Answers to in-text Questions in Economics (6th edition) Chapter 1 Page 4 Could production and consumption take place without money? If you think they could, give examples. Yes. People could produce things for their own consumption. For example, people could grow vegetables

in their garden or allotment; they could do their own painting and decorating. Alternatively people could engage in barter: they could produce things and then swap them for goods that other people had produced.

Before reading on, how would you define scarcity? Must goods be at least temporarily unattainable to be

scarce? See page 2 of text for a definition of scarcity. Goods need not be unattainable to be scarce. Because

peoples incomes are limited, they cannot have everything they want from shops, even though the shops are stocked full. If all items in shops were free, the shelves would soon be emptied!

If we would all like more money, why does the government not print a lot more? Could it not thereby solve

the problem of scarcity at a stroke? The problem of scarcity is one of a lack of production. Simply printing more money without producing

more goods and services will merely lead to inflation. To the extent that firms cannot meet the extra demand (i.e. the extra consumer expenditure) by extra production, they will respond by putting up their prices. Without extra production, consumers will end up unable to buy any more than previously.

5 (Box 1.1) What is it that makes each one of the above news items an economics item? Each one of the items has something to do with production, consumption or exchange, and/or the money

incomes and expenditures involved. 6 Which of the following are macroeconomic issues, which are microeconomic ones and which could be

either depending on the context? (a) Inflation. (b) Low wages in certain service industries. (c) The rate of exchange between the pound and the euro. (d) Why the price of cabbages fluctuates more than that of cars. (e) The rate of economic growth this year compared with last year. (f) The decline of traditional manufacturing industries. (a) Macro. It refers to a general rise in prices across the whole economy. (b) Micro. It refers to specific industries (c) Either. In a world context, it is a micro issue, since it refers to the price of one currency in terms of

one other. In a national context it is more of a macro issue, since it refers to the euro exchange rate at which all UK goods are traded internationally. (This is certainly a less clearcut division that in (a) and (b) above.)

(d) Micro. It refers to specific products. (e) Macro. It refers to the general growth in output of the economy as a whole. (f) Micro (macro in certain contexts). It is micro because it refers to specific industries. It could, however,

also help to explain the macroeconomic phenomena of high unemployment or balance of payments problems.

Answers to questions in Economics (6th edition) by John Sloman Page 7 (Box 1.2) 1. Has the UK generally fared better or worse than the other three countries? Generally worse until recent years. Unemployment was higher than in Germany and Japan, and also than in the USA from 1981 to 2000.

In the last period, however, UK unemployment has been lower than in Germany. Inflation has generally been higher than in the other countries, although in the last period it has been lower than the US rate.

In the 1960s and 70s, UK growth was lower than in the other three countries. In the last two periods, economic growth in the UK has been higher than that in Germany and Japan and only slightly lower than that in the USA.

If current account deficits are regarded as undesirable, then both the USA and the UK have fared significantly worse than Japan and somewhat worse than Germany for most of the time since 1961. The UKs deficit, however, has generally been less severe than the USAs, especially in the latest period.

(Box 1.2) 2. Was there a common pattern in the macroeconomic performance of each of the four

countries over these 45 years? With inflation yes, but not with the other indicators. Unemployment has been rising throughout in Germany and Japan, whereas in the UK it has fallen in

the last two periods. The USA has not followed a similar pattern to any of the other three countries, with unemployment lowest in the middle period (the period in the UK when unemployment was at its highest).

Inflation was highest for all four countries in the second period. Since then each subsequent period has recorded lower inflation than the previous one.

Growth rates in Germany and Japan have slowed, whereas rates in the UK and the USA have generally been maintained.

UK and US current account deficits have deteriorated, with a dramatic worsening in the USA in the last period. German and Japanese current account surpluses have increased, with the exception of Germany in the penultimate period.

Note that the figures given are merely the averages for each period. They do not indicate, therefore, the fluctuations that took place within the periods. For example the early 1980s and early 1990s were periods of low growth and high unemployment, whereas the late 1970s and late 1980s were periods of relatively high growth and high inflation and the late 1990s was also a period of relatively high growth.

8 (Threshold Concept 1) 1. Think of three things you did yesterday. What are the opportunity costs of each

one? Obviously, this depends on the three things you choose. In the case of things you purchased, the

opportunity cost is the next best thing you could have purchased with the money. In the case of other activities, the opportunity cost is the next best thing you could have done with the time.

(Threshold Concept 1) 2. Assume that a supermarket has some fish that has reached its sell-by date. It

was originally priced at 10, but yesterday was marked down to 5 for quick sale. It is now the end of the day and it still has not been sold. The supermarket is about to close and there is no-one in the store that wants fish. What is the opportunity cost for the store of throwing the fish away.

It is simply the cost of disposing of it which may be zero, if its waste disposal is not charged per unit. The price it paid for the fish is irrelevant since it cannot recoup this cost.

9 Assume that you are looking for a job and are offered two. One is more unpleasant to do, but pays more.

How would you make a rational choice between the two jobs? You should weigh up whether the extra pay (benefit) from the better paid job is worth the extra hardship

(cost) involved in doing it. How would the principle of weighing up marginal costs and benefits apply to a worker deciding how

much overtime to work in a given week? The worker would consider whether the extra pay (the marginal benefit) is worth the extra effort and loss

of leisure (the marginal cost).

2

Chapter 1 10 (Threshold Concept 2) 1. Assume that a firm is selling 1000 units of a product at 20 each and that

each unit on average costs 15 to produce. Assume also that to produce additional units will cost the firm 19 each and that the price will remain at 20. To produce additional products will therefore reduce the average profit per unit. Should the firm expand production? Explain?

Yes. Additional units still earn extra profit of 1 each (i.e. 20 19). If the firm wants to increase profits, therefore, it should increase production, even though additional units earn only an extra 1 and not the average of 5 earned on previous units. We consider the concepts of marginal cost and marginal revenue in Chapter 5.

(Threshold Concept 2) 2. Assume that a ferry has capacity for 500 passengers. Its operator predicts

that it will typically have only 200 passengers on each of its mid-week sailings over the winter. Assume also that each sailing costs the company 10,000. This means that mid-week winter sailings cost the company an average of 10,000/200 = 50 per passenger. Currently tickets cost 60. Should the company consider selling stand-by tickets during the winter for (a) less than 60; (b) less than 50? (Clue: think about the marginal cost of taking additional passengers.)

It should consider the additional cost of taking the extra passengers. This is likely to be close to zero, given that there is room for extra passengers and the ferry is sailing anyway. In considering how much to reduce the stand-by price below the current price of 60, the company must weigh up the extra passengers attracted by the lower price against the lower amount earned per stand-by passenger. If a 20 per cent cut in price, say, resulted in an increase in passengers of more than 20 per cent, then the ferry company would earn more as a result of that price cut. We will consider these calculations when we look at the concept of elasticity in section 2.4. These calculations assume that selling stand-by tickets does not affect the number of passengers on regular tickets. However, if cheap stand-by tickets reduce the number of people buying regular tickets, then the net gain in revenue will be less.

11 (Box 1.3) What might prevent you from making the best decision? Lack of knowledge. You will not know just how much benefit you will gain from the textbook until you

have read it, taken your exams or had your assignments marked! Another cause of making poor decisions is the lack of care taken in making them.

(Box 1.3) 1. If there are several other things you could have done, is the opportunity cost the sum of all of

them? No. It is the sacrifice of the next best alternative. (Box 1.3) 2. What is the opportunity cost of spending an evening revising for an economics exam? What

would you need to know in order to make a sensible decision about what to do that evening? The next best alternative might be revising for another exam, or it might be taking time off to relax or to

go out. To make a sensible decision, you need to consider these alternatives and whether they are better or worse for you than studying for the economics exam. One major problem here is the lack of information. You do not know just how much the extra study will improve your performance in the exam, because you do not know in advance just how much you will learn and you do not know what is going to be on the exam paper. Similarly you do not know this information for studying for other exams.

(Box 1.3) 1. Why is the cost of food not included? Because you would buy food anyway. If, however, food were being provided free of charge by your

parents if you lived at home, but you had to pay for it if you went to university or college, then food would be an opportunity cost to you.

(Box 1.3) 2. Make a list of the benefits of higher education. The benefits to the individual include: increased future earnings; the direct benefits of being more

educated; the pleasure of the social contacts at university or college.

