1987-2007 AL-Econ-Micro-Past Paper (Sorted in Topics)

2008-AL-ECON-I Past Questions on Microeconomics
Prepared by A.Chow
Unit 1 – The Scope of Economic Analysis
(i) Basic Economic Problems
1. Scarcity implies
A. there is no such thing as a free good.

B. competition is inevitable.
C. a lack of proper planning.
D. price is the only viable criterion for the allocation of resources.
(87-06)
2. Which one of the following statements about economic goods is FALSE?
A. An economic good is a good for which the amount available is less than
amount people want at zero price.
B. An economic good is a good that is subject to competition.
C. An economic good is a good for which more of it is not preferred.
D. None of the above. (87-10)
3. Which of the following statements about competition is FALSE?
A. Waiting in line is a form of competition.

B. The rules of competition define the criteria that determine who wins and who
loses.
C. Price is the main criterion of competition in a free enterprise economy.
D. There is no competition in a socialist economy because resource allocation is
determined by the government. (87-18)
4. The Open Learning Institute accepted only 3 000 students out of 60 000
applicants. Which of the following methods of allocating the places would be
discriminatory?
A. First come, first served.

B. Raising the entrance requirements until only 3 000 applicants were eligible.
C. Random selection by computer.
D. All of the above. (90-18)
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5. Which of the following describe(s) a ‘shortage’?
A. A shortage exists whenever the price is fixed by the government.

B. A shortage exists when a queue is found.
C. A shortage exists when, at the given price, the quantity demanded exceeds
the quantity supplied.
6. Scarcity
A. is implied by the existence of price.

B. is the same as shortage.
C. applies to all kinds of goods.
7. Which of the following statements about scarcity is FALSE?
A. Scarcity implies competition.

B. Scarcity doesn’t exist in a Robinson Crusoe economy.
C. Scarcity implies discrimination.
D. Scarcity means we want more than the amount available at zero price.
(97-02)
8. Which of the following about shortage is correct?
A. Shortage is the same as scarcity.

B. Shortage results form the absence of private property rights.
C. Shortage means not enough of the good is available.
D. There is no shortage as described in supply-demand analysis in the real
world. (97-06)
9. A free good
A. is provided by the government free of charge.

B. has no use value and is not preferred.
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C. is a good the supply of which is so abundant that more of it is not preferred.

D. is a gift of nature. (97-07)
10. In a one-man economy,
A. scarcity exists.
B. competition is inevitable.
C. transaction costs are positive.
11. For a resource to be a good,
A. the resource must be limited in quantity.

B. having some of the resource must be preferable to having none of it.
C. there must be competition for the resource.
12. Speeding increases the risk of car accidents. The observation that some
drivers do exceed speed limits implies
A. safety is not a good for these drivers.

B. safety is a free good for these drivers.
C. these drivers are willing to substitute speeding for safety.
D. the postulate of constrained maximization cannot be used to analyze the
behaviour of these drivers. (00-03)
13. Which of the following statements about scarcity and shortage is correct?
A. Scarcity implies shortage.

B. The existence of market prices implies scarcity.
C. Shortages are caused by reduction in supply.
D. There is no scarcity in a one-man economy. (02-17)
14. Scarcity
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A. is the same as shortage.

B. does not exist in a one-man economy.
C. exists for any economic good.
D. exists for any and all goods. (03-01)
15. Scarcity implies
A. everything is not enough.

B. there is a shortage, and without a shortage there will be no price.
C. than an individual is willing to sacrifice something for something else.
D. a market will emerge. (04-01)
16. Competition will NOT arise if
A. all individual are identical.

B. there is a monopoly in each and every market.
C. there is no market.
D. all goods are free goods. (04-02)
17. Which one of the following pairings has terms that are closest in meaning?
A. scarcity and shortage.

B. monopoly and competition.
C. private property and social cost.
D. competition and discrimination. (05-03)
18. Which of the following exists in a one-man economy?
A. shortage.
B. Pareto Condition.
C. institution.
19. In a one-man economy, there will still be
A. property rights.
B. shortage.
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C. transaction costs.
D. scarcity. (06-24)
20. Scarcity implies
A. the market is the most efficient place for allocating resources.

B. shortage if the market does not exist.
C. the concept of equilibrium is essential.
D. some people must be discriminated against in a society. (07-03)
MC Answers on Basic Economic Problems

A C D D D A B D C A
D C B C C D D D D D
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(ii) Economic Theory
1. An economic theory is useful or testable if
A. it is potentially refutable by facts.

B. it is logically consistent.
C. it is not always true.
2. Which of the following statements about economic theory is correct?
A. A theory should be abandoned when its assumption are found to be

unrealistic.
B. A theory is useless when it cannot be refuted by facts.
C. A useful theory may not have testable implications.
D. It is important to know whether a theory is right or wrong. (90-
22)
3. A government official said, ‘Our unemployment problem will be solved if the

unemployed find jobs.’ The above statement
A. is a definitional identity.
B. tells us nothing about the real world.
C. is a tautology.
4. Selfishness and scarcity
A. imply constrained maximization.

B. are realistic assumptions.
C. are assumptions that may yield testable implications.
D. A and C above. (92-06)
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5. ‘Experts’ complain that voluntary water conservation programs are not working
and water shortages will continue to occur in Hong Kong. Which of the
following conclusions is most consistent with economic theory?
A. Water shortages are unavoidable as Hong Kong’s population has grown rapidly
in recent years.
B. There will be no water shortages in Hong Kong if the price is determined in the
market.
C. Water conservation programs will be more effective if the government
imposes a price ceiling on water.
D. The demand for water is always inelastic because water is vital to human life.
(92-15)
6. Which of the following statements about an economic theory is correct?
A. A useful theory must contain hypotheses that are refutable by facts.

B. A testable implication may contain variables that are not observable.
C. If a theory is to be useful, its assumptions must be realistic and its
predictions must be correct.
D. The implications of a theory must always be true. (93-19)
7. Which of the following statements about an economic theory is INCORRECT?
A. A useful theory must have refutable implications.

B. A useful theory must be conceivably wrong.
C. A theory is useful if its postulate are observable.
D. A useful theory can have unrealistic assumptions. (94-29)
8. Economic theory is useful because
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A. it is proved by evidence.
B. it is refuted by evidence.
C. it is refutable by evidence but not refuted.
D. its assumptions are realistic. (95-07)
9. Which of the following is NOT an attribute of a useful economic theory?
A. The theory is always true.

B. The implications of the theory are refutable by facts.
C. The postulate may be unreal.
D. The theory is logically consistent. (97-01)
10. A useful theory should
A. always be true.
B. have testable implications.
C. have observable postulates.
D. have an indefinite number of possible outcomes. (98-06)
11. Which of the following is a tautology?
A. The area of Victoria Park is greater than that of Kowloon Park.

B. Visitors should not litter in public areas.
C. The quantity of vegetables supplied increases because more quantities are
available for sale.
D. The price of vegetables increases because the cost of production rises.
(98-22)
12. The explanatory power of an economic theory will be weaken if
A. the theory is consistent with maximizing behaviour.

B. the number of the test conditions is increased.
C. the postulates of the theory are not observable.
D. the real world cannot be fully described. (99-02)
13. Which of the following is a refutable statement?
A. When an individual’s preference changes, his consumption behaviour also
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changes.
B. An increase in the number of university graduates will drive up the market
wage rate.
C. A demand curve can be either upward sloping or downward sloping,
depending on whether the good is a Giffen Good or not.
D. An inferior good has a negative income effect. (99-03)
14. Which of the following statements is NOT refutable?
A. If price falls, the quantity transacted will fall.

B. If price falls, the quantity transacted will increase.
C. If the income increases, the quantity transacted will increase.
D. If the price elasticity of demand for a good is unitary, the percentage change
in price will be the same as the percentage change in the quantity
demanded. (00-01)
15. A theory with an indefinite number of possible outcomes
A. is more general in application.

B. is easier to refute.
C. has no refutable implication.
D. is more realistic. (00-26)
16. Which of the following statements is testable?
A. An increase in the available quantity of a good will lead to a reduction in its

market price, other things being equal.
B. When two individuals have different marginal use values over a good, they
will trade.
C. Marginal use values of buyers and sellers are equal in market equilibrium.
D. The demand curve is downward sloping. (00-27)
17. A useful theory
A. may not be refutable by facts.

B. must fully describe the real world.
C. may start out from a tautology.
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D. must always be true. (02-08)
18. Which of the following is a tautological statement?
A. The price of seafood will go up if its supply is reduced.

B. Bond price will be affected by interest rate fluctuations.
C. Market equilibrium will be attained when the quantity demanded is equal to
D. The crime rate will fall when heavier penalty is imposed on criminals.
(02-18)
19. A theory is said to be useful if it succeeds in explaining or interpreting

observations. A theory is NOT useful if
A. its implications are refutable by facts.

B. its assumptions are unrealistic.
C. it is always true.
D. it is logically consistent. (03-29)
20. A necessary condition for the theory to be useful in explaining behaviour is:
A. that is always true.

B. that it must be conceivably false.
C. that it is rejected by facts some of the time.
D. that it is supported by facts most of the time. (04-03)
21. A tautological statement is NOT refutable because
A. it is conceptually useless.
B. it may generate no theory.
C. it is always true.
D. it cannot be observed. (04-04)
22. Individual maximization subject to constraints is
A. a postulate.
B. the nature of mankind.
C. true for some societies but not for others.
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D. a useless statement. (04-06)
23. Which of the following statements is testable (i.e., refutable by facts) as it

alone stands?
A. If the price of a good does down, its quantity demanded goes up.
B. If tuition fees are high enough, schools will have no students.
C. When a person jumps out of the windows, he is maximizing utility.
D. The quantity of a good sold is equal to the quantity of that good purchased.
(05-01)
24. A testable implication requires
A. the support of an unrealistic theory.

