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UNDERSTANDING ECONOMICS
A2 Level (Fourth Edition)

Complete Textbook Topical MCQs (2002 – 2016)

* *
Useful for Economics Essays
*

Written by:
Muhammad Kamran Malik
MBA, MA Economics
Keynesian Institute of Management & Sciences (KIMS)

Edited by:
Amna Ansari
M Sc Development Administration & Planning
University College London (UCL)

9-F, Main Market Gulberg II, Lahore.

Tel: 042-35714038 Cell: 0336-5314141
E-mail: [email protected]
Facebook page: readandwritepublications/Shop
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All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or
transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise,
without the prior written permission of the Publisher.

Cambridge International has not provided these questions or answers and can take no responsibility
whatsoever for their accuracy or suitability for the examinations.

Title Understanding Economics (A2 Level)

Author Muhammad Kamran Malik

Cell: 0300-8488585
E-mail: [email protected]

Edited by Amna Ansari

Published by Read & Write Publications

Composed by Rashid Mehmood

Title designed by Rashid Mehmood

Legal Advisor Mian Tariq Ahmad (Advocate Supreme Court)

Room No. 10, 11, 12 Al-Majeed Centre
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Edition: 2016-17

Price Rs.650/-

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PREFACE
I feel delighted in presenting the fifth edition of Understanding Economics A2 as apart
from other useful changes in accordance with the revised syllabus for exams in June
2016 onwards, it includes exercises that augment students‟ ability to tackle tricky
examination questions. I always advise students to pull up their socks in second year
as A2 Economics syllabus is far more demanding, challenging and complex. It,
therefore, comes as little surprise that I myself have invested much more time in
writing this book than I had initially calculated. I am hopeful that my efforts will reflect
in the text you‟re about to read. More exercises have been incorporated into the text
so as to make the entire experience of learning much more rigorous and thorough.

It took me nearly six months to complete this book, leaving my colleagues to wonder
if it was possible to produce a good quality textbook in a few months‟ time. My
answer to that lies in my 20 year struggle to teach this course well to all my students.
In fact, I must not hesitate in giving them credit for what you hold in your hands right
now- had it not been for my students‟ intelligent and not so intelligent questions, I
would never have been able to come up with a comprehensive text as this. As
mentioned earlier, the A2 syllabus is trickier to deal with as all sections are largely
interlinked and weaknesses in any reflect more pronouncedly in others. Consistency,
therefore, demands that students attend classes regularly and seek help from other
textbooks as well.

Lastly, I look forward to your criticism and suggestions as they will help me improve
subsequent editions of this book. I am extremely thankful to all those who
appreciated my efforts in Understanding Economics- AS Level (text book) and An
Easy Approach to AS Economics (essays and data responses). I present the fifth
edition of Understanding Economics- A2 with the hope that I do justice to your
valuable comments and do not disappoint any of my readers.

Thank you.

Muhammad Kamran Malik

Principal,
KIMS.

Keynesian Institute of Management & Sciences

(Cambridge International Fellowship Centre)
3-C, Zahoor Elahi / Maratab Ali Road, Gulberg II, Lahore. Phone: 35715467
Email: [email protected], [email protected]
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This book covers the entire A2 syllabus designed by Cambridge International Examinations
for exams in June 2016 onwards. It has been divided into 30 sections according to the
sequence mentioned in the syllabus, with only slight alterations where needed.

HOW TO USE THIS BOOK

 Apart from the relevant text, every section contains a topical arrangement of
multiple choice questions from 2002-2012‟s examination papers (Both May/June
and October/November sessions). Students are advised to read the text before
attempting them.
 Students must use a lead pencil to answer all questions and avoid writing in the
margins, so that repeated attempts can be made without clues to the correct
answers.
 Every section ends with a student evaluation card. Students must make use of it
by making entries for the question numbers they get wrong in each attempt. The
correct answers for each section are listed at the end of the book so that
students can compare them with their own answers and evaluate their
performance.
 Repeated mistakes in each successive attempt in the evaluation card signal that
a student has trouble with topics that those particular questions concern. He
must, therefore, refer to the text again for a better understanding of those topics.
 Essay questions have been answered within the text provided to students. A
careful study of the text will yield, either directly or indirectly, the answers to the
toughest of essay type questions in past examination papers.
 Lastly, this book is by no means the only source of a comprehensive A2 text.
We, therefore, recommend that students complement its use with other reputed
textbooks.
Note: In case students desire to locate them in the yearly past papers, all questions
have been assigned labels such as J/02/1/01. It provides information about the
session, the year of examination, the paper number and the question number
respectively. J/02/1/09 implies that the selected question is the ninth in June
2002‟s Paper 1. Similarly, N/07/1/12 refers to the twelfth question in November
2007‟s Paper 1.
For popular subjects like Economics, CIE introduced three variants of
examination papers in June 2010 preceded by two variants in November 2009.
Students appearing for CIE A Level examinations from Pakistan follow the
second variant. This book, therefore, provides guidance on only Variant 2
Multiple Choice Question Papers. However, students are encouraged to attempt
essays from all variants for good practice. To identify the variant of a certain
examination paper, students may refer to the code in the top right corner of the
paper‟s cover page. 9708/42 can be deciphered as the syllabus code for
Economics (9708) followed by the Paper No. (4) and the Variant No.
(2).Likewise, 9708/31 refers to variant 1 of paper 3.

Mathematical derivations are not a requirement of the CIE syllabus, yet they
have been produced extensively in a few topics like monopoly and multiplier to
help students attain a good grasp over key concepts.
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CONTENTS
Section: 1 Utility ........................................................................................................................... 8
Law of Diminishing Marginal Utility .............................................................................................. 8
Law of Equi Marginal Utility ........................................................................................................ 11
Indifference Analysis .................................................................................................................. 13
Multiple Choice Questions ......................................................................................................... 16
Section: 2 Budget Line .............................................................................................................. 26
Shifts In Budget Line .................................................................................................................. 27
Multiple Choice Questions ......................................................................................................... 32
Section: 3 Normal, Inferior and Giffen Goods ......................................................................... 44
Real Income and Substitution Effects of a Price Change .......................................................... 44
Consumer's Equilibrium ............................................................................................................. 45
Income Consumption Curve (ICC) ............................................................................................. 47
Impacts of Changes in Price ...................................................................................................... 48
Multiple Choice Questions ......................................................................................................... 50
Section: 4 Costs of the businesses ......................................................................................... 52
Laws of Variable Proportion ....................................................................................................... 53
Multiple Choice Questions ......................................................................................................... 65
Section: 5 Cost Curves in the Long Run ................................................................................. 75
Economies of Scale ................................................................................................................... 75
Least Cost Combination ............................................................................................................. 77
Isoquant and Isocost Approach ................................................................................................. 77
Minimum Efficient Scale (MES) ................................................................................................. 81
Minimum Efficient Scale (MES) And The Size Of Firms ............................................................ 81
Natural Monopoly ....................................................................................................................... 82
Reasons For The Existence Of Small Firms .............................................................................. 83
Section: 6 Economist’s Versus Accountant’s Definition of Costs ....................................... 97
Decisions to Continue or Shutdown Businesses ..................................................................... 100
Multiple Choice Questions ....................................................................................................... 102
Section: 7 Market Structures .................................................................................................. 108
Perfect Competition ................................................................................................................. 108
Multiple Choice Questions ....................................................................................................... 117
Section: 8 Monopoly ................................................................................................................ 121
Multiple Choice Questions ....................................................................................................... 126
Section: 9 Externalities ........................................................................................................... 136
Negative Externalities .............................................................................................................. 136
Positive Externalities ................................................................................................................ 138
Multiple Choice Questions ....................................................................................................... 141
Section: 10 Cost Benefit Analysis ............................................................................................ 150
Multiple Choice Questions ....................................................................................................... 151
Section: 11 Comparison between Perfect Competition and Monopoly ............................... 157
Efficiency: Productive and Allocative Efficiency ....................................................................... 159
Remedies to Monopoly Abuse ................................................................................................. 161
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Multiple Choice Questions ....................................................................................................... 163

Section: 12 Objectives of Firms ............................................................................................... 185
Multiple Choice Questions ....................................................................................................... 187
Section: 13 Price Discrimination .............................................................................................. 196
Multiple Choice Questions ....................................................................................................... 200
Section: 14 Monopolistic Competition..................................................................................... 203
Oligopoly .................................................................................................................................. 206
Price rigidness in Oligopoly...................................................................................................... 207
Cartels ...................................................................................................................................... 208
Non-Collusive Oligopoly: Game Theory .................................................................................. 209
Prisoner's Dilemma .................................................................................................................. 209
Concentration Ratio (Lorenz Curve & Gini Coefficient) ........................................................... 210
Growth of Firms........................................................................................................................ 211
Multiple Choice Questions ....................................................................................................... 213
Section: 15 Contestable Market ................................................................................................ 223
Multiple Choice Questions ....................................................................................................... 224
Section: 16 Factor Market ......................................................................................................... 228
Marginal Revenue Productivity Theory .................................................................................... 228
Labour Supply Curve ............................................................................................................... 230
Multiple Choice Questions ....................................................................................................... 232
Section: 17 Monopsony ............................................................................................................. 244
Trade Unions............................................................................................................................ 245
Wage Differentials .................................................................................................................... 247
Economic Rent ......................................................................................................................... 248
Multiple Choice Questions ....................................................................................................... 251
Section: 18 National Income Accounting ................................................................................ 264
Multiple Choice Questions ....................................................................................................... 269
Section: 19 Per Capita Income and Standard of Living ......................................................... 277
Poverty Trap............................................................................................................................. 278
Intergenerational Equity ........................................................................................................... 278
Net Economic Welfare (NEW) ................................................................................................. 279
An Introduction of BRICS ......................................................................................................... 279
Human Poverty Index .............................................................................................................. 279
Multidimensional Poverty Index (MPI) ..................................................................................... 279
Kuznets Curve.......................................................................................................................... 280
Multiple Choice Questions ....................................................................................................... 281
Section: 20 Equilibrium National Income ................................................................................ 286
Squaring The Economic Cycle ................................................................................................. 290
Equilibrium Income (a Graphical Treatment) ........................................................................... 291
Close Economy without Government....................................................................................... 293
Investment Expenditures ......................................................................................................... 301
Equilibrium National Income .................................................................................................... 303
A Situation of Disequilibrium .................................................................................................... 306
Multiple Choice Questions ....................................................................................................... 310
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Section: 21 Close Economy with Government ....................................................................... 317

Equilibrium Income in a Close Economy with Government ..................................................... 317
Equilibrium National Income (Three Sectoral Economy)- Graphical Analysis ......................... 320
Transfer Payment Multiplier ..................................................................................................... 324
Induced Taxes.......................................................................................................................... 325
Inflationary and Deflationary Gaps........................................................................................... 327
Systems of Taxation ................................................................................................................ 333
Laffer Curve ............................................................................................................................. 336
Nudge Theory .......................................................................................................................... 336
Means-Tested Benefit .............................................................................................................. 337
Negative Income Tax ............................................................................................................... 337
Multiple Choice Questions ....................................................................................................... 338
Section: 22 Open Economy ...................................................................................................... 351
Equilibrium Income in an Open Economy................................................................................ 351
Multiple Choice Questions ....................................................................................................... 354
Section: 23 Principle of Accelerator ........................................................................................ 359
Multiple Choice Questions ....................................................................................................... 361
Section: 24 Aggregate Demand (AD) ....................................................................................... 365
Comparison: Classicals, Monetarists and Keynesians ............................................................ 367
Aggregate Supply (AS) ............................................................................................................ 368
Multiple Choice Questions ....................................................................................................... 370
Section: 25 Liquidity Preference Theory ................................................................................. 378
Loanable Fund Theory ............................................................................................................. 382
Multiple Choice Questions ....................................................................................................... 383
Section: 26 Quantity Theory of Money .................................................................................... 393
Credit Creation Process ........................................................................................................... 394
Multiple Choice Questions ....................................................................................................... 396
Section: 27 Unemployment ....................................................................................................... 406
Philips Curve ............................................................................................................................ 408
Supply Side Policies And Natural Rate Of Unemployment ..................................................... 409
Multiple Choice Questions ....................................................................................................... 412
Section: 28 Interdependence of Economic Policies............................................................... 435
Multiple Choice Questions ....................................................................................................... 439
Section: 29 Developing Economies ......................................................................................... 452
Multiple Choice Questions ....................................................................................................... 453
Answer Key ................................................................................................................................ 460
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Section: 1 Utility
As consumers, each one of us can imagine the amount of satisfaction derived from a cool drink
on a hot summer day, or a pack of salted pop corns during a movie at the cinema – thus each
one of us has some idea what utility is all about. Utility is the power, ability or capacity of a
product to satisfy a human need or want. It is subjective, since products differ in their utility to
different people, in different places and at different times. Thus, utility varies from:
 person to person: A walking stick provides an old man with more utility than a young lad.
This simple observation acts as a guiding principle for firms, helping them devise their
marketing strategies and target segments with needs which they can serve better.
 place to place: A gas station on a busy road or a grocery store near one‟s residence has
a higher utility than less accessible outlets. An intensively distributed product adds „place
utility‟ making purchases convenient and thus provides an edge to the manufacturing firm
over its competitors.
 time to time. Emergency goods such as medicines have „time utility‟ and can fetch a good
price only when provided on time. Thus firms not maintaining proper stocks lose out on
business opportunities when demand emerges.

It is impossible to measure utility and assign it a value, yet we use utils or units of utility obtained
by consuming different units of a product for the purpose of comparison. The theory of utility is
discussed below with the help of two economic laws.

Law of Diminishing Marginal Utility

“Assuming other factors constant, a consumer receives lesser and lesser satisfaction from
additional units of a product, when consumed successively”.

To understand this economic law, a simple example of a thirsty man is taken. Assuming all other
factors such as the quality of water unchanged, the amount of satisfaction that the individual
gains from drinking the second glass of water is lesser than the satisfaction he gets from drinking
the first glass.

Total Utility (TU) is the utility obtained by consuming all the units of a product.

Marginal Utility (MU) is the utility obtained by consuming one extra unit of a product. MU is the
change in total utility.

MUn = TUn – TUn – 1

Marginal Utility of a certain number of units is the total utility for that quantity minus the total utility
for a unit less.

Diminishing marginal utility (assuming MU is positive) implies rising total utility but, at a falling rate.

Total Utility falls only when MU is negative.

Total Utility from a single commodity is maximized when MU is zero. It is the point of saturation.
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The following table shows different units of utility that a consumer obtains from consuming
different units of the same product. MU diminishes when more and more units of the same
product are consumed successively. However, TU rises till the individual consumes the seventh
unit whose MU is negative. TU is maximized by consuming six units. MU at this point is zero.

Total Utility (TU) Marginal Utility (MU)

Number of units
Units of Utility Units of Utility
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0
7 28 -2

Diagram 1.1
MU

Point of saturation
Q
6
MU
Link between demand and marginal utility
One of the reasons consumers pay a lower price for additional units (Law of Demand) is that they
provide lesser and lesser satisfaction (Law of diminishing Marginal Utility). Consider the table
above. Assuming constant marginal utility of money (i.e. marginal utility of money does not
increase when a consumer parts with a greater amount), a consumer who assigns a monetary
value of $1 for 1 unit of utility is willing to pay $10 for unit 1 but only $4 for unit 4. Thus, the MU
curve drawn in diagram 1.1 is also the demand curve.
Conditions
This law holds true only if the following conditions are met:
 Quality of different units of the product is similar.
 Quantity of different units is reasonable, like a glass of water instead of a teaspoon or a jug!
 Consumption of different units occurs without a time lag.
 Income, tastes, preferences and expectations of the consumer remain unchanged.
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Example: The following table shows the marginal utility an individual derives from a good at
different levels of consumption.

Quantity (number of units) 1 2 3 4 5 6

Marginal utility (units) 120 100 80 60 40 20

The utility derived from the last $ spent on every good is 2 units. Assuming constant marginal
utility of money, which quantity is purchased, given a price of:
(i) $70
(ii) $60
(iii) $50
(iv) $45
(v) $20

Answer
(i) No amount of the good is purchased since none of the units yields 140 units of utility,
the minimum acceptable utility from spending $70 ($1 gives 2 units of utility).
(ii) At a price of $60 the consumer purchases 1 unit.
(iii) At a price of $50 the consumer purchases 2 units.
(iv) At a price of $45 the consumer purchases 2 units since unit number 3 yields only 80
units of utility, less than the minimum 90 needed to justify spending $45.
(v) At a price of $20 the consumer purchases 5 units.

Exceptions
According to some economists, this law does not apply to wealth. However, others argue that the
satisfaction of earning the first million dollars is more than the satisfaction of earning the second
or the third million.

Paradox of value
The following example may force some of you to wonder what queer buying habits do human
beings possess! Think about this- water is essential to human life, yet we pay a petty price for it
compared to something as fancy as diamonds which cannot save a human life. This paradox of
value is resolved by the fact that relative prices of goods reflect their marginal utilities rather than
total utilities. Water is available in abundance, hence its marginal utility is quite low whereas
diamonds are scarce and possess a much higher marginal utility- thus, they are priced higher.
The marginal utility of water, used to wash cars, feed plants etc is almost zero in our daily lives
and we pay a negligible price for it. Exceptions however, may exist. Consider a thirsty man lost on
a desert- for him, water has a higher marginal utility and given an opportunity, the individual
would readily exchange his diamonds (if he has any!) for water.
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Law of Equi Marginal Utility

Lying at the heart of the theory of consumer choice, rational behavior involves considering the
relative costs and benefits of the alternatives we could spend our money on. Relative benefits are
measured by calculating satisfaction at the margin, or in terms of marginal utilities and relative
costs, in terms of prices consumers have to pay. Total utility is maximized when the utility derived
from the last dollar worth of say good A equals that derived from the last dollar worth of good B.
This is what the Equi Marginal Principle states:

“A household maximizes total utility from a given level of income by equating the weighted
marginal utilities of last units of all products it purchases, ceteris paribus.”
Weights imply prices of products and weighted marginal utility is the ratio of marginal utility and
MU
price i.e. utility per dollar. In the following equation, is equal for ALL commodities – thus total
P
utility is being maximized.
MU A MU B MU C MU D MU Z
   .......... ...
PA PB PC PD PZ
Consider the example of a consumer who spends his entire daily income, £10, on just two
commodities: X and Y, which cost £2/unit and £1/unit respectively. Given these market prices and
the consumer‟s level of income, he can buy any of the following combinations.
X 5 4 3 2 1 0
Y 0 2 4 6 8 10

However, the decision rests upon the utilities derived from consuming different units of X and Y.
The table below provides information regarding the utility obtained from consuming successive
units of X and Y.
MU X
Unit # MUx W .M.U X  MUY = W.M.UY
Px
1 20 10 9
2 18 9 7
3 16 8 5
4 14 7 3
5 12 6 1
A rational agent chooses the product with a higher weighted marginal utility, a dollar spent on
which would yield greater satisfaction. Consider the following table:

No of Utility Money Remaining

Options Decision
units obtained spent amount
Product X Product Y
No W.M.U No W.M.U Utility units
I 1 10 1 9 X 20 £2 £8
II 2 9 1 9 X 18 £2 £6
III 3 8 1 9 Y 9 £1 £5
IV 3 8 2 7 X 16 £2 £3
V 4 7 2 7 X 14 £2 £1
VI 5 6 2 7 Y 7 £1 0
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W.M.U of first unit of X is 10 units whereas that of Y is a unit less i.e. 9. The consumer opts
for the product with a higher W.M.U- he purchases the 1st unit of X. For the second unit, the
consumer compares the weighted marginal utility of second unit of X and FIR ST unit of Y.
Since both are equal, the consumer is indifferent between X and Y. However, we assume
that he continues buying X. Continuing likewise, we learn that the consumer chooses to buy 4
units of X and 2 units of Y. This combination maximizes total u tility (84 units of utility) since
th nd
weighted marginal utility for last (i.e. 4 ) unit of X equals that of the last (i.e. 2 ) unit of Y.
There is no way to increase total utility by reallocating resources i.e. shifting expenditures
from X to Y or vice versa.

Example: Assuming a consumer spends his income on just two commodities, X and Y, he should
purchase quantities as suggested by the following table in each of cases I, II and III.

To maximize utility, a consumer consumes:

Situation
Quantity of X Quantity of Y

MUx MUy
I  More Less
Px Py
MUx MUy
II  Less More
Px Py
MUx MUy
III  Unchanged Unchanged
Px Py

MUx MUy
The consumer should purchase more X and less Y if  since spending £1 on buying
Px Py
X provides more utility than Y. The consumer increases utility by buying more X and less Y since
utility gained by buying more of X outweighs the loss in total utility by consuming fewer units of Y.
MUX diminishes with additional units of X and MUY increases. The process continues till
MUx MUy MUx MUy
equals . Likewise, he must substitute Y for X if  . A utility maximizing
Px Py Px Py
MUx MUy
combination is obtained where  - no other combination of X and Y increases total
Px Py
utility (try N/04/3/02).

The utility theory however, has its own criticisms. Utility is subjective in nature and it is almost
impossible to quantify the benefit derived from consuming a good or service. Moreover, the
assumption of rational behavior may seem unrealistic at times since co nsumers do not have
complete information regarding all products and may be influenced by advertisements or
impulse buying.

J/02/3/03
Q. The table shows the marginal utility derived by a consumer who devotes the whole of his
weekly income of $32 to two goods X and Y, whose unit prices are $2 and $4
respectively.
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Marginal utility Marginal utility

Unit
of X (units) of Y (units)
1 9 28
2 8 26
3 7 24
4 6 22
5 5 20
6 4 18
7 3 16
8 2 14

In order to maximise his utility, which quantities of X and Y should the consumer
purchase?

X Y
(A) 2 7
(B) 4 6
(C) 6 4
(D) 8 3

Answer:
 MUx 8 
Option A is correct since weighted marginal utility of second (last) unit of X is 4    and
 Px 2
 MUy 16 
equals weighted marginal utility of 7 unit of Y    . Consumer spends his entire income
th

 Py 4
of $32 to buy two units of X and seven units of Y. This is the utility maximizing combination
because:
 Weighted marginal utility of last units of both products are equal
 Entire income is spent

Indifference Analysis
The problem with the use of marginal utility theory in explaining consumer choice and equilibrium
is that utility is subjective and cannot be measured accurately. The alternative approach is
indifference curves analysis. Instead of measuring utility, this approach ranks various
combinations of commodities in order of preference.

An indifference curve (see diagram 1.2), shows combinations of two commodities that yield the
SAME utility for the consumer. Thus the consumer is indifferent towards any two combinations on
an indifference curve i.e. he cannot prefer one combination over another. Indifference curve is
negatively sloped because if a consumer chooses to have one more unit of a product e.g. X, he
will have to give up the other product Y to keep his total utility unchanged. In this case, utility lost
by consuming less of Y will be compensated by gain in utility because of a greater quantity of X.
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A higher indifference curve yields greater utility, and given the affordability (see budget line), a
consumer would like to move to a higher indifference curve. In diagram 1.3, all combinations on
IC1 give the same utility to the consumer, whereas combinations on IC 2 give a higher utility than
combinations on IC1. There are an infinite number of indifference curves between two indifference
curves, however they can never intersect each other as such an intersection is against the
principle of consistency. This principle states that if a consumer prefers A over B and B over C,
then he must prefer A over C. This is explained with the help of diagram 1.4.

Diagram 1.2
y

1C

Diagram 1.3

1C2
1C1

x
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Diagram 1.4
y

A
C

In this diagram, combinations A and B are on the same indifference curve, so they should give
the same utility to the consumer. Similarly, A and C are also on the same indifference curve, so
they should also be yielding the same utility for the consumer. Consistency demands that
combinations B and C should also give the same utility, but combination C gives a higher utility
than B as it is on a higher indifference curve, violating the principle of consistency.

An indifference curve is not a straight line, rather it is convex if viewed from the origin i.e. its slope
decreases throughout. The reason for the convex shape of an indifference curve is that the
consumer is willing to give up smaller and smaller quantities of Y to have additional units of X
because of the law of diminishing marginal utility. The following table helps to explain this:

X 1 2 3 4 5
Y 20 15 11 8 6

All combinations of X and Y shown in this table are on the same indifference curve, thus providing
the same level of satisfaction to the consumer. In order to increase his consumption of X from 1
to 2 units, the consumer is willing to give up 5 units of Y, as he believes that utility lost by not
having 5 Y is compensated by having one more X. However, the utility of the third unit of X is
lesser than the second X, so he is willing to give up a smaller quantity of Y (only 4 Y). Similarly,
for the fourth X, he is willing to sacrifice an even smaller quantity of Y (3 Y). The slope of
indifference curve is known as Marginal Rate of Substitution (MRS), which decreases throughout
along an indifference curve. It is the ratio of the change in Y to the change in X. It is also the ratio
of MUx to MUY. For example, if MUx is 20 units and MUY is 10 units, the consumer is willing to
give up 2 units of Y to have 1 more unit of X, so the slope of indifference curve is:
dy MUX 20
   2Y / X
dx MUY 10
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Multiple Choice Questions

(Section 1)
J/02/3/03
1 The table shows the marginal utility derived by a consumer who devotes the whole of his
weekly income of $32 to two goods X and Y, whose unit prices are $2 and $4
respectively.
Marginal utility Marginal utility
Unit
of X (units) of Y (units)
1 9 28
2 8 26
3 7 24
4 6 22
5 5 20
6 4 18
7 3 16
8 2 14

In order to maximise his utility, which quantities of X and Y should the consumer
purchase?

X Y
A 2 7
B 4 6
C 6 4
D 8 3

N/02/3/02
2 The table shows the total utility that a consumer obtains from consuming good X.

quantity (units) TU (units of utility)

1 10
2 18
3 24
4 28
5 30
6 31

The price of good X is $4.

What additional information is needed to determine the quantity of X that the consumer
will purchase?

A the consumer‟s income elasticity of demand for good X

B the consumer‟s price elasticity of demand for good X
C the marginal utility of money to the consumer
D the marginal utility that the consumer obtains from substitute goods
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J/03/3/02
3 A household makes the following purchases of fruit.
fruit quantity price per
purchased (kg) kg ($)
bananas 5 1.00
apples 10 0.50
The household derives twice as much utility from the fifth kg of bananas as from the tenth
kg of apples.
What should the household do to maximise utility from the purchase of these fruits?

purchase of purchase of
bananas apples
A increase decrease
B decrease increase
C increase increase
D no change no change

N/03/3/02
4 A utility-maximising consumer spends his disposable income on food and clothing. When
his weekly income is $40 he buys 5 units of food at a unit price of $5. His marginal utility
from food consumption is 10 utility units.
If the price of a clothing unit is $0.50, the consumer's marginal utility from clothing is
1
A equal to that derived from food. B utility unit.
10
C 1 utility unit. D 10 utility units.

N/04/3/02
5 A consumer allocates his expenditure between three goods, X, Y and Z.
The table shows the prices of goods and the consumer's marginal utilities.
Good X Y Z
Price($) 20 15 10
Marginal utility (units) 40 30 15
How should the consumer's expenditure be reallocated in order to maximise his utility?

X Y Z
A more more less
B more less more
C less more less
D less less more

J/05/3/02
6 The relative prices of goods reflect their marginal utilities rather than their total utilities.
What is explained by this statement?
A the law of diminishing returns
B the limitations of marginal utility theory
C the paradox of value
D the role of prices as a rationing mechanism
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N/05/3/02
7 The table shows the total utility that an individual derives from consuming different
quantities of a good.

quantity of good total utility

(units) (units)
1 20
2 36
3 50
4 62
5 72
6 80

The individual's marginal utility of money is $1 = 2 units of utility.

What is the maximum quantity of the good that the individual will buy when its price is
$6?

A 2 units B 3 units C 4 units D 5 units

N/06/3/02
8 The diagram shows the marginal utility that an individual derives from a good at different
levels of consumption.
80
70
60
50
utility 40
(units) 30
20
10 MU
0
1 2 3 4 5 6 7 8
quantity (units)
The utility he derives from the last $ he spends on every good is 2 units.
Assuming the marginal utility of money is constant, which quantity will he purchase if the
price of the good is $20?
A 4 units B 5 units C 6 units D 7 units

J/07/3/02
9 A consumer seeks to maximise their utility. Up to what point should they continue to
consume each good?

A until the marginal utility from each good is the same

B until the marginal utility per dollar from each good is the same
C until the marginal utility from each good reaches a maximum
D until the marginal utility from each good is zero
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N/07/3/02
10 A consumer allocates his expenditure between three goods, X, Y and Z.
The table shows the consumer's marginal utilities for these goods and their prices.

good X Y Z

marginal utility (units) 50 30 25

price ($) 20 15 10

How should the consumer's expenditure be reallocated in order to maximise his utility?

X Y Z
A more more Less
B more less More
C less more Less
D less less More

J/08/3/02
11 The table shows the total utility that an individual derives from consuming different
quantities of a good.
quantity of good total utility
(units) (units)
1 24
2 45
3 63
4 78
5 90
6 99

The individual‟s marginal utility of money is $1 = 2 units of utility.

What is the maximum quantity of the good that the individual will buy when its price is $6?

A 2 units B 3 units C 4 units D 5 units

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J/09/3/02
12 The table shows the marginal utility derived by a consumer who devotes the whole of his
weekly income of $42 to two goods X and Y, whose unit prices are $3 and $6
respectively.

marginal utility marginal utility

unit
of X (units) of Y (units)
1 12 34
2 11 30
3 10 26
4 9 22
5 8 18
6 7 14
7 6 10
8 5 6

In order to maximise his utility, which quantities of X and Y should the consumer
purchase?

X Y
A 2 6
B 4 5
C 6 4
D 8 3

N/09/3/01
13 The schedule shows the total utility derived by a consumer of a good X at different levels
of consumption.

quantity of X consumed 1 2 3 4 5 6 7 8
total utility (units) 28 40 50 58 64 68 71 73

The consumer obtains two units of satisfaction from the last cent she spends on each
good that she purchases.
What is the maximum number of units of X that she will consume if the price of X is 6
cents?
A 2
B 5
C 7
D 8
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J/10/3/01
14 The diagram shows the marginal utility (MU) that an individual derives from a good at
different levels of consumption.

80
70
60
50
utility
40
(units)
30
20
10 MU
0
1 2 3 4 5 6 7 8
quantity (kilos)
The utility he derives from the last $ he spends on every good is 3 units.
Assuming the marginal utility of money is constant, which quantity will he purchase if the
price of the good is $10?
A 4 kilos B 5 kilos C 6 kilos D 7 kilos

N/10/3/02
15 The schedule shows the total utility derived by a consumer of a good X at different levels
of consumption.

quantity of X consumed 1 2 3 4 5 6 7

total utility (units) 30 50 65 75 80 83 84

The consumer obtains three units of utility from the last $ she spends on each good that
she purchases.
What is the maximum number of units of X that she will consume if the price of X is $5?
A 3 B 4 C 5 D 6

J/11/32/01
16 A consumer seeks to maximise his utility.
Up to what point should he continue to consume each good?

A until the marginal utility per dollar from each good is the same
B until the marginal utility from each good is the same
C until the marginal utility from each good reaches a maximum
D until the marginal utility from each good is zero
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J/12/32/2
17 The table shows the total utility that an individual obtains from consuming different
quantities of a good.

quantity of good total utility

(units) (units)
1 20
2 36
3 50
4 62
5 72
6 80

The individual‟s marginal utility of money is $1 = 3 units of utility.

What is the maximum quantity of the good that the individual will buy when its price is $4?
A 2 units B 3 units C 4 units D 5 units

N/12/32/02
18 A consumer who aims to maximise his utility will arrange his consumption so that

A the total utility obtained from each commodity is the same.

B the total utility per $ spent on each commodity is the same.
C the same utility is obtained from the last unit of each commodity.
D the same utility is obtained from the last unit of expenditure on each commodity.

J/13/32/02
19 The table shows the total utility that an individual derives from consuming different
quantities of a good.

quantity of good total utility

(units) (units)
1 20
2 36
3 50
4 62
5 72
6 80

The individual‟s marginal utility of money is $1 = 2 units of utility.

What is the maximum quantity of the good that the individual will buy when its price is
$6?

A 2 units B 3 units C 4 units D 5 units

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N/13/32/02
20 The table shows the total utility that an individual derives from consuming different
quantities of a good.

quantity of good total utility

(units) (units)
1 24
2 45
3 63
4 78
5 90
6 99

The individual‟s marginal utility of money is $1 = 2 units of utility.

What is the maximum quantity of the good that the individual will buy when its price is
$6?

A 2 units B 3 units C 4 units D 5 units

N/14/32/02
21 A household makes the following purchases of fruit.

quantity price per

fruit
purchased (kg) kg ($)
bananas 5 1.00
apples 10 0.50

The household derives twice as much utility from the tenth kg of apples as from the fifth
kg of bananas.
What should the household do to maximise utility from the purchase of these fruits?

purchase of purchase of
bananas apples
A decrease increase
B increase decrease
C increase increase
D no change no change
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J/15/32/02
22 A utility-maximising consumer spends the whole of his disposable income of $40 on food
and clothing.
The table shows the price of food, the quantity purchased by the consumer, and the
marginal utility he derives from food consumption.
food
price per unit $5
quantity demanded 5
marginal utility (units) 10
His marginal utility from clothing is 2 units.
What is the price of clothing per unit and the quantity purchased by the consumer?
clothing
price quantity
($) (units)
A 0.5 30
B 1.0 15
C 3.0 5
D 5.0 3

N/15/32/02
23 The diagram shows an individual‟s total utility from consuming glasses of fruit juice.

total
utility
total
utility

O number of glasses
of fruit juice
How can this information help to derive the individual‟s demand curve for fruit juice?

A by revealing the individual‟s marginal utility curve

B by revealing the money value of marginal utility
C by showing how total utility is maximized
D by showing the relationship between utility and expenditure
J/16/32/05
24 To maximise the satisfaction he derives from a given level of expenditure on two goods,
X and Y, a consumer should allocate his expenditure between the two goods so that
A marginal utility of X = price of X and marginal utility of Y = price of Y.
B marginal utility of X plus marginal utility of Y is maximised.
C marginal utility of X = marginal utility of Y.
marginal utility of X price of X
D =
marginal utility of Y price of Y
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Section: 2 Budget Line

If a product‟s demand is represented by a coin, utility is just one side of it. This is because effective
demand entails both the willingness (desirability) and the ability (affordability) to obtain a product.
The concept measuring affordability i.e. budget lines, represents the other side of the coin.

A budget line shows all possible combinations of two products that a consumer can purchase with
a given income and fixed market prices. Considering the example in Section 1, where consumer‟s
income is £10 and prices of X and Y are £2 and £1 per unit respectively, any of the following
combinations of X and Y can be purchased.

X 5 4 3 2 1 0
Y 0 2 4 6 8 10

Diagram 2.1
Y

10

X
O
1 2 3 4 5
A budget line slopes downward, depicting scarcity- as income is limited, buying more units of one
product requires buying fewer of the other.
The following equation shows the entire income being spent on the two commodities.
M = PX . X + P Y . Y
Where:
M = Consumer‟s money income
PX = Price of X/unit PY= Price of Y/unit
X = Quantity of X purchased Y = Quantity of Y purchased
Dividing both sides by Py,
M P
 X . X Y
PY PY
Rearranging,
M P
Y   X . X
PY PY
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M M
This is the linear equation of the budget line where is the vertical intercept, is the
PY PX
PX
horizontal intercept and , the slope of the budget line. The slope is negative as the budget line
PY
is downward sloping. (See diagram 2.1 (a))

Diagram 2.1(a)

Y
M
Py

Px
Py

M
Px

X
In diagram 2.1, the slope or price ratio of X and Y is -2. The respective intercepts have been
calculated assuming 0 units of the other good, thus the Y intercept and X intercept are 10 and 5
respectively.

Shifts In Budget Line

Changes in either consumer‟s income or prices of X and Y shift the budget line. The impacts of
such changes on the intercept and slope of the budget line are explained below:

Changes in income: Increase in income (while prices remain unchanged) increases the vertical
M  P 
intercept   but has no effect on the slope of the budget line  X  . The budget line shifts
 PY   PY 
rightward, as shown in diagram 2.2. Similarly, a decrease in income causes a leftward shift.
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Y
Diagram 2.2
y′

x x′
X
O

Changes in prices of both X and Y: The slope of the budget line remains unchanged if prices of
both X and Y change with the same percentage and in the same direction. The vertical intercept
falls in case prices of X and Y increase. Budget line shifts rightwards with an unchanged slope
(as shown in diagram 2.2) if prices of both X and Y decrease with the same percentage. Thus
diagram 2.2 is relevant for both an increase in income and a proportionate fall in the prices of X
and (try J/06/3/02).

Change in the price of X: Decreased price of X (while money income and price of Y remain
P 
unchanged) decreases the slope of budget line  X  , making it flatter. The resulting rightward
 PY 
shift is pivoted around the Y intercept, as shown in diagram 2.3(a). When price of X rises,
consumer affords fewer units of X at the same income level. In this case, the budget line shifts
from LL to LL1 as shown in diagram 2.3(b).

Diagram 2.3(a) Diagram 2.3(b)

Y Y
L L

L1 L1 L
L
X X
O O
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Changes in the price of Y: Changes in the price of Y (assuming unchanged money income and
M  P 
price of X) change vertical intercept   as well as the slope of budget line  X  .
 PY   PY 
Increased price of Y reduces vertical intercept and the budget line becomes flatter, as shown in
diagram 2.4(a). Likewise, decrease in the price of Y makes the budget line steeper, pivoting
about the X intercept (see diagram 2.4(b)).

Diagram 2.4(a) Diagram 2.4(b)

Y Y
L L1

L1 L

L L
X X
O O

Diagram 2.5
Y

L2

L1
X
O

Now consider diagram 2.5, which presents a rather interesting case. The budget line shifts from
L1 to L2 showing that more units of Y and less of X can now be purchased (L 2 is steeper than L1
and product X becomes expensive in relation to product Y). The Y intercept has increased and
that could be either because of increased income or decreased price of Y. The X intercept has
decreased and that could be either because of decreased income or increased price of X. The
only certain change is an increase in the slope- otherwise, we remain uncertain of what causes it
since it can be either of the two reasons mentioned.
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Example: The following diagram shows a consumer‟s budget line L 1 when the consumer‟s
income is $50 per day and the prices of X and Y, $5 and $2.5 respectively.

Diagram 2.6
Y

20 L 1

15

L2
X
O 10 15

Consumer‟s income increases to $60 and prices of X and Y change at the same time. If the new
budget line is L2, find the new prices of X and Y.

Answer: Remember that:

M
 Vertical (Y) intercept is
Py
M
 Horizontal (X) intercept is
Px
Px
 Slope is
Py
Before After
M 50 M 60
Vertical intercept   20   15
Py 2.5 Py 4
M 50 M 60
Horizontal intercept   10   15
Px 5 Px 4
Px 5 Px 4
Slope   2  1
Py 2.5 Py 4

Thus, price of X and Y is $4 each (try J/02/3/04).

The following diagrams help students understand the reasons for changing plans to buy
commodities from consumers‟ point of view and reasons for changing plans for buying (hiring)
different quantities of labour and capital from firm‟s point of view.
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Diagram 2.7(a) Diagram 2.7(b)

Y Y

A A

B B

X X
Diagram 2.7(c) Diagram 2.7(d)
Capital Capital

A A

B B

Labour Labour
The following discussion explains the movement from point A to B in each of the diagrams shown
above:

Diagram 2.7(a) : Both points lie on the same budget line so budget constraint i.e. income and
prices of X and Y are unchanged and consumer‟s decision to buy more X only means increased
preference for product X.

Diagram 2.7(b) : Points A and B lie on different budget lines so consumer‟s decision to buy more
X can be attributed to decreased price of X. The preferences of X and Y are unchanged however
decreased price of X has encouraged consumers to increase the demand for X.

Diagram 2.7(c) : Budget constraint i.e. resources and prices of labour (wage) and capital (interest
rate) are unchanged however the increased productivity of labour (may be through better training
or increased motivation) has encourage the firm to hire more workers.

Diagram 2.7(d) : Productivity of labour and capital is unchanged however decreased price of
labour has probably encouraged the firm to hire more workers. A relative increase in the price of
capital (may be because of increased interest rates or removal of a subsidy on capital) could also
encourage firms to hire more labour in relation to capital (try N/02/3/03 & J/02/3/05)
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Multiple Choice Questions

(Section 2)
J/02/3/04
1 The diagram shows a consumer‟s budget line PQ when the consumer‟s income was $20
per day and the prices of X and Y were $2 and $1.25 respectively.
Y

16 P

12
R

Q S
0 X
10 20

The consumer‟s income increases to $30 and, at the same time, the prices of X and Y
change.
If the consumer‟s budget line is now RS, what are the new prices of X and Y?
X Y
A $1.50 $2.50
B $1.80 $1.00
C $2.50 $1.50
D $3.00 $2.50

N/02/3/03
2 In the diagram, KN is a budget line showing the different combinations of two normal
goods, X andY, that a consumer is able to purchase. A consumer initially chooses point L
on the budget line.

L
good X

O good Y N

In a subsequent period, the consumer chooses the combination of X and Y shown by

point M.
What could explain this change?
A a change in the consumer‟s preferences
B an increase in the consumer‟s income and an increase in the price of Y
C a reduction in the consumer‟s income
D a reduction in the consumer‟s income and a reduction in the price of X
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J/03/3/03
3 The diagrams show a change in a consumer's budget line from an initial position of LL 1 to
LL2.
Which diagram shows the effect of a fall in the price of X, money income remaining
unchanged?
A B
L2 L
L
all 1 all
other other
goods goods

O L O
L2 L1
units of X units of X

C D
L1 L
L
all 2 all
other other
goods goods

O O
L L1 L2
units of X units of X

N/03/3/03
4 In the diagram a consumer's budget line shifts from JK to GH.

good Y

O K H
good X
Which of the following must be correct?
A There has been a change in the consumer's money income.
B There has been a change in the consumer's real income.
C The prices of both goods have changed.
D The price of good Y has increased relative to the price of good X.
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N/04/3/04
5 In the diagram a consumer‟s initial budget line is JK.

J
G

good Y

O good X K H

Assuming no change in the price of X, what could explain a shift in the consumer‟s
budget line to GH?

consumer‟s money
price of good Y
income
A decrease decrease
B decrease increase
C increase decrease
D increase increase

J/05/3/03
6 In the diagram a consumer's budget line shifts from GH to JK.

G
good Y

O H K
good X
Regardless of any other changes that might occur, what must be correct?

A There has been an increase in the consumer's money income.

B There has been an increase in the consumer's real income.
C There has been an equal proportionate increase in the price of X and Y.
D There has been an equal proportionate decrease in the price of X and Y.
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N/05/3/03
7 In the diagram a consumer's budget line shifts from GH to JK.

J
good Y

O H K
good X
What must be true?

A The prices of both goods have changed.

B There has been no change in the consumer‟s real income.
C There has been no change in the consumer‟s money income.
D The price of good Y has increased relative to the price of good X.

J/06/3/02
8 In the diagram a consumer's budget line shifts from JK to GH.

good Y J

O K H
good X
What can definitely be deduced from the diagram?

A There has been an increase in the consumer's money income.

B There has been a reduction in the price of both X and Y.
C There has been no change in the price of X or Y.
D There has been no change in the price of X relative to the price of Y.
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J/07/3/03
9 In the diagram a consumer's budget line shifts from JK to JH.

good Y

O K H
good X
What can definitely be concluded from the diagram?

A There has been no change in the price of good Y.

B There has been a reduction in the price of good X.
C There has been an increase in the consumer's money income.
D There has been an increase in the consumer's real income.

J/08/3/03
10 In the diagram a consumer‟s initial budget line is JK.

J
G

quantity of
good Y

O K H
quantity of good X
Assuming no change in the price of Y, what could explain a shift in the consumer‟s
budget line to GH?

consumer‟s money
price of good X
income
A decrease decrease
B decrease increase
C increase decrease
D increase increase
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N/08/3/03
11 In the diagram a consumer' s budget line shifts from GH to JK.

G
good Y

O H K
good X
Regardless of any other changes that might occur, what must be correct?

A There has been an equal proportionate increase in the price of X and Y.

B There has been an equal proportionate decrease in the price of X and Y.
C There has been an increase in the consumer's money income.
D There has been an increase in the consumer's real income.

J/09/3/03
12 In the diagram a consumer‟s budget line shifts from JK to GH.

J
G

quantity of
good Y

O K H
quantity of good X
Which statement must be correct?

A There has been an increase in the consumer‟s money income.

B There has been a decrease in the consumer‟s real income.
C Good Y has become relatively more expensive.
D The price of good X has increased.
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N/09/3/02
13 In the diagram, an individual initially chooses combination N on budget line LM.
An increase in his money income accompanied by an increase in the price of good Y
causes his budget line to shift to RS, and he now chooses combination T.

L
R

good Y N
T

O M S
good X
How does this affect his economic welfare?

A He is definitely better off because his money income has increased.

B He is definitely worse off because he has to pay more for good Y.
C He is better off since combination T, which he now chooses, was not previously
available to him.
D He is worse off since combinations of X and Y along LN are no longer available
to him.

J/10/3/02
14 In the diagram a consumer‟s budget line shifts from GH to JK.

good Y

O K H
good X
Which statement must be correct?

A The price of good X has increased relative to the price of good Y.

B The prices of both goods have fallen.
C There has been an increase in the consumer‟s real income.
D There has been an increase in the consumer‟s money income.
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N/10/3/03
15 The line RS in the diagram shows the different combinations of goods X and Y that a
consumer can afford with his present income.

N
quantity
of Y M

S
O quantity of X

The consumer's original equilibrium is at M.

What could explain a change in his equilibrium position to N?

A a change in his tastes

B a decrease in the price of X and a bigger percentage increase in the price of Y
C an increase in the price of X and an increase in his income
D equal percentage increases in his income and in both prices

J/11/32/02
16 In the diagram, a consumer‟s initial budget line is JK.

G
J

good Y

O good X H K

Assuming no change in the price of X, what could explain a shift in the onsumer‟s budget
line to GH?

price of good Y consumer‟s money

income
A decrease decrease
B decrease increase
C increase decrease
D increase increase
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J/12/32/3
17 The curve GH in the diagram is a consumer‟s initial budget line.

J
good Y

O H K
good X

Which combination could cause the budget line to shift to JK?

price of consumers‟
good X money income
A decrease decrease
B decrease increase
C increase decrease
D increase increase

N/12/32/03
18 In the diagram a consumer's budget line shifts from JK to JH.

good Y

O K H
good X

What can definitely be concluded from the diagram?

A There has been a decrease in the price of good Y.

B There has been a decrease in the consumer's money income.
C There has been an increase in the consumer‟s real income.
D There has been no change in the price of good X.
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J/13/32/03
19 In the diagram a consumer‟s budget line shifts from GH to JK.

J
G

quantity of
good Y

O K H
quantity of good X

Which statement must be correct?

A The price of good Y has fallen relative to the price of good X.

B There has been a decrease in the price of good Y.
C There has been an increase in the price of good X.
D There has been an increase in the consumer‟s real income.

N/13/32/03
20 The line RS in the diagram shows the different combinations of goods X and Y that a
consumer can afford with her present income.

quantity N
of Y
M

S
O quantity of X
The consumer‟s original equilibrium is at M.
What could explain a subsequent change in her equilibrium position to N?

A a change in her tastes

B an increase in the price of X and a fall in the price of Y
C an increase in the price of X and a smaller percentage increase in the price of Y
D equal percentage increases in her income and in both prices
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J/14/32/02
21 In the diagram, a consumer‟s initial budget line is JK.

G
J

quantity of
good Y

O H K

Assuming no change in the price of X, what could explain a shift in the consumer‟s
budget line to GH?

consumer’s
price of good
money
Y
income
A decrease decrease
B decrease increase
C increase decrease
D increase increase

N/14/32/03
22 In the diagram a consumer‟s budget line shifts from GH to JK.

Which statement must be correct?

A There has been an increase in the consumer‟s real income.

B There has been a decrease in the consumer‟s real income.
C Good Y has become relatively more expensive.
D Good X has become relatively more expensive.
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N/15/32/03
23 In the diagram, PQ is a consumer‟s original budget line.

16 P
quantity of Y
12
R

Q S
0 10 20
quantity of X
The consumer‟s income increases from $80 to $120 and, at the same time, the prices of
X and Y change.
If the consumer‟s budget line is now RS, what are the new prices of X and Y?

price of X ($) price of Y ( $)

A 4 12
B 6 10
C 10 8
D 12 6
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Section: 3 Normal, Inferior and Giffen Goods

Normal goods are those, the demand of which varies directly with income whereas that of inferior
goods moves inversely with income. Giffen goods are a special type of inferior goods, the
demand of which rises directly with price. They are named after a farmer who observed an
abnormal relationship between price and quantity demanded of potatoes. To his surprise,
increased prices of potatoes increased their demand and consumers purchased fewer potatoes
when they were cheaper. Potatoes were considered to be a low quality inferior good and the
money saved from their price reduction was spent on other food items with a higher nourishment
value rather than potatoes themselves.
Consider the example of a hotel undergoing major renovation work. The owner, wanting to furnish
100 rooms with high definition LCD televisions, finds out that his budget does not allow this lavish
expense. He decides to furnish only 30 rooms with modern high definition (HD) televisions and
purchase 70 traditional televisions for remaining ones. However, just before the actual purchase,
the price of old fashioned televisions decreases, increasing the purchasing power of the hotel
owner.
Where is he more likely to spend this “gain” in purchasing power? Will he buy more of the
cheaper, old fashioned televisions or more of HD televisions?
It is pretty likely that the owner will buy more of better quality televisions and less of low quality
ones, even though they‟re cheaper.
Consider another example where a family regards mutton as a normal good and beef, inferior.
Their budget restraints the consumption of mutton to twice a week and beef is consumed on the
remaining days. What does the family do when beef becomes cheaper? The amount saved from
reduced price of beef is more likely to be spent on mutton. Likewise, increased price of beef
forces the family to consume beef more frequently and forgo the luxury of eating mutton. Thus
price and quantity demanded of beef are directly related.
Old fashioned televisions and beef are examples of Giffen goods. The increased purchasing
power of consumers resulting from decreased prices of Giffen goods is spent on buying more of
better quality goods rather than low quality Giffen goods.

Real Income and Substitution Effects of a Price Change

The difference between normal, inferior and Giffen goods brings us to the discussion of price,
income and substitution effects.
Substitution effect and real income effect are the two components of total price effect.
Price effect = substitution effect + real income effect
Price effect is usually negative- price of a product and its quantity demanded move inversely,
hence a downward sloping demand curve. However, price effect may be positive in an
exceptional case and result in an upward rising demand curve.
The substitution effect of price change is ALWAYS negative as increased price makes consumers
substitute away from the relatively expensive product to cheaper alternatives.
Real income shows the purchasing power and decreases whenever price level rises.
Money income
Purchasingpower / real income 
Price level
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Real income effect could either be positive or negative. Income effect is positive where increased
real income raises quantity demanded i.e. in the case of normal goods and negative for inferior
goods.
Negative substitution effect and positive real income effect reinforce each other, resulting in a
negative price effect.
Negative substitution effect and negative real income effect weaken each other. Where
substitution effect outweighs the income effect, total price effect remains negative. It becomes
positive and results in an upward sloping demand curve if negative income effect offsets the
negative substitution effect. This happens in the case of Giffen goods.
For Giffen goods, income effect is not only negative but also stronger than the substitution effect.
Thus every Giffen is inferior but every inferior is not Giffen. The following table summarizes the
effects of a price increase for different categories of products.

Substitution Real income

Product categories Price effect Demand curve
effect effect
Normal Qd ↓ Qd ↓ Qd ↓ Downward sloping

Inferior
Non – Giffen inferior Qd ↓ Qd ↑ Qd ↓ Downward sloping

Giffen Qd ↓ Qd ↑ Qd ↑ Upward rising

Consumer's Equilibrium
The concepts of normal, inferior Giffen goods, and substitution and income effects are explained
below with the help of indifference curves. A consumer attains equilibrium by allocating his limited
resources in such a manner that he maximizes his utility. Graphically, it is established by the
intersection of the budget line (which highlights the consumer's affordability) and indifference
curves (which highlight a consumer's aspirations) as shown in diagram 3.1.
Diagram 3.1
Y

A
D

B
y1

C
E

x1 X

Though combinations A, B and C provide the same utility, the consumer will choose B, as
combinations A and C lie outside the budget line, and are hence unaffordable. Similarly,
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combinations D, B and E lie on the same budget line and hence cost the same to the consumer,
but the consumer chooses B, as combinations D and E are on lower indifference curves, giving
lesser utility to the consumer. Thus, the consumer's equilibrium is combination B, where he
consumes x1 units of commodity X and y1 units of commodity Y. The slope of the indifference
curve is MUX / MUY and the slope of the budget line is PX / PY, so at the point of intersection, MU x
/ MUY equals PX / PY, which is exactly similar to the condition of consumer‟s equilibrium
established earlier in law of equi marginal utility.

Impacts of Changes in Consumer's Income on Consumer's Equilibrium

Increased income shifts the budget line towards the right, raises the demand for normal goods
and decreases it for inferior goods. Diagram 3.2 illustrates the effects of increased income over
consumer's equilibrium.
Diagram 3.2
Y
x2

IV

I
x1

y1 II

III

x1 x2
x1 X

The initial budget line is xx1, where the consumer buys x1 units of commodity X and y1 units of
commodity Y. Increased income shifts the budget line towards xx2 and the new consumer's
equilibrium will be between points III and IV as the consumer chooses to move to a higher
indifference curve as a result of increased income and purchasing power. However, the exact
location of the new equilibrium depends on the consumer's perception of X and Y. Assuming that
both X and Y are normal goods, the new consumer's equilibrium will be somewhere between
point I and II, showing an increased demand for both X and Y. However, if the consumer
perceives Y as a normal good and X as an inferior one, the new consumer's equilibrium will be
between points I and IV, showing a decreased demand for X and a higher demand for Y.
Assuming Y to be inferior and X to be a normal good, the new equilibrium will be between points
II and III, showing an increased demand for X and a lower demand for Y as a result of increased
income. It is worth noting that both X and Y can be normal goods at the same time but both
cannot be inferior.
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Income Consumption Curve (ICC)

A higher income induces consumers to move to a higher indifference curve, so there is a
separate equilibrium point for every different level of income, given by the intersection of
indifference curves and budget lines. The curve which joins all such equilibrium points is known
as Income Consumption Curve (ICC). ICC is upward rising if the consumer perceives all
commodities as normal (Diagram 3.3a). However, it is negatively sloped if the consumer
perceives one of the two commodities as inferior. In diagram 3.3b, X is assumed to be inferior
(higher income reduces demand) and Y a normal good (higher income raises demand), whereas
in diagram 3.3c, Y is assumed to be inferior and X is a normal good.
Diagram 3.3a
Y

ICC

X
Diagram 3.3b
Y

X
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Diagram 3.3c
Y

ICC

Impacts of Changes in Price

The budget line pivots when either price of commodity X or Y changes. Diagram 3.4 shows the
impact of reduction in price of X on the budget line. Before price reduction, the consumer was
buying x1 units but after the reduction in price of X, the quantity demanded rises to x 2. This is
known as price effect. Price effect can be divided into substitution and real income
effects. Diagram 3.5 illustrates substitution and real income effects separately.
Diagram 3.4
Y

x1 x2 X
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Diagram 3.5

IV
III

II

B1 B3 B2
x1 x2

The initial quantity purchased by the consumer is quantity x 1. The decrease in price of X causes a
pivotal move to the new budget line B2. To show the substitution effect separately, a hypothetical
budget line B3 is drawn, which is parallel to B2 AND tangent to the initial indifference curve. This
budget line shows the new price ratio of X and Y but the unchanged income. According to the
substitution effect alone, the consumer raises the demand of X from x 1 to x2. Substitution effect is
always negative and raises the demand of relatively cheaper products. However, real income
effect may be positive or negative, depending on the nature of the product. The increased real
income prompts the consumer to move to a higher indifference curve tangent to B 2. This is real
income effect. Assuming that X is a normal good, the demand for X increases as a result of
increased income and the new equilibrium will be to the right of x2 (between I and II). In this case,
income effect is positive and is reinforced by the substitution effect i.e. they both raise the
demand for X. However, if X is inferior, the new equilibrium will be between II and IV i.e.
increased real income lowers the demand of X. In this case, the income effect is negative and
tries to outweigh the substitution effect. In case the income effect is smaller than the substitution
effect, the new equilibrium will be between II and III. Though the demand decreases as a result of
increased income (negative income effect), the net effect on demand is an increase in demand,
as a stronger substitution effect outweighs the income effect. This is a case of non Giffen inferior
goods. In case negative income effect is stronger and outweighs the substitution effect, the new
equilibrium will be between III and IV. This is a case of Giffen goods, where a decrease in price
decreases the demand and results in an upward rising demand curve.
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Multiple Choice Questions

(Section 3)
J/04/3/02
1 What is not held constant when calculating the income effect of a change in the price of a
good?
A the consumer‟s money income
B the consumer‟s preferences
C the consumer‟s real income
D the prices of other goods

N/04/3/03
2 What explains the slope of an individual‟s demand curve for a normal good?
A market imperfections
B the law of variable proportions
C diminishing returns
D diminishing marginal utility

N/07/3/03
3 What is not held constant when calculating the substitution effect of a change in the price
of a good?
A the consumer‟s expenditure on other goods
B the consumer‟s money income
C the consumer‟s tastes
D the prices of other goods

N/11/32/01
4 Why does a normal demand curve for a product slope downwards from left to right?
A Buyers‟ additional satisfaction declines as consumption rises.
B Consumers are faced with choices between competing products.
C Sellers are willing to accept lower prices on larger orders.
D The average cost of production falls as the scale of production increases.

N/11/32/04
5 For the purposes of measuring the income effect of a change in the price of a good, what
is not held constant?
A consumer preferences
B relative prices
C the consumer‟s money income
D the consumer‟s real income

J/15/32/03
6 For the purposes of measuring the income effect of a change in the price of a good, what
is not held constant?

A consumer preferences
B relative prices
C the consumer‟s money income
D the consumer‟s real income
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J/16/32/04
7 In the indifference curve diagram point M is the consumer‟s initial equilibrium and MN is
the substitution effect of a fall in the price of good X.
If good X is a Giffen good which point will be the consumer‟s new equilibrium point after
the fall in the price of good X?

A
B
C
good Y
D
M
N

I
O K L
good X
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Section: 4 Costs of the businesses

While looking at the theory of consumer choice and how much should people consume, we learnt
that rational agents maximize total utility by consuming up to the point where relative benefits
equal relative costs. Likewise, observing producer behavior typically yields that rational producers
maximize profits and make pricing and output decisions accordingly. However, these decisions
require some measure of input costs and the output obtained- cost curves are precisely, a way of
obtaining that.

A production function measures the maximum amount of output that can be obtained using a
given amount of inputs. Inputs, typically called factors of production, include land, labour, capital
and entrepreneurship. Output directly depends on the quantity of inputs so employing a higher
number of labor hours and machine hours per week produces higher output per week.

Costs on the other hand, can be split up into short run and long run costs on the basis of time.
Short run costs are dictated by the Law of Diminishing Returns (see below) whereas long run
costs are determined using the concept of returns to scale (see Section 5).

Short run is an economic period of time where at least one input is fixed i.e. its quantity can‟t be
varied. Inputs, the quantity of which can not be varied immediately are said to be fixed e.g.
purchasing and installing new equipment and machinery takes considerable time, thus rendering
capital fixed. However, all types of capital are not fixed e.g. raw materials, the quantity of which
can be altered instantly.

Labour on the other hand, is considered to be a variable input as its quantity can be varied
according to the firm‟s requirements. An immediate labour requirement for instance, can be met
through overtime, which is one way of increasing labour supply

Following is a short run production function where X denotes output made in a certain period of
time, L, the number of labour hours and K, the number of machine/capital hours (Note that the
quantities of inputs are in terms of hours and not in terms of number of workers or number of
machines).

 
X = f L, K

K shows that capital is a fixed input, the quantity of which can not be changed in the short run.

The cost of inputs depends on both their quantities and prices. The cost of labour and capital for
instance, depends on their respective number of hours employed and „w‟ and „r‟, where w is the
wage rate per hour and r, the cost of one machine hour. Cost of machine hour includes the
opportunity cost of capital tied up in plant and equipment as well as depreciation and normal wear
and tear. Since an ordinary firm employs only a fraction of such a large market, input prices are
beyond the control of an individual firm- w and r are given and constant.
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Laws of Variable Proportion

(Laws of returns to a variable input)

“When increasing quantities of a variable input are combined with a given amount of fixed input,
there comes a point beyond which extra output from additional units of the variable input
diminishes, ceteris paribus.”

Adding increasing quantities of a variable input to a given quantity of fixed input changes the
proportion in which these inputs are hired. Thus, the law of diminishing returns is also known as
law of variable proportion as it examines the effects on output of varying the proportion in which
fixed and variable inputs are employed.
Consider the following example. A farmer‟s productivity is expected to be low when working on a
large piece of land since he would not be able to cultivate the whole of it. Hiring another farmer
therefore, may increase the output more than proportionately since work is sensibly split up
between the two. Eventually however, additional farmers have lesser space to work with so their
contribution to output diminishes i.e. the process of combining increasing quantities of variable
input (labour) with a given quantity of fixed input (land) does not increase output at an increasing
rate forever.
Total Product (TP) measures output obtained per period of time using a given amount of inputs.
Marginal product of labour (MPL) shows number of units of output made by hiring an additional unit of
labour. MPL is the rate of change of total product with respect to labour. For a production function
exhibiting law of variable proportion, MPL initially increases and eventually starts to diminish.

The following table shows how total product increases (see column 3), but at different rates. The
production function yields increasing returns till four workers are employed. Diminishing returns
start i.e. MPL starts to decrease after the fifth worker is employed (see column 4).
Table 4.1
1 2 3 4 5 6 7 8 9 10 11 12 13 14
K L TP MP AP w r FC VC TC MC AFC AVC AC
number number of
(£)
of hours units
1 0 0 - - 10 10 10 0 10 - - - -
1 1 10 10 10 10 10 10 10 20 1 1 1 2
1 2 22 12 11 10 10 10 20 30 0.83 0.45 0.91 1.36
1 3 36 14 12 10 10 10 30 40 0.71 0.28 0.83 1.11
1 4 52 16 13 10 10 10 40 50 0.625 0.19 0.77 0.96
1 5 66 14 13.2 10 10 10 50 60 0.71 0.15 0.76 0.91
1 6 78 12 13 10 10 10 60 70 0.83 0.13 0.77 0.90
1 7 88 10 12.57 10 10 10 70 80 1.0 0.11 0.80 0.91
1 8 96 8 12 10 10 10 80 90 1.25 0.10 0.83 0.93
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dTP
K = Machine hours FC = Fixed Cost MP 
dL
TP
L = Labour hours VC = Variable Cost AP 
L
TP = Total Product i.e total output TC = Total Cost TC = FC + VC
dTC
MP= Marginal Product MC = Marginal Cost MC 
dTP
AFC = Average Fixed FC
AP= Average Product AFC 
Cost TP
AVC = Average VC
w = wage rate/hour AVC 
Variable Cost TP
TC
r = interest rate i.e. cost of AC   AVC  AFC
AC = Average Cost TP
capital/hour

Relationship between Marginal Product (MP) and Total Product (TP)

Marginal Product (MP) represents the slope of the Total Product function (the slope of every total
is its marginal!) i.e. the ratio of change in TP and change in quantity of labour.
dY dTP
Slope of Total Product    MPL
dX dL
Relationship between Marginal Product (MP) and Average Product (AP)
Consider your class, where the average age is say, 18 years. Supposing that a new student
decides to join your class, the average age of the class increases if his age exceeds 18 years and
decreases if it is less than that. The same rule applies to Average Product (AP) i.e. the ratio of
Total Product (TP) and quantity of labour (L) and Marginal Product (MP). Observing columns 4
and 5 simultaneously we notice that AP rises as long as MP is higher than AP and falls when MP
is less than AP, as shown in the diagram below. Direction of the change in MP does not
determine the direction of the change in AP. AP increases as long as MP is above AP,
irrespective of the direction of the change in MP.
Diagram 4.1
MP
AP

AP

L
L1 L2 L3

MP
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The diagram shows that AP rises as long as MP is above AP and falls when MP is below AP. MP
cuts AP from above and at its maximum point. Thus, AP is maximized when MP equals AP.

Marginal Product (MP) is maximized when L1 labour hours are employed and diminishing returns
set in beyond this point so that total product rises but at a falling rate. As table 4.1 shows,
th th
diminishing returns set in between the 4 and 5 labour hour.

Average Product (AP) is maximized when L 2 labour hours are hired, beyond which AP begins to
fall as MP lies below AP.

Total Product (TP) is maximized when L3 labour hours are hired, beyond which MP becomes
negative and Total Product falls.

Thus along a Total Product curve, which is steep to start with but becomes increasingly flatter
later on (rising MP i.e. increasing returns followed by falling MP i.e. decreasing returns), MP is the
first to decrease, followed by AP and then Total Product.
(try J/07/3/04)

In order to examine the effects of law of variable proportion on a firm‟s costs, we need to define
the nature of costs. In the short run, total cost can be divided into two categories: fixed cost and
variable cost.

Fixed cost
Fixed cost is that portion of total cost which does not vary with the number of units made. It may
change due to other factors like inflation but not the units of output produced. Examples include
rent of building, depreciation, interest payments made to bank, royalties and salaries.

Our initial example (table 4.1) assumes price of labour and capital to be £10 per hour
(see columns 6 & 7). Column 8 shows Fixed Cost (FC), the product of amount of capital (K) and the
price of 1 machine hour (or r). Fixed Cost curve is a straight horizontal line as shown in diagram 4.2.
Since Fixed Cost does not change with output, Average Fixed Cost (AFC) decreases with each
additional unit produced as greater output spreads fixed costs over a larger volume- hence Average
Fixed Cost is downward sloping, as shown in diagram 4.3 (try J/08/3/07 and N/02/3/07).

Diagram 4.2 Diagram 4.3

Cost
Costs

FC
AFC
Output Output
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Variable Cost
Variable cost is that portion of total cost which varies directly with the number of units produced
e.g. the cost of raw materials and piece rate wages.

Variable Cost (VC) (see column 9) is the product of the quantity of variable input i.e. labour and
the price of one labour hour (or w). Variable Cost very obviously increases with additional units of
output; however Average Variable Cost (AVC), the ratio of Variable Cost and Total Product may
increase, decrease or stay the same. In the given example, it initially decreases but eventually
increases with output (see column 13).

The following example should make the distinction between fixed and variable costs clearer.
Consider the rent of a building that a tenant must pay- it is fixed for the period of lease
agreement. The rent must be paid to the landlord through out the lease period, irrespective of the
sales revenues or profits made. Thus, rent is a fixed cost. However, rent becomes variable once
the lease period expires. It is then upto the tenant to either vacate the building and avoid paying
the rent or renew the agreement with the landlord for another lease period. Rent becomes fixed
once again when the lease agreement is renewed.

Following is a Short Run Total Cost function derived from a short run production function.
 
X = f L, K
SRTC = VC + FC
SRTC = L.w + K.r

In the equation above:

SRTC = Short Run Total Cost (Assuming that capital is fixed)
L= Number of labour hours
w = Wage rate per hour
K = Number of machine hours
r = Cost of capital per hour
VC= Total variable cost
FC= (total) fixed cost.

Marginal Cost
Marginal cost is the cost incurred on producing an additional unit of output. It is the change in
total cost due to a change in the number of units produced. The following formula is used to
calculate marginal cost:
Changein total cost
Marginal cost 
Changein output
dTC
MC 
dX
As capital is fixed and prices of labour and capital i.e. w & r are beyond the control of an ordinary
firm, any change in total cost is precisely because of the change in the quantity of variable input
i.e. labour hours. Thus,

dTC = w.dL

where dTC is change in TC, w is the wage rater per hour and dL is the change in the quantity of
labour.
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The relationship between Law of Returns and Marginal Cost is very interesting. Increasing returns
occur when additional quantities of variable input combined with a fixed input increase output at
an increasing rate. In other words, firms experiencing increasing returns face diminishing costs as
they have to hire fewer labour hours to increase output at a constant rate. The following table
helps understand the relationship between law of returns and law of costs.

Table 4.2
dTP dTC dTC
TP L MP  K W R TC = w.L + r.K MC  
dL dTP MP

0 0 - 5 10 10 50 -
100 5 20 5 10 10 100 0.5
200 9 25 5 10 10 140 0.4
300 12 33.3 5 10 10 170 0.3
400 15 33.3 5 10 10 200 0.3
500 19 25 5 10 10 240 0.4
600 24 20 5 10 10 290 0.5
700 30 16.67 5 10 10 350 0.6

The production function above initially shows increasing returns and then decreasing returns. 5
labour hours are required to produce the first 100 units but only 4 are needed to make an
additional 100. Increasing returns continue till 12 labour hours. Constant returns occur i.e. total
product rises at a constant rate between 9 and 15 labour hours. Diminishing returns set in beyond
15 labour hours since increasing output by the same quantity i.e. 100 units requires ever
increasing quantities of labour hours. The last column shows Marginal Cost and it is interesting to
note that there are diminishing (marginal) costs whenever there are increasing returns. Total Cost
starts to increase at an increasing rate i.e. MC begins to rise when diminishing returns set in.

Alternatively,
dTC dTC dL
MC    w.
dTP MP MP
Note: As discussed earlier, dTC equals w.dL, the product of wage rate and change in the quantity
of labour.

Thus, it is clear that whenever MP rises (increasing returns to variable input) MC falls (diminishing
cost) and there are increasing costs (MC rises) when there are diminishing returns (MP falls).

Table 4.1 also proves this relationship (see column 4 and 11). It is also shown that MC is lowest
when MP is at its maximum (try N/06/3/03).

Average Cost
Average Cost (column 14) is the ratio of Total Cost and Total Product (output). Average Cost may
also be computed by summing Average Variable Cost (AVC) and Average Fixed Cost (AFC).
TC = FC + VC
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Dividing both sides by X i.e. output:

TC FC VC
 
X X X
AC = AFC + AVC
The following diagram helps understand the relationship between AC and AVC. Costs are shown
along Y axis and output along X axis.

Diagram 4.4
AC
AVC AC
AVC

Output
AC and AVC are both U shaped but are not parallel. The vertical distance between AC and AVC
i.e. (AC – AVC) equals AFC and since AFC always decreases with output, the vertical distance
between AC and AVC always decreases with increases in output. As AFC never becomes zero,
AVC always lies below AC.

