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© Pearson Education New Zealand 2008 iii

Contents

Exercise Set Page Text chapter(s)

To the student

iv

Part One: Resources and sustainability

1 The economic problem

1 1 and 2

Part Two: The price mechanism 2 Demand and supply 14 3 3 Elasticity and its application

25 4

Part Three: Theory of the firm 4 Costs of production 34 5 5 Market structure and business

decision-making

43 6 and 7

Part Four: Market failure and government intervention

6 Addressing market failure

54 8, 9 and 10

Part Five: The macroeconomic environment 7 Macroeconomic indicators 62 2, 10, 11 and 22 8 Aggregate demand and aggregate supply 70 14 9 Money and financial markets

77 15 and 16

Part Six: Macroeconomic policy 10 Monetary policy 81 15 and 16 11 Government and fiscal policy

85 17 and 18

Part Seven: The environment of international trade 12 International trade, balance of payments

and the exchange rate

92 19, 20 and 21

Solutions [download separate PDF] 103 Solutions 103

© Pearson Education New Zealand 2008 iv

To the student Welcome to your economics learning guide that has been prepared to help you maximise the benefits you receive from studying economics and reading your course textbook: Economic Concepts and Applications, Fourth Edition.

A variety of tasks have been chosen to establish and develop your skills related to the economics discipline.

Working through each set of exercises will enable you to benefit more fully from your reading of the textbook and will assist in your understanding of material presented to you in the class or lecture room.

Topics have been selected and grouped to allow for a manageable quantity of tasks suitable for a 12–15 week semester course.

We wish you success in your studies.

James Stewart and Keith Rankin

© Pearson Education New Zealand 2008 1

Part One: Resources and sustainability

Overview All societies must choose how best to use the productive resources which they possess. Efficient resource allocation – otherwise known as good housekeeping – is the prime concern of economics. Resources are scarce in relation to the demand for them by consumers, producers and government. Therefore, societies must choose between the different uses to which resources may be put.

As the sustainable management of natural resources becomes more important, the basic economic problem is increasingly seen as that of allocating resources in a way that provides for today’s consumers, while ensuring that future generations are not disadvantaged by the choices we make today.

For a national economy taken as a whole, the key indicators of wise decision-making by households, firms and governments are: sustainable growth of output and living standards; full employment; price stability, and some semblance of balance between all international payments and receipts.

One of the major problems that unsettles these national performance goals is the business cycle, which represents fluctuations in the rate of economic growth. Extended periods of excessive growth in spending lead to resource depreciation, inflation, and escalating balance-of-payments deficits. On the other hand, prolonged periods of negative or very low growth lead to high unemployment and sometimes deflation. ‘Good housekeeping’ at the national level means stable and sustainable management of the pressures that create the business cycle.

Exercise Set 1: The economic problem

Learning objectives • learn that economics is a decision-making discipline • consider how the basic economic problem of scarcity is linked to the need to choose • apply the concept of opportunity cost to decision-making • learn how to apply the production possibility model to the issues of efficiency,

opportunity cost and economic growth • describe the characteristics of a mixed economy • identify the phases of the business cycle.

Part One Resources and sustainability Exercise Set 1 The economic problem


A Economic concepts and definitions

After reading Chapters 1 and 2 of the textbook, choose the definition for each of the key concepts listed.

Key concept Definition [Enter correct number] a scarcity _______________________________ b opportunity cost _______________________________ c production possibility curve _______________________________ d economic growth _______________________________ e technology _______________________________ f economic systems _______________________________ g allocative efficiency _______________________________ h specialisation _______________________________ i ceteris paribus _______________________________ j labour _______________________________ k capital _______________________________ l natural resources _______________________________ m increasing cost _______________________________ n free market _______________________________

Definitions 1 The collective name given to productive services provided through human effort and skill. 2 The stock of goods produced for use in the production of other goods. 3 A situation in which a nation’s resources are insufficient to produce the amount of goods and services

required to satisfy all of its citizens’ wants. 4 The assumption that all other factors are constant. 5 The cost of a good or service measured in terms of the best alternative foregone. 6 A graph illustrating the attainable choices available to a firm or economy, assuming a given level of

resources and a given state of technology. 7 As the production of a good expands, the opportunity cost of producing additional units generally

increases. 8 Each production unit concentrates on producing those commodities in which it has special expertise. 9 The annual percentage increase in national income or output. 10 The combination of goods and services which maximises a society’s well-being. 11 Used to increase productivity of other resources. 12 Arrangements which determine how scarce resources are owned and used. 13 The resources of nature on or in the land, sea and air. 14 Economic outcomes are determined by economic forces alone, without interference from government

or influential groups within the economy.

B Short answer questions and problems

Question 1 Production possibilities: opportunity cost and allocative efficiency

Bob lives alone on a small island, which has fertile soil and good fishing. Bob has kept a record of his production over the past year and has estimated his yearly production possibility schedule as follows.



Bob’s production possibility schedule Combination Baskets of Baskets of possibilities fish vegetables

A 50 0 B 48 5 C 40 10 D 30 15 E 18 20 F 0 25

a Draw a production possibility curve (PPC) using the data from Bob’s production possibility schedule.

(Use the graph provided below.)

Bob’s production possibility curve

b Label the points A to F along the PPC.

c Label the point ‘G’ on your graph, representing a combination of 40 fish and 20 vegetables. Comment on this point.

d Label the point ‘H’ on your graph, representing a combination of 20 fish and 15 vegetables.

Comment on this point.



e Calculate the opportunity cost of moving from combination C to D, D to E and E to F.

f Describe your findings from question e.

g If Bob were producing at combination C, what value do you think he would place on one basket of

vegetables? Express your answer in terms of fish.

h Which of the combinations shown (A through F) represent efficient resource utilisation by Bob?

Explain your answer.

i How would Bob determine the ‘allocatively efficient’ combination of fish and vegetables?



j Describe the advantages and disadvantages to Bob of spending some time making a fishing net.

k How would the fishing net affect his production possibility curve in the long run? Sketch any change

in his production possibility curve below.



Question 2 Production possibilities and opportunity cost

Bob is interested in varying the combination of vegetables he grows. He has estimated the following seasonal production possibility combinations from his current plot of land under cultivation.

Bob’s vegetable production possibility schedule Combination Tomatoes Beans possibilities (kg) (kg)

A 100 0 B 80 30 C 60 60 D 40 90 E 20 120 F 0 150

a Draw the production possibility curve (PPC) from the above data on the graph below.

Bob’s vegetable production possibility curve

b Calculate the opportunity cost of moving from A to B, B to C, C to D, D to E and E to F.



c Comment on the shape of the production possibility curve you have drawn.

d Explain why Bob’s vegetable production possibility curve differs from his overall (fish and

vegetable) production possibility curve you drew in Question 1.

Question 3 Production possibilities and economic growth

The following production possibility curve shows that economies are faced with a trade-off between consumer goods and capital goods.

Study the graph and answer the questions which follow.

Economy X: Production possibility curve

a Describe what is happening in this economy if combination A is chosen, and show on the graph below what may happen in the economy’s future if they remain at point A.



Economy X: Present investment decision ‘A’ and future outcomes

b Consider points B and C. Why might the economy benefit in the future by choosing combination C and why might this be superior to combination B? Show your answer on the graphs below.

Economy X: Present investment decision ‘B’ and future outcomes

Economy X: Present investment decision ‘C’ and future outcomes



c In choosing between points B and C, what present misgivings may citizens have? (Hint: Use opportunity cost in your answer.)

d Consider combination D. Explain what is happening at this combination. Discuss why this

combination may be inferior to combination C.

Question 4 Opportunity costs

a In deciding to attend a tertiary institution a student must weigh up the opportunity costs. What are some common opportunity costs associated with attending a tertiary institution?

b How does the level of public support for tertiary education influence the overall level of opportunity

costs of tertiary education to society?



Question 5 Business cycle

Draw a diagram which shows how economic activity fluctuates around a trend rate of growth. Label each phase of the cycle. Explain your diagram.

C Multiple-choice questions

Circle the best answer.

1 Economics is the study of a how to minimise waste b how to avoid opportunity cost c how to maximise production d how society utilises its scarce resources 2 Opportunity cost is measured by a the cost of lost opportunities b the benefit foregone of other alternatives c the benefit less the cost of another alternative d the foregone benefit from the next best alternative 3 Which of the following is true of a mixed economic system? a Most productive resources are owned by the state. b Productive resources are owned by the tribe. c Productive resources are privately owned. d Productive resources are mainly privately owned but with some state ownership. 4 Which of the following is true of a pure market economic system? a Allocation of resources is determined by leaders or tribal groups. b Allocation of resources is determined mainly by the state. c Allocation of resources is determined automatically by the price system. d Allocation of resources is determined mainly by the price system but with some government

influence.



5 Which of the following is not part of the opportunity cost of going on holiday? a the money you could have earned if you didn’t take time off work b the goods that could have been purchased with the money spent on an airline ticket c the classes you missed through going on holiday d the money you spent on food 6 A point lying inside a production possibility curve indicates that a technology is limited b opportunity costs are irrelevant c the economy is capable of producing more goods and services d the economy is investing in capital formation 7 A production possibility curve is bowed outwards (concave) because a resources are not perfectly mobile b assets are often specific to the production process of a given good or service c opportunity costs increase as resources are transferred from the production of one good to another d all of the above 8 A production possibility curve will shift outwards when a taxation increases b the productivity of the labour force improves c the money supply increases d exports increase 9 Economic models are evaluated by a testing the assumptions upon which they are based upon b comparing their predictions with actual outcomes c the Commerce Commission d how realistic they are 10 If a production possibility curve is linear (a straight line), then a opportunity cost is constant b resources are perfectly mobile c the goods being produced have identical resource requirements d all of the above 11 Which of the following are scarce in the New Zealand economy? a highly skilled workers b machinery c farmland d all of the above 12 Normative economics a provides unequivocal answers to economic problems b emphasises measurement and quantitative data c reflects value judgements about ‘what should be’ d is relevant to microeconomics only



13 In a market economy, the mix of goods and services produced will reflect a government policies b the cost of inputs available to the country c the types of good demanded by consumers d the types of production technique available 14 Scarcity means that a rich people don’t face opportunity costs b poor countries must make choices but rich countries don’t have to c opportunity costs always exist d some choices involve opportunity costs, while others do not 15 Which of the following is not a factor of production? a an unemployed person b a bank loan to establish a business c a computer d a section of land 16 The slope of the production possibilities curve indicates a technological change b the rate of growth c how much of one good must be given up for a unit of another d all of the above 17 Which of the following is not an assumption under which the production possibilities curve is drawn? a The prices of all inputs are fixed. b There is no unemployment. c Technology is held constant. d Factors of production are fixed. 18 Which of the following is fundamental to a market economy? a the profit motive b private property rights c the existence of competition d all of the above 19 If an economy is operating inside the PPC a more output could be produced with zero opportunity costs b the level of technology is limiting production c there are not enough resources available to reach the PPC d more output could be produced but at a high opportunity cost 20 Which of the following is not an example of investment? a A business builds a new factory. b An individual buys Telecom shares. c A polytechnic upgrades its computer system. d Shops increase their inventories before Christmas.



D Paragraph writing

1 After reading pages 22 to 24 of the textbook, write a paragraph explaining why most modern economies are mixed economies.

2 Explain, using production possibility analysis, how allocative efficiency is achieved in a market

economy.


Part Two: The price mechanism

Overview The most important information in a market economy is that of price. Changing prices act as signals to consumers and producers, suggesting that they might buy or offer for sale more or less of various goods and services which all ‘compete’ for the use of resources.

