Book Answer Key for Managerial Economics

Chapter 1
1. What are the key microeconomic issues
and why are they important?
© David Barrows and John Smithin and Captus Press Inc., 2008

Solution: Problem 1
• Key Microeconomic Issues
– individual choice analysis
– how forces behind demand and supply work
– how price and quantity are determined
– production cost analysis
– market structure and business strategy analysis
– trade and competitiveness in the global economy

Chapter 1
2. What are the key macroeconomic issues
and why are they important?

Solution: Problem 2
• Key Macroeconomic Issues
– aggregate choice / output analysis
– relevance of economic indicators and the basis of
data of the macro-economy
– business cycle, employment and investment
analysis
– fiscal and monetary policy instruments and effects
– relationship between money and inflation
– role of interest rate
– balance of payments, capital flow, exchange rates
– relevance of government intervention

Chapter 1
3. In the long run, what is the trade-off
between “efficiency” and “equity”?

Solution: Problem 3
• Long run efficiency and equity
– Efficiency focuses on extracting best possible output
– Equity focuses on quality of distribution of output
– Proponents of market capitalism argues that the best (most
efficient) possible outcome is only possible when the market
determines the distribution (who gets what)
– Proponents of socialism/communism argues that distribution
based on market outcome leads to unequal distribution of
output
– Fall of communist regimes provides empirical basis to argue
that market based solutions are preferred to ‘equity’ based
solutions
– The trade-off between ‘efficiency’ and ‘equity’ is mainly due to
heterogeneity in endowment and ability

Chapter 1
4. What is opportunity cost and why is it
important?

Solution: Problem 4
• Opportunity Cost
– production requires inputs
– various combinations of inputs generate various
production outcomes
– given scarcity of inputs we can choose among
alternatives by reallocating inputs
– when an outcome is chosen other alternative
outcomes are given up
– opportunity cost is the cost of ‘giving up’ the
possible alternative outcome
• Importance
– provides benchmark and basis for ranking among
alternatives © David Barrows and John Smithin and Captus Press Inc., 2008

Chapter 1
5. What is the “neoclassical” approach to
economic analysis?

Solution: Problem 5
• Neoclassical approach
– focus on optimal / efficient choice
– based on rationality of agents (individuals,
households, firms)
– analysis based on the assumption of ‘optimal’
choice by the agents
• individuals maximize utility
• firms maximize profits

Chapter 2
1. Suppose you are in charge of a toll bridge
that costs essentially nothing to operate.
The demand for bridge crossings, Q, is
given by P = 15 - 0.5Q.
• 1a. Draw the demand curve for bridge crossings.

Solution: Problem 1(a)
• Demand Curve: P = 15 - 0.5Q
30
15
P
Q
Demand Curve

Chapter 2
given by P = 15 - 0.5Q.
• 1b. How many people would cross the bridge if
there were no toll?

Solution: Problem 1(b)
• No toll; P = 0; Q = 30
• Therefore, if there is no toll 30 people
would cross the bridge

Chapter 2
given by P = 15 - 0.5Q.
• 1c. What is the revenue associated with a bridge
toll of $5?

Solution: Problem 1(c)
• P = 5; Q=20
• Revenue = P.Q = $ 100

Chapter 2
given by P = 15 - 0.5Q.
• 1d. Consider an increase in the toll to $7. At this
new higher price, how many people would
cross the bridge? Would the toll bridge
revenue increase or decrease? What does
your answer tell you about the elasticity of
demand?

Solution: Problem 1(d)
• P = 7; Q=16
• Revenue = P.Q = $ 112
• Revenue increases from $ 100 to $ 112 if
the price is increased from $ 5 to $ 7.
• The demand is inelastic in this case, since
the percentage decrease in demand (from
20 to 16, ie. 20%) is less than the
percentage increase in price (from 5 to 7,
ie. 40%).

Chapter 2
2. If both the supply and demand curves shift
right, we know the direction of the change
in quantity, but not the direction of the
price change. If supply shifts right but
demand shifts left, we cannot know the
direction of either the price or quantity
change. Explain why you agree or
disagree with these statements.

Solution: Problem 2
• Agree with the statement
• If both the supply and the
demand curves shift to the
right
– consumers are willing to buy
more at the same price as
before
– producers are willing to sell
more at the same price as
before
– there will be an increase in the
equilibrium quantity
– direction of change in price
depends on the extent of shift
of the curves
P
Q
D0
D1
S0
S1
Q0
Q1
P0
P1

Solution: Problem 2 Continued.
• If the supply curve shifts
to the right and the
demand curve shifts to
the left
– consumers are willing to
buy less at the same price
as before
– producers are willing to
sell more at the same
price as before
– direction of change in both
price and quantity will
depend on the extent of
shift of the curves
P
Q
D0
D1
S0
S1
Q0 Q1
P0
P1

Chapter 2
3. It is generally accepted that the demand
for food is relatively price inelastic. If a
severe drought reduces production by
half, can you determine the effect on farm
revenue? If not, what other factors would
determine farm revenue?

Solution: Problem 3
• If a severe drought reduces production by half
and if the demand for food is inelastic, then the
farm revenue will go up
• By definition of inelastic demand:
– % Change in Quantity < % Change in Price
– If % Change in Quantity = 50%, then % Change in
Price is greater than 50%
– Total Revenue increases with price increase
• Assumption: Equilibrium quantity reduces by
50% with the reduction in supply
Q

Chapter 2
4. Which of the following events would cause
a movement along the demand curve for
European-produced clothing, and which
would cause a shift in the demand curve?
• 4a. Higher costs for producing clothing outside
Europe, passed on to consumers in the form of
higher prices
• 4b. An increase in the income of European
consumers
• 4c. A reduction in costs in the European clothing
industry

Solution: Problem 4
• 4a. Shift in the demand curve
• 4b. Shift in the demand curve
• 4c. Movement along the curve

Chapter 2
5. You have been asked to analyze the world
market for wheat. You have estimated the
following supply and demand curves:
• Qs = 440 + 165P
• Qd = 1,600 - 12P
– 5a. Calculate the equilibrium price and
quantity.

