Hong Kong Polytechnic University

School of Accounting and Finance

AF1605
INTRODUCTION TO
ECONOMICS

Problem Set Questions

Second Semester 2019/20

Topic 1 The Scope of Economic Analysis

1.1 “According to the definition of opportunity cost, the more alternatives that we have given up
in undertaking an action, the higher the opportunity cost.” Please make a critical comment
on this statement and explain your answers using examples.

1.2 Consider the following customers of a Japanese sushi restaurant. Their total benefit (TB)
measured in terms of the maximum amount of money they are willing to pay for n dishes are
given below.

Total Benefit ($)

Dish of sushi Customer A Customer B Customer C
0 0 0 0
1 50 60 30
2 90 90 55
3 120 115 65
4 145 125 70
5 160 120 55
6 165 110 40
7 160 95 20
8 140 70 0
As postulated in economics, customers are maximizing their economic surpluses. One can
decide not to dine in this Japanese restaurant and get zero economic surplus.
(a) The sushi restaurant is now charging customers $20 per dish. How many dishes do the
three customers choose to buy under this pricing arrangement respectively? Use both
total and marginal approach to solve the problem. Show your steps.
(b) Now the sushi restaurant changes its pricing policy. Now they charge each customer
$100 and let them order as much as they want. Will these three customers continue to
dine in this restaurant? If so, how many dishes would they choose to buy? Show your
calculations.
(c) A student think that “for those who would order fewer than 5 dishes of sushi, his average
price per dish he needs to pay is higher in the scheme in part (b) than in that of part (a),
so he will order fewer dishes in the scheme in part (b).” Critically comment on this
statement.

1.3 Your good friend asks you to go with her to a concert tonight. But you have already
scheduled to give a tuition lesson to a secondary school student and you cannot reschedule
the lesson to another time. To go to the concert, you will have to cancel the lesson, from
which you could earn $250. To go with your friend to the concert, you will have to pay $500
for the ticket and spend $120 eating dinner with her at a nice restaurant. To ensure there is
enough time to have dinner before the concert and return home not too late, you will have
to take a taxi to the restaurant, which is right next to the concert hall, and then back home
after the concert. The two taxi rides will cost you a total of $60. If you go to the tuition lesson
as usual, you will spend only $40 on your dinner and you can walk to your student’s home.
What is the opportunity cost of going out with your good friend tonight?

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1.4 A (very, very small) country produces milk and shirts and its production possibilities frontier
is stated in the table below.

a) Suppose the nation is currently producing at point B. What is the opportunity cost of two
additional gallons of milk? How about at point C? and at point D? Does the opportunity cost
increase, decrease or keep constant along the PPF when more gallons of milk are produced?
What is the economic reason behind?

b) Suppose the nation is initially producing 4 gallons of milk and 40 shirts. What is the opportunity
cost of 2 additional gallons of milk? Explain your answer.

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Topic 2 The Price Mechanism: Demand, Supply and Market

2.1 Answer the following questions using demand-supply diagrams.

a) What will happen to the equilibrium price and quantity of apples if the wage paid to apple
pickers rises? Explain your answer.

b) Under the African swine fever, many pigs have died or killed without the pork supplied to the
market. How would it affect equilibrium price and quantity for pork chop noodles in restaurants?
Explain your answer.

c) Suppose that there is a medical report suggesting that eating mutton helps to prevent cancer
and the majority of people believe in it. Explain how this event may affect the equilibrium prices
of mutton and wool?

d) There is a technological advance that reduces the costs of producing digital cameras. What
will be the effect of this event on the equilibrium price and quantity of digital cameras? Explain
your answer.

2.2 a) Illustrate by example the meaning of complement in consumption.

b) Illustrate by example the meaning of substitute in production.

c) Suppose product A and product B are complements in consumption, product A and product C
are substitutes in production, and product B and product C are not related to each other. The
demand curves of these three products are downward sloping and the supply curves of these
three products are upward sloping. Explain with a demand-supply diagram the effects to the
equilibrium price and equilibrium quantity of product A if the government imposes a unit-tax to
the suppliers on the production of product B and product C.

