Economics - Sheet Q and A

Question Sheet 1 – Tutorial 1 Week 16 Suggested answers. Ch23 1. What components of GDP (if any) would each of the following transactions affect? Explain. a) b) c) d) e) f) g) A a. b. c. d. e. f. g. Ch23 2. A. Consumption increases because a refrigerator is a good purchased by a household. Investment increases because a house is an investment good. Consumption increases because a car is a good purchased by a household, but investment decreases because the car in Rover’s inventory had been counted as an investment good until it was sold. Consumption increases because fish and chips is a good purchased by a household. Government purchases increase because the (local) government spent money to provide a good to the public. Consumption increases because the bottle is a good purchased by a household, but net exports decrease because the bottle was imported. Investment increases because new structures and equipment were built. The “government purchases” component of GDP does not include spending on transfer payments such as Social Security. Thinking about the definition of GDP, explain why transfer payments are excluded. With transfer payments, nothing is produced, so there is no contribution to GDP. Ch23 7. A. A family buys a new refrigerator. Aunt Jane buys a new house. Rover sells a Mini from its inventory. You buy fish and chips. Leicester City Council resurfaces University Road. Your parents buy a bottle of French wine. Nissan expands its factory in Sunderland. If prices rise, people’s income from selling goods increases. The growth of real GDP ignores this gain, however. Why, then, do economists prefer real GDP as a measure of economic wellbeing? Economists ignore the rise in people's incomes that is caused by higher prices because although incomes are higher, the prices of the goods and services that people buy are also higher. Therefore, they will not necessarily be able to purchase more goods and services. For this reason, economists prefer to look at real GDP instead of nominal GDP. Ch23 10. Goods and services that are not sold in markets, such as food produced and consumed at home, are generally not included in GDP. Can you think of how this might cause the numbers in the second column of Table 3 (in the book) to be misleading in a comparison of the economic wellbeing of the United States and India? Explain. A. In countries like India, people produce and consume a fair amount of food at home that is not included in GDP. So GDP per person in India and the United States will differ by more than their comparative economic well-being. Ch24 1. Suppose that people consume only three goods, as shown in this table: Tennis Balls Tennis Racquets strawberries 2003 price 2003 quantity £2 100 £40 10 £1 200 2004 price 2004 quantity £2 100 £60 10 £2 200 a) b) A. a. What is the percentage change in the price of each of the three goods? What is the percentage change in the overall price level? Do tennis racquets become more or less expensive relative to strawberries? Does the well-being of some people change relative to the well-being of others? Explain. The price of tennis balls increases 0 percent; the price of tennis racquets increases 50 percent [=(£60-£40)/£40 x 100%]; the price of strawberries increases 100 percent [= (£2 - £1)/£1 x 100%]. To find the percentage change in the overall price level, follow these steps: 1) Determine the fixed basket of goods: 100 balls, 10 racquets, 200 strawberries 2) Find the price of each good in each year: Year 2001 2002 Racquets Gatorade £40 £1 £60 £2 3) Compute the cost of the basket of goods in each year: 2001: (100 x £2) + (10 x £40) + (200 x £1) = £800 2002: (100 x £2) + (10 x £60) + (200 x £2) = £1,200 4) Choose one year as a base year (2001) and compute the CPI in each year: 2001: £800/£800 x 100 = 100 2002: £1,200/£800 x 100 = 150 5) Use the CPI to compute the inflation rate from the previous year: 2002: (150 - 100)/100 x 100% = 50% b. Tennis racquets are less expensive relative to strawberries, since their price rose 50 percent while the price of strawberries rose 100 percent. The well-being of some people changes relative to the well-being of others. Those who purchase a lot of strawberries become worse off relative to those who purchase a lot of tennis racquets or tennis balls. Ch24 4. In the US beginning in 1994, environmental regulations have required that petrol contain a new additive to reduce air pollution. This requirement raised the cost of petrol. The US Bureau of Labour Statistics (BLS) decided that this increase in cost represented an improvement in quality. a) b) A. Balls £2 £2 Given this decision, did the increased cost of petrol raise the CPI? What is the argument in favour of the BLS’s decision? What is the argument for a different decision? a. Since the increase in cost was considered a quality improvement, there was no increase registered in the CPI. b. The argument in favor of this is that consumers are getting a better good than before, so the price increase equals the improvement in quality. The problem is that the increased cost might exceed the value of the improvement in air quality, so consumers are worse off. In this case, it would be better for the CPI to at least partially reflect the higher