, but the consumption of Y remains constant, the consumption of X must fall (from Qx1 to Qx2). There is a movement from point a to point Diagram 4.1 Fall in income and in the price of Y: b. consumption of Y remains constant 16

Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

*6.

Distinguish between a normal good, an inferior good and a Giffen good. Use indifference curves to illustrate your answer.

▪

With a normal good, its demand rises as income rises, and falls as price rises.

▪ With an inferior good, its demand falls as income rises, and falls as price rises.

▪ With a Giffen good, its demand falls as income rises, and rises as price rises.

When price rises there will be negative substitution effect (people will buy less of this good and more of alternatives). With a normal good this is reinforced by a negative income effect with respect to the price rise (i.e. a positive effect with respect to income): the price rise reduces people‟s real incomes and therefore they will buy less of this good. With an inferior good and with a Giffen good, although the substitution effect is still negative, the income effect is now positive with respect to price (i.e. negative with respect to income): the rise in price reduces people‟s real incomes and makes them consume less of goods in general. With the simple inferior good, the substitution effect is larger than the income effect, and people will still buy less of the good when its price rises. With the Giffen good, however, the income effect is larger than the substitution effect, and people will therefore buy more of the good when its price rises. These effects are illustrated in Figures 4.16, 4.17 and 4.18 in the text. *7. Assume that commuters regard bus journeys as an inferior good and car journeys as a normal good.

Using indifference curves, show how (a) a rise in incomes and (b) a fall in bus fares will affect the use of these two modes of transport. How could people’s tastes be altered so that bus journeys were no longer regarded as an inferior good? If tastes were altered in this way, what effect would it have on the indifference curves?

Referring to Figure 4.17 in the text, assume that bus journeys are good X (the inferior good) and car journeys are good X (the normal good). Assume also that initially consumption is at point h, with Qx3 bus journeys made. (a) A rise in incomes is illustrated by a parallel outward shift in the budget line. In Figure 4.17, this is illustrated by a shift in the budget line from B2 to B1a. Consumption moves to point g. This illustrates how consumption of the inferior good (bus journeys) falls as income rises. Consumption falls from Qx3 to Qx2. (b) A fall in bus fares is illustrated by a pivoting outward of the budget line around the point where it crosses the vertical axis. In Figure 4.17 this is illustrated by a shift in the budget line from B2 to B1.

Consumption moves from point h to point f. Bus journeys increase from Qx3 to Qx1, but this is solely due to the substitution effect. The income effect is to reduce the number of bus journeys made from Qx3 to Qx2.

Bus journeys could be made quicker and more comfortable by having more and better buses and dedicated bus lanes. Buses could be advertised to promote the image of being time saving and environmentally friendly.

The horizontal difference between the indifference curves would increase relative to the vertical distance, so that they became more like the curves illustrated in Figure 4.16.

Answers to End-of-Chapter Questions in Chapter 5 (11th edition)

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

1.

A country’s central bank (e.g. the Bank of England or the US Federal Reserve) has a key role in ensuring the stability of the banking system. In many countries the central bank is prepared to bail banks out which find themselves in financial difficulties. Although this has the benefit of reducing the chance of banks going bankrupt and depositors losing their money, it can create a moral hazard.

Explain why.

Banks may be more willing to grant high-risk loans or undertake other risky ventures, knowing that they will be bailed out by the central bank if they get into difficulties. If we think about the impact on an individual bank, we could argue that such effects are fairly limited, since a bank would much rather not have to be rescued by the central bank: it would hardly be a good advertisement for attracting new custom! However this is exactly what happened in the banking crisis of 2007–8. In the UK, Northern Rock was the first bank to suffer a run on its resources as savers queued in September 2007 to withdraw their money. After receiving interim loans from the Bank of England, Northern Rock was eventually taken into public ownership in early 2008. Later that year the Royal Bank of Scotland and HBOS had to be „bailed out‟ by the Bank of England with very substantial injections that left them mainly owned by the taxpayer. Some commentators believe that allowing just one bank to fail might have been the most effective method of ensuring that in future banks adopted less risky strategies.

2.

Discuss the EU ruling that gender may not be used to differentiate insurance premiums. Which insurance markets would be affected by outlawing age ‘discrimination’ in a similar manner? What would be the impact?

Markets affected would include car insurance, where younger drivers currently pay higher premiums and much older drivers may be refused cover at all. Some travel insurance is also not available to the elderly, even under actuarially fair premiums. Both health and life insurance, unsurprisingly, use age as part of a proxy for risk.

If insurers were no longer able to „discriminate‟ by age, there might be a very substantial impact on premiums, with sharp increases for younger people wishing to insure. This is what happened in terms of gender in the market for car insurance: premiums for women rose while those for men fell by a small amount. In terms of life and health insurance, it is likely that insurance companies will make greater use of individual screening; they will no longer be able to assume that old age is correlated with ill-health.

3.

Euro NCAP carries out crash tests on new cars in order to assess the extent to which they are safer than the minimum required. The cars are given a percentage score in four different categories, including adult occupant protection and child occupant protection. An overall safety rating is then awarded. Based on the test results in 2020, the Volkswagen ID. 3 was judged to be the safest car on the market. If you observed that these cars were more likely to be involved in traffic accidents, could this be an example of adverse selection or moral hazard? Explain.

It could be an example of both adverse selection and moral hazard. Less skilful and more reckless drivers will be more likely to buy this particular car because they know they have a greater chance of being involved in a car accident and so value the safety characteristics very highly. Also, once a person purchases the car their driving behaviour may change because they know that if they are involved in an accident there is less chance of them being injured because of the safety characteristics of the car.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

4.

How does economics predict rational consumers will treat spending on credit cards compared with spending cash? Do you think there are likely to be differences in the way people spend by each? If so, can you explain why?

If you act in a manner predicted by the rational choice model, you will make choices about purchases today and in the future to maximise discounted utility, subject to your expected lifetime income.

Economic theory assumes that most people are impatient most of the time. To capture this idea, mainstream theories use exponential discounting as explained in section 4.2. If people pay with cash the cost will feel more immediate, which might deter people from buying some goods. In other words, the immediate cost is greater than the immediate benefit. If people pay with their credit cards then the cost is delayed – the bill does not need to be paid until the end of the month. In this case, the discounted present value of the future costs might be less than the immediate benefits from consuming the good today. A rational and impatient person therefore might be more willing to buy a product if they can use a credit card rather than paying by cash.

Individuals may also use credit cards as a method of „consumption smoothing‟ when current income is relatively low but future income is expected to be much higher (e.g. a student).

However, the standard life cycle model finds it difficult to explain the behaviour of many people who have high levels of both credit card borrowing and are unlikely to have access to greater funds in the future. A life cycle model developed by Laibson, Repetto and Tobacman (2009) which takes account of present bias is better able to account for this behaviour. Research by Meier and Sprenger (2010) also found that individuals with present biased preferences had significantly higher levels of credit card debt after controlling for the impact of a range of factors. Therefore some credit card spending may be more consistent with the predictions of behavioural economics than simple rational choice theory.

5.

How does behavioural economics differ from standard economics?

Standard economic theory is built on the rational choice assumption that people can: ▪

accurately assess the costs and benefits of all the different choices available to them even when the decision is really complicated: i.e. they have unlimited computational abilities.

successfully pick the options that maximise their own self-interest/happiness. In many economic theories self-interest is assumed to be the same as selfishness: i.e. people only care about pay-offs they receive and not the pay-offs to others.

It is important to remember that economists assume that this is the way people behave in standard theoretical models as a way of simplifying reality. They do not believe that people behave like this in the real world and have rarely argued that this is the way people actually make decisions. This is an important point that is often misunderstood.

Behavioural economics integrates some simple insights from psychology into the assumptions used in economic theory. In particular, it is assumed that in certain circumstances people make systematic and predictable errors. For example, they exhibit loss aversion and present bias. Behavioural economics aims to complement rather than replace standard economic theory.

Behavioural economists accept that standard theory is very good at predicting human behaviour in many different circumstances. However, in certain situations it is argued that models based on assumptions that allow for systematic errors or biases are better able to explain and predict real-world behaviour. However, it is always important to remember that, just like standard economic theory, assumptions are being made about the decision making of people within a theory rather than in the real world. These assumptions may not be accurate in all circumstances.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

6.

Give some examples of mental short-cuts/heuristics that you use. Why do you use them?

Some examples include: ▪

overweighting the experience of a friend/relative when making judgements about the expected quality of a good or service; ▪ overweighting the likelihood of quality associated with a particular brand name; ▪ never purchasing the most expensive or cheapest version of a good or service in the belief that they would provide the worst value for money; ▪ incorrectly believing that past outcomes have an impact on the likelihood of an event happening in the future; anchoring to the initial presentation of a price and not fully adjusting to information on subsequent charges.

People use them because they are mental short cuts that save on the time and effort required to work out the precise choices that would maximise utility/happiness. In simple terms, they place less strain on our brains when trying to solve complex/difficult problems. In many circumstances, using these mental short-cuts lead to choices which are either the same as, or very close to, those that would maximise utility. However, using heuristics can sometimes lead to people making systematic and predictable mistakes.

7.

What is the representativeness heuristic? Explain how the gamblers and hot-hand fallacies are examples of the representativeness heuristic.

The representativeness heuristic is where people tend to evaluate the likelihood that a person/item belongs to a certain category based on how much they resemble a typical person/item in that category.

In other words, judgements on probability are based on similarity or representativeness. In some circumstances the use of this heuristic works well. Unfortunately, in other cases the use of similarity is over weighted and other important information is ignored. For example, if people are told that a woman called Helen likes aromatherapy and meditation and belongs to a spirituality group, they tend to think she is more likely to be an alternative health therapist than a schoolteacher. However, they are ignoring information about the relative number of alternative health therapists and schoolteachers in the population: i.e. there are far more schoolteachers than alternative health therapists.

One explanation of the gambler‟s fallacy is that people expect a pattern of outcomes from a small sample (i.e. 5 tosses of a coin) to be representative of what they expect to see in large samples (e.g.

100 tosses of coin). In other words, they believe the law of large numbers is „in a hurry‟ to work.

Therefore, if a coin is tossed on four consecutive occasions and comes up heads each time, people think a tail is more likely on the next toss. The representativeness heuristic leads them to believe that the number of heads and tails must quickly begin to resemble the pattern that occurs if the coin is tossed a hundred times. In people‟s minds, there is a self-correcting mechanism at work that makes the pattern of outcomes in a small sample quickly resemble the pattern in a large sample. Tversky and Kahneman (1974) refer to this as „insensitivity to sample size‟.

The explanation of the hot-hand fallacy is similar. Once again, people expect a pattern of outcomes in a small sample to be representative of what they expect to see in a large sample. If a football player scores in three or four games in a row, the sequence will not feel representative of an average player‟s performance. Hence a fan may conclude that the sequence is caused by the player‟s exceptional skill level and this makes it highly likely they will score again in the next game: i.e. they have a „hot hand‟.

The use of the heuristic leads fans to underestimate the likelihood that the player is of average ability and has simply been lucky for three or four games in a row.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

8.

Using the availability heuristic, explain hindsight bias.

Hindsight bias is an example of the availability heuristic. It is where events that actually take place are easier to imagine and visualise than those that do not. Therefore, people tend to (a) overestimate the chances that an event would happen after it has actually occurred and (b) underestimate the chances that an event would happen that did not occur. For example, after watching their team lose, football fans believe that the tactics chosen by the manager were always more likely to fail than they actually were before the game began. The same may be true for policies implemented by both firms and governments that fail to achieve their objectives. People believe they were always more likely to fail than they actually were.

9.

Outline the so-called ‘disposition effect’. Provide an explanation of why it might occur.

The disposition effect is where investors hold on to losing investments (i.e. those that fall below the price they paid for them) too long and sell winning investments (i.e. those that increase above the price they paid for them) too quickly. This behaviour is inconsistent with rational choice theory, as selling and holding decisions should depend on the perceived future value of an investment, not its purchase price. Some studies have found that the performance of winning stocks (i.e. the amount they increased in value after they were sold) was greater than the losing stocks that investors held onto. The holding onto to losing investments is an example of loss aversion.

10.

Dean supports Leicester City football club and has paid £80 for a ticket to watch them play in a cup final. The maximum amount he is willing to pay for the ticket is £200. Another Leicester City supporter offers him £400 for the ticket. Even though there are no restrictions on the resale of the tickets, Dean decides not to sell. Is his decision consistent with the predictions of rational decision making in standard economic theory? Explain your answer.

The rational choice model predicts that Dean will sell the ticket as the offer of £400 is greater than his willingness to pay (WTP) of £200. However, his behaviour could be explained by the endowment effect i.e. where the ownership of a product has an impact on consumers‟ valuation of that product.

After Dean has purchased and come to own the ticket, he values it more than before he purchased the ticket. This means the minimum amount he is willing to accept to sell the ticket (WTA) is greater than the maximum amount he was willing to pay for the ticket (WTP) in the first place.

11.

Draw a utility/value function that illustrates the concepts of reference dependent preferences, loss aversion and diminishing marginal sensitivity to gains/losses.

A value function that illustrates reference dependent preferences, loss aversion and diminishing marginal sensitivity to gains and losses is illustrated in Diagram 1 below.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

Subjective Value

a

V3 V2 V1 Losses −100

b c

−50

+50

+100

Gains

Reference point

d

e

−V1

f

−V2

−V3

Diagram 1

Diminishing marginal sensitivity means that the value function for gains is concave, as shown by the blue line in the top right quadrant of Diagram 1. If people code outcomes as gains (i.e. above their reference point), the value function predicts they will have risk averse preferences. For example, people prefer a £50 gain for certain (see point b) over a gamble with a 50:50 chance of a gain of 0 or £100 (see point c). The certain gain gives a greater subjective value of V2 whereas the gamble gives a subjective value of V1.

The value function has an abrupt change in slope at the reference point. This captures the idea of loss aversion. Coding a £100 as a loss (see point d) provides far more displeasure, than the happiness from a £100 coded as a gain (see point a).

Diminishing marginal sensitivity means the value function for losses is convex, as shown by the blue line in the bottom left quadrant of the diagram. If people code outcomes as losses (i.e. below their reference point), the value function predicts they will have risk loving preferences. For example, the displeasure people experience from a certain £50 loss (see point f) is greater than the displeasure they experience from a gamble with a 50:50 chance of a loss of 0 or a loss of a £100 (see point e). The certain loss gives a subjective displeasure of −V2 whereas the gamble only gives displeasure of −V1.

12.

Using the theory of present bias, provide an economic rationale for government regulation of the payday loan market.

Present bias means that people act in a time-inconsistent manner. They borrow money from a payday loan company to finance their immediate spending on things they enjoy in the belief that they will cut down on consumption later in the month and pay off the loan. At the beginning of the month, the costs (forgone consumption later in the month) and benefits of paying off the loan are all in the future.

Unfortunately, people with present bias preferences overestimate their ability to reduce future spending.

As time passes, the future becomes today. The weight placed on the benefits of immediate consumption are now far greater than the costs of paying off the loan in the future. People do not stick to their plans and continue to spend more money on the things they enjoy. They behave in a time

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

inconsistent manner in the constant belief that they will be able to cut down consumption in the future.

They end up getting into much greater debt than they had ever initially planned.

Government intervention that limits interest rates and charges can help to prevent consumers from building up large unplanned debts. It may also make it more difficult for organisations in the payday loan market to stay in business.

13.

Give some examples of how governments try to nudge people to help them make better decisions.

Some examples in the UK include: ▪

▪

▪

▪

Tax policy: For a number of years the government sent a standard reminder letter to people whose taxes were falling due. In a field experiment, a group of people were sent a reminder letter with the following additional information: ‘9 out of 10 people with a debt like yours in your local area pay their tax on time’. Compared with the standard letter, the additional information increased the number of people paying taxes on time by 6 per cent.

Pensions: Starting with the largest employers in October 2012, the Government switched the default from one in which employees had to make an active choice to sign up for a pension to one in which they are automatically enrolled into a workplace pension. They can still choose to opt out if they wish. The policy appears to have had a significant impact. The number of eligible employees in the private sector with pension savings increased from 31 per cent in 2013 to 73 per cent in 2016. The effect was strongest amongst those who did not traditionally have a pension.

Participation rates amongst eligible private-sector employees earning between £10 000 and £20 000 per year increased from 20 per cent in 2012 to 63 per cent in 2016.

Health care: Eight hundred doctors in Britain were sent letters stating that ‘80 percent of practices in your local area prescribe fewer antibiotics per head than yours’. Information on three possible alternatives to antibiotic prescriptions was also provided. This led to the number of antibiotic prescriptions in these practices falling by 73 406.

Vaccinations: Avoiding images of needles when advertising and promoting vaccinations helps to increase the take up.

Answers to End-of-Chapter Questions in Chapter 6 (11th edition) 1.

The following table shows the average cost and average revenue (price) for a firm at each level of output.

Output

1

2

3

4

5

6

7

8

9

10

AC (£)

7.00

5.00

4.00

3.30

3.00

3.10

3.50

4.20

5.00

6.00

AR (£)

10.00

9.50

9.00

8.50

8.00

7.50

7.00

6.50

6.00

5.50

(a) Construct a table to show TC, MC, TR and MR at each level of output (put the figures for MC and MR mid-way between the output figures). (b) Using MC and MR figures, find the profit-maximising output. (c) Using TC and TR figures, check your answer to (b). (d) Plot the AC, MC, AR and MR figures on a graph. (e) Mark the profit-maximising output and the AR and AC at this output. (f) Shade in an area to represent the level of profits at this output.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

(a)

See the following table:

Outpu 1 t

2

3

4

5

6

7

8

9

10

AC (£)

7.00

5.00

4.00

3.30

3.00

3.10

3.50

4.20

5.00

6.00

TC (£)

7.00

10.0 0

12.0 0

13.2 0

15.0 0

18.6 0

24.5 0

33.6 0

45.0 0

60.0 0

3.00

MC (£)

2.00

1.20

1.80

3.60

5.90

9.10

11.4 0

15.0 0

AR (£)

10.0 0

9.50

9.00

8.50

8.00

7.50

7.00

6.50

6.00

5.50

TR (£)

10.0 0

19.0 0

27.0 0

34.0 0

40.0 0

45.0 0

49.0 0

52.0 0

54.0 0

55.0 0

MR (£)

9.00

8.00

7.00

6.00

5.00

4.00

3.00

2.00

1.00

(b) Profit is maximised where MC = MR: at an output of 6. (c) Total profit equals TR – TC. At an output of 5, total profit is £40.00 – £15.00 = £25.00 At an output of 6, total profit is £45.00 – £18.60 = £26.40 At an output of 7, total profit is £49.00 – £24.50 = £24.50 Profit rises up to 6 units of output and then falls. Profit is thus maximised at 6 units: it is £26.40 per period of time. (d) See Diagram 6.1 on the next page. (e) See Diagram 6.1. Profit is maximised where MC = MR, at an output of 6. At this output, AR = £7.50 (point a); AC = £3.10 (point d). (f) This area is shown by the rectangle abcd.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

£ 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0

MC

a

b AR

AC c

d

MR 0

1

2

3

4

5

6

7

8

9

10

Q

Diagram 6.1 Profit maximisation for a firm facing a downward-sloping demand curve

*2

Draw the isoquant corresponding to the following table, which shows the alternative combinations of labour and capital required to produce 100 units of output per day of good X. K

16

20

262/3

40

60

80

100

L

200

160

120

80

531/3

40

32

(a) Assuming that capital costs are £20 per day and the wage rate is £10 per day, what is the least-cost method of producing 100 units? What will the daily total cost be? (Draw in a series of isocosts.) (b) Now assume that the wage rate rises to £20 per day. Draw a new set of isocosts. What will be the least-cost method of producing 100 units now? How much labour and capital will be used? (a) See Diagram 6.2 (a) below.

The least-cost method of producing 100 units is to use 40 units of capital and 80 workers.

The daily total cost is £1600 (i.e. 40 @ £20 + 80 @ £10).

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

K 100

K 100

90

90

80

80

70

70

60

60

50

50

40

40

30

30

20

20

10

10

0

0

40

(a)

80

120

PK = £20, P L = £10

160

200

L

0

0

40

(b)

80

120

PK = £20, PL = £20

Diagram 6.2 Least-cost method of producing 100 units per day

26

160

200

L

Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

(b) See Diagram 6.2 (b) on previous page.

The least-cost method of producing 100 units is now to use 60 units of capital and 531/3 workers costing £2267 (i.e. 60 @ £20 + 531/3 @ £20). (The one-third of a worker could be part-time.)

3.

Choose two industries that you believe are very different. Identify factors used in those industries that in the short run are (i) fixed; (ii) variable.

English Premier League. Most of the costs for the clubs of employing the players are fixed in the short run. A small part of the wage bill will vary with the number of games played: i.e. appearance and win bonuses. However, the majority of players‟ wages remain the same no matter how many games they play and the details are stipulated in their contracts. These contracts are also for a fixed period of time – typically up to five years. Therefore, if a club wanted to terminate a contract of employment after just one year, it would have to pay four years‟ worth of compensation to the player. Therefore most of the costs of employing players does not change with output (the number of games played) or revenue.

Similar arguments would apply to the costs associated with the stadium. The majority of these would be fixed, although some costs (i.e. stewards, people serving drink/food) would vary with the number of games played.

Fast-food restaurant. The costs of employing most of the staff in a fast-food restaurant are quite variable. As they are employed on a casual basis, their hours of work per week can be altered in response to demand, so the wage costs will be more responsive to changes in output: i.e. the number of customers served. The cost of raw materials (burgers, potatoes, etc) will also vary with the amount of food the fast-food restarant sells. The costs of the restarant building are fixed. They remain the same no matter how many customers the restaurant serves in the short run.

4.

Taking the same industries, identify as many economies of scale as you can.

See if you can identify the various economies of scale that are given in section 6.3.

5.

‘Both short-run and long-run average cost curves may be respective shapes are quite different.’ Explain this statement.

-shaped, but the explanations for their

In the short run, the explanation for the downward-sloping part is (a) the ability of firms to spread their fixed costs over a larger output (b) increasing returns to a variable factor. As output continues to expand firms will begin to experience diminishing marginal returns as some factors are fixed in supply. A point will be reached where the impact of diminishing marginal returns is greater than the impact of spreading fixed costs and this explains the upward-sloping part of the average total cost curve.

In the long run, the explanation for the downward-sloping part is the existence of economies of scale, given that the whole scale of the firm‟s operations can be expanded (no factors being fixed in supply).

The upward-sloping part, if it occurs, is due to diseconomies of scale (see the text for examples). It is not due to diminishing returns since all factors are variable.

6.

Why do marginal cost curves intersect both the average variable cost curve and the average cost curve at their lowest point?

When marginal cost is below either average or average variable cost, each additional unit produced will cost less than the respective average and therefore, when averaged in with the rest, will pull the average down: the average curve will be downward sloping. When marginal cost is above either average or average variable cost, each additional unit produced will cost more than the respective average and therefore, when averaged in with the rest, will pull the average up: the average curve will be upward sloping. The marginal cost curve, therefore, must cut both the average and average variable cost curves at their lowest point.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

7.

Draw a diagram like that in Figure 6.21. Now illustrate the effect of a rise in demand for the product.

Mark the new profit-maximising price and output. Will the profit-maximising output, price, average cost and profit necessarily be higher than before?

See Diagram 6.3 below The rise in demand is illustrated by a shift in the average revenue curve from AR1 to AR2. Profit is maximised at the output where MC = MR. With a demand curve of AR1, this gives a profit-maximising output of Q1. When demand shifts to AR2, profit-maximising output rises to Q2.

Price is given by the AR curve. With an output of Q1, price is AR1. With an output of Q2, price is AR2.

The profit-maximising output will normally be higher (as illustrated), since the AR curve has shifted to the right, and normally, therefore, the new point where the new MR curve crosses the MC will also be to the right of the old point. The exception, however, is where demand has also become much less elastic, so that, although the new AR curve is to the right of the old one at the old price, the new MR curve is to the left of the old one at the point where the old one crossed the MC curve.

£ MC

AR2

AC

AR1

AR2

AC1 AC2

AR1 MR2 Q1

Q2

MR

Q

Diagram 6.3 Effect of a rise in demand on a firm’s profit-maximising price and output

The profit-maximising price will also normally be higher (as illustrated), since at the original output, AR2 is above AR1. The exception in this case is where demand has become much more elastic. In such a case it is possible for the MR curve to swing round so much to the right that there is such a big increase in the profit-maximising output that the profit-maximising point on this new more elastic demand curve is at a lower price than on the original curve.

Average cost could be either higher or lower depending on whether the new profit-maximising output is further up or further down the curve than the original output. In Diagram 6.3, Q2 is at a lower point on the AC curve than Q1. It could easily have been the other way round, if, for example, Q1 had been to the right of the minimum point of the AC curve.

Profit will necessarily be higher (as illustrated). With an increase in demand, then at the original point on the AC curve AR will be higher, and therefore profit will be higher.

8.

Why might it make sense for a firm which cannot sell its output at a profit to continue in production for the time being? For how long should the firm continue to produce at a loss?

Because that way it might minimise its loss. If a loss-making firm can more than cover its variable costs, then by continuing in production it will go some way to paying its fixed costs. If it ceased production, since it will have already incurred these fixed costs (assuming they are sunk), its loss would be higher. When fixed factors need replacing (e.g. machines are worn out), then it should close down if it cannot cover all its costs, including the cost of replacing machines, etc.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

Answers to End-of-Chapter Questions in Chapter 7 (11th edition) 1.

A perfectly competitive firm faces a price of £14 per unit. It has the following short-run cost schedule: Output

0

1

2

3

4

5

6

7

8

TC (£)

10

18

24

30

38

50

66

91

120

(a) Copy the table and put in additional rows for average cost and marginal cost at each level of output. (Enter the figures for marginal cost in the space between each column.) (b) Plot AC, MC and MR on a diagram. (c) Mark the profit-maximising output. (d) How much (supernormal) profit is made at this output? (e) What would happen to the price in the long run if this firm were typical of others in the industry? Why would we need to know information about long-run average cost in order to give a precise answer to this question? (a) Output

0

1

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8

TC (£)

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18

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120

AC (£)

–

18

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10

9½

10

11

13

15

MC (£)

8

6

6

8

12

16

25

29

(b) See Diagram 7.1 below. (c) Profit is maximised where MC = MR (point b): i.e. at an output of 5. (d) £20 Profit per unit is given by AR – AC. AR (=MR) is constant at £14; AC at an output of 5 units is £10.