Marginal Cost, Average Cost and Average Variable Cost

Diagram 4.5
AC MC
AVC AC
AVC
MC

Output
X1 X2 X3
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The Marginal Cost curve is somewhat hockey shaped as MC falls initially (increasing returns)
and then rises (decreasing returns). AC and AVC fall as long as MC is below AC and AVC. MC
cuts AVC and AC from below and at their respective minimum points. Diminishing returns set in
at output X 1. AVC and AC continue to fall till output X 2 since MC is still below them. AVC starts
to increase at X 2 but AC continues to fall till X 3. Between X2 and X3, the decrease in AFC
outweighs the increase in AVC. AC increases beyond X 3 as decreasing AFC no longer
outweighs increasing AVC.

Viewing from origin, MC increases first, followed by AVC and AC respectively.

There is no relationship between Marginal Cost and Average Fixed Cost curve. MC can cut AFC
at any point.

Total Cost (TC), Variable Cost (VC) and Fixed Cost (FC)
In the panel of output and costs, Fixed Cost shows as a straight horizontal as it does not change
with the number of units made. Total Cost and Variable Cost are parallel curves, the constant
difference between them measuring Fixed Cost. Total Cost and Fixed Cost share the same
vertical intercept as Total Cost equals Fixed Cost at zero output. Put another way, variable costs
are zero when no output is generated and TVC therefore begins from the origin.

The slope of both TC and TVC measures Marginal Cost. In the diagram, Total and Variable Cost
Curves initially become flatter showing decreasing Marginal Cost and increasing returns to a
variable input. Then roughly around output X 1, TC and VC start becoming steeper showing
increasing Marginal Cost and diminishing returns to variable input.

The relationship between Marginal Cost, Average Variable Cost and Average Cost can also be
verified by looking at the following pair of diagrams:
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Diagram 4.6(a)
Costs TC

VC

FC

Output
Diagram 4.6(b) X1 X2 X3
Costs

MC
AC
AVC

Output
X1 X2 X3

Diagrams 4.6(a) and 4.6(b) are drawn assuming initial increasing returns followed by diminishing
returns later on. Marginal cost is represented by the slope of TC in diagram 4.6(a) whereas the
slope of a straight line drawn from origin to certain point on Total Cost measures Average Cost
i.e. the ratio of Total Cost and output.
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At output X3, the straight line drawn from origin not only measures AC but also MC- thus MC
equals AC at this point. Average Cost is minimized at an output level where a straight line drawn
from origin (the slope of which measures AC) becomes tangent to the Total Cost Curve (the slope
of which measures MC). MC equals AC at this level of output, is less than AC at output levels
below it and higher than AC at output levels beyond it. AC decreases till X3 and increases beyond
it since the straight lines drawn from origin towards Total Cost Curve become increasingly flatter
till X3 and increasingly steeper beyond it.

At output X2, AVC equals MC since the straight line drawn from origin not only calculates AVC but
also MC at this point. Average Variable Cost is minimized at the output level where a straight line
drawn from origin becomes tangent to the Variable Cost Curve. MC equals AVC at this output.
MC is lesser than AVC at output levels below this quantity and higher than AVC beyond it. Thus,
AVC decreases till X2 and increases beyond it.

The vertical distance between AC and AVC measures AFC. Average Fixed Cost (AFC)
decreases whenever output increases so the vertical distance between AC and AVC decreases
throughout.

Total Cost and Variable Cost curves are always parallel whereas Average Cost and Average
Variable Cost curves can never be parallel.

Linear Total Cost Curve

Total Cost Curve can be straight line if we assume constant returns to a variable input. Constant
returns mean that Total Product and Total Cost rise at a constant rate i.e. MP and MC are
constant. The following table is constructed assuming constant returns to scale and represents
the pair of diagrams 4.7 (a) & (b).

Average Average
Total Fixed Variable Marginal Average
Output Variable Fixed
Cost Cost Cost Cost Cost
Cost Cost

0 10 10 0 - - - -
1 20 10 10 10 20 10 10
2 30 10 20 10 15 10 5
3 40 10 30 10 13.33 10 3.33
4 50 10 40 10 12.5 10 2.5
5 60 10 50 10 12 10 2
6 70 10 60 10 11.67 10 1.67
7 80 10 70 10 11.42 10 1.42
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Diagram 4.7(a)
Costs

TC
TVC

A FC

O Output
C D

Diagram 4.7(b)
Costs

AC
AVC = MC

Output

In diagram 4.7(a) Total Cost and Variable Cost are straight line, hence Marginal Cost is constant.
Additionally, the slope of the Variable Cost Curve also measures Average Variable Cost i.e.
Variable Cos t
.
output
dVC VC Ob
MC     AVC
dQ Q Od

Thus MC and AVC are equal and constant throughout.

The slope of AC can be determined by extending straight lines from the origin to various points on
the Total Cost Curve. Average Cost diminishes throughout since these straight lines become
flatter and flatter, however, Average Cost always stays higher than Marginal Cost since slope of
the straight line i.e. AC is always higher than the slope of Total Cost i.e. MC.
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dTC AB
MC  
dQ OC
TC OB
AC  
Q OC
OB  AB

Average Cost > Marginal Cost

Alternatively, given the linear Total Cost Curve:

TC  a  bQ
a equals FC or the vertical intercept of Total Cost Curve and b is the slope of Total Cost Curve
which is Marginal Cost (bQ = VC).
dTC
MC  b (first derivative of total cost with respect to output)
dQ
TC a b Q a
AC     b
Q Q Q Q
VC b Q
AVC    b
Q Q
The workings above show that AVC and MC are equal and constant whereas AC decreases
whenever output i.e. Q increases (a and b are positive and constant). Since a is positive, AC is
always higher than AVC and MC.

Assuming zero fixed costs, Average Cost, Average Variable Cost and Marginal Cost are equal
and constant for a straight line Total Cost function. Refer to the following table and diagrams.

Average
Average
Total Fixed Variable Marginal Average Fixed
Output Variable
Cost Cost Cost Cost Cost Cost
Cost

0 0 0 0 - - - -
1 10 0 10 10 10 10 10
2 20 0 20 10 10 10 10
3 30 0 30 10 10 10 10
4 40 0 40 10 10 10 10
5 50 0 50 10 10 10 10
6 60 0 60 10 10 10 10
7 70 0 70 10 10 10 10
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Diagram 4.8 (a)

Costs

TC

Output
Diagram 4.8 (b)
Costs

AVC = AC = MC

Output

For a straight line Total Cost Curve (assuming Fixed Cost > 0)
 Average Cost decreases throughout and is parallel to Average Fixed Cost
 Average Cost exceeds Marginal Cost at all points
 Marginal Cost equals Average Variable Cost and both are constant throughout

For a straight line Total Cost Curve (assuming Fixed Cost=zero)

 Average Cost, Marginal Cost and Average Variable Cost are equal and constant
throughout
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Multiple Choice Questions

(Section 4)
J/02/3/11
1 A firm is producing at the level of output at which its average variable cost is equal to its
marginal cost.
What will happen initially to its average variable cost and to its average total cost if it
increases its output?
Average Average
variable cost total cost
A decreases decreases
B decreases increases
C increases decreases
D increases increases

N/02/3/07
2 The diagram shows the short-run cost curves of a firm.

costs
4

3
2

1
O output
Which statement is correct?
A Curve 1 is the average fixed cost curve.
B Curve 2 is the marginal cost curve.
C Curve 3 is the average variable cost curve.
D Curve 4 is the average total cost curve.

N/03/3/10
3 The schedule shows the short-run marginal cost of producing good X.

units of X 1 2 3 4 5 6
marginal cost ($) 40 30 26 34 50 90

Given that the total fixed cost is $30 what is the level of output that minimises average
total cost?
A 2 units B 3 units C 4 units D 5 units
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N/04/3/05
4 Which statement explains why in the short run labour is subject to the law of diminishing
returns?
A As additional workers are hired, output decreases.
B As employment increases, the capital-labour ratio falls.
C As employment increases, wage rates will have to be increased.
D As output expands, sooner or later diseconomies of scale will set in.

N/04/3/10
5 What is marginal cost?
A the difference between the total cost of producing n and n -1 units of output
B the difference between the average variable cost of producing n units and n -1
units of output
C the difference between the average total cost of producing n units and n -1 units
of output
D the average variable cost of producing one more unit

J/05/3/04
6 According to the law of diminishing returns, what happens as more of a variable factor is
combined with a fixed factor?
A An increase in the price of the variable factor will eventually result in an increase
in production costs.
B A reduction in the quality of the variable factor will eventually result in an increase
in production costs.
C Fewer units of the variable factor will be needed to produce equal increases in
output.
D The proportions in which the factors are combined will eventually result in
progressively smaller increases in output.
J/05/3/09
7 In the diagram, XY is a firm‟s total cost curve.
Y

total
costs X

O output
What happens to the firm‟s costs as output is increased?
average fixed costs marginal costs
A decrease constant
B decrease increase
C constant constant
D constant increase
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N/05/3/04
8 The table shows the output of chairs at a factory when different numbers of workers are
employed.

number of workers 0 1 2 3 4 5
number of chairs produced 0 7 17 29 38 42

Diminishing marginal returns to labour will set in when

A the second worker is employed.
B the third worker is employed.
C the fourth worker is employed.
D the fifth worker is employed.

N/06/3/03
9 The diagram shows the marginal product of labour curve (MPL) for a firm.

marginal MPL
product
of labour

O N
number of workers
Labour is the only variable factor and the firm pays its workers the market wage.
At the level of employment ON, which statement is correct?
A The firm is maximising its output.
B The firm is minimising its total costs.
C The firm is minimising its wage bill.
D The firm is minimising its marginal cost of production.

N/06/3/06
10 If a firm experiences an increase in its fixed costs, how will its average variable cost and
its marginal cost be affected?

average variable cost marginal cost

A rise rise
B rise no change
C no change rise
D no change no change
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J/07/3/04
11 The diagram shows the total product curve for a single variable factor, assuming all other
factor inputs are held constant.

total product TP

O
quantity of variable factor
In which order do the total product (TP), average product (AP) and marginal product (MP)
begin to decrease as the input of the variable factor is increased?

First Second Third

A AP MP TP
B AP TP MP
C MP AP TP
D MP TP AP

J/07/3/09
12 The short-run total costs of a firm are given by the formula
2
SRTC = $(10 000 + 5X )
where X is the level of output.
What are the firm‟s average fixed costs?

A $10 000

B
 
$ 10 000  5 X 2
X
$10 000
C
X

D

$ 5 X 2  10 000 
X
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N/07/3/04
13 The diagram shows the short-run relationship between the total output of a firm and the
quantity of labour.

total output
total
output

0
quantity of labour

What can be concluded about the firm?

A It is experiencing increasing returns to scale.
B It is experiencing constant returns to scale.
C The marginal physical product of capital is constant.
D The marginal physical product of labour eventually diminishes.

N/07/3/07
14 The table shows a firm‟s total and marginal costs.

output total cost ($) marginal cost ($)

1 200 20
2 215 15
3 225 10
4 240 15
5 260 20

What is the average fixed cost of producing 6 units?

A $20 B $30 C $180 D $200

J/08/3/07
15 Which diagram shows a firm‟s total fixed cost curve?

A B C D

costs costs costs costs

O output O output O output O output

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N/08/3/04
16 Which statement explains why labour is subject to the law of diminishing returns in the
short run?
A As additional workers are hired, total output decreases.
B As employment increases, the capital-labour ratio falls.
C As employment increases, wage rates will have to be increased.
D As output increases, eventually diseconomies of scale will occur.

N/08/3/08
17 The table shows the production of a firm.

production total cost

(tonnes) ($)
0 20
1 30
2 35
3 40
4 45
5 50

What is the average variable cost of producing 5 tonnes of output?

A $4.00 B $5.00 C $6.00 D $10.00

N/09/3/03
18 Which statement describes a situation in which a rise in input of factor X, all other factors
being constant, results in no change in a firm‟s output?
A There are diminishing returns to factor X.
B Returns to scale are constant.
C There are diseconomies of scale.
D The marginal product of X is zero.

J/10/3/06
19 The schedule shows the short-run marginal cost of producing good X.

units of X 1 2 3 4 5

marginal cost ($) 40 30 30 60 120

Given that the total fixed cost is $20, what level of output minimises average total cost?
A 2 units B 3 units C 4 units D 5 units
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N/10/3/05
20 In the diagram, the curve shows the various combinations of labour and capital that can
be employed to produce a given level of output.
A firm chooses the combination of labour and capital shown by point X on the curve.

capital

O labour
What could explain why the firm later chooses the combination of labour and capital
shown by point Y?
A an increase in capital productivity
B an increase in interest rates
C an increase in labour productivity
D an increase in wage rates

N/10/3/08
21 The diagram shows a firm's short-run marginal cost curve.
SRMC

cost

O Q
output
What explains why the curve is upward sloping at output levels above OQ?

A diseconomies of scale
B inelasticity of supply
C rising fixed costs
D the law of variable proportions
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J/11/32/04
22 Which diagram correctly shows the relationship between the average product (AP) and
the marginal product (MP) of labour given that the quantities of other factor inputs remain
constant?
A B
MP
AP

product product

MP AP
O labour O labour

C D
MP
AP

product product

AP MP
O labour O labour

N/11/32/08
23 The short-run total costs (SRTC) of a firm are given by the formula
2
SRTC = $(10 000 + 5X )
where X is the level of output.

What are the firm‟s average fixed costs?

A $10 000

B

$ 10000  5X2 
X
$10000
C
X
$10000
D
5X2
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N/13/32/08
24 In the diagram, TC is a firm‟s short-run total cost curve.
TC

costs

O Q1 Q2 Q3
output
Which statement is correct?

A Average total cost is minimised at output OQ2.

B Average variable cost is minimised at output OQ1.
C Average variable cost is minimised at output OQ3.
D Marginal cost is minimised at output OQ1.

J/14/32/03
25 The table shows the output of chairs at a factory when different numbers of workers are
employed.

number of workers 1 2 3 4 5
number of chairs produced 6 17 27 32 30

Diminishing marginal returns to labour will set in when

A the second worker is employed.

B the third worker is employed.
C the fourth worker is employed.
D the fifth worker is employed.
J/14/32/09
26 The table shows a firm‟s marginal costs.

output marginal cost ($)

1 40
2 30
3 20
4 30
5 40

The average fixed cost of producing 5 units is $6.

What is the total cost of producing 5 units?

A $46 B $70 C $190 D $230

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J/14/32/10
27 What could explain why the proportion of total employment in an economy accounted for
by small firms decreases?

A a trend towards the use of sub-contractors to produce specialised components

B growing technical economies of scale in manufacturing
C growth of the service sector and a decline in manufacturing
D the opening up of specialist markets as real incomes rise

J/15/32/04
28 The diagram shows the total product of labour (TPL) curve for a firm whose only variable
factor input is labour.

TPL

total product
of labour

O
number of workers employed
What explains the shape of the curve?

A diminishing marginal disutility of work

B increasing marginal disutility of work
C technical diseconomies of scale
D the law of variable proportions

J/15/32/08
29 The table shows a firm‟s total and marginal costs.

output total cost ($) marginal cost ($)

1 340 40
2 375 35
3 400 25
4 435 35
5 475 40

What is the average fixed cost of producing 6 units?

A $50 B $60 C $180 D $300

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Section: 5 Cost Curves in the Long Run

Long run is a period of time where quantity of all factors of production can be changed and
consequently, all costs become variable. Long run production function describes the relationship
between the output firm produces and quantities of factors of production it hires.

There are no fixed factor constraints in the long run and costs are determined using the concept
of returns to scale. Law of returns to scale examines the effects on output of varying the scale or
the size of the business. The scale or the size of the business changes only in the long run, since
that is when the quantities of all inputs may be changed. This is why it becomes possible for a
firm to employ production factors in a fixed proportion contrasting with variable proportions in the
short run.

Increasing returns to scale occur when the percentage increase in output is greater than the
percentage increase in the quantities of all inputs whereas diminishing returns to scale mean that
doubling all inputs brings a less than 100% increase in output.

The following diagram shows the corresponding Long Run Marginal Cost function. Cost
decreases where there are increasing returns to scale and increases when diminishing returns
set in i.e. beyond output Q1.
Diagram 5.1
Costs LMC

Output
Q1

Economies of Scale
Economies of scale are reductions in per unit cost due to increased business size/scale. They
can be categorized into internal and external economies. Whereas internal economies of scale
are reductions in average cost attributed to business size, external economies arise either due to
increased size of the industry or due to the location of the firm.
Internal economies of scale are further divided into the six types given below:
(i) Commercial economies of scale
A larger business can win a discount by buying raw materials and other inputs in bulk.
Per unit material cost of a meal served in a big restaurant thus may be lower than that
of serving the same meal in a smaller restaurant. Bigger stores like Wal Mart can win
favourable credit terms and prices from suppliers, leading to reduced Average Variable
Cost.
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(ii) Financial economies of scale

A larger business carries lesser risk of failure and can provide adequate securities to
banks. Thus, it can borrow money relatively easily and at lower mark-ups compared to
smaller businesses. It may float shares to the general public, the per unit cost of which
is less than that of a business which issues only a limited number of shares.

(iii) Managerial economies of scale

Firms need not double the number of managers when number of workers is doubled.
The same number of managers can effectively manage a larger group of employees,
thus per unit cost of managers decreases whenever business grows and number of
employees increases.

(iv) Technical economies of scale

A larger business may better afford and justify the purchase of latest, modern
technology to help improve efficiency and reduce per unit cost. For instance, a large
furniture factory can employ automated machinery for greater efficiency and lower per
unit cost. However, a smaller firm neither affords this technology nor does its small
volume lead to a reduction in per unit cost.

(v) Risk bearing economies of scale

Larger businesses usually have diversified portfolios, with their risks spread over a
range of products and activities. Profits of other products can cross subsidies those that
incur losses. This cushion is unavailable to a smaller firm, where losses may easily
lead to a complete collapse.

(vi) Marketing economies of scale

Per unit cost of reaching customers through marketing is lesser for a larger firm with a
huge network. For example, a restaurant with 10 branches spending £100000 on
marketing has a lower per branch cost compared to a restaurant with a single branch
spending £25000 on marketing annually.

Diseconomies of scale
Contrasting economies are diseconomies of scale-increases in per unit cost due to increased
size/scale of the business. Managerial diseconomies of scale are the most common where a
business becomes too large to coordinate and control, thus, per unit cost increases as pilferage
and wastage tend to increase. A firm experiencing higher transportation costs as its market
expands incurs a higher per unit cost and hence, internal diseconomies of scale. Likewise, per
unit cost rises when it becomes increasingly difficult to motivate workers in a large organization.

External economies of scale

External economies of scale are reductions in per unit cost due to increased size of industry
or/and location of the firm. The improved infrastructure, availability of skilled labour, supplies of
raw materials and other inputs helps firm reduce their production costs. Training sessions at an
industry financed technical center, better communication resulting from growth of the local
industry and trade information from a new trade journal are examples of external economies of
scale.

External diseconomies of scale arise when per unit cost begins to rise due to factors beyond a
firm‟s control e.g. as industry expands, it leads to increased traffic congestion, hence raising
firms‟ transportation costs.
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Least Cost Combination

Profit maximizing firms use least cost combinations of labour and capital, ensuring that production
occurs at the lowest possible cost. A least cost combination, as shown below, is where £1 spent
on hiring either capital or labour yields the same return.
MPL MP k

w r
where MPL and MPK are the marginal products of labour and capital respectively, w , the wage
rate/hour and r, capital cost/hour.
MPL MP k
The firm must hire more labour and less capital if  since spending £1 on hiring labour
w r
MPL MPk
gives greater output than capital. Likewise, it must substitute labour for capital if  .
w r
Consider the numerical example where:
MPL = 100 units
w = £10/hour
MPk = 100 units
r = £5/hour

MPL MPk

w r
100 100

10 5
10 < 20

Spending £1 on hiring capital provides 20 units whereas spending the same on hiring labour
yields only 10 units. The firm can reduce its cost by employing more capital and less labour. MP K
MPL
diminishes with additional amounts of capital and MPL increases. The process continues till
w
MP k MPL MP k
equals . A least cost combination is obtained where  - no other combination of
r w r
labour and capital decreases total cost of producing output. (Attempt J/04/3/13)

Isoquant and Isocost Approach

Isoquant shows different combinations of labour and capital, which can be employed to produce a
given level of output. All combinations on one isoquant show the same output, and a higher
isoquant indicates higher output.

Isoquant is downward sloping, as more quantity of a factor of production (for example, labour) is
required to produce the same output if the firm chooses to hire fewer units of the other input e.g.
capital. The substitution of capital with labour results in a movement along isoquant, as indicated
in diagram 5.2.
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Diagram 5.2
K

1Q

An isoquant is not a straight line, rather it is convex if viewed from the origin i.e. its slope
decreases throughout. The reason for the convex shape of an isoquant is that the firm is required
to give up smaller and smaller quantities of capital (K) to have additional units of labour (L) to
produce the same output. This is because of the law of diminishing marginal utility. The following
table helps to explain this:
L 1 2 3 4 5
K 20 15 11 8 6

All combinations of K and L shown in this table are on the same isoquant, thus generating the
same output. In order to substitute capital for labour i.e. to increase labour quantity from 1 to 2,
the firm is required to give up 5 units of capital, as the loss of output by not having 5 units of
capital is compensated by having one more unit of labour. However, the marginal product (MP)
of the third unit of labour is lesser than the second, so the firm is required to give up a smaller
quantity of capital (only 4 K) when it chooses to employ the third unit of labour. Similarly, for the
fourth unit of labour, the firm is required to sacrifice an even smaller quantity of capital (3 K). The
slope of isoquant is known as Marginal Rate of Factor Substitution (MRS), which decreases
throughout, along an isoquant. MRS is the ratio of the change in K to the change in L. It is also
the ratio of MPK to MPL. For example, if MPK is 20 units and MPL is 10 units, the firm is required to
hire 2 more units of labour to compensate for the loss in output for not having 1 unit of capital, so
the slope of isoquant is;
dK MPL 20
   2K / L
dL MPK 10

An isocost shows all possible combinations of labour and capital that a firm can employ with
given resources and fixed factor i.e. wage rate (w) and interest rate (r). Assuming the firm has
10 and w and r are £2 and £1 per unit respectively, any of the following combinations of L and K
can be employed.

L 5 4 3 2 1 0
K 0 2 4 6 8 10
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Diagram 5.3
K

10

L
O
1 2 3 4 5
The following equation assumes, that all resources being spent on employing labor and capital.
R = w. L+ r. K
Where:
R = Firm‟s money resources
w = wage rate/ hour r = Cost of capital/hour
L = Quantity of Labor employed K = Quantity of capital employed
Dividing both sides by r,
R w
 .L  K
r r
Rearranging,
R w
K  .L
r r
R R
This is the linear equation of the isocost where is the vertical intercept, is the horizontal
r w
w
intercept and , the slope of the isocost. The slope is negative as the isocost is downward
r
sloping. (See diagram 5.4)
Diagram 5.4
K

R
r

w
r

R
w
L
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Least Cost Combination of Factors

The least cost combination is given by the intersection of isocost and isoquant as shown in the
following diagram.
Diagram 5.5
K

A
D

K1 B

C
E

L1 L

Though factor combinations A, B and C result in the same output, the firm will choose B, as
combinations A and C lie outside isocost, and are hence unaffordable. Similarly, combinations D,
B and E lie on the same isocost and hence cost the same to the firm, but the firm chooses B, as
combinations D and E are on lower isoquants, giving lesser output to the firm. Thus, the
combination B minimizes the cost of producing this output, where the firm employs L 1 units of
labour and K1 units of capital. The slope of the isoquant is MPL / MPK and the slope of the isocost
is w / r, so at the point of intersection, MPL / MPK equals w / r, which is exactly similar to the
condition of least cost factor combination established earlier with the help of a numerical
example.

Long run average cost curve

The relationship between short and long run average cost curves is shown in diagram 5.6. The
long run average cost curve is tangential to SRAC curves.
Diagram 5.6
Costs

LRAC
SRAC4
SRAC1
SRAC2 SRAC3

Q
MES
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Assume that the firm owns one factory whose short run average cost curve is SRAC 1. The firm
can only increase production by setting up another factory in the long run with SRAC2, which is
lower than SRAC1 due to economies of scale. It continues to exploit economies of scale till
control and co ordination issues spring up and it reaches a higher average cost curve, SRAC 4.
Long run average cost curve is also known as the envelope curve, as it touches and envelopes
all the short run average cost curves. (Attempt N/03/3/11)

Minimum Efficient Scale (MES)

Minimum Efficient Scale (MES) is the size beyond which no significant economies of scale are
observed. In other words, it is the point beyond which long run average cost curve rises or
flattens out. Long run marginal cost curve (LMC) cuts LRAC at its minimum point- at MES.
Diagram 5.7
Costs LMC

LRAC

Diseconomies
Economies of of scale
scale

Size of
MES business

Minimum Efficient Scale (MES) And The Size Of Firms

MES can be expressed as a percentage of the total size of the market or total domestic
production. Few large firms tend to dominate the industry where MES is high, the steel industry
for instance. Fixed cost is extremely high and per unit cost is more likely to fall whenever output is
increased. The long run average cost for such an industry looks somewhat similar to the one
shown in diagram 5.8.
Diagram 5.8
Cost

LRAC

Q
MES
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Natural Monopoly
Consider an extreme case where total costs of a firm almost equal fixed cost. For such firms,
increasing output always results in decreased per unit cost. Examples are firms providing utilities
whose major cost is that on infrastructure such as laying down pipe lines, poles, transformers,
cables etc. The service can be provided to additional customers at an almost zero marginal cost
and long run average cost decreases with every increase in output. The corresponding long run
cost curve looks like that in diagram 5.9
Diagram 5.9
Costs

LRAC
Q
In such industries, firms may attract more customers by lowering prices and still be profitable as
average cost decreases with increased output. Such a market situation incentivizes the market
leader to act as a monopolist and drive out relatively weaker firms. Since it sells a larger volume
at a lower price, its per unit cost is lower than that of firms producing lower quantity and hence, is
still profitable.
Consider an industry consisting of just two firms, A and B, each producing quantity q 1 at an
average cost AC1 as shown in diagram 5.10. Assume firm A decides to attract B‟s customers by
lowering price. Whereas B‟s quantity sold decreases to q 3 and average cost increases to AC 3, A
operates at output q2 and average cost AC2. Despite the lower price it charges, A is still profitable
and enjoys monopoly power as B is soon forced to leave the market. This is the case of a natural
monopoly which exists when market conditions do not allow the existence of more than one firm.
For a natural monopoly, LRAC slopes downward showing that per unit cost decreases
throughout. MES is infinite and the size of the market demand determines the output the firm
produces.
Diagram 5.10
Costs Costs
Firm A Firm B

AC3

AC1
AC1

AC2 LARC
LARC

Q Q
q1 q2 q3 q1
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What does the MC curve of a natural monopoly look like? Try answering this question before
proceeding further!
Natural Monopoly and Allocative Efficiency
Marginal Cost curve always lies below LRAC curve for firms whose Long Run Average Cost
(LRAC) decreases with every increase in output.
Allocative efficiency requires a firm to charge a price that equals Marginal Cost. In case of a
natural monopoly, charging a price equal to MC means charging below Average Cost. Thus, a
natural monopoly can not be profitable and allocatively efficient at the same time (see section 11).
An industry consists of few large sized firms where MES is high and a large number of small
sized firms if MES is low. Only 2 efficient firms survive in an industry where MES is 50%. As
explained in the case of Natural Monopoly, the two firms can lower prices and still remain
profitable since economies of scale are available upto 50% of the market output. Other firms have
no option but to incur losses because of lower output and higher per unit cost and eventually
leave the industry.
Market size
Number of firms 
MES
Number of firms will still be 2 even if MES is higher than 50% but smaller than 100%.

Reasons For The Existence Of Small Firms

There exist industries where diseconomies of scale set in at very low levels of output. Firms
operating in such industries are more likely to be small sized, for example services that have to
be provided at an arm‟s length distance like a hair dresser, a dentist, an architect and a
consultant. The major strength of these businesses is to provide direct, one on one service to
their customers. This strength is lost if the firm tries to expand its size. Thus, as shown in
diagram 5.11, long run average cost begins to increase at fairly low levels of output, implying a
low MES.
Diagram 5.11
Cost
LRAC

Q
MES

Small firms may better serve market niches. Niches are small segments of markets which large
firms often find unprofitable and thus leave un-served. For instance, a large A Level school may
ignore the segment of students who wish to complete A Level in one year instead of the regular
two year course. A smaller firm is flexible enough to cater to this small segment.
Smaller firm can co exist with larger firms as the latter may not produce all components of
products. They can out source few of them, creating opportunities for smaller firms. A car
manufacturer for example, can buy seat covers for its cars from an outside firm.
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Multiple Choice Questions

(Section 5)
J/02/3/05
1 In the diagram, the curve shows the various combinations of labour and capital that can
be employed to produce a given volume of output.
A firm initially chooses the combination of labour and capital shown by point X on the curve.
In a subsequent period the firm chooses the combination of labour and capital shown by
point Y.

X
labour

O capital

What could explain this change?

A a decrease in capital productivity
B an increase in labour productivity
C an increase in the cost of labour
D an increase in the cost of capital
J/02/3/12
2 The table below shows the relationship between total output and total costs of a firm
given constant factor prices and fixed factor proportions.
output costs ($)
100 80
200 180
300 300
400 440
500 600
It follows that, over this range of output, the firm experiences
A decreasing returns for output between 100 and 300 and increasing returns for
output larger than 300.
B increasing returns for output between 100 and 300 and decreasing returns for
output larger than 300.
C decreasing returns throughout.
D increasing returns throughout.
N/02/3/06
3 Which of the following is a financial economy of scale?
A less risk due to diversification
B lower costs in raising capital
C lower costs of marketing
D lower variable costs of production
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J/03/3/04
4 A given production process uses both labour and capital.
What will be the effect on the quantities of labour and capital employed if the government
introduces a subsidy on capital investment?
quantity of labour quantity of capital
A decreases uncertain
B uncertain uncertain
C decreases increases
D uncertain increases

J/03/3/07
5 Which of the following is an internal economy of scale?
A improved communications as a result of the growth of local industry
B lower risk associated with supplying a wider range of customers
C the training of skilled labour at a technical college financed by all local firms
D trade information from a new trade journal

N/03/3/08
6 In the diagram the heights of the vertical broken lines show levels of output
corresponding to different combinations of labour and capital.

out
put

r ca
ou p it
al
la b

What does the diagram show?

A a cost function
B a long-run production function
C an input function
D a production possibility function
N/03/3/11
7 Which statement about the long-run average cost curve of a firm is correct?
A It falls continuously because of economies of scale.
B It passes through the minimum points of the firm's short-run average cost curves.
C It assumes that factor input proportions are held constant as output increases.
D It indicates the minimum average cost at which each level of output can be
produced.
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N/03/3/12
8 The proportion of total employment in an economy accounted for by small firms
increases.
Which explanation for this is least likely to be valid?
A a trend towards the use of sub-contractors to produce specialised components
B growing technical diseconomies of scale in manufacturing
C growth of the manufacturing sector and a decline in services
D the opening up of market niches as real incomes rise

J/04/3/13
9 A firm employs three factors of production. The table shows the marginal products of
these factors and their respective costs at the current level of output.
land labour capital
Marginal product
1 2 9
(units)
Marginal cost per unit
4 6 3
of factor($)
Which adjustment in factor use would be most likely to bring the firm nearer to the least-
cost combination of inputs for its current output level?

land labour capital

A less no change more
B less no change no change
C more less no change
D more less more

N/04/3/09
10 A firm‟s long-run production function describes the relationship between
A the firm‟s output and the quantities of factor inputs employed.
B the firm‟s long-run average cost of production and the level of output.
C the firm‟s long-run average cost of production and the quantities of factor inputs
employed.
D the prices of factor inputs and the quantities of factor inputs employed.

J/05/3/08
11 What is generally thought to be the main reason why firms might experience decreasing
returns to scale when they grow beyond a certain size?
A financial diseconomies
B managerial diseconomies
C marketing diseconomies
D technical diseconomies

J/05/3/10
12 What is the shape of the long run average cost curve for a firm with economies of scale?
A It is horizontal.
B It is „U‟ shaped.
C It slopes downwards.
D It slopes upwards.
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N/05/3/08
13 The table below shows the relationship between total output and total costs of a firm
given constant factor prices and fixed factor proportions.
output costs ($)
100 80
200 180
300 300
400 440
500 600
It follows that, over this range of output, the firm experiences
A decreasing returns for output between 100 and 300 and increasing returns for
output larger than 300.
B increasing returns for output between 100 and 300 and decreasing returns for
output larger than 300.
C decreasing returns throughout.
D increasing returns throughout.

N/05/3/10
14 As a firm expands, what is most likely to prevent its long run average costs falling?
A increased interest rates on borrowing
B increased labour specialisation
C increased labour supervision costs
D substitution of capital for labour

J/06/3/06
15 As firm X grows in size, it specialises in a narrower range of products.
Which economies of scale will the firm be less able to benefit from?
A financial
B marketing
C risk-bearing
D technical

N/06/3/07
16 Which of the following is an example of an external diseconomy?
A difficulties in co-ordinating activities in a large organisation
B difficulties in motivating workers in a large organisation
C higher transport costs as a firm‟s market expands
D increased traffic congestion as industries expand

N/06/3/08
17 Which small firms are most likely to survive for only a relatively short period?
A those producing components for large firms
B those producing specialised products for small markets
C those engaged in activities with low start-up costs
D those engaged in activities that require flexibility in meeting customer
requirements
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J/07/3/08
18 Which of the following is a financial economy of scale?
A lower risk due to diversification
B lower costs in raising capital
C lower costs of marketing
D lower variable costs of production

J/07/3/11
19 How might a firm benefit from external economies?
A by increasing its expenditure on advertising
B by increasing its scale of production
C by locating in an area in which the industry is already established
D by merging with another domestic firm engaged in the same industry

N/07/3/08
20 Which of the following costs of a firm is most likely to rise as it expands?
A the rate of interest paid on borrowing
B the price of components
C the cost of monitoring workers‟ inputs
D energy costs per unit of output

J/08/3/04
21 The table shows the current position of a firm in a perfectly competitive industry.

factor X factor Y
marginal physical product 2 8
factor price $5.00 $10.00

If the firm sells its product for $1 and aims to maximise profits, what should it employ?
A more of both X and Y
B more of X and less of Y
C more of Y and less of X
D less of both X and Y

J/08/3/06
22 What is the name for the relationship between a firm‟s output and the quantities of factor
inputs that it employs?
A a long-run production function
B a long-run average cost function
C productive efficiency
D returns to scale

J/08/3/08
23 What explains why both large and small firms are often found within the same industry?
A There are significant barriers to the entry of new firms into the industry.
B Firms that assemble the final product buy component parts from other specialist
firms.
C Production is subject to diseconomies of scale.
D All firms in the industry produce identical products.
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N/08/3/07
24 When a firm increases all its inputs by 300 %, its output increases by 200 %.
What does this illustrate?
A the law of diminishing returns
B increasing returns to scale
C diseconomies of scale
D the law of variable proportions

J/09/3/01
25 In the diagram, the firm is operating at point X on its long-run average cost curve.
LRAC

X
cost

O output
Which statement about the firm is correct?
A It is operating at its optimal level of output.
B It is operating below its cost-minimising level of output.
C It is productively inefficient.
D It could produce its current level of output at a lower cost.
J/09/3/06
26 A manufacturing firm has one plant of optimum size.
The firm builds a second plant identical to its first plant. The firm then finds that its long-
run average cost has risen.
What could account for the change in its long-run average cost?
A diminishing returns
B external diseconomies of scale
C managerial diseconomies of scale
D technical diseconomies of scale
N/09/3/08
27 The table shows the inputs of the two factors of production, capital and labour, needed to
produce varying levels of output.
output capital labour
100 5 10
200 8 16
300 14 28
400 20 40
500 26 52
Over which output range do increasing returns to scale occur?
A 100 to 200 B 200 to 300
C 300 to 400 D 400 to 500
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J/10/3/07
28 Which is an example of an external diseconomy?
A difficulties in co-ordinating activities in a large organisation
B difficulties in motivating workers in a large organisation
C higher transport costs as a firm‟s market expands
D increased traffic congestion as industries expand

N/10/3/04
29 A firm in a perfectly competitive industry employs two factors of production, X and Y.
The table shows the factor price and the current marginal physical product of these two
factors.
factor X factor Y
factor price $2.50 $6.00
marginal physical product 2 8

If the firm sells its product for $1 and aims to maximise profits, what should it do?
A employ less of both X and Y
B employ less of X and more of Y
C employ more of both X and Y
D employ more of X and less of Y

J/11/32/05
30 What is the name for the relationship between a firm‟s output and the quantities of factor
inputs that it employs?
A a long-run average cost function
B a long-run production function
C productive efficiency
D returns to scale

N/11/32/07
31 The table shows the levels of output of a good which can be produced with different
combinations of labour and capital.

capital Labour output

(number of machines) (number of workers) (units)
2 6 100
2 7 106
2 8 108
4 12 200

Which characteristic of the production function for this good does the table show?
A a fixed ratio between capital and labour inputs
B constant returns to scale
C increasing marginal productivity of labour
D technical economies of scale
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N/11/32/09
32 What would be most likely to constrain a firm‟s ability to grow?
A the increased difficulty faced by the firm in marketing its product
B the increased risks arising from product diversification
C the increasing costs of distributing goods from a given location
D the increased difficulties faced by the management in coordinating production

J/12/32/5
33 A firm experiences diseconomies of scale over its entire range of output.
What is the shape of its long-run average cost curve?
A It is horizontal. B It is „U‟ shaped.
C It slopes downwards. D It slopes upwards.

J/12/32/6
34 Which is a financial economy of scale?
A lower costs in raising capital B lower costs of marketing
C lower risk due to diversification D lower variable costs of production

J/12/32/7
35 The table shows a firm‟s total costs of production.

production (tonnes) total cost ($)

0 40
1 60
2 70
3 80
4 90
5 100

What is the average variable cost of producing 5 tonnes of output?

A $8.00 B $10.00 C $12.00 D $20.00

J/12/32/9
36 The diagram shows a firm‟s short-run and long-run average cost curves.

M N
J K
cost
L

O
output
Which curve is the firm‟s long-run average cost curve?
A JLN B JLM C KLM D KLN
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J/12/32/13
37 The diagram shows a firm‟s short-run total cost curve (TC).

TC

total
cost

O Q
output
What is minimised at output OQ?
A average fixed cost B average total cost
C average variable cost D marginal cost

N/12/32/09
38 A manufacturing firm has one plant of optimum size.
The firm builds a second plant identical to its first plant. The firm then finds that its long-
run average cost has risen.
What could account for the change in its long-run average cost?
A diminishing returns B external diseconomies of scale
C managerial diseconomies of scale D technical diseconomies of scale
J/13/32/08
39 The diagram shows the long-run average cost curve of a firm which faces constant factor
prices.

LRAC

cost

O
output
Which economic concepts in the table explain the shape of the LRAC curve?

economies and the law of the law of

diseconomies diminishing variable
of scale returns proportions
A   
B   
C   
D   
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J/13/32/09
40 Which feature of an economy would be most favourable for the survival of small firms?

A capital intensive production

B economies of scale in production
C the presence of a stock exchange
D the widespread availability of bank lending

N/13/32/07
41 The table shows a firm‟s long-run total cost schedule.

output of goods
total cost (US$)
per month
100 100
200 120
300 150
400 200

Which graph shows the shape of the firm‟s long-run average cost curve?

A B
LRAC
LRAC

cost cost

O output O output

C D
LRAC

cost cost

LRAC

O output O output

N/13/32/09
42 What is an internal diseconomy of scale that often arises as a firm becomes larger?

A a more complex decision-making process

B an increase in the cost of raising finance for investment
C an increase in traffic congestion
D upward pressure on wages in the local labour market
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J/14/32/07
43 The table gives information about a firm‟s costs over a given range of output in the short
run and in the long run.

output (thousand) 21 22 23 24 25
short-run average cost ($) 20 19 18 17 16
long-run average cost ($) 12 13 14 15 16

Which conclusions can be drawn about the characteristics of production over this output
range in the short run and in the long run?

short run long run

A decreasing returns to scale diminishing returns
B economies of scale diminishing returns
C C increasing returns decreasing returns to scale
D increasing returns economies of scale

N/14/32/08
44 The table below shows the relationship between total output and total costs of a firm
given constant factor prices and fixed factor proportions.

output costs ($)

100 100
200 160
300 180
400 320
500 500

It follows that, over this range of output, the firm experiences

A decreasing returns for output between 100 and 300 and increasing returns for
output larger than 300.
B increasing returns for output between 100 and 300 and decreasing returns for
output larger than 300.
C decreasing returns throughout.
D increasing returns throughout.

J/15/32/07
45 What relationship does a firm‟s long-run production function describe?

A the firm‟s output and the quantities of factor inputs employed

B the firm‟s long-run average cost of production and the level of output
C the firm‟s long-run average cost of production and the quantities of factor inputs
employed
D the prices of factor inputs and the quantities of factor inputs employed
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J/15/32/09
46 A firm experiences external diseconomies of scale and decreasing returns to scale.
How would these changes be illustrated on a cost curve diagram?

shift in long-run movement along longrun

average cost curve average cost curve
A downward downward
B downward upward
C upward downward
D upward upward

N/15/32/08
47 A fourfold increase in all of a firm‟s inputs results in a threefold increase in its output.
What does this illustrate?

A decreasing returns to scale

B economies of scale
C the law of diminishing returns
D the law of variable proportions

N/15/32/09
48 A firm employs two factors of production. The table shows the marginal products of these
factors and their respective costs at the current level of output.

land labour
marginal
1 5
product (units)
marginal cost per unit
4 3
of factor ($)

Which adjustment in factor use would be most likely to bring the firm nearer to the least-
cost combination of inputs for its current output level?

land labour
A less less
B less more
C more less
D more more

J/16/32/10
49 Which is a risk-bearing economy of scale?

A greater bargaining power in purchasing from suppliers

B greater diversification of the product range
C lower costs in raising capital
D lower distribution costs by increasing market share
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J/16/32/12
50 In many developed economies, clothes are designed by small firms and retailed by large
firms.
What is the most likely explanation for this pattern?

clothes design firms clothes retail firms

need to be flexible to cope need to exploit marketing
A
with frequent fashion changes economies of scale
need to employ highly need to operate at a low
B
specialised and skilled workers minimum efficient scale
need to operate at a high need to offer a wide range
C
minimum efficient scale of products to survive
need to overcome high need to take advantage of
D
barriers to entry into the industry technical economies of scale
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97 6- Economist’s Vs Accountant’s definition of Costs

Section: 6 Economist’s Versus Accountant’s Definition of Costs

It may seem nonsensical at first glance, to differentiate between an economist‟s and an
accountant‟s definition of costs. Why would the numbers differ in the eyes of either after all, when
the price and quantity of inputs employed by any particular producer remains the same for both?
However, an economist needs to account for another type of costs- opportunity cost. Whereas an
accountant only considers explicit payments made to factors of production (e.g. rent of the
building, salaries to workers etc), what matters to an economist in addition is the concept of
implicit costs, i.e. the foregone earnings or opportunity cost involved in providing any particular
product (e.g. foregone interest on owners‟ equity and the opportunity cost of owners‟ time). This
difference in costs is what explains the difference in profits calculated by accountants and
economists.

Profits are the excess of sales revenues over total cost. Sales revenues are a product of sale
price and quantity sold whereas Total Cost equals the sum of fixed costs and variable costs.

The following example helps understand the difference in profits calculated by accountants and
economists.

The monthly sales revenue of a small businessman equals £10000. He pays £2000 per month as
salaries, £1000 as mark-up on the amount borrowed from the bank and £1000 for raw material
purchases. He works full time for his business and conducts it in his own premises. He estimates
that he can earn a monthly salary of £1500 and a monthly rent of £800 if he decides to shut down
the business.

His explicit costs are £4000 (salaries to employees + markup on bank loan + cost of raw
materials) and according to accountants, his monthly profit is £6000.

Accountant profit = sales revenue – explicit cost

= £10000 – £4000 = £6000

Economists on the other hand, account for implicit costs too which in this case are £2300
(forgone salary + forgone rent). Total Costs are thus £6300 (explicit cost + implicit cost) and
profits, £3700.

Economist profit = sales revenue – (explicit cost + implicit cost)

= £10000 – (£4000 + £2300) = £3700

The owner is better off shutting down if his monthly accountant profit is less than £2300. Thus,
£2300 is the minimum acceptable profit for this owner to continue his business-it is the normal
profit.

Normal profit is the earning possible from next best alternative use of resources i.e. if the
business is closed and resources owned are released and invested elsewhere. A firm earns
normal profit when its economic profit is zero and accountant profit equals implicit cost. Super
normal profits occur when economic profit exceeds zero.
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98 6- Economist’s Vs Accountant’s definition of Costs

Business Objective: Profit Maximization or Loss Minimization

Though some firms may pursue different objectives, others typically aim at profit maximization.
How firms determine the profit maximizing output is explained with the aid of an example below.
For simplicity, sale price is assumed to be constant at $10 per unit. Marginal Revenue (MR), the
revenue generated from the sale of an additional unit thus equals sale price. Diminishing returns
occur with MC falling initially and rising later on.

Table 6.1

Sale Total Marginal Total Fixed Marginal Profits

Quantity
Price Revenue Revenue Cost Cost Cost (losses)
0 10 0 - 2 2 - (2)
1 10 10 10 14 2 12 (4)
2 10 20 10 24 2 10 (4)
3 10 30 10 32 2 8 (2)
4 10 40 10 38 2 6 2
5 10 50 10 46 2 8 4
6 10 60 10 56 2 10 4
7 10 70 10 68 2 12 2

Producing units contributing more to revenue and less to cost increases firm‟s profits, hence a
profit maximizing firm must produce all units whose MR exceeds MC. Likewise, production must
not exceed the level where additional units contribute more to cost and less to revenue i.e. where
MC is exceeding MR. Profits are thus maximized where cost of making an extra unit i.e. MC
exactly equals the revenue generated from the sale of that unit i.e. MR. The Marginal Profit i.e.
the profit from an additional unit is zero for the last unit (unit no 6 in above table).
(Try N/03/3/15)

In the table above, MC equals MR at two output levels: 2 and 6. Losses are maximized where
falling MC equals MR i.e. at 2 units of output and profits, where MR equals rising MC, i.e. at 6
units. Thus, the intersection of rising Marginal Cost and Marginal Revenue determines the profit
maximizing (or loss minimizing) output. As stated earlier, profit maximizing firms should increase
output if MR exceeds MC and decrease output if MR falls short of MC. The following pair of
diagrams illustrates this concept.
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99 6- Economist’s Vs Accountant’s definition of Costs

Diagram 6.1(a) TC TR
Revenue
Cost

Output

Diagram 6.1(b)
Revenue
Cost

MC

P = AR = MR = D

Output
X1 X2

In the diagrams 6.1 (a & b), profits are maximized at X 2 units of output and total revenue and total
cost curves become parallel here. The lower panel shows that the slope of Total Revenue i.e. MR
equals the slope of Total Cost i.e. MC at this output.

Total Cost and Total Revenue are also parallel when X 1 units are produced. However, that is
where losses are maximized.
A situation may sometimes arise when a business can not be run except at a loss. A firm making
losses should consider closing down but may continue to operate in the short run if its losses are
less than Fixed Cost (this concept is explained later in the section). However in the short run,
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such a business should only produce output where rising Marginal Cost equals Marginal
Revenue, minimizing losses. The loss minimizing output in the following pair of diagrams is X2.

Diagram 6.2(a)
TC
Revenue
Costs

TR

Output

Diagram 6.2(b)
Revenue
Cost

MC

P = AR = MR = D

Output
X1 X2

Decisions to Continue or Shutdown Businesses

The following table shows five hypothetical firms which operate at profit maximizing (or loss
minimizing) output levels. Whereas revenues differ for all five, Fixed and Variable Costs are
assumed to be 500 and 1500 respectively for each.
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101 6- Economist’s Vs Accountant’s definition of Costs

Table 6.2
A B C D E
Total Revenues 3000 2000 1800 1500 1200
Fixed Cost 500 500 500 500 500
Variable Cost 1500 1500 1500 1500 1500

Total Cost 2000 2000 2000 2000 2000

Profit (Loss) 1000 0 (200) (500) (800)

Firms A and B earn super normal and normal profits respectively and should thus, continue in
both the short and long run. Firms C, D and E incur losses and exactly when do they shut down is
determined by comparing their respective sales revenues and variable costs.
Continuing business in the short run requires a firm‟s revenues to exceed variable cost and
contribute positively towards Fixed Cost. Firm C incurs a loss (TR < TC), but it should continue in
the short run since TR exceeds VC. The excess of Total Revenue over Variable Cost i.e. £300
contributes to Fixed Cost of £500 which would otherwise have to be paid in full by the owner. The
losses of shutting down in the short run equal Fixed Cost. This business should continue in the
short run since its losses are less than fixed cost. However, it should shut down in the long run.
Firm D incurs a loss of £500 and its losses in the short run stay the same, regardless of its
decision to shut down. The contribution towards Fixed Cost is zero. This firm operates exactly at
the shut down point and is indifferent between continuing and shutting down in the short run.
However, the choice is clear in the long run- the firm must shut down.
Firm E incurs a loss of £800 and should cease business activity immediately since contribution
towards Fixed Cost (TR – VC) is negative. By closing down immediately, the losses of firm E
decrease to £500 in the short run and zero in the long run.
Continuing business in the long run requires sales revenue to equal total cost at least. In the table
above, only firms A & B should continue to operate in the long run.
A firm must be charging a price higher than Average Cost (AC) when Total Revenue (TR)
exceeds Total Cost (TC).
TR > TC
P.Q > AC.Q
P > AC
Therefore, firms make supernormal profit when Total Revenue exceeds Total Cost (Price > AC),
normal profit when Total Revenue equals Total Cost (Price = AC), losses but continue in the short
run if Total Revenue falls below Total Cost but exceeds Variable Cost (AVC < Price < AC) and
shutdown immediately when Total Revenue is less than Variable Cost (Price < AVC).
AVC is the minimum acceptable price to continue business in the short run whereas minimum
acceptable price to continue in the long run is AC.
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102 6- Economist’s Vs Accountant’s definition of Costs

Multiple Choice Questions

(Section 6)
J/02/3/10
1 A firm earns supernormal profit when its profit is above that

A earned by competing firms.

B needed to cover its fixed costs.
C needed to keep the firm in production in the short run.
D required to keep its resources in their present use.

N/02/3/10
2 Which of the following items would not appear in a firm‟s financial accounts but would be
included in an economist‟s calculation of the cost incurred by the firm?

A interest on bank loans used to purchase assets that have no alternative uses
B interest forgone on finance provided by the firm‟s owner
C depreciation
D rent

J/03/3/08
3 An economist calculates that a firm has incurred the following costs over the course of a
year.
$(000)
wages and salaries 150
opportunity cost of owner‟s time 40
materials 80
rent 30
marketing fees 20
interest on bank loans 25
interest forgone on finance provided by owner 15
depreciation 20

What would an accountant calculate to be the total cost incurred by the firm?

A $275 000 B $305 000 C $325 000 D $340 000

J/03/3/13
4 A firm produces both X and Y in fixed proportions. A permanent increase in demand for X
occurs.
The entrepreneur will increase output of X as long as
A the addition to revenue in the X and Y markets combined is greater than the
addition to costs.
B the cost of producing more X is offset by a decrease in the cost of producing Y.
C the marginal cost of X is less than the marginal cost of Y.
D there is a fall in average costs of production.
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103 6- Economist’s Vs Accountant’s definition of Costs

N/03/3/09
5 An entrepreneur takes out a $500 000 loan at a rate of interest of 10 %, and invests a
further $500 000 of his own funds to set up a new firm.
In the first year he pays himself a salary of $40 000.
The rate of interest he could have obtained by investing his funds elsewhere is 8%, and
the wage he could have earned in alternative employment is $30 000.
By how much will an economist‟s calculation of the firm‟s first year costs exceed an
accountant's calculation?
A $20 000 B $30 000 C $40 000 D $50 000

N/03/3/15
6 The diagram shows how a firm's average profit and marginal profit vary at differing levels
of output.
At which level of output does the firm maximise total profit?

profit

0
A B C D output

marginal average
profit profit

N/03/3/16
7 When will a firm in a perfectly competitive industry cease to produce in the short run?
A if it earns less than normal profits
B if total revenue is less than the total cost of production
C if marginal revenue is less than the average total cost of production
D if total revenue is less than the total variable cost of production

N/05/3/09
8 Which item would not appear in a firm‟s financial accounts but would be included in an
economist‟s calculation of the costs incurred by the firm?
A interest on bank loans used to purchase assets that have no alternative uses
B interest forgone on finance provided by the firm‟s owner
C depreciation
D rent

J/06/3/07
9 What is included in an economist‟s definition of costs but not an accountant‟s?
A advertising expenditure
B depreciation
C insurance
D normal profit
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104 6- Economist’s Vs Accountant’s definition of Costs

J/07/3/10
10 The table shows data for an owner-managed firm for a particular year.

$
total revenue 250 000
raw material costs 30 000
wages and salaries 110 000
salary that the owner could have
40 000
earned elsewhere
interest paid on bank loan 30 000
interest forgone on owner's capital 50 000

What is the firm‟s profit according to an economist?

A –$10 000 B $40 000 C $80 000 D $100 000

J/07/3/12
11 A firm earns supernormal profit when its profit is
A above that earned by competing firms.
B above that needed to cover its fixed costs.
C above that needed to keep the firm in production in the short run.
D above that required to keep its resources in their present use in the long run.

J/09/3/05
12 An economist calculates that a firm has incurred the following costs over the course of a
year.

$(000)
wages and salaries 150
opportunity cost of owner‟s time 40
materials 80
rent 30
marketing fees 20
interest on bank loans 25
interest forgone on finance provided by owner 15

By how much does total cost as defined by an economist exceed the total cost as define
by an accountant?
A $15 000 B $40 000 C $55 000 D $85 000

J/09/3/12
13 In which circumstance will a firm cease production in the short run?
A It makes a profit that is less than its total variable costs.
B It makes a profit that is less than its total fixed costs.
C Its average revenue is less than its average cost.
D Its average revenue is less than its average variable cost.
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105 6- Economist’s Vs Accountant’s definition of Costs

J/10/3/10
14 The table shows information about a profit-maximising firm.

output 17 000 units

price per unit $1.75
fixed costs $10 000
variable costs per unit $1.70

What should the firm do?

A close down immediately because it is not covering its fixed costs
B close down immediately because it is not covering its average costs
C close down immediately because it is not covering its total costs
D continue production in the short run because it is covering its variable costs

J/12/32/8
15 An economist calculates that a firm has incurred the following costs over the course of a year.

$(000)
wages and salaries 150
opportunity cost of owner‟s time 35
materials 80
rent 30
marketing fees 20
interest on bank loans 25
interest forgone on finance provided by owner 10

By how much does total cost as defined by an economist exceed the total cost as defined
by an accountant?
A $75 000 B $45 000 C $35 000 D $10 000

N/12/32/08
16 An economist calculates that an owner-managed firm has incurred the following costs
over the course of a year.
$(000)
wages of two employees 150
fee paid to wife for secretarial services 20
opportunity cost of owner‟s time 30
Materials 80
Rent 30
marketing fees 20
interest on bank loans 25
interest forgone on finance provided by owner 15
By how much does total cost as defined by an economist exceed the total cost as defined
by an accountant?
A $15 000 B $30 000
C $45 000 D $65 000
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106 6- Economist’s Vs Accountant’s definition of Costs

J/13/32/06
17 A fashion model is paid $100 000 a year.
The next best paid job she could get is as a teacher at $60 000 a year.
What are her transfer earnings and her economic rent?

transfer earnings $ economic rent $

A 60 000 zero
B 60 000 40 000
C 100 000 zero
D 100 000 40 000

J/13/32/07
18 An economist calculates that a firm has incurred the following costs over the course of
the year.
$(000)
wages and salaries 150
opportunity cost of owner‟s time 40
materials 80
rent of buildings 30
marketing fees 20
interest on bank loans 25
interest forgone on finance provided by owner 15
depreciation of equipment 20

By how much would the economist‟s calculation of the total cost incurred by the firm
exceed an accountant‟s calculation of the firm‟s total cost?
A $15 000 B $40 000 C $55 000 D $75 000

N/14/32/04
19 A worker is considering accepting a job she has been offered. She draws up a list of the
annual monetary values she places on the advantages and disadvantages of the job.

advantages and value

disadvantages of the job ($)
income 750
dangerous working conditions 500
long working hours 250
high prestige of the job 200
cost of providing own uniform 150
opportunity for travel 100
short holidays 50

What can be concluded from the table?

A She values the pecuniary advantages more highly than the non-pecuniary
advantages.
B She would take the job even if it had none of the non-pecuniary advantages.
C The job has no pecuniary disadvantages.
D The non-pecuniary advantages outweigh the non-pecuniary disadvantages.
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N/14/32/13
20 The diagram shows how a firm‟s average profit and marginal profit vary at differing levels
of output.

If the firm produces output OQ, which statement is correct?

A The firm is earning a zero profit.

B The firm is making a normal profit.
C The firm is maximising its profit.
D The firm is producing above its profit-maximising output.

J/15/32/13
21 The table shows information about a profit-maximising firm.

price per unit $1.70

fixed costs $10 000
variable costs per unit $1.75

What can be concluded about the firm‟s behaviour?

A It should close down immediately because it is not covering its average costs.
B It should close down immediately because it is not covering its variable costs.
C It should continue production in the long-run because it is covering its total costs.
D It should continue production in the short-run because it is covering its fixed
costs.
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108 7- Market Structures

Section: 7 Market Structures

It is hard to imagine a firm that operates successfully without having any clue as to who its
customers and competitors are, their relative size and the decisions they undertake. A successful
firm ought to be well informed about the market environment it functions in. This is exactly why
studying market structures is important. The motivation to study them stems from three important
sources: their usefulness in depicting firm behavior, in revealing pricing and output decisions and
lastly, in functioning as an evaluative space, allowing firms to know where they stand in terms of
profits and efficiency.

It is needless to mention that firms operate differently in different market situations. The structure
of a market is explained by many factors, such as the number of buyers and sellers, nature of the
product, the degree of freedom of entry and exit, and the nature of information. The four market
structures are Perfect Competition, Monopolistic Competition, Oligopoly and Monopoly. The
characteristics of these market structures are briefly given in the following table:

Table 7.1
Size
No. of Nature of the Entry & Price Control Nature of
Type of
firms product Exit of a firm information
firms
Perfect
Perfect Very Very No price knowledge
Homogenous Very easy
Competition large small control
Imperfect
Monopolistic Very Very Little price knowledge
Differentiated Very easy
Competition large small control
Imperfect
Homogenous/ knowledge
Oligopoly Few Large Difficult Interdependent
Differentiated
Imperfect
Very knowledge
Monopoly One Unique Impossible Considerable
large

Perfect Competition
A perfectly competitive market structure comprises a very large number of buyers and sellers
trading small quantities. Products sold by a perfectly competitive firm are exactly identical and
similar to products made by other firms- they are homogenous and thus, perfect substitutes. Entry
barriers are non-existent, allowing new firms to enter a perfectly competitive industry fairly easily.
All consumers and producers are assumed to have perfect information about market conditions.

An individual perfectly competitive firm is so small relative to the size of the industry that its
decisions to supply more or less don‟t affect market supply. A perfectly competitive firm finds it
impossible to influence market demand since there is no scope for advertising or marketing- all
products are exact replicas of each other. It is therefore a price taker and accepts the market
price determined by market forces.
Market price is determined by the intersection of downward sloping market demand curve and
upward rising market supply curve. Market demand and supply reflect the independent choices
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109 7- Market Structures

and decisions of countless number of buyers and sellers. A perfectly competitive firm faces a
straight horizontal demand curve showing that the firm can sell infinite quantities at the prevailing
market price. Since buyers have perfect knowledge and products are homogenous, a firm‟s
decision to charge a price higher than the market price results in zero sales. Charging anything
below market price attracts the entire market demand but the firm‟s small size doesn‟t allow it to
cater to such a large customer base. Consider the following pair of diagrams:

Diagram 7.1(a) Diagram 7.1(b)

Market Firm
P
S P

P0 D

D
Output Output

The panel on the left shows how equilibrium price is determined by the intersection of demand
and supply curves at P0. The demand curve faced by any particular firm is a straight horizontal
line at the market price. The price elasticity of demand is infinity because of the existence of
perfect substitutes.

Revenue curves of a perfectly competitive firm

The demand and revenue schedule for a hypothetical firm operating in the conditions of perfect
competition is given below.

Table 7.2
Price (P) = Average Marginal Revenue
Quantity (Q) Total Revenue (TR)
Revenue (AR) (MR)

10 0 0 -
10 1 10 10
10 2 20 10
10 3 30 10
10 4 40 10
10 5 50 10
10 6 60 10

To verify that Average Revenue (AR) always equals sale price, consider the following set of
equations:
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110 7- Market Structures

Total Revenue = Sale Price × Quantity

Total Revenue Sale Price  Quantity

Average Revenue   = Sale Price
Quantity Quantity
Thus AR  Price
Since a perfectly competitive firm can sell infinite amounts at the prevailing market price, revenue
generated from the sale of an additional unit (MR) equals sale price.

Diagram 7.2 shows the revenue curves of a perfectly competitive firm.

Diagram 7.2
Price
Revenues

D = P = AR = MR

Output

Cost curves of a perfectly competitive firm

Diagram 7.3 shows cost curves assuming law of variable proportions.

Diagram 7.3
Cost
MC
AC
AVC

Output
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111 7- Market Structures

Price and output determination in perfect competition

The intersection of MC and MR determines the equilibrium output for a perfectly competitive firm.
The following set of diagrams show the five possible short run equilibria for a perfectly
competitive firm. In each case, firms choose to produce the profit maximizing (or loss minimizing)
output, Q*, determined by the intersection of upward rising MC and MR.
Diagram 7.4(a)
Revenue
Cost MC
AC
AVC
b
a P = AR = MR = D
c
d

Output
Q*
Diagram 7.4(b)
Revenue MC
Cost
AC
AVC

P = AR = MR = D

Output
Q*
Diagram 7.4(c)
Revenue MC
Cost
AC
AVC

a b
d P = AR = MR = D
c
f e
Output
Q*
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112 7- Market Structures

Diagram 7.4(d)
Revenue
Cost MC
AC
AVC

b
a

c
d P = AR = MR = D

Output
Q*
Diagram 7.4(e)
Revenue MC
Cost
AC AVC

b
a

f e
d P = AR = MR = D
c
Output
Q*
Diagram 7.4(a) shows equilibrium where sale price exceeds average cost, resulting in
supernormal profit. It is measured by the area abcd, the product of per unit profit i.e. the vertical
distance between sale price and average cost and the profit maximizing quantity.

The firm shown in diagram 7.4(b) earns normal profit as sale price exactly equals average cost.
Firms shown in diagram 7.4(a) & 7.4(b) continue to operate in the long run.

Diagram 7.4(c) shows losses for the firm (abcd) but sale price exceeds per unit variable cost. The
excess of sale price over per unit variable cost (ce or df) is contribution margin and area dcef is
total contribution towards fixed cost. This firm should continue in the short run but shut down in
the long run.

Diagram 7.4(d) shows a firm at the shut down point. A small increase in price allows it to continue
in the short run and a marginal decrease necessitates immediate shut down.

The firm shown in diagram 7.4(e) should shut down immediately as the price it charges is below per
unit variable cost. The firm‟s losses, abcd, reduce to fixed cost, abef, if the business shuts down.
Fixed cost is the product of the vertical distance between AC and AVC (i.e. per unit fixed cost) and
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113 7- Market Structures

the quantity produced. In the given situation, losses are minimized at zero output level and not
where rising MC equals MR.
Put briefly, the intersection of rising MC and MR determines loss minimizing quantity provided sale
price exceeds per unit variable cost. Businesses should shut down immediately to minimize losses
where sale price is below average variable cost.

Long run equilibrium of a perfectly competitive firm

Unlike the short run, there exists only a single equilibrium for a perfectly competitive firm in the long
run- where it earns normal profits. When firms making short run losses exit the industry in the long
run, the remaining firms get to charge higher prices and start earning normal profits. On the other
hand, firms earning supernormal profits in the short run attract new firms into the industry,
increasing market supply, lowering prices and diluting profits. Ease of entry and exit makes it
impossible for a perfectly competitive firm to charge a price higher than average cost in the long
run. The maximum price it may charge is minimum average cost, thus only normal profits can be
earned. The following pair of diagrams explains the conversion of supernormal profits earned in the
short run to just normal profits in the long run.

Diagram 7.5
Market S0
P Firm
P
MC
S1
AC
P0 P0 D0

P1 P1 D1
D0

Output
Q1 Q2 q2 q1

In the panel on the left, D0 and S0 show the initial demand and supply curves of the perfectly
competitive industry. Equilibrium price is P0 and market output, Q1. The perfectly competitive firm
shown on the right chooses to produce the profit maximizing output q 1. The firm makes
supernormal profit in the short run which attracts new firms into the industry. Due to ease of
entry/exit, the market supply curve shifts towards right and the industry moves downwards along its
demand curve, lowering market price. Entrants enter till price becomes equal to average cost at P 1
and allows firms to make only normal profits. The output made by the industry increases to Q2 and
that made by an individual firm reduces to q2. Firms produce a smaller output but overall industry‟s
output stands increased due to the increased number of firms.
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114 7- Market Structures

Short run supply curve of a perfectly competitive firm

The supply curve of a firm shows the relationship between price and the quantity it chooses to
supply. For a profit maximizing perfectly competitive firm, quantity supplied is determined by the
intersection of rising MC and MR. As price equals MR in a perfectly competitive setting, the
intersection of price and MC determines the output firm supplies. Thus, the MC curve becomes
the supply curve of a perfectly competitive firm. However, Marginal Cost Curve fails to determine
output if price is below Average Variable Cost. In such a case, the business shuts down
immediately. Thus the short run supply curve of a perfectly competitive firm is the rising portion of
MC over and above AVC. Refer to the following diagram which shows the supply curve for a
perfectly competitive firm. The firm chooses to produce Q1 if the price is P1. However, no quantity
is supplied at P2 as this price is below AVC.

Diagram 7.6
Price
MC

P1

AVC

P2

O Output
Q1

Industry’s supply curve

The supply curve of a perfectly competitive industry is the horizontal summation of firms‟
individual supply curves i.e. the summation of rising portions of all individual Marginal Cost
Curves over and above the minimum Average Variable Cost.

Output determination in perfect competition

(Total Revenue and Total Cost approach)

The following four diagrams show short run equilibrium positions of a perfectly competitive
industry. In the first three cases (diagrams 7.7 (a, b and c)) firm produces X 1. At this output Total
Revenue and Total Cost are parallel meaning MR equals MC. In diagram 7.7 (a) firm makes
supernormal profit i.e. ab. In diagram 7.7 (b) firm is making only normal profit. This is the long run
equilibrium of a perfectly competitive firm. In diagram 7.7 (c) firm is incurring losses (a – b) but it
should continue in the short run as losses are less than Fixed Cost (c – a). The vertical distance
between the hypothetical line drawn from the vertical intercept of Total Cost curve and the Total
Revenue curve measures Fixed Cost. In diagram 7.7 (d) the firm should immediately shut down
since losses are higher than Fixed Cost.
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115 7- Market Structures

Diagram 7.7 (a)

TC TR

Revenue
Cost

Output
X1

Diagram 7.7 (b)

TC TR
Revenue
Cost

Output
X1
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116 7- Market Structures

Diagram 7.7 (c)

TC
Revenue
Costs
TR

Output
X1
Diagram 7.7 (d)

Revenue TC
Costs

c
TR
b

Output
X1
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Multiple Choice Questions

(Section 7)
N/02/3/01
1 New technology makes it possible to produce more of a good at every given price.
What effect will this have on equilibrium price and output in a competitive industry?

price output
A decrease decrease
B decrease increase
C increase decrease
D increase increase

N/02/3/09
2 If a profit-maximising company believes that the market price of a good will not be
affected by its own output, it will
A produce until marginal cost equals price.
B produce until average cost equals price.
C produce until marginal revenue is zero.
D sell as much as it can produce.

J/04/3/12
3 A perfectly competitive firm is producing 2000 boxes of biscuits per week, which it sells
for $2.50 per box. The table shows the firm‟s costs.

total fixed cost $2000

total variable cost $4000
marginal cost $2.50

In the short run, what should the firm do to maximise its profits or minimise its losses?
A cease production altogether
B increase its output
C lower its price
D maintain its output at the present level

N/04/3/13
4 A perfectly competitive firm is currently producing at a level of output where its marginal
cost is above its average total cost but below the market price.
What would be the effect on price and output if the firm were to maximise its profit?

effect on output effect on price

A decrease increase
B decrease unchanged
C increase decrease
D increase unchanged
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N/05/3/11
5 The diagram shows the position of a firm in a perfectly competitive industry.

MC AC

AR = MR

costs,
revenue

O Q
output
What describes the position of the firm and the industry at output OQ?

firm industry
A disequilibrium disequilibrium
B disequilibrium equilibrium
C equilibrium disequilibrium
D equilibrium equilibrium

J/06/3/09
6 A firm in perfect competition currently sells 100 units at $5 each.
What will be the revenue obtained by the firm if it increases its price to $6?
A zero B $100 C $500 D $600

N/06/3/13
7 The price that a firm obtains for its product is not affected by the volume of goods that it
produces.
What should it do to maximise profits?
A produce until marginal cost equals price
B produce until average cost equals price
C produce until marginal revenue is zero
D sell as much as it can produce
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N/10/3/11
8 A perfectly competitive firm finds that at its current level of output, marginal revenue is
$2.00 and marginal cost is $2.50.
If the firm is a profit maximiser, what will happen to its price and output?

price output
A increases decreases
B increases unchanged
C unchanged decreases
D unchanged unchanged

J/12/32/11
9 The diagram shows the cost curves of a firm in a perfectly competitive market.

MC
Z ATC
AVC
X

cost
W

U
O output
Which segment of a curve shows the quantity that the firm would be willing to supply to
the market in the short-run?

A VX B UZ C VZ D WZ

J/12/32/12
10 A perfectly competitive firm is currently producing at a level of output where its marginal
cost is above both its average total cost and the market price.
What will be the effect on price and output if the firm were to maximise its profit?

effect on output effect on price

A decrease increase
B decrease unchanged
C increase decrease
D increase unchanged
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J/13/32/04
11 The table shows the current position of a firm in a perfectly competitive industry.

factor X factor Y
marginal physical product 3 12
factor price $5.00 $10.00

If the firm sells its product for $1 and aims to maximise profits, what should it employ?

A more of both X and Y

B more of X and less of Y
C more of Y and less of X
D less of both X and Y
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Section: 8 Monopoly
As one may notice, the conditions of perfect competition are rather exhaustive and difficult to
meet in the real world. When any of these conditions breaks down, we have a situation of what is
known as imperfect competition. Monopoly, typically placed on the contrasting end of perfect
competition along the continuum of market structures, is the most popular form of imperfect
competition and studied in detail below. Others i.e. monopolistic competition and oligopoly are
discussed later, under section 12.