The laws of demand and supply say that when the price of a good increases, consumers will choose to buy less of that good, whereas firms will offer more of that good for sale. These choices about ‘how much’ represent market behaviour. The combined market behaviour of all buyers and all sellers determines the equilibrium price.

We are not only interested in whether quantities increase or decrease following changes in prices. We also want to be able to gauge by how much quantities will change. Hence the concept of price elasticity is important. A good with elastic demand will show a large change in quantity relative to the change in price, whereas an inelastic good will experience a comparatively small change in quantity demanded.

Exercise Set 2: Demand and supply Learning objectives

• consider the characteristics of a market • examine the determinants of demand and supply • distinguish between a change in demand and a change in quantity demanded • distinguish between a change in supply and a change in quantity supplied • learn how demand and supply determine equilibrium price and quantity • learn how to analyse market events using the supply-and-demand model • examine the role of prices in co-ordinating production and consumption decisions and

in determining the allocation of resources • consider the effect of government intervention in markets through price controls and

indirect taxes • identify efficiency considerations using consumer surplus, producer surplus and

deadweight loss.

Part Two The price mechanism Exercise Set 2 Demand and supply



After reading Chapter 3 of the textbook, choose the definition for each of the key concepts listed.

Key concept Definition [Enter correct number] a demand _______________________________ b marginal unit _______________________________ c utility _______________________________ d demand curve _______________________________ e demand schedule _______________________________ f market demand curve _______________________________ g supply schedule _______________________________ h market equilibrium _______________________________ i excess supply _______________________________ j substitutes _______________________________ k supply curve _______________________________ l excess demand _______________________________ m complements _______________________________ n market supply curve _______________________________ o consumer surplus _______________________________ p Pareto efficiency _______________________________ q pricing system _______________________________ r indirect tax _______________________________ s producer surplus _______________________________ t market _______________________________ u allocative efficiency _______________________________ v tax burden _______________________________ w deadweight loss _______________________________

Definitions 1 The quantity that buyers wish to buy exceeds that which sellers wish to sell at a given price. 2 This shows the total amount of a commodity or service which consumers wish to buy at each price

and represents the sum of all individual demands. 3 A table showing the quantity of a commodity demanded over a range of prices. 4 The quantity which sellers wish to sell exceeds that which buyers wish to buy at a given price. 5 A method of facilitating the exchange of commodities and services. 6 This shows the total amount of a commodity or service which suppliers wish to sell at each price and

represents the sum of all individual firms’ supply. 7 A table showing the quantity of a commodity supplied at various prices. 8 A curve relating price per unit of a commodity to the quantity a producer wishes to sell. 9 Commodities which to some degree may replace one another. 10 Commodities which are habitually consumed together. 11 A curve relating price per unit of a commodity to the quantity a consumer wishes to buy. 12 The willingness and ability to pay for a particular commodity or service. 13 The last unit of a commodity consumed in the time period. 14 The satisfaction or pleasure gained from consuming a certain quantity of a good. 15 A state in which the quantity of a good or service demanded by consumers at the prevailing price is

exactly matched by the quantity sellers wish to sell.



16 The difference between what consumers are willing to pay for a commodity and what they actually have to pay in the market.

17 The method by which resources are allocated based on the movement of price. 18 A payment to government which is added to the price of goods and services. 19 The amount an individual, group or business must pay in tax. 20 The difference between total revenue from supplying a good and the costs represented by the area

under the supply curve. 21 A loss of welfare by an individual or group which is not offset by a welfare gain to some other

individual or group. 22 The place on the production possibility curve that best meets consumers’ wants – where the bundle

(combination) of goods that consumers prefer is being produced. 23 When it is not possible to change an existing resource allocation in a way that makes someone better

off and no one worse off.

B Short answer questions and problems Question 1 Demand and supply

The table below shows weekly data for demand and supply of lamb chops at a city supermarket.

Price Quantity of Quantity of ($ per kg) lamb chops lamb chops

demanded supplied (00 kg) (00 kg)

15 0 18 14 1 16 13 4 14 12 7 12 10 10 10 9 13 8 8 17 6 7 20 4 6 23 2 5 27 0



a Plot these schedules on the graph below, labelling the demand and supply curves.

Market for lamb chops

b Identify the equilibrium price and quantity on your graph.

c Suppose the supermarket set a price of $12.00 per kg. Illustrate this on your graph, and comment on the market situation and what would be likely to happen to price and quantity.

d Suppose the supermarket set a price of $7.00 per kg. Illustrate this on your graph, and comment on the market situation and what would be likely to happen to price and quantity.



e What may happen if the government sets a maximum price of $7.00 per kg for lamb chops?

f Assume that the export (overseas) price of lamb rose sharply. Draw a new sketch graph for the domestic market for lamb. Use the graph below, using lamb chops as an example. Explain the reason for any shifts in demand or supply.

Domestic (NZ) market for lamb chops



g Assume that the supermarket runs a promotion on lamb chops by reducing the price of mint sauce. Explain the rationale behind this promotion and show the potential result on the demand for the two products concerned on the graphs shown below. (Price before the promotion is indicated by Pe.)

Mint sauce Lamb chops

h Assume that the supermarket runs a ‘special’ (reduced) price for beef. Explain the impact that this

may have on the demand for lamb chops and beef. Sketch the likely impact on the graphs below.

Beef Lamb chops



i Assume that a successful advertising campaign promotes lamb as a good source of iron. Sketch the impact this will have on the market for lamb chops. Briefly comment on the impact on price and quantity.

Lamb chops

j Assume scientists genetically modify sheep so as to produce a greater number of lamb chops per

sheep. Sketch the impact this may have on demand and supply of lamb chops and comment on any potential adverse effects of this strategy.

Lamb chops





1 Which of the following would increase the demand for strawberries? a a reduction in the price of strawberries b a reduction in the price of cream, a complement c a reduction in the price of blackberries, a substitute d a reduction in the income of consumers 2 An increase in demand combined with an increase in supply will a raise price and quantity traded b raise price and reduce quantity supplied c increase quantity traded and decrease price d increase quantity traded; price may either increase or decrease 3 An increase in supply will a cause more to be supplied at each and every price b shift the demand curve outwards c cause price to increase d shift the supply curve to the left 4 If the quantity and the price increase, the cause is a an increase in demand and decrease in supply b an increase in demand and increase in supply c an increase in demand with no change in supply d a decrease in both demand and supply 5 A cold snap that destroys half of the apple crop in Hawkes Bay will likely a reduce the price of apples, decreasing supply of apples b reduce the demand for apples, forcing price down c reduce the supply of apple juice, forcing price up d reduce the price of pears, a substitute 6 Which of the following will not cause the supply curve for a good or service to shift? a technological progress b rising labour costs c increased demand for the good or service d increased price for other goods and services 7 An increase in quantity demanded would be caused by a an increase in income b a decrease in income c a decrease in price d a decrease in supply



8 A movement down a supply curve a is consistent with an increase in supply b is consistent with a decrease in quantity supplied c is brought about by an increase in price d is inconsistent with the law of supply 9 Consumer surplus is measured by a price multiplied by quantity traded b the area beneath the demand curve c the area beneath the demand curve and above the price line d the area between demand and supply and below equilibrium price 10 Market equilibrium is best described as a the situation where the amount bought equals the amount sold b demand equals supply c the price at which the quantity consumers wish to buy equals that which producers

willingly supply d the position where the quantity traded adequately meets consumers’ needs 11 Demand for a good or service means a the price of the good is low b there is a buyer who would like to have the good or service c there is someone who would like to have the good and is able to pay for it d the good or service can be purchased 12 Which of the following will cause a change in quantity demanded? a the number of buyers b expectations about future price c the price of the good d the price of a complement 13 Which of the following illustrates the law of supply? a Falling labour costs cause an increase in supply. b A fall in price leads to a decrease in quantity supplied. c New producers enter the industry and cause an increase in supply. d Price falls and there is more of the product available. 14 The equilibrium price in a market a is determined by the quantity consumers wish to purchase b is determined by the price of inputs c is determined by the quantity supplied d determines the quantity actually traded 15 Excess demand will lead to a rise in price a because buyers do not wish to buy as much as sellers want to sell at that price b when there are price controls c because sellers will reduce their production in response to higher prices d none of the above



16 As consumption increases, total utility a remains constant beyond a certain point b increases, so long as marginal utility is positive c increases only if marginal utility increases d always increases 17 The quantity traded of a good a will be less than the quantity supplied if the price is below equilibrium b will be less than the quantity demanded if the price is above equilibrium c will be equal to the quantity demanded at the equilibrium price d will be more than the quantity demanded if the price is below equilibrium 18 Water generally has a low price. Which of the following statements best explains this? a The marginal utility of water is high. b The total utility of water is low. c Consumers do not value additional units of water very highly. d The abundance of water means the price of water doesn’t matter. 19 When a café offers free coffee refills, the typical customer will consume a refills until the marginal utility of the last cup is zero b refills until total utility is zero c refills until the marginal utility of the last unit is maximised d infinite refills 20 Goods are substitutes if a a fall in the price of one causes quantity demanded of the other to fall b a fall in the price of one causes demand for the other to fall c a fall in the price of one causes demand for the other to rise d a rise in the price of one causes quantity demanded of the other to fall

D Paragraph writing

1 Tom, the owner of a city petrol station, does not believe the law of demand. He observes that although the price of petrol continues to rise, the demand for petrol has not been falling but rather has been increasing.

Explain, with the aid of graphs, why Tom’s observation does not conflict with the law of demand.



2 Read Box 3.3 on page 58 of the textbook. Using supply and demand analysis, describe why

Mississippi farmers are growing more corn. (Suggestion: Draw supply and demand graphs for corn, ethanol and cotton.)

Part Two The price mechanism Exercise Set 3 Elasticity and its application


Exercise Set 3: Elasticity and its application

Learning objectives • learn the meaning of elasticity • learn to distinguish between elastic and inelastic demand • examine the determinants of price elasticity of demand • apply the concept of price elasticity of demand to the pricing decisions of the firm • consider the income elasticity of demand for luxuries, necessities and inferior goods • consider the cross-price elasticity between substitutes and complements • combine demand, supply and elasticity and apply them to a range of market situations

including government intervention • examine the determinants of price elasticity of supply.



Key concept Definition [Enter correct number] a price elasticity of demand _______________________________ b elastic demand _______________________________ c incidence of a tax _______________________________ d coefficient of elasticity _______________________________ e unit elastic demand _______________________________ f statutory incidence _______________________________ g arc elasticity _______________________________ h tax burden _______________________________ i normal good _______________________________ j inelastic demand _______________________________ k zero elasticity _______________________________ l inferior good _______________________________ m elasticity _______________________________ n cross elasticity of demand _______________________________ o point elasticity _______________________________ p inelastic supply _______________________________ q price elasticity of supply _______________________________ r elastic supply _______________________________ s infinite elasticity _______________________________ t income elasticity of demand _______________________________

Definitions 1 The response to a given change in price is a more than proportionate change in quantity demanded. 2 The response to a given change in price is an equal proportionate change in quantity demanded. 3 The allocation of the burden of a tax to specific groups or individuals. 4 The response to a given change in price is a less than proportionate change in quantity demanded. 5 A pure number, used in comparing elasticities of demand for various commodities. 6 The legal obligation to pay a given tax.