Thus profit per unit = 14 – 10 = 4 Total profit is then found by multiplying this by the number of units sold: i.e. £4  5 = £20.

This is shown by the area abcd.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

(e) Supernormal profit would encourage new firms to enter the industry. This would cause price to fall until it was equal to the minimum point of the long-run average cost curve (at that point, there would be no supernormal profit remaining and hence firms would stop entering and the price would stop falling).

2.

If the industry under perfect competition faces a downward-sloping demand curve, why does an individual firm face a horizontal demand curve?

Because the firm‟s output makes such an infinitesimally small contribution to total industry output.

The firm cannot affect industry price by changing its output. In other words, any change in an individual firm‟s output would cause such a minute movement along the industry demand curve that price would not change.

3.

If supernormal profits are competed away under perfect competition, why will firms have an incentive to become more efficient?

Because if they did not do so, and other firms did, firms would still enter the industry and compete price down. The firms that had not become more efficient would then find themselves making less than normal profit. They would then either have to become more efficient pretty quickly, or go out of business.

4.

Is it a valid criticism of perfect competition to argue that it is incompatible with economies of scale?

The criticism should really be directed at the market system as a whole: that where significant economies of scale exist, markets are bound to be imperfect. Of course, there may be significant benefits to consumers and society generally from such imperfect markets (see pages 213 and 239–40): there are advantages as well as disadvantages of imperfect markets. What is more, if the market is highly contestable, many of the advantages of perfect competition may be achieved even though the industry is actually a monopoly (or oligopoly).

5.

On a diagram similar to Figure 7.4, show the long-run equilibrium for both firm and industry under perfect competition. Now assume that the demand for the product falls. Show the short-run and longrun effects.

S2

P

£

AR1 AR2

D2 O

Q

O

Q Firm

Industry

Diagram 7.2 Long-run equilibrium under perfect competition

This is illustrated in Diagram 7.2. The long-run equilibrium is shown where the AR curve is tangential to the LRAC curve (and where, therefore, there is no supernormal profit). If the demand curve now shifts from D1 to D2, the equilibrium price will fall to P2. Less than normal profit will now be made.

Firms will therefore leave the industry. As they do, so the industry supply curve will shift to the left,

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

causing the price to rise again. Once the supply curve has reached S2 and price has risen back to P1, long-run equilibrium will have been restored, with the remaining firms making normal profit again.

Why is the profit-maximising price under monopoly greater than marginal cost? In what way can this be seen as inefficient?

6.

Because profit is maximised where MR = MC. Under monopoly, AR is downward sloping and MR is therefore less than AR (price). Thus price is greater than MC. This is seen as inefficient, since, other things being equal, if more units were produced, the value of them to consumers (i.e. the price people are prepared to pay) would exceed the marginal cost of producing them: therefore „society‟ is losing out by increased production not taking place. These arguments are explored in section 12.1.

7.

On three diagrams like Figure 7.8, illustrate the effect on price, quantity and profit of each of the following: (a) a rise in demand; (b) a rise in fixed costs; (c) a rise in variable costs. In each case show only the AR, MR, AC, and MC curves.

See Diagram 7.3.

£

£ MC

MC

y

P2 x P1 b

a w

AC2

AC P b

c

AC1

c

f AR2

d

a

d

z AR

AR1 MR2 Q1

Q2

Q

Q

MR1

(a) Rise in demand

MR

(b) Rise in fixed costs

£

MC2 MC

1

AC2 P2 s P1 b

r

a

t

AC1

c

u d AR

MR (c) Rise in variable costs Diagram 7.3 Profit maximising under monopoly

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

8.

Think of three examples of monopolies (local or national) and consider how contestable their markets are.

Three examples might include: ▪ A university food outlet: unless the catering is offered on a franchise basis to outside caterers, or,

say, to the student‟s union, the monopoly will not be contestable. There may, nevertheless, be competition from local restaurants, cafés and food shops.

▪ Bus company operating a particular route: the market may be large enough for only one company, but the market is highly contestable, especially if other bus companies are already established on other routes in the area.

▪ Local water company: the market is not contestable, because the entry and exit costs would be extremely high. It would be possible through regulation, however, to force local water companies to grant use of their pipelines to other companies provided the various pipe networks are linked between one area and another.

Answers to End-of-Chapter Questions in Chapter 8 (11th edition) 1.

Assume there are just two firms (X and Y) and they are considering which of two alternative prices to charge. The decisions are made simultaneously: i.e. without either firm knowing the choice of its rival.

The various profits are illustrated in the following pay-off matrix: X’s price £25

A

£15

B £2m, £5m

£6m, £6m

£20

Y’s price

£19

C

D £4m, £3m

£4m, £4m

Profits for firms X and Y at different prices

(a) What is firm Y’s best response to each of the different prices firm X could charge? Does firm Y have a dominant strategy? (b) What is firm X’s best response to each of the different prices firm Y could charge? Does firm X have a dominant strategy? (c) What is/are the Nash equilibrium/equilbria? What is the most likely outcome of this game? Explain your answer. (a) If firm X charges £25, firm Y‟s best response is to charge £20 earning it £6 million in profits as illustrated in cell A. If firm Y sets its price at £15, it makes a lower profit of £4 million as illustrated in cell C. If firm X charges £19, firm Y‟s best response is to charge £15 earning it £4m in profits as illustrated in cell D. If firm Y sets its price at £20, it makes a lower profit of £2 million as illustrated in cell B. Firm Y does not have a dominant strategy as its best response changes depending on what price firm X charges.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

(b) If firm Y charges £20, firm X‟s best response is to charge £25 earning it £6 million in profits as illustrated in cell A. If firm X sets its price at £19, it makes a lower profit of £5 million as illustrated in cell B. If firm Y charges £15, firm X‟s best response is to charge £19 earning it £4m in profits as illustrated in cell D. If firm X sets its price at £25, it makes a lower profit of £3million as illustrated in cell C. Firm X does not have a dominant strategy as its best response changes depending on what price firm Y charges. (c) Having worked out the best responses of each firm we can see that there are two Nash equilibria in the game. These are where (i) firm Y charges £20 and firm X charges £25 in cell A and (ii) where firm Y charges £15 and firm X charges £19 in cell D. It is impossible to say which outcome is the most likely to occur. This would change if players followed a mixed strategy (randomising their actions) instead of following a pure strategy (choosing a particular action with certainty). Mixed strategies are studied in more advanced courses.

2.

Assume that a monopolistically competitive industry is in long-run equilibrium. On a diagram like Figure 8.1(b), show the effect of a fall in demand on a firm’s price and profit in (a) the short run and (b) the long run.

See Diagram 8.1 below. In long-run equilibrium the firm will be making normal profit, with its average revenue curve (AR1) tangential to the LRAC curve. £

AC2 a P1 P2

d

Diagram 8.1 A firm under monopolistic competition

(a) If there is now a fall in demand, shown by AR2, the „profit-maximising‟ output will fall to Q2, where MC = MR2. This will, in fact be a loss-minimising position, with the loss shown by the area abcd (assuming that AC = LRAC). (b) In the long run, firms will leave the industry, and, if this firm manages to survive, it will find that its demand curve (AR) shifts back to the right. Once the demand curve has become tangential to the LRAC curve again, the firm will once more be making normal profit. Firms will stop leaving the industry and long-run equilibrium will have been restored.

3.

In what ways is a monopolistically competitive firm likely to be less efficient than one under perfect competition?

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

In the long run the firm will be operating at the bottom of its LRAC curve under perfect competition.

Under monopolistic competition, however, it will not be operating at the bottom of the LRAC curve: it will be operating to the left of this point where the downward-sloping AR curve is tangential to the LRAC curve (see Figure 8.2 in the text). It is in this sense that there is said to be excess capacity under monopolistic competition. Thus, assuming that the LRAC curve is the same in the two types of market, the firm under monopolistic competition will be selling less, and at a higher cost and hence at a higher price.

The cost of product differentiation means that the LRAC may be greater for a firm in a monopolistically competitive market as opposed to one in a perfectly competitive market. This would make the difference in prices even greater.

In perfect competition P = MC so the outcome is allocatively efficient. In monopolistic competition P > MC so the outcome is allocatively inefficient.

4.

Are there any shops in your area that stay open later than others? If so, does this affect the prices they charge? Why do you think this is?

If they are higher, it could well be because the demand is less elastic in the evenings, when other shops are closed. The shop may well be prepared to lose some business during the day for the sake of higher profits in the evenings.

If they are similar, it could be that other shops (or petrol stations) also stay open late and that therefore there is still considerable competition in the evenings. It could also be due to the shop believing that if it raised its prices, then any increase in profits during the evenings would be more than offset by a decline in profits during the day as a result of a loss in custom to its daytime competitors.

Whether it is profitable for such shops to charge higher prices, therefore, largely depends on the local competitive environment. The less the competition in the evenings, the more likely it is to charge higher prices.

5.

Give three examples of oligopolistic industries. In what ways do the firms in each of these industries compete? Why do they choose to compete in the way that they do?

You should identify the various forms of price and non-price competition. Generally, industries where there are fewer firms will compete less in terms of price and will be more likely to collude (see page 234). Firms will tend to make more use of non-price competition (e.g. advertising) where it is possible to differentiate their product from those of their rivals.

6.

Why, under oligopoly, might a particular industry be collusive at one time and yet highly price competitive at another?

Because the market environment, or the firm‟s assessment of it, may well change. For example, if just one firm in an oligopoly introduces a price cut, the other firms may feel obliged to follow suit, with the result that collusion breaks down. Alternatively, a new firm may enter the market (e.g. a foreign multinational), or costs may change, or rivals develop new varieties of the product, etc.

7.

What is meant by the ‘prisoners’ dilemma game’ when applied to the behaviour of oligopolists? What will determine the outcome of the game?

If oligopolists engage in a price or advertising war, industry profits are likely to fall: thus collusion would seem to be the best strategy. If, however, one firm breaks the agreement (open or tacit) by cutting its price, or launching a new product or an aggressive advertising campaign, it may well gain at the other firms‟ expense. There is thus the temptation to cheat and break the agreement. Knowing this, each firm is afraid that its rivals will cheat, in which case it would be best to cheat itself. Thus cheating may occur with the result that all, or the majority of, firms in the industry lose.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

So this is the dilemma: it is best for firms collectively not to break the agreement, but it may well be in the interest of all firms individually to do so!

This is true if it is a single move game. The outcome could change if the game is repeated. In a repeated game, whatever firms choose to do in any given period could have an impact on the behaviour of its rivals in future periods. Hence if a firm sticks to an agreement in one period it may encourage its rivals to stick to the agreement in future periods. If a firm cheats on an agreement in one period it may encourage its rivals to cheat in future periods. Therefore whatever a firm chooses to do in one period not only influences its profits in that period it also influences its profits in future periods.

Firms are more likely to maintain agreements if (a) they value future profits relatively highly (b) they compete against each other frequently (c) the higher profits from cheating in any given period are relatively small (d) they can very quickly observe that rivals are cheating (e) they are both playing the trigger strategy (f) the end-date of competition is unknown (g) competition policy on cartel behaviour is weak.

If the end-date of competition is known by firms then co-operation is less likely because of backwards induction.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

8.

What three characteristics must a strategic move have if it is to be successful in altering the behaviour of a competitor later in the game.

A competitor muct be able to see and understand the strategic move. With the example given in the chapter, Airbus‟s decision to build a 400-seater plane must be clearly visible to Boeing. The strategic move must also be credible i.e. the move must be irreversible. If the decision is easily reversible then rivals may believe that the firm will not go through with the strategic move at a later date.

9.

Give two examples of price discrimination. What category of price discrimination are they? In what ways do the consumers gain or lose? What information would you need to be certain in your answer?

Some possibilities include: ▪

Cheaper travel prices for particular categories of person (children, students, elderly people). This is third -degree price discrimination: i.e. based on observable characteristics.

▪ On-line vouchers for cheaper entry to tourist attractions/theme parks. This is second-degree price discrimination: i.e. vouchers are available to everyone and consumers are free to choose.

▪ Charging different prices for medicines/drugs in different countries. This is third-degree price discrimination: i.e. based on observable characteristics Supermarkets selling value/economy/own-label versions of products. This is second-degree price discrimination: i.e. all consumers are free to choose whether or not to purchase the value or the standard version of the product. Note that this is only price discrimination if the lower price for the economy/value version of the good cannot be fully accounted for by any lower costs of production.

Generally consumers gain if they buy in the low-price market and lose if they buy in the high-price market. Also price discrimination may enable some sales to take place that would not happen with uniform pricing: i.e. price discrimination enables firms to charge some groups a price below the uniform pricing level.

It could create misallocation effects if some units of the product are re-allocated away from those consumers with a higher willingness to pay to those with lower willingness to pay.

The use of price discrimination, by enabling the firm to make higher profits, may also enable it to compete more effectively with its rivals. This could help consumers if competition thereby increased (e.g. if a firm used price discrimination to enable it to compete more effectively against a powerful rival), but could be against consumers‟ interests if firms used it to drive rivals out of business.

In order to form a judgement, it is necessary to know the extent of the gains and losses to consumers. It is also important to know to what extent differences in prices are the result of genuine price discrimination, rather than merely a reflection of the different costs that firms incur in different markets, or a reflection of a different service. For example, it is not price discrimination to charge a higher price for a better seat on a plane if the higher price can be fully accounted for by the higher costs of of providing the seat. It is only price discrimination if the higher price cannot be fully explained by the higher costs. In other words detailed information would be required on the different costs.

10.

Explain why the rise of e-commerce might increase the number of firms engaging in person-specific pricing.

Person-specific pricing is often a difficult and time-consuming process in traditional markets. Sellers have to try to „size up‟ a customer by individual observation and negotiation. For example, the clothes people wear, the cars they drive and their ethinicity/nationality might indicate something about their willingness to pay. The costs of carrying out this process may be greater than the extra revenue it generates. This might be especially true for a firm that sells a large volume of products.

E-commerce may enable firms to obtain information about individual customers‟ willingness to pay in a more cost-effective manner. For example, whenever people use their smart phones, laptops

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

and tablets to purchase goods, they are providing huge amounts of information to the seller. This is known as „big data‟. If this information can be effectively collected and processed then it could be used by the seller to predict different customers‟ willingness to pay. Some of this big data provides information similar to that observed by sellers in traditional off-line transactions. However, instead of visual clues observed by a salesperson, the firm is able to collect and process far greater quantities of information from the devices that people use. For example, the Internet Protocol (IP) address could be used to identify the geographical location of the customer – whether, for example, they live in a relatively affluent or socially deprived area. The operating system and browser might also indicate something about a buyer‟s income and willingness to pay. The travel website, Orbitz, found that Apple users were 40 per cent more likely to book four- or five-star hotel rooms than customers who used Windows.

The most controversial element to big data is the large amount of individual-level information that exists about the behaviour of customers. In particular, browsing histories can be used to find out (a) what types of goods people have viewed; (b) how long they typically spend on-line; and (c) their previous purchase history. This behavioural information might accurately predict price sensitivity.

Interestingly, although increasingly possible, there has been very little evidence to date that firms are implementing personalised pricing on the internet. One possible explanation is that firms fear a backlash from customers who are deeply opposed to this type of pricing. In a widely cited survey of consumers, 91 per cent of the respondents believed that first-degree price discrimination was unfair.

11.

For a firm to be able to implement a strategy of price discrimination it must be able to prevent re-sale amongst its customers. What factors would tend to make it more difficult for a consumer to resell a good?

The following factors would make it more difficult for a consumer to re-sell a good: ▪ ▪ ▪ ▪ ▪

▪

It is consumed immediately at the time of purchase (e.g. a hair cut) or is highly perishable: e.g. fresh fish.

It is highly personalised: e.g. contact lenses/glasses and plane tickets where personal identification is required to board the plane.

The costs of transporting the good are significant.

There is greater uncertainty about the quality of the product: e.g. medicines – brand names vs. generics.

Thin markets – fewer buyers and sellers in the market make it more difficult for one customer to find other customers for re-sale. Electronic market places, such as Amazon and eBay, may make re-sale easier.

Terms of sale/contracts – the purchase contract might might clearly state that the re-selling of the product by the consumer is illegal and/or any warranties may be non-tranferable: i.e. they are valid only for the first customer who purchases the product.

Answers to End-of-Chapter Questions in Chapter 9 (11th edition)

1.

Assume that a firm faces a downward-sloping demand curve. Draw a diagram showing the firm’s AR, MR, AC and MC curves. (Draw them in such a way that the firm can make supernormal profits.) Mark the following on the diagram: (a) The firm’s profit-maximising output and price. (b) Its sales-revenue-maximising output and price. (c) Its sales-maximising output and price (subject to earning at least normal profit).

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

See Diagram 9.1 below. (a) This is found from the intersection of the MC and MR curves (point a). Price is P1; quantity is Q1. (b) This is found from the point where the MR curve crosses the horizontal axis (point b). As output increases to point b, revenue rises. As output increases beyond point b, MR becomes negative and hence revenue falls. Revenue is therefore maximised at point b. Price is P2; quantity is Q2. (c) This is found from point c, where P = AC. Beyond this, less than normal profit is made. Price is P3; quantity is Q3.

MC

£

AC P1 P2 P3

c a

AR

b Q1

Q2

Q3

Q

MR

Diagram 9.1 Profit maximising (a); sales-revenue maximising (b); sales maximising (c)

2.

Would it be possible for firms to calculate their maximum-profit output if they did not use marginal cost and marginal revenue concepts?

Yes, by estimating the total revenue and total cost at a range of different outputs and finding the output where the gap between the two was the greatest.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

3.

What is meant by the principal–agent problem? Give two examples of this problem that you have come across in your own experience.

Principal–agent theory provides a systematic framework for analysing situations where one person/party (the principal) reaches an agreement with another person/party (the agent) for them to undertake activities/tasks that are beneficial to the principal. Principals prefer agents to carry out the task on their behalf because they neither have the expertise or time to carry out the task themselves. A principal–agent problem can arise in the following circumstances: There is potential for both the principal and agent to be better off from the agreement.

▪ The interests of the principal and agent differ in some way: e.g. the actions required to fulfil the agreement are beneficial to the principal but costly to the agent.

There is asymmetric information. The principal cannot be sure that the agent is truly acting in the principal‟s best interests. It is often because agents are better informed that people employ them in the first place. Without affordable and effective methods to monitor agents‟ performance, they may well be able to get away with carrying out the activity in ways that are not in the principal‟s interest – for example, providing a poor service.

If you employ a builder to alter your house, can you be sure that they will do a good job, given that you are no expert on the quality of building work? If you book a holiday with a travel agent, can you be sure that the holiday will be the same as that described in the brochure? Similar arguments can be made about the service provided by GPs and dentists.

4.

‘A firm will always prefer to make more profit rather than less.’ Do you agree with this statement? Is it compatible with alternatives to the profit-maximising theory of the firm?

On the surface, the statement sounds reasonable: who would prefer less profit to more? On closer examination, however, the statement is ambiguous. If the „firm‟ is defined as its owners, then the statement is probably largely true. Shareholders would normally prefer more profit to less, given that both dividends and share prices directly depend on the firm‟s profits. However, shareholders may prefer to sacrifice short-term profit for the sake of higher profits in the long run. For example, they may be happy to forgo some dividends in order to allow more profits to be ploughed back into investment.

If we define a „firm‟ in terms of its decision makers – the managers – then the statement is much more questionable. It is not always in managers‟ best interests to seek to maximise profits, as Chapter 9 argues. The divorce between the ownership and control of companies means that many of them do not behave as profit maximisers, but rather as sales-revenue maximisers, or growth maximisers, or merely as satisficers of a number of potentially conflicting goals.

5.

A firm under monopoly or oligopoly that aims to maximise sales revenue will tend to produce more than one that aims to maximise profits. Does this conclusion also apply under (a) perfect competition and (b) monopolistic competition, given that there is freedom of entry?

In most cases, no. Given that such firms can only make normal profit in the long run, then if they attempted to produce more than the profit-maximising output, they would make less than normal profit and would have to close down. The only exception would be if such firms were willing to accept a lower than normal level of profit in the long run (for example, if the owners were willing to accept a lower income from their firm for the sake of increased sales).

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

6.

What are the potential costs and benefits of mergers to (i) shareholders; (ii) managers; (iii) customers?

Benefits (i) Increased profits, and hence increased dividends and higher share values. The higher profits could result from economies of scale or increased market power. (ii) A larger organisation may provide greater scope for promotion, and may pay higher salaries. The managers may enjoy the challenges of reorganisation that mergers bring. (iii) The new merged company may provide more effective competition with rivals. The resulting reorganisation may lead to a reassessment of products and a resulting improvement in quality.

Costs (i) Depending on the assessment by investors in the stock market of the likely success of the new merged company, share prices may go up or down. Major shareholders are likely to find their power reduced, as they are now part of a larger body of shareholders. (ii) Job security may be reduced, especially if there is a process of reorganisation after the merger has taken place. Many managers may directly lose their jobs. Others may find the new working environment alien to them, or not like the new individuals they are working for. (iii) The increased market power of the merged company may enable it to charge higher prices. It may also stop producing certain lines, which may upset certain customers.

7.

Why is it difficult to test the assumption that firms seek to maximise long-run profits?

Because the means of achieving higher profits in the long run are debatable, given the uncertainties about future market conditions, product developments and production methods. Thus what turns out to be unprofitable could have been embarked on with the intention of maximising long-run profits. On the other hand, what turns out to be highly profitable could have been adopted more by chance than good judgement or in order to meet other objectives.

Rather than looking at profit outturns, an alternative would be to interview the decision makers to establish their motives. This may be a better way of establishing whether the decision makers were attempting to maximise long-run profits. But even this method is highly unreliable, given that managers may give dishonest, or unthinking answers to questionnaires. Even if it could be established that managers did seek to maximise long-run profit, this does not help a great deal in predicting firms‟ behaviour, given that one manager‟s judgement about how to set about maximising long-run profit may be very different from another‟s, as may his or her view as to what constitutes the „long run‟: is it two years, five years, ten years...?

8.

Do behavioural theories of the firm allow us to make any predictions about firms’ prices and output?

Not precise predictions. They can, however, by focusing on the decision-making process and the various constraints and objectives under which decisions are made, enable broad predictions to be made. For example, a firm with a dominant sales department and which is making supernormal profit (and thus might be seen by managers as having some „slack‟) is likely to cut prices and increase advertising in order to increase sales.

9.

Are special offers likely to benefit consumers?

They may do, but probably only if the consumer is able to ensure that s/he is not „bounced‟ into buying something simply because it is on special offer for a limited time. We saw in Box 8.8 that behavioural economists have identified that a state of excitement can induce consumers to deviate from rational behaviour. Many of us can testify to this, citing as evidence unused purchases, hastily made in the January sales. Despite this, if a special offer reduces the price of a good which would have been bought anyway, or if it allows a consumer to buy a different (and preferred) bundle of goods, there will be a gain in utility.

Answers to End-of-Chapter Questions in Chapter 10 (11th edition) 41

Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

1.

The wage rate a firm has to pay and the output it can produce varies with the number of workers as follows (all figures are hourly): Number of workers

1

2

3

4

5

6

7

8

Wage rate (ACL) (£)

3

4

5

6

7

8

9

10

Total output (TPPL)

10

22

32

40

46

50

52

52

Assume that output sells at £2 per unit. (a) Copy the table and add additional rows for TCL, MCL, TRPL and MRPL. Put the figures for MCL and MRPL in the spaces between the columns. (b) How many workers will the firm employ in order to maximise profits? (c) What will be its hourly wage bill at this level of employment? (d) How much hourly revenue will it earn at this level of employment? (e) Assuming that the firm faces other (fixed) costs of £30 per hour, how much hourly profit will it make? (f) Assume that the workers now formed a union and that the firm agreed to pay the negotiated wage rate to all employees. What is the maximum to which the hourly wage rate could rise without causing the firm to try to reduce employment below that in (b) above? (See Figure 10.10.) (g) What would be the firm’s hourly profit now? (a) See the following table: Number of workers

1

2

3

4

5

6

7

8

ACL (£)

3

4

5

6

7

8

9

10

TCL (£)

3

8

15

24

35

48

63

80

5

MCL (£)

7

9

11

13

15

17

TPPL (units)

10

22

32

40

46

50

52

52

TRPL (£)

20

44

64

80

92

100

104

104

MRPL (£)

24

20

16

12

8

4

0

(b) 5 workers. Employing a fifth worker adds £12 to the firm‟s total revenue (MRPL = £12), but only £11 to total cost (MCL = £11). It is thus profitable for the firm to employ the fifth worker.

Employing a sixth worker, however, is not profitable. The sixth worker would add £13 to costs but only £8 to revenue. (c) £35. (d) £92. (e) Total cost will be £35 + £30 = £65. The firm thus makes an hourly profit of £92 – £65 = £27. (f) A fraction under £12 (= MRPL at the profit-maximising employment). So long as additional workers add at least £12 to the firm‟s revenue – as they do up to 5 workers – they will be profitable to employ. At a wage rate fractionally below £12, if the firm were to reduce employment below 5 workers, it would lose more in revenue than it would save in wages. (g) Total cost is fractionally under £90 (i.e. £30 fixed costs plus fractionally under £60 in wage costs).

Total revenue is still £92. The firm thus makes a total hourly profit of just over £2.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

2.

If a firm faces a shortage of workers with very specific skills, it may decide to undertake the necessary training itself. If on the other hand it faces a shortage of unskilled workers it may well offer a small wage increase in order to obtain the extra labour. In the first case it is responding to an increase in demand for labour by attempting to shift the supply curve. In the second case it is merely allowing a movement along the supply curve. Use a demand and supply diagram to illustrate each case. Given that elasticity of supply is different in each case, do you think that these are the best policies for the firm to follow? What would happen to wages and economic rent if it used the second policy in the first case?

In the first case (skilled workers), the supply curve is less elastic. A rightward shift in demand would mean that the firm would have to give a substantial rise in wages (the second policy) in order to attract sufficient workers from outside. As a result, existing workers would now earn wages considerably above the level of transfer earnings: this would be economic rent. Thus it may be profitable for the firm to undertake the expense of training itself to avoid having to pay these high wages. There is a danger, however, that once it has trained its workers, their transfer earnings will increase: i.e. they could now get a higher wage elsewhere. The effect would be a vertical shift in the supply curve, and the firm may end up having to pay the higher wages anyway.

