EC202: Intermediate Microeconomics

Semester 1, 2023
Tutorial 1 Solution (Week 2)

Question 1
Differentiate between an exogenous variable and an endogenous variable in an economic model?
Why isn’t it useful to construct an economic model that contains only exogenous variables (and
no endogenous variables)?
Exogenous variables are taken as given in an economic model, i.e., they are determined
by some process outside the model, while endogenous variables are determined within the
economic model being studied. An economic model that contained no endogenous
variables would not be very interesting. With no endogenous variables, nothing would be
determined by the model so it would not serve many purposes.
Question 2
Why do economists undertake comparative statics analysis? What role do endogenous variables
and exogenous variables play in comparative statics analysis?
Comparative statics analyses are performed to determine how the level of endogenous
variables changes as some exogenous variable is changed. This type of analysis is very
important since in the real world the exogenous variables, such as weather, policy tools,
etc. are always changing and it is useful to know how changes in these variables affect the
levels of other, endogenous, variables. An example of comparative statics analysis would
be asking the question: If extraordinarily low rainfall (an exogenous variable) causes a 30
per cent reduction in corn supply, by how much will the market price for corn (an
endogenous variable) increase?
Question 3
What is the difference between positive and normative analysis? Which of the following
questions/statements would entail positive analysis, and which normative analysis?
Positive analysis attempts to explain how an economic system works or to predict how it
will change over time by asking explanatory or predictive questions. Normative analysis
focuses on what should be done by asking prescriptive questions.
a) What effect will Internet auction companies have on the profits of local automobile
dealerships?
Because this question asks whether dealership profits will go up or down (and by how
much) – but refrains from inquiring as to whether this would be a good thing – it is an
example of positive analysis.
b) Should the government impose special taxes on sales of merchandise made over the Internet?
This question asks whether it is desirable to impose taxes on Internet sales, so it is
normative analysis. Notably, this question does not ask what the effect of such taxes
would be.
c) If the United States lifts the tariffs on imports of Chinese goods, the price of Chinese goods
will fall.

Positive analysis – this statement indicates what the consequences of the U.S. action will
be, ignoring any value judgment when making the claim.

d) To provide revenues for public schools, taxes on alcohol and tobacco should be raised instead
of increasing income taxes.

Normative analysis – here the author implies that there are two possible solutions to
providing additional revenues for public schools and suggests, based on a value
judgment, which of the alternatives is better.

e) Government subsidies to farmers are too high and should be phased out over the next decade.

Normative analysis – here the author is making a prescriptive statement about what
should be done. This is a value judgment about the policy to subsidize farmers.

Question 4
Discuss the following statement: “Since supply and demand curves are always shifting due to
various demand and supply-side disturbances, markets never actually reach an equilibrium.
Therefore, the concept of equilibrium is useless.”

While the claim that markets never reach equilibrium is probably debatable, even if
markets do not ever reach equilibrium, the concept is still of central importance. The
concept of equilibrium is important because it provides a simple way to predict how
market prices and quantities will change as exogenous variables change. Thus, while
we may never reach a particular equilibrium price, say because a supply or demand
schedule shifts as the market moves toward equilibrium, we can predict withrelative
ease, for example, whether prices will be rising or falling when exogenous market
factors change as we move toward equilibrium. As exogenous variables continue to
change, we can continue to predict the direction of change for the endogenous
variables, and this is not “useless.”
Question 5
Why is defining markets important for economic analysis?

The market definition identifies which buyers and sellers should be included in each market.
However, to determine which buyers and sellers to include, we must first determine the extent
of a market—its boundaries, both geographically and in terms of the range of products to be
included in it.

Market definition is important for two reasons:

• A company must understand who its actual and potential competitors are for the
various products that it sells or might sell in the future. It must also know the product
boundaries and geographical boundaries of its market in order to set prices, determine
advertising budgets, and make capital investment decisions.

• Market definition can be important for public policy decisions. Should the government
allow a merger or acquisition involving companies that produce similar products, or
should it challenge it? The answer depends on the impact of that merger or acquisition
on future competition and prices; often this can be evaluated only by defining a market.

Question 6
Briefly, discuss how economists test theoretical economic models.

Economic models are simple theoretical descriptions that capture the essentials of how
the economy work. You have already come across various macroeconomic models (AD-
AS model in EC101/EC201). In this course, we are more concerned with
microeconomic models that help explain consumer choice, firm’s input choice and
labour market choice, among many others. Production Possibility Frontier is an
example of an economic model that you have already learnt in EC102. Another
example is the Supply and Demand Model which helps understand how the interaction
of demand and supply conditions determine the price of a good/service.

Economist verify models by testing: a) assumptions upon which the model is based and;
b) the ability of the model to explain and predict real-world events (test the predictions
of the model). We would like to keep the assumptions of our model as reasonable as
possible and test them by collecting real-world data. For instance, if we assume firms’
objective is to maximize profit, we can conduct a survey of various firms and test
whether indeed this is true.

Question 7
a) John is an economist working for the Ministry of Tourism in Suva, earning $30,000 per
year. There are, say, three alternative careers available for John. He can work for Reserve
Bank or the Ministry of Economy in Suva for $25,000 and $28,000 per year respectively. Still
anotheralternative is that he can set up his own economic consultancy firm, expecting to
make a profit of $27,500 a year himself. What is John’s opportunity cost of working in the
 Ministry of Tourism?
The next best alternative is to work for the Ministry of Economy, the value of which
optionis $28,000 per year. Hence, this amount is the opportunity cost of working for the
Ministry of Tourism.
b) An auto-parts company of Australia wants to establish a plant outside Australia. The
alternatives are Fiji, PNG, Samoa and NZ. Given its financial situation, the company is
constrained to set up only one plant outside Australia. Assume that the setting-up costs and
the operating costs of a plant in any of these four countries are the same. The marketing
research department offers a projection that if the plant is set up in Fiji, PNG, Samoa or NZ,
it will fetch a turnover (revenue) of $2.5 million, $2 million, $2.3 million and $2.8 million
respectively. Of course, given these choices, the company will opt to set up a plant in NZ.
What is then its opportunity cost?
Among the remaining alternatives, the maximum expected revenue is $2.5 million (if
the plant is set up in Fiji). Hence, this amount is the opportunity cost.

***The End**