7 The amount which an individual, group or business must pay in tax. 8 A measurement of elasticity using finite changes in price and quantity demanded of a commodity. 9 The responsiveness of quantity demanded to changes in income. 10 A measurement of elasticity, using infinitely small changes in price and quantity demanded. 11 A good for which quantity demanded moves in the same direction as income changes, i.e. with an

increase in income, demand increases. 12 A good for which the quantity demanded moves in the opposite direction as income changes, i.e.

with an increase in income, demand decreases. 13 The degree of responsiveness of quantity supplied of a good or service to changes in price. 14 A given price change causes no change in quantity supplied/demanded. 15 The response to a given change in price is a more than proportionate change in quantity supplied. 16 An infinite quantity supplied at a given price. 17 The response to a given change in price is a less than proportionate change in quantity supplied. 18 The degree of responsiveness of quantity demanded of a good or service to changes in price. 19 The degree of responsiveness of one variable to changes in another. 20 The degree of responsiveness of quantity demanded to a change in price of another good.


Question 1 Price elasticity of demand

The table below shows the demand schedule for mid-week movie tickets at a suburban movie theatre.

a Complete the table. (Use the mid-point method to calculate price elasticity of demand.)

Demand for mid-week movie admission Price

($)

Quantity of tickets

demanded Total

revenue % change

in Q % change

in P Elasticity coefficient

0 250 1 225 2 200 3 175 4 150 5 125 6 100 7 75 8 50 9 25 10 0



b Assume that the current price of a ticket is $7. Comment on the level of elasticity at this price and suggest whether the price should increase, decrease or remain the same.

c What price would the theatre charge if it wants to maximise total revenue? (Use the table results.)

Question 2 Indirect tax

The table below shows a city’s weekly demand schedule and the supply schedules for petrol, before and after the government imposes indirect tax at $0.40 per litre.

Price Quantity Quantity Quantity ($ per litre) demanded supplied supplied

(000 litres) pre-tax post-tax (000 litres) (000 litres)

2.00 20 81 63

1.80 22 72 54

1.60 24 63 45

1.40 28 54 36

1.20 32 45 27

1.00 36 36 18

0.80 40 27 9

0.60 44 18 0

0.40 48 9

0.20 52 0

0.10 56

0.00 60



a Sketch the data from this table showing the demand curve and the supply curves before and after the tax is imposed. Clearly label the equilibrium price and quantity before the imposition of the tax.

b Estimate from your graph the equilibrium price after the tax is imposed.

c Show on your graph the new price to consumers (Pc) and the price to producers (Pp).

d Calculate the weekly tax revenue that the government will receive from the city petrol market.

e Show on your graph the deadweight loss created by the imposition of the tax.

f Calculate the incidence (share) of the tax, i.e. how much of the tax is paid by producers and how much by consumers.



g Explain how the incidence (burden) of an indirect tax varies with relative elasticity of demand and supply.

h Discuss the objectives that the government might have for indirect taxes on each of the following, and

comment on the demand conditions that would best suit the government’s objective in each case.

i cigarettes

ii petrol

iii perfume

iv all goods and services





1 A price elasticity of demand of 2 means that a 10% increase in price will result in a a 10% decrease in quantity demanded b a 20% decrease in quantity demanded c a 2% increase in total revenue d a 5% decrease in quantity demanded 2 If a 10% rise in price causes a 5% decline in quantity demanded, a the price elasticity of demand is 0.2 b the price elasticity of demand is 0.5 c the price elasticity of demand is 5 d the price elasticity of demand is 2 3 A horizontal demand curve a is more likely in the short run b has price elasticity of infinity c has price elasticity of zero d has elasticity of equal to one 4 Which of the following is likely to have the most inelastic demand? a rice b perfume c petrol d insulin for a diabetic 5 Demand will be more price inelastic a the fewer close substitutes are available b the higher the price of the good c for luxuries d the longer the time elapsed after the price increase 6 Demand will be more price elastic a the more close substitutes are available b the lower the price of the good c for necessities d immediately after the price increase than after some time has passed 7 If a price decrease results in an increase in total revenue, then demand must be a elastic over that range b inelastic over that range c unit elastic over that range d zero elastic over that range



8 If a 5% decrease in quantity demanded results from a 10% increase in income, the income elasticity of demand is

a 0.5 b –0.5 c 2 d –2 9 If Sue’s income rises from $450 to $550 per week and she decides to increase the amount she spends

on shoes by 5%, then her demand for shoes a is price elastic b is income elastic c is price inelastic d is income inelastic 10 If goods X and Y are complements, then a the cross elasticity of demand between X and Y is negative b the cross elasticity of demand between X and Y is positive c the cross elasticity of demand between X and Y will equal zero d their combined elasticities will equal 1 11 Elasticity of supply is greater in a the short-run time period b the monetary or market time period c the long-run time period d markets for luxury goods 12 Elasticity of supply is determined by a the availability of substitutes b how expensive the good is c time d resource costs 13 A price elasticity of demand of 5 means that quantity demanded will increase a 5 units for each $1 decrease in price b 1 unit for each $5 decrease in price c 5% for each 1% decrease in price d 1% for each 5% decrease in price 14 A successful advertising campaign will a make the demand curve less price elastic b make demand more income elastic c make demand more price elastic d increase supply 15 Demand for consumer credit tends to be inelastic. What sort of elasticity does this refer to? a price elasticity of supply b price elasticity of demand c income elasticity d cross-price elasticity



16 A normal good a is one which consumers will purchase more of only if their incomes increase b may be either a luxury good or a necessity good c is one for which quantity demanded rises as incomes increases d is defined as a good which the ‘average’ consumer purchases 17 If the cross-price elasticity of demand is negative, a the two goods are complements b demand for one good increases while demand for the other decreases c the two goods may be substitutes or complements, depending on the direction of the price

change d the two goods are substitutes 18 The government has recently imposed a higher tax on some types of alcohol. This will reduce

consumption of those drinks if a the price elasticity of demand for them is elastic b the price elasticity of demand for them is inelastic c alcohol is a normal good d alcohol is a luxury good 19 The primary outcome of the higher tax on those types of alcohol will be increased tax revenue if a the price elasticity of demand for them is elastic b the price elasticity of demand for them is inelastic c alcohol is a normal good d alcohol is a luxury good 20 Which of the following will increase the degree of price elasticity of demand for a service? a a shorter time frame in which to make purchase decisions b fewer substitutes c increased competition d a price rise



D Paragraph writing 1 Refer to textbook pages 76–78 on the application of elasticity to public transport. Write a paragraph

on the short-run impact of rising oil prices. Explain how elasticity of demand may vary in the long run and the impact of this on the market for oil.

2 Refer to Table 4.2 on page 72 of the textbook. Explain what the elasticity coefficients for food and for furniture tell you about the demand for those goods and describe the effect of a price increase on those goods.


Part Three: Theory of the firm

Overview Firms seek to make profits, and it’s always better to make a larger profit than a smaller profit. Thus normal economic theory assumes that firms are profit maximisers. This means that they wish to maximise total revenue less total cost, which turns out to be the same as deciding to produce the quantity at which the extra revenue from producing one more item is equal to the extra cost of producing one more item.

Costs are understood to be opportunity costs, so the economic costs of production are typically greater than the accounting costs. In the short run, costs are variable or fixed. In the long run, firms are much more flexible than in the short run, and may choose to reduce average costs by increasing the scale of their operations.

While almost all firms are subject to some form of competition, if only from a substitute product, most firms in a modern economy can be said to supply goods or services in imperfectly competitive markets. The alternative market structures – monopoly, oligopoly, monopolistic competition and perfect competition – spawn alternative competitive strategies in pursuit of the maximisation of profits. While imperfectly competitive market structures offer some advantages in terms of bringing about product and technological innovation, only perfect competition yields market outcomes that cannot be made more efficient with government intervention.

Exercise Set 4: Costs of production

Learning objectives • learn the distinction between economic cost and accounting cost • make the distinction between the short run and the long run • examine the behaviour of firm’s short-run costs of production • calculate and graph short-run costs of production • examine the implications of diminishing returns and economies of scale • discuss a firm’s capacity constraints and output decision in the short run • examine the impact of short-run capacity constraints on the firm’s long-run capacity

decisions.

Part Three Theory of the firm Exercise Set 4 Costs of production




Key concept Definition [Enter correct number] a production _______________________________ b the law of diminishing returns _______________________________ c economic costs _______________________________ d factors of production _______________________________ e fixed cost _______________________________ f marginal cost _______________________________ g accounting costs _______________________________ h variable cost _______________________________ i short run _______________________________ j average cost _______________________________ k long run _______________________________ l external economies of scale _______________________________ m technical optimum _______________________________ n economies of scale _______________________________

Definitions 1 A process by which resource inputs are transformed into outputs of capital or consumer goods. 2 Land, capital, labour and entrepreneurship. 3 The money cost of producing goods or services. 4 As increasing quantities of a variable input are added to a fixed amount of another input, the

additions to output gained as a result will eventually start to decrease. 5 A period of time during which it is assumed that at least one factor of production is fixed. 6 A time period in which a firm is able to vary the quantities of all inputs used. 7 A cost that has to be paid whether or not anything is produced. 8 Reductions in costs of production for individual firms when there is an expansion in one locality of

the operations of an industry or group of firms. 9 The cost of producing goods and services including both money costs and an estimate of income

foregone through using resources owned by the firm. 10 The extra cost of increasing output by one unit. 11 The cost per unit. 12 A cost that varies directly with output level. 13 An expansion of the scale of production causes long-run average costs to fall. 14 The level of production where the average cost curve is at its minimum level.



B Short answer questions and problems Question 1 Cost Concepts

The table below shows production data for a haymaking operation.

Units of labour Total product Marginal product (labour days) (bales per day) (bales per day)

0 0 1 100 2 300 3 800 4 1200 5 1400 6 1500 7 8 1550

100

200

50

a Complete the table above by calculating the missing figures. b Draw a line graph to illustrate total output and marginal output from the table shown above.

(Note: Plot the marginal output values at mid-points between labour days.)

Haymaking production

c Identify the input level where diminishing returns first occur.



d Given that labour is the only variable cost at $100 per labour day and fixed costs are $400 per day, complete the following table. (Refer to pages 95–96 of the textbook for examples.)

Units of Total Marginal Total Total Total Average Average Average Marginallabour product product fixed variable cost fixed variable cost cost

cost cost cost cost ($) ($) ($) ($) ($) ($) ($) ($) 0 0 400 400

1 100

2 300

3 800

4 1200

5 1400

6 1500

7 1550

8 1550

100

200

500

400

200

100

50

0

e Plot your findings for average fixed cost (AFC), average variable cost (AVC), average total cost (ATC), and marginal cost (MC) onto the graph below.

Haymaking production costs



f Using the table (or your graph) estimate the output level corresponding to the technical optimum condition.

g Comment on the relationship you observe between the AFC, AVC and ATC curves.

h Comment on the relationship you observe between the MC, AVC and ATC curves.

i Assume that hay has a price of $1.00 per bale. What would be the maximum number of labour units (days) the farmer would employ if he is to maximise profits. (Recall that the wage (price) of labour is $100 per day.)



