Suggested Answer Section A Multiple Choice Choose the best answer _(30 marks) 1 2 3 4 5 6 7 8 9 10 c D A A B B A A D ul 12 B 4 15 16 17 18 19 20 c D A A B A D G c D 21 2 23 24 25 26 27 28 | 29 30 ei B B D ce} c c A D D Section B ‘There are 5 questions in this section. Attempt ALL Questions (40 marks) J. Since the existence of markets necessarily involves some burden of transaction costs, wouldn't a command economy dispensing with markets always be more efficient? Explain. (8 marks) Ans: * Define the term of efficient; +A command economy could avoid transaction costs by dispensing with markets, but it probably would incur larger enforcement costs than the transaction costs saved. Where market economies use resources to coordinate individual decisions, command economies must use resources to enforce central decisions. At least as important, the commanders would require an enormous input of information if the economy is to function nationally — information automatically provided by price signals in market economies. Most importance of all, what the command economy will aim at is ‘efficiency’ in carrying out the desires of the commanders, which may be quite different from the desires of consumers. + explanation e Mente 2 a) met, co OA Trane an | Teta \ en \ \ | \ fese be oy a be(teny SY fe pple 3. In Hong Kong. why do neighbourhood convenience stores typically charge a few cents more for 1can of (4. marks) Ans: * Define opportunity cost; *Buyer’s viewpoint: The cost of buying a can of Coke, like the cost of anything else, includes the value of the time expended to acquire it. Conveniently some buyers, particularly those whose time relatively valuable, are willing to pay more for ‘the’ product. + explanation Seller’s viewpoint: The reason of charging higher price in convenience stores; + explanation (4 marks) B)__Isit true that a farmer with a lot of children will find it less costly to harvest his crops than a Explain. (4 marks) farmer with no children, since he can put his children to work without pay: Ans: * Define opportunity cost; **False. Suppose that the going wage for child labour on farms is $10 per hout. Then the farmer without children must pay $10 per hour to employ someone else’s children; the farmer with children must forgo $10 per hour (which he could earn by renting his children out to neighbouring farms) to employ his own t.+ explanation (4 marks) 4. Income is a flow of receipts per unit of time. Wealth is a stock of assets: cash, shares of stock, buildings, tools and so on. A) _ Is an engineering degree wealth? (2 marks Ans: It is wealth because it is expected to yield a stream of future services, principally money income. + explanation — (2 marks) B) What determines the value of such adegree? _(3 marks) Ans: Its value depends largely on the future salary an engineer can expect + market condition of this degree children. Both farmers face the same (e.g. the demand of it) + explanation (3 marks) A) How could an engineer with a recently conferred degree who is just beginning her first job convert some of her wealth into current income in order to buy furniture for her apartment? _(3 marks) Ans: eparation Theorem + Engineers cannot easily sell this wealth, since our laws and morality prohibit slavery. But she could probably borrow money on the basis of her expected earnings. This suggests a useful way to decide ‘what counts as a person’s wealth. It is everything that a bank would want on a financial statement if it ‘was considering a personal loan. That certainly includes the present discounted value of future earnings. explanation (3 marks) S. What is a firm? What is the difference between a firm and a market? (8 marks) Ans:A firm is a way of organizing production activities without using market prices for every contribution produced. For example, a manager or a visible hand directs the production activities of workers while paying the latter wages measured by time, not through the invisible hand of the market where remunerations to workers are paid according to their contributions or outputs. A firm therefore differs from the market in that different contracts are used: a firm uses proxy measure contracts and a market uses piece rate contracts. + explanation (8 marks) Section C ‘There are 3 questions. AttemptALL Questions (30 marks) 2‘Any reasonable explanation; For example: |A) If the difference in price per unit between a package of product with a larger amount and a package with a smaller amount is accordance with the differences in the costs of production or selling the product, the examples in the above questiuus ate not practices of price discrimination, ‘Therefore, if the production of ice-cream cones involves more packaging costs (i.e. cost of production), the higher price per volume of ice-cream cone is not a practice of price discrimination. (5 marks) B) On the other hand, a large bag of rice and a small bag of rice has similar packing costs, but a large bag will usually have a lower price per ‘kg" than a small bag, Hence, the difference in the prices of rice may be due to price discrimination. In the case of the rice, the seller may try to discriminate between customers with different price elasticity of demand. Customers with a lower price elasticity of demand will buy a smaller bag with a higher price per ‘kg’, and customers with a higher price elasticity of demand will buy a larger bag with a lower price per ‘kg’. (5 marks) (a) The selling price and supply are fixed with the demand possibly fluctuates due to the presence of speculation. Some are high valued users (collectors) and some are just speculators for marginal