Unit 7 - Factor Income Determination

Unit 7 – Factor Income Determination
(i) The Determination of Wage
1. A monopolist’s demand for a factor of production is
A. the value of marginal product.

B. marginal value of social product.
C. marginal revenue product.
D. marginal product. (85-14)
2. Which of the following groups would most likely be harmed by a minimum wage
law?
A. teenagers with low productivities.

B. salesmen who are paid by commission.
C. waiters who are paid mainly by tips.
D. technicians skilled in specialized techniques. (85-28)
3. In the labour market, it is said, a worker is paid a wage equal to the marginal
revenue product. Therefore,
A. civil servants in Hong Kong has enjoyed significant increases in real wages
during the last decade because of significant increases in their productivities.
B. a businessman earns a windfall profit because he is more productive.
C. in the University of Hong Kong, a professor is paid twice the salary of a
lecturer because the professor knows twice as much and is twice as
productive.
D. None of the above. (86-14)
4. Assume only two inputs are used in agriculture: land and labour. If adding
labour to work on a limited area of land were NOT subject to diminishing
marginal productivity,
A. scarcity would no longer exist.

B. land rents would be zero.
C. wage rates would be zero.
D. people would be infinitely wealthy. (86-26)
5. The more human capital an individual worker brings to the labour market,
A. the higher will be his real wage.

B. the lower will be his marginal product because he produces more.
C. the more difficult it will be for him to find work because of his exceptional
ability.
D. the more hours of labor he will be able to supply. (86-27)
6. The demand curve for labour corresponds to
A. the entire marginal revenue product curve.

B. the entire average revenue product curve.
C. the marginal revenue product curve below the maximum of the average
revenue product curve.
D. the average revenue product curve below the maximum of the marginal
revenue product curve.
(87-
16)
7. Under which of the following situations will the marginal revenue product of a
factor of production be smaller than the value of its marginal product?
A. When the quantity of the factor employed decreases, the price of the factor
falls.
B. When the price of the product falls, the quantity of the product demanded
increases.
C. When the quantity of the factor employed increases, the price of the factor
rises.
D. The price of the product is fall over time. (88-06)
8. Diminishing returns begin to occur when
A. the marginal product begins to rise.

B. the marginal product begins to fall.
C. the average product begins to rise.
D. the average product begins to fall. (89-12)
9. The demand curve for a factor of production is downward sloping because
A. the product market is perfectly competitive.

B. the factor market is imperfect.
C. of the law of diminishing marginal returns.
D. the product demand curve is downward sloping. (89-18)
10. Suppose land and labour are the only factors involved in farming. If the use of
land for farming is reduced by law, then the marginal product of land will _____
and that of labour will _____.
A. rise, rise
B. fall, fall
C. rise, fall
D. fall, rise (90-09)
11. Workers in Hong Kong earn higher wages than those in the Philippines
because
A. there is a smaller labour supply in Hong Kong.

B. the labour unions in Hong Kong are stronger.
C. the workers in Hong Kong are more productive than those in the Philippines.
D. the living standard in Hong Kong is higher. (91-12)
12. If all firms in an industry are price takers in the market for factor A, then
A. changes in industry output will not affect the price of factor A.

B. the marginal product of the last unit of factor A will be the same in all firms.
C. the marginal cost of factor A to firms will be higher than the price of factor A.
D. the demand curve for factor A is horizontal. (91-13)
13. God may have started out to create all men equal, but our parents intervened.
Natural differences in abilities, attributes and tastes go far to explain wage
differences. Economics tells us that
A. the government should therefore set things right, and a socialist state is
therefore preferable.
B. the best condition is from whom according to ability and to whom according
to needs.
C. with equal education, people will have equal ability.
D. with private property rights, the more productive your labour and the greater
the demand for your services relative to its supply, the higher your wage
rate. (91-24)
14. Assume leisure is a normal good. If the income effect of a wage increase is
greater than the substitution effect,
A. the supply curve of labour will be positively sloped.

B. the supply curve of labour will be negatively sloped.
C. the demand curve of labor will shift leftward.
D. the demand curve of labour will be negatively sloped. (92-
16)
15. A monopsonist will pay a wage rate

A. lower than the marginal factor cost.
B. higher than the marginal factor cost.
C. equal to the marginal factor cost.
D. lower than the average factor cost. (92-18)
16. Under which of the following situations will the marginal revenue product of a
factor of production be smaller than the value of its marginal product?
A. When the quantity of the factor employed decreases, the price of the factor
falls.
B. When the quantity of the factor employed decreases, the price of the factor
rises.
C. When the product demand curve facing the producer is downward sloping.
D. When the price of the product is rising over time. (93-06)
17. The more human capital an individual worker brings to the labour market,
A. the higher will be his marginal product.

B. the easier it will be for him to find work.
C. the more difficult it will be for him to find work.
D. the more hours of labour he will be willing to supply. (93-26)
18. An employer observes that when one employee is sick (and does not come to
work), the value of output falls by $500 per day. If two workers are sick, the
value of output falls by $1 200 and when three workers are sick the value of
output falls by $2 100. Suppose the wage rate is $750 per man-day, the
employer should
A. keep the same number of workers.

B. fire one worker.
C. fire two workers.
D. fire three workers. (93-30)
19. When firm is a price-taker in the product market, its demand curve of a factor
input is
A. the upward sloping portion of its value of marginal product curve.

B. its marginal product curve.
C. the portion of its value of marginal product curve below its average revenue
product curve.
D. the downward sloping portion of its value of marginal product curve.
(94-21)
20. An individual’s labour supply curve may be backward-bending because
A. the substitution effect between work and leisure is smaller than the income
effect when the wage increases.
B. the substitution effect between work and leisure is greater than the income
effect when the wage increases.
C. the worker’s preference for leisure has decreased.
D. the opportunity cost of leisure increases when the wage increases.
(94-22)
21. If Hong Kong’s construction industry is free to import workers from China, it
will
A. lower the average product labour in the construction industry.

B. increase the total product in the construction industry.
C. lower the marginal cost of production in the construction industry.
D. All of the above. (95-11)
22. Assume that leisure is a normal good. Which of the following is implied by an
upward sloping labour supply curve?
A. Leisure and income are substitutes.

B. The income effect of a wage increase is smaller than its substitution effect.
C. There are labourers who may receive an economic rent.
23. In a competitive labour market, two industries require the same type of labour.
Suppose the marginal productivity of labour in Industry A is higher than that in
Industry B. In the absence of transaction costs, which of the following
statements is correct?
A. If labourers are switched from Industry B to Industry A, then the value of the
total output of the industries will increase.
B. Employers in Industry A will lay off some workers who will then be employed
in Industry B.
C. The labour demand curve for industry A will shift upward and that for
industry B will shift downward.
D. The labour demand curve for Industry A will shift downward and that for
Industry B will shift upward. (96-03)
24. According to the marginal productivity theory, a worker is paid a wage rate
equal to his marginal product. Thus,
A. in the University of Hong Kong, a professor earns twice the salary of a

lecturer because the professor is twice as productive.
B. medical interns (young doctors under training) earn very little because their
marginal products are very low.
C. the marginal productivity theory is not useful because in the real world
marginal products are not measured.
D. none of the above is correct. The marginal productivity theory does not apply
in some property rights arrangements or in the absence of a free market.
(96-26)
25. If the law of diminishing returns does not hold,
A. product price will be zero.

B. marginal cost curves will not be rising.
C. only inferior land will be cultivated.
D. all usable land will be cultivated. (97-24)
26. The law of diminishing returns means the following EXCEPT:
A. Output will increase at a decreasing rate, when all inputs increase together.
B. Output will increase at a decreasing rate, when one input increases and
another input stays constant.
C. Output will increase at a decreasing rate, when all inputs except one increase.
D. Output will increase at a decreasing rate, when all inputs increase at declining
proportions.
(97-
26)
27. In a competitive market, the observed wage rates of men are generally higher
than those of women. This implies
A. more men will be employed.

B. more women will be employed.
C. the marginal productivity of men is generally higher than that of women.
28. An effective wage floor imposed on imported workers by the government will
lead to _____ in marginal productivity and _____ in the average productivity of
imported workers.
A. an increase ... an increase

B. an increase ... a decrease
C. a decrease ... an increase
D. a decrease ... a decrease (98-05)
29. If the law of diminishing returns does NOT hold,
A. rent will increase indefinitely.

B. output will increase indefinitely.
C. the short-run average cost curve will not be upward sloping.
30. The demand curve of labour is downward sloping because
A. the demand curve of the product is horizontal.

B. increases in the labour-capital ratio will result in decreases in the marginal
productivity of labour.
C. the firm is a price searcher.
31. Suppose labour is mobile between a country’s two competitive industries,

farming and garment-making. The amount of land used in farming is fixed. If a
sales tax is imposed on garment products,
A. the marginal product of land used in farming will increase.

B. the marginal product of land used for garment making will increase.
C. the marginal product of labour in the garment industry will decrease.
D. the marginal product of labour in farming will increase. (99-
11)
32. In a competitive labour market, the wage rate received by a worker depends
on
A. his marginal productivity.

B. the alternative offers he receives.
C. the market demand for the product he produces.
33. The demand curve of labour
A. will not be affected if the quantity of other factors employed changes.

B. will be horizontal if the producer faces a horizontal demand curve of his
product.
C. is the downward sloping portion of the marginal revenue product curve below
the average revenue product curve.
34. If the law of diminishing returns does not hold,
A. wage cannot be determined.

B. rent cannot be determined.
C. Both wage and rent cannot be determined.
D. Both wage and rent can still be determined. (02-04)
35. One flower shop makes money and stays in business; another flower shop
loses money and also stays in business. Both shops will stay in business
indefinitely, that is, they have no plan to close down.
A. The owner of the shop that is losing money is irrational.

