Tutorial 1

Q1. China’s Prosperity Brings Income Gap

The Asian Development Bank [ADB] reports that China has the largest gap between the
rich and the poor in Asia. Ifzal Ali, the ADB’s chief economist, claims it is not that the
rich are getting richer and the poor are getting poorer, but that the rich are getting
richer faster than the poor.
Source: Financial Times, August 9, 2007
Explain how the distribution of personal income in China can be getting more unequal
even though the poorest 20 per cent are getting richer.

Answer: The distribution of income in China can be getting more unequal even when
the poorest 20 per cent are getting richer because the richest 20 per cent are getting
richer even faster. Because the rich are getting richer faster, the fraction of the nation’s
total income received by the poorest 20 per cent falls, which makes the personal
distribution of income more unequal.

Q2. The Clean Energy Council reported that, at the end of 2013, Australia had 1,639 turbines
spread over 68 wind farms. These farms produced 4 per cent of Australia’s overall
electricity. During 2013, six new wind farms came online and $1.5 billion was spent on
new wind projects which will come online in the coming years. Farmers received
$250,000 for land rental. (Think of these dollar amounts as dollars’ worth of other goods
and services.)

a. Wind farms sit in farmers’ fields. Is the $250,000 that farmers receive a free lunch or
an opportunity cost? Explain your answer.
The $250,000 in land rental is an opportunity cost. Farmers would use that land for
production, such as growing crops or grazing animals, so the land rental is the
compensation for the alternative use of the land.
b. Explain how the six new projects in 2013 influenced Australia’s PPF for electricity
and other goods and services.
When six new wind farms came online in 2013, Australia’s production possibilities for
electricity and other goods and services increased. With electricity on the x-axis,
Australia’s 2013 PPF rotated outward, becoming less steep. Also in 2013, the $1.5 billion
spent on new wind projects that would come online in the future decreased the
resources available to produce electricity and other goods and services in 2013, which
shifted Australia’s PPF for electricity and other goods and services in that year inward.
 Tutorial 2

Q1. Why Australia Missed the Invite to a ‘Cattle Price Party’

As world demand for beef has increased, global cattle prices have risen in all cattle-
producing nations, except Australia where graziers who are experiencing severe drought
conditions have been selling off their livestock.
Source: ABC Rural, 10 April 2014
Explain why global cattle prices have risen while Australian cattle prices have not.
Draw a graph of each market to illustrate.

Answer: As world demand for beef has

increased, the price of beef increased. As
cattle are a major input to beef production,
the demand for cattle by beef producers
increased. The demand curve for cattle
shifted rightward and graziers received
higher prices and the quantity of cattle
traded increased. Figure 4.5(a) illustrates
the market for cattle ready for slaughter.

But in Australia, the severe drought

increased the cost of producing cattle ready
for slaughter. Many graziers decided to de-
stock their land and sold off their herds. As
the supply of cattle to the Australian cattle
market increased, the supply curve shifted
rightward from S0 to S1 and the market
price of cattle fell. Australian graziers
missed the “cattle price party”. Figure
4.5(b) illustrates the Australian cattle
market.
Q2. “As more people buy mobile phones, the demand for mobile phone service increases
and the price of mobile service falls, which decreases the supply of mobile service.” Is
this statement true or false? Explain.

Answer: The assertion that the demand for mobile phone service increases as more
people buy mobile phones is true. However the claim that the increase in demand
reduces the price of mobile phone service is false; the increase in demand raises the
price of mobile phone services. The second sentence is false. Regardless of whether the
price of mobile phone service rises or falls, the supply of mobile phone service does not
change. Rather the change in price changes the quantity of mobile phone service
supplied.

Q3. The income elasticity of demand for haircuts is 1.5, and the income elasticity of demand
for food is 0.14. You take a weekend job, and the income you have to spend on food and
haircuts doubles. If the prices of food and haircuts remain the same, will you double
your expenditure on haircuts and double your expenditure on food? Explain why or
why not.