2.3 Consider a competitive market with the following equations of demand (D) and supply (S).
D0: P = 60 – ½Qd
S0: P = 20 + ½Qs
a) If this market has 1,000 consumers with identical individual demand curve, what is the equation
of the demand curve of each of these consumers? [Hint: Denote the quantity demanded by
each consumer by qd.]
b) Derive the equilibrium price (P0) and quantity (Q0) in this market.
c) If the demand equation becomes D1: P = 80 – ½Qd while the supply remains as S0, propose
and briefly explain two possible reasons that can lead to such a change. Derive the equilibrium
price (P1) and quantity (Q1).
d) If the supply equation becomes S2: P = 40 + ½Qs while the demand remains to be D0, propose
and briefly explain two possible reasons that can lead to such a change. Derive the equilibrium
price (P2) and quantity (Q2).

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 Topic 3 Elasticity of Demand

3.1 Consider two goods A and B that have the same supply curve and the same equilibrium
price and quantity as shown in the following diagram.

a) What is the formula to derive the price elasticity of demand? Explain why you can determine
which of the goods (A or B) in the diagram faces a more elastic demand by comparing the
slopes of the demand curves at the equilibrium price.

b) Suppose a per-unit tax of $5 is imposed on both A and B. How will the per-unit tax affect the
market equilibrium price and quantity of A and B?

c) From which good can the government collect more tax revenue? Explain your answer clearly
with necessary illustration in the given diagram. [Hint: Do not draw two diagrams.]

d) Which group of consumers (A or B) will bear a larger proportion of the tax burden? Explain
your answer clearly with necessary illustration in the given diagram. [Hint: Do not draw two
diagrams and state the calculation of share of tax burden.]

3.2 a) “The agricultural product market will automatically provide insurance to the farmers when there
is a bad harvest.” Explain whether you agree with the above statement with the help of a
diagram. [Hint: Assume demand does not change and compare demand and supply.]

b) “Farmers should be happy in the season with a good harvest as they are able to earn a larger
revenue.” Please make a critical comment on this statement. [Hint: Consider the change in
price and its relationship with revenue and elasticity of demand.]

3.3 a) Explain why the cross elasticity of demand for substitute goods is positive and the cross
elasticity of demand for complements is negative.

b) How are the cross elasticity of demand and income elasticity of demand similar and how are
they different from the price elasticity of demand?

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Topic 4 Production and Cost

4.1 Mr. Wong is the owner of a Chinese restaurant. The quantity of equipment used in his restaurant
is fixed. He observed the following decrease in daily output of dim sum when some cooks are
absent from work due to sickness:

Number of sick cook(s) absent from Decrease in daily output

work (units of dim sum)
1 40
2 90
3 150
4 220
5 300

a) Is Mr. Wong’s restaurant operating in the short run and why?

b) Is law of diminishing returns illustrated in Mr. Wong’s restaurant? [Hint: Suppose the firm
employs 5 cooks, and the total product is 300 units of dim sum per day. Observe the change
in marginal product when more cooks are added.] Show your calculations.

c) The following list shows some of the cost items of Mr. Wong’s restaurant:

• Business registration fee • Electricity charge

• Wages of cooks • Water charge
• Fire insurance premium • Commercial telephone line charge

Identify the fixed cost(s) and variable cost(s) in the above list and provide explanation for your
answers.

4.2 Dr. Sze starts his own dental practice after quitting his $150,000/per year job at The ABC
Dental Clinic. His revenues in the coming year are $500,000. He paid $90,000 in rent for the
dental office, $60,000 for his office manager's salary, $24,000 for the dental hygienist,
$150,000 for insurance, and $6,000 for other miscellaneous costs.

Dr. Sze also needs to buy an equipment which costs him $300,000. In the first year, the value
of the equipment will decrease by 20%, which is also the accounting rule used for the
depreciation of this machine.

To finance the initial investment and operating costs, Dr. Sze has to use his saving of
$200,000, from which he could earn an interest of 1 percent in the coming year. He also has
to borrow $400,000 at 2.5 percent from a bank in the coming year [Assume he can recover
these amounts whenever he decides to terminate this business.]

Considering the risk involved, he believes he can earn a $20,000 extra return for any
alternative investment similar to this type of investment.

a) What are the explicit and implicit costs of Dr. Sze’s dental practice in the coming year?

b) What are the accounting profit and economic profit of Dr. Sze’s dental practice in the coming
year?

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4.3 The owner of a large department store currently only allows his customers to pay by cash
but not by electronic debit card. Under the current cash system, a cashier can handle an
average of 60 transactions per hour. The department store currently has an average of 1,440
transactions per hour and employs 24 cashiers. Each cashier is paid $36 per hour. The fixed
cost of the current cash system is zero.

a) What is the average total cost (ATC) of processing a transaction under the current cash
system?