B. at least one observable variable.
C. at least two observable variables.
D. no observable variables because observations are always subject in nature.
(05-02)
25. If the number of test conditions specified for a theory increases,
A. the theory will become more general in explaining behaviour.

B. the explanatory power of the theory will be more restrained.
C. the empirical usefulness of the theory will not be affected.
D. the theory will become a tautology. (06-04)
26. An economic theory is useful if it contains
A. at least two observable variables.

B. implications refutable by facts.
C. postulate that are themselves testable.
D. implications refuted by facts. (07-01)
27. Armen Alchian once illustrated the methodology of science by predicting the density of leaves on
trees, asserting that leaves would move around at midnight to maximize sunlight the next day.
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Which of the following is correct?
A. Alchian is right because leaves do move around.

B. Alchian is right in that a useful theory need not be realistic.
C. Alchian is wrong because there are rarely trees and leaves in deserts where sunlight is plentiful.
D. Alchian is right because he provided a realistic description of the situation. (07-02)
28. Which of the following is a tautology?
A. The demand for water is less elastic than the demand for beef.
B. The more substitutes that are available, the higher the price elasticity.
C. A consumer’s total expenditure remains constant over time.
D. He is said to be selfish because he is asserted to be selfish. (07-04)
MC Answers on Economic Theory

D B D D B A C C A B
C B B D C A C C C B
C A B C B B B D
The Scope of Economic Analysis
1986 Q. 3
What does price do? (8 marks)
Price performs three functions. It serves as a criterion to determine

who wins and who lose (i.e. who gets how much of what); it transmits
information for the allocation or use of resources; it rewards or
penalizes decision and performances.
Annual report: Candidate is not required to point out all three to obtain
full credit. A good discussion of one is a good answer.
1986 Q. 5
Explain the difference between ‘scarcity’ and ‘shortage’.
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(8 marks)
Shortage is defined as the quantity demanded is greater than the

quantity supplied at the prevailing price, it can be represented in the
diagram, the distance between A and B while scarcity, which is defined
as the quantity demanded is greater than the quantity supplied at zero
price, exists if its quantity supplied is to the left of C.
1990 Q. 5
What is competition? (5 marks)
In a society, when two or more individuals each wanting more of the

same economic good, competition is implied. Thus, competition always
exists in society.
1991 Q. 3
‘Whenever there is scarcity, there is competition.’ Define this
statement. ‘Whenever there is competition, there is
discrimination.’ Defend this statement also. (10 marks)
A good is said to be scarce if, to an individual, more of it is preferred to

less of it. When two or more individuals in society want more of the
same good, competition is implied.
With competition, some criteria are needed to determine who wins and
who loses. For whatever criterion chosen, it will necessarily be
discriminatory in nature because different individuals will have different
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advantages in winning under the same criterion.
2007 Q. 1
What is normative economics? In what exact sense is it not a
science? (5 marks)
2007 Q. 6
‘In a one-man economy there is scarcity, but not shortage.’ Do
you agree? Explain. ‘In a society there is no shortage.’ Do you
agree? Explain. (8 marks)
- END -
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Unit 2 – Consumer Demand: The Marginal Use Value Approach
1. Suppose there were a law of increasing marginal personal use value, i.e., the
more the consumer had of a good, the higher its marginal personal use
valuation. The economic theory would predict that the consumer would
A. refuse to purchase any goods.
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B. spend all his income on only one good.

C. allocate his income until the marginal use values of the last dollar spent on
each good are equal.
D. buy more than one good and obtain the same total use value from each good
purchased. (87-27)
2. A British economist wrote: ‘The effect of a tax on a commodity might seem at

first sight to be an advance in price to the consumer. But an advance in price
will diminish the demand. And a reduced demand will send the price down
again. It is not certain; therefore, after all that the tax will really raise the price.’
A. The statement is false because it is rejected by evidence.

B. The statement is false because the decrease in demand will not lead to a fall
in price.
C. The statement is false because the supply of the commodity may be perfectly
inelastic.
3. ‘Consumer equilibrium’ means
A. to each individual, the marginal valuation of a good is equal to its price.

B. to each individual, the marginal valuation of every good is equal.
C. to each individual, his total expenditure is equal to his total income.
D. the marginal valuation of a good is the same for all consumers in the market.
(90-02)
4. The price of a good is said to be in equilibrium when
A. it is determined in the long run.

B. it is observed in the market.
C. it will not often fluctuate.
D. we have sufficient information to explain its existence. (90-
03)
5. In 1989, the Light Transit System in the New Territories proposed to increase its
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toll in order to raise revenue. No change in demand was expected. If the

proposed increase in toll would in fact lead to an increase in revenue, then
before the toll increase,
A. the marginal revenue must be negative.

B. the demand must be inelastic at the existing toll.
C. the Light Transit System must not be maximizing its wealth.
6. The sharp increase in car thefts in Hong Kong suggests that
A. there is too much freedom in Hong Kong.

B. the Coase Theorem is rejected.
C. the market has failed to solve social issues.
D. insurance premiums will rise. (91-04)
7. If an individual regards each of the following combinations as equally

preferable:
Options Goods
X Y
A 100 and 70
B 105 and 69
C 110 and 68
D 115 and 67
A. he denies all the postulate of economic theory.

B. he denies that the goods are scarce.
C. he denies that he seeks a multitude of goods.
D. he denies that the more one has of any good, the lower his personal marginal
valuation of it is.
(91-
07)
8. Which of the following statements about use value is true?
A. When a good has a use value, it must have an exchange value.

B. A good has a high exchange value if it has a high use value.
C. The total use value of a good is the intrinsic value of that good.
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D. The marginal use value of a good to a person depends on the quantity of that
good which he already possesses. (91-08)
9. Under which of the following conditions will consumer bear the smallest tax
burden as a result of a unit tax?
A. an elastic demand and an inelastic supply curve.

B. an elastic demand and an elastic supply curve.
C. an inelastic demand and an inelastic supply curve.
D. an inelastic demand and an elastic supply curve. (91-10)
10. Good X and Y are substitutes. A decrease in the price of X relative to the price
of Y will lead to
A. an increase in demand for X but a decrease in demand for Y.

B. an increase in the total revenue of X but a decrease in the total revenue of Y.
C. a decrease in the total revenue of Y but the change in the total revenue for X
is uncertain.
D. an increase in demand for X but the change in demand for Y is uncertain.
(91-16)
11. Which of the following about the price is correct?
A. Price is the maximum the consumer is willing to pay at the margin.

B. Price does not exist without money.
C. Price is the fairest allocative device.
D. Price is a measure of consumer satisfaction. (91-17)
12. According to the Law of Demand, if taxi drives impose a $5 additional charge
per trip regardless of distance,
A. the number of short distance trips will have a larger percentage fall than long
distance trips.
B. the number of short distance trips will have a smaller percentage fall than
long distance trips.
C. the number of short distance and long distance trips will both fall by the same
percentage.
D. the ratio of short to long distance trips will not change. (92-
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08)
13. Good X and Good Y are complements. At their prevailing prices, both of them
have a price elasticity of demand greater than one. An increase in the price of
Good X, ceteris paribus, will lead to a _____ in the total revenue of X and a _____
in the total revenue of Y.
A. fall, fall
B. rise, rise
C. rise, fall,
D. fall, rise (92-11)
14. Suppose the Environmental Protection Department requires industries to
install costly anti-production equipment. Under which of the following
situations would you expect the additional costs to be borne mainly by
producers?
A. Demand is inelastic and supply is elastic.

B. Demand is elastic and supply is inelastic.
C. Demand and supply are both inelastic.
D. Demand and supply are both elastic. (92-14)
15. While the prices of fresh produce, such as vegetables, tend to fluctuate daily,
those for consumer durables, such as refrigerators, are more stable. This
happens because
A. the demand for consumer durables is less than that for fresh produce.
B. people’s preferences for different types of fresh produce vary daily, while their
preferences for consumer durables tend to remain constant.
C. the sole agents of consumer durables have a greater control of the market
than farmers who are selling fresh produce.
D. it is costly to keep buffer stocks of fresh produce, and fresh produce tends to
have significant seasonal fluctuations in supply.
(92-20)
16. In the following figure, D1 and D2 are two straight line demand curves.
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Which of the following statement is correct?
A. D1 is more price elastic than D2 at every positive price.

B. D2 is more price elastic than D1 at every positive price.
C. D1 and D2 have the same price elasticity at every positive price.
17. Suppose the airport tax per passenger leaving Hong Kong is increased from
$150 to $1 000. Which of the following will be true?
A. The average length of airplane journeys will tend to rise.

B. The variance of travellers’ ages will fall.
C. The ticket prices of shorter flights will fall.
18. If a consumer set aside $100 per month for going to movies and never spends
a dollar more or a dollar less on movies, then his demand for movies is
A. elastic.
B. inelastic.
C. unitarily elastic.
19. Most people in Hong Kong travel on the Mass Transit Railway (M.T.R.) or buses.
Suppose the fares of the M.T.R. decrease by 20% while the bus fares remain
unchanged. The total fare revenue will
A. remain unchanged for buses but increase for the M.T.R.
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B. increase for buses but decrease for the M.T.R.

