Lecture 12: Review

1. Use the following production possibility frontier for a country to answer the
questions.
a. Which point(s) are unattainable? Briefly explain why.
b. Which point(s) are efficient? Briefly explain why.
c. Which point(s) are inefficient? Briefly explain why.
d. At which point is the country’s future growth rate likely to be the
highest? Briefly explain why.

a. Point E is outside the production possibility frontier, so it is unattainable.

b. Points B, C and D are on the production possibility frontier, so they are
efficient.
c. Point A is inside the production possibility frontier, so it is inefficient, as the
maximum output possible with the given resources is not being achieved.
d. At point B, the country is devoting the most resources to producing capital
goods, so production at this point is most likely to lead to the highest growth rate
in the future.
2. A study indicated that ‘stricter university alcohol policies, such as raising
the price of alcohol or banning alcohol on campus, decrease the number of
students who use marijuana’. i

a. On the basis of this information, are alcohol and marijuana

substitutes or complements?

b. Suppose that campus authorities reduce the supply of alcohol on

campus. Use demand and supply graphs to illustrate the impact on
the campus alcohol and marijuana markets.

a. Complements.
b. Referring to Figure I below, in the situation where campus authorities
reduce the supply of alcohol the supply curve will shift to the left to S2, equilibrium
price has increased and equilibrium quantity has decreased. In Figure II, as the
supply of alcohol has decreased the demand for marijuana (a complementary
good) has decreased and both equilibrium price and quantity have decreased.

Figure I Figure II
3. What are the key determinants of the price elasticity of demand for a
product?
The factors determining the price elasticity of demand for a product include the
availability of substitutes, the passage of time, whether the good is a necessity or
a luxury, how narrowly the market for the good is defined, and the share of the
good in the consumer’s budget.

4. A study of the price elasticities of products sold in supermarkets contained

the following data:i

PRODUCT PRICE ELASTICITY OF DEMAND

Soft drinks –3.18

Canned soup –1.62
Cheese –0.72
Toothpaste –0.45

a. The demand for which products is inelastic? Discuss reasons why the
demand for each product is either elastic or inelastic.
b. Use the information in the table to predict the change in the quantity
demanded for each product following a 10 per cent price increase.
a. Soft drinks and canned soup are price elastic; cheese and toothpaste are
price inelastic. Cheese and toothpaste are probably necessities, perhaps with
fewer substitutes, while soft drinks and canned soup probably have more
substitutes.
b. Soft drinks: 31.8% decline in quantity demanded; Canned soup: 16.2%
decline in quantity demanded; Cheese: 7.2% decline in quantity demanded;
Toothpaste: 4.5% decline in quantity demanded.
5. Suppose that Bill owns a vehicle smash repair shop. The table below shows
how the quantity of cars Bill can repair per month depends on the number
of workers that he hires. Assume that he pays each worker $4000 per
month and his fixed costs are $6000 per month. Using the information
provided, complete the table.

QUANTITY QUANTITY OF
FIXED VARIABLE TOTAL AVERAGE
OF CARS PER TOTAL
COSTS COSTS COST
WORKERS MONTH COST

0 0 $6000 —
1 20
2 30
3 40
4 50
5 55

QUANTITY AVERAGE
QUANTITY FIXED VARIABLE TOTAL
OF CARS TOTAL
OF COST COST COST
PER COST
WORKERS $ $ $
MONTH $
0 0 $6,000 0 $6,000 —
1 20 6,000 $4,000 10,000 $500
2 30 6,000 8,000 14,000 467
3 40 6,000 12,000 18,000 450
4 50 6,000 16,000 22,000 440
5 55 6,000 20,000 26,000 473
6. Draw a graph showing a monopolist earning economic profit. Make sure
your diagram includes the monopolist’s demand, marginal revenue, average
total cost and marginal cost curves. Make sure you indicate the profit-
maximising level of output and price.
7. a. Give an example of a positive externality in production and of a
negative externality in production.
b. Give an example of a positive externality in consumption and of a
negative externality in consumption.
a. An example of a positive externality in production is the benefits received
by a passerby who enjoys a beautiful garden; an example of a negative externality
in production is the pollution emitted by a factory.
b. An example of a positive externality in consumption is the benefits from a
university education that go to one’s children, grandchildren, coworkers, or
complete strangers; a example of a negative externality in consumption is the
noise from a loud party or from a busy road.

8. Briefly explain whether each of the following transactions represents the

purchase of a final good.
a. The purchase of wheat from a wheat farmer by a bakery.
b. The purchase of an aircraft carrier by the federal government.
c. The purchase of French wine by an Australian consumer.
d. The purchase of a new machine by BHP Billiton for an iron-ore mine in
Australia.
a. The purchase of wheat by a bakery is the purchase of an intermediate good,
not a final good.
b., c. and d. are all purchases of final goods.