1 The short run is a time period during which a the firm cannot hire additional labour b the firm is unable to increase output c there are shortages of all inputs d some inputs can be varied while others are fixed



2 The long run is a time period during which a labour is flexible but capital is fixed b the firm makes only normal profit c all factors of production can be varied d most equipment becomes obsolete 3 Suppose that a firm increases labour employed from 9 to 10 workers and, as a result, output increases

from 1200 units to 1400 units. The marginal product of the 10th worker is a 120 units b 1400 units c 20 units d 200 units 4 The law of diminishing returns state which of the following? a As a firm employs more of a variable factor, with a given quantity of fixed factors, its average

cost eventually decreases. b As plant size increases, marginal product eventually decreases. c As a firm uses more of variable input, with a given quantity of fixed inputs, its marginal

product eventually decreases. d As plant size increases, average cost eventually decreases. 5 Marginal cost is calculated by a deducting total fixed cost from total cost b dividing total cost by total output c dividing output by the total cost d dividing the increase in total cost by the increase in output 6 Which of the following is not true of short-run costs? a The difference between average total cost and average variable cost diminishes as output

increases. b Average cost and average fixed cost are U-shaped. c Marginal cost cuts average variable cost and average total cost at their minimum point. d Marginal cost is above average total cost when average total cost is rising. 7 Average variable cost is at its minimum at the output level where a it equals marginal cost b average fixed cost is at its minimum c average total cost is at its minimum d technical optimum is achieved 8 The output level at which a plant’s average total cost is at a minimum is known as a excess capacity b overutilised capacity c the technical optimum d shut-down point



9 Suppose that an ice-cream manufacturer could double its production of ice-cream by tripling its plant size. This is an example of

a economies of scale b diseconomies of scale c increasing returns to scale d diminishing returns to scale 10 There are diseconomies of scale if an increase in plant size causes a long-run average cost to increase b long-run average cost to decrease c diminishing returns d output to decrease 11 When firms exit a market, there is a a leftward shift of the market supply curve b an increase in profits for existing firms c a decrease in the equilibrium level of output for the market d all of the above 12 According to the law of diminishing returns, beyond a certain output level a marginal cost must rise b total cost must fall c average cost must fall d marginal cost must fall 13 Rising marginal cost result from a the rising prices of all inputs b the rising prices of variable inputs only c declining marginal physical product d rising average cost 14 As long as a firm produces at the point MR = MC, we can be sure that a profits are positive b losses are minimised c profits are maximised or losses are minimised d profits are maximised 15 Economies of scale a are always caused by increasing returns to scale b may be caused by increasing returns to scale c are the same as increasing returns to scale d are not connected to the concept of returns to scale 16 If average cost is greater than marginal cost, then increasing output means a average cost will fall b average cost will rise c marginal cost will rise d total cost will fall



17 In the short run, all firms must decide a what price to charge b how much to produce c whether to use implicit or explicit costs to calculate economic profit d how much to invest. 18 Normal profits a are a feature of competitive markets only b are a characteristic of ‘mature industries’ c never occur in oligopolistic industries d can only occur in the long run 19 Economic costs a are implicit costs b include explicit costs c will always differ from accounting costs d mean that economic profits are greater than accounting profits 20 The shut-down point a indicates the minimum price a firm should accept b is the price level where a firm will always be better off producing zero output c is equal to minimum average cost d is equal to fixed cost

D Paragraph writing

1 Refer to Figure 5.5 on page 100 of the textbook. Discuss the factors which a firm must consider when deciding whether to increase its plant size.



2 Write a paragraph distinguishing the principle of economies of scale from the law of diminishing marginal returns.

Part Three Theory of the firm Exercise Set 5 Market structure & decision-making


Exercise Set 5: Market structure and business decision-making

Learning objectives

• examine competition under the various market structures • consider how market structure impacts on the price and non-price marketing strategies

of firms • consider how market structure impacts on the revenue of firms • discuss the nature and importance of barriers to market entry • consider what motivates a firm’s strategy, including the goal of profit maximisation • apply the profit-maximising rule (MR = MC) and the shut-down rule (MR = MC =

AVC) to the production decision of a firm in perfect competition • explain the short- and long-run production decision for the perfectly competitive firm

and discuss possible profit levels • apply the profit-maximising rule (MR = MC) to the production decision of a firm in

imperfect competition • explain the short- and long-run production decision for the imperfectly competitive firm

and discuss possible profit levels.



List 1 Market structures

Key concept Definition [Enter correct number] a market power _______________________________ b monopsony _______________________________ c perfect competition _______________________________ d monopolist _______________________________ e monopsonist _______________________________ f cartel _______________________________ g total revenue _______________________________ h average revenue _______________________________ i trademark _______________________________ j oligopoly _______________________________ k price leadership _______________________________ l patent _______________________________ m marginal revenue _______________________________ n gentlemen’s agreement _______________________________ o game theory _______________________________ p new industrial economics _______________________________ q monopolistic competition _______________________________ r contestable markets _______________________________ s product differentiation _______________________________ t duopoly _______________________________



Definitions 1 A single buyer of a commodity or service. 2 A market structure in which there are only two producers of a commodity or service. 3 A method of analysing strategic behaviour. 4 A right given under law to a person or organisation to be the sole producer or seller of a particular

commodity. 5 An informal agreement by competitors on pricing policy. 6 The degree of control a firm has over the price of its product. 7 A market situation typified by a large number of small firms selling products which are close

substitutes and which are, in some way, differentiated from the products of competitors. 8 The creation of differences, either real or contrived, in a similar product. 9 One buyer of a commodity or service. 10 A market structure in which a small number of firms produce the entire output of a particular

commodity or service. 11 A group of firms that enter into an agreement to establish mutually acceptable prices for their

products. 12 A market structure in which no firm or individual is able to influence prices set in the market. 13 A market situation where even a monopolist will adopt a competitive pricing policy. 14 A set of theories that attempts to explain actual behaviour of firms and their effects on the economy. 15 A single seller of a commodity or service for which there are few, if any, substitutes. 16 The revenue received from all units of output sold. 17 The change in total revenue resulting from increasing sales by one unit. 18 The total revenue received from the sale of a given output divided by the number of units sold. 19 A special mark placed on a particular brand of an article to distinguish it from similar goods

manufactured by other producers. 20 A situation whereby the price of a commodity or service is determined by a major firm in an industry

and followed by others.

List 2 Equilibrium of the firm

Key concept Definition [Enter correct number] a monopoly profit _______________________________ b imputed cost _______________________________ c price discrimination _______________________________ d break-even point _______________________________ e marginal cost pricing _______________________________ f economic profit _______________________________ g natural monopoly _______________________________ h shut-down point _______________________________ i price regulation _______________________________ j normal profit _______________________________ k social optimum _______________________________ l exit _______________________________ m supernormal profit _______________________________ n short run _______________________________ o long run _______________________________



Definitions 1 A return to entrepreneurs in excess of that required to hold them in their present activity. 2 The return just sufficient to hold entrepreneurs in their present activity. 3 A time period in which firms can neither enter nor leave an industry. 4 The difference between revenue and costs (including the imputed costs of inputs owned by the firm). 5 Long-run decision to sell a plant. 6 A price at which revenue covers all economic costs. 7 A time period in which firms wishing to earn more than normal profits may enter an industry while

those earning less than normal profit may leave. 8 The opportunity cost of input owned by the firm which could be put to alternative uses. 9 The supernormal profit which a firm operating in an imperfectly competitive market may earn and

retain in either the short- or long-run time periods. 10 A situation in which price is equal to marginal cost. 11 The administering of price by government in accordance with a particular aim or aims, in regard to

controlling the ill-effects of monopoly activity in the market. 12 An enterprise whose average cost curve falls throughout the entire output range. 13 An equilibrium at which a monopolist is forced by price controls to supply the quantities equivalent

to that of perfect competition. 14 The practice of charging different prices to different consumers in circumstances where costs of

production are the same. 15 A price at which revenue only just covers variable cost.


Question 1 Equilibrium of the firm: perfect competition

In Exercise Set 4, you calculated production costs for a haymaking operation, which we will assume exists in a perfectly competitive market. The cost schedule is shown below:

Total Fixed Variable Total Marginal Average Average Total Marginal Average Profit

output cost cost cost cost variable total revenue revenue revenue cost cost

Q (TFC) (TVC) (TC) (MC) (AVC) (ATC) (TR) (MR) (AR) (TR–TC) ($) ($) ($) ($) ($) ($) ($) ($) ($) ($)

0 400 0 400

100 400 100 500 1.00 5.00

300 400 200 600 0.67 2.00

800 400 300 700 0.38 0.88

1200 400 400 800 0.33 0.67

1400 400 500 900 0.36 0.64

1500 400 600 1000 0.40 0.67

1550 400 700 1100 0.45 0.71

1550 400 800 1200

1.00

0.50

0.20

0.25

0.50

1.00

2.00

∞ 0.52 0.78



a Assuming that the market price for hay is $1.00 per bale, complete the total revenue, marginal revenue, average revenue and profit columns (show any losses in brackets).

b What is the profit-maximising output, and what is the total profit?

c Explain how you arrived at your answer to question b.

d If the price of hay fell to $0.50, what output level would be profit maximising and how much profit would be made?

e What would you expect to happen to the market in the long run following the outcomes from questions c and d above?



f Assuming price rose to $2.00 per bale of hay, what output level and profit would the firm make?

g Using the information from the table, draw a sketch graph. Show the average cost (AC) curve,

average variable cost (AVC) curve, marginal cost (MC) curve, and marginal revenue/average revenue/demand curve. Show the profit-maximising price and output level and shade in the profit/loss area.

Equilibrium of the firm

h Show the competitive firm’s supply curve on the graph you have drawn, labelling it SS. Briefly explain why this is the supply curve for the firm.



Question 2 Equilibrium of the firm: monopoly

The table below shows the cost and revenue (demand) data for Mono Phones, a local monopolist of mobile phones.

Price (P) (= AR) ($ per phone)

Quantity (Q) (no. of phones

per month)

Total revenue (TR) ($)

Total cost (TC) ($)

Marginal cost (MC)

($)

Marginal revenue

(MR) ($)

250 0 2 000

225 25 5 000

200 50 7 000

175 75 8 375

150 100 10 250

125 125 13 000

100 150 17 000

75 175 22 500

50 200 30 000

25 225 45 000

a Complete the total revenue (TR), marginal cost (MC) and marginal revenue (MR) schedules.

b Draw a graph from the data in the table showing the average revenue (AR), marginal revenue (MR) and marginal cost (MC) curves. Identify the profit-maximising price and output level on your graph.



c Draw a graph showing the total revenue curve.

d Estimate the total profit made by the monopolist at profit-maximisation output level from your table.

e Estimate the total revenue (sales) maximising price and output level from your table. What profit is earned at this level?

f Comment on any relationships you observe between TR and MR from your graphs.





1 A price-taking firm faces a a downward-sloping demand curve b downward-sloping marginal revenue curve c downward-sloping average revenue curve d perfectly elastic demand curve 2 Under perfect competition a firm’s marginal revenue equals its a average revenue b price c demand curve d all of the above 3 Which of the following is not true in the case of the perfectly competitive firm? a Marginal revenue equals average revenue. b Marginal revenue is less than average revenue. c Price remains constant when quantity sold changes. d Firms and buyers are completely informed about the prices of the products of each firm in the

industry. 4 If price falls below the minimum of average variable cost, the best a firm can do is a increase production b reduce production c cease production and make a loss equal to variable cost d cease production and make a loss equal to total fixed cost 5 A firm maximises profit by producing the output level where marginal cost equals a average revenue b marginal revenue c average cost d average variable cost The figure below relates to questions 6–8.