cost. Ch24 10. When deciding how much of their income to save for retirement, should workers consider the real or the nominal interest rate that their savings will earn? A. In deciding how much income to save for retirement, workers should consider the real interest rate, since they care about their purchasing power in the future, not the number of dollars they will have. Ch25 2. List the capital inputs necessary to produce each of the following: a) b) c) d) A. A. cars high school education plane travel fruits and vegetables a. Producing cars requires a factory with machines, robots, and an assembly line, as well as human capital that comes from training workers. b. Producing a high-school education requires books and buildings as well as human capital from the teachers. c. Producing plane travel requires planes and airports as well as human capital in terms of pilots' knowledge. d. Producing fruits and vegetables requires irrigation systems, harvesting machinery, and trucks to transport the goods to the market, as well as human capital in the form of agricultural knowledge. Ch25 7. What is the opportunity cost of investing in capital? Do you think a country can “over-invest” in capital? What is the opportunity cost of investing in human capital? Do you think a country can “over-invest” in human capital? Explain. The opportunity cost of investing in capital is the loss of consumption that results from redirecting resources towards investment. Over-investment in capital is possible because of diminishing marginal returns. A country can "over-invest" in capital if people would prefer to have higher consumption spending and less future growth. The opportunity cost of investing in human capital is also the loss of consumption that is needed to provide the resources for investment. A country could "over-invest" in human capital if people were too highly educated for the jobs they could get⎯for example, if the best job a Ph.D. in philosophy could find is managing a restaurant. Ch25 10. In the countries of South Asia in 1992, only 56 young women were enrolled in secondary school for every 100 young men. Describe several ways in which greater educational opportunities for young women could lead to faster economic growth in these countries. A. Greater educational opportunities for women could lead to faster economic growth in the countries of South Asia because increased human capital would increase productivity and there would be external effects from greater knowledge in the country. Second, increased educational opportunities for young women may lower the population growth rate because such opportunities raise the opportunity cost of having a child. Ch26 3. A. Theodore Roosevelt once said, “There is no moral difference between gambling at cards or in lotteries or on the race track and gambling in the stock market.” What social purpose do you think is served by the existence of the stock market? The stock market does have a social purpose. Firms obtain funds for investment by issuing new stock. People are more likely to buy that stock because there are organized stock markets, so people know that they can sell their stock if they want to. Ch26 5. A. When the Russian government defaulted on its debt to foreigners in 1998, interest rates rose on bonds issued by many other developing countries. Why do you suppose this happened? When the Russian government defaulted on its debt, investors perceived a higher chance of default (than they had before) on similar bonds sold by other developing countries. Thus the supply of loanable funds shifted to the left, as shown in Figure 1. The result was an increase in the interest rate. Figure 1 Ch26 6. A. Many workers hold large amounts of shares issued by the firms at which they work. Why do you suppose companies encourage this behaviour? Why might a person not want to hold shares in the company where he woks? Companies encourage their employees to hold stock in the company because it gives the employees the incentive to care about the firm’s profits, not just their own salary. Then, if employees see waste or see areas in which the firm can improve, they will take actions that benefit the company because they know the value of their stock will rise as a result. And it also gives employees an additional incentive to work hard, knowing that if the firm does well, they will profit. But from an employee’s point of view, owning stock in the company for which she or he works can be risky. The employee’s wages or salary is already tied to how well the firm performs. If the firm has trouble, the employee could be laid off or have her or his salary reduced. If the employee owns stock in the firm, then there is a double whammy⎯the employee is unemployed or gets a lower salary and the value of the stock falls as well. So owning stock in your own company is a very risky proposition. Most employees would be better off diversifying⎯owning stock or bonds in other companies⎯so their fortunes wouldn’t depend so much on the firm for which they work. Ch26 8. A. Suppose GDP is £8 trillion, taxes are £1.5 trillion, private saving is £0.5 trillion, and public saving is £0.2 trillion. Assuming this economy is closed, calculate consumption, government purchases, national saving, and investment. Given that Y = 8, T = 1.5, Sprivate = 0.5 = Y - T - C, Spublic = 0.2 = T - G. Since Sprivate = Y - T - C, then rearranging gives C = Y - T - Sprivate = 8 - 1.5 - 0.5 = 6. Since Spublic = T G, then rearranging gives G = T - Spublic = 1.5 - 0.2 = 1.3. Since S = national saving = Sprivate + Spublic = 0.5 + 0.2 = 0.7. Finally, since I = investment = S, I = 0.7. Question Sheet 2 – Tutorial 2 Week 18 Suggested answers. Ch27 1. A. About 400 years ago, native Americans sold the island of Manhattan for $24. If they had invested this money at an interest rate of 7 percent per year, how much would they have today? 