Answer: Your expenditure on haircuts will more than double because the income
elasticity of demand exceeds 1.0. Your expenditure on food will not double because the
income elasticity of demand is less than 1.0. Only if the income elasticity of demand
equals 1.0 will the expenditure on a good or service change proportionally with income.
 Tutorial 3
In the Murray-Darling Basin, irrigators can choose to trade water. If a person wants to
use more water than they have been allocated, they can choose to buy it from another
person, and if a person does not want to use all the water they have been allocated,
they can choose to sell it to another person. Use this information to work on Q1 and
Q2.

Q1. What is this method of allocation of water resources? Is this allocation of water
efficient? Is this use of scarce water fair? Why or why not?

Answer: This method of allocation of surplus water allocation is a market price

allocation system. If one irrigator values additional water more highly than another
irrigator values the use of some or all of their water allocation, then they are able to
voluntarily trade the water at a price at which both are better off. This is an efficient use
of water, as the marginal benefit to the buyer exceeds or equals the marginal cost to the
seller. This use of spare allocations of water is fair under the “fair rules” approach
because the purchases are entered into voluntarily and both the buyer and the seller are
better off after the trade.

Q2. If all water in the Murray–Darling basin is sold for the market equilibrium price, would the
allocation of water be more efficient? Why or why not?

Answer: Water use would be more efficient. It would be extremely difficult to have a
water allocation system that allocated water to the irrigators so that the marginal benefit
for all the water allocated equalled the marginal cost of the water. Yet this is relatively
easy to do under a market price system for the entire water allocation system.

Q3. Thailand’s rice subsidy and state-buying program resulted in a stockpile of 12.8 million
tonnes of rice by 2013, or about a third of the global export market. The program has
now ended and Thailand is selling off its stockpile. Who in Thailand and other Asian
countries will lose and who will gain from ending the subsidy and state-buying
program?

Answer: Thai rice farmers are the losers when the subsidies are ended, as they will
receive a lower price for the rice they sell, and they will sell less rice as the market
equilibrium quantity of rice will be traded and the government no longer buys excess
rice. Further, Thai rice farmers and other sellers of rice in other Asian countries, and
elsewhere, will also lose in the short run, as the Thai government sells off the stockpile,
adding to world supply and reducing the price of rice on the global market. Winners are
the Thai consumers of rice, who will be able to buy rice at a lower price than previously,
and also Thai taxpayers who will no longer have to finance the purchase of the excess
rice production.
 Tutorial 4

Q1. A380 and Dreamliner Battle for Air Space

Airbus’s A380, the world’s largest passenger plane, was the most expensive civilian
airplane ever developed and it is also the most fuel efficient aircraft. The Dreamliner
travels the same distance as the A380 at the same speed but carries half the passegers.

Source: popularmechanics.com, 15 June 2010

Thinking of a plane as a production plant, explain why some airlines might choose a
large plant size and some a small plant size.

Answer: The A380 has higher fixed costs but a lower marginal cost of additional
passengers due to the greater fuel efficiency. At higher levels of production, the average
total cost per passenger would decrease. If the airline needed to operate at these higher
outputs, the A380 would have the lower total cost than two smaller Dreamliners.
The Dreamliner’s lower fixed costs but higher marginal cost per passenger would have a
lower average cost of production at lower outputs. For airlines requiring production
levels in this range, the Dreamliner would be their best option.

Q2. Which Shop has the lower costs: Coles or 7-Eleven? Draw a graph to show how the
retailers’ cost curves would change if they introduced cost-saving self-checkouts.

Answer: The substitution of capital—self-serve

checkouts—for labour—shop assistants—increases
7-11’s and Coles’ average total costs at low levels
of output. The substitution, however, decreases
these costs at higher levels of output. These
changes are illustrated in Figure 13.1. The initial
average total cost curves for 7-11 and Coles are in
grey; the curves after the substitution has been
made are in black.
 Tutorial 5

Q1. Why did Amazon enter the market for recorded music and why did independent
record stores exit?

Answer: Amazon entered because the entrepreneurs running Amazon realised that
with their new, low-cost Internet technology, they could make an economic profit by
selling recorded music. The entry of Amazon into the market lowered the price of
recorded music. The independent record stores, using the old retail-store technology,
had higher average costs than did Amazon. The fall in the price of recorded music
inflicted an economic loss on the traditional firms and so they exited the market.