9. Assume that real GDP in a country grew from $2 300 000 million in 2014 to
$2 360 000 million in 2015. Calculate the rate of economic growth over that time
period.
The rate of economic growth is:
[($2 360 000 – $2 300 000)/$2 300 000] x 100 = 2.61%.
10. Use the following graph to answer the questions.

a. True or False: The movement from point A to point B shows the effects
of technological change.
b. True or False: The economy can move from point B to point C only if
there are no diminishing returns to capital.
c. True or False: To move from point A to point C the economy must
increase the amount of capital per hour worked and experience
technological change.
a. False, because technology is assumed constant along a given per-worker
production function.
b. False, because the movement from point B to point C represents
technological change, which occurs despite the existence of diminishing returns to
capital.
c. True, because point C represents both a higher level of capital per hour
worked and a higher level of technology than point A.
11. Outline the three main types of unemployment.

The three main types of unemployment are frictional unemployment, structural

unemployment and cyclical unemployment. Frictional unemployment is
short-term unemployment that arises from the process of matching
workers with jobs. Structural unemployment is unemployment that arises
from a persistent mismatch between the skills and attributes of workers
and the requirements of jobs. Cyclical unemployment is unemployment
caused by a business cycle contraction or recession. Cyclical unemployment
and structural unemployment result in greater hardship than frictional
unemployment, but it is difficult to conclude whether greater hardship
results from cyclical or structural unemployment. An important
consideration is the length of time before the unemployed can find new
jobs.

12. Consider a simple economy that produces only three products. Use the
information in the following table to calculate the inflation rate for 2015 as
measured by the consumer price index.

Base 2014 2015

Year
2012
Product Quantity Price Expenditure Price Expenditure Price Expenditure
Haircuts 2 $20.00 $40.00 $22.00 $44.00 $25.00 $50.00
Hamburgers 10 4.00 40.00 4.20 42.00 4.50 45.00
DVDs 6 15.00 90.00 15.00 90.00 14.00 84.00
Total 170.00 176.00 179.00

CPI for 2014 = [($176/$170) x 100] = 103.53; CPI for 2015 = [($179/$170) x
100] = 105.29. So, the inflation rate for 2015 = [((105.29 – 103.53)/103.53) x
100)] = 1.7%.
 13. Suppose the price of a barrel of oil rose from US$100 to US$150.
Use a basic aggregate demand and aggregate supply diagram to show
the short-run and long-run effects on the Australian economy.

The increase in oil prices decreases SRAS, causing the short-run real GDP to
decrease and the price level to increase. Short-run equilibrium moves from
point A to point B. In the long run, the increased unemployment leads
workers to accept lower wages and firms to accept lower prices, which shifts
the SRAS curve back to its initial position. Potential GDP is restored at the
initial price level (point A).

14. Identify each of the following as (i) part of an expansionary fiscal policy, (ii)
part of a contractionary fiscal policy or (iii) not part of fiscal policy.
a. The company income tax rate is increased.
b. Defence spending is increased.
c. Families are allowed to deduct all their expenses for child care from
their taxable income.
d. The personal income tax rate is decreased.
e. The state of New South Wales builds a new highway in an attempt to
expand employment in the state.

a. Contractionary fiscal policy.

b. Although an increase in defence spending will lead to an increase in
aggregate demand, it is not part of fiscal policy because it is not intended
to achieve a macroeconomic policy goal.
c. Not part of fiscal policy (unless it is a change to existing policy to
stimulate spending).
d. Expansionary fiscal policy.
e. Not part of fiscal policy (as fiscal policy refers to federal government
policy).
15. Which can be changed more quickly: monetary policy or fiscal policy? Briefly
explain.
Monetary policy can be changed more quickly. The Reserve Bank Board
can change monetary policy at any of its monthly meetings, or more
frequently if need be. Fiscal policy has to go through the legislative
process of the parliament approving a fiscal policy action. Even once
approved, it takes time to implement the fiscal policy change.

16. How does an increase in interest rates affect aggregate demand? Briefly
discuss how each component of aggregate demand is affected.

An increase in interest rates slows down the rate of growth in aggregate

demand. Higher interest rates decrease spending on business investment,
new homes and consumption, particularly spending on durable goods. Net
exports also drop as higher interest rates raise the exchange rate
between the dollar and foreign currencies.

17. If the RBA believes the economy is about to fall into a recession what actions
could it take?

If the RBA believes the economy is about to fall into recession, it could
conduct expansionary monetary policy, increasing liquidity and reducing
the cash rate and therefore reducing other interest rates.

18. If the RBA believes that the inflation rate is about to increase above its
target rate, what actions could it take? Should it always take this action
whenever the inflation rate exceeds its target rate?

If the RBA believes that the inflation rate is about to increase, it could
conduct contractionary monetary policy, reducing liquidity and increasing
the cash rate and therefore increasing other interest rates.