The owner is considering accepting his customers to pay by electronic debit cards. The
electronic debit card system enables his cashiers to handle an average of 80 transactions
per hour such that he is only required to employ 18 cashiers under the current sales level of
1,440 transactions per hour. However, the owner has to pay a fixed cost of $180 per hour
for the operation of the electronic debit card system.

b) Explain whether the owner should shift to use the electronic debit card system at the sales
level of 1,440 transactions per hour. [Hint: Calculate ATC for answering this question.]

c) Suppose a new competitor is expected to open in the same area and the owner of the
department store estimates his sales level to reduce to 960 transactions per hour. Explain
whether the owner should shift to use the electronic debit card system or remain to use the
current cash system at the expected sales level of 960 transactions per hour. [Hint: Calculate
ATC for answering this question.]

d) Calculate the expected sales level such that the owner is indifferent between the cash
system and the electronic debit card system. [Hint: Use ATC for your calculation.]

e) Use an appropriate diagram to show the ATC curve of the cash system and the ATC curve of
the electronic debit card system. How does it relate to the answers to part (a) to (d) of this
question? [Note: Use the vertical axis to show the ATC and the horizontal axis to show the
sales level (or number of transactions).]

f) Explain how we can apply the relationship between short run and long run average cost
curves in this situation. Draw the long run cost curve on the diagram for part (e).

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Topic 5 Market Structure

5.1 Suppose the poultry industry in country X is perfectly competitive with the supply of chickens
coming from both domestic farms and farms located in the neighboring country Y. The
industry is greatly disturbed by the threat of bird flu which is a deadly disease spreading
among chickens.

a) The threat of bird flu reduces consumers’ demand for chickens. Explain how the market
equilibrium price and quantity are affected in the short run assuming other things being equal.

b) The government of country X forbids the import of chickens from country Y in order to prevent
the spreading of bird flu. Explain how the output level of a typical domestic farm is affected in
the short run assuming that there is no change in the demand for chickens since the chicken
sold in the market are healthy.

c) The government of country X requires both domestic farms and farms in country Y to install
new facilities to raise their hygiene standard. The installation of these new facilities will
increase the farms’ average cost but has no effect on the marginal cost. Explain how the
market equilibrium price, market equilibrium quantity, and output level of a typical domestic
farm are affected in the long run assuming that there is no change in the demand for chickens.

5.2 In a large economics class of 400 students, each student would buy either one copy of the
textbook or would not buy it. Students with different reservation prices for the textbook can
be grouped as below:
Group Reservation Price ($) Number of students in
the group
A 550 40
B 500 50
C 450 60
D 400 60
E 350 60
F 300 50
G 250 40
H 200 40
There are also a few sellers who are willing to sell the textbook at or above the following
prices. The sellers are price takers.
Seller Reservation Price ($) Number of copies it sells
I 250 100
II 300 100
III 350 70
IV 400 50
V 450 100

(a) What are the possible factors that would affect each student’s reservation price?
(b) What are the equilibrium price and quantity of the textbook?
(c) What are the consumer surplus and producer surplus in this equilibrium?
(d) To encourage students to buy the textbook, a subsidy of $100 is given to the students
who buy the textbook. What are the equilibrium price and quantity after the subsidy is
imposed? (Note: the market price is the price paid by students including the subsidy.)
(e) Following part (d), if there is indeed no externalities, is there any deadweight loss? If so,
how much is the deadweight loss?

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 5.3 ABC Electric is the only company that provides electricity in City X. The market demand
for electricity in City X is given by P = 30 – Q. The marginal cost function for ABC Electric
to generate electricity is MC = Q. [Note: If the demand curve is P = a – b Q, then the
MR curve is MR = a – 2b Q.]

a) Draw a clearly labelled diagram including the market demand curve, the MR curve and the
MC curve for the monopolist.

b) Calculate profit-maximizing price (PM) and quantity (QM). Show PM and QM in the diagram for
part (a).

c) Label in the diagram the consumer surplus (CS) and producer surplus (PS) for the monopoly
and calculate their values.

d) Explain why the monopolist is allocative inefficient. Is there any deadweight loss (DWL)? If
so, label it in the diagram and calculate its value.

e) Is there enough information for us to calculate the profit? If so, how much is the profit? Explain.