Monopoly is an extremely large firm serving the entire market single handedly. The products
made by a pure monopoly have no substitutes finding a real life example of which is almost
impossible. Utilities such as electricity, water, gas and telephone are usually provided by
monopolies in most of the countries. Note that these still can not be regarded as pure monopolies
as weaker substitutes usually exist.
As the Monopoly and Merger Commission (MMC) of UK defines it, any firm or group of firms is a
monopoly if it produces more than 25% of the total market output.
Revenue Curves of Monopoly
Being a single seller, a monopoly can either raise price or sell more but can not do both
simultaneously. Quantity demanded decreases when it decides to charge a higher price and
likewise, selling more requires a cut in price. Although substitutes are unavailable, consumers still
demand less at higher prices since they reduce either the frequency or quantity of use. A
monopolist thus faces a downward sloping demand curve showing a trade off between higher
prices and more sales.
Monopoly demand curve need not be linear but for simplicity, we assume a linear demand curve
throughout our discussion on monopoly.

Sale price (P) = Average Revenue (AR) 11 10 9 8 7 6 5 4 3 2 1

Quantity 0 1 2 3 4 5 6 7 8 9 10

Total Revenue (TR) 0 10 18 24 28 30 30 28 24 18 10

Marginal Revenue (MR) - 10 8 6 4 2 0 (2) (4) (6) (8)

Shown above is a hypothetical demand schedule for a non-discriminating monopoly, one which
charges the same price for all the units it sells. For instance, if price is reduced to £9 to sell the second
unit, price is lowered on both the first and second units. Thus total revenue generated from selling two
units is £18 i.e. £9 × 2. Similarly, Total Revenue from selling three units equals £24 i.e. £8 for each of
the three units. Had it been a discriminating monopoly, total revenue from selling 2 units would have
been £19 i.e. £10 from the sale of the first unit plus £9 from the sale of the second.
Marginal Revenue (MR) is less than Sale Price as lowering price to £9 to sell second unit means
additional revenue generated is £9 less £1, the loss from selling first unit at a lower price.
The demand, MR and TR curves corresponding to the given schedule are shown in diagram
8.1(a) & (b).
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Diagram 8.1(a)
Revenue
Cost
Price

Ed>1

Ed=1

Ed<1

D=P=AR
Output
Diagram 8.1(b) ½ Q1 ½
TR MR

TR

Output
Q1

Diagram 8.1(a) shows a downward sloping demand curve which also depicts price and AR. MR
curve lies below the demand curve and bisects the distance between the origin and the x intercept
of demand curve. MR lies below AR (sale price), since a non-discriminating monopolist has to lower
price on ALL units to sell more.
Demand is price elastic in the upper half of the linear demand curve, unitary price elastic at its
mid point and price inelastic in the lower half. A price reduction therefore increases Total
Revenues (MR is positive) in the upper half and decreases them (MR is negative) in the lower
half of the demand curve. Diagram 8.1(b) shows Total Revenues, which rise initially and then fall.
Total Revenues are maximized where elasticity of demand equals 1 and MR equals zero i.e. at
output Q1.
The following derivation helps establish an equation confirming the relationship between MR and
elasticities of demand.
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dTR
MR 
dQ
TR = P.Q
dP . Q
MR 
dQ
dQ dP
MR  P. Q.
dQ dQ
dP
MR  P  Q .
dQ
 Q dP 
MR  P 1  . 
 P dQ 
 1 
MR  P 1  
 Ed 
Since price elasticity of demand is negative:
 1 
MR  P 1  
 Ed 

Marginal Revenue (MR) is positive when elasticity of demand exceeds unity i.e. in the upper half
of linear demand curve.
Marginal Revenue (MR) equals zero when elasticity of demand is unity i.e. at the midpoint of linear
demand curve.
Marginal Revenue (MR) is negative when elasticity of demand is less than unity i.e. in the lower
half of linear demand curve.

The equation also confirms that price equals MR in case of a perfectly competitive firm, i.e. where
price elasticity of demand is infinity.

The equation defining the linear demand function faced by a monopolist is:
P = a – bQ (i)
where P & Q represent sale price and quantity sold. –b shows the slope of the demand curve, the
negative sign confirming the inverse relationship between price and quantity sold.

Given equation (i), total revenues are given by:

2
TR = PQ = aQ – bQ (ii)
Differentiating (ii) with respect to quantity, we obtain:
dTR dPQ
MR    a  2b Q
dQ dQ
MR = a – 2bQ

Demand and MR curves share the same vertical intercept, a, whereas their slopes are –b and
–2b respectively. The MR curve has a slope twice as large as the demand curve‟s.
The x-intercept of AR (or price) function is calculated by assuming price to be zero.
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P = a – bQ
0 = a – bQ
a
Q
b

The x-intercept of MR function is found out by calculating quantity at zero MR.

P = a – 2bQ
0 = a –2 bQ
a
Q
2b

MR‟s x-intercept is exactly half of that of the demand (price or AR function) curve. As stated
earlier, MR bisects the distance between the origin and the x-intercept of demand curve.
Price and output determination in monopoly
As explained before, a monopolist can either choose the price or quantity it wishes to sell but not
both simultaneously. Decision to choose a certain amount of one automatically determines the
other. A profit maximizing monopolist chooses to produce where the cost of making the last unit
(MC) equals the revenue generated from selling that unit (MR). It then sells this output at the
highest possible price, given by the height of the demand curve.

Diagram 8.2
Price

MC

a
P1
AC

c
b
D = AR = P
Output
Q*
MR
Diagram 8.2 shows the profit maximizing output (Q*), determined by the intersection of MC and
MR. The monopolist sells this output at the highest possible price (P 1), given by the height of the
demand curve. Per unit profit is a – b (or P1 – c) and total profits (per unit profit times output, Q *),
area abcP1. The monopolist earns super normal profits and may continue to have them even in
the long run as entry of new firms is impossible. Diagram 8.2 therefore shows both the short run
and long run equilibrium for a monopolist.
However, It is not certain that the monopolist always makes profits. The inability of a monopolist
to charge a price in excess of AC results in losses. The following diagram shows this scenario.
The firm incurs losses equaling area cbaP1.
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Diagram 8.3
Price

AC
MC

c b

P1 a

D = AR = P
Output
Q*
MR
Where does the profit maximizing monopolist produce?
It is generally thought that monopolists produce goods possessing price inelastic demand. Yet in
reality, a monopolist always produces in the upper half of the linear demand curve where demand
is price elastic. In the lower half of the demand curve (where demand is price inelastic), a profit
maximizing monopolist will always be tempted to raise price which raises revenues and
decreases Total Cost (since fewer units are sold at higher price), hence increasing profits. At the
mid point of the linear demand curve, raising price leaves revenues unchanged but decreases
Total Cost, hence profits increase. Thus a profit maximizing monopolist never produces at the
mid point or in the lower half of the linear demand curve since there exists a possibility of
increasing profit by lowering output.
A profit maximizing monopolist chooses to produce an output where MC equals MR. Since MC
can never be zero or negative it can only equal MR in the upper half of the demand curve where
MR is positive (try N/07/3/13)
What should a profit maximizing firm do if Marginal Cost differs from Marginal Revenue?
A profit maximizing firm should increase output if MR exceeds MC and decrease it if MR falls
short of MC. A perfectly competitive firm can supply more or less at an unchanged price, however
a monopolist can sell more only when price is decreased (try N/04/3/12).
Supply curve of monopoly- Is there any?
For a perfectly competitive firm, the short run supply curve is given by the rising portion of MC
over and above AVC. However, for a monopolist, the supply curve does not exist. Profit
maximizing output is determined where MC = MR and since price and MR differ, determining a
relationship between price, Marginal Cost and quantity supplied is not possible.
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Multiple Choice Questions

(Section 8)
J/03/3/09
1 A monopolist faces a downward sloping, straight-line demand curve.
Which diagram shows his total revenue curve (TR)?
A B

total total
revenue revenue
TR
TR
O output O output

C D
TR
total total
revenue revenue
TR

O output O output

J/03/3/11
2 The diagram shows a firm's cost and revenue curves.

MC

Q AC
cost / P
revenue S R

O MR AR
output
What does the shaded area SPQR measure?
A abnormal profit
B consumer surplus
C total revenue
D transfer earnings
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N/03/3/13
3 The diagram shows the relationship between a firm's total revenue and the quantity of
goods sold.

revenue

TR

O quantity
What is the price elasticity of demand for the good?
A zero
B between zero and one
C one
D between one and infinity

J/04/3/10
4 The diagram shows a firm‟s total revenue curve.

TR

revenue

O output
At the curve‟s highest point
A marginal revenue is equal to marginal cost.
B average revenue is equal to average cost.
C marginal revenue is equal to average revenue.
D marginal revenue is zero.
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N/04/3/12
5 A monopolist finds that at his current level of output, marginal revenue is $2.00 and
marginal cost is $2.50.
In order to increase his current level of profits, which strategy should the monopolist
adopt?
price output
A decrease unchanged
B decrease increase
C increase decrease
D increase unchanged
J/05/3/11
6 The diagram shows a firm‟s demand curve and its marginal revenue curve.

price
P

D
O
MR
quantity
What is the price elasticity of demand at price OP?
A Zero B 0.5 C 1.0 D infinity
N/06/3/09
7 The diagram shows a firm‟s average revenue curve.

revenue

AR
O output
What can be deduced from the average revenue curve about the firm‟s total revenue as it
increases output?
A It will rise continuously.
B It will fall continuously.
C It will rise initially then fall.
D It will fall initially then rise.
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N/06/3/15
8 The diagram shows the initial cost and revenue curves of a monopoly supplier.
MC

P
costs,
revenue
AR

MR
O J K L M
output
What will be the firm's profit-maximising level of output if the government fixes the price at
OP?
A OJ B OK C OL D OM

N/07/3/09
9 A monopolist faces a downward-sloping straight-line demand curve.
Which diagram shows his total revenue curve (TR)?

A B

total total
revenue revenue
TR
TR
O output O output

C D
TR
total total
revenue TR revenue

O output O output
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N/07/3/13
10 At its current level of output a monopolist is on the price-inelastic part of its demand
curve.
Which changes should it make to price and output in order to maximise its profits?

price output
A increase increase
B increase decrease
C decrease decrease
D decrease increase

J/09/3/07
11 A firm estimates that, all else remaining unchanged, an increase in its output will result in
an equal proportionate increase in its revenue.
What can be deduced from this about the price elasticity of demand for the firm‟s
product?

A It is –1.
B It is +1.
C It is perfectly inelastic.
D It is perfectly elastic.

J/09/3/08
12 The diagram shows the initial cost and revenue curves of a profit-maximising monopolist.

MC

costs,
revenue P
AR

MR
O J K L M
output
What output will the firm produce if the government fixes the price at OP?

A OJ B OK C OL D OM
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J/09/3/13
13 The diagram shows the cost and revenue curves of a profit-maximising monopolist.

ATC
MC

J
revenue,
cost
K
M

AR

MR
O Q
output

What measures the monopoly profit per unit of output made by the firm?
A JM B JK C JM × OQ D JK × OQ

N/09/3/10
14 The price elasticity of demand for a firm‟s product is zero.
What will be the effect on the firm‟s revenue if it increases its price by 5 %?
A Its revenue will be unchanged.
B Its revenue will increase by 5 %.
C Its revenue will decrease by 5 %.
D Its revenue will fall to zero.

J/10/3/08
15 The diagram shows a firm‟s demand curve and its marginal revenue curve.

price

D
O
MR
quantity
What is the approximate price elasticity of demand at price OP?
A 0.25 B 0.5 C 1 D 2
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N/11/32/03
16 To prevent a surplus of milk, each milk producer is given a production quota which
specifies the volume of milk he is allowed to supply.
Initially the quotas are not tradable, but then trade in quotas is allowed.
Who would gain or lose when trade in quotas takes place?
purchasers of quotas sellers of quotas
A gain gain
B gain lose
C lose gain
D lose lose

J/12/32/14
17 In the diagram the imposition of a tax on a commodity causes its supply curve to shift
from S1 to S2.

D S2

S1
P2 J
price
P1 K
N

O Q2 Q1
quantity
Which area measures the resulting deadweight loss?
A P1P2JK B JKQ1Q2 C JKM D JKN

J/13/32/10
18 The demand for a firm‟s product is perfectly inelastic.
What will be the effect on the firm‟s revenue if it increases its price by 5%?

A Its revenue will be unchanged.

B Its revenue will increase by 5%.
C Its revenue will decrease by 5%.
D Its revenue will fall to zero.
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J/14/32/11
19 A monopolist faces a downward-sloping straight-line demand curve.
Which diagram shows his total revenue curve (TR)?
A B

total total
revenue revenue
TR
TR
O output O output

C D

TR

total total
revenue TR revenue

O output O output

N/14/32/10
20 The price elasticity of demand for a firm‟s product is zero.
What will be the effect on the firm‟s revenue if it reduces its price by 5%?
A Its revenue will be unchanged. B Its revenue will decrease by 5%.
C Its revenue will increase by 5%. D Its revenue will fall to zero.
N/14/32/11
21 The diagram shows an industry producing under conditions of constant average costs.

Under perfect competition, the industry produces output OV.

Which area measures the increase in the industry‟s profits if it were to become a
monopoly?

A XYSO B XYWT C XYZT D YZW

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N/14/32/17
22 A government introduces tax incentives which promote effort and enterprise. They also
redistribute income from those who receive a higher marginal utility from money to those
with a lower marginal utility from money.
What effect will these tax incentives have on efficiency and equity?
efficiency equity
A increase increase
B increase reduce
C reduce increase
D reduce reduce

J/15/32/10
23 The diagram shows the demand curve for a firm‟s product.

price

D
O
quantity
Which diagram depicts the shape of the firm‟s corresponding total revenue (TR) curve?

A B C D
TR TR

revenue revenue revenue revenue

TR TR

O O O O
quantity quantity quantity quantity
N/15/32/13
24 The diagram shows the initial cost and revenue curves of a profit-maximising monopolist.

MC

cost,
revenue P
AR

MR
O J K L M
output
What output will the firm produce if the government fixes the price at OP?
A OJ B OK C OL D OM
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J/16/32/07
25 A monopolist changes its objective from profit maximisation to sales revenue
maximisation.

MC

H AC
P1
cost,
revenue P2 J K
G
F L

AR
MR
O Q1 Q2
output
On the diagram, which areas represent the monopolist‟s total profit?

original profit final profit

A P1HJP2 P2KLF
B P1HJP2 JKLG
C P1HGF P2KLF
D P1HGF JKLG

J/16/32/08
26 A firm estimates that, all else remaining unchanged, an increase in its output will result in
a fall in its revenue.
What can be concluded from this?

A The demand for the firm‟s product is price-elastic.

B The demand for the firm‟s product is price-inelastic.
C The supply of the firm‟s product is price-elastic.
D The supply of the firm‟s product is price-inelastic.
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Section: 9 Externalities
Externalities are factors which result in a benefit or cost to a firm or society which originate, in
part, from outside the firm or as an adjunct to productive activity. A firm which does not invest in
training its labour force itself, for example, may nonetheless benefit from being able to attract
employees who have been trained by other firms or by the government. Pollution is an example
of external cost imposed on society: a chemical company which pollutes the air or contaminates
river water incurs only the immediate cost of producing its product, while society suffers the extra
cost of cleaning up the atmosphere and river.

Externalities are „third party‟ or „spill over‟ effects of an economic transaction. They exist when the
costs or benefits of an economic transaction are split over to a third party i.e. to people other than
buyers and sellers of the product. Externalities can be categorized as follows:
(1) Negative
(2) Positive

Negative Externalities
Negative externalities exist when a non member is forced to pay a cost of an economic
transaction. For example, residents in the neighborhood of a steel mill are forced to live in a noisy
and polluted environment. The cost borne by them is the external cost of this transaction. The
opening of a night club leading to increased street crime in the surrounding areas is another
example of a negative externality. External cost exceeds zero when negative externalities exist.

External cost
External cost is the cost incurred, either knowingly or unknowingly, by the non-members of a
transaction. External cost for neighbors of a steel factory are reduced sleep hours, increased
medical bill, increased expenditures on making their houses sound proof and decreased
productivity at their work places.

Private (internal) cost

Private or internal cost is the cost incurred by the members of the transaction. Private cost of
producing steel is the cost of raw material, salaries of workers, utility bills of the factory, rent of
the building etc.

Social cost
Social cost is the cost borne by society as a whole and hence includes both private and external
costs.
Social cost = private cost + external cost
For transactions with negative externalities, social cost exceeds private cost.

Marginal private cost (MPC)

Marginal private cost is the cost incurred by members of a transaction for producing an extra unit
of the product.

Marginal external cost (MEC)

Marginal external cost is the cost incurred by non-members of a transaction with the production of
an extra unit of the product.
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Marginal social cost (MSC)

Marginal social cost is the cost incurred by the society for producing an extra unit of the product.
Marginal social cost = Marginal private cost + Marginal external cost
MSC = MPC + MEC
Resource allocation when there are negative externalities

Fig. 9.1
P
S1 = MSC
B S0 = MPC
MEC
A

D = MPB = MSB

Q
O Q2 Q1

In Fig. 9.1, the height of the demand curve shows marginal social benefit (MSB) as well as
marginal private benefit (MPB). The height of supply curve S0 shows marginal private cost (MPC).
The height of supply curve S1 shows marginal social cost (MSC). Marginal social cost is higher
than marginal private cost since marginal external costs are assumed to be positive. The vertical
distance between both supply curves is the marginal external cost (MEC).

The firm maximizes its profits by producing Q 1, where the private benefit of the last unit equals its
private cost (MPB = MPC). However, society‟s welfare is maximized at Q 2, where the society‟s
cost of making the last unit equals society‟s benefit (MSC = MSB). Units between Q 2 and Q1 cost
more to the society and benefit less to society-hence their production decreases society‟s
welfare. The firm makes these units since they benefit more than they cost (MPB > MPC) - hence
their production increases firm‟s profits.

The firm‟s insistence to produce profit maximizing output i.e. Q 1 diminishes society‟s welfare by
area ABC. Price mechanism over allocates and overproduces products when there are negative
externalities.

Negative Externalities-How to correct market failure

Price mechanism fails to allocate resources efficiently in the case of negative externalities,
making government interference desirable. Governments can intervene in more than one way to
check overproduction where negative externalities exist.
 Taxes
One of the ways to rectify over allocation of resources is to impose taxes. Taxes
internalize external cost by making the firm pay for the pollution it emits. The (indirect) tax
raises production cost and shifts supply curve upwards, forcing the firm to decrease its
production and bringing it closer to the socially optimal level i.e. Q 2 in Fig. 9.1.
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Taxes can be used to correct market failure but can create their own third party effects.
To minimize them, governments can impose heavier taxes on firms using outdated
technology and undesirable production methods. Firms using environment friendly
production techniques on the other hand, can be given a tax relief. Such a tax system
minimizes third party effects of taxes by inducing producers to reduce pollution.

 Legislation
Governments can pass laws, restricting firms from polluting the environment or creating
other negative externalities. Firms can be asked to fulfill certain requirements before
being issued licenses. Government inspectors can periodically monitor the performance
of firms and renew licenses for firms which keep pollution within acceptable limits.

 Tradable pollution permits

Governments can issue permits to firms, allowing them to pollute up to a certain level.
More efficient firms can meet their production targets without fully utilizing the permits
and make profits by selling unutilized permits to less efficient firms. This market based
system provides a monetary incentive to firms to be more efficient and socially
responsible.

As the right to pollute becomes expensive, firms should be discouraged from acting this
way.

Climate change is a global issue and in 1997, most of the world‟s governments adopted
an international agreement, the Kyoto Protocol, to tackle climate change. Like tradable
pollution permits, carbon emission trading is one way in which countries can meet their
obligations under protocol. Firms that can reduce their emissions at a low cost can sell
their credits to firms that struggle to reduce them.

 Media and public campaigning

Media can play an important role in informing stakeholders about the consequences of
production activities carried out by different firms. The increased awareness among
general public can create a pressure on firms to use environment friendly production
techniques.

Positive Externalities
Positive externalities exist when the benefit of a transaction is passed on to outsiders of a
transaction. For example, a public inoculation program does not only benefit the people getting
vaccinated but also others, since the probability of a person catching an infection is low when
more people are vaccinated. Similarly, the construction of an underground railway line yields a
positive externality in the form of reduced number of accidents and road congestion.

 Marginal private benefit (MPB)

It is the benefit accruing to members of the transaction from producing an extra unit.
From a firm‟s point of view, it is the revenue generated from selling an extra unit i.e.
marginal revenue (MR).

 Marginal external benefit (MEB)

It is the benefit enjoyed by non-members with the production of an extra unit. Marginal
external benefit exceeds zero for transactions with positive externalities.
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 Marginal social benefit (MSB)

Marginal social benefit is the benefit enjoyed by society overall, for having an extra unit of
the product.
Marginal social benefit = Marginal private benefit + Marginal external benefit
MSB = MPB + MEB
Fig. 9.2
P
S = MPC = MSC
C
MEB B

D1 = MSB
A

D0 = MPB

Q
O Q1 Q2
In Fig.9.2, the height of the supply curve shows marginal private cost (MPC) as well as marginal
social cost (MSC). The height of demand curve D0 shows marginal private benefit (MPB) and the
height of demand curve D1 shows marginal social benefit (MSB). The vertical distance between
two demand curves measures marginal external benefit. Marginal social benefit exceeds marginal
private benefit since marginal external benefit (MEB) is positive. The society‟s welfare is
maximized at output Q2 (MSB = MSC), but the firm‟s profits are maximized at output Q 1(MPB =
MPC). Units between Q1 and Q2 increase society‟s welfare (MSB > MSC) but decrease profits
(MPB < MPC). Firms fail to allocate resources efficiently and underproduce this product by
choosing to produce profit maximizing output, Q1.Society is deprived of a possible welfare gain of
area ABC. Firms ignore the external benefits as they cannot charge a price for providing these
benefits.

Price mechanism under allocates and under produces goods when there are positive
externalities.

Positive Externalities-How to correct market failure

 Subsidies
Governments can provide subsidies (negative taxes) that reduce production cost. The
supply curve shifts downwards and the firm is encouraged to increase production-getting
closer to the socially optimal level of production.

 Self financing
Government can provide goods itself, such as schools, hospitals and parks, knowing they
will be under produced if left to market forces alone.

 Media and public campaign

Media can play an important role in informing and persuading people to produce and
consume greater quantities of goods having positive externalities. For instance, the
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importance of education, a public inoculation program and planting trees can be greatly
emphasized through media.

 Legislation
Governments can pass laws to ensure that production and consumption of products
bearing positive externalities is increased. For example, in some countries, not sending
children to school is considered a crime. Similarly, governments can restrict planning
permissions to those housing societies only which provide adequate space for parks, play
grounds, community centres and educational institutions.
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Multiple Choice Questions

(Section 9)
J/02/1/11
1 The output of Firm X depends not only on the quantities of factors of production employed
by Firm X. It also depends directly on the level of output of Firm Y. What does this
illustrate?
A complementary goods B cross-elasticity of demand
C an externality D joint production

J/02/1/16
2 The diagram shows the supply curve and the demand curve for a good.
The curve labelled MSC shows the marginal social cost of producing the good.

MSC

x
price,
costs
y

O output Q
Which area measures the social cost of producing output OQ?
A x B y C z D x+y+z

N/02/1/14
3 Jones‟s well-being not only depends on the amounts of goods and services he himself
consumes but is also directly affected by the amount of good X consumed by Smith.
What does this illustrate?
A an externality B cross-elasticity of demand
C joint demand D substitute goods

N/02/1/15
4 An Environment Agency requires companies to introduce more expensive but
environmentally cleaner methods of production.
What effect will this have on the private, external and social costs of production?

private costs external costs social costs

A increase Decrease decrease
B increase Decrease uncertain
C decrease Increase uncertain
D decrease Increase decrease
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J/04/1/14
5 In the diagram, Q1 is the quantity produced of a good as the result of market forces.

S2 (social cost)

S1 (private cost)
price

D
O Q1
quantity
What concept is present at output Q1?

A a government subsidy B a negative externality

C excess supply D price instability

J/04/1/18
6 An international oil company announced in 2002 that it would not continue to explore for
oil off the coast of Namibia. This was because there was only enough oil to support a
local power station for Namibia and not enough to allow exports of oil.
What might be a possible advantage and disadvantage to Namibia of this decision?

Advantage Disadvantage
a saving in costly research paid for by
A a loss of employment opportunities
the oil company
a reduction in taxes paid by the oil the conservation of a natural
B
company to the Namibian government resource
a reduction in potential external costs of the loss of cheaper oil
C
pollution
D The exploitation of a natural resource the loss of potential exports

N/04/1/14
7 Which combination shows examples of the private and external costs of the particular
activity?

activity private cost external cost

A car journeys traffic police costs labour mobility
B foreign holidays crowded beaches airport taxes
C jet flights night flight disturbance landing fees
D pop concerts admission charges noise intrusion
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J/05/1/14
8 The growing of flowers in a private garden results in a positive externality.
What can be concluded from this?

A External benefits exceed private costs.

B External costs exceed private costs.
C Private costs exceed social benefits.
D Social benefits exceed private benefits.

N/05/1/14
9 In some countries in the last twenty years the amount of freight traffic carried by roads has
increased and the amount carried by railways has decreased.
Recently, there has been an attempt to reverse this trend. What could be the most likely
reason for this attempt?

A The external benefits of road transport are higher than the external benefits of rail
transport.
B The private benefits of road transport are high.
C The private costs of road transport are low.
D The social costs of road transport are higher than the social costs of rail
transport.

J/06/1/14
10 In which situation are there definitely positive externalities?

A Private benefits exceed private costs.

B Private benefits exceed social benefits.
C Social benefits exceed private benefits.
D Social benefits exceed private costs.

N/06/1/14
11 What is an external cost of building new houses in a city centre?

A the cost of compensating residents for mud on local roads

B the cost of city centre traffic congestion resulting from the building
C the cost of obtaining planning permission
D the cost of painting the outside of the new houses

J/07/1/15
12 Which consequence of building an underground railway line would be classified as an
externality?

A a reduction in road accidents

B the gain in profit for the train operators
C the revenue from foreign visitors travelling on the line
D the saving in travel time by passengers who travel on the line
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J/07/1/17
13 Vandalism and crime have increased in an area of a city following the opening of a night
club. As a result, additional police have been sent to patrol the area.
What does this statement illustrate?

A a negative externality and a merit good

B a negative externality and a public good
C a positive externality and a merit good
D a positive externality and a public good

J/08/1/14
14 What will be the result, from society‟s view, if the market price for a product does not
reflect the negative externalities in its production?

A too much consumption and too much production

B too much consumption and too little production
C too little consumption and too little production
D too little consumption and too much production

N/08/1/15
15 Which statement about externalities is correct?

A Externalities are easier to value than private costs and benefits.

B Externalities are only associated with industrial production.
C Externalities can be both beneficial and harmful.
D Externalities cannot exceed private costs and benefits.

N/08/1/16
16 The table shows, for two different quantities of good X, the total amount consumers are
willing to pay and the total external benefits that are generated.

quantity of good X consumers' willingness total external benefits

(units) to pay ($) ($)
3 240 54
4 280 68

What is the additional social benefit when 4 units rather than 3 units are produced?

A $14
B $40
C $54
D $348
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J/09/1/14
17 A government is planning to intervene in a market to fix output at the economically
desirable level by giving a subsidy.

MSC

T
costs / Y
benefits S
X
MSB
MPB
O R W
output
To achieve its objective, what should be the subsidy per unit?

A ST B SX C TY D XY

J/09/1/15
18 A town council estimated the costs and benefits of operating a bus service in 2006 and
2007.
These are shown in the table.

2006 2007
$000 $000
private costs 2000 2200
external costs 500 900
private benefits 1500 2300
external benefits 1000 800

What can be concluded from the table?

A Between 2006 and 2007, social costs fell and social benefits rose.
B Between 2006 and 2007, social costs rose and social benefits fell.
C In both years, positive externalities exceeded negative externalities.
D In both years, social costs equalled social benefits.

J/10/1/13
19 James grows fruit trees in his garden. They attract butterflies and bees.
What is not an externality of this?

A Neighbours may be stung by the bees that pollinate the trees.

B Neighbours may buy fruit more cheaply from James than the local supermarket.
C Neighbours may enjoy better air quality as the trees naturally improve the
atmosphere.
D Neighbours may like to watch the activity of the wildlife at no cost.
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J/10/1/14
20 The table shows some of the costs when a firm produces a good.

total cost to society external cost

output
$ $
23 316 16
24 322 18

th
What is the additional cost to a firm of producing the 24 unit?

A $2 B $4 C $6 D $8

J/11/1/14
21 The consumption of a good generates external benefits. Its market equilibrium is E.
Which diagram shows the change in the equilibrium (E to E1) necessary to reflect the
correct value of the good to society?

A B C D
S1 S
S S S
E1 E E1 E S1
price price price price
E D1 E1 E E1
D D1 D D D
O quantity O quantity O quantity O quantity

N/11/1/14
22 A congestion charge of £10 per day has been imposed on motorists taking their cars into
Central London.
What is it about driving into Central London that provides the economic justification for
this charge?
A The external benefits are greater than the external costs.
B The private costs are greater than the external costs.
C The social benefits are greater than the private benefits.
D The social costs are greater than the private costs.

J/12/1/14
23 Which statement is correct?
A External cost equals social cost minus private cost.
B Private cost equals external cost minus social cost.
C Social cost equals external cost minus private cost.
D Social cost equals private cost minus external cost.

N/12/1/14
24 Which policy adopted by an airline is the result of an externality?
A price cutting against rival airlines
B the prohibition of smoking on aircraft
C the provision of different classes of seating accommodation
D the use of internet booking facilities
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N/12/1/15
25 What will be the result, from society‟s view, if the market price for a product does not
reflect the negative externalities in its production?

A too little consumption and too little production

B too little consumption and too much production
C too much consumption and too little production
D too much consumption and too much production

J/13/1/14
26 Which is not an example of an externality?

A The establishment of a new firm in an area increases the general level of wage
rates in the area.
B The flowers planted by a householder in his garden give pleasure to his
neighbours.
C The immunisation of children against smallpox reduces the danger of the risk of
infection to others.
D The installation of security cameras in a city centre results in an increase in thefts
elsewhere.

N/13/1/15
27 What will be the result, from society‟s view, if the market price for a product does not
reflect the positive externalities in its production?

A too little consumption and too little production

B too little consumption and too much production
C too much consumption and too little production
D too much consumption and too much production

J/14/1/14
28 The existence of a positive externality is possible when

A consumers are not the best judges of the future benefits from consuming a
product.
B groups of consumers act together to negotiate a discount on the sale of a
product.
C producers use a government scheme to clear waste from their offices at no cost
to themselves.
D social costs of production exceed private costs of production.
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J/14/1/15
29 A firm opens a new factory on derelict ground on the outskirts of a town.
What will be included among the externalities arising from the opening of the new
factory?

an increase in the change in

an increase in
the rents of the appearance
air pollution
neighbouring factory sites of the neighbourhood
A no no yes
B no yes no
C yes no yes
D yes yes no

J/14/1/16
30 A firm owns a bridge and charges all vehicle users who cross it.
How might the charge be classified?

A a private benefit and a private cost

B a private benefit and an external cost
C an external benefit and a private cost
D an external benefit and an external cost

N/14/32/18
31 The diagram shows the private and social costs and the private benefits that arise as the
number of car journeys into a city centre increases.
In the absence of any external benefits, which volume of traffic would maximise the
community‟s welfare if entry could be restricted through the issue of permits?

N/14/1/14
32 A firm wishes to build a factory extension.
Permission is required from the government because the extension may increase

A comparative costs. B external costs.

C opportunity costs. D private costs.
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N/14/1/15
33 The diagram shows the private and social costs and benefits that arise from the
consumption and production of a good.

If there is no government intervention, what is the value of the marginal external benefit?

A $2 B $3 C $4 D $6

J/15/1/14
34 What is an example of an externality?

A Production of good X directly affects the cost of producing good Y.

B The entry of a new firm reduces the profits of existing firms producing good X.
C The introduction of bus-only lanes reduces the travel times of bus passengers.
D The opening of a new underground railway reduces the revenue of bus
operators.
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Section: 10 Cost Benefit Analysis

Cost benefit analysis (CBA) is an investment appraisal technique which judges the economic
viability of a project by comparing its social costs and benefits. Projects whose (discounted) social
benefits exceed social costs are considered viable and can be given a go ahead.

Cost benefit analysis is usually conducted for mega public sector projects such as building of a
motorway, construction of a dam or of an airport. Such projects have a wide range of negative
and positive effects. These effects should be carefully considered and weighed before deciding to
undertake a project. For example, the cost benefit analysis for the construction of a motorway
linking a major city with a port but passing through an area of breathtaking natural beauty can be
conducted to judge the viability of this project. Some of the social benefits of this project are
increased export revenues, increased employment opportunities, increased economic activity and
improved transport network. The social costs could be the damage to the environment and the
opportunity cost of resources used to construct the motorway.

However, conducting a cost benefit analysis is not a simple task. Identifying all the social costs
and benefits and assigning an exact monetary value to them makes this analysis difficult to
conduct.

Value judgment also complicates this analysis. Value judgment arises when different groups of
people assign different values to the benefits and costs associated with a project. For example,
some people might support the idea of cutting trees to widen a road, enabling commuters to
travel safely and quickly. Another group, fearing a damaged environment, might oppose the idea.

Another problem that authorities confront while conducting CBA is that the costs of projects are
immediate and concern a specific group of people whereas the benefits are remote and widely
dispersed. For example, the construction of a water reservoir forces the displacement of people
living near the proposed site. These people are adversely affected both economically and socially
but the benefits of the dam accrue to the entire country. It is more likely that the affected group
would succeed in forming a pressure group and increase the costs associated with this project.
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Multiple Choice Questions

(Section 10)
J/03/1/15
1 A financial investigation by a private firm finds that a new railway line would not be
profitable.
A cost-benefit analysis finds that the line is worth constructing.
What could explain this difference?
A There are external costs not included in the financial investigation.
B There are external benefits not included in the financial investigation.
C A higher rate of interest is used in cost-benefit analysis.
D Cost-benefit analysis uses a higher estimate for wage costs.

N/03/1/15
2 What would not be included in a cost-benefit analysis of a proposed new
university?
A the costs of building the new university
B the extra income earned by the new university‟s graduates
C the future staffing costs of other universities
D the future staffing costs of the new university five years into the future

J/04/1/15
3 The table shows the expected costs and benefits from four government projects. The
government can afford only one project.
Which project should the government choose?
private external private costs external costs
benefits benefits $m $m
$m $m
A 40 200 60 70
B 60 160 100 20
C 100 210 100 120
D 150 90 120 140

N/04/1/15
4 The government has to choose the best one of four possible sites to locate a port. The
costs and benefits of each site are shown in $m in the table.
Which site would be chosen?
Site private external private external
costs costs benefits benefits
A 10 50 900 600
B 20 5 1 000 800
C 80 40 800 1 100
D 100 200 1 000 900
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J/05/1/15
5 Prior to an election, the government proposes to build a new urban motorway.
In a cost-benefit analysis, what would not be included among the prospective benefits?

A the lower operating costs of public transport

B the lower running costs incurred by private motorists
C the value of time saved by commuters
D the improved chance of the re-election of the government

N/05/1/15
6 When is cost-benefit analysis most likely to be used?

A by a firm when deciding whether to relocate

B by a firm when deciding to purchase new machinery
C by a government when choosing between two road schemes
D by a local authority when deciding its tax rate

J/06/1/15
7 Correct use of cost-benefit analysis should produce an outcome where

A social costs are minimised and social benefits are maximised.

B social benefits are in excess of social costs.
C marginal private benefits equal marginal social benefits.
D marginal social benefits equal marginal social costs.

N/06/1/15
8 What is an advantage of using cost-benefit analysis in decision-making rather than using
only private costs and private benefits?

A It does not require detailed calculations.

B It is easier to calculate social costs than private costs.
C It speeds up the decision-making process.
D It takes into account a wider range of effects.

J/07/1/16
9 The costs and benefits of building a bridge have been calculated as follows.
$ million
building costs 100
disturbance to people nearby 10
time saved by using the bridge 90
less congestion on other routes 30

Which of the following is true?

A The external cost exceeds the private costs.
B The private benefit exceeds the private costs.
C The social benefit exceeds the social costs.
D The external cost exceeds the external benefits.
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N/07/1/14
10 A government decided to approve a private airport-building scheme because it was
socially beneficial. In making its decision it calculated private costs at $700 m, private
benefits at $800m and external costs at $200 m.
What does this suggest must have been true about the external benefits of the scheme?
A External benefits equalled private benefits.
B External benefits exceeded $100m.
C External benefits exceeded external costs.
D There were no external benefits.

N/07/1/15
11 In cost-benefit analysis the term net social benefit refers to
A private benefit plus social benefit.
B social benefit minus private benefit.
C social benefit minus private cost.
D social benefit minus social cost.
J/08/1/16
12 The government has to choose the best one of four possible sites to locate a port.
The benefits and costs of each site are shown in $m in the table.
Which site would be chosen?
private external private external
benefits benefits costs costs
A 900 600 10 50
B 700 1100 20 5
C 800 1100 80 40
D 1000 900 100 200

J/09/1/16
13 When would cost-benefit analysis definitely indicate that a government project should be
approved?
A if it eliminated all external costs
B if it gave a higher rate of return than a private sector project
C if it maximised net social benefit D if it minimised total social cost

N/09/1/13
14 The government is considering building flood defences along a river. It has calculated the
costs and benefits as follows.
costs $m benefits $m
private 450 260
external 60 190
According to cost-benefit analysis, which decision and reasoning about flood defences is
correct?
decision reasoning
A Build. External benefits are greater than external costs.
B Build. Social benefits are greater than private benefits.
C Do not build. Private costs are greater than the external benefits.
D Do not build. Social costs are greater than the social benefits.
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J/10/1/15
15 What makes it particularly difficult to take decisions using cost-benefit analysis?

A External costs are difficult to estimate accurately.

B Government have no method of valuing time savings.
C Market forces have no influence on the outcome.
D Private costs can vary from one day to the next.

N/10/1/15
16 How would net external benefit be calculated?

A external benefit minus external cost

B external benefit plus private benefit
C private benefit plus social benefit
D social benefit minus private cost

N/10/1/16
17 The table shows the expected costs and benefits from four government projects. The
government can afford only one project.
Which project should the government choose?
private benefits external benefits private costs external costs
$m $m $m $m
A 40 200 60 70
B 60 160 100 20
C 100 210 100 120
D 150 90 120 140

J/11/1/13
18 The table shows some of the costs and benefits at a given level of production of a good.

costs $m benefits $m
private 80 private 90
social 200 external 100

What is correct at this level of production?

A External benefits exceed external costs.
B Private benefits exceed external costs.
C Private costs exceed social benefits.
D Social costs exceed social benefits.

J/11/1/15
19 What is an advantage, rather than a disadvantage, of cost-benefit analysis in deciding on
a government investment project?

A Economic agents place different values on external costs and external benefits.
B Estimates of external costs and external benefits are included.
C Forecasts of future costs and benefits vary over time.
D Miscalculations of the costs are financed by the taxpayer.
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N/11/1/15
20 A cost-benefit analysis of a proposed underground railway produced the following
statistics.
annual costs and benefits $ million
annual capital cost 10
operating and maintenance costs 3
fare revenue 6
savings to private travellers 5
savings to business 10
other economic benefits 7
What can be concluded from the statistics?

A If undertaken by the private sector there would be a loss of $13m.

B If undertaken by the private sector there would be a profit of $3m.
C If undertaken by the public sector there would be a net social benefit of $15m.
D If undertaken by the public sector there would be a net social cost of $1m.

J/12/1/15
21 In deciding whether to invest in a new project, what would be taken into account in
government cost-benefit analysis but not by a private company?

A consultancy fees B consumer surplus

C interest charges D tax payments

N/12/1/16
22 The table shows some of the costs and benefits, in $ millions, associated with a road
building project. Both a government department and a profit-maximising private firm are
considering building the road.
PRIVATE EXTERNAL EXTERNAL SOCIAL
COSTS COSTS BENEFITS BENEFITS
450 75 50 550

Who would be willing to build the road?

A Both would be willing to build it.
B Neither would be willing to build it.
C Only the government department would be willing to build it.
D Only the private firm would be willing to build it.

J/13/1/15
23 A government decided to approve a private airport-building scheme because it was
socially beneficial. In making its decision it calculated private costs at $700 m, private
benefits at $800 m and external costs at $200 m.
What must have been true about the external benefits of the scheme?

A External benefits equalled private benefits.

B External benefits exceeded external costs.
C External benefits exceeded $100 m.
D There were no external benefits.
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N/13/1/14
24 The table shows the expected costs and benefits from four government projects. The
government can afford only one project.
Which project should the government choose?

private benefits external benefits private costs external costs

($m) ($m) ($m) ($m)
A 40 200 60 70
B 60 160 100 20
C 100 210 100 120
D 150 90 120 140

J/14/1/17
25 The table shows the results of a cost-benefit analysis into the building of a new runway at
an airport.
Costs US$m Benefits US$m
private 100 125
external 25 20
Which statement about the new runway is correct?
A The net external benefit is US$5 million.
B The net private benefit is US$25 million.
C The net social benefit is US$105 million.
D The net social benefit is US$145 million.

J/15/1/01
26 In 2013, there was much criticism of a government project to build a new high-speed rail
link between two cities.
What is the most likely reason for abandoning such a project?
A The construction cost is greater than the running cost.
B The external cost is greater than the external benefit.
C The future costs are difficult to calculate.
D The opportunity cost is too high.

J/15/1/15
27 The table gives the estimated costs and benefits of a proposed new leisure complex.
$000s
private benefits 120
external benefits 80
private costs 140
external costs 20
What is the estimated value of the social benefits of the project?

A $40 000 B $60 000 C $80 000 D $200 000

J/15/1/16
28 The production of what is most likely to require a government cost-benefit analysis?
A houses B medicines C roads D schools
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Section: 11 Comparison between Perfect Competition and Monopoly

The following diagram helps us analyze how the two market structures studied so far, perfect
competition and monopoly differ on the basis of their efficiency.

Diagram 11.1
Price

MC
PM

III
PC
V
IV

D = AR = P
Output
QM QC
MR
The equilibrium price and quantity for a perfectly competitive industry are determined by the
intersection of downward sloping demand curve and upward rising supply curve at Pc and Qc.
The intersection of MR and MC determines the profit maximizing output for monopoly Q M which
the monopolist sells at price PM. Assuming a similar marginal cost curve for both, it is clear that
the monopolist sells too little at too high prices compared to a perfectly competitive setting.

Whereas consumer surplus for a monopolist is only area I, that for a perfectly competitive industry
comprises areas I, II and III. Monopoly reduces consumer surplus by selling a lower output at a
relatively high price. Producer surplus for a monopolist is areas II and IV whereas that for perfect
competition is IV and V. Monopolist gains area II by charging a high price but loses area V since
fewer units are sold at a higher price. However, the gain shown by II must be greater than the
loss, V, to incentivize producers to monopolize an otherwise perfectly competitive industry.

The sum of consumer and producer surplus equals area I, II, III, IV and V for the perfectly
competitive industry but only I, II and IV for monopoly. Area III and V are those components of
consumer and producer welfare losses which do not become the gain of any one. Thus III and V
show the dead weight loss caused by a monopoly.
A perfectly competitive firm is allocatively efficient as it charges a price equal to the marginal cost
of the last unit and total welfare of society is maximized. Monopoly on the other hand, is
allocatively inefficient since it charges a price higher than the marginal cost and results in a
welfare loss to society i.e. III and V. Marginal social benefit (given by the height of the demand
curve) exceeds marginal cost of units between Q M and Qc so their production increases society‟s
welfare but reduces monopolist‟s profits (since marginal cost exceeds marginal revenue). The
temptation to maximize profits forces monopolists to restrict output to Q M where MR equals MC.
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A perfectly competitive firm must be productively efficient to be able to continue operating in the long
run. Productive efficiency requires a firm to produce at minimum possible Average Cost (AC). A
perfectly competitive firm can not charge a price higher than average cost in the long run as firms that
do so incur a loss and are unable to survive. However, the ability of a monopolist to charge a price in
excess of average cost provides room for complacency. A monopolist may still be productively
efficient but the pressure to be so is decreased because of its ability to make super normal profits.

Note that assuming the supply curve of perfectly competitive market to be similar to the Marginal
Cost (MC) curve of monopoly ignores the possibility of economies of scale which monopoly may
exploit because of its large size.

The following set of diagrams show how the conversion of a perfectly competitive industry into a
monopoly affects market price and output. The equilibrium price P C and quantity QC of a perfectly
competitive market are given by the intersection of supply curve, S (C) and demand curve.
Assuming the industry is monopolized, Marginal Revenue (MR) and demand curve diverge and
Marginal Cost (MC) curve shifts downwards due to the existence of economies of scale. The
intersection of the MC curve, MC (M) and MR determines the profit maximizing quantity Q M for a
monopoly and the demand curve yields the corresponding price, PM. Compare this price and
quantity with the initial ones under perfect competition in each of the following diagrams.

In diagram 11.2 (a) monopoly, compared to perfect competition, sells too little at too high prices.
In diagram 11.2 (b) price and output are the same under both scenarios.
In diagram 11.2 (c) the downward shift in Marginal Cost (MC) is large enough to allow monopoly
to sell a greater output and charge a lower price compared to perfect competition.

Diagram 11.2 (a) Diagram 11.2 (b)

P P
S(C)
MC(M)
S(C)
PM
PC MC(M)
PC = PM

AR=P=D
AR=P=D

MR MR
Q Q
QM QC QC = QM
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Diagram 11.2 (c)

S(C)

PC MC(M)
PM

AR=P=D

MR
Q
QC Q M

Impacts on price and output of monopolizing a competitive market

Marginal cost Price Output
Economies of scale are
not available and cost
Unchanged Increases Decrease
conditions remain
unchanged
Monopoly exploits
economies of scale and Decreases Uncertain Uncertain
costs decrease

Efficiency: Productive and Allocative Efficiency

The following summary combines information on productive and allocative efficiency from AS and
A Level divisions of the syllabus and helps attempt essays as well as solve multiple choice
questions.

Productive Efficiency Allocative Efficiency

A resource allocation is productively efficient A resource allocation is efficient when welfare of
when output is maximized and more of a the society is maximized and it is impossible to
product can only be produced by choosing to make someone better off without making
produce less of something else. All points on a someone else worse off. This principle is known
production possibility curve (PPC) are as Pareto Optimality. (see N/02/3/11)
productively efficient. However, productive A resource allocation is efficient when the
efficiency does not guarantee full employment marginal social cost of last unit equals marginal
of ALL factors of production. social benefit
Consider a factory with two machines, each
producing 25 units/hour. The firm employs
seven workers to pack the finished product, the
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average speed of each worker being 8

units/hour. In a working day of 8 hours, workers
can process 448 units (7 workers × 8 units × 8
hours) whereas machines can only produce
400 units (2machines × 25 units × 8 hours).
Although the firm produces its maximum
possible output i.e. 400 units each day and
does not have excess capacity, six working
hours remain idle. This firm is productively
efficient, yet it does not employ ALL factors of
production (see J/02/3/01)
Productive efficiency implies that all output is A firm is allocatively efficient when it charges a
produced at minimum cost i.e. average cost price equal to the marginal cost (MC) of the last
(AC) is lowest. unit produced.
A firm tends to be productively inefficient if it A perfectly competitive firm is likely to be
charges a price higher than AC. However, firms allocatively efficient in both the short run and
making only normal profits can not survive if long run since it charges a price equal to the
they are productively inefficient. marginal cost of the last unit. However, it may
Perfectly and monopolistically competitive* be allocatively inefficient if marginal social cost
firms may be productively inefficient in the and marginal private cost diverge.
short run (since charging a price higher than In almost all cases, allocative efficiency implies
average cost is possible) but they must be productive efficiency. However, productive
productively efficient in the long run if they are efficiency does not guarantee allocative
to survive (since charging a price higher than efficiency.
average cost is not possible). Question:
Think of a case where a firm is allocatively
efficient but productively inefficient (consult
table in section 14 for answer)

Monopoly can be productively inefficient both in Profit maximizing monopoly and monopolistic
the short and long run (since charging a price competition (section 14) are allocatively
higher than average cost is possible) inefficient since demand (price) and marginal
revenue diverge and equating MC and MR (to
maximize profits) implies that price exceeds MC

Efficiency and Equity are two different principles and an efficient resource allocation does not
guarantee equitable income distribution (try J/03/3/01).

A socially optimal level of output maximizes social welfare and is determined by the intersection
of Marginal Social Benefit, MSB and Marginal Social Cost, MSC. The following cases highlight
instances where the price mechanism fails to result in such a level of output, causing a welfare
loss to society:

 Monopoly restricts output below socially optimal level to maximize its profits.
 A profit maximizing firm causing negative externalities tends to ignore external cost and
produce above the socially optimal level. Thus a profit maximizing monopolist generating
negative externalities may produce either below or above the socially optimal level.
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 Production activities generating positive externalities under produce goods i.e. operate
below the socially optimal level. Thus a profit maximizing monopolist generating positive
externalities is bound to produce output below the socially optimal level.
 Price mechanism under produces merit goods and over produces demerit goods.

Cases of market failure other than monopoly have been discussed in detail in Understanding
Economics- AS Level. Students must prepare this topic using both books and attempt following
essays.

J/02/4/07 J/05/4/06 N/07/4/04 N/09/42/02(b) J/11/42&43/02

N/02/4/03(a) N/05/4/02 J/08/4/02 J/10/41/02 N/11/41/02

J/03/4/02 J/06/4/02 N/08/4/04 J/10/42/02 N/11/42/02(b)

N/03/4/02 N/06/4/02 J/09/4/07(b) N/10/42/02 N/11/43/02

J/04/4/05 J/07/4/02 N/09/41/02 J/11/41/02

For popular subjects like Economics, CIE introduced three variants of examination papers in June
2010 preceded by two variants in November 2009. Students appearing for CIE A Level
examinations from Pakistan follow the second variant. This book, therefore, provides guidance on
only Variant 2 Multiple Choice Question Papers. However, students are encouraged to attempt
essays from all variants for the sake of good practice. To identify the variant of a certain
examination paper, students must refer to the code in the top right corner of the paper‟s cover
page. 9708/42 can be deciphered as the syllabus code for Economics (9708) followed by the
Paper No. (4) and the Variant No. (2).Likewise, 9708/31 refers to variant 1 of paper 3.

Remedies to Monopoly Abuse

As discussed in the previous section, monopoly is allocatively inefficient since it charges a price
higher than MC and produces below the socially optimum level of output. It could also be
productively inefficient since its ability to make super normal profits erodes the pressure to
produce at the minimum Average Cost. In order to make them socially responsible, governments
can force monopolists to increase output and reduce profits through various forms of intervention.
The following discussion examines one such line of intervention- taxing monopolies to force them
closer to the socially optimal level. Governments can tax monopoly profits to make them
productively efficient and prevent them from using otherwise huge profits to erect entry barriers.

The taxes discussed below are indirect and do not affect the position of demand curves.
However, they may affect the position of supply and cost curves of a firm, hence altering output
decisions and profits.
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Lump sum tax

Lump sum tax is imposed on production capacity and is independent of a firm‟s output. Like fixed
cost, it increases average cost and lowers profits but does not affect the position of marginal cost
curve- output, determined by the intersection of MC and MR remains unchanged. However, a
monopolist can be forced to shut down if the tax is high enough to convert its profits into losses.
Lump sum tax fails to achieve the objective of increasing output but does reduce monopoly
profits, increasing the pressure to be productively efficient.

Per unit tax

Per unit tax is applicable on the number of units a monopolist produces. This tax shifts both the
average and marginal cost curves upwards. Profits decrease and so does the output since new
marginal cost curve intersects the downward sloping MR curve at a higher point i.e. a lower output.

Like lump sum tax, per unit tax decreases monopoly profits but fails to meet the objective of
raising output and achieving allocative efficiency.

Per unit subsidy

Like per unit tax, per unit subsidy is also applicable on the number of units a monopolist
produces. It reduces both average and marginal cost, shifting their curves downwards. Profits
increase and so does the output since new marginal cost curve intersects the downward sloping
MR curve at a lower point i.e. a higher output.

To achieve goals of both increased output and decreased profits simultaneously, a combination
of lump sum tax and per unit subsidy may be used. A per unit subsidy encourages the monopolist
to produce more and a lump sum tax reduces profits.

The government can also use its legislative powers to control monopoly power. The Monopoly
and Merger Commission (MMC) and the Office of Fair Trading (OFT) in UK continuously monitor
firms‟ performances and take action against unfair trading practices. Firms spending an
unreasonably high percentage of their sales revenues on promotion can be questioned about the
intentions behind such lavish spending. Regulators can order them to decrease advertisement
budgets if they suspect erection of entry barriers. Regulators should also intervene where firms
are suspected to collude and formulate price fixing agreements. Ceilings can be imposed on firm
size and those exceeding the ceiling can be forced to split. Agreements giving exclusive rights for
supplies, production and distribution can be declared illegal in order to open doors for more
competition. Government can impose price ceilings, reducing monopoly profits and hence,
reducing the scope for consumer exploitation.

The role of regulatory authorities is crucial to controlling monopoly abuse and protecting
consumers. In Pakistan, the job of regulating markets has been assigned to Monopoly Control
Authority (MCA).

Monopolies- The iPhone example

The launch of the iPhone in the UK in November 2007 was a great success for Apple and its
partner O2. Apparently, more than 40,000 iPhones were bought in the first weekend. Buyers had
to pay $269 for the device, then sign up for $35 for 18 months, making the total commitment
$899. The high cost largely resulted from Apple‟s deal with O2, giving it a network monopoly on
the phones. When Apple tried the same in Germany, Vodafone threatened legal action under the
country‟s anti-monopoly laws forcing Apple to back down. People in UK have criticized British
anti-monopoly laws for not being effective in controlling monopoly abuse.
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Multiple Choice Questions

(Section 11)
J/02/3/01
1 Which condition defines productive efficiency?
A All factors of production are fully employed.
B All firms are producing at their profit maximising levels of output.
C The output of all goods is produced at minimum cost.
D There are no further opportunities for substituting capital for labour.

J/02/3/15
2 The diagram shows the cost and revenue curves of a profit-maximising monopolist.
Which area measures the deadweight loss arising from the exercise of monopoly power?

MC
x
y AC
cost,
revenue z
w

AR
MR
O output

A x+y
B y
C y+z
D w+y+z

N/02/3/11
3 When is allocative efficiency achieved in an economy?

A when nobody can become better off without somebody else becoming worse off
B when the economy is operating at its natural rate of unemployment
C when the level of social costs is minimised
D when the rate of economic growth is maximised
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N/02/3/12
4 The diagram shows the supply and demand curves for a good. The curve labelled MSC
shows the marginal social cost of producing the good.

MSC

price,
costs x

z
D

O Q2 Q1
output
Which area measures the net welfare gain to society from reducing output from OQ 1 to
OQ2?

A x B y C x+y D x+y+z

J/03/3/01
5 In an economy, no one can be made better off without making someone else worse off.
What does not necessarily follow from this?

A The distribution of income is socially acceptable.

B The conditions for allocative efficiency have been met.
C The economy is operating at a point on its production possibility frontier.
D The conditions for productive efficiency have been met.

J/03/3/14
6 A perfectly competitive industry becomes a profit maximising monopoly.
The marginal cost curve of the monopolist is identical to the supply curve of the perfectly
competitive industry.
How will output and price be affected?

output price
A increases increases
B increases decreases
C decreases decreases
D decreases increases
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J/03/3/15
7 In the diagram the imposition of a tax on a commodity causes its supply curve to shift
from S1 to S2.

D S2

S1
P2 J
price
P1 K
N

O Q2 Q1
quantity

Which area measures the resulting deadweight loss?

A P1P2JK B JKQ1Q2 C JKM D JKN

J/03/3/16
8 In what circumstances will the entry of additional fishing boats into the fishing industry
necessarily result in a net loss in welfare?

A The entry of the new boats reduces fish caught by other boats.
B The entry of the new boats reduces the profits of other boat owners.
C The value of the increase in the fish caught is less than the loss in value of output
elsewhere in the economy.
D The entry of the new boats reduces the overall fish stock.

N/03/3/01
9 An economy is operating at a point inside its production possibility curve.
Why is this described as inefficient?

A Individuals are enjoying too much leisure.

B Labour and capital are combined in the wrong proportions.
C More of one good can be produced without decreasing production of another.
D There are shortages of some goods and an excess supply of others.

N/03/3/17
10 By reallocating resources an economy produces more of one good but no less of other
goods.
What change has necessarily occurred?

A improved technology
B improved efficiency
C increased equity
D increased employment
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J/04/3/01
11 What does not pose a threat to the achievement of allocative efficiency?
A imperfect information on the part of consumers
B income inequalities
C the existence of externalities
D the presence of monopolistic elements

J/04/3/11
12 The diagram shows an industry producing under conditions of constant average costs.

Y
X
cost,
revenue
Z
T LRAC, LRMC
W

AR
O S MR V
output
Under perfect competition, the industry produces output OV.
Which area measures the increase in the industry‟s profits if it were to become a
monopoly?

A XYSO B XYWT C XYZT D YZW

J/04/3/15
13 The diagram shows the market supply and demand curves for corn.
D S

P2

P1
price

O K L R
output
What should a government do if it is to maintain a minimum price of OP2?
A buy quantity KR B buy quantity LR
C sell quantity KL D sell quantity OL
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N/04/3/01
14 A firm is operating in a perfectly competitive market.
What would ensure that it is both productively and allocatively efficient?
A It is in long-run equilibrium.
B It is maximising total revenue.
C It is producing where marginal revenue is equal to marginal cost.
D Long-run average costs are falling and sales are rising.
N/04/3/16
15 What might prevent an economy in which all firms are required to equate price and
marginal cost from achieving allocative efficiency?
A differences in preferences between consumers
B divergences between private and social costs
C inequalities of income and wealth
D product differentiation

N/04/3/17
16 A good gives rise to external benefits and is produced under conditions of imperfect
competition.
Which statement must be true?
A Consumers of the good are paying too low a price.
B Firms producing the good will make a loss.
C Output of the good is below the socially optimum level.
D Social costs of production exceed private costs.
J/05/3/01
17 Which condition defines productive efficiency?
A All factors of production are fully employed.
B All firms are producing at their profit-maximising levels of output.
C The output of all goods is produced at minimum cost.
D There are no further opportunities for substituting capital for labour.

J/05/3/13
18 The government imposes a specific tax equal to $0.20 per unit on the output of a
monopoly producer.
What will be the effect on the price charged by the monopoly and on the quantity it
produces?
price quantity
A increases by $0.20 decreases
B increases by less than $0.20 decreases
C increases by $0.20 unchanged
D increases by less than $0.20 unchanged

J/05/3/14
19 In an economy no one can be made better off without making others worse off.
What can be deduced from this?
A All markets are perfectly competitive.
B There are no externalities.
C The economy is operating on its production possibility curve.
D The distribution of income reflects what each individual deserves.
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N/05/3/01
20 What will happen if a firm is subsidised by an amount equivalent to the external benefits
that it confers on the rest of society?

A Resource allocation will be improved.

B The firm will produce less.
C There will be a misallocation of resources.
D There will be no effect upon production.

N/05/3/15
21 Which area of skill possessed by the managers of government-owned enterprises in a
planned economy is less relevant when industries are privatised?

A financial management
B marketing
C production targeting
D stock quality and control

J/06/3/01
22 The diagram shows the production possibility curve for an economy.

L
good Y

O good X
What might make it possible for consumers in this economy to consume the combination
of goods X and Y indicated by the point L?

A a reduction in unemployment
B the attainment of productive efficiency
C the elimination of a monopoly in the production of good X
D trade with other economies

N/06/3/01
23 An economy is operating at a point on its production possibility curve.
What is true about the way the economy‟s resources are being used at this point?

allocatively efficient productively efficient socially desirable

A possibly yes yes
B yes possibly possibly
C possibly yes possibly
D yes possibly yes
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N/06/3/14
24 The diagram shows the cost and revenue curves of a profit-maximising monopolist.

MC
x
AC
y
costs,
revenue z

AR

MR
O output
Which area measures the deadweight loss arising from the exercise of monopoly power?

A x+y B y C y+z D w+z

J/07/3/01
25 In an economy, no one can be made better off without making someone else worse off.
What does not necessarily follow from this?

A The conditions for allocative efficiency have been met.

B The conditions for productive efficiency have been met.
C The distribution of income is socially acceptable.
D The economy is operating at a point on its production possibility frontier.

J/07/3/15
26 A perfectly competitive industry becomes a monopoly.
What would prevent a deadweight welfare loss resulting?

A The government converts it to a profit-maximising nationalised industry.

B The government places an indirect tax on the monopolist‟s product.
C The monopolist uses marginal cost pricing.
D The monopolist charges the same price to all consumers.

J/07/3/17
27 In 1995 the Canadian government increased the specific tax on each packet of cigarettes
by $3.50.
What is the most likely explanation for the resulting fall in tax revenue from cigarette
sales?

A Consumers switched to cheaper brands.

B The demand for cigarettes is price-inelastic.
C There was an increase in illegal imports of cigarettes from the USA.
D The whole of the increase in tax was borne by the cigarette manufacturers.
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N/07/3/01
28 In the diagram, a firm increases its output from OY to OZ.

MC

costs and
revenue

AR

O Y Z
output
Which statement about the effect on economic efficiency is correct?
A It will increase because a greater quantity will be produced and higher total
revenue will be earned.
B It will increase because the value that consumers place on the product comes
closer to the cost of producing the last unit.
C It will decline because both average and marginal revenue will fall.
D It will decline because both total and marginal cost will rise.

N/07/3/14
29 What is not an example of „market failure‟?
A inequality in the distribution of income
B a monopolist charging prices above marginal cost
C the damage to common land due to overgrazing
D aircraft noise affecting individuals living near airports

N/07/3/16
30 What should an industry regulator control if it wishes to provide an incentive for a
privatised firm to improve its productive efficiency?

A dividends
B output
C prices
D profits

N/07/3/17
31 The introduction of a congestion charge on private motorists entering a city centre results
in a significant reduction in traffic congestion.
What will be the net welfare effects on the following groups of car users?
those who continue to those who no longer those who switch to
use their cars travel public transport
A uncertain lose uncertain
B uncertain uncertain gain
C lose lose gain
D lose uncertain uncertain
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J/08/3/01
32 What will happen if a firm is subsidised by an amount equal to the external benefits that it
confers on the rest of society?
A Resource allocation will be improved.
B The firm will produce less.
C There will be a misallocation of resources.
D There will be no effect upon production.

J/08/3/10
33 A perfectly competitive industry becomes a profit-maximising monopoly.
The marginal cost curve of the monopolist is identical to the supply curve of the perfectly
competitive industry.
How will output and price be affected?
output price
A increases increases
B increases decreases
C decreases decreases
D decreases increases

J/08/3/12
34 In the diagram the imposition of a tax on a commodity causes its supply curve to shift
from S1 to S2.

D S2

S1
P2 J
price
P1 K
N

O Q2 Q1
quantity
Which area measures the resulting deadweight loss?
A P1P2JK B JKQ1Q2 C JKM D JKN

J/08/3/13
35 A good gives rise to external costs and is produced under conditions of monopolistic
competition.
Which statement must be true?

A Output of the good is at the socially optimum level.

B Output of the good is below the socially optimum level.
C Private costs of production exceed social costs.
D Social costs of production exceed private costs.
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J/08/3/15
36 A government decides to privatise a state monopoly.
What should the government do to try to ensure that this will result in an improvement in
efficiency?

A allocate vouchers to all citizens entitling them to a share in the ownership of the
monopoly
B encourage competition
C impose a maximum profit margin
D privatise the monopoly as a going concern

N/08/3/01
37 Which condition must be met for economic efficiency to be achieved?

A Marginal social costs are zero in the production of all goods.

B Marginal social costs equal marginal social benefits in the production of all
goods.
C Marginal social benefits are at a maximum in the production of all goods.
D Marginal social costs are at a minimum in the production of all goods.

N/08/3/02
38 The diagram shows the levels of utility corresponding to different allocations of resources
between two people.
The initial allocation is Z.
Which reallocation of resources would definitely be more Pareto efficient?

B
person Z D
Y‟s utility
C

45°
O person X‟s utility
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N/08/3/11
39 The diagram shows the cost and revenue curves of a profit-maximising monopolist. The
monopolist's average cost curve is identical to the long-run supply curve which would
exist if the industry was perfectly competitive.

X
W

$ V
Z AC = MC
Y

AR
MR
O T U
output

Which area shows the deadweight loss resulting from this monopoly situation?

A WXYZ B WXYZ C XVY D XVUT

J/09/3/14
40 In the diagram the introduction of a government subsidy causes an industry‟s supply
curve to shift from S1 to S2.
S1
D J S2
N
P1
price
P2 K
L

O Q1 Q2
quantity
Which area measures the resulting deadweight loss to society?

A P1NKP2 B JKN C NLK D Q1Q2JN

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Competition and Monopoly

N/09/3/09
41 The diagram shows an industry producing under conditions of constant average costs.

Y
X

$
Z
T LRAC, LRMC
W

AR
O S MR V
output

Under perfect competition, the industry produces output OV.

Which area measures the loss in consumer surplus if it were to become a monopoly?

A YWZ B XYWT C XYZT D SYZV

N/09/3/14
42 What could prevent a market economy achieving allocative efficiency?

A disagreement among consumers over resource allocation

B inequalities in the distribution of income and wealth
C an inability to produce free goods
D an inability to produce public goods

J/10/3/12
43 A competitive market becomes a monopoly.
What is likely to happen?

A Consumer surplus will be reduced by the amount of the deadweight loss.

B Producer surplus will be reduced by the amount of the deadweight loss.
C The loss in consumer surplus will be balanced by the increase in producer
surplus.
D There will be a transfer of surplus from consumer to producer.
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J/10/3/30
44 Which is a correct statement about efficiency?

A Allocative efficiency occurs when marginal revenue equals marginal cost.

B An economy is productively efficient when it is producing at a point on its
production possibility curve.
C An economy will improve its allocative efficiency when its production possibility
curve moves outward.
D Productive efficiency occurs when the prices of goods equal their marginal cost
of production.

N/10/3/01
45 In an economy no one can be made better off without making others worse off.
What can be concluded from this?

A All markets are perfectly competitive.

B There are no externalities.
C The economy is operating on its production possibility curve.
D The distribution of income reflects what each individual deserves.

N/10/3/12
46 The diagram shows the outcome when a perfectly competitive market is taken over by a
monopoly.

$
X
AC

MR D
O quantity
What does area X represent?

A monopoly profit
B the reduction in consumer surplus
C the resulting deadweight loss
D transfer earnings

N/10/3/14
47 Which is not a policy designed to correct market failure?

A competition policy
B free inoculation against infectious diseases
C minimum wage policy
D regulations to limit river pollution
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J/11/32/07
48 A product with infinite elasticity of supply has sales of 1000 units a week at a price of $1
per unit.

Price elasticity of demand is 1.5 over the relevant range.

The government imposes a tax of 10 %.

What will be the government‟s weekly tax revenue?

A $15 B $85 C $100 D $150

J/11/32/10
49 The diagram shows the private and social marginal costs and benefits at different
volumes of traffic.
MSC

MPC + tax
x
z MPC
costs, y
benefits

MPB = MSB

O volume of traffi c
The imposition of a congestion tax raises the MPC curve to MPC + tax.
Which area measures the resulting reduction in the deadweight loss?

A x + y only B x+y+z C y only D z only

J/11/32/11
50 A government imposes a maximum price for electricity.
Which statement justifying this measure might be considered valid on economic
grounds?

A It will encourage electricity suppliers to invest in additional capacity.

B It will increase the incentive for consumers to conserve energy.
C It will prevent the monopolistic exploitation of consumers.
D It will prevent the rationing of electricity through power cuts.
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J/11/32/30
51 In the diagram, LM is an economy‟s production possibility curve.

L E

G
good X
F

O good Y M
Which statement is correct?

A E only is attainable.
B F is economically efficient.
C G may be economically efficient but is not productively efficient.
D H is productively efficient but may not be economically efficient.

N/11/32/02
52 The diagram shows a firm‟s long-run cost and revenue curves.

LRMC LRAC

costs,
revenue

AR

MR
O AB C D
output
At which level of output is the firm both allocatively and productively efficient?

A OA B OB C OC D OD
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N/11/32/15
53 The diagram shows the supply and demand curves of a commodity.
A government subsidy causes the supply curve to shift from S1 to S2.
Which area measures the difference between the cost to the economy of producing the
resulting increase in output (Q1 – Q2) and the value consumers place on this increase in
output?

D
S1
S2

price A
B
C

O Q1 Q2
quantity

J/12/32/01
54 When is economic efficiency achieved in an economy?

A when nobody can become better off without somebody else becoming worse off
B when the economy is operating at its natural rate of unemployment
C when the level of social costs is minimised
D when the rate of economic growth is maximized

J/12/32/15
55 A good gives rise to external benefits and is produced under conditions of imperfect
competition. Which statement must be true?

A Benefits to consumers exceed the benefits to society.

B Firms producing the good will make a loss.
C Output of the good is below the socially optimum level.
D Social costs of production exceed private costs.
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J/12/32/16
56 The diagram shows the long-run cost and revenue curves of a monopolist.

AR

revenue,
costs

LRAC

LRMC

O W X Y Z
MR
output
Which level of output satisfies the condition for an efficient allocation of resources?

A OW B OX C OY D OZ

N/12/32/01
57 What will happen if a firm is subsidised by an amount equal to the external benefits that it
confers on the rest of society?
A There will be no effect upon production.
B The firm will produce less.
C There will be a misallocation of resources.
D Resource allocation will be improved.

N/12/32/07
58 What would be the effect of imposing a specific tax on each item produced by a profit
maximizing monopolist?

A Average revenue falls by the amount of the tax.

B Marginal costs rise by the amount of the tax.
C Price increases by the amount of the tax.
D There will be no change in price or output.

N/12/32/14
59 All firms in an economy produce at levels of output where price and marginal private cost
are equal.
Why might this not be sufficient to ensure that allocative efficiency is achieved?

A a small number of buyers and sellers

B differences in consumers‟ preferences
C product differentiation
D the presence of externalities
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J/13/32/12
60 A firm operates in a perfectly competitive market.
Which relationship between the firm‟s cost and revenue describes a position where
allocative efficiency would be improved if the firm reduces its present level of output?