3

Answers to questions in Economics (6th edition) by John Sloman Page 11 (Box 1.3) 3. Is the opportunity cost to the individual of attending higher education different from the

opportunity costs to society as a whole? Yes. The opportunity cost to society as a whole would include the costs of providing tuition (staffing

costs, materials, capital costs, etc.), which could be greater than any fees the student may have to pay. On the other hand, the benefits to society would include benefits beyond those received by the individual. For example, they would include the extra profits employers would make by employing the individual with those qualifications.

Would it ever be desirable to have total equality in an economy? The objective of total equality may regarded as desirable in itself by many people. There are two problems

with this objective, however. The first is in defining equality. If there were total equality of incomes then households with

dependants would have a lower income per head than households where everyone was working. In other words, equality of incomes would not mean equality in terms of standards of living. If on the other hand, equality were to be defined in terms of standards of living, then should the different needs of different people be taken into account? Should people with special health or other needs have a higher income? Also, if equality were to be defined in terms of standards of living, many people would regard it as unfair that people should receive different incomes (according to the nature of their household) for doing the same amount of work.

The second major problem concerns incentives. If all jobs were to be paid the same (or people were to be paid according to the composition of their household), irrespective of peoples efforts or skills, then what would be the incentive to train or to work harder?

13 (Box 1.4) 1. There is a saying in economics, There is no such thing as a free lunch (hence the sub-title for this box). What does this mean?

That there is always (or virtually always) an opportunity cost of anything we consume. Even if we do not incur the cost ourselves (the lunch is free to us), someone will incur the cost (e.g. the institution providing the lunch).

(Box 1.4) 2. Are any other (desirable) goods or services truly abundant? Very few! Possibly various social interactions between people, but even here, the time to enjoy them is not

abundant.

14 1. What is the opportunity cost of the seventh million units of clothing? 3 million units of food. (Food production falls from 3 million units to zero.) 2. If the country moves upward along the curve and produces more food, does this also involve increasing

opportunity costs? Yes. Ever increasing amounts of clothing have to be sacrificed for each extra unit of food produced. 3. Under what circumstances would the production possibility curve be (a) a straight line; (b) bowed in

toward the origin? Are these circumstances ever likely? (a) When there are constant opportunity costs. This will occur when resources are equally suited to

producing either good. This might possibly occur in our highly simplified world of just two goods. In the real world it is unlikely.

(b) When there are decreasing opportunity costs. This will occur when increased specialisation in one good allows the country to become more efficient in its production. It gains economies of scale sufficient to offset having to use less suitable resources. We shall look at economies of scale in Chapter 5, sections 5.3 and 5.4. Economies of scale are common in the real world.

4

Chapter 1 Page 14 Will economic growth necessarily involve a parallel outward shift of the production possibility curve? No. Technical progress, the discovery of raw materials, improved education and training, etc., may favour

one good rather than the other. In such cases the gap between the old and new curves would be widest where they meet the axis of the good whose potential output had grown more.

17 Do you agree with the positions that the eight countries have been given in the spectrum diagram? Explain why or why not.

Given that there is no clearly defined scale by which government intervention is measured, the precise position of the countries along the spectrum is open to question.

20 Can you think of any examples where prices and wages do not adjust very rapidly to a shortage or surplus? For what reasons might they not do so? Many prices set by companies are adjusted relatively infrequently: it would be administratively too

costly to change them every time there was a change in demand. For example a mail order company, where all the items in its catalogue have a printed price, would find it costly to adjust prices very frequently, since that would involve printing a new catalogue, or at least a new price list.

Many wages are set annually by a process of collective bargaining. They are not adjusted in the interim.

21 (Threshold Concept 3) 1. Give two other examples of perverse incentives. How could the incentives be improved? If the government caps the amount of money that local authorities can raise in council tax in order

to encourage them to cut waste and reduce their bureaucracy, it might have the perverse effect of reducing the quality of services the local authority provides.

If house prices rise in response to the excess of demand over supply, this may have the perverse effect of increasing demand, not choking it off. The reason is that people may see prices rising and rush to buy now before they rise any further. We examine this destabilising speculation in section 2.5.

If the government, or firm or anyone else is offering incentives for people to do things, they need to think closely about the unintended consequences of these incentives and, if necessary, change the incentives so as to avoid them. In general it is best to tackle a problem as close to source as possible if these unintended consequences or side effects are to be minimised.

(Threshold Concept 3) 2. Find out just what the learning objectives are of the economics course or module that you are studying. What positive incentives are there for you to meet these learning objectives? Identify any perverse incentives and how you would change them.

Perverse incentives are likely to arise from assessment capturing only some of the learning objectives, with the result that others will be ignored by some students. Lecturers are encouraged to consider constructively aligning their courses. What this means is that teaching and study methods, class activities, reading and assessment should all match the learning objectives of the course or module.

22 (Threshold Concept 4) 1. If there is a shortage of certain skilled workers in the economy, how will market forces lead to an elimination of the skills shortage?

The shortage of skilled workers will drive up their wages relative to other workers, thereby choking off the excess demand firms will try to economise on these skilled workers, perhaps by using alternative techniques of production. The higher wages will encourage more people to train. It will also encourage skilled workers to move to the country from abroad. Over time, then, this will lead to increased supply. This will have a dampening effect on the wage rate, making the net rise smaller.

5

Answers to questions in Economics (6th edition) by John Sloman Page 22 (Threshold Concept 4) 2. If consumers want more of a product, it is always desirable that market

forces result in more being produced? No. People may be unaware of the harmful consequences to themselves from the increased

consumption of certain products. Also the consumption of certain products may have adverse consequences on other people (e.g. the effects of passive smoking, or the nuisance of litter). Similarly the production of certain goods may result in pollution.

1. Why do the prices of fresh vegetables fall when they are in season? Could an individual farmer prevent the price falling?

Because supply is at a high level. The increased supply creates a surplus which pushes down the price. Individual farmers could not prevent the price falling. If they continued to charge the higher price, consumers would simply buy from those farmers charging the lower price.

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

You would try to reduce the price of each item as little as was necessary to get rid of the remaining stock. The problem for shop owners is that they do not have enough information about consumer demand to make precise calculations here. Many shops try a fairly cautious approach first, and then, if that is not enough to sell all the stock, they make further end of sale reductions later.

3. The number of owners of compact disc players has grown rapidly and hence the demand for compact discs has also grown rapidly. Yet the prices of discs have fallen. Why? The costs of manufacture have fallen with improvements in technology and mass-production

economies. Competition from increased numbers of manufacturers has increased supply and driven prices down. Budget-priced CDs of original analogue recordings cost less to produce (there are no new studio

costs). In the early 2000s, the advent of copying CD tracks from the Internet has reduced the demand for

CDs. This change in demand has further compounded the fall in price.

23 Summarise this last paragraph using symbols like those in Figure 1.7.

Are different factor markets similarly interdependent? Give examples. Yes. A rise in the price of one factor (e.g. oil) will encourage producers to switch to alternatives (e.g.

coal). This will create a shortage of coal and drive up its price. This will encourage increased production of coal.

Factor Market

Si surplus(Si > Di)

Pi Si

Di until Di = Si

Goods Market

Pi surplus(Sg > Dg)

Pg Sg

Dg until Dg = SgSg

The price mechanism: the effect of the discovery of raw materials

6

Chapter 1 Page 24 (Threshold Concept 5) 1. Would you ever swap things with friends if both of you did not gain? Explain

your answer. In most cases you would not do so. The exceptions would be:

where you thought you would gain at the time you made the swap, but afterwards find that the item you have obtained does not give you the benefit you thought it would. The problem here is one of imperfect knowledge at the time of the swap.

where you were thinking more about the other person than yourself, and swapped something you know they really wanted from you for something you did not really want from them. The question here, however, is whether you can still be said to have gained because you made a sacrifice yourself for someone else. A similar question is whether you gain from giving to charity or giving someone a gift.

(Threshold Concept 5) 2. Give one or two examples of involuntary (i.e. compulsory) economic

interaction where one side gains but the other loses. Paying taxes; robbery; parking fines.

26 (Threshold Concept 6) 1. If global warming affects all of us adversely, why in a purely market economy would individuals and firms continue with activities that contribute towards global warming?

Partly out of ignorance of the effects, but mainly because people individually gain more from such activities than they lose. Although each time you use your car, or use electricity generated by fossil fuels, you are contributing to global warming, your individual contribution is minuscule. What is more, the amount you suffer personally from global warming is again minuscule compared with the total amount the whole population of the world suffers. Thus many people selfishly ignore the environmental costs of their actions. But when the majority of people do this, then the costs to all of us may be considerable, let alone the costs to wildlife and the planet generally.