5.4 Ms. Wong is a fitness trainer providing personal fitness training course to her customers.
She can be taken as a monopoly in providing her unique way of training. The following
table shows her customers’ maximum price willing to pay for her weekly one-hour
training course in two centers at Tsim Sha Tsui (TST) and Tai Po (TP) respectively. The
rental cost of the center is fixed at $200 in total for Ms. Wong, while for each hour of
course given, she needs to give up her work as a piano teacher that earns $290 per
hour. Assume no other costs for simplicity.
Customer Center Maximum Price Willing to Pay($)
A TST 400
B TST 390
C TST 380
D TST 370
E TP 360
F TST 350
G TP 340
H TP 330
I TST 320
J TP 310
K TP 300
L TST 290
M TP 280
N TP 270

(a) Suppose Ms. Wong charges one single price to all of her customers. What is the
profit maximizing price she has to charge? What is the amount of her economic profit?
S`how your calculation.
(b) Suppose Ms. Wong knows that customers who go to different centers are likely to
have different maximum price they are willing to pay on average. Therefore, she
plans to charge one single price to customers in TST center and another single price
to customers in TP center. What is the profit maximizing price for the TST customers
and TP customers respectively? Will she serve more customers in this case? Can
she earn more in total than charging a single price? Show your calculations.
(c) Is the pricing strategy in part (b) likely to be successful? Why?
(d) If Ms. Wong is able to carry out perfect price discrimination, how many customers
will she serve? How large is the profit? In this context, what will make it more
plausible?

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5.5 Consider that the two companies Moonbucks and Atlantic Coffee form a duopoly in the
freshly brewed coffee market in a university a distance away from the city center. Let QA
and QB be the number of cups of coffee Moonbucks and Atlantic Coffee sold a day
respectively. The market demand curve if the freshly brewed coffee is given by
𝑃 = 50 − 0.1(𝑄* + 𝑄, ) = 50 − 0.1𝑄

The cost function for Moonbucks is given by 𝑇𝐶* (𝑄* ) = 8𝑄* and similarly the cost
function for Atlantic Coffee is also given by 𝑇𝐶, (𝑄, ) = 8𝑄, . Moonbucks and Atlantic
Coffee each can choose a high output level of 140 cups a day, or a low output level of
105 cups a day.

(a) Complete the following table about the market quantity supplied (Q) and the price
(P) that a cup of coffee can be sold under each possible scenario.
Atlantic Coffee
QB = 105 QB = 140
Moonbucks QA = 105 (Q = ,P= ) (Q = ,P= )
QA = 140 (Q = ,P= ) (Q = ,P= )

(b) The payoff of each company is the profit they can earn each day. Complete the
following payoff matrix about the payoff of each firm.
Atlanctic Coffee
QB = 105 QB = 140
Moonbucks QA = 105 (πA = , πB = ) (πA = , πB = )
QA = 140 (πA = , πB = ) (πA = , πB = )
(Hint: As usual, profit for each firm is equal to its total revenue minus its total cost.)

(c) Find the Nash Equilibrium. Show your reasoning.

(d) Is it likely to be successful for them to collude to produce less output and earn a
higher profit together? Explain using the logic of game theory.

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Topic 6 Market Failure

6.1 After students skipped their lunch, they are hungry and can be disruptive and inattentive in
class. In order to remedy the situation, suppose the government provides vouchers for
school to provide lunch to students.

a) Discuss how the positive consumption externalities arise. In particular, who create(s) the
externalities and who benefit from them.

b) Consider the diagram below. Indicate the unregulated market quantity, the price of per
school lunch under this quantity and the efficient quantity of lunches. Is there under-
consumption in the unregulated market?

c) What is the dollar value of a voucher necessary to move the economy to the efficient number
of lunches?

d) When vouchers are used, what is the dollar price of the lunch that suppliers receive and
what is the dollar price that consumers pay?

6.2 a) Discuss the validity (i.e., whether it is true or false) of the following statement in economic
sense.

