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Suggested Solution for the A-L Post Mock Economics Papers

Paper 1:

Section A:

1.    A
2.    B
3.    D
4.    B
5.    A
6.    B
7.    C
8.    C
9.    D
10.    C
11.    D
12.    A
13.    C
14.    D
15.    A
16.    D
17.    C
18.    A
19.    C
20.    D
21.    B
22.    A
23.    B
24.    B
25.    B
26.    C
27.    A
28.    A
29.    D
30.    B

Section B:

1.
Pareto condition refers to a state of resource allocation under which it is impossible to reallocate the resources so that one can gain without the loss of other people. A point on the production possibility frontier only implies production efficiency, i.e., all the resources available are fully utilized. however, it does not implies consumption efficiency nor the Pareto efficiency. Even if all the resources are fully utilized, it may still be possible for a person to have a gain without harming others through reallocating the resources.

2.
A suitable diagram is expected, as in text book chapter 3. From the diagram, I would like to see no matter what the initial endowment of goods is on the left or on the right hand side of the final endowment, both parties will trade until the marginal use value of person A is equal to the marginal use value of person B.

In other words, the equilibrium state will be attained when the allocation of goods between A and B is at the final endowment, which is also the efficient allocation of goods. hence, the initial endowment of goods does not affect the Pareto efficient allocation of goods.

On the contrary, the initial endowment of goods for person A and person B will affect the total gain from exchange.

3.
All or nothing pricing refers to a pricing arrangement in which the customers are given the choice of taking all of the amount offered by the seller at a given price or of taking none of the good at all. This pricing tactic does not necessary mean price discrimination because all customers may end up paying the same all or nothing price for identical package of the god. It should be noted that price discrimination occurs only when identical goods produced at the same cost are sold at different buyers or different units of them are sold at different prices to the same buyer. Under the all or nothing pricing the same pricing arrangement is applicable to all customers. Thus, it is not a price discrimination.

4.
This price elasticities of demand for the two goods will both be unitarily elastic. Given any amount of money income, Knight will always spend a fixed amount on both clothing or housing, even when the price is changed. This implies, say, when the price of either clothing or housing increases by 10%, the quantity demanded for it must also decrease by 10%, so that the expenditure on it remains unchanged. Therefore, the price elasticities of demand for both clothing and housing must be 1 which means that any change in price level will lead to equal proportionate change in quantity demanded so that total expenditure on the goods remains unchanged.

5.
A goose which lays golden egg is not invaluable. This goose is a capital because it is an asset that can generate future income. Its capital value would be equal to the discounted value of the future income that it can generate. Thus the value of the goose which lays golden egg would be equal to the discounted value of the golden egg that it can lay during its life time. Its value can be measured so it is not invaluable.

Section C:

1.
a. At the price of $8 per unit, the customer will purchase 3 units of commodity Z, at where its MUV=P. The consumer's surplus is TUV - TEV = ($10 + $9 + $8) - ($8*3) = $3.

b. At the price of $4 per unit, the consumer will purchase 7 units, at where MUV = P. The consumer's surplus is = $(10+9+8+7+6+5+4) - $(4*7) = $(21-3) = $18.

c. The seller may charge the maximum price for each unit up to the fifth unit, i.e. charging $10, $9, ...,$6 for the first unit respectively.

   Or the seller may charge a uniform price $6 (such that the buyer would purchase 5 units) together with a membership fee equal to the consumer's surplus so as to extract the whole of it. The membership fee is = $(10+9+8+7+6) - $(6*5) = $10.

  The seller may also charge an all or nothing price = average use value = $(10+9+8+7+6) /5 =$8, i.e., a per unit price of $8 for a package of 5 units.
 

2.
Although the average cost of production in off-peak (load) hours is larger than that in peak hours, the cost to raise an additional unit of output, the marginal cost, is still very small. As long as the marginal revenue can cover the marginal cost, it is profitable to attract more customers.

In peak hours, MTR has already reached its full capacity. Thus it has no intention to cut price to raise the number of the consumers.

In off-peak hours, with excess capacity, as long as its MR is larger than MC, it is profitable for the MTR to cut price to attract more customers.