(Threshold Concept 6) 2. In what ways do your own consumption patterns adversely affect other people? You may what to take a while to reflect on the costs to others of what you do yourself. Are you ever

inconsiderate, and if so, in what ways? Do you ever chuck litter away? Do you ever drive without giving due care and attention to other road users, pedestrians or residents, or do you ever park inconsiderately? Do you ever play music in public places that others can hear?

(Threshold Concept 7) 1. How may welfare benefits be seen as a means of correcting market failures? Does the payment of such benefits create any problems for society?

A market economy may lead to a very unequal society. To the extent that this is seen as a market failure, then benefits can help to correct it by redistributing income from richer to poorer people. The main problems from benefits are: They may discourage people from looking for work if this will result in them losing their benefits. They may be set at too low a level to make a significant difference to inequality. The higher taxes that must be paid to fund the benefits may act as a disincentive to taxpayers generally

to work so much. This will reduce the level of the countrys production and income. These issues are examined in section 10.2.

(Threshold Concept 7) 2. Assume that the government sees litter as a market failure that requires government action. Give some examples of policies it could adopt to reduce litter. Having litter wardens who could fine people for dropping litter; increasing fines for dropping litter; having an anti-litter campaign on television or on posters; requiring schools to include litter awareness as part of citizenship education; requiring fast food outlets to provide adequate wastebins and encourage their use; putting a tax on plastic bags and packaging to encourage manufacturers, shops and consumers to find alternatives.

7

Answers to questions in Economics (6th edition) by John Sloman

Page 29 Which of the following are positive statements, which are normative statements and which could be either

depending on the context? (a) Cutting the higher rates of income tax will redistribute incomes from the poor to the rich. (b) It is wrong that inflation should be reduced if this means that there will be higher unemployment. (c) It is wrong to state that putting up interest rates will reduce inflation. (d) The government should raise interest rates in order to prevent the exchange rate falling. (e) Current government policies should reduce unemployment. (a) Positive. This is merely a statement about what would happen. (b) Normative. The statement is making the value judgement that reducing inflation is a less desirable

goal than the avoidance of higher unemployment. (c) Positive. Here the word wrong means incorrect not morally wrong. The statement is making a

claim that can be tested by looking at the facts. Do higher interest rates reduce inflation, or dont they? (d) Both. The positive element is the claim that higher interest rates prevent the exchange rate falling.

This can be tested by an appeal to the facts. The normative element is the value judgement that the government ought to prevent the exchange rate falling.

(e) Either. It depends what is meant. If the statement means that current government policies are likely to reduce unemployment, the statement is positive. If, however, it means that the government ought to direct its policies towards reducing unemployment, the statement is normative.

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Chapter 2 Page 35 Assume that there are 200 consumers in the market. Of these, 100 have schedules like Traceys and 100

have schedules like Darrens. What would be the total market demand schedule for potatoes now?

Price (pence per kg)

Total market demand (kg)

20 40 60 80 100

4400 2600 1400 800 600

1. How much would be demanded at a price of 6p per kilogram? Reading off from the graph: at a price of 6p per kg, total market demand is 600 000 tonnes per month (or a

little under). 2. Assuming that demand does not change from month to month, plot the annual market demand for

potatoes. The amount demanded would be 12 times higher at each price. If the scale of the horizontal axis were

unaltered, the curve would shift way out to the right. A simple way of showing the new curve, therefore, would be to compress the scale of the horizontal axis. (If each of the numbers on the axis were multiplied by 12, the curve would remain in physically the same position.)

36 1. Draw Traceys and Darrens demand curves for potatoes on one diagram. Note that you will use the

same vertical scale as in Figure 2.1, but you will need a quite different horizontal scale. This is shown in Diagram 2.1.

Diagram 2.1 Tracey's and Darren's demand for potatoes

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Answers to questions in Economics (6th edition) by John Sloman

Page 36 2. At what price is their demand the same? The two curves cross at a price of 10p per kg and at a demand of 10 kg per month.

3. What explanations could there be for the quite different shapes of their two demand curves? One explanation could be that Tracey is quite happy to eat rice, pasta or bread instead of potatoes. Thus

when the price of potatoes goes up she switches to these other foods, and switches to potatoes when the price of potatoes comes down. Darren, by contrast, may not see these other foods as close substitutes and thus his demand for potatoes will be less price sensitive. (See section 2.4 on elasticity.)

37 (Box 2.1) From this equation, calculate what would happen to the demand for lamb if: (a) the price of lamb went up by 10p per kg (at 1985 prices). (b) the price of beef went up by 10p per kg (at 1985 prices). (c) personal disposable income per head went up by 100 per annum (at 1985 prices). (a) The demand would go down by 1.12 grams per person per week (i.e. 10 0.112). (b) The demand would go up by 1.25 grams per person per week (i.e. 10 0.125). (c) The demand would go down by 1.98 grams per person per week (i.e. 100 0.0198).

(Box 2.1) 1. How does the introduction of the TIME term affect the relationship between the demand for lamb and (a) the price of beef and (b) personal disposable income per head?

(a) The demand for lamb is less sensitive to a change in the price of beef than in the first equation. (b) The demand for lamb is slightly more sensitive to a change in disposable income than in the first

equation and the relationship is now a positive one: i.e. when income rises, the demand for lamb rises..

(Box 2.1) 2. Is lamb a normal good or an inferior good? An inferior good in the first equation and a normal good in the second. In the first equation, as personal

disposable income rises so the demand for lamb falls. In the second equation as personal disposable income rises so the demand for lamb rises. The reason is that, by introducing the TIME term, we are now allowing for the fall in demand for lamb over time as a result of a shift in tastes away from meat. In other words, the second equation allows us to take this factor out of account when looking at the effect of a change in the price of lamb on the demand for lamb.

(Box 2.1) Use the second equation to estimate the demand for lamb in 1994, 1996 and 2000. In which of these three years was the estimation closest to the actual figure? Explain the divergences in the actual figures from the figures derived from the equation.

1994: Qd = 192.3 (0.530 301.6) + (0.0738 343.0) + (0.0261 8266) (7.352 29) = 192.3 159.85 + 25.31 + 215.74 213.21 = 60.29 (grams per person per week) 1996: Qd = 192.3 (0.530 296.2) + (0.0738 325.6) + (0.0261 8607) (7.352 31) = 192.3 156.99 + 24.03 + 224.64 227.91 = 56.07 (grams per person per week) 2000: Qd = 192.3 (0.530 310.7) + (0.0738 320.1) + (0.0261 9604) (7.352 35) = 192.3 164.67 + 23.62 + 250.66 257.32 = 44.59 (grams per person per week) The equation most closely predicted the actual consumption in 1994: actual consumption (54 grams pppw)

was 6 grams pppw less than predicted by the equation. In 1996 and 2000, consumption was approximately 10 grams pppw more than predicted. This can be explained by BSE, which caused a shift in demand from beef to lamb in these later two years.

10

Chapter 2 Page 37 Do all these six determinants of demand affect both an individuals demand and the market demand for a

product? All except the distribution of income. The (national) distribution of income simply affects an individuals

income and thus is not a separate determinant from income.

Relate each of these six determinants to the demand for butter. Tastes: if it is heavily advertised, demand is likely to rise. If, on the other hand, there is a cholesterol

scare, people may demand less for health reasons. Substitutes: if the price of margarine goes up, the demand for butter is likely to rise as people switch

from one to the other. Complements: if the price of bread goes up, people will buy less bread and hence less butter to spread

on it. Income: if peoples income rises, they may well turn to consuming butter rather than margarine or feel

that they can afford to spread butter more thickly on their bread. Income distribution: if income is redistributed away from the poor, they may have to give up

consuming butter and buy cheaper margarine instead, or simply buy less butter and use it more sparingly.

Expectations: if it is announced in the news that butter prices are expected to rise in the near future, people are likely to buy more now and stock up their freezers while current prices last.

38 1. Assume that in Table 2.1 the total market demand for potatoes increases by 20 per cent at each price due, say, to substantial increases in the prices of bread and rice. Plot the old and the new demand curves for potatoes. Is the new curve parallel to the old one?

See Diagram 2.2 below. As you can see, the curves are not parallel. A constant percentage increase in quantity demanded gives a bigger and bigger absolute increase as quantity increases.

