01/02 ~ BE EXAM (Answers)

Q1. (a) To consumers, the law of diminishing marginal utility states that marginal utility will eventually decrease when their consumption of a good or service increases. Price has to fall together with the diminishing marginal utility.

To firms, with more and more of variable input applied to fixed input, the marginal product of the variable input diminishes eventually. Average cost will increase. To increase output, expansion of production scale is a long run solution.

    (b) SR in the period of the which variable inputs such as materials and workers can be adjusted, but insufficient length of time for all inputs to be changed. It is the time period when the law of diminishing returns applies.
LR is the period such that all fixed and variable inputs employed by the firm, can be adjusted. It in the time period when the law of returns to scale applies.

    (c) The concept of opportunity cost is fundamental to economics in the allocation of scare resources. Opportunity cost of an action is the highest valued alternative foregone. It is the real cost of satisfying a want.
In a society, human wants for goods and services are ever increasing as living standards improve. Given finite productive resources, only some wants are satisfied while some other wants are unsatisfied.
In shout, opportunity cost arises because of scarce resources and unlimited wants.

    (d) A production possibility frontier is a curve linking the combinations of goods and services that can be produced in an economy when all its resources are fully and efficiently employed.
Underneath the frontier are attainable but inefficient utilization of limited resources. Above the frontier are combinations currently unreachable but will become attainable with economic growth.

 

Q2.  (a) A change in price of the goods, other things being equal, result in a movement along the demand curve. For example, as tuition fee increases from $500 to $1000, quantity demanded for kindergarten places decreases from 60000 to 40000.
A change in demand is either an increase or decrease in quantity demanded for the goods caused by factors other than the change in price of the goods. For example, as birth rate increases, the quantity demanded for kindergarten places may increase to 65000 even through tuition fees remains unchanged at $500.

     (b) Market equilibrium refers an equilibrium price and an equilibrium quantity for the goods. At the tuition fee of $1500 a month, quantity supplied of kindergarten equals quantity demanded for 32000 places, $1500 and 32000 places are respectively the equilibrium price and equilibrium quantity which constitutes the market equilibrium.
Increases in rental of kindergarten premises and teacher salaries, which are factor costs, are changes in supply condition. They lead to an increase in cost of providing kindergarten services. Other things being equal, the supply of kindergarten places will decreases. Provided that demand condition remains unchanged, the decrease in supply will lead to an increase in tuition fees and a decrease in equilibrium quantity of kindergarten places. An increase in birth rate is a change in demand condition. The increase in the number of children raises the market demand for kindergarten places. Provided that supply condition remains unchanged. The tuition fee will increases and equilibrium quantity of kindergarten places increases too.
As both the demand and supply conditions change, the final impact on tuition fee and equilibrium quantity will depend on the relative strength in the decrease of supply and the increase of demand forces.

    (c) The prices elasticity of supply is
[(17000/23500)]/[(500/1250)] = 1.80
Price elasticity of supply measures the responsiveness of quantity supplied of the goods to a change in the price of that goods. The supply for kindergarten places is elastic as its value is more than 1. When tuition fee changes, the quantity of kindergarten places varies by a greater proportion. The factors contributing to this value include few entry barriers to new producers.
As tuition fee increases, the number of kindergarten increases. Besides, the time required to organize factors of production to run a kindergarten in relatively short. The quantity supplied responds quickly to a change in tuition fee.

 

Q3. (a)

Quantity	TR$	MR$	TC$	MC$
4	330	60	300	60

       Profit-maximizing output is where marginal revenue equal MC output is 4 watches
P is $82.5
Economic Profit is $30

    (b) Economic Profit is the excess of total revenue over total costs. In an alternative description, economic profit is achieved when AR, which is market price for the goods, is higher than ATC of the product. The existence of economic profit will attract new producer to the market. The increase in S, other things being equal, will bring down market price. As market price is lowered, economic profit decreases.
To keep economic profit, the watch manufacturer could set up barriers in terms of costs efficiency. If the new producers have to enter the production in higher ATC, the attraction of economic profit to them will diminish. The achievement of brand loyalty from customers means that other producers can’t significantly increase the S of the product. Besides, the firm could establish legal barriers such as patent rights for its product to limit new entrants to the market. In essence, these barriers are to reduce competition as to retain economic profit for the existing producer in the LR.