gain. The supply is highly inelastic (or perfectly inelastic supply) so that once demand inereases, the second —hand price of the stamps could be very high. It is an example of excess demand because the selling price of the stamps initially was set and controlled by the Post Office. With inelastic supply, an excess demand becomes natural, + Full cost method (b) To the buyers, so long as their MUV being greater than their MC including the expected cost of waiting, they will wait, Otherwise, they would not bother to queue and wait. Whether it is a waste to them or not depends on the possiblity of other means of allocation that could avoid the cost of waiting Basically it is wasteful because waiting uses up resources (time or to be more specifi, the option forgone during the time) in competing without a corresponding gain to someone. From the social point of view, ifthe stamps are allocated by market forces with free competition and market price, the cost of waiting could be avoided. The waiting time is a waste to the economy as a whole if the use of market force involves a lower transaction cost than the cost of waiting. The use of auction may avoid the cost of waiting ‘but other administration costs may arise. (Waiting in a queue could also be efficient.) + Dissipation of rent (5 marks) 3. A) Competition is an inevitable result of scarcity. No matter what the new competitive criterion is, so long as both the number of places in the famous schools and the number of children competing for the places remain more or less unchanged, the degree of competition can never be reduced. However, under the new system, the form of competition will probably be changed, e.g. internal exam results, sports or other spevial talents. | explanation 'A) Most probably, students and their parents will spend more resources in preparing for the tests and exams in schools. The workload will not be reduced. Only the form of the students’ work will change from the drilling exercises designed for the aptitude test to exercises for school subjects. + explanation‘87 Mock Examination 2008-09 Economics Paper Il ~~ Suggested Answers MCQ (30 marks) Section 1 plz 0/3 cla cls. clé alz cls dio clio A 11. Al 12, 8/43. 0/14. dD] 45. cla6. ali7. D[ 18 B[19. 8/20. A 24, 6 | 22, 6[ 23, | 24. ¢|25. c|26. 6|27. A|28. Al 29. 0/30. 6 Section B: Short Questions (40 marks} 1a) Inflation is defined as a continuous increase in the general price level. Stagflation is different from inflation : both high unemployment rate and high inflation rate are usually found in times of stagflation whereas a low (high) unemployment rate and 2 high (low) inflation rate are usually found in times of inflation. (2 M) b)Nominal interest rate = Real interest rate + Expected inflation rate Deflation implies a negative inflation rate. Nominal interest rate = Real interest rate ~ Expected inflation rate From the above equations, nominal interest rate will be lower than the real interest rate. (4M) ) i) If defiation is expected so that the expected inflation rate is negative, and such negative inflation rate outweighs the positive real interest rate, resulting nominal interest rate negative. li) The nominal interest rate can be manipulated by the government. When the economy is experiencing deflation, the government can use expansionary fiscal policy to raise the nominal interest rate and the general price level./Banks have the incentive to maintain a positive interest rate because of profit consideration. if the nominal interest rate is negative, the banks will not get any deposits from the public and they will probably make loss by lending less money to borrowers. (Other sound explanations are accepted) (4M) 2a) The difference between the two models lies in their assumptions about the interest rate. In the elementary Keynesian model, interest rate is an exogenous variable and is determined outside the goods market. The level of output is determined by the level of aggregate demand in the goods market which consists of investment. Investment depends on the marginal efficiency of capital and income but does not depend on interest rate. Thus the goods market alone can determine the 1level of output via Y = C+! +6 + (X-M). And interest rate can be separately determined by the equilibrium in the money market. In the IS-LM model, Interest rate Is an endogenous varlable and is determined by an interplay of goods market and money market. In particular, investment is negatively related to interest rate. Thus neither goods market nor money market alone can find the value of output (Y) and interest rate (r). Instead, both goods market and money market are taken into consideration to get the value of Y and r. In other words, the goods market is separated from the money market in the elementary Keynesian model but the two markets are interdependent in the IS-LM model. (5M) 2b) A vertical IS curve indicates that investment is perfectly interest inelastic. It means that investment does not depend on interest rate, which is the same as the elementary Keynesian model. The elementary Keynesian model can be regarded as a special case of the IS-LM model in which the IS curve is vertical. A vertical IS curve implies that the goods market alone is enough to determine the level of output, which is consistent with the assumption of the elementary Keynesian model. This special case with a vertical IS curve occurs when the crowding out effect is zero. (5 M) 3a) Given S?= I, substitute S?= Y-T -C into Y= C +146 +(X-M), Y=C+ (VTC) +6 + (X-M) therefore T+ M = G +X i.e. TG (fiscal budget balance) = X ~ M (trade balance) So, if G> T (fiscal deficit), it requires M > X (trade deficit) to restore the equality of the above equation. In other words, when there is a fiscal deficit, there must. when S?