400 The future value of $24 invested for 400 years at an interest rate of 7 percent is (1.07) × $24 = $13,600,000,000,000 = $13.6 trillion. Ch27 3. For each of the following kinds of insurance, give an example of behaviour that can be called moral hazard and another example of behaviour that can be called adverse selection. a) b) A. a. health insurance car insurance A sick person is more likely to apply for health insurance than is a well person. This is adverse selection. Once a person has health insurance, he may be less likely to take good care of himself. This is moral hazard. b. A risky driver is more likely than a safe driver to apply for car insurance. This is adverse selection. Once a driver has insurance, he may drive more recklessly. This is adverse selection. Ch27 4. A. Imagine that you intend to buy a portfolio of ten stocks with some of your savings. Should the stocks be of companies in the same industry? Should the stocks be of companies located in the same country? Explain. To reduce the risk associated with the portfolio, it is better to diversify. This means that the stocks should be of companies from different industries as well as located in different countries. Ch28 6. Are the following workers more likely to experience short-term or long-term unemployment? Explain. a) b) c) d) e) A. a construction worker laid off because of bad weather a manufacturing worker who loses her job at a plant in an isolated area a stagecoach-industry worker laid off because of competition from railroads a short-order cook who loses his job when a new restaurant opens across the street an expert welder with little formal education who loses her job when the company installs automatic welding machinery a. A construction worker who is laid off because of bad weather is likely to experience short-term unemployment, since the worker will be back to work as soon as the weather clears up. b. A manufacturing worker who loses her job at a plant in an isolated area is likely to experience long-term unemployment, since there are probably few other employment opportunities in the area. She may need to move somewhere else to find a suitable job, which means she will be out of work for some time. c. A worker in the stagecoach industry who was laid off because of the growth of railroads is likely to be unemployed for a long time. The worker will have a lot of trouble finding another job when his entire industry is shrinking. He will probably need to gain additional training or skills to get a job in a different industry. d. A short-order cook who loses his job when a new restaurant opens is likely to find another job fairly quickly, perhaps even at the new restaurant, and thus he will probably have only a short spell of unemployment. e. Ch28 7. A. An expert welder with little education who loses her job when the company installs automatic welding machinery is likely to be without a job for a long time, since she lacks the technological skills to keep up with the latest equipment. To remain in the welding industry, she may need to go back to school and learn the newest techniques. Using a diagram of the labour market, show the effect of an increase in the minimum wage on the wage paid to workers, the number of workers supplied, the number of workers demanded, and the amount of unemployment. Figure 2 Figure 2 shows a diagram of the labor market with a binding minimum wage. The initial equilibrium with minimum wage m1 has quantity of labor supply L1S greater than the quantity of labor demanded L1D, with unemployment equal to L1S - L1D. An increase in the minimum wage to m2 leads to an increase in the quantity of labor supplied to L2S and a decrease in the quantity of labor demanded to L2D. As a result, unemployment increases as the minimum wage rises. Ch28 11. Some workers in the economy are paid a flat salary and some are paid by commission. Which compensation scheme would require more monitoring by supervisors? In which case do firms have an incentive to pay more than the equilibrium level (as in the worker-effort variant of efficiency-wage theory)? What factors do you think determine the type of compensation firms choose? A. Workers need to be monitored if they earn a flat salary but little monitoring is needed under a commission structure. Under a system with flat salaries, the wage needs to exceed the equilibrium wage to encourage greater effort by workers. The wage need not exceed the equilibrium wage under a system with commissions, since workers can choose their level of effort and get paid in proportion to their effort. The factors that determine the type of compensation scheme include the