6 Given the market price, P0, the firm is

a making a loss b breaking even c making a supernormal profit d making shut-down losses 7 Given price P0, in the long run

a demand will decrease b supply will decrease c demand will increase d supply will increase 8 Given the market price P0, in the long run

a remaining firms will reduce production b remaining firms will increase production c remaining firms will maintain current production levels d remaining firms will enjoy supernormal profit 9 Price competition in an oligopoly market will a harm consumers b reduce efficiency c reduce industry profit d increase industry profit 10 A natural monopoly exists when a there are no rival firms in the market b government protects the firm by regulation c the marginal cost of production decreases as the output level increases d the firm controls key raw material supplies 11 Which of the following is a characteristic of a perfectly competitive market? a There are low barriers to entry. b Firms advertise their products. c Firms are price makers. d The market price is determined by an organisation of sellers. 12 In a perfectly competitive industry a profits may be supernormal in the long run b firms will continue to enter indefinitely c firms have identical cost structures d none of the above 13 Long-run equilibrium in a competitive market means that price a is similar to what it would be under a monopoly b is equal to the demand curve of the firm c is equal to minimum average cost d is always lower than it would be under a monopoly



14 Market power indicates that a consumers place a high value on the firm’s product b the firm can influence price c the demand curve for the firm is very elastic d the firm is an effective competitor 15 A monopolist a is the sole firm in an industry b is the largest firm in an industry c is a firm that sets market prices d exists because high capital costs prevent competition 16 Consumers may prefer monopolistic competition to perfect competition where a they are primarily concerned about low prices b they are looking for specific features in a product c brand names are irrelevant to them d they want to know that they are receiving the same service as everyone else 17 An oligopolist may increase market share by a setting the price equal to minimum average cost b making an agreement with other firms in the industry c setting price equal to marginal revenue d having non-price incentives to attract customers 18 Normal profits are a feature a of all industries in the long run b of perfect competition only c of perfect and monopolistic competition in the long run d of industries on the decline 19 From an economics perspective, advertising is a positive because it informs customers about product differences b positive or negative, depending on whether you like advertisements c negative because it only results in higher costs and prices d positive or negative; it depends on the product and the advertisement 20 Non-price competition is a feature of oligopolies because a price competition makes all firms worse off b competitions and giveaways are a way of capturing market share c product differences are so great that advertising them is worthwhile d none of the above



D Paragraph writing 1 Consider Figure 6.1 on page 108 of the textbook. Categorise the following consumer goods and

services into one of the market structure categories shown in Figure 6.1: bread, apples, soft drink, hamburgers, doctor, milk, banking, pop music, paperback novels. Explain which of these goods/services’ market structures will be most dependent on the size of the market, i.e. city versus small town.

2 Read Box 7.2 on page 138 of the textbook. Describe the characteristics of market structure reflected

by the New Zealand domestic aviation market and comment on Air New Zealand’s likely response to the entry of Pacific Blue.


Part Four: Market failure and government intervention

Overview Under an extremely restrictive set of conditions, a pure market economy can achieve a socially optimum level of allocative efficiency. It’s as if an ‘invisible hand’ organises efficiently the allocation and distribution of resources.

Under real-world conditions, however, resource allocation can generally be improved, at least in theory, through the use of government policy intervention. Generally, markets on their own over-allocate resources to some (usually private) uses, while under-allocating resources to products that give indivisible benefits to society as a whole.

There is a variety of ways in which governments can intervene to enable markets to work better than they would if left alone. One important method is to provide many public goods and mixed goods collectively, making access to them free of charge. Another important policy intervention is to use taxes to discourage expenditure on socially undesirable goods, while also offering subsidies to encourage additional expenditure on socially desirable goods and services.

Exercise Set 6: Addressing market failure

Learning objectives • examine the efficiency and equity of the market • consider the necessary conditions for the market to achieve optimal efficiency • consider the consequences of imperfect competition for market efficiency • consider the difficulties involved in achieving a socially optimal allocation of resources • consider public goods as a form of social good • examine the impact of externalities on the attainment of social equilibrium • compare equality and equity as outcomes for individuals and society • consider whether the distribution of income is equitable • consider how government attempts to correct for inefficiency and inequity of market

outcomes • discuss the issues surrounding the provision of public goods • learn about policy options for correcting externalities • consider the economic roles of government and common economic policy objectives • consider the trade-off between economic efficiency and equity.

Part Four Market failure & government intervention Exercise Set 6 Addressing market failure



Choose the definition for each of the key concepts listed.

Key concept Definition [Enter correct number] a allocative efficiency _______________________________ b public goods _______________________________ c negative externalities _______________________________ d marginal social cost _______________________________ e market failure _______________________________ f free rider behaviour _______________________________ g positive externalities _______________________________ h consumer sovereignty _______________________________ i marginal social benefit _______________________________ j collective goods _______________________________ k social wage _______________________________ l income in kind _______________________________ m paternalism _______________________________ n merit goods _______________________________ o equity _______________________________ p equality of income _______________________________

Definitions 1 The allocation of resources which maximises the well-being of society. 2 When the conditions for the market system to work perfectly are not met, the price system fails to

achieve allocative efficiency. 3 Consumer preferences dictate what goods are produced, and in what quantities. 4 Goods which are non-rival and non-excludable. 5 Avoidance of contribution to the cost of providing a public good on the grounds that once it is

provided no one can be excluded. 6 Spillover costs from production or consumption. 7 Spillover benefits from production or consumption. 8 The sum of the private cost and the spillover cost of consuming an extra unit. 9 The sum of the private benefit and the spillover benefit of consuming an extra unit. 10 The government decides what is best for us regardless of the choices we would make in a free-market

situation. 11 Commodities (or services) which government says people ought to have because they are considered

to be good for them. 12 Any good that government provides free of direct charge and which is paid for by taxes. 13 The non-cash benefits enjoyed from government expenditure on goods such as health and education. 14 Income earned in the form of other goods or services. 15 Disposable incomes are the same for all income earners. 16 The income distribution is considered to be fair.



B Short answer questions and problems Question 1 Externalities, efficiency and regulation

Study the graph below and answer the questions that follow.

a Define and give an example of a positive externality.

b Consider the market for education illustrated in the graph below and identify the following.

Education

i The curves labelled A, B and C.

ii The level of education that is consumed in an unregulated market.



iii The level of education that is consumed in a regulated market.

iv The level of subsidy necessary if economic efficiency is to be achieved.

v The level of schooling that would be consumed if a 100% subsidy were applied to education.

c Is a 100% subsidy efficient? Explain your answer.

d Explain why the unregulated market is inefficient.





Given in the graph below are the marginal private cost, the marginal social cost and the market demand curve. Study the graph and answer the questions below.

1 In an unregulated market the output will be a Q2 b Q3 c Q1 d 0 2 In an unregulated market the price will be a P1 b P2 c P3 d P4 3 If the market is unregulated, then at equilibrium output level, the marginal social cost of production is a less than the marginal benefit to consumers b equal to the marginal benefit to consumers c greater than the marginal benefit to consumers d equal to the marginal private cost of production 4 In an unregulated market a the allocation of resources will be efficient b the allocation of resources will be maximised c too little output will be produced d too much output will be produced



5 The government could attempt to achieve allocative efficiency in the market by imposing a tax equal to

a P2 – P1 b P4 – P1 c P3 – P1 d P1 6 If the government does introduce a tax and allocative efficiency is achieved, then the output level will

be a Q1 b Q2 c Q3 d 0 7 If allocative efficiency is achieved through a tax, then the price to consumers will be a P1 b P2 c P3 d 0, since we have a ‘corner solution’ 8 If allocative efficiency is achieved through a tax, then the price producers will receive will be a P1

b P2

c P3 d 0, since we have a ‘corner solution’ 9 In cases of market failure, unregulated markets will a minimise costs b ensure the efficient allocation of resources c fail to achieve an efficient allocation of resources d result in rising production costs 10 It is generally accepted that an unregulated market system will result in more income inequality than

most people would prefer. Inequality can be reduced by any of the following except: a increased unemployment b increased government transfer payments c a more graduated income tax scale d increasing the provision of collective goods 11 When consumption is non-rivalrous and non-exclusive, the product is a a private good b a mixed good c a pure public good d a merit good



12 Which of the following is not a characteristic of pure public goods? a People who do not pay can be excluded from consumption. b People who do not pay cannot be excluded from consumption. c One person’s consumption of the good does not prevent or inhibit the consumption of another

person. d The cost of providing the good or service to an additional individual is zero. 13 Antilock braking systems (ABS) in motor vehicles generate a negative externalities b positive externalities c market failures d the provision of public goods 14 An example of a pure public good is a street lighting b a sports utility vehicle (SUV) c a cream bun d a public swimming pool 15 An example of an activity that generates positive externalities is a higher education b toxic waste poured into a river c a circus d buying and eating a hamburger 16 Allocative efficiency occurs when a marginal revenue equals marginal cost b marginal benefit exceeds marginal cost c marginal revenue equals marginal social benefit d marginal social benefit equals marginal social cost 17 Government intervention in the economy as a result of market failure a will improve the mix of output produced b may worsen the mix of output produced c will increase total output d may lead to any of the above 18 The economic question of how to produce electricity is important because a different methods of production have different costs b third parties could be harmed c externalities could occur d all of the above 19 The fundamental distinction between private and public goods is based on a whether consumption is linked to payment b who produces the goods c how much the goods cost d who consumes the goods



20 Typically, the marginal cost of reducing pollution a remains the same as the environment becomes cleaner b is not affected by the cleanliness of the environment c increases as the environment becomes cleaner d decreases as the environment becomes cleaner

D Paragraph writing 1 After reading Chapter 10 of the textbook, write a paragraph explaining why government intervention

exists in market-based economies.

2 After reading pages 181–188 of the textbook, write a paragraph explaining why externalities (positive or negative) create market failure and how government intervention may achieve allocative efficiency.


Part Five: The macroeconomic environment

Overview In Part Five we examine the determinants of the most important aggregate of the national economy: national income. The models we use to demonstrate how the economy works in the aggregate are the circular flow model (which expands into the income-expenditure model), and the aggregate demand and aggregate supply model. Remember that a model is designed to be a simplified version of reality in order to highlight the most important relationships between the variables.

We take advantage of the circular flow model to explain how we measure national income and average living standards. This requires a development of our understanding of the concepts of aggregate economic activity such as gross domestic product, measures of the price level and inflation, and measures of the labour force and unemployment.

In addition, we investigate the workings of the labour market, and the country’s money and financial systems. Our understanding of these aspects of the economic environment enables us to consider macroeconomic policy (Part Six), which represents government’s attempts to improve the economic performance of our nation.

Exercise Set 7: Macroeconomic indicators

Learning objectives • identify the basic components of the macroeconomy and demonstrate how they

interrelate in the circular flow model of the economy • identify injections and withdrawals in the circular flow model • describe how equilibrium in the economy is determined • examine approaches to the measurement of GDP • consider the distinction between real and nominal GDP • examine the construction and use of the consumers price index (CPI) • discuss the assessment of the standard of living within a country and between countries • consider the measurement of unemployment within an economy • consider how wage rates are determined.

Part Five Macroeconomic environment Exercise Set 7 Macroeconomic indicators




Key concept Definition [Enter correct number] a factor inputs _______________________________ b national income _______________________________ c income _______________________________ d gross domestic product or GDP _______________________________ e nominal value of output _______________________________ f base year _______________________________ g price index _______________________________ h equilibrium income _______________________________ i intermediate goods _______________________________ j final goods _______________________________ k imputed value _______________________________ l inventories _______________________________ m gross investment _______________________________ n real GDP _______________________________ o economic indicators _______________________________

Definitions 1 New investment plus replacement investment. 2 Finished goods for sale to households. 3 The flow of money earned over a period of time. 4 The money value of output in current dollar terms. 5 A weighted average of prices in one year expressed in relation to prices in the base year. 6 Variables that move in predictable ways in relation to the business cycle. 7 The year taken as the reference point. 8 Where withdrawals are balanced by injections and there are no unplanned changes to stocks. 9 The total income generated over a period of time, usually one year. 10 The name given to the national output or income produced in one year. 11 Goods which are used in the production of other goods for final consumption. 12 Real sources of land, labour and capital supplied by households to firms. 13 Stocks of unsold goods. 14 A value which is estimated from the value of comparable assets or activities. 15 The value of output expressed in base year dollars.