• Qs = 440 + 165P
• Qd = 1600 - 12P
• In equilibrium, Qs=Qd
440+165P = 1600 - 12P
P=6.55
Q=1521

Chapter 2
5. You have been asked to analyze the world
market for wheat. You have estimated the
following supply and demand curves:
• Qs = 440 + 165P
• Qd = 1,600 - 12P
– 5b. Calculate the price elasticity of supply and
demand at equilibrium.

• Price elasticity of supply:
P/Q . dQ/dP
= (6.55/1521).165 = 0.72
• Price elasticity of demand:
P/Q . dQ/dP
= (6.55/1521).(-12) = -0.05

Chapter 3
1. Ticket prices for sporting and entertainment
events are often regulated by municipalities.
For example, the city of Los Angeles oversees
pricing of events at baseball’s Dodger
Stadium. If scalping is not illegal, there will be
a market price for tickets, set in the “black
market”. However, if it is illegal, it is possible to
impose a penalty on either the seller (the
scalper) or the buyer. Using supply and
demand analysis, show that there will be a
larger impact upon the equilibrium level of
scalping if penalties are imposed on both sides
of the market.

Solution: Problem 1
• If penalty is only on the sellers
– penalty amount (T) is added to
the cost
– supply curve shifts left
– equilibrium quantity falls to Q1
• If penalty is only on the buyers
– penalty amount (T) is added to
the price
– demand curve shifts left
– equilibrium quantity falls to Q1
Q0
P
Q
Q1
D
S+T
S
Q0
P
Q
Q1
D
D+T
S

Chapter 3: Problem 1 continued.
• If penalty on both the buyers
and the sellers
– Penalty amount (T) is added to
the price for buyers
• Demand curve shifts left
– Penalty amount (T) is added to
the cost of the sellers
• Supply curve shifts left
– Equilibrium quantity is further to
the left of Q1
– New equilibrium Q2
– Effect is greater if penalty is
imposed on both sides
Q0
P
Q
Q1
D
S+T
S
Q2
D+T

Chapter 3
2. The rent control agency in Bucharest has found
that the demand for apartments is Qd = 320 –
16P. Quantity is measured in tens of thousands
of apartments. Price, the average monthly rental
rate, is measured in hundreds of Euros. The
agency also noted that the increase in Q at
lower P results in more three-person families
coming into the city and demanding apartments.
The city’s board of realtors acknowledges that
this is a good estimate of demand and has
shown that supply is Qs = 140 + 14P.

Chapter 3
2(a) If both the agency and the board are
right about demand and supply, what is
the free market price? What would be
the change in the population of the city if
the agency sets a maximum average
monthly rental in Euros, and all those
families who cannot find an apartment
leave?

• Qd= 320 - 16P
• Qs=140 + 14P
• (A) Free Market
 Qs = Qd=Qf
 Pf = 6
 Qf = 224
• If monthly maximum rent is
fixed at a lower level the free
market, then there will be
shortage of apartments and
population will reduce
Rent
Apt
Qf
D
S
Qc
Maximum
Pf
Shortage

Chapter 3
2(b) Suppose the agency bows to the wishes
of the board and sets a rental rate of
¤1800 per month on all apartments to
allow landlords a “fair” rate return. If 50%
of any long-run increase in apartment
comes from new construction, how
many apartments are constructed?

• P = 1800
• Qs=140 + 14P
• Qs = 892
• The supply will increase by 892-224
= 658 units
• If 50% of the increase comes from
new construction, then 658.(0.5) =
329 units will be constructed
• 1 unit = 10,000 apartments
Rent
Apt
224
D
S
892
18
6

Chapter 3
3. Suppose that a government argues that it
can increase revenue from a particular
sector by actually lowering tax rates.
Choose a constant excise (specific) tax,
and show a case in which this is possible.
Would it make a difference if demand is
elastic or inelastic?

Solution: Problem 3
• Revenue can be increased by lowering tax rates
• Suppose,
– a firm has constant marginal cost of $ 100
– government charges 20% excise tax
– effective price is $ 120
– equilibrium quantity is 1,000
– government tax revenue = $ 20,000
• Now,
– government reduces tax rate to 8%
– effective price is $ 108 (10% decline)
– equilibrium quantity goes up to 2,500+ (150%+ increase; highly elastic)
– government tax revenue = $ 20,000+ (increases from before)
• If the demand were inelastic, then with lower price, total expenditure
would have declined, and tax revenue could not be higher than
before

Chapter 3
4. The city council of a small college town
decides to regulate rents in the town order
to reduce student living expenses.
Suppose the average annual market-
clearing rent for a two-bedroom apartment
has been $900 per month, and rents were
expected to increase to $1,200 within a
year. The city council limits rents to the
current $900 per month level.

Chapter 3
4(a) Draw a supply and demand diagram to
illustrate what will happen to the number
of rental apartments after the imposition
of rent control.
4(b) Do you think this policy will benefit all
students? Why or why not?

Solution: Problem 4
(a) The number of
apartments available for
rent would reduce with
the imposition of rent
control
(b) This will benefit only the
students who would be
able to rent the
apartments. Other
students will face difficulty
in finding
accommodation.
Rent
Apt
Q
D
S
900
1200
Shortage

Chapter 3
5. The market supply and demand functions
for milk are:
Qs = 800 + 100P
Qd = 2,000 - 500P
To assist milk producers, the government
is implementing a price floor of 2.25, per
unit. How many units of milk must the
government buy at 2.25? How much
money must the government spend?
What is the increase in producer surplus?