In the second case (unskilled workers), supply is more elastic: workers can readily transfer from and to other jobs. Thus a rightward shift in demand will only lead to a relatively small rise in wages.

If it used the second policy (of offering a wage rise) in the first case (that of a shortage of skilled workers), the wage rise is likely to have to be substantial in order to recruit the necessary extra labour (imagine that the demand curve has shifted to the right in the diagram in Case Study 10.1 on the student website). Thus both transfer earnings and economic rent will rise. The less elastic the supply of labour, the higher the rise in wages will have to be and the more it will represent a rise in economic rent.

3.

Why do the world’s top footballers earn millions of pounds per year, while the top lacrosse players are paid less than the equivalent of £30 000?

Because of differences in the extra revenue earned from the output of additional workers (MRPL = MPPL  MRgood) in the two industries. Marginal revenue depends on the market for that good. The higher the marginal revenue of the good, the higher will be the marginal revenue product. Football players generate a much higher marginal revenue for their clubs than lacrosse players because both gate receipts and the income from the sale of media rights to broadcast football matches on television are much higher than from lacrosse games.

4.

For what reasons is the median hourly wage rate of women some 16 per cent lower than that of men in the UK, and the average gross weekly pay, including overtime, more than 21 per cent less?

See the reasons given in Box 10.7: „The persistent gender pay gap‟

5.

Given the analysis of bilateral monopoly, if the passing of minimum-wage legislation forces employers to pay higher wage rates to low-paid employees, will this necessarily cause a reduction in employment?

No. Referring to Figure 10.10, if the legislation forced employers with monopsony power to pay a wage rate between W1 and W2, employment would actually be greater! The reason is that employers no longer have the incentive to reduce employment to keep wage rates down: they have to pay the minimum wage rate.

If, however, the minimum wage rate were above W2, then, other things being equal, employment would be reduced (below Q1). Other things may not be equal, however. Given that the minimum-wage legislation applies to all firms, employers are more likely to be able to afford to employ people on the new minimum wage rate since their competitors are having to do the same. Although the price of goods produced using a high proportion of low-paid workers would rise relative to those using more highly paid workers, and although this would lead to some decline in the consumption of such goods,

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

at least firms using low-paid workers would know that their direct competitors would also be raising their prices too.

6.

Using a diagram like Figure 10.13, demonstrate what will happen under perfect competition when there is an increase in the productivity of a particular type of capital. Consider the effects on the demand, price (rental rate) and quantity supplied of the services of this type of capital.

In diagram (a) in Figure 10.13, the MRPK curve will shift upwards to the right. In diagram (b), the demand curve will shift to the right and cause the rental rate (Re) to rise. In diagram (c) the rise in the rental rate gives an upward shift in the D line. This will cause a movement up along the S curve to a new equilibrium at a higher output of capital services.

7.

What factors could cause a rise in the market rate of interest?

▪

▪

8.

An increase in the demand for loanable funds. This could be due to a general rise in confidence by investors that the economy is going to expand, or to a worry that prices are going to rise and therefore a desire to borrow money to buy now before prices do rise.

A reduction in the supply of loanable funds, because of a reduction in saving. This could be due to people believing that their jobs were more secure and/or that their incomes were going to grow. In such circumstances they may decide to spend more of their current income (and save less). It could also be due to a rise in taxes, leading to some people cutting down on the amount they save. Or it could again be the result of a worry that prices are going to rise: people draw on their savings in order to buy more.

How is the market price of land related to its productivity?

By the formula: P = R/i where P is the price of land, R is the rent per year and i is the market rate of interest. Since the amount people are prepared to pay in rent will vary with the productivity of the land (see Figure 10.16), the higher the land‟s productivity, the higher will be its market price.

In recent years there have been a number of changes in planning laws to make it easier for commercial properties to be converted to housing. What would be the impact on property values?

This will increase the price elasticity of supply of both commercial property and housing more, as property can be converted from one use to the other according to prices and profitability. The effect will be to pivot the supply of housing to the right above the price level where it becomes profitable to convert commercial property. If this is above the current level, then the effect will be to reduce the price of housing.

This is illustrated in Diagram 10.1.

The initial supply curve of housing is given

by S1. Above P0, it becomes profitable to convert commercial property to housing.

The supply curve pivots from S1 to S2. The P1 effect is to reduce the price of housing from P 2 P1 to P2.

P0 The pivot point will depend on the profitability in both markets. Thus if the demand for commercial property rises, the pivot point will move upwards along curve S1 in the diagram. In other words, if commercial property rises in price, there would need to be a correspondingly higher Quantity of housing on market Price

9.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

price of housing to make the conversion of commercial property profitable.

Answers to End-of-Chapter Questions in Chapter 11 (11th edition)

Using the data shown on the pie charts in Figure 11.1, construct two Lorenz curves (on the same diagram), corresponding to the before- and aftertax income figures. Interpret and comment on the diagram you have drawn.

The unequal distribution of income in the UK can clearly be seen by the considerable „bowing‟ of the two curves in Diagram 11.1. The effect of taxes and benefits, however, is to reduce this inequality: the after taxes and benefits curve is less bowed than the before taxes and benefits curve.

2.

100

Percentage of national income

1.

80

60

and benefits

40

and benefits

20

0

0

20

40

60

80

100

Percentage of population

Can taxes be used to relieve poverty?

A reduction in taxes on the poor can go Diagram 11.1 Lorenz curves a small way to helping relieve poverty, but given that the poor pay little in the way of direct taxes and that it is difficult to target reductions in indirect taxes on the poor, any relief is bound to be very limited. Of course, the revenues raised from taxing those who are not poor can be used for providing benefits to the poor – both cash benefits and benefits in kind. In that sense, therefore, taxes can be used to relieve poverty

3.

In what ways might the views of different politicians on what constitutes a ‘good’ tax system conflict?

Politicians on the left are likely to stress the importance of vertical equity, arguing that the rich ought to be taxed substantially more than the poor. Politicians on the right are more likely to stress the benefit principle. Clearly these two objectives are likely to be conflicting. Most politicians would agree, however, that taxes ought to be horizontally equitable, cheap to collect, difficult to evade, nondistortionary, convenient to the government and to the taxpayer and should have minimal disincentive effects. This last objective, however, may conflict with the objective of vertical equity, if it is argued that it is vertically equitable to have steeply progressive taxes.

4.

Distinguish between proportional, progressive and regressive taxation. Could a progressive tax have a constant marginal rate?

A progressive tax is defined as one whose average rate with respect to income rises as income rises. It is possible for this to happen even when the marginal rate is constant. For example, if people can earn a certain proportion of their income tax-free, and above that pay at a constant marginal rate, then the average rate will go on rising as income rises because the tax-free element will account for a smaller and smaller proportion of the total. This is illustrated in Figure 11.11: the average rate of income tax in the UK in 2020/21 went on rising throughout the range of incomes above the point where people

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

started paying the basic rate of 20 per cent.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

5.

Consider the cases for and against a poll tax.

There are very few arguments in favour, as became clear in the considerable public debate in the UK when a poll tax was introduced by the Conservative government as the form of local taxation in Scotland in 1989 and in England and Wales in 1990. The government at the time argued that it should be seen as a charge for local services (it was called the „community charge‟) and would make local councils more obviously accountable to their constituents. The benefits principle was used as a justification for regarding it as a charge. Since we all benefit from local services, we should all contribute equally. The argument can be extended to the use of other flat charges, such as licence fees (e.g. UK TV licences).

The arguments against are substantial. The prime objection is that a poll tax is highly regressive.

The poorer you are, the more you have to pay as a proportion of your income. For this reason, poll taxes can be highly divisive socially, and can lead to civil disobedience. What is more, in most cases they do not even conform to the benefits principle: people have to pay the same amount of tax, however much or little they make use of the services the tax is supposed to finance.

6.

Under what circumstances would a rise in income tax act as (a) a disincentive and (b) an incentive to effort?

A rise in income tax has an income and a substitution effect. Higher taxes reduce people‟s incomes: this is the income effect. Being poorer they have to work more to make up for some of their lost income. The income effect, therefore, makes income tax increases an incentive to work more. Higher taxes, however, also mean that work is worth less than before, and therefore people might well substitute leisure for work: there is no point in working so much if you bring home less. This is the substitution effect, and makes income tax increases a disincentive. (a) If the substitution effect is bigger than the income effect, then a rise in income tax will act as a net disincentive to work. A shown in the text, is likely for those people with few commitments and for second-income earners in families where the second income is not relied on for „essential consumption‟. It is also likely for those who are only currently paying a small amount of tax, and for whom, therefore, the income effect is likely to be small; and also for those just in a higher tax bracket when that higher tax rate is raised. (b) If the income effect is bigger than the substitution effect, a rise in tax will act as a net incentive.

This is most likely for those currently paying a large amount of tax and who would suddenly be faced with a substantial increase in their tax bill. It is also likely if the tax increase takes the form of a cut in tax allowances. Except for those having to pay tax for the first time, or those pushed into a higher tax band, cutting allowances has no substitution effect since it does not alter the marginal rate.

7.

What is meant by ‘the poverty trap’? What design of benefit system would offer the best solution to the problem of the poverty trap?

This is when poor people have little or no incentive to get a job, because the combined effect of paying taxes and losing benefits would make them virtually no better off than before (or even worse off).

Universal benefits would help because, not being means tested, they would not be lost as a person‟s income increased: the marginal tax-plus-lost-benefit rate would be lower. The problem is that they are less narrowly targeted, and therefore are paid to people who are less needy. This means that it costs the taxpayer a lot more to help the poor through universal benefits than through means-tested ones. The result would be either less help for the poor or higher taxes (which could themselves act as a disincentive). Thus a mix of moderate universal benefits plus additional help targeted to those in need is

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probably the best compromise.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

8.

How would you go about deciding whether person A or person B gets more personal benefit from each of the following: (a) an electric fire; (b) a clothing allowance of £x; (c) free higher education; (c) child benefit? Do your answers help you in deciding how best to allocate benefits?

You would have to have information about their personal circumstances (e.g. their current income, the size of the rooms in which they live, the state of repair of their accommodation). This could be obtained from questionnaire information, interviews, home visits, etc. These investigations may provide some guide as to the different needs of different people, but the problem with all these forms of means testing are that they are personally intrusive, provide incomplete information and may miss people who require help.

9.

Just under two million pensioners were identified as living in poverty in the UK in 2020. In the same year it was estimated that total property wealth of pensioner households had grown to a record high of £1.133 trillion. What does this imply about inequality and poverty?

There are at several possible explanations to this. The first is that there is substantial inequality amongst pensioner groups, as well as between pensioners and younger age groups. Much of this will be due to educational differences, subsequent work history and property ownership. In the 1950s and 1960s a relatively small percentage of the population went to university. Many of these went on to earn much more than average income, to buy property and to enjoy generous pensions. In fact, even amongst those who did not go into higher education, there will be a high proportion who have enjoyed steady work, bought houses and have been able to save for their old age. Others, however, may have had an erratic work history, suffered periods of ill health and have lived in rented housing all their lives. It is highly likely that they will be living in poverty. Regional differences may also play a role here; property values have increased sharply across the UK since the 1980s, but particularly so in the south-east of England.

A further factor may be that the figures are measuring two different concepts. Under current definitions, poverty is a measure of relative income, while housing equity is a major component of wealth. Thus an older person living in their own house, but dependent on the state pension and other benefits, could both be „in poverty‟ and have housing equity. th

Answers to End-of-Chapter Questions in Chapter 12 (11 edition) 1.

Assume that a firm discharges waste into a river. As a result, the marginal social costs (MSC) are greater than the firm’s marginal (private) costs (MC). The following table shows how MC, MSC, AR and MR vary with output.

Out put

1

2

3

4

5

MC

23

21

23

25

27

MSC

35

34

38

42

TR

60

102

138

AR

60

51

MR

60

42

6

7

8

30

35

42

46

52

60

72

168

195

219

238

252

46

42

39

36.5

34

31.5

36

30

27

24

19

14

(a) How much will the firm produce if it seeks to maximise profits? (b) What is the socially efficient level of output (assuming no externalities on the demand side)? (c) How much is the marginal external cost at this level of output?

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

(d) What size tax would be necessary for the firm to reduce its output to the socially efficient level? (e) Why is the tax less than the marginal externality? (f) Why might it be equitable to impose a lump-sum tax on this firm? (g) Why will a lump-sum tax not affect the firm’s output (assuming that in the long-run the firm can still make at least normal profit)? (a) 5 units. This is the output where the firm‟s marginal revenue equals its marginal (private) cost. (b) 4 units. This is the output where price (AR) equals marginal social cost. (c) £17. Marginal external cost is marginal social cost minus marginal private cost (= £42 – £25). (d) £5 per unit of output. This would raise the firm‟s MC by £5. At 4 units of output the firm‟s marginal cost would now be £30, which would be equal to its marginal revenue. (e) Because the firm has market power: it faces a downward-sloping AR curve. This means that its MR is below the price (AR). At 4 units of output (the social optimum), MR is £12 lower than AR. Since the firm, in order to maximise profit, equates MC with MR and not AR, the tax needs to be £12 lower than the marginal externality: i.e. £5, not £17. (f) Because the firm is not paying the full amount of the externality that it is imposing on society and could thus be argued to be making excessive profit at society‟s expense. A lump-sum tax can remove this excessive profit. (g) Because it is a fixed cost and thus does not affect the firm‟s marginal cost. Therefore it does not affect the profit-maximising output: it simply reduces the amount of profit at that output.

2.

Why might it be argued that a redistribution of consumption, while not involving a Pareto improvement, could still be desirable?

Because it is considered that the gains to the beneficiaries outweigh the costs to the losers. Clearly this will involve judgements on the part of the government or other decision makers as to the relative size of the gains and losses to the people affected, and will involve making inter-personal comparisons of utility: something that is virtually impossible to do in an uncontroversial way.

Frequently such decisions are motivated primarily by issues of equity rather than efficiency. For example, the redistribution of income from the rich to the poor through the tax and benefit system is justified on these grounds. They certainly do not involve a Pareto improvement.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

3.

Assume that a country had no state education at all. For what reasons might the private education system not provide the optimal allocation of resources to and within education?

Virtually all the categories of market failure (except public goods) apply to a free-market system of educational provision.

▪ ▪ ▪ ▪ ▪ ▪

4.

In any given area there may oligopolistic collusion to keep fees high.

There are positive externalities from education: for example, the benefits to other members of society from a well-educated workforce. Thus too few resources would be allocated to education.

Education can be seen as a merit good: something that the government feels that people are entitled to and should not depend on ability to pay.

Access to education would depend on parents‟ income: this could be argued to be unfair.

Children would also be dependent on their parents‟ willingness to pay. Parents differ in the amount that they care for their children‟s welfare.

Parents and potential students may be ignorant of the precise benefits of particular courses, something that unscrupulous educational establishment might exploit, by pushing the „merits‟ of their establishment.

Why might it be better to ban certain activities that cause environmental damage rather than to tax them?

When the potential costs are significant, banning can be a simple and straightforward solution and often the decision can be taken quickly.

5.

Distinguish between publicly provided goods, 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 nonexcludability. 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 one that the government feels 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.

6.

Consider the advantages and disadvantages of extending property rights so that everyone would have the right to prevent people imposing any costs on them whatsoever (or charging them to do so).

The disadvantages would outweigh the advantages. The advantages would occur when there were relatively few people involved – culprits and sufferers, and where it was legislatively or administratively simple to seek redress (for example by calling in a government agency, such as health and safety officers, to enforce the law).

The disadvantages would be several: ▪

▪ ▪

There is the practical question of how to enforce your rights when there are many people imposing small costs on you: you cannot take them all to court. It depends here on how law abiding people are, and how respectful they are of other people‟s property. Also, if you need to take civil action to enforce your rights, it can be very costly, especially if you lose.

If the sufferers disagree about the nature of the problem, then what should be done?

Then there is the fundamental problem of where property rights should be drawn. If you live next door to me and play your music and I don‟t like it, should I be able to prevent you doing so? If so, my preventing you from imposing costs on me is directly imposing costs on you! Should I have the right not to be disturbed and you have the right to play your music in your own home? Clearly the two are incompatible.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

▪

7.

If existing property rights are strengthened, then those with a lot of property will gain at the expense of those with little.

The food industry provides a great deal of information about its products. Why, despite this, does the government run various campaigns about healthy eating?

The information provided by the food industry tends to fall into one of two categories. The first relates to advertising; while this is legally obliged to be truthful, it will inevitably involve marketing the food in an attractive manner in order to increase demand. Secondly, government legislation requires the provision of a variety of nutritional information. However, this will always relate to an individual foodstuff. For example, the UK Department of Health introduced a voluntary traffic light labelling scheme in 2013 with red, amber and green used to signify how much salt, sugar and fat is contained in the product. Since our health does not depend on consumption of any one foodstuff, but rather on our overall diet, there remains a role for government in the provision of general advice.

8.

Should all investment be subject to a social cost–benefit appraisal?

No. It depends on whether the benefits of conducting the appraisal outweigh the costs of doing so! In many cases, there is sufficient existing knowledge to be able to make an informed decision. The problem with CBA is that it can be costly and time-consuming.

9.

Make out a case for (a) increasing and (b) decreasing the role of the government in the allocation of resources.

Arguments for (a) are contained in section 12.2; arguments for (b) are contained in section 12.5.

Answers to End-of-Chapter Questions in Chapter 13 (11th edition) 1.

Assume that as traffic density increases along a given stretch of road, there comes a point when traffic begins to slow down. The following table gives the times taken for a car to travel the stretch of road (in minutes) according to the number of cars entering the road per minute.

Cars entering the road

5

6

7

8

9

10

11

Journey time

10

10

11

13

16

22

30

(a) Copy out the table and add the following rows: (i) total journey time for all cars; (ii) extra journey time as traffic increases by one more car (marginal social time cost); (iii) additional time cost imposed on other road users for each additional car entering the road (marginal external time cost). (See Table 13.3 in the text.) (b) Assume that time is valued at 10p per minute. On a graph, plot the marginal private time cost (journey time) and the marginal social time cost. (c) Assume that electronic road pricing is introduced. What charge should be levied when traffic density reaches (i) 6 cars per minute; (ii) 8 cars per minute; (iii) 11 cars per minute? (d) What additional information would you need in order to work out the socially efficient traffic density on this particular stretch of road? (a) (1) Cars entering the road

5

52

6

7

8

9

10

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(2) Journey time

10

10

11

13

16

22

30

(3) Total journey time (1)  (2)

50

60

77

104

144

220

330

(4) Marginal social time cost (3)

10

17

27

40

76

110

(5) Marginal external time cost (4) – (2)

0

6

14

24

54

80

Row 2 shows the marginal private time cost: in other words, the time taken for the individual to travel along the stretch of road. (i)

The total journey time for all cars is simply the sum of the journey times of all the individual motorists using the road: row 1 multiplied by row 2.

(ii) The extra journey time for all users as one more person uses the road is the private time cost of the new user plus the extra journey time (as a result of increased congestion) for existing users.

This is the marginal social time cost and is given by the extra time in row 3 as each extra car uses the road. (iii) If the time taken by the new person joining the road (i.e. that person‟s private time cost) is subtracted from the marginal social time cost (row 4 minus row 2), we have the marginal external time cost: i.e. the additional cost imposed on other road users by one more car using the road. (b) See Diagram 13.1 on next page. The curves are constructed from rows 2 and 4 in the table on the

previous page. (c) The charge should be equal to the marginal external cost. This will then mean that individual

travellers are paying the marginal social time cost. (i) No charge (ii) £1.40 (iii) £8 (d) You would need to know

MSC

the other externalities, such as pollution and costs to pedestrians. A monetary value would then have to be put on these externalities, and then this would have to be added to the charge to produce the socially optimum traffic flows.

2.

MC

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 Diagram 13.1 Marginal private and social time costs 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 could reflect local conditions if the rates varied from one location to another. This could be

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achieved either by having local effluent charges, levied, say, by a local authority. Or you could have national taxes in two or more bands, depending on the location of the factory, with factories in the densest populated areas being in the highest band. 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. They are claimed to have advantages of both green taxes and controls. The control element gives the security that pollution will be reduced to a specified level (assuming that the permit system is enforced), while the trading element leads to an efficient achievement of the pollution reduction target. 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.

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3.

Make out a case from a deep green perspective for rejecting the ‘social efficiency’ approach to the environment.

The social efficiency approach is essentially human orientated. The thrust of the approach is that the environment is a resource and should be efficiently used in achieving social and economic goals, with externalities being taken into account. But these externalities are primarily, if not wholly, the external effects of people‟s actions on other people. They are generally not seen as externalities to the human race: saving the environment is primarily about saving it for ourselves and our children. Deep green environmentalists would argue that the environment is valuable in itself, irrespective of humans. They would argue that we have no moral right to despoil it. Thus they would see the social efficiency approach as ultimately selfish (for humans as a whole) and immoral.

4.

Why might efforts to address the issue of global warming be hampered by a lack of understanding of probability amongst the general public?

If outcomes of current emissions (e.g. a given percentage rise in global temperatures by a certain date) are not absolutely certain, which of course they will not be, then people may dismiss them as „unlikely‟. In other words, people may be overly optimistic. This could be partly that people are risk lovers, partly that people do not trust forecasts and partly that people believe that there is a built-in tendency for experts to exaggerate the adverse effects of forecast outcomes. Research by behavioural economists also suggests that as well as overestimating the likilhood of low probability events people underestimate the likihood of high probability events. Thus even when experts assign a relatively high probability value to an adverse outcome, people may dismiss or underestimate it.

5.

In 2007 China overtook the USA as the world’s largest emitter of CO2. Yet USA per capita emissions are three times that of China. What issues arise from this in the formulation of a global policy to reduce CO2 emissions?

The fact that the world‟s two largest emitters are at such different stages of development makes it hard to agree on a common global approach to cutting back on emissions. The USA might well argue that all countries need to make similar cutbacks. China would object, however, arguing that the USA has a much higher level of emissions per head. China would prefer the high per-capita polluters to make much bigger cutbacks. The issue is one of the global distribution of emissions reduction. Even if countries agree on the necessary total size of reductions, most countries would prefer to make relatively small reductions while others make relatively large ones, and will find arguments to support their position.

6.

Make out a case for adopting a policy of individual tradable carbon permits, allocated to all citizens within a country. Could such a policy be extended globally?

In principle, this may be an efficient way of allocating carbon. One method would be for everyone to be allocated a certain number of credits. They could then sell surplus ones, or buy additional ones if they wanted more. This buying and selling could take place through agencies. An alternative would be for people not to be given permits but to have to buy them. In both cases, the price would be determined by demand and supply, where the total supply of permits is fixed by the government to reflect its target level of emissions.

In either scheme, because people have to pay to emit, there is an incentive to cut emissions.

Also, permits will end up being allocated to those willing to pay the most for them. There are three issues, however, with individual tradable permits. The first is the administrative one. How do the costs of operating such a scheme compare to other schemes, such as the use of carbon taxes or using regulation to limit the permitted amount of emissions from cars, factories, power stations, etc. The second is the question of distribution. People may argue that it is unfair that richer people will be able to afford more permits. But, of course, this is little different from any other good that is sold; the rich 55

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can afford more. Also, under a system of free allocation, poor people will be given something that they could sell to the rich. The third is how allocation of permits would take place under a free system. Is everyone given the same allocation, or would allocation depend on needs, in which case there could be a complicated and expensive system of means testing.

Whether such a scheme could be extended globally depends on how serious the above issues were perceived to be by various countries. Politically it could be difficult to reach international agreement requiring countries to adopt such a system.

7.

Compare the relative merits of increased road fuel taxes, electronic road pricing and tolls as means of reducing urban traffic congestion.

Increased road fuel taxes have the advantage of being simple and virtually costless to administer, given that fuel taxes are already used. This policy also has the political advantage of not involving the introduction of a new form of tax or charge – something that could prove unpopular with the electorate.

The main problem is that fuel taxes increase the costs of all motoring whether or not it causes congestion.

People living in the countryside and who cause little congestion could well feel aggrieved by having to pay substantially higher fuel taxes.

Tolls can be used on roads subject to congestion and could be varied with the time of day. Automatic toll booths are relatively cheap to administer. Nevertheless, the use of tolls is impractical in city areas where there are many alternative routes that people could use. Tolls on some roads may simply have the effect of diverting traffic, and hence congestion, to roads where there are no tolls. What is more, toll booths can cause tailbacks of traffic from the booths at peak times.

Electronic road pricing through the use of smart cards in cars or centralised debiting is the most sophisticated of the three methods and can be directly targeted to relieving congestion by varying the charge according to the degree of congestion. What is more, with roadside sensors or overhead gantries the traffic does not have to slow down in order for the charge to be made. New global satellite systems would remove the need for overhead gantries and might make it possible to alter the size of the charge with the length of congested road travelled along. Nevertheless, such systems are expensive to install and could prove highly unpopular politically.

In all three cases there is the problem that demand may be insensitive to a rise in charges, and therefore the charge might have to be very high to have a significant impact on traffic: something that could cost a government (central or local) the next election! Demand would be more elastic if there were closer substitutes to private motoring. Part of the answer to traffic congestion, therefore, is to make demand more elastic by improving public transport and making it a more attractive alternative to the car, for example by introducing park-and-ride schemes or light rail systems.

8.

Why is the price inelasticity of demand for private car transport a problem when formulating a policy for the reduction of traffic congestion? What could be done to change the price elasticity of demand in a desirable direction?

The demand for private car transport tends to be relatively price inelastic. For example, various studies of the price elasticity of demand for petrol and diesel give a value somewhere between –0.1 and –0.4 in the period up to a year. The main determinant of price elasticity of demand is the number and closeness of substitutes. For many people, there is no alternative to using their car. For example, commuters not living on a bus route and living too far from work to walk or cycle will be forced to use their car for getting to work. If travelling is made more expensive through road pricing, higher road fuel taxes, parking charges, etc. the price inelasticity of demand may result in little reduction in congestion.

If congestion is to be reduced through pricing, it is important also to make demand more price elastic through the provision of more, closer and cheaper substitutes, such as more and cheaper public

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transport, building cycle lanes in cities and employers providing more opportunities for working from home and staggering working times.

9.

How would you set about measuring the external costs of road transport?

External time costs could be estimated in minutes by observing the effects of increased traffic on journey times. Minutes would then have to be converted to monetary values. This could be done by observing how much people were prepared to pay to save time (see Case Study 13.6 on the student website).