B Short answer questions and problems Question 1 Circular flow of income

Chapter 11 introduces the circular flow of income diagram as a means of explaining how mixed market economy operates. Complete the diagram below by filling in the empty label boxes.

Question 2 Aggregate expenditure

Define each variable in the equation: Y = C + I + ΔR + G + (X – M).

Question 3 National income equilibrium

The economy is in equilibrium when planned injections equal withdrawals. Show this by means of an equation.



Question 4 National income measurement (the ‘national accounts’)

Define the following measures:

a GDP

b Real GDP

c Real GDP per capita

d Gross National Expenditure

Question 5 Living standards

a Suggest a measure of living standards from the national accounting measures that you investigated in Question 4.

b Comment on possible limitations of this as a comprehensive measure of living standards. (See pages 233–237 for a discussion of the issues.)





1 Gross domestic product (GDP) is defined as the value of all a goods produced in an economy in one year b goods and services produced in an economy in one year c intermediate and consumer goods produced in an economy in one year d final goods and services produced in an economy in one year 2 Expenditure on GDP is expressed as a Y = C + I + ∆R + G (M – X) b Y = C + I – ∆R + G + (X – M) c Y = C + I + ∆R + G + (X – M) d Y = C + S 3 An economy is in equilibrium when a X + M = C + S + T b X + I + G = C + S + T c X + I + G = M + S + T d Y = C + S + T 4 If there is an increase in injections, then, most likely, a real GDP will decrease b nominal GDP will decrease c real GDP will increase d nominal GDP will be unchanged 5 In the simple circular flow diagram a households sell factors of production to government b households sell factors of production to firms c firms buy factors of production from government d governments buy goods and services from households 6 The circular flow model is used to a show how consumer demand falls during recession b show the impact of inflation of economic activity c show the real flows and money flows between different sectors of the economy d explain how factor prices are determined 7 In calculating yearly GDP, all of the following are excluded, except a the value of second-hand goods b the value of intermediate goods c the value of all houses built during the year d the value of all transfer payments



8 A decrease in real GDP could result from an increase in all of the following except a tax rates b import payments c export receipts d savings 9 Which of the following is included in GDP? a spending to relieve traffic congestion b clean-up after an accident c hospital treatment of accident victims d all of the above 10 When the CPI is based on 2006 prices, a CPI of 1061 in 2008 means that a prices of consumer goods have risen by 61 times b a good that cost $1000 in 2006 now costs $1061 in 2008 c a market basket of consumer goods and services costs $61 more in 2008 than in 2006 d a market basket of consumer goods that cost $1000 in 2006 costs $1061 in 2008 11 When economists refer to constant dollar GDP, they mean that a nominal GDP has been adjusted for price level changes b the economy is stagnating c the inflation rate is zero d the rate of economic growth is zero 12 Real GDP will necessarily increase when a the price level falls b the price level rises c the quantity of goods and services produced increases d the velocity of circulation increases 13 What are the main macroeconomic goals of any government? a zero employment, zero inflation, economic growth b full employment, price stability, economic growth c maximising the welfare of individual consumers and producers d maximising the use of labour and capital 14 A value that has been adjusted for changes in the price level is called a a nominal value b a current value c a real value d a net value 15 For future generations to enjoy a better standard of living, which of the following must occur? a economic growth b easier access to healthcare and education c an inward shift of the PPC d a more equitable distribution of income



16 The per capita GDP will always rise when a the population increases b the rate of economic growth increases c there is an increase in the rate at which the economy’s labour force grows d the rates of economic growth exceed the rate of population growth 17 GDP for any given year most closely measures a the total output generated by citizens of a country b a summary of the world’s output c the total value of all final goods and services a country produces d the average standard of living of a country 18 The type of unemployment that falls as the economy expands is called a cyclical unemployment b frictional unemployment c structural unemployment d the natural level of unemployment 19 The productivity of labour a is the average output per unit of labour b is vital for economic growth c increases as capital intensity increases d all of the above 20 Labour productivity is higher in the USA than in China because a the USA has a higher capital to labour ratio b the USA has a lower capital to labour ratio c China has a larger population so it doesn’t see productivity as being an important objective d the USA is more exposed to international competition

D Paragraph writing

1 After reading Box 12.3 on page 227 of the textbook, explain why it is necessary from time to time to revise the make-up of the consumers price index.



2 After reviewing Box 12.5 on page 230 of the textbook, explain why very high inflation can be a serious problem for a country’s citizens.

3 Explain why it is important to distinguish between real GDP and nominal GDP growth, especially in

times of price instability.

4 Explain why wages for some classes of skilled workers are higher than for other classes of skilled

workers.

Part Five Macroeconomic environment Exercise Set 8 Aggregate demand & supply


Exercise Set 8: Aggregate demand and aggregate supply

Learning objectives

• apply the aggregate demand aggregate supply (AD/AS) model to show how GDP is determined in the short run

• examine how current equilibrium GDP compares with potential (full capacity) GDP in the creation of inflationary and recessionary gaps

• apply the ADAS model to show how shifts in AD or AS can cause economic instability • examine how specific events can bring about the economic phenomena of stagflation,

inflationary spirals, and deflation.



Key concept Definition [Enter correct number] a capacity utilisation _______________________________ b investment multiplier _______________________________ c aggregate demand curve _______________________________ d aggregate supply curve _______________________________ e equilibrium _______________________________ f stagflation _______________________________ g exogenous expenditure _______________________________

Definitions 1 The multiple by which national income changes when investment changes. 2 The real output purchased at different price levels. 3 A combination of real output and the price level which is stable for the economy. It occurs at the

intersections of AD and AS. 4 The degree to which firms are producing at maximum output levels. 5 Falling output and employment along with rapidly rising prices (inflation). 6 The real output that firms are willing to supply at each price level. 7 Expenditure unrelated to national income.




Question 1 Aggregate demand and supply analysis

Assuming that an economy is operating at a moderate level of capacity utilisation, analyse the effects on real GDP and the price level of the following events. Draw sketch graphs to support your findings.

a An increase in export earnings.

b An increase in wage rates.



c An increase in income taxes.

d An increase in labour productivity.

e Households increase savings in order to make it through an expected recession.





1 Which of the following is not held constant along a given aggregate demand curve? a the interest rate b government spending c tax rates d the price level 2 If excess supply exists at the current price level in the AD/AS model, then a unemployment will fall b the price level will fall c tax rates will rise d the price level will rise 3 The marginal propensity to consume is a the fraction of the last dollar of income received that is saved b the fraction of the last dollar of income received that is consumed c the proportion of all income that is consumed d generally lower than the marginal propensity to save 4 The marginal propensity to save a plus the marginal propensity to consume equals 1 b plus the marginal propensity to consume equals 0 c minus the marginal propensity to consume equals 0 d plus the average propensity to save equals 1 5 If interest rates increase, the a aggregate demand curve shifts to the right b aggregate demand curve shifts to the left c aggregate supply curve shifts to the right d aggregate supply curve shifts to the left 6 If net exports increase due to an export boom, the a aggregate supply curve shifts to the right b aggregate demand curve shifts to the right c aggregate supply curve shifts to the left d aggregate demand curve shifts to the left 7 The discovery of an improved production technique will shift the a aggregate demand curve to the right b aggregate supply curve to the right c aggregate demand curve to the left d aggregate supply curve to the left



8 Stagflation means that real GDP grows more slowly or even declines and a employment increases b unemployment increases c the economy experiences inflation d the economy experiences deflation 9 Which of the following variables is not held constant in deriving the short-run aggregate supply

curve? a the interest rate b the tax rate c the price of raw materials and wages d the price level 10 Which type of unemployment will mainly be affected by changes in aggregate demand? a seasonal b cyclical c frictional d structural 11 Which of the following does not cause the aggregate demand curve to shift to the left? a a decrease in government spending b a decrease in consumer confidence c a decrease in taxes d a decrease in net exports 12 ‘Crowding out’ refers to a a fall in investment spending as interest rates decrease b the effects on aggregate demand caused by a fall in the price level c a fall in investment spending as interest rates increase d a fall in business confidence 13 A natural disaster that makes it difficult to obtain raw materials is called a a positive supply shock b a negative supply shock c a positive demand shock d a negative demand shock 14 An increase in planned investment spending of $500 million causes aggregate demand to a increase by at least $500 million b increase by less than $500 million c decrease by $500 million d decrease by less than $500 million 15 If aggregate income is falling, a national output is falling b unemployment will rise c GDP is falling d all of the above



16 If aggregate demand exceeds current output, the likely effect is that a the economy will experience a recession b aggregate output will decrease c the level of unemployment will rise d the price level will rise 17 Potential output a is less than equilibrium output in a recession b is the same as equilibrium output c is determined by aggregate demand in the long run d is determined by aggregate supply in the long run 18 An increase in aggregate demand will be inflationary a if the economy is operating a high capacity b if the economy is operating at a low capacity c always, since to increase supply, prices must increase d regardless of the phase of the business cycle the economy is in 19 An increase in potential output means a the economy is in an expansionary phase of the business cycle b the economy is able to produce more without inflationary pressures c consumption expenditures are less than investment expenditures d more resources must be available 20 In the long run, a certain way by which an economy can increase its potential rate of growth is a increasing labour productivity b encouraging the public to invest in the share market c encouraging firms to employ more workers d ensuring taxes are spent on investment projects

D Paragraph writing 1 Explain why a recession in the USA is likely to cause the rate of economic growth in New Zealand to

decline.



2 Read Box 14.4 on page 277 of the textbook. Explain, using aggregate demand and supply analysis, how rising oil prices impact on the economy of an oil-importing nation.

3 Read Box 14.5 on page 280 of the textbook. Explain, using aggregate demand and supply analysis,

how immigration impacts on the New Zealand economy.

Part Five Macroeconomic environment Exercise Set 9 Money & financial markets


Exercise Set 9: Money and financial markets Learning objectives

• describe the functions and characteristics of money • describe the monetary aggregates used in New Zealand • describe the functions of the banking system • discuss the structure of New Zealand’s financial system in relation to the money supply • describe the credit or money multiplier.



Key concept Definition [Enter correct number] a barter _______________________________ b commodity money _______________________________ c EFTPOS _______________________________ d token money _______________________________ e financial intermediary _______________________________ f settlement cash deposits _______________________________ g Reserve Bank _______________________________ h M1 money supply _______________________________ i M2 money supply _______________________________ j M3 money supply _______________________________ k liquidity _______________________________ l fractional banking _______________________________ m prudential reserve ratio _______________________________

Definitions 1 Money with no intrinsic value. 2 M1 plus other at-call funds at registered banks and other M3 institutions. 3 Deposits held by the major registered banks at the Reserve Bank for use by the banks to settle

between themselves and the government. 4 The ratio of reserves to deposits chosen by the banks. 5 Electronic funds transfer at point of sale. 6 Notes and coin held by the public plus their transaction account balances operable by cheque and

EFTPOS. 7 The exchange of goods in some negotiated ratio for other goods. 8 The ease with which an asset may be used as a medium of exchange. 9 Goods with intrinsic value which circulate as money. 10 The concept of holding only some proportion of bank deposits and lending out the rest. 11 New Zealand’s central bank. 12 M2 plus other funds held by the public at registered banks and other M3 institutions. 13 An institution that accepts deposits from those saving, and makes loans (advances) to investors.




Question 1 Credit creation

Explain how banks create deposits by making advances, and describe the factors that limit how much credit and deposits they are able to create.