Diagram 2.2 Market demand for potatoes

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Newdemand

Olddemand

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Answers to questions in Economics (6th edition) by John Sloman Page 38 2. The price of cashew nuts rises and yet it is observed that the sales of cashew nuts increase. Does this

mean that the demand curve for cashew nuts is upward sloping? Explain. No not necessarily. For example, the price of substitutes such as peanuts or other nibbles may have risen

by a larger amount. In such cases the demand curve for cashew nuts will have shifted to the right. Thus although a rise in the price of cashew nuts will cause a movement up along this new demand curve, more cashew nuts will nevertheless be demanded because cashew nuts are now relatively cheaper than the alternatives.

(Looking at the Maths) 1. Complete the demand schedule in Table 2:2 up to a price of 50. See the following table:

P Qd 5 10 15 20 25 30 35 40 45 50

9000 8000 7000 6000 5000 4000 3000 2000 1000 0

(Looking at the Maths) 2. What is it about equation (2) that makes the demand curve (a) downward sloping; (b) a straight line?

(a) The fact that the 200P term has a negative sign. This means that as P rises, so Qd falls. (b) The fact that there is no P to a power term. The curve thus has a constant slope of 1/200

(Looking at the Maths) 1. Referring to equation (3), if the term a has a value of 50 000 and the term b a value of 0.001, construct a demand schedule with respect to total income (Y). Do this for incomes between 100 million and 300 million at 50 million intervals.

See the following table:

Y (millions) Qd 100 150 200 250 300

50 000 100 000 150 000 200 000 250 000

(Looking at the Maths) 2. Now use this schedule to plot a demand curve with respect to income. Comment on its shape.

The curve will be an upward-sloping straight line, crossing the horizontal axis at 50 000. It would rise by 100 000 units for each 100 million rise in national income. (See Diagram 2.3 on next page).

12

Chapter 2

40 1. How much would be supplied at a price of 70p per kilo? About 430 000 tonnes per month. 2. Draw a supply curve for farmer X. Are the axes drawn to the same scale as in Figure 2.4? The supply curve for farmer X will merely plot the relevant two columns from Table 2.3. The vertical axis

can be drawn to the same scale as in Figure 2.4, but a different scale will have to be used for the horizontal axis (e.g. tonnes rather than thousands of tonnes).

41 By referring to each of the above determinants of supply, identify what would cause (a) the supply of

potatoes to fall and (b) the supply of leather to rise. (a) Fall in supply of potatoes:

The cost of producing potatoes rises. The profitability of alternative crops (e.g. carrots) rises. A poor potato harvest. Farmers may find producing other crops more enjoyable. Farmers expect the price of potatoes to rise (short-run supply falls). Potato farmers may leave the industry.

(b) Rise in supply of leather The cost of producing leather falls. The profitability of producing alternative products decreases. The profitability of rearing sheep falls. The price of beef rises. A long-running industrial dispute involving leather workers is resolved. Producers expect the price of leather to fall (short-run supply increases). An increase in leather imports.

42 This question is concerned with the supply of oil for central heating. In each case consider whether there

is a movement along the supply curve (and in which direction) or a shift in it (left or right). (a) New oil fields start up in production. (b) The demand for central heating rises. (c) The price of gas falls. (d) Oil companies anticipate an upsurge in demand for central-heating oil. (e) The demand for petrol rises. (f) New technology decreases the costs of oil refining. (g) All oil products become more expensive.

(a) Shift right. (b) Movement up along (as a result of a rise in price). (c) Movement down along (as a result of a fall in price resulting from a fall in demand as people switch to gas-fire central heating). (d) Shift left (if companies want to conserve their stocks in anticipation of a price rise). (e) Shift right (more of a good in joint supply is produced). (f) Shift right. (g) Movement up along.

Diagram 2.3 Market demand (with respect to income)

0

50

100

150

200

250

300

0 50 100 150 200 250 300Quantity demanded

Inco

me

( m

illion

s)

Demand

13

Answers to questions in Economics (6th edition) by John Sloman Page 42 (Looking at the Maths) 1. If P was originally measured in s, what would happen to the value of the d

term if P were now measured in pence? It would now have a value of 10. (Looking at the Maths) 2. Draw the schedule (table) and graph for equation (8) for prices from 1 to 10.

What is it in the equation that determines the slope of the supply curve?

P Qs

1

2

3

4

5

6

7

8

9

10

1500

2500

3500

4500

5500

6500

7500

8500

9500

10500 The graph is an upward sloping straight line crossing the horizontal axis at 500 units. The slope is given

by the value of the d term: i.e. the slope is 1/1000 (for every 1 increase in price, quantity supplied increases by 1000 units).

(Looking at the Maths) Explain why the P and j terms have a positive sign, whereas the a1 and a2 terms

have a negative sign. A rise in the price of the good (P) and a rise in the profitability of a good in joint supply (j) will cause

supply to increase, whereas a rise in the profitability of an alternative good (a) will cause supply to fall.

43 Explain the process by which the price of houses would rise if there were a shortage. People with houses to sell would ask a higher price than previous sellers of similar houses (probably with

the advice of an estate agent). Potential purchasers would be prepared to pay a higher price than previously in order to obtain the type of house they wanted.

44 What would happen to price and quantity if the demand curve shifted to the left? Draw a diagram to illustrate your answer.

Both price and quantity will fall. Imagine in Figure 2.7 that the original curve were D2 and that it shifted to D1. Price would fall from Pe2 to Pe1 and quantity would fall from Qe2 to Qe1.

Diagram 2.4 Market supply

0

1

2

3

4

5

6

7

8

9

10

0 2000 4000 6000 8000 10000

Quantity supplied

Pric

e

Supply

14

Chapter 2 Page 45 What will happen to the equilibrium price and quantity of butter in each of the following cases? You

should state whether demand or supply (or both) have shifted and in which direction. (In each case assume ceteris paribus.)

(a) A rise in the price of margarine; (b) A rise in the demand for yoghurt; (c) A rise in the price of bread; (d) A rise in the demand for bread; (e) An expected rise in the price of butter in the near future; (f) A tax on butter production; (g) The invention of a new, but expensive, process for removing all cholesterol from butter plus the passing of a law which states that all butter producers must use this process.

(a) Price rises, quantity rises (demand shifts to the right: butter and margarine are substitutes). (b) Price falls, quantity rises (supply shifts to the right: butter and yoghurt are in joint supply). (c) Price falls, quantity falls (demand shifts to the left: bread and butter are complementary goods). (d) Price rises, quantity rises (demand shifts to the right: bread and butter are complementary goods). (e) Price rises, quantity rises or falls depending on relative sizes of the shifts in demand and supply

(demand shifts to the right as people buy now before the price rises; supply shifts to the left as producers hold back stocks until the price does rise).

(f) Price rises, quantity falls (supply shifts to the left). (g) Price rises, quantity rises or falls depending on the relative size of the shifts in demand and supply

(demand shifts to the right as more health-conscious people start buying butter; supply shifts to the left as a result of the increased cost of production).

47 (Box 2.2) 1. Draw supply and demand diagrams to illustrate what was happening to house prices (a) in the second half of the 1980s and the late 1990s and early 2000s; (b) in the early 1990s.

(a) Demand was rising rapidly. There was thus a continuing rightward shift in the demand curve for houses and a resulting rise in the equilibrium price.

(b) Demand was falling. The leftward shift in the demand curve for houses led to a fall in the equilibrium price.

(Box 2.2) 2. Are there any factors on the supply side that influence house prices? Yes. Although they are less important than demand-side factors, they are, nevertheless important in

determining changes in house prices. The two most important are the expectations of the construction industry. If house building firms are confident that demand will continue to rise, and with it house prices, they are likely to start building more houses. The resulting increase in the supply of houses (after the time taken to build them) will help to dampen the rise in prices.

The other major supply-side factor is the expectations of house owners. If people think that prices will rise in the near future and are thinking of selling their house, they are likely to delay selling and wait until prices have risen. This (temporary) reduction in supply will help to push up prices even further.

(Box 2.2) 3. Find out what has happened to house prices over the past three years. Attempt an explanation of what has happened.

You can find details from websites B7 and 8, accessed from the Hotlinks section of the books website. Your explanation should focus on the various factors listed in the box.

50 Why will the price elasticity of demand for a particular brand of a product (e.g. Texaco) be greater than that for the product in general (e.g. petrol)? Is this difference the result of a difference in the size of the income effect or the substitution effect?

The price elasticity of demand for a particular brand is more elastic than that for a product in general because people can switch to an alternative brand if the price of one brand goes up. No such switching will take place if the price of the product in general (i.e. all brands) goes up. Thus the difference in elasticity is the result of a difference in the size of the substitution effect.