External accident costs could be measured by estimating the costs of treatment of accident victims, their loss of earnings and the amount they would be prepared to pay to avoid accidents. The problem here is that the costs of accidents involving richer people, especially those in work, would be given a higher value than those involving poorer people. Also there is the problem of estimating the cost of a human life something that raises a whole range of issues as to whether different people are worth different amounts according to their earning capacity, the number of family dependent on them, their age and life expectancy, etc. (see Box 12.5).

Pollution costs are extremely difficult to measure, given the uncertainties over the amounts and effects of pollution. Nevertheless, some idea of costs can be gained by estimating the amount that people are prepared to pay to avoid pollution. This is a complex issue, however, since the effects of pollution may build up over time and thus have long-term effects. This raises the whole question of sustainability and how the environment ought to be valued. For example, many in the ecological movement would argue that the environment is not just for human use, and therefore pollution should be costed not simply in terms of its effects on people.

10.

Many London councils now have residents’ street parking permits, with charges that vary according to the carbon emissions of the registered vehicle. Explain the thinking behind this policy.

There are several issues relating to private car ownership that concern the authorities in London. These include congestion (which is addressed by the Congestion Charge), pollution and the tendency for those living outside the capital to drive in and park in residential areas. Street parking permits used to be issued with a standard charge for any car. While this addressed the problem of non-residents trying to park, it had a limited impact on pollution resulting from residents‟ cars. The introduction of charges that vary with carbon emissions allow a single policy to address two specific problems.

11.

Since 2008, the UK government has provided free off-peak bus travel for the over-60s in England and Wales. What do you think the impact of this policy has been on car usage? Is there a case for extending the policy to (a) bus travel for pensioners at all times of the day, as is the case in Scotland (b) bus travel for all?

The measure was introduced largely for distributive purposes (i.e. increasing mobility for older people), rather than as a means of reducing congestion. To the extent that working people over 60 have thereby been persuaded to use buses to travel to work, there may have been some reduction in congestion, although in most parts of England and Wales passes can be used only after 9:30am. People over 60 with cars are likely to have a relatively low price elasticity of demand and thus may still prefer to use their cars, given the obvious convenience. Those without cars who now use buses more do not thereby contribute to a reduction in congestion as the additional bus journeys are not offset by fewer car journeys.

If the scheme were extended to bus travel at all times of the day, this may encourage more working people over 60 to commute by bus and thus make more contribution to reducing congestion in the morning rush hour (and hence the evening one too). Free bus travel for all could make a substantial contribution provided there were enough buses and an extensive network of routes. Of course, this

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would put considerable demands on public funds to provide the buses or to subsidise private companies to do so.

12.

In 2010 the number of air passengers using UK airports fell by 3.4 per cent compared with 2009. In 2015, passengers were 5.5 per cent up compared with 2014. Can we deduce anything about people’s attitude to the environment and their behaviour from these data?

If we looked at the 2010 figures in isolation it would be tempting to draw the conclusion that people were flying less due to concerns over the environment. In fact the 2015 figures highlight the danger of drawing conclusions from small amounts of data. Unless we believe that attitudes to the environment hardened between 2010 and 2015, we have to look for alternative explanations. In 2010 these might have included a downturn in demand caused by the recession, outstanding weather at home, leading to more people holidaying at home, or a strengthening of the pound, resulting in fewer overseas visitors.

Conversely all, or some, of these factors may have reversed in 2015, giving rise to the increases seen.

In order to identify the impact of individual factors, we could carry out multivariate time-series analysis, using data on air passengers, incomes, weather, currencies, etc., over a number of years.

Answers to End-of-Chapter Questions in Chapter 14 (11th edition)

1.

Should governments or regulators always attempt to eliminate the supernormal profits of monopolists/ oligopolists?

No. If the barriers to competition are not total, then supernormal profits may have the important role of attracting new competitors into the market. Even if there are significant barriers to entry, supernormal profits might not necessarily be a sign of the exploitation of market power (higher revenue): they might arise from increased efficiency (lower costs). To eliminate all supernormal profits through regulation could discourage firms from operating more efficiently and from innovating. It is for these reasons that regulation in the UK has been based on an RPI – X formula: the aim being to permit only those supernormal profits that arise from internally generated cost reductions.

2.

Compare the relative merits of banning certain types of market structure with banning certain types of market behaviour.

Banning certain types of market structure is a blunt weapon. For example, not all monopolies and oligopolies necessarily act against the interests of consumers. For this reason most countries prefer to focus on controlling or banning undesirable forms of behaviour: e.g. predatory pricing. There are two broad approaches to controlling behaviour. The first is to consider only those firms falling within a certain market structure (e.g. firms with more than a quarter share of the market, or firms operating a cartel) and then to prevent behaviour of certain types or behaviour deemed to be against the public interest. This has been the approach in the UK. The alternative is to focus purely on behaviour, without first referring to market structure.

3.

Consider the argument that whether an industry is in the public sector or private sector has far less bearing on its performance than the degree of competition it faces.

Evidence suggests that this is largely true. Monopolies, whether public or private, if not contestable are often inefficient and insensitive to consumers‟ wishes.

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4.

If two or more firms are charging similar prices, does this imply that collusion is taking place? What evidence would you need to determine the existence of collusion?

In highly competitive markets, firms will charge very similar prices for similar goods (assuming cost conditions are similar). In the extreme case, under perfect competition the price will be the same for all firms – they each have to accept the market price. Thus firms charging similar prices does not necessarily imply collusion – it could simply be the result of fierce competition.

To establish, then, whether firms are colluding would require additional evidence. One important piece of evidence is the number of firms. The fewer the firms, the more likely are similar prices to be the result of collusion. Of course, if it could be established that firms were meeting, whether openly or behind closed doors, to discuss joint issues, then this would indicate collusion. The trouble here is that if firms do wish to collude, something that is illegal in most countries under their competition legislation, they are likely to go to considerable lengths to avoid detection.

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5.

There exists a view that the UK is too small an economy to benefit from competition in many industries, with firms failing to reach minimum efficient scale. What does this imply for competition policy?

The first question to establish is the number of industries where the market is not large enough to allow enough firms to achieve minimum efficient scale (see evidence in Box 6.9). This, after all, is an empirical issue – i.e. a question of evidence. Then, where there is only limited domestic competition, the question is whether there is sufficient competition from imports to allow the industry to be competitive. A policy of open trade will help here (see Chapter 24, sections 1 and 2).

Where competition is restricted by the small size of the market, then competition legislation will be necessary to ensure that firms do not collude or use monopoly power to make excessive profits.

6.

Should regulators of utilities that have been privatised into several separate companies allow (a) horizontal mergers (within the industry); (b) vertical mergers; (c) mergers with firms in other industries?

If the aim of regulators is to prevent monopoly abuse and to encourage competition, the test should be whether the mergers restrict competition. Generally horizontal mergers are more likely to restrict competition than vertical ones, and vertical mergers are more likely to restrict competition than mergers with firms in other industries. But even here, competition could be reduced. For example, if a bus company merged with a train company, competition in public transport in a given region could be restricted.

7.

Summarise the relative benefits to consumers of (a) privatising a nationalised industry; (b) keeping it in the public sector but introducing competition. (a) The arguments for privatisation can be found towards the beginning of section 14.2. (b) In all the former nationalised industries that were privatised, there have been opportunities for introducing competition. An alternative is to keep the industry in the public sector, but there is still considerable scope for introducing competition. There are two main ways in which this can be done:

8.

▪

Outsourcing. This is where the industry employs private companies to perform services or supply materials that were previous produced in-house. Examples include the National Health Service employing outside catering or cleaning companies. Competition can be introduced through a process of franchising.

▪

Internal markets. This is where various parts of the industry buy and sell from each other.

Competition can be introduced into this process . For examples hospitals may compete with each other for patients referred by family doctors or schools may compete for students.

If an industry regulator adopts an RPI – X formula for price regulation, is it desirable that the value of X should be adjusted as soon as cost conditions change?

It is desirable to adjust X in the light of changes in cost conditions external to the firm, otherwise a firm could gain windfall profits from cost reductions in which it played no part (or make losses if costs external to it rose). For example, if fuel costs fall, it is desirable that the X factor for an electricity generator should be adjusted upwards correspondingly (unless there is a separate „Y‟ element in the formula for changes in costs outside the firm‟s control).

As for cost changes brought about by the firm‟s internal operations, it is desirable that the X factor should be changed eventually (maybe after a few years). If, however, it is changed too quickly, it will reduce the incentive for firms to cut costs. What have they got to gain from doing so, if the regulator takes any increased profit away from them by increasing the value of X?

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9.

Examine the case for public ownership of an industry where a natural monopoly exists.

Where a natural monopoly exists, there will be a lack of competition. This is an argument for some form of government intervention. This could be in the form of public ownership (nationalisation) but could alternatively be in the form of regulation, as has been the case with privatised industries. In many of the privatised industries, only part is a natural monopoly (such as the grid). In the parts where there is scope for competition, then this could be introduced .

10.

If price regulation results in lower profits, will this always imply lower investment? How might a government incentivise innovation in a regulated industry?

Lower profits may not result in reduced investment; there could instead be lower dividends paid to shareholders, or some mix of the two. If we consider the incentive for the firm to invest, as long as the return to capital remains above that which is contained in normal profits, there will be funds flowing to the company. If however the regulator reduces profits so much that the return is the same as could be obtained in competitive industries, investment may fall sharply. Government could give higher tax breaks for investment or could require that the regulator takes investment requirements into account when setting prices. If this approach were adopted, the regulator might specify how much investment would be required if the firm were to be allowed to charge more. Alternatively, government might choose to co-fund investment, concluding that the benefits to consumers of lower prices are sufficient to justify use of tax revenues for capital projects.

11.

Price-cap regulation was abandoned in the gas and electricity industries because the regulator (Ofgem) felt that there was sufficient competition. Consider whether this was a wise decision.

Since privatisation, there have been several mergers of gas and electricity companies in the UK. As the number of firms has fallen, so the scope for some form of oligopolistic collusion has increased.

Although open collusion between the companies is illegal, many commentators have argued that tacit collusion has taken place with companies watching each other‟s prices and following each other when one decides to change price. Prices have been much more responsive to rises in costs (such as oil and wholesale gas prices) than to reductions. As competition has become more limited, the argument for reintroducing price-cap regulation has grown stronger. This issue is discussed in more detail in the answers to the questions in Box 14.4.

Answers to End-of-Chapter Questions in Chapter 15 (11th edition)

1

In 1974 the UK economy shrank by 2.5 per cent before shrinking by a further 1.5 per cent in 1975.

However, GDP measured in the prices of the time rose by 13 per cent in 1974 and by 24 per cent in 1975. What explains these apparently contradictory results?

Output growth measures the change in the volume of output of an economy. In 1974 and 1975 the volume of output and, hence, real GDP fell. GDP growth measured in the prices of the time – in the statistics this is referred to as „GDP at current prices‟ – captures the change in the value of an economy‟s output. This is nominal GDP growth and is affected by both changes in prices and quantities. When real GDP falls, as it did in 1974 and 1975, and yet nominal GDP increases, an increase in prices is more than offsetting the contraction in output. In 1975, the annual rate of inflation exceeded 25 per cent.

2

Economists sometimes refer to the ‘twin characteristics of economic growth’. What are these characteristics?

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The twin characteristics reflect two fundamental concepts. First, growth is inherently volatile. Hence, if we look at short-run growth rates they can vary considerably. This makes the path of real GDP (output) volatile too. Second, over the longer term, growth is positive. Positive long-term growth reflect an increase in the productive potential of economies.

3

(i) What do you understand by the term financialisaton? (ii) How might we assess the financial wellbeing of households? (i)

Financialisation is a generic term which captures the increasing economic importance of the financial system. This was demonstrated vividly by the financial crisis of the late 2000s. A range of theories continue to evolve which explore the impact of the financial system for economic agents and the wider economy.

(ii)

There is a range of possible metrics. It may be measured most simply by households‟ stock of net worth. This is the summation of the stock of net financial assets and the stock of physical assets (non-financial assets). The former is calculated by subtracting the stock of financial liabilities (debts) from the stock of financial assets. Hence, an increase in the stock of financial liabilities reduces net financial wealth and so net worth.

We could also look in more detail at the composition of net worth. We might look, for example, at the exposure of households to debt perhaps by focusing on their ability to service their debts out of their income. Alternatively, we might look at the types of the assets held by households.

4.

Explain how the financial sector could amplify the effects of shocks to the economy, such as those from the COVID-19 pandemic.

Amplifiers are examples of propagation mechanisms that amplify the impact of economic shocks.

Credit and financial market conditions are potential examples of such amplifiers. They can create a positive feedback loop and therefore generate the process of cumulative causation. A positive (negative) economic shock causes economic activity to rise (fall), which then may lead to credit and financial market conditions improving (deteriorating). This in turn boosts (dampens) spending by households and firms, which then feeds back to further amplify the effects of the shock on economic activity.

5.

Explain how equilibrium would be restored in the circular flow of income if there were a fall in investment.

The fall in investment represents a fall in injections into the circular flow of income. National income will fall. As it does so, so withdrawals will fall until they have fallen to equal the new lower level of injections. At that point, national income will stop falling and equilibrium will have been restored.

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6.

Explain the circumstances under which an increase in pensions and child benefit would (a) increase national income; (b) leave national income unaffected; (c) decrease national income. (a) If an increase in pensions and child benefit (a negative withdrawal) were not matched by an increase in taxation or a cut in government expenditure, there would be a boost to the economy.

Aggregate demand would rise and hence so too would national income. (b) If there were no change in net injections and withdrawals, there would be no change in national income. This would occur if the increase in pensions and child benefit were financed by an increase in taxation and if the cut in expenditure from the increased taxation exactly offset the increased expenditure from the extra pensions and child benefit. (c) This would be likely to occur if the increased pensions and child benefit were financed by a cut in direct government expenditure on goods and services (e.g. education, health or transport infrastructure). Since part of the increased pensions and child benefit would be saved (and hence withdrawn) there would be a decline in net expenditure and hence national income.

7.

For what reasons might GDP be a poor indicator of (i) the level of development of a country; (ii) its rate of economic development?

See Sections 15.2 and 26.3.

8.

9.

(i) Will the rate of actual growth have any effect on the rate of potential growth? (ii) For what possible reasons may one country experience a persistently faster rate of economic growth than another? (i)

Yes. If businesses respond to increased actual growth by investing in new plant and equipment, human capital and research and development, this will increase the capacity of the economy to produce. Thus higher actual growth can lead to higher potential growth. Similarly, if the economy is in recession, with negative actual growth, firms may cut back on their investment: what is the point in investing in increased capacity if they cannot sell all that they are currently producing? This cutback in investment will lead to lower potential growth.

It is not only domestic firms that will respond to the current state of the economy and its prospects, but also foreign ones. A buoyant economy is likely to attract inward investment, which will increase potential as well as actual growth.

(ii)

A country is likely to experience a persistently faster rate of economic growth than another if its productivity rises faster and hence its potential output rises faster. This is likely if it invests more in research and development, more in physical capital and more in human capital through education and training. The rate of investment depends on a number of factors, including the education system, tax incentives, the willingness of financial institutions to finance investment and various social and cultural factors that influence entrepreneurialism and risk taking.

Why will investment affect both actual (short-term) growth and the long-term growth in potential output? What will be the implications if these two effects differ in magnitude?

Investment is an injection into the circular flow of income. An increase in investment will therefore increase aggregate demand and cause short-term growth in actual output. But increased investment will also increase the capacity of the economy to produce and hence increase potential output.

If the increase in actual output exceeds the increase in potential output (as it is likely to in the short run), then the gap between actual and potential output will be reduced and unemployment will fall but inflation could rise, especially if the gap becomes very small. If, however, the growth in potential output exceeds the growth in actual output, the gap will increase. In other words, the rise in expenditure in the economy will be insufficient to match the increase in capacity. Hence unemployment will rise and inflation is likely to fall.

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10.

At what phase of the business cycle is the average duration of unemployment likely to be the highest?

Explain.

Towards the end of the recession or the period just after it. As explained in the text, at the onset of a recession unemployment will rise, but as yet the average length of unemployment is likely to have been relatively short. Once a recession has lasted for a period of time, however, people on average will have been out of work longer, and this long-term unemployment is likely to persist even when the economy is pulling out of recession.

11.

Consider the most appropriate policy for tackling each of the different types of unemployment.

Generally economists argue that an economic problem should be tackled at source: i.e. that it is better to tackle the root of a problem than merely treating its symptoms. This means that if unemployment is caused by a deficiency of aggregate demand, then the most appropriate policy would be to ensure that demand is sufficient. Economists disagree, however (as we shall see in later chapters), as to whether it is better to manage aggregate demand over the short term (say, by increasing government expenditure or reducing taxes) or to provide a more stable environment over the longer term in which the economy will be less subject to recessions.

If unemployment is caused by structural or technological change, or by too many „frictions‟ in the economy, the best approach is to make the economy adapt more rapidly to these changing conditions. This involves what are called „supply-side policies‟. These could involve „freeing up‟ markets to remove impediments to labour and capital mobility (e.g. deregulation or reducing the power of trade unions). Such policies tend to be favoured by the political right. The alternative would be to have interventionist supply-side policy. For example, the government could invest in education and training in order to create a more flexible workforce, or provide better job information, or invest in the transport infrastructure. Supply-side policies are examined in Chapter 23.

12.

Do any groups of people gain from inflation?

The main gainers are: those who own assets which are increasing in value faster than the rate of inflation.

▪ debtors, if the rate of interest on their debts is below the rate of inflation (or at least has not risen as much as have prices).

▪ firms or unions with market power which can use their estimates of future inflation as a justification for pushing through price or pay rises above the current rate of inflation.

▪ people who benefit from speculating against relative price changes (e.g. of stocks and shares, or property), or against changes in the exchange rate.

▪ people whose business it is to provide insurance or other services to help people cope with inflation (e.g. financial experts).

If the inflation is the direct result of a rise in aggregate demand, then one of the effects of that rise will be a fall in unemployment (at least temporarily).

13.

If everyone’s incomes rose in line with inflation, would it matter if inflation were 100 per cent or even 1000 per cent per annum?

Most of the costs of inflation would disappear, but menu costs would still remain. Investment, balance of payments and speculation costs would only disappear if everyone correctly anticipated future inflation.

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14.

Imagine you had to determine whether a particular period of inflation was demand pull, or cost push, or a combination of the two. What information would you require in order to conduct your analysis?

In practice, it is very difficult since most periods of inflation have a number of different but interconnected causes. Nevertheless, if there are clear independent rises in demand (say, for example, the government decides to cut income tax and increase benefits just before an election), then it would be fair to categorise any resulting inflation as „demand pull‟. Likewise if there are clear independent rises in costs or reductions in aggregate supply (say, for example, a major oil price increase or a natural disaster), then it would be fair to categorise any resulting inflation as „cost push‟. Of course, in both types of case it would be necessary to have clear evidence that subsequent inflation was indeed caused by these events and not by other factors.

The problem is that in most cases cost-push and demand-pull factors interact. A rise in consumer demand (a seemingly demand-pull factor) might have been the result, at least in part, of pay increases secured by trade unions. Those pay rises (a seemingly cost-push factor) might, in turn, have been demanded because unions saw their position being strengthened by a fall in unemployment, itself caused by higher demand. That rise in demand might have been caused, in part, by previous pay increases, and so on.

15.

Explain how the current account of the balance of payments is likely to vary with the course of the business cycle.

During the boom, the current account will tend to deteriorate. There are two reasons. The first is the direct result of higher incomes. Part of the extra incomes will be spent on imports. The second is the result of higher inflation. Higher prices of domestic goods and services relative to foreign ones will lead to both an increase in imports and a decrease in exports. (These effects may be offset to some degree by changes in the exchange rate: see sections 25.1 and 25.3.)

The opposite effects are likely to occur during a recession. Lower incomes and relative prices of domestic goods and services will cause a fall in imports and a rise in exports: the current account will improve.

In both cases we are assuming that other countries are not at the same time experiencing similar effects. If other countries were at the same phase of their business cycle, the above effects could be neutralised. For example, any fall in demand for imports by country A from country B could be offset by a fall in demand for imports by country B from country A. Imports and exports of both countries would fall (but not necessarily by the same amount).

16.

What do you understand by people’s expectations of inflation becoming ‘anchored’? Why might this be important for actual rates of inflation?

This is the idea that inflationary expectations become stable around a given rate of inflation. It is argued that inflation rate targeting and the independence of the monetary authorities in the conduct of monetary policy are important in achieving this. The inflation rate target then becomes credible and acts as the anchor for people‟s inflationary expectations. This then influences price setting behaviour, including the determination of wages, such that the growth of actual prices tends to reflect people‟s now anchored expectations of inflation.

17.

The overall balance of payments must always balance. If this is the case, why might a deficit on one part of the balance of payments be seen as a problem?

If there is a current account deficit, this will have to be matched by a financial + capital account surplus. This could be seen to be a problem to the extent that it increases overseas ownership of domestic assets and hence creates a claim on domestic income for the future (an income outflow on the current account).

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18.

List some factors that could cause an increase in the credit items of the balance of payments and a decrease in the debit items. What would be the effect on the exchange rate (assuming that it is freely floating)? What effect would these exchange rate movements have on the balance of payments?

A fall in inflation relative to that in other countries; a fall in incomes relative to those in other countries; a fall in interest rates relative to those in other countries; an improvement in investment prospects at home; speculation that the exchange rate is about to appreciate; shifts in consumer tastes away from foreign goods to domestic goods; an improvement in the quality of domestic goods.

The surplus on the balance of payments at the existing exchange rate (an excess of demand for the domestic currency over supply) would cause the exchange rate to appreciate. The appreciation, in turn, would eliminate the balance of payments surplus. In Figure 15.18, the factors listed above would cause the demand and supply curves to shift from D2 and S2 to D1 and S1, respectively. The exchange rate for the pound would appreciate from €1.10 to €1.20, and in the process would eliminate the excess demand for sterling (i.e. eliminate the balance of payments surplus).

19.

Explain how you would derive a figure for households’ disposable income if you were starting from a figure for GDP? You would use the following formula: Households‟ disposable income = GDP + Net income from abroad – Taxes paid by firms + Subsidies received by firms – Depreciation – Undistributed profits – Personal taxes + Benefits th

Answers to End-of-Chapter Questions in Chapter 16 (11 edition)

1.

In a given economy, the supply of money is £10 billion; the velocity of circulation of money (spent on final goods and services) is 3; and the price index is 2.00. (a) What is the level of real national income? (b) How much have prices risen (in percentage terms) since the base year? (c) Assume that money supply increases by 10 per cent and that the velocity of circulation remains constant. What will be the rate of inflation if (i) there is no increase in real national income; (ii) real national income increases by 10 per cent; (iii) real national income increases by 5 per cent? (a) The values of the terms in the quantity equation, MV = PY, are as follows: M = £10 billion V=3 MV = £30 billion  PY = £30 billion P=2  Y = £30 billion / 2 = £15 billion. (b) 100 per cent (they have doubled) (c) (i) 10 per cent MV now equals £11 billion  3 = £33 billion  PY = £33 billion  P = £33 billion / £15 billion = 2.2, which is a 10 per cent increase. (ii) zero PY = £33 billion

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But Y is now £16.5 billion (i.e. 10 per cent higher)  P = £33 billion / £16.5 billion = 2 (i.e. there has been no change in the price level). (iii) 4.76 per cent PY = £33 billion But Y is now £15.75 billion (i.e. 5 per cent higher)  P = £33 billion / £15.75 billion = 2.0952 (i.e. 4.76 per cent higher).

2.

In what way will the nature of aggregate supply influence the effect of a change in aggregate demand on prices and real national income?

The more elastic is aggregate supply with respect to changes in aggregate demand, the more will real national income be affected by a change in aggregate demand, and the less will the level of prices. The key is in understanding the supply decisions of firms. The larger the change in prices necessary for firms to change the level of aggregate supply, the less real national income is affected when aggregate demand changes.

In the extreme case, nominal increases in aggregate demand could result in proportionately equivalent price changes which mean that real aggregate demand and hence real national income are unchanged. When firms can affect aggregate supply with little change in the levels of prices, then changes in nominal aggregate demand result in similar proportionate changes in real aggregate demand and hence real national income.

3.

Criticise the classical theory that higher government spending will necessarily crowd out private spending.

If higher government spending leads to an increased use of idle resources, then there can be both more government spending and more private spending too.

4.

Criticise the use of increasing government expenditure as a means of reducing unemployment.

It could lead to some crowding out, a problem that is likely to increase as unemployment falls and hence the amount of idle resources decreases. The rise in aggregate demand resulting from the increased government expenditure could lead to an increase in the rate of inflation, a problem aggravated by a rise in the expected rate of inflation. The increased size of the budget deficit may create problems for funding the national debt (the accumulated government debt over the years).

5.

In what way may short-term demand-management policies help to stabilise the economy? What problems occur in the use of such policies?

If the economy is booming, then cuts in government expenditure or increases in taxes, or an increase in interest rates could dampen the growth in aggregate demand and slow down the rise in income. If the economy is in recession, then increases in government expenditure or cuts in taxes, or a reduction in interest rates could help to bring the economy out of recession. The earlier these policies are introduced, the less serious the problem will have become by the time the policies take effect.

If the government wrongly predicts the course of the business cycle and hence introduces the wrong demand management policies, or introduces otherwise correct policies but too late, they could actually make the problem worse (see section 22.2).

6.

What explanations can you give for the increase in both unemployment and inflation in the 1970s?

A rapid rise in aggregate demand accompanied by cost-push pressures (e.g. a four-fold increase in oil prices) led to a large rise in the rate of inflation, aggravated by rising inflationary expectations: there

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were upward shifts in both aggregate demand and aggregate supply, with little or no reduction in demand-deficient unemployment. At the same time, there were increases in equilibrium unemployment, caused by changes in technology and structural changes in the economy.

7.

What do you understand by the policy ineffectiveness proposition? On what assumptions is the proposition based?

The proposition implies that anticipated changes in economic policy will have no effect on output or employment and so on real variables. Policy surprises will have only temporary effects on output and employment. Once economic agents recognise the „surprise‟ and the implications for prices, then output and employment will return to their equilibrium levels.

The proposition is based on the key assumptions of continuous market clearing and rational expectations.

8.

How is the distinction between nominal and real relevant to misperceptions theory?

Central to misperceptions theory is that people confuse changes in general prices with changes in relative prices. Relative price changes are real price changes. If a particular price increases (falls) relative to prices generally then there is a real increase (fall) in its price. On the other hand, if the proportionate increase (fall) in its price is the same as that experienced by prices generally, then there is only a nominal change and its real price is unchanged.