C. decrease for buses but may increase or decrease for the M.T.R.
D. increase for the M.T.R. but may increase or decrease for buses.
(93-22)
20. Consumer surplus is extracted by a seller when
A. consumers are prohibited by the seller from buying less than a stipulated
quantity.
B. an entrance fee is required to enter an amusement park, and inside the park
the customer will have to pay an extra fee for each game he plays.
C. members of a club are required to pay membership fees before they are
allowed to dine in the club.
21. The following table shows the marginal use value schedule of Mr. Chan on
good X:
Quantity Marginal use value

1 12
2 10
3 8
4 6
5 4
If the seller charges Mr. Chan $30 for three units on an all-or-nothing basis, the
consumer’s surplus of Mr. Chan will be
A. 0
B. 6
C. 8
D. 30 (94-05)
22. A swimming club charges its members in either one of two ways. For a swim, a
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member either pays $P1 each time, or paying a $M membership fee, he pays a
lower fee of $P2 each time. A customer would
A. prefer to be a member.
B. not prefer to be a member.
C. be indifferent to either option.
D. lose some of his consumer’s surplus under the $M scheme.
(94-06)
23. Country A imports two brands of garments, X and Y, from Country B. Brand X
is of better quality and is higher priced. Now, a tariff rate of 10% is imposed on
both X and Y. If there is no other source of supply of garments, we predict that
A. the proportion of X in the total garments imported decreases.

B. the proportion of X in the total garments imported increases.
C. The proportion of X in the total garments imported remains unchanged.
D. the total amount of garments imported remains unchanged.
(94-07)
24. Each person is willing to forsake some of a good to get more of some other
goods. Which of the followings is NOT implied from the above statement?
A. Each person desires many goods.

B. For each person, some goods are scarce.
C. The more of a good one has, the lower the marginal use value of a unit.
D. To each person, goods are substitutable. (94-27)
25. Currently, with no entrance fee, the flow of visitors to the Hong Kong Park
does not reach its full capacity. If the government now charges an entrance
fee,
A. the consumers’ surplus will rise.

B. the total use value will decline.
C. the marginal use value will fall.
D. the cost of maintenance will rise. (95-03)
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26. If floods in China destroyed half the output of rice, the total use value of rice
will
A. rise but the total exchange value may rise or fall.

B. fall but the total exchange value may rise or fall.
C. fall but the total exchange value will rise.
D. rise but the total exchange value will fall. (95-06)
27. The Law of Demand is useful because
A. when the price of a good goes up, its quantity demanded always goes down.
B. refutable implications can be derived from this law.
C. its assumption is realistic.
D. the law is asserted, not derived. (96-10)
28. Which of the following is NOT implied by the Law of Demand?
A. Relatively more high quality vegetables are sold in urban markets than in rural
markets which are closer to the farms.
B. An ad valorem tax on whisky leads to a greater drop in the sale of lower-priced
whisky.
C. People tend to eat more in buffet dinners than in ordinary dinners.
D. The number of car accidents rises when the law requires the drivers to wear
seat belts. (97-11)
29. Market equilibrium
A. is attained when the flow of quantity transacted remains the same over a
long period of time
B. is not attained when people are waiting in line to buy a good.
C. is asserted to exist when each individual can obtain all he wants of a good if
he is willing to pay the price for it.
D. is more efficient than disequilibrium. (97-14)
30. In the following figure, D1 and D2 are two parallel linear demand curves.
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Which of the following statement is correct?
A. D1 is more price elastic than D2 at P0.

B. D2 is more price elastic than D1 at P0.
C. D1 and D2 have the same price elasticity at P0.
31. Suppose the market price of a commodity increases by $3 per unit after the
imposition of a $5 per unit sales tax. This indicated that
A. its elasticity of demand is lower than its elasticity of supply.

B. its elasticity of demand is higher than its elasticity of supply.
C. its demand is inelastic.
D. Its supply is inelastic. (98-08)
32. Due to exceptionally good weather, the supply of wheat has increased. The
total use value of wheat will _____ and the total exchange value _____.
A. decrease ... will decrease

B. increase ... will increase
C. decrease ... may decrease or increase
D. increase ... may decrease or increase (98-12)
33. Suppose over a period of time the market demand for commodity X remains
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unchanged but its price falls. This could be explained by
A. the introduction of a complement to X.

B. an increase in the unit tax levied on X.
C. the introduction of a subsidy on the production of X.
D. an increase in the unit tax levied on a substitute for X. (99-
22)
34. Which of the following statements may be consistent with a downward sloping
demand curve?
A. Price and quantity transacted are observed to increase together.

B. Price rises and quantity transacted falls.
C. A student is not willing to give up anything for an addition distinction in one
other subject.
35. A telephone company raises the monthly charge from$68.5 to $90. Which of
the following will be true for a household that continues to use the service of
this company?
A. The average time of telephone calls the household makes will increase.
B. The household will make more telephone calls.
C. All of the household’s consumer surplus will be fully extracted.
D. The household’s total use value of using the telephone service is at least $90
per month. (00-30)
36. Market price
A. is a criterion which determines who wins and who lose.

B. is the maximum amount a consumer is willing to pay at the margin.
C. may not be necessary in directing the use of scarce resources.
37. A swimming club charges $10 per swim, but only $5 per swim for a cub
member with a membership fee of $200 a year. Which of the following
statements about consumer surplus is correct?
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A. The consumer surplus of a club member is larger.

B. The consumer surplus of a non-member is larger.
C. The consumer surplus is roughly the same either way.
D. There is not enough information to tell which way yields a larger consumer
surplus. (03-06)
38. Which of the following statements is inconsistent with the Law of Demand?
A. The larger the quantity demanded, the greater the price elasticity of demand.
B. When people expect the price of a product to rise, the demand for that
product will increase.
C. Job promotion unrelated to productivity is more common in private-owned
firms than in public enterprise.
D. Tuition fees and student numbers are negatively related. (03-
30)
39. Under which of the following arrangements is consumer surplus extracted by

the seller?
A. A country club requires members to pay annual membership fees before they
can dine there.
B. A shoes seller requires customers who buy a pair of shoes to also buy one pair
of socks.
C. A private university requires student applicants to pay application fees.
D. A restaurant offering a set menu along side a choice of separate dishes.
(04-16)
40. In some Chinese cities, metered taxi fares are increased by about 30 per cent
after 11:00 p.m. when taxi customers decline in number. This is because
A. the market demand for taxi service increase after 11:00 p.m.
B. the market demand for taxi service decrease after 11:00 p.m.
C. most restaurants close around 11:00 p.m. and the government wants to
discourage entertainment late at night.
D. The price elasticity of the market demand for taxi services decreases after
11:00 p.m. (04-17)
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41. There are two types of cars : luxury cars and ordinary cars. If a uniform lump-
sum tax is imposed on the purchase of a new car.
A. the proportion of luxury cars will increase.

B. the proportion of ordinary cars will increase.
C. the number of luxury cars will increase.
D. the number if ordinary cars will increase. (04-21)
42. If the price elasticity of demand is greater than one, it means
A. when demand increases total revenue increases.

B. when demand increases the price goes up.
C. when the price goes down total revenue decreases.
D. when the price goes up total revenue decreases. (05-07)
43. Disneyland charges an entry fee before a customer is allowed to enter the
park, and then the customer will have to buy separate for each ride. Which of
the following is correct?
A. The consumer surplus of this customer is fully extracted.

B. The consumer surplus of the customer is not extracted at all.
C. The consumer surplus of this customer will never be fully extracted.
D. If this customer hates taking rides but pays only to enter and enjoy the park,
his consumer surplus is not extracted.
(05-08)
44. Consumer surplus is
A. the difference between exchange value and use value.

B. the extra amount a consumer is willing to pay on an all-or-nothing basis.
C. the extra amount a consumer is willing to pay over and above what he
actually pays.
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45. The marginal use value of an individual on a good
A. is observable.
B. is asserted to be decreasing.
C. always begins with a positive value.
D. has to be expressed in terms of money. (06-02)
46. Consumer surplus
A. cannot be extracted if no lump sum fee is charged.

B. cannot be extracted of a uniform price is charged.
C. can be extracted if proper quantity restriction is imposed.
D. cannot be fully extracted even if transaction costs are zero.
(06-03)
47. The Law of Demand
A. is useful as it is not refutable by facts.

B. cannot be derived from indifference curve analysis.
C. itself contains two observable variables.
D. cannot be used to explain non-pecuniary choices. (06-07)
48. Which of the following pairs of incident is inconsistent with the Law of
Demand?
A. terrorist attacks in a country and a fall in the number of visitors to that

country.
B. heavier penalties for speeding and a reduced number of casualties in car
accidents.
C. an imposition of quotas on garment exports and a fall in the quality of
garments exported.
D. an invention of a new software program which tracks the illegal downloading
of movies and an increase in the sales revenue of movie companies.
(06-08)
49. In the market, a consumer will purchase a good up to the point where his marginal use value equals
the price. Which of the following is correct?
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A. This is an assertion.
B. This statement is empty.
C. This statement is always true.
D. This is a statement of fact. (07-07)
50. Which of the following pairs of observations is inconsistent with the law of demand?
A. An increase in unemployment benefits and an increase in the number of unemployed people.