Q2. Microsoft: We’re not gouging Europe on Windows 7 pricing

Regulators in the European Union have charged Microsoft with illegally tying Internet
Explorer (IE) to Windows and mandated that a version of Windows be offered stripped
of IE. A news report suggested that when Microsoft launches Windows 7, it will charge
a higher price for the IE-stripped version than the price for a full version that includes
IE. Microsoft denied this report but announced that it would offer the full version of
Windows 7 at a lower upgrade price.
Source: computerworld.com

a. How does Microsoft set the price of Windows and would it be in the firm’s self-
interest to set a different price for a version stripped of IE?

Answer: Microsoft sets the price of Windows at the amount that maximises its profit.
Stripping IE increases Microsoft’s fixed costs but has no effect on its variable cost or its
marginal cost. Microsoft will set different prices if the marginal revenue of the two
Windows versions are different.

b. Why might Microsoft offer the full version of Windows 7 to European customers at a
lower upgrade price?

Answer: Stripping IE increases Microsoft’s costs. Microsoft might set a lower price—the
upgrade price—for the full version of Windows 7 than for the stripped version because
Microsoft’s cost of the full version is less than its cost for the stripped version.
 Tutorial 6

Q1. A New Swing for Female Golfers

Callaway and Nike, two of the leading golf-equipment manufacturers, recently released new
clubs designed for women. They are the hottest innovation in golf.
Source: Time, 21 April 2008

a. How are Callaway and Nike attempting to maintain economic profit? Draw a graph to
illustrate Callaway’s or Nike’s short-run economic profit in the market for golf clubs for
women.

Answer: Callaway and Nike are

innovating by creating golf clubs for
women. They are producing a
differentiated product—clubs designed for
women. They expect that the demand for
women’s clubs will be high and so they
will be able to (temporarily) make an
economic profit.
Figure 16.7 shows the situation at
Callaway or Nike. The firm produces
200,000 golf clubs per year and sets a
price of $140 per club. The economic
profit equals the area of the darkened
rectangle labelled A in Figure 16.7.

b. Explain why the economic profit that Callaway and Nike make in this market is
likely to be temporary. Draw a graph to illustrate their excess capacity in the long
run.

Answer: The economic profit is temporary because there are no

barriers to entry. If Callaway and Nike are indeed able to make an
economic profit other firms will enter the
market by producing women’s golf clubs.
As more firms produce the clubs the
demand for Callaway and Nike clubs
will decrease. As a result the quantity
and price of Callaway and Nike clubs
will decrease, which lowers their
economic profit. In the long run, entry
eliminates the economic profit.
Figure 16.8 shows the long-run
equilibrium for Callaway or Nike. The
firm produces 150,000 golf clubs and sets
a price of $130 per club. The firm makes
zero economic profit because its price
equals its average total cost. The firm’s
 excess capacity is 150,000 golf clubs, shown in the figure by the length
of the grey arrow between the quantity the firm produces and the
quantity that minimises the firm’s average total cost.

Q3. The United Nations Framework

Convention on Climate Change is
seeking agreement to carbon emission
limits by the developed and developing
economies. The biggest carbon emitters
are the United States and China, with
Europe and India not far behind.
Thinking of the process as a game, the
strategies of each player (country) are to
cut emissions to a level that contributes
to ending the global climate change
threat or do nothing.

What is the United States’ and China’s best strategies? What is the
outcome of this game? Explain.

Answer: The United States and China have two possible strategies: to do
nothing and have a positive payoff and to spend money on cutting their
emissions and have a negative payoff. China’s best strategy is to do nothing,
because if the United States cuts emissions to the level that ends global
climate change they will get the full benefit without having to pay for their
own reduction technologies; and if the United States does not cut its
emissions, then China is better off not incurring those costs themselves. The
United States’ best strategy is also to do nothing, because if China cuts
emissions to the level that ends global climate change, they will get the full
benefit without incurring costs, and if China does not cut their emissions,
they will not have to incur emission reduction costs. The outcome is that
they both do nothing because they both have a dominant strategy to do
nothing.