cost of monitoring, the willingness of workers to bear risk under the commission scheme, and the interdependence of tasks. Ch19 4. At some colleges and universities, economics professors receive higher salaries than professors in some other fields. a) b) Why might this be true? Some other colleges and universities have a policy of paying equal salaries to professors in all fields. At some of these schools, economics professors have lighter teaching loads than professors in some other fields. What role do the differences in teaching loads play? A. a. Economics professors may receive higher salaries than professors in some other fields because they have better opportunities outside academia. For example, they could find jobs in the private sector or the government. b. Differences in teaching loads can make up for lower pay. If professors in all fields are paid the same, the pay level is probably below what economics professors could earn elsewhere. To attract economics professors, the university would have to offer them some other compensation, such as a lower teaching load. Ch19 5. A. Sara should take the other job if Gianni’s attitude problem is worth £10,000 or more to her. She should view the £10,000 difference in salary as a compensating differential for putting up with Gianni. The question Sara must answer is this: Is £10,000 enough of a compensating differential? If so, she will stay in her current job. If not, she will take the new job. Ch19 7. A. When recording devices were first invented almost 100 years ago, musicians could suddenly supply their music to large audiences at low cost. How do you suppose this development affected the income of the best musicians? How do you suppose it affected the income of average musicians? The development of recording devices led to a superstar phenomenon in which the best musicians were paid significantly more than average musicians. So the incomes of the best musicians rose and the income of the average musician fell. Ch19 8. A. Sara works for Gianni, whom she dislikes profoundly because of his snobbish attitude. Yet when she looks for other jobs, the best she can do is find a job paying £10,000 less than her current salary. Should she take the job? Analyse Sara’s situation from an economic point of view. When Alan Greenspan (future chairman of the US Federal Reserve) ran an economic consulting firm in the 1960s, he hired primarily female economists. He once told The New York Times, “I always valued men and women equally, and I found that because others did not, good women economists were cheaper than men.” Is Greenspan’s behaviour profit-maximising? Is it admirable or despicable? If more employers were like Greenspan, what would happen to the wage differential between men and women? Why might other economic consulting firms at the time not have followed Greenspan’s business strategy? Yes, his behavior is profit maximizing. He is hiring labor at a lower cost. You might claim that Alan is despicable because he is discriminating against men. Some might claim that Alan was admirable, though, since he is maximizing profit and giving women a better opportunity to find a job. If more employers were like Alan, the wage differential between men and women would shrink, as employers would be competing for women workers, so women would have as many job options as men. Ultimately, the wage differential could disappear. Other firms at the time may not have followed his strategy because their customers may have preferred male consultants. Ch19 12. Chapter 19 considers the economics of discrimination by employers, customers, and governments. Now consider discrimination by workers. Suppose that some brunette workers did not like working with blonde workers. Do you think this worker discrimination could explain lower wages for blonde workers? If such a wage differential existed, what would a profit-maximising entrepreneur do? If there were many such entrepreneurs, what would happen over time? A. If brunette workers do not like working with blonde workers, a blonde worker's marginal product of labor is likely to be lower, since the firm's output will not be as high compared to the case if the firm had a brunette worker instead. Thus firms might find that blonde workers are not worth as much and may reduce their wages relative to brunette workers. A profit-maximizing entrepreneur could create a firm using all blonde workers, so there would be no frictions between brunette and blonde workers. If there were many such entrepreneurs, the wage differential between brunette and blonde workers would disappear over time. Question Sheet 3 – Tutorial 3 Week 20 Suggested Answers. Ch20 4. Chapter 20 discusses the importance of economic mobility. a) What policies might the government pursue to increase economic mobility within a generation? b) What policies might the government pursue to increase economic mobility across generations? c) Do you think we should reduce spending on current welfare programs in order to increase spending on programs that enhance economic mobility? What are some of the advantages and disadvantages of doing so? A. a. b. c. Ch20 7. To increase economic mobility within a generation, the government could support training programs (to provide skills