King’s College Half-yearly Examination 2007-2008 ‘86 Economics, Suggested Answers Section A: MCQ (30 marks) 1 c[2 d[3. pi4 Bls. ale Bl[7 ala D[9 D[10 B u. c{i2. alas. piia. alas. Bl 16 c[17. B18, a [19 A[ 20. D 2. A|22. Bl 23. c[ 24. D[ 2s. Bi 26. D[27. a[ 28. C/ 29. B| 30. B Section B (30 marks) 1, The marginal use value is the maximum a consumer is willing to pay for the last unit purchased. If the price is lower than his marginal use value, the consumer will buy more until, the price is equal to his marginal use value. Therefore, in equilibrium price equals marginal use value, or the maximum a consumer is willing to pay. In a situation when a good is priced on an all-or-nothing basis, the maximum a consumer is, willing to pay is the average use value, or the all-or-nothing price, which is an average price. (7 marks) 2. The law of demand states that when the price of a good increases and its quantity demanded decreases, vice-versa, other factors remain unchanged. A Giffen good is an inferior good whose negative income effect outweighs its substitution effect. Thus, a Giffen good is associated with a positively sloped demand curve ie. quantity demanded will increase when the price increases, other factors remain unchanged. Thus, a Giffen good is inconsistent with the law of demand, (5 marks) 3. In the short run, a firm will produce only if the price can cover AVC. The firm need not consider the fixed costs since they become sunk costs when the fixed factors have zero resale values. In the long run, a firm will produce only if the price can cover AC since the firm can decide whether to replace old equipment; if the price cannot cover AC, the firm will not replace fixed factors and shut down. (6 marks) 4. ATC = AFC + AVC. As the two firms have identical AVC curves but different AFC curves, their ATC curves also differ. (2 marks) TVC = AVC x Q. Since the two firms have identical AVC curves, their TVC curves are also ‘identical. MC is the slope of TVC curve or slope of TC curve. As their TVC curves are ‘identical, their MC curves are also the same. (3 marks) 5. The aw of diminishing marginal productivity states that if variable factors are continuously added to a fixed quantity of fixed factors, holding technology constant, marginalproducts will eventually fall. In other words, the phenomenon in which less output is produced for each additional unit of a factor employed, is equivalent to increasing marginal cost, where for each additional unit of output, the cost to produce the last unit rises. ‘The statement is true for most firms. In a perfectly competitive market, the supply curve of a firmis the same as part of the upward sloping portion of the MC curve above the minimum point of the AVC curve. If MC is upward sloping, so is the supply curve. Thus, the upward sloping supply curve is always the result of diminishing marginal productivity. Since when output increases to a certain level, MC also increases as diminishing marginal productivity sets in, (7 marks) Section C (40 marks) 6a) Waiting processes involve time costs. So the true price of public medical services is its monetary price + the non-monetary price (ie. time costs) which equals the monetary price of private medical service at the margin ‘When the government increases the supply of public medical service, its true price decreases because of lower time costs. This will attract those who have a higher wage rates and hence higher time costs to switch from private medical service to public service. Therefore, the quantity demanded of public medical service would increase. If the government reduces the supply after a period, the true price and quantity demanded of public medical service would return to its original level. So the policy does not work. (5 marks) b) As long as monetary price of public medical service is lower than that of private medical service, non-price competition e.g. waiting , would be used to allocate resources to make true prices the same at the margin. There should be no waiting for private medical service, otherwise the private medical service suppliers would increase price to clear the market. To eliminate waiting for public medical service, the only way is to charge the same price, i. to increase the monetary price of public medical service up to the level of private medical service which is the market-clearing price determined by market forces. The above analysis assumes that the public medical service and private medical service are perfect substitutes. (5 marks) B 4) As good X is an inferior good, when income falls, the consumption of good X Hecreases. y Li ul IN x G marks) x2 XI gl) If real income is held constant, only the substitution effect will exhibit. As substitution effect must be negative, after arise in the price of good X, the consumption of good X drops. holding real income constant, parallel to L3 (4 marks) 3 (holding mone¥ income constant) ©) The budget line remains unchanged. The change in preference shifts the indifference map and raises the consumption of good X. ¥1 ul U2 x (3 marks) x1 x2 8a) Price discrimination exists only where a different price is charged for the exact same good or service produced at the same cost on different customers so as to extract part or all of the consumer surplus. The case in the question is not price discrimination. Possible reasons: - the costs of flying out of HK may be higher e.g, higher airport departure tax, higher labour cost in Hong Kong, lower production costs in Shenzhen. - the flight industry and the price of air ticket may be regulated by the Chinese government - the services provided in these two airlines are different.