B. A sharp rise in the prices of dinners during Christmas Eve and a decrease in the number of people
eating at home.
C. An increase in the rental of parking spaces and a decrease in the average quality of vehicles.
MC Answers on Consumer Demand: The Marginal Use Value

Approach
B D B D D D D D A C
A A A B D B D C C D
A D C C B B B B C A
A D C D D D D C A D
A D D D B C B C A C
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Consumer Demand: The Marginal Use Value Approach
1988 Q. 3
What is consumer’s surplus? Can you think of one example in
the real world in which this concept helps to explain pricing
behaviour? (8 marks)
Given that the quantity demanded, consumer’s surplus
- is the extra amount consumer is willing to pay over and above

what he actually pays; or
- is the extra amount he is willing to pay on an all-or-nothing basis;

or
- is the difference between total use value and total market value.
without changing one’s behaviour.
In the real world we can observe that many sellers, apart from
changing a uniform price, require buyers to buy additional charges
such as membership fees, entrance fees or buyers are forced to buy
not less than a specified quantity. All these practices reflect the
existence of consumer surplus in the consumption processes. Thus,
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besides paying the price, buyers are willing to pay an extra amount
without changing their behaviour.
1991 Q. 6
What will be the effects of the following changes upon price?
Explain your answers.
(a) If the price of gasoline rises sharply, what effect do you

expect this increase to have upon the prices of large versus
small automobiles? And what would the effect be upon the
price of automobiles in general? (8 marks)
If the price of gasoline rises sharply, the cost of operating an

automobile will raise a lot. This is because gasoline and automobiles
are complements. Thus, the demand for automobiles will fall and so will
the prices. Moreover, since large automobiles consume more gasoline
than small automobiles, the demand for large automobiles will fall
relatively greater than the demand for small automobiles. Hence, the
relative prices of large automobiles will fall while the relative prices of
small automobiles will rise.
(b) A price ceiling is imposed by the government on butter, i.e.

the price of butter is forcibly controlled to a level
significantly below its market price. What would you expect
the effect to be upon the price of margarine? (8
marks)
As price ceiling is imposed on butter which is significantly below its

market price, a shortage of butter will exist, as margarine and butter
are substitutes, when people are unable to buy butter at the controlled
price, they will change to buy margarine. As a result, the demand for
margarine will rise and its price will also rise.
1992 Q. 5
What is ‘consumer surplus’? Explain how it may be extracted
by the seller of a good.
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or
The consumer’s surplus exists is due to the postulate of diminishing

marginal use value. As an individual’s marginal use value on a good
diminishes when more is possessed, he will not purchase any more
when the price paid is equal to the MUV of the last unit concerned.
Under a uniform price arrangement, as each unit is being charged the
same price, the MUV of previous units will inevitably higher than the
price paid. In this case the difference between the summation of the
MUV of the purchased unit, i.e. the total use value and the total market
value becomes the consumer’s surplus.
The seller of a good may extract consumer surplus by making

consumer pay an amount equal to the extra amount he is willing to pay
for the goods. This can be done by:
- using perfect price discrimination, i.e. charging each unit a price

which is equal to the marginal use value of the corresponding unit;
or
- using all-or-nothing pricing, i.e. forcing consumer to buy a specified

quantity at a unit price equal to the average use value of each unit;
or
- charging consumer a lump-sum as a pre-condition to purchase the

good such as membership fee or entrance fee. Hence, besides
paying for the goods, consumer has to pay an extra amount which
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makes the total amount he pays equal to the total use value of the
goods purchased.
1993 Q. 9
Consider a country which seeks to impose a significant tax on
the import of automobiles. This country may (a) impose a
uniform unit tax for each and every automobile imported, or
(b) impose an ad valorem tax as a percentage of the market
value of the automobile.
Suppose with either (a) and (b) the government would receive
the same total tax revenue. Which of the two schemes would
have a higher average quality of the automobiles imported?
Explain. (10 marks)
If a uniform unit tax is imposed, the prices of both lower and higher
quality cars will rise by the same amount. Thus, the quantity
demanded of both types of cars will fall. However, since the tax is a
fixed lump-sum, the rise in price of higher quality cars will be relatively
smaller than that of lower quality cars. Thus, the price of a higher
quality car will fall relative to the price of lower quality cars. In this
case, the percentage fall of the higher quality cars will be smaller than
that of lower quality cars. So the relative quantity of higher quality cars
will rise and the relative quantity of lower quality cars will fall. As a
result, the average quality of the cars imported will become higher
than before.
If an ad valorem tax is imposed, the prices of both lower and higher

quality cars will rise by the same percentage. Thus, the quantity
demanded of both types of cars will fall. However, since the tax is a
percentage of the market value of the cars, the percentage rise in price
of higher quality cars will be the same as that of lower quality cars.
Thus, the relative prices of high and low quality cars will remain the
same. In this case the percentage fall of the higher quality cars will be
the same as that of lower quality cars. So the relative quantity of
higher quality cars and lower quality cars will remain the same. As a
result, the average qualities of the cars imported remain unchanged.
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1994 Q. 4
What is consumer’s surplus? If the consumer’s surpluses of all
consumers are fully extracted by sellers, will the income
distribution of individuals in society necessarily become more
unequal? (8 marks)


or
The consumer’s surplus exists is due to the postulate of diminishing

marginal use value. As an individual’s marginal use value on a good
diminishes when more is possessed, he will not purchase any more
when the price paid is equal to the MUV of the last unit concerned.
Under a uniform price arrangement, as each unit is being charged the
same price, the MUV of previous units will inevitably higher than the
price paid. In this case the difference between the summation of the
MUV of the purchased unit, i.e. the total use value and the total market
value becomes the consumer’s surplus.
In our society, each individual is a consumer (buyer) as well as a

supplier (seller), during his productive years. This means that as a
seller, one extracts the buyers’, consumer’s surpluses. However, when
we play the role of a buyer, his consumer’s surplus is being extracted
by the seller. Hence, if all consumers’ surpluses are fully extracted, the
distribution of income may not become more unequal. This is because
an individual whose consumer’s surplus is extracted by others will in
turn extract the surpluses of other consumers to who he sells his goods
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and services.
1995 Q. 1
What is price elasticity of demand? Construct, with
explanation, a demand curve with unitary elasticity at every
price. (8 marks)
The price elasticity of demand measures the responsiveness of the

quantity demanded to a change in price. Because the quantity
demanded and prices are of different units, the responsiveness is not in
terms of absolute changes. Instead, the responsiveness is in terms of
relative/ percentage change. Specifically, the price elasticity of demand
is the ratio of the percentage change in quantity demanded to the
percentage change in price.
Ed = % change in Qd / % change in P
If the percentage change in quantity demanded is larger than the

percentage change in price, the demand is said to be elastic. With an
elastic demand, an increase in price will lead to a fall in total revenue
as the fall in quantity demanded is proportionately larger than the
increase in price, vice versa.
Demand is said to be unitary elastic if the percentage change in

quantity demanded is the same as the percentage change in price. In
this case the elasticity of demand is equal to one. In this case a change
in price will result in no change in total revenue. The demand curve
that is entirely unitary elastic is a rectangular hyperbola, along which
every price and quantity demand combination gives rise to constant
total revenue, i.e. any change in price will not affect the total revenue.
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1996 Q. 3
‘Two straight-line demand schedules with the same vertical
intercept, with one schedule steeper than the other, have the
same price elasticities at any given price.’ Do you agree?
(8 marks)
This is a half-geometry and half-economics question. First of all, define

price elasticity of demand and shows its formula.
Price elasticity of demand is a measure of the responsiveness of the

quantity demanded to a given change in price. Mathematically, it is:
Ed = % change in Qd / % change in P
A common way of measuring is to use the point method. The formula

for Ed becomes:
Ed = (△Q / Q) / (△P / P)
where △Q and △P are infinitesimally small changes
By rearranging the terms, Ed = △Q / △P x P / Q and geometrically, the

Ed can be found by the following method:
Ed1 = (0Q1 / P1P2) x (0P1 / 0Q2)
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= 0P1 / P1P2
Ed2 = (0Q1 / P1P2) x (0P1 / 0Q2)