Solution: Problem 5
• Qs= 800 +100P
• Qd= 2000 - 500P
• In equilibrium,
– Qs=Qd
– P = 2
– Q = 1000
• If government imposes price floor of $ 2.25, then P= 2.25
and Qs=1025; Qd= 875
• The government has to purchase 1025-875 = 150 units of
milk at $ 2.25 and will have to pay $ 337.5 to the
producers
• Increase in producer surplus:
(2.25-2).1000 + 0.5.(2.25-2)(1025-1000) = 253.125

Chapter 4
1. Suppose you are an employer seeking to
fill a vacant position in your factory. Are
you more concerned with the average
product of labor, or the marginal product of
labor for the last person hired? If you
observe that the average product is just
beginning to decline, should you hire any
more workers? What does this situation
(that AP is beginning to decline) imply
about the marginal product of the last
worker hired?

Solution: Problem 1
• Will be more concerned with the marginal productivity of
the person to be hired.
• If marginal productivity is positive then output will
increase.
• Declining Average Product
– If the objective is to maximize output per worker then no new
worker should be hired when the AP is just beginning to decline
– If the objective is to maximize total output then the firm can
continue to hire workers until marginal productivity is zero
– This situation (AP just beginning to decline) implies that marginal
product of the last person hired is below the average productivity
level

Chapter 4
2. Suppose a chair manufacturer is
producing in the short run with a fixed
level of plant and equipment. The
manufacturer has observed the following
levels of production corresponding to
different numbers of workers.

Chapter 4
2(a) Calculate the marginal and average
product of labor for this production
function.

Number of Chairs Number of Workers Average Product Marginal Product
1 20 1/20 = 0.050 1/20= 0.050
2 28 2/28 = 0.071 1/8 = 0.125
3 34 3/34 = 0.088 1/6 = 0.167
4 38 4/38 = 0.105 ¼ = 0.250
5 40 5/40 = 0.125 ½ = 0.500
6 38 6/38 = 0.158 - ½ = -0.500
7 35 7/35 = 0.200 - 1/3 = -0.333

Chapter 4
2(b) Suppose wage rate is $10 an hour.
Work out the total variable cost,
average variable cost, and marginal
cost for each level of output.

Number of Chairs Number of
Workers
Total Variable
Cost
Average
Variable Cost
Marginal Cost
1 20 200 200 200
2 28 280 140 80
3 34 340 113.33 60
4 38 380 95 40
5 40 400 80 20
6 38 380 63.33 -20
7 35 350 50 -30
• Wage Rate $ 10

Chapter 4
2(c) Based on the information obtained
above, how would you characterize cost
conditions in the chair industry, in
general terms?

Solution: Problem 2c
• Average Cost is falling
• Marginal Cost is falling
• Therefore, this is a decreasing cost industry

Chapter 4
3. Is it true that constant returns to scale
imply constant average and marginal
costs, and that marginal and average
costs will be equal? Why or why not?

Solution: Problem 3
• Constant Returns to Scale implies that both marginal and
average costs are constant and equal
• By increasing the quantity neither the average nor the
marginal cost is affected
• The AC=MC=Supply Curve is horizontal
• If MC changes with quantity, then AC will also change,
and consequently any change in output cannot be
produced at the same cost as before

Chapter 4
4. Explain why a continuously falling average
cost curve might tend to eliminate
competition in that particular industry.

Solution: Problem 4
• Continuously falling Average Cost means there is no
effective limit on the plant size.
• A firm achieves more efficiency with higher quantity of
production.
• This leads to natural monopoly.
• The first mover / incumbent has an advantage over any
potential entrant (the firm can always increase capacity to
achieve lower cost of production).
• This tends to eliminate competition in the industry.

Chapter 4
5. What is the difference between
diminishing returns to a variable factor and
decreasing returns to scale?

Solution: Problem 5
• Diminishing Returns to Variable Factor
– the output increases at a decreasing rate when that particular
factor is increased
– eg. With 100 units of labor production is 1000, with 200 units of
labor production is 1800, with 300 units of labor production is
2400.
• Decreasing Returns to Scale
– the output increases by less than the proportion at which all the
factors have been increased
– eg. If labor and capital are the only factors and if output increases
by less than 2 times when these factors have been doubled, then
it is a case of decreasing returns to scale.

Chapter 5
1. You notice that the fans get thirsty at a soccer game.
Therefore, you set up a refreshment stand. After raw
materials, you clear 500 Pesos for the afternoon. Are
your economic profits 500 Pesos? Why or why not?
Now suppose your friends hear about your success.
What are your chances for a repeat success at the next
game? If the stadium officials auction off refreshment
stand rights to the highest bidder, what would you be
willing to bid? Under the bidding system, who gets the
profits? Comment on how easy, or difficult, it might be to
earn positive economic profits.

Solution: Problem 1
• Economic profit is not 500 Pesos
– economic profit is the residual profit once the opportunity cost and the
raw materials cost have been taken into consideration
– if I could have earned for instance 400 Pesos working elsewhere during
the time that I spent on selling refreshments, then my economic profit
would be 500-400=100 Pesos.
• If the economic profit is positive and if my friend has similar
opportunity cost then the chances of repeat success would reduce.
This is due to the possible entry by my friend in the refreshment
selling activity.
• If the officials auction off the rights to highest bidder, I would bid my
economic profit. The officials would get the profits under the bidding
system.
• In a perfectly competitive environment earning economic profit would
not be possible. Market imperfection must exist to earn such profit.

Chapter 5
2. Suppose you are a regulator of the local
public electric utility, a natural monopoly
with decreasing average costs throughout
the relevant range of production. What is
your job? What information do you need in
order to carry it out? How would you
obtain such information? Would you rather
price according to marginal or average
cost? Why?

Solution: Problem 2
• Job as a regulator
– monitor the pricing decision by the utility manufacturing unit
– ensure that the market price generates maximum possible social welfare.
• The information required to carry out the job
– demand function
– marginal revenue function
– marginal cost function
– price and quantity
• Obtaining above information
– statistics of historical market prices and quantities
– firm’s accounting books
• Marginal Cost / Average Cost pricing
– would make pricing based on marginal cost
– by equating price and marginal cost maximum social welfare is ensured.

Chapter 5
3. Consider an industry dominated by a
single monopolist. The demand for the
product is given by Qd = 12 - 0.2P. Costs
per unit of output are constant, and the
firm estimates these to be $35 per unit.
3(a) What will be the profit-maximizing
quantity of output produced by the firm,
and what price will they charge?