to unskilled workers) and workfare instead of welfare (to help the poor increase their incomes). To increase economic mobility across generations, the government might increase its support for education. The advantage of reducing spending on welfare to increase spending on programs that enhance economic mobility is that it gives people greater incentive to work hard to get ahead. The disadvantages are that such programs are expensive and are hard on those who do not make it. Suppose there are two possible income distributions in a society of ten people. In the first distribution, nine people would have incomes of £30,000 and one person would have an income of £10,000. In the second distribution, all ten people would have incomes of £25,000. a) If the society had the first income distribution, what would be the utilitarian argument for redistributing income? b) Which income distribution would Rawls consider more equitable? Explain. c) Which income distribution would Nozick consider more equitable? Explain. A. a. b. c. A utilitarian would argue that the marginal utility of income for the person with an income of £10,000 is higher than the marginal utility of income for someone with an income of £30,000, so income should be redistributed. Rawls would prefer the second distribution since the worst-off person is better off than in the first distribution. Nozick would not find either more equitable. He would think the most equitable distribution is the one in which people got what they deserved. If the rules of the game are fair, either distribution is quite acceptable. Ch20 11. Do you agree or disagree with each of the following statements? a) “Every parent has the right to work hard and save in order to give his or her children a better life.” b) “No child should be disadvantaged by the sloth or bad luck of his or her parents.” A. a. If you agree with the statement that "Every parent has the right to work hard and save in order to give his or her children a better life," then you will think that inheritance taxes should be low. If you disagree, you will think that inheritance taxes should be high. b. If you agree with the statement that "No child should be disadvantaged by the sloth or bad luck of his or her parents," then you will think that inheritance taxes should be high. If you disagree, you will think that inheritance taxes should be low. Ch12 8. A. Suppose that your state raises its sales tax from 5 percent to 6 percent. The state revenue commissioner forecasts a 20 percent increase in sales tax revenue. Is this plausible? Explain. If the state raises its sales tax from 5 percent to 6 percent, it isn't plausible that sales tax revenue will increase 20 percent. The increase in the tax rate is 20 percent, so the only way tax revenue could increase 20 percent would be if total spending didn't fall in response to the tax increase, which is unlikely. Instead, the higher tax would raise the price of goods, so people would spend less. Thus tax revenue might go up, because the tax rate is higher, but by less than 20 percent. There is even some possibility that tax revenues will fall. Ch12 11. Categorise each of the following funding schemes as examples of the benefits principle or the ability-to-pay principle. a) b) c) A. a. b. c. Visitors to many national parks pay an entrance fee. Local property taxes support elementary and secondary schools. An airport trust fund collects tax on each plane ticket sold and uses the money to improve airports and the air traffic control system. The fact that visitors to many national parks pay an entrance fee is an example of the benefits principle, since people are paying for the benefits they receive. The fact that local property taxes support elementary and secondary schools is an example of the ability-to-pay principle, since if you own more expensive property you must pay more tax. The setup of airport trust funds is an example of the benefits principle, since use of the airport generates a tax that pays for upkeep of the airport. Ch12 13. What is the efficiency justification for taxing consumption rather than income? If the UK were to adopt a consumption tax, do you think that would make the UK tax system more or less progressive? Explain. A. The efficiency justification for taxing consumption rather than income is that taxing income discourages saving. If the United States were to adopt a consumption tax, the U.S. tax system would become less progressive because the poor spend a greater proportion of their income than the rich. However, tax rates could be modified or deductions increased to make the tax more progressive. Ch29 6. A. Your uncle repays a £1000 loan from NatWest Bank by writing a £1000 check from his NatWest Bank current account. Use T-accounts to show the effect of this transaction on your uncle and on NatWest Bank. Has your uncle’s wealth changed? Explain. When your uncle repays a £100 loan from NatWest by writing a check from his NatWest checking account, the result is a change in the assets and liabilities of both your uncle and NatWest, as shown in these T-accounts: Your Uncle Assets Before: Current Account After: Current Account Liabilities £100 Loans £100 £0 Loans £0 NatWest Assets Before: Loans After: Liabilities £100 Deposits £100