= 0P1 / P1P2
As proved above, I agree with the statement. For two straight-line

demand curves with the same vertical intercept, their demand
elasticities at a given price will be the same. This illustrates that the
demand elasticity is not the same as the slope of the demand curve.
1997 Q. 7
In 1776, Adam Smith advanced the now famous water-diamond
paradox. In Smith’s view, water, which has a very high use
value, often has a low exchange value; on the other hand,
diamond, which has little use value, has a very high exchange
value.
Use supply-demand diagrams to explain how this paradox can

be resolved. Your analysis should centre around use and
exchange values and their relationship with consumer surplus,
and all values should be discussed in total, average, as well as
marginal terms. (10 marks)
Before using the supply-demand diagrams to resolve the water-diamond paradox, it is

better for us to clarify the concepts o fuse value and exchange value. Since there are three
types of use value, we have to clear about what type of use value we are concerned with.
By total use value, it measures the maximum amount of other good one is willing to forgo
in order to obtain a certain quantity of the good concerned. As for average use value, it
measures the maximum amount of other good on average one is willing to forgo in order
to obtain certain of the good concerned. While for marginal use value, it measures the
maximum amount of other good one is willing to forgo in order to get an extra unit of the
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good concerned. As marginal use value is diminishing when more of a good is being
possessed, the marginal use value curve is also downward sloping curve.
As long as marginal use value is positive, when more is being possessed, the total use
value will keep on increasing while the average use value will fall continuously.
As a maximizer, one will purchase a good as long as the use value one obtains form
possessing a good is greater or equal to the price paid. Thus, under a uniform price
arrangement, one will buy until price is equal to the marginal use value of the last unit
possessed. Hence, the MUV curve is also the same as the demand curve.
According to the water-diamond paradox, water has a high use value

while diamond has a low use value. Firstly, we have to be clear that
what type of use value is concerned in this paradox. In fact the use
value concerned is the total use value. Since the quantity of water is
more abundant than that of diamond, more water can be used by
people, the total use value of water will be higher than that of
diamond. This explains why water has a high use value while diamond
has a low use value.
As for the exchange value, it measures the amount of other good one is
willing to forgo in order to obtain an additional unit of the good
concerned. As mentioned above, the exchange value of a good is equal
to the marginal use value of the last unit concerned. As marginal use
value diminishes when more is being possessed, the greater the
quantity, the lower the marginal use value will be. Since water in more
abundant than diamond, the marginal use value of water will be lower
than that of diamond. This explains why water has a lower exchange
value than diamond.
So, after clarifying the difference between total use value and marginal
use value, we can find out why water has a high use value but low
exchange value while diamond has a low use value but high exchange
value. Moreover, since the total use value equals to the summation of
MUV of all units consumed while the total exchange value equals to
price, i.e. MUV of last unit concerned, times the quantity consumed, the
total use value is greater than the total exchange value. The difference
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is known as consumer surplus. Thus, we can also conclude that the

greater quantity, the greater the consumer surplus will be. Hence,
users of water can enjoy more consumer surplus than users of
diamonds.
1999 Q. 8
Farmers welcome increases in the prices of their crops. The
periodic global weather disturbance known as EI Nino has been
blamed for driving up prices of many agricultural goods
because the bad weather has led to bad harvests.
(a) Will the farmers generally gain or lose from the global bad
harvests? (7 marks)
Bad harvest leads to a fall in the supply of agricultural products and

shifts the supply curve to the left. The market price will rise and
quantity transacted will fall. However, whether farmers will gain or lose
depends on the price elasticity of demand at the relevant price range.
If demand for crops is elastic at the relevant price range, the

percentage fall in quantity demanded will be greater than the
percentage rise in price. The loss in revenue due to fall in quantity
transacted will be greater than the gain in revenue due to rise in price.
As a result the total revenue will fall and farmers will lose from the
global bad harvests.
If demand for crops is inelastic at the relevant price range, the

percentage fall in quantity demanded will be smaller than the
percentage rise in price. The gain in revenue due to rise in price will be
greater than the gain in revenue due to fall in quantity demanded. As a
result the total revenue will rise and farmers will gain from the global
bad harvests.
If demand for crops is unitary elastic at the relevant price range, the
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percentage fall in quantity demanded will be the same as the

percentage rise in price. The gain in revenue due to rise in price will be
the same as the gain in revenue due to fall in quantity demanded. As a
result the total revenue will remain unchanged and farmers will incur
no lose from the global bad harvests.
(b) Crop insurance – that is, private companies insuring

farmers against bad harvests – is seldom practiced. The
reason typically offered is that is would be difficult for the
insurance companies to measure crop losses and to enforce
against cheating. However, an economist has suggested that
in the event of a general bad harvest, the market may
automatically provide insurance. Do you agree with the
economist?
(7
marks)
Yes, I agree. As bad harvest shifts the supply curve of agricultural
products to the left, equilibrium price rise and quantity transacted fall.
Since insurance is known as compensation against loss due to

accidental events, if farmers, revenue can be maintained at the level
prior to bad harvests, we can say that the market automatically provide
insurance against bad harvest. This can happen when market price of
crops rise due to fall in supply.
Whether the compensation to farmers depends on the price elasticity

of demand at the relevant price range. If demand for crops equal to
one at the relevant price range, the rise in price will lead to no change
in total revenue. Since the total revenue remains unchanged, the
market can be regarded as providing full insurance. If demand for crops
is inelastic at the relevant price range, the resulting total revenue will
be higher than before. In this case the market can be regarded as
providing over-insurance as farmers gain from the bad harvests.
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2001 Q. 8
The cost of buying, preparing and cooking a chicken in a Hong
Kong restaurant is over $20. Some restaurants sell cooked
chickens to dine-in customers for $1 each, way below cost.
(a) Why would these restaurants do this? Why don’t they

reduce the price a little for each of all the other instead?
(5 marks)
When one buys a pair of shoes for $200, it makes no difference

whether the price is $200 per pair, or $100 for each shoe, or $190 for
the right shoe and $100 for the left, so long as one has to buy by the
pair.
Now if one goes into a restaurant and is going to eat chicken anyway,
plus other dishes as a package, then of course it is the total price of the
package that counts. This being the case, $1.00 per chicken is an eye-
catching feature to attract customers, particularly when some
customers may feel that if they select their menu carefully, then may
get away with a cheap chicken without being taxed by other items in
the package. Some of them may overlook the price of tea, of rice, and
of sauces.
(b) Some customers have little preference for chicken. To them

a cooked chicken is worth, no more than $10 in use value,
also way below cost. Of such customers make up a large
proportion of those who dine in these restaurants, would
you expect the one-dollar-per-chicken pricing be adopted?
Explain. (5 marks)
In actual practice the dinner package is not fixed like a pair of shoes.
Some customers who normally will not order chicken will now be
induced to eat chicken because of the $1.00 price. This implies
economic efficiency in the traditional textbook sense of the term.
However, such economic waste would be minimal if many customers
will order chicken anyway at the normal price, and for the remaining
customers who would not order chicken at the normal price, their
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marginal use value of chicken should not be far off from the normal
price because chicken is perhaps the most popular dish in a Chinese
restaurant.
Customers who would place, say, only $10 use value for one chicken
must be very rare for the restaurants to adopt the one-dollar-per-
chicken pricing arrangement. If a large proportion of customers in
these restaurants place a marginal use value of chicken below marginal
cost, the one-dollar-per-chicken pricing policy would not be adopted.
This explains why duck is never offered for $1.00 to draw customers. A
duck dish is nowhere near as popular as a chicken dish under normal
pricing, and much larger economic waste would result if a duck were
offered for $1.00 to lure customers.
(c)Under what condition would the one-dollar-per-chicken

pricing not imply economic waste (deadweight loss) in the
textbook usage of the terms? (5 marks)
If all customers would order chicken anyway at the normal price, then
pricing $1.00 per chicken is similar to charging $10 for the left shoe.
2003 Q. 6
In November 2002, public hospitals in Hong Kong adopted a
policy of charging $100 per patient requesting emergency
treatment. This treatment was free of charge before this date.
(a) The number of patients requesting emergency treatment

declined as a result of the newly imposed fee. Why?
(2 marks)
As the number of patients requesting emergency treatment declined

due to the increases in fee from zero to $100, such phenomenon is an
implication of the Law of Demand which states that the higher the
price the lower the quantity demanded will be.
(b) The decline in the number of patients rose as time went on,
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i.e. the decline was relatively small at the beginning of the

newly imposed fee but became considerably larger after two
weeks. What happened to the price elasticity of demand for
the emergency treatment over the time period in question?
(2 marks)
With the rise in fee, the decline in number of patients became larger as
time went on; this means that the fall in quantity demanded id
increasing with the passage of time. Thus the price elasticity of
demand for the emergency treatment over the time period is
increasing, i.e. the longer the time the greater the percentage fall in
quantity demanded.
The Second Law of Demand: The longer the time allowed to adjust
amounts demanded in response to price change, the greater is the
change in amount demanded. (The greater the elasticity)
(c) How would you explain the observations in (b) above?

(6 marks)
Firstly, at the very beginning, some patients may not know the $100
fee newly imposed due to the existence of information cost.
Secondly, when people knew the existence of the fee, they have to find
out substitutes in the market. As they may not know the availability of
substitutes due to the existence of information cost, the fall in quantity
demanded may be small at the beginning.
However, as time went on, people can have more information about
the substitutes for medical treatment. Hence the fall in quantity
demanded for medical treatment in public hospital will become greater
and so will be the price elasticity of demand.
(d) Offer an example in the real world that contradicts (b)

above. (2 marks)
In the process of trying new substitutes for the good concerned, people
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may find out that the substitutes available are not so satisfactory, i.e.
they cannot satisfy people’s need as fully as the good concerned. Thus,
as time want on people may turn to buy the good again even at a
higher price. Hence, the price elasticity of demand may fall as time
increases.
Examples for price elasticity of demand as a decreasing function of

time are an increase in taxi fares and an increase in the toll charged for
harbour crossing in Hong Kong.
2006 Q. 1
Price is the maximum a consumer is willing to pay at the margin.
Why the maximum? Under what condition will a consumer be
willing to pay the maximum on the average?
(8
marks)
The marginal use value is the maximum a consumer is willing to pay
for the last unit purchased. If price is lower than his marginal use
value, the consumer will buy more until the price is equal to his
marginal use value. Therefore, in equilibrium price equals marginal
use value, or the maximum a consumer is willing to pay.
In a situation when a good is priced on an all-or-nothing basis, the