Remark:
AC does not help to determine the income maximizing quantity, only MR and MC do. AC helps to determine whether the output is worth producing.

3.
Journeys of different distances are of different value to travelers and hence different prices should be charged to maximize the wealth of the transport companies. However, defining and enforcing property rights and charging different fares according to distances involve high transaction costs.

The MTR providers a faster and more comfortable transportation service which are of higher value to customers than the services offered by bus companies.

So, it is profitable for the MTR to define and enforce property rights of its transport services and practice a variable toll system according to the distance of the journeys while it is not worth for bus companies to do so.

As maximiers, both the MTR and bus companies would weigh the benefit and cost in practicing the variable toll system as well as the single toll system and choose the system which maximizes their wealth.

As long as the present fare system is accepted by both the companies and customers, the cost in adjusting the prevailing fare system is larger than the gain. So the prevailing system remains unchanged and is efficient. it maximizes the gains of the economic agents involved.

4.
Mr. Wong is not irrational in his decision. Although he lost $550,000 as a result, he has already minimized his loss. We can explain this with the concept of cost.

Cost is defined as the highest valued option forgone in making a choice. It is a forward looking concept. in making a decision, one always compares the alternatives available now and tries to minimize the cost involved.

Let's look at the situation faced by Mr. Wong.

He has paid HK$500,000 of deposit to the property owner and also needs to pay HK$50,000 of commission fee to the property agent. I

In making his decision, he should not consider the HK$50,000 of commission fee to the property agent because no matter he choose to complete the contract or not, he needs to pay this amount commission fee to the property agent. On the other hand, the HK$500,000 of deposit should be considered. If he refuses to complete the contract, he would lose this amount of deposit.

However, if he agrees to complete the contract, he would lose HK$1,500,000 because he uses HK$500,000 to buy something with a market value of $3,500,00. To minimize his loss, it is rational for Mr. Wong to refuse to complete the contract.
 
 

Paper 2:

Section A:

1.    C
2.    C
3.    A
4.    D
5.    A
6.    D
7.    B
8.    A
9.    B
10.    A
11.    C
12.    D
13.    D
14.    B
15.    B
16.    D
17.    C
18.    C
19.    C
20.    A
21.    D
22.    C
23.    C
24.    D
25.    C
26.    B
27.    B
28.    C
29.    B
30.    D

Section B:

1.
a. According to the data provided, the expenditure approach will be used to calculate the GDP.

GDP = private consumption expenditure + government consumption expenditure + gross domestic fixed capital formation + changes in inventories + exports of goods + exports of services - imports of goods - imports of services.

i.e. GDP = $(516+72+246+4+1046+218-1076-127)= HK$899 million.
 
 

b. GNP = GDP + net income from abroad.

i.e. GNP = $899 + $(318-308)= HK$909 million.

NNP= GNP - capital consumption allowance= HK$(909-120) million=HK$789 million.
 

c. Implicit GDP deflator = (GDP at current market prices/GDP at constant prices) *100
i.e. implicit GDP deflator = $(899/$692)*100 = 130
 

2.
a. If the MPC is greater than 1, the expenditure multiplier will become negative. Then the equilibrium income will increase as autonomous expenditure decrease and vice versa.

b. With an autonomous increase in expenditure, national income will increase by the same amount. If the government expenditure is positively related to income, the subsequent increase in expenditure is enlarged, equal to the sum of included consumption expenditure and indeed government expenditure. So, the size of multiplier increases.

3.
a. Unemployment rate = unemployed / labour force = (800/20,800)*100% = 3.85%

b. The unemployment rate announced by the government may probably understate the unemployment problem in Hong Kong due to the following reasons:

The unemployment rate announced do not take into account workers who suffer wage cuts, are forced to shift from full-time to part-time work, etc.

The unemployment rate announced do not measure disguised unemployment; that is , workers who are working below their full potential. Although the unemployment rate in Hong Kong has not risen above 7% now, the underemployment rate rose continuously.

A worker is defined as unemployed only if he/she is currently looking for a job but unable to find a job. Some workers may have given up looking for jobs after a long period of job searching, and so withdraw themselves from the labour force. The unemployment rate will consequently be lower because they would not be considered as unemployed. in the definition of unemployment rate, if we deduct one unemployed worker for the numerator and worker from the denominator, the unemployment rate will fall.