• Qd=12-0.2P  P = 60 - 5Q
• MR = 60 - 10Q
• Constant MC = 35
• Profit maximizing condition MR = MC
• Profit maximizing quantity Q = 2.5
• Profit maximizing price P = 47.5

Chapter 5
3(b) What will be the total revenues, total
costs, and total profit at the profit-
maximizing level of output?

Solution: Problem 3b
• At the profit maximizing level of output,
– Total Revenue = 47.5(2.5) = $ 118.75
– Total Cost = 35 (2.5) = $ 87.5
– Total Profit = 118.75 - 87.5 = $ 31.25

Chapter 5
3(c) Suppose that this industry was perfectly
competitive instead of a monopoly,
would the market price and level of
output be any different from the above?
If so, what would they be?

Solution: Problem 3(c)
• Price and quantity will be different in perfectly competitive market
• Perfect Competition condition, P = MC = 35
• Perfect Competition Quantity, Q = 12 - 0.2P = 5

Chapter 5
3(d) Suppose the government decides to
regulate this industry, and the price is
set at $40 per unit. Will this change the
firm’s profit from the pure monopoly
case? How will it affect the total of
output produced by the industry?

Solution: Problem 3(d)
• Regulated price P = 40
• Q = 12 - 0.2(40) = 4
• Firm’s profit = Quantity (Price - Cost) = 4.(40-35) = 20
– profit reduces from $ 31.25 to $ 20
– output increases from 2.5 units to 4 units

Chapter 5
4. Why do firms enter an industry when they
know that in the long run economic profit
will be zero?

Solution: Problem 4
• Firms enter an industry even when they know that the
long run profits will be zero, in order to
– cover opportunity cost
– gain short run economic profit
– gain competitive advantage to enter related market where market
imperfection (ie opportunity for economic profit) exists

Chapter 5
5. Zeon Industries is a monopoly provider of electricity. The
demand for electricity is:
Qd = 49 - 0.7P
The marginal revenue curve is:
MR = 70 - (20/7)Q
The marginal cost is:
MC = 10 - 0.02Q
The average cost function is:
AC = 10 - 0.01Q
If a price ceiling of $10 per unit is implemented, will social welfare
increase? Will Zeon Industries remain in operation?

Solution: Problem 5
• Monopoly pricing condition, MR = MC
• Demand function, Q = 49 - 0.7P
• MR = 70 - (20/7)P
• MC = 10 - 0.02Q
• At MR = MC,
– Q = 21.15
– P = 39.78
• If price ceiling is $ 10
– Q = 49 - 0.7(10) = 42
– Average Cost AC = 10 - 0.01Q = 9.58
– Profit for Zeon = 42(10-9.58)=17.64
• Therefore, with price ceiling at $ 10,
– Zeon still earns positive profit
– Buyers buy more quantity than in monopoly condition with lower price
– Social Welfare increases.
• Since, there is still positive profit Zeon will remain in operation.

Chapter 6
1. Suppose all the firms in a
monopolistically competitive industry
were merged into one large firm. Would
that new firm produce as many different
brands? Would it produce only a single
brand?

Solution: Problem 1
• If all firms in a monpolistically competitive firm were merged into one
large firm
– the new firm would take advantage of economies of scale and increased
market power
– the new firm would not produce as many different brands as before
• It is likely that the new firm would produce only one single brand to
be able to set monopoly price
– if there are independent markets with different demand characteristics
for the products, then the firm would likely produce on brand for each of
these markets

Chapter 6
2. Why has the OPEC oil cartel succeeded in
raising prices substantially, while the
CIPEC copper cartel, for example, has
not? What conditions are necessary for a
successful cartel? What organizational
problems must a cartel overcome?

Solution: Problem 2
• OPEC cartel succeeded in raising prices, but CIPEC cartel has not
been able to do so, since
– total demand of oil is fairly inelastic, while total demand for copper is fairly elastic
– MC for OPEC members is low compared to MC for non-OPEC members,
whereas, CIPEC members do not enjoy substantially low MC compared to the
non-CIPEC members
– OPEC has substantial monopoly power, whereas CIPEC does not
• Conditions necessary for successful cartel
– demand must be price inelastic
– control on significant portion of the total supply
– cost advantage in production
• Organizational problems
– sufficiently strong mechanism to deter no-cooperative outcome (in a dynamic
setting it is possible, for instance tit-for-tat strategy)
– if one or two firms have control on major portion of the supply then the cartel is
not likely to work

Chapter 6
3. What is a “strategic move”? Can the
development of a certain kind of reputation
be a strategic move?

Solution: Problem 3
• Strategic Move
– a choice among a set of alternatives with each alternative comprising of unique
set of combination of inputs resulting in varied outcomes
• ‘Development of reputation’ as a strategic move
– possible if this allows the firm to get competitive edge
– for instance, development of strong and unique brand image allows firms to
charge higher price compared to generic products

Chapter 6
6. Do you agree with the following
statement?
The Schumpeterian concept of creative
destruction is the main explanation offered
by economists as to why monopoly or
imperfect competition is an undesirable
market structure from the social point of
view.

Solution: Problem 4
• Disagree.
• Schumpeterian concept of ‘creative destruction’ defends monopoly
and imperfect competition
– basis: excess profits stimulate environment for renovation / innovation
• Main argument offered by economists as to why monopoly / imperfect
competition is undesirable
– imperfection generates dead-weight loss in an economy
– maximum possible social welfare cannot be achieved with imperfection

Chapter 6
5. Two firms are in the market for chocolate
confectionery. Each can choose to go for
the high end of the market (high quality) or
the low end (low quality). Resulting profits
are given in the payoff matrix [See text, pg
90].
(a) What outcomes, if any, are Nash equilibria?
(b) If the manager of each firm is conservative and
each follows a maximin strategy, what will be the
outcome?
(c) What is the cooperative outcome?
(d) Which firm benefits most from the cooperative
outcome? How much would that firm need to offer
the other to persuade it to collude?