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9.

Identify a series of possible frictions which could affect the speed with which markets adjust or which affect the nature of market equilibria.

A series of frictions are identified in section 16.5. These include: menu costs, sticky nominal wages, imperfect competition, anticipating other firms‟ pricing strategy, efficiency wages and imperfections in financial markets.

10.

What is meant by hysteresis when applied to unemployment? How do you account for this phenomenon in the 1980s?

When unemployment caused by a deficiency of aggregate demand in a recession is not eliminated when the recession comes to an end: the labour market does not return to the previous equilibrium. The reasons for this phenomenon include the deskilling of labour, a decline in firms‟ capacity, insiders preventing outsiders from bidding down the wage rate and firms being cautious about taking on extra labour when the recovery does come.

11.

What is meant by super-hysteresis? What mechanisms might explain how this phenomenon occurs?

Super-hysteresis captures the idea that economic shocks affect not only subsequent levels of national output but also subsequent rates of growth. The growth-rate effect reflects the impact that shocks may have on the growth of potential output. In the case of recessions, the decline in investment, research and development expenditure, „learning by doing‟ and the accumulation of human capital are channels by which the rate of long-term growth may be reduced.

12.

What will cause people to expect higher rates of inflation? How will expectations of inflation affect the actual rate of inflation?

Seeing current rates of inflation rising; seeing policies being taken or other economic events that are typically followed by an increase in inflation (e.g. higher wage settlements or an increase in the size of the budget deficit); forecasts of higher inflation.

The higher the rate of inflation that people expect, the higher will be the level of wage demands and wage settlements, the more will firms raise their prices, and hence the higher will be the actual rate of inflation. This is one of the main arguments for central banks having clear inflation rate targets.

13.

Explain how pro-cyclical lending criteria applied by financial institutions could amplify fluctuations in real GDP. The key argument here is that levels of lending to economic agents are positively related to the rate of economic growth and that lending positively affects the growth of aggregate demand and, in turn, the rate of growth. If so, stronger economic growth induces additional flows of lending which, by increasing aggregate demand, further strengthen economic growth. On the other hand, a weakening of economic growth (perhaps even negative growth) causes a reduction in flows of lending which further contribute to a weakening of economic growth.

14.

What is meant by the paradox of aggregates? Of what importance might they be for how we analyse macroeconomic problems?

The paradox of aggregates is another name for the fallacy of composition: what is true for one case or one individual is not necessarily true in all cases or for groups of individuals.

A commonly cited example is the paradox of thrift. If one individual increases their propensity to save, the individual‟s saving increases and they can consume more in the future. However, if this is repeated by all individuals, it can lead to a fall in aggregate saving because the fall in consumption causes firms to produce less, which reduces national income.

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More generally, paradoxes of aggregates, like the paradox of thrift, illustrate how group behaviour affects individual behaviour and well-being. Therefore, they demonstrate downward causation from aggregates to individuals. It is argued by some economists, particularly groups of Keynesian economists that individual behaviour or outcomes cannot be fully understood without accounting for the interaction between individuals.

15.

What policy prescriptions could be recommended for an economy experiencing a balance sheet recession?

The policy prescription is for a sustained loosening of fiscal policy, particularly through government spending. The financial distress of the private sector that underpins a balance sheet recession limits the effectiveness of monetary policy. Since the private sector is focused on repaying debt and/or saving to rebuild net worth (wealth), a loose monetary policy is unlikely to have the necessary impact on stimulating aggregate demand, Hence, the role of the public sector becomes important in stimulating and sustaining aggregate demand. th

Answers to End-of-Chapter Questions in Chapter 17 (11 edition) 1.

An economy is currently in equilibrium. The following figures refer to elements in its national income accounts. £ billions Consumption (total)

60

Investment

5

Government expenditure

8

Imports

10

Exports

7

(a) What is the current equilibrium level of national income? (b) What is the level of injections? (c) What is the level of withdrawals? (d) Assuming that tax revenues are £7 billion, how much is the level of saving? (e) If national income now rose to £80 billion and, as a result, the consumption of domestically produced goods rose to £58 billion, what is the mpcd? (f) What is the value of the multiplier? (g) Given an initial level of national income of £80 billion, now assume that spending on exports rises by £4 billion, spending on investment rises by £1 billion, whilst government expenditure falls by £2 billion. By how much will national income change? (h) Given this new level of national income, assume that full employment is achieved at a national income of £100. Is there an inflationary or a deflationary gap? (i) What is the size of this gap? (a) In equilibrium, income (Y) = expenditure (E) E =C+I+G+X–M = £60bn + £5bn + £8bn + £7bn – £10bn = £70bn (b) J

=I+G+X = £5bn + £8bn + £7bn = £20bn

(c) In equilibrium, W = J. As this economy is in equilibrium, withdrawals will equal current injections.

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W = £20bn (d) W = S + T + M = S + £7bn + £10bn S = £20 – £7bn – £10bn = £3bn (e) Cd = C – M = £50bn mpcd = Cd/Y = (£58bn – £50bn) / (£80bn – £70bn) = £8bn/£10bn = 0.8 or 4/5 (f) Multiplier = 1 / (1 – mpcd) = 1 / 1/5 =5

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(g) Injections have risen by £4bn + £1bn – £2bn = £3bn  national income will rise by 5 times this amount = increase of £15bn (h) New national income = £80bn + £15bn = £95bn With full-employment national income at £100bn, there is a deflationary gap. (i) With a multiplier of 5, injections would need to increase by £1bn to make up the £5bn shortfall in national income. Thus the deflationary gap is £1bn.

2.

What is the relationship between the mpc, the mpcd and the mpw?

The mpc is the proportion of a rise in national income that consumers spend (including the consumption of imports, and measured at prices that include taxes on goods, such as VAT, and the effects of any subsidies on goods). mpc = C/Y The mpcd is the proportion of a rise in national income that accrues to domestic firms from consumption (and thus excludes those parts of consumption that go on imports, and is measured in prices that firms actually receive: i.e. after the payment of taxes on goods and the receipt of any subsidies on goods). mpcd = Cd/Y The mpw is the proportion of a rise in income that is withdrawn from the circular flow of income: i.e. the proportion that does not accrue to domestic firms. mpw = 1 – mpcd

3.

Why will the short-run consumption function be different from the long-run consumption function?

If people have a rise in their incomes, they may take a time to adjust their spending patterns. Thus in the short run they may only increase their consumption slightly, but over the longer term they may alter their living style to match their income: they may buy a house rather than rent, or buy a bigger house; they may choose to run a car or, if they already have one, a bigger car; and so on. Also, a shortrun rise in incomes may be seen as temporary rather than permanent, and for this reason too, people will not immediately take on long-term spending commitments.

4.

Construct a table similar to Table 17.3, only this time assume that the mpcd is ¾. Show that national income will increase by £640 million.

Table 17.1(a)

The multiplier round: original table in text ————————————————————— Period J Y Cd W (£m) (£m) (£m) (£m) ————————————————————— 1 160 160 80 80  2 – 80 40 40  3 – 40 20 20  4 – 20 10 10  5 – 10 5 5  6 – 5 . . . . . .

————————————————————— 1→ 320 160 160 —————————————————————

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Table 17.1(b) The multiplier round: answer to question: mpcd = ¾ —————————————————————— Period J Y Cd W (£m) (£m) (£m) (£m) —————————————————————— 1 160 160 120 40  2 – 120 90 30  3 – 90 67.5 22.5  4 – 67.5 50.6 16.9  5 – 50.6 38.0 12.6  6 – 38.0 . . . . . .

—————————————————————— 1→ 640 480 160 ——————————————————————

Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

5.

Assume that the multiplier has a value of 3. Now assume that the government decides to increase aggregate demand in an attempt to reduce unemployment. It raises government expenditure by £100 million with no increase in taxes. Firms, anticipating a rise in their sales, increase investment by £200 million, of which £50 million consists of purchases of foreign machinery. How much will national income rise? (Assume ceteris paribus.)

Injections rise by £100m + (£200m – £50m) = £250m. Therefore, with a multiplier of 3, national income will rise by £750m.

6.

What factors could explain why some countries have a higher multiplier than others?

▪ ▪ ▪

▪

7.

The lower a country‟s national income, the higher will tend to be its mpc and thus the higher will be its multiplier.

In some countries there is much more of a „savings culture‟ and thus the mps is higher. Those with less of a savings culture will tend to have a lower mps and hence a higher multiplier.

In some countries, especially large ones, trade accounts for a relatively smaller proportion of national income. In such countries the mpm will be lower and hence the multiplier will be higher than in countries with a higher proportion of trade relative to national income.

The marginal tax rate, the mpt, differs from one country to another. The lower the mpt the higher the multiplier.

How can the interaction of the multiplier and accelerator explain cyclical fluctuations in national income?

See section 17.4 and Case Study 17.9 on the student website.

8.

Why is it difficult to predict the size of the accelerator?

▪ ▪ ▪

▪ ▪ ▪

9.

Many firms may have spare capacity and/or carry stocks. This will enable them to meet extra demand without having to invest.

The willingness of firms to invest will depend on their confidence in future demand. Firms will only respond to a rise in demand by investing if they think that the rise in demand will persist.

The ability of firms to invest will depend on the access finance. Some of this finance may come through borrowing from financial institutions where credit criteria and the price of credit may fluctuate.

Firms may make their investment plans a long time in advance and may be unable to change them quickly.

Even if firms do decide to invest more, the producer goods industries may not have the capacity to meet a sudden surge in demand for machines.

Machines do not as a rule suddenly wear out. A firm could thus delay replacing machines and keep the old ones for a bit longer if it was uncertain about its future level of demand.

What is meant by consumption smoothing and of what significance might it be for the relationship between spending and income?

Consumption smoothing occurs when households use the financial system to shift incomes across time periods through saving or borrowing to experience a more even flow of consumption.

An implication of consumption smoothing is that current levels of consumption are less dependent on current levels of income than they otherwise would be. Hence, while spending will be constrained by incomes over the longer run, this constraint is likely to be less binding in the short run. In other words, households face a multi-period budget constraint, sometimes referred to as an inter-temporal budget constraint. Furthermore, this implies that while the long-run marginal propensity to consume out of income is close to one, it will be increasingly smaller the shorter the time period in question.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

10.

How might uncertainty propagate the impact of shocks, such as the COVID-19 pandemic, on the macroeconomy?

Macroeconomic uncertainty may be interpreted as the range of possible outcomes for key macroeconomic indicators, such as the growth in real incomes. In the face of greater uncertainty, economic agents (households and firms) would tend to be more prudent and more cautious. They would be expected to want a larger buffer of resources to draw on in the face of unexpected adverse shocks. In the case of households, this may lead to increasing levels of buffer-stock saving, while firms may „wait and see‟ before undertaking investment. Therefore the effect of greater uncertainty would be expected to be a reduction in aggregate demand. th

Answers to End-of-Chapter Questions in Chapter 18 (11 edition)

1.

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? (a) £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.

2.

What is meant by the terms narrow money and broad money? Does broad money fulfil all the functions of money?

Narrow money is money that can be spent directly (i.e. cash and money in accounts that are instantly accessible by cheque or debit card without penalty). Broad definitions of money include the items in narrow definitions plus other highly liquid assets (i.e. items that can be readily converted into cash).

Broad money fulfils all the functions of money, albeit somewhat imperfectly. Like narrow money, 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 most forms of narrow money, 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.

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3.

How does money aid the specialisation and division of labour?

It enables people and firms to be paid in a single form for doing just one thing, but then to use the money to buy a whole range of things. By facilitating trade, money enables people to produce just type of product, without spending vast amounts of time trying to find people to swap it with.

4.

What enables banks safely to engage in both maturity transformation and risk transformation?

The fact that they are able to spread their risks over a very large number of customers. If, however, there is a general problem of increased risk applying to all banks, as occurred during the credit crunch of 2008/9, they will not be able to do this so safely (see Boxes 18.2 and Box 18.3 in Chapter 18).

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5.

Why do banks hold a range of assets of varying degrees of liquidity and profitability?

So that they can balance the two objectives of liquidity and profitability and also spread their risks, given that the relative profitability and security of different types of assets may change. For reasons of profitability the banks will want to minimise their holdings of cash; but to avoid the risks of insufficient liquidity, they hold a whole range of other liquid assets (such as money at call), which, although they are highly liquid, do, nevertheless, earn some interest for the bank.

6.

What is meant by the securitisation of assets? How might this be (a) beneficial and (b) harmful to banks and the economy?

Securitisation involves a financial institution selling some of its assets to financial investors, often other financial institutions. 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 helps facilitate the provision of credit. In terms of mortgage lending, it is argued that, in countries like the UK and USA, it has helped to facilitate owner-occupation. However, it is also argued that in doing so during the 2000s, lenders often relaxed lending criteria. This therefore increased the riskiness of their mortgage portfolio and of the collateralised debt obligations supported by the lending. For further discussion on securitisation see section 18.2 and Boxes 18.2 and 18.3.

7.

What were the causes of the credit crunch and the banking crisis of 2008?

This is discussed at length in section 18.2. In particular, it discusses: (i) the conflict between profitability and liquidity; (ii) the impact of an increased reliance on wholesale funding; (iii), the development of new funding techniques, including securitisation; (iv) the expansion and mismanagement of banks‟ balance sheets; (v) increased gearing; (vi) insufficient loss-absorbing capital; and (vii) the role of regulators and policy makers.

8.

If the government reduces the size of its public-sector net cash requirement, why might the money supply nevertheless increase more rapidly?

Because one of the other determinants of money supply may cause it to grow more rapidly even though the reduction in the PSNCR, other things being equal, is causing the growth in the money supply to slow down. For example, if the economy is experiencing a boom, the growth in national income will increase the level of tax receipts and reduce the amount paid out in government benefits, thereby reducing the PSNCR. At the same time, however, the buoyant demand for bank loans is likely to increase bank lending. As Figure 18.6 shows, the money supply grew robustly in the late 1980s and early 2000s even though there was a public-sector surplus.

9.

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.

10.

What effects will the following have on the equilibrium rate of interest? (You should consider which way the demand and/or supply curves of money shift.) (a) Banks find that they have a higher liquidity ratio than they need. (b) A rise in incomes. (c) A growing belief that interest rates will rise from their current level. (a) They will increase credit and hence the money supply. Ms will shift to the right. The equilibrium rate of interest will therefore fall. (b) Higher incomes will increase the transactions plus precautionary demand for money (L1). L will shift to the right. The equilibrium rate of interest will therefore rise.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

(c) If people believe that interest rates will rise, the speculative demand for money (L2) will rise. L will shift to the right. The equilibrium rate of interest will therefore rise.

Answers to End-of-Chapter Questions in Chapter 19 (Updated 10e) 1.

Using one or more diagrams like Figures 19.2, 19.7, 19.8, 19.9 and 19.10, illustrate the following: (a) The effect of a contraction in the money supply on national income. Refer to both the interest-rate and the exchange-rate transmission mechanisms and show how the shapes of the curves affect the outcome. (b) The effect of a fall in investment on national income. Again show how the shapes of the curves affect the outcome. Specify your assumptions about the effects on the supply of money. (a) Referring first to the interest-rate mechanism, a contraction in the money supply will shift the money supply curve from M to M in Figure 19.2(a), causing the real rate of interest to rise from r2 to r1. This will cause a fall in investment from I2 to I1 in diagram (b), and a multiplied fall in national income from Y2 to Y1 in diagram (c). The effects will be greater the steeper is the L curve in diagram (a), the shallower the I curve in diagram (b) and the flatter the W curve (and hence the bigger the multiplier) in diagram (c).

The exchange-rate mechanism is illustrated in Figure 19.7. The supply of money curve will shift from Ms to Ms in diagram (a), causing the rate of interest to rise from r2 to r1. This will cause a rise in the exchange rate from er2 to er1 in diagram (b). Imports will rise from M2 to M1, and exports will fall from X2 to X1 in diagram (c), causing a multiplied fall in national income from Y2 to Y1 in diagram (d). The effects will be greater the steeper is the L curve in diagram (a), the less elastic the supply of international finance and hence the bigger the change in the exchange rate in diagram (b), the more elastic the demand for imports and exports to changes in the exchange rate in diagram (c) and the flatter the W curve (and hence the bigger the multiplier) in diagram (d). (b) A fall in investment will reduce the demand for money: in Figure 19.9 (either diagram), the demand for money will shift from L to L. The real rate of interest will fall from r2 to r1. This, in turn will increase investment demand: in Figure 19.10 (either diagram), investment will rise from I2 to I1. The effect on interest rates is greater the steeper the L curve and the less responsive the supply of money to a change in the demand for money (Figure 19.9(b)). The effect on investment of a change in real interest rates will be greater the flatter is the I curve (Figure 19.10(b)).

2.

Controlling the money supply is sometimes advocated as an appropriate policy for controlling inflation. What implications do different assumptions about the relationship between M and V, and M and Y in the equation MV = PY have for the effectiveness of this policy?

If both V (the velocity of circulation) and Y (real national income) are exogenously determined – in other words, they do not depend on the money supply – then any change in money supply must be wholly reflected in a change in the price level. Under such circumstances, controlling the money supply will be an effective means of controlling inflation.

If, however, a change in money supply affects V and/or Y, especially if the effect is unpredictable, then the simple quantity theory of money breaks down and controlling the money supply may not necessarily control inflation and may have undesirable consequences. For example, if a fall in money supply led to a rise in the velocity of circulation, as people sought to spend a reduced stock of money more quickly, prices may not fall. Even if V were constant and hence a fall in money supply did lead to a reduction in PY (nominal spending), the effect may be a reduction in production and hence real income (Y), rather than a reduction in prices (P).

3.

Why may an expansion of the money supply have a relatively small effect on national income? Why

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

may any effect be hard to predict?

Referring to Figures 19.2 and 19.7 in the text, if there is an elastic liquidity preference curve (Figure 19.2(a)), if investment is unresponsive to changes in real interest rates (Figure 19.2(b)), if international finance is relatively mobile (the supply curve in Figure 19.7(b)), if imports and exports are relatively unresponsive to changes in exchange rates (Figure 19.7(c)) and if the marginal propensity to withdraw is relatively low, giving a small multiplier, then an expansion of the money supply will have only a small effect on national income. If there is little spare capacity in the economy, then any rise in aggregate demand resulting from the rise in money supply will be largely reflected in higher prices rather than in increased (real) national income.

The effect is hard to predict, because the response of investors or consumers to changes in interest rates depends on questions of confidence and expectations about inflation: and these are hard to predict.

4.

What impact might the balance sheets of economic agents have on the influence of interest rates in affecting aggregate expenditure?

Financial assets attract interest income while financial liabilities incur interest charges. Therefore, the magnitude of the stock of both financial assets and liabilities can potentially influence the impact of interest rate changes on aggregate expenditure. This is because the cash flow effect is greater the larger the stock of financial assets and liabilities. For instance, for an increase in interest rates a larger stock of financial liabilities will tend to increase the negative impact on aggregate expenditure, while a larger stock of financial assets will tend to increase the positive impact on aggregate expenditure of a rise in interest rates.

5.

Why does the exchange-rate transmission mechanism strengthen the interest-rate transmission mechanism?

Because changes in exchange rates affect aggregate demand (via changes in imports and exports) in the same direction as do changes in interest rates (via changes in investment and consumption). For example, a rise in money supply will cause a fall in interest rates and a fall in the exchange rate. Their effects will reinforce each other. The lower interest rates will cause a rise in investment and consumption and hence higher aggregate demand. The lower exchange rate will cause a rise in exports and a fall in imports and hence, again, higher aggregate demand.

6.

Explain how the holding of a range of assets in people’s portfolios may help to create a more direct link between changes in money supply and changes in aggregate demand.

Because any rise in money supply will cause a general rise in assets held in people‟s portfolios. Some of these assets will be physical assets (such as new housing, home improvements and consumer durables), the demand for which will stimulate aggregate demand.

7.

Explain how financial crowding out can reduce the effectiveness of fiscal policy. What determines the magnitude of crowding out?

Assume that the government adopts an expansionary fiscal policy and raises government expenditure and/or cuts taxation, with the result that the level of government borrowing increases. The increased borrowing is likely to drive up the rate of interest. This in turn reduces private-sector borrowing and hence reduces consumption and investment. Private-sector expenditure is „crowded out‟. The expansion of aggregate demand from the fiscal policy is thus wholly or partially offset by the reduction in private-sector spending.

The magnitude of crowding out depends primarily on what happens to money supply. If money supply endogenously expands in response to the higher demand for money, or if the central bank deliberately keeps interest rates down by allowing money supply to expand, then there may be no

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

financial crowding out. Even if money supply does not expand, crowding out is likely to be limited if the demand for money is relatively elastic and investment is relatively unresponsive to changes in interest rates (see pages 613–4).

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

8.

What determines the shape and position of the IS curve?

See the sections on the elasticity of the IS curve and on shifts of the IS curve (pages 616–8).

9.

What determines the shape and position of the MP curve?

See the sections on the elasticity of the MP curve and on shifts of the MP curve (page 619).

10.

Using the IS/MP model analyse the possible effect of an increase in aggregate expenditure on output, the real interest rate and inflation.

The increase in aggregate expenditure causes in a rightward shift in the IS curve from IS1 to IS2.

This causes national income and the rate of inflation to rise. The central bank responds to the higher inflation rate by raising the real rate of interest (the nominal rate is increased by more than the rate of inflation). There is a movement up along the MP curve. A new equilibrium is reached at point b at a level of national income of Y2 and a real rate of interest of r2. This will not be a sustainable equilibrium if national income is now above its potential level and/or the rate of inflation is above its target rate.

MP

b r2

a

r1

IS2 IS1 O

Y1

Y2

Y

Diagram 19.1 A rise in aggregate demand

Using the IS/MP model analyse how a lower bound on real interest rates might cause the economy to enter a deflationary spiral following a significant decrease in aggregate expenditure.

Since economic agents are unlikely to want to deposit monies at negative interest rates, the effective lower limit for nominal interest rates is zero. The real interest rate, however, can be negative. This is because it is defined as the nominal rate (i) less the rate of inflation (). a The result could be an MP curve r1 which ceases to be positively sloped c 0–2 at very low levels of output.

0– b Consider monetary policy IS1 curve MP1 on the diagram opposite, IS2 which is drawn such that at output Y4 Y3 Y2 Y1 O Real national income (Y) levels below Y2, the inflation rate falls to 1 and the lowest possible Diagram 19.2 Lower bound on real interest rates real interest rate become 0–1. This means that at output levels above Y2 the MP curve is positively sloped: the central bank reacts to decreases in output by reducing real interest rates. However, at output levels below Y2 the central bank can no longer reduce interest rates to boost output.

Real rate of interest (r)

11.

r

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

Assume now that the economy is in equilibrium at point a, with national income at its potential level of Y1 and a real rate of interest of r1. Assume that there is a significant decrease in aggregate expenditure, such as that which followed the financial crisis, which saw a massive reduction in credit, a collapse in consumer and business confidence and desire to cut spending in order to rebuild financial wealth. This is illustrated by the shift in the IS curve to IS2. Central banks cut nominal interest rates to (near) zero, giving a negative real interest rate of 0–1. Equilibrium is now at point b and national income has fallen to Y3.

If the central bank were to relax monetary policy, this would typically shift the MP curve to the right. This is illustrated as the move to MP2. However, this would have no effect on real national income as nominal rates could fall no further. In fact, a deflationary spiral could result and the situation deteriorate further. If, as a result of the massive decline in output, the rate of inflation were now to fall further, to say 2, the MP curve could move to MP3. The lowest possible real interest rate becomes 0– 2 and the gap between nominal and real interest rates has closed. Equilibrium would be represented by point c and national income has fallen further to Y4.

A further deflationary effect would occur if, at the same time as central banks and savings accounts were paying interest rates close to zero, borrowing rates, although lower than before, did not fall as much as rates on saving. The gap between borrowing and saving rates would widen, thereby further dampening demand. This illustrates what is known as the financial accelerator and would cause the IS curve to move further to the left than it would otherwise.

12.

What impact does the financial accelerator have on the marginal propensity to consume domestically produced goods (mpcd)? How does this affect the IS curve?

Financial accelerator effects are an additional channel by which changes in national income affect aggregate demand. If we assume that credit conditions loosen (tighten) as national income rises (falls) and/or that the borrowing interest rate falls (rises) relative to the saving interest rate, then, all other things being equal, aggregate demand increases (decreases) by more following a rise (fall) in national income than would otherwise be the case. Hence, financial accelerator effects increase the marginal propensity to consume domestically produced goods (mpcd).

Since the mpcd is larger with financial accelerator effects the IS curve is flatter. This is illustrated in Figure 19.16 in the text (see page 624).

Illustrate the impact on the IS curve of a general increase in interest-rate differentials following a credit market disruption like that experienced during the financial crisis of the late 2000s.

The interest-rate differential can be written as (rb – rs). The differential is assumed to fall as national income rises. Hence, the mpcd is larger and the IS curve flatter in the presence of interest-rate differentials.

An increase in interest ratedifferentials means that for any saving interest rate (rs) the borrowing interest rate (rb) is now higher than previously. The general effect, therefore, is to move the IS curve downwards to the left. If, as illustrated in Diagram 19.3, the increase in the differential is

Saving real rate of interest (rs)

13.

IS1 (pre-disrumption) IS2 (post-disruption)

O

Real national income (Y)

Diagram 19.3 An increase in interest-rate differentials 10

Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

14.

proportionately larger at lower levels of national income, then the IS curve will also become flatter and the mpcd would increase.

Using the IS/MP framework illustrate how the financial accelerator affects the extent of the rise in output following a positive demand-side shock.

Real interest rate on savings (rs)

The steeper IS curves, IS1 and IS2, are assumed to represent the economy in the absence of financial accelerator With financial effects. The flatter dashed IS accelerator effects, b curves, IS′1 and IS′2, a given positive demand shock will incorporate financial lead to a bigger r3 accelerator effects. Assume rise in Y and r. that for ease of exposition, r2 regardless of whether r1 financial accelerator effects operate, the economy is at point a with the real interest on saving (and the real central bank policy rate) at r1 and Y1 Y2 Y3 O real national income at Y1.

Real national income (Y) The positive demand Diagram 19.4 Positive demand-side shock shock can be captured by a given vertical upward move of the IS curves. The vertical difference between points a and b in the diagram indicates the amount that the saving rate, rs rises at each output level such that there is equilibrium in the goods market: aggregate demand equals national income at each point on the IS curve.