"Robinson Crusoe, the sole inhabitant of "Shangri-La" Island, fishes in a river for food. At the
same time he pollutes the river and kills the fish by bathing in it every day. Clearly, Crusoe
has created a negative externality."

b) Explain the meaning of "non-excludable" and " non-rival".

c) Explain whether each of the following products are non-excludable and non-rival:

(i) Fish in the ocean

(ii) Apps (the application software) installed in smart phones

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6.3 Suppose there are 30 companies in a commercial building. Initially there is no fire sprinkler
system in the public area of the building. The companies have identical individual demand
curve for the fire sprinklers which is given by the equation: P = 10 - 0.5 Q, where P is the
price of fire sprinkler and Q is the quantity of fire sprinkler.

a) Explain why the fire sprinkler system can be considered as a public good. (Hint: try to explain
beyond repeating the definitions.)

b) Suppose each fire sprinkler costs $40. What is the optimal quantity of fire sprinklers to be
installed? (Hint: calculate and explain the social marginal benefit function of the fire
sprinklers.)

c) Explain why it is difficult for this commercial building to install the optimal quantity of fire
sprinklers if there is no central party to coordinate the installation.

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Topic 7 Nature of Macroeconomics and Measurement of Macroeconomic Performance

7.1 Country T produces rice and vegetable and imports pork. The following table shows the price
and quantity of the production and imports in 2017 and 2018. In both years, Country T exports
half of the vegetable produced to Country S. All the imports and outputs without being exported
are for consumption within Country T. (For simplicity, no capital investment and no government
expenditure are involved in this country.) Use 2017 as the base year.

2017 2018
Price ($/kg) Quantity (billion kg) Price ($/kg) Quantity (billion kg)
Produced
Rice 10 50 11 55
Vegetable 10 40 10.5 45
Imported
Pork 10 22 9 25

(a) Calculate the growth rates of real and nominal GDP of Country T for 2018 over 2017.
Why are they different?

(b) Calculate the GDP deflator of Country T for 2018.

(c) Calculate the size of each component under the expenditure approach for Country T
in 2018 at current market prices. (Hint: Some components may be zero. Also, make
sure that they add up to the nominal GDP you have calculated in part (a).)

(d) Calculate the consumer price index (CPI) for Country T using 2017 as the base year.
Why is it different from the GDP deflator calculated in part (b)?

7.2 a) A Chinese-owned ice-cream parlour located in the U.S. has the following accounting record
related to its business during 2018:

Total sales revenue $2,400

Total costs include the following items:
Wages paid to U.S. workers $500
Wages paid to Chinese workers $300
Interest paid to a U.S. bank $100
Rent paid to a U.S. landlord $600
Costs on raw materials imported from Australia $600
Total costs $2,100

(i) What was the value of U.S. GDP contributed by this firm using the expenditure approach?
Which component(s) of the expenditure approach was involved?

(ii) What was the value of U.S. GDP contributed by this firm using the income approach?
Which component(s) of the income approach was involved?

(iii) What was the value of U.S. GDP contributed by this firm using the output approach?

(iv) What was the value of this firm’s contribution to the Chinese GNP?

b) If a Japanese tourist drinks German beer in a hotel in New York City, how will the U.S. GDP
be affected? Give your answer using both the expenditure approach and the output approach.

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7.3 Country X produces only two final products in 2016: canned salmon fish and truck. The
production processes of these two products during the year are described as follows:

Production of canned salmon fish:

Output Market Required Market value of

Stage of Output produced Value of intermediate intermediate
production produced by output input input

Fresh Local $5
First salmon fishermen million None Zero
fish

Canned Local $7 Fresh

Final salmon factory million salmon fish $5 million
fish

Production of truck:

Output Market Required Market value of

Stage of Output produced value of intermediate intermediate
production produced by output input input

Factory
First Engine located in $4 None zero
foreign million
country

Final Truck Local $12 Engine $4 million

factory million

During 2016 half of the output of canned salmon fish has been purchased by local
households and the other half purchased by foreigners. One-third of the output of truck has
been purchased by local firms, another one-third purchased by government and the
remaining one-third unsold.

a) Discuss how each of the four products (i.e., fresh salmon fish, canned salmon fish, engine
and truck) mentioned in the above table contributes to Country X’s GDP under the output
approach of national income accounting. What is the value of GDP under the output
approach?

b) Discuss how Country X’s GDP in 2016 would be recorded using the expenditure approach
of national income accounting. You have to give explanation for each of the relevant
products and expenditure categories.

c) Suppose the factory which produces engine earns a profit of $0.8 million in 2016 and half
of this factory is owned by the citizens of Country X. Calculate the GNP of Country X.