A P = MR > MC B P = MR < MC
C P > MR = MC D P > MR > MC

J/13/32/14
61 The curve in the diagram shows the minimum combinations of capital and labour that are
needed to produce 100 units of output.

capital

Q = 100

O
labour

A firm‟s management hires the combination of capital and labour indicated by point G in
the diagram to produce 100 units of output.
Which term best describes this situation?

A lack of specialization B managerial diseconomy

C market failure D X-inefficiency

J/13/32/16
62 The diagram shows the market supply and demand curves for corn.

D S

P2

P1
price

O K L R
output

What should a government do if it is to maintain a minimum price of OP2?

A buy quantity KR
B buy quantity LR
C sell quantity KL
D sell quantity OL
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N/13/32/01
63 What is the purpose of trying to achieve economic efficiency?

A to ensure that economic decisions are made equitably

B to ensure that firms are internationally competitive
C to ensure that firms maximise their profit levels
D to ensure that the economy does not waste scarce resources

N/13/32/16
64 The firms in a perfectly competitive industry combine to form a monopoly.
What would prevent a deadweight welfare loss resulting?

A The government imposes an indirect tax on the monopolist‟s product.

B The government requires the monopolist to charge a price equal to average cost.
C The monopolist adopts marginal cost pricing.
D The monopolist charges the same price to all consumers.

J/14/32/01
65 In the diagram, LM is an economy‟s production possibility curve.
L E

G
good X F

O M
good Y
Which statement must be correct?

A F is productively inefficient.
B G and H are productively efficient but economically inefficient.
C Only E is economically efficient.
D Only G is productively efficient.

J/14/32/13
66 A country‟s government reduces the specific tax on packets of cigarettes.
What could explain why this leads to an increase in tax revenue from cigarette sales?

A Consumers switch to dearer brands.

B The demand for cigarettes is price-inelastic.
C The price of cigarettes falls by less than the reduction in tax.
D There is a reduction in illegal imports of cigarettes.

J/14/32/14
67 Which is not a policy designed to correct market failure?

A competition policy
B free inoculation against infectious diseases
C minimum wage policy
D regulations to limit river pollution
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J/14/32/15
68 In the diagram the imposition of a specific tax causes an industry‟s supply curve to shift
from S1 to S2.
S2
D J
S1
N
P1
price
P2 K

O Q1 Q2
quantity
A NLK B JKN
C P1NKP2 D Q1Q2JN

N/14/32/01
69 Which condition defines productive efficiency?

A All factors of production are fully employed.

B All firms are producing at their profit-maximising levels of output.
C There are no further opportunities for substituting capital for labour.
D The output of all goods is produced at the lowest possible cost.

J/15/32/01
70 What need not pose a potential threat to allocative efficiency in a market economy?

A externalities
B differentiated products
C monopolistic elements
D perfect knowledge

J/15/32/17
71 Which government policy would not be classified as regulation?

A bans on heroin and cocaine consumption

B compulsory wearing of seatbelts in cars and coaches
C licences for the extraction of water from lakes and rivers
D taxation of cigarettes and tobacco products
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N/15/32/01
72 The diagram shows the production possibility curve for a successful transition economy
that moves from point X to point Y over time.

X
public
sector
output
Y

O private sector
output
During the transition process the population of the country expressed a strong preference
for increased privatisation.
What happens to economic efficiency as a result of the transition from point X to point Y?

productive allocative
efficiency efficiency
A increases decreases
B increases increases
C unchanged decreases
D unchanged unchanged

N/15/32/15
73 The diagram shows the demand curve, DC, and supply curve, SC, of a perfectly
competitive industry.

cost,
revenue PC SC = LRACM

DC = AR M
O QC
output
The industry is taken over by a monopolist. The monopolist‟s long-run average cost
curve, LRACM, is identical to the supply curve of the perfectly competitive industry.
What will be the effects of the takeover on profit and allocative efficiency?
allocative
profit
efficiency
A decreases decreases
B decreases increases
C increases decreases
D increases increases
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N/15/32/16
74 Which government microeconomic policy is not usually aimed at correcting allocative
inefficiency in an economy?

A anti-monopoly legislation
B congestion charges for the use of roads in cities
C pollution taxes imposed on various firms
D subsidies for agricultural producers
J/16/32/01
75 What action by a firm is most likely to raise its dynamic efficiency?

A distributing all its current profit to its existing shareholders

B maximising the labour productivity of its current workers
C minimising the average cost of producing its current output
D retaining its current profit for product research and development
J/16/32/02
76 The current distribution of goods between two individuals in a two-person economy with
given technology and resources is at point X.
According to the Pareto criterion, which point would definitely indicate increased
allocative efficiency?

Tariq‟s
goods X B
C
D

O Samir‟s goods

J/16/32/03
77 The concept of allocative efficiency assumes that each individual in society is the best
judge of their own economic welfare.
Which example of government intervention is based on an argument which rejects this
assumption?

A pollution controls B subsidies for merit goods

C the provision of public goods D the regulation of monopolies
J/16/32/18
78 A government regulates the price charged by a monopolist.
In which circumstance will such intervention improve economic efficiency?

A The government sets the price where average revenue equals marginal cost.
B The government sets the price where marginal cost is below average cost.
C The intervention results in an increase in producer surplus.
D The intervention results in predatory pricing.
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Section: 12 Objectives of Firms

So far, our analysis has revolved around the assumption that firms seek to maximize profits by
producing at an output level where revenue generated from selling an extra unit (MR) equals the
cost incurred on producing that unit (MC). However, it is reasonable to argue that this theory of
maximizing profits may not always depict how firms operate in the real world.

Firms may not be able to calculate the MR and MC of every individual unit, hence rendering the
idea of indentifying the MR=MC output a mathematical fantasy. It is difficult for a hotel manager
or a principal at school for instance, to determine the marginal cost of serving an extra customer
in a restaurant or teaching an extra student in the school.

In reality, firms seem to be aiming at a level of profits that is enough to satisfy their owners.
„Satisficing profits‟ theory assumes that firms don‟t aim to maximize profits by calculating MC and
MR for individual units, instead they set a target for profits and are happy achieving it.

Moreover, there are situations where firm behavior has little to do with making profits in the first
place and tunes in to more important objectives. For example, firms penetrating new markets
forgo higher prices and profits as their immediate aim is to establish themselves and build brand
awareness among customers and distributors. Threatened existence attributed to entry by hostile
competitors or changes in consumers‟ tastes and preferences induce firms to ensure survival
rather than profits.

Likewise, instead of focusing on profit maximization, firms desiring to be market leaders aim to
maximize sales and market share. Increased market share provides greater control over market
and hence profits, that sustain over a longer period of time. Such firms can afford to charge lower
prices in order to keep potential competitors away.

Today‟s modern world witnesses the existence of many firms that are driven by motivations like
social responsibility. As environmental concerns by consumers and society become increasingly
pressing onto firms, the latter are forced into forgoing their profits and switch production methods
to environment friendly technologies. “Greener” production techniques aid promotions and exhibit
adequate concern on part of the firm towards the welfare of their work force. Implementing such
costly techniques may first appear to be in conflict with the traditional goal of profit maximization
but it improves the firm‟s image in the eyes of all stakeholders and may very well win generous
profits.
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Diagram 12.1 shows various pricing and output options firms pursue while seeking different
objectives.

Diagram 12.1
Cost

MC
P1
AC
P2
P3
P4

P = AR = D
Output
q1 q2 q3 q4
MR

Firm‟s objective Point of production Price charged Output obtained

Profit maximization MC = MR P1 q1
Sales revenue maximization MR = 0 P2 q2
Allocatively efficient output P = MC P3 q3
Maximum quantity ensuring that at
P = AC P4 q4
least normal profits are made
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Multiple Choice Questions

(Section 12)
J/02/3/02
1 The diagram shows a firm‟s cost and revenue curves.
At which level of output will the firm be making only normal profit?

marginal cost

average cost

revenue/cost

average revenue

O A BC D

marginal revenue
quantity

J/03/3/10
2 The diagram shows the cost and revenue curves for the production of a textbook. The
contract with the publisher entitles the author to a fixed percentage of the value of sales.
Which price would maximise the author's income from the book?

A
cost / B
revenue
C AC
D MC
AR
O number of copies
MR
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N/03/3/14
3 The diagram shows a firm's cost and revenue curves.

MC
cost /
AC
revenue

MR AR
O output
The firm changes its objective from profit maximisation to sales revenue maximisation.
Which groups are likely to be winners and losers as a result of this change?
winners losers
A customers shareholders
B managers customers
C workers managers
D shareholders workers

J/04/3/14
4 The diagram shows the demand and cost curves of a monopolist who initially produces at
his profit-maximising level of output.

MC
AC

cost,
revenue

O output
If the monopolist were required by the government to adopt marginal cost pricing, what
would be the effect on the price charged and the output produced?
price output
A increase increase
B increase decrease
C decrease increase
D decrease decrease

N/04/3/11
5 To maximise total revenue, up to which point should a monopolist increase output?
A where marginal revenue equals average revenue
B where marginal revenue is maximised
C where marginal revenue is zero
D where price elasticity of demand is zero
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J/06/3/10
6 The diagram shows the cost and revenue curves of a monopoly.

MC
AC

MR AR

O X
quantity
What is the firm‟s objective if it produces output OX?

A to achieve normal profit

B to maximise profit
C to maximise total revenue
D to minimise average cost

J/06/3/14
7 The maximum price that a privatised natural monopoly is allowed to charge its customers
is determined by the following formula:
the price charged in the previous year plus the annual % change in the consumer price
index minus 2 %.
Assuming the firm charges the maximum price allowed, how will an increase in
productive efficiency affect customers and the company's shareholders?

customers shareholders
A gain gain
B gain no effect
C no effect gain
D no effect no effect

N/06/3/10
8 A firm decides to aim to maximise sales revenue rather than profits.
What is likely to be one of the consequences of this decision?

A an increase in the price of the firm‟s product

B a reduction in the price of the firm‟s shares
C a reduction in the firm‟s market share
D a reduction in the number employed by the firm
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N/07/3/10
9 The diagram shows a firm‟s cost and revenue curves.

MC
cost / revenue
AC

O MR Q AR
output
Which policy objective is consistent with a decision by the firm to produce output OQ?
A maximising profit
B maximising revenue subject to earning a normal profit
C maximising sales revenue
D satisficing profits

N/08/3/12
10 The diagram shows the demand and cost curves of a monopolist who initially produces at
the profit-maximising level of output.

MC
AC

O output
The monopolist is required by the government to adopt marginal cost pricing.
What will be the effect on the price charged and the output produced?

price output
A increase increase
B increase decrease
C decrease increase
D decrease decrease
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N/09/3/12
11 he diagram shows the cost and revenue curves of a monopoly producer whose only cost
of production is a fixed cost.

$ X
Y

AFC

AR
O MR
output
What will such a monopolist do?

A set a price of OX in the short run and the long run

B set a price of OY in the short run and the long run
C set a price of OX in the short run, but discontinue production in the long run
D set a price of OY in the short run, but discontinue production in the long run

N/11/32/11
12 The diagram shows the cost and revenue curves of a monopoly.

MC AC

cost,
revenue

AR

O W XYZ
output
MR
Which movement between levels of output would indicate a wish to change from unit cost
minimisation to earning a normal profit?

A W to Y B W to Z C X to W D X to Z
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N/12/32/13
13 The diagram shows a profit-maximising firm‟s cost and revenue curves.
MC
MR

AC

cost ,
revenue

AR

O W X Y Z
output
What would be the increase in the firm‟s output if it was required to charge a price equal
to marginal cost?

A WX B XY C WY D XZ

J/13/32/11
14 The diagram shows a firm‟s cost and revenue curves.

MC
cost,
revenue AC

MR AR
O output

The firm changes its objective from sales revenue maximisation to profit maximisation.
Which groups are most likely to be winners and losers as a result of this change?

winners losers
A customers managers
B managers workers
C workers shareholders
D shareholders customers
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N/13/32/10
15 The diagram shows a firm‟s cost and revenue curves.

MC
cost,
revenue AC

MR AR
O
output
The firm changes its objective from profit maximisation to sales revenue maximisation.
Which groups are likely to be winners and losers as a result of this change?

winners losers
A customers shareholders
B managers customers
C workers managers
D shareholders workers

N/13/32/12
16 The diagram shows the initial cost and revenue curves of a profit-maximising monopolist.

MC

costs,
revenue P

AR

MR
O J K
output

What would cause the firm to increase its output from OJ to OK?

A The government fixes the price at OP.

B he government requires the firm to charge a price equal to marginal cost.
C The government imposes an indirect tax on the firm‟s product.
D The firm is allowed to earn only a normal profit.
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N/13/32/13
17 What makes it most likely that a firm‟s profits will be volatile and subject to substantial
fluctuations?

A Fixed costs are a high percentage of total costs.

B It produces a diversified range of products.
C It produces basic consumer products.
D It sells its product in a number of different markets.

J/14/32/12
18 The diagram shows the cost and revenue curves of a monopolist.
Which output will the firm produce if its aim is to maximise sales revenue?

MR

MC AC

costs,
revenue

AR
O A B C D
output
J/15/32/12
19 The diagram shows the cost and revenue curves of a monopoly.

MC
AC

cost,
revenue

MR AR

O X
output
What is the firm‟s objective if it produces output OX?
A to achieve normal profit B to maximise profit
C to maximise total revenue D to minimise average cost
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N/15/32/11
20 A firm, operating in an imperfectly competitive market, produces at the level of output
where the price elasticity of demand for its product is equal to unity.
What has the firm achieved?

A normal profit B maximum profits

C maximum revenue D maximum sales volume

J/16/32/11
21 A firm wishes to eliminate competition and become a monopoly.
What should it do?

A maximise output
B maximise profit
C reduce prices
D reduce the number of its suppliers

J/16/32/13
22 What is likely to have its cause in the separation of ownership and control in a firm?

A contestable markets
B diseconomies of scale
C principal-agent problem
D prisoner‟s dilemma
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Section: 13 Price Discrimination

Price discrimination is the process of charging different prices from different customers or for
different units sold, for reasons unrelated to costs. Price discrimination can only be successful if:

 Discriminating firms have some monopoly power

 Firm are able to identify and separate different market segments with different elasticities
of demand. Market segments are sub-groups comprising customers with similar
characteristics such as age, income or gender. Separating different market segments
implies that re-sale is impossible- those obtaining the product at lower prices cannot earn
profits by re-selling it in segments where higher prices are charged. This condition
explains why examples of price discrimination are most commonly found in the services
sector, as services cannot be resold.

Keeping these conditions in mind, consider some of the following examples of price
discrimination:

Time: We typically experience high prices from phone companies, airlines, rail/bus operators,
electricity firms etc during peak hours and lower rates in off peak hours.

Age: Children and elderly people for instance, may be charged lower prices in theme parks,
restaurants or libraries etc.

Timing of purchase: Fabulous discounts can be won if an airline or a train ticket is purchased
well in advance or at the last minute. Making reservations just before the departure of a train or
flight can make unsold tickets available at much discounted prices.

Quantity: Discounts encouraging bulk buying may be an example of price discrimination as long
as price reductions are not attributed to reduced packaging and handling costs.

Place: Cinemas, theatres and live concerts cost more for people occupying seats with a better
view whereas people with a restricted view generally have to pay less. A more contentious
example is that of business class travelers paying higher fares versus economy class. It could be
argued that the price differential is related to costs- the cost of serving a business class traveller
is high as better services are provided both on ground as well as on plane, seats have extra leg
space and customers are allowed to carry more weight. However, this exercise may still be
regarded as price discrimination if the difference in fares is not fully explained by the difference in
airlines‟ costs.

Though the difference in costs of serving a business class traveller compared to an economy
class passenger is almost the same on London-New York and London-Delhi routes, the
difference in business and economy class fares is much higher on London-New York route. The
reason is high purchasing power and lower price elasticity of demand for business travellers on
the London-New York route, thus making it an example of price discrimination.

Frequency of purchase: Day passes or monthly cards for frequent commuters cost much less
per journey than the ticket for a single travel.
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Executing price discrimination

Given that the cost of selling the product to different customers and in different segments is the same,
profits are maximized when Marginal Revenue (MR) is equated in all market segments. Thus, price
discrimination is the process of equating MR in all segments. The following equation (derived in
section 8) explains that firms charge different prices in different segments only when price elasticities
of demand differ.
 1 
MR  P 1  
 Ed 
Marginal revenue must be equated in both segments („a‟ and „b‟) for maximizing profits
MRa = MRb
 1   1 
Pa 1    Pb 1  
 Ed a 
  Ed b 

Assuming elasticities of demand are equal in both segments;

 1   1 
1    1  
 Ed a   Ed b 

In a situation as above, Marginal Revenue can only be equated by charging same price in both
segments i.e. Pa = Pb. Firms find it profitable to charge high prices in segments with price
inelastic demand and lower prices in segments where demand is price elastic.
Now assume that demand in segment „a‟ is more price elastic than demand in segment „b‟.
1 1
Ed a  Ed b 
Ed a Ed b
1 1
1 
Ed a
1  Ed b

In such a situation, Marginal Revenue can only be equated by charging a lower price in segment
„a‟ and a higher price in segment „b‟ i.e. Pa  Pb
The following example provides a graphical representation of successful price discrimination by
an airline operator.
Diagram 13.1
Price Price

P2
P1 P1
P3 b AR=P=D
c c

a
AR=P=D MR

MR No. of Seats No. of Seats

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The panel on the left shows a price inelastic demand curve for business travelers, compared to a
flatter demand curve for tourists, shown in the figure on the right. Initially, the price charged in
both the segments is the same, P1. At this price, revenue generated from selling an extra seat to
a business traveler, „a‟ is smaller than that generated by offering the same seat to a tourist, „b‟. A
profit maximizing monopolist may therefore decide to reduce the number of seats for business
travellers and offer the same to tourists. Increased Total Revenues and unchanged Total Costs
imply greater profits for the monopolist. The monopolist continues to sell more seats to tourists till
the revenue generated from the sale of an extra seat becomes equal in both segments. This
happens at point “c” in the given figure. Eventually, the airline operator charges a higher price, P2
in the segment where demand in price inelastic and a lower price, P 3 from tourists, whose
demand is price elastic. Once MR is equated in all market segments, there is no further possibility
of increasing total revenues and profits by selling more or less in a certain segment.
Perfect Price Discrimination
Perfect price discrimination occurs when each unit is sold at a different price. In such a case, the
divergence between sale price and MR disappears and revenue generated from selling an extra
unit equal the sale price charged.

Consider the following demand schedule:

Price Q TR MR
10 1 10 10
9 2 19 9
8 3 27 8
7 4 34 7
6 5 40 6
Assuming the monopolist can sell all units at different prices, total revenue from selling 2 units
would be 19 (10 from selling the 1st unit and 9 from selling the 2nd), 27 from selling 3 units
(10 + 9 + 8) and so on. MR is equal to price.
The following diagram shows the revenue curves for the perfectly price discriminating monopolist.
Diagram 13.2

P
MC

AR=P=D=MR
Q
O Q
*
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The firm sells quantity Q* but there exists no market price as all units are sold at different prices.
Such a firm can be described as allocatively efficient since the price it charges equals MC of the
last unit. However, consumer surplus is zero as all of it becomes the gain of the monopolist. This
is because the producer succeeds in charging a price for every unit such that it is the maximum
price consumers are willing to pay for that unit.

Is price discrimination desirable?

It may appear that price discrimination is completely intolerable as it increases the profits of
monopolists at the expense of the surplus enjoyed by consumers. Another distributive effect of
price discrimination is that consumers with price elastic demand gain at the expense of those with
price inelastic demand. However, price discrimination enables the seller to offer products at lower
prices in segments which may remain unserved otherwise (because of high prices). Thus,
quantity traded increases. Price discrimination may be desirable and beneficial, as highlighted by
the following examples:
 Intelligent students getting scholarships
 The poor and less privileged getting food stamps and other essentials at subsidized rates
 Organizations giving discounts to their employees on buying goods produced by them,
for instance an airline offering discounted prices for air tickets to its employees (however,
misuse of subsidies and discounts should not be overlooked)
 An airline offering discounts to commuters in less privileged areas and cross subsidizing
the losses by providing the same service in a more affluent segment of society with
relatively high purchasing power.
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Multiple Choice Questions

(Section 13)
J/02/3/14
1 A firm produces only one product. Under which condition is it most likely to be able to
pursue a policy of price discrimination?
A Both price and marginal revenue are identical in all markets.
B It is benefiting from economies of scale.
C Its product has a low elasticity of demand.
D There are separate and distinct markets for its product.

N/04/3/15
2 A discriminating monopolist, faced with two demand curves of differing elasticity, will
equate the combined marginal cost of production with
A marginal revenue in each market.
B average revenue in each market.
C the difference between the marginal revenues in the two markets.
D the difference between the average revenues in the two markets.

N/06/3/12
3 A firm wishes to acquire some of the consumer surplus its customers currently enjoy.
How might it achieve this?
A by charging a price that maximises revenue
B by introducing price discrimination
C by reducing operating costs
D by taking advantage of economies of scale

N/07/3/12
4 Instead of charging all its customers the same price, a firm decides to charge different
prices in different markets.
How is this likely to affect consumers' surplus and the firm's marketing costs?

consumers' marketing
surplus costs
A decreases decreases
B decreases increases
C increases increases
D increases decreases

J/08/3/11
5 Why might a firm introduce a policy of price discrimination?

A to achieve allocative efficiency

B to achieve productive efficiency
C to avoid diseconomies of scale
D to turn consumer surplus into producer surplus
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N/10/3/10
6 A firm wishes to acquire some of the consumer surplus its customers currently enjoy.
How might it achieve this?

A by introducing price discrimination

B by reducing operating costs
C by setting a price that maximises revenue
D by taking advantage of economies of scale

J/11/32/09
7 A firm is engaging in price discrimination.
In order to maximise profits, what should the firm do?

A charge a higher price to consumers earning higher incomes

B charge a higher price to consumers earning lower incomes
C charge a higher price to consumers whose demand for the product is price
inelastic
D charge a higher price to consumers whose demand for the product is price
elastic

N/11/32/10
8 Which would be least likely to practise price discrimination?

A a baker B a cinema
C a hairdressing salon D a restaurant

N/12/32/12
9 Instead of charging all its customers the same price, a firm decides to charge different
prices in different markets.
How is this likely to affect consumer surplus and the firm's marketing costs?

consumer
marketing costs
surplus
A decrease decrease
B decrease increase
C increase decrease
D increase increase

N/14/32/14
10 A firm wishes to acquire some of the consumer surplus its customers currently enjoy.
How might it achieve this?

A by introducing price discrimination

B by reducing operating costs
C by setting a price that maximises revenue
D by taking advantage of economies of scale
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N/15/32/14
11 Instead of charging all of its customers the same price, a firm decides to charge different
prices in different markets.
How is this likely to affect consumer surplus and the firm's marketing costs?

consumer surplus marketing costs

A decrease decrease
B decrease increase
C increase decrease
D increase Increase
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Section: 14 Monopolistic Competition

Meeting the conditions of a perfectly competitive market structure, particularly that of
homogenous products is beyond the scope of firms in the real world. In reality, goods not only
differ from those made by other firms but also those produced and sold by the same firm. For
example, a Toyota car is different not only from those manufactured by other brands such as
Honda but also from other Toyota models.

For consumers, products may seem to have real differences or what is known as „perceived‟
differences. Real attributes include better quality, superior design, extra features or/and improved
performance etc whereas consumers may be made to perceive a product as “better” through
advertisements and various marketing tools.

Differences, whether perceived or real, provide firms with some control over price. Unlike perfect
competition where a firm loses all its customers by raising price, a monopolistically competitive
firm can retain some customers even when charging high prices- the demand curve faced by a
monopolistically competitive firm slopes downwards. The price elasticity of demand depends
upon the firm‟s ability to retain customers at high prices, which is determined by the degree of
product differentiation. Successful price differentiation lowers PED, meaning that the firm loses
few customers if it raises price.

As in the case of a monopoly, the marginal revenue (MR) curve for a monopolistically competitive
firm lies below the demand curve. A profit maximizing monopolistically competitive firm chooses
to produce an output level where MR equals MC.

Diagram 14.1
P
MC

AC
P1

AC1

AR=P=D

MC

Output
Q*
The shaded area in the figure above shows profits earned by a monopolistically competitive firm
as it sells output Q* at Price P1. However, these profits can only be earned in the short run. Like
perfect competition, ease of entry dilutes supernormal in the long run till the point they completely
disappear. What is different in the case of monopolistic competition is the mechanism through
which these profits disappear.
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In perfect competition, the arrival of new firms attracted by supernormal profits raises market
supply and industry moves downwards along its demand curve resulting in reduced price and
profits. New firms continue to enter till supernormal profits completely disappear. On the other
hand, under monopolistic competition, products are differentiated and defining a market is difficult
since different kinds of products are meant to satisfy different market segments. Entry by new
firms, instead of increasing market supply, decreases demand for existing firms‟ products shifting
their demand curves leftwards and hence lowering prices. Firms continue to enter till price equals
Average Cost and super normal profits disappear completely.

Diagram 14.2 shows the long run equilibrium for a monopolistically competitive firm. Firms make
normal profits in the long run and charge a price exactly equal to AC.

Diagram 14.2
P MC

AC
P=AC

AR=P=D

MR
Q
O Q
*

Is product differentiation desirable?

The key feature differentiating between perfectly and monopolistically competitive firms is product
differentiation. It is by virtue of differentiated products that monopolistically competitive firms have
downward sloping demand curves and their prices and MR diverge.

Monopolistically competitive firms are allocatively inefficient since they charge a price higher than
the MC of the last unit. Output produced is below the socially optimum level and society is
deprived of a possible welfare gain. Monopolistically competitive firms are criticized for leaving
excess capacity. Excess capacity is the difference between the output where AC is minimized
(where AC equals MC) and the profit maximizing output (where MC = MR).

Excess capacity arises when it is possible for a firm to increase its output and reduce per unit
cost simultaneously. Consider the following facts regarding monopolistically competitive firms:

MC = MR Profit maximizing output

P > MR MR curve lies below demand/price
P > MC Firms are allocatively inefficient as price and MR diverge
P = AC Firms can only make normal profits in the long run
MC < AC Profit maximizing monopolistically competitive firms are bound to leave
excess capacity i.e. produce where MC is below AC. (AC is falling).
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Diagram 14.3
P MC
AC

AR=P=D

MR
Q
O Q1 Q2
Excess Capacity
Firms operating in the falling portion of their Average Costs Curves leave excess capacity. As
shown above, a monopolistically competitive firm is bound to leave excess capacity since Price
diverges from MR but equals AC. The firm produces where MC equals MR and hence cannot
operate at the lowest point of Average Cost (AC) if it produces the profit maximizing output. In
diagram 14.3, output Q2 – Q1 is excess capacity.

Product differentiation reduces society‟s welfare via two sources- allocative inefficiency as P>MC
of the last unit and excess capacity. However, it may benefit consumers by satisfying diverse
ranges of their wants. Imagine how dull and colourless a market would be with just one type of
cars, TVs, crisps or clothes. Different designs, brands, features and styles of packaging not only
add colours to the shelves of super markets and shopping centers but also make the experience
of shopping joyful and exciting. Some economists may argue that providing unnecessary varieties
of the same basic product involves huge wastage of resources. The availability of a 1000 variants
of toothpastes and anti dandruff shampoos for instance, is no more likely to result in brighter teeth
and dandruff free hair than a society where only a limited variety of such products is available.

It is debatable though whether the benefits of being variety oriented and satisfying ever changing
wants outweigh the costs of excess capacity. However, it is safe to say that product differentiation
adds utility to products, makes them more attractive for one group of customers and yet
affordable for another. For example, fully loaded, luxurious cars can be sold in segments where
purchasing power is high whereas simpler versions of the same car can be offered in more price
sensitive segments.

Productive efficiency
Allocative efficiency
Market structure Short run Long run
Perfect
May be Yes Yes
competition
Monopolistic
May be Yes No
Competition
Monopoly May be May be No
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Oligopoly
None of the market structures described so far explains the operations of most of today‟s famous
businesses. For instance, Coke and Pepsi together dominate the beverage industry of the world
but can not be categorized as perfectly or monopolistically competitive firms. Neither is there a
monopoly as the number of sellers exceeds one. Such industries are classified as „oligopolies‟,
the world oligopoly meaning fewness. It specifies a market structure where a significant
percentage of industry‟s output is concentrated in the hands of few firms. Automobiles,
electronics, newspapers, soaps, cosmetics, oil companies and many other industries are
dominated by few large firms and are thus oligopolies.

An oligopolistic market structure highlights the importance of strategic interdependence i.e.

strategies of a particular firm do not only affect its own position and profitability but other firms‟ as
well. When firms try to win an advantage over rivals by lowering prices or raising marketing
budgets, competitors come up with their own promotional and marketing gimmicks to safeguard
their positions. The outcome of such a strategic decision thus depends upon the reactions of
competitors. Raising promotional budget or lowering prices is likely to provide intended benefits to a
firm only if competitors fail to match the budget increase or price cut. Since it is almost impossible to
accurately predict the reactions of rival firms, oligopolistic firms operate in a situation of uncertainty.

Kinked demand curve

Given uncertain outcomes, it follows that a demand curve cannot exist in oligopolistic market
structures. It is difficult to predict changes in quantity demanded with changes in price, as much
depends on the reaction of competitors, which are both beyond a firm‟s control and knowledge.
One may however, derive a hypothetical demand curve assuming the behavior of rival firms. The
resulting „kinked‟ demand curve is shown in the diagram below. It is assumed that the decision to
raise price by a given firm is unmatched by competitors as their sales automatically increase by
virtue of relatively lower prices. The decision to lower prices on the other hand, induces rivals to
match the price cut due to threatened sales.

Diagram 14.4
P

P1

Q
O Q1

Diagram 14.4 shows a kinked demand curve, assuming that a given firm initially sells output Q 1 at
price P1. The demand curve has two components- a flatter component showing price elastic
demand beyond price P1, as consumers switch to rivals whose unchanged prices are relatively
lower and a steeper component showing price inelastic demand below P 1, where the firm‟s
decision to lower price fails to attract many customers as competitors match the price cut.
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Price rigidness in Oligopoly

The kinked demand curve derived above helps us understand why oligopolistic firms avoid
competing on prices and support price rigidness. As explained already, changing price reduces
the firm‟s revenues as raising price results in loss of existing customers and lowering price fails to
attract new customers. The profit maximizing quantity is determined by the intersection of MC and
MR curves and price, by the height of the demand curve at the point where the two intersect. The
MR curve is however, tricky to derive as it has two components corresponding to the elastic and
inelastic portions of the kinked demand curve. The portion ab of the MR curve corresponds to the
elastic component of the demand curve whereas cd corresponds to the inelastic portion. The
straight vertical line bc shows a mathematical discontinuity exactly below the point of initial price
and quantity. The firm continues to sell 100 units at price P 1 as long as the MC curve shifts to lie
somewhere between MC1 and MC2.

Diagram 14.5
P
a

P1
MC2

MC1
b

c
d AR=P=D
Q
O 100 110 200 220

Criticism on kinked demand curve

 Kinked demand curve assumes an initial price and quantity, but remains silent on how it
is arrived at.
 It also fails to explain the new price and quantity if the MC curve falls outside the range
determined by MC1 and MC2 (see diagram 14.5).
 Assuming that competitors always match a price cut and never follow a price increase is
an over simplification of how markets and competitors behave in real life.

Why avoid price competition?

The issue of price competition is specific to oligopoly, as monopolistically and perfectly firms are
too small to compete on price and monopolies don‟t have anyone to compete against. As stated
earlier, oligopolistic firms are interdependent due to their large size and small number. A price cut
fails to win firms a Unique Selling Point (USP) since such an action is easily matched by
competitors. Firms therefore avoid lowering prices to attract customers fearing that such an action
is more likely to initiate a price war, a lose-lose scenario for all. Whereas producers struggle with
declining revenues and profits, customers and employees lose since cost cutting measures by
firms affect quality of the product and salaries and other benefits provided to workers.
Distributors‟ commissions also decrease during a price war and pressure by distributors may
force producers into fixing prices, ensuring reasonable sales margin for the former. Moreover,
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lowering prices may damage the repute and image of firms in the market, and hence result in
declining sales. Customers may also decide to postpone purchases in hope of further price
reductions.
Cartels
(Collusive Oligopoly)
A cartel is a form of collusion between a group of suppliers aimed at suppressing competition
between them, wholly or in part. Cartels are typically found in markets dominated by a few firms
which are hence, interdependent. Since rivals‟ actions are important but cannot be predicted,
firms always exist in a situation of uncertainty. It is to overcome this uncertainty that firms decide
to collude and sign price fixing agreements, having a uniform policy regarding price and output.
Member firms are assigned production quotas to ensure price is raised by restricting market
supply.
Diagram 14.6 illustrates the impacts of cartel formation on market price and output.
Diagram 14.6
P MC

P1
P0

MR
Q
Q1 Q0

In a competitive market, equilibrium price and output is determined by the intersection of demand
and supply curves, shown by Pc and Qc in the diagram above. Cartel formation monopolizes a
competitive market and demand and MR curves begin to diverge. Equilibrium price and output is
determined by the intersection of MC and MR curves at P1 and Q1. The cartel successfully raises
price by restricting output.

However, cartels can only be successful when:

 The industry is dominated by a few large firms and all significant firms join the agreement
 Members don‟t cheat and stick to their assigned production quotas
 Product is homogeneous, as better quality firms would have an incentive to decline any
offer to join.
 Entry barriers are high
 Firms have accurate information about each other‟s output levels.
 The firms‟ costs of production are quite similar.
 Demand is relatively stable.
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Non-Collusive Oligopoly: Game Theory

In a situation of oligopoly, where a few large firms dominate the market, the outcome of a
strategic move of a firm does not only depend on that move but also on the reactions of other
firms. In a non-collusive oligopoly, where firms act independently, predicting such reactions is
often hard. Game Theory examines the best strategy a firm may employ while assuming
reactions of competitors.

Let us take a simple example where only two firms X and Y operate, which have identical cost,
and offer a homogenous product. Initially, they are both charging a price of £5 and making a profit
of £50 million each. Let us assume that both firms are independently considering lowering the
price to increase profits. If X is cautious, it may think that if it leaves its price unchanged, Y may
lower it to £4 and increase its profits to £60 million, reducing X‟s profits to just £25 million (box 3).
Alternatively, if X decides to cut its price to £4 to gain a bigger market share, the outcome will
depend on the reaction of Y. The profits of both X and Y will decrease to £40 million (box 4) if Y
decides to match the price cut (another cautious assumption of X about Y). Out of the two
cautious approaches, X is better off if it lowers the price, instead of waiting for Y to do so. This is
known as maximin approach, which involves choosing the better of the two options giving lower
returns.

Profits for firms X and Y at different prices

X‟s price
£5 £4
1 2
£5 £25m for Y
£50m each
£60m for X
Y‟s price
3 4
£4 £60m for Y
£40m each
£25m for X

However, if X views the whole situation optimistically, it will assume that Y will leave its price
unchanged, giving a greater market and profit to X i.e. £60 million shown in box 2 (Y‟s profits will
decrease to £25 million). This strategy is maximax, where a firm chooses the outcome which
maximizes its gains.

Interestingly, X picks the same strategy i.e. lowering the price to £4, whether it thinks
optimistically or cautiously. This is known as dominant strategy game, where both approaches,
maximin and maximax, lead to the same strategy.

The same scenario will apply to Y, which will also be tempted to lower the price. However, if both
X and Y lower the price, they both lose, as their profits decrease from £50 million each (box 1) to
£40 million each (box 4). Thus, they should collude and agree on a price-fixing agreement to
avoid a price war, making both firms better off, yet they will both be tempted to cheat and cut
prices. This is known as prisoner‟s dilemma (see section 30).

Prisoner's Dilemma
The prisoner's dilemma is a standard example of a game analyzed in game theory that shows
why two completely "rational" individuals might not cooperate, even if it appears that it is in their
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best interests to do so. It was originally framed by Merrill Flood and Melvin Dresher working
at RAND in 1950. Albert W. Tucker formalized the game with prison sentence rewards and
named it, "prisoner's dilemma" presenting it as follows:
Two members of a criminal-gang are arrested and imprisoned. Each prisoner is in solitary
confinement with no means of communicating with the other. The prosecutors lack sufficient
evidence to convict the pair on the principal charge. They hope to get both sentenced to a year in
prison on a lesser charge. Simultaneously, the prosecutors offer each prisoner a bargain. Each
prisoner is given the opportunity either to: betray the other by testifying that the other committed
the crime, or to cooperate with the other by remaining silent. The offer is:
 If A and B each betray the other, each of them serves 2 years in prison
 If A betrays B but B remains silent, A will be set free and B will serve 3 years in prison
(and vice versa)
 If A and B both remain silent, both of them will only serve 1 year in prison (on the lesser
charge)

These options are shown in the table below:

Prisoner B stays Prisoner B betrays

silent (cooperates) (defects)
Prisoner A stays Prisoner A: 3 years
Each serves 1 year
silent (cooperates) Prisoner B: goes free
Prisoner A betrays Prisoner A: goes free
Each serves 2 years
(defects) Prisoner B: 3 years

Here, regardless of what the other decides, each prisoner gets a higher reward by betraying the
other ("defecting"). The reasoning involves an argument by dilemma: B will either cooperate or
defect. If B cooperates, A should defect, because going free is better than serving 1 year. If B
defects, A should also defect, because serving 2 years is better than serving 3. So either way, A
should defect. Parallel reasoning will show that B should defect.
In traditional game theory, some very restrictive assumptions on prisoner behaviour are made. It
is assumed that both understand the nature of the game, and that despite being members of the
same gang, they have no loyalty to each other and will have no opportunity for retribution or
reward outside the game. Most importantly, a very narrow interpretation of "rationality" is applied
in defining the decision-making strategies of the prisoners. Given these conditions and the
payoffs above, prisoner A will betray prisoner B. The game is symmetric, so Prisoner B should act
the same way. Since both "rationally" decide to defect, each receives a lower reward than if both
were to stay quiet. Traditional game theory results in both players being worse off than if each
chose to lessen the sentence of his accomplice at the cost of spending more time in jail himself.

Concentration Ratio (Lorenz Curve & Gini Coefficient)

The CONCENTRATION RATIO records the percentage of a market‟s sales accounted for by a
given number (maybe 3-5) of the largest firms in that market.
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cumulative share of market size (%)

100

75

50

25

0 25 50 75 100
cumulative proportion of firms (from largest)
(b)
The Lorenz curve shows the cumulative share of market size on one axis accounted for by
various (cumulative) percentages of the number of firms in the market.
Relative concentration measures are concerned with inequalities in the share of total firms
producing for the market (or the inequalities in income distribution). Such irregularities (or income
inequalities) can be recorded in the form of a Lorenz curve as in Fig. The diagonal straight line
shows what a distribution of complete equality in firm shares (or complete equality in the
distribution of income) would look like, so the extent to which the Lorenz curve deviates from this
line gives an indication of relative seller concentration (or income inequality). For example, the
diagonal line shows how we might expect 50% of market sales to be accounted for by 50% of the
total firms, whilst in fact 50% of market sales are accounted for by the largest 25% of total firms,
as the Lorenz curve indicates. The Gini coefficient provides a summary measure of the extent to
which the Lorenz curve for a particular market deviates from the linear diagonal. It indicates the
extent of the bow-shaped area in the Fig. by dividing the shaded area below the Lorenz curve by
the area above the line of equality. The value of the Gini coefficient ranges from zero (complete
equality) to one (complete inequality).

Growth of Firms
Firms can increase their size by either extending production capacities internally i.e. organic
growth, or through acquisitions, mergers and takeovers i.e. external growth.

External growth not only increases firm size but also eliminates competition. Firms acquire an
established customer base and a complete network of suppliers, workers and distributors.
However, external growth poses serious challenges as merging two firms with different cultures
and work ethics may become difficult, costly and time consuming.
Integration may take up the following forms:

Horizontal integration
A firm integrates horizontally by expanding or specializing at a particular level of a product‟s
production or distribution e.g. a manufacturer doubling production capacity or merging with
another manufacturer. Advantages of horizontal integration include economies of scale resulting
in lower per unit cost, greater market share, reduced competition and increased market power.
Avoidance of duplication of activities also makes firms more efficient and competitive. However,
control and coordination costs may increase if the business becomes too large to manage.
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Vertical integration
A firm grows vertically when it takes control of an activity which is performed either prior to
(backward vertical integration) or after the existing level of business activity (forward vertical
integration).

Backward vertical integration is a firm‟s move towards its source of supply e.g. a tea
manufacturing firm purchasing a tea garden or a car manufacturing firm producing components
itself which it previously bought from an outside supplier.

Forward vertical integration is a firm‟s move towards its market. This may involve a firm opening
its own outlets to sell its products directly to the consumer e.g. a car manufacturer opening a
company owned car showroom. Increased popularity of e-commerce and the possibility of placing
orders online has facilitated vertical integration.

Vertical integration allows control over the entire production chain and hence, the resulting quality
of the product. However, apart from requiring investment in additional resources, vertical
integration may increase costs as core activities receive only divided attention compared to
previous times. Firms wanting to concentrate on a narrower band of activities opt for outsourcing
i.e. vertical disintegration.

Diagram 14.7 compares the cost structure of two firms: Firm 1 being fully integrated and Firm
opting to outsource. TC1 is flatter than TC2, showing that total cost rises slowly when an extra
unit is produced using the firm‟s own production facility. Fixed costs are also positive in this case.
Fixed costs are zero if the firm purchases from an outside supplier but total cost curve is steeper
i.e. a higher price is paid to the outside supplier and total costs rise faster. Outsourcing is cheaper
when less than Q1 units are required. However, in house production facility becomes more
economical beyond Q1, when required volume is large.

Diagram 14.7
TC
TC2
TC1

Q
Q1
Diversification
A firm may decide to grow by entering spheres unrelated to its existing activities. Such firms are
better able to exploit risk bearing economies of scale, where they can survive and grow despite
some of their activities/products resulting in losses. However, these firms are deprived of the
benefits of specialization and may lose a portion of profits because of the divided attention paid to
different types of activities. Before heading for it, firms must also ensure that they have the
expertise and skills required to manage activities after diversification.
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Multiple Choice Questions

(Section 14)
Monopolistic Competition
J/04/3/07
1 An industry consists of a large number of firms, all of which produce an identical product.
What could explain why the demand curve facing each individual firm is downward-sloping?
A diminishing marginal utility
B freedom of exit and entry
C imperfect knowledge on the part of consumers
D a limit on the amount consumers have available to spend
J/04/3/09
2 The diagram shows the cost and revenue curves of a monopolist.
MC

AC

cost, P2
revenue
P1

AR

O Q2 Q1

output MR
The monopolist is currently producing output OQ1 and charging a price OP1.
How might the monopolist make a profit?

A by adopting marginal cost pricing

B by maximising sales revenue
C by practising price discrimination
D by reducing output to OQ2 and charging price OP2.
N/04/3/14
3 In which way does monopolistic competition differ from perfect competition?
A Average revenue exceeds average cost in long-run equilibrium.
B Barriers exist to the entry of new firms.
C Marginal revenue exceeds marginal cost in long-run equilibrium.
D Products are differentiated.
J/08/3/09
4 The table shows some of the assumptions of perfect competition and monopolistic competition.
Which pairing is correct?
perfect competition monopolistic competition
A barriers to entry small number of firms
B differentiated products large number of firms
C freedom of entry and exit differentiated products
D large number of firms barriers to entry
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J/09/3/09
5 What is a feature of monopolistic competition, but not of perfect competition?

A a small number of buyers

B product differentiation
C the existence of abnormal profits
D the existence of barriers to entry

N/13/32/11
6 The table shows some of the assumptions of perfect competition and monopolistic
competition.
Which pairing is correct?

perfect competition monopolistic competition

A barriers to entry small number of firms
B differentiated products large number of firms
C freedom of entry and exit barriers to entry
D large number of firms differentiated products

Oligopoly
J/02/3/08
7 Which of the following is an assumption underlying the kinked demand curve in
oligopoly?

A A firm will increase its price in response to a price increase by a rival.

B A firm will not match a price cut by a rival.
C Consumers are less sensitive to price increases than price decreases.
D Rivals are expected to match any reduction in price.

N/02/3/08
8 In which of the following market situations will a firm take account of the reactions of its
competitors before deciding to cut its price?

A monopoly
B monopolistic competition
C oligopoly
D perfect competition
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J/03/3/12
9 The diagram shows the cost and revenue curves of an oligopolist. In the initial situation,
AC1 is its average cost curve, MC1 is its marginal cost curve and the firm is in equilibrium
at output OQ and price OP.
The cost of labour rises, so that AC2 and MC2 become the relevant cost curves.

MC2
P MC1 AC2

AC1
cost /
revenue
AR

MR
O Q
output
What should the firm do to maximise profit in this new situation?

A leave both price and output unchanged

B leave price unchanged and increase output
C leave price unchanged and reduce output
D raise price and leave output unchanged

N/05/3/13
10 The diagram shows a firm‟s cost and revenue curves.

costs, MC
revenue MR

D
MR
O Q
output
Which features are associated with the situation shown in the diagram?

A economies of scale and allocative efficiency

B interdependence and allocative efficiency
C price rigidity and economies of scale
D price rigidity and interdependence
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N/07/3/11
11 Which feature of oligopoly is being assumed when the demand curve for an individual
firm is as shown in the diagram?

price

O
quantity
A price discrimination
B price leadership by the dominant firm
C interdependence between firms
D collusion between firms

J/09/3/11
12 The diagram shows the long-run average cost curve of a typical firm in an industry and
the demand curve for the industry‟s product.
Dindustry
LRACfirm

revenue,
cost

D industry
O
output
Which market structure is most likely to occur in this industry?

A monopolistic competition B monopoly

C oligopoly D perfect competition

J/12/32/10
13 The five firm concentration ratio for an industry changes from 50 % to 60 %.
Which statement about the industry is correct?

A Each firm has become more efficient.

B The industry has become more oligopolistic.
C The industry has benefited from external economies of scale.
D The industry now has fewer barriers to entry.
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N/12/32/11
14 What is meant by a four firm concentration ratio of 25 %?

A The largest four firms‟ market share totals 25 %.

B The largest four firms have a market share of 25 % each.
C There are only four firms in the industry.
D The largest firm has a 25 % market share.

J/13/32/01
15 In which market situation will a firm take account of the reactions of its competitors before
deciding to cut its price?

A monopoly
B monopolistic competition
C oligopoly
D perfect competition

N/14/32/12
16 When is collusion likely to be successful in an oligopolistic market?

A Barriers to entry are relatively low.

B Firms have accurate information about each other‟s output levels.
C There are significant differences in the firms‟ costs of production.
D There are significant fluctuations in demand from one period to another.

J/15/32/11
17 The firms in an industry all produce a homogeneous product, but each firm is able to
influence the price it charges for its own product.
In which market structure do the firms operate?

A perfect competition B monopolistic competition

C oligopoly D monopoly

Cartels
J/02/3/13
18 Which of the following characteristics is most likely to be present when collusion occurs
between firms in an industry?
A low barriers to entry
B a large number of firms
C the absence of significant economies of scale
D product homogeneity
J/06/3/13
19 What will increase the likelihood that the firms in an industry will collude to maximise their
joint profits?
A The industry has many differentiated products.
B The industry is characterised by rapid technological change.
C The industry consists of a large number of producers.
D There are significant barriers to prevent new firms entering the industry.
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J/07/3/14
20 An industry consists of a dominant producer and a number of smaller producers.
The dominant producer joins with some of the other producers to form a cartel with a
view to maximising their joint profits.
Who will derive the greatest short-run benefit from this arrangement?

A the industry's suppliers

B the dominant firm
C smaller producers within the cartel
D the producers who do not join the cartel

N/08/3/10
21 Which characteristic would make it easier for firms in an industry to collude?

A low barriers to entry

B a large number of firms
C rapid technological change
D product homogeneity

N/08/3/13
22 The table shows the costs of two milk producers.
costs per litre
firm X $9
firm Y $7

The price received by producers is $10 per litre. Both firms have been given quotas
allowing them to produce 200 litres per day. Firm X sells its quota to firm Y.
Assuming constant costs of production and zero costs of entry and exit, what price did
firm Y pay (per day) to buy X's quota?
A $200
B $600
C $700
D between $200 and $600

N/09/3/13
23 A country‟s steel producers are members of a cartel. Each member is allocated a
production quota, and initially produces the maximum allowed under its quota.
What will be the effect on total steel production and the industry‟s total profits of allowing
the producers to trade the quotas among themselves?

effect on effect on total

production profits
A increase increase
B increase no change
C no change increase
D no change no change
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J/10/3/11
24 The diagram shows a firm‟s marginal and average cost curves.
The firm enters a collusive agreement with other firms in the industry. It is agreed that
each firm will charge a common price, OP, and will restrict the level of its output to a
production quota set by the industry cartel.
The firm is allocated a production quota, Oq.

MC AC

P G H
$
L K
M J
N

O q
quantity
The firm decides to cheat in order to maximise its profits.
What is its short-run increase in profits?
A PGKL B PHJL
C PHJL minus PGNM D PGKL minus LKNM

N/11/32/12
25 What will increase the likelihood that the firms in an industry will collude to maximise their
joint profits?
A The industry consists of a large number of producers.
B The industry has many differentiated products.
C The industry is characterised by rapid technological change.
D There are significant barriers to prevent new firms entering the industry.

J/13/32/13
26 Which change would make it easier for a cartel to operate effectively?
A an increase in competition from closely related industries
B an increase in the number of firms in the industry
C an increase in the range of products made by cartel members
D an increase in the stability of the market for its products

N/14/32/15
27 A country‟s steel producers are members of a cartel. Each member is allocated a
production quota, and initially produces the maximum allowed under its quota.
What will be the effect on total steel production and the industry‟s total profits of allowing
the producers to trade the quotas among themselves?

effect on production effect on total profits

A increase increase
B increase no change
C no change increase
D no change no change
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N/14/32/19
28 The diagram shows the number and amount of fines ($m) imposed by the US
Department of Justice for firms‟ illegal cartel behaviour between 1980 and 2011.

What is the most likely conclusion from the diagram about the view of the US Department
of Justice of firms‟ cartel behaviour?

A It believed that cartel behaviour was unimportant before 1980.

B It believed that illegal cartel behaviour was insignificant in 2011.
C It believed that increasing fines was necessary to deter cartel behaviour.
D It believed that the free market can regulate cartel behaviour.

J/15/32/16
29 A country‟s steel producers are members of a cartel. Each member is allocated a
production quota and initially produces the maximum allowed under its quota.
What will be the effect on productive efficiency and on the industry‟s profits if the
producers are allowed to trade the quotas amongst themselves?

effect on productive effect on

efficiency profits
A improvement increase
B improvement no change
C no change increase
D no change no change

Growth of firms/Integration
J/06/3/08
30 Samsung Electronics, which began as a semiconductor firm making simple memory
chips, has used continuous research and investment to emerge as an industry leader.
In addition, it has applied its strength in semiconductors to other markets including
televisions and mobile phones.
What has taken place?
A external growth and diversification
B external growth and sales revenue maximisation
C internal growth and diversification
D internal growth and sales revenue maximisation
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J/06/3/12
31 An example of forward vertical integration for a computer manufacturer would be a
merger with

A another computer manufacturer.

B a computer retailer.
C a silicon chip manufacturer.
D a software developer.

N/14/32/09
32 In 2009, the United Kingdom‟s largest grocery supermarket, Tesco plc, created Tesco
Bank offering a range of financial services to customers.
This is an example of

A external growth and horizontal merger.

B external growth and vertical merger.
C internal growth and diversification.
D internal growth and market concentration.

N/15/32/10
33 Firms can grow either externally or internally.
What represents internal growth?

finding new merging with rival firms merging with firms

export markets in the same industry in other industries
A no no yes
B no yes no
C yes no no
D yes yes yes

N/15/32/11
34 The table shows the five-firm concentration ratios for a selection of industries in an
economy.

percentage of total sales

industry accounted for by the five largest
firms in the industry (%)
tobacco 95
steel 60
water supply 60
printing 12

What can be concluded from the table?

A The firms are of equal size in the steel industry and the water supply industry.
B The printing industry is more competitive than the tobacco industry.
C The tobacco industry is a monopoly market.
D There are more firms in the tobacco industry than in the water supply industry.
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J/16/32/06
35 Which statement about the „kinked demand curve‟ model of oligopoly is incorrect?

A The kink in the demand curve of each firm is based on expectations about other
firms‟ responses to changes in its price.
B The marginal revenue curve of the firm has a vertical segment at the market
price.
C The model explains how the equilibrium market price is determined.
D The model suggests price stickiness within a certain range of marginal costs.

J/16/32/09
36 The diagram shows the cost and revenue curves of a firm.

MC
ATC

cost,
revenue

D
MR
O quantity
What does the diagram represent?

A a firm in monopolistic competition making normal profit

B a firm in monopolistic competition making short-term losses
C a firm in perfect competition at long-run equilibrium
D a monopoly making abnormal profits
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Section: 15 Contestable Market

Competitive markets are differentiated on the basis of number of firms, a more competitive
market being one with a large number of firms.

Contestable markets are characterized by low barriers to entry and exit. Contestable firms
behave in a similar fashion as competitive firms as fear of entry by potential competitors forces
them to adopt consumer friendly policies. Firms in a contestable market may deliberately lower
prices and sacrifice profits to discourage entry by potential competitors. A high number of firms is
therefore not required to make firms adopt consumers‟ friendly policies, instead, lowering entry
barriers is enough.

Students are encouraged to prepare following essays:

J/02/4/03 J/05/4/05 N/08/4/03 J/11/42&43/04

N/02/4/02 N/05/4/04 J/09/4/04 N/11/41/03

J/03/4/04 J/06/4/04 N/09/42/02 N/11/42/03

N/03/4/04 N/06/4/04 J/10/42/03

J/04/4/03 N/07/4/02(b) & 3 N/10/42/03

N/04/4/07 J/08/4/04 N/10/43/02 & 03

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Multiple Choice Questions

(Section 15)
J/02/3/09
1 What is the essential feature of a contestable market?

A ease of entry and exit

B interdependence between firms
C large number of buyers and sellers
D product homogeneity

J/04/3/08
2 A firm operates in a contestable market.
Which statement correctly describes the firm‟s conduct?

A It will set a price to maximise profits in the short run.

B It will set a price to maximise its revenue.
C It will set a price to deter the entry of new firms.
D It will produce at minimum average cost.

J/05/3/12
3 What determines the contestability of a market?

A the degree of differentiation of the product

B the costs of entry and exit
C the price elasticity of demand for the product
D the number of firms in the industry

N/05/3/12
4 The diagram shows the demand curve and the long-run cost curves of a firm that
operates in a perfectly contestable market.

LRMC

P4 LRAC
P3
$ P2
D

P1

O output
Which price will the firm charge for its product?

A OP1 B OP2 C OP3 D OP4

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J/06/3/11
5 A firm charges the maximum price it is able to charge without attracting competition from
new entrants.
In which type of market does this firm operate?
A a contestable market
B a monopolistically competitive market
C a monopsonistic market
D a perfectly competitive market

N/06/3/11
6 Which assumption is essential for a market to be contestable?
A The market is supplied by a large number of firms.
B Firms are free to enter and leave the market.
C Firms cannot earn abnormal profits in the short run.
D Firms produce differentiated goods.

J/07/3/13
7 The diagram shows a firm‟s cost and revenue curves.

MC
cost / revenue
AC

O MR Q AR
output
What could explain why the firm produces output OQ?
A Its aim is to maximise profits.
B Its aim is to maximise sales revenue.
C It is operating in a contestable market.
D It is operating in a perfectly competitive market.

N/08/3/09
8 Which feature does a contestable market share with a perfectly competitive market?
A Firms must be price takers.
B Firms must operate on a small scale.
C There must be freedom of entry to and exit from the industry.
D There must be many firms in the industry.

J/09/3/10
9 Which assumption is essential for a market to be contestable?
A The market is supplied by a large number of firms.
B Firms are free to enter and leave the market.
C Firms cannot earn abnormal profits in the short run.
D Firms produce differentiated goods.
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N/09/3/11
10 The diagram shows the short-run position of a monopolist who believes that, in the long
run, excessive profits might attract new entrants to the industry.
If the monopolist believes that at prices above Pe new competitors would enter, which
output would he choose to protect his long-run profits?

$ Pe
MC = AC
AR

MR
O A B C D
output

J/10/3/09
11 In the absence of regulation, why is it likely that the market for air travel on the
Singapore-Sydney route would be highly contestable?
A An airline entering the market would lose little if it later exited that market.
B The airline industry‟s capacity to expand its operations in the short-run is limited.
C The demand for air travel on the Singapore-Sydney route is price-elastic.
D There is no effective substitute for air travel for journeys between Singapore and Sydney.
N/10/3/09
12 The diagram shows a firm's cost and revenue curves.

MC
$ AC

O MR Q AR
output
What could explain why the firm produces output OQ?
A It is operating in a contestable market.
B It is operating in a perfectly competitive market.
C It is seeking to maximise profits.
D It is seeking to maximise sales revenue.
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J/11/32/08
13 What is the likely outcome for producers and consumers when a market moves from
being non-contestable to being a contestable market?

producers consumers
A gain from higher prices gain from a wider choice of products
B gain from likely higher profits lose from likely higher prices
C lose from likely lower output lose from a reduced choice of products
D lose from likely lower profits gain from likely lower prices
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Section: 16 Factor Market

So far, we have familiarized ourselves with output markets where firms supply goods and services to
households and households demand them. This section sheds light on factor markets, where factor
services such as labour and capital are traded. Here firms purchase factor services whereas
households supply them.

Marginal Revenue Productivity Theory

Marginal Revenue Productivity (MRP) theory helps determine the quantity of factors of production
hired at a certain factor price. The theory applies to all production factors but the following
discussion focuses exclusively on labor.
MRP theory assumes perfect competition in both product and factor markets. With regards to
factor markets, it implies a large number of buyers (employing firms) and suppliers i.e. laborers.
All firms are small sized so that their decisions to hire fewer or more workers do not influence the
market wage. There are no trade unions and workers make their decisions regarding supply of
labor hours independently. Workers are assumed to be “homogenous”, meaning that all workers
are identical in terms of abilities, qualifications, experience and attitudes towards work. Needless
to mention, such an assumption is unlikely to hold in the real world. Entry and exit is easy and
more workers can quickly be attracted from alternative occupations. This is because the level of
skills and qualifications required is low and can be acquired quickly.

Given a perfectly competitive labor market, the supply curve for labor is straight horizontal line
showing that an individual firm can buy any quantity of labour hours at the prevailing wage rate. In
other words, the cost of hiring an additional unit of labour i.e. Marginal Input Cost (MIC) equals
the wage rate. The latter is always equal to Average Input Cost (AIC).
TIC
AIC  TIC = Total Input Cost
L
TIC = W.L AIC = Average Input Cost
W .L
AIC  L = Total labour hours
L
AICWage W = wage rate per hour
Table 16.1 shows the revenues and costs of a firm hiring labour hours and selling goods in
competitive markets. The firm can hire additional labour hours without offering a higher wage and
sell more units without reducing prices. Thus, cost incurred to hire an extra input, MIC equals the
wage rate, w and revenue generated from selling an extra unit, MR equals sale price, P.

No of
Wage =
labour TIC MIC MP Price = MR MRP
AIC
hours (L)
21 100 2100 100 18 10 180
22 100 2200 100 16 10 160
23 100 2300 100 14 10 140
24 100 2400 100 12 10 120
25 100 2500 100 10 10 100
26 100 2600 100 8 10 80
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In the given example, labour hours beyond 21 give diminishing returns i.e. additional inputs of labour
increase total output but at a diminishing rate (MP is falling). Marginal Product, MP, is the number of
extra units obtained by hiring an extra labour hour. Marginal revenue product (MRP) is the additional
revenue generated by hiring an additional unit of labour. MRP is the product of MP (which physically
measures changes in output) and Marginal Revenue (MR). In case of perfectly competitive product
markets, price equals Marginal Revenue (MR) and MRP can be calculated by multiplying MP with
sale price. MRP of monopoly is steeper than the MRP of a perfectly competitive firm since monopolist
has to decrease price to sell more whereas more units can be sold at the same price by a perfectly
competitive firm.

MRP slopes downwards due to diminishing returns. The profit maximizing rule suggests that the
firm be hiring all labour hours contributing more to revenues (MRP) and less to costs (MIC) so
that labour hours whose MIC exceeds MRP should not be employed. The equilibrium is where
the MRP of the last labour input equals MIC.

Diagram 16.1 shows the horizontal labour supply curve, which also shows wage rate, w, Average
Input Cost, AIC, and Marginal Input Cost, MIC. The firm hires 25 labour hours (determined by the
intersection of MRP and MIC) at the wage rate of 100/hour. In case wage rate increases to 120,
the firm demands only 24 labour hours and so on. Thus, the MRP is also the demand curve for
labour.

Diagram 16.1

180

160

140

120

100 W=AIC=MIC=S

80
MRP=D
L
21 22 23 24 25 26
Increased productivity i.e. increased Marginal Product and/or increased price of the final product
raises MRP and hence the demand for labour.
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Labour Supply Curve

Having studied the components of total price effect, we now move on to the derivation of the labor
supply curve. The impacts of changes in wage rate on the supply of labour hours are studied by
separating the income and substitution effects of wage change. Workers allocate 24 hours
between labour and leisure such that any hour not spent on work is spent on leisure.

Increase in hourly wage rate increases the opportunity cost of leisure and induces workers to
substitute leisure for work, increasing the number of hours spent working. Substitution effect of a
wage change is always negative, meaning workers demand less leisure and supply more labour
hours when wage rate rises.

Increased hourly wage rate also raises real income and purchasing power. Assuming leisure is
inferior, the real income effect is negative meaning that increased wage rate reduces the demand
for leisure and raises the supply of labour.

Negative substitution effect and negative income effect of a wage change operate in same
direction- labour supply curve slopes upward for workers who perceive leisure to be inferior.

However, leisure can‟t be an inferior good. Workers affording luxuries also demand free time to enjoy
them. Assuming leisure is normal, the real income effect of the wage is positive meaning increased
hourly wage rate raises the demand for leisure and hence reduces the supply of labour hours.

Negative substitution effect and positive income effect work in opposite directions. Where
substitution effect outweighs the real income effect, labour supply curve slopes upward. It is
backward bending where the income effect turns out to be stronger than the substitution effect.

Substitution effect Income effect Wage effect

Supply curve of labour
SE IE WE
Leisure is Upward rising supply
SL ↑ SL ↑ SL ↑
inferior curve

Leisure is SL ↑ SL ↓ SL ↑
Upward rising supply
curve
normal
SL ↑ SL ↓ SL ↓
Backward bending supply
curve

Diagram 16.1 shows an initially upward rising supply curve where increased wage rate incentives
workers to supply more work hours. However, after a certain point, the curve bends backwards,
showing that workers reduce the supply of labour hours with further increases in wage rate.

Labour supply curve is upward rising in a highly unlikely case of leisure being inferior. However, if
leisure is normal, labour supply curve could either be backward bending or slope upward,
depending upon the relative strength of income and substitution effects.

Substitution effect is initially stronger. A worker working 4 hours a day finds it easy to substitute
leisure for work compared to one working 10 hours a day. Thus, substitution effect is weaker for
workers with longer working hours and increased wage rate in their case implies a relatively
strong income effect.
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Consider the example of a fresh medical graduate who initially takes up more than one job to
earn his livelihood and establish his name. Substitution effect is stronger and increased wage rate
induces him to work for longer hours. This makes leisure relatively scarce and over time, he
begins to demand more time at his disposal to enjoy the luxuries of life which he may very well be
affording then. Substitution effect becomes increasingly weak compared to income effect,
reducing the supply of labour hours with increases in the wage rate.

Diagram 16.2
w Income effect outweighs
SL substitution effect

Substitution effect outweighs

income effect
L

Shifts in Labour Supply Curve

Labour supply increases and supply curve of labour shifts towards right because of:

 a fall in wages paid in similar occupations

 a weakening of trade union influence in the industry
 an increase of the rate of female participation
 an increase in the wages of male workers
 an increase in immigration
 a decreased preference for leisure
 a decrease in the level of unemployment benefits
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Multiple Choice Questions

(Section 16)
Labour Supply Curve
J/02/3/06
1 What could cause a perfectly competitive firm‟s marginal revenue product of labour curve
to shift to the right?

A an increase in wages
B a higher rate of sales tax
C an increase in labour supply
D a rise in the price of the final product

N/02/3/05
2 An individual works 40 hours per week when the wage rate is $7 per hour. When the
wage rate is increased to $9 per hour, the individual works 36 hours per week.
What explains the change in the number of hours worked?

A a negative income elasticity of demand for leisure

B an income effect offsetting a substitution effect
C an income effect reinforcing a substitution effect
D a zero income effect

J/03/3/05
3 Which of the following will necessarily cause the supply curve of labour in a particular
industry to shift to the right?

A a fall in wages paid in similar occupations

B a greater use of machinery
C an increase in demand for the product
D a strengthening of trade union influence in the industry

J/03/3/06
4 The introduction of equal pay legislation in a country increases the wages of female
workers.
What will be the most likely effect of this increase?

A a reduction of the rate of female unemployment

B a reduction in the wages of male workers
C an expansion in the supply of female workers
D substitution of female workers for male workers
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N/03/3/04
5 The diagram shows the total product curve for a single variable factor, assuming all other
factor inputs are held constant.

total product TP

O
quantity of variable factor
In which order do the total product (TP), average product (AP) and marginal product (MP)
begin to decrease as the input of the variable factor is increased?

first second third

A AP MP TP
B AP TP MP
C MP AP TP
D MP TP AP

N/03/3/05
6 The table shows the marginal revenue product of labour schedule of a profit-maximising
firm producing under conditions of perfect competition.
number of workers 1 2 3 4 5 6 7
marginal revenue product ($) 135 140 145 150 145 140 135
If the wage is $140, what is the maximum number of workers the firm will employ?
A 2 B 4 C 5 D 6

J/04/3/03
7 A firm is operating in an imperfectly competitive market.
Why does the marginal revenue product of a factor of production employed by the firm
fall as more of the factor is employed?
A Its marginal physical product alone falls.
B Its marginal revenue alone falls.
C Its marginal physical product and its marginal revenue both fall.
D The supply price of the factor rises.

J/04/3/05
8 There is an increase in the supply of female labour.
What will be the likely effect on male and female wages?
male wages female wages
A decrease decrease
B decrease increase
C increase decrease
D increase increase
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N/04/3/06
9 What will cause the demand curve for labour to shift to the right?

A a fall in the money wage rate

B a rise in real wages
C an increase in immigration
D an increase in labour productivity

N/04/3/07
10 A worker responds to an increase in his hourly wage rate by reducing the number of
hours he works per week.
What would explain this?

A The income effect of the wage rate increase outweighs the substitution effect.
B The opportunity cost of leisure has increased.
C The worker prefers leisure to work.
D The worker‟s supply of labour is wage inelastic.

J/05/3/06
11 In the diagram S1 is an individual worker's initial supply of labour curve.

S2
S1

wage
rate

O hours of work
What could cause the curve to shift to S2?

A an increase in the hourly wage rate

B an increased preference for leisure
C an increase in the opportunity cost of leisure
D an increase in work satisfaction

J/05/3/07
12 Wages in industry X are significantly higher than in industry Y.
What could explain this difference?

A Workers in industry Y are highly mobile.

B Trade union organisation in industry Y is relatively strong.
C Industries X and Y compete with each other for workers.
D There are non-pecuniary advantages to working in industry Y.
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N/05/3/05
13 What could cause a perfectly competitive firm's marginal revenue product of labour curve
to shift to the right?

A an increase in wages
B a higher rate of sales tax
C an increase in labour supply
D a rise in the price of the final product

N/05/3/06
14 What is likely to be the direction of the income and substitution effects of a wage rate
increase on the number of hours workers will choose to work?

income effect substitution effect

A decrease decrease
B decrease increase
C increase decrease
D increase increase

J/06/3/03
15 „The addition to revenue which results from employing one additional unit of a factor of
production, the quantities of all other factors of production remaining constant‟.
What does this define?

A marginal factor cost

B marginal revenue
C marginal revenue product
D the law of diminishing returns

J/06/3/05
16 The table shows the main characteristics of employment in two occupations.
occupation A occupation B
average annual wage $ 100 000 $60 000
number of weeks annual leave 5 weeks 10 weeks
average length of working week 48 hours 44 hours
job security low high
length of training course to obtain job qualification 1 year 2 years

What can be deduced from the table?

A Those employed in occupation B attach greater importance to job security.

B Those employed in occupation A attach less importance to leisure activities.
C There will be more competition for places on training courses to enter occupation
A than Occupation B.
D Occupation B has greater non-pecuniary advantages than occupation A.
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N/06/3/04
17 A firm working in perfect competition sells its product for $1. The table gives the average
physical product with different numbers of workers.

number of workers average physical product

1 20
2 18
3 16
4 14
Which wage rise would cause the firm to employ two instead of three workers?

A $8 to $10 B $10 to $14 C $14 to $18 D $16 to $18

N/06/3/05
18 An individual works 40 hours per week when the wage rate is $7 per hour. When the
wage rate is increased to $9 per hour, the individual works 36 hours per week.
What explains the change in the number of hours worked?

A a negative income elasticity of demand for leisure

B an income effect outweighing a substitution effect
C an income effect reinforcing a substitution effect
D a zero income effect

J/07/3/05
19 For a firm in imperfect competition, the marginal revenue product of labour at any given
level of employment is equal to
A marginal revenue divided by the number employed.
B marginal revenue divided by the wage rate.
C the marginal physical product of labour multiplied by marginal revenue.
D the marginal physical product of labour multiplied by the wage rate.

N/07/3/05
20 The introduction of equal pay legislation in a country increases the wages of female
workers.
What will be the most likely effect of this increase?
A a reduction of the rate of female unemployment
B a reduction in the wages of male workers
C an expansion in the supply of female workers
D substitution of female workers for male workers

J/08/3/27
21 The number of people employed in a country and the level of unemployment both
increase.
What could make this possible?
A net inward immigration
B a decrease in the level of unemployment benefits
C a decrease in the age at which state pensions are payable
D an increase in the number of students
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N/09/3/04
22 What could cause a perfectly competitive firm‟s marginal revenue product of labour curve
to shift to the right?

A an increase in wages
B a higher rate of sales tax
C an increase in labour supply
D a rise in the price of the final product

J/10/3/03
23 What could cause the demand curve for labour to shift to the left?

A a decrease in immigration
B a decrease in labour productivity
C a fall in real wages
D a rise in the money wage rate

J/10/3/04
24 In the diagram S1 is an individual worker‟s supply of labour curve.

S1
S2

wage
rate

O hours of work
What could cause the curve to shift from S1 to S2?

A a decrease in the hourly wage rate

B a decrease in work satisfaction
C a decrease in the opportunity cost of leisure
D a decreased preference for leisure

N/10/3/15
25 What is meant by 'real wages'?