B. The behaviour of shop owners is unpredictable.
C. When non-pecuniary gains exist, a shop may stay in business though losing
money.
D. The shop owner who is making money is more rational than the shop owner
who is losing
money. (03-04)
36. In a government-regulated school, a teacher with 15 year’s experience is paid

a salary double that of a teacher with only 5 year’s experience. The marginal
revenue product of the more experience teacher is higher than that of the less
experienced teacher by an amount that is _____ the marginal revenue product
of the less experienced teacher.
A. equal to
B. greater than
C. smaller than
D. There is not enough information to tell. (03-14)
37. The factor demand curve of a price-taking firm is
A. horizontal.
B. downward sloping.
C. upward sloping.
D. first upward sloping and then downward sloping. (03-22)
38. A factory, using valuable machines, pays higher piece rates for workers who
produce more pieces than other workers over the same period of time. All
workers use the same machines. Which of the following statements is correct?
A. The observation is inconsistent with the theory that the marginal products of
different workers will be equated.
B. Without paying different piece rates the rents of the same machines will not
be equal; therefore it would be inconsistent with the postulate of wealth
maximization.
C. The observed pricing practice is inconsistent with the theory that workers are
paid according to their marginal products.
D. The observed piece rates would be inconsistent with the theory that machine
rents are paid according to the marginal products of the machines.
(04-30)
39. In China, the rental return of land designated for industrial usage is several
times higher than that of land designated for agricultural usage. Assume both
land and labour are homogeneous so that both could be readily employed in
either industry or agriculture. Which of the following statements about China is
correct?
A. The marginal productivity of land is higher in industrial usage than in

agricultural usage.
B. The marginal productivity of labour is higher in agricultural usage than in
industrial usage.
C. The marginal productivity of labour is lower in agricultural usage than in
industrial usage.
D. The marginal productivities of both land and labour are higher in industrial
usage than in agricultural usage. (05-12)
40. In mainland China, the highest denomination of currency notes in Renminbi
(RMB) 100. Most restaurants there adopt the following practice. When a
customer asks a waitress for the invoice after dinner, the waitress returns with
two folders: one containing the invoice, the other containing the exact change
– just in case the customer does not pay the exact change – just in case the
customer does not pay the exact amount. This practice saves servicing cost
because
A. the highest denomination of a RMB bill is RMB 100.

B. restaurant customers in mainland China do not give tips (gratuity).
C. customers in mainland China do not use credit cards.
D. labour costs in mainland China are lower than elsewhere. (05-
15)
41. If the law of diminishing marginal productivity does NOT hold,
A. with a small wheat farm, one could add successive fertilizer and labour to
produce enough wheat to feed the world.
B. with a constant wage level, all workers would participate in farming.
C. the marginal productivity theory will not be affected.
42. The law of diminishing marginal productivity is
A. itself not testable.

B. a law of empirical regularity.
C. in principle not observable.
MC Answers on The Determination of Wage

C A D B A C B B C C
C B D B A C A C C A
D D A B D A C A C B
A D C C C D B B A A
A B
The Determination of Wage
1990 Q. 7
In the 14th century, the Black Death (Bubonic Plague) killed a
large number of the population of England (possibly 1/3) within
three years.
(a) It was allegedly observed that in the ensuing years there
was a strong tendency for real wages to rise and land rents
to fall. Is this consistent with economic theory? Explain in
terms if an aggregate marginal productivity schedule for
labour. (Note that production of the time was largely
confined to the use of land and labour.)
(8
marks)
Given only two factors of production, land and labour, the above
diagram shows the marginal product of labour, holding land constant. A
decline in population, shift the labour supply from S1 to S2, results in a
rise in real wage from W1 to W2. However, the total wage may rise or
fall, depending on the elasticity of the MPL.
(b) It was also allegedly observed that amidst the evidence of

economic decline (abandonment of marginal lands,
reduction in trade), there were indications of a rise in the
general standard living. Is this consistent with economic
theory? Explain with the aid of a diagram.
(8 marks)
To measure the general standard of living, we can simply look at the

per capita income of people, which is equal to the average product of
labour.
With a decline in labour supply, the rents receives by the landlords

would necessarily fall. However, this fall in rents will not likely bring
down the per capita income, in the above diagram, the average
product of labour (APL), which includes rent, and rise from A1 to A2.
Hence, there would be a rise in general standard of living.
(c) The population density in England today is far higher than

that in the 14th century, and yet their general living
standard today is also far higher. How can you reconcile this
with (a) and (b) above? (9 marks)
The presence of other factors of production, such as human capital,

knowledge and technical know-how were not popularly used in the 14th
century as compared to today. Moreover, with capital accumulation, the
productivity of labour today is much higher than that of the 14th
century. Besides, with the improvement of the economic system as the
result of widespread introduction of private property rights and the
growing specialization of production through international trade, the
marginal productivity of labour and their general living standard today
become much higher than before.
1991 Q. 5
Agricultural land has different levels of fertility, i.e. given the
same non-land inputs their productivities are not the same.
Why do farmers cultivate both superior and inferior land, i.e.,
why do they not cultivate only superior land? (10 marks)
This can be explained by the law of diminishing marginal productivity.

According to this law, when more and more of a variable factor is being
continuously added to a fixed factor, the marginal product of the
variable factor will eventually diminish. Hence, with an increasing
quantity of farmers working on a superior land, the marginal product of
farmers will fall. At some point, this marginal product using the superior
land will fall below that of the inferior land. In this case the inferior land
will be cultivated.
Hence, in equilibrium, the marginal products of farmers in the superior

land and inferior land will be the same.
1995 Q. 5
What will the price of land be if the law of diminishing
marginal productivity does not hold? Explain.
(8 marks)
Briefly speaking, the price of land is the same as land rent. With land
being fixed and labour the only variable factor, if diminishing marginal
productivity holds, the amount of land rent will be equal to the total
product less the income to labour.
If diminishing marginal productivity does not hold, this means that a

tiny piece of land can produce all the food to feed the world. Since
there are actually a lot more lands than just one tiny piece, all land
owners will compete for labour services. To compete for labour
services, land owners must pay to each unit of labour service according
to its marginal product.
With one tiny piece capable of producing all lands combined could, all
the land owners will try to sell their land on the market but the demand
for land is very small. Hence, the price of land would be driven down to
nearly zero under competition.
Another explanation for zero land rent is that since marginal productivity of labour is
increasing, in order to employ an additional unit of labour, higher wage has to be offered.
Since marginal revenue product is higher than average revenue product, it is impossible
for the employer to raise the wages of the previous unit. Hence, the wage paid will be
equal to the marginal revenue product of corresponding unit of labour employed. In this
case the total wage payment will be equal to total revenue product and there will be no
residual income for land.
1999 Q. 5
The law of diminishing marginal productivity (diminishing
returns) is neither a postulate nor an assertion, but a
statement of fact. Do you agree? (7 marks)
The law of diminishing marginal productivity states that when more

and more of a variable factor is continuously added to a fixed factor,
the marginal output will eventually diminishes.
A postulate is an assumption stating the characteristics, properties,

behaviour or relationship of different items defined, e.g. the postulate
of utility maximization.
An assertion is an entity which can neither be derived nor proved, e.g.

the Law of Demand which states that when price of good falls,
consumers will be willing to buy more, vice versa, ceteris paribus. Since
willingness is not observable, the relationship between price and
quantity demanded is asserted to exist as long as it is not being
refuted.
However, the law of diminishing marginal productivity is an empirical

law based on observation that means it is induced from real world
observation.
If the law of diminishing marginal productivity does not holds, we can

observe that only an infinitely small piece of land will be cultivated as
marginal product will rise indefinitely by adding labour continuously.
However, in real world observation we can see that both fertile and
infertile will be cultivated. This implies the validity of the law.
So, to conclude, since the law is the result of generalization from

factual observations, it is a statement of fact instead of a postulate or
assertion.
2000 Q. 5
Consider agricultural production which requires only two
inputs, labour and land. Suppose the law of diminishing
returns does not hold, so that the marginal product curve of
labour is upward sloping.
(a) How much land will be used for farming? (3

marks)

and more of a variable factor i.e. labour, is continuously added to a
fixed factor i.e. land, the marginal output of labour will eventually
diminishes and the marginal product curve of labour will slope
downwards. Hence, solely adding labour to a piece of land will
eventually lead to a fall in marginal product as well as total product.
However, if the above law does not hold so that the product curve of
labour is upward rising, the marginal product of labour will keep on
increasing with the amount of labour. This means that by cultivating
only a small piece of land, output can be increased indefinitely and is
sufficient to feed the whole world. Hence, if the law of diminishing
returns does not hold, only a tiny, or infinitely small, piece of land will
be used for farming.
(b) Can we determine the rental value of agricultural land?

(5 marks)
In market economy, the price of a good is determined by the

interaction of demand and supply. Like the price of other goods, the
rental value of agricultural land. As only a small piece of land will be
used, the amount of land available is much more than the amount of
land needed for farming. Thus landlords will have to compete with
others for the user of their land. Eventually the relatively abundant
supply of agricultural land will tend to drive the market rent to zero.
Another explanation for zero land rent is that since marginal productivity of labour is
increasing, in order to employ an additional unit of labour, higher wage has to be offered.
Since marginal revenue product is higher than average revenue product, it is impossible
for the employer to raise the wages of the previous unit. Hence, the wage paid will be
equal to the marginal revenue product of corresponding unit of labour employed. In this
case the total wage payment will be equal to total revenue product and there will be no
residual income for land.
2001 Q. 5
In agriculture, when two persons work together on a given
piece of land, helping each other, the output may be more than
double that of one person working singly on the same piece of
land. Is this consistent with the law of diminishing marginal
productivity? (6 marks)
The law of diminishing marginal productivity or the law of variable

proportions states that when more and more of a variable factor i.e.
labour, is continuously added to a fixed factor i.e. land, the marginal
output of labour will eventually diminishes.
From the above information, if we observe that when two persons work
together on a given piece of land and the output is more than double
that of one person working singly on the same piece of land, this
implies that the marginal output of the additional worker is increasing.
However, it does not imply that this is inconsistent with the law of
diminishing marginal productivity.
An important point we must note is that the law states that marginal
output will eventually diminish when more and more variable factors is
being employed. However, before diminishing marginal productivity
sets in, the marginal output may be increasing with the increase of
variable factors. This may be due to the fact that in the initial stage,
the increase of workers can give rise to better division of labour which
enables the fixed factor, i.e. land, to be better utilized. Hence, the
percentage increase in outputs is greater than the percentage increase
in workers employed. This explains the increase in marginal output.
However, when more and more workers are employed, the amount of
fixed factor becomes insufficient and over-utilized. Eventually the
percentage increase in output become smaller than the percentage
increase in workers employed and diminishing marginal productivity
results.
So, to conclude, the above observation is consistent with the law of

diminishing marginal productivity.
2002 Q. 2
The upward sloping supply curve of a firm is always the result
of diminishing marginal productivity. Do you agree? Explain.
(8 marks)

and more of a variable factor i.e. labour, is continuously added to a
fixed factor i.e. land, the marginal output of labour will eventually
diminishes.
With factor prices remaining constant, the wage of each factor

employed is the same. In short run, with some factors being fixed, the
increase in output can only be achieved by employing more factor
inputs, including workers. With the increase in some factors while
others are fixed, the marginal output of variable factors will eventually
diminish.
As factor prices are kept constant, when marginal output diminishes,

the marginal cost of producing of an extra unit will become higher than
the previous units. Hence, the MC curve of the firm will become upward
sloping.
The supply curve of a firm shows the quantities it is willing to supply at

various prices. Since it is derived from its MC curve, it shows the
wealth-maximizing output at various prices, i.e. MC = MR, the supply
curve is in fact the rising portion of its MC curve above AVC curve. So, I
agree that the upward sloping supply curve of a firm is always the
result of diminishing marginal productivity.
- END -
(ii) The Determination of Rent
1. Economic rent is
A. a payment which does not affect the availability of a good.