Some people work when the economy is blooming and readily offers them jobs; for example,housewives and school-leavers. some students continue with their studies just because they expect they cannot find a job in the adverse economic situation. The unemployment rate announced do not include these workers, who do not wish to join the labour force during a recession.
 

4.

To deal with demand pull inflation, some economists (Keynesian) suggests to raise income taxes.

The increase in income taxes will reduce the disposable income and also the consumption expenditure. The reduction in aggregate expenditure. The reduction in aggregate expenditure may release the demand -pull inflation.

On the other hand, some economists (supply side economists) suggest to lower income taxes instead.

The reduction in income taxes will raise people's incentive to work and invest. Hence the potential GNP increase and the demand-pull inflation is relieved.

However, in the short run, an decrease in income taxes will raise disposable income and also aggregate expenditure. Therefore, the effectiveness is arguable.

On the other hand, some economists suggest to reduce indirect taxes so that aggregate supply will rise and lower the price level. However, the effectiveness will be subject to elasticity of demand and supply.
 

5.

As a country's balance of payment is determined by many different factors, we cannot answer this question only with the figure of the balance of payments.

How about if we know the cause of the surplus or the deficit? Some people think that balance of payments surplus are favorable if they come from net exports (which reflects the competitiveness of domestic products in international market); or from net capital inflow on projects creating job opportunities. They believe that surpluses are unfavorable if they are the result of a net sale of assets to foreigners (i.e., it represents a reduction of wealth of the domestic country).

Actually, both payments surpluses and deficits are resulted from the maximizing behavior of rational economic agents. in other words, they must be beneficial to the participants. Thus , neither a payments surplus nor deficit, at least in the short run, is unfavourable to a country.

However, persistent payments surpluses or deficits are not favourable. Persistent deficits are unfavourable as the country may run out of reserves to meet contingent needs. They have to be financed by an increase in external debts or a sale of assets. However, external debts will cause a heavy interest burden while a sale of assets will reduce a country's wealth. Thus, persistent deficits cannot be tolerated.

Although persistent payments surpluses raise official reserves, there exists the risks of default of international loans and devaluation of foreign currencies held as reserves. In these cases, the wealth of the country decreases. On the other hand, if the domestic currency is revaluated, the terms of trade and standard of living of the country will be improved. A country's gains from trade is determined by its volume of trade and the terms of trade but not its balance of payments. A mere accumulation of money without spending would not improve economic welfare.
 
 

Section C:

1.
a.

The law of comparative advantage states that if each country specializes in the production of the commodity in which it has a comparative advantages (or a lower opportunity cost), world output will increase.
 
 
Japan Hong Kong
Amount of input Production Cost Amount of input Production Cost
1 unit of Car 10 10/2  G = 5G * 20 20/2.5  G = 8G
I unit of Garment 2 2/10  C = 0.2C 2.5 2.5/20  C = 0.125C *
Key:
G represents 1 unit of garment;
C represents 1 unit of Car;
* represents the commodity of which the country has a comparative advantage in its production.
 

b.

Hong Kong has a comparative advantage in producing garment. With trade, hong Kong will have complete specialization in producing garment. it will produce 1000/2.5 G = 400 G. In exporting 140 G, it imports 140/7 C = 20C. So it can consume 20C and 260G (= 400G - 140G).

Under autarky, in producing 20C, Hong Kong has to use 20*20 = 400 units of resources. So it can produce and consume (1000-400)/2.5  G = 240 G, together with 20C. So Hong Kong's gains from trade is 20G ( = 260G - 240G ).

With trade, japan will have complete specialization in producing car. it will produce 1000/10 C = 100 C. in exporting 20C, it imports 20*7G = 140G. So it can consume 140G and 80C (= 100C -20C).

Under autarky, in producing 80C, japan has to use 80*10 = 800 units of resources. So, it can produce and consume (1000-800)/2  G = 100G, together with 80C. So, Japan's gains from trade is 40 G (=140G-100G).
 

2.