15

Answers to questions in Economics (6th edition) by John Sloman Page 50 Will a general item of expenditure like food or clothing have a price-elastic or inelastic demand?

(Consider both the determinants we have considered so far.) The income effect will be relatively large (making demand relatively elastic). The substitution effect will

be relatively small (making demand relatively inelastic). The actual elasticity will depend on the relative size of these two effects.

Demand for oil might be relatively elastic over the longer term, and yet it could still be observed that over time people consume more oil (or only very slightly less) despite rising oil prices. How can this apparent contradiction be explained?

Because there has been a rightward shift in the demand curve for oil. This is likely to be the result of rising incomes. Car ownership and use increase as incomes increase. Also tastes may have changed so that people want to drive more. There may also have been a decline in substitute modes of transport such as rail transport and buses. Finally, people may travel longer distances to work as a result of a general move to the suburbs.

51 Assume that demand for a product is inelastic. Will consumer expenditure go on increasing as price rises? Would there be any limit?

So long as demand remains inelastic with respect to price, then consumer expenditure will go on rising as price rises. However, if the price is raised high enough, demand always will become elastic.

52 Can you think of any examples of goods which have a totally inelastic demand (a) at all prices; (b) over a particular price range?

(a) No goods fit into this category, otherwise price could rise to infinity with no fall in demand but people do not have infinite incomes!

(b) Over very small price ranges, the demand for goods with no close substitutes may be totally inelastic.

To illustrate these figures, draw the demand curve corresponding to the following table.

P () Q TE ()

2.50 5.00

10.00 20.00 40.00

400 200 100 50 25

1000 1000 1000 1000 1000

If the curve had an elasticity of 1 throughout its length, what would be the quantity demanded (a) at a

price of 1; (b) at a price of 10p; (c) if the good were free?

The curve will be a rectangular hyperbola: it will be a smooth curve, concave to the origin which never crosses either axis. (See Figure 2.13(c) in text.)

(a) 1000 units. (b) 10 000 units. (c) There would be an infinite demand!

53 (Box 2.3) 1. Think of some advertisements which deliberately seek to make demand less elastic. Those that strongly promote a brand, so that in the consumers mind there is no close substitute.

16

Chapter 2 Page 53 (Box 2.3) 2. Imagine that Sunshine sunflower margarine, a well-known brand, is advertised with the

slogan, It helps you live longer. What do you think would happen to the demand curve for a supermarkets own brand of sunflower margarine? Consider both the direction of shift and the effect on elasticity. Will the elasticity differ markedly at different prices? How will this affect the pricing policy and sales of the supermarkets own brand?

It depends on the extent to which the consumer is led to believe that sunflower margarines generally help you to live longer, in which case the demand for the supermarkets brand is likely to shift to the right and become less elastic as consumers are less prepared to switch to non-sunflower margarines. If, however, the consumer was led to believe that it was specifically Sunshine margarine that made you live longer, then the demand for the supermarkets brand (and all others) will shift to the left.

54 (Box 2.4) 1. Estimate the price elasticity of demand between 8p and 10p and between 10p and 12p. The mid-point formula (see pages 546 of the text) for price elasticity is Qd/average Qd P/average P. Thus between 8p and 10p, price elasticity equals 2/5 2/9 = 9/5 = 1.8 (elastic) And between 10p and 12p, price elasticity equals 1/3.5 2/11 = 11/7 = 1.57 (elastic) (Box 2.4) 2. Was the 10p fare the best fare originally? No. A profit of 400 000 360 000 = 40 000 was made. At a price of 8p, however, a higher profit of

480 000 360 000 = 120 000 could have been made. (Box 2.4) 3. The company considers lowering the fare to 6p, and estimates that demand will be 8

million passenger miles. It will have to put on extra buses, however. How should it decide? If it lowers the price to 6p, the revenue will rise to 510 000 (6p 8.5m). But putting on extra buses will

also increase costs. It will only, therefore, be worth lowering the price if the increase in revenue is greater than the increase in costs. (See Chapter 5, section 5.6 of the text.)

Referring to Figure 2.15, use the mid-point formula to calculate the price elasticity of demand between (a) P = 6 and P = 4; (b) P = 4 and P = 2. What do you conclude about the elasticity of a straight-line demand curve as you move down it?

Using the formula: (Q/mid Q) (P/mid P) gives the following answers: (a) 10/25 2/5 = 10/25 5/2 = 50/50 = 1 (which is unit elastic) (b) 10/35 2/3 = 10/35 3/2 = 30/70 = 0.43 (which is inelastic) The elasticity decreases as you move down a straight-line demand curve.

56 (Box 2.5) Calculate the price elasticity of demand on the above demand curve at a price of (a) 5; (b) 2; (c) 0.

Given that Qd = 60 15P + P then dQ/dP = 15 + 2P. Thus using the formula, Pd = dQ/dP P/Q, the elasticity at the each of the above prices equals: (a) (15 + (2 5)) (5/(60 (15 5) + 5)) = 5 5/10 = 2.5

17

Answers to questions in Economics (6th edition) by John Sloman Page (b) (15 + (2 2)) (2/(60 (15 2) + 2)) = 11 2/34 = 0.65 (c) (15 + (2 0)) (0/(60 (15 0) + 0)) = 15 0/60 = 0 56 (Looking at the Maths) These questions still refer to the diagram. 1. What is the price elasticity of demand at points l and k?

Given that Pd = dQ/dP P/Q, and given that dQ/dP = 5, then: at point l, (with P = 4 and Q = 30), Pd = 5 4/30 = 0.6 at point k, (with P = 2 and Q = 40), Pd = 5 2/40 = 0.25 2. What is the price elasticity of demand at the point (a) where the demand curve crosses the vertical axis;

(b) where it crosses the horizontal axis? (a) Infinity: (P/Q = 10/0 = ) (b) Zero: (P/Q = 0/50 = 0) 3. As you move down a straight-line demand curve, what happens to elasticity? Why? It decreases. P/Q gets less and less, but dQ/dP remains constant. 4. Calculate price elasticity of demand between points n and l using the arc method. Does this give the

same answer as by the point method? Would it if the demand curve were actually curved? By the arc method: Q/average Q P/average P = 20/20 4/6 = 1.5 By the point method, at point m (midway between n and l): dQ/dP x P/Q = 5 x 6/20 = 1.5 Thus both methods give the same answer. If the demand curve were actually curved, the answer would only be the same if the tangent to the point (in

the point method) were the same as the slope of the line (the chord) joining the two points of the curve (in the arc method).

58 (Looking at the Maths) Given the following supply schedule:

P 2 4 6 8 10

Q 0 10 20 30 40

(a) Draw the supply curve. (b) Using the arc method calculate price elasticity of supply (i) between P = 2 and P = 4; (ii) between P = 8 and P = 10 (c) Using the point method calculate price elasticity of supply at P = 6. (d) Does the elasticity of the supply curve increase or decrease as P and Q increase? Why? (e) What would be the answer to (d) if the supply curve had been a straight line but intersecting the

horizontal axis to the right of the origin?

(a) The supply curve will be an upward sloping straight line crossing the vertical axis where P = 2. (b) (i) Using the formula Q/average Q P/average P, gives: 10/5 2/3 = 3 (ii) 10/35 2/9 = 1.29 (c) Using the formula dQ/dP P/Q, and given that dQ/dP = 5 (= 10/2), gives: 5 6/20 = 1.5 (d) The elasticity of supply decreases as P and Q increase. It starts at infinity where the supply curve

crosses the vertical axis (Q = 0 and thus P/Q = ). (e) No. At the point where it crossed the horizontal axis, the elasticity of supply would be zero (P = 0 and

thus P/Q = 0). Thereafter, as P and Q increased, so would the elasticity of supply.

18

Chapter 2 Page 59 (Threshold Concept 8) 1. What would you understand by the wage elasticity of demand for labour?

How would the magnitude of this elasticity affect the working of the market for plumbers?

It is the responsiveness of demand for labour to a change in the wage rate. Its formulae is: %QDL %W

Where QDL is the quantity of labour demanded and W is the wage rate.

The less the wage elasticity of demand for plumbers, the more the wage rate will change with any given change in the supply of, or demand for, plumbers. Thus a rise in house building would shift the demand curve for plumbers to the right. The less the wage elasticity of demand for plumbers, the larger will be the rise in the wage rates of plumbers. If high wage rates led to a large increase in the numbers training to be plumbers, then after a time the supply of plumbers will increase. With a wage inelastic demand for plumbers, this will lead to a significant fall in their wage rates.