B. a payment in excess of cost.
C. a profit obtained without risk.
D. a payment necessary to keep a resource at its present use.
(88-21)
2. Economic rent
A. is income earned by the owner of land.

B. may exist in any economic resource.
C. is a part of profit.
D. will be eliminated by competition. (90-04)
3. Mr. Leung and Miss Tang are equally skilled at their jobs as teachers; their
productive capacities in everything else are also similar except Miss Tang has
more entrepreneurial talent. If both of them have the same salary as teachers,
then
A. their economic rent as teacher is the same.

B. Miss Tang has a lower economic rent in teaching.
C. Mr. Leung has a lower economic rent in teaching.
4. Economic rent is
A. the difference total revenue and total cost.

B. a part of cost if the outright sale of the business is an option.
C. a payment to the owner of a fixed factor.
D. a payment to keep the factor input in its current use. (94-
14)
5. Which of the following correctly shows the difference between rent and cost?
A. Rent is windfall but cost is expected.

B. A change in rent does not affect resource allocation, whereas a change in
cost does.
C. Rent is not transferable but cost is.
D. Rent is payment for land but cost is payment for any factor of production
other than land. (95-05)
6. Economic rent is
A. a payment to a factor above the cost of production.

B. an income to the owner of a natural resource.
C. part of the cost if the option of outright sale is included.
D. a payment which is necessary to keep a factor in its current use.
(98-27)
7. Suppose the alternative earnings of all workers, both existing and new, in a
particular trade are identical and constant, and suppose new workers in that
trade accepts a 15% wage cut. Which of the following statements about workers
in that trade is correct?
A. Both existing and new workers would definitely earn economic rents.
B. The cost of quitting the job would remain unchanged for the existing workers.
C. The transfer earnings of the existing workers would decrease by 15%.
8. Economic rent is
A. a payment which does not affect the current availability of a good.

B. not a cost.
C. a payment necessary to keep a factor in its present use.
D. a profit. (02-29)
9. A flower shop owner loves flowers so much that even when he loses money in
the business, he still stays in business. When this flower shop breaks even in
terms of money,
A. the owner will be making a profit.

B. the owner is earning a rent.
C. the owner is earning zero income.
10. Which of the following statements about rent and cost is correct?
A. Rent can be capitalized but cost cannot.

B. Cost is relevant to decision making but rent is not.
C. Rent is a part of cost but cost is not necessarily rent.
D. A change in cost will affect resource use but a change in rent will not affect
resource use in all dimensions. (06-05)
MC Answers on The Determination of Rent

A B B B B C B A B
C
The Determination of Rent
2003 Q. 2
What is rent? (i.e. economic rent)? Is rent a cost? Explain.
(6 marks)
Rent is that part of income a change of which will not affect quantity
supplied of a resource in a particular direction or dimension. That is,
the availability or the supply of a good or a factor of production will not
change in a particular dimension as result of a price change or a
change in income to the seller of the good or factor owner, and such
income is known as rent.
It is important to note the phrase a particular dimension because with a

price change or an income change some other dimensions may
change, and rent only applies to that dimension where no change
occurs. For example, a salary cut for an administrative officer may
induce him to do some administrative work with less effort (hence with
respect to effort change there is no rent), but the administrative officer
remains as an administrative officers, hence with the respect to supply
of administrative offices the cut in salary is rent.
Rent is a cost because there is always an opportunity foregone, not
least with an outright transfer of ownership as an opportunity. For
example, after a salary cut, one may begin to shirk but stay in the job.
When the salary is high (before the salary cut), shirking is an
opportunity forgone, not shirking is a cost. In the administrative officer
example, before the salary is reduced, paying less effort to do the job is
an opportunity forgone and not paying less effort is a cost.
An alternative answer can be that: When we have production which

involves a fixed factor and a variable factor, the return above the
variable cost is rent to the fixed factor. In this case, rent is cost of
staying in the business as there is a forgone opportunity of an outright
transfer of the ownership.
2004 Q. 7
Many people go deer hunting. It is reported that among all the
people who go deer hunting, less than 10 per cent of them (the
superior hunters) get more than 90 per cent of the hunted
deer, while the remaining 90 per cent or more of them (the
inferior hunters) get less than 10 per cent, or each of them get
hardly any deer. Assume for this question that all people who
go deer hunting have the same time cost and that they enjoy
hunting equally.
(a) What would you call that part of hunting income a superior
hunter earns over and above that of an inferior one? Why?
(4 marks)
Rent. It is called rent because even if this part of income does not exist,
a superior hunter would still go hunting as his time cost is no more
than that of an inferior hunter. In other words, the rent captured by a
superior hunter is an income that would not be competed away.
2005 Q .4
Rent is cost, but cost is not necessarily rent. Do you agree?
Explain. (8 marks)
Rent is a cost when we consider cost is the highest-valued option

forgone, including the option of selling out a business. On the other
hand, cost is not necessarily rent in that a change in rent will not
change supply or alter behaviour in a certain dimension, and this is the
reason why the concept of rent is introduced in economics. We may say
rent is a part
of cost, but if we are only concerned with changing behaviour, there is
no rent component
in cost.
2009 Q.2
What is the law of diminishing return? Why is this law essential in the determination of
rents and wage?
The law of diminishing returns is the same as the law of diminishing marginal
productivity, which states that when one factor input increases while other factor inputs
are held constant, output will rise at a decreasing rate, and at some point the marginal
product will become zero and then negative. If this law does not hold, one may keep
adding fertilizers to a small plot of land to grow enough food to feed the world.
Therefore, if this law does not hold the price of land cannot be determined, and likewise
the price of other inputs cannot be determined.
- END -
(iii) Profit
1. Profits arise as a result of
A. an unanticipated increase in demand.

B. an increase in monopoly in monopoly power as a result of patent protection.
C. producers having usually good foresight.
D. an anticipated fall in interest rates. (85-24)
2. Profits are earned by
A. an owner of a resource whose ability is superior.

B. an owner of a resource the value of which has increased unexpectedly.
C. a monopolist who sets a price above the marginal cost.
D. a producer whose marginal cost is above the average cost.
(87-04)
3. The statement that a businessman maximizes profit is troublesome because
A. in economics, there is no such thing as profit.

B. profit arises only if it is unanticipated.
C. in competitive equilibrium, profit will be driven down to zero.
D. a businessman may be more concerned with reputation than profit.
(88-05)
4. Profit cannot be used to predict behaviour because
A. in economics, there is no such thing as profit.

B. profit arises only if it is unanticipated.
C. profit will not persist under competition.
D. profit does not exist in an economy without free markets. (89-
11)
5. Which of the following is true of profit?
A. Profit is an unanticipated gain in wealth.

B. A monopolist will earn a higher profit than a competitor.
C. The tax base for the Hong Kong government’s profits tax is what we mean by
profit.
D. Profit is interest payment on capital. (90-05)
6. Profit occurs when
A. total revenue exceeds total cost of production.

B. total revenue increases faster than total production cost.
C. total net income unexpectedly increases at a rate greater than the rate of
interest.
7. Which of the following about profit and rent is correct?
A. Profit is unexpected but rent is expected.

B. Profit will not persist but rent will.
C. Profit cannot be capitalized but rent can be.
8. Mrs. Wong had bought a solar heater and has saved some electricity cost.
A. Mrs. Wong has a profit if the electricity price is increased unexpectedly.

B. Mrs. Wong has a profit if the interest rate rises unexpectedly.
C. Mrs. Wong has a profit if the cost of operating the solar heater is increased
unexpectedly.
D. Mrs. Wong cannot earn a profit from her purchase of the solar heater.
(96-11)
9. Windfall profit is irrelevant to decision making because
A. it is a matter of luck.
B. there is a chance of suffering loss.
C. it is totally unanticipated.
D. it cannot be measured. (97-21)
10. Profit is
A. what individuals seek to maximize.

B. the same as rent.
C. a part of cost.
D. not anticipated and therefore cannot be discounted. (04-
11)
11. After SARS in 2003 and the introduction of the Individual Visit Scheme; the
housing market in Hong Kong has unexpectedly soared, with the property
value rising about 40 per cent from the SARS period. Which of the following is
correct?
A. All property owners enjoying this price are making profit.