maximum a consumer is willing to pay is the average use value, or
the all-or-nothing price, which is an average price.
2006 Q. 7
At the Hong Kong Disneyland, a customer pays one entrance
fee to enter the park and afterwards may participate in any
and all of the rides at no further charge. In the earlier days of
Disneyland in California, however, a customer paid an entrance
fee, and after entering the park this customer would have to
pay separate fees for whatever rides he or she chose to go on.
Are consumer surpluses extracted in both pricing schemes? If
so, which scheme could extract consumer surpluses more
fully? (10 marks)
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If a customer pays one fee to enter the park, allowing him only to walk
around, taking no ride, his consumer surplus is not extracted. If a
customer pays one fee to enter the park after which he may take any
ride free of charge, it is one form of all-or-nothing pricing arrangement
and some consumer surpluses will likely be extracted. If a customer
pays an entrance fee and then pays again to take each ride, this
entrance fee may be a lump-sum extraction of consumer surplus. This
latter device tends to extract more consumer surpluses because it is
more numbers of rides if each of them would have to pay for each ride.
In principle, the dual-fee scheme allows pricing at marginal cost for
each ride, and the entrance fee is taken from consumer surpluses. If
difference entrance fees are charged, the scheme approaches perfect
price discrimination.
Annual Report: Many of candidates failed to illustrate how consumer surpluses are
extracted under different pricing arrangements.
2006 Q. 9
Whereas ladies from mainland China are coming to Hong Kong
to buy authentic handbags bearing prestigious brand names,
ladies from Hong Kong are going to Shenzhen to buy fake
handbags bearing the same brand names. The handbags look
alike, but the authentic ones cost nearly 50 times more than
the fake ones, even though they are only slightly more
durable. Does this imply that the ladies from China are richer
than the Hong Kong ladies? Can the ladies who come to Hong
Kong to buy handbags tell the authentic ones from the fake
ones? Why would they pay such high prices for handbags
which are expected to be only slightly more durable? (10
marks)
If all ladies could not tell authentic handbags from fake ones, then no
one will buy the authentic ones at sharply higher prices. Some ladies,
or most of them, must be all able to tell them apart for the sharp
difference in prices to occur. It does not mean ladies in mainland China
are richer than those in Hong Kong. Some are, but mainly those who
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could afford to come to Hong Kong to purchase the authentic

handbags.
Even at that it is not certain those mainland ladies who travel to Hong
Kong are necessarily richer than Hong Kong ladies. Many ladies do care
for famous or prestigious brand names and it is possible that mainland
ladies in general have a higher preference for prestige.
Reference Question
Use one real life example to reveal the validity of the law of
diminishing marginal use valuation.
(4 marks)
If the law of diminishing marginal use valuation does not hold, there
will be increasing marginal use valuation. With increasing marginal use
valuation, the more of a good one possesses, the higher the marginal
use value will be. In this case one will spend all his budget on one good
in order to maximize his benefits.
However, in real life observation, we can observe that no specialization

in consumption exists. Everyone spends their budget on a great variety
of goods. This reveals that when the consumption of a good increase,
its MUV diminishes and will eventually fall below the MUV of other
goods. Hence, as a maximizer, one will consume more than one good.
- END -
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Unit 3 – Consumer Demand: The Indifference Curve Approach
1. The theoretical possibility of the Giffen Paradox in the indifference curve

analysis
A. implies that the paradox exists in reality.

B. means that the law of demand is asserted rather than derived.
C. implies that the demand curve cannot be derived.
2. Utility
A. is observable.
B. measures that satisfaction obtained from the consumption of goods.
C. is the assignment of numbers to rank options.
D. is a measure of welfare. (87-09)
3. The indifference curves of an individual do not intersect because
A. that would imply inconsistency in choice making.

B. they are downward sloping.
C. they represent different levels of satisfaction.
D. they are convex to origin. (87-08)
4. The ‘Law of Demand’
A. is derived from the indifference curve analysis.

B. is an assertion.
C. is a tautology.
D. does not apply in the case of ‘conspicuous consumption’. (90-
01)
5. The convexity of the indifference curves to the origin
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A. is asserted by economists.
B. has no testable implications.
C. is inconsistent with the Giffen Paradox.
D. is inconsistent with the Law of Demand. (90-23)
6. Utility
A. is a measure of social welfare.

B. is a number assigned to rank options.
C. measures the satisfaction derived from consuming goods and services.
D. must be a negative number if we are consuming a bad. (91-
22)
7. Which of the following about indifference curve analysis is FALSE?
A. The income effect is positive for a normal good.

B. The negative income effect outweighs the substitution effect for a Giffen
Good.
C. The substitution effect can either be positive or negative.
D. The income effect can either be positive or negative. (92-
29)
8. Consider the budget line of an individual with a fixed income. This individual
buys two goods, X and Y, of which Y may be regarded as money income.
Suppose this individual’s income rises by 50% and the relative price of X
doubles. In a diagram with X on the horizontal axis and Y on the vertical axis,
the new budget line
A. is the same as the old one.

B. intersects the old one and is steeper.
C. lies to the left of the old one and is steeper.
D. lies to the right of the old one and is flatter. (93-01)
9. Suppose good X is measured on the horizontal axis and good Y on the vertical
axis. If the price-consumption curve for X is a vertical straight line, then
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A. Y is an inferior good.
B. X is an inferior good.
C. X is a normal good.
D. X is a Giffen Good. (93-07)
10. When the price of good X rises, a consumer responds by reducing her quantity
demanded of the good. The substitution effect, being part of this change, is
measured by
A. holding all other things constant.

B. holding the substitution of other goods constant.
C. holding her money income constant.
D. holding her real income constant. (93-12)
11. If Mr. Hau spends all the money in his pocket, he can buy 5 bowls of red bean
soup and 2 bowls of noodles (combination X) or 3 bowls of red bean soup and 6
bowls of noodles (combination Y). It follows that both combinations are points
on the same _____.
A. indifference curve.
B. income-consumption curve.
C. budget line.
D. price-consumption curve. (93-20)
A. is derived form the indifference curves.

B. states that quantity demanded and income are positively related.
C. states that price elasticity is always lower for a necessity.
13. Utility
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A. is a measure of individual satisfaction.

B. is a measure of social welfare.
C. is an arbitrary assignment of numbers to rank options.
14. The Law of Demand is asserted because
A. quantity demanded is not observable.

B. it cannot be tested.
C. it may be refuted by facts.
D. it cannot be derived from the indifference curve analysis. (94-
04)
15. Mr. Lee thinks Coke and Pepsi are perfect substitutes for each other. Suppose
Pepsi costs $3 per can and Coke costs $2.5 per can, and that Mr. Lee has 10
coupons, each of which can be used to buy one of Pepsi for $2. If he has $45 to
spend on cans of Coke and Pepsi, Mr. Lee will buy
A. 15 cans of Pepsi and 4 cans of Coke.

B. 5 cans of Pepsi and 14 cans of Coke.
C. 10 cans each of Pepsi and Coke.
D. There is not enough information to tell. (93-07)
16. The price of higher education has increased in the last three years, but the
percentage of university-age people going to university has also increased.
This phenomenon
A. rejects the Law of Demand.

B. implies that higher education is a Giffen Good.
C. implies that higher education is an inferior good.
17. If an individual is indifferent among points A, B and C:
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A. he denies the postulate of substitution.

B. he denies the postulate of diminishing marginal rate of substitution.
C. Good X and Good Y are perfect complements.
18. Utility maximization is the same as maximizing
A. annuity income.
B. the total income in one’s life span.
C. wealth.
19. Which of the following about the Giffen Paradox is INCORRECT?
A. It involves a good with a negative income effect which is greater than its
substitution effect.
B. It is a logical possibility.
C. It supports the Law of Demand.
D. It implies that real income is not held constant. (95-29)
20. Saying that a person maximizes utility may seem an elaborate camouflage to
hid our ignorance; for it would appear that whenever a person voluntarily does
anything, he can said to be maximizing his utility,
A. This claim is correct and because of it, economists no longer use a utility
theory.
B. This claim would be correct if economics could not specify what entities are
goods and the relative costs of acquiring them.
C. This claim is incorrect only to economists.
D. This claim is incorrect because it does not make sense. (96-
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13)
21. For a buffet dinner, a customer pays $200 per head, and he can eat as much
as he wants. Naturally, the customers eat until the marginal use value of
additional food to him is zero.
A. This pricing practice is inefficient because the marginal cost of producing

food is positive, resulting in a situation where the marginal cost is higher than
the marginal value of food.
B. This pricing practice is efficient, because it is costly to specify and monitor
how much a customer can eat, and the buffet arrangement saves these
costs.
C. This pricing practice demonstrates that the restaurant operator may not
know what he is doing.
D. This practice means that the restaurant operator wants to maximize sales.
(96-19)
22. Indifference curves do not intersect because
A. their intersection rejects the postulate of maximization.

B. the consumer is asserted to make consistent choices.
C. economic goods are substitutable.
D. the marginal rate of substitution is diminishing. (97-20)
23. Which of the following statements about utility analysis is correct?
A. Its usefulness is restricted to goods which are not marketable, such as

prestige or friendship.
B. Interpersonal comparison of utility is possible only if all goods are
marketable.
C. The behaviour of an individual who does not know what utility is cannot be
analysed.
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24. Utility
A. is an index designed to rank options.

B. is an arbitrary assignment of numbers to predict behaviour.
C. cannot be aggregated among different individuals to measure welfare.
25. Which of the following statements about utility is correct?
A. Utility is assigned by a decision maker to represent his own preference.