    (c) In the first instance, price discrimination targets to increase the firm’s TR. It is possibly achieved when some customers are charged a higher price than other for the identical goods. Besides, an individual customer may be charged differently for successive units bought. Given that cost conditions remain unchanged to the firm, price discrimination will increase economic profit for the firm.
The implementation of price discrimination requires fulfillment of the following conditions. The watch manufacturer must be able to separate its customers into different markets. The separated markets are with different price elasticities of D. One market could exhibit a more inelastic market D than another market. The match manufacturer could set a higher P in the S market, talking adv. Of the customers’ higher willingness to pay for the goods. As such, to succeed in charging a higher P on the market, the firm has to be able to prevent the resale of the watches from a lower-priced market to the higher-priced market.

 

Q4. (a) To satisfy the requirements of a perfectly competitive market, there must be a large number of firms selling the product. The supply of a firm for the product is insignificant to the market supply.
As a result, no single firm is able to influence the market price by changing its firm’s supply. Market demand and supply determines the market price for the product. A perfectly competitive firm has to take the market price and be a price or loses all its sales. The firm is facing a perfectly elastic demand at the market price. In a perfectly competitive market, the product sold must be homogenous. That is, there are no differences in quality and any other relevant features of the product to customers. With perfect mobility of factors of production, there is freedom of entry and exit of firms in a perfectly competitive market. Last but not the least, both the firms and customers have perfect information of the market.

 

    (b)

Total output (units/day)	Total variable costs ($)	Total cost ($)	Marginal cost ($)
5	245	345	75

       As market price for the product is $75, marginal revenue is $75. Profit-maximization is achieved when marginal cost equals marginal revenue. Profit maximizing output is 5.
Economic profit is $30.

    (c) The existence of economic profit will attract new firms entering the market. As there is freedom of entry into the market, the additional producers will increase market supply of the goods. The increase in market supply will lower the market price. However, new producers will still enter the goods market until they earn no economic profits. Therefore, in a perfectly competitive market, economic profit will be eliminated in the LR.

    (d) As the market price decrease to $50. Profit-maximizing output for the firm is 4. At that level of output, the firm suffers a loss of $70. However, total revenue $200 is still able to cover more than variable cost of $170. So, at least some of the fixed costs are recovered. In this respect, the firm is losing less money than to close down the business in which all fixed costs become irrecoverable. Therefore, the firm should choose to continue production in the SR.

 

Q5. (a) Real flow refers to the flow of factor services and flow of final goods and services. Peter renders his labour services to the fast-food restaurant which is a flow of factor services from households to firms. Today, he and Mary consume steaks which is a flow of final goods and services from firms to households. Respectively, the transactions happen in the factor market and the goods market.
Money flow refers to the flow of expenditure on final goods and services and the flow of factor income. Peter receives his salary of $6000 as factor income for his services to the fast-food restaurant. The $100 bill is the expenditure for the steaks that Peter and Mary enjoy.

Real flow

(Café sells steaks)

Money flow

(Peter pays $100 bill)

	Firms		Households

 

 

 

Money flow

(Peter’s $6000 salaries)

Real flow

(Peter’s service to restaurant)

    (b) In the steaks transactions, the steaks bought from the meat shop are intermediate goods. Intermediate goods are raw materials for further production. Value will be added to these intermediate goods as further productive efforts are put on the products. The steaks sold to Peter and Mary are final goods which are eventually consumed.
In the measurement of national income, intermediate goods and final goods have to be separated. If not, the inclusion of intermediate and final goods in national income accounting will lead the error of double counting. For example, the value of $20 steaks will be counted twice if national income is taken as the sum of the $20 steaks and the $100 bill.
To measure properly the transactions, the value-added approach is adopted. In the steaks transactions, the value added will be $20 on the steaks and a further of $80 for the sales of the steaks to Peter and Mary. The total income generated is $100 and avoid the double counting of the $20.

    (c) In an economy, income measures the households total factor income earned during a year. Expenditure measures the households’ total expenditure on final goods and services produced in a year. In measuring the flows of economics activities of this economy, the equality of income and expenditure in national income accounting is established. The identity assumes that there is no net leakage of any sort from the circular flow, whatever revenues received by the firms will be distributed to the owners of the factors of production.

 

Q6. (a) At different levels of real gross domestic product, the households, the firms, the government and the foreigners respectively have consumption expenditure, investment expenditure, government expenditure and net exports which constitute the aggregate planned expenditure.
Autonomous expenditure refers expenditure that does not change when real GDP varies. Between certain levels of real GDP, I, G, and X are assumed to remain fixed. Induced expenditure is expenditure that varies with the changes in real GDP. As real GDP fluctuates, the variable portion of consumption expenditure and the expenditure on imports change.

    (b) A 45∘line is constructed to represents all the cases where aggregate planned expenditure equals real GDP. As aggregate planned expenditure equals real GDP. Equilibrium expenditure is achieved. In other words, the planned spending matches with the actual production. Graphically, it is the aggregate expenditure curve intersecting the 45∘line.