In the absence of the financial accelerator, the economy expands and equilibrium moves to point c, where IS2 and MP intersect. National income rises to Y2. However, in the presence of financial accelerator effects, the economy expands by more, to point d, where IS′2 and MP intersect. National income rises to Y3. This is because, as aggregate demand rises, the interest rate differential narrows.

Additionally, banks may loosen lending criteria, so increasing the volume of credit that they make available. The result is that there are now additional forces causing the economy to expand.

15.

What implication does the financial instability hypothesis have for the balance sheets of different sectors of the economy?

Hyman Minsky‟s financial instability hypothesis suggests that the balance sheets of economic agents go through distinct phases, mirroring the lending behaviour of financial institutions. These phases are known as financial tranquillity, financial fragility and financial bust.

As we move between these phases, the balance sheets deteriorate. This deterioration can be viewed in terms of the ability of economic agents to afford their debts. From a position of having sufficient resources to meet all their debt obligations (financial tranquillity), economic agents are then only able to meet their interest payments (financial fragility) and, finally, can only meet current debt obligations by taking on further debt (financial bust). The result is a financial cycle culminating in a period of financial restraint that might be particularly severe and such that there is balance sheet recession.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

*16. Using the IS/LM model. under what circumstances will (a) a rise in investment and (b) a rise in money supply cause a large rise in national income? (a) This is represented by a rightward shift in the IS curve. The effect on national income will be bigger, the flatter the LM curve (i.e. the more responsive is the demand for money to a change in interest rates). It will also be bigger, the steeper the IS curve, since the less will any rise in the rate of interest dampen investment again (after its initial rise). (b) This is represented by a downward shift in the LM curve. The effect on national income will be greater the flatter is the IS curve (i.e. the more responsive investment and saving are to changes in interest rates, and the bigger is the multiplier). It will also be greater the steeper is the LM curve since the more interest rates will have to fall (and hence the more investment and national income will rise) in order to restore equilibrium in the money market. th

Answers to End-of-Chapter Questions in Chapter 20 (11 edition) 1.

For what reasons might the long-run aggregate supply curve be (a) vertical; (b) upward sloping; (c) downward sloping? (a) All the following must apply: (i) long-run equilibrium can only be at the natural rate of unemployment (i.e. there can be non long-run deficiency of demand); (ii) perfectly flexible wages and prices in the long run; (iii) no long-run money illusion; (iv) no increase in capacity as a result of investment stimulated by a rise in demand, or decrease in capacity caused by lack of investment during a recession. (b) If (i), (ii), (iii) and especially (iv) above do not hold. (c) If a rise in demand causes such a large rise in investment and such a large increase in capacity that in the long run increased output can be produced at a lower price level. In terms of the quantity equation (MV = PQ), what we are saying here is that an increase in MV has caused such a large rise in Q that P has fallen.

2.

How would you attempt to assess whether a particular period of inflation was the result of cost-push or demand-pull pressures?

As both Box 20.2 and the answer to Q13 at the end of Chapter 15 point out, it is very difficult, since most periods of inflation have a number of different but inter-connected causes. Nevertheless, if there are clear independent rises in demand (say, for example, the government decides to cut income tax and increase benefits just before an election) then it would be fair to categorise any resulting inflation as „demand pull‟. Likewise if there are clear independent rises in costs or reductions in aggregate supply (say, for example, a major oil price increase or a natural disaster) then it would be fair to categorise any resulting inflation as „cost push‟. Of course, in both types of case it would be necessary to have clear evidence that subsequent inflation was indeed caused by these events and not by other factors.

For this purpose you would need a model which showed the link between inflation and changes in either aggregate demand or costs, so that the influence of the various causes could be identified.

The problem is that, in most cases, cost-push and demand-pull factors interact. Thus it is difficult to distinguish „root‟ causes from secondary causes. As the answer to Q7 at the end of Chapter 15 argued, a rise in consumer demand (a seemingly demand-pull factor) might have been the result, at least in part, of pay increases secured by trade unions. Those pay rises (a seemingly cost-push factor) might, in turn, have been demanded because unions saw their position being strengthened by a fall in

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

unemployment, itself caused by higher demand. That rise in demand might have been caused, in part, by previous pay increases, and so on.

3.

Repeat the analysis undertaken in Figure 20.5 to consider the possible subsequent effects following a period of demand-pull deflation.

The analysis begins with the economy having experienced leftward shifts of the AD curve. Hence, both real national income and the economy‟s price level have fallen. Subsequent effects depend crucially on the impact of expectations and of adjustments in factor markets, notably the labour market. Therefore we would expect the short-run aggregate supply to start shifting.

If we assume that firms throughout the economy are reducing their prices and workers are willing to reduce wage demands then the short-run aggregate supply curve will begin to move downwards. All other things being equal, this would help to increase the economy‟s real national income.

However, some economists would question the extent to which wages are flexible downwards which would affect the extent to which the SRAS curve moves downwards. Furthermore, there may could be negative supply-side effects from the economic contraction perhaps in the form of lower investment by firms or a reduction in human capital, particularly if the downturn was to persist for any length of time. Such effect would work to push the SRAS curve vertically upwards.

4.

What implications would a vertical short-run aggregate supply curve have for the effects of demand management policy?

It would make it totally ineffective as a means of controlling output and employment in any systematic way.

What would cause (a) a steep DAD curve; (b) a gently sloping DAD curve? (a) If the central bank is more concerned about preventing fluctuations in national income than in keeping to the target rate of inflation – „the dove‟. (b) If the central bank is more concerned about keeping to the target rate of inflation than preventing fluctuations in national income – „the hawk‟.

Compare the short-run and long-run effects of (i) a temporary adverse supply shock and (ii) a permanent supply reduction under each of (a) and (b).

For (a)(i) and (b)(i), see Diagram 20.1. (a)(i) The dove. There would be a relatively large temporary increase in inflation (* to 1) and a relatively small temporary fall in national income (Y0 to Y1) as the economy moves along DAD1. In the long run, as the DAS curve reverts to its original level, so will inflation and national income

Rate of inflation (π)

5.

DAS2

1 2 *

DAS1

b c a

DAD2 DAD1 O

Real national income

Diagram 13 20.1 A temporary decrease in aggregate supply under different DAD curves

Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

(i.e. there will be a relatively big reduction in inflation and a relatively small rise in national income back to the original levels). (b)(i) The hawk. In this case, there would be a relatively small temporary increase in inflation (* to 2) and a relatively large temporary reduction in national income (Y0 to Y2) as the economy moves along DAD2. In the long run, as aggregate supply reverts to its original level, again so will inflation and national income (i.e. there will be a relatively small fall in inflation and a relatively large rise in national income back to the original levels).

For (a)(ii) and (b)(ii), see Diagram 20.2.

(a)(ii) The dove. The initial effects would be as in (a)(i) above. But, recognising the permanent nature of the fall in aggregate supply, the central bank would have to raise its target rate of interest, thereby shifting the (steep) DAD curve from DAD1 to DAD3. Long-term equilibrium would move from point a to point d. There would thus again be a big effect on inflation as it fell back to its target rate (2 to *). There would also have to be a relatively big reduction in national income (Y1 to Y3) given that there has been only a relatively modest reduction in the first place.

Rate of inflation (π)

Assume that the initial position is at point a with aggregate supply given by DAS1 while aggregate demand is given by DAD1 in the case of the dove and DAD2 in the case of the hawk. Aggregate supply now shifts to DAS2.

DAS2

2

DAS1

b c

1 *

d

a DAD2 DAD4 DAD3

O

Y3 Y2 Y1 Y0

DAD1 Real national income

Diagram 20.2 A permanent decrease in aggregate supply under different DAD curves

(b)(ii) The hawk. The initial effects would be as in (b)(i) above. But again, recognising the permanent nature of the fall in aggregate supply, the central bank would have to raise its target rate of interest, thereby shifting the this time shallower DAD curve (DAD2) to DAD4. Again, long-term equilibrium would move to point d. This time, however, the fall in inflation would need to be only modest ( 1 to *) as it had risen only a small amount above target in the first place. The required reduction in national income would also be relatively modest (Y2 to Y3), given that it had already fallen substantially in the first place.

6.

Under what circumstances would a rightward shift in the DAD curve lead to a permanent increase in real national income?

If it was accompanied by a rightward shift in the DAS curve. This could occur for totally unconnected reasons (e.g. the advance in technology), or it could be the result of a rise in investment leading not only to a rise in DAD but also a rise in capacity and hence a rise in DAS too.

7.

What impact would an increase in potential output have on the DAS curve? How would the long-term rate of economic growth be reflected by the DAS curve?

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

The DAS curve will move rightwards by the amount of the increase in potential output. The longerterm rate of growth is reflected in the rate at which the DAS curve moves rightwards.

8.

For what reasons may the natural rate of unemployment increase?

Imperfections and rigidities in the labour market increase (e.g. people become de-skilled or demotivated by prolonged unemployment in a recession), or the rate of structural change in the economy accelerates.

9.

Assume that there is a positive technological shock. How would this impact on the equilibrium level of employment and the economy’s potential output? Illustrate using diagrams of both the labour and goods markets.

There would be an increase in potential output. The effect on the natural level of employment would depend on whether the technology shock is labour augmenting and hence accompanied by an increase in the demand for labour or alternatively reduces the demand for labour. In the former case the increase in potential output would be accompanied by a decrease in the natural level of unemployment whereas in the latter case it would be accompanied by an increase in the natural level of unemployment.

Diagram 20.3 illustrates the possible economic impact of a positive technology shock that is labour augmenting. In diagram (a) the demand for labour curve shifts rightwards from ADL1 to ADL2 reflecting the increase in the productivity of labour. Equilibrium employment rises from Q1 to Q2. In diagram (b) the positive technology shock causes an upward movement of the economy‟s production function from PF1 to PF2 . Hence, with the equilibrium level of employment now Q2 and production function PF2, the equilibrium level of output has risen from Y1 to Y2. This is reflected in diagram (c) in rightwards shifts of both the short-run and long-run aggregate supply curves. If, in due course, the increase in potential real national income is reflected in an equivalent increase in real aggregate demand and so a rightward shift of the AD curve from AD1 to AD2 then equilibrium will be represented by point f in diagram (c).

d

Y2

W2 W1

Real national income

Real wage rate

ASL

b

(c) Goods market Price level (P)

(b) Production function

(a) Labour market

LRAS1 LRAS2

P1

e

SRAS1 SRAS2

PF2 c

Y1

f

PF1

a ADL2 ADL1 Q1 Q2 Number of workers

AD2 AD1 Q1 Q2 Number of workers

Y1 Y2 Real national income

Diagram 20.3 Labour-augmenting positive technology shock

10.

How might fluctuations in aggregate demand lead to changes in output even under the assumption of continuous market clearing?

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

Short-run changes in output are possible if the change in aggregate demand is unexpected. New classical economists sometimes refer to the short-run aggregate supply curve as the „surprise supply curve‟. This reflects the fact that changes in aggregate demand will have real effects in the short run if they come as a surprise. Some economists argue that there can be longer-term effects on output from changes in aggregate demand if there are subsequent supply-side effects. These may arise, for example, if investment levels are affected or if there are effects on the economy‟s human capital.

11.

Given the Keynesian explanation for the persistence of high levels of unemployment after the early 1980s and early 1990s recessions, what policies would you advocate to reduce unemployment in the years following a recession?

A careful management of demand so as to avoid slipping back into recession but also to avoid demand expanding too fast and hence unsustainably. This should encourage more investment and more training and prevent people being forced into long-term unemployment (and thereby becoming de-skilled).

Also, supply-side policies should be used. These would involve increased government expenditure on training and education and improved infrastructure.

12 What are the possible channels through which hysteresis effects can arise, such that demand shocks have persistent effects on the macroeconomy?

The labour market is a key channel. As we explain in the text, this may, for example, relate to the impact of unemployment on the accumulation of human capital or the pressure that the unemployment exerts on wage determination.

Other important channels include investment and R&D expenditure by firms, development opportunities for workers, learning by doing effects, knowledge transfer and the number of business start-ups. All of these factors are important in affecting the level and perhaps the growth of potential output. To the extent, therefore, that these are positively related to levels of economic activity, so current levels of economic activity affect the economy‟s potential output.

Answers to End-of-Chapter Questions in Chapter 21 (11th edition)

1.

Assume that inflation depends on two things: the level of aggregate demand, indicated by the inverse of unemployment (1/U), and the expected rate of inflation (π et). Assume that the rate of inflation (πt) is given by the equation: πt = (48/U – 6) + πet Assume initially (year 0) that the actual and expected rate of inflation is zero. (a) What is the current (natural) rate of unemployment?

With the actual and expected rate of inflation being zero, unemployment will currently be at the natural rate. To find this, therefore, we need to solve the above equation for where πt and πet equal zero.

0 = 48/U – 6 + 0  48/U = 6  48 = 6U  U=8 The natural rate of unemployment is therefore 8 per cent.

(Note that the natural rate of unemployment is given by the vertical Phillips curve, and therefore by any rate of inflation where the actual rate equals the expected rate. This can be demonstrated by

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

simply setting πt equal to πe t in the above equation. The solution will be exactly as demonstrated.) (b) Now assume in year 1 that the government wishes to reduce unemployment to 4 per cent and continues to expand aggregate demand by as much as is necessary to achieve this. Fill in the rows for years 0 to 4 in the following table. It is assumed for simplicity that the expected rate of inflation in a given year (πet) is equal to the actual rate of inflation in the previous year (πt–1).

See the top part of Table (b) below. (a)

(b)

Year

U

48/U – 6

+

πe

=

π

Year

U

48/U – 6

+

πe

=

π

0

...

...

+

...

=

...

0

8

0

+

0

=

0

1

...

...

+

...

=

...

1

4

6

+

0

=

6

2

...

...

+

...

=

...

2

4

6

+

6

=

12

3 4

... ...

... ...

+ +

... ...

= =

... ...

3 4

4 4

6 6

+ +

12 18

= =

18 24

5

...

...

+

...

=

...

5

16

–3

+

24

=

21

6

...

...

+

...

=

...

6

16

–3

+

21

=

18

7

...

...

+

...

=

...

7

16

–3

+

18

=

15

(c) Now assume in year 5 that the government, worried about rising inflation, reduces aggregate demand sufficiently to reduce inflation by 3 per cent in that year. What must the rate of unemployment be raised to in that year?

The term (48/U – 6) must now equal –3. Solving gives: 48/U – 6 = –3;  48/U = 3;  48 = 3U;  U = 16 (d) Assuming that unemployment stays at this high level, continue the table for years 5 to 7.

See the bottom part of Table (b) above.

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2.

In the accelerationist model, if the government tries to maintain unemployment below the natural rate, what will determine the speed at which inflation accelerates?

It will depend on the amount by which the government is trying to keep unemployment below the natural rate (a process which is determined by the level of excess demand). The more that unemployment is kept below the natural rate, the higher will be the value of f(1/U), and thus the more will inflation accelerate.

3.

What is the difference between adaptive expectations and rational expectations?

Adaptive expectations, as the name suggests, are expectations of inflation (or other economic phenomena) that people adjust in the light of new information. Thus, if people had expected a rate of inflation this year of 5 per cent and it turned out to be 8 per cent, then they would adjust their expectations upwards for next year‟s inflation – say to 6 or 7 per cent. Thus the expected rate of inflation for next year is a weighted average of this year‟s inflation and previous years‟.

Rational expectations are based on people‟s current assessment of the state of the economy and its likely effect on the economy. For professional forecasters and economists the reasoning may be very sophisticated. For most people, the reasoning will be based on what they hear or read and on hunches or guesses, but it is still based on a form of reasoning (however simple) rather than on the mechanical operation of a rule about the carry-through effect of past inflation rates into the future.

4.

How can adaptive expectations of inflation result in clockwise Phillips loops? Why would these loops not be completely regular?

If the economy starts at the natural rate of unemployment and the government expands aggregate demand, then the rate of inflation will rise, but, given that expectations (being adaptive) take a time to adjust, the rise in aggregate demand will not be fully absorbed in higher prices: there will be some fall in unemployment. In terms of Figure 21.4, this is consistent with a move from point a to b to c.

If this lower level of unemployment is to be maintained, nominal aggregate demand must go on being expanded in order to „keep ahead‟ of the upward adjustment in inflationary expectations. After a while, the government, becoming increasingly worried about rising inflation, will be prepared to let unemployment rise somewhat, but if unemployment is still below the natural rate there will still be a rise in inflation. In terms of Figure 21.4, there will be move from point c to d to e. If the government is then prepared to let unemployment rise above the natural rate in order to achieve a reduction in the rate of inflation, there will now be an increase in unemployment and a fall in inflation: but inflation will take a time to fall as expectations take a time to adjust downwards. In Figure 21.4, there will be movement down round the right-hand side of the loop, from point f to point i.

The loops are not regular because (a) there are many shocks to inflation and unemployment (e.g. major international events); (b) the natural rate of unemployment may change over time; (c) governments may change their economic policies according to their political agenda.

5.

For what reasons may the NAIRU increase?

Imperfections and rigidities in the labour market increase; people become de-skilled or demotivated by prolonged unemployment in a recession; or the rate of structural change in the economy accelerates.

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6.

What is meant by inflation bias? What factors affect the potential magnitude of inflation bias?

Inflation bias is the additional inflation caused by discretionary government policies without any longterm impact on the rate of unemployment (or output level). The concept has been an important theoretical justification for constraining government discretion and for central bank independence.

With inflationary bias, low inflation announcements lack credibility because the government has an incentive to renege on them and generate surprise inflation. In a new classical setting, with continuous market clearing and rational expectations, this results in a temporary reduction (increase) in unemployment (output).

The extent of inflation bias will depend largely on: (a) the preferences of policy-makers and the benefit they attribute to surprise inflation; (b) the extent to which policy-makers fear the future reputational costs from reneging; (c) their discount rate; (d) the extent to which there exists an exploitable short-run Phillips curve trade-off.

7.

Using the integrated DAD/DAS and EAPC/LRPC framework, analyse the effect of an unexpected increase in aggregate demand assuming that markets adjust relatively rapidly. Compare the adjustment path of the economy when inflationary expectations remain anchored with that when expectations are based on actual inflation in the previous period.

If inflationary expectations remain anchored, the EAPC and DAS curves will be unaffected by an unexpected increase in aggregate demand. If, however, inflationary expectations adjust to the increase in aggregate demand, the EAPC and DAS curves will shift. Specifically, a rise in inflationary expectations causes the EAPC and DAS curves to move vertically upwards which, as well as generating additional inflation, reduces economic activity.  (%)

(a) EAPC

 (%)

(b) DAD/DAS

LRPC

DAS2 (e = 1) DAS1 (e = )

1 2

b

*

1 2

c a

EAPC2 (e = 1)

*

b'

c' a'

DAD1 EAPC1 (e = *) O

U1

Un U2

U (%) O

DAD0 Y2 Yp

Y1

Y

Diagram 21.1 EAPC and DAD/DAS frameworks: demand-side shock

Take the case of a temporary unexpected positive demand-side shock. This causes the DAD curve in figure (b) in Diagram 21.1 to move rightwards from DAD0 to DAD1 and, as a result, real national income to rise from Yp (potential output) to Y1. The move in figure (b) along the DAS curve from point aꞌ to bꞌ, is mirrored by a move along EAPC1 in figure (a) from point a to point b. The

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unexpected increase in the rate of inflation from * to 1 makes it profitable for firms to increase economic activity. Unemployment therefore falls below the natural rate, Un, to U1. If for ease of argument we assume that this is a one period demand-shock, then in the second period the DAD curve moves back leftwards. Therefore, in the case of constant inflationary expectations (also known as anchored inflationary expectations), we see a move back down the unchanged EAPC and DAS curve.

Consequently, the unemployment rate and real national income return to their original values of Un and Yp respectively, and the inflation rate to *.

But now consider the potential economic impact of adaptive inflationary expectations such that the expected inflation rate equals the actual inflation rate of the previous period. In period 2, following the rise the rate of inflation * to 1, people revise their expectations of inflation upwards to 1. This causes the EAPC and DAS curve to move vertically upwards to EAPC2 and DAS2, respectively. At the same time, the demand shock dissipates and the DAD curve moves back to DAD0. The result, as illustrated, is that output falls below its potential level, say to Y2, and unemployment rises above its natural rate, say to U2. All other things be equal, as inflationary expectations then adjust downwards, the EAPC and DAS curve move vertically downwards. Gradually, the unemployment rate and real national income return to their original values of Un and Yp respectively, and the inflation rate to *.

8.

In what sense is it true to say that the Phillips curve is horizontal today?

Many countries today operate inflation rate targets. Since 1997, for example, the Bank of England has had operational responsibility to meet a symmetrical inflation rate target of 2 per cent, plus or minus 1 per cent. People have generally grown to believe that the target will be achieved. Indeed, inflation forecasts were particularly accurate up to the financial crisis. This reflected belief that the Bank of England would be successful in meeting its inflation target. A similar analysis holds for many other countries too.

So, does this mean that the Phillips curve has now become horizontal? The answer is that it depends on policy and, hence, on the central bank‟s remit. If the remit is to target inflation and the central bank successfully meets this target, and if people believe that it will continue to be successful, the path of inflation and unemployment will be a horizontal straight line. Movements left and right along the line will depend on what happens to unemployment. Even if the central bank remains committed to inflation targeting and does succeed in achieving the target rate of inflation, in the short term unemployment will fluctuate with the business cycle. Thus, there may be movements left or right from one year to the next depending on the level of economic activity. Such fluctuations in unemployment are consistent with a stable inflation rate, provided that the fluctuations are mild and are not enough to alter people‟s expectations of inflation. Over the longer term, movements left or right will depend on what happens to equilibrium unemployment.

9.

Assume that the economy is at potential output and the natural rate of unemployment and that inflation is at the target rate set for the central bank by the government. In each of the following scenarios apply the integrated EAPC, DAD/DAS and IS/MP framework to analyse the economy’s adjustment path. (a) A temporary fall in aggregate demand under the assumption that inflationary expectations remain anchored. (b) A temporary fall in aggregate demand where inflationary expectations are based on the rate of inflation in the previous period. (c) A temporary positive supply shock where inflationary expectations are based on the rate of inflation in the previous period.

In each of the following cases, the shock is assumed to last for one period.

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(a) See Diagram 21.2. The negative demand-side shock results in both the IS and DAD curves moving leftwards. This causes economic activity to fall: real national income falls (to Y1) and unemployment rises (to U1). The negative shock causes the inflation rate to fall below target (from * to 1) which results in the central bank reducing real interest rates to r1 (represented by the slide down the short-run MP curve, MP1). In this scenario, the shock dissipates and the IS and DAD curves move back rightwards to their original positions with the initial equilibrium position restored. (a) EAPC

(b) DAD/DAD



LRPC



LRDAS

*

a'

*

a

b'

1

1

(c) IS/MP DAS1

b

r1

b''

DAD1 U

U1

a''

r*

EAPC1 Un

MP1

r

DAD2 Y1 Yp

IS Y

IS1 Y

Y1 Yp

Diagram 21.2 Decrease in real aggregate demand with anchored inflationary expectations

(b) See Diagram 21.3. The initial effects of the negative demand-side shock are given in the answer above, with real national income falling to Y1, unemployment rising to U1 and the inflation rate falling below target to 1. As before, the central bank reducing real interest rates to r1. But now, as we move into period 2, despite the demand shock dissipating and the DAD and IS curves moving back to their original positions, inflationary expectations are lower at 1. This is reflected in the vertical downward shifts of the EAPC and DAS and MP curves. (a) EAPC

 * 2 1

(b) DAD/DAD



LRPC a' c'

b' EAPC1

* 2 1

U1

r

MP1

r* r2

a''

LRDAS DAS1 DAS2 a c

b

r1

MP2 c'' b''

DAD1

EAPC2 U2 Un

(c) IS/MP

DAD2 U

Y1 Yp Y2

IS2

Y Y1 Yp Y2

Diagram 21.3 Decrease in real aggregate demand with adaptive inflationary expectations

There are now conflicting pressures on monetary policy. Lower inflation-rate expectations allow monetary policy to be eased as captured by the lower vertical position of MP2 compared with MP1. However, the dissipation of the negative demand shock puts upward pressure on interest rates. For the time being, lower inflation-rate expectations mean that, despite the removal of the negative demand shock, real interest rates are below their natural rate, r*. Hence, as illustrated in the diagram, unemployment now falls below its natural rate (to U2), while output rises above its potential output level (to Y2). Meanwhile, the inflation rate rises to 2 on the back of the monetary

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easing and rising levels of aggregate demand. Gradually, all other things being equal, the economy returns to its initial long-run equilibrium as inflationary expectations rise and monetary policy is tightened.

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(c) See diagram 21.4. The positive supply shock has the effect of causing the EAPC and the DAS and MP curves to shift vertically downwards to EAPC2, DAS2 and MP2, respectively. Hence, the central bank lowers real interest rates in response to the lower rate of inflation. (a) EAPC



LRPC

a'

* 2 1

c' b'

U1 U2 Un

(b) DAD/DAD



LRDAS

* 2 EAPC1 1 EAPC3 EAPC2 U

(c) IS/MP DAS1 DAS3 DAS2

MP1

r

MP3 MP2

a

r* r2 r1

c b

a'' c'' b''

DAD1 Yp Y2 Y1

IS1 Y

Yp Y2 Y1

Diagram 21.4 Positive supply shock with adaptive inflationary expectations

The extent of the cut in interest rates will, other things being equal, depend on the monetary policy rule. Despite the loosening of monetary policy, inflationary expectations fall in period 2.

Hence, although the initial inflationary shock has now disappeared, the EAPC and the DAS and MP curves remain below their initial position. Thereafter, they gradually shift upwards as inflationary expectations rise, for example to EAPC3, DAS3 and MP3. As they do, real interest rates rise and economic activity falls back. Eventually, the economy returns to its initial long-run equilibrium.

Answers to End-of-Chapter Questions in Chapter 22 (11th edition)

1.

What are the problems of relying on automatic fiscal stabilisers to ensure a stable economy at full employment?

▪ ▪

▪ ▪ ▪ ▪

2.

They can only reduce fluctuations (by reducing the size of the multiplier), not eliminate them.

The more strongly they stabilise the economy (i.e. the smaller they make the multiplier), the more that taxation and government expenditure will have to change as income changes. For them to have a strong stabilising effect, therefore, tax rates would have to be high, as would the marginal rate of benefit reduction. This could have serious disincentive effects.