(Threshold Concept 8) 2. How is the concept of income elasticity of demand relevant in understanding

how the structure of economies changes over the years.

The higher the income elasticity of demand for a particular product, the more will industries that supply it expand over time as national income rises. Conversely, products with a low income elasticity of demand will suffer a relative decline. In cases where income elasticity of demand is negative, this decline will be absolute.

60 Look ahead to Box 3.4 (page 79). It shows the income elasticity of demand for various foodstuffs. Explain the difference in the figures for milk, bread and fresh fish.

Milk can be regarded as an inferior good (which is defined a good whose demand decreases as consumer incomes increase). Inferior goods therefore have a negative income elasticity. According to the figures. Bread and fresh fish, on the other hand, have a positive income elasticity. This means that as income rises, so more of these two products are purchased. (Note that the figures have been corrected to take into account changes in food prices, but there are still dangers in using such figures. They assume that all the other determinants of demand are constant. This may well not be true. For example, consumer tastes for fresh fish may have increased, as it is associated with healthy eating. Likewise there may have been a shift in consumer tastes away from milk as a drink and towards other soft drinks.)

Which are likely to have the highest cross elasticity of demand: two brands of coffee, or coffee and tea? Two brands of coffee, because they are closer substitutes than coffee and tea.

63 In Figures 2.21 and 2.22, the initial change in price was caused by a shift in the demand curve. Redraw these two diagrams to illustrate the situation where the initial change in price was caused by a shift in the supply curve (as would be the case in the wheat market that we have just considered).

See Diagram 2.5(a) and (b) on the next page. 64 Redraw Figures 2.23 and 2.24 assuming, as in the previous question, that the initial change in price was

caused by a shift in the supply curve.

See Diagram 2.5(c) and (d) on the next page.

19

Answers to questions in Economics (6th edition) by John Sloman

Good b

Goo

d a E

xpor

ts

Imports

P2

C2P1C1

I2

I1

Diagram 2.5 Speculation: initial shift in the supply curve

65 (Box 2.6) If speculators believed that the price of cocoa in six months was going to be below the six-month future price quoted today, how would they act?

They would make a future contract to sell cocoa in six months time at the future price quoted today (even though they do not yet have any cocoa to sell!). They hope then to buy cocoa in six months time at the lower (spot) price in order to supply it as agreed. In other words, they buy at the lower spot price and sell at the higher future price. Their profit, after commission, is the difference in price.

66 Give some examples of decisions you have taken recently that were made under conditions of uncertainty.

With hindsight do you think you made the right decisions? An example would be an item you purchased that you had never consumed before: maybe because you

had seen it advertised. You might then subsequently regret the purchase if it does not live up to your expectations. Another example would be a part-time job. Only when you have started doing the job do you find out how onerous it is to do.

20

Chapter 3

Page 70 Draw a supply and demand diagram with the price of labour (the wage rate) on the vertical axis and the

quantity of labour (the number of workers) on the horizontal axis. What will happen to employment if the government raises wages from the equilibrium to some minimum wage above the equilibrium?

The diagram will look like Figure 3.1 in the text. Employment will fall to Qd workers. The supply of workers will rise to Qs. There will thus be unemployment (a surplus of workers) of Qs minus Qd.

71 (Box 3.1) 1. How could housing supplied by the public sector be made to rectify some of the problems we have identified above? (What would it do to the supply curve?)

It would shift the supply of rental accommodation to the right, and thereby reduce the free-market rent; or it would reduce the shortage of accommodation in the case where rents are fixed below the equilibrium.

(Box 3.1) 2. If the government gives poor people rent allowances (i.e. grants), how will this affect the level of rents in an uncontrolled market?

They will increase (the demand for rented accommodation will increase).

(Box 3.1) 3. The case for and against rent controls depends to a large extent on the long-run elasticity of supply. Do you think it will be relatively elastic or inelastic? Give reasons.

Relatively elastic. Below a certain rent, it will not be worth the owners incurring the costs and time of renting out the accommodation. The solution, therefore, to cheap affordable accommodation is to tackle the supply directly: either by public housing or by subsidising or giving tax relief to the private sector.

72 (Box 3.2) 1. What would be the effect on black-market prices of a rise in the official price? Other things being equal, there would probably be a fall in the black-market price. A rise in the official

price would cause an increase in the quantity supplied and a reduction in the quantity demanded and hence less of a shortage. There would therefore be less demand for black-market products.

(Box 3.2) 2. Will a system of low official prices plus a black market be more equitable or less equitable than a system of free markets?

More equitable if the supplies at official prices were distributed fairly (e.g. by some form of rationing). If, however, supplies were allocated on a first-come, first-served basis, then on official markets there would still be inequity between those who are lucky enough or queue long enough to get the product and those who do not get it. Also, the rich will still be able to get the product on the black market!

Think of some examples where the price of a good or service is kept below the equilibrium (e.g. rent controls). In each case consider the advantages and disadvantages of the policy.

Two examples are: Rent controls. Advantages: makes cheap housing available to those who would otherwise have

difficulty in affording reasonable accommodation. Disadvantages: causes a reduction in the supply of private rented accommodation; causes demand to exceed supply and thus some people will be unable to find accommodation.

Tickets for a concert. Advantages: allows the price to be advertised in advance and guarantees a full house; makes seats available to those who could not afford the free-market price. Disadvantages: causes queuing or seats being only available to those booking well in advance.

21

Answers to questions in Economics (6th edition) by John Sloman Page 74 (Looking at the Maths) Assuming that the pre-tax equations were:

QD = 120 10P and QS = 10 + 5P What is (a) the consumer share of the tax and (b) the producer share?

First we find the pre-tax price. This is found by setting the two equations equal to each other:

33.7

1101551010120

==

+=

PP

PP

We now find post-tax price received by producers (P1) and the post-tax price paid by consumers (P1 + t). In the text we saw that:

db

btcaP+

=1

6

5102010120

1

=+

=P

and that the market price is:

81 =+ tP Thus the producers share is: 7.33 6 = 1.33 and the consumers share is: 8 7.33 = 0.67

75 (Box 3.3) 1. If raising the tax rate on cigarettes both raises more revenue and reduces smoking, is there any conflict between the health and revenue objectives of the government?

There may still be a dilemma in terms of the amount by which the tax rate should be raised. To raise the maximum amount of revenue may require only a relatively modest increase in the tax rate. To obtain a large reduction in smoking, however, may require a very large increase in the tax rate. Ultimately, if the tax rate were to be so high as to stop people smoking altogether, there would be no tax revenue at all for the government!

(Box 3.3) 2. You are a government minister; what arguments might you put forward in favour of maximising the revenue from cigarette taxation?

That it is better than putting the taxes on more socially desirable activities. That there is the beneficial spin-off from reducing a harmful activity. (You would conveniently ignore the option of putting up taxes beyond the point that maximises revenue and thus cutting down even more on smoking.)

(Box 3.3) 3. You are a doctor; why might you suggest that smoking should be severely restricted? What methods would you advocate?

That the medical arguments concerning damage to health should take precedence over questions of raising revenue. You would probably advocate using whatever method was most effective in reducing smoking. This would probably include a series of measures from large increases in taxes, to banning advertising, to education campaigns against smoking. You might even go so far as to advocate making smoking tobacco illegal. The problem here, of course, would be in policing the law.

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Chapter 3 Page 75 Supply tends to be more elastic in the long run than in the short run. Assume that a tax is imposed on a

good that was previously untaxed. How will the incidence of this tax change as time passes? How will the incidence be affected if demand too becomes more elastic over time?

As supply becomes more elastic, so output will fall and hence tax revenue will fall. At the same time price will tend to rise and hence the incidence will shift from the producer to the consumer. The situation will move from being more like case (3) to more like case (4) in Figure 3.5 in the text.

As demand becomes more elastic, so this too will lead to a fall in sales. This, however, will have the opposite effect on the incidence of the tax: the burden will tend to shift from the consumer to the producer. The situation will move from being more like case (1) to more like case (2) in Figure 3.5.

77 Schooling is free in state schools in most countries. If parents are given a choice of schools for their

children, there will be a shortage of places at popular schools (the analysis will be the same as in Figures 3.6, with the number of places in a given school measured on the horizontal axis). What methods could be used for dealing with this shortage? What are their relative merits?