B. Those property owners who purchased property at higher prices before SARS
are not making profits.
C. Those property owners who choose not to sell to realize a gain have no profit.
D. There are only capital gains and losses but no profits. (05-
24)
12. Profit
A. is a part of cost.
B. is an income that cannot be discounted.
C. is a part of rent.
D. may exist in a perfectly certain world. (07-05)
MC Answers on Profit
A B B A A B B A B B
A B
Profit
1991 Q. 2
What is the main difference between profit and rents? Give
two examples (one example each) to illustrate this difference.
(10 marks)
Profits are unexpected returns to investments at a rate over and above

the rate of interest. They are not expected to last under competition.
Rents are expected returns, but a reduction in rent will not affect the
resources available. Rents, therefore, are returns over and above the
opportunity costs of the resources employed in alternative uses.
(However, we should note that rent is not the returns over the
alternative of a transfer in ownership.)
Since rents are expected and profits are not, rent can be discounted
and capitalized in decision-making. Profits cannot be so discounted.
Moreover, since with a transfer in ownership, the resource owner can
also realized the same amount of return of rent, he incurs a cost in
obtaining rent for not selling the resource ownership to others.
However, since profits are totally unexpected, they will not be
considered in the process of decision-making and so they are not part
of costs.
An example of rent is that a monopolist protected by the government is

earning rent when his income is in excess of cost, i.e. he is earning an
amount which is over and above the amount he can earned in his
highest-valued alternative use.
Owing to unexpected increase in demand for his product, the earnings
of the monopolist may be higher than the amount expected. If this is
the case, the earnings in excess of the expected amount is an example
of profit.
1993 Q. 2
What is profit? What is the difference between profit and rent?
(8 marks)
In Economics, profit is defined as an unexpected increase in wealth. In

other words, it is the unexpected return to capital at a rate higher than
the rate of interest, i.e. the expected rate of return.
For rent, it is defined as a return over and above the amount which is
necessary to keep the resource in its present use. In other words, it is
the amount over and above the highest alternative use of the
resources.
For example, an investment made by a firm worth $100 000 with an
expected return of 10% means income of $10 000 per time period. If
there is a sudden change in demand which gives rise to a realized
return of 15% to this investment, then a profit of $5 000 will exist. If
the $5 000 is expected to persist in future, such amount will become
rent.
To conclude, since rent is expected while the profit is unexpected, rent

can be capitalized while profit cannot. Moreover, rent can be use to
predict behaviour as ‘rent maximization’ is a real possibility. However,
profit cannot be used to predict behaviour as it is impossible for an
individual to maximize what is unexpected. Besides, profit is not part of
cost in the decision-making process while rent forms part of cost if the
option of outright sale is included. Finally, profit is an ex-post concept
while rent is an ex-ante concept.
1995 Q. 4
Is rent part of cost? Is profit part of cost? Explain.
(8 marks)
In Economics, profit is defined as an unexpected increase in wealth. In

other words, it is the unexpected return to capital at a rate higher than
the rate of interest, i.e. the expected rate of return.
For rent, it is defined as a return over and above the amount which is
necessary to keep the resource in its present use. In other words, it is
the amount over and above the highest alternative use of the
resources.
For example, an investment made by a firm worth $100 000 with an
expected return of 10% means income of $10 000 per time period. If
there is a sudden change in demand which gives rise to a realized
return of 15% to this investment, then a profit of $5 000 will exist. If
the $5 000 is expected to persist in future, such amount will become
rent.
To conclude, since rent is expected while the profit is unexpected, rent

can be capitalized while profit cannot. Moreover, rent can be use to
predict behaviour as ‘rent maximization’ is a real possibility. However,
profit cannot be used to predict behaviour as it is impossible for an
individual to maximize what is unexpected. Besides, profit is not part of
cost in the decision-making process while rent forms part of cost if the
option of outright sale is included. Finally, profit is an ex-post concept
while rent is an ex-ante concept.
2005 Q.1
What is dissipation of rent? Explain how and why this dissipation take place. (8 marks)
When rent of income has no exclusive claimant, or when price is not used as a criterion
for allocation, competition for resource use or for a good will lead to what has become
known as the dissipation of rent. That is the value of a resource or a good will be
absorbed by the cost incurred under competition for using the resources or for getting the
good, not by producing something of value to exchange in return. ~~
2005 Q.4
Rent is cost but cost is not necessarily rent , do you agree? Explain. (8 marks)
Rent is a cost when we considered cost is the highest valued option forgone, including the
option of selling out a business. On the other hand, cost isn’t necessarily rent in that a
change in rent will not change supply or alter behavior in a certain dimension, and this is
the reason why the concept of rent is introduced in economics. We may say rent is a part
of cost, but if we are only concerned with changing behavior, there is no rent component
in cost.
2006 Q. 2
What is the difference between rent and profit? Can they both
be capitalized? Explain.
(8
marks)
Rent is that part of income an alternation of which will not affect
behaviour, normally at a specific margin. Profit is windfall, an
unanticipated return at a rate higher than the rate of interest. Rent can
be capitalized because it is anticipated; profit cannot be capitalized as
a windfall it is not anticipated.
2008 Q.3
What is “dissipation of rent ”? Will it occur without competition? Why is it so
important for the interpretation of equilibrium in economies?
Any scare resource has a rental value. However this rental value may not be competed
away if that resource is subject to unrestricted common exploitation, as in the case
when the cost of use increase when people compete to capture that rent. Rent
dissipation will not occur without competition, as in a one man economy the rent of
any scare resource is fully captured by only one man.
Dissipation of rent is an important concept in economic analysis because if at the
margin there are some rents without exclusive claimants left in the analysis, that
analysis must be wrong. Equilibrium analysis requires that at the margin there is no
rent left without exclusive claimants.
2009 Q.5
What is the relationship between income and wealth? Does wealth exist in a one
man economy? Explain.
Wealth is income discounted. W=Y/r , where r is the rate of interest. Interest is a

price, which does not exist without any kind of market. In a one man economy, there
is income, but there is no market. Hence there is no interest and no rate of interest.
Without r , wealth cannot be determined. Wealth does not exist in a one man
economy.
- END -
(iv) Capital
1. A capital asset is any asset
A. that is capable of generating income.

B. except land and labour.
C. except labour.
D. except untrained labour. (85-15)
2. Which of the following statements about capital is correct?
A. A consumer durable is not a capital good.

B. Labour is a capital asset because of its future income potential.
C. The price of a capital good determines the value of its future income.
D. Land and labour cannot both be capital assets because they are different in
their physical features.
(94-
19)
3. A goose which lays golden eggs
A. is invaluable.
B. will not be raised if the present value of the cost of feeding it is higher than
the market value of the goose.
C. will be worth more when the interest rate rises.
D. should be protected by the government. (96-01)
4. Which of the following is LEAST likely to have a capital value?
A. the ability to speak Putonghua.

B. a goldmine inaccessible for another thousand years.
C. the voice of a professional singer.
D. a duck that does not lay eggs. (97-17)
5. Capital refers to
A. land but not labour.

B. neither land nor labour, but money.
C. all assets which generate income.
D. machinery, equipment and money. (97-29)
6. Which of the following statements about capital is correct?
A. Workers and machines are both capital although they are very different in
appearance.
B. A horse used for farming is not capital.
C. A residential house is a consumer good and therefore not capital.
7. A researcher reported that people with good looks receive an income about 5% higher than average
workers, other abilities adjusted. This implies
A. discrimination.
B. good looks are a capital asset.
C. it pays to dress nicely.
MC Answers on Capital
A B B B C A D
(v) Interest
1. Assume the relative prices of all goods are constant. If an apple today can be
exchanged for the right to one and half apples a year from today, we can infer
that
A. an exceptionally good apple harvest is expected for the next year.

B. market preference for apples is shifting.
C. the annual rate of interest is 50%.
D. there has been technological change in apple farming. (85-
05)
2. Assume the annual rate of interest is 12%. If the cost of operating a taxi is $200
000 a year, gross business income is $350 000 a year, and the tax is 20% of net
income, the market value of a taxi licence will be approximately
A. $500 000.
B. $1 000 000.
C. $1 200 000.
D. $2 000 000. (85-19)
3. Suppose the expected market rental annuity of a flat is $60 000 per year, the
government imposes rent controls restricting the annual rent to $20 000. Once
rented, the landlord cannot evict a tenant has a right to the tenancy in
perpetuity. The annual rate of interest is 10%. If the flat is now vacant, the
landlord can, as a condition for occupying the flat, sell a broken chair to a
prospective tenant for approximately
A. $40 000.
B. $600 000.
C. $400 000.
D. $200 000. (86-01)
4. When the interest rate increases from 10% to 15%, the owner of a perpetual
bond, receiving $450 each year, will
A. enjoy an increase in wealth of $1 500.
B. suffer a fall in wealth of $1 500.
C. enjoy an increase in wealth of $2 250.
D. suffer a fall in wealth of $2 250. (87-11)
5. Which of the following statements about interest is FALSE?
A. Interest is the price of earlier availability.

B. The higher the rate of interest, the lower will be the present value of a given
income stream.
C. Interest will not exist without money.
D. Interest is not part of income, but the whole of it. (87-24)
6. Which of the following statements about interest is INCORRECT?
A. Interest is the price we pay for the earlier availability of goods.

B. Interest is not part of income, but the whole of income.
C. Interest is a monetary phenomenon because without money there will be no
interest.
D. Interest is a premium of future over present consumption.
(88-26)
7. How will the price of a durable good change relative to the price of a non-
durable good if the interest rate falls?
A. The price of the durable good will rise relative to that of the non-durable
good.
B. The price of the durable good will fall relative to that of the non-durable
good.
C. The relative price will remain unchanged.
8. Interest will not exist without money. This statement is
A. true because interest is the premium of present over future money.

B. true because in the loan market, we pay interest when we borrow.
C. false because interest is the premium of present over future consumption.
D. false because interest is a payment for liquidity. (89-20)
9. Which of the following statements about interest is FALSE?
A. Interest is a price.
B. Interest is a flow concept.
C. Interest is the whole of income.
D. When a man buys a house with his own cash, the interest cost of his house to
him is zero. (89-30)
10. If you can exchange 2 bushels of wheat today for the right to receive 2.3
bushels of wheat a year from today,
A. the rate of interest is 0.3.
B. the rate of profit is 0.3.
C. the rate of interest is 0.15.
D. the rate of profit is 0.15. (91-09)
11. A rise in interest rates will result in
A. a rise in the price of longer-life light bulbs relative to shorter-life ones.

B. a rise in the price of all light bulbs.
C. a fall in the price of longer-life light bulbs relative to shorter-life ones.
D. a fall in the price of shorter-life light bulbs only. (91-14)
12. Which of the following about the market value of a piece of machinery is
FLASE?
A. It will increase if the scarp value is expected to rise.

B. It will increase if the annual income generated by the machinery increases.
C. It will increase if the rate of interest rises.
D. It will increase if the cost of maintaining the machinery falls.
(91-26)
13. Suppose you are given the following choices of payment methods for
purchasing a machine which lasts forever. Which of the following is the lowest
price if the annual interest rate is 10%?
A. the present cash price of $10 000.