Solution: Problem 5
(a) Nash Equilibria:
(1) Firm 1 chooses High, Firm 2 chooses Low
(2) Firm 1 chooses Low, Firm 2 chooses High
(b) Maximin outcome:
Firm 1 chooses High, Firm 2 chooses High
(c) Cooperative outcome:
Form 1 chooses Low, Firm 2 chooses High
(d) Firm 1 benefits most from collusion. Firm 1 offers firm 2 an amount of $ 200.

Chapter 7
1. “I oppose a free trade agreement with
Bolivia because Brazilian workers will lose
jobs to lower-paid Bolivian workers.”
Explain whether you agree or disagree
with this statement.

Solution: Problem 1
• Agree, partially.
• With free trade the Brazilian workers will lose jobs as some of the
production will shift to Bolivia due to lower cost of production
• However, Brazil will be able to increase production in the sector
where they enjoy comparative advantage, which can accommodate
some of the labor who will lose jobs
• Overall gains from trade outweighs the loss in wages for some of the
Brazilian workers, who can be compensated from the gains
achieved.

Chapter 7
2. South Africa can produce 1,000 shoes if it
specializes in shoe production.
Alternatively, it can produce 500 shirts.
Egypt can produce 500 shoes or 200
shirts. Explain which country will
specialize in shoe production, and which
in shirt production. What is the possible
range of the terms of trade?

Solution: Problem 2
• South Africa: 1 shoe = 0.5 shirt
• Egypt: 1 shoe = 0.4 shirt
• Shirt is relatively cheaper in
South Africa; Shoe is relatively
cheaper in Egypt
• South Africa will specialize in
shirt and Egypt will specialize in
shoe.
• Possible range of terms of
trade:
– 1 shoe for 0.4-0.5 shirt
1000
500
Shirts
Shoes
South Africa
500
200
Shirts
Egypt
Shoes

Chapter 7
3. Table 1 presents the demand and supply
schedules for television sets in Japan and
Canada. If there is no trade between these
countries, what are the equilibrium price
and equilibrium quantity in Canada?
Solution: (e) P = $500, Q = 50

Chapter 7
Canada. If there is no trade between these
countries, what are the equilibrium price
and the equilibrium quantity in Japan?
Solution: (c) P = $300, Q = 70

Chapter 7
Canada. If Japan and Canada trade with
each other, what will be the equilibrium
price in the world market for television
sets?
Solution: (d) $400

Chapter 7
Canada. If Japan and Canada trade with
each other, which country will export
television sets, and how many?
Solution: (a) Japan will export 20,000
television sets to Canada

Chapter 7
Canada. If Canada and Japan trade with
each other, what will happen to the output
of television sets in Canada?
Solution: (a) TV production in Canada will fall
by 10,000 units

Chapter 7
Canada. If Canada and Japan decide to
trade with each other, what will happen to
the output of television sets in Japan?
Solution: (d) TV production in Japan will
increase by 10,000 units

Chapter 8
1. What are the components of aggregate
expenditure, and what is the relative
importance of each of them?

Solution: Problem 1
• Components of aggregate expenditure
– consumption
– investment
– government expenditure
– net exports (export - import)
• While each component has unique importance, generally
consumption has the maximum weight followed by investment,
government expenditure and net exports.

Chapter 8
2. Briefly explain how nominal GDP can
increase, yet real GDP decrease, during
the same period.

Solution: Problem 2
• Nominal GDP = P.Y
• Real GDP = Y
• If P increases by 10% (inflation 10%) and output decreases by 5%,
then the new nominal GDP = (1.1P).(0.95Y)
• Therefore, growth rate of nominal GDP = 1 - [ (1.1P)(0.95Y) / PY ] =
4.5%
• Fall in real GDP is simply the fall in Y, ie 5%

Chapter 8
3. What would happen to GDP if large
numbers of stay-at-home parents suddenly
entered the workplace and hired others to
cook, clean, and care for their children? Is
this change reflective of an actual change
in the physical output of the economy?

Solution: Problem 3
• If large numbers if stay-at-home parents suddenly entered the
workplace and hired others to cook, clean and care for their children,
then
– aggregate output of the economy would increase with the increase in
labor input
• A sudden change like this is reflective of increase in demand for
labor, which in turn reflects increase in demand for output.
• In addition, the new hires for cooking and cleaning will also add to
the increase in labor force and aggregate output. Here, the wage
expenditure will increase and will have multiplied effect on output.

Chapter 8
4. The Fisher equation says that the nominal
interest rate i is equal to the real interest
rate r plus the expected inflation rate pe.

Solution: Problem 4
• Fisher equation
r = i-pe
Real interest rate Nominal interest rate Expected inflation rate
6% 10% 4%
2% 10% 8%
-2% 10% 12%
4% 7% 3%
-2% 12% 14%
3% 8% 5%
-2% 7% 9%

Chapter 8
5. What is the expectations theory of the
term structure of interest rates?

Solution: Problem 5
• The expectations theory of term structure of interest rate
– there cannot be any arbitrage opportunity with the short term interest
rates of consecutive periods and the long term interest rates for the total
period.
– For instance, if 6 months interest rate is “is”, the expected interest rate
for the 6-month period following current 6 month period is “ie” and the 1
year interest rate is “il”, then by expectations theory
• (1+ il)2 = (1 + is)(1 + ie)

Chapter 9
1. How would government officials use
knowledge of the marginal propensity to
consume when considering a tax cut?

Solution: Problem 1
• The tax multiplier can be calculated using the marginal propensity to
consume (c)
– Tax multiplier = [ -c / (1-c) ]
• If the government officials have knowledge of “c”, then this
information can be used to calculate the tax required to reach the
objective output level.

Chapter 9
2. Explain why investment is more volatile
than consumption.