Question 2 Credit creation and banking

Assume that the combined registered banks operating in a simplified banking system have a prudential ratio of 10% and gain $2000 of new reserves.

a Calculate the total change in the money supply (M).

Simplified balance sheet of combined registered banks

Assets $m Liabilities $m Reserves Deposits

Loans Total Total

b What will be the amount of credit created?





1 Which of the following is not recognised as a function of money? a a medium of exchange b a means of deferred payment c a source of income d a unit of account 2 A prudential reserve ratio of 0.12 suggests a simple credit multiplier of a 8.33 b 0.88 c 9.6 d 12 3 If the interest rate is 7.5% and the expected inflation rate is 2.5%, then the expected real interest rate

is a 10% b 5% c 2.5% d 7.5% 4 If the price of an apple is 20 grams of salt and the price of a banana is 60 grams of salt, then salt is a more expensive than bananas b a measure of relative value c a standard of deferred payment d a measure of credit 5 When Bob transfers money from his cheque account to his savings account a M2 increases and M3 falls b M2 increases and M1 falls c M2 increases and M1 remains the same d M2 remains the same and M1 falls 6 The most liquid measure of the money supply is a EFTPOS b M1 c M2 d M3 7 If a bank receives a new deposit of $5000 and has a prudential reserve ratio of 12%, how much new

money can it create through additional lending? a $600 b $60,000 c $4,400 d $2,000



8 Excess reserves are defined as a actual reserves minus desired reserves b desired reserves minus actual reserves c required reserves minus desired reserves d required reserves minus actual reserves 9 Which of the following is not a desirable characteristic of financial intermediaries? a minimising the costs of borrowing funds b treating all loan applicants identically c pooling risk d providing a secure place for deposited funds 10 Liquidity refers to a notes and coin in the economy b the entire money supply c credit creation by financial intermediaries d the ease with which an asset can be converted to a medium of exchange

D Paragraph writing 1 Read Box 15.2 on page 292 of the textbook. Describe the desirable characteristics that money should

possess and comment on which of these was missing from the coins issued by the RBNZ.


Part Six: Macroeconomic policy

Overview Macroeconomic policy is art as much as science. Policy makers must draw information (including forecasts) from many sources, and make the best judgements possible about risks to the medium-term future of a nation’s economic health.

In Part Six we examine the ways in which public policy can manage aggregate demand in order to improve the performance of a nation’s economy, in particular with reference to the three macroeconomic objectives discussed in Part Five: sustainable growth; low unemployment; low inflation.

Principally, aggregate demand can be influenced either through the public management of interest rates and the money supply by a country’s central bank (monetary policy), or through the expenditure and taxation policies of the central government (fiscal policy).

We also look at the role of the government’s Budget in greater depth, for those students with a particular interest in or focus on public sector management.

Exercise Set 10: Monetary policy

Learning objectives • consider the relationship between money growth and inflation • examine the determination of the equilibrium interest rate in the money market • learn how inflation targeting is central to monetary policy in New Zealand • learn how the Official Cash Rate (OCR) operates to influence monetary conditions • examine how monetary policy works through transmission channels to influence

spending decisions and, ultimately, inflation • discuss the key concerns surrounding the operation of monetary policy in New Zealand.


Choose the definition for each of the key concepts listed.

Key concept Definition [Enter correct number] a money supply _______________________________ b monetary policy _______________________________ c open market operations _______________________________ d Official Cash Rate (OCR) _______________________________ e real rate of interest _______________________________

Definitions 1 Policy of government, administered through the central bank, that affects monetary conditions. 2 Sales and purchases of securities by the Reserve Bank in order to affect the reserve base of the banks. 3 An interest rate which, when reduced by the Reserve Bank, represents expansionary monetary policy. 4 The rate of return on lending after inflation has been allowed for: calculated (approximately) by

subtracting the rate of inflation from the nominal interest rate. 5 The sum of bank reserves and credit creation.

Part Six Macroeconomic policy Exercise Set 10 Monetary policy


B Short answer questions and problems Question 1 The equation of exchange

State the equation of exchange and give an explanation for what it tells us about how economies work.



1 The Policy Targets Agreement represents an instruction by the government for the Reserve Bank to principally manage

a the rate of unemployment b the rate of inflation c the current account deficit d the rate of economic growth per capita 2 Price stability is desirable for a variety of reasons, including a inflation indicates unsustainability b inflation increases certainty d inflation disadvantages borrowers c deflation disadvantages savers 3 The opportunity cost of holding cash is a higher when interest rates are low b higher when interest rates are high c positive, so a rational person should never carry cash d negative, so a rational person should always carry cash 4 Which of the following statements is true when taking inflation into account when calculating

opportunity costs? a Inflation necessarily changes relative prices. b If relative prices remain unchanged, then opportunity costs are unchanged. c Inflation will always change opportunity cost. d A rising average price level will never affect opportunity costs.



5 If you are an elderly person supplementing your pension with your accumulated savings, in which of the following environments are you better off?

a a high inflation environment, because you are a lender b a low-inflation environment, because you are a borrower c a low-inflation environment, because you are a lender d a high-inflation environment, because you are a borrower 6 If you have just entered the workforce after many years of study and now have to start paying off your

loans, in which of the following environments are you better off? a a high-inflation environment, because you are a lender b a low-inflation environment, because you are a borrower c a low-inflation environment, because you are a lender d a high-inflation environment, because you are a borrower 7 If Australian banks are offering 4% on deposits and New Zealand banks are offering 3% on deposits,

then you know a the real interest rate is higher in Australia b the nominal interest rate is higher in New Zealand c the nominal interest rate is higher in Australia d the real interest rate is higher in New Zealand 8 The Official Cash Rate (OCR) represents a the interest rate on medium-term government bonds b the interest rate set by the Reserve Bank that applies to overnight lending and borrowing

between banks c the interest rate at which the government borrows money from the Reserve Bank d the exchange rate of the New Zealand dollar 9 A decrease in the Official Cash Rate is likely to a increase aggregate demand and create a period of deflation b increase aggregate demand and lead to an increased risk of inflation c increase aggregate demand and create a period of unemployment d represent a contractionary monetary policy 10 Which of the following is not a transmission pathway for contractionary monetary policy? a decreased aggregate demand b increased exchange rate c increased money supply d reduced expectations of future inflation



D Paragraph writing 1 Consider Figure 16.1 on page 310 of the textbook. Using the equation of exchange and the quantity

theory of money, explain the results portrayed in this graph.

2 Read Box 16.2 on page 323 of the textbook. Explain the rationale behind the Policy Targets

Agreement.

3 Read Box 16.6 on page 330 of the textbook. Comment on the principal considerations of the Reserve Bank when deciding on the direction of any change in interest rates.

4 Read Box 16.7 on pages 332 of the textbook. Outline how monetary policy is linked to the main

economic objectives of governments, and why conflict between objectives may occur.

Part Six Macroeconomic policy Exercise Set 11 Government & fiscal policy


Exercise Set 11: Government and fiscal policy Learning objectives

• learn how the government attempts to achieve its economic objectives via fiscal policy • examine how fiscal policy options can be used to stabilise fluctuations in economic

activity • consider how co-ordination of monetary policy and fiscal policy is required to achieve

economic objectives.



Key concept Definition [Enter correct number] a fiscal policy _______________________________ b fiscal deficit _______________________________ c inflationary gap _______________________________ d full employment or potential GDP _______________________________ e recessionary gap _______________________________ f contractionary policies _______________________________ g long-run aggregate supply curve _______________________________ h overfull employment _______________________________ i expansionary policies _______________________________ j demand management _______________________________ k monetised deficit _______________________________ l fully funded deficit _______________________________

Definitions 1 The difference between equilibrium and full employment income when AD and AS curves intersect

below full employment. 2 The level of aggregate supply consistent with a fully employed economy. 3 Policies which restrain the outward movement of the AD curve (i.e. the level of spending in the

economy). 4 The difference between equilibrium and full employment income when the AD and AS curves

intersect above full employment. 5 A situation where the economy works beyond its normal capacity. 6 Decisions about government spending and taxation, which influence the level of aggregate demand in

the economy. 7 Policies which encourage the outward movement of the aggregate demand curve (i.e. encourage an

increase in the level of spending). 8 The level of output which the economy can achieve if all resources are fully employed. 9 The difference between government spending and revenue that needs to be financed. 10 Fiscal policies designed to alter the level of GDP by influencing aggregate demand. 11 A Budget deficit funded by government borrowing from the public and financial intermediaries. 12 A Budget deficit that adds to the money supply because the loans that fund it create new money.




Question 1 Fiscal policy

Use aggregate demand and supply analysis to answer the following. (Use the graph below.)

a Show an economy experiencing a recessionary gap and demonstrate how fiscal policy could be used to restore the economy to full capacity equilibrium. Explain your diagram.

b Suggest specific fiscal policy measures that could be used to bring about the result you outlined in

question a.



c Outline some of the difficulties a government might encounter when attempting to use fiscal policy to achieve economic stability.

Question 2 Aggregate demand and supply analysis

Demonstrate how a reduction in tax rates can have either positive or negative consequences for an economy depending on the level of capacity utilisation at the time they are introduced. Use the graphs below.

Tax cuts when excess capacity exists

Tax cuts when economy is near full capacity





1 An increase in New Zealand’s exports will a have no effect on GDP because GDP only includes spending in New Zealand b cause an increase in GDP because there is more demand for New Zealand’s output c cause a decrease in GDP because the money flows out of the economy d cause a decrease in the price level 2 Expansionary fiscal policy will a shift the aggregate supply curve rightwards and raise real output b shift the aggregate demand curve rightwards and raise real output c shift the aggregate demand curve leftwards and reduce real output d shift the aggregate supply curve leftwards and raise real output 3 If an economy goes into an expansion, then the government’s a outlays, such as transfer payments, will automatically fall, and receipts such as tax revenue will

automatically rise b outlays will automatically rise and receipts will automatically fall c outlays and receipts will automatically rise d outlays and receipts will automatically fall 4 A significant ‘shock’ to the economy, caused by a major earthquake, for example, may lead to a an inflationary gap b a decline in potential GDP c both a and b d neither a nor b 5 The use of government spending and taxation for the purpose of stabilising the economy is called a budget policy b monetary policy c fiscal policy d trade policy 6 A budget deficit exists when a net tax revenue exceeds government spending b government spending equals government revenues c government spending exceeds government revenues d the public debt decreases 7 Which one of the following is true of contractionary fiscal policy? a The budget is balanced. b Aggregate demand increases. c The tax rate increases. d A budget surplus occurs.