Some form of rationing (selection) will have to be applied. This could be done on the basis of ability. If the objective is to have schools that cater for the full range of abilities, then this objective will not be met. If the objective is to recruit the most able children, then selection by ability is consistent with this goal. An alternative is to select by geographical location, with the students living nearer to the school being given preference over those living further away. This is the system used by most state primary and comprehensive schools. It could well disadvantage children with particular needs, however, for whom the school would be particularly suitable. It can also lead to the development of ghetto schools in deprived areas, especially if schools rely for part of their funding on parental contributions. Other methods include the sibling rule, whereby children who have older brothers or sisters already at the school are given preference. This, however, could lead to children living nearer the school being deprived of a place.

Under what circumstances would making a product illegal (a) cause as fall in its price; (b) cause the

quantity sold to fall to zero. (a) Where the shift in demand was greater than the shift in supply (perhaps because of very law abiding

consumers, or where consumers faced harsher penalties than suppliers. (b) Where the penalties were very harsh and the law was strictly enforced, and/or where people were very

law abiding. What are the arguments for and against making the sale of alcoholic drinks illegal? To what extent can an

economist help to resolve the issue? Clearly this involves making normative judgements about how far people should be free to choose their

own lifestyle and how much the state has a responsibility for controlling peoples behaviour that adversely affects other people (or themselves). Benefits of making alcoholic drinks illegal include: a reduction in road accidents and other drink-related accidents; a reduction in drink-related illnesses (and a saving to the nations health budget); a reduction in drink-related anti-social behaviour; more money available to children and other family members in families where there are one or more drinkers. Disadvantages include: curbing an activity that gives many people pleasure; limiting human freedom (freedom to choose what to do, rather than freedom from having to suffer other peoples drunken behaviour); problems of enforcing the law; encouraging the development of criminal activity and the development of an illegal drink underworld (as occurred during the Prohibition in the USA); preventing responsible, moderate drinking (which can have health benefits).

Economists can contribute to the debate by identifying the costs and benefits and measuring many of them (such as the money saved on treating road casualties in drink-related accidents). They cannot, however, make the final moral judgements, since the weighting that should be attached to the costs and benefits is a normative issue.

79 (Box 3.4) 1. The income elasticity of demand for milk is negative (an inferior good). What is the

implication of this for milk producers? Milk producers would expect to earn less as time goes past, given that national income rises over time.

Thus if the incomes of individual milk producers are to be protected, production should be reduced (with some dairy farmers switching to other foodstuffs or away from food production altogether).

23

Answers to questions in Economics (6th edition) by John Sloman Page 79 (Box 3.4) 2. Why do pork and lamb have relatively high price elasticities of demand compared with the

other foodstuffs in the table? What are the implications of this for the relative stability or instability of the prices of pork and lamb compared with other foodstuffs?

They have relatively high price elasticities of demand because they are relatively close substitutes for each other and for other meats. Shifts in supply of a particular meat will have a relatively small effect on price. This suggests that their prices would be more stable than those of other broader categories of foodstuff, assuming similar variations in supply. If the supply of all meats are affected, however, there will be a greater effect on the price of each of the meats, since the demand for meat as a whole (as opposed to a particular type of meat) is relatively price inelastic.

If, however, we compare them with narrower categories of other foodstuffs (e.g. a particular type of vegetable), which therefore themselves have more substitutes and hence have a higher price elasticity of demand, then the prices of the meats might not expected to be more stable. If, however, particular crops vary more in supply than the output of particular meats, then the price of meats would be more stable, even if the price elasticity of demand were no different from that of particular crops.

Why is the supply curve drawn as a vertical straight line in Figure 3.8? Because, in the short run, the supply of food is virtually fixed. Once a crop is grown and harvested, then it

is of a fixed amount. (In practice, the timing of releasing crops on to the market can vary, given that many crops can be stored. This does allow some variation of supply with price.)

Why dont farmers benefit from a high income elasticity of demand for convenience foods? Because most of the increased expenditure goes on value added in the processing, not on the basic food

content. Thus it is the food processors who get the benefit, not the farmers.

80 (Box 3.5) 1. Can you think of any other (non-farming) examples of the fallacy of composition? Two examples are: People standing to get a better view at a concert. When one person does this, then that person will get

a better view. When everyone does it, there is no gain. In fact, there is a net loss, because people would presumably prefer to sit than stand!

If one person gets a pay increase 5 per cent above the current rate of inflation, he or she will be 5 per cent better off (assuming no change in the rate of inflation). If everyone gets a pay increase 5 per cent above the current rate of inflation, then that will drive the rate of inflation up. People will not be 5 per cent better off.

(Box 3.5) 2. Would the above arguments apply in the case of foodstuffs that can be imported as well as being produced at home?

In the case of a foodstuff that can be imported, the demand curve for the domestically produced foodstuff would be more elastic (given that the imports are a substitute). Thus a good domestic harvest may only depress the price slightly, with consumers merely switching from the imported to home-grown food. Thus producers would gain from a good harvest (their incomes would rise if elasticity was greater than one).

If, however, the good harvest were world-wide, so that total world supply of the product increased, then the problem would still occur if the overall demand (for home-grown plus imported food) were inelastic.

82 The total amount paid in subsidies is greater in Figure 3.11 than in Figure 3.12. Will it always be the case

that for a given after-subsidy price to the farmer (Pg), a greater amount will be paid out in subsidies if the country is self-sufficient in the foodstuff than if it has to import part of the total amount consumed? (Assume that the demand curve is the same in both cases.)

Yes. The free-market domestic price will not be above the world price. If it were (temporarily), then the foodstuff would be imported, pushing the price back down to the world price. Thus the height of the green

24

Chapter 3

rectangle in Figure 3.11, cannot be less than that in Figure 3.12. But the width of the green rectangle in Figure 3.11 must be greater than that in Figure 3.12 (given that part of the demand in Figure 3.12 is supplied from imports). Thus the area of the rectangle in Figure 3.11 must be bigger than that in Figure 3.12. Thus more is paid out in subsidy in the case where the country is self-sufficient (assuming the demand curve is the same).

82 What will be the amount paid out in Figure 3.14 if instead of the government buying the surpluses, export subsidies were given to farmers so as to guarantee them a price (plus subsidy) of Pmin?

The same as when the government sells the surpluses on the world market, namely the rectangle edcf. With a guaranteed price of Pmin from exporting, farmers will produce Qs2. The farmers will therefore only be prepared to supply domestic consumers at that same price (otherwise it would be more profitable to export). Thus domestic consumers buy Qd2. Thus Qs2 Qd2 is exported at a subsidy per unit of Pmin Pw.

83 Compare the relative merits of (a) quotas on output, (b) limits to the amount of land used for a particular product and (c) farmers being required to take land out of food production.

All these methods will restrict supply and thus help to raise the free-market price and thereby eliminate (or reduce) the need for having a minimum price above the equilibrium.

(a) Quotas have the advantage of being a direct limitation on output (as opposed to land) and will thus lead to a more stable supply than with the other two methods. They could, however, prevent efficient farmers expanding, unless farmers quotas could be sold to other farmers (as has happened with dairy quotas in the EU).

(b) This can allow land to be reallocated to some alternative use (e.g. recreational, forestry or growing a different crop). It could, however, lead to a lower reduction in output than planned because of less productive land being taken out of use, rather than more productive land (although this could be seen as an efficient use of land).

(c) This is similar to (b), but has the problem of being less focused. For example, if there is a surplus of one particular crop, it does not make sense to prevent farmers producing other crops (which are not in surplus) on their land. It could lead to a neglect of the land taken out of use (with problems of weeds, etc.). On the other hand, it could help prevent the extinction of various natural species.

86 Does the requirement to set aside 5 per cent of land reduce output by 5 per cent? Probably not. Farmers may well attempt to increase output on their remaining land or attempt to set aside

the poorest quality land.

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Chapter 4 Page 92 1. Do you ever purchase things irrationally? If so, what are they and why is your behaviour irrational? A good example is things you purchase impulsively, when in fact you do have time to reflect on whether

you really want them. It is not a question of ignorance but a lack of care. Your behaviour is irrational because the marginal benefit of a bit of extra care would exceed the marginal effort involved.

2. If you buy something in the shop on the corner when you know that the same item could have been bought more cheaply two miles up the road in the supermarket, is your behaviour irrational? Explain.

Not necessarily. If you could not have anticipated wanting the item and if it would cost you time and effort and maybe money (e.g. petrol) to go to the supermarket, then your behaviour is rational. Your behaviour a few days previously would have be irrational, however, if, when making out your weekly shopping list for the supermarket, a moments thought could have saved you having to make the subsequent trip to the shop on the corner.