Solution: Problem 2
• Investment is the flow of expenditure which adjusts capital stock to
the desired level.
• Investment is generally only a small portion of the total capital stock.
• A small adjustment requirement for the capital stock has large effect
on investment.
• This results in high volatility of investment.
• On the other hand, consumption is the expenditure of the
households on food, rent, education etc. These expenditures are
generally stable over some period of time.

Chapter 9
3. The economy is in a recession. To increase
income by $1,000, government spending must
increase by $100. The consumption function is
C = cY; investment is $400; government
purchases are $300; taxes are $150; and net
exports are (-)$100.
(a) What is the current level of GDP?
(b) To double GDP from its current level,
what must be the size of the primary
deficit?

Solution: Problem 3
• If $ 100 increase in government spending increases output by $
1000, then the government expenditure multiplier is 1000/100 = 10.
• But the government expenditure multiplier = [ 1/(1-c) ], where “c” is
the marginal propensity to consume.
– Therefore, 1/(1-c) = 10  c = 0.9
(a) Y = C + G + I + NX = cY + G + I + NX
If G = 300, I = 400 and NX = -100, then
Y = 0.9Y + 400 + 300 -100  Y = 6000 (current level of GDP)
(b) To double GDP, Y must be 12,000
– required increase 6000
– required increase in G = 600 (since multiplier is 10)
– Primary deficit = 600 + 400 = 1000

Chapter 9
4. Explain why public policy-makers are so
often concerned about:
(a) The size of the annual budget deficit
(b) The ratio of the national debt to
GDP

Solution: Problem 4
• The public policy makers are often concerned with the size of the
annual budget deficit, because
– increased deficit puts pressure on the interest rate which reduces
investments; this results in low capital formation over time
– if a significant portion of the deficit is financed by external borrowing,
then large taxes would be required at maturity to pay off the debt
• The public policy makers are also concerned with the ratio of the
national debt to GDP, because
– if the ratio is high then a significant portion of the GDP will go towards
debt-servicing
– at maturity, there has to be major cutbacks in government expenditure
and increase in taxes to fulfil debt obligation, which could put the
economy into severe recession.

Chapter 9
5. What are the key components of the
simple Keynesian model? What is the role
of the multiplier in the Keynesian model?

Solution: Problem 5
• Components of the Keynesian model:
– Income (Y) and Expenditure (E)
– Income: total output
– Expenditure: consumption, government spending, investment and net export
– The economy is in equilibrium with Y = E
• The multiplier plays a major role in the Keynesian model
– change in government spending / taxes / investment affects output with a multiplied
effect
– as output changes, consumption being a function of output also changes
– but as consumption changes the output is again affected
– this simultaneous change in output and consumption continues until the residual effect
is negligible
– the multiplier estimates the extent of final change in output due to such changes in
government spending / taxes etc.
– proper estimate of the multiplier helps policy makers take more prudent decisions on
these issues

Chapter 10
1. The simple quantity theory of money
assumes that velocity is relatively
constant, and that real GDP increases at
its long-run rate of growth. Suppose that
over the past few decades, the long-run
growth rate of real GDP has been about
3% per year. This figure is supposed to be
the result of changes in population,
resources and technological change,
which are all typically viewed as
exogenous.

Chapter 10
10(a) Substituting these values into the percentage change
version of the quantity equation yields (fill in the
blanks):
% change in M + ________ = % change in P + ________
or, rearranging:
% change in P = % change in M - ________%.
10(b) Given the assumptions above concerning velocity
and real GDP growth, complete the following table
for four successive periods (the values for V and Y in
period 2 are already entered). Calculate the price
level P by using the quantity equation MV = PY.

Chapter 10
10(c) Use a calculator to verify that the percentage change
version of the quantity equation is a good
approximation to the percentage changes in Table 1.

Solution: Problem 1
(A) % change in M + % change in V = % change in P + % change in Y
or, % change in P = % change in M - 3%
since, % change in V = 0 and % change in real GDP = 3%
(B)/(C)Table 1 Period M %
change
in M
V %
change
in V
P %
change
in P
Y %
change
in Y
1 100 2.0 1 200
2 103 3% 2.0 0% 1 0 206 3%
3 97 -5.8% 2.0 0% 0.912 -8.9% 212.8 3%
4 107 10.3% 2.0 0% 0.976 7.02% 219.2 3%

Chapter 10
2. Recall that the Fisher equation says that the nominal interest rate is equal to
the real interest rate plus expected inflation. Thus, the Fisher equation is (fill
in the blanks using the notation of Chapter 8):
_____ = _____ + _____
2(a) Recall from Question 1 that if the long-run annual growth of real
output is 3%, and velocity is constant, then the quantity equation
implies that (fill in the blanks):
% Change in P = % Change in M - _____ %.
2(b) Since the percentage change in P is the same thing as the rate of
inflation, the above equation suggests that an increase in the rate
of money growth of 1% causes a 1% increase in inflation. Assume
“perfect foresight”, meaning that the expected rate of inflation turns
out to be the actual rate. Then, according to the Fisher equation, a
1% increase in inflation causes a 1% increase in the nominal
interest rate i (the real interest rate r is presumed to be affected only by
real variables). Now use all of this information to complete Table 2.

Solution: Problem 2
• Fisher equation:
r% = i% + pe%
(a) % change in P = % change in M - 3%
(b) Table 2 % change in
P
% change in
M
Inflation rate
%
Real interest
rate %
Nominal
interest rate
%
0 3 0 3 3
1 4 1 3 4
1 5 1 3 4
-3 2 -3 3 0
6 8 6 3 9

Chapter 10
3. Compare and contrast the ways monetary
policy and fiscal policy influence the
economy.

Solution: Problem 3
• Monetary policy instrument
– money supply
• Fiscal policy instrument
– government spending / taxes
• These policies can be either expansionary or contractionary
– expansionary policy leads to increase in output (eg increase
government spending, increase money supply)
– contractionary policy leads to decrease in output (increase taxes,
decrease money supply)
• Both monetary and fiscal policies influence the aggregate demand
curve
• Effect of these policies has been debated by various schools of
economics
– Keynesians believe fiscal policies are effective
– Monetarists believe fiscal expansion cannot increase output if there is
no increase in money supply (based on quantity theory and constant
velocity assumption)

Chapter 10
4. Do you think that an improvement in
banking technology would lead to an
increase or decrease in the aggregate
price level?