8 Stagflation is said to occur when the economy experiences both a inflation and growth b deflation and recession c inflation and recession d deflation and growth 9 Which of the following is not a major macroeconomic policy target? a unemployment at its natural rate b steady growth in real GDP c balance of payment sustainability d a government budget surplus 10 The greatest contribution to government revenues in New Zealand comes from a income taxes b company taxes c indirect taxes d state-owned enterprises 11 The largest component of government spending in New Zealand is a health b education c superannuation d transfer payments, excluding superannuation 12 New Zealand’s rate of economic growth matters because a we don’t want our standard of living to decline in relative terms b more consumption makes everyone better off c otherwise we will have nothing in the future d high rates of growth are always preferable 13 The government should reduce the unemployment benefit to make the unemployed try harder to find

paid work. This is an example of a a positive statement b a normative statement c both a positive and a normative statement d neither a positive nor a normative statement 14 The probability that an expansion of the economy will end will a rise as the expansion continues b remain constant through the business cycle c fall as the expansion continues d be greatest at the beginning of the expansion 15 An economic policy is said to improve efficiency if a it makes at least one person better off b it makes no-one worse off and at least one person better off c it makes no-one worse off d it makes the majority of people better off



16 Which part of government spending is not included in aggregate demand? a spending on hospitals and roads b spending on superannuation c spending on environmental policies d spending on government services 17 A government budget surplus a is always a positive outcome b means taxation rates are too high c means government spending is too low d provides options for policy changes 18 An inflationary gap may be caused if, due to the time-lag of policy decisions, a the effects of expansionary fiscal policies occur during an expansion b the effects of expansionary fiscal policies occur during a contraction c the effects of contractionary fiscal policies occur during an expansion d the effects of contractionary fiscal policies occur during a contraction 19 A recessionary gap may be worsened if a the effects of contractionary fiscal policies occur during an expansion b the effects of contractionary fiscal policies occur during a contraction c the effects of expansionary fiscal policies occur during an expansion d the effects of expansionary fiscal policies occur during a contraction 20 A balanced government budget a is always desirable b occurs when government revenues equal government expenditures c suggests that the government is unwilling to adequately invest in the economy d is only desirable in times of strong economic growth

D Paragraph writing

1 Briefly outline the difference between a ‘monetised’ and a ‘fully funded’ Budget deficit.



2 Outline the limitations of fiscal policy as a means of stabilising economic activity.


Part Seven: The environment of international trade

Overview In Part Seven we examine a country’s economic connections with the rest of the world. First we investigate the theoretical arguments in favour of free trade between all nations, and then the practical arguments for countries’ restricting imports in a number of possible situations.

New Zealand’s patterns of trade have changed significantly since the 1960s (much more trade with Asia and more diversification of exports). We consider New Zealand’s trading future in the light of a process of globalisation that requires economists to think of economies without traditional national borders.

The fourth of the Magic Square (introduced in Chapter 2 of the textbook) performance objectives is the current account of the balance of payments (BOP). New Zealand, which has spent in imports and debt servicing more than it has earned in every year since 1974, has since the 1980s found this objective the hardest to achieve.

The setting of the exchange rate of the New Zealand dollar (NZ$) has a considerable impact on the ability of New Zealand firms to export or to compete with imports. New Zealand has an exchange rate that is almost completely determined by international market forces. Firms in New Zealand’s tradable sector struggle to compete with their overseas competitors whenever the exchange rate rises above levels that are considered normal.

Exercise Set 12: International trade, balance of payments and the exchange rate

Learning objectives

• apply the principles of absolute and comparative advantage to show the benefits of specialisation and trade

• consider the arguments for and against free trade • identify the methods by which government can restrict free trade • evaluate the economic and non-economic arguments for trade restrictions • consider the significance of the terms of trade • discuss recent developments in international trade • learn the key terms appearing in the BOP accounts • establish why the current account balance will always equal the net capital outflow • discuss the significance of the BOP current account as an indicator of a country’s

economic performance • learn what an exchange rate is • learn how exchange rates are determined • consider how a country’s exchange rate may appreciate or depreciate • discuss the economic consequences of currency appreciation and depreciation • establish how the exchange rate may function as a transmission mechanism of monetary

policy • distinguish between the nominal exchange rate and the real exchange rate.

Part Seven Environment of international trade Exercise Set 12 International trade, …



After reading Chapters 19–21 of the textbook, choose the definition for each of the key concepts listed.

Key concept Definition [Enter correct number] a absolute advantage _______________________________ b terms of trade _______________________________ c tariff _______________________________ d quota _______________________________ e comparative advantage _______________________________ f infant industry _______________________________ g balance of payments _______________________________ h current account _______________________________ i net exports _______________________________ j capital account balance _______________________________ k exchange rate _______________________________ l floating exchange rate _______________________________ m clean float _______________________________ n trade-weighted index (TWI) _______________________________ o real exchange rate _______________________________ p foreign exchange market _______________________________ q appreciation _______________________________ r depreciation _______________________________ s pegged exchange rate _______________________________ t free trade _______________________________

Definitions 1 A ratio of an index of export prices to an index of import prices. 2 An industry which is not yet operating at its optimum least-cost output and which needs time to grow

and become competitive. 3 The difference between inward and outward flows related to international borrowing, lending and

investment. 4 A tax levied on commodity imports. 5 The price at which one currency exchanges for another. 6 A situation in which a country could produce a commodity at a lower opportunity cost than could its

potential trading partners. 7 The average of the separate exchange rates between one national currency and all others, with the

weightings being based on the importance of each country as a trading partner. 8 A tabulation of receipts and payments in terms of goods traded and of services plus investment

income received and paid. 9 The international market in which transactions are conducted to effect the exchange of one national

currency for another. 10 A quantitative limit on the import of a particular commodity. 11 A fall in the price of one currency in terms of another. 12 A situation in which a country can produce a commodity with less resources than its potential trading

partners. 13 An exchange rate expressed in terms of a key currency or currency basket. 14 The price of currencies in terms of each other as determined in the market for foreign exchange. 15 A floating exchange rate determined by the supply and demand for currencies with no government

intervention.



16 Flows of goods between countries unhindered by formal or informal barriers. 17 Accounts that record all the transactions of one country with the rest of the world. 18 The difference between export income and import payments. 19 TWI adjusted for the difference in the rate of inflation in New Zealand compared to other countries. 20 A rise in the price of one currency in terms of another.


Question 1 Absolute advantage

The table below shows the production capabilities for New Zealand and Finland in the production of cheese and mobile phones.

Output per worker per annum Cheese Mobile phones (cartons) (units)

New Zealand 10 30 Finland 5 90

a i Which country has an absolute advantage in the production of cheese?

ii Which country has an absolute advantage in the production of mobile phones?

b Assuming both countries have 1000 workers and, before trade, employ 500 workers in each industry: i Calculate the pre-trade production of cheese and mobile phones, and total world production.

ii Calculate production of cheese and mobile phones after both countries specialise in their

absolute advantage.



iii Calculate the gains in world production from specialisation.

c Suggest an exchange ratio between cheese and mobile phones that would be acceptable to both New

Zealand and Finnish producers.

Question 2 Comparative advantage

The table below shows the production capabilities for an extra worker for New Zealand and Australia in fish and wool.

Output per additional worker per annum Wool Fish (bales) (tonnes)

New Zealand 60 90 Australia 50 30

a i Which country has an absolute advantage in the production of wool?

ii Which country has an absolute advantage in the production of fish?

b i New Zealand must give up _____ bales of wool in order to produce one additional tonne of fish.

ii Australia must give up _____ bales of wool in order to produce one additional tonne of fish. c i The opportunity cost in New Zealand of producing one bale of wool is _____ units of fish.

ii The opportunity cost in Australia of producing one bale of wool is _____ units of fish.



d Which country has a comparative advantage in the production of wool?

e Which country has a comparative advantage in the production of fish?

f Which economist developed the principle of comparative advantage used in international trade

theory?

Question 3 Exchange rates

For each of the situations described in a through d below, construct a demand and supply graph representing the foreign exchange market for the New Zealand dollar (NZ$). Use the trade-weighted index (TWI) to represent price. Analyse the situations by showing any changes in demand and supply of NZ$ and the impact (appreciation or depreciation) on the overall value of the NZ$.

a An economic recession in the USA impacts adversely on both the price and volume of New Zealand’s exports to the USA and other markets.



b New Zealand’s interest rate increases relative to its major trading partners.

c There is an expansion of industries in New Zealand which compete successfully against imported substitutes and also succeed in export markets.

d New Zealand’s inflation rate falls relative to its major trading partners.





1 If the value of exports exceeds the value of imports, then there is a a balance of trade deficit b balance of trade surplus c balance of payments surplus d balance of current account surplus Examine the table below and answer questions 2 and 3.

Description $m Exports 20 000 Imports 18 000 Current account balance –3 000

2 The balance of trade is a $2,000m surplus b $3,000m deficit c $2,000m deficit d $3,000m surplus 3 Based on the information provided, the balance on investment income and transfers is a $3,000m surplus b $3,000m deficit c $5,000m surplus d $5,000m deficit 4 The capital account a records changes in New Zealand’s overseas assets b records changes in New Zealand’s overseas liabilities c records foreign investment in New Zealand d does all of the above 5 Currency appreciation will likely benefit a exporters and importers b exporters and foreign tourists c importers and foreign tourists d importers and citizens travelling overseas 6 Currency depreciation will likely benefit a exporters, foreign tourists, and those with overseas debts b exporters, foreign tourists and those with overseas investments c importers, citizens travelling overseas and domestic producers d exporters, citizens travelling overseas and domestic producers



7 In the short run, a country’s currency will likely appreciate when a import prices rise and capital outflows increase b export prices rise and capital inflows increase c export prices fall and capital inflows increase d export prices rise and capital inflows decrease 8 An improvement in a country’s terms of trade a will always improve the balance of trade b means that export prices have risen relative to import prices c means a country’s industries have become more efficient d means that trade relationships have improved The table below relates to questions 9 and 10.

Year Export price index

Import price index

2000 1090 900 2001 1060 970

9 The terms of trade in 2000 is a 972 b 1211 c 1030 d between 1060 and 1090 10 From 2000 to 2001, the terms of trade a improved because import prices fell faster than export prices b deteriorated because export prices decreased while import prices increased c improved because export prices rose faster than import prices d deteriorated because export prices rose less than import prices 11 In a globalised economy a all countries are treated equally b income differences between countries will be driven to zero c international trade and money flows are vital to the well-being of countries d a country that exports more than it imports will always be better off 12 Which of the following would be the best way of increasing the rate of economic growth? a find more resources b increase immigration c lower our exchange rate to make foreign investment cheaper d improve productivity 13 The account that shows all of a country’s international transactions is called a the current account b the balance of payments c the capital account d the balance of trade



14 The terms of trade is defined as a the rate at which goods are exchanged internationally b the price of one export good in terms of an imported good c the price of one export good in terms of another export good d the average of trading partners domestic prices 15 As the exchange rate increases, the effects on trade flows means a the current account improves b the capital account improves c the current account deteriorates d the capital account deteriorates 16 A lower exchange rate a benefits student loan-holders who are making repayments from overseas b benefits emigrants c benefits domestic consumers d harms New Zealanders returning from working overseas 17 A recession in the USA may harm other countries a only if the USA is a major trading partner b because the US dollar will depreciate c because the USA is the largest economy in the world d if it leads to the USA increasing trade barriers 18 The foreign exchange rate a is the rate at which the currency of one country is exchanged for the currency of another

country b is the rate at which one country’s goods are exchanged for another country’s goods c is the value of the domestic currency in terms of the country’s trading partners d is determined by export flows 19 The demand for New Zealand exports is a countercyclical with the New Zealand business cycle b procyclical with the New Zealand business cycle c countercyclical with the business cycle of the destination nation d unrelated to the business cycle of either country 20 New Zealand’s demand for imports is a countercyclical with the domestic business cycle b procyclical with the domestic business cycle c countercyclical with the business cycle of the source nation d procyclical with the business cycle of the source nation



D Paragraph writing

1 Read Box 19.2 on page 380 of the textbook. Comment on the short-run and long-run economic consequences of the trend described in the article.

2 Assume that you are a newly established footwear manufacturer producing a specialised product for a

niche market. Write a case to government arguing for some form of trade protection. See pages 377–379 of the textbook.



3 Consider the two cartoons in Box 21.7 on page 413 of the textbook. Explain the factors that cause a country’s currency to appreciate and depreciate, and outline the positive and negative consequences of each.

4 Read Box 21.10 on page 422 of the textbook. Outline the tensions that exist between the operation of

monetary policy and the economic performance objectives of government.

econ con4e slg main

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