A the marginal physical product of labour

B the opportunity cost of labour
C the purchasing power of money wages
D wages net of tax
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J/11/32/03
26 The table shows the main characteristics of employment in two occupations.
occupation X occupation Y
average annual wage $100 000 $60 000
number of weeks annual leave 5 weeks 10 weeks
average length of working week 48 hours 44 hours
job security low high
length of training course to obtain job qualification 1 year 2 years

What can definitely be deduced from the table?

A Those employed in occupation Y attach greater importance to job security.

B Those employed in occupation X attach less importance to leisure activities.
C There will be more competition for places on training courses to enter occupation
X than occupation Y.
D Occupation Y has greater non-pecuniary advantages than occupation X.

J/11/32/06
27 The diagram shows the supply and demand for labour in an industry.
S

wage rate

D
O L M N
employment
Initially the industry‟s labour market is in equilibrium.
What effect will the introduction of a minimum wage OW have on the level of employment
in the industry?

A It will decrease by an amount LM. B It will decrease by an amount LN.

C It will increase by an amount LN. D It will increase by an amount MN.

J/11/32/12
28 Individuals are free to choose the number of hours they work, how much of their income
they save and which goods and services they buy.
Which type of tax will not distort the choices individuals make?

A a tax levied on the wealth accumulated by individuals

B a uniform tax which raises the same fixed amount from all individuals
C indirect taxes on specific goods
D proportional income taxes
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J/12/32/04
29 The diagram shows a perfectly competitive firm‟s average product of labour (APL) and
marginal product of labour (MPL) curves.

wage
($),
labour
product W
(units)
APL
MPL

O N1 N2 N3 N4
workers employed
The market price of the firm‟s product is $1.
How many workers will the firm employ at a wage of OW?

A ON1 B ON2 C ON3 D ON4

N/12/32/04
30 In the diagram, MRPL is a firm‟s marginal revenue product of labour curve, S is its supply
of labour curve, and MCL its marginal cost of labour curve.

MCL

W4 S
W3
$
W2
W1

MRPL

O N1 N2
labour
Assuming profit maximisation, how many workers will the firm employ and what wage will
it pay?

number
wage
employed
A N1 W1
B N1 W3
C N2 W2
D N2 W4
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N/12/32/05
31 The diagram shows a backward sloping supply curve of labour.
S

real
wage W
rate

O hours worked
per week
What is correct about the substitution effect and the income effect when the real wage
rises above OW?

substitution income effect

effect
A negative negative
B negative positive
C positive negative
D positive positive

J/13/32/05
32 A firm operates under perfect competition in both product and factor markets with labour
as the only variable factor input.
In the diagram, the line JK shows the relationship between the marginal physical product
of labour and the man-hours hired.
J
10

8
marginal physical 6
product of labour
(units) 4

2
K
0
0 1 2 3 4 5
thousand man-hours

When the hourly wage is $3.20, the firm employs 4000 man-hours per day.
What is the price of the product?

A $1.60 B $2.00 C $3.20 D $6.40

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N/13/32/04
33 A firm operates under perfect competition in both product and factor markets with labour
as the only variable factor input.
In the diagram, the line JK shows the relationship between the marginal physical product
of labour and the man hours hired.
J
10

8
marginal physical 6
product of labour
(units) 4

2
K
0
0 1 2 3 4 5
thousand man-hours
The price of the product is $1.60.
What will be the number of man-hours hired by the firm if the hourly wage is $6.40?

A 1000 B 2000 C 3000 D 4000

J/14/32/04
34 In the diagram S1 is an individual worker‟s supply of labour curve.

S1
S2

wage
rate

O hours of work

What could cause the curve to shift from S1 to S2?

A a decrease in the hourly wage rate

B a decrease in work satisfaction
C a decrease in the opportunity cost of leisure
D a decreased preference for leisure
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J/14/32/05
35 The table shows the marginal revenue product of labour schedule of a profit-maximising
firm producing under conditions of perfect competition.

number of workers 1 2 3 4 5 6 7
marginal revenue product ($) 125 130 135 140 135 130 125

If the wage is $135, what is the maximum number of workers the firm will employ?

A 3 B 4 C 5 D 6

N/14/32/05
36 To increase its labour force from 100 to 101 workers, a firm has to increase its daily wage
rate from $500 to $502.
What is the marginal cost of labour per day?

A $2 B $200 C $202 D $702

J/15/32/05
37 A firm operates under perfect competition in both product and factor markets with labour
as the only variable factor input.
In the diagram, the line JK shows the relationship between the marginal physical product
of labour and the hours worked:

J
10

marginal physical 6
product of labour
(units) 4

2
K
0
0 1 2 3 4 5
thousand hours
When the price of the product is $1.60, the firm uses 3000 hours of labour.
What is the hourly wage?

A $0.40 B $2.40 C $5.60 D $6.40

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N/15/32/05
38 Which diagram correctly shows the relationship between the average product (AP) and
the marginal product (MP) of labour, given that the quantities of other factor inputs remain
constant?
A B
MP
MP AP
AP
average average
product, product,
marginal marginal
product product

O labour O labour

C D

average average
product, product,
marginal marginal
product product
MP AP
AP MP
O labour O labour

J/16/32/14
39 A firm employs a worker who adds less to output than the previous worker employed.
What does this illustrate?

A decreasing marginal costs B diseconomies of scale

C increasing returns to scale D the law of diminishing returns

J/16/32/15
40 To increase the number of cleaners at a local school from 10 to 11, the employer has to
raise the hourly rate of pay from $8.00 to $8.50.
What is the marginal cost of labour per hour to the employer?

A $0.50 B $13.50 C $88.50 D $93.50

J/16/32/16
41 For a firm in imperfect competition, the marginal revenue product of labour at any given
level of employment is equal to

A marginal revenue divided by the number employed.

B marginal revenue divided by the wage rate.
C the marginal physical product of labour multiplied by marginal revenue.
D the marginal physical product of labour multiplied by the wage rate.
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Section: 17 Monopsony
Just as monopoly means single seller, monopsony means single buyer. It can either pay low
wages to workers or hire more workers but can not control both wages and labour hours
simultaneously. The supply curve of labour for monopsony is upward rising as more labour hours
can only be hired by offering higher wages.

As different workers cannot be offered different wages and increasing wage for one means
increasing it for all, the cost of hiring an additional input (MIC) always exceeds the wage rate.
Consider Table 17.1 which shows the costs of hiring labor hours for a monopsony. In order to hire
the second labour hour, wage rate has to be increased to 60. Marginal Input Cost, MIC for hiring
second labour hour is 70 i.e. greater than the wage rate, 60, since wages are increased for both
the first and second labour hours. Apart from 60 being paid to the second labour hour, an
additional 10 has to be paid to the 1st labour hour.

Table 17.1
AIC = w L TIC MIC
50 1 50 50
60 2 120 70
70 3 210 90
80 4 320 110
90 5 450 130
100 6 600 150

Diagram 17.1
W
MIC

a AIC= W =S

W1

MRP
L
L1
Diagram 17.1 shows quantity of labour hours, L along the x-axis and hourly wage rate, w along
y-axis. Supply curve (showing wage and Average Input Cost) slopes upward showing higher
wage rates being offered to induce workers to work for a higher number of hours. As stated
earlier, Marginal Input Cost, MIC is higher than supply curve of labour as hiring more labour hours
requires wages to be increased for all labour hours.

Marginal Revenue Product (MRP) slopes downward and intersects MIC at point „a‟. The
intersection of MRP and MIC determines the number of labour hours to be employed by
monopsony. Monopsony hires L1 labour hours and pays them the lowest possible wage, w1 given
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by the height of the supply curve. Compared to perfect competition, monopsony hires too few
labour hours and pays low wages.

Whereas the Marginal Revenue Product (MRP) curve shows demand for labor under perfect
competition, the demand curve for labour doesn‟t exist under monopsony. Unlike perfect competition,
wages and MIC diverge in monopsony so determining the number of labour hours firms demand at a
certain wage rate is not possible.
Trade Unions
Given the weak bargaining power of workers, wages determined through free, unrestricted
movements of demand and supply curves are likely to be low. Such weak bargaining power may
be due to the fact that:
 Workers sell the most perishable thing- time. Thus workers have no option but to accept
lower wages.
 Workers, in the absence of trade unions, negotiate wages individually and independently
of each other. An individual worker can not influence the prevailing wage rate.
 Workers, compared to employers (firms), are large in number and less likely to have a
uniform demand regarding wages and working conditions.
 Firms are fewer in number and large in size, hence more likely to dictate the labour
market.
A trade union is a workers‟ body aiming to win a fair day‟s pay for a fair day‟s work through
collective bargaining. Trade unions can restore some bargaining power for workers and help
them collectively negotiate wages and working conditions with firms.

Trade union in a perfectly competitive labour market

Diagram 17.2 shows quantity of labour (L) along x-axis and wage rate (w) along y axis. Point x
i.e. the point of intersection of demand and supply curves for labour determines the equilibrium
wage, W 1 and employment level, L1.
Diagram 17.2
W
d
SL

WT a b
c
x
W

DL

L
L3 L1 L2

Unemployment
Trade unions are expected to demand a wage higher than W 1. Assuming they demand wage W T,
the supply curve of labour becomes abcd. The straight horizontal portion of supply curve of labour,
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abc, shows that firm can hire labour hours till L2 without raising wages. However, hiring labour hours
beyond L2 requires a wage increase, shown by the upward rising portion of the supply curve, cd.

The new equilibrium is established at b, where firm hires fewer labour hours, L 3 at a higher wage
rate, W T. Although the trade union wins a wage increase for its members, the number of
employment opportunities decreases from L1 to L3.Trade unions may decide to settle this trade off
in favor of higher wages i.e. choose to win higher wages for members (insiders, L 3 workers who
succeed in retaining their jobs) and ignore the costs of reduced employment opportunities on
those forced out of work (outsiders). This insider/outsider theory supports the view of few
economists who believe that unemployment results from unions‟ insistence on high real wages.

Trade union is monopsony

Trade unions under monopsony can win both an increase in wages and employment
opportunities simultaneously. Consider diagram 17.3 where the intersection of MRP and MIC
curve determines number of labour hours, L 1 and wage,W 1, given by the height of labour supply
curve.

Diagram 17.3
E MIC

W D

C
AIC = W = S L

WT A
B

W1

MRP

L
L1 L3 L2
When trade unions demand a higher wage rate W T, the firm continues to hire workers till L2
without raising wages and the supply curve of labour equals MIC. This is shown by the straight
horizontal portion of supply curve, AB. The wage rate must be raised to attract workers beyond
L2, shown by upward sloping supply curve, BC. For the upward sloping labour supply curve, MIC
i.e. DE is higher than the supply curve. The complete MIC curve is ABDE with the vertical line BD
showing a mathematical discontinuity connecting AB and DE. The intersection of new MIC and
MRP determines the new number of labour hours, L3 and wage rate, W T. Thus, intervention by a
trade union wins both an increase in the wage rate and employment opportunities.
Powers of trade union
A trade union is more likely to win higher wages for its members when:
 The economy is booming and businesses are growing
 Substituting labour with capital is difficult
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 Trade unions have the support and representation of a majority of workers

 Demand for firm‟s product is price inelastic
 The firm faces lower competition, both domestically and internationally
 Labour costs are a small proportion of total costs
 The firm is a monopsony
 The government is following a flexible exchange rate system
 Weak national currency

Where labor costs constitute a small proportion of total costs, for instance in capital intensive
industries like shipbuilding, higher wages don‟t have a significant impact on the firm‟s budget.
This “importance of being unimportant” enables worker to command higher wages.

Wage Differentials
Wage differentials are a pervasive phenomenon in our everyday lives. We may be forced to
wonder why a stock market analyst earns a higher salary than a school teacher or a nurse, who
can save a human life is paid less than an accountant. Showbiz celebrities, football and tennis
players, rock stars etc all earn unusually higher salaries than people working in other
occupations. Wage differentials may very often base themselves on discrimination, with females
being paid relatively lower salaries than male counterparts and white Americans enjoying higher
pays and benefits than Blacks and Hispanics. We would thus want to explore what explains these
occupational, gender and ethnic wage differentials?

The answer, to some extent, lies in the MRP theory. Demand for labour is a derived demand i.e.
we don‟t demand labour but the goods and services it helps to produce. Any increase in the
demand for goods and services raises the demand for workers and hence their wages. Marginal
Revenue Product (MRP), the product of sale price and Marginal Product shows the demand for
labour. Workers whose products can fetch a higher price in the market have higher MRP, higher
demand and hence higher wages. For example, tickets for a famous rockstar‟s concert sell at a
higher price, enabling him to command a higher fee for his performance. Likewise, workers with a
higher Marginal Product also have a higher MRP and higher wages. In the given example,
Marginal Product of a rock star is high since very few people possess the talent and ability to
entertain people. By virtue of this innate ability, the number of successful rock stars is
automatically restricted leading to higher MP, higher MRP, higher demand and higher wages.

However, other factors like trade unions, government regulations, non financial incentives and
learning opportunities for workers etc also play a role in wage determination. Wage differentials
between men and women may exist for a host of reasons as specified below:
 Women cannot take up highly rewarding jobs involving long working hours and excessive
traveling. This decreases the average wage earned by female workers.
 Women may have to exit the labor market while developing their families, thus losing out
years of work experience and earning lower wages on re entry.
 Women usually don‟t join trade unions and this reduces their average wage.
 Women prefer part time job opportunities, resulting in lower average wages for them.
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Economic Rent
Economic rent refers to the payment made to a factor of production over and above the minimum
payment required by it to stay in its current use. The latter equals the earning possible from the
next best occupation, also known as the opportunity cost or transfer earning.

Economic rent may thus be defined as the excess of actual payment made to a production factor
over and above transfer earning.
Economic rent = Actual payment – transfer earning
Economic rent possesses three key characteristics: it arises due to scarcity, it is a surplus
payment and marginal input does not yield any economic rent. The following discussion explores
how different factors of production-land, labour and capital earn economic rent.

Land
Assume that a farmer may grow either wheat or rice on the land he possesses. The table below
shows the output of wheat obtained for different pieces of land:
Piece of land A B C D E
Output (wheat) tones 100 80 60 40 20

The opportunity cost of growing wheat is the forgone output of rice. Market prices of both wheat
and rice are assumed to be the same. Assuming that the farmer could have obtained 40 tones of
rice the opportunity cost of using land for growing wheat is 40 tones of rice. A, B and C yield more
output if used for growing wheat whereas E is more suited to rice production. E is „marginal land‟
and does not yield a „surplus‟, hence it may be used for growing either wheat or rice. A, B and C
generate economic rent i.e. they produce a surplus over and above the opportunity cost equaling
60 tones (100 – 40), 40 tones (80 – 40) and 20 tones (60 – 40) respectively. Increase in the price
of wheat increases economic rent whereas increased price of rice lowers it.
Labour
The following table shows quantities of labour hours workers are willing to supply at different
wage rates.
No of labour hours (L) 1 2 3 4 5
Wage rate (w) Rs. 100 110 120 130 140
First labour hour will only be supplied if wage equals Rs.100 and the minimum payment needed
nd
to supply 2 labour hour is Rs. 110. Assuming the firm hires 4 labour hours at an hourly wage
rate of Rs.140, the economic rent produced by different labour hours is given as:
Labour hours 1 2 3 4 5
Actual wage 140 140 140 140 140
Transfer earning 100 110 120 130 140
Economic rent 40 30 20 10 0

Diagram 17.4 is a graphical representation of economic rent where the firm employs L 1 labour
hours at wage rate, W 1. The total payment made to hire all labour hours equals W 1AL1B (i.e.
wage rate w1 times labour hours L1). Height of the supply shows the minimum acceptable
payment needed by workers, therefore, the entire area below the supply curve upto L 1 number of
labour hours (ABL1) shows total transfer earnings. The difference between actual payments made
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to workers (W 1AL1B) and transfer earnings (ABL1) gives economic rent i.e. area W 1AB. Economic
rent is thus given by the area below wage and above supply curve.
The height of the demand curve for labour shows Marginal revenue product (MRP), additional
revenue generated from hiring an extra labour input. The firm hires workers as long as their
contribution to revenues exceeds the costs of employing them (i.e. MRP exceeds MIC). Thus, the
minimum requirement from a firm‟s point of view for hiring an extra labour input is the wage rate
paid (i.e. equal to MIC if more workers are employed at the same wage). The excess of MRP
over wage is firm‟s surplus which it may use to hire other factors of production. Area below
demand curve and above wage rate is buyers‟ or consumers‟ surplus. This is given by CW 1A in
diagram 17.4.

Diagram 17.4
w
C

SL

A
w1

DL = MRP
B L
L1

Price elasticity of supply and Economic Rent

As stated earlier, economic rent arises due to scarcity in factors of production. Thus, factors with
a low price elasticity of supply, PES are more likely to earn economic rent. Diagram 17.5(a)
shows a straight horizontal supply curve or perfectly price elastic supply and 17.5(b) shows a
straight vertical line exhibiting perfectly price inelastic supply.
Diagram 17.5(a) Diagram 17.5(b)
w w S

S
D
D

L L
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Even a marginal decrease in wages in diagram 17.5(a) forces all workers to leave the labour
market. In this case, payment earned by workers exactly equals their transfer earnings and
economic rent is zero. In diagram 17.5(b), workers continue to supply the same number of labour
hours irrespective of the wage offered. Thus, transfer earnings are zero and economic rent is
maximized equaling the entire actual payment. It is thus concluded that economic rent is lower for
production factors whose supply is price elastic.
Economic Rent (Short Run v/s Long Run)
As more options and substitutes can be developed in the long run, elasticity of supply increases
in the long run and decreases economic rent. For example, a doctor may earn economic rent in
the short run by opening his clinic in a small town but entry by competitors i.e. springing up of
other clinics in the long run reduces his ability to earn rents.
Diagram 17.6 compares economic rent in the short and long run. Supply curve S 1 is the short run
supply curve, steeper than the long run supply curve, S2. Economic rent decreases from ABE to
ABC and transfer earnings increase from BEQ1 to BCEQ1 in the long run.
The portion of economic rent which becomes transfer earning in the long run is termed Quasi
Rent. Put differently, Quasi Rent is that portion of economic rent which can only be earned in the
short run. This is shown by EBC in diagram 17.6.
Diagram 17.6
Price

S1
S2

B
A

D
E Q
Q1
Given that the minimum requirement for a firm to continue operating in the long run is normal
profit, it can be said that transfer earnings are the same as normal profit and super-normal profit
is economic rent.
A monopoly can earn economic rent in the long run because entry of new firms is impossible whereas
economic rent disappears for perfectly and monopolistically competitive firms in the long run.
Students are encouraged to prepare following essays:

J/02/4/05 J/05/4/02 N/08/4/05 J/10/42/04

J/03/4/03 N/05/4/03 J/09/4/03 N/10/42/04
N/03/4/03 J/06/4/07 N/09/41/04 N/10/43/04
J/04/4/04 J/07/4/03 N/09/42/03
N/04/4/04 J/08/4/08 J/10/41/04
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Multiple Choice Questions

(Section 17)
N/03/3/06
1 To increase the labour force from 30 to 31 workers, an entrepreneur is forced to increase
the daily wage rate from $40 to $42.
What is the marginal cost of labour per day?
A $2 B $42 C $62 D $102

J/04/3/04
2 To increase its labour force from 50 to 51 workers, a firm has to increase the daily wage
rate from $600 to $610.
What is the marginal cost of labour per day?
A $10 B $510 C $610 D $1110

J/04/3/06
3 In the diagram, MRPL is a firm‟s marginal revenue product of labour curve, S is its supply
of labour curve, and MCL its marginal cost of labour curve.

MCL

W4 S
$ W3
W2
W1

MRPL

O N1 N2
labour
Assuming profit maximisation, how many workers will the firm employ and what wage will
it pay?
Number employed Wage
A N1 W3
B N1 W1
C N2 W2
D N2 W1

N/08/3/05
4 A firm currently employs 30 workers at a daily wage rate of $40.
It calculates that the marginal cost per day of hiring an additional worker would be $102.
By how much would the daily wage rate have to be increased to attract an extra worker?
A $2 B $42 C $62 D $102
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J/09/3/04
5 To increase its labour force from 100 to 101 workers, a firm has to increase its daily wage
rate from $400 to $405.
What is the marginal cost of labour per day?
A $5
B $405
C $905
D $40 905

N/09/3/05
6 In the diagram, MRPL is a firm‟s marginal revenue product of labour curve, S is its supply
of labour curve, and MCL its marginal cost of labour curve.

MCL

W4 S
$ W3
W2
W1

MRPL

O N1 N2
labour
Assuming profit maximisation, how many workers will the firm employ and what wage will
it pay?
number
wage
employed
A N1 W3
B N1 W1
C N2 W2
D N2 W4

N/10/3/06
7 To increase its labour force from 100 to 101 workers, a firm has to increase the daily
wage rate from $300 to $302.
What is the marginal cost of labour per day?
A $2
B $202
C $302
D $502
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Trade Unions
J/02/3/07
8 The workers in a firm have not previously belonged to a trade union but now join one.
In which circumstance is this most likely to raise their wages?
A Capital is highly substitutable for labour.
B Labour costs constitute a large fraction of the firm‟s costs.
C The demand for the firm‟s product is price-elastic.
D The firm has enjoyed monopsony power in the market for its labour.
N/02/3/04
9 In the diagram, HN is the initial supply of labour curve faced by a firm, and RM is its initial
marginal cost of labour curve.

M N

wage/
cost of J K
X
labour W
R

H
O
quantity of labour
What will be the firm's new labour supply curve, if the workers join a trade union and
achieve a union negotiated wage, OW?
A RJX B HKX C WJM D WKN

N/03/3/07
10 The diagram shows the supply and demand for labour in an industry.
S

wage rate

D
O L M N
employment
Initially the industry's labour market is in equilibrium.
What effect will the introduction of a minimum wage OW have on the level of employment
in the industry?
A It will decrease by an amount LM.
B It will decrease by an amount LN.
C It will increase by an amount LN.
D It will increase by an amount MN.
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J/05/3/05
11 When would a trade union be most likely to secure a wage rise for its members?

A when labour costs are a small proportion of total costs

B when the demand for the product is price-elastic
C when there are a large number of small producers
D when the supply of labour is elastic

N/05/3/07
12 A trade union seeks to increase the wages that a firm pays to its workers while at the
same time preserving jobs.
What will strengthen the union‟s negotiating position?

A Capital and labour are perfect substitutes.

B The firm operates in a competitive market.
C The demand for the good produced by the firm is price-inelastic.
D The supply of labour to the firm is perfectly elastic.

J/06/3/04
13 In which situation is it likely that the demand for labour would be inelastic?

A Labour and capital are close substitutes.

B Labour costs are only a small proportion of total costs.
C Demand for the final product that the labour produces is elastic.
D A large quantity of unemployed labour is available in the economy.

J/06/3/15
14 The introduction of a minimum hourly wage for all workers over 21 years of age is
expected to increase the average wages of these workers.
What will be the likely effect on workers under 21?

unemployment for under 21s average wages for under 21s

A falls fall
B rises fall
C falls rise
D rises rise
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J/07/3/07
15 In the diagram, S is a monopsonist‟s supply of labour curve, MCL its marginal cost of
labour curve and MRPL its marginal revenue product of labour curve.
MCL

wage
rate W

MRPL

O
number employed
The firm's workers join a trade union which negotiates a wage rate, OW, with the firm's
owners.
What will be the effect on the firm's total wage bill and on the number of workers
employed?
Total wage bill Number employed
A increase increase
B increase decrease
C decrease increase
D decrease decrease

N/07/3/06
16 The diagram shows an industry‟s demand for and supply of labour.
S

W0

wage
rate

D
O L M N
employment
Initially the labour market is in equilibrium. The workers then form a trade union which
negotiates a wage equal to OW0 with the employers.
What will be the effect on the level of employment in the industry?
A an increase equal to MN B an increase equal to LM
C a decrease equal to LN D a decrease equal to LM
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N/08/3/06
17 In which circumstances is a trade union most likely to be successful in raising wage
rates?
A The demand for the good produced is price-elastic.
B The industry faces substantial foreign competition.
C The industry's cost structure is capital-intensive.
D The workers are unskilled.

N/09/3/07
18 The diagram shows the initial position of a labour market.

D S

weekly
wage

O
number of workers
The government introduces a law reducing the statutory working week from 39 hours to
36 hours.
How will this affect the supply and demand curves in the diagram?

employers‟ workers‟ supply

demand curve curve
A shifts to right shifts to left
B shifts to right shifts to right
C shifts to left shifts to left
D shifts to left shifts to right

J/10/3/05
19 A firm‟s workers join a trade union which negotiates an increase in the workers‟ wage
rate.
The increase in the wage rate results in an increase in the number employed by the firm.
What could explain this?
A The demand for the firm‟s product is price-elastic.
B The firm is a monopsonist within its local labour market.
C The firm operates in a perfectly competitive labour market.
D There is a high degree of substitutability between capital and labour.
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Wage Differentials
Economic Rent
N/04/3/08
20 The diagram shows an individual worker‟s supply curve of labour.

x
W
hourly z
wage

O 40
number of hours
The hourly wage is OW and the worker is required to work a standard 40-hour week.
Which area measures the difference between the total amount the worker is paid per
week and the minimum amount he would be willing to accept?
A x B z C x+z D z–x

J/07/3/06
21 The diagram shows an individual‟s supply of labour curve.
S
80
w
x
60
z
hourly wage ($) 40
y
20

0
40
number of hours
He is offered a job which would require him to work a standard 40-hour week.
Which area measures the lowest amount he would have to be paid per week to get him
to accept this job offer?
A w+z B x+y C x+y-z D w+x+z+y

J/08/3/05
22 The government imposes a maximum earnings limit on recording artists.
What must result in the short run if the measure is effective?

A a decrease in the economic rent earned by recording artists

B a decrease in the transfer earnings of recording artists
C a decrease in the supply of recording artists
D a decrease in the profits of record companies
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N/09/3/06
23 What is an example of a wage differential that compensates for the disadvantages
associated with particular jobs?

A male workers earning more than female workers in the same job
B the tendency for wage rates negotiated by trade unions to exceed those for non-
unionised labour
C labourers on off-shore oil rigs earning more than those employed on-shore
D government office workers being paid more than private sector office workers

N/10/3/07
24 The diagram shows a worker's supply of labour curve.

S
wage rate
per hour y
W
x
z

0 10 20 30 40
hours per week
The worker is required to work a minimum of 40 hours a week at the hourly wage, 0W.
Which area measures the economic rent obtained by the worker?
A x–y B x+y C y–x D y+z

N/11/32/05
25 An actor is paid $100 000 a year. The next best paid job he could get is as a lecturer at
$60 000 a year.
What are his transfer earnings and his economic rent?

transfer earnings economic rent

A $60 000 $40 000
B $60 000 zero
C $40 000 $60 000
D $40 000 zero
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N/12/32/06
26 In the diagram D1 and S are the initial demand and supply curves for building workers.

S
Y Z
U
wage T
X

D2
R
D1
O V W
quantity of labour
If the demand for building workers increases to D2 by how much does the economic rent
earned by building workers rise?

A RZU B TXZU C VWZX D XZY

N/13/32/05
27 The diagram shows the initial position of a labour market.

weekly
wage

O
number of workers
The government increases the number of statutory paid holidays to which workers are
entitled from 10 days a year to 15 days a year.
How will this affect the supply and demand curves in the diagram?

employers‟ workers‟
demand curve supply curve
A shifts to left shifts to right
B shifts to left shifts to left
C shifts to right shifts to right
D shifts to right shifts to left
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N/13/32/06
28 In the diagram, HN is the initial supply of labour curve faced by a firm, and RM is its initial
marginal cost of labour curve.

M N

wage,
cost of J K
W X
labour

R
H
O
quantity of labour

What will be the firm‟s new labour supply curve, if the workers join a trade union and
achieve a union negotiated wage, OW?

A RJX B HKX C WJM D WKN

J/14/32/06
29 In 2004 union officials and businessmen in Argentina agreed to increase the minimum
wage from 350 to 450 pesos.
In which circumstances would such a rise increase employment?

A Investment increases at a more rapid rate than consumption.

B Labour and product markets are competitive.
C The higher wage rate produces a proportionately greater rise in labour
productivity.
D The minimum wage is set above the equilibrium level.

J/14/32/08
30 The diagram shows an individual worker‟s supply curve of labour.

x
W
hourly z
wage

O 40
number of hours
The hourly wage is W and the worker is required to work a standard 40-hour week.
Which area measures the minimum amount per week he would be willing to accept?

A v B v+x C v–x D z–x

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N/14/32/06
31 The diagram shows an individual worker‟s supply curve of labour.

The hourly wage is W and the worker is required to work a standard 40-hour week.
Which area measures the net improvement in the worker‟s welfare if he were allowed to
choose the number of hours he wished to work per week?

A x B z–x C z+x D z

N/14/32/07
32 A firm‟s workers join a trade union which negotiates an increase in the workers‟ wage
rate.
The increase in the wage rate results in an increase in the number employed by the firm.
What could explain this?

A The demand for the firm‟s product is price-elastic.

B The firm is a monopsonist within its local labour market.
C The firm operates in a perfectly competitive labour market.
D There is a high degree of substitutability between capital and labour.

N/14/32/16
33 The introduction of a minimum hourly wage for all workers over 21 years of age is
expected to increase the average wages of these workers.
What will be the likely effect on workers under 21?

unemployment average wages

for under 21s for under 21s
A falls fall
B falls rise
C rises fall
D rises rise
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J/15/32/06
34 The diagram shows an individual‟s supply of labour curve.

S
80
w
x
60
z
hourly wage ($) 40
y
20

0
40
number of hours

He is offered a job which would require him to work a standard 40-hour week.
Which area measures the lowest amount he would have to be paid per week to get him
to accept this job offer?

A w+z B x+y C x+y-z D w+x+z+y

J/15/32/15
35 The government introduces a minimum wage above the equilibrium market wage rate.
How will this affect low-paid workers?

A All those initially in employment will receive the new guaranteed minimum wage.
B Fewer of those not already in employment will enter the labour force.
C There will be an increase in the number of low-paid workers in employment.
D Some low-paid workers will lose their job.

N/15/32/04
36 What will result from the differences in the non-pecuniary advantages of various
occupations?

A disequilibrium in the labour market

B long-term differentials in wage rates
C monopsony in particular labour markets
D shortages of labour in particular occupations
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N/15/32/06
37 A firm currently pays its employees on an hourly basis.
Even though the management acknowledges that its employees work to the best of their
ability and could not work any harder, the firm decides to switch to a piece-rate system of
remuneration whereby the wage paid to each employee depends on their level of output.
Why might this new system of remuneration result in a significant improvement in labour
productivity?

A It will dispense with the need for management to monitor the actions of its
employees.
B It will increase the losses that workers will incur if they are dismissed for not
working hard enough.
C It will lead to the recruitment and retention of more highly talented workers.
D It will strengthen the incentives for workers to increase their earnings.

N/15/32/07
38 A fashion model is paid $500 000 a year.
If the next best paid job he could get is as a teacher at $100 000 a year, what are his
transfer earnings and his economic rent?

transfer earnings economic rent

$ $
A zero 400 000
B 100 000 400 000
C 400 000 zero
D 400 000 100 000
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Section: 18 National Income Accounting

National income statistics are of crucial importance in helping governments plan for the future,
identify required changes in policies, ascertain overall growth rates and those in different sectors
of the economy and compare them with previous years and other countries. National income may
be calculated employing any of the following methods:

(i) Expenditure method

(ii) Income method
(iii) Output method

(i) Expenditure method: All expenditures incurred within the geographical borders of a
country during a year‟s time are added up to measure national income. These include
consumer expenditures (C), investment expenditures (I), government expenditures (G)
and export revenues (X) (less import expenditures, M).

(ii) Income method: This approach calls for adding up incomes earned by all production
factors in a country in a certain year i.e. wages, interest, rent and profits. Wages also
include salaries, fees, commissions and royalties paid to labour against their contribution
towards production. Interest payments are payments received on bank deposits and from
other interest bearing financial documents. Rent is income from immovable property and
profits include those of sole proprietorships, partnerships, limited companies and the
public sector i.e. government owned businesses.

(iii) Output method: National income is calculated by adding up the market value of all
goods and services produced in a country within a year‟s time. Double counting is
avoided by counting „value added‟ portions only so that the value of a product is not
included in national income statistics more than once. Alternatively, only the market value
of the final product is taken into consideration.

Consider the example of cotton bales that pass through several stages (conversion to yarn, grey
cloth and cloth) before getting converted into a shirt. Assume that cotton bale is valued at $20,
yarn at $100 (value addition worth $80) and grey cloth at $260 (value addition of $160). National
income is determined by adding up the value added portions only: $20 + $80 + $160 i.e. $260,
instead of adding up $20, $100 and $260.

There may exist differences between the incomes calculated through expenditure and income
approaches which are discussed in greater detail below.

Gross Domestic Product (GDP)

Gross Domestic Product is the total value of final goods and services produced within a territorial
boundary over a period of time.

Consumers‟ (C), investment (I) and Government (G) expenditures together show expenditures by
a country‟s citizens on the goods and services produced within it. This figure could equal Gross
Domestic Product (GDP) for a completely closed economy. A close economy is one which does
not allow free movement of goods and services across borders- net exports i.e. export revenues
less import expenditures are zero. Open economies on the other hand, allow free and
unrestricted movements of goods and services. For such economies, export revenues i.e.
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foreigners‟ expenditures on locally made goods are included in National Income and import
expenditures are excluded.
However, all expenditure components could have a portion relating to imports. Consumers for
instance, spend a portion of their income on buying imported items such as automobiles,
cosmetics, cellular phones, tinned food items etc. Investment by firms may also focus on
imported machinery and equipment. Governments such as that of Pakistan spend a hefty
amount on importing a variety of significant items like defence equipment. Even exported items
may have much to do with imports, in the form of raw materials, oil etc. Import expenditures are
therefore deducted to arrive at an accurate figure for Gross Domestic Product (GDP).
Consumers‟ expenditures (C)
+ Gross investment expenditures (I)
+ Government expenditures (G)
+ Export revenues (X)
– Import expenditures (M)
Gross Domestic Product (GDP)
Gross National Product (GNP)
It is common that a country‟s factors of production get employed in production activities outside
its borders e.g. many Pakistani labourers successfully find work elsewhere, say in the United
States or East Asian economies. Foreign remittances (or property income) i.e. income remitted by
these workers to their families in Pakistan is not included in GDP as it is not earned from
domestic production activities. However, since such income streams are generated by a country‟s
own citizens, they are included in Gross National Product (GNP).
Property income includes salaries and wages, interest payments on bonds and foreign bank
deposits, rent on properties and dividends and profits from business activities carried out in other
countries. However, gross values for property income lead to imprecise results- they must be
netted off so that property income sent abroad from the home country is also accounted for. A
positive figure for net property income indicates that Pakistani residents receive more profits from
assets owned in other countries, than overseas residents receive from assets they own in
Pakistan. Gross National Product could be smaller than Gross Domestic Product in case net
property income is negative.

Gross Domestic Product (GDP)

+ Net property income
Gross National Product (GNP)
Gross National Product therefore captures incomes accruing to a country‟s factors of production
from production activities performed within or outside its geographical borders.

Net National Product (NNP)

Capital goods such as machinery and plant have a finite life and must be replaced after few
years. Depreciation is an accounting method which spreads the cost of an asset over its useful
life e.g. assets whose expected useful life is five years lose 20% of their value after one year,
40% after 2 years and 60% after 3 years. Simply put, depreciation is the value of capital goods
consumed and therefore, a non-cash expense- unlike other expenses, it does not become
anyone‟s income. This is why it is deducted from GNP while measuring national Income through
the income approach. Net National Product (NNP) is Gross National Product (GNP) less
depreciation (capital consumption).
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Whereas gross investment captures investment expenditures in full (Ig), net Investment (In) is the
net addition in a country‟s capital stock i.e. it is obtained after a depreciation allowance (R) from
Gross Investment.

Example: Assume a country possesses 100 machines in capital stock at a year‟s start, of which
10 are worn out and need replacement. Capital stock remains unchanged (In is zero) if new
investments during the year exactly equal 10 machines as both Gross Investment (Ig) and
replacement/depreciation (R) are equal. Such an economy neither grows nor declines and is thus
static- there is no change in the capital stock of the economy.

Economies grow when gross investment exceeds replacement and net investment is positive.
Growth rate is negative when gross investment falls short of replacement and net investment is
negative. For such economies, capital stock decreases and the Production Possibility Curve
shifts inwards or leftwards.

Gross National Product (GNP)

– Capital consumption (Depreciation)
Net National Product (NNP)

Net Domestic Product (NDP) is Gross Domestic Product less depreciation

NNP at factor cost

Expenditures are measured at market value i.e. prevailing market prices. The market value of a
product equals the payments of wages, interest, rent and profit, or the income accruing to factors
of production involved in making that good or service. Profits act as a balancing item and are
negative (losses) if the market value falls short of the cost incurred on making the product.

However, there may be cases where payments received by factors of production differ from
market value. For instance, indirect taxes imposed on expenditures and paid to governments
(which are not a factor of production!) are deducted whereas subsidies are added to market value
to calculate national income at factor cost. Subsides are negative indirect taxes and encourage
producers to increase production.

Net National Income (NNP) at market value

– Indirect taxes
+ Subsidies
NNP at factor cost i.e. National Income

Personal Income
There is a portion of income that is earned but not received e.g. corporate taxes, retained profits,
tax deductions at source and social security payments.

Limited companies are recognized by law as having independent legal identities and hence have
their incomes taxed, so that taxes are deducted from profits before being distributed among owners.
A portion of profit can be retained and reinvested in the business. Thus, corporate taxes (i.e. taxes
paid by incorporated businesses such as private and public limited companies) and retained profits
are earned but not received by their owners and are hence deducted to calculate Personal Income.
Transfer payments such as pensions, unemployment allowances, old age benefits and social
security payments are payments received but not earned. They are excluded from national
income as no production activity takes place against such payments.
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NNP at factor cost i.e. National Income

– Payments earned but not received
+ Payments received but not earned
Personal Income

Disposable Income
Disposable income measures income at the disposal of the person who earns it. Direct taxes
(e.g. income taxes) are deducted to calculate disposable income.

Personal Income
– Direct taxes
Disposable Income

The following table summarizes the formulas for various types of national income statistics.

Consumers‟ expenditures (C)

+ Gross investment expenditures (I)
+ Government expenditures (G)
Total expenditures incurred domestically
+ Export revenues (X)
– Import expenditures (M)
Gross Domestic Product (GDP)
+ Net property income
Gross National Product (GNP)
– Capital consumption (Depreciation)
Net National Product (NNP) at market value
– Indirect taxes
+ Subsidies
NNP at factor cost i.e. National Income
– Payments earned but not received
+ Payments received but not earned
Personal Income
– Direct taxes
Disposable Income

Real National Income

Money value of national income shows the market value of goods and services produced in a
country whereas real national income is measured in terms of goods and services. Increased
price level raises money income but real national income increases only if money income
increases at a faster rate than the price level. From an individual‟s point of view (in micro
economics) real income decreases whenever price level rises but changes in price level have no
impact on the real income of the economy (i.e. macro economics).

Nominal national income measures national income at current prices and thus takes no account
of inflation. Real national income on the other hand, measures national income at constant prices
that ruled in some particular year i.e. base year. To discard the element of prices or calculate real
income, we need to multiply nominal national income by a GDP deflator, the ratio of price indices
of base year and current year.
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Question: Calculate change in real national income for a country whose money income rises by
10% and price level rises by 4%.

Answer: Assuming money income and price level were initially 100, a 10% and 4% increase
raises them to 110 and 104 respectively. Base year price level is 100.

Price index of base year

Real income  Money income
Price index of current year
100
 110
104
=105.77

Increase in real national income is 5.77% i.e. almost 6%.

Per Capita Real Income

Per capita real income for a country is obtained by dividing real national income by its total
population.
Real nationalincome
Per capita real income 
Population

Per capita real income decreases when increases in population outweigh an increase in real
national income. For example, per capita real income falls by 2% if real national income increases
by 4% and population, by 6%.

Difficulties in measuring national income

Calculating national income with precision is an uphill task, particularly for developing countries.
Apart from coping with low literacy rates and concealed incomes for tax evasion, countries find it
hard to track down and measure non documented or „informal‟ economic activities. Large
countries with geographically dispersed populations find data collection a lengthy, tedious and
time consuming job. Errors, omissions and staff incompetence reduce the accuracy and reliability
of national income statistics.

The presence of parallel economy (i.e. illegal trade) understates the figures of national income.
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Multiple Choice Questions

(Section 18)
J/02/3/17
1 Over a given period, the nominal value of a country‟s national income increased by 20%
and the rate of inflation was 10%.
Which of the following statements is correct?

A There was an increase in the volume of output.

B There was an increase in the income velocity of circulation.
C There was a reduction in the demand for money.
D The country‟s money supply increased by 10%.

N/02/3/14
2 Assuming that all indexes have 1990 as 100, the national income figures for 2000 at
1990 prices may be obtained by multiplying 2000 national income at current prices by

the index for 2000 prices

A
the index for 1990 prices
the index for 2000 prices
B
the index for 1990 output
the index for 1990 output
C
the index for 2000 output
the index for 1990 prices
D
the index for 2000 prices

N/02/3/15
3 During a year, a country's national income in money terms increased by 6%, prices
increased by 4% and total population increased by 2%.
What was the approximate change in real income per head?

A a decrease of 2%
B nil
C an increase of 2%
D an increase of 4%
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J/03/3/18
4 The graphs indicate economic performance in a country between 1996 and 1999.

Which conclusion may be drawn from the graphs?

A Between 1996 and 1997 industrial production and GDP fell but prices rose.
B Between 1997 and 1998 the rates of growth of industrial production, GDP and
prices all increased.
C GDP and industrial production were at their lowest in 1997.
D At no time did industrial production, GDP or prices fall.

N/03/3/19
5 Over a given period the nominal value of a country's national income increased by 10%
and its value of output by 12%.
What could explain this?
A The country's money supply fell by 2%.
B There was an increase in the income velocity of circulation.
C There was an increase in the balance of trade deficit.
D The country's general price level fell by 2%.
N/04/3/18
6 Which of the following will directly result in an increase in China's Gross National
Product?
A increased wages earned in a Malaysian-owned factory in China
B increased imports of goods and services
C increased outflows of net property income
D increased taxes on domestic expenditure
J/05/3/16
7 The information in the table is taken from a country‟s national income accounts.
$ million
national income 500
consumer spending 200
investment spending 75
government spending 150
taxation 140
exports 125
What is the value of imports?

A $125 million B $75 million C $50 million D $25 million

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N/05/3/16
8 Over a given period, money income in an economy increased by 8 %. Over the same
period, prices rose on average by 6 %.
What can be deduced from this?
A Real income decreased by 2 %.
B The income velocity of circulation decreased by 2 %.
C The money supply increased by 14 %.
D The volume of output increased by 2 %.
J/06/3/16
9 The table gives data for an economy.

2000 2001 2002 2003 2004

Gross Domestic Product (GDP)
200 220 240 300 320
at current prices ($ billion)
GDP deflator 100 109 118 149 154

In which year did real GDP decline compared with the previous year?
A 2001 B 2002 C 2003 D 2004
N/06/3/16
10 Over a given period, the nominal value of a country‟s national income increased by 20 %
and the rate of inflation was 10 %.
Which statement is correct?
A There was an increase in the volume of output.
B There was an increase in the income velocity of circulation.
C There was a reduction in the demand for money.
D The country‟s money supply increased by 10 %.
N/06/3/17
11 The table shows data on a country's gross national product at market prices and on
domestic spending.

year 1 year 2 year 3

($m) ($m) ($m)
GNP at market prices 400 480 560
private consumption 200 260 300
government consumption 120 120 140
gross investment 90 80 130
In which of these years will the country be faced with a deficit on the current account of
the balance of payments?

year 1 year 2 year 3

A
B
C
D
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J/07/3/18
12 The graphs indicate economic performance in a country between 2001 and 2004.
annual % increase in annual % increase annual % increase in
industrial production in consumer prices GDP
12 6
16

8 12 4
% % 8 %
4 2
4

0 0 0
01 02 03 04 01 02 03 04 01 02 03 04

Which conclusion may be drawn from the graphs?

A Between 2001 and 2002 industrial production and GDP fell but prices rose.
B Between 2002 and 2003 the rates of growth of industrial production, GDP and
prices all increased.
C GDP and industrial production were at their lowest in 2002.
D At no time did industrial production, GDP or prices fall.

N/07/3/18
13 What will directly result in an increase in China's Gross National Product?
A increased wages earned in a Malaysian-owned factory in China
B increased imports of goods and services
C increased outflows of net property income
D increased taxes on domestic expenditure

N/07/3/19
14 Over a given period, the nominal value of a country‟s national income increased by 10 %
and the average price level increased by 20 %.
What can be deduced from this information?
A The country‟s money supply increased by 10 %.
B There was an increase in the income velocity of circulation.
C There was a reduction in the demand for money.
D There was a reduction in the volume of output.
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J/08/3/16
15 The graphs show how consumer prices and real GDP changed in a country between
1995 and 2005.
consumer prices
% increase on a year earlier
6

0
1995 96 97 98 99 00 01 02 03 04 05

GDP
% increase on a year earlier
6

0
1995 96 97 98 99 00 01 02 03 04 05
Which conclusion may be drawn from the graphs?
A Living standards remained roughly constant between 1995 and 2005.
B The country experienced continuous economic growth between 1995 and 2005.
C The level of GDP was lower in 2005 than in 2000.
D The price level fell between 2000 and 2003.
J/08/3/17
16 During a year, a country‟s national income in money terms increased by 8 %, prices
increased by 4 % and total population increased by 2 %.
What was the approximate change in real income per head?
A a decrease of 2 % B nil
C an increase of 2 % D an increase of 4 %
J/08/3/18
17 The table shows data on a country‟s gross domestic product at market prices and on
domestic spending.
year 1 year 2 year 3
($m) ($m) ($m)
GDP at market prices 630 650 680
private consumption 480 470 480
government consumption 160 160 150
gross investment 20 30 40
In which of these years will the country be faced with a balance of trade deficit?
year 1 year 2 year 3
A no no yes
B yes yes no
C no yes yes
D yes no no
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J/08/3/26
18 The table shows the figures for consumption, capital formation and depreciation in four
economies, all measured in US $.
Assuming that the state of technology remains unchanged, which economy is most likely
to experience economic growth?

consumption capital formation depreciation

($ m) ($ m) ($ m)
A 100 20 10
B 500 200 200
C 1000 1200 1400
D 20 000 5 000 6 000

N/08/3/14
19 During a year, a country's national income in money terms increased by 6 %, prices
increased by 4 % and total population increased by 2 %.
What was the approximate change in real income per head?

A a decrease of 2 %
B nil
C an increase of 2 %
D an increase of 4 %

N/08/3/26
20 The chart shows the rates of economic growth and unemployment in a country for the
period 2000 to 2003.
10
9
8
7
6 percentage change
in real GDP
% 5
4 percentage rate of
unemployment
3
2
1
0
2000 2001 2002 2003
year
What does the chart show?

A Real GDP was lowest in 2003.

B The total labour force declined between 2000 and 2002.
C The standard of living fell between 2002 and 2003.
D The unemployment rate fell when the growth rate increased.
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N/09/3/15
21 The information in the table is taken from a country‟s national income accounts.
$ million
national income 600
consumer spending 400
investment spending 80
government spending on goods and services 100
taxation 90
imports 120
What is the value of exports?

A $100 million B $120 million C $140 million D $230 million

J/10/3/14
22 Between 2008 and 2009 a country‟s national income at current prices increased by 15 %.
At the same time the country experienced 5 % inflation.
Which index number most closely represents the country‟s national income in 2009 at
2008 prices (2008 = 100)?

A 103 B 110 C 115 D 120

J/11/32/13
23 The table shows data on a country‟s gross national product at market prices and on
domestic spending.

year 1 year 2 year 3

($m) ($m) ($m)
GNP at market prices 420 440 560
private consumption 200 260 300
government consumption 120 120 140
gross investment 90 80 130

In which of these years will the country be faced with a deficit on the current account of
the balance of payments?

year 1 year 2 year 3

A × √ √
B × √ ×
C √ × √
D √ × ×

N/12/32/10
24 What is most likely to be associated with a firm that is growing rapidly?

A a high rate of labour turnover

B a low level of net investment
C a low percentage of profits paid as dividends to shareholders
D attainment of the necessary conditions for allocative efficiency
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N/12/32/16
25 Over a given period, the nominal value of a country‟s national income increased by 20 %
and the rate of inflation was 10 %.
What can be deduced from this information?

A There was an increase in the volume of output.

B There was a reduction in the demand for money.
C There was an increase in the income velocity of circulation.
D The country‟s money supply increased by 10 %.

J/14/32/16
26 Over a given period, money income in an economy increased by 6%. Over the same
period, prices rose on average by 4%.
What can be deduced from this?

A Real income increased by 2%.

B The income velocity of circulation decreased by 2%.
C he money supply increased by 10%.
D The volume of output decreased by 2%.

N/14/32/20
27 During a year, a country‟s national income in money terms increased by 8%, total
population increased by 2% and real income per head remained constant.
What was the approximate change in the average price level?

A a decrease of 4%
B an increase of 4%
C an increase of 6%
D an increase of 10%
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Section: 19 Per Capita Income and Standard of Living

Per capita income estimates reflect living standards, as higher per capita income means greater
purchasing power and access to more goods and services. While making cross country
comparisons for living standards, it is advisable that per capita Gross National Product (GNP) be
relied upon, rather than Net National Product (NNP). This is because different countries employ
different methods to calculate depreciation and over or under state NNP in some cases.

National income statistics however, may still not compare living standards truly and fairly across
countries due to certain limitations discussed below. Before anything else, it must be borne in
mind that measuring national income with accuracy is difficult and hence any estimates of per
capita income can not be relied upon.

Per capita income shows the average income of citizens but because it remains silent on issues
regarding income distribution, it may not necessarily reflect the „average‟ standard of living. The
average income of two households, A earning $50,000 and B earning $0 is $25,000 that is, it fails
to account for distributional effects. Countries with wide income inequalities have overrated living
standards because in reality, majority of the people are poorer than what is reflected by per capita
income.

It is useful to analyze the individual components of GNP, rather than the aggregate. For instance,
countries spending a greater portion of national income on debt servicing and defense expenses
have a poorer standard of living compared to those where greater proportions are consumed by
general public or spent by governments on improving law and order and building infrastructure.

Imports are deducted from national income, but countries with trade deficits (exports falling short
of imports) experience better current living standards as they have access to a greater amount of
good and services than what they produce. Countries importing machinery, equipment and other
capital goods may be sacrificing existing quality of life but experience rapid economic growth and
a better standard of living in future years.

Traditional exchange rates are determined by the flow of tradable commodities i.e. exports and
imports only. Purchasing power parity theory however, determines exchange rates considering
the flow of not just tradable commodities but also non-tradable commodities. Non-tradable
commodities such as a hair cut, car repair, dentist‟s treatment and all services which are provided
at an arm‟s length distance are cheaper in developing countries. The exchange rate moves
favourably for developing countries, once non-tradable commodities are also included in
exchange rate calculations. Per capita income is usually expressed in US dollars for comparison
between different countries. Using purchasing power parity theory to express per capita income in
place of traditional exchange rate improves the figure for developing countries. Determining
exchange rates this way better reflects the buying potential and hence standard of living.
According to the estimates in The Economist (The World in 2009) the forecast per capita income
of a Pakistani citizen is $900 when measured using traditional exchange rates and $2780 using
Purchasing Power Parity!

Better law and order conditions resulting in lower crime rate, political and economic stability,
access to health and educational services, freedom of expression and speech, entertainment
opportunities, supremacy of law, justice and good governance also contribute positively to
standard of living but are not covered by per capita income.
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Alternatively, standard of living may be measured using Net Economic Welfare (NEW) or the
Human Development Index (HDI).

There is no denying the fact that countries whose citizens work for fewer hours and have more
leisure time enjoy better living standards than those whose people work for longer hours to earn
the same amount of income. Likewise, people living in countries with healthier, cleaner
environments experience a better standard of living than those forced to live in polluted and
congested areas. Net Economic Welfare (NEW) adds factors to per capita income which improve
standard of living such as leisure time and deducts factors that reduce quality of life e.g. negative
externalities arising from polluted environments.

NEW: per capita income + leisure – negative externalities

One may still be forced to employ per capita income as an indicator of living standards rather
than NEW as assigning exact monetary values to leisure time and negative externalities is a
difficult task.

As stated earlier, standard of living may also be measured using the Human Development Index
(HDI). Human Development Index measures national socioeconomic development based on
measures of life expectancy at birth, educational attainment and adjusted real per capita income.
Developed economies where most of the people have access to better educational opportunities
and medical care are likely to have a better standard of living than reflected by per capita income.

Poverty Trap
A mechanism which makes it very difficult for people to escape poverty. A poverty trap is created
when an economic system or an individual lacks various forms of capital and resources to escape
poverty.
In order to escape the poverty trap, it is argued that individuals in poverty must be given sufficient
aid so that they can acquire the critical mass of capital necessary to raise themselves out of
poverty and break the vicious cycle of poverty. This theory of poverty helps to explain why certain
aid programs which do not provide a high enough level of support may be ineffective at raising
individuals from poverty.

Intergenerational Equity
Intergenerational equity is a concept that says that humans 'hold the natural and cultural
environment of the Earth in common both with other members of the present generation and with
other generations, past and future. It means that we inherit the Earth from previous generations
and have an obligation to pass it on in reasonable condition to future generations.
The idea behind not reducing the ability of future generations to meet their needs is that, although
future generations might gain from economic progress, those gains might be more than offset by
environmental deterioration. Most people would acknowledge a moral obligation to future
generations, particularly as people who are not yet born can have no say in decisions taken today
that may affect them.
There are two different ways of looking at the need to ensure that future generations can supply
their needs. One is to view the environment in terms of the natural resources or natural capital
that is available for wealth creation, and to say that future generations should have the same
ability to create wealth as we have. Therefore, future generations will be adequately
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compensated for any loss of environmental amenity by having alternative sources of wealth
creation. This is referred to as 'weak sustainability'.
During the late 1960s, many economists began to question the over-reliance of governments and
agencies on narrow, exclusively GDP-based, measures of economic welfare. It was at this time
that the adverse environmental effects of uncontrolled economic growth began to be considered,
prompting the search for a wider measure of welfare, not exclusively based on raw GDP figures.

Net Economic Welfare (NEW)

NEW took national output as a starting point, but adjusted it to include an assessment of the
value of leisure time and the amount of unpaid work in an economy, hence increasing the welfare
value of GDP. They also included the value of the environment damage caused by industrial
production and consumption, which reduced the welfare value of GDP. NEW can be seen as the
forerunner of later attempts to create a sophisticated index of sustainable development.

An Introduction of BRICS
The BRICS, made up of Brazil, China, India, Russia, and South Africa, are characterized by
rapidly growing economies and increasing international influence. With over 40 percent of the
world‟s population, these countries‟ combined output constitutes more than 20 percent of global
GDP. Economists predict that Brazil, China, India, and Russia will join the United States as
the five largest economies in the world by 2050.

Human Poverty Index

The United Nations has for some time constructed human poverty indices for developing
countries. A recent innovation has been the publication of a new Human Poverty Index (HPI-2)
measures poverty in industrial countries. The composite measure focuses on economic
deprivation in three separate dimensions:
% of people likely to die before the age of 60
% of people whose ability to read and write is far from adequate
proportion of the population with disposable incomes of less than 50% of the medium
proportion of long term unemployed (12 months of more)

Multidimensional Poverty Index (MPI)

The global Multidimensional Poverty Index (MPI) is an international measure of acute poverty
covering over 100 developing countries. It complements traditional income-based poverty
measures by capturing the severe deprivations that each person faces at the same time with
respect to education, health and living standards.
The MPI assesses poverty at the individual level. If someone is deprived in a third or more of ten
(weighted) indicators, the global index identifies them as „MPI poor‟, and the extent – or intensity
– of their poverty is measured by the number of deprivations they are experiencing.
The MPI can be used to create a comprehensive picture of people living in poverty, and permits
comparisons both across countries, regions and the world and within countries by ethnic group,
urban/rural location, as well as other key household and community characteristics.

The index uses the same three dimensions as the Human Development Index: health, education,
and standard of living. These are measured using ten indicators.
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Dimension Indicators
 Child Mortality
Health
 Nutrition
 Years of schooling
Education
 School attendance
 Cooking fuel
 Toilet
 Water
Living Standards
 Electricity
 Floor
 Assets

Kuznets Curve
In economics, a Kuznets curve graphs the hypothesis that as an economy develops, market
forces first increase and then decrease economic inequality. The hypothesis was first advanced
by economist Simon Kuznets in the 1950s and '60s.
One explanation of such a progression suggests that early in development investment
opportunities for those who have money multiply, while an influx of cheap rural labor to the cities
holds down wages. Whereas in mature economies, human capital accrual, or an estimate of cost
that has been incurred but not yet paid, takes the place of physical capital accrual as the main
source of growth; and inequality slows growth by lowering education levels because poorer,
disadvantaged people lack finance for their education in imperfect credit-markets.
The Kuznets curve implies that as a nation undergoes industrialization – and especially the
mechanization of agriculture – the center of the nation‟s economy will shift to the cities.
As internal migration by farmers looking for better-paying jobs in urban hubs causes a significant
rural-urban inequality gap (the owners of firms would be profiting, while laborers from those
industries would see their incomes rise at a much slower rate and agricultural workers would
possibly see their incomes decrease), rural populations decrease as urban populations increase.
Inequality is then expected to decrease when a certain level of average income is reached and
the processes of industrialization – democratization and the rise of the welfare state – allow for
the trickle-down of the benefits from rapid growth, and increase the per-capita income. Kuznets
believed that inequality would follow an inverted “U” shape as it rises and then falls again with the
increase of income per-capita.
Kuznets curve diagrams show an inverted U curve, although variables along the axes are often
mixed and matched, with inequality or the Gini coefficient on the Y axis and economic
development, time or per-capita incomes on the X axis
Inequality

Income per Capita

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Multiple Choice Questions

(Section 19)
J/02/3/19
1 Why might GNP per capita of different countries, measured in US$, be a poor indicator of
their comparative standards of living?

A Their exchange rates are different from purchasing power parities.

B Their population growth rates are different.
C Their rates of inflation are different.
D Their ratios of imports to national income are different.

J/04/3/16
2 A country's national income per head falls, but there is a rise in consumption.
What could explain this?

A a decrease in the net property income from abroad

B a fall in population
C an increase in the trade deficit
D a rise in negative externalities

N/04/3/19
3 A country‟s GDP declines but the welfare of its population rises.
What could explain this?

A a fall in leisure time

B a fall in the size of the subsistence sector
C a rise in positive externalities
D a rise in the size of the population

N/05/3/21
4 A government uses real personal disposable income as a measure of the standard of
living.
What does this measure not take into account?

A the distribution of income

B the level of national income
C the size of the population
D the average price level

J/07/3/19
5 Why might GNP per capita of different countries in a given year, measured in US dollars,
be a poor indicator of their comparative standards of living?

A Their exchange rates are different from purchasing power parities.

B Their population growth rates are different.
C Their rates of inflation are different.
D Their ratios of imports to national income are different.
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N/07/3/24
6 Between 2000 and 2004 Botswana experienced economic growth but there was a fall in
its Human Development Index.
Which combination of events could explain this apparent paradox?

aggregate demand productive capacity life expectancy

A increase increase increase
B increase increase decrease
C decrease decrease increase
D decrease decrease decrease

J/09/3/15
7 A country‟s national income per head increases.
What could explain why this is accompanied by a fall in households‟ standard of living?
A an increase in personal taxes
B an increase in the trade deficit
C an increase in population
D a rise in the exchange rate

N/09/3/25
8 An economy‟s GDP per capita grows over a certain period of time, but its development
when measured by the Human Development Index remains unchanged.
What could explain the difference?

A longer working hours

B increased pollution
C an increased crime rate
D a decline in life expectancy

J/10/3/13
9 A government requires all its young citizens to undertake community service for a period
of 6 months. The wages paid to those on the community service are below what they
would otherwise have earned.
What effect will this have on recorded GDP and on national welfare?

effect on GDP effect on national welfare

A reduction increase
B reduction uncertain
C unchanged increase
D unchanged uncertain

N/10/3/24
10 Which feature of the Indian economy could explain why the purchasing power parity
exchange rate of the Rupee is much higher than its market exchange rate?

A high levels of duty on imported goods

B high levels of rural unemployment
C the relatively low price of goods not traded internationally
D the relatively low rate of inflation
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N/11/32/16
11 Which change would directly affect a country‟s Human Development Index?

A a change in average hours worked by the labour force

B a change in life expectancy of the population
C a change in the level of carbon dioxide emissions
D a change in the size of the population

J/12/32/17
12 A government uses real personal disposable income per head as a measure of the
standard of living.
What does this measure not take into account?

A the distribution of income B the level of national income

C the size of the population D the average price level

J/12/32/18
13 The graphs indicate economic performance in a country between 2007 and 2010.
annual % increase in annual % increase annual % increase in
industrial production in consumer prices GDP
12 6
16

8 12 4
% % 8 %
4 2
4

0 0 0
07 08 09 10 07 08 09 10 07 08 09 10
Which conclusion may be drawn from the graphs?

A Between 2007 and 2008 industrial production and GDP fell but prices rose.
B Between 2008 and 2009 the rates of growth of industrial production, GDP and
prices all increased.
C GDP and industrial production were at their lowest in 2008.
D At no time did industrial production, GDP or prices fall.

J/13/32/17
14 National income statistics show that real GDP per head is 25% higher in country X than
in country Y.
Why might this difference exaggerate the gap in average living standards between the
two countries?

A Country X has a larger population than country Y.

B Country X has a higher rate of inflation than country Y.
C The proportion of services people provide for themselves is higher in country Y.
D The proportion of the country‟s industry which is owned by foreign firms is higher
in country Y.
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N/13/32/17
15 What might cause the growth of measured GNP to overstate the „true‟ rate of economic
growth in an economy?

A People move from unpaid housework to paid employment.

B The exchange rate is overvalued according to purchasing power parity.
C There is a reduction in environmental pollution.
D There is a reduction in the rate of investment in physical capital.

N/14/32/25
16 Which change would cause an increase in a country‟s Human Development Index?

A a decrease in gender inequality

B a decrease in income inequality
C an increase in the mean years of schooling
D an increase in the retirement age

J/15/32/14
17 When will a society have achieved an equitable distribution of income?

A when all individuals have equal job opportunities

B when all workers are paid wages equal to their marginal value product
C when the incomes within the society are equally distributed
D when the society believes that the distribution of income is fair

N/15/32/23
18 Gross Domestic Product (GDP) per head is an indicator sometimes used to compare
living standards of various countries. GDP is converted into a common currency at
market exchange rates.
What might cause this indicator to exaggerate the relative position of an individual
country?

A a high level of female participation in the labour force

B a high level of foreign ownership in domestic industry
C a high level of subsistence farming
D relatively low hours worked by the labour force

J/16/32/19
19 What would cause estimates of the money value of the „Measure of Economic Welfare‟
for a country to be greater than the value of „Gross National Product‟?

A negative externalities such as pollution

B property income received from abroad
C regrettable necessities
D the value of non-marketed activities and leisure
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J/16/32/20
20 In 2012 a United Nations report calculated the stock of wealth of 20 countries in terms of
human, natural and produced resources. This was measured as the Inclusive Wealth
Index (IWI).

The diagram shows the annual percentage (%) change in the IWI between 1990 and
2008 of the economies with the fastest and the slowest growth in IWI. It also shows their
2008 GDP per head ($).

GDP change in inclusive wealth index, 1990-2008 key

human
China 3404
Kenya 722 natural
Nigeria 1401 produced
Russia 11 704 inclusive
wealth index
–25 0 25 50 75
%
What can be concluded from the diagram?

A A low level of GDP per head meant an inability to build stocks of wealth.
B No country was able to prevent depletion of its natural resources.
C The faster the growth in a country‟s IWI the higher was its GDP.
D There was an increase in human resources in all four countries.
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Section: 20 Equilibrium National Income

(Circular flow of National Income)
National output/product shows the market value of goods and services produced in a country in a
year‟s time.

National income shows the income earned by factors of production employed to produce goods
and services in a country.

Since a product‟s market value equals the payments made to production factors, national income
(Y) always equals national output.

Y  output is the most important identity in macro economies and shows that a country‟s income
is the output the country‟s citizens produce.

Equilibrium in the economy can only be achieved when all goods and services produced are sold
i.e. Aggregate Expenditures (AE) equal national income (Y):

Y = AE or Y = E

Withdrawals or leakages represent the portion of income not spent on currently and locally made
goods and services. Withdrawals (leakages) reduce the demand for goods and services, resulting
in some of them to remain unsold. This disequilibrium prevails till demand is „injected‟ into the
economy, encouraging purchases of unsold goods. Equilibrium national income is thus arrived at,
when income (Y) equals expenditures (E) or withdrawals (W) equal injections (J).

Income (Y) = Expenditures (E)

Demand withdrawals (W) = Demand Injections (J)

Equilibrium National Income- a mathematical treatment

Expenditures (E) and withdrawals (W) are a direct function of income i.e. expenditures and
withdrawals rise whenever income rises.

E = f(Y) W = f(Y)

Income equals the sum of expenditures and withdrawals

Y=E+W
Y  E  W Δ (delta) is a symbol of change.
Dividing the entire equation by Δ Y
Y E W
 
Y Y Y

1 = MPE + MPW
1=e+w

e (or MPE, marginal propensity to spend) is the fraction of an added £ in income that is spent.
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w (or MPW, marginal propensity to withdraw) is the fraction of an added £ in income that is not
spent and withdrawn from the system.
To satisfy the above equation, values of MPE and MPW must lie between zero and one and add
up to 1. If MPE is 0.8, MPW becomes 0.2, implying that an additional income of £100 raises
expenditures by £80 and withdrawals by £20.
E W
MPE  e  MPW  w 
Y Y
E  e. Y W  w . Y
 0.8  100  0.2  100
 80  20
For a linear expenditure function, marginal propensity to spend (MPE) and thus marginal
propensity to withdraw (MPW) are assumed to be constant.
Expenditures can further be split up into:

(i) Income induced expenditures: This component changes directly with income.
Mathematically, it is the product of marginal propensity to spend and income i.e. MPE.Y
or eY.
(ii) Income autonomous expenditures: This component does not change with changes in
income. Any change in income autonomous expenditures (A) is represented by a shift in
the expenditure function. Factors causing this, such as changes in interest rate are
discussed later.
An expenditure function can be represented in the form of a linear equation as follows:
E = A + eY
Where:
E = Aggregate Expenditures
A = Autonomous Expenditures
e = MPE = marginal propensity to spend
Y = National Income
Autonomous expenditures (A) form the vertical intercept of the expenditure function and marginal
propensity to spend, MPE or e represents the slope.
Equilibrium income is arrived at when:
Y=E
Y = A + eY
Y – eY = A
Y(1 – e) = A
1
Y A .
1 e
1
Y A . (1 = e + w or w = 1 – e)
w
Therefore, equilibrium income is the product of income autonomous expenditures (A) and the
inverse of marginal propensity to withdraw (w).
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Example: Calculate equilibrium income for an economy whose expenditure function is given by
the linear equation E = 150 + 0.8Y.
Answer: In the given equation, autonomous expenditures (A) are 150 and marginal propensity to
spend (e), 0.8. Marginal propensity to withdraw (w) is therefore 0.2 (MPW = 1 – MPE = 1 – 0.8).
and the inverse of marginal propensity to withdraw, 5.

Equilibrium income is given by:

1
Y A .
w
= 150 × 5
= 750

This figure for national income can be counter checked by examining the Y=E identity:
E = 150 + 0.8Y
= 150 + 0.8 (750)
= 150 + 600
= 750
1
Since marginal propensity to withdraw (w) is a fraction and its inverse   exceeds 1, any
w 
increase in (income autonomous) expenditures brings a multiplied increase in national income.
1
Y A .
1 e
1
Y  A .
1 e
1
Y  A .
w
A change in autonomous expenditures triggers a series of changes in income and expenditure,
the final change in income being larger than the initial change in expenditures.
1 1
or is the autonomous expenditure multiplier. In the example given above, the value of
1 e w
the multiplier is 5.
National income rises by 250 (to 1000) if autonomous expenditures increase by 50.
1
Y  A .
w
1
250  50 .
0.2
The following example illustrates how a certain change in expenditures leads to a series of
changes in income and expenditures and eventually, a larger increase in national income.
Assume that an increase of £1 in income raises expenditures by £ 0.9 and withdrawals by £0.1.
As expenditures by one individual become the earnings of another, assuming an increase in
autonomous expenditures of £1, income of „A‟ increases by £1 and his spending, by £0.9. This
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2 2
£0.9 becomes B‟s income, who raises his spending by £0.81 (0.9 × 0.9 or 0.9 i.e. e ) and the
process repeats itself infinitely as shown in the table below:

∆Y ∆E ∆W
A £1 £0.9 £0.1 ∆E = e (∆Y) = 0.9(1) = 0.9 =e
2
B £0.9(e) £0.81 £0.09 ∆E = e (∆Y) = 0.9(0.9) = 0.81 =e
2 3
C £0.81(e ) £0.719 £0.081 ∆E = e (∆Y) = 0.9(0.81) = 0.719 = e
3 4
D £0.719(e ) £0.656 £0.073 ∆E = e (∆Y) = 0.9(0.719) = 0.656 = e
4
E £0.656(e )
. . . .
. . . .
. . . .
. . . .
. . . .
. . . .
. . . .
_________________________________________
K = 10 9 1

The final change in income is calculated by summing up the contents of column 1, given by K.

K = 1 + 0.9 + 0.81 + 0.719 + 0.656 ……..