Solution: Problem 4
• An improvement in banking technology would
– increase the velocity of money
– less transaction cost of going to the bank for most transactions
• According to quantity theory
– increased velocity will result in higher nominal income
– upward pressure on prices is also likely

Chapter 10
5. What policies would a “classical” or
“monetarist” economist suggest to reduce
persistent unemployment?

Solution: Problem 5
• A ‘classical’ or ‘monetarist’ economist would suggest improvement in
the supply side by encouraging innovation to reduce persistent
unemployment.
• If unemployment persists for a long time then that is more reflective
of the natural rate of unemployment
• The current level of technology therefore cannot accommodate more
employment.
• With technological improvement the aggregate long run supply
curve can shift to the right, which will reduce the natural rate of
unemployment.
• Any interventionist approach is not recommended by the ‘classical’
economists.

Chapter 10
6. Suppose that statistical information tells us that the aggregate
demand curve for a particular economy can be approximated by the
equation P = 15,000/Y:
6(a) Construct a graph for the aggregate demand curve over a range
for the aggregate price index of P = 120 to P = 50.
6(b) What is total nominal aggregate demand at Y = 200, Y = 160,
and Y = 130, respectively?
6(c) What does the above information tell you about the elasticity of
the aggregate demand curve? (Recall Chapter .)
6(d) Suppose V = 3, and the money supply doubles. Redraw the new
aggregate demand curve. Is the elasticity of the aggregate
demand curve affected?

Solution: Problem 6
(A) P = 120; Y = 15000/120 = 125
P = ; Y = 0
(B) Since P = 15000/Y, therefore PY =
15000
At any income level price will adjust to
generate a nominal aggregate demand
of 15000
(C) P = 15000/Y  dY/dP = -15000/P2
Elasticity, P/Y. dY/dP = -15000/PY =
-15000/15000 = -1
The demand curve is of constant elasticity
type.
(D) PY = 15000 = MV. If V=3, then M=5000.
If M doubles (M=10000), then PY = MV
= 30000
Y
P
0
120
125
P= 15000/Y
Y
P
0
120
125
P= 15000/Y
P= 30000/Y
250

Chapter 11
11. At one time, policy makers interpreted
the Phillips curve as offering a viable
menu of inflation-unemployment choices.
Today, the curve is no longer viewed this
way. Why has the interpretation
changed?

Solution: Problem 1
• At one time, policy makers interpreted the Phillips curve as a viable
menu of inflation-unemployment choice.
• This view no longer holds due to the ‘stagflation’ experience in the
early 70’s
– OPEC oil embargo created a situation of both high inflation and low
unemployment, contrary to the hypothesis reflected by the Phillips curve
• The ‘stagflation’ experience rekindled interest in the classical view
that the nominal variables have less of a significant impact on the
economic adjustments.
• Present day economists only allow for a short-run trade-off between
inflation and unemployment, but not a permanent trade-off as
proposed by the Phillips curve.

Chapter 11
2. Suppose that inflation is 3%,
unemployment 7%, and the budget deficit
is 3 billion Rand. Make the cases for and
against expansionary and contractionary
monetary and fiscal policies. Explain
which policy you favor.

Solution: Problem 2
• Inflation 3%; unemployment 7%; budget deficit 3 billion.
Policy Expansionary Contractionary
Fiscal Pros
Short run reduction in
unemployment through
increased aggregate
demand
Cons
Higher inflation
Higher deficit
Pros
Long run fall in prices
Smaller deficit
Cons
Short run increase in
unemployment
Monetary Pros
Decrease in interest rate
would stimulate investment
Increase in employment
without increase in budget
deficit
Cons
Higher inflation
Pros
Higher interest rate would
attract foreign capital inflow
Lower inflation
Cons
Higher interest rate would
dampen domestic investment

Chapter 11
3. Suppose the Okun’s law coefficient has
increased for a number of countries. Does
this increase cause unemployment to be
more or less sensitive to deviations of
output growth from normal? Briefly
explain.

Solution: Problem 3
• Okun’s Law:
– for unemployment to fall by 1%, the growth rate of real GDP has to
increase by 2.5%
• If the coefficient of Okun’s Law increases from 2.5, then 1% fall in
unemployment would require more growth in the GDP
• In other words, it would take more change in GDP to change
unemployment by the same percentage
• Unemployment is less sensitive.

Chapter 11
4. Explain why you agree or disagree with
the following statement:
The acceptance of rational expectations
totally discredits the notion that policy
activism should be pursued if output lies
below its natural rate.

Solution: Problem 4
• Agree.
• Rational expectation hypothesis claims that agents will form
expectation rationally based on all available information. Agents will
take into consideration any action by the government and its effects
on the economy.
• If output is below its natural rate then output will increase to the
natural rate automatically.
• Rational expectators will view policy activism as only a distortion as
output cannot be sustained beyond natural rate and would create
changes in the prices only.

Chapter 11
5. What is the natural rate of unemployment?
What would explain the differences in the
natural rate between developed countries?

Solution: Problem 5
• The natural rate of unemployment is the level where the only reason
of unemployment is frictional (ie due to job shift, job search etc).
• Business cycles create more or less unemployment than the natural
level.
• The natural level of unemployment is considered the ‘full
employment’ level given a particular stage of technology which
determines the long run supply capacity of an economy.
• Differences in natural rate among developed countries:
– due to policy differences in government welfare structures
– due to differences in resources per population
– due to socio-cultural differences

Chapter 12
1. Economists are divided on whether a
country should join a system in which
members agree to limit fluctuations in the
exchange rates among their currencies.
Describe the advantages and
disadvantages of such a move.