93 Are there any goods or services where consumers do not experience diminishing marginal utility? Virtually none, if the time period is short enough. If, however, we are referring to a long time period, such

as a year, then initially as more of an item is consumed people may start getting more of a taste for it and thus experience increasing marginal utility. But even with such items, eventually, as consumption increases, diminishing marginal utility will be experienced.

94 If Darren were to consume more and more crisps would his total utility ever (a) fall to zero; (b) become negative? Explain.

Yes, both. If he went on eating more and more, eventually he would feel more dissatisfied than if he had never eaten any in the first place. He might actually be physically sick!

(Box 4.1) Complete this table to the level of consumption at which TU is at a maximum.

Q 60Q 4Q2 = TU

1 60 4 = 56

2 120 16 = 104

3 180 36 = 144

4 240 64 = 176

5 300 100 = 200

6 360 144 = 216

7 420 196 = 224

8 480 256 = 224

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Chapter 4 Page 94 (Box 4.1) Derive the MU function from the following TU function: TU = 200Q 25Q + Q From this MU function, draw up a table (like the one above) up to the level of Q where MU becomes

negative. Graph these figures. MU = dTU/dQ = 200 50Q + 3Q

Q 200 50Q + 3Q2 = MU

1 200 50 + 3 = 153

2 200 100 + 12 = 112

3 200 150 + 27 = 77

4 200 200 + 48 = 48

5 200 250 + 75 = 25

6 200 300 + 108 = 8

7 200 350 + 147 = 3

96 If a good were free, why would total consumer surplus equal total utility? What would be the level of marginal utility?

Because there would be no expenditure. At the point of maximum consumer surplus, marginal utility would be equal to zero, since if P = 0, and MU = P, then MU = 0.

Why do we get less consumer surplus from goods where our demand is relatively elastic? Because we would not be prepared to pay such a high price for them. If price went up, we would more

readily switch to alternative products. How would marginal utility and market demand be affected by a rise in the price of a complementary

good? Marginal utility and market demand would

fall (shift to the left). The rise in the price of the complement would cause less of it to be consumed. This would therefore reduce the marginal utility of the other good. For example, if the price of lettuce goes up and as a result we consume less lettuce, the marginal utility of mayonnaise will fall.

97 (Box 4.2) The diagram illustrates a persons

MU curves of water and diamonds. Assume that diamonds are more expensive than water. Show how the MU of diamonds will be greater than the MU of water. Show also how the TU of diamonds will be less than the TU of water.

See Diagram 4.2 opposite.

Diagram 4.1 MU = 200 50Q + 3Q2 -20

0

20

40

60

80

100

120

140

160

180

0 1 2 3 4 5 6 7

MU

MU waterMU diamonds

MU, P

Quantity of waterQuantity of diamonds

Pd

Pw

Qd Qw

Diagram 4.2 MU of water and diamonds

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Answers to questions in Economics (6th edition) by John Sloman Page 99 (Box 4.3) Imagine that you are going out for the evening with a group of friends. How would you decide

where to go? Would this decision-making process be described as rational behaviour? You would probably discuss it and try to reach a consensus view. The benefits to you (and to other group

members) would probably be maximised in this way. Whether these benefits would be seen as purely selfish on the part of the members of the group, or whether people have more genuinely unselfish approach, will depend on the individuals involved.

101 (Threshold Concept 9) 1. What risks are involved in buying a house? That mortgage interest rates may go up; that the price of the house may not rise as rapidly as you thought;

that the house may suffer from some structural defect that you had not known about at the time of purchase; that there may be some accident to the property; that the neighbours may be unpleasant in one way or another. In most of these cases, the problem is largely one of uncertainty rather than risk as the probability of the occurrence and magnitude of these events is not known. Insurance can help here. Insurance companies are likely to be able to assess risks much more accurately than you, and they can spread their risks over a large number of properties where, at least, they can assess the average risk.

(Threshold Concept 9) 2. Give some examples of ways in which it is possible to buy better information. Your answer should suggest that there is profitable business to be made in supplying information.

You could use an estate agent when selling a house, or an employment agency when finding a job. In both cases a charge is made, either to you or to the other party (i.e. the employer in the case of the job). The problem is whether you are always given accurate information. This is known as the principalagent problem and is Key Idea 22 on page 208.

Define risk and uncertainty. Risk: when an outcome may or may not occur, but its probability of occurring is known. Uncertainty: when an outcome may or may not occur and its probability of occurring is not known.

102 Give some examples of gambling (or risk taking in general) where the odds are (a) unfavourable; (b) fair; (c) favourable.

(a) Betting on the horses; firms launching a new product in a market that is already virtually saturated and where the firm does not bother to advertise.

(b) Gambling on a private game of cards which is a game of pure chance; deciding which of two alternative brands to buy when they both cost the same and you have no idea which you will like the best.

(c) The buying and selling of shares on the stock exchange by dealers who are skilled in predicting share price movements; not taking an umbrella when the forecast is that it will not rain (weather forecasts are right more often than they are wrong!); an employer taking on a new manager who has excellent references.

(Note that in the cases of (a) and (c) the actual odds may not be known, only that they are unfavourable or favourable.)

Which gamble would you be more likely to accept, a 60:40 chance of gaining or losing 10 000, or a 40:60 chance of gaining or losing 1? Explain why.

Most people would probably prefer the 40:60 chance of gaining or losing 1. The reason is that, given the diminishing marginal utility of income, the benefit of gaining 10 000 may be considerably less than the costs of losing 10 000, and this may be more than enough to deter people, despite the fact that the chances of winning are 60:40.

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Chapter 4 Page 102 Do you think that this provides a moral argument for redistributing income from the rich to the poor?

Does it prove that income should be so redistributed? Arguments like this are frequently used to justify redistributing income and form part of peoples moral

code. Most people would argue that the rich ought to pay more in taxes than the poor and that the poor ought to receive more state benefits than the rich. The argument is frequently expressed in terms of a pound being worth more to a poor person than a rich person. It does not prove that income should be so redistributed, however, unless you argue (a) that the government ought to increase total utility in society and (b) that it is possible to compare the utility gained by poor people with that lost by rich people something that is virtually impossible to do.

103 If people are generally risk averse, why do so many people around the world take part in national

lotteries? Because the cost of taking part is so little, that they do not regard it as a sacrifice. They also are likely to

take a hopeful view (i.e. not based on the true odds) on their chances of winning. What is more, the act of taking part itself gives pleasure. Thus the behaviour can still be classed as rational: i.e. one where the perceived marginal benefit of the gamble exceeds the marginal cost.

104 (Box 4.5) What details does an insurance company require to know before it will insure a person to drive

a car? Age; sex; occupation; accident record; number of years that a licence has been held; motoring convictions;

model and value of the car; age of the car; details of other drivers. (Box 4.5) How will the following reduce moral hazard? (a) A no-claims bonus. (b) You having to pay the first so many pounds of any claim. (c) Offering lower premiums to those less likely to claim (e.g. lower house contents premiums for those

with burglar alarms). In the case of (a) and (b) people will be more careful as they would incur a financial loss if the event they

were insured against occurred (loss of no-claims bonus; paying the first so much of the claim). In the case of (c) it distinguishes people more accurately according to risk. It encourages people to move into the category of those less likely to claim (but it does not make people more careful within a category: e.g. those with burglar alarms may be less inclined to turn them on if they are well insured!).

1. Why are insurance companies unwilling to provide insurance against losses arising from war or civil insurrection?

Because the risks are not independent. If family A has its house bombed, it is more likely that family B will too.

2. Name some other events where it would be impossible to obtain insurance. Against losses on the stock market; against crop losses resulting from drought.

107 Although indifference curves will normally be bowed in toward the origin, on odd occasions they might not be. Which of the diagrams correspond to which of the following?

(a) X and Y are left shoes and right shoes. (b) X and Y are two brands of the same product, and the consumer cannot tell them apart. (c) X is a good but Y is a bad like household refuse. (a) Diagram (ii). An additional left shoe will give no extra utility without an additional right shoe to go

with it! (b) Diagram (i). The consumer is prepared to go on giving up one unit of one brand provided that it is

replaced by one unit of the other brand. (c) Diagram (iii). If consumers are to be persuaded to put up with more of the bad, they must have more

of the good to compensate.

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Answers to questions in Economics (6th edition) by John Sloman Page 107 Draw another two indifference curves on Figure 4.6, one outward from and one inward from the original

curve. Read off various combinations of pears and oranges along the