B. $6 000 cash now and $5 000 one year from now.
C. $900 at the end of each year forever.
D. $3 500 at the end of the next three years. (92-13)
14. Mr. A owns $100 000 worth of long-term bonds while Mr. B owns $100 000
worth of short-term bonds. There exists only one interest rate in the market. A
rise in the interest rate will
A. reduce the wealth of both men by the same amount.

B. reduce the wealth of both men but Mr. A will suffer more.
C. reduce the wealth of both men but Mr. B will suffer more.
D. increase the wealth of Mr. B but reduce the wealth of Mr. A.
(93-03)
15. Interest exists even without money. This statement is
A. true because we pay interest when we borrow.

B. true because interest is the premium one pays for the earlier availability of
goods.
C. false because interest is a compensation for inflation.
D. false because money is used in all societies. (93-28)
16. If the interest rate decreases from 16% to 10%, the present value of a
perpetual bond yielding $500 per year will
A. decrease by $1 875.
B. increase by $1 875.
C. decrease by $8 333.
D. increase by $8 333. (94-20)
17. If the rate of interest rises significantly,
A. people tend to seek the jobs with lower income at the earlier stage of their
career.
B. the price of compact discs will rise relative to the price of cassette tapes.
C. the demand for less durable cars will increase while the demand for more
durable cars will fall.
D. the average size of privately farmed fish sold in the market will be larger.
(95-04)
18. Mr. Chan owns a taxi licence and drives his own taxi. Suppose the price of a
taxi licence is increased by $50 000 due to the government policy to restrict
the issue of taxi licenses. Which of the following is correct?
A. Mr. Chan’s cost of operation will increase.

B. Mr. Chan’s will sell his taxi licence.
C. Mr. Chan’s wealth will not be affected as he can earn the same income.
D. If the interest rate is 10% and it is assumed that income generated is
perpetual, then Mr. Chan’s wealth will be increased by $500 000.
(96-02)
19. Suppose a university student borrows $10 000 which is subject to repayment
in 3 years at zero interest rate. If the market interest rate during this three-
year period is 10% p.a., the discounted present value of the benefits from
borrowing the money is
A. $0
B. $2 487
C. $3 000
D. $3 310 (98-03)
20. Given the opportunity to borrow or lend at a constant interest rate, the choice
among alternative income streams depends on
A. their stability.
B. their discounted present values.
C. the preferred present values.
21. Which of the following statements about interest is true?
A. Interest will not exist without money.

B. Interest is a price for the earlier availability of a good.
C. If there is no inflation, the interest rate will be zero.
D. Interest refers to the return to man-made resources and thus it is only a part
of income. (98-26)
22. In Hong Kong, some taxi drivers rent taxis form taxi owners, while other
drivers own their taxis. This implies that
A. the market rent collected by a taxi owner is a monopoly rent.

B. the driver of a taxi will net be able to earn any economic rent.
C. the cost of the taxi service provided by a taxi owner is usually lower.
D. there exists a capital market where the market rent of a taxi is capitalized
into the price of a taxi and its licence.
(99-08)
23. The real interest rate will
A. rise in an economy when a popular religious organization convinces the

people that the world will end in a year’s time.
B. fall in a newly industrialized economy.
C. fall in agricultural economy where a typhoon has destroyed most of the
crops.
D. rise with an increase in the anticipated rate of inflation. (99-
10)
24. A corporate bond promises to pay $100 interest a year. It matures in 3 years,
at which time it pays out its full face value of $1 000 to the bond owner, in
addition to the interest payment. If the market interest rate is 8% p.a., the
present value of the bond is:
A. $1 032
B. $1 051.5
C. $1 093.8
D. $1 257.7 (99-29)
25. Interest
A. will not exist if no one borrows or lends.

B. is a price pays for earlier consumption.
C. must have monetary value.
D. is a part of income. (02-02)
26. Which of the following statements about interest is correct?
A. Interest is a premium received for postponing current consumption.

B. If there is no transaction cost interest rate approaches zero.
C. A more patient individual is willing to pay a higher interest rate for earlier
consumption.
D. If there is deflation, interest rate must be negative. (03-
24)
27. During the past several years, the number of young men and women in China
seeking a college education has sharply increased. This is because
A. the rate of interest has fallen substantially.

B. the job market has turned weak.
C. inflation has been bought under control.
D. the Chinese government has a long history of employing scholars.
(04-23)
28. A wine brewer keeps wine in a barrel to mellow. The wine grows in value as
time goes by. The wine brewer will sell his wine at a later date if
A. storage cost increases.

B. the growth rate of the wine’s value begins to fall.
C. the market interest rate decreases.
29. Although people in Shenzhen at present have a much lower per capita income
than people in Hong Kong, the former tend to consume a larger fraction of their
current incomes than the latter. Which of the following explains this?
A. Interest rates are lower in Shenzhen.

B. Because of their lower current incomes, Shenzhen people are forced to spend
a larger fraction.
C. Because of Shenzhen’s fast growth, the annuity incomes of the Shenzhen
people are far higher than their current incomes.
D. The tax rate in Shenzhen is higher. (05-21)
30. Trees, one planted, will grow to produce valuable wood. A forest owner will cut
the trees earlier if
A. land rent is higher.

B. land rent is lower.
C. the interest rate is stable.
D. the interest rate is lower. (05-22)
31. An apple orchard yields apple, and the value of the orchard is determined by
the value of the apples. Which of the following about the above statement is
correct?
A. The value of apples is income and the value of the apple orchard is wealth.
B. If there is no money the value of the apple orchard cannot be determined.
C. The statement is false. The value of the apple orchard determines the value
of apples, because if the value of the apple orchard rises, the value of the
apples will rise.
D. The statement is false. The value of apples and the value of the apple
orchard are not related.
(05-25)
32. Interest exists in the absence of
A. money.
B. risks.
C. a banking system.
33. An increase in interest rates will result in
A. a fall in the price of long-life light bulbs relative to short-life ones.

B. an increase in investment in human capital.
C. an increase in the price of wine.
D. an increase in the price of land. (06-12)
MC Answers on Interest
C B C B C C A C D C
C C C B B B C A B D
B D A D B A A C C A
A C
(vi) Investment
1. Which of the following about an investment decision is correct?
A. The cost of an investment project will be lowered if it is completed earlier.

B. The more one has invested in a project, the more reluctant one is to abandon
it.
C. Given an investment project, wealth maximization may not imply cost
minimization.
D. The net present value of an investment project is the key factor in an
investment decision. (90-27)
2. Investment take place when
A. young people play more and study less.

B. people produce fewer perishable goods and more durable goods.
C. companies issue new bonds.
D. the interest rate falls. (91-03)
3. People will invest more in human capital if
A. the premium of earlier consumption over later consumption falls.

B. the real rate of interest declines.
C. medical advances have led to an increase in life expectancy.
4. Assume the interest rate is 10% per annum and will remain so forever. Suppose
you do not drink wine but are storing wine as an investment. Assume that there
are no storage costs and that the market value of a bottle of wine purchased
today at $500 will increase by $50 every year. To maximize wealth, you should
sell the wine you store
A. after any number of years.

B. after two years.
C. after one year.
D. There is not enough information to tell. (93-13)
5. Which of the following is NOT an investment?
A. Trees are cut down for burning.

B. Students play less and study more.
C. People convert fresh milk into cheese.
D. Mary deposits $1 000 into her account in the bank instead of spending it.
(94-30)
6. You are investing when you
A. go to bed early tonight.

B. take vitamin pills.
C. buy shares.
7. Given the opportunity to borrow or lend at a constant interest rate, in a given

period of time
A. consumption may exceed income.

B. consumption must equal to income.
C. consumption cannot exceed income.
D. consumption equals wealth times interest rate. (98-10)
8. Suppose there are opportunities to borrow or lend at a constant interest rate
A. will choose the one which yields the highest present value of net worth.
B. will choose the one which can be acquired at the lowest cost.
C. will choose the one which has the largest total income.
D. is indifferent to any two which yield the same total income.
(03-25)
9. Investment decisions are separate from consumption decision if
A. an individual is sufficiently rich, he could consume all he wants and still have
money left to invest.
B. there is a market in which one may lend or borrow at the market rate of
interest.
C. an individual sets a target for himself for how much he must invest per
period of time.
D. the government provides interest-free loans to the poor. (05-
20)
MC Answers on Investment
D B D C A D A A B
(vii) Wealth and Income
1. Suppose you are given $100 000 by a rich uncle. At an annual interest rate of
12%,
A. your wealth increases by $100 000; your income increases by $12 000; and
your maximum annual rate of saving is $100 000.
B. your wealth increases by $100 000; your income increases by $12 000; and
your maximum consumption is $12 000.
C. your wealth increases by $100 000; your income increases by $100 000; and
your interest income per year is $12 000.
D. your wealth increases by $100 000; your income increases by $12 000; and
your maximum annual rate of saving is $12 000.
(86-02)
2. You have an income of $10 000 annually. Suddenly you receive a gift of $5 000
in cash. Assume a 10% rate of interest per year. Your wealth increases by _____;
your income increases by _____ and your maximum possible rate of saving is
_____ per year.
A. $15000 ... $ 5000 ... $15000
B. $5000 ... $ 500 ... $10500
C. $5000 ... $ 500 ... $5000
D. $5000 ... $ 5000 ... $10500 (96-25)
3. If both income and interest rate fluctuate over time,

A. consumption may still be constant over time.
B. wealth cannot be determined.
C. consumption will necessarily fluctuate over time.
D. the postulate of income maximization will be preferred to the postulate of
wealth maximization.
(00-21)
4. Wealth cannot be determined if
A. interest rate fluctuate over time.

B. income fluctuates over time.
C. the market rate of interest does not exist.
5. Wealth maximization and income maximization are the same
A. in the absence of a market rate of interest.