Solution: Problem 1
• Advantages
– reduced uncertainty in exchange rates helps foster conducive conditions
for business risk taking
– insulation from disturbances in other economies
• Disadvantages
– lack of maneuverability with monetary policy
– requires substantial reserve to maintain exchange rate within a band if
there is any shock

Chapter 12
2. An American tourist wants to buy a
Mercedes while traveling in Germany, but
she is currently carrying nothing but British
pounds. The Mercedes costs ¤200,000.
The identical car costs $40,000 in the
USA. The exchange rate for dollars and
British pounds is $2 = £1, while £1
exchanges for ¤10. Should she buy the
Mercedes in Germany or the USA?

Solution: Problem 2
• Price of Mercedes
– DM 200,000
– $ 40,000
•  1 = DM 10 = $ 2
• If she buys in Germany, she spends DM 200,000 =  20,000
• If she buys in USA, she spends $ 40,000 =  20,000
• Indifferent.

Chapter 12
3. Explain the international gold standard of
the late 19th and early 20th centuries, and
the reasons for its demise.

Solution: Problem 3
• Gold Standard (late 19th - early 20th century)
– each country would fix the price of gold in domestic currency
– the ratio of the prices of two countries would determine the exchange
rate of the two currencies
– this standard prices forced symmetric monetary adjustments and
controlled execution of monetary policies
• Reasons for demise
– monetary policy too constrained
– price stability depended on demand/supply of gold
– international reserve limited by availability of gold
– large producers of gold would have significant macroeconomic influence
on the other economies

Chapter 12
4. Distinguish between the devaluation and
revaluation of a currency.

Solution: Problem 4
• Devaluation:
– In a fixed exchange rate system if the central bank intervenes by
announcing that the it would operate in foreign exchange market (mainly
by buying foreign currency) to set the price of the foreign currency at a
higher level (ie it would take more domestic currency to buy one unit of
foreign currency), then it is called a devaluation of the domestic
currency.
– This is generally done to increase foreign currency reserve, to deter
imports and to make local goods less expensive for foreign countries
• Revaluation:
– Is the opposite of the above
– The price of foreign currency is fixed at a lower level than before and
the central bank ensures the stability at that price.

Chapter 12
5. Explain why an increase in the supply of
dollar-denominated assets leads to a
depreciation of the currency under flexible
exchange rates.

Solution: Problem 5
• Increase in the supply of dollar-denominated assets makes the
interest rates on dollar-assets lower
• capital outflow to foreign countries
• value of dollar goes down
• depreciation of dollar

Chapter 13
1. There is now a single European currency:
(a) How has this changed the ability of each
member country to conduct independent
countercyclical monetary and fiscal policies?
(b) How has this system impacted the ability of
the United Kingdom, which is not currently a
member of the system, but maintains a
floating exchange rate, to conduct
independent countercyclical monetary and
fiscal policies?

Solution: Problem 1
(a) Independent monetary policy cannot be undertaken.
Independent fiscal policy can be effective
(b) Able to conduct independent monetary and fiscal
policies effectively.

Chapter 13
2. What is the correct answer? Suppose that
under covered interest parity (CIP), foreign
interest rates are greater than domestic
interest rates. Then (defining exchange
rates as we have done above) it must be
true that…
• Solution: (b) the forward rate must be
greater than the spot rate

Chapter 13
3. What is the correct answer? In a “credible”
fixed exchange rate regime, the domestic
interest rate for the small open economy is
determined by…
Solution: (a) demand and supply in the
domestic capital market

Chapter 13
4. What is the correct answer? Suppose that
interest rates in London are around 9.5% per
annum, compared with rates of 4.5% for
comparable securities in New York. Assuming
that uncovered interest parity (UIP) holds, a
reasonable prediction for the behavior of the US
dollar against the British pound over the next
year would be…
• Solution: (d) depreciate by about 4.5%

Chapter 13
5. What is purchasing power parity? Why is
this concept so important?

Solution: Problem 5
• The PPP asserts that the relative price of foreign and domestic
goods determine the real exchange rate (E).
• According to PPP,
– E = Pf / P; Pf: foreign prices; P: domestic prices
• Importance
– based on law of one price (no arbitrage condition)
– helps explain long term exchange rate behavior

Chapter 14
1. Explain the relationships among output,
investment, and savings.

Solution: Problem 1
• Output (Y):
– production of real goods in an economy
– dependent broadly on two factors: capital (K) and labor (L)
– mathematical expression: Y = f(K,L)
• Investment (I):
– investment forms capital
– the change in capital is the investment amount
– K = I
• Savings (S):
– Savings is the residual output after consumption (C)
– S = Y - C
– Investment is done from savings: I =S

Chapter 14
2. What conditions would be necessary to
cause another world-wide Great
Depression like that of the 1930s?

Solution: Problem 2
• Conditions necessary to cause another world-wide Great
Depression
– drastic fall in consumer confidence and in business confidence
– lack of insurance(such as ‘too-big-to-fail’) and investment protection
– severe destruction of capital
– complete halt on innovation
– anarchy

Chapter 14
3. How might endogenous growth theory be
of benefit to developing nations?

Solution: Problem 3
• Endogenous growth theories hypothesize that
– there could increasing returns to scale for capital input (including human
capital)
– increase in savings and investment increase both the level and the
growth rate of output
– no steady state; perpetual growth
• How developing countries can benefit
– focus on capital formation
– invest on social-infrastructure (education, transportation etc) to allow
speedy growth of human capital

Chapter 14
4. Is corruption caused by poverty, or does
corruption cause poverty?

Solution: Problem 4
• Empirical evidence suggests strong correlation between poverty and
corruption
• Correlation cannot pinpoint direction of causality
• Proponents of economic freedom argue that low ratings on the HDI
(Human Development Index) is a result of lack of economic freedom
and of less honest society.
• It could be argued that lack of resources create poverty which forces
people to resort to illegal means.

Chapter 14
5. What are the key characteristics of the
Porter model of economic development?

Solution: Problem 5
• Key characteristics of the Porter model of economic development:
– Factor Driven Stage
– Investment Driven Stage
– Innovation Driven Stage
– Wealth Driven Stage
Growth
Decline

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