2 3 4 n
K = 1 + e + e + e + e …… e (i)
2 3 4 n+1
eK = e + e + e + e …… e (ii) (multiplying equation (i) by MPE = e)
n+1
K – eK = 1 – e (subtracting equation (ii) from (i))
n+1
Given that n is an extremely large number, e is almost zero and may safely be ignored.
K eK 1
Taking K common:
K 1e 1
1
K
1 e
1 1
Thus, it is proven that expenditure multiplier (K) is or . In the given example, autonomous
1 e w
expenditure multiplier is 10 and a change in autonomous expenditures by £1 changes national
income by £10.
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Squaring The Economic Cycle

Humorist Art Buchwald examines the multiplier
The recession hit so fast that no body knows exactly how it happened. One day we were land of
milk and honey and next day we were the land of sour cream and load stamps.
There is one explanation. Holberger, the Chevy salesman in Tomcat, called up Littelton of
Littleton of Menswear and Haberdashery and said, “Good News, the new Fords have just come in
and I have put aside one for you and your wife.
Littleton said, “I can‟t Holberger, my wife and I are getting a divorce. I am sorry but I can‟t afford a
car this year. After I settle with my wife, I will be lucky to buy a bicycle.”
Holberger Hung up. His phone rang after a few minutes.
“This is Bedcheck, the painter,” the voice on the other hand said. “When do you want me to start
painting the house?”
“I changed my mind” said Holberger, “I am not going to paint the house”
“But I ordered the paint” Bedcheck said. “Why did you change your mind?”
“Because Littleton is getting a divorce and he can‟t afford a new car”
That evening Bedcheck came home and his wife said, “The new color television set arrived from
Gladstone‟s TV shop”
“Take it back” Bedcheck told his wife.
“Why?” she demanded.
“Because Holberger is not going to have his house painted now that Littletons are having divorce.”
The next day Mrs. Bedcheck dragged the TV set in its carton back to Gladstone. “We don‟t need it”
Gladstone‟s face dropped. He immediately called his travel agent, Sandstorm. “You know the trip
you have scheduled for me to the Virgin Islands?”
“Right, the tickets are all written up”
“Cancel it! I cannot go. Bedcheck just sent back his TV because the Holberger didn‟t sell the car
to Littletons who are getting a divorce”
Sandstorm tore up the tickets and went over to see his banker, Gripsham. “I can‟t pay back my
loan this month because Gladstone cancelled his trip”
Gripsham became furious and when Rudemaker came to borrow money for his new kitchen,
Gripsham turned him cold. “How can I loan you money when Sandstorm hasn‟t repaid the money
he borrowed?”
Rudemaker called up the contractor, Eagleton and said he couldn‟t put a new kitchen...and
Eagleton lay off eight men.
Meanwhile, General Motors announced it was giving a rebate on its new models. Holberger called
Littleton. “Good news,” he said. “Even if you are getting a divorce, you can still afford a new car”.
“I am not getting a divorce,” Littleton said. “It was all a misunderstanding and we have made up”
“That‟s great” Holberger said. “Now you can buy the Ford”
“No way,” said Littleton. “My business has been lousy. I don‟t know why I keep the doors open”
“I didn‟t realize that” said Holberger.
“Do you realize that I have not seen Bedcheck, Gladstone, Sandstorm, Gripsham, Rudemaker or
Eagleton for more than a month? How can I stay in business if they do not patronize my store?
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Equilibrium Income (a Graphical Treatment)

Diagram 20.1 shows what a linear expenditure function looks like, where income/output is shown
along the x axis and expenditures along y axis. As explained before, the vertical intercept of the
expenditure function measures income autonomous expenditures (A) and its slope, marginal
 E 
propensity to spend (MPE) i.e.  .
 Y 
Diagram 20.1
E
E

MPE

A
Y= output

Locating equilibrium income graphically requires that a hypothetical 45º line be drawn, containing all
points where income equals expenditures. Consider points I, II & III in diagram 20.2. Whereas, income
is the same at all three, it equals expenditures at II only, since it lies on the 45º line. Expenditures
exceed income at point I and fall short of it at III. It is therefore concluded that all points at the 45º line
show equilibrium income, whereas those above it have expenditures exceeding income and those
below it have expenditures falling short of income (see diagram 20.3)

Diagram 20.2
E

Y=E
I
II

III

45º Y = output
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Diagram 20.3
E
Y=E

Y<E

Y>E

Y = output
Equilibrium income is achieved where the expenditure function intersects the 45º line. The two
are bound to intersect since the slope of the expenditure function (MPE) is a fraction and hence,
less than 1, the slope of the 45º line. Y1 in diagram 20.4 is one such point, showing equilibrium
income. At income levels below Y1, expenditures exceed income (since expenditure function is
above 45º line in this range) and at income levels above Y1, income is less than expenditures
(since expenditure function is below 45º line in this range).

Diagram 20.4
E
Y=E
E

Y = output
Y1
Changes in equilibrium national income
Changes in autonomous expenditures change equilibrium income by bringing about a shift in the
expenditure function.
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Diagram 20.5
E
Y=E
E1
E0

A1

A
Y = output
Y0 Y1
As shown in diagram 20.5, an increase in autonomous expenditures from A to A1 shifts
expenditure functions upwards from E0 to E1 and raises equilibrium income from Y0 to Y1.
Increase in national income is larger than increase in expenditure because of expenditure
multiplier.

We now proceed to the process of determining equilibrium income in three different kinds of
economics models:

1. Close Economy without Government (two sectoral model)

2. Close Economy with Government (three sectoral model)
3. Open Economy (four sectoral model)

Close Economy without Government

(two sectoral model)

As the name implies, a two sectoral model (or close economy without government) focuses on
two sectors, households and firms, and their respective expenditures: consumer expenditures (C)
and investment expenditures (I).
E=C+I

Consumer expenditures may take up any of the following forms:

(i) Non durable such as food and fuel
(ii) Durables such as furniture, cars, electronics
(iii) Services such as education, medical care, insurance etc.

In a two sectoral model, income is either consumed (C) or saved (S) so that:

Y=C+S

S includes savings of both households and firms- the portion of income which is not consumed in
the year it is earned.
S=Y–C
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Saving is negative (dissavings) when consumption exceeds current income. A household must
borrow money to finance its consumption expenditures in case they exceed its income. Borrowing
is thus a form of dissaving and repayment of loans is saving.
Marginal Propensities to Consume (MPC) and Save (MPS)
Y=C+S
∆Y = ∆C + ∆S
Y C S
 
Y Y Y
1 = MPC + MPS.
1 = c + s.

c (or marginal propensity to consume, MPC) is the fraction of an added £ in income that is
consumed.
s (or marginal propensity to save, MPS) is the fraction of an added £ in income that is saved.
In a close economy without government, the sum of MPC and MPS equals 1 and marginal
propensity to save is 1 – MPC. For example, where MPC is 0.8, MPS becomes 0.2 and an
additional income of £100 raises consumption by 80 and savings by 20.
C
mpc  mpc.Y  C 0.8 × 100 = 80
Y
S
mps  mps. Y  S 0.2 × 100 = 20
Y

According to John Maynard Keynes, consumption (C) and savings (S) are a function of income:

C = f(Y) S = f(Y)

Every change in income brings about changes in both consumer expenditures, C and saving, S
so that values of MPC and MPS can never be zero and must be less than 1.
Keynes suggested two components of consumption: autonomous consumption (Co) and induced
consumption (c.Y). The former represents the portion of total consumption not varying with
changes in income. Determinants of autonomous consumption include wealth, savings from
previous years, availability of loans and interest rates. Induced consumption (c.Y) is that portion
of consumption that varies directly with income. Keynesian consumption function is thus given by
the linear equation:

C = Co + cY

where
C = consumption
Co = Autonomous consumption
MPC = c= marginal propensity to consume
Y = income
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Diagram 20.6
C
C

MPC= c

Co
Y = output
Diagram 20.6 shows a consumption function with income/output along x axis and consumer
expenditures along y axis. The vertical intercept of the linear consumption function is given by
autonomous consumption (Co) whereas marginal propensity to consume, c, is its slope.

Given the consumption function, the saving function can automatically be determined as:

Y=C+S
S=Y–C
C = Co + cY
S = Y – (Co + cY)
= Y – Co – cY
= –Co + Y – cY
Taking Y common:
= –Co + (1 – c)Y
= –Co + sY

Thus, the saving function is given by:

–Co + sY

where
Co = Autonomous consumption
S = MPS = marginal propensity to save = 1 – MPC = 1 – c
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Diagram 20.7
S

MPS= s
Savings
Y = output
– Co
Dissavings Y1

Diagram 20.7 shows a saving function with income/output along x-axis and savings along y axis.
–Co shows the vertical intercept of the saving function whereas its slope measures marginal
S
propensity to save i.e. MPS = s = .
Y
Vertical intercepts of consumption and saving functions are equal but their signs are opposite and
their sum equals zero. The sum of MPC and MPS i.e. the slopes of consumption function and
saving function always equals 1. Try attempting the following question:
In which situation are consumption and saving functions parallel?

Average Propensities to Consume (APC) and Save (APS)

Average Propensity to Consume (APC) is the ratio of total consumption (C) and total income (Y)
C
APC 
Y
Likewise, Average Propensity to Save (APS) is the ratio of saving (S) and income (Y).
S
APS 
Y
Now, Y C  S

Y C S
 
Y Y Y

1 = APC + APS.

The sum of both APC and APS, and MPC and MPS equals 1 so that:

APC + APS = MPC + MPS = 1.

For a linear consumption function, MPC is a fraction and constant throughout. However, APC
may be higher than 1 if consumption exceeds income and savings are negative (dissavings). In
diagram 20.7, this happens at all income levels below Y1.Thus at income below Y1, APC exceeds
1 and APS is negative.
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When Y = Y1 S=0 APS = 0 Y=C APC = 1

When Y < Y1 S<0 APS < 0 C>Y APC > 1
When Y > Y1 S>0 APS > 0 C<Y APC < 1

Consider table 20.1 where consumption exceeds income at all income levels below 500 and
saving is negative. APC exceeds 1 and APS is negative for this income range. APC equals
1(since consumption equals income) at the income of 500, and APS is zero. At income levels
higher than 500, APC is a fraction and APS exceeds zero.

Relationship between Average and Marginal Propensities to Consume

C  Co  cY
C Co  cY Co cY Co
APC      c
Y Y Y Y Y
Given that autonomous consumption, Co and marginal propensity to consume, c are constant,
APC decreases whenever Y increases. However, APC is always higher than MPC as Co is
positive. Thus, for a linear consumption function, APC always exceeds MPC but decreases
whenever income increases.

Relationship between APS and MPS

S   Co  sY
S Co  sY Co sY Co
APS      s
Y Y Y Y Y
Co
Given that Co is negative, any increase in income reduces and hence increases APS.
Y
However, APS is always less than MPS.

Therefore, the following hold true for a linear consumption function (Co > 0):

 MPC and MPS are constant

 APC decreases whenever income increases
 APC always exceeds MPC
 APS increases whenever income rises
 APS is always less than MPS.

If Co = 0, the consumption function becomes C = c.Y and the saving function, S = s.Y

C cY
APC    mpc
Y Y
S s .Y
APS    mps
Y Y

Table 20.1 drawn assuming C= 100+0.8Y confirms the above mentioned observations.
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Table 20.1
Y C S MPC MPS APC APS
0 100 -100 0.8 0.2 - -
100 180 -80 0.8 0.2 1.8 -0.8
200 260 -60 0.8 0.2 1.3 -0.3
300 340 -40 0.8 0.2 1.13 -0.13
400 420 -20 0.8 0.2 1.05 -0.5
500 500 0 0.8 0.2 1 0
600 580 20 0.8 0.2 0.97 0.03
700 660 40 0.8 0.2 0.94 0.06

For a linear consumption function where Co = 0:

 MPC and MPS are constant
 APC and APS are also constant
 APC always equals MPC
 APS always equals MPS

Table 20.2 drawn assuming C= 0.8Y confirms the above mentioned observations.

Table 20.2
Y C S MPC MPS APC APS
0 0 0 0.8 0.2 - -
100 80 20 0.8 0.2 0.8 0.2
200 160 40 0.8 0.2 0.8 0.2
300 240 60 0.8 0.2 0.8 0.2
400 320 80 0.8 0.2 0.8 0.2
500 400 100 0.8 0.2 0.8 0.2
600 480 120 0.8 0.2 0.8 0.2
700 560 140 0.8 0.2 0.8 0.2

When MPC is 0.5, MPS is also 0.5 and the two thus become equal. This is the only possibility of
the consumption and saving functions becoming parallel to each other.

 C 
The slope of the consumption function   gives marginal propensity to consume whereas the
 Y 
C 
slope of a straight line drawn from origin shows average propensity to consume   . Consider
Y 
II
diagram 20.8 where slope of the consumption function (MPC) is given by whereas that of the
III
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I  II
dotted line drawn from origin (APC) at income of Y is given by . APC therefore exceeds
III
MPC. In order to calculate APC at a higher income level, another straight line can be drawn from
origin. Such a line is flatter than the dotted line shown below, implying APC decreases whenever
income increases.

Diagram 20.8
C
C
I
II
III

Co
Y = output
Y
Diagram 20.9 shows the case where Co is zero and hence MPC equals APC at all points.

Diagram 20.9
C
C

Y = output

Non-linear composition function

A linear consumption function assumes that marginal propensity to consume, MPC, is the same
for people from different income groups whereas in reality, poor people are likely to have a higher
MPC as they tend to spend more out of additional income and save less. With time however, the
ability to save increases with additional income so that richer people possess a lower MPC.

The consumption function shown in diagram 20.10 is therefore, flatter at higher income levels as
MPC falls with every increase in income. Decreased MPC means MPS must be rising, hence
implying a saving function that gets steeper at higher income levels.
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Diagram 20.10
C C

Co
Y = output

Co Co
In diagram 20.10, decreases along the consumption function. Since APC   mpc and
Y Y
Co
both and mpc decline over the given function, APC decreases with every increase in income.
Y
Any increase in APC implies an offsetting decrease in APS as the sum of APC and APS equals 1.
Thus, APS decreases along the consumption function. Whereas APC exceeds MPC throughout
Co
the range of income, APS stays below MPS since APS  mps  . Summarizing whatever is
y
explained in diagram 20.10:
 MPC falls throughout
 MPS rises throughout
 APC decreases throughout
 APS rises throughout
 APC exceeds MPC at all points
 APS is less than MPS at all points
A consumption function may rarely be similar to the one shown in diagram 20.11. This
consumption function is steeper at higher income levels i.e. MPC increases whenever income
increases. Saving function in this situation, is flatter at higher income levels meaning MPS
decreases when income increases.
Diagram 20.11
C C

Co
Y = output
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Co Co
falls with increases in income but MPC increases so that effects on APC(given by  m pc )
Y y
are ambiguous- it may increase or decrease.

Thus, along the consumption function shown in diagram 20.11:

 MPC rises
 MPS falls
 APC can increase or decrease
 APS can increase or decrease
 APC always exceeds MPC
 APS is always less than MPS

Investment Expenditures
Investment expenditures are of three types:

(i) Fixed capital formation i.e. the purchase of fixed assets such as plant and machinery,
equipment and fixtures.
(ii) Changes in inventories: Firms maintain inventories (stocks), which are further
categorized into:

(a) Raw material prior to use

(b) Finished goods prior to sale
(c) Work in progress (WIP)
Inventory investment is positive when stocks pile up and negative when stocks deplete.
(iii) New construction

It must be noted that only those activities are classified as investment expenditures that increase
demand for currently made goods and services. None of the following activities shows investment
as none increases the demand for currently made goods and services.
 Depositing money in a bank.
 Buying bonds
 Buying shares
 Buying second hand machinery or an old factory
 Buying property: However renovating old property could be regarded as investment
 Importing machinery
According to Keynesian theory, investments are income autonomous and do not depend on the
level of current income. Investment function is therefore given by:
I = Io
Determinants of investment
Rate of interest
Rate of interest is the cost of investment. For zero geared firms (firms raising finance wholly
through equity, with zero borrowings), interest rate is the opportunity cost of equity invested in a
business. Increased interest rates raise the opportunity cost of capital and discourage
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investments, thus, interest rates and quantity of investments move inversely. This inverse
relationship between rate of interest and quantity of investment may be explained using the
concept of Net Present Value (NPV). NPV is the difference between present value of cash inflows
and outflows. Projects with positive NPV are feasible and thus carried out by businesses.
Cashinflow
Present value  where r is the rate of interest and n, number of years.
1  r n
NPV = Cash InflowPV – outflow.

For any increase in interest rates, present value of cash flows and thus NPV decreases. Interest
rates may increase to an extent where positive Net Present Value becomes negative and
otherwise feasible projects become unattractive. A project is feasible as long as its internal rate of
return exceeds market interest rates. Internal rate of return, IRR or marginal efficiency of capital,
MEC is that discount rate which makes NPV zero. Projects with IRR below market interest rate
are not feasible and rejected.

Diagram 20.12 shows Marginal Efficiency of Capital, MEC. MEC slopes downwards, recording
projects in a descending order i.e. projects with lower IRR are shown later.

Diagram 20.12
Interest
rates (%)

r2
r1

MEC

Quantity of investments
I2 I1
Quantity of investment is shown along x axis and rate of return, r along y axis. At the market
interest rate of r1, all projects upto (and including) I1 are feasible and thus carried out. As the
market interest rate rises from r1 to r2, fewer projects remain feasible and investments decrease
from I1 to I2.

Future expectations
Investors‟ confidence is key to their investment decisions. Investors are more optimistic and
confident in booming economies, with sales and profits growing rapidly. They may want to invest
even if prevailing interest rate is high. In contrast, investors‟ pessimism caused by fear of
recession forces them to delay their investment plans. Even a decrease in interest rates may not
be sufficient to induce them to invest.
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Taxes
Since taxes are deducted from cash inflows, Net Present Value (Cash inflowspv – cash outflow)
and hence, investment decreases whenever taxes are raised.

Political and economic stability reduces the uncertainties associated with investments and
encourages people to invest more. Strong and sound infrastructure helps firms produce goods
and services at lower per unit cost, further encouraging investments. Government policies
regarding international trade also have a bearing on investment decisions e.g. trade protection for
a certain industry may trigger investments in that industry. Geographical disparities compel
governments to announce tax reliefs for businesses locating in less privileged and under
developed areas. This strategy of making capital mobile instead of labour not only reduces
regional disparities but also population pressure on major cities. Road congestion and over
utilization of civic resources is significantly reduced as villagers get jobs near their own residence.

Availability of cheap and skilled labour also encourages investment. Expensive labour, if
possessing a positive attitude to work and trained properly may cost firms less compared to
workers who accept a low wage but lack the ability and aptitude required to carry out the job
effectively. In such a case, „cheap labour costs more‟. Higher wages do not necessarily translate
into higher costs for the firms as workers‟ productivity may improve with wage. However, firms are
reluctant to invest wherever strong and militant trade unions demand wage increases in excess of
productivity improvements. Likewise, a national minimum wage legislation raises labor cost and
makes investments less feasible.

Law and order and availability of required inputs such as raw materials and sources of energy
also determine the level of investments.

Equilibrium National Income

(in 2 sectoral model)

In a close economy without government (two sectoral economy), income is either consumed or
saved.
Y=C+S

Expenditures in a two sectoral model are of two types: consumer expenditures (C) and
investment expenditures (I).
E=C+I

For the economy to be in equilibrium:

Y=E
C+S=C+I
S = I.

Saving is a demand withdrawal, the portion of income not spent on goods and services. Investment is a
demand injection, raising the demand for currently made goods and services.

Consumption function is given by a linear equation, C = Co + cY where Co is autonomous

consumption and c is marginal propensity to consume. Investments are assumed to be income
autonomous so that I = Io.Thus, expenditures in a close economy are given by:
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E C  I .
= Co  cY  Io
For equilibrium income,
Y E
Y  Co  cY  Io
Y  cY  Co  Io
Y 1 c   Co  Io

Y  Co  Io  Co  Io

1 1
1 c s
In a close economy without government:
 We consider two sectors: households and firms
 Expenditures are given by: consumer expenditures (C) and investment expenditures (I)
 Demand injection (J) is investment expenditure (I)
 Demand withdrawal (W) is savings (S)
 Autonomous expenditures, A equal Co + Io
 Marginal propensity to spend equals marginal propensity to consume- MPE = MPC
 Marginal propensity to withdraw equals marginal propensity to save- MPW = MPS
1 1
 Autonomous expenditure multiplier is given by or .
1 c s
In order to derive autonomous expenditure multiplier in a two sectoral model,
Y = E or Y = C+I (as E= C+I)

∆Y = ∆C + ∆ I

Dividing the equation by Δ Y:

Y C I
 
Y Y Y
I
1 c 
Y
I
1  c
Y
Y 1

I 1  c
Investment expenditure multiplier is therefore the ratio of change in income and change in
investment.
Y 1
K 
I 1 c

Example: Calculate equilibrium national income when C = 100 + 0.8Y and Io = 50.

Answer: Equilibrium income can be calculated in two ways:

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(i) Income Expenditure Approach

Y=E
Y=C+I
Y = 100 + 0.8Y + 50
Y – 0.8 Y = 150
Y(1 – 0.8) = 150
1
Y 150
1  0.8
1
= 150 
0.2
=150 × 5 = 750

or simply multiply the autonomous expenditures, 150 (Co + Io = 100 + 50) with 5, the inverse of
MPS (as MPS= 0.2)

(ii) Withdrawal-Injection Approach.

W=J
S=I

Saving is the only withdrawal (W) and investment, the only injection (J) in a two sectoral model.

I = Io = 50
S = –Co + sY

= – 100 +0 .2Y

S=I
–100 + 0.2Y = 50
0.2Y = 150
1
Y 150 
0.2
= 750

Question: What happens to equilibrium income if Investment increases by 50 for the data given
above?

Answer: Increased investment expenditures increase national income by 250 (to 1000).
Y
K 
I
Y  I . K
1
= I .
s
1
= 50 .
0.2
= 250
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A Situation of Disequilibrium
There is no guarantee of buyers‟ purchasing decisions matching the plans of producers to supply
a certain volume of goods and services. A state of disequilibrium results when either output (Y)
exceeds aggregate expenditures (E) or expenditures exceeds income.

Consider an economy where producers plan to supply output worth $1000 m but consumers plan
to spend $600m. Apart from an inventory investment of $50m, investors plan to buy new plant
and machinery (fixed capital formation) worth $300m so that total planned investment is $350m.
Total planned expenditures (consumer expenditures plus investment expenditure) are $950m and
thus fall short of available output, $1000m. Goods and services worth $50m are unsold.

These unsold goods are not wasted or thrown away, instead, they become part of inventories.
This addition in stocks is however, unplanned. Inventories pile up and inventory investment is
positive when planned expenditures fall short of income. On the other hand, inventories deplete
when planned expenditures exceed income and unplanned inventory investment is negative.

Actual expenditures include both planned and unplanned expenditures and always equal income
since unplanned expenditures act as a balancing item.

Income  Actual expenditures

Income  Planned + Unplanned expenditures
Equilibrium income is reached when unplanned expenditures are zero and income (Y) equals
planned expenditures (E) or planned withdrawals (W) equal planned injections (J).
Equilibrium National Income (two sectoral model)-Graphical analysis
Consider the two components of expenditures in a two sectoral model, consumer and investment
expenditures given by :
C = Co + cY I = Io = 50
= 100 + 0.8Y
Diagram 20.13(a) shows a linear consumption function, the vertical intercept of which shows
autonomous consumption (Co) and slope, marginal propensity to consume (MPC = c).

Diagram 20.13(a)
C
C

MPC= 0.8

Co = 100

Y = output
An investment expenditure function, as shown in diagram 20.13(b) is a straight horizontal line
implying that it is income autonomous.
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Diagram 20.13(b)
I

50 Io

Y = output
Diagram 20.13(c) shows the expenditure function. Its vertical intercept measures autonomous
expenditures, measured by the sum of individual intercepts i.e. 150 (A = Co + Io).

The slope of the expenditure function equals the slope of the consumption function
(MPC = MPE).

Diagram 20.13(c)
E
E=C+I

MPE =MPC = 0.8

A = Co + Io = 150
Y = output
The intersection of 45º line and expenditure function, given by the total of consumer and
investment expenditure functions, determines equilibrium income at 750(see diagram 20.15).

Equilibrium income may also be determined by the intersection of withdrawals and injections (J),
which in a two sectoral model means the intersection of savings and investments.

C = 100 + 0.8Y.
S = –100 – 0.2Y
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Diagram 20.14
S

MPS= 0.2

Y = output

–100

The vertical intercepts of the saving and consumption functions are equal in amount but differ in
signs. The slope of saving function measures MPS, marginal propensity to save. Its intersection
with investment function determines equilibrium income at 750 (see diagram 20.15)

Diagram 20.15
E
Y=E
E

150

45º Y = output
750
Investments
&
Savings

50 I0

Y = output
750

–100

Changes in equilibrium income

Increased autonomous expenditures shift the expenditure function and injections (J) upwards and
raise national income. Diagram 20.16 shows the initial expenditure function as Eo and injections
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(J), Io. Equilibrium income is 750. Increasing investment expenditures by $50m shifts the
expenditure and investment functions upwards by $50m and raises equilibrium income by $250m.
As explained earlier, the increase in national income exceeds the increase in autonomous
expenditures because of the multiplier effect (multiplier= 5 in this case).

Diagram 20.16
E Y= E
E1
E0

200
150

45º
Y = output
750 1000
Investments
&
Savings

S
100 I1

50 I0

Y = output
750 1000

–100
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Multiple Choice Questions

(Section 20)
J/02/3/21
1 The marginal propensity to consume in a country is 0.9 and the average propensity is
0.8.
What is the value of the multiplier?

A 1.1
B 1.25
C 5
D 10

N/03/3/21
2 The table shows the level of consumption at various levels of national income for a
closed economy with no government.

national income consumption

($ million) ($ million)
10 11
12 12
14 13
16 14
18 15
20 16

What happens to the average and marginal propensities to consume as income

increases?

average propensity marginal propensity

to consume to consume
A constant constant
B falls constant
C falls falls
D rises falls

J/04/3/17
3 In a closed economy with no government sector the multiplier shows the impact of a
change in

A consumption on investment.
B investment on national income.
C national income on consumption.
D national income on investment.
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J/04/3/18
4 The diagram shows an economy's consumption function.

C
consumption

O income
What might explain why the consumption function shifts over time?
A Autonomous consumption is greater than zero.
B Income is only one of several variables that affect consumption.
C The average propensity to consume falls as income increases.
D The marginal propensity to consume falls as income increases.

N/04/3/22
5 A country's initial consumption function is C1C1.

C2
C1
consumption C2

C1

O personal disposable income

What will cause the consumption function to shift from C 1C1 to C2C2?
A an increase in wealth
B an increase in interest rates
C an increase in personal disposable income
D an increase in the expected future rates of income tax

J/05/3/18
6 In a closed economy with no government, consumption is three-quarters of income at all
levels of income.
The present equilibrium level of income is $220 million.
The full employment level of income is $240 million.
By how much would investment have to increase to reach full employment?

A $5 million B $15 million

C $20 million D $30 million
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J/05/3/19
7 The diagram shows a shift in the economy's saving function from S1 to S2.
S2

S1
Y2 Y1
saving O
income

What can be deduced from the diagram?

A The multiplier has increased.
B The marginal propensity to save has increased.
C Autonomous consumption has increased.
D Equilibrium national income has fallen from OY1 to OY2.

J/06/3/20
8 A closed economy with no government has an equilibrium level of national income of
$10 000 million. Consumption expenditure is $8000 million.
Assuming that the MPC = APC what will be the change in national income following an
increase in investment of $100 million?
A $100 m B $120 m C $400 m D $500 m

N/06/3/21
9 In a closed economy with no government C = 30 + 0.8 Y and I = 50, where C is
consumption, Y is income and I is investment.
What is the equilibrium level of income?
A 64 B 80 C 250 D 400

J/07/3/22
10 The diagram shows the equilibrium levels of national income in a closed economy with no
government, at two levels of investment, I1 and I2.

saving / S
investment
X I2
I1
T Y

O
U Z national income

Which ratio gives the value of the multiplier?

TX UZ UZ XY
A B C D
UZ TX XY UZ
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N/07/3/21
11 The diagram shows a two-sector economy. Initially consumption is (C), investment is I1
and the equilibrium level of income is Y1. Investment increases to I2 giving a new
equilibrium level of income, Y2.

C + I2
U
T C + I1
consumption,
investment R S

45°
O Y1 Y2
real national income
What is the value of the multiplier?

RS RS RU TU
A B C D
TU RU TU RU
J/09/3/18
12 A country‟s initial consumption function is C1.

C1
C2
consumption

O personal disposable income

What would be most likely to cause the consumption function to shift from C 1 to C2?

A a decrease in personal disposable income

B a decrease in the expected future rates of income tax
C an increase in interest rates
D an increase in wealth
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J/09/3/19
13 In a closed economy with no government C = 30 + 0.7Y, where C is consumption and Y
is income.
The equilibrium level of income is 300.
What is the level of investment?
A 60 B 100 C 210 D 270

J/10/3/17
14 The diagram shows the relationship between household income and household
consumption.
C2

C1

household
consumption

O household income
What would be likely to cause the household consumption curve to shift from C 1 to C2?
A a decrease in household income
B a decrease in the value of household assets
C an increase in interest rates
D an increase in the expected future level of household income

J/10/3/18
15 The diagram shows a consumption function for a closed economy with no government.

consumption

45°
O Y
income
What can be concluded from the diagram?
A At income levels below OY, saving is negative.
B At income levels below OY, there is an inflationary gap.
C The equilibrium level of income is OY.
D The marginal propensity to consume increases as income increases.
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N/10/3/19
16 The diagram shows the relationship between consumption expenditure and income.

consumption

O income
Which statement is correct?

A The average propensity to consume is constant.

B The average propensity to consume is rising.
C The marginal propensity to consume is equal to the average propensity to
consume.
D The marginal propensity to consume is less than the average propensity to
consume.

J/11/32/16
17 The diagram shows a consumption function.

consumption

45°
O personal disposable income
As income increases, what happens to the average propensity to save and the marginal
propensity to save?

average propensity marginal propensity

to save to save
A decreases decreases
B decreases increases
C increases decreases
D increases increases
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J/13/32/30
18 Without any change in government policy, what will be the effect of an economic
recession on tax revenue and on government expenditure?

government
tax revenue
expenditure
A decrease decrease
B decrease increase
C increase increase
D increase decrease

N/14/32/23
19 In a closed economy with no government C = 40 + 0.8 Y and I = 60, where C is
consumption, Y is income and I is investment.
What is the equilibrium level of income?

A 80 B 100 C 300 D 500

J/15/32/21
20 In a closed economy with no government, investment increases by $400.
At the new equilibrium level of income, consumption has increased by $1200.
What is the value of the investment multiplier?

A 2 B 3 C 4 D 8
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Section: 21 Close Economy with Government

(3 sectoral economy)
Analysis of a three sectoral economy introduces a third sector to us- the government, the
influence of which stems through three powerful sources:

(i) Government expenditures (G)

(ii) Net Taxes (T) = Direct taxes – transfer payments
(iii) Government lending and borrowing

Government budget, a statement of its expenditures and revenues is decided upon few months
before a financial year begins so that government expenditures do not depend on the level of
income of the year in which they are spent. Government expenditures are thus autonomous and
given by:
G = Go

Taxes can either be autonomous or induced. Autonomous taxes (T = To) do not change with
changes in national income. Although a real life example of autonomous taxes is impossible to
find, the poll tax in UK (a tax on every adult member of population irrespective of his income) may
be considered a good example.

Disposable income, Yd is income less net taxes and therefore decreases whenever taxes rise

Yd = Y – T

Equilibrium Income in a Close Economy with Government

Consider the three types of expenditures in a three sectoral model: consumer expenditures (C),
investment expenditures (I), Government expenditures (G).

E=C+I+G

Consumption function is given by: C = Co + cYd

Taxes are assumed to be income autonomous: T = To

C = Co + c(Y – T)
= Co + c(Y – To)
= Co + cY – c To

As known, investment and government expenditures are income autonomous.

I = Io
G = Go

Now, E=C+I+G
E = Co + cY – cTo + Io + Go
Y=E
Y = Co + cY – cTo + Io + Go
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Y – cY = Co + Io + Go – cTo

Taking Y common:
Y (1– c) = Co + Io + Go – cTo
1
Y  (Co  Io  Go - cTo)
1- c
Example: Calculate equilibrium national income for the economy with:

C = 100 + 0.8Yd
I = Io = 100
G = Go = 75
T = To = 50

Answer:

C = 100 + 0.8Yd
= 100 + 0.8 (Y – T)
= 100 + 0.8 (Y – 50)
= 100 + 0.8 Y – 40
= 60 + 0.8Y

I = 100
G = 75

E=C+I+G
E = 60 + 0.8Y + 100 + 75
= 235 + 0.8Y

Y=E
Y = 235 + 0.8Y
Y – 0.8Y = 235
Y (1 – 0.8) = 235
1
Y = 235 ×
1  0 .8
= 235 × 5
= 1175

Alternatively, national income may be calculated by directly multiplying autonomous expenditures

with the expenditure multiplier. Autonomous expenditures equal Co + Io + Go – cTo
(100 + 100 + 75 – 40 = 235) and the multiplier, 5 so that equilibrium income becomes 1175.

It must be noted that only a fraction of tax, cTo is deducted from autonomous expenditures and
not the entire tax amount. Taxes reduce disposable income by 50 and consumption (and hence
expenditures) by 40 since marginal propensity to consume is 0.8.

Equilibrium income may also be determined using the withdrawals and injections approach. In
this model, withdrawals are given by Savings (S) as well as Taxes, T, as they represent the
portion of income paid to the government and hence unavailable to spend on goods and services.
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Withdrawals = Savings + Taxes

W=S+T

Investment expenditure (I) injects demand into the economy and so does government
expenditure (G).

Injections = Investments + government expenditures

J=I+G

Equilibrium income is achieved when demand withdrawals equal demand injections

W=J
S+T= I+G

The following procedure shows how equilibrium national income is calculated:

S = –100 + 0.2Yd (Saving function is obtained by deducting consumption function from income)

I = Io = 100
G = Go = 75
T = To = 50

S+T=I+G
–100 + 0.2Yd + 50 = 100 + 75
0.2(Y – T) = 175 – 50 + 100
0.2(Y – 50) =225
0.2Y – 10 =225
0.2Y = 225 + 10
0.2Y = 235
1
Y  235
0.2
= 1175

As expected, income calculated through income expenditure and leakages injections approaches
is the same.

As stated earlier, government budget is a statement of its revenues (mainly taxes) and
expenditures. A budget surplus is said to occur when tax revenues exceed government
expenditures whereas a deficit results from tax revenues falling short of government
expenditures. When taxes equal expenditures, we have a balanced budget. Budget deficit means
a demand injection and budget surplus, demand withdrawal.

Government budget need not be balanced for equilibrium to hold in a close economy with
government. Equilibrium income may still be achieved in case of a budget deficit, if savings
exceed investments.

Example: Consider a budget deficit of Rs.20 bn and investment expenditures, I worth Rs.70 bn.
Calculate savings, S for such an economy in equilibrium.

Answer: Budget deficit implies government expenditures, G exceed tax revenues, T by Rs.20 bn.
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S+T=I+G
S = I + (G – T)
= 70 + 20
= 90

Budget deficits show governments‟ dissaving. Private sector saving must therefore exceed
private sector investment expenditures for the economy to be in equilibrium. In the example given
above, savings exceed investment expenditures by 20 i.e. private sector surplus equals public
sector (government) deficit and thus, the economy is in equilibrium.

Summing up, in a three sectoral model (when taxes are autonomous):

 There are 3 sectors: households, firms and government
 Expenditures are: consumer expenditures (C), investment expenditures (I) and
government expenditures (G)
 The two demand injections (J) are investment expenditures (I) and government
expenditures (G)
 The two demand withdrawals (W) are savings (S) and Taxes (T)
 Autonomous expenditures are given by: A = Co + Io + Go – cTo
 Marginal propensity to spend equals marginal propensity to consume i.e. MPE = MPC
 Marginal propensity to withdraw equals marginal propensity to save i.e. MPW = MPS
1 1
 Autonomous expenditure multiplier is given by or .
1 c s

Equilibrium National Income (Three Sectoral Economy)-

Graphical Analysis
Consider consumer, investment and government expenditures being given by following
equations:

C = Co + cYd I = Io = 100 G = Go = 75
= 100 + 0.8Yd
= 100 + 0.8(Y – T)
= 100 + 0.8(Y – 50)
= 100 + 0.8Y – 40
= 60 + 0.8Y

T = To = 50

Diagram 21.1(a) shows consumption function C1 without taxes. The imposition of autonomous
taxes equaling 50 causes a parallel shift of the function downwards by 40, so that C 2 lies below
C1 but possesses the same slope or marginal propensity to consume. Disposable income is
reduces by 50 at every income level and consumption, by 40 as marginal propensity to consume
is 0.8.
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Diagram 21.1(a)
C C1
C2

100
c.T = 0.8 × 50 = 40
60
Y = output
Given that consumption function is given by C = 100 + 0.8Yd, saving function becomes S = –100
+ 0.2Yd. The imposition of autonomous taxes of 50 decreases disposable income by 50 and
savings by 10 (MPS × T = 0.2 × 50) at every income level. Autonomous taxes cause a downward
parallel shift in the saving function, as shown in diagram 21.1(b).

Diagram 21.1(b)
S

S1
S2

Y = output

MPS . T –100
–110
Autonomous taxes therefore:
 do not alter the slope of consumption, saving and expenditure functions
 reduce the vertical intercepts of consumption and expenditure functions by an amount
equaling the product of marginal propensity to consume and the amount of tax levied
 reduce the vertical intercept of saving function by an amount equaling the product of marginal
propensity to save and the tax amount

Diagrams 21.1(c) & (d) show investment and government expenditure functions as straight,
horizontal lines as they are income autonomous.
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Diagram 21.1(c)
I

100 I0

Y = output

Diagram 21.1(d)
G

75 G0

Y = output
We may now aggregate these expenditure functions (consumer, investment and government) as
shown in diagram 21.1(e). The vertical intercept shows autonomous expenditures, A, as 235- the
sum of (Co – cTo), Io and Go (75 – (0.8 × 50) + 100+75 = 235). The slope of the expenditure
function is given by marginal propensity to consume (MPE=MPC) as slopes of government and
investment functions are zero.
Diagram 21.1(e)
E
E=C+I +G

MPE =MPC = 0.8

235

Y = output
The upper panel in diagram 21.2 shows how equilibrium income is determined by the intersection of
the 45º line and the expenditure function. The lower panel demonstrates the injection and
withdrawal approach for a three sectoral model, where injections are given by investment and
government expenditures (Io + Go = 100 + 75= 175) and withdrawals, by savings and taxes. As
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shown in diagram 19.2 and explained earlier, autonomous taxes shift the saving function downward
by 10. This shift decreases the vertical intercept of saving function to -110 (see diagram 21.1 (b)).
Since taxes are 50, the vertical intercept of withdrawal function becomes –60 (–110 + 50).
It must be noted that the vertical intercept of the expenditure functions equals demand injections‟
intercept less withdrawals‟ (175- (-60)= 235). The product of autonomous expenditures, 235, and
expenditure multiplier, 5 determines equilibrium income at 1175.

Diagram 21.2
E
Y=E
E

235

Y = output
1175
Investments
&
Savings

S+T
175

Y = output
1175
–60

Impacts of changes in autonomous taxes on equilibrium income

The concept of the tax multiplier is crucial to understanding the impact on equilibrium income, of
changes in autonomous taxes. The autonomous tax multiplier is less than the expenditure
multiplier since the imposition of taxes changes expenditures by only a fraction of the tax amount.
Increased taxes reduce consumer expenditures by an amount equaling the product of the tax
amount and marginal propensity to consume.
The tax multiplier may be derived as follows:
1
Y A 
1 e
1
Y  (Co  Io  Go - cTo)
1- c
1
Y  (Co  Io   Go - cTo)
s
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c
Y  To (  ) assuming that Co, Io and Go remain unchanged
s
The equation above shows how changes in income may be calculated when autonomous taxes
c
change.  shows the autonomous tax multiplier, which is negative since national income
s
decreases when taxes rise. The value of the autonomous tax multiplier is less than that of the
expenditure multiplier by 1.
Autonomous tax multiplier = 1 - Autonomous expenditure multiplier
c 1
 1
s s

Transfer Payment Multiplier

Net taxes are taxes less transfer payments i.e. payments received but not earned like pensions,
unemployment allowances, old age benefits and social security payments. They are excluded
from national income since no production activity takes place against such payments.
Transfer payment multiplier is positive since increased transfer payments raise disposable
income, consumption and hence national income. The co-efficient of transfer payment multiplier
however, equals that of the autonomous tax multiplier.
c
Transfer paymentmultiplier 
s
Question: Explain the impact on national income if taxes and pensions rise by the same amount
Answer: Whereas increased taxes decrease national income, increased transfer payments have
an expansionary effect on it. Change in national income equals the sum of changes resulting from
changes in both taxes and transfer payments
c c
Y   transfer payments    taxes 
s s
Y  transfer payment  taxes 
c
s
Increasing taxes and transfer payments by the same amount has a neutral impact on national
income. However, the transfer payment multiplier may differ from the tax multiplier in reality.
Pension holders are relatively poor and have no option but to spend a higher fraction of their
income, thus their marginal propensity to consume is likely to exceed that of tax payers who are
usually rich and able to save more, implying a lower MPC. Thus tax multiplier is likely to be less
than the transfer payment multiplier so increasing taxes and pensions by the same amount may
have an expansionary effect on national income.

It must be noted however, that increased taxes reduce the post tax wage rate and assuming an
upward rising supply curve for labour, induce workers to work for fewer hours. Likewise,
increased pensions may prompt workers to seek early retirements. The combined effect on
national income of increased taxes and pensions in this case is contractionary, as such a policy
dampens the incentive to work.
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Induced Taxes
Induced taxes are those, the amount of which varies directly with income. In a linear equation, the
tax rate, t, stays the same so that induced taxes may be given by the following equation:

T = tY

Equilibrium income in a close economy with government and induced taxes are induced may be
calculated in the following manner:

Yd = Y – T
T = tY

C = Co + cYd
= Co + c(Y – T)
= Co + c(Y – tY)
= Co + cY – c tY

I = Io
G = Go

E=C+I+G
E = Co + cY – ctY+ Io + Go

Y=E
Y = Co + cY – ctY + Io + Go
Y – cY + ctY = Co + Io + Go
Taking Y common:
Y (1– c + ct) = Co + Io + Go
Taking c common:
Y (1– c (1 – t)) = Co + Io + Go
1
Y  (Co  Io  Go)
1- c 1 t 
Diagram 21.3 shows expenditure function E1 without taxes, with its slope equaling both marginal
propensities to spend and consume (MPE = MPC). Induced taxes reduce expenditures and
cause the function to shift downwards to E2, which has a smaller slope equaling MPC(1 – t). The
vertical intercept of the expenditure function remains unchanged.
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Diagram 21.3
E
E1
MPE = MPC

E2

MPE = MPC(1– t)

A
Y = output

Induced taxes do not change the vertical intercept but reduce the slope of the expenditure function
whereas autonomous taxes do not change the slope but reduce the vertical intercept.
Induced taxes also create a divergence between marginal propensities to spend and consume,
which were equal so far. Marginal propensity to spend decreases after the imposition of induced
taxes and equals MPC (1 – t). The new expenditure function is flatter and decreases equilibrium
income since it intersects the 45º line at a lower income level.

After taxes
Expenditure function Without taxes
Autonomous taxes Induced taxes
Vertical intercept (A) C0 + I0 + G0 C0 + I0 + G0 – cTo C0 + I0 + G0
Slope (MPE) MPC MPC MPC (1 – t)

To understand the difference between marginal propensity to spend (MPE = e) and marginal
propensity to consume (MPC = c) assume that MPC before tax equals 0.8 and tax rate, 20% so that
increased income of £1 raises taxes by £0.2 and disposable income by £0.8. Consumers increase
spending by £0.64 (MPC × ∆Yd = 0.8 × 0.8) and savings by £0.16 (MPS × ∆Yd = 0.2 × 0.8).

Marginal propensity to spend is a fraction of an added £ in income that is spent, 0.64 in this case.
MPE = MPC (1 – t) = 0.8 (1 – 0.2) = 0.8 (0.8) = 0.64
1
The autonomous expenditure multiplier is and decreases whenever the tax rate rises.
1  c 1  t 
Marginal propensity to tax, MPT is the fraction of an added £ in income that is taxed. It equals tax
rate, t, if tax rate does not change with changes in income.

In the example given above, marginal propensity to consume is 0.8 and tax rate is 0.2. Plugging
these values in the formula for expenditure multiplier, we get:
1 1 1 1 1
=     2.78
1  c 1  t  1 0.8 1 0.2 1 0.8 0.8 1 0.64 0.36
We observe that the expenditure multiplier is the inverse of marginal propensity to withdraw, the
sum of marginal propensities to save and tax.
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MPW = MPS + MPT

1 1 1 1
e=     2.78
MPS  MPT s  t 0.16  0.20 0.36

Marginal propensity to save before tax is 0.2 (since marginal propensity to consume is 0.8) but
marginal propensity to save after tax is 0.16 since increased income of £1 increases disposable
income by £0.8 (taxes increase by £0.2) and savings increase by £0.16. Marginal propensity to
tax is 0.2. Marginal propensity to withdraw equals the sum of marginal propensity to save (post
taxes) and marginal propensity to tax.

Inflationary and Deflationary Gaps

Full employment level of national income is obtained when all available factors of production are
fully utilized to produce output. Inflationary or deflationary gaps result whenever an economy
produces an output level where its equilibrium differs from the full employment income level.

Inflationary or deflationary gaps are the vertical distances between the 45º line and expenditure
function at full employment. Diagram 21.4(a) shows an economy operating at full employment
output level. The 45º line and expenditure function coincide at Ye, hence there is neither an
inflationary nor a deflationary gap.

Diagram 21.4(a)
E
Y= E
E

o
45 Y = output
Y e = Yf
Diagram 21.4(b) shows a deflationary gap, which occurs when the expenditure function lies below
the 45º line at the full employment level of output. The economy produces an output level below
that of full employment and hence faces unemployment. „ab‟, the vertical distance between the
expenditure function and the 45º line measures the deflationary gap at full employment. The gap
in output is represented by the difference between output at full employment and the output
currently made.
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Diagram 21.4(b)
E
Y= E
a
E
b

Y = output
Ye Yf

Output gap
An inflationary gap, „cd‟ is shown in diagram 21.4(c), occurring when the expenditure function lies
above the 45º line at the full employment level. In this case, the economy is overheated and
produces at an output level above full employment.

Diagram 21.4(c)
E

Y= E
E
c
d

o
45 Y = output
Yf Ye

Output gap

Filling inflationary and deflationary gaps

Deflationary gaps can be eliminated by increasing autonomous expenditures, which through the
multiplier effect, bring about a larger change in national income. A deflationary gap may be filled
in the following ways:

(i) Government expenditures increase

(ii) Taxes decrease
(iii) Governments wanting balanced budgets increase their spending and taxes by the same
amount

Diagram 21.5(a) shows an expenditure function E1 with vertical intercept A and slope (MPE), 0.8.
The economy produces output worth 800 whereas income at full employment is 1000. There
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exists an output gap of 200 and a deflationary gap, „ab‟. Students are urged to calculate this gap,
along with the value of A before they discover the answers in the ensuing text.

Diagram 21.5(a)
E
a Y=E

b E1

o
45
Y = output
800 1000
The vertical intercept may be calculated as follows:
1
Y  A.
1 e
1
800  A.
1  0.8
800 = A.5
A = 160

Point „a‟ lies on the 45º line, thus income and expenditures equal each other at this point.
However, point „b‟ is below 45º line showing that expenditures fall short of income. Expenditures
at „b‟ (full employment level) may be calculated by as:

E = A + eY = 160 + 0.8 (1000) = 160 + 800 = 960

Question: Calculate the vertical intercept of the withdrawal function for the given example,
assuming autonomous demand injections are 50.

Answer: The vertical intercept of the expenditure function, A measures the difference between
the intercepts of demand injections and demand withdrawals.
A = Vertical intercept of demand injections – vertical intercept of demand withdrawals

Vertical intercept of demand withdrawals = vertical intercept of demand injections – A

= 50 – 160
= –110

The vertical distance between the 45º line and the expenditure function or between injections and
withdrawals functions at full employment level captures the deflationary gap. This gap, equaling
40 in the given example may be filled if government spending, G, increases by 40 or taxes
decrease by an amount higher than 40. Since the tax multiplier is less than the expenditure
multiplier, a greater change in taxes is required to bring about the same desired change in
national income.
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Can you calculate the needed change in taxes to fill this deflationary gap?

Diagram 21.5(b)
E
Y=E
1000 a
E
960
b

160

45o
Y = output
800 1000

Leakages
&
Injections

S
90
50 I0

Y = output
800 1000

–110

Impacts of increased government spending on national income

Diagram 21.6(a) shows what happens if the government decides to raise spending by 40. The
expenditure function shifts upwards and raises equilibrium national income to 1000. As may well
be known by now, increase in national income is larger than increase in expenditures because of
the multiplier effect (multiplier=5 in this case).

The lower panel shows that increasing government expenditures shifts the injection function
upwards from Io to (Io + G). Equilibrium income which is determined by the intersection of
injections and withdrawals functions increases from 800 to 1000.
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Diagram 21.6(a)
E Y= E
E1 = C + I + G
E0 = C + I

200
160

o
45
Y = output
800 1000
Leakages
&
Injections

S
90 I0 + G

50 I0

Y = output
800 1000

–110

Impacts of decreased taxes on national income

The tax multiplier is negative and less than the expenditure multiplier by 1. Since the latter is 5,
the tax multiplier is -4. Taxes must be decreased by 50 if national income is to increase by 200
and reach full employment.

∆Y = ∆T.Tax multiplier
= ∆T (-4)
Y 200
T     50
4 4

Consider the upper panel in the pair of diagrams shown in figure 21.6(b). Decreasing taxes by 50
raises disposable income by 50 and spending by 40 (MPC . ∆Yd = 0.8 × 50). This increase in
consumer expenditures shifts the expenditure function upwards, from Eo to E1 by 40 and
increases national income from 800 to 1000.

The lower panel shows how decreased taxes shift the withdrawal curve (So + T) downwards by
50. Taxes, which were assumed to be 50, become zero and savings remain the only withdrawal.
However, decreased taxes raise disposable income by 50 and savings by 10 at every income
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level so the saving function shifts upwards by 10. The new saving function, S 1 intersects the
injection function, Jo at an equilibrium income of 1000.
Diagram 21.6(b)
Y=E
E
E1
E0

200
160

45o
Y = output
Leakages 800 1000
&
Injections

S0 + T

S1
S0
50 J0

Y = output
800 1000

–110

–150
–160

Impacts of a balanced budget policy on national income

Changes in government spending and taxes of the same amount and direction change national
income with the same amount and in the same direction. Governments willing to pursue a
balanced budget may raise government spending and taxes by 200 to fill the deflationary gap and
increase national income by 200. Increasing government spending, G, by 200 increases national
income by 1000:
∆G.K = ∆Y
200 . 5 = 1000
Increasing taxes by 200 reduces equilibrium income by 800.
∆To.Tax multiplier = ∆Y
200.(–4) = –800
The resulting effect is an increase in national income of 200. The balanced budget multiplier is
the sum of the autonomous expenditure and tax multipliers and equals unity.
1 c 1  c
Balanced budget multiplier = expenditure multiplier + tax multiplier =   1
1 c 1 c 1 c
Summing up, a government can fill a deflationary gap by either:
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(i) increasing government spending by the amount of the deflationary gap, or

deflationary gap
(ii) decreasing taxes by an amount higher than the deflationary gap ( ), or
mpc
(iii) increasing government spending and taxes by the same amount, equal to the output gap.
Likewise, an inflationary gap may be dealt with, by either:
(i) decreasing government spending by the amount of the inflationary gap, or
(ii) increasing taxes by an amount higher than the inflationary gap, or
(iii) decreasing government spending and taxes by the same amount, equal to the output gap.

Systems of Taxation
There exist three tax systems:
(i) Progressive
(ii) Proportionate
(iii) Regressive
Progressive taxation
This system calls for increasing the tax rate with increase in income i.e. rich people pay a greater
portion of their income in taxes. Consider the following example of a progressive tax system.
Progressive taxation
Y (individual‟s income) Tax rate(t) = ART Tax amount (T) MRT
0 - 0 -
100 10% 10 10%
200 12% 24 14%
300 14% 42 18%

The tax rate, t, rises as the individual‟s income increases. The tax rate also equals the Average
Rate of Tax (ART).
Tax amount
Average Rate of Tax 
Income
T
ART 
Y
tax rate  income

Y
tY

Y
=t
Marginal Rate of Tax (MRT) shows additional tax paid due to an increase in income. It is the ratio
of change in tax amount and change in income
T
MRT 
Y
For a progressive system of taxation:
 Tax rate (t) increases with every increase in income.
 Tax amount increases more than proportionately when income increases
 Marginal Rate of Tax (MRT) exceeds the tax rate (t).
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Proportionate Taxation
This system charges the same tax rate, irrespective of the level of income. The following table
presents an example of proportionate taxation.
Proportionate taxation
Y Tax rate(t) = ART Tax amount (T) MRT
0 10% 0 -
100 10% 10 10%
200 10% 20 10%
300 10% 30 10%

For a proportionate tax system:

 Tax rate (t) stays the same at every income level.
 Tax amount increases proportionately when income increases.
 Marginal Rate of Tax (MRT) equals tax rate (t).
Regressive Taxation
This system of taxation has a decreasing tax rate for every increase in income. Consider the
following tables as examples of regressive taxation
Regressive Taxation
(Case I)
Y Tax rate(t) = ART Tax amount (T) MRT
0 - 0 -
100 10% 10 10%
200 8% 16 6%
300 6% 18 2%

(Case II)
Y Tax rate(t) = ART Tax amount (T) MRT
0  10 -
100 10% 10 0%
200 5% 10 0%
300 3.33% 10 0%

(Case III)
Y Tax rate(t) = ART Tax amount (T) MRT
0 - 0 -
100 10% 10 10%
200 4% 8 -2%
300 2% 6 -2%

For regressive taxation:

 Tax rate (t) decreases with every increase in income.
 Tax amount can increase, stay the same or can even decrease when income increases.
 Marginal Rate of Tax (MRT) is less than the rate of tax (t).
 Marginal Rate of Tax (MRT) is positive when tax amount increases. However, tax amount
increases less than proportionately with increases in income. Case I shows a situation
where tax rate decreases when income increases but tax amount still increases.
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 Marginal Rate of Tax (MRT) is zero when tax amount does not change with increase in
income. This happens in the case of autonomous taxes- taxes that do not vary with
changes in income, as in case II. All autonomous taxes are regressive in their impact but
all regressive taxes are not autonomous.
 Case III shows a situation where tax amount decreases with increase in income. In this
case, Marginal Rate of Tax (MRT) is negative.
 All indirect taxes (taxes on expenditures) are regressive in their impact since rich people
are less affected by them. Thus countries collecting a greater portion of tax revenues
through indirect taxes and less through direct taxes have a less progressive tax system.

Diagram 21.7 provides a graphical representation of the three systems of taxation

Diagram 21.7
Tax rate

Progressive

Proportionate

Regressive

Income

Principles of taxation and systems of taxation

Equity and efficiency are the two fundamental principles of taxation. A progressive tax system is
more likely to satisfy the principle of equity as it leads to a more equal distribution of income. Rich
people pay a greater portion of their income as taxes, thus reducing gap between the incomes of
the rich and poor. However, a highly progressive tax system dampens the incentive to work as a
high top tax rate (tax rate at the highest income range) discourages people to work and forces
them to invest less (try J/08/3/14). High income earners are encouraged to work and invest under
a less progressive system of taxation so it is more likely to satisfy the principle of efficiency.
However, this comes at the cost of a less equal distribution of income.

Example: J/02/3/16
Which of the following elements of a tax and benefits system is regressive?
A the taxation of capital gains
B the payment of child benefits to families
C specific taxes on beer and tobacco
D rent subsidies to tenants of publicly owned housing

Option A: Capital gain is the excess of sale and purchase price of an asset and is common in the
real estate and stock markets. Investment in real estate and stock markets usually comes from
rich people, so taxation of capital gains affects them more, making the system progressive.
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Option B: Paying child benefits to families benefits poor income earners more than the rich. Thus,
this presents a progressive system of tax and benefit, where rich people pay a greater portion of
their income as taxes or get benefits worth a smaller portion of their income.

Option C: This is an example of indirect tax, which does not increase with increase in income.
Thus rich people pay a smaller portion of their income as indirect taxes. Indirect taxes are
regressive in their impact so option C is the correct answer.

Option D: Publicly owned houses are built by governments for use by poor families who may not
afford accommodation otherwise. A subsidy on rent of publicly owned housing benefits poor
income earners more, making it an example of progressive taxation.

Laffer Curve
Laffer curve is a curve depicting the possible relationship between INCOME TAX rates and total
TAX revenue received by the government. Fig. shows a typical Laffer curve. As tax rates per
pound of income are raised by the government, total tax revenue or yield initially increases.
However, if tax rate is increased beyond OR, then this higher tax rate has a disincentive effect so
that fewer people will offer themselves for employment and existing workers will not be inclined to
work overtime. The result is that the tax base declines and government tax receipts fall at higher
tax rates. The possible Laffer curve relationship has been used by governments in recent years
as a justification for cuts in tax rates as part of a programme of work incentives, which is often
regarded as a supply side tool.

tax rate (%)

100

0 tax revenue

Nudge Theory
Nudge Theory (or Nudge) is a concept in behavioural science, political theory and economics
which argues that positive reinforcement and indirect suggestions to try to achieve non-forced
compliance can influence the motives, incentives and decision making of groups and individuals,
at least as effectively – if not more effectively – than direct instruction, legislation, or enforcement.
“A nudge, as we will use the term, is any aspect of the choice architecture that alters people‟s
behavior in a predictable way without forbidding any options or significantly changing their
economic incentives. To count as a mere nudge, the intervention must be easy and cheap to
avoid. Nudges are not mandates. Putting fruit at eye level counts as a nudge. Banning junk food
does not.”
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Means-Tested Benefit
A Means-Tested Benefit in the United Kingdom is a payment available to people who can
demonstrate that their income and capital are below specified limits. It is a central part of
the Welfare state in the United Kingdom for example Income Support, Pension Credit, Guarantee
Credit, Child Tax Credit, Housing Benefit etc.

Negative Income Tax

In economics, a negative income tax (NIT) is a progressive income tax system where people
earning below a certain amount receive supplemental pay from the government instead of paying
taxes to the government. Such a system has been discussed by economists but never fully
implemented.
In a negative income tax system, people earning a certain income level would owe no taxes;
those earning more than that would pay a proportion of their income above that level; and those
below that level would receive a payment of a proportion of their shortfall, which is the amount
their income falls below that level.
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Multiple Choice Questions

(Section 21)

Inflationary and Deflationary Gaps

Systems of Taxation
J/02/3/16
1 Which of the following elements of a tax and benefits system is regressive?
A the taxation of capital gains
B the payment of child benefits to families
C specific taxes on beer and tobacco
D rent subsidies to tenants of publicly owned housing

N/02/3/13
2 The table shows the marginal tax rates paid by a country‟s taxpayers at different levels of
income.
income tax rate
first $4000 zero
$4001 - $20 000 20%
above $20 000 40%

Which of the following correctly describes this tax?

A It is regressive over the entire range of income.

B It is proportional over the income range $4001 – $20 000.
C It is proportional over the range of income above $20 000.
D It is progressive over the range of income above $4000.
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N/02/3/16
3 The diagram shows a number of expenditure functions. The original expenditure function
is shown by E.
E1
E2

E3
E

expenditure E4

O income
The government announces an increase in government expenditure on goods and
services and increases the standard rate of income tax.
Which line shows the new expenditure function resulting from these changes?
A E1 B E2
C E3 D E4

N/02/3/20
2
4 In a closed economy, the full employment level of income is $90 million, C  Y and
3
I = $ (40-3r) million, where C = consumption, Y = income, I = investment and r = the rate
of interest.
If planned government expenditure is $20 million, what rate of interest would be required
for there to be full employment?
A 10% per annum
B 12% per annum
C 14% per annum
D 16% per annum

N/02/3/24
5 In a closed economy with no government the full employment level of output is $25
million, the actual level of output is $20 million, and the marginal propensity to consume
is 4/5. What is the size of the deflationary gap?

A $1 million
B $4 million
C $5 million
D $16 million
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J/03/3/19
6 In the diagram, OP is the equilibrium level of income and OQ the full employment level of
income in a closed economy.

U C+I+G
expenditure T C+I
R C

45 O

O P Q
income
What is the deflationary gap?

A RV B TV C UV D PQ

J/03/3/22
7 In the diagram, C1 shows the initial relationship between consumption and national
income.
C1
C2

consumption

O national income
What could cause the consumption function to shift to C2?
A an increase in exports
B an increase in investment
C a decrease in the rate of unemployment benefits
D a decrease in the standard rate of income tax

N/03/3/18
8 A regressive tax is defined as one which requires
A all taxpayers to pay the same absolute amount of their income in taxation.
B high income earners to pay less in taxes than low income earners.
C high income earners to pay more in taxes than low income earners.
D high income earners to pay a lower proportion of their income in taxes than low
income earners.
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J/04/3/19
9 In an economy, the marginal propensity to consume of the unemployed is higher than
that of taxpayers.
The government increases both expenditure on unemployment benefits and taxation by
$10 million.
What will be the impact on aggregate demand?

A It will be unchanged.
B It will increase by less than $10 million.
C It will increase by $10 million.
D It will decrease by $10 million.

J/04/3/29
10 What is most likely to be increased by a policy of increased direct taxes and lower
government spending?
A the balance of payments deficit
B the budget deficit
C the rate of inflation
D the level of unemployment

N/04/3/21
11 In a closed economy, households pay $0.40 in tax on every $1 increase in their gross
income, and spend 5/6 of every increase in their disposable income.
What is the value of the multiplier?

A 2 B 2½ C 3 D 6

J/05/3/27
12 Which of the following is an appropriate government policy for closing a deflationary gap?

A an increase in the rate of interest

B an open market sale of bonds
C an increase in government spending
D an increase in income tax

J/07/3/16
13 Which combination of fiscal policy measures would be most effective in reducing income
inequality?

top rates of income tax indirect taxes value of state benefits

A increase increase increase
B reduce increase reduce
C increase reduce increase
D reduce reduce reduce
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J/08/3/14
14 The government of a country decides to increase the proportion of its tax revenue that it
obtains from income tax and to reduce the proportion it obtains from indirect taxes. Total
tax revenue is left unchanged.
What is likely to be the impact on the distribution of income and on work incentives?

distribution work
of income incentives
A more equal increase
B more equal decrease
C less equal increase
D less equal decrease

J/08/3/20
15 In a closed economy, the full employment level of income is $200 million.
C = 3 Y,
4
I = $(50 – 5r) million,
where C = consumption,
Y = income,
I = investment,
r = the rate of interest.
If planned government expenditure is $30 million, what rate of interest would be required
for there to be full employment?

A 2 % per annum B 4 % per annum

C 6 % per annum D 8 % per annum

J/08/3/21
16 In the diagram, C1 shows the initial relationship between consumption and national
income.
C2
C1

consumption

O national income
What could cause the consumption function to shift to C2?

A an increase in exports
B an increase in investment
C a decrease in the rate of unemployment benefits
D a decrease in the standard rate of income tax
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J/09/3/20
17 The diagram shows the saving and investment curves of a closed economy with no
government.

S
saving,
investment J
L G H I
45
O YP
output

The potential level of output is OYP.

Which distance measures the gap between actual and potential output?

A LG B GH C JH D KJ

N/09/3/20
18 The diagram shows a number of expenditure functions. The original expenditure function
is shown by E.
E1
E2
E

E3
expenditure
E4

O income
The government announces a decrease in government expenditure on goods and
services and reduces the standard rate of income tax.
Which line shows the new expenditure function resulting from these changes?
A E1 B E2 C E3 D E4

J/10/3/29
19 What will be the impact of an increase in marginal tax rates?
A an increase in the propensity to save
B an increase in the value of the investment multiplier
C a strengthening of work incentives
D a strengthening in the operation of automatic stabilisers
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N/10/3/13
20 A tax is said to be regressive when
A low income earners pay a higher proportion of their income in tax than high
income earners.
B marginal tax rates exceed average tax rates.
C the cost of collecting the tax exceeds the revenue raised.
D the marginal rate of tax is higher for high income earners than low income
earners.

N/10/3/20
21 In a closed economy with no government
the full employment level of income = $400 billion
and the equilibrium level of income = $380 billion
If the deflationary gap is $4 billion, what is the marginal propensity to consume?
1 1 3 4
A B C D
5 4 4 5
N/10/3/29
22 The government of a country decides to increase the proportion of its tax revenue it
obtains from direct taxes and to reduce the proportion it obtains from indirect taxes.

distribution of
work incentives
income
A less equal decrease
B less equal increase
C more equal decrease
D more equal increase

J/11/32/25
23 Which tax is most likely to be regressive?
A an inheritance tax
B a property tax
C a sales tax
D income tax

N/11/32/14
24 The government of a country decides to increase the proportion of its tax revenue that it
obtains from indirect taxes and to reduce the proportion it obtains from income tax.
Total tax revenue is left unchanged.
What is likely to be the impact on the distribution of income and on work incentives?

distribution of income work incentives

A less equal decrease
B less equal increase
C more equal decrease
D more equal increase
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N/11/32/18
25 In a closed economy, households pay $0.10 in tax on every $1 increase in their gross
5
income, and spend /6 of every increase in their disposable income.
What is the value of the multiplier?
A 1.5 B 4.0 C 6.0 D 7.5

N/11/32/25
26 A government currently has a balanced budget. It is considering the possible variations in
tax revenue and government expenditure shown.

options tax revenue government expenditure

W increase Increase
X increase reduce
Y reduce increase
Z reduce reduce

Which three options have the potential to move the budget into surplus?
A W, X and Y B W, X and Z C W, Y and Z D X, Y and Z

N/11/32/29
27 Assuming no change in tax rates or tax-free allowances, for which tax would the amount
paid in tax become a smaller proportion of taxpayers‟ income during a period of wage
and price inflation?
A a progressive income tax
B a specific tax on tobacco
C capital gains tax
D value added tax

J/12/32/22
28 In the diagram, C is an economy‟s initial relationship between consumption and national income.
C4
C3
C
C2

C1

consumption

O
national income
Which curve could show the economy‟s new consumption function following a reduction
in the rate of unemployment benefits?
A C1 B C2 C C3 D C4
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N/12/32/15
29 What is most likely to be regressive?

A corporate profit taxes B state pension benefits

C specific tax on cigarettes D unemployment benefits

N/12/32/17
30 An economist wishes to judge whether an economy‟s budget deficit is excessive.
What would be the most appropriate way to measure the budget deficit when making this
judgement?

A as a percentage of foreign currency reserves

B as a percentage of GDP
C in inflation adjusted terms
D in purchasing power parity terms

N/12/32/18
31 In a closed economy with no government, the level of investment is $5 million, the
equilibrium level of income is $22 million, the full employment level of income is $25
million and there is a deflationary gap of $1 million.
What can be deduced from this information?
2
A The marginal propensity to consume is .
3
1
B The marginal propensity to consume is
3
C The value of the investment multiplier is 5.
D The value of the investment multiplier is 1.5.

N/12/32/29
32 Why is it more effective to increase regressive taxes rather than progressive taxes when
pursuing a deflationary fiscal policy?

A Changes in VAT have minimal effect on consumers‟ spending.

B It is much more unfair to increase progressive taxes.
C Many workers reduce the hours they work when income taxes are raised.
D Low income households spend a larger proportion of their incomes.

N/12/32/30
33 In an economy, the marginal propensity to consume of the unemployed is higher than
that of taxpayers.
The government increases expenditure on unemployment benefits by $10 million.
What will the government need to do if it wishes to keep aggregate demand unchanged?

A raise taxation by less than $10 million

B raise taxation by more than $10 million
C raise taxation by $10 million
D leave taxes unchanged
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J/13/32/15
34 The table shows the marginal tax rates paid by a country‟s taxpayers at different levels of
income.

income tax rate

first $4000 zero
$4001 - $20 000 20 %
above $20 000 40 %

What correctly describes this tax?

A It is regressive over the entire range of income.

B It is proportional over the income range $4001 - $20 000.
C It is proportional over the range of income above $20 000.
D It is progressive over the range of income above $4000.

N/13/32/14
35 A country has a negative income tax.
The curve NT in the diagram shows the country‟s initial tax schedule.
+ NT1

tax
NT

O
income

A change in the tax rate causes the schedule to shift to NT 1.

How will this affect work incentives and the after-tax distribution of income?

work distribution
incentives of income
A strengthen more equal
B strengthen less equal
C weaken less equal
D weaken more equal

N/13/32/20
36 In an economy, the marginal propensity to consume of the unemployed is higher than
that of taxpayers.
The government increases expenditure on unemployment benefits by $10 m and
increases taxation by $10 million.
What will be the impact on aggregate demand?

A It will be unchanged. B It will increase by less than $10 million.

C It will increase by $10 million. D It will decrease by $10 million.
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N/13/32/27
37 What is a reflationary fiscal measure?

A reducing interest rates B increasing the money supply

C increasing taxes D increasing government spending

N/13/32/30
38 During year 1, a government announces a temporary one-year reduction in the level of
indirect taxation balanced by an equivalent temporary one-year increase in direct
taxation.
What is most likely to be the impact on household saving in year 1 and in year 2?

impact on household impact on household

saving in year 1 saving in year 2
A decrease decrease
B decrease increase
C increase decrease
D increase increase

J/14/32/19
39 In a closed economy with no government, consumption is 4/5 of income at all levels of
income.
The present equilibrium level of income is $220 million.
The full employment level of income is $240 million.
By how much would investment have to increase to reach full employment?

A $2 million B $4 million
C $16 million D $20 million

J/14/32/27
40 What will be the impact of an increase in marginal tax rates?

A an increase in the propensity to save

B an increase in the value of the investment multiplier
C a strengthening of work incentives
D a strengthening in the operation of automatic stabilisers

J/15/32/30
41 A government‟s budget is balanced at a time when the economy is fully employed, but an
aggregate demand shock causes a decline in national income.
What will be the result if the government keeps its tax rates and level of spending
unchanged?

A a cyclical budget deficit

B a cyclical budget surplus
C a structural budget deficit
D a structural budget surplus
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N/15/32/17
42 A country has a negative income tax.
In the diagram, the curve NT shows the country‟s initial tax schedule.

+
NT1

tax
NT

0
income

What could cause the tax schedule to shift to NT 1?

A a higher marginal tax rate

B a more equal distribution of income
C an increase in household disposable income
D an increase in the marginal propensity to consume

N/15/32/24
43 In the absence of offsetting changes, what will result in an increase in a government‟s
fiscal deficit?

A a decrease in household saving

B a decrease in interest rates on government bonds
C a decrease in private sector investment
D a decrease in the country‟s trade deficit

N/15/32/27
44 An economy has underemployed resources.
Which method of financing an increase in government expenditure is likely to have the
greatest expansionary effect?

A borrowing from the central bank

B borrowing from the non-bank private sector
C increased direct taxation
D increased indirect taxation

J/16/32/17
45 Which policy would be most effective in achieving a more equal distribution of disposable
incomes between households?

A government support for trade unions

B import duties on manufactured goods
C minimum wage policy
D progressive income taxes
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J/16/32/27
46 When would an economic recession result in an increase in a government‟s budget
deficit?