B. if the market rate of interest is zero.
C. if we are referring to annuity income.
D. if there is no profit. (03-03)
6. Which of the following is least likely to occur under rent control?
A. corruption.
B. sub-letting.
C. tie-in rentals of premises and furniture.
D. more maintenance of the rented premises. (04-22)
7. In one housing development in Shanghai, the land cost of the second phase is
six times that of the first phrase, and as such professional calculations indicate
the price per house in the second phase should double that of the first phase.
However, with the second phase not yet built, the price per house in the first
phase remains unchanged. Which of the following is correct?
A. Given no further information, we have no explanation as to why the price of

housing in the first phase has to gone up.
B. The cost of land per house in the first phase is far below the second phase,
and under competition the developer cannot sell above the cost he had
incurred.
C. Since the cost of land is all rent, its variation will not affect housing supply
and therefore the price of housing is insensitive to changing land cost.
D. The developer is not maximizing wealth. (05-17)
8. Which of the following statements about wealth and income is correct?
A. Without an interest rate, wealth is the same as expected income.

B. If resources are not private properties, there can be neither wealth nor
income.
C. Wealth exists even without income.
D. Maximizing wealth is the same as maximizing annuity income.
(06-13)
9. Choices that have no market price or pecuniary value, such as friendship or prestige,
A. must be explained by utility maximization.

B. cannot be explained by wealth maximization.
C. can be explained by wealth maximization with the postulate of substitution.
D. cannot be explained by utility maximization or wealth maximization. (07-11)
MC Answers on Wealth and Income

D B A C C D A D C
Capital, Interest, Investment, Wealth and Income
1987 Q. 10
A student entering the University of Hong Kong will have no
income for three years, but after graduation his income will
rise at a fairly rapid rate for years thereafter. As an
alternative, this student could go out to work immediately
after matriculation, and his initial income will be considerably
higher than if he enters the University, although his income
through time will increase at a slower rate. Assume wealth
maximization is the only objective of the student.
(a) If the total income in life of getting a university education

is greater than that of not entering the university, will the
student always choose the university education? Explain.
(8 marks)
If the interest rate is positive, a student will not choose to enter the
university. It is because to maximize wealth, one has to choose the
option which provides highest discounted future income. Since the
income obtained after attending university education is later than that
of a non-graduate, if the life income of a university graduate is lower
than that of a non-graduate, the discounted future income of a
university graduate will definitely be lower than that of a non-graduate.
Hence, he will not choose to enter the university.
(b) If the total income in life is higher without the university

education, will the student ever choose to enter the
university? Explain. (8 marks)
Whether he will choose to enter the university still depends on the

discounted future income. If the interest rate is low, the discounted
future income of a university graduate will be higher than that of a
non-graduate. In this case he will choose to enter the university.
However, if the interest rate is high, the discounted future income of a
university graduate may be lower than that of a non-graduate. If this is
the case, he will not choose to enter to enter the university.
As farther incomes are discounted more heavily; the higher income

earned from non-graduate in the early years can be invested to earn a
higher interest income.
(c)Will your answers in (a) and (b) be different if the university

makes available low-interest loans to students? Explain.
(8 marks)
The availability of low-interest loans to students will not affect the

decision made in (a) since wealth without the university education is
still higher at any rate of interest. Loans to student are not an
alternative to those who can maximize wealth by working earlier.
In (b), if a student initially chooses to enter the university, his decision

will be the same as before. However, if he previously chooses not to
enter the university, the low-interest loans may encourage him to enter
the university. This is because by considering the lower interest cost,
the interest income foregone for entering the university can be partly
compensated by investing the low-interest loan in investment which
yields higher rate prevailing in the market.
1989 Q. 6
Before and after World War II, the Hong Kong government
imposed rent control on all domestic premises in the city, with
the controlled rent significantly below the market rent.
However, when a flat was vacant, the landlord could charge a
prospective tenant a large lump-sum called key-money, for
acquiring the right to lease. Following this, once the tenant
moved in, he would only have to pay controlled rent.
(a) Let K = key money

Rm = the would-be free-market rent
Rc = the constant controlled rent, which is
significantly below Rm
R = the constant rate of interest
(a) Suppose the rent control is expected to last forever. How
would the key money, K, be determined in the market?
(8 marks)
The would-be free-market rent is Rm and the constant controlled rent is

Rc, and Rm > Rc. If rent control is expected to last forever, the
difference between Rm and Rc also last forever. To recover the losses,
the landlord will charge a prospective tenants lump-sum which adds up
to the sum of his loss for all these different time periods i.e. (Rm - Rc)
is the loss per time period. The lump-sum can be calculated as K = (Rm
- Rc) / r
(b) What would you expect of the change, if any, in the

turnover rate of tenants under rent control, as compared to
a free-market situation? Explain. (8 marks)
Tenants would have to pay a lump-sum in addition to monthly rent in

order to live in the flats. The lump-sum or key money would serve as a
deterrent to those tenants who want to move out. This lump-sum in
effect is prepaid rent for the future use of a flat so that moving out
means the loss of rent paid in advance. The turnover rate of tenants
under rent control will be lower.
(c) Suppose the law allows the landlord to evict the tenant at
will if the former chooses to reconstruct a leased building.
What would happen to the rate of housing reconstruction of
leased buildings under rent control? Explain. (9 marks)
The landlord would like to evict the tenants and then reconstruct the
building more often. For each reconstruction of a leased building, the
landlord can charge the new tenants the market rent through the key
money payment. The rate of reconstruction will tend to rise.
1989 Q. 4
‘Capital is the same as wealth.’ Do you agree? Explain.
(10 marks)
In Economics, wealth is defined as the stream of future income

discounted. If income is perpetuity, wealth will be equal to
W=I/r where W is wealth
I is the annual income
r is the market interest rate
According to the generalized concept of capital, it is defined as any asset which is able to
generate a stream of future income. If income is perpetuity, the market value of a capital
asset is equal to the present value of the income stream generated from this asset, i.e.
Capital value = I / r where I is the annual income

r is the interest rate
Hence, wealth is the same as the capital as it is the same as the capital
value of an asset.
Moreover, if Y0 is income of an infinitesimally short period and therefore approaching
zero, then W0 = K0. Capital and wealth may therefore be regarded as the same because
they are both future income discounted.
1990 Q. 2
‘Capital, land and labour are all capital.’ Is this statement
correct? Explain your answer. If your answer is ‘yes’, then why
is ‘capital’ often treated as neither land nor labour?
(10 marks)
Yes, any productive asset that can generate a stream of future income
is a capital asset, and the discounted value of the income stream is its
capital value. Thus, land and labour are different entities engaged in
production, and as such they are different factors of production.
However, since the value of land and labour rest on their ability to
generate income, they can also be defined as capital assets.
Before the concept is generalized, the different productive entities

were often treated as conceptually different. Today, the different terms
are used only to denote different physical factors of production. So
labour has different characteristics from machines, say, in the aspect
that labour cannot be stored but service from machinery can.
1991 Q. 7
Gold was found in California in 1848, and the famous gold rush
was on. It was reported that gold miners thought that they
would become very rich in the future, although the actual
incomes they earned were, at least in the beginning, very
small. California at that time was isolated from the east coast
of the United States because the transcontinental railroad was
not yet built.
(a) What would you expect the effects to be upon the real rate
of interest when the gold rush began? Explain.
(9 marks)
The real interest rate will rise. With the expected sharp rise in wealth,
gold miners tended to consume more based on their expected wealth
increase. With their relative low actual income they earned, they would
borrow from non-miners to increase their current consumption,
therefore driving up the real interest rate. This rise in interest rate was
accentuated (intensified) by the lack of a transcontinental railroad,
which forced the miners to borrow from the local and small loan
markets.
(b) What would the effects of the change in interest rate be

upon the consumption behaviour of the gold miners and
other citizens in California? Explain. (8 marks)
The rise in real interest rate would restrain the consumption of all the
people in California. However, because it was the miners who wanted
to borrow fro consumption and drove up the interest rate, no matter
how high the interest rate was, they would consume more than if
borrowing was possible.
On the other hand, the consumption of other citizens would fall. This is
because without a similar expected rise in wealth, a higher real interest
rate would encourage consumption. Thus, as non-miners loaned to
miners, there will be a fall in consumption for the non-miners and a rise
in consumption for the miners.
(c)What would the effects upon the interest rate and

consumption pattern in California after the transcontinental
railroad was built a few years later? Explain.
(8
marks)
The interest rate in California would fall as a result of the construction
of the transcontinental railroad. With the railroad, funds from areas of
lower interest rates, e.g. the east coast, would be transferred to
California to warn a higher interest rate. This would drive down the
interest rate in California. With the fall in interest rate, there will be an
increase in consumption generally.
1992 Q. 2
Interest is a price. Why is it a price? What is it a price of?
(12 marks)
In Economics, price is the average exchange value of a good or the

value of a good at the margin. If we say that interest is a price, it is
equal to the price of earlier availability.
In terms of consumption, the equilibrium interest rate indicates the

average exchange value of earlier consumption with delayed
consumption. For example, if an individual would like to have more
consumption earlier, he will pay the price for it, i.e. borrowing, but
when the debt is repaid, he has less consumption. The lender in this
case receives the price or compensation for giving up consumption
now for more consumption in future. Since market is competitive, every
transaction of this sort involves the same price as well as the same
average exchange value.
Besides, interest is also the value at the margin. In terms of

consumption, the equilibrium interest rate measures the value of
earlier consumption at the margin. For example, if the interest under
consideration is $10, it means the earlier availability by itself is worth
$10.
Moreover, interest can also be interpreted as the value of net

productivity of investment at the margin. It is also the average
exchange value because under competition every one pays the same
price or interest for the privilege of getting the investment good earlier.
1992 Q. 3
Give different types of examples to illustrate the generalized
concept of capital.
(12 marks)
According to the generalized concept of capital, capital is defined as
any asset which is able to generate a stream of future income. Since it
is able to generate future income, the capital value of an asset is equal
to its discounted present value.
According to this definition, a factory or a piece of machinery, a piece

of land and labour are all capital.
A factory is capital because it is durable and is used to generate a

stream of future income.
A piece of land can be used to grow, say, vegetable for a long period of
time. Thus it is able to generate a stream of future income.
As education and training for workers can increase their income

generating ability which lasts for a period of time, they can also be
defined as capital. In fact, even untrained labour is also a capital as it
can be used to generate a stream of future income overtime.
1993 Q. 1
Explain the relationship between income and interest.
(8 marks)
Since W = I / r, the interest income is defined as the maximum amount

one can consume per period of time without affecting one’s wealth. As
one’s wealth, or capital stock, consists of everything one possesses
which can generate a stream of future income, even land and labour
(human capital) can also be defined as capital in this sense. The
returns to land and labour also reflect their productivities and the price
of these human as well as noon-human capitals is equal to the
discounted value of the future income generated.
So, to conclude, as interest is the return to capital, since all factors can
be defined as capital, either human or non-human, all factor income is
interest. Hence, we have to bear in mind that ‘Interest is the whole of
income, not part of it.’
1994 Q. 3
What is wealth? Why does the concept of wealth become
ambiguous if there is no market?
(8 marks)
By wealth, we mean the future income discounted. To discount the

future income, we have to make use of the market interest rate. Hence,
to determine the value of the total stock of assets, i.e. wealth, the
following discounting process is needed:
W=I/r where I is the annual income
Without a market, there will be no market interest rate. Then future
income cannot be discounted. Then it will be unclear what wealth is
and the concept of wealth becomes ambiguous.
1995 Q. 2
What is the difference between wealth maximization and
income maximization? Compare the two criteria of
maximization in terms of their usefulness in interpreting
behaviour. (8 marks)
As wealth is the discounted future income flow from assets, maximizing

wealth implies maximizing the discounted future income flow from
assets. The value of wealth can be derived as follows:
W=I/r where I is the annual income