    (c) In a case of below equilibrium, aggregate planned expenditure rises above real GDP. Inventories have unplanned decreases as a result. When inventories fall below the target levels, firms respond with increase production to replenish inventories. As firm employ more resources to expand production, real GDP increase forward the equilibrium national income level.
In a situation of above equilibrium, real GDP exceeds aggregate planned expenditure. Inventories have unplanned increases as a consequence. The unplanned additions to inventories compel the firms to cut back on production.
As firms employ lesser resources and lay off labour to slim the production level, real GDP decreases toward the equilibrium national income level.

 

Q7. (a) A country’s balance of payments is a record of all transactions of a country with the rest of the world over a given period of time, usually a year. These transactions include the country’s export and import of goods and services, income flows like interest and dividend, inflows and outflows of funds as assets and liabilities of the country and changes in the country’s foreign exchange reserves. The information are important to the government as balance of payments informs the government authories of the country’s position in international receipts and payments.

    (b) The three accounts are the current account, the capital account and the official reserve account.
The current account records the country’s export and import of goods which leads to a balance in visible trade. The balance in invisible trade in this account records the export and import of services, interest income and payments, dividends flows and transfers like remittance. The current account reports and overall surplus or deficit after these transaction.
The capital account shows the flows of funds between the country and the rest of the world. Short-term capital flows highlight the flow of hot money. A country offers higher interest rate could attract capital inflows. Long-term capital flows refers movement of funds looking for long-term profit yielding assets. The capital account also arrives at and overall surplus or deficit after these transactions.
The official reserve account records the changes in reserves of foreign currencies in the country as a result of the international transactions summarized in the current account and the capital account. The change could either be an addition to or deduction from the foreign exchange reserves of the country.
The debit entries in these accounts mean the payments of foreign currencies. On the contrary, the credit entries refer the receipts of foreign currencies.

    (c) In theory, when all the international payments and receipts in the three accounts, and balance of payments are added up, the balance must be equal to zero.
It is similar to a balance sheet which always balances the assets on one side and liabilities and capital on the other side.
In day-to-day usage, a country’s balance of payments deficit refers to an overall deficit after balancing off the transactions in the current account and the capital account. This means the debits (i.e. payments) exceed the credits (i.e. receipts) in the two accounts.
In the immediate time frame, the official reserves of foreign curries in the country will decrease.
In the longer time frame, the exchange rate of the country’s currency would depreciate. This depreciation may increase exports from the country and stimulate foreign direct investment in the country and reduce balance of payments deficit.

Q8. (a) Fiscal policy is government actions to vary its income and expenditure to regulate aggregate expenditure to influence economic activities. If government income is greater than government expenditure in a financial year, it is government budget surplus. If government income is smaller than government expenditure in a financial year, it is government budget deficit. Therefore, government budget surplus and deficit has a significant role in fiscal policy.

    (b) Economic growth is basically achieved by an uplift of both quantity and quality of resources. Monetary policy to stimulate saving will greater more capital resources to meet increase investment needs. Trade policy to stimulate international flows of goods and services will boost up the competitiveness of a country’s productivity. Economic policy to enhance research and development will improve the quantity and quality of a country’s output. Education policy to cultivate the quality of human resources will boost the country’s productivity.

    (c) Demand-pull inflation is caused by an increase in aggregate demand. The increase can be the result of an increase in consumption expenditure, investment expenditure, government purchases or exports. Demand-pull inflation is usually associated with full employment in an economy.
Imported inflation is caused by an increase in the prices of imports, leasing to an increase in the cost of production and hence the prices of the final goods and services. It is applicable to a small open economy which depends heavily on foreign trade, i.e. most of the inputs of production are mainly imported.

    (d) The marginal propensity to consume (MPC) indicates the fraction of the dollar change in disposable income that is spent on consumption, whereas the marginal propensity to save (MPS) indicates the fraction of the dollar change in disposable income that is saved. With a dollar change in disposable income, one can either spend all or part of it or save all or part of it. Therefore, the two fractions must sum to one. The higher the MPC and the lower the MPS, the greater will be the value of the expenditure multiplier.

    (e) Money policy is a deliberate action of the monetary authorities to expand or contract money supply respectively as expansionary and contractionary monetary policy so as to achieve economic goals on inflation, employment and national output.
Discount rate is the interest rate the monetary authorities charged on their loans to commercial banks. An increase in discount rate will discourage commercial banks to lend out their excess reserves. Moral suasion refers to the oral or written appeals to commercial banks, usually requesting them to reduce lending. Comparatively, more suasion is less effective as the banks may not respond positively to the appeals.