They can only react to problems, not anticipate them.

They will need to be adjusted as the full-employment level of income itself changes over time.

They can act as a drag on recovery from recession.

Attempting to maintain full employment through (automatic) demand management could be inflationary.

Does it matter if a country has a large national debt as a proportion of its national income?

It means that the government will have to finance the payment of a large amount of interest. This is not necessarily a problem, given that a large proportion of the interest payments will be made to domestic residents, who may then be willing to lend it back to the government or can use it to pay the otherwise higher taxes that would be necessary to finance the interest payments. It does have a redistributive

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effect, however, from taxpayers generally to the holders of government debt. If the interest payments are financed by further loans, then total debt will increase and there will arise the possible problem of additional government borrowing crowding out additional private borrowing.

To the extent that recipients of interest payments reside abroad, then there will be a drain on the investment income part of the current account of the balance of payments. Of course, that could be largely offset by receipts of interest on the national debt of other countries.

Large amounts of interest payments do make government finances particularly vulnerable to fluctuations in international interest rates.

Larger debt-to-GDP ratios tend to be more problematic for countries with lower longer-term economic growth rates and/or high real interest rates. For such countries, the debt-to-GDP ratio has the potential to rise quickly, increasing the significance of the issues identified above but also raising concerns around the sustainability of their public finances. When such concerns increase, countries can find it increasingly more difficult to use the financial markets to raise the funds they need.

3.

If the government is running a budget deficit, does this mean that national income will increase?

National income will rise if injections (J) exceed withdrawals (W). A budget deficit means that government expenditure (an injection) exceeds taxation (a withdrawal). Whether total injections exceed total withdrawals, however, depends on the size of the other two injections (I and X) and the other two withdrawals (S and M). A budget deficit will cause national income to rise, therefore, provided its expansionary effect is not negated by the other two withdrawals exceeding the other two injections: i.e. so long as (G – T) > [(S + M) – (I + X)].

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4.

Of what significance are primary deficits or surpluses for the dynamics of a government’s debt-toGDP ratio?

As explained in the text, the primary balance is important for analysing the path of a government‟s debt-to-GDP ratio. In simple terms, for this ratio to fall government needs to run a given primary balance-to-GDP ratio. However, the particular value of primary balance-to-GDP ratio that is needed depends on: (i) the current debt-to-GDP ratio (D/Yn), (ii) the real rate of interest (r); (iii) the real economic growth rate (Yr/Yr). For any country, where the real rate of interest is greater than its real growth rate (r > Yr/Yr), it must run a primary balance surplus. This surplus will need to be larger the higher the existing debt-to-GDP ratio and the higher the real rate of interest relative to the real rate of economic growth.

5.

6.

What factors determine the effectiveness of discretionary fiscal policy?

▪

The accuracy of forecasting the course the economy would take without the policy (in order to determine what policy measures are needed).

▪

The ability to forecast the magnitude of the effect of changes in G and T on other injections and withdrawals (e.g. the amount of crowding out).

▪

The ability to forecast the size and timing of the multiplier and accelerator effects.

▪

The ability of governments to act quickly.

▪

The relative effects of changes in aggregate demand on the various macroeconomic objectives.

▪

The size and nature of any side effects.

▪

The size and nature of any random shocks.

Why is it difficult to use fiscal policy to ‘fine tune’ the economy?

Because of (a) the difficulties in forecasting the course of the economy and any random shocks, and thus the difficulty in deciding on the appropriate magnitude of any changes in G or T; (b) the difficulties in predicting the magnitude of the effects of any changes in G and T; (c) the difficulties in predicting the timing of the effects of fiscal policy, given the substantial time lags involved; (d) the difficulties in taking policy measures early enough, again given the time lags involved.

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7.

Assume that a bank has the following simplified balance sheet, and is operating at its desired liquidity ratio.

Liabilities

(£m)

Assets

Deposits

100

Balances with the central bank

10

Advances

90

—— 100

(£m)

—— 100

Now assume that the central bank repurchases £5 million of government bonds on the open market.

Assume that the people who sell the bonds all have their accounts with this bank. (a) Draw up the new balance sheet directly after the purchase of the bonds. (b) Now draw up the eventual balance sheet after all credit creation has taken place. (c) Would there be a similar effect if the central bank rediscounted £5 billion of Treasury bills? (d) How would such open market operations affect the rate of interest? (a)

Balance sheet directly after purchase of bonds Liabilities

(£m)

Assets

Old deposits New deposits

100 5

Old balances with the central bank

10 5

New balances with central bank

90

—— 105

(b)

Advances

(£m)

—— 105

Eventual balance sheet after credit creation has taken place (assuming a 10% liquidity ratio) Liabilities

(£m)

Assets

Old deposits

100

New deposits Further deposits

5 45

Old balances with the central bank

—— 150

(£m) 10

New balances with central bank

5 90

Old advances

45

Further advances

—— 150

(c) No. To the extent that the holding of Treasury bills by the banking sector was reduced, this would reduce the size of the increase in banks‟ liquidity and hence reduce the size of the increase in advances. Only if all the bills purchased by the central bank came from outside the banking sector would the effect be the same as in (b) above. If all the bills came from the banking sector, there would be little or no increase in liquidity, and hence little or no increase in advances. (d) The extra demand for bills by the central bank would increase their price and hence reduce their rate of rediscount. The effect would be to drive down interest rates.

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8.

Is it possible for the government to target the money supply over the longer term without targeting the level of public-sector net borrowing?

Yes, providing that it is prepared to adjust interest rates as necessary to keep money supply on target.

Control of public-sector net borrowing, nevertheless, would help in this process. The reason is as follows: targeting money supply normally means restricting its growth. But since public-sector borrowing is a major source of growth in the money supply, restricting the size of borrowing would help.

9.

What are the mechanics whereby the central bank raises the rate of interest?

The central bank conducts open-market operations in the bill and gilt repo markets. By keeping banks generally short of liquidity, it can decide the rate of interest at which it will make liquidity available through its open-market operations. By raising this rate, there is then a knock-on effect on other interest rates.

10.

What is Goodhart’s Law? How is it relevant to (a) monetary policy; (b) using assignment grades to assess a student’s ability; (c) paying workers according to the amount of output they produce; (d) awarding local authority contracts to cleaning or refuse disposal companies on the basis of tendered prices?

Controlling a symptom of a problem, or targeting an indicator of a problem, will not cure the problem: it will simply mean that the part being controlled ceases to be a good indicator of the problem. „To control is to distort.‟ (a) Controlling a given measure of the money supply will simply divert business in money markets away from assets included in that measure, with the result that that measure becomes a poor indicator of economic or financial activity. (b) Students will tend to devote most of their energies into doing well in their assignments and tend to neglect non-assessed parts of the course. Thus performance in assignments becomes a poor indicator of a student‟s overall ability in that subject. (c) Workers will tend to produce as much as possible and tend to neglect quality. This was a problem in the former Soviet Union, where factories were set targets in terms of the number of units produced, or in terms of weight or volume. As a result, the quality of output was often very poor. (d) Companies will often tender a low price to get the contract and will then provide an inferior service. The contract will often specify targets: for example, number of houses‟ refuse collected in a day. The refuse disposal company may then spill rubbish or leave bins in the street rather than returning them to the house/garden.

11.

‘It is easier to control the monetary base than broader money, but it is less relevant to do so.’ Do you agree with this statement?

The monetary base is much more within the direct control of the Bank of England. On the other hand, by controlling only the monetary base, disintermediation may take place (Goodhart‟s law). The overall cash ratio in the economy may fall.

Controlling broad money may be more difficult because it has to be done more indirectly through controlling interest rates. On the other hand, general changes in interest rates throughout the economy will not lead to disintermediation (within the country), and therefore will have a more reliable effect. (Note, however, that aggregate demand may be insensitive to interest rate changes.)

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12.

Compare the relative merits of targeting (a) the money supply; (b) the exchange rate; (c) the rate of inflation. (a) Money supply targets are difficult to achieve and even if they are achieved, they may, as a result, become a poor indicator of the state of aggregate demand (Goodhart‟s Law). (b) Exchange-rate targets may be useful if a country is trying to align itself with another country‟s currency with a view to forming a monetary union (e.g. the UK getting ready to join the euro). If successful, they can help to create a more stable business environment for exporters and importers and can encourage inward investment to the country. But exchange rate targets bring serious disadvantages if the targeted exchange rate is not the long-term equilibrium one. Adherence to a disequilibrium exchange rate target can lead to destabilising speculation against the currency and a possible resulting abandoning of the target (as was the case when the UK was forced to leave the ERM in 1992: see section 26.2). Also there is the problem that the main instrument for achieving the target exchange rate is the interest rate. But if the interest rate is being used to achieve an exchange rate target, it cannot at the same time be used for managing aggregate demand for the purposes of keeping inflation on target or avoiding recession. (c) Inflation targets are the easiest to achieve and have had considerable success around the world in creating a stable macroeconomic environment. But they have become a victim of their own success. As people expect the inflation target to be met, the target rate can be consistent with both a growing economy and a relatively stagnant one. In other words, inflation ceases to be a good indicator of the state of aggregate demand (Goodhart‟s Law again). In such cases, the central bank must take a more discretionary approach to the use of monetary policy. It should attempt to use interest rates to achieve a stable growth in aggregate demand in line with the growth in potential output.

13.

Is there a compromise between purely discretionary policy and adhering to strict targets?

Yes. Targets could be set, but reassessed periodically in the light of the evidence of the success of the policy and of changing circumstances. Alternatively, loose targets for a number of different objectives could be set, and then the government could seek to achieve the best compromise between them if there were any apparent conflict. th

Answers to End-of-Chapter Questions in Chapter 23 (11 edition) 1.

For what reasons do countries experience very different long-run rates of economic growth from each other?

Because they have different rates of growth in (a) the quantity of factors and (b) factor productivity.

Different rates of growth in the quantity of factors may be the result of differences in the rate of investment, differences in the rate of discovery and exploitation of new resources (e.g. oil), differences in population growth and participation rates. Different rates of growth in factor productivity may be the result of differences in incentives for and attitudes towards risk-taking, different rates of technological progress and the implementation of new technology, differences in education and training, differences in institutions and other infrastructure supporting innovation.

2.

Why do developed countries experience a degree of convergence over time? Would you expect there to be total convergence of GDP per head?

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Because technological innovations in one country tend to be copied by other countries. Also capital tends to be attracted to low-wage countries, helping to increase their rate of economic growth. Total convergence is unlikely, however, given differences in factor endowments between countries and differences in attitudes and institutions.

3.

If increased investment (using current technology) does not lead to increased long-run economic growth, does it bring any benefits?

Yes, it leads to a higher steady-state level of national income.

4.

What determines the rate of depreciation of capital? What would happen if the rate of depreciation fell?

The durability of capital equipment and the speed with which old machines become obsolescent as a result of new technology or changing tastes.

If the rate of depreciation fell, there would be a higher steady-state level of national income per worker. In other words, the economy could support a higher capital stock per worker with the current rate of investment. In terms of Figure 23.5, the Ir/L line would pivot downwards, leading to a higher equilibrium level of K/L and Y/L.

5.

What is meant by the ‘steady-state economic growth path’? What determines its slope?

The long-run equilibrium rate of economic growth. Its slope depends on the rate of technological progress. The faster the rate of technological progress, the higher the equilibrium rate of economic growth and the steeper the steady-state growth path in Figure 23.11.

6.

What is the significance of the term ‘endogenous’ in endogenous growth theory? What, according to this theory, determines the long-run rate of economic growth?

The endogenous element is technological progress. In other words, instead of assuming that technological progress is a „given‟ (i.e. is exogenous), endogenous growth theory assumes that technological progress can be encouraged by investment in education and training (i.e. investment in human capital), research and development and appropriate infrastructure. It is also encouraged by a social and economic environment that encourages risk-taking and innovation. In endogenous growth theories, the more favourable is the political, social and economic environment to technological progress and innovation, the faster will be the long-run rate of economic growth. Endogenous growth theory recognises that „virtuous circles‟ can arise whereby faster growth encourages greater innovation and risk-taking, and this in turn leads to faster economic growth.

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7.

Under what circumstances would a higher rate of investment lead to a higher rate of economic growth?

Unless the higher rate of investment resulted in faster technological progress, a higher rate of economic growth would be only temporary. Once the higher rate of investment had been absorbed by higher replacement investment, growth would be no higher than it would have been (e.g. by the underlying rate of technological progress): output, however, would be higher. If a higher rate of investment is to lead to a permanent increase in the rate of economic growth, the higher investment must result in a faster rate of technological progress. This might occur perhaps through the impact of more R&D or through the external benefits of investment projects, such as knowledge spill-overs, whereby new ideas generate further new ideas and so on.

8.

What determines the rate of growth in total factor productivity?

There are several determinants, which include: ▪ Private investment in new physical capital (machinery and buildings) and in research and development (R&D).

▪ Public investment in education, R&D and infrastructure.

▪ Training and the development of labour skills.

▪ Innovation and the application of new technology.

▪ The organisation and management of factors of production.

▪ The rate of entry of new firms into markets: generally such firms will have higher productivity than existing firms.

▪ The business environment in which firms operate. Is there competition over the quality and design of products? Is there competitive pressure to reduce costs?

9.

What policy prescriptions do the neoclassical and endogenous growth theories offer policy makers who are looking to raise their country’s long-run growth rate?

While the neoclassical model clearly illustrates the importance of technological progress in raising long-run growth rates and in preventing economies from being stuck at the „steady state‟, technology is exogenous to the model. In other words, technological progress is not formally incorporated into the model. Endogenous growth theories, however, do attempt to model technological progress.

Determinants of technological progress in these models include: ▪ composition of capital stock, e.g. proportion of capital stock embodying new technologies; ▪ public and private investment in education science and research and development; ▪ degree of competition amongst firms; ▪ incentives for firms to innovate (including tax breaks or government grants); ▪ willingness of financial institutions to lend to support investment opportunities.

For more analysis on specific government policies to increase long-run economic growth rates see sections 23.4 to 23.6 on supply-side policies.

10.

For what possible reasons may a country experience a persistently faster rate of economic growth than another?

Any or all of the following: ▪ A higher rate of savings and investment.

▪ Greater investment in education and training.

▪ A faster rate of increase in productivity.

▪ A more stable economy.

▪ A business environment conducive to investment (e.g. tax relief for investment, a minimum amount of government bureaucracy surrounding investment, an efficient capital market).

▪ A better transport and communications infrastructure.

▪ A more adventurous and entrepreneurial business culture.

▪ The discovery of new raw materials (e.g. oil).

▪ More harmonious industrial relations.

▪ A better motivated workforce.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

11.

What is the relationship between ‘successful’ supply-side policies and unemployment in (i) the short run and (ii) the long run, according to (a) Keynesian and (b) monetarist assumptions?

It depends on the nature of the supply-side policy. If it has the effect of increasing labour productivity, then, in Keynesian analysis, both in the short run and in the long run, the effect may be to increase unemployment. What is happening here is that the supply-side policy has increased potential output: it has shifted the (non-vertical) aggregate supply curve to the right. Unless there is a corresponding increase in aggregate demand, the gap between potential and actual output will widen. Thus it may be necessary to have active reflationary policy, especially in the short run when markets are less likely to be responsive to such changes. Monetarists argue that markets are much more likely to be able to cope with such shifts in aggregate supply without a rise in unemployment, and certainly in the long run, when the aggregate supply curve is vertical.

If the supply-side policy acts directly on employment (rather than on output), then the effect will be to reduce equilibrium unemployment. For example, improved job information would help to reduce frictional unemployment, and improved education and training would tend to increase labour mobility and reduce structural unemployment. Both Keynesians and monetarists would accept that supply-side policies to reduce unemployment can be effective, and will shift the Phillips curve (vertical or nonvertical) to the left. They would disagree, however, as to what type of supply-side policies (interventionist or non-interventionist) are most likely to be successful.

12.

Why might market-orientated supply-side policies have undesirable side effects on aggregate demand?

Tax cuts to increase incentives, other things being equal, will lead to a rise in aggregate demand.

Unless the supply-side policy is able to cause a matching rightward shift in the aggregate supply curve, or unless the economy is currently operating below capacity, the effect will be inflationary. Cuts in government expenditure, if applied during a recession, will tend to make the recession worse.

13.

What types of tax cuts are likely to create the greatest (a) incentives; (b) disincentives to effort?

Cuts in income tax will tend to encourage people to work more/harder, because they increase the opportunity cost of leisure. This is the substitution effect: an incentive. However, by increasing aftertax incomes, they will also tend to make people feel that they can afford to work less. This is the income effect: a disincentive. Cutting marginal rates of tax, especially for those just into a given tax bracket, will have a substitution effect, but very little income effect, and therefore have a net incentive effect. Increasing allowances, however, will have an income effect, but no substitution effect, since the marginal rate of tax is not altered. Cutting the marginal rate for those already paying a considerable amount of the tax will have a large income effect relative to the substitution effect. In both these cases there is a net disincentive effect.

Tax cuts for business will tend to have more of an incentive effect the more that the benefits of the tax cuts are conditional upon increasing investment or cutting costs. Simple cuts in corporation tax (tax on profits), like cuts in income tax, will have both an income and a substitution effect. When the cut is first made, the windfall rise in profits may have a net disincentive effect. However, a country with relatively low corporation taxes is likely to encourage more investment over the longer term, both domestic and inward.

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14.

Is deindustrialisation necessarily undesirable?

If it is one of the results of a prolonged recession, then it can be a serious problem, especially if capacity is lost in the process that cannot then be used as the economy recovers. However, a decline in older inefficient industries and their replacement by more efficient alternative industries is an important part of economic development and change. Of course, there may be serious adjustment costs, and certainly those losing their jobs in the older industries will suffer from the process, at least in the short run.

Does it matter if the new industries tend to be in the service sector, with the result that manufacturing as a proportion of total production declines? This is not necessarily a problem if it merely reflects a rise in the demand for services relative to manufactured products, or if the output of the service sector can be exported in exchange for imports of manufactures. If, however, there is not a corresponding rise in service exports, serious balance of payments problems may develop (see Chapter 25).

15.

In what ways can interventionist industrial policy work with the market, rather than against it? What are the arguments for and against such policy?

By providing various forms of modern infrastructure (roads, railways, telecommunications, etc.) to help private-sector firms operate more effectively; by subsidising or giving tax relief for private-sector investment and training.

By relying on such measures, rather than on regulation, the government is still allowing the market to continue providing the incentives to firms to innovate and invest, and at the same time the government can use the policy to correct for various market failures (such as externalities). However, when there is a serious problem of the abuse of monopoly power or serious externalities, regulation or direct government provision (e.g. educational establishments) may be more appropriate (see the arguments developed in sections 12.2 and 12.3).

16.

What are the arguments for and against relying entirely on discretionary regional and urban policy?

For: ▪ ▪

They can be targeted on those firms or those projects that will create the most jobs, and hence are more „cost effective‟ than automatic grants.

They can be used to encourage firms to invest in labour-intensive technology.

Against: ▪ The government may be reluctant to grant them if it is anxious to cut its overall expenditure.

▪ The government, or one of its agencies, will have to investigate each case, which is costly in terms of administration.

▪ Even with investigation, the government may only obtain highly imperfect information about the number of jobs that will be created. Firms, in order to secure the grant, may exaggerate the number of jobs they will create.

17.

Select a European country other than the UK and compare its regional and urban policy with that of the UK. You will probably need to do a Web search to answer this question. A good starting place for information on regional policy in the UK and in the EU, is site E2 and G12 respectively in the hotlinks section of the Sloman Economics News site. th

Answers to End-of-Chapter Questions in Chapter 24 (11 edition) 32

Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

1.

Imagine that two countries, Richland and Poorland, can produce just two goods, computers and coal.

Assume that for a given amount of land and capital, the output of these two products requires the following constant amounts of labour: Richland

Poorland

1 computer

2

4

100 tonnes of coal

4

5

Assume that each country has 20 million workers. (a) Draw the production possibility curves for the two countries (on two separate diagrams). (b) If there is no trade, and in each country 12 million workers produce computers and 8 million workers produce coal, how many computers and tonnes of coal much will each country produce?

What will be the total production of each product? (c) What is the opportunity cost of a computer in (i) Richland; (ii) Poorland? (d) What is the opportunity cost of 100 tonnes of coal in (i) Richland; (ii) Poorland? (e) Which country has a comparative advantage in which product? (f) Assuming that price equals marginal cost, which of the following would represent possible exchange ratios? (i) 1 computer for 40 tonnes of coal; (ii) 2 computers for 140 tonnes of coal; (iii) 1 computer for 100 tonnes of coal; (iv) 1 computer for 60 tonnes of coal; (v) 4 computers for 360 tonnes of coal. (g) Assume that trade now takes place and that 1 computer exchanges for 65 tonnes of coal. Both countries specialise completely in the product in which they have a comparative advantage. How much does each country produce of its respective product? (h) The country producing computers sells 6 million domestically. How many does it export to the other country? (i) How much coal does the other country consume? (j) Construct a table like Table 24.4 to show the no-trade and with-trade positions of each country?

12

6

10

5

Computers (millions)

Computers (millions)

(a) See Diagram 24.1.

8 6 4 2

4 3 2 1

0

0 0

100

200

300

400

500

600

0

100

200

300

400

Tonnes of coal (millions)

Tonnes of coal (millions)

(a) Richland

(b) Poorland

Diagram 24.1 Production possibilities for Richland and Poorland

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(b) Richland: 6 million computers; 200 million tonnes of coal Poorland: 3 million computers; 160 million tonnes of coal Total: 9 million computers; 360 million tonnes of coal (c) (i) 50 tonnes of coal (for every 2 workers diverted to computer production, 50 tonnes of coal are sacrificed). (ii) 80 tonnes of coal (for every 4 workers diverted to computer production, 80 tonnes of coal are sacrificed). (d) (i) 2 computers (i.e. 4/2) (ii) 1¼ computers (i.e. 5/4) (e) Richland has a comparative advantage in computers (it can produce them at a lower opportunity cost than can Poorland).

Poorland has a comparative advantage in coal (it can produce it at a lower opportunity cost than can Richland) (f) Before trade 1 computer exchanges for 50 tonnes of coal in Richland and for 80 tonnes of coal in Poorland. If the computer:coal trade ratio is anywhere between 1:50 and 1:80, both countries can gain from trade, and therefore trade would take place.

Ratios (ii) and (iv) meet this condition, and are therefore possible exchange ratios. In the case of (i) it would benefit neither country to export computers. In the cases of (iii) and (v) it would benefit neither country to export coal. Thus (i), (iii) and (v) are not possible exchange ratios. (g) Richland: 10 million computers Poorland: 400 million tonnes of coal (h) 4 million (i.e. 10 million – 6 million) (i) Poorland must import 4 million computers, for which it must export 260 million tonnes of coal (i.e. 4 million  65 tonnes). It will therefore consume the remaining 140 million tonnes of coal. (j) See the following table: Richland Production Consumption

Poorland Imports (–)

Production Consumption

Exports (+)

2.

Total Imports (–)

Production Consumption

Exports (+)

No trade Computers (m)

6

6

0

3

3

0

9

9

Coal (tonnes m)

200

200

0

160

160

0

360

360

With trade Computers (m)

10

6

+4

0

4

–4

10

10

Coal (tonnes m)

0

260

–260

400

140

+260

400

400

If capital moves from developed to less developed countries, and labour moves from less developed to developed countries, what effects will these factor movements have on wage rates and the return on capital in the two types of country?

Wage differentials between developed and less developed countries will be reduced (i.e. the movement of labour will reduce wages in developed countries and increase them in less developed countries). The return on capital will increase in the developed countries and decrease in the less developed countries.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

3.

What factors determine a country’s terms of trade?

The terms of trade are given by the average price of exports (Px) divided by the average price of imports (Pm). This price ratio is determined by the demand and supply of tradable goods and services.

The higher the demand for exports and the lower the demand for imports, the higher will be the terms of trade. Anything, therefore, that causes the demand for exports to rise relative to the demand for imports (a rise in incomes abroad relative to domestic incomes, a shift in tastes towards domestically produced goods, an improvement in the quality of domestically produced goods relative to goods produced abroad, etc.) will cause the terms of trade to rise.

A major influence on the terms of trade is the exchange rate: the higher the exchange rate, the higher the terms of trade. Thus, anything that influences the exchange rate will also influence the terms of trade. For example, a rise in interest rates, by causing an inflow of capital, will lead to an appreciation of the exchange rate and therefore an increase in the terms of trade.

4.

Go through each of the arguments for restricting trade (both those of general validity and those having some validity for specific countries) and provide a counter-argument for not restricting trade.

The infant industry argument. Infants may never „grow up‟: the support may allow them to remain inefficient; not all those industries claiming and receiving infant-industry protection are genuine infants (i.e. those which have a potential comparative advantage); infants may be better promoted through subsidies or other support, rather than by restricting trade – imposing tariffs, by raising prices, cuts down on the consumption not only of imported substitutes, but also of the goods produced by the infant itself.

Changing comparative advantage and the inflexibility of markets. Factor immobility is better tackled directly, rather than by protecting industries which have growth potential in export markets. Examples of schemes to encourage greater factor mobility are: retraining schemes, investment grants, tax relief for companies‟ relocation expenses and government advice on exporting.

To prevent dumping and other unfair trade practices. In the short run, consumers will gain from cheap imports. Even if the country loses in the long run from the dumping, the use of protection to stop the dumping may contribute to growing worldwide protectionism. It would be better to try to negotiate an end to the dumping, perhaps through the auspices of the World Trade Organization.

To prevent the establishment of a foreign-based monopoly. There might be international competition to prevent individual foreign companies gaining monopoly power. Also, in practice it would be very difficult to decide when protection is warranted, given that many domestic companies would want to make a case for protection for themselves.

To reduce reliance on goods with little dynamic potential. In many cases, world market conditions change relatively slowly, and thus most firms will be able to adjust to new opportunities and declining old ones without the need for intervention.

To spread the risks of fluctuating markets.

If countries are vulnerable to fluctuations in international markets, then individual companies trading in such markets will also be vulnerable, and therefore may themselves decide to diversify.

To reduce the influence of trade on consumer tastes.

Given the global nature of mass communication, it is very difficult in practice to prevent people‟s tastes being influenced by the products and marketing of multinational companies.

To prevent the importation of harmful goods.

If it is agreed that the goods are harmful (e.g. certain drugs), then attempting to stop imports may well be desirable, but should probably be part of a much broader strategy to stop the production, sale and consumption of such products.