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Topic 8 Spending and Output in the Short Run

8.1 Explain the errors of the following arguments made by an economics student:

a) “The textbook said that a higher interest rate lowers investment, but that doesn’t make sense.
I know that if I can get a higher interest rate, I am certainly going to invest more in my savings
account.”

b) “The newspaper said that the recent recession was caused by a decline in investment. This
can’t be true. If there had just been a decline in investment, the only firms hurt would have
been construction firms and other firms selling investment goods. In fact, many firms
experienced falling sales during that recession, including department stores and firms selling
consumer electronic products.”

8.2 Company A in country X is considering the investment in a project with the following
(estimated) cost and benefit. The project has a life of 3 years and has zero value after the
third year.

Period (year) 0 1 2 3
Cost of investment ($ million) 11.70 - - -
Profits ($ million) - 2.5 4.5 6.0

a) Suppose in year 0 Company A could borrow or lend at an annual interest rate of 4%.
Explain clearly with calculation whether Company A will invest in this project.

b) Based on your answer in part (a) explain how an increase in interest rate to 5% will affect
Company A’s investment decision.

c) There is a concern about the unemployment problem in country X and the lack of
investment demand is regarded as one of the major reasons of unemployment. Suppose
other firms in country X will be affected in the same way as Company A as described in
part (a) and (b) above. Use the Keynesian model to explain the process of how a change
in interest rate may help to solve the unemployment problem.

8.3 Consider the following Keynesian model:

Consumption: C = 200 + 0.7Yd
Lump-sum tax: T0 = 50
Proportional Tax Rate: t = 0.2
Government Expenditure: G = 435
Planned Investment: I = 300
Exports: X = 100
Imports: M = 0.06Y
Yd: Disposable Income
Numbers are in billion dollars.

Disposable Planned Government

Output income Consumption Investment expenditure Export Import
(Y) (Yd) (C) (Ip) (G) (X) (M) PAE
1500
1750
2000
2250
2500

a) Each row corresponds to one possible output level. Fill in the remaining columns of the table
given the equations given above.

b) What is the equilibrium output level of this economy?

c) What is the level of unplanned investment at the output level of 1500 and at the level of
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 2500? If it is not in equilibrium, describe how the economy would adjust to the equilibrium
in each case.

d) What is the change of equilibrium output when government expenditure increases to 560?
Explain your steps. What kind of policy is it?

e) If investment decreased to 175 billion dollars under policy uncertainty, how does it change
the equilibrium output level? Is the change in equilibrium output larger than the change in
investment? Why?

f) What factors would affect the size of expenditure multiplier? Briefly explain.

8.4 Suppose you are the government’s chief economist of country X and after careful investigation
you discover the following economic data apply to your country:

Autonomous consumption = $120 billion

Marginal propensity to consume (MPC) = 0.6
Autonomous investment = $80 billion
Autonomous government spending = $90 billion
Lump sum tax = $100 billion
Proportional tax rate = 0.15
Autonomous exports = $40 billion
Marginal propensity to import (MPM) = 0.01

You also know that the output of country X is currently at $500 billion.

a) Is the economy currently in equilibrium? Why?

Now, the economy has adjusted to the equilibrium output level.

b) Suppose the potential output of country X is $600 billion, what is the level of output gap?

c) Suppose the government would like to bring the equilibrium output level to the potential
output level by fiscal policy through increasing the amount of government expenditure,
calculate the required amount of stimulus.

d) Suppose you know that autonomous investment will be changed by $10 billion when interest
rate is changed by 1%, explain the direction and magnitude of changes in interest rate for
country X in order to reach potential output level at equilibrium.

e) Suppose the people in country X prefer to purchase more foreign goods such that there is an
increase in marginal propensity to import, explain how such change in preference affects the
multiplier effect. (Note: try to explain both in terms of expression for the multiplier and also in
terms of economic reasoning.)

f) Suppose the people in country X prefer to save more under a bigger risk of recession such
that there is a decrease in marginal propensity to consume, explain how such change in
preference affects the multiplier effect. (Note: try to explain both in terms of expression for the
multiplier and also in terms of economic reasoning.)