However, income is ambiguous, since it is not the same as annual

income, income itself may fluctuate from time to time.
Though maximizing wealth implies maximizing annual income, it is not

the same as maximizing income that fluctuates. Thus, maximizing
income is not useful in interpreting behaviour because we do not know
income of which particular period we should use.
More specifically, maximizing wealth is consistent with maximizing

consumption through time, and so is maximizing annual income.
However, maximizing total income through time, or maximizing income
of a particular period, is not the same as maximizing the consumption
stream. Hence, income maximization is not useful in interpreting
behaviour. Only if there is no market and market interest rate does not
exists will maximizing income become the only choice as wealth cannot
be calculated.
1995 Q. 3
Interest is not part of income, but the whole of income. Do you
agree? Explain.
(8
marks)
Since W = I / r, the interest income is defined as the maximum amount
one can consume per period of time without affecting one’s wealth. As
one’s wealth, or capital stock, consists of everything one possesses
which can generate a stream of future income, even land and labour
(human capital) can also be defined as capital in this sense. The
returns to land and labour also reflect their productivities and the price
of these human as well as noon-human capitals is equal to the
discounted value of the future income generated.
So, to conclude, as interest is the return to capital, since all factors can
be defined as capital, either human or non-human, all factor income is
interest. Hence, we have to bear in mind that ‘Interest is the whole of
income, not part of it.’
1995 Q. 7
The authors of books may be paid by the publisher in one of
three ways: (1) a royalty based on a percentage of the gross
sale of books; (2) a fixed unit royalty for each book sale; and
(3) a lump-sum payment to the author on a once-and-for-all
basis.
Which would the likely form of payment be in the event of (a)

perfect certainty of the future income of book sale; (b)
certainty of the future quantity of book sales but uncertainty
about the future price of the book; and (c) certainty of future
price but uncertainty about the future quantity of sale?
Explain. (15 marks)
In the event of perfect certainty of the future income stream, the lump-
sum payment would most likely be chosen, since it incurs the lowest
transaction costs among all payment systems.
To the authors, the cost to keep an eye on book sales in order to avoid
being cheated by the publisher is saved. To the publisher, the once-
and-for-all property allows him to save costs of further negotiations;
also, arguments on things like the honesty of his reported sales can be
prevented.
In the event of certainty of the future quantity of book sales but

uncertainty about the future price of the book, the percentage royalty
payment would most likely be chosen, since risk burdens can be shared
by both parties.
If the future price is uncertain, under a fixed unit royalty and a lump-
sum payment, the risk burden is shifted on the publisher. Being a risk-
adverser, the publisher will try to shoulder as little risk as possible. The
percentage royalty payment enables the reduction and sharing of risk
and the transaction costs between both parties, e.g. information cost of
searching the future market price, measurement cost and pricing cost.
In the event of certainty of future price but uncertainty about the future
quantity of sale, the fixed unit royalty payment would most likely be
chosen, since it can spread risk burdens and at the same time bears
the lowest transaction costs.
Under a lump-sum payment, the risk burden is shifted on the publisher,

with the future quantity of sale being uncertain. On the other hand,
while the percentage royalty can also spread the risk burdens, to the
authors, the cost of preventing being cheated the price is greater than
when the fixed unit royalty payment is adopted.
Thus, bearing the properties of risk-spreading and minimal transaction

costs, the fixed unit royalty payment would be chosen.
1996 Q. 4
Economists may speak of maximizing wealth, maximizing
income, maximizing rent, maximizing utility, and last but not
the least, maximizing profit. In terms of economic explanation,
which of the above is the worst choice? Explain your answer.
(8 marks)
In economics, wealth is the discounted value of net income flow over

time. For income, it is the flow of potential consumption without
reducing one’s wealth. While rent is the expected income of a resource
owner in excess of the amount to keep the resource in its present use.
Fourthly, utility is an index ranking options according to the preference
of an individual. Lastly, profit is an unexpected increase in wealth.
To say an individual is a maximizer, we are concerned with an expected

target to maximize. Thus, in order to show that an individual’s
behaviour is heading towards maximization, the things he is
maximizing must be expected magnitudes. Since wealth, income, rent
and utility are all expected magnitudes, we can use it as a criterion to
compare among various options so as to identify maximization choice.
However, since profit is only unexpected increase in wealth, its
existence has nothing to do with one’s expectation. Thus, it is not
useful or relevant in one’s decision making process as one cannot
maximize what is unexpected. Hence, maximizing profit is the least
useful postulate as it cannot be used to explain and predict human
behaviour.
1996 Q. 8
In Hong Kong, the number of children an average woman
expects to bear in a lifetime has fallen from 4.5 in 1965 to
around 1.3 in 1995.
(a) A child may be regarded as a consumption good, for which

a cost or a price must be paid. Considering a child as a
consumption good, how would you explain the sharp fall in
fertility rate? (5 marks)
If a child is regarded as a consumption good, we can use indifference

curve analysis to explain the sharp fall infertility rate.
Assuming that children are normal goods, a rise in income will increase
the demand for children from C1 to C2. However, since the cost of
raising children also increase, the demand for children will fall from C2
to C3.
If the income effect is smaller than the substitution effect, the demand
for children falls from C1 to C3.
The reasons for the rise in the cost of raising children may be that
there is rising wage rate of female workers as well as domestic
servants. Moreover, the rising level of rents and cost of obtaining a
high quality education may also explain the rise in the cost of raising
children.
(b) A child may be regarded as an investment good, from

which a return or an income must be expected. Considering
a child as an investment good, how would you explain the
sharp fall in fertility rate? (5 marks)
A child may be regarded as an investment good as raising children is

an act of reducing consumption now in the hope of increasing
consumption in the future.
An individual’s investment decision depends on the relationship
between marginal efficiency of investment (MEI), i.e. rate of returns
and market interest rate.
If MEI > r, investment will be made. On the other hand, if MEI < r, the
same investment will be abandoned. Given the market interest rate,
the MEI of raising children has fallen steadily in recent years. As a
result, the number of children in each family has also decreased
steadily.
Given the interest rate (r), as the MEI of rising children falls, the MEI
curve shifts from MEI1 to MEI2, thus resulting the number of children in
each household from C1 to C2.
The reasons for the falling MEI or rate of return may be rising cost of
raising children as well as falling apart of traditional family value, e.g.
sons and daughters less willing to support their parents financially.
Thus, the expected returns from children become lower than before.
1997 Q. 1
‘In order to maximize consumption over time, it is essential to
maximize wealth.’
Do you agree? Explain. (8 marks)
By maximizer wealth, we mean the maximization of the present value

of income stream over time. If the income concerned is perpetuity,
W=I/r where W is wealth

I is the annual income
Whatever the pattern of consumption over time, maximizing wealth

enables a person to maximize consumption. The simple reason is that
with greater wealth one can have greater consumption capability.
Moreover, even different individuals may have different patterns of

income stream; they can accommodate different patterns of
consumption over time by lending and borrowing. For example, low
income at younger age can be matched to high consumption by
borrowing. The money so borrowed can be repaid be expected higher
income at the later stage of one’s life.
Thus, whatever the preference of consumption over time, the criterion
of choosing different income stream is to choose the one which
maximizes its present value, i.e. wealth.
1997 Q. 8
University education in Hong Kong is heavily subsidized by the
government. Under this system, admission to university as
well as the selections of university and field of study is based
on examination results. Imagine that there is an alternative
system in which students are admitted according to their
willingness and ability to pay the higher price (tuition). Of the
numerous differences between these two systems, analyze
only the following:
(a) How hard students will study in a university, when each

and every university sets a firm standard requirement for
graduation and the award of a degree. (5 marks)
When a student is required to pay a high tuition out of his own pocket
to buy university education, his own marginal valuation of university
education will also be high. He will therefore treasure education more,
with the result that he would study harder than when he does not have
to pay and put a low marginal valuation on education.
(b) The quality of students admitted, with the provision that

any student may borrow from the government at the market
rate interest to finance his university education, and this
education loan must be repaid when the student gets a job
after admission.
(5
marks)
Education is an investment. When a student has to borrow to pay a

high tuition to enter a university, his cost of investment increases. He
therefore must have a higher expected rate of return before he decided
to invest on education. He may make a mistake in calculating this
investment prospect, but in general a poor quality student is less likely
to invest in university education because his expected return is
relatively low. The average quality of students entering university
therefore increases.
1998 Q. 1
Given the postulate of constrained maximization, an individual
may be said to maximize utility, income, wealth, rent, or profit.
Briefly comment on the shortcomings of each of these criteria
of maximization. (10 marks)
For utility maximization, since utility is non-observable, thus
maximizing something non-observable means maximizing something
non-measurable. One problem with non-measurability is there are no
objective criteria to make comparison.
Another problem with non-measurability is without proper specification

of constraints in the use of maximization postulate, in this case we
tend to make tautological statements and everything can then be
explained by maximizing utility.
For income maximization, if income is not expressed in annuity term,

i.e. income fluctuates in different time periods, maximizing income of
one time period does not mean maximizing one’s life-long income.
Moreover, since present income is worth more than future income,