To take account of externalities.

If the externalities are within the country, then they are better dealt with by tackling them at source: e.g. taxing production or consumption that involves negative externalities and subsidising production or consumption that involves positive externalities.

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To improve a country’s terms of trade by exploiting its market power. Although the export monopoly argument is valid in a static context for certain products, it is likely that export taxes will erode the country‟s monopoly power over the longer term. By driving up the price of exports in which the country has monopoly power, other firms in other countries are likely to break into the international market. In practice there are few goods in which individual countries do have significant monopoly power (except for a few raw materials). There are even fewer where countries have significant monopsony power in importing: with a growing process of globalisation, companies have many alternative markets in which to sell.

To protect declining industries.

There are various ways of helping individuals cope with the adjustment costs of economic change that are not as drastic as cutting down on trade. For example, retraining and special redundancy settlements could help workers who lose their jobs in declining industries.

To improve the balance of payments.

In virtually all cases, there are other methods of dealing with balance of payments problems, both short term and long term.

5.

If countries are so keen to reduce the barriers to trade, why do many countries frequently attempt to erect barriers?

This is an example of the prisoners’ dilemma (see section 8.3). There may be a net gain to all countries from a reduction in trade barriers, but any one individual country may gain if it alone erects a barrier against other countries, and will suffer if it does not erect barriers and other countries do. The effect of this is that countries will all tend to increase their protection unless international agreements (such as those under the auspices of the WTO) can be signed, binding the signatories to refrain from increasing the protection of their industries.

6.

What factors will determine whether a country’s joining a customs union will lead to trade creation or trade diversion?

▪ ▪

7.

Why is it difficult to estimate the magnitude of the benefits of completing the internal market of the EU? ▪ ▪ ▪ ▪

8.

The size of the external tariff. The higher the external tariff, the more likely it is that trade diversion will take place.

The difference in costs of production between countries inside and outside the union. The smaller the cost differences, the more likely it is that trade diversion will take place.

Removing barriers to trade creates opportunities. The degree to which firms and individuals will take advantage of those opportunities is uncertain.

It depends on whether any barriers remain (e.g. administrative barriers), and on whether there will be a single currency, and if so when and for which countries.

It depends on the rate of economic growth and other macroeconomic factors. The macroeconomy is difficult to forecast more than a few months ahead.

It is difficult to predict the degree to which the increased competition in the single market will stimulate increased technical progress and the increased spread of skills and information.

Look through the costs and benefits that we identified from the completion of the internal market. Do the same costs and benefits arise from the enlarged EU of 27 members?

The possible benefits of trade creation, economies of scale and greater competition all apply, as do the costs of adverse regional multiplier effects, the costs of change and the possible increase in monopoly power. The bigger the EU becomes, however, the less the likelihood of trade diversion.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

9.

Was a ‘hard Brexit’ (reverting to WTO rules and negotiating bilateral trade deals) necessarily an inferior alternative for the UK to remaining in the European single market or, at least, in the customs union?

As explained in section 24.5, the consensus amongst economists is that leaving the EU amounts to a reduction in openness of the UK economy. In the run-up to the EU referendum vote, HM Treasury published forecasts that suggested that the annual loss of GDP per household of a complete exit („hard Brexit‟) would after 15 years amount to £5200 per annum. This compared with a loss after 15 years of £2600 in the case of membership of the European Economic Area, like Norway. However, as the text notes, there were a smaller number that argued that leaving the EU would lead to a stronger economy.

This rested on the belief that UK would be more able to pursue trade creation freed from various EU rules and regulations.

10.

What is meant by the concept of ‘learning by exporting’?

This refers to firms entering export markets and having to compete with other firms in those markets.

To do so they must learn from these other firms‟ products and processes and thereby produce the best products for those markets and make productivity gains by copying or improving on the techniques used by these other firms. These improvements can then benefit the home market too. th

Answers to End-of-Chapter Questions in Chapter 25 (11 edition) 1.

Assume a free-floating exchange rate. Draw a diagram like Figure 25.6, only this time show an initial equilibrium national income with a balance of payments surplus. (a) Mark the size of the surplus. (b) Show the resulting shifts in the (X–M) and the E curves. (c) Mark the eventual equilibrium. (d) Show the size of the income and substitution effects (of the change in the exchange rate). (e) Under what circumstances will the income effect be (i) ‘desirable’; (ii) ‘undesirable’? (f) Could the income effect of the change in the exchange rate ever be larger than the substitution effect?

Equilibrium national income is where Y = E. Thus with the initial expenditure curve being given by E1 in Diagram 25.1 below, equilibrium national income is at Y1. (a) With the balance of payments shown by (X–M)1, at Y1 there is a balance of payments surplus of b–a. (b) The exchange rate thus appreciates. This causes a substitution effect: imports rise and exports fall.

The X–M line shifts downwards. But this fall in exports and rise in imports causes an income effect.

Aggregate demand falls, and the E line shifts downwards. (c) An eventual equilibrium is reached at Y2, where the new lower E line crosses the 45 line and where the new lower X–M line crosses the horizontal axis. (d) The substitution effect of the appreciation is b–c. The downward shift in the (X–M) line of b– has been caused by the rise in price of imports and the fall in price of exports. The result of the substitution effect alone would be to cause a balance of payments deficit of a–c (at Y1).

The income effect of the appreciation is a–c. It results from the fall in income to Y2, which causes a fall in imports (a movement along (X–M)2, and hence an improvement in the balance of payments.

The joint result of the income and substitution effects, therefore, is to eliminate the surplus of b–c.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

E, X, M

Y E1 E2

b O

a Y

Y

Y (X–M)1

c

(X–M)2

Diagram 25.1 Income effect of an appreciation

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

(e) The income effect will be desirable if there is a conflict between internal and external objectives.

Thus if there were a balance of payments surplus, but a problem of excess demand domestically (suggesting the need for deflation), then the resulting appreciation would reduce domestic demand, as desired. If, however there is not a conflict, the income effect will be undesirable. For example, if there were a balance of payments surplus and a problem of deficiency of demand (both of which would suggest that a reflationary policy is desirable), then the appreciation resulting from the surplus will bring a deflationary income effect, which this time is undesirable. (f) No. Consider Diagram 25.1. There has to be a fall in national income (the substitution effect is bigger than the income effect) for there to be an income effect reducing that fall! a–c (the income effect) cannot be bigger than b–c (the substitution effect), since point b is above point a.

2.

Compare the relative effectiveness of fiscal and monetary policy under (a) fixed; (b) free-floating exchange rates.

See Boxes 25.3 (fixed rates) and 25.6 (floating exchange rates), or the Appendix, using IS/LM/BP analysis.

3.

What will be the effects on the domestic economy under free-floating exchange rates if there is a rapid expansion in world economic activity? What will determine the size of these effects?

The demand for the country‟s exports will rise. This will cause a multiplied rise in national income.

There will be three effects on the exchange rate: (i) the rise in exports will directly improve the current account; (ii) the rise in aggregate demand will cause imports to rise, and, via higher prices, will dampen the increased demand for exports; it will also push up interest rates; (iii) the higher interest rates will cause an inflow on the financial account.

Effects (i) and (iii) will cause the exchange rate to appreciate; effect (ii) will dampen effects (i) and (iii). The bigger effects (i) and (iii) are relative to effect (ii), the larger will be the appreciation.

The larger the appreciation and the greater the price elasticity of demand for imports and exports (i.e. the more responsive are imports and exports to the appreciation), the bigger will be the dampening effect on national income, and thus the smaller will be the eventual rise in national income.

This analysis has assumed that there has been no change in international interest rates. If the expansion in world economic activity has not been accompanied by an expansion in world money supply, and hence there has been a rise in world interest rates, then effect (iii) may be negative: in other words, the rise in domestic interest rates may not match the rise in world interest rates, and therefore there will be an outflow on the financial account. If this is big enough, the exchange rate may even depreciate.

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Solutions Manual for Economics 11th Edition by Dean Garratt, John Sloman, Jon Guest

4.

The following table shows a selection of exchange rate indices (effective exchange rates) for the years 2011 to 2020, based on 2011 = 100.

Australian $ US $ Japanese yen Sterling Euro S Korean won

2011 100.0 100.0 100.0 100.0 100.0 100.0

2012 102.92 103.33 102.54 104.38 93.97 100.53

2013 98.18 106.20 83.08 101.83 99.03 108.53

2014 92.39 109.11 76.60 108.00 99.26 115.72

2015 85.21 125.17 72.43 115.04 89.19 118.84

2016 84.03 125.97 81.74 102.05 91.08 114.17

2017 86.31 124.84 78.12 95.67 93.65 116.96

2018 82.54 121.94 77.94 96.12 96.77 118.01

2019 78.82 126.12 81.31 95.70 94.08 113.58

2020 77.43 124.89 82.30 94.77 94.79 110.79

Source: Based on data from Monthly Effective Exchange Rate Indices (narrow) (Bank for International Settlements, April 2021)..

(a) Explain what is meant by an exchange rate index or an effective exchange rate. (b) Calculate the annual rate of appreciation or depreciation for each currency for each year from 2011. It is suggested that you use an Excel spreadsheet. (c) Calculate the percentage appreciation or depreciation of each currency when comparing 2020 with 2010. (a) An exchange rate index allows us to compare the strength of a currency, such as sterling, against a basket of currencies. In other words, it is a weighted exchange rate index where the weights are determined by the percentage of trade done with each of the countries whose currencies are included within the basket. (b) See table below for annual rates of appreciation/depreciation of each currency. (c) See table below for the percentage change in each currency between 2011 and 2020.

Australian $ US $ Japanese yen Sterling Euro S Korean (KRW)

5.

won

2012

2013

2014

2015

2016

2017

2018

2019

2020

2011–2020

2.9 3.3 2.5 4.4 –6.0

–4.6 2.8 –19.0 –2.4 5.4

–5.9 2.7 –7.8 6.1 0.2

–7.8 14.7 –5.5 6.5 –10.1

–1.4 0.6 12.9 –11.3 2.1

2.7 –0.9 –4.4 –6.3 2.8

–4.4 –2.3 –0.2 0.5 3.3

–4.5 3.4 4.3 –0.4 –2.8

–1.8 –1.0 1.2 –1.0 0.8

–22.6 24.9 –17.7 –5.2 –5.2

0.5

8.0

6.6

2.7

–3.9

2.4

0.9

–3.8

–2.5

10.8

For what reasons might the exchange rate diverge from the purchasing-power parity rate over the longer term?

If there is a persistent balance of trade deficit or surplus (with a matching surplus or deficit elsewhere on the balance of payments account). Thus the Swiss franc has been persistently overvalued relative to its purchasing-power parity rate because the surplus on Switzerland‟s financial account has kept the exchange rate above the level that would be necessary to give a balance of trade (see Box 25.4). Other countries have persistent financial account deficits (perhaps because of the risks of holding the currency if it is likely to depreciate). Such countries will tend to have persistently undervalued currencies relative to their purchasing-power parity rates. This undervaluation will be necessary to generate a trade surplus sufficient to offset the financial account deficit.

6.

Why does exchange rate overshooting occur? What determines its magnitude?

Assume that the country adopts a deflationary policy of raising interest rates. Assume that, after a time, the effect will be to reduce inflation below that of other countries and that the result of this will be an appreciation of the exchange rate (say, by 10 per cent). The effect of the higher interest rates will be an inflow of finance and a resulting appreciation above 10 per cent: there will be overshooting. This will go on until the likely capital loss from the higher exchange rate later depreciating again (back to just 10 per cent higher than the original rate) offsets the gain to be made from the higher interest rate. Later, as the

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deflationary policy begins to reduce inflation, so interest rates will come down again and the exchange rate will begin to fall back again towards the long-run rate of just 10 per cent above the original rate.

7.

Consider the argument that in the modern world of large-scale short-term international financial movements, the ability of individual countries to affect their exchange rate is very limited.

The answer is that it depends on the effect of government policy on the views of speculators. The point is that the power of speculation to influence the exchange rate is likely to exceed the power of governments. The reason is that the exchange rate is dependent on the demand for and supply of the domestic currency on the foreign exchange market. If there are very large-scale short-term international financial movements, these will be the major short-term determinant of the rate of exchange – far more important than central bank intervention from the reserves. If speculators believe that the government is not going to be able to maintain the current exchange rate at such a high level, no matter how much it intervenes on the foreign exchange market or raises interest rates, then their actions will virtually ensure that the government will fail. This is why the UK was forced out of the ERM in September 1992.

If, however, the government can convince speculators that it intends to maintain interest rates above international ones and that therefore the current rate of exchange is not too high, then speculators will not sell the currency and the rate of exchange will be maintained.

The main conclusion is that speculative movements in international finance are normally too hard to resist merely by the government trying to create flows in the opposite direction by intervention from the reserves or by changing interest rates. What is necessary is to stop the speculation itself. This is as much an art as a science: persuading speculators that the current rate will remain the equilibrium rate.

8.

If speculators had better information about future exchange rates, would their actions be more or less stabilising than at present?

They would probably be more stabilising because there would be less exchange rate movements based on rumour or mood. This does not mean that exchange rates would be totally stable: there would still be all the various other factors that can shift currency demand and supply curves. Also, there would still tend to be overshooting, as temporary changes in interest rates caused exchange rates to move off their long-term trend.

*9. Using IS/LM/BP analysis, trace through the effect of (a) a deflationary fiscal policy and (b) a deflationary monetary policy under (i) a fixed exchange rate; (ii) a free-floating exchange rate. (i) Fixed exchange rate (a) Deflationary fiscal policy A deflationary fiscal policy will shift the IS curve to the left. This will cause a fall in interest rates and a balance of payments deficit. As a result the money supply will fall and the LM curve will shift to the left, thereby reinforcing the effect of the leftward shift in the IS curve.

(In Figures 25.15 and 25.16 this is represented by a shift in the IS curve from IS2 to IS1, causing a fall in the rate of interest, in turn causing the LM curve to shift from LM2 to LM1.

National income fall from Y3 to Y1.) (b) Deflationary monetary policy A deflationary monetary policy will shift the LM curve to the left. This will cause a balance of payments surplus, which will cause the money supply to expand back again. The economy will return to the original position. (In Figure 25.17 this is represented by a shift in the LM curve from LM2 to LM1 and back again, and likewise a fall in national income from Y2 to Y1 and back again.)

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(ii) Floating exchange rate (see Diagram 25.2) r

r

LM

LM2 LM1 BP2 BP 1

BP1 BP2 a

r1 r3 r2

b

r2 r3 r1

c

c

a

b

IS1

IS1 O

IS2 IS3 Y2 Y3

Y1

IS2 O

Y

Y3

Y2

Y1

(b) Monetary policy

(a) Fiscal policy

Diagram 25.2 Effects of fiscal and monetary policies under floating exchange

(a) Deflationary fiscal policy The IS curve will shift to the left (from IS1 to IS2 in diagram (a), with a new internal equilibrium at point b). This will cause a balance of payments deficit, assuming that the LM curve is steeper than the BP curve (point b is below the BP1 curve). This will cause the exchange rate to depreciate and the BP curve to shift downwards (to BP2). The lower exchange rate will also cause a rise in exports and a fall in imports. This will cause the IS curve to shift back to the right (to IS3), thus reducing the effectiveness of the deflationary fiscal policy: income rises back from Y2 to Y3. Full equilibrium is achieved at point c. (b) Deflationary monetary policy The LM curve will shift to the left (from LM1 to LM2 in diagram (b), with a new internal equilibrium at point b: national income rises to Y2). The resulting rise in the rate of interest (to r2) will cause a balance of payments surplus (point b is above the BP1 curve) and a resulting appreciation of the exchange rate and an upward shift in the BP curve. The appreciation will reduce the demand for exports and increase the demand for imports. This decrease in aggregate demand will shift the IS curve to the left (from IS1 to IS2), thereby reinforcing the deflationary monetary policy. National income falls further, from Y2 to Y3.

Answers to End-of-Chapter Questions in Chapter 26 (11th edition)

1.

Under what circumstances does a growth in financial flows make exchange rates less stable?

If speculative flows are influenced by rumour and mood rather than by economic fundamentals; if there are relatively rapid changes in economic circumstances of different countries, and if previously, with smaller financial flows, governments would have been able to operate effective exchange rate stabilisation (policies which now, with the growth in financial flows, would no longer be effective).

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2.

Assume that countries in the eurozone decide to pursue a deflationary fiscal policy. What effect is this likely to have on the UK economy?

The fall in aggregate demand would lead to a fall in demand for imports (some from the UK) and a lower rate of inflation, making exports more competitive, and import substitutes more so. Exports would rise (some to the UK) and imports fall (some from the UK). As UK imports rose and exports fell, so UK income would fall: in other words, the effect on the UK economy would be deflationary.

Whether there would be a change in eurozone interest rates would depend on monetary policy.

If there were no change in money supply and aggregate demand fell (through the deflationary fiscal policy), interest rates would also fall. This would tend to lead to a depreciation of the euro, thereby making UK goods less competitive in the eurozone and making eurozone goods more competitive in the UK. This would therefore enhance the deflationary effect on the UK economy. If, however, interest rates were kept at their previous level, the deflationary effect on the UK economy would be smaller.

3.

It is often argued that international convergence of economic indicators is a desirable objective. Does this mean that countries should all seek to achieve the same rate of economic growth, monetary growth, interest rates and budget deficits as a percentage of their GDP, etc?

Given the differences between countries, it is unlikely that the same levels of these indicators could all be achieved simultaneously: achieving the same level of one indicator may mean divergence of another. What is more important is that countries‟ economies should be progressing together with the minimum degree of divergence of the various indicators. This will normally mean that countries need to be at the same phase of their business cycles and should be pursuing complementary policies.

4.

Did the exchange rate difficulties experienced by countries under the ERM strengthen or weaken the arguments for progressing to a single European currency?

They had little bearing on the debate between those advocating a single currency and those advocating flexible exchange rates between members. They did highlight the dangers, however, of fixed exchange rates when economies are not in harmony. There is therefore a problem for any group of countries in progressing to a single currency if it involves an intermediate stage of fixed exchange rates. Once sufficient harmony has been achieved, it is better to move directly to a single currency: there can be no speculation between the members if they all have the same currency (any more than there can be between the English pound and the Scottish or Welsh pounds, or the Californian and Maryland dollar).

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5.

Assume that just some of the members of a common market like the EU adopt full economic and monetary union, including a common currency. What are the advantages and disadvantages to those members joining the full EMU and to those not?

Trade is likely to be attracted to those countries which have joined and they may have greater influence in determining future EU policy. Those that did not join, however, are in principle able to take advantage of exchange rate movements to deal with any economic shocks that have a different effect on them from other members. They are vulnerable, however, to speculative international capital movements between their currency and others, including the euro: movements which are not merely a reflection of their trade account divergences..

6.

Is the eurozone an optimal currency area? Explain your answer.

At the time the euro was launched in 1999, the eurozone was probably not an optimal currency area.

There was still too much divergence between the member economies, insufficient labour and capital mobility, and insufficient price and wage flexibility. Nevertheless, with the further dismantling of trade barriers within the eurozone, with more and more firms operating in several eurozone countries, with growing capital mobility and growing competition within the eurozone, some progression towards optimality will have occurred. However, this has to be set in the context of the subsequent expansion of the eurozone, including new members from eastern Europe. It is doubtful that this larger area or indeed a further expanded eurozone is optimal (at least for the foreseeable future).

7.

How are asymmetric shocks dealt with within a country? To what extent can this process be mirrored within the eurozone?

By price movements and movements of labour and capital. Thus an industry or region affected by a fall in demand would experience a relative fall in wages and prices. People would move away from the industry or region, and capital might be attracted to the region because of lower-priced factors of production. The government‟s regional, urban and industrial polices can help to alleviate the effects of the shocks and help to make the economy more adaptable (see sections 23.4 and Case Study 23.13 on the student website).

This can be mirrored in the eurozone through price and factor movements and through European regional policy. Although capital mobility is quite high in the eurozone, and set to grow, labour mobility is generally lower than within member countries. Reasons include language, social and cultural barriers.

8.

Would the world benefit from the general imposition of controls on the movement of international finance?

To the extent that such controls could be enforced and could reduce speculative flows, then the world economic and financial system could be more stable and „contagions‟, such as that stemming from the Asian crisis of 1997–8 (see Case Studies 26.2 and 26.3 on the student website), could be avoided or at least lessened. Financial movements are not purely speculative, however. Finance flows to where it will receive a higher return and thereby favours potentially more profitable investments over less profitable ones. There are thus costs as well as benefits from restricting financial flows. Ideally, restrictions should be increased as long as the marginal benefit of so doing is greater than the marginal cost. In practice, however, it is very difficult to identify and measure these costs and benefits, not least because the question is highly normative, involving, as it does, the fundamental functioning of the world capitalist system!

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9.

Compare the relative merits of using GNY statistics with those of various basic needs indicators when assessing both the level and the rate of a country’s economic development.

GNY, by being not totally comprehensive, does tend to understate the level of economic development, but because it focuses mainly on marketed items, which normally increase as a proportion of total output as national income rises, it tends to overstate the rate of economic development.

The basic needs approach, by definition, puts a zero weighting on those items that are not considered as basic. Two countries which meet basic needs to the same extent will therefore be judged the same, even if one of the two countries meets non-basic needs to a much greater extent than the other. However, whilst it is less comprehensive than using GNY for assessing both the level and rate of economic development, for countries at an early stage of development it does highlight the extent of poverty and its rate of eradication (or deepening). For GNY to focus on poverty, it would have to be „poverty weighted‟, so that the poorest groups‟ incomes received a higher weighting than those of richer groups.

The problems associated with the two types of measure are discussed on pages 869–71.

10.

If a developing country has a comparative advantage in primary products, should the government allow market forces to dictate the pattern of trade?

Given that markets are imperfect and factors are immobile, government intervention would normally be justified (unless governments themselves were even more imperfect than the market forces!). Even though a country may have an initial comparative advantage in primary production, the gains from specialising in primaries and exporting them may be offset by other disadvantages – disadvantages that build over time. With a low world income elasticity of demand for many primary products, with the development of synthetic substitutes for minerals and with the protection of agriculture in developed countries, the demand for primary exports from developing countries has generally grown only slowly.

At the same time, the demand for manufactured imports into developing countries has grown rapidly.

The result has been a worsening balance of trade problem; and with a price-inelastic demand for both imports and exports, the terms of trade have worsened too.

In addition to these problems, there is also the danger that comparative costs may change over time; that most of the benefits from primary exports may accrue to foreign owners of mines and plantations, or to wealthy elites in the domestic population; that mines and plantations can involve substantial environmental and other external costs; and that export earnings can fluctuate, given instabilities in supply and unstable world prices.

Even if it is agreed that government intervention is warranted, the method of intervention is highly controversial. Some argue that the whole focus of intervention should be to make the private sector more responsive to market forces, so that it can respond quickly to changing market opportunities. For example, the country could be opened to international financial markets, regulations could be dismantled and there could be a programme of privatisation. Others argue that the focus ought to be on improving the country‟s infrastructure – transport, communications, education, etc. This will require government expenditure, but it could still be seen as the government working with the market by helping to increase factor mobility, both occupationally and geographically. Others argue that the problems with trade are so great that the country‟s exposure to international market forces ought to be minimised and the country should pursue an active policy of import substitution.

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11.

What are the advantages and disadvantages for a developing country of pursuing a policy of ISI? See pages 877–80. The advantages include the dynamic gains from specialising in products with both internal and external economies of scale, with a greater rate of cost reduction from technical improvements, and with income-elastic demands. The disadvantages, however, are many. ISI often led to the establishment of inefficient industries, protected from foreign competition and facing little or no competition at home either. It led to considerable market distortions, with tariffs and other forms of protection haphazardly applied and with resulting huge variations in effective rates of protection; to overvalued exchange rates with a resulting bias against exports and the agricultural sector generally; to a deepening of inequalities and to large-scale social problems as the cities expanded, as poverty and unemployment grew and as traditional values were undermined; and to growing environmental problems. Finally, the problem that ISI was supposed to ease – the balance of payments constraint – was in many cases made worse as the new industries became increasingly dependent on imported inputs and as growing urbanisation caused a growing demand for imported consumer goods.

12.

Should all developing countries aim over the long term to become exporters of manufactured products?

Not necessarily: it depends on each country‟s resource endowments – both present and potential future; on the nature of the manufactured products – their income elasticity of demand and their resource requirements; and on the world trading environment – whether countries would face barriers to the export of such products, either from countries or from multinationals controlling distribution channels. If countries do seek to become exporters of manufactures, the Hecksher–Ohlin version of the law of comparative advantage is still highly relevant: they should specialise in labour-intensive manufactures or manufactures that use local materials, especially if such materials are costly to transport.

13.

How would you attempt to assess whether the technology used by an industry in a developing country was ‘inappropriate’?

Whether technology is inappropriate depends on the economic objectives of the country. For example, labour-intensive techniques are likely to be more appropriate for achieving maximum current levels of employment and a more equal distribution of income. Capital-intensive techniques, however, may be more appropriate for generating higher profits, higher investment and faster long-term economic growth.

At a more specific level, particular techniques may be inappropriate if there are likely to be problems in obtaining complementary inputs (such as spare parts, or labour with specific skills). Then there is the obvious point that, other things being equal, if there are two or more techniques available, it is better to choose the one with the highest output/cost ratio (assuming that costs measured in market prices are a true reflection of opportunity costs).

14.

To what extent was the debt crisis of the early 1980s caused by inappropriate policies that had been pursued by the debtor countries?

Several of the causes of the crisis were outside the control of developing countries and could not therefore be blamed on them: for example, the world recession of the early 1980s and the much higher real interest rates that accompanied it. Nevertheless, it is easy with hindsight to put some of the blame on the policies of import-substituting industrialisation that many developing countries were pursuing: policies that involved large-scale borrowing to finance investment, with much of the borrowing at

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variable rates of interest. Although real rates of interest were low in the 1970s, there was still the risk that they might subsequently rise, making it difficult for the developing countries to service their debts.

15.

Assess the operation and success of the HIPC programme?

See page 888. Since the World Bank and the IMF launched the HIPC initiative in 1996 the effect on various debt indicators has been dramatic. As of 2021, $76 billion had been cancelled under the HIPC programme (and a further $50 billion under Multilateral Debt Relief Initiative (MDRI)). However, HIPC relief has been criticised for the severity of the adjustment programmes, for having had an excessively long qualifying period and setting high debt sustainability thresholds.

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