A The government increases tariffs on imports with inelastic demand and keeps the
total amount it spends on unemployment benefit unchanged.
B The government keeps the unemployment benefit rate and direct and indirect tax
rates unchanged.
C The government reduces foreign aid and widens the tax base.
D The government reduces the unemployment benefit rate and decreases the tax
free allowance on income tax.
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Understanding Economics 351
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Section: 22 Open Economy

(Four sectoral economy)
We finally consider a fourth sector, the international market, which influences an economy in the
following three ways:

(i) Exports and imports of goods only

(ii) Exports and imports of services only
(iii) Financial capital flows

Exports and imports of goods are recorded in the balance of trade whereas that of services are
recorded in the invisible section of the current account. Capital or financial accounts record the
flows of financial capital.

Equilibrium Income in an Open Economy

In a four sectoral model, expenditures are given by: consumer expenditures (C), investment
expenditures (I), Government expenditures (G) and net export revenues (Xn), export revenues
less import expenditures (Xn = X – M). Exports inject demand and imports withdraw it.
E=C+I+G+X–M

Exports are income autonomous as they only depend on the income of other countries and are
thus given by:
X = Xo

A recession in the international market such as the current one in USA and Europe decreases
exports for countries like Pakistan which export textiles etc to these developed economies.

Imports are income induced and an increase in consumers‟ income encourages them to spend
more on both locally made and imported products. Marginal propensity to import (MPM = m) is
the fraction of an added £ in income that is spent on imports and is assumed to be constant for a
linear expenditure function. Import function is given by:
M = mY

Assuming marginal propensity to import equals 0.1, imports rise by £10 if income rises by £100

Equilibrium income in an open economy may thus be calculated in the following manner:
Considering taxes to be induced:

T = tY

C = Co + cYd
= Co + c(Y – T)
= Co + c(Y – tY)
= Co + cY – c tY
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I = Io
G = Go
X=Xo
M=mY

E=C+I+G+X–M
E= Co + cY – ctY+ Io + Go + Xo – mY

Y=E
Y = Co + cY – ctY+ Io + Go + Xo – mY
Y – cY – ctY + mY = Co + Io + Go + Xo
Taking Y common:
Y (1– c – ct + m) = Co + Io + Go + Xo
Taking c common:
Y (1– c (1 – t) +m) = Co + Io + Go + Xo
1
Y  (Co  Io  Go  Xo)
1- c 1 t  m
A country‟s trade is balanced when its export revenues, X equal import expenditures, M. A trade
surplus exists when export revenues exceed import expenditures whereas a deficit implies export
revenues fall short of import expenditures. A trade surplus injects demand into the economy
whereas a trade deficit is a demand withdrawal.

Question: Calculate savings for an economy in equilibrium, with trade and budget deficits of
£20m each. Assume investment expenditures are £10m.

Answer: Trade deficit means import revenues exceed export expenditures by £20m (M-X= 20)
and budget deficit implies government spending exceeds tax revenues by £20m (G-T= 20). Thus
for the economy to be in equilibrium, savings must equal investments- savings equal £10m.
S+T+M=I+G+X
S + (M – X) = I + (G – T)
S + 20 = 10 + 20
S = 10
An open economy with induced taxes has:
 Four sectors: households, firms, government and international market
 Expenditures given by: consumer expenditures (C) investment expenditures (I)
government expenditures (G) and net export revenue (Xn)
 Three demand injections (J): investment expenditures (I), government expenditures (G)
and export revenue (X)
 Three demand withdrawals (W): savings (S), Taxes (T) and import expenditures (M)
 Autonomous expenditures given by: A = Co + Io + Go + Xo
 Marginal propensity to spend as c (1 – t) + m
 Marginal propensity to withdraw as MPS + MPT + MPM (where MPS is post taxes)
1
 Autonomous expenditure multiplier given by:
1- c 1  t   m
1 1
 Expenditure multiplier expressed as 
s t m s t m
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Equilibrium National Income in an Open Economy- Graphical analysis

As in all preceding cases, equilibrium national income in a four sectoral model is determined by
the intersection of income and expenditure functions or demand injections and withdrawals. This
is shown in diagram 22.1.

Diagram 22.1
E
Y= E
E= C+ I+ G+ X– M

o
45
Y = output
Y1
Injections
&
withdrawals

S+ T+ M

J0 I 0 + G0 + X0

Y = output
Y1
– C0
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Multiple Choice Questions

(Section 22)
J/02/3/20
1 Which of the following is not a leakage from the circular flow of income?
A corporation tax
B expenditure on foreign goods
C personal saving
D retirement pensions

N/03/3/22
2 Out of any addition to national income, 20 % is spent on imports, 25 % is paid in taxes,
5% is saved and the rest is spent on domestically produced goods.
What is the value of the multiplier?
A 20 B 5
C 2 D 0.5

N/05/3/19
3 What is the value of the multiplier in an economy with no government where the marginal
1 1
propensity to save is , and the marginal propensity to import is ?
6 3
1 1
A B 1
2 2
C 2 D 3

J/06/3/17
4 Which of the following are injections into the circular flow of income?
private sector surplus
trade surplus government budget deficit
(saving – investment)
A
B
C
D

N/06/3/20
5 The national income is initially in equilibrium.
If there were a decrease in exports, which change of equivalent value would restore
national income to its initial equilibrium level?

A an increase in investment
B an increase in saving
C a reduction in government expenditure on goods and services
D a reduction in taxation
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N/08/3/16
6 The table shows some data for an economy.

government national
Investment Exports Savings Imports Taxation
expenditure income
$m $m $m $m $m
$m $m
200 100 50 50 120 100 700
200 100 50 60 140 150 800
200 100 50 75 160 200 900
200 100 50 100 180 275 1000

What is the equilibrium level of national income?

A $700 m B $800 m C $900 m D $1000 m

J/09/3/16
7 Which of the following correctly identifies net leakages from the circular flow of income?

trade surplus government budget deficit private sector surplus

(exports - imports) (government spending - taxes) (saving - investment)
A
B
C
D

N/09/3/19
8 Out of any addition to national income, 20 % is spent on imports, 15 % is paid in taxes, 5
% is saved and the rest is spent on domestically-produced goods.
What is the value of the multiplier?
A 2.5 B 5 C 6 D 20

J/10/3/19
9 When national income equals $40 000 million and government spending equals $15 000
million, an economy is in equilibrium below full employment. Out of every increase of
$100 in national income, $15 is taken in taxes, $30 is spent on imports and $5 is saved.
To raise national income to the full employment level of $50 000 million, to which level
will the government need to raise its own spending?

A $15 500 million B $20 000 million

C $25 000 million D $35 000 million

N/10/3/16
10 What is not a leakage from the circular flow of income?
A expenditure on foreign goods B indirect taxes
C undistributed profits D unemployment benefits

J/11/32/15
11 What will reduce the value of the investment multiplier?
A a low marginal propensity to import B automatic stabilisers
C low marginal tax rates D low rates of unemployment benefit
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N/11/32/19
12 The table shows some data for an economy.
investment exports government savings imports taxation national
$m $m expenditure $m $m $m $m income $m

200 100 50 125 62.5 62.5 600

200 100 50 150 75 75 700
200 100 50 175 87.5 87.5 800
200 100 50 200 100 100 900
What is the equilibrium level of national income?

A $600 m B $700 m C $800 m D $900 m

J/12/32/19
13 Which represents an injection into an economy‟s circular flow of income?

A a balance of trade surplus

B a government budget surplus
C the retained profits of private companies
D household saving

J/13/32/20
14 Which correctly identifies injections into a country‟s circular flow of income?

private sector government sector trade sector

I>S G>T M>X
A no yes yes
B yes no no
C yes yes no
D no no yes

J/13/32/29
15 What will increase the multiplier effect of an increase in government spending on national
income?

A an increase in direct taxation

B an increase in interest rates
C an increase in the marginal propensity to consume
D an increase in the marginal propensity to import

J/14/32/20
16 Other things being equal, what will result in a decrease in aggregate demand?

A a decrease in interest rates

B a decrease in the balance of trade deficit
C a decrease in the government‟s budget deficit
D a decrease in the household saving ratio
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J/14/32/22
17 The diagram shows the contribution of four components of aggregate demand to the
change in US real GDP in the four quarters of 2010.

8
key
6 personal
consumption
4 gross private
domestic
% 2 investment
government
0
expenditure
& investment
–2
net exports
–4
quarter 1 quarter 2 quarter 3 quarter 4
2010

Which component made the greatest contribution and which component the least
contribution to the positive growth in real GDP in 2010?

greatest contribution least contribution

A gross private domestic government expenditure and
investment investment
B gross private domestic net exports
investment
C personal consumption government expenditure and
investment
D personal consumption net exports

J/15/32/19
18 Which is not an injection into a country‟s circular flow of national income?

A inward direct investment by multinational corporations

B private gross domestic fixed capital formation
C the sale of government bonds to members of the public
D wages paid to civil servants

J/15/32/20
19 The national income is initially in equilibrium.
If there is an increase in exports, which change of equivalent value will restore national
income to its initial equilibrium level?

A a decrease in imports
B a decrease in investment
C an increase in government expenditure on goods and services
D a reduction in taxation
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N/15/32/18
20 The information in the table is taken from a country‟s national income accounts.

$ million
national income 600
consumer spending 400
investment spending 80
government spending on goods and services 100
exports 140

What is the value of imports?

A $100 million B $120 million

C $140 million D $240 million

N/15/32/19
21 Which represents an injection into a country‟s circular flow of income?

A corporate taxes
B interest payments on government bonds
C the payment of dividends to foreign shareholders
D the repayment of bank loans

J/16/32/26
22 In a 4-sector economy, consisting of households, firms, government and foreign trade,
the level of national income is in equilibrium where
C + I + G + (X – M) = Y.
What must Y include for an equilibrium to exist?

A C+S+M
B C+S+T
C S+T
D S+T+M

J/16/32/30
23 What will increase the multiplier effect of an increase in government spending on national
income?

A an increase in direct taxation

B an increase in interest rates
C an increase in the marginal propensity to consume
D an increase in the marginal propensity to import
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Section: 23 Principle of Accelerator

As seen earlier, the autonomous expenditure multiplier shows the relationship between changes in
autonomous expenditures (e.g. investment expenditures) and changes in national income. We now
turn to the accelerator theory, which studies the relationship between changes in either income or
consumption and changes in investment expenditures. The accelerator coefficient is either given by
the ratio of change in investment expenditures and change in national income or change in
investment expenditures and change in consumer expenditures.

I I
Accelerator coefficien t  or
Y C

Increased income and consumption encourage firms to increase production capacities so as to

meet extra demand. Assuming firms invest £50m to produce extra output worth £10m, the
accelerator co efficient is 5. The coefficient is large when firms increase investment spending
significantly with increases in demand. This may happen in following situations:

 Firms operate at full capacities and must increase production capacities to satisfy fresh
demand.
 The stock of unsold goods is low.
 Firms are certain that demand increase is permanent.
 Factors of production are easily available.
 Capital and labour are substitutable
 Economic indicators are favourable and show stability and growth.
 Government policies are investment and business friendly.
 Interest rates are low.

According to the accelerator theory, net investment increases whenever output increases at an
increasing rate. Net Investment (In) shows the net addition in a country‟s capital stock and the
difference between Gross Investment (Ig) and depreciation (R).

The following chart helps understand the relationship between changes in output and changes in
net investments.

Capital Gross investment Depreciation Net investment

Years Output
stock (Ig) (R) (In)
10 1000 100 - - -
11 1000 100 10 10 0
12 1100 110 20 10 10
13 1200 120 20 10 10
14 1400 140 30 10 20
15 1450 145 15 10 5
16 1400 140 5 10 -5
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Assume that the capital stock of the country consists of 100 machines accumulated over a period of
10 years. The expected life of every machine is 10 years implying that 10 machines purchased in
year 1 wear out in year 11, 10 purchased in year 2 wear out in year 12 and so on. One machine can
produce output worth 10 so 100 machines are needed to produce an output worth 1000. The
following summary explains the behaviour of net investment at different rates of economic growth

 Net investment is positive for growing economies (all years except year 11 and 16)
 Net investment is zero for static economies (year 11)
 Net investment is negative for declining economies (year 16)
 Net investment increases for economies whose income increases at an increasing rate
(between years 13 and 14)
 Net investment stays the same for economies whose income increases at a constant rate
(between years 12 and 13)
 Net investment decreases for economies whose income increases at a decreasing rate
(between years 14 and 15)

Try J/03/3/21-

The correct option is A, though wrongly worded. Net investment increases (and is not just
„positive‟) when income increases at an increasing rate. This point has been validated by the
examiners‟ report.
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Multiple Choice Questions

(Section 23)
N/02/3/19
1 In the diagram, the curve I depicts the accelerator relationship between net investment
and the change in national output.

I
net
investment

O
change in national output
What does the slope of the curve measure?

A the capital-output ratio

B the marginal propensity to invest
C the marginal propensity to save
D the multiplier

J/03/3/21
2 According to the accelerator theory
A net investment is positive if output is rising at an increasing rate.
B net investment may rise even if output rises at a declining rate.
C increases in investment occur when interest rates are falling.
D increases in investment will cause a more than proportionate increase in national
income.
J/04/3/20
3 A closed economy is initially in equilibrium with a national income of $100 million, and a
capital stock of $25 million. Aggregate demand increases by $10 million.
According to the accelerator principle, by how much will net investment increase?

A $10 m B $5 m
C $2.5 m D $2 m

N/04/3/20
4 The accelerator principle refers to a relationship between investment and

A the level of GDP.

B changes in GDP.
C the level of interest rates.
D changes in interest rates.
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N/05/3/18
5 According to the accelerator theory, what determines this year‟s net investment?

A last year‟s consumption

B last year‟s output
C the change in last year‟s output
D the change in last year‟s investment

J/06/3/21
6 What does the accelerator principle state?

A Consumption is a function of the rate of change of income.

B Income is a function of the rate of change of investment.
C Investment is a function of the rate of change of income.
D Investment is a function of the rate of interest.

J/09/3/24
7 The table shows the figures for consumption, gross capital formation and depreciation in
four economies, all measured in US $.
Assuming that the state of technology remains unchanged, which economy is most likely
to experience economic growth?
economy gross capital
depreciation
consumption formation
($ m)
($ m) ($ m)
A 200 40 50
B 500 200 150
C 1 000 1 200 1 400
D 20 000 6 000 6 000

N/09/3/18
8 The table gives the national income of a country over six years.

year national income (Y)

1 2100
2 2110
3 2125
4 2145
5 2160
6 2170

According to the accelerator principle, in which year did net investment first fall to a level
below that of the previous year?

A year 3 B year 4 C year 5 D year 6

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J/12/32/21
9 In the diagram, YE indicates the equilibrium level of income corresponding to different
levels of investment.

YE

equilibrium
income

O
investment
What does the slope of the line YE measure?

A the investment multiplier

B the marginal propensity to save
C the rate of growth of investment
D the rate of growth of national income

N/12/32/19
10 The table gives the national income of a country over six years.

year national income (Y)

1 2100
2 2110
3 2125
4 2135
5 2140
6 2135

According to the accelerator principle, in which year did net investment first fall to a level
below that of the previous year?

A year 3 B year 4 C year 5 D year 6

J/14/32/18
11 What will cause the level of investment to fall according to the accelerator model?

A a decrease in business confidence

B a decrease in the rate of growth of national income
C an increase in the price of capital equipment
D an increase in the rate of interest
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N/15/32/22
12 The table shows the figures for consumption, capital formation and depreciation in four
economies, all measured in US $.
Assuming that the state of technology remains unchanged, which economy is most likely
to experience economic growth?

capital
consumption capital formation
economy depreciation
($ million) ($ million)
($ million)
A 100 10 20
B 500 200 100
C 1 000 1 200 1 400
D 20 000 5 000 6 000
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Section: 24 Aggregate Demand (AD)

Aggregate Demand and Aggregate Supply are a part of the extension (A2) syllabus, but will be
shifted to the core (AS) component with effect from June 2013. Students appearing in A Level in
or after June 2013 should prepare this topic for the AS component while students taking only the
A2 component should not expect a direct question from this topic.

Aggregate Demand (AD)

Aggregate Demand represents the total demand for all goods and services by consumers, firms,
government and foreigners. Aggregate Demand (AD) or Aggregate Monetary Demand (AMD) as
it is sometimes called, expresses demand in terms of money. The AD curve slopes downwards in
the panel of average price level (x-axis) and real national income/output (y-axis), as shown in
diagram 24.1.

Diagram 24.1
Price level

P2
P1

AD

Real national income

Y2 Y1
Whereas Aggregate Demand (AD) measures total expenditures by taking price level and real
income into account, the Aggregate expenditures (AE) approach measures the same by
employing expenditures versus nominal national income. In an open economy, Aggregate
Expenditures (AE) and Aggregate Demand equal consumer expenditures (C), Investment
expenditures (I), government expenditures (G) and net export revenues (Xn) (see J/08/1/22)

Why does the AD curve slope downwards?

The negative slope of the AD curve indicates that increased price level decreases Aggregate
Demand. Before learning why this happens, we reiterate the reasons for an individual market‟s
demand curve sloping downwards (see section 3) and analyze if these changes help explain the
slope of the AD curve.

We studied how the income and substitution effects determine the negative slope of an individual
market‟s demand curve. Real income decreases whenever prices rise, lowering the demand for
normal goods. However in macro economics, real income shows the number/volume of goods
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and services produced and suffers no impact with changes in price level. Thus, the real income
effect fails to explain the downward slope of the Aggregate Demand curve.

Substitution effect shows how a price increase makes people substitute the relatively expensive
good for alternatives that seem cheaper. However, substituting one locally made product with
another does not affect the Aggregate Demand of an economy. Thus, the substitution effect too
can not explain the slope of the AC curve.

The following reasons help us understand the negative slope of the Aggregate Demand curve:

Real wealth/money balances effect: Income is a flow concept and measured for a period of
time, say a month or a year whereas wealth is a stock concept and measured at a certain point in
time e.g. bank balance, real estate, bonds, gold, shares etc.

Changes in price level do not affect real income but increased price level reduces the purchasing
power (real value) of wealth/money balances. Money balances are important determinant of
expenditures and decreased real balances lower expenditures (try N/05/3/20).

Interest rate effect: Households are forced to demand more money for their day to day and
emergency requirements at higher price levels. Increased demand for money raises interest rates
and interest sensitive expenditures such as consumption and investments decrease (see liquidity
preference theory) (try J/02/3/22).

International trade effect: Increased price level in a country makes its products less price
competitive both at home and abroad. Demand for exports falls and imports rises, resulting in
decreased Aggregate Demand (try N/02/3/18).

Shifts in Aggregate Demand

All factors causing an upward shift in the expenditure function shift aggregate demand towards
right. The only exception to this rule is changes in price level, which shift the expenditure function
but cause a movement along the AD curve. Otherwise, factors like increased wealth and booms in
real estate or stock markets encourage households to spend more, shifting the expenditure function
upwards and Aggregate Demand towards right. The recent slump of real estate market worldwide
shifted the expenditure function downwards and Aggregate Demand towards left.

Decreased interest rates, lower (direct) taxes, increased budget deficit, improved consumer and
business confidence, availability of loans, increased popularity and use of credit cards,
depreciation of currency, improved export quality or better export marketing all increase
expenditures and hence, Aggregate Demand.

It must be noted that any change in interest rate, price competitiveness of locally made goods or
wealth attributed to changes in price level brings a movement along the AD curve whereas the
AD curve shifts whenever interest rates or wealth change due to other factors.
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Comparison: Classicals, Monetarists and Keynesians

Classicals support the view that economies always operate at full employment, government
intervention in economic affairs is undesirable and its role is restricted to upholding individuals‟
property rights. People are rational and the “invisible hand”, as envisaged by Adam Smith, guides
people to the most prudent and efficient allocation of resources. The profit motive promotes
efficiency and people, through working for their own betterment, bring about improvements in
society at large.

Any deviation from full employment in the form of unemployment or inflation is only temporary as
the price mechanism helps economies return to full employment level of national income.
Consider a demand shock (leftward shift in AD), which reduces equilibrium national income and
causes unemployment. According to Classicals, the flexible price and wage mechanism makes
the economy resilient to these short lived changes. Unutilized production capacity forces firms to
reduce prices, though profits remain unchanged as wage costs fall with unemployed workers
accepting lower wages. Workers accept a wage cut as they‟re aware of the decrease in price
level and hence cost of living- real wages remain unaltered. Both firms and workers are rational
agents in that they see through money illusions and accept decreased prices and decreased
wages. However the Great Depression of the 1930s lasted for several years, proving wrong all
economists who believed that the recession would soon fade away in the face of flexible wage
and price mechanism.

In contrast to all such economists, John Maynard Keynes argued that strong government
intervention was desirable if an economy had to recover from recession. Government injects
demand to cure its deficiency and reduce unemployment which according to Keynes, only results
from demand deficiency. Keynesians are thus known as demand side economists- they aim to
solve economic problems such as unemployment through demand management. Increased
demand encourages producers to increase production and hire more workers, thus reducing
unemployment.

Keynesians argue that prices and wages are not downward flexible i.e. firms and workers may
welcome higher prices and wages respectively but neither would accept reductions in the same.
Thus, expecting economic recovery from a recession through flexible price and wage mechanism
is unwise.

Any decrease in demand makes firms slow down production and accumulate stocks of unsold
items but not decrease price. Also, strong and militant trade unions and government legislation
regarding minimum wages overrule the possibility of a wage cut. Strikes, work stoppages and
street demonstrations further slow down the pace of economic recovery when firms try to cut
wages. Firms and workers are not rational enough to see through money illusions and assign
greater importance to nominal and money values. A reduction in money wages is therefore
resisted by workers even when price level decreases, leaving real wages unchanged.

According to Keynesians, waiting for an automatic recovery is a mistake since such a recovery is
very slow and painful for economic agents. What is essential to economic recovery is increased
government spending or reduced taxes, injecting demand into the economy and shifting the
Aggregate Demand curve towards right.
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Aggregate Supply (AS)

Whereas economists remain in harmony over the shape of the Aggregate Demand curve, dispute
arises over what the Aggregate Supply curve looks like.
Keynesian Aggregate Supply (AS) curve
Keynesians argue that excess capacity and unemployed resources always exist, as full
employment is nothing but a special case. Aggregate Supply is a straight horizontal line showing
that increased Aggregate Demand helps utilize unemployed resources and leads to increased
real output whereas price level remains unaffected (see diagram 24.2).
Diagram 24.2
Price level

P0 AS

AD2
AD1
Real national income
Y0 Y1

In contrast, the classical school of thought supports full employment and argues that excess
capacity never really exists. Therefore, increased Aggregate Demand raises the price level but
not real output- Classicals‟ Aggregate Supply curve is a straight vertical line, as shown in
diagram 24.3.
Price level AS

P1

P0
AD2

AD1
Real national income
Y0
Diagrams 24.2 & 24.3 may be used to develop the Aggregate Supply curve as drawn in diagram
22.4 where in the Keynesian range, changes in Aggregate Demand only influence real output and
not the price level. In the classical range, changes in Aggregate Demand only influence price
level whereas real output remains unchanged. However, there exists an intermediate range of the
AS curve too, where changes in Aggregate Demand partially influence real output and partially
influence the price level.
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Diagram 24.4
Price
level AS

Classical

Intermediate
Keynesian

Real output

Wage rates are assumed to be constant along an Aggregate Supply curve so any change in them
may shift the AS curve.
Unit labour cost (ULC) is the ratio of the cost of hiring a labour hour and the output produced by
hiring it.
wage rate / hour
ULC 
output / hour
Increased wages motivate workers and encourage them to work harder, making them more
productive. Unit labour cost remains unchanged and cause no shift in the AS curve if a wage
increase is fully offset by an equivalent improvement in productivity. Any wage increase in excess
of productivity improvements increases unit labour cost and shifts the Aggregate Supply upwards
(leftwards). Productivity improvements (assuming wage rate stays the same or rises slowly), shift
the AS curve downwards (rightwards). Training, better work practice and a motivated workforce
all result in improved productivity and lower unit labour cost.

Lower unit labour cost may also result from increased female participation, increased net
immigration and increased birth rate since all these changes make labour cheaper by increasing
its supply. Likewise, increased participation in the workforce resulting from governments‟
decisions to reduce unemployment benefits and pensions and spend more money on education,
training and infrastructure shift Aggregate Supply downwards. Improved technology and
increased resources also shift the Aggregate Supply curve towards right.
Strong and militant trade unions win a wage increase for their members in excess of productivity
improvements, hence shifting Aggregate Supply towards left.
Equilibrium national income may be determined and analyzed using either the
income/expenditure or Aggregate Demand/Aggregate Supply approach. The latter is however
superior, since it separates the effects of increased injections on price level and real output,
which are discussed in detail in the section on fiscal policy.
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Multiple Choice Questions

(Section 24)
Aggregate Demand (AD)
J/02/3/22
1 An aggregate demand curve slopes downwards from left to right. One reason for this is
that a reduction in the average price level will lead to

A a reduction in the real value of money balances.

B a reduction in interest rates.
C a decline in the country‟s international competitiveness.
D the expectation of further price falls.

N/02/3/17
2 In the diagram AD1 and AS1 are an economy‟s initial aggregate demand and aggregate
supply curves.

AS1

price level

AD 2 AD 1
O output

What will cause the aggregate demand curve to shift to AD2?

A a depreciation of the currency

B an increase in the price level
C an increase in the real wage
D a reduction in the money supply

N/02/3/18
3 One of the reasons why a country‟s aggregate demand curve slopes downwards is that a
fall in the average price level

A leads to an increase in interest rates.

B reduces the real value of money balances.
C makes the country‟s goods cheaper relative to foreign goods.
D leads to the expectation of further price falls.
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N/04/3/23
4 The diagram shows an economy's aggregate demand curve.

price
level

AD
O output
What is held constant when drawing an AD curve?

A the exchange rate B the money supply

C the rate of interest D the price level

J/05/3/20
5 The diagram shows an economy's aggregate demand curve.

price
level K

AD

O output
Which change will occur as the economy moves from point J to point K?

A an increase in the money supply

B a decrease in the money supply
C an increase in interest rates
D a decrease in interest rates

N/05/3/20
6 An aggregate demand curve slopes downwards from left to right.
One reason for this is that a reduction in the average price level will lead to

A an increase in the real value of money balances.

B an increase in interest rates.
C a decline in the country‟s international competitiveness.
D the expectation of further price falls.
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N/05/3/30
7 Which government policy will increase aggregate demand?

A raising indirect taxation B reducing the budget surplus

C removing import quotas D removing subsidies

J/06/3/19
8 The diagram shows an aggregate demand curve.

price level

AD
O
national output
What helps to explain why the curve is downward sloping?

A When exports increase there will be an increase in national income.

B When investment increases there will be an increase in consumption.
C When the price level increases there will be an increase in interest rates.
D When government expenditure increases there will be an increase in national
output.

J/08/3/22
9 The diagram shows an aggregate demand curve (AD).

price
level

AD
O X
What is measured on the horizontal (X) axis?

A money national output

B nominal national income
C real disposable income
D real GDP
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J/09/3/21
10 The diagram shows a country‟s aggregate demand curve.

price level

AD

0
national output
What could explain why the curve slopes downwards?
A A fall in the price level increases the real value of money balances.
B A fall in the price level leads to an increase in interest rates.
C A fall in the price level leads to a rise in the real exchange rate.
D A fall in the price level leads to the expectation of a further decrease in the price
level.

N/10/3/21
11 The diagram shows an aggregate demand curve.

price level

AD
O
national output
What helps to explain why the curve is downward sloping?
A When exports increase there will be an increase in national income.
B When government expenditure increases there will be an increase in national
output.
C When investment increases there will be an increase in consumption.
D When the price level increases there will be an increase in interest rates.

J/11/32/17
12 Other things being equal, what will result in a decrease in aggregate demand?
A a decrease in interest rates
B a decrease in the balance of trade deficit
C a decrease in the government‟s budget deficit
D a decrease in the household saving ratio
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Aggregate Supply (AS)

J/02/3/23
13 The diagram shows the aggregate demand and aggregate supply curves for an
economy.

AD AS2
AS 1

price
level

O
output

What could cause the aggregate supply to shift from AS1 to AS2?

A an increase in the balance of payments deficit

B an increase in the price level
C an increase in raw material costs
D an increase in labour market flexibility

J/03/3/23
14 In the diagram an economy is initially in equilibrium at point X.
The government increases spending on education. This coincides with an increase in
wage rate inflation.
Which point shows the most likely new equilibrium of the economy?

AS2
C AS
D B
AS1
price level A
X

AD1

AD2 AD

O real output
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N/03/3/23
15 An economy is currently in equilibrium at point X.
Government expenditure is increased on retraining programmes for those out of work.
This raises the productivity of the trainees.
Which point shows the new equilibrium in the economy?

AS2
D AS
B
AS1
price level A
X
C
AD1

AD

O output
J/04/3/23
16 What is likely to cause a decrease in aggregate supply?
A a decrease in consumption expenditure
B an increase in labour productivity
C a decrease in rates of unemployment benefit
D an increase in wage costs per unit of output

N/06/3/19
17 What would explain why an economy's short-run aggregate supply curve is upward
sloping?
A a constant price level B constant money wages
C diseconomies of scale D economies of scale

J/07/3/23
18 An economy is currently in equilibrium at point X.
Government expenditure is increased on retraining programmes for those out of work.
This raises the productivity of the trainees.
Which point shows the new equilibrium in the economy?

A S2
A AS1

B AS3

price level C
X

D
AD2

AD1
O output
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N/07/3/22
19 What is likely to cause a decrease in aggregate supply?
A a decrease in consumption expenditure
B an increase in labour productivity
C a decrease in rates of unemployment benefit
D an increase in wage costs per unit of output

N/08/3/17
20 In the diagram an economy is initially in equilibrium at point X.
The government increases spending on education. At the same time there is a decrease
in money wage rates.
Which point shows the most likely new equilibrium of the economy?

AS2
C AS
D B
AS1
price level A
X

AD 1

AD2 AD

O real output

N/09/3/21
21 The diagram shows an economy‟s aggregate supply curve.

AS

price
level

O output

What is likely to cause the curve to shift to the left?

A improvements in technology
B schemes to increase the geographical mobility of labour
C an increase in investment due to a reduction in interest rates
D an increase in the marginal rate of income tax
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J/10/3/20
22 In the diagram AS1 is an economy‟s long-run aggregate supply curve.
AS 1 AS2

price level

0
national output
What will cause the aggregate supply curve to shift from AS1 to AS2?
A an increase in consumer spending
B an increase in inflation
C an increase in productivity
D an increase in net exports

N/11/32/20
23 What will be the effect, in the short run, on the price level and on national output of an
increase in aggregate demand if firms are working at full capacity?

price level national output

A rise rise
B rise unchanged
C unchanged rise
D unchanged unchanged

N/11/32/21
24 The diagram shows an economy‟s aggregate demand and aggregate supply curves.
AS

price
level
AD 1
AD 2

O national output
What could cause the aggregate demand curve to shift from AD1 to AD2?
A an appreciation in the exchange rate
B an increase in the money supply
C a decrease in the interest rate
D a fall in the unemployment level
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Section: 25 Liquidity Preference Theory

John Maynard Keynes‟ liquidity preference theory helps us understand why people demand
money. We assume that households possess wealth in the form of just two assets- bonds and
cash. Bonds are debt instruments, so that firms can borrow money by issuing them. People
subscribing bonds are entitled to a periodic interest payment, usually at a pre-determined fixed
rate. The principal amount is returned to the holder, once the bond matures. Bonds are thus
illiquid i.e. they can not be converted into other assets conveniently but are profitable since bond
holders are entitled to receive an interest payment. Cash on the other hand does not generate
interest streams but is liquid and allows flexibility in use as a medium of exchange.

Market interest rates move inversely with the market value of a fixed interest rate bond. Assuming
a bond is issued and subscribed at an annual interest rate of 6%, an increase in the market
interest rate to 7% at a later date forces initial subscribers to rid themselves of these bonds,
which unfortunately only sell at reduced prices. On the other hand, decreased market interest
rates render older bonds with higher fixed interest rate more attractive, hence increasing their
market value.

According to Keynes, people prefer liquidity and are willing to sacrifice interest streams for three
reasons:

(i) transaction motives

(ii) precautionary motives
(iii) speculative motives

Transaction motive shows demand for money for regular and routine consumers and business
requirements. Businesses experience a gap between making payments for purchase of raw
materials, salaries etc and receiving payments from sale of finished goods. Firms typically
demand liquidity i.e. cash to bridge this gap.

Precautionary motive is the demand for money arising due to unexpected and emergency
requirements. A change in market conditions for example, may delay sales of firms‟ products or
payments from debtors and hence, increase the gap between making payments to suppliers and
receiving sale revenues.

Demand for transaction and precautionary motive is the active portion of money demand,
expected to be used immediately. It does not depend on the interest rate. However, increased
income, increased price level and decreased popularity of credit cards all increase the demand
for money and shift the „demand for money‟ curve towards right.

Consumer with higher incomes and businesses with higher sales turnover are likely to demand
more money for transaction and precautionary motives. At higher prices, households and firms
have to demand more money for their routine and emergency requirements. Credit cards are
money substitutes and their popularity decreases demand for transaction and precautionary
motives. Financial innovations such as Automatic Teller Machines (ATM) and debit cards also
decrease the demand for money and shift the curve towards left.
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Workers receiving salaries on a monthly basis demand more money than those getting it weekly.
Increased frequency and hence a smaller interval between two payments decreases the need to keep
liquid assets. Therefore, the shorter the gap there is between making payments and receiving
payments, the lesser will be the demand for money for transaction and precautionary reasons.
Diagram 25.1 shows a straight vertical line representing demand for money for transaction and
precautionary motives, implying that changes in interest rate do not influence money demand.
Increased demand for money shifts the demand curve rightwards.
Diagram 25.1
Demand for money i.e. Liquidity Preference (LP) for transaction and precautionary motives
Interest rate LP0 LP1

Quantity of money
Demand for speculative motives however moves inversely with interest rates. At higher interest
rates, bonds are thought to be under valued and households convert their liquid assets into
bonds. Thus, households demand less money when interest rates are high. Money demanded for
speculative motives is passive or idle since this part of liquidity is not likely to be used in near
future. Consider diagram 25.2, showing demand for money for speculative reasons. The negative
slope suggests that more money is demanded when interest rate falls. Decreased interest rate
from r0 to r1 increases demand for money from Q0 to Q1.
Diagram 25.2
Demand for money (LP) for speculative motives
Interest
rate (%)

r0
r1

LP

Quantity of money
Q0 Q1
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Diagram 25.3 shows a combined demand curve for money, its slope being given by speculative
motive and position, by transaction and precautionary motives.

Diagram25.3
Interest
rate (%)

LP

Quantity of money

Equilibrium interest rate

Equilibrium interest rate is determined by the intersection of demand and supply curves for
money. Diagram 25.4 shows the downward sloping demand curve for money and the supply
curve of money, SM as a straight vertical line. This is because the government has monopoly
power to control money supply and changes in interest rate do not change supply for money.r 0
shows the equilibrium interest rate. At interest rates lower than r 0, demand for money exceeds
supply and people sell bonds to overcome the shortage of liquidity. Increased supply of bonds
lowers their market value and increases market interest rate to the equilibrium point. At interest
rates higher than r0, demand for money falls short of supply and people buy bonds to utilize
excess liquidity. Increased demand for bonds raises their market value and lowers market interest
rate to the equilibrium point.
Diagram 25.4
Interest Buy SM
rate (%) bonds

r0

Sell bonds LP

Quantity of money
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Impacts of changes in money supply on interest rate

Government‟s decision to raise money supply or credit creation by commercial banks shifts the
supply curve for money from SM0 to SM1. Demand for money falls short of money supply at r 0 and
extra liquidity encourages households to buy bonds, raising their prices. The market interest rate
falls to r1.

Diagram 25.5
Interest SM0 SM1
rate

r0 Buy bonds

r1
LP

Quantity of money

The quantity theory of money (section 26) emphasizes that increased money supply raises the
price level whereas Keynesians believe that increased supply of money decreases interest rate.
They argue that changes in money supply do not change Aggregate Demand in the
product/output market and hence the price level remains unaffected. The increased supply of
money is spent on buying financial instruments such as bonds in the financial market, pushing up
their prices and lowering interest rate.

Impacts of changes in money demand on interest rate

The following factors increase money demand, shifting the demand for money curve rightwards,
from LP0 to LP1 as shown in diagram 25.6.
 Increased real income
 Increased price level
 Decreased popularity of credit cards
 Increased interval between two payments made to a worker. For example, a worker who
was previously paid on weekly basis increases demand for money for transaction and
precautionary motives if he is now paid on monthly basis.

Supply for money exceeds demand at r0 and the liquidity shortage forces households to sell
bonds, decreasing their market value and raising interest rate to r 1. Demand for money and
interest rate thus move directly.
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Diagram 25.6
Interest SM
rate

r1

Sell
r0 bond
LP1

LP0
Quantity of money

Loanable Fund Theory

According to the loanable fund theory, equilibrium interest rate is determined by the intersection
of demand and supply for loans as shown in diagram 25.7. Demand curve for loans slopes
downward since more money is borrowed for consumption and investment purposes at lower
interest rates. Supply curve for loans slopes upward since higher interest rate encourage people
to save more.

Consumer and business confidence, improved technology and infrastructure and increased
availability of better quality cheaper raw materials encourage borrowing, causing a rightward shift
in the demand curve for loanable funds. On the other hand, improvement in the saving culture of
the economy (i.e. increased propensity to save) or banks‟ lenient policy towards loans shifts the
supply curve for loanable funds rightwards, decreasing interest rate.

Diagram 25.7
Interest
rate (%)
S

re

Quantity of loans
Qe
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Multiple Choice Questions

(Section 25)
Liquidity Preference Theory
J/02/3/24
1 The diagram shows the determination of the rate of interest in the economy where M
represents the money supply and LP represents liquidity preference.
LP1 LP2 M

r2
rate of
interest
r1

O
quantity of money
What could cause the rise in the rate of interest from r 1 to r2?
A an increase in national income
B an increase in the money supply
C a reduction in investment expenditure
D a reduction in the loans made by the private sector

N/03/3/25
2 The diagram shows three different levels of money supply (MS) and three different
demand curves for holding money balances (LP). The initial equilibrium is at point X.
Banks create more credit and people decide to hold more money as a precaution against
emergencies.
What is the new equilibrium point?

D X B
rate of LP
interest LP
C
LP

MS MS MS
O
quantity of money
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J/04/3/21
3 What will cause interest rates to rise?

A an unexpected increase in the prices of bonds

B an increase in the nominal money supply
C an increase in the volume of output
D a reduction in the price level

N/04/3/25
4 What would cause an increase in the transactions demand for money?

A an increase in the rate of interest

B an increase in nominal national income
C a fall in the price of bonds
D an increase in unemployment

J/05/3/23
5 The diagram shows the determination of the rate of interest in an economy where MS
represents the money supply and LP represents liquidity preference.

MS
LP1 LP2

rate of
interest r2

r1

O
quantity of money

The rate of interest rises as a result of a shift in the liquidity preference curve from LP 1 to
LP2.
Which policy might be used to try to maintain the rate at r1?

A the purchase of bonds in the open market

B reductions in income tax rates
C increases in indirect taxes
D increased government expenditure
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N/05/3/22
6 The diagram shows three different levels of the supply of money (MS) and three different
demand for money curves (LP). The initial equilibrium is at point X.
There is an increase in the level of money income and at the same time there is a
contraction in bank credit.
Which point could be the new equilibrium point?

rate of
interest X D
B
LP3

LP1
C
LP2
MS2 MS1 MS3
O
quantity of money

J/06/3/23
7 What is most likely to cause the public to hold less cash in relation to the level of money
income?
A a fall in interest rates
B a fall in the level of output
C a greater availability of cash substitutes
D a rise in the general price level

N/06/3/22
8 According to Keynesian theory, what would cause individuals to want to hold more idle
money balances?
A an increase in bond prices
B an increase in the rate of interest
C an increase in the rate of inflation
D an increase in the level of output
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N/07/3/23
9 The diagram shows the two main components (X and Y) of the liquidity preference curve.

XY

rate of
interest

O
quantity of money

What can be concluded about component X?

A It is an active balance and is interest-elastic.

B It is an active balance and is interest-inelastic.
C It is an idle balance and is interest-elastic.
D It is an idle balance and is interest-inelastic.

N/08/3/20
10 The diagram shows three different levels of money supply (MS) and three different
demand curves for holding money balances (LP). The initial equilibrium is at point X.
Banks create more credit and people decide to hold less money as a precaution against
emergencies.
What is the new equilibrium point?

D X B
rate of LP
interest LP
C
LP

MS MS MS
O
quantity of money
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J/09/3/22
11 According to Keynesian theory, in which circumstance would there always be an increase
in the demand for money?

real income price level interest rates

A increase decrease increase
B constant constant increase
C increase increase decrease
D constant decrease decrease

J/11/32/19
12 According to Keynesian theory, in which circumstance will there always be an increase in
the demand for money?

real income price level interest rates

A constant decrease increase
B constant increase decrease
C increase decrease decrease
D increase increase increase

N/11/32/22
13 According to Keynesian analysis, what will be the result of a decrease in the money
supply?

A The rate of interest will be reduced, thereby reducing the levels of investment
and income.
B The rate of interest will be increased, thereby reducing the levels of investment
and income.
C The level of income will be increased as a result of a lower rate of interest and a
higher level of investment.
D The price level will fall by the same percentage change as the decrease in the
money supply.

N/11/32/23
14 What will be the likely effects on interest rates and bond prices of an increase in the
demand for money?

interest rates bond prices

A fall fall
B fall rise
C rise fall
D rise rise
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Loanable Fund Theory

J/05/3/21
15 The diagram shows the market for loanable funds.

D2 S1

D1 S2

rate of E1
interest E2

O loanable funds
Which changes could cause the equilibrium to move from E1 to E2?

A an increase in the propensity to save and an increase in bank lending

B the discovery of oil reserves and an increase in the propensity to save
C advances in technology and a decrease in bank lending
D a decrease in the propensity to save and the introduction of new products

J/06/3/22
16 The diagram shows the demand curves and supply curves of loanable funds.

D2
S1
S2
D1

rate of E2
E1
interest

O loanable funds
Which changes could cause the equilibrium in the market for loanable funds to move
from E1 to E2?

A an increase in the money supply combined with a decrease in the propensity to

save
B a decrease in bank lending combined with an increase in the productivity of
capital
C an increase in bank lending combined with an increase in business confidence
D a decrease in the money supply combined with an increase in the propensity to
save
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N/06/3/23
17 The diagram shows the market for loanable funds.

D2
S2
S1
D1
E2
rate of
interest
E1

O loanable funds
Which changes could cause the equilibrium to move from E1 to E2?
A an increase in bank lending and a depletion of natural resources
B an increase in the propensity to save and the discovery of new mineral deposits
C advances in technology and a reduction in the propensity to save
D a decline in business confidence and a decrease in bank lending

J/08/3/25
18 The diagram shows the market for loanable funds.

D2 S1

D1 S2

rate of E1
interest E2

O loanable funds
Which changes could cause the equilibrium to move from E1 to E2?
A an increase in the propensity to save and an increase in bank lending
B the discovery of oil reserves and an increase in the propensity to save
C advances in technology and a decrease in bank lending
D a decrease in the propensity to save and the introduction of new products
N/09/3/23
19 According to loanable funds theory, what will cause the rate of interest to rise?
A an increase in the rate of investment
B an increase in liquidity preference
C an increase in the level of savings
D an increase in the supply of money
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J/10/3/21
20 The diagram shows the demand curves and supply curves of loanable funds.

D1
S2
S1
D2

rate of E1
E2
interest

O loanable funds
Which changes could cause the equilibrium in the market for loanable funds to move
from E1 to E2?

A a decrease in bank lending combined with a decrease in business confidence

B a decrease in the money supply combined with an increase in the propensity to
consume
C an increase in bank lending combined with an increase in the productivity of capital
D an increase in the money supply combined with a decrease in the productivity of labour

N/10/3/23
21 The diagram shows the market for loanable funds.

D1
S1
S2
D2
E1
rate of
interest
E2

O loanable funds
Which changes could cause the equilibrium to move from E1 to E2?

A a decline in business confidence and an increase in bank lending

B a decrease in bank lending and depletion of natural resources
C an increase in the propensity to save and the discovery of new mineral deposits
D improvements in technology and reduction in the propensity to save
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N/13/32/21
22 According to loanable funds theory, what will cause the rate of interest to rise?
A a decrease in the demand for money
B an increase in the level of savings
C an increase in the rate of investment
D an increase in the supply of money

J/14/32/21
23 The diagram shows the market for loanable funds. The market is in equilibrium at point X.
What could be the new equilibrium point if there was a decline in business confidence
and an increase in bank lending?

S1
D3
D2 S2
D1 B
S3

rate of A
C
interest X

O
loanable funds

J/15/32/24
24 The diagram shows the determination of the rate of interest in the economy, where M
represents the money supply and LP represents liquidity preference.

LP1 LP2 M

rate of r2
interest
r1

O
quantity of money
What could cause the rise in the rate of interest from r 1 to r2?
A an increase in national income
B an increase in the money supply
C a reduction in investment expenditure
D a reduction in the loans made by the private sector
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N/15/32/21
25 What is likely to be the effect on interest rates and the supply of money of a purchase of
government securities by a central bank?

interest rates money supply

A increase increase
B increase decrease
C decrease decrease
D decrease increase
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Section: 26 Quantity Theory of Money

Quantity Theory of Money (QTM) presents one of the most important theories of inflation
according to which money supply and price level are directly and proportionately related. So for
instance, doubling or halving money supply doubles or halves the price level respectively. Irving
Fisher, a mathematician turned economist, reaffirmed the quantity theory of money using the
following equation: MV = PT

where M = Stock of money

V = Velocity of circulation i.e. number of times money changes hands
P = Price level
T = Volume of goods and services traded (it is also the real income)

The left hand side of the equation, MV represents the supply of money whereas the other side,
PT shows demand for money (PT also gives the value of money income). For equilibrium to hold,
MV must always equal PT, that is supply must always equal demand. An increase in quantity of
money by 10% raises money income by 10% assuming an unchanged velocity of circulation
(try N/02/3/21).

Quantity Theory of Money assumes that:

 Changes in money supply do not affect velocity of circulation
 There is always full employment in the economy and changes in money supply do not
change volume of goods and services traded.
MV
MV = PT P
T
Given the two assumptions mentioned above, a 100% increase in money supply raises price level
by 100% since V and T do not change. The value or the purchasing power of money is halved.
1
Value of money
Price level

Keynesian criticism on the Quantity Theory of Money

Keynesians argue that the assumption of velocity remaining unchanged with changes in money
supply is unrealistic. Increased supply of money decreases interest rates and the opportunity cost
of being liquid. As a result, people use their liquidity rather slowly, thus decreasing velocity of
circulation. This view is supported by empirical evidence, as supply of money has indeed proven
to be inversely related to velocity of circulation.
Secondly, as stated earlier, demand side economists believe that unemployed resources and
excess capacity always exist. Increased supply of money may therefore increase the volume of
goods and services produced, having little or no impact on the price level.
According to Keynes, increased supply of money is not spent in the product market so has no
impact on the price level. The extra liquidity is more likely to go into purchasing financial assets
such as bonds, increasing their market prices and lowering interest rate.
Lastly, Keynes argued that money supply does not determine the price level but is itself, price
determined. Increased price level raises the demand for money and people use near money to
fulfill increased liquidity requirements, raising money supply.
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Credit Creation Process

Banks attract households to deposit their cash surplus with them, so that deposits become the
liability of banks and deposit holders earn a markup. On the other hand, banks lend money to
consumers and firms for consumption and investment and charge borrowers a markup, since
these loans are banks‟ assets. The difference between the lending rate (average rate at which
bank lends money) and the deposit rate (average rate which bank pays to deposit holders)
measures a commercial bank‟s profit margin.

However, depositors may approach banks to withdraw their deposits any time they like. In order
to fulfill such requirements, commercial banks maintain a portion of bank deposits in the form of
liquid assets. The percentage of bank deposits which must be kept in liquid form may be decided
by banks themselves, with profit maximizing ones keeping a very low percentage. In most
countries however, it is the Central Bank which declares a compulsory ratio commercial banks
must maintain to remain liquid and solvent enough to meet their depositors‟ obligations. Such
regulation is expected to help the banking system operate smoothly.
Commercial banks thus create credit by lending money. Assume that:
 People keep all their liquid assets in banks.
 Liquid asset ratio is 10% i.e. banks lend 90% of deposits and keep the remainder in the
form of cash.
 There is infinite demand for bank loans.

Suppose £100 is deposited in bank A, which lends £90 and keeps £10 in the form of cash. £90 do
not go out of the banking system since the borrower, buying either consumer or investment goods
sooner or later deposits them in either the same or another bank. Assuming £90 get deposited in
bank B, it would lend £81 and keep cash worth £9. £81 may become bank C‟s deposit and the
process repeats infinitely. This process of credit creation is shown below, assuming an initial
deposit worth £1 for simplicity.

Banks ∆ Deposits ∆ Loans ∆ Cash

A £1 £0.9 £0.1
B £0.9 £0.81 £0.09
C £0.81 £0.719 £0.081
D £0.719 £0.656 £0.073
E £0.656
. . . .
. . . .
. . . .
. . . .
. . . .
. . . .
. . . .
_________________________________________
10 9 1

Column 2 appears as liabilities on a commercial bank‟s balance sheet whereas columns 3 & 4
are recorded as assets.
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The deposit multiplier, derived in a manner similar to the expenditure multiplier (see section 18) is
10 in this example. Deposit or monetary multiplier is the inverse of liquid asset ratio and loan
multiplier is always less than deposit multiplier by 1.

1 1
Deposit(monetary) multiplier Loan multiplier 1
Liquid asset ratio Liquid asset ratio

Excess reserves are the difference between liquid assets actually held by commercial banks and
the minimum amount of assets which must be kept liquid. Assuming a liquid asset ratio of 10%,
bank X with liquid assets worth £100 has excess reserves of £90.

Excess reserves = Actual liquid assets – required liquid assets

The credit creation ability of a banking system, £900 in the example above, is given by:
Credit creation ability = Excess reserves × monetary multiplier

The credit creation ability of an individual bank however, is restricted to excess reserves since it
is impossible to guarantee that money lent by it is re deposited in it too. Credit creation ability of
bank X therefore becomes £90.
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Multiple Choice Questions

(Section 26)
J/02/3/18
1 In which circumstance will an increase in the public sector deficit not lead to an increase
in the money supply, other things being equal?
A The deficit is financed by an increase in government borrowing from private
individuals.
B The rate of interest is held constant.
C There is large-scale unemployment.
D Commercial bank lending to the private sector is held constant.

J/02/3/28
2 A country has a floating exchange rate, full employment and an expansionary fiscal
policy. The government decides to make the central bank independent with the power to
determine monetary policy.
If the central bank adopts a zero inflation target, what is likely to happen to interest rates
and the exchange rate?

Interest rates Exchange rates

A fall fall
B fall rise
C rise fall
D rise rise

J/02/3/29
3 Which measure could be expected to reduce the pressure of demand-pull inflation in an
open economy?
A a depreciation of the foreign exchange rate
B a reduction in interest rates
C a reduction in the rate of tax on goods and services
D a removal of import controls

N/02/3/21
4 A 6% increase in the money supply leads to a 4% increase in the level of money income.
What can be deduced from this?
A There has been an increase in interest rates.
B There has been a decrease in the level of output.
C There has been a decrease in the velocity of circulation.
D The price level has increased by 2%.

N/02/3/22
5 What would result in a reduction in the volume of bank deposits?
A an increase in the public‟s desire to hold cash
B an increase in government expenditure financed by borrowing from the central
bank
C a reduction in the proportion of their deposits that banks hold in cash
D an open market purchase of securities by the central bank
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J/03/3/24
6 Assuming a constant income velocity of circulation of money, if real output grows by 3 %,
and the rate of growth of the money supply is 10 %, what will be the approximate change
in the price level?

A –7% B +7%
C + 10 % D + 13 %

N/03/3/24
7 Which method of financing a government deficit will leave the money supply unchanged?
A the sale of government securities to the central bank
B the sale of government securities to the commercial banks
C the sale of government securities to domestic residents
D the sale of government securities to overseas residents

J/04/3/24
8 A closed economy has a banking system consisting of a single bank. The bank operates
with a cash ratio of 10 %.
Customers deposit $10 000 in cash.
Assuming no subsequent change in notes and coins in circulation what is the maximum
amount of loans that the bank can create?
A $1000 B $9000
C $90 000 D $100 000

J/04/3/30
9 What would represent a monetarist anti-inflationary policy?
A an increase in indirect taxation
B direct foreign exchange rate intervention
C the introduction of maximum prices
D the sale of securities on the open market

N/04/3/24
10 Assuming a constant income velocity of circulation of money, if real output grows by 5 %,
and the money supply grows by 2 %, what will be the approximate change in the price
level?
A –3 % B +2 %
C +3 % D +7 %

N/04/3/30
11 An economy has a low level of unemployment. The government increases its
expenditure.
Which method of financing the additional expenditure is most likely to cause inflation?
A an increase in borrowing from the Central Bank
B an increase in income taxes
C an increase in sales of state assets to the non-bank public
D an issue of bonds to the non-bank public
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J/05/3/22
12 In a closed economy, if the income velocity of circulation of money remains constant,
what will be the result of an increase in the money supply?
A a proportionate increase in the level of money income
B a proportionate increase in the level of output
C a proportionate increase in the rate of growth of money income
D a proportionate increase in the rate of growth of output
J/07/3/24
13 What is likely to happen to interest rates and aggregate demand when a central bank
sells government securities?
interest rates aggregate demand
A fall fall
B fall rise
C rise fall
D rise rise

N/07/3/20
14 A country‟s government runs a budget surplus of $10 billion.
What must the country‟s central bank do to prevent cash reserves of the commercial
banks from falling?

A buy bonds of a value at least equal to $10 billion

B buy bonds of a value less than $10 billion
C sell bonds of a value at least equal to $10 billion
D sell bonds of a value less than $10 billion
N/07/3/29
15 In which combination of circumstances is an increase in government expenditure likely to
result in the largest increase in output?

initial level
means of financing additional expenditure
of unemployment
A high borrowing from the banking system
B high increase in tax rates
C low increase in tax rates
D low issues of bonds to non-bank private sector

J/08/3/23
16 In a banking system, all banks maintain 20 % of deposits as cash.
One bank receives a new cash deposit of $200. Subsequent net withdrawals of cash
from the banking system are zero.
What will be the resulting increase in bank loans and the total increase in bank deposits?

increase in bank loans total increase in deposits

A $160 $200
B $160 $360
C $800 $1000
D $1000 $1000
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N/08/3/18
17 In an economy, the volume of output rises by 3 % in a year, while the quantity of money
rises by 5%.
If the velocity of circulation of money remains the same, what will be the approximate
increases in the money value of national income and the price level?
increase in money
increase in price level
value of national income
A 5% 2%
B 5% 3%
C 8% 2%
D 8% 3%

N/08/3/19
18 What is likely to be the effect on interest rates and the supply of money of a sale of
government securities to the public by a central bank?

interest rates money supply

A increase increase
B increase decrease
C decrease decrease
D decrease increase

N/09/3/16
19 Assuming a constant income velocity of circulation of money, if the rate of growth of the
money supply is 8 % and the average price level increases by 5 %, what will be the
approximate change in real output?

A –3 % B +3 % C +8 % D +13 %

N/09/3/22
20 The government sells $1 million of bonds to the commercial banks. It uses the proceeds
from the sale to provide subsidies to sugar producers who pay them into their bank
accounts.
Assuming that notes and coins in circulation remain unchanged, what will be the
immediate effect on the assets and liabilities of the commercial banks?

assets liabilities
bonds +$1 million
A unchanged
reserves –$1 million
B bonds +$1 million deposits +$1 million
C reserves –$1 million deposits –$1 million
D unchanged unchanged
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J/10/3/15
21 The diagram shows changes in broad and narrow measures of money supply between
2004 and 2006.
Narrow money
12
9
% 6
3
0
key
–3
2004 2005 2006 Euro area
Britain
Broad money Japan
16 United States

12
% 8

4
0
2004 2005 2006

Which is the only area to have experienced a contraction in either of its measures of
money supply?

A Euro area B Britain C Japan D United States

N/10/3/22
22 An increase in the money supply leads to a fall in interest rates. What else will decrease
as a result of these changes?

A the desire to hold idle money balances

B the price of equities
C the price of government bonds
D the velocity of circulation of money
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J/11/32/24
23 The diagram shows a government‟s revenue and expenditure for three years.
revenue
2008
expenditure

revenue
2009
expenditure

revenue
2010
expenditure

0 1 2 3 4
$m
What can be concluded from the diagram?

A A budget deficit was replaced by a budget surplus.

B A government borrowing requirement emerged.
C The economy moved from a recession into a boom period.
D The yield from taxation continuously increased.

N/11/32/17
24 Despite a government budget deficit, a country‟s money supply remains unchanged.
What could explain this?

A The country has a balance of payments surplus equal to the government budget
deficit.
B The country‟s foreign exchange rate is fixed.
C The government budget deficit is financed by borrowing from the central bank.
D The government budget deficit is financed by selling government bonds to
members of the public.

J/12/32/23
25 What would result in an increase in the volume of bank deposits?

A an increase in the public‟s desire to hold cash

B an increase in government expenditure financed by borrowing from the central bank
C an increase in the proportion of their deposits that banks hold in cash
D an open market sale of securities by the central bank

J/12/32/24
26 In a banking system all banks maintain 10 % of deposits as cash.
Customers withdraw $20 000 in cash.
Assuming no subsequent net change in notes and coins in circulation, by how much will
the banks have to reduce their net loans?

A $2000 B $18 000 C $180 000 D $220 000

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N/12/32/20
27 In 2009 the US central bank, the Federal Reserve, increased the money supply.
Which policy measure taken by the Federal Reserve would have achieved this outcome?

A a purchase of government securities in the open market

B a reduction in the issue of short-term government debt
C a requirement for commercial banks to increase their liquidity ratios
D an increase in the bank rate
N/12/32/21
28 The diagram shows three different levels of money supply (MS) and three different
demand curves for holding money balances (LP). The initial equilibrium is at point X.
Banks create more credit and people decide to hold more money as a precaution against
emergencies.
What is the new equilibrium point?

D X B
rate of LP
interest LP
C
LP

MS MS MS
O
quantity of money
J/13/32/18
29 A country‟s central bank engages in a policy of quantitative easing (open market
purchase of securities).
How is this policy meant to affect the quantity of narrow money and the quantity of broad
money?

effect on narrow money effect on broad money

A increase increase
B increase decrease
C decrease increase
D decrease decrease

J/13/32/21
30 Other things remaining unchanged, what is likely to be a consequence of an increase in
net cash withdrawals from the commercial banks?

A an inflationary spiral
B an increase in the cash reserves of the commercial banks
C an increase in the liquidity of the commercial banks
D a restriction in the ability of the commercial banks to lend
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J/13/32/22
31 The diagram shows the determination of the rate of interest in an economy where MS
represents the money supply and LP represents liquidity preference.
MS
LP1 LP 2

rate of
interest r2

r1

O
quantity of money
The rate of interest rises as a result of a shift in the liquidity preference curve from LP1 to
LP2.
Which policy might be used to try to maintain the rate at r1?
A increased government expenditure
B increases in indirect taxes
C reductions in income tax rates
D the purchase of bonds in the open market

N/13/32/18
32 The diagram shows changes in broad and narrow measures of money supply between
2004 and 2006.
narrow money
12
9
% 6
3
0
key
–3
2004 2005 2006 Euro area
Britain
broad money Japan
16 United States

12
% 8

4
0
2004 2005 2006

Which is the only area to have experienced a contraction in either one of its measures of
money supply?
A Euro area B Britain
C Japan D United States
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N/13/32/19
33 Which assertion could be described as monetarist rather than Keynesian?

A The interest elasticity of investment expenditure is close to zero.

B The money supply is the main determinant of aggregate monetary expenditure.
C The money supply is the main determinant of output in the long-run.
D The velocity of circulation of money is unstable over time.

J/14/32/17
34 A closed economy has a banking system consisting of a single bank. The bank operates
with a cash ratio of 10%. Customers deposit $20 000 in cash.
Assuming subsequent net withdrawals of cash from the banking system are zero, what is
the maximum amount of loans that the bank can create?

A $2000 B $18 000

C $180 000 D $200 000

N/14/32/21
35 A central bank pursues a policy of quantitative easing by purchasing government
securities.
What is likely to happen to interest rates and aggregate expenditure?

aggregate
interest rates
expenditure
A fall fall
B fall rise
C rise fall
D rise rise

N/14/32/27
36 A government decides to pursue a more reflationary fiscal policy and a more deflationary
monetary policy.
Which combination of changes in policy instruments is consistent with this?

government
interest rate taxation
expenditure
A decrease decrease decrease
B decrease decrease increase
C increase increase decrease
D increase increase increase

J/15/32/18
37 Other things being equal, the money supply in an open economy will increase if

A domestic banks increase their lending to foreign borrowers.

B the central bank buys foreign currency in the foreign exchange market.
C the government sells bonds to domestic residents.
D there is an increase in the volume of imports to the economy.
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J/15/32/22
38 Assuming a constant income velocity of circulation of money, if the price level increases
by 5% and the money supply grows by 2%, what will be the approximate change in real
output (transactions)?

A –3% B –2.5% C +3% D +7%

J/15/32/23
39 Why will an inflationary process be brought to a halt if the money supply is held constant?

A Consumption will decrease as money incomes decline.

B Government expenditure will have to be reduced as government revenues
decline.
C The rate of interest will rise as more money is required for transactions purposes.
D The stimulus to invest will decline as the real burden of company debt rises.

N/15/32/20
40 Over one year the money income in an economy increased by 6%. In the same period
prices rose by 4%.
What can be concluded from this?

A Real incomes decreased by 2%.

B The velocity of circulation decreased by 2%.
C The money supply increased by 10%.
D The volume of output increased by 2%.

N/15/32/28
41 The table shows how the government finances its budget deficit in a closed economy.

$
budget deficit 200 billion
sale of government securities to the central bank 50 billion
sale of government securities to the non-bank private sector 150 billion

If there is no change in notes and coins in circulation and commercial banks maintain a
10% cash reserve ratio, what will be the resulting increase in the money supply?

A $50 billion B $150 billion

C $200 billion D $500 billion
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Section: 27 Unemployment

The main types of unemployment

Frictional unemployment
 This occurs when people are 'between jobs' and the number of job vacancies provides a
rough estimate of the size of frictional unemployment.
 The longer the „search time‟, the higher the number of frictionally unemployed people.
(Search time is the time taken by workers in finding out a job)
 The availability of unemployment benefits slows down workers‟ efforts in searching for
jobs and also increases their aspirations, hence increasing search time.
 Frictional unemployment may be reduced by reducing unemployment benefits and/or
improving communication between employers with vacancies and job applicants
 Governments can help by setting up a computerized job information service in Job
Centres.

Casual unemployment
 People are casually unemployed when changing jobs becomes frequent
 Daily wagers and workers working in construction are casually unemployed

Seasonal unemployment
 Frictional unemployment, when frequent and taking place at regular intervals, becomes
seasonal unemployment
 This is caused by the seasonal variation of demand in certain industries or sectors of the
economy such as construction, tourism and agriculture
 Affected industries may be encouraged to diversify their products to attract demand
throughout the year, such as tourism venues competing for income from the conference
market
 Employees in the affected sectors may be encouraged to compete for jobs in sectors
unaffected by seasonal variation in demand

Structural unemployment
 This type of unemployment is caused by a mismatch between the characteristics i.e. the
requirements of a job and the abilities, qualifications and expertise of workers
 Rapid technological developments create a divergence between workers‟ skills and job
requirements leading to increased technological and structural unemployment.
 As the structure of the economy alters over time, people have to adapt to find new jobs in
new parts of the economy. In UK for instance, the process of deindustrialization i.e. a
move from industrial sector to tertiary (service) sector caused massive unemployment
 This may mean that unemployed workers have to relocate or retrain or do both, in order
to get a new job
 Due to labour immobility, large pockets of unemployment can remain trapped in particular
regions where the old industries were located
 Governments can help by providing subsidies to employers in regions with high levels of
unemployment or by improving labour mobility
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Cyclical unemployment
 This is caused by low levels of demand and prevails during recessions. Falling demand in
the economy leads to reduced demand for labour
 Governments can help by boosting the level of aggregate demand in the economy. This
would involve increasing public expenditure and/or cutting taxation

Technological unemployment
 This is seen when firms use capital investment to reduce their reliance on unskilled or
semi-skilled labour
 A good example is car production where automation and computer-aided manufacture
has been introduced or administrative jobs where the use of information technology has
become widespread
 Workers affected by technological unemployment must retrain to seek new jobs
Regional unemployment
 This is where high levels of unemployment prevail in specific areas
 It exists in areas of high concentration of industries, which have declined with changes in
the structure of the economy
 Governments can help by offering regional aid, including incentives for new industries to
relocate in affected areas
 Governments can also help by encouraging local pay agreements instead of setting a
minimum national wage

International unemployment
 This is where domestic producers are replaced by firms based overseas. The attempt of
domestic producers to find cheaper production opportunities in overseas markets i.e.
outsourcing, is one reason of this type of unemployment
 The home country may be seen as uncompetitive in terms of price or quality
 Governments may choose to use trade policies such as quotas or tariffs to avoid this, but
may face pressure from the World Trade Organization if it does so
 Artificially lowered exchange rates could be used to make domestic goods less expensive
to overseas buyers
Voluntary unemployment
 Some of the economically inactive may be so through choice
 Powerful trade unions and their ability to win high real wages reduce job opportunities
 Some people may find it more attractive to live off social security benefits. Such people
are victims of the famous „unemployment trap‟
 Governments can make working more attractive by using the tax system to allow low-
paid workers to keep more of their income. At the same time, these people could have
their benefit payments reduced if they refuse to accept suitable job opportunities
 Classical economists believe that people are unemployed only voluntarily. According to them,
there won‟t be unemployment if workers and strong trade unions didn‟t insist on too high real
wages. However, Keynes maintains a distinction between voluntary and involuntary
unemployment. According to him, demand deficient unemployment is involuntary and can be
overcome by an active government role targeting an increased aggregate demand.
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Unemployment cannot be dealt with effectively, without identifying its type. The following table
summarises few policy options to reduce various types of unemployment.

Type of Unemployment Possible solution

Reduce welfare spending on benefits, improve
Frictional
information about job vacancies
Reduce tax rates, reduce interest rates,
Cyclical and Demand deficient
increase government spending (try J/03/3/29)
Structural Education and train workers (try N/02/3/27)

Philips Curve
On analyzing the 90 year data (1860-1950) of the UK economy, A. W. Philips discovered a stable
but non-linear relationship between wage inflation and the rate of unemployment, as shown in
diagram 27.1. The downward sloping curve represents a trade off between the two important
macro economic objectives of reducing unemployment and stabilizing price level.

Diagram 27.1
Wage inflation

A B
5%

Unemployment
U1 U* (%age of working population)
At an unemployment rate of U* in the diagram above, wages and hence prices are stable.
Assume that the government finds U* too high a level of unemployment and wishes to trade off
along the Philips curve. It may very well succeed in decreasing unemployment from U* to U 1, but
wages and price level are no longer stable. Increased wages raise price level through both
demand pull (increased wages raise purchasing power and hence aggregate demand) and cost
push effects (increase in wages in excess of productivity improvements raises unit labour cost
and results in cost push inflation).
Increasing wages by 5% increases unit labour cost by 5%, given that labour productivity remains
unchanged. At point A, the government has reduced unemployment to U 1 but inflation rate has
increased to 5%. More workers are willing to work thinking their wages have increased but fail to
see that real wages are unchanged (Real wage is the ratio of money wage and price level and a
proportionate increase in money wages and price level leaves real wages unchanged). Likewise,
firms believe their profits have risen after the price increase whereas in reality, profits are
unchanged since costs of production have also risen (due to increased wages). According to
Keynes the economy rests at point A with a reduced unemployment at U 1 since both workers and
firms remain victims of money illusions.
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However, monetarists disagree and assert that the economy may temporarily move to point A
since increased money supply and aggregate demand are unanticipated. However long run
provides sufficient time to economic agents to make necessary adjustments to expectations
about future price levels and see through money illusions, workers exit the job market and firms
also lay off „additional‟ workers employed and economy moves back to point B. Unemployment
increases to the previous level of U*, but wages and price level are no longer stable. Hence, the
short run trade off or conflict between the objectives of full employment and price stability does
not exist in the long run. (try J/05/3/17).
*
U is natural rate of unemployment, the level of unemployment where the labour market is in
equilibrium. Frictionally, casually and structurally unemployed people all form part of natural
unemployment. Any attempt to reduce unemployment below this level will only inflate the price
level and Philips curve shifts upward. Height of the curve at natural rate of unemployment i.e. U*
gives the expected inflation rate. Expected inflation rate which was 0% has now risen to 5%.
There is a separate Philips curve for every expected inflation rate and a higher rate shifts the
curve upwards. See N/02/3/28
At point B, both the current and expected inflation rate is 5%, so workers demand a wage
increase of 5%. Wages and price continue to rise at 5%.The economy may stay at point B if the
government does not repeat its „mistake‟ of trading off along the Philips curve. If the latter
happens, unemployment remains unchanged whereas the price level increases continuously (try
J/03/3/26).
Philips curve is a straight vertical line in the long run, implying that any attempt to reduce
unemployment below the natural rate only inflates the price level but leaves the employment level
unchanged. This natural rate, however, may itself be decreased when the long run Philips curve
shifts leftwards.
Diagram 27.2
Wage inflation Monetarist Philip
Curve

Unemployment
U*

Supply Side Policies And Natural Rate Of Unemployment

What follows is a list of supply side measures that shift the long run Philips curve towards left,
decrease the natural rate of unemployment, shift the production possibility curve outwards and
increase potential rate of economic growth.
 Government decreases or restricts the provision of unemployment benefits. This
pressurizes unemployed workers into searching for jobs more aggressively, thus
decreasing frictional unemployment.
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 Government increases expenditures on training and education. A trained and educated

work force is occupationally more mobile and results in reduced structural unemployment
 Lowering top tax rates (tax rates at higher income level) encourages workers and
investors to work and invest more, increasing the pace of economic growth and lowering
unemployment.
 Improved infrastructure increases workers‟ geographical mobility, helping them find jobs
quickly and reducing overall unemployment.
 Widening inter-regional wage differentials incentivize workers to move to other areas,
increasing their geographical mobility and reducing the natural rate of unemployment.
 Narrowing inter-regional house price differentials makes sale and purchase of houses
easier, raising the level of geographical mobility and reducing the natural rate of
unemployment.
 Checking the number of trade union members weakens their power to demand high
wages, in excess of productivity and helps reduce the natural rate of unemployment (try
J/07/3/29)
 Abolishing national pay legislation and encouraging local pay agreements also helps
reduce natural unemployment.