B. Utility is designed by economists to rank the options of an individual.
C. Utility determined preference.
D. Individuals derive from consumption. (00-02)
26. As money income rises while relative prices remain constant, the income
effect for good X may be positive or negative. This implies that
A. inferior goods and normal goods exist in equal proportions in the real world.
B. normal goods are more common than inferior goods in the real world.
C. refutable implications on income effect cannot be derived.
D. demand curves are downward sloping. (00-04)
27.
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In the above diagram, basket A is the choice of an individual on the original

budget line BB. Suppose indifference curves are downward sloping and convex to
the origin. If the budget line changes to B’B’ after changes in money income and
relative prices,
A. the individual will consume less of Good X.

B. the individual will consume more of Good X.
C. the individual will consume the same amount of Good X.
D. it is uncertain whether the individual will consume more or less of Good X.
(00-05)
28. If the indifference curves of an individual are downward sloping and convex to
the origin, then
A. the Law of Demand can be derived.

B. the law of diminishing marginal rate of substitution holds.
C. the individual will consume more than one good at any relative price.
29. In an indifference curve analysis of two goods X and Y, when the price of X
falls and the quantities purchased of Both X and Y increase, holding money
income constant, the price elasticity of demand for X is
A. larger than unity.

B. smaller than unity.
C. equal to unity.
D. uncertain. (00-14)
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30. Which of the following is a refutable implication derived from indifference

curve analysis?
A. The relative price of two goods is equal to the marginal rate of substitution
when utility is maximized.
B. If real income or apparent real income is held constant, a decrease in the
price of a good will lead to an increase in its quantity purchased.
C. When the price of a good decrease, its quantity demanded may decrease or
increase.
D. The income effect is positive for a normal good and negative for an inferior
good. (02-05)
A. is not useful because it is refutable by facts.

B. holds most of the time.
C. yields the same implications as indifference curve analysis if the real income
is held constant.
D. will not hold of the Giffen Paradox is logically possible. (02-
09)
32. Utility
A. measures satisfaction derived form consumption.

B. is an index showing how much an individual’s welfare improves or
deteriorated.
C. is essential for the explanation of behaviour.
33. Which of the following statements about utility analysis is correct?
A. Comparison of utility among different goods consumed by the same

individual is possible.
B. Utility analysis is not useful because utility is not measurable.
C. It is not possible to explain or predict the behaviour of consumers who do not
maximize utility.
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34. The Law of Demand is asserted because
A. it cannot derived from the postulate of convexity.

B. it cannot be derived from the postulate of substitution.
C. real income is not held constant.
35. An individual is willing to forsake 5 units of Good A to get 1 more unit of Good
B. It implies that the indifference curve between Good A and Good B is
A. a straight line.
B. convex to the origin.
C. concave to the origin.
36. Utility
A. is an index for happiness.

B. can be negative numbers.
C. exists in the real world.
D. exists in economics only when indifference curves are used.
(04-05)
A. cannot be tested without adding other conditions.

B. is derived from indifference curve analysis.
C. can itself be observed in the real world.
D. cannot be rejected by facts because it yields no testable implications.
(04-07)
38. The postulate of diminishing marginal rate of substitution is supported by
A. the Law of Demand because the this postulate implies the demand curve is
always downward sloping.
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B. the non-existence of Giffen Goods.

C. the fact that we have not observed specialization in consumption.
D. the existence of scarcity. (04-08)
39. Indifference curves are convex to origin. This convexity is supported by
A. the fact that an individual does not specialize in consumption.

B. that there are no Giffen Goods.
C. the fact that an individual specializing in consumption will alter this
consumption bundle after a long period of time.
D. that the demand curve is always downward sloping. (05-
04)
40. Indifference curves do not intersect because
A. if they intersect the individual will be making inconsistent choices.

B. if they intersect constrained maximization becomes ambiguous.
C. if they intersect the demand curve cannot be logically derived.
41. An inferior good means
A. for the same type of goods, its quality is inferior.

B. a good consumed mostly by poor people.
C. a good an individual demands more as his income falls.
D. a good an individual demands less as his income falls. (05-
06)
42. Utility
A. is an arbitrary assignment of numbers to rank options.

B. cannot be measured because it is not observable.
C. measures happiness.
43. Indifference curves are convex to the origin. This convexity is
A. asserted.
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B. supported by the observation that individuals do not specialize in

consumption.
C. consistent with diminishing marginal use value.
44. Which of the following is refutable?
A. Price does not change when quantity demanded and quantity supplied of a good are equal.
B. The market is in equilibrium.
C. Indifference curves are convex to the origin.
D. With price controls there may be shortages or surpluses. (07-09)
45. The income effect of a change in the price of a good in indifference-curve analysis
A. renders such analysis useless if and when we cannot predict how quantity demanded changes when
price changes.
B. would refute the law of demand because the demand curve so derived may not be downward
sloping.
C. is useless because we do not have inferior goods in the real world.
D. would not affect the empirical usefulness of such analysis because we always hold real income
constant when deriving the demand curve. (07-10)
MC Answers on Consumer Demand: The Indifference Curve

Approach
B C A B A B C B B D
C D C D C D B D C B
B B D D B C B B B B
C D A D D B A C A D
C A D D D
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Consumer Demand: The Indifference Curve Approach
1989 Q. 5
In demand analysis, what is the difference between ‘holding
real income constant’ and ‘holding money income constant’?
Under which of the above conditions may the Giffen Paradox
arise? (10 marks)
In demand analysis, we analyse the effect of a price change on the

quantity demanded of a good. By holding real income constant, we
mean that even when there is a fall in price, the purchasing power of
an individual will still remain unchanged. This implies that he can only
stay at the same utility level as before, or possess the income which
enables him to purchase the original bundle of goods.
However, by holding money income constant, if there is a fall in price,

an individual’s real income will rise as he can purchase more of either
good or both with the same amount of money income.
By holding money income constant, if there is a fall in price of a good,

the real income of a person will rise. Hence, the income effect will
arise. If the resulting effect is negative and is greater than the
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substitution effect, the quantity demanded of such good will fall even
there is a fall in its price. In this case the good concerned will be a
Giffen Good and the Giffen Paradox arises. As we have known, the
existence of the Giffen Paradox us due to the existence of a negative
income effect. This means that it will arise only if there is a change in
real income. Thus, if the real income is being held constant, there will
be no income effect. So only by holding money income constant will
the Giffen Paradox arise.
1990 Q. 1
‘The Giffen Paradox is logically inconsistent with the Law of
Demand.’ Do you agree with this statement? Explain.
(10 marks)
The Law of Demand states that price and quantity are negatively
related, ceteris paribus (or keeping other things constant). While the
Giffen Paradox states that price and quantity demanded are positively
related. However, the Giffen Paradox is logically consistent with the
Law of Demand.
The reason for the existence of Giffen Good is that with money income
being kept constant, when there is a fall in price of a good, two effects
will arise. With a fall in relative price, an individual will tend to consume
more of the relatively cheaper good; this is known as the substitution
effect. However, as his real income rises, he will consume fewer of the
good concerned as the good is an inferior good. In this case the
negative income effect outweighs the (negative) substitution effect,
thus the quantity demanded will fall with a fall in price. This is what we
call the Giffen Paradox.
However, the Giffen Paradox is not logically inconsistent with the Law
of Demand. This is because the Law of Demand only predicts the effect
of a change in price on the quantity demanded of a good, keeping
other things constant. In this case it only analyses the effect of a
change in relative price on quantity demanded, i.e. the substitution
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effect, without considering the income effect as real income is

assumed to remain constant. As the substitution effect muse be
negative, price and quantity demanded must be negatively related.
Hence, there exists no inconsistency between the Giffen Paradox and
the Law of Demand because they tend to explain different things under
different conditions.
1991 Q. 1
What is the postulate of diminishing marginal rate of
substitution? What would we observe in the real world if this
postulate does not hold, i.e. if the marginal rate of substitution
is increasing? (10 marks)
Marginal rate of substitution measure the amount of other goods one is

willing to sacrifice in order to obtain an additional unit of the good
concerned. In other words, it measures the amount of other goods an
additional unit of the good concerned can substitute.
The postulate of diminishing marginal rate of substitution states that

with constant utility, as more of a good is possessed, the amount of
other goods an additional unit of the good concerned can substitute
will fall. This implies that the more of a good one possesses, the fewer
other goods he is willing to give up to obtain an additional unit of the
good concerned.
The postulate of diminishing marginal rate of substitution also holds

the utility or real income of the individual constant, which is revealed
by a convex indifference curve. In order to maximize one’s utility, one
will try to reach the highest utility level with his budget. As equilibrium
is attained when one’s budget line is tangent to the indifference curve,
this shows that an individual will tend to consume more than one good.
However, if the marginal rate of substitution is increasing, the
indifference curve will become concave. In this case consumer
equilibrium will be corner solution. This means that as a maximizer, an
individual will specialize in consumption, i.e. he will consume one good
only.
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1992 Q. 7
In some communities in the United States, water is priced
according to the following pricing scheme. Each individual is
required to make an initial lump-sum payment which entitles
him to a specified quantity of water. If he wishes to consume
more than this quantity of water, he can buy additional water
on a per gallon basis at a declining price per gallon.
Given that an individual has paid the initial lump-sum fee, so

you expect him to consume an amount less than, equal to, or
more than the amount which the fee entitles him? Explain your
answer using the budget line and indifference curves. (15
marks)
After paying the lump-sum fee, the cost of consuming additional units
of water (within the specified quantity) us zero, therefore there is a
horizontal segment of the budget line.
The portion of AB is equal to the specified quantity of water allocated