simply adding up all income in different time periods gives an incorrect
measure of the true market value of an income producing activity.
As wealth is the present value of income stream from assets, without

market interest rate, wealth cannot be measured. Moreover, since
wealth concerns only with marketable goods, it cannot take into
account non-pecuniary goods even though they are important to choice
making.
For rent, one important point is that whether rent exists or not depends
very much on a person’s viewpoint, i.e. what he thinks his transfer
earning is. Moreover, like income, since rent may also fluctuate in
different time period, hence maximizing rent does not mean
maximizing one’s life-long rent.
Since profit is an unexpected increase in wealth, such windfall gains

are totally unexpected. Thus, it is impossible to maximize something
which is unexpected. Furthermore, since the wealth increase is
unexpected, profit cannot be capitalized. So profit maximization is
irrelevant in one’s decision making process and cannot be used to
explain and predict human behaviour.
1998 Q. 3
Labour, land, equipment, money, education, good looks, etc.
are all capital. Do you agree? Explain.
(10 marks)
As capital is defined as any asset which is capable of generating

income over time, the capital value is equal to the discounted present
value of an income stream from an asset.
Since labour, land, equipment, money, education, good looks, etc. are
all assets which can be used to generate income over time; they can all
be defined as capital.
1998 Q. 6
A mandatory (i.e., compulsory) pension system (the Mandatory
Provident Fund) will soon be introduced to all employees in
Hong Kong. Under this system employers and employees will
each contribute 5% of the employee’s salary to an investment
fund. At the age of 65, the employee will be able to withdraw
from his account the accumulated savings plus investment
return.
(a) If the Hong Kong labour market is freely competitive, and

if, to an employee, a dollar of mandatory investment has the
same value as a dollar of take home pay, roughly what
would you expect to be the net increase in income of an
employee as a result of the introduction of the provident
fund? Explain. (6 marks)
In equilibrium, wage is equal to the marginal revenue product (MRP) of

labour in a competitive labour market. With unchanged MRP as well as
labour supply, the amount paid to workers should remain unchanged.
Hence, the net increase in income of an employee will be equal to zero.
Since to the employee, a dollar of mandatory investment has the same
value as a dollar of take home pay, the employer can simply cut the
employees’ pay by 5% and then use this amount as the employer’s
contribution to the Provident Fund. In this case, there is no change in
the amount employer pays as well as the amount an employee
received.
(b) International statistics indicate that most mandatory

pension investments have yielded lower returns than
voluntary private investment. How, then would you explain
the adoption of the mandatory pension system? (6
marks)
Under political or labour union pressures, employers generally will not

be successful in cutting employees’ pays by 5%, although over time
pay increases under the Mandatory Provident Fund will be less than
with the system. The employees may therefore have an illusion that
they actually gain from the MPF system.
On the other hand, under voluntary private investment (or savings),

there are always some people who choose not to save, and some of
them may become a liability to society when they have to sleep out
and beg in the streets when they become old. There will be social
pressure to tale care of these people.
Moreover, many workers with relative low income have very limited
investment alternatives available to them. Thus, investment through
mandatory provident fund would actually yield higher returns than
making investment themselves.
1999 Q. 1
Let Y be the annuity income return to an investment and r be
the rate of interest. Explain why Y divided by r is generally the
simplest and most useful guideline for investment decision.
(6 marks)
In making investment decision, we have to determine whether the
investment is worthwhile or not. This can be done by comparing the
price and the present value
i.e. ‘the amount which enables us to obtain the same amount of
income in the future’,
of the investment.
Since the investment can generate income in future, we have to

discount the future income in order to arrive at the present value. With
Y being the annuity income return to an investment and r be the rate of
interest, the present value of the investment will be equal to Y divided
by r, i.e.
PV = Y / r where PV is present value
Y is the annuity income
r is the rate of interest
On the other hand, the price of capital is equal to
P = Y / MEI where P is the price of investment

Y is the annuity income
MEI is the marginal efficiency of
investment
If the PV is higher than the price of the investment i.e. MEI > r, then
the investment should be made. While if the PV is lower than the price
of the investment i.e. MEI < r, then the investment should not be
made.
2001 Q. 4
What is investment? When you read a book, are you investing
or consuming?
(7
marks)
In economics, investment is the balancing of consumption over time. To
engage in investment, we have to forgo present consumption for future
consumption. With positive marginal time preference, earlier
availability is preferred to later availability. Hence, to justify the
sacrifice of present consumption, more future consumption is expected
to compensate for later availability.
Thus, investment occurs when future income can be expected from an
act.
When I read a book, whether I am investing or consuming depends on

the outcome of the act. If I read a book which only consists of
information such as news of movie stars or sports, then I am
consuming.
On the other hand, if I read a book which can increase my skills or

knowledge in specific fields such as information technology or law, then
I am investing as the knowledge acquired enables me to generate
more income in future.
However, we must note that in many cases both investment and

consumption apply. For example, reading a cook book or car repair
book can be regarded as consuming as it generates interest but at the
same time investing as it may enable me to generate income form the
knowledge acquired.
2003 Q. 4
According to the Irving Fisher, income is a series of events,
why? Is wealth also a series of events? Explain.
(8 marks)
Income is a series of events because it is a flow and arises continuously
through time. For example, a wheat field grows or deteriorates every
second, meaning that events are continuously occurring through time.
These events have values, called incomes, which may be positive or
negative, or even constant.
Wealth is incomes at different periods of time discounted to one single

present value. Therefore wealth is a stock defined at a particular point
in time, not a flow. Wealth is not a series of events.
2004 Q. 5
Interest would not exist without money. Do you agree? Explain.
(8 marks)
Disagree. Interest is the price of earlier availability of goods, and

without money this price or premium still exists. I loan you an apple,
when you return it a year later, our agreement would be your return an
apple plus a bite from another apple. That bite is interest. Money is not
implied.
2005 Q. 2
Explain the disadvantages and advantages of utility
maximization as compared to wealth maximization.
(8 marks)
Utility maximization is said to have the advantage of handling choices

that have no market value price or pecuniary value, such as friendship,
prestige, love and the like. The disadvantage is that utility is not itself
observable, and in testing hypothesis all variables of a test implication
must be observable. Deriving a testable implication from a utility
function is therefore difficult, and tautological statements often result.
Wealth or price or a pecuniary measure of choices, if available, is far
easier generating testable testing implications without falling into a
tautological trap.
Remark: However, Wealth maximization complicates the handling of
non-pecuniary choices. One way out is that while prestige and
friendship cannot themselves be measured in pecuniary terms, as they
are not transacted in the market, they are nonetheless substitutable
with pecuniary choices. Look for substitutes at the margin, a non-
pecuniary choice may then be converted to a pecuniary-choice
equivalent.
2007 Q. 3
Is rent a cost? Is income a cost? Is interest a cost? What is not
cost? (8 marks)
Rent is a cost in that it is an opportunity forgone if outright sale is

considered, or if a change in use is considered. Income is a cost
because the highest valued option forgone is typically the same
income. Interest is a cost because it is the whole of income. Profit is not
cost because it is windfall, totally unanticipated and therefore cannot
be counted as an option forgone.
2008 Q.4
What is capital when we refer to Fisher’s concept as a generalized concept of capital?
Is there any difference between labour and capital?
Capital is future income discounted. In Fisher’s view, any resource that generates
income is a capital asset, and the discounted present value of the income is capital
value. This is a generalized concept of capital because any productive input capable of
generating future income is a capital asset. The difference between labours and
machines can be distinguished in that they are different physical entities, but they are
all capital assets according to Fisher.
- END -

Unit 7 - Factor Income Determination

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Unit 7 - Factor Income Determination

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Unit 7 – Factor Income Determination

(i) The Determination of Wage

1. A monopolist’s demand for a factor of production is

A. the value of marginal product.

A. teenagers with low productivities.

A. scarcity would no longer exist.

A. the higher will be his real wage.

6. The demand curve for labour corresponds to

A. the entire marginal revenue product curve.

8. Diminishing returns begin to occur when

A. the marginal product begins to rise.

9. The demand curve for a factor of production is downward sloping because

A. the product market is perfectly competitive.

A. there is a smaller labour supply in Hong Kong.

A. changes in industry output will not affect the price of factor A.

A. the supply curve of labour will be positively sloped.

15. A monopsonist will pay a wage rate

A. the higher will be his marginal product.

A. keep the same number of workers.

A. the upward sloping portion of its value of marginal product curve.

20. An individual’s labour supply curve may be backward-bending because

A. lower the average product labour in the construction industry.

A. Leisure and income are substitutes.

A. in the University of Hong Kong, a professor earns twice the salary of a

25. If the law of diminishing returns does not hold,

A. product price will be zero.

26. The law of diminishing returns means the following EXCEPT:

A. more men will be employed.

A. an increase ... an increase

29. If the law of diminishing returns does NOT hold,

A. rent will increase indefinitely.

30. The demand curve of labour is downward sloping because

A. the demand curve of the product is horizontal.

31. Suppose labour is mobile between a country’s two competitive industries,

A. the marginal product of land used in farming will increase.

A. his marginal productivity.

33. The demand curve of labour

A. will not be affected if the quantity of other factors employed changes.

34. If the law of diminishing returns does not hold,

A. wage cannot be determined.

A. The owner of the shop that is losing money is irrational.

36. In a government-regulated school, a teacher with 15 year’s experience is paid

37. The factor demand curve of a price-taking firm is

A. The marginal productivity of land is higher in industrial usage than in

A. the highest denomination of a RMB bill is RMB 100.

41. If the law of diminishing marginal productivity does NOT hold,

42. The law of diminishing marginal productivity is

A. itself not testable.

MC Answers on The Determination of Wage

(b) It was also allegedly observed that amidst the evidence of

To measure the general standard of living, we can simply look at the

With a decline in labour supply, the rents receives by the landlords

(c) The population density in England today is far higher than

The presence of other factors of production, such as human capital,

This can be explained by the law of diminishing marginal productivity.

Hence, in equilibrium, the marginal products of farmers in the superior

If diminishing marginal productivity does not hold, this means that a

The law of diminishing marginal productivity states that when more

A postulate is an assumption stating the characteristics, properties,

An assertion is an entity which can neither be derived nor proved, e.g.

However, the law of diminishing marginal productivity is an empirical

If the law of diminishing marginal productivity does not holds, we can