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Topic 9 Money and Banking

9.1 During World War II, an Allied soldier named Robert Radford spent several years in a large
German prisoner-of-war (POW) camp. There were more than 50,000 prisoners in the camp,
and the prisoners had some freedom to move about within the compound. Radford latter
wrote an account of his experiences. He described how an economy developed in the camp,
in which prisoners traded food, clothing, and other items. Services, such as barbering, also
were exchanged. Lacking paper money, the prisoners began to use cigarettes (provided
monthly by the Red Cross) as money.

a) In Radford’s POW camp, how did cigarettes provide the three functions of money?

b) Do you think a nonsmoking prisoner would have been willing to accept cigarettes in
exchange for a good or service in Radford’s camp? Why or why not? How should a smoking
prisoner decide whether to smoke or not in the camp if he/she was making rational economic
decision?

9.2 a) Suppose the desired reserve ratio is 10% and there is no currency drain. Calculate the
change in money supply resulted from a $400 increase in the monetary based in the bank
system. Show your calculation.

b) Suppose the desired reserve ratio is 10 percent. Peter deposits $1,000 in Bank A. Bank
A keeps its minimum desired reserves and lends the excess to John. John spends his loan
at Company A. Company A deposits the money it receives from John in Bank B. Bank B
keeps its minimum desired reserves and lends the excess to Mary. Calculate the amount
that Bank B lends to Mary. Show your calculation.

c) When Peter deposits $100 in currency in his checkable deposit at ABC Bank, how would
that affect quantity of M1? Provide brief explanation to your answer.

9.3 a) Country T is currently under a recession and its central bank is considering to conduct
expansionary monetary policy to raise the GDP. In particular, the central bank would like to
lower the interest rate by 1% to boost investment. The commercial banks in the economy of
Country T hold $100 billion reserve in the central bank and the commercial banks do not
hold any excess reserve, with the required reserve ratio of 20%. Furthermore, for 1%
increase in interest rate, the quantity of money demanded decreases by $20 billion.

(i) How much should the money supply change to achieve the target of a 1%
reduction in interest rate?
(ii) If the central bank would like to achieve the target through open market
operation, how should the central bank do? How large is the amount of
bonds the central bank need to buy or sell to achieve this? (Hint: the money
the central bank gives to or takes from the commercial bank is through the
banks’ reserve.)
(iii) If the central bank would like to achieve the target through changing the
required reserve ratio, what are the size and direction of change required?

b) (i) State the Equation of Exchange and briefly explain its meaning.
(ii) If the central bank of Country T doubles the amount of reserve of all banks in the
accounting record, what is expected to happen according to Quantity Theory of Money?
Explain your reasoning.

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 Revision Questions

1. Bobby is a PolyU student coming from Malaysia. Currently he pays $0.60 per minute for
making long distance call from Hong Kong to Malaysia and his calls are never shorter than
7 minutes. Two days ago Bobby found another telecom company which charges $1.80 per
minute for the first two minutes and $0.12 per minute for additional minutes in each call. If
Bobby switches to the new telecom company, what will happen to the length of his calls?

2. “Depending on the price of the Economics textbook, each student will buy either one copy
or none. Therefore, both the individual and market demand curve for an Economics
textbook is a vertical line.” Explain whether this statement is true or false.

3. “Suppose the market of good X consists of only two consumers A and B with identical
demand curve. The price elasticity of market demand for good X is larger than the price
elasticity of individual demand for good X at a given price level.” Explain whether the above
statement is true or false.

4. The following table shows the number of students and the reservation price (i.e. maximum
price they are willing to pay for an Economics textbook. Suppose each student will buy at
most one textbook. Fill in the column of “Quantity demanded” and explain whether the
market demand is consistent with the law of demand.

Reservation price Number of Market price Quantity demanded

(maximum price the students
students are willing to pay)
$400 10 $400
$350 20 $350
$300 30 $300
$250 40 $250
$200 50 $200
$150 60 $150
$100 70 $100
$50 80 $50

5. The demand and supply for chairs in City A have the following characteristics: each buyer
will demand either zero or one chair, and each seller will supply either zero or one chair.
The buyer will demand one chair if the market price is below or equal to the maximum price
he is willing to pay, and the seller will supply one chair if the market price is above or equal
to the minimum price he is willing to receive. The number of buyers at each maximum price
willing to pay and the number of sellers at each minimum price willing to receive are shown
in the following tables:

Maximum price Number of Minimum price Number of

willing to pay buyers willing to receive sellers
$100 10 $100 15
$90 20 $90 20
$80 10 $80 25
$70 35 $70 20
$60 20 $60 15
$50 20 $50 15
$40 30 $40 15
$30 20 $30 10