Potential versus Actual Rate of Economic Growth

Factors such as increase in resources, technology improvements, increased spending on
training/education of workforce and increased female participation in workforce shift the
production possibility and aggregate supply curves rightwards, showing an increase in potential
output. The actual growth, on the other hand, requires the use of unemployed, idle and newly
discovered resources. Increased rate of potential growth may increase unemployment if
governments fail to utilize the additional resources. Unemployment falls only when the actual rate
of economic growth exceeds potential rate of economic growth (try N/07/3/27). Factors raising
potential rate of economic growth also raise actual rate of economic growth except the following
ones which may increase actual rate of economic growth in the short run but diminish the
potential rate of economic growth in the long run.

 Increased government budget deficit injects demand and increases the actual rate of
economic growth. However, the increased role of a less efficient public sector at the
expense of the so called more efficient private sector crowds out resources, diminishing
the potential rate of economic growth in the long run (try J/06/3/26).
 Import barriers and devaluation of the national currency make local goods relatively
cheap and switch expenditures towards them, increasing the actual rate of economic
growth in the short run. However, elimination of competition makes local producers
complacent and inefficient, diminishing the potential rate of economic growth in the long
run. Therefore, a stronger currency and removal of trade barriers promote competition
and enhance efficiency, increasing the rate of potential growth (try J/07/3/25).

Poverty Trap
A poverty trap is a „bad‟ equilibrium that exists at an individual, societal or national level and
involves a vicious cycle of poverty and underdevelopment breeding more poverty and
underdevelopment, often from one generation into the next. For poorest countries, it may involve
an income level too low to generate the savings necessary for initiating the process of sustained
growth. Total saving may be too small to compensate depreciation, let alone add to capital stock.
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Classical versus Keynesian school of thought- A summary

Classical/Monetarists Keynesians
Price mechanism has the capacity to allocate Price mechanism alone is highly insufficient
resources efficiently and solve all economic and government intervention is essential for
problems automatically without any intervention. smooth running of economic systems.
The role of government is thus restricted to
upholding property rights. “Less government is
the best government”.
Unemployment is only voluntary and can be Keynes maintains a distinction between
decreased by allowing real wages to fall till voluntary unemployment and involuntary or
demand for labour equals its supply and demand deficient unemployment. Wages
unemployment becomes zero. Likewise, the and prices are sticky downwards as neither
price level falls whenever Aggregate Demand workers accept lower wages nor firms lower
falls short of Aggregate Supply. Thus flexible prices. Government intervention is required
price and wage mechanisms help the economy to overcome demand deficiency and reduce
recover from recessions. unemployment by injecting demand.
People are rational enough to see through People are victims of money illusion and
money illusions and their behaviour is attach more importance to nominal figures
influenced by changes in real wages. For
example, workers raise supply of labour only
when real wages increase and won‟t mind a cut
in wage as long as prices fall as well.
Saving is a function of interest rate and Saving is a function of income. Changes in
investments also respond to changes in interest interest rate have little or no effect on
rates, thus changes in interest rates are investment and the interest elasticity of
sufficient to bring equality between savings and investment expenditure is close to zero.
investments. Future expectations and expected rate of
return determine the level of investment
instead of changes in interest rate. Thus
changes in interest rates can‟t bring equality
between savings and investments.
Increased money supply increases Aggregate Increased money supply reduces interest
Demand and hence the price level. Thus, the rates. Aggregate Demand increases when
money supply is the main determinant of either government or consumers increases
aggregate monetary expenditure. their spending.
An attempt to reduce unemployment below its There is a trade off between unemployment
natural rate accelerates inflation in the short and inflation. Unemployment can be
run- thus a trade off between unemployment decreased by allowing price level to
and inflation is possible in the short run. increase. Demand injections through budget
However in the long run, such a trade off does deficits reduce unemployment and raise
not exist and any attempt to reduce economic growth.
unemployment below its natural rate only
accelerates inflation but leaves the level of
employment unchanged (try J/08/3/19).
Increased budget deficit and trade restrictions
increase Aggregate Demand and might
increase actual rate of economic growth but
diminish the potential rate of economic growth.
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Multiple Choice Questions

(Section 27)
J/02/3/26
1 An economy is operating initially at its natural rate of unemployment.
According to monetarist theory, compared to the initial position, what will be the effect on
unemployment in the short run and in the long run of an unanticipated increase in the
money supply?
short run long run
A no change no change
B no change reduction
C reduction no change
D reduction reduction
J/02/3/27
2 What is likely to increase a country‟s actual output but may reduce its long-run rate of
growth of potential output?
A an increase in the size of the labour force
B increased government spending on education
C an increase in the size of the government‟s budget deficit
D increased female participation in the labour force
N/02/3/27
3 Which of the following policies is specifically designed to reduce the level of structural
unemployment?
A a reduction in interest rates
B a reduction in the level of direct taxation
C the provision of retraining schemes
D an increase in the level of state benefit paid to the unemployed
N/02/3/28
4 The diagram shows the relationship between the rate of increase in wages and the rate
of unemployment.

rate of
increase in
wages

O
rate of unemployment
Which of the following would be likely to cause the curve in the diagram to shift upwards
and to the right?
A a reduction in regional differences in unemployment rates
B a reduction in the proportion of the workforce belonging to trade unions
C an increase in the unemployment rate
D the expectation of a higher rate of inflation
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J/03/3/17
5 The government of a centrally planned economy decides to replace central planning with
a market system.
What does the experience of the former Communist states suggest is likely to happen in
the early stages of the transition process to national output and to the inflation rate?

national output inflation rate

A decrease decrease
B decrease increase
C increase increase
D increase decrease

J/03/3/20
6 Which statement is consistent with a Keynesian view of the workings of the
macroeconomy?

A Recessions can result from fluctuations in private investment expenditure.

B Interest rates move to ensure continuous equality between savings and
investment plans.
C Money wages in the economy in the short run are perfectly flexible.
D Changes in aggregate demand cannot occur without equivalent changes in the
money supply.
J/03/3/26
7 A government uses monetary policy in an attempt to keep actual unemployment
continuously below the „natural‟ rate of unemployment.
What is likely to be a consequence of this policy?

A a high but constant rate of inflation

B a low but constant rate of inflation
C a decelerating rate of inflation
D an accelerating rate of inflation

J/03/3/28
8 Real output in an economy grows by 1.5 % but at the same time the level of
unemployment increases.
What can be deduced from this information?

A Labour productivity has decreased.

B Actual output has grown more slowly than potential output.
C Population of working age has fallen.
D There has been an increase in the rate of inflation.

J/03/3/29
9 If the unemployment that exists in a country is judged to be mainly cyclical, which is the
most effective policy the government could implement?

A cut welfare spending on benefits

B improve information about job vacancies
C reduce tax rates
D raise interest rates
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N/03/3/20
10 An economy is operating initially at its natural rate of unemployment.
According to monetarist theory, what will be the effect on unemployment in the short run
and in the long run of an unanticipated increase in the money supply?
short run long run
A no change no change
B no change reduction
C reduction no change
D reduction reduction

N/03/3/28
11 Which type of unemployment arose from the worldwide decline in the demand for
electronic goods beginning in the summer of 2001?

A seasonal
B voluntary
C frictional
D structural

J/04/3/22
12 According to monetarist theory, what will be the short-run effect of an unexpected
increase in the money supply?

A an appreciation of the foreign exchange rate

B an increase in employment
C an increase in real wages
D an increase in the rate of interest

J/04/3/25
13 Between 2000 and 2002 national output in the United States increased by 2 %.
Over the same period the unemployment rate increased from 4 % to 6 %.
What would explain this?

A There was a decrease in labour productivity.

B There was a decrease in the size of the labour force.
C There was a fall in the rate of inflation.
D Potential growth in national output was above actual growth.

J/04/3/26
14 The natural rate of unemployment in an economy is 5 %.
What will happen if a government persists in trying to achieve a target rate of
unemployment of 3 % by expansionary monetary policy?

A an accelerating rate of inflation

B a diminishing rate of inflation
C a high but constant rate of inflation
D a negative rate of inflation
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J/04/3/27
15 Which policy is most likely to result in a decrease in the natural rate of unemployment?

A a reduction in interest rates

B an increase in government expenditure on goods and services
C an increase in trade union membership
D a decrease in the level of government payments to the unemployed

N/04/3/26
16 In the long run, productive potential in an economy grows at an average rate of 3 % per
year. In a particular year actual growth is zero because of a fall in domestic consumption.
What is likely to occur?

A an increase in the rate of inflation

B an increase in the trade deficit
C an increase in unemployment
D a reduction in the government budget deficit

N/04/3/27
17 The diagram shows the relationship between the rate of inflation and the rate of
unemployment.

J
F

inflation
rate

K
G
O unemployment rate
What would cause the curve FG to shift to JK?

A a decrease in government expenditure

B a fall in the level of employment
C an increase in the rate of change of wages
D the expectation of an increase in inflation

J/05/3/17
18 According to monetarist theory, which policy objectives are in conflict in the short run, but
not in the long run?

A economic growth and full employment

B economic growth and price stability
C full employment and price stability
D price stability and equilibrium in the balance of payments
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J/05/3/25
19 What will assist a country's potential growth in national output?

A a reduction in cyclical unemployment

B an increase in the rate of inflation
C an increase in the government's budget deficit
D increased participation in the labour force

N/05/3/14
20 The value of government benefits that households are able to claim currently depends on
their level of income.
What would reduce the extent of the resulting poverty trap?

A a campaign to encourage more households to apply for the benefits to which

they are entitled
B an increase in the level of government benefits
C a reduction in the rate at which benefits are withdrawn as a household‟s income increases
D the targeting of benefits on those in greatest need

N/05/3/17
21 According to monetarist theory, when will an increase in the money supply leave the level
of output unchanged?

A when the increase in the money supply was not anticipated

B when the exchange rate is flexible
C when the liquidity trap is operative
D when there is an immediate adjustment to expectations about future price levels

N/05/3/24
22 In an economy the long-run rate of growth of potential output is 2.5 %.
What must happen in the short run if actual output grows at 5 %?

A an increase in employment
B an increase in the rate of inflation
C a deterioration in the balance of trade
D an increase in labour productivity

N/05/3/25
23 All else remaining unchanged, which measure would be most likely to increase the
natural rate of unemployment?

A an increase in expenditure on education and training

B an increase in the rate of unemployment benefits
C a reduction in the government‟s budget deficit
D a reduction in the general level of interest rates
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N/05/3/26
24 The diagram shows an economy's short-run Phillips curve.

SRPC

inflation
rate

O
unemployment rate

What is assumed to remain constant when drawing this curve?

A the average price level
B the money supply
C the exchange rate
D the natural rate of unemployment

J/06/3/18
25 What is a central assertion of „Monetarist‟ economics?
A Fiscal policy should be used for the continuous management of the economy.
B Major recessions can occur despite an unchanged money supply.
C The money supply dominates the determination of aggregate monetary
expenditure.
D The velocity of circulation of money is unstable over time.

J/06/3/25
26 What is likely to increase a country‟s actual output in the short run but may reduce its
long-run rate of growth of potential output?
A an increase in the size of the labour force
B increased government spending on education
C an increase in the size of the government‟s budget deficit
D increased female participation in the labour force

J/06/3/27
27 Which type of unemployment is associated with a deficiency in aggregate demand?

A cyclical B frictional
C structural D voluntary

N/06/3/18
28 Which statement is consistent with a Keynesian view of the workings of the
macroeconomy?
A Recessions can result from fluctuations in private investment expenditure.
B Interest rates move to ensure continuous equality between savings and
investment plans.
C Money wages in the economy in the short run are perfectly flexible.
D There is no short-run trade off between inflation and unemployment.
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N/06/3/27
29 In an economy the proportion of the working age population in employment increases
from 70 % to 80 %.
What is likely to be the effect on labour productivity and on GDP per head?

labour productivity GDP per head

A increase increase
B increase decrease
C decrease increase
D decrease decrease

N/06/3/28
30 What would be most likely to result in an increase in an economy's long-run rate of
growth of potential output?

A an appreciation of the currency

B an increase in interest rates
C an increase in the government's budget deficit
D an increase in the level of private investment

J/07/3/21
31 Which assertion could be described as monetarist rather than Keynesian?

A Central banks must directly control interest rates to influence the money supply.
B The interest elasticity of investment expenditure is close to zero.
C The money supply is the main determinant of aggregate monetary expenditure.
D The velocity of circulation of money is unstable over time.

J/07/3/25
32 What will be most likely to decrease a country‟s national output in the short run but to
increase its potential for long-run growth?

A a decrease in the level of import tariffs

B a decrease in the rate of immigration
C an increase in female participation in the labour force
D an increase in the money supply
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J/07/3/26
33 In the diagram SRPC is an economy's short-run Phillips curve and LRPC is its long-run
Phillips curve.

SRPC LRPC

rate of
inflation
V

W
O
unemployment rate

The economy is initially at point W.

An increase in monetary growth moves the economy to point V.
Why is it that the economy cannot stay at point V?

rate of inflation at point V unemployment rate at point V

A above the expected rate above the natural rate
B above the expected rate below the natural rate
C below the expected rate above the natural rate
D below the expected rate below the natural rate

J/07/3/27
34 What is most likely to lead to an increase in the natural rate of unemployment?

A more rapid technological change

B a widening in inter-regional wage differentials
C a narrowing in inter-regional house price differentials
D a decrease in the number of workers who are members of trade unions

J/07/3/29
35 Legal reforms to reduce the power of trade unions have in many countries reduced
inflationary pressures.
Of which policy is this an example?

A monetary policy
B demand side policy
C fiscal policy
D supply side policy
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N/07/3/26
36 The diagram shows the relationship between the rate of increase in wages and the rate
of unemployment.

rate of
increase in
wages

O
rate of unemployment
What would be likely to cause the curve in the diagram to shift upwards and to the right?

A a reduction in regional differences in unemployment rates

B a reduction in the proportion of the workforce belonging to trade unions
C an increase in the unemployment rate
D the expectation of a higher rate of inflation
N/07/3/27
37 What would be most likely in the short run to cause an increase in a country‟s
unemployment rate?

A an increase in its potential output

B an increase in its balance of trade surplus
C an increase in the government‟s budget deficit
D an increase in the money supply
N/07/3/28
38 What is an example of an expansionary supply side policy?

A an increase in tariffs
B an increase in interest rates
C an increase in spending on welfare
D an increase in spending on training benefits
J/08/3/19
39 An economy is operating initially at its natural rate of unemployment.
According to monetarist theory, what will be the effect on unemployment in the short run
and in the long run of an unanticipated increase in the money supply?
short run long run
A no change no change
B no change reduction
C reduction no change
D reduction reduction
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J/08/3/28
40 The diagram shows the relationship between the rate of inflation and the rate of
unemployment.

J
F

inflation
rate

K
G
O unemployment rate

What would cause the curve FG to shift to JK?

A a decrease in government expenditure

B a fall in the level of employment
C an increase in the rate of change of wages
D the expectation of an increase in inflation

N/08/3/15
41 What will be the short-run effect on the level of output of an increase in the money
supply, according to Keynesian theory (assuming the liquidity trap does not apply) and
according to monetarist theory (assuming the increase is unanticipated)?

effect on output
Keynesian theory monetarist theory
A increase increase
B increase unchanged
C unchanged increase
D unchanged unchanged

N/08/3/21
42 Real output in an economy grows by 1.5 % but at the same time the level of
unemployment increases.
What can be deduced from this information?

A Labour productivity has decreased.

B Actual output has grown more slowly than potential output.
C Population of working age has fallen.
D There has been an increase in the rate of inflation.
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N/08/3/22
43 Which pattern of labour market data is likely to indicate an increase in cyclical
unemployment?
changes in
compulsory redundancies voluntary resignations
A decrease increase
B increase increase
C decrease decrease
D increase decrease

N/08/3/23
44 The natural rate of unemployment in an economy is 5%.
What will happen if a government persists in trying to achieve a target rate of
unemployment of 3 % by expansionary monetary policy?

A an accelerating rate of inflation

B a diminishing rate of inflation
C a high but constant rate of inflation-
D a negative rate of inflation

N/08/3/25
45 What would increase an economy's actual output but not its potential output?

A an increase in the capital available to the labour force

B an increase in the labour force's skill level
C an increase in the number in the labour force
D an increase in the proportion of the labour force employed

N/08/3/30
46 A country's government wishes to switch demand away from private consumption
towards investment and net exports.
Which combination of policy measures would be most likely to help it achieve this
objective?

interest rates rate of income tax

A increase increase
B increase decrease
C decrease increase
D decrease decrease

J/09/3/17
47 According to monetarist theory, which policy objectives are in conflict in the short run, but
not in the long run?

A economic growth and full employment

B economic growth and price stability
C price stability and full employment
D price stability and equilibrium in the balance of payments
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J/09/3/26
48 Which combination of factors is most likely to result in more rapid economic growth?

A increases in employment and in the balance of payments deficit

B increases in the level of investment and in the size of the working population
C more equal distribution of wealth and a higher level of unemployment benefits
D more rapid inflation and an increase in the national debt

N/09/3/17
49 According to monetarist theory, what will be the short-run effect of an unexpected
increase in the money supply?

A an appreciation of the foreign exchange rate

B an increase in employment
C an increase in real wages
D an increase in the rate of interest

N/09/3/24
50 In the diagram, the curve X1 shows an economy‟s initial trade-off between inflation and
unemployment.

X1 X2

rate of
inflation

unemployment rate

What could cause the curve to shift to X2?

A an increase in the natural rate of unemployment

B a decrease in the money supply
C the expectation of a decrease in the inflation rate
D an increase in the rate of interest

J/10/3/16
51 What is a central assertion of monetarist economics?

A Fiscal policy should be used for the continuous management of the economy.
B Major recessions can occur despite an unchanged money supply.
C The money supply is the main determinant of aggregate monetary expenditure.
D The velocity of circulation of money is unstable over time.
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J/10/3/24
52 An economy is operating at its natural rate of unemployment.
According to monetarist theory, what will be the effect on unemployment in the short run
and in the long run of an unanticipated increase in the money supply?

short run long run

A no change no change
B no change reduction
C reduction no change
D reduction reduction

J/10/3/25
53 The diagram shows the relationship between the rate of increase in wages and the rate
of unemployment.

rate of
increase in
wages

O
rate of unemployment
What would be likely to cause the curve in the diagram to shift downwards and to the
left?

A a reduction in regional differences in unemployment rates

B an increase in the proportion of the workforce belonging to trade unions
C an increase in the unemployment rate
D the expectation of a higher rate of inflation

J/10/3/27
54 Which is most likely to result in an increase in the natural rate of unemployment?

A a decrease in government expenditure on goods and services

B a decrease in the level of government payments to the unemployed
C an increase in trade union membership
D an increase in interest rates
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N/10/3/17
55 According to Keynesian theory, when will an increase in the money supply leave the level
of output unchanged?

A when the liquidity trap is operative

B when the money supply increase was not anticipated
C when there is a floating exchange rate
D when there is an immediate adjustment to expectations about future price levels

N/10/3/18
56 According to monetarist theory, what will be the short-run and the long-run effect of an
unexpected increase in the money supply on the real wage level?

short-run long-run
A decrease increase
B decrease unchanged
C unchanged increase
D unchanged unchanged

N/10/3/25
57 What is likely to be the effect of a fall in oil prices on the global economy?

A a decrease in the rate of economic growth

B a decrease in unemployment
C a strengthening of cost-push inflation
D a weakening of demand-pull inflation

N/10/3/26
58 What is an unavoidable cost of long-run economic growth?

A an increase in inflation
B an increase in the working hours of the population
C a sacrifice of potential present consumption
D greater inequality in the distribution of income

N/10/3/27
59 What could be expected to increase the pressure of demand-pull inflation in an open
economy?

A an appreciation of the foreign exchange rate

B an increase in indirect taxes
C an increase in interest rates
D the imposition of import controls
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J/11/32/14
60 An economy is operating at its natural rate of unemployment.
According to monetarist theory, what will be the effect on unemployment in the short run
and in the long run of an unanticipated increase in the money supply?

short run long run

A no change no change
B no change reduction
C reduction no change
D reduction reduction

J/11/32/21
61 Which cause of economic growth would involve the least cost for present and future
generations of a country‟s population?
A increased exploitation of a country‟s mineral resources
B investment financed by borrowing from abroad
C investment financed by high rates of domestic savings
D technological innovations in productive processes

J/11/32/23
62 The diagram shows the relationship between the rate of inflation and the rate of
unemployment.

F
J

inflation
rate

G
K
O unemployment rate
What would cause the curve FG to shift to JK?

A a lower exchange rate

B a lower expected rate of inflation
C an increase in government expenditure
D a rise in the level of employment

J/11/32/27
63 What would be classified as a supply side policy measure?

A additional legislation to restrict the power of trade unions

B a reduction in the government‟s fiscal deficit
C an open market sale of securities
D the imposition of a tariff on imported goods
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N/11/32/06
64 The table shows the labour market for an economy in four separate years.
In which year was there excess demand in the labour market?

working population unemployment job vacancies

(millions) rate (%) (thousands)
A 19 1.0 180
B 19 2.0 80
C 20 1.1 240
D 20 1.5 100

N/11/32/13
65 What would economists agree should be the aim of any health care system?

A to meet all the health care demands of the population

B to provide every patient with the latest and best available treatment
C to provide free medical treatment
D to secure the maximum health gain from the resources available

N/11/32/26
66 The diagram shows an economy‟s short-run Phillips curve (SRPC).

SRPC

the rate of change

in money wages

O
unemployment rate

What is assumed to remain constant when drawing this curve?

A the average price level B the exchange rate

C the expected rate of inflation D the money supply

J/12/32/20
67 According to monetarist theory, what will be the short-run effect of an unexpected
increase in the money supply?

A an appreciation of the foreign exchange rate

B an increase in output
C an increase in real wages
D an increase in the rate of interest
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J/12/32/25
68 Which change is most likely to increase both economic growth and economic development
in the long-run?

A a decrease in the savings ratio

B an increase in investment in human capital
C the depletion of non-renewable resources
D the greater use of compulsory overtime working of labour

J/12/32/26
69 What is likely to result from the discovery of oil reserves in a developing economy?

A a more equal distribution of income and wealth

B an increase in the real exchange rate
C an increase in the competitiveness of commercial agriculture
D a reduction in the volume of imports of manufactured goods

J/12/32/27
70 What will be most likely to decrease a country‟s national output in the short run but to
increase its potential for long-run growth?

A a decrease in the level of import tariffs

B a decrease in the rate of immigration
C an increase in female participation in the labour force
D an increase in the money supply

J/12/32/28
71 The number of people employed in a country and the level of unemployment both decrease.
What could explain this?

A net inward immigration

B an increase in the level of unemployment benefits
C an increase in the age at which state pensions are payable
D an increase in the number of students

N/12/32/22
72 An economy‟s unemployment rate is below the natural rate.
What is likely to be the implications of this for inflation and what can be deduced from this
about the economy‟s actual level of output?

inflation actual output

A accelerating below potential output
B accelerating above potential output
C decelerating below potential output
D decelerating above potential output
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N/12/32/23
73 The diagram shows a country‟s production possibility curve and a number of alternative
production points.

U
V
capital goods
Y

Z
O
consumer goods

Which change in the country‟s output would be most likely to lead to a fall in potential
growth?

A U to V B U to X C Y to X D Y to Z

N/12/32/24
74 What is most likely to lead to an increase in the natural rate of unemployment?

A more rapid technological and structural change

B a widening in regional wage differentials
C a narrowing in regional house price differentials
D a decrease in trade union membership

N/12/32/25
75 Which type of unemployment arose from the worldwide decline in the demand for
electronic goods beginning in the summer of 2001?

A seasonal
B voluntary
C frictional
D structural

N/12/32/26
76 What will assist a country‟s potential growth in national output?

A an increase in cyclical unemployment

B an increase in the rate of inflation
C an increase in the government's budget deficit
D increased participation in the labour force
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J/13/32/19
77 According to monetarist theory, what will be the short-run effect on the level of output and
on the price level of an unanticipated increase in the money supply?

effect on the
effect on output
price level
A increase increase
B increase no change
C no change increase
D no change no change

J/13/32/24
78 Which policy is specifically designed to reduce the level of structural unemployment?

A an increase in the level of state benefits paid to the unemployed

B a reduction in interest rates
C a reduction in the level of direct taxation
D the provision of retraining schemes

J/13/32/25
79 What would be most likely to stimulate long-run growth in an economy?

A employment protection legislation

B government policy to raise aggregate demand
C technical innovations by firms
D the development of trade unions

J/13/32/28
80 What is the main objective of supply side policies?

A to bring a country‟s potential output up to the level of its actual output

B to ensure a budget surplus
C to ensure that the composition of output matches the pattern of demand
D to increase potential output by increasing efficiency

N/13/32/15
81 What is most likely to contribute to households finding themselves in a poverty trap?

A means-tested benefits B progressive taxation

C regressive taxation D universal benefits

N/13/32/22
82 What is most likely to contribute to high long-term growth rates of GNP per head?

A government imposition of maximum prices for particular goods

B high rates of trade union membership amongst the labour force
C high ratios of saving to GNP
D restrictions on inward foreign investment
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N/13/32/23
83 A country experiences cyclical unemployment due to a decrease in domestic spending.
If the government takes no action in response, what will be a likely consequence?

A an increase in the current account deficit on the balance of payments

B an increase in the government‟s budget deficit
C an increase in the rate of inflation
D an increase in the volume of investment

N/13/32/24
84 What is a possible combination of a cost and a benefit of rising levels of unemployment?

cost benefit
A a deterioration in human capital an increase in capital expenditure
B an increase in import expenditure a decrease in government tax revenue
C an increase in the rate of economic growth a more responsive workforce
D an irretrievable loss of output a reduction in inflationary pressure

N/13/32/25
85 What would increase an economy‟s actual output but not its potential output?

A an increase in the capital available to the labour force

B an increase in the labour force‟s skill level
C an increase in the number in the labour force
D an increase in the proportion of the labour force employed

N/13/32/29
86 A government aims to achieve steady and stable growth, in line with the economy‟s long-
run increase in productivity.
If this objective is achieved, how is this likely to affect average living standards and the
level of unemployment?

average living level of

standards unemployment
A constant falling
B falling unchanged
C rising rising
D rising unchanged

J/14/32/23
87 An economic recession leads to an increase in unemployment.
Why might this cause a fall in an economy‟s long-term growth rate?

A It is impossible to regain consumption lost in recession.

B Rising unemployment is likely to raise real wage levels.
C Social attitudes become less accepting of unemployment.
D There will be a harmful effect on human capital.
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J/14/32/26
88 It is often argued that the present rate of economic growth will soon lead to the
exhaustion of reserves of material resources, such as minerals and oil.
What does this argument fail to take into account?

A the drawbacks of present GDP levels as an indicator of the „happiness‟ of the

population
B the effect of increasing resource prices on the discovery and exploitation of new
reserves
C the right of future generations to enjoy present standards of living
D the role of education in economic development

N/14/32/22
89 According to monetarist theory, if there is an unanticipated increase in the money supply
what will be the short-run effect on money wages, real wages and the level of
employment?

money wages real wages employment

A decrease decrease increase
B decrease increase decrease
C increase decrease increase
D increase increase decrease

N/14/32/24
90 A developing economy experiences a rapid growth in labour productivity.
What is most likely to result from this?

A an increase in the country‟s balance of trade deficit

B an increase in the country‟s relative labour costs
C a depreciation of the country‟s currency
D an increase in real income per head

N/14/32/26
91 Real output in an economy grows by 2.5% but at the same time the level of employment
decreases.
What can be deduced from this information?

A Actual output has grown more quickly than potential output.

B Labour productivity has increased.
C Population of working age has fallen.
D There has been an increase in the rate of inflation.
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J/15/32/26
92 The diagram shows a country‟s production possibility curve and a number of alternative
production points.
X

U
V
capital goods
Y

Z
O
consumer goods
Which change in the country‟s output would be most likely to lead to a fall in potential
growth?

A U to V B U to X C Y to X D Y to Z

J/15/32/27
93 A developing country receiving foreign financial aid is most likely to experience economic
growth in the long-run if it uses the money to

A boost welfare benefits for the poorest households.

B pay for imports of capital goods.
C reduce environmental pollution.
D reduce income tax for all households.

J/15/32/28
94 Increased borrowing by the government results in higher interest charges and this leads
to less private investment expenditure.
Of what is this an example?

A an automatic stabiliser
B crowding out
C the accelerator
D the substitution effect

N/15/32/25
95 An economy is operating at its natural rate of unemployment.
According to monetarist theory, what will be the effect on unemployment in the short run
and in the long run of an unanticipated increase in the money supply?

short run long run

A no change no change
B no change reduction
C reduction no change
D reduction reduction
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J/16/32/22
96 Which change is most likely to increase both economic growth and economic
development in the long run?

A a decrease in the saving ratio

B an increase in investment in human capital
C the depletion of non-renewable resources
D the greater use of compulsory overtime working of labour

J/16/32/23
97 Which type of unemployment occurs when aggregate demand is deficient?

A cyclical unemployment B regional unemployment

C seasonal unemployment D structural unemployment

J/16/32/24
98 The diagram shows the annual percentage (%) change in employment and output in the
UK private sector between 2000 and 2012.
4 output 10

2 5

0 0
employment employment output
–2 –5

–4 –10

–6 –15
2000 02 04 06 08 10 12
In which year did labour productivity increase the most?

A 2003 B 2007 C 2009 D 2012

J/16/32/25
99 According to Keynesian theory, when will an increase in the money supply leave the level
of output unchanged?

A when the liquidity trap is operative

B when the money supply increase was not anticipated
C when there is a floating exchange rate
D when there is an immediate adjustment to expectations about future price levels

J/16/32/28
100 What will be most likely to rise if unemployment is increasing in an economy?

A the human capital of unemployed workers

B the living standards of all workers
C the nominal money wage rate of employed workers
D the tax burden on employed workers
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Section: 28 Interdependence of Economic Policies

The Philips curve brought forth an important trade off between the macroeconomic objectives of
inflation and unemployment. Such trade offs and interdependence, as will be observed in the
ensuing text, is not uncommon in economic objectives and economic policies.

Consider an economy facing both inflation and a trade deficit. In such a situation, deflation helps
solve both problems simultaneously. Deflationary policies, by withdrawing demand, not only
control inflation but also help increase net exports, as locally made goods become more price
competitive both at home and abroad. However, a country facing a trade deficit and
unemployment confronts a trade off between the two policy objectives. The use of the
deflationary policies can help reduce trade deficit but intensifies the problem of unemployment. In
order to reduce unemployment, officials must reflate the economy, which is likely to increase the
trade deficit. To cut down both unemployment and the trade deficit, officials can decide to forego
the aim of defending exchange rates and revert to flexible exchange rate mechanism. Flexible
exchange rates take care of the trade deficit and officials are free to employ reflationary policies
to reduce unemployment. In case reflationary policies raise the inflation rate, the national
currency automatically depreciates to keep the balance of trade balanced.

Generally speaking, contractionary demand management policies have an expenditure reducing

impact- thus their use to decrease trade deficit is more likely to intensify the problem of
unemployment. However, inflationary trends, if any, will be neutralized.

The use of expenditure switching strategies such as devaluation of national currency, trade
barriers and exchange controls reduce trade deficit as well as unemployment. However, extra
demand injected into the economy can trigger inflation.

The following table summarizes the impacts of the use of expenditure reducing and expenditure
switching strategies on unemployment and inflation.

Trade Deficit Aggregate Demand Unemployment Inflation

Expenditure
reducing/dampening
policies e.g.
deflationary policies Decreases Decreases Increases Decreases
(increased interest
rates and taxes,
lower government
spending)
Expenditure
switching strategies
such as Decreases Increases Decreases Increases
devaluation, trade
barriers and
exchange controls
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Trade offs between macro-economic objectives

The following paragraphs discuss policy options for achieving different macro-economic
objectives.

As stated earlier, deflation helps economies solve the problems of trade deficit and inflation
simultaneously. However, countries facing unemployment and a trade deficit face a trade off-
demand management policies used to reduce unemployment increase the trade deficit and any
attempt to decrease trade deficit by deflating the economy increases unemployment. Such
countries may use any of the following options:

Option 1
The government can revert to flexible exchange rate mechanism to solve the problem of trade
deficit and use demand management policies to reduce unemployment.

Option 2
It can employ supply side tools, such as providing more incentives and tax concessions to
producers to increase production and exports. Subsidies can also be given for producing import
substitutes. This export led growth can increase employment as well as net export revenues.
Option 3
The two demand management policies, fiscal and monetary policy, can be used in differing
directions to simultaneously reduce unemployment and trade deficit. Contractionary monetary
policy i.e. increased interest rates may be used to attract capital inflows to finance the trade
deficit and its effects on economic activity and employment can be off set using expansionary
fiscal policy i.e. increasing government spending or decreasing taxes.

Officials can reflate an economy using demand management policies to simultaneously solve the
problems of trade surplus and unemployment. However, a trade off occurs when trade surplus
and unemployment co-exist. In such a case, officials can forget about defending exchange rate
and revert to flexible exchange rate regime. Flexible exchange rate regime gives the freedom to
officials to use demand management policies to solve the problem of inflation.

The table below summarizes the policy options discussed so far

Inflation Unemployment
Flexible exchange rate to solve the
problem of trade deficit and reflationary
policies to reduce unemployment
Trade Use deflationary policies to solve both
OR
deficit problems simultaneously
The use of expenditure switching
strategies such as devaluation, trade
barriers and exchange controls
Flexible exchange rate to solve the
problem of trade surplus and
deflationary policies to control inflation
Trade Use reflationary policies to solve both
OR
surplus problems simultaneously
The use of expenditure switching
strategies such as revaluation, export
controls
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Students must understand the impact of changes in interest rate on domestic employment, price
level and balance of payment. An increase in the interest rate attracts (financial) capital inflows ad
discourages capital outflows, increasing the demand and reducing the supply of national currency
in the world market. Increased capital inflows and decreased capital outflows improve the
financial (capital) account of balance of payment. National currency appreciates if exchange rate
is flexible and official reserves of foreign currencies pile up if exchange rate is fixed.

Increased exchange rate (appreciation of national currency) makes exports expensive and
imports cheaper. Decreased demand for exports and increased demand for imports causes a
worsening of visible section of current account (balance of trade). On the other hand, increased
interest rate slows down domestic economic activity and forces consumers to reduce
expenditures on domestically produced goods as well as on imports, resulting in improved
balance of trade. Thus the impact of increased interest rate on balance of trade (when exchange
rate is flexible) is uncertain. However, increased interest rate is likely to improve trade balance if
exchange rate is fixed.

Government and financial institutions have to make higher interest payments on borrowed funds
from overseas. This causes a worsening of invisible section of current account.

Briefly speaking, increased interest rates

 Increase demand for national currency in international market
 Decrease supply for national currency in international market
 Increase net capital inflows
 Improve financial account of balance of payment
 Increase exchange rate
 Have an uncertain effect on trade balance if exchange rate is flexible
 Improve trade balance if exchange rate is fixed
 Deteriorate invisible section of current account
 Slow down the pace of economic activity
 Decrease consumers‟ expenditures
 Decrease investment expenditures
 Decrease national income and employment
 Decrease inflation rate
 Increase unemployment
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The impacts of changes in exchange rates (appreciation or depreciation of national currency) on

balance of payment and on domestic economy are summarized in the following table:

Aggregate Demand
Net export revenue

Cost push inflation

Volume of export

Volume of import

Unemployment
Terms of trade
Price of export

Price of import

Demand pull
Description

inflation
Appreciation/rev

If Ed (Xn) < 1
Increase in
aluation of

Decreases

Decreases

Decreases

Decreases

Decreases
exchange Increases

Increases

Increases

Increases

Increases
national
rate
currency

If Ed (Xn) > 1
Depreciation/de
Decrease in
Decreases

Decreases

Decreases

Decreases
Increases

Increases

Increases

Increases

Increases

Increases
valuation of
exchange
national
rate
currency
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Multiple Choice Questions

(Section 28)
J/02/3/30
1 What is most likely to increase as a result of a rise in interest rates in a country?

A the level of house prices

B the inflow of short-term foreign capital
C the level of private investment
D the return on capital investment

N/02/3/23
2 If a country has a surplus in its balance of payments, all else being equal, what is likely to
happen to its money supply?

A It will fall, because more of its goods were purchased by foreign consumers than
by consumers at home.
B It will remain unchanged, because its exports are bought with foreign currency.
C It will remain unchanged, because the surplus is automatically offset by a loan for
the deficit countries.
D It will rise, because the foreign currency received for exports will be exchanged
for domestic currency.

J/03/3/30
3 Which policy is likely to reduce a balance of payments deficit without causing inflation?

A a reduction in government spending

B a devaluation of the exchange rate
C an increase in import tariffs
D an increase in indirect taxes

J/04/3/28
4 The monetary authorities increase interest rates in order to control inflation.
What is likely to increase as a result of this?

A firms' sales revenue

B investment expenditure
C net capital outflows
D the exchange rate

N/04/3/28
5 Why might a rise in domestic interest rates improve a country‟s balance of payments on
current account?

A Domestic firms will become more competitive.

B It will result in a fall in the exchange rate.
C It will result in a reduction in spending.
D There will be an inflow of short-term capital.
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J/05/3/15
6 In the diagram D is a country's demand curve for an imported good. The world price of
the good is OPW .

Pc
price x y
Pw

z
D

O quantity
Which area measures the deadweight loss to the country of imposing an import tariff
equal to PW PC on the good?
A x B y C x+y D y+z
J/05/3/26
7 In an economy with flexible exchange rates an increase in government spending is
financed by borrowing from the public.
What is likely to be the effect on interest rates and on the level of net exports?
effect on interest rates effect on net exports
A increase increase
B increase decrease
C decrease decrease
D decrease increase
J/05/3/29
8 What is most likely to increase as a result of a rise in interest rates in a country?
A the inflow of short-term foreign capital
B the level of company profits
C the level of private investment
D the level of share prices
J/05/3/30
9 A country introduces import quotas.
The suppliers of imported goods charge market-clearing prices.
Assuming the demand for imports is price-elastic, what will be the impact on the country‟s
balance of trade and on its terms of trade?

balance of trade terms of trade

A improves improves
B improves worsen
C worsen worsen
D worsen improves
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N/05/3/27
10 The economy of a country is simultaneously experiencing a balance of payments deficit,
a budget deficit, demand inflation and unemployment. The government decides to cut
personal income taxes.
What does this suggest is its main macroeconomic objective?

A to improve the balance of payments position

B to reduce the budget deficit
C to reduce the level of unemployment
D to reduce the rate of inflation
N/05/3/28
11 A developing economy attracts additional foreign direct investment.
What is likely to be the effect on its visible trade balance and on its invisibles balance?

visible trade balance invisibles balance

A improve improve
B improve worsen
C worsen improve
D worsen worsen
J/06/3/28
12 Which combination indicates that a country has a freely floating exchange rate?
nominal exchange rate foreign currency reserves
A depreciates by 20% decrease by $1 billion
B depreciates by 20% unchanged
C unchanged decrease by $1 billion
D unchanged unchanged

J/06/3/29
13 A government decides to pursue a more deflationary fiscal policy and a more reflationary
monetary policy.
Which combination of changes in policy instruments is consistent with this?
government expenditure interest rate taxation
A decrease decrease increase
B decrease decrease decrease
C increase increase decrease
D increase increase increase
N/06/3/26
14 An economy has unemployed resources and a flexible exchange rate. It lowers interest
rates below the level prevailing in other countries.
What will be the likely effect on the level of domestic demand for goods and services and
on the demand for the country‟s exports?
domestic demand export demand
A increase increase
B increase decrease
C decrease decrease
D decrease increase
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N/06/3/29
15 An economy with a floating exchange rate is in recession and at the same time has a
deficit on the current account of its balance of payments.
Which policy combination would be most likely to help with both of these problems?

interest rates tax rates

A decrease unchanged
B decrease increase
C increase unchanged
D increase increase

J/07/3/30
16 Which combination of policy measures is most likely to reduce unemployment?

A lowering both the exchange rate and domestic interest rates

B lowering the exchange rate and increasing direct taxation
C raising both the exchange rate and domestic interest rates
D raising both the exchange rate and direct taxation

N/07/3/15
17 In the diagram, (D) is a country‟s demand curve for an imported good which cannot be
produced domestically. The world market price is OPw.

Pc
x
price y
Pw

D
O quantity

Which area measures the deadweight loss to the country of imposing an import tariff
equal to PwPc on the good?

A x+y
B x
C y
D x–y
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N/07/3/30
18 In the diagram, D1 is the initial demand curve for a country‟s currency, S1 is the initial
supply curve, and OE1 is the initial exchange rate.

S1

E2
exchange
E1
rate

D2
D1
O
quantity of currency
The demand curve then shifts to D2 and the exchange rate moves to E2.
What can be deduced from this?

A Exchange rates are freely fluctuating.

B The country‟s authorities are operating a managed float.
C At E2, the country‟s foreign exchange reserves will fall.
D Interest rates have fallen.

J/08/3/29
19 Other things being equal, what is likely to result from an increase in interest rates in a
country?

A a capital outflow from the country

B a depreciation of the country‟s currency
C a decrease in consumption
D an increase in investment

J/08/3/30
20 Why might a reduction in domestic interest rates improve the current account of a
country‟s balance of payments?

A It will cause an appreciation in the exchange rate.

B It will reduce the amount of interest paid to foreign holders of the country‟s
financial assets.
C The resulting higher level of economic activity is likely to increase imports.
D There will be an outflow of capital from the country.

N/08/3/28
21 The European Union imposes a quota on the volume of garments imported from China.
What is likely to be a consequence?
A a reduction in the profit margins on garments produced by Chinese textile firms
B a reduction in the inflation rate in the EU
C a switch to producing higher-value garments by Chinese textile firms
D the closure of Chinese-owned textile factories in Thailand
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J/09/3/28
22 An economy with a floating exchange rate is in recession and at the same time has a
deficit on the current account of its balance of payments.
Which policy combination would be most likely to help with both of these problems?

interest rates tax rates

A decrease unchanged
B decrease increase
C increase unchanged
D increase increase

J/09/3/29
23 In 2004 China‟s ability to exploit its comparative advantage in cotton production
increased.
What could explain this change?

A a fall in the value of the currency of India, a major cotton producer

B a reduction of the import quota on Chinese cotton into the European Union
C a rise in the wages of Brazilian cotton workers matched by an increase in their
productivity
D the removal of the United States of America‟s subsidy to its cotton growers

J/09/3/30
24 In the diagram D is the demand curve for Indian tea exports and S 1 is the initial supply
curve.
D S2

S1
price x

w
y

O
quantity
The Indian government imposes a tax on tea exports, which causes the supply curve to
shift to S2.
Which areas in the diagram measure the resulting gain in tax revenue to the Indian
government and the resulting loss in producer surplus to its tea producers?

gain in tax revenue loss in producer surplus

A x w+y
B x+y y
C x y
D x+y w+y
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N/09/3/27
25 An economy has unemployed resources and a flexible exchange rate. It lowers interest
rates below the level prevailing in other countries.
What will be the likely effect on the level of domestic demand for goods and services and
on the demand for the country‟s exports?

domestic demand export demand

A increase increase
B increase decrease
C decrease decrease
D decrease increase

N/09/3/28
26 Which policy is most likely to help to correct an adverse balance on the current account
of the balance of payments?

A abolishing tariffs B devaluing the currency

C reducing direct taxes D reducing indirect taxes

N/09/3/29
27 A government decides to pursue a more deflationary fiscal policy and a more reflationary
monetary policy.
Which combination of changes in policy instruments is consistent with this?

government
interest rate taxation
expenditure
A decrease decrease increase
B decrease decrease decrease
C increase increase decrease
D increase increase increase

N/09/3/30
28 An economy is operating at a point on its production possibility curve.
What is true about the way the economy‟s resources are being used at this point?

allocatively efficient productively efficient socially desirable

A possibly yes yes
B yes possibly possibly
C possibly Yes possibly
D yes possibly Yes

J/10/3/22
29 If the money supply is fixed, a decrease in economic activity

A increases interest rates.

B increases the transactions demand for money.
C raises the liquidity preference schedule.
D reduces the income velocity of circulation.
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J/10/3/26
30 Which policy is most likely to reduce a balance of payments deficit without causing
inflation?

A a devaluation of the exchange rate

B an increase in import tariffs
C an increase in indirect taxes
D an increase in direct taxes

N/10/3/30
31 A country introduces import quotas.
The suppliers of imported goods charge market-clearing prices.
Assuming the demand for imports is price-inelastic, what will be the impact on the
country‟s balance of trade and on its terms of trade?

balance of trade terms of trade

A improves improve
B improves worsen
C worsens improve
D worsens worsen

J/11/32/22
32 The table shows some indicators of macro-economic performance in the US economy for
five decades.

economic target 1950s 1960s 1970s 1980s 1990s

real GDP growth (average %) 4.18 4.43 3.28 3.02 3.03
inflation (average %) 2.07 2.33 7.09 5.66 3.00
unemployment (average %) 4.51 4.78 6.22 7.27 5.76

Between which decades did the US government achieve an overall improvement in its
performance with no trade-off between individual policy goals?

A 1950s to 1960s
B 1960s to 1970s
C 1970s to 1980s
D 1980s to 1990s

J/11/32/26
33 Why might a reduction in domestic interest rates have an adverse effect on a country‟s
balance of payment on current account?

A It will cause a rise in the exchange rate.

B It will make the country‟s industry less competitive.
C The resulting higher level of economic activity is likely to increase imports.
D There will be an outflow of capital from the country.
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J/11/32/28
34 A country decides to join a group of countries which maintain fixed parities for their
currencies and forbid any restriction on foreign trade and payments.
What will the country have to forgo to maintain a fixed parity for its currency?

A an independent anti-monopoly policy

B an independent fiscal policy
C an independent interest rate policy
D an independent prices and incomes policy

J/11/32/29
35 What would be an economic benefit to a major economy of imposing a tariff on imported
goods?

A It would increase labour productivity.

B It would increase pressure on foreign suppliers to reduce their prices.
C It would make the country‟s exports more competitive.
D It would reduce the prices paid by consumers for imported goods.

N/11/32/24
36 A developing country experiences a rapid growth in labour productivity.
What is likely to result from this?

A an appreciation of the country‟s nominal exchange rate

B an increase in the country‟s balance of trade deficit
C an increase in the country‟s inflation rate
D an increase in the country‟s relative labour costs

N/11/32/27
37 The economy of a country is simultaneously experiencing a balance of payments deficit,
a budget deficit, demand-pull inflation and unemployment. The government decides to
cut personal income taxes.
What does this suggest is its main macroeconomic objective?

A to improve the balance of payments position

B to reduce the budget deficit
C to reduce the level of unemployment
D to reduce the rate of inflation

N/11/32/28
38 What is not a valid economic argument for developing economies to pursue a policy of
import substitution?

A to embark on industrialisation as a basis for export-led growth

B to exploit their relative abundance of labour in order to produce labour intensive
manufacturing goods
C to increase the opportunities for exporting goods in which they already have a
comparative advantage
D to reduce their dependence on a narrow range of primary products
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N/11/32/30
39 An economy has a flexible exchange rate. It raises interest rates above the level existing
in other countries.
What will be the likely effect on the level of domestic demand for goods and services and
on the demand for the country‟s exports?
domestic demand export demand
A decrease decrease
B decrease increase
C increase decrease
D increase increase

J/12/32/29
40 What would be an appropriate government action to reduce both a balance of payments
current account surplus and the rate of inflation?
A increase the money supply B increase direct taxes
C remove tariffs on imports D devalue the currency

J/12/32/30
41 The government of Lesotho introduces a programme to promote exports and to
encourage firms to grow by subsidising local entrepreneurs.
What effect is this likely to have on incomes, the balance of payments current account
deficit and government expenditure in Lesotho?

balance of
government
incomes payments current
expenditure
account deficit
A fall uncertain rise
B rise reduce no change
C fall reduce rise
D rise uncertain rise

N/12/32/27
42 How might a developing economy gain from a multilateral reduction in import tariffs and
the removal by developed economies of subsidies on food exports?

A through increased specialisation leading to higher productivity

B through increased ability to protect infant industries
C through a reduction in the cost to the economy of imported food
D through increased tariff revenues

N/12/32/28
43 During a recession, a government increases its expenditure on goods and services by
$10 million but leaves tax rates unchanged.
Why might the subsequent increase in national income be less than $10 million?

A Increased government borrowing increases interest rates.

B The marginal propensity to consume is less than 1.
C The marginal propensity to import is greater than 0.
D There is no accelerator effect on investment.
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J/13/32/26
44 The European Union imposes a quota on the volume of garments imported from Brazil.
What is likely to be a consequence?

A a decrease in the price paid by EU consumers for Brazilian garments

B a reduction in the inflation rate in the EU
C a switch to producing lower-value garments by Brazilian textile firms
D the closure of Brazilian-owned textile factories

J/13/32/27
45 Other things being equal, what is likely to result from an increase in interest rates in a
country?

A a capital outflow from the country

B a depreciation of the country‟s currency
C a decrease in consumption
D an increase in investment

N/13/32/26
46 Which combination indicates that a country is operating a „dirty float‟?

nominal exchange rate foreign currency reserves

A depreciates by 20% decrease by $1 billion
B depreciates by 20% unchanged
C unchanged decrease by $1 billion
D unchanged unchanged

N/13/32/28
47 A country‟s government wishes to switch demand away from private consumption
towards investment and net exports.
Which combination of policy measures would be most likely to help it achieve this
objective?

rate of value
interest rates
added tax
A decrease decrease
B decrease increase
C increase decrease
D increase increase

J/14/32/28
48 A central bank increases interest rates in order to control inflation.
What is likely to increase as a result of this?
A firms‟ sales revenue B investment expenditure
C net capital outflows D the exchange rate
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J/14/32/29
49 What is most likely to result from a devaluation of the £ sterling?

A an increase in foreign direct investment in the UK by global manufacturing firms

B an increase in the number of UK residents taking holidays abroad
C an increase in the number of UK students applying for places in North American
universities
D an increase in the supply of foreign workers seeking temporary employment over
the summer in the UK

J/14/32/30
50 A fair trade scheme encourages consumers in developed countries to buy food produced
by farming cooperatives in developing countries at a higher price than that charged by
commercial firms.
Why might this be harmful to economic development?

A It will cause a worsening in the terms of trade of developing economies.

B It will reduce the amount of government aid provided to developing economies.
C It will reduce the prices subsistence farmers receive for their produce.
D It will slow the process of economic diversification in developing economies.

N/14/32/28
51 The table shows some indicators of macro-economic performance in the US economy for
five decades.

economic target 1950s 1960s 1970s 1980s 1990s

real GDP growth (average %) 4.18 4.43 3.28 3.02 3.03
inflation (average %) 2.07 2.33 7.09 5.66 3.00
unemployment (average %) 4.51 4.78 6.22 7.27 5.76

Between which decades did the US government achieve an overall improvement in its
performance with no trade-off between individual policy goals?

A 1950s to 1960s
B 1960s to 1970s
C 1970s to 1980s
D 1980s to 1990s

N/14/32/29
52 Why might a reduction in domestic interest rates have an adverse effect on a country‟s
balance of payments on the current account?
A It will cause a rise in the exchange rate.
B It will make the country‟s industry less competitive.
C The resulting higher level of economic activity is likely to increase imports.
D There will be an outflow of capital from the country.
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N/14/32/30
53 At present, a country‟s government has set its central bank a target rate of inflation of
2%.
What is likely to happen to interest rates and the exchange rate if the target inflation rate
is raised to 3%?

interest rates exchange rate

A fall fall
B fall rise
C rise fall
D rise rise

J/15/32/25
54 An economy is experiencing economic growth.
What will be the effect on its rate of inflation, level of unemployment and current account
surplus?

level of current account

rate of inflation
unemployment surplus
A lower lower lower
B raise lower raise
C raise raise uncertain
D uncertain uncertain Uncertain

N/15/32/26
55 What are likely to be the impacts on an economy of increased competition from abroad?

impact on
impact on trade impact on rate
unemployment
balance of inflation
rate
A improve raise decrease
B improve reduce decrease
C worsen raise increase
D worsen reduce increase
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Section: 29 Developing Economies

It is easy to find characteristics that are common to and typical of developing economies. Some of
the most important ones are briefly discussed below:

 Low per capita income- most developing economies possess a low level of per capita
income, since citizens mostly take up subsistence occupations and population growth is high
 Low saving ratio- just as relatively poor people tend to spend more and save less,
developing economies too, possess a low saving ratio. In fact, as mentioned earlier,
many are likely to be caught up in the poverty trap where the level of savings and hence
investment is too low to promote growth in the economy.
 High external debt and high national debt to GDP ratio- given that developing
economies possess a low level of per capita income and low saving ratios, their reliance
on high external debt does not come as a surprise.
 Low capital-labour ratio- developing economies are labour abundant and as
emphasized by the resource endowment theory, specialize in labour intensive products.
Capital- labour ratio remains low partly because of initial endowments and partly because
capital is difficult to obtain and employ, given poor resources and unskilled workers etc.
 Low and fluctualting terms of trade- exports of developing economies typically
comprise primary products, which possess low price elasticities of demand and supply.
This is why prices of primary commodities fluctuate widely, resulting in fluctuating terms
of trade (try N/02/3/26)
 High trade deficit- developing economies typically exchange low value added, low
priced products against sophisticated manufactured goods with a high degree of value
addition. This runs them into a trade deficit.
 Low literacy rates- majority of the population in developing economies does not gain
access to educational facilities. Low private and public spending on education and
training results in an unskilled and uneducated labour force with low productivity. Low
spending is however, part of the problem- the effectiveness of education in terms of
learning outcomes remains a big question mark. Also, increasing the supply of education
is not enough- it must be complemented with an increase in the demand for education
and educated workers, as the incentive to seek education would be lost otherwise.
 High population growth- whereas developed economies succeed in maintaining low
population growth rates, developing economies strive to check population growth and
birth rates. Some of them may be bound by social/cultural factors where checking
population by artificial means may become a source of conflict and instability.
 High unemployment- Low literacy rates and high population growth rates together
translate into the problem of unemployment. With rapid increases in population, it
becomes increasingly difficult to maintain a supply of jobs for all. Where jobs do become
available however, people lack the level of education and skills required to take them up.
 High inflation- factors like a weaker currency tied in with import cost push inflation,
unregulated markets, supply bottlenecks with low production against pressing demand all
result in high inflation rates for developing economies.
 High percentage of rural population- majority of the population in developing
economies like Pakistan dwells in rural areas. When labor does move out of them
however in search of better wages, it presents the challenges of increased urbanization
like congestion and strain on other facilities in urban areas.
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Multiple Choice Questions

(Section 29)
J/02/3/25
1 Which of the following combinations is usually found in less developed economies?

low high
A capital : output ratio saving ratio
B external debt capital : output ratio
C population growth external debt
D saving ratio population growth

N/02/3/26
2 What would explain why the prices of the primary commodities produced by less
developed countries fluctuate widely from year to year?

A the development of artificial substitutes for natural products

B the introduction of more capital-intensive methods of production by mineral
producers
C inelasticity of both the supply and demand for these products
D improvements in agricultural productivity

N/02/3/29
3 Which of the following is most likely to lead to an increase in a developing country‟s
long-run rate of growth of income per head?

A a higher birth rate

B a higher saving ratio
C the imposition of import controls
D an increase in government spending on defence

J/03/3/25
4 Which of the following is most likely to be found in a developing economy?

A a low capital : labour ratio

B a high capital : labour ratio
C a high capital : output ratio
D a low labour : output ratio

J/03/3/27
5 Workers in poor countries are often less productive than workers using the same
technology in rich countries.
What would be most likely to remedy this situation?

A an increase in the saving ratio in poor countries

B increased investment in education in poor countries
C increased freedom of migration from poor countries to rich countries
D the removal of trade barriers imposed by rich countries on imports from poor
countries
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N/03/3/26
6 The table shows the figures for consumption, capital formation and depreciation in four
economies, all measured in US $.
Assuming that the state of technology remains unchanged, which economy is most likely
to experience economic growth?

consumption capital formation depreciation

economy
($ m) ($ m) ($ m)
A 100 20 10
B 500 200 200
C 1 000 1 200 1 400
D 20 000 5 000 6 000

N/03/3/27
7 What is the major cause of high rates of inflation in many developing economies?
A balance of payments deficits
B budget deficits
C low levels of unemployment
D overvalued exchange rates

N/03/3/29
8 What is most likely to result from foreign direct investment in developing economies?
A a deterioration in the visible trade balances of developing economies
B a reduction in migration to urban areas
C a reduction in the transfer of technology to developing economies
D a rise in per capita levels of consumption in developing economies

J/05/3/24
9 A developing economy experiences a rapid growth in labour productivity.
What is likely to result from this?
A an increase in the country's balance of trade deficit
B an increase in the country's relative labour costs
C a depreciation of the country's currency
D an increase in real income per head

N/05/3/23
10 What is likely to increase GDP per worker in a developing economy?
A a decrease in the numbers engaged in subsistence agriculture
B a decrease in the numbers engaged in manufacturing
C an increase in the employment rate
D an increase in the population of working age

J/06/3/24
11 Which change would best indicate that a country has experienced economic
development?
A an improvement in the average citizen‟s quality of life
B an increase in the country‟s real GDP
C an improvement in the country‟s trade balance
D an appreciation in the country‟s currency
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J/06/3/26
12 What is most likely to lead in the long run to an increase in world real GDP per head?

A faster population growth

B trade liberalisation
C a lower propensity to save
D faster growth of the money supply

J/06/3/30
13 What is likely to be the effect of an oil price increase on the global economy?

A a strengthening of demand inflation

B a weakening of cost inflation
C a decrease in the rate of growth
D a decrease in unemployment

N/06/3/24
14 Which of the following are characteristics of most developing economies?
high government a high average
debt: GDP ratio propensity to save
A
B
C
D

J/07/3/28
15 What is likely to be the effect on developing economies of an increase in inward foreign
direct investment?

A an increase in the burden of debt

B a slowdown of rural-urban migration
C an increase in visible trade deficits
D an acceleration of technology transfers

N/07/3/25
16 What would explain why the prices of the primary commodities produced by less
developed countries fluctuate widely from year to year?

A the development of artificial substitutes for natural products

B the introduction of more capital-intensive methods of production by producers
C inelasticity of both the supply and demand for these products
D improvements in agricultural productivity

J/08/3/24
17 What is likely to result in an increase in GDP per worker in a developing economy?

A an increase in the employment rate

B an increase in the population of working age
C a shift from working in subsistence agriculture to working in manufacturing
D a shift from working in manufacturing to working in subsistence agriculture
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N/08/3/24
18 A developing economy experiences a rapid growth in labour productivity.
What is most likely to result from this?
A an increase in the country's balance of trade deficit
B an increase in the country's relative labour costs
C a depreciation of the country's currency
D an increase in real income per head

N/08/3/27
19 What is a necessary feature of economic growth?
A the elimination of an economy's output gap
B a continuing increase in the level of employment
C a continuing outward shift in an economy's production possibility frontier
D an increase in an economy's nominal GDP
J/09/3/23
20 How is outward migration from a developing economy likely to affect its balance of
payments?
A It may improve its balance of payments by increasing its export capacity.
B It may improve its balance of payments by increasing inflows of current transfers.
C It may worsen its balance of payments by causing a currency depreciation.
D It may worsen its balance of payments by increasing consumer expenditure on
imported goods.
J/09/3/25
21 Which change would best indicate that a country has experienced economic
development?
A an improvement in the average citizen‟s quality of life
B an increase in the country‟s real GDP
C an improvement in the country‟s trade balance
D an appreciation in the country‟s currency

J/09/3/27
22 How might a developing economy gain from a multilateral reduction in import tariffs and
the removal by developed economies of subsidies on food exports?

A through increased specialisation leading to higher productivity

B through increased ability to protect infant industries
C through a reduction in the cost to the economy of imported food
D through increased tariff revenues
N/09/3/26
23 What is most likely to be the impact on economic growth and on the rate of inflation in
developed economies of an inflow of migrant labour from developing economies?

impact on impact on
economic growth rate of inflation
A increase increase
B increase decrease
C decrease increase
D decrease decrease
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J/10/3/23
24 What could explain why the terms of trade of most developing economies tend to worsen
over time?
A Their currencies are over-valued in foreign exchange markets.
B They impose lower barriers on imports than developed economies.
C They produce a narrower range of goods than developed economies.
D They produce goods with a low income elasticity of demand.

J/11/32/20
25 Which characteristics are usually found in developing countries?

saving ratio capital output ratio

A low low
B high low
C low high
D high high

J/13/32/23
26 The table gives the percentage of employment in the primary, secondary and tertiary
sectors in four countries.
Which country is most likely to be a developing country?

primary secondary tertiary

sector % sector % sector %
A 15 40 45
B 30 40 30
C 35 45 20
D 45 35 20

J/14/32/24
27 The table shows the annual income thresholds per person used by the World Bank to
classify countries according to their nominal Gross National Income (GNI) in 2000 and
2010.

2000 2010
low income $755 or less $1005 or less
lower middle $756 to $2995 $1006 to $3975
upper middle $2996 to $9625 $3976 to $12 275
high income $9266 or more $12 276 or more

What could explain the changes recorded in the table?

A Income inequality between countries increased between 2000 and 2010.

B On average, real GNI in low income countries increased by roughly one third
between 2000 and 2010.
C On average, world prices increased by roughly one third between 2000 and
2010.
D Some of the countries in the upper middle income category in 2000 were re-
classified as high income countries in 2010.
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J/14/32/25
28 What is likely to result in an increase in GDP per worker in a developing economy?

A an increase in the employment rate

B an increase in the population of working age
C a shift from working in subsistence agriculture to working in manufacturing
D a shift from working in manufacturing to working in subsistence agriculture

J/15/32/29
29 The data below relate to a particular country for the four years shown:

Year 1 2 3 4
real GNP / head (Year 1 = 100) 100 110 121 121
life expectancy at birth (years) 65 64 65 67
% of age group enrolled in secondary
40 38 42 42
education

What can definitely be concluded from these data?

A Economic growth between Year 2 and Year 3 was 11%.

B The level of economic development was better in Year 2 than in Year 1.
C There was both economic growth and an improvement in economic development
between Year 2 and Year 3.
D No conclusions can be drawn as to whether the level of economic development
was better in Year 4 than Year 3.

N/15/32/29
30 What is likely to be the effect on developing economies of an increase in inward foreign
direct investment?

A an acceleration of technology transfer

B an increase in the burden of debt
C an increase in visible trade deficits
D a slowdown of rural-urban migration

N/15/32/30
31 Economists have proposed that the best policy to promote development is „trade not aid‟.
What is implied by this proposal?

A Developing countries should become self-sufficient.

B Developing countries should be given greater access to markets in developed
countries.
C Developing countries should use foreign aid to invest in their export industries.
D Developing countries should use trade barriers to promote import substitution.
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J/16/32/21
32 Which combination is usually found in less developed economies?

low high
A capital : output ratio saving ratio
B external debt capital : output ratio
C population growth external debt
D saving ratio population growth

J/16/32/29
33 What is most likely to result from foreign direct investment in developing economies?

A a deterioration in the trade balances of developing economies

B a reduction in migration to urban areas in developing economies
C a reduction in the transfer of technology to developing economies
D a rise in per capita levels of consumption in developing economies
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Answer Key
Section 1
1 2 3 4 5 6 7 8 9 10
A C D C A C C B B B
11 12 13 14 15 16 17 18 19 20
D B A C A A C D C D
21 22 23 24
A B A D

Section 2
1 2 3 4 5 6 7 8 9 10
A A D D D B D D D A
11 12 13 14 15 16 17 18 19 20
D C C A C A A C A B
21 22 23
A D B

Section 3
1 2 3 4 5 6 7
C D A A D D A

Section 4
1 2 3 4 5 6 7 8 9 10
C A C B A D B C D D
11 12 13 14 15 16 17 18 19 20
C C D B C B C D B B
21 22 23 24 25 26 27 28 29
D B C C B C B D A

Section 5
1 2 3 4 5 6 7 8 9 10
C C B D B B D C A A
11 12 13 14 15 16 17 18 19 20
B C C C C D C B C C
21 22 23 24 25 26 27 28 29 30
D A B C B C A D B B
31 32 33 34 35 36 37 38 39 40
B D D A C A C C B D
41 42 43 44 45 46 47 48 49 50
C A C B A D A B B A
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Section 6
1 2 3 4 5 6 7 8 9 10
D B C A B C D B D A
11 12 13 14 15 16 17 18 19 20
D C D D B C B C A C
21
B

Section 7
1 2 3 4 5 6 7 8 9 10
B A D D C A A C C B
11
C

Section 8
1 2 3 4 5 6 7 8 9 10
C A B D C C C C C B
11 12 13 14 15 16 17 18 19 20
D B B B D A C B C B
21 22 23 24 25 26
B B C B C B

Section 9
1 2 3 4 5 6 7 8 9 10
C D A B B C D D D C
11 12 13 14 15 16 17 18 19 20
B A B A C C D D B B
21 22 23 24 25 26 27 28 29 30
A D A B D A A A C A
31 32 33 34
C B C A

Section 10
1 2 3 4 5 6 7 8 9 10
B C A C D C D D C B
11 12 13 14 15 16 17 18 19 20
D C C D A A A D B C
21 22 23 24 25 26 27 28
B A C A B D D C
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Section 11
1 2 3 4 5 6 7 8 9 10
C B A A A D C C C B
11 12 13 14 15 16 17 18 19 20
B B A A B C C B C A
21 22 23 24 25 26 27 28 29 30
C D C B C C C B A C
31 32 33 34 35 36 37 38 39 40
A A D C D B B A C B
41 42 43 44 45 46 47 48 49 50
C D D B C C C B A C
51 52 53 54 55 56 57 58 59 60
D C A A C D D B D B
61 62 63 64 65 66 67 68 69 70
D A D C A D C A D D
71 72 73 74 75 76 77 78
D B C D D B B A

Section 12
1 2 3 4 5 6 7 8 9 10
D B A C C C C B D C
11 12 13 14 15 16 17 18 19 20
D D C D A A A B C C
21 22
C C

Section 13
1 2 3 4 5 6 7 8 9 10
D A B B D A C A B A
11
B

Section 14
1 2 3 4 5 6 7 8 9 10
C C D C B D D C A D
11 12 13 14 15 16 17 18 19 20
C C B A C B C D D D
21 22 23 24 25 26 27 28 29 30
D D C C D D C C A C
31 32 33 34 35 36
B C C B C A
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Section 15
1 2 3 4 5 6 7 8 9 10
A C B B A B C C B C
11 12 13
A A D

Section 16
1 2 3 4 5 6 7 8 9 10
D B A C C D C A D A
11 12 13 14 15 16 17 18 19 20
B D D B C D B B C C
21 22 23 24 25 26 27 28 29 30
A D B D C D A B C A
31 32 33 34 35 36 37 38 39 40
C A C D C D D D D B
41
C

Section 17
1 2 3 4 5 6 7 8 9 10
D D B A C B D D D A
11 12 13 14 15 16 17 18 19 20
A C B C A D C D B D
21 22 23 24 25 26 27 28 29 30
B A C A A B A D C B
31 32 33 34 35 36 37 38
A B B B D B C B

Section 18
1 2 3 4 5 6 7 8 9 10
A D B D D A C D C A
11 12 13 14 15 16 17 18 19 20
C D A D B C B A B D
21 22 23 24 25 26 27
C B A C A A C

Section 19
1 2 3 4 5 6 7 8 9 10
A C C A A B A D B C
11 12 13 14 15 16 17 18 19 20
B A D C A C D B D D
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Section 20
1 2 3 4 5 6 7 8 9 10
D B B B A A B D D C
11 12 13 14 15 16 17 18 19 20
A C A D A D D B D C

Section 21
1 2 3 4 5 6 7 8 9 10
C D C A A C C D B D
11 12 13 14 15 16 17 18 19 20
A C C B C D B B D A
21 22 23 24 25 26 27 28 29 30
D C C B B B B B C B
31 32 33 34 35 36 37 38 39 40
A D B D D B D B B D
41 42 43 44 45 46
A A C A D B

Section 22
1 2 3 4 5 6 7 8 9 10
D C C A A B D A B D
11 12 13 14 15 16 17 18 19 20
B C A C C C D C B B
21 22 23
B B C

Section 23
1 2 3 4 A 6 7 8 9 10
A A C B C C B C A B
11 12
B B

Section 24
1 2 3 4 5 6 7 8 9 10
B D C B D A B C D A
11 12 13 14 15 16 17 18 19 20
D C C C A D B C D A
21 22 23 24
D C B A
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Section 25
1 2 3 4 5 6 7 8 9 10
A B C B A A C A B C
11 12 13 14 15 16 17 18 19 20
C B B C B C C B A A
21 22 23 24 25
A C D A D
Section 26
1 2 3 4 5 6 7 8 9 10
A D D C A B C C D A
11 12 13 14 15 16 17 18 19 20
A A C A A C A B B B
21 22 23 24 25 26 27 28 29 30
D D B D B C A B A D
31 32 33 34 35 36 37 38 39 40
D D B C B C B A C D
41
D
Section 27
1 2 3 4 5 6 7 8 9 10
C C C D B A D B C C
11 12 13 14 15 16 17 18 19 20
D B D A D C D C D C
21 22 23 24 25 26 27 28 29 30
D A B D C C A A C D
31 32 33 34 35 36 37 38 39 40
C A B A D D A D C D
41 42 43 44 45 46 47 48 49 50
A B D A D C C B B A
51 52 53 54 55 56 57 58 59 60
C C A C A B B C D C
61 62 63 64 65 66 67 68 69 70
D B A C D C B B B A
71 72 73 74 75 76 77 78 79 80
D B D A D D A D C D
81 82 83 84 85 86 87 88 89 90
A C B D D D D B C D
91 92 93 94 95 96 97 98 99 100
B D B B C B A A A D
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Section 28
1 2 3 4 5 6 7 8 9 10
B D A D C B B A B C
11 12 13 14 15 16 17 18 19 20
B B A A A A C B C B
21 22 23 24 25 26 27 28 29 30
C A D D A B A C D D
31 32 33 34 35 36 37 38 39 40
D D C C B A C C A C
41 42 43 44 45 46 47 48 49 50
D A A D C A B D A D
51 52 53 54 55
D C A D D

Section 29
1 2 3 4 5 6 7 8 9 10
D C B A B A B D D A
11 12 13 14 15 16 17 18 19 20
A B C D D C C D C B
21 22 23 24 25 26 27 28 29 30
A A B D A D C C C A
31 32 33
B D D