=1 (2M) Y-T-C#T-G-1 G=NX Since the country is running a current account deficit (NX <0), the inpayments it, receives from foreigners cannot cover the outpayments it makes to foreigners. In other words, the country is a net importer, which absorbs more than it produces. Therefore, it must borrow from foreigners or sell some local assets to foreigners. This implies that national saving falls short of domestic investment. ‘The net foreign borrowing represents capital inflow into the country and an increase in foreign assets held by local residents. Thus, it shows up as a credit item in the capital account, resulting in the capital account surplus. (5 M)3c) In a closed economy, the goods market equilibrium condition is Y=C+1+Gwhen NX=0. National saving, S = $°+ S°= Y-T-C+(T-6) In other words, when goods market is in equilibrium, Y-C-G = I. In equilibrium, planned | is equal to planned $ as both refer to the willingness to invest and to save respectively. But if the income level is deviated from the equilibrium level, planned $ is not equal to planned |. Instead, actual S is always equal to actual | at every income level. As it is an accounting identity that what is not consumed is regarded as saved, vice versa. (3M) 4a) In the short run, if an increase in inflation is unanticipated and people suffer money illusion. (2 M) Job-seekers will mis-interpret that the rise in money wage rates brought by the unanticipated inflation. This implies an increase in their marginal costs of search. Hence the unemployment rate falls. (2M) Therefore the short-run Phillips curve is downward sloping, i.e. the inflation rate and the unemployment rate are negatively related. (2M) 4b) People are misled by the increase in money wage rates only if the inflation is under-anticipated. Once they realize the actual inflation rate, they will adjust their expected marginal benefits from search and the unemployment rate will restore its initial value, ie, the natural rate. (2M) So, unless the inflation rate accelerates and people suffer money illusion continuously, will the unemployment rate fall below the natural rate persistently. Otherwise, there is no trade-off between inflation rate and unemployment rate in the long run. (2 M) Section C: 30 marks 5a) Portfolio rebalancing under financial instability would shift the money demand curve, hence the (upward-sloping) LM curve, around ~ thus resulting in fluctuations in the equilibrium interest rate and output, given the downward sloping IS curve. Downturn in the financial market > up / rightward shift of the M% curve => up Neftward shift of the LM curve © interest rate ‘* and output Y (4M) b) Financial instability that affects the ability of business corporations to finance their investment projects would shift the investment demand curve, hence the IS curve, 3around. Downturn in the financial market + down/leftward shift of the investment curve © down /leftward shift of the IS curve. Combined with the LM shift described in (a) above, this implies an ambiguous change In Interest rate and a significant drop inoutput. (4M) ©) Financial stability in the sense of asset-price stability could, in principle, be achieved by the central bank through the use of expansionary monetary policy ~ rightward shift of LM curve ~ to sta crest rate, given the direct (negative) relation between asset (e.g. bond) prices on the one hand and the interest rate on the other. (2M) ize the 6a) Suppose Ms of HK 4 > LM (HK) shifts rightward > r (HK) Y > More capital flows from HK to the US > Demand for USD 4 > market rate of USD 4 > Licensed banks buy USD from the Exchange Fund and sell then in the foreign exchange market (i.e. licensed banks sell HKO to the Exchange Fund) > Ms (HK)\Y, LM (HK) shifts leftward and r (HK) until their initial values are restored. (i.e. HK does not have its own monetary policies) (5 M) 6b) A possible problem faced by China is an increase in unemployment rate of import-competing industries, Since the revaluation of Renminbi against the USD, it is relatively cheaper for import-competing industries to buy goods or/and materials from the US than producing its own therefore there would be a rise in unemployment in those industries. A second possible problem is that it would hurt the Chain’s export sector as its exports have become more expensive than before so its quantity demanded for them would drop. (Other sound reasons are accepted) (5 M) 7a) The production possibility curve shows only the outputs of the two countries. Without any information on the amount of resources used in production, we cannot compare their productivities to determine the absolute advantage. (3 M) 7b) According to the PPC of country A, it can produce either 10 F or SOC. Its production cost of 1F = SOC/10 = SC, while the production cost of 1C = 10F/50 = 0.26. According to PPC of country B, it can produce either 100 F or 80 C. Its production cost of 1F is 80C/100 = ORC, while the production east of 10 = 4100F/80=1.25F. Hence, country B has a comparative advantage in the production of food while country A has a comparative advantage In the production of clothing. (4M) 7c) If the world price is higher (lower) than the autarkic production cost of a country, the country will export (import) the good. For international trade to take place, both exporter and importer should exist. Hence the world price of food must lie between the autarkic production costs of the two countries, ie. lying between 0.8 Cand 0.5 C. (3M)