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 a) What is the equilibrium price for chairs?

b) What is the equilibrium quantity for chairs?

c) What is the magnitude of consumer surplus when the market is at equilibrium?

d) What is the magnitude of producer surplus when the market is at equilibrium?

e) Now suppose the government in City A imposes a price ceiling of $50 to the market for
chairs and only those sellers with a minimum price willing to receive which is equal to or
lower than $50 will supply the chairs to the market. What are the magnitudes of excess
demand and producer surplus associated with this price ceiling in the absence of black
market?

f) Now suppose a black market for chairs exists after the imposition of the price ceiling. What
is the resulting black market price?

6. The market for good X is perfectly competitive. The demand and supply functions of good
X are given as follows:

Qd = 2000 – 30P
and Qs = –400 + 10P

where Qd is quantity demanded in thousand units, Qs is quantity supplied in thousand units,

and P is the unit price in dollars for good X. All firms in the market are identical. The market
is in long-run equilibrium and there are 1,000 firms producing good X under this initial long-
run equilibrium.

a) What are the equilibrium market price and market quantity for good X?

b) What is the output of each firm in the initial long-run equilibrium?

Now suppose the government gives an $4 per-unit subsidy to the consumers for each unit
of good X consumed.

c) After the provision of the per-unit subsidy to the consumers, what are the short-run
equilibrium market price and market quantity for good X?

d) Out of the $4 per-unit subsidy of good X, how much is the share received by the suppliers
in the short run? How much is the share received by the consumers in the short run?

e) What are the new long-run equilibrium market price and market quantity for good X?

f) Out of the $4 per-unit subsidy of good X, how much is the share received by the consumers
in the long run?

g) Compare the number of firms and output of an individual firm between the initial and new
long-run equilibrium.

7. In studying for his economics final exam, Sam is concerned about only two things: his
grade and the amount of time he spends on studying. A good grade will give him a benefit
of 30; an average grade, a benefit of 15; and a poor grade, a benefit of 0. By studying a lot,
Sam will incur a cost of 10; by studying a little, a cost of 6. Moreover, if Sam studies a lot
and all other students study a little, he will get a good grade and they will get poor ones. But
if they study a lot and he studies a little, they will get good grades and he will get a poor
one. Finally, if he and all other students study the same amount of time, everyone will get
average grades. Other students share Sam’s preferences regarding grades and study time.

a) Model this situation as a two-person prisoners’ dilemma in which the strategies are to study
a little and to study a lot, and the players are Sam and all other students. State the payoffs
in the matrix.
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 b) What is the equilibrium outcome in this game? From the students’ perspective, is it the best
outcome?

8. The following equations apply to Country K.

C = 1,800 + 0.7 (Y – T)
T = 200 + 0.1 Y
I = 400
G = 600
X = 450
M = 0.08 Y

At present, the current actual aggregate output level of Country K is 6,500 and the potential
output level of Country K is 7,500.

a) Calculate the aggregate output level of Country K at equilibrium.

b) Discuss how Country K could adjust back to equilibrium from its current output level.

c) If Country K wants to make the equilibrium output level to be equal to the potential output level
by a fiscal policy, calculate the change of government spending that is required to achieve
the goal.

d) Suppose that there is a large amount of money falling from the sky onto Country K. There are
two possible cases: (1) The money is picked up by some low-income people, and (2) The
money is picked up by some high-income people. Explain the effects on the output of Country
K between case (1) and case (2). [Notes: (1) This is a question on aggregate output, but NOT
on legal aspects. (2) No calculation is required.]

9. Country Y produces only three products which are apple, wheat and chair. The price and output
of these three products in 2010, 2011 and 2012 are shown in the following table. Country Y
uses 2010 as the base period in calculating real GDP.

a) Calculate the nominal GDP in 2011 and 2012.

b) Calculate the real GDP in 2011 and 2012.

c) Calculate the GDP deflator in 2011 and 2012.

Suppose Country Y is in short-run equilibrium during 2010, 2011 and 2012 under the Aggregate
Demand – Aggregate Supply framework.

d) Explain whether Country Y has experienced a demand-pull inflation or a cost-push inflation in

2011 by comparing the economic data between 2010 and 2011.

e) Explain whether Country Y has experienced a demand-pull inflation or a cost-push inflation in

2012 by comparing the economic data between 2011 and 2012.

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