It is true that there is no central bank in Hong Kong and thus the carrying out of monetary policy by various tools are not so extensive in Hong Kong, but it does not mean the Hong Kong Government cannot carry out any monetary policy. the Hong Kong Government do carry out monetary policy from time to time by various tools.

Although there is no central bank in hong Kong, the Hong Kong Government can still carry out open market operation by issuing or redemption of Exchange Fund Bill in the inter bank market so as to affect the liquidity of the commercial banks.

Sometimes the HK Government can affect the demand for loanable fund by affecting the marginal requirement. For example, in order to stabilize the property market, the government put pressure on the commercial banks to reduce the percentage of mortgage from 90% to 70% several years ago.

Although there is no discount rate of bank in hong Kong, there is discount window of the Hong Kong Monetary Authority (HKMA). The attitude of HKMA in lending money to commercial banks affect the inter bank interest rate in HK.

However, the interest rate in HK can hardly be controlled by the HK Government because it is affected by many other external factors. Under the current Linked Exchange Rate System in HK, the interest rate in Hong Kong tends to fluctuate in greater extent and is strongly affected by interest rate of the U.S.A.
 

3.
a.

IS equation:

Y=C+I+G (Commodity market equilibrium)

Y=100+0.2 (Y-T) +150+200

Y=100+0.2(Y-100)+150+200

Y=100+0.2Y-20+150+200

0.8Y=430

Y=537.5    (IS equation)
 

LM equation:

Md = Ms (Money market equilibrium)

0.2Y-2r+10=50

0.2Y=50-10+2r

Y=200+10r    (LM equation)
 
 

Therefore:

Y=537.5.............(IS equation)

Y=200+10r........(LM equation)

So, 537=200+10r,

r=33.75
 

The equilibrium Y is 537.5 and the equilibrium r is 33.75.
 

b.

Since the economy has a vertical IS curve, the expenditure multiplier will be equal to 1/(1-mpc) = 1/(1-0.2)= 1.25

If the government increases its spending to 300, the new equilibrium Y will be equal to 537.5 + (300-200) * expenditure multiplier = 537.5 + 100*1.25 = 662.5

Y=200+10r................(LM equation)

Y=662.5.....................(IS equation)

Therefore, 662.5=200+10r

r=46.25

The new equilibrium r is 46.25
 

c.

According to the above model, investment is an autonomous variable. Therefore, the rise in interest rate due to an expansionary fiscal policy has no effect on private investment expenditure. There will be no crowding out effect.
 

4.
a.

Under the present Linked Exchange Rate System in Hong Kong, if there is speculation against Hong Kong dollars, the HK$ will tend to depreciate. if the exchange rate is higher (e.g. HK$ 8.0 = US$ 1) than the official rate (HK$7.8 = US$ 1), banks will try to earn money by arbitrage activities. They will buy HK$8.0 with US$ 1 in the open market and sell HK$7.8 to the Exchange Fund for US$ 1. They can earn HK$0.2 for each unit of US$. the buying of HK$ in the open market by the commercial banks will, on the one hand increase the demand for HK$ which will tend to appreciate. On the other hand, it will reduce the money supply in HK and raise the interest rate in HK. Thus, the cost for speculators to speculate against HK$ will rise. Besides the rise in interest rate in HK will attract capital inflow into HK and HK$ will tend to appreciate again. All these will help to wipe out speculators against HK$.
 

b.

Despite the automatic adjustment mechanism described in part (a), the HKMA still intervene in the foreign exchange market in October 1997 when there was speculation against HK$. It is because in the process of adjustment described in part (a), a large amount of foreign exchange reserve of the Exchange Fund will be lost in the arbitrage activities of the commercial banks. There will be a risk for the Exchange Fund to lose too much foreign exchange reserve.

Besides, the adjustment process will lead to rise in interest rate in HK. The intervention of the HKMA in foreign exchange market will also lead to rise in interest rate. The rise in interest rate is rather destructive to the HK economy. Compare the two alternatives, the rise in interest rate will last for longer period of time under the automatic adjustment in part (a). Thus, the HKMA want to shorten the period of high interest rate and wipe out the speculators in shorter period of time.
 
 
 

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