for the lump-sum payment.
Then the budget line is convex to the origin (0) as one can buy
additional water on a per gallon basis at a declining price per gallon.
After paying the lump-sum charge, the maximum amount of all other
goods he can obtain reduces by BC.
As long as water is a good, i.e. indifference curve is downward sloping;

people will consume at least the amount of their entitlement.
Whether people will consume more than their entitlement or not

depends on the per unit price of water. If the per unit price is high,
people are likely to consume only their entitlement as greater
consumption will reduce their utility level.
However, if price falls far enough, people may buy more water.
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1994 Q. 1
Would there still be economics if the concept of utility had
never been invented? And would there still be economics if the
postulate of constrained maximization had never been
invented? (8 marks)
Utility is nothing more than an arbitrary assignment of numbers among

options which indicate the ranking of options in accordance with one’s
preference. It sets a criterion for us to analyze how individual behaves
to maximize his benefits. If utility as criteria for maximization had
never been invented, economics would still exist because the study of
economics concerns with how people maximize under constrains. Thus,
if utility was never invented, some other entity would have been
invented to take its place which would become the criteria to analyze
how individual behaves to maximize, or economics may turn to other
entities such as wealth, income, or even rent as a criterion of
maximization.
However, if the postulate of constrained maximization had never been

invented, economics would not have survived, at least not in its
present form. This is because economics is founded upon the basis that
individuals make choices among options, which implies that we try to
analyze how people make decisions under constraints. Thus,
constrained maximization sets an essential restriction on behaviour
without which individual choices would become unpredictable.
1996 Q. 1
What is utility? (8 marks)
This seems to be an easy and straightforward question, but it is not. A good answer to this
question should extend to a discussion on the Methodology of Economics.
First of all, do not define ‘utility’ as ‘satisfaction’. Utility is nothing more than an
arbitrary assignment of numbers among options which indicate the
ranking of options in accordance with one’s preference. To measure
utility on a certain entity, we assign a number to it to indicate our
preference; a larger number indicates a stronger preference. Utility is
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an ordinal measure and it cannot be compared between individuals.
Just like many other what is question in Section B, do not just give the
definition. Try to elaborate on the behaviour implications of the
concept. Utility is a term invented by the economists, and it does not
actually exist in the real world. The justification of such an invention is
because it can be used together with other specifications of constraints
to derive refutable implications so that human behaviour can be
explained and be predicted. Suppose we assume that making friends
can give us utility and we can also specify the relevant costs involved
in acquiring friends, then we can explain and predict the situations
under which we would make more friends or what types of friends.
1996 Q. 2
Measuring money income on the vertical axis and Good X on
the horizontal axis, the indifference curves of an individual are
said to be vertically parallel if they have the same slope along
any vertical straight line. In this case, is it possible that Good X
is a Giffen Good? (8 marks)
When we say that indifference curves are vertically parallel, we are

suggesting that the income elasticity of demand is zero, i.e. a change
in income will result in no change in quantity demanded of the good
concerned, ceteris paribus.
Giffen Good is defined as one whose quantity demanded changes

positively with its price, ceteris paribus. A Giffen Good does not obey
the Law of Demand. Use a diagram incorporating the real income effect
and substitution effect to argue that Giffen Good is impossible if the
income elasticity of demand is zero.
When indifference curves are vertically parallel, the income effect of a

price change on Good X is zero. A change in price of Good X will
therefore affect the quantity demanded for Good X through the
substitution effect only. As substitution is asserted to be always
negative, a fall in price will therefore unambiguously lead to an
increase in quantity demanded. Hence, Good X cannot be a Giffen
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Good in such a case.
Another way of arguing your case is that Giffen Good must be an

inferior good with a negative real income effect. But if indifference
curves are vertically parallel, the good in question must not be an
inferior good as the real income effect is zero. Therefore it must not be
a Giffen Good, instead of neutral good.
1999 Q. 6
The following dialogue is famous in Chinese culture: Happy is
the fish! You are not a fish. How do you know the fish is happy?
What does this dialogue have to do with utility analysis? Can
we use utility analysis to explain the behaviour of the fish?
(7
marks)
In utility analysis there is no way we know whether an individual whose
behaviour we seek to explain is or is not happy. All we can say is
whether the individual chooses to do something or not to do. If we
throw some fish food into a pond and can predict before hand that the
fish will go after the food, we can say the fish prefers or chooses to
have than not to have the food, and we may well assign utility numbers
to different kinds of fish food and their varying quantities.
2000 Q. 1
Explain one chief difference between diminishing marginal use
value and diminishing marginal rate substitution.
(8 marks)
Marginal use value is the maximum amount of other goods one is willing to sacrifice in
order to obtain an extra unit of the good concerned. As one possesses more of a good, the
maximum amount of other goods one is willing to sacrifice for an extra unit of the good
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will diminish. Hence the MUV curve of a good is downward sloping.
Marginal rate of substitution reflects that with constant utility, the amount of other good
an additional unit of a good can substitute. Diminishing marginal rate of substitution
implies that with constant utility, as one possesses more of good, the amount of other
good an additional unit of the good can substitute will diminish. This explains why an
indifference curve is convex to the origin.
The chief difference between diminishing marginal use value and diminish marginal rate
of substitution is that for diminishing marginal rate of substitution to hold, utility must be
held constant. If utility varies, it will no longer be valid. Such problem will not arise in
the concept of diminishing marginal use value. Under MUV approach, an individual will
consume a good unit P = MUV. If P = MUV, consumer surplus will arise meaning that he
gains in the exchange process due to diminishing marginal use value.
However, even if all consumer surplus is being extracted, diminishing marginal use value
will still holds. This is the chide difference between them.
2001 Q. 1
What is Law of Demand? What is Giffen Good? Is a Giffen Good
consistent with the Law of Demand?
(7 marks)
The Law of Demand reveals the relationship between price and

quantity demanded at various prices, keeping other things constant. It
states that when there is a fall in price of a good, its quantity
demanded will rise, vice versa, ceteris paribus. This implies that price
and quantity demanded of a good are negatively correlated. This can
be shown by a downward sloping demand curve in a diagram.
Giffen Good is known as a good which has a positive relationship

between price and quantity demanded. Hence, for a Giffen Good, the
higher the price, the greater the quantity demanded will be. The reason
for the existence of Giffen Good is that with money income being kept
constant, when there is a fall in price of a good, two effects will arise.
With a fall in relative price, an individual will tend to consume more of
the relatively cheaper good; this is known as the substitution effect.
However, as his real income rises, he will consume fewer of the good
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concerned as the good is an inferior good. If the negative income effect

outweighs the (negative) substitution effect, the quantity demanded
will fall with a fall in price. This can be shown by an upward sloping
demand curve in a diagram.
Since the relationship between price and quantity demanded revealed

by a Giffen Good is opposite to that of the Law of Demand, the
existence of a Giffen Good is not consistent with the Law of Demand.
However, the Giffen Paradox is not logically inconsistent with the Law
of Demand. This is because the Law of Demand only predicts the effect
of a change in price on the quantity demanded of a good, keeping
other things constant. In this case it only analyses the effect of a
change in relative price on quantity demanded, i.e. the substitution
effect, without considering the income effect as real income is
assumed to remain constant. As the substitution effect muse be
negative, price and quantity demanded must be negatively related.
Hence, there exists no inconsistency between the Giffen Paradox and
the Law of Demand because they tend to explain different things under
different conditions.
2003. Q. 1
Show the logical existence of a Giffen Good with indifference
curve analysis. Can such a good logically exist in the market?
(8 marks)
Show the Giffen Good case with indifference curves. The reason for the
existence of Giffen Good is that when there is a fall in price of a good,
two effects will arise. With a fall in relative price, an individual will tend
to consume more of the relatively cheaper good; this is known as the
substitution effect. However, as his real income rises, he will consume
fewer of the good concerned as the good is an inferior good. In this
case the negative income effect outweighs the substitution effect, thus
the quantity demanded will fall with a fall in price. This is what we call
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the Giffen Paradox.
Such a good will not be traded in the market because the higher the
price, a buyer would want to buy more while a seller would want to sell
less. In a two-individual world, for example, if one or both of the
individuals have upward rising demand curve(s), it may be possible to
have one price equating the MUVs of both individuals, but that would
be an unstable or explosive situation, where no testable implications
can be obtained or no stable equilibrium price is possible.
Remark: Marshall, who brought out Giffen Goods in his Principles, was
well aware of the difficulties in his second book on Commerce, where
offer-curve analysis was employed. However, Marshall did not go back
to point this out in the later revisions of Principles.
2004 Q. 2
What is Law of Demand? Explain why this law is not derived,
but asserted. (8 marks)
The Law of Demand reveals the relationship between price and

quantity demanded at various prices, keeping other things constant. It
states that when there is a fall in price of a good, its quantity
demanded will rise, vice versa, ceteris paribus. This implies that price
and quantity demanded of a good are negatively correlated. This can
be shown by a downward sloping demand curve in a diagram.
The reason why this law is asserted but not derives is that it cannot be
derived from the indifference curve analysis. This is because by
analyzing the effect of a change in price on the quantity demanded of a
good from indifference curve analysis, we may derive a case which
reveals that price and quantity demanded are positively correlated if
the good concerned is Giffen Good. The existence of a Giffen Good is
due to the fact that with money income being kept constant, when
there is a fall in price of a good, two effects will arise. With a fall in
relative price, an individual will tend to consume more of the relatively
cheaper good; this is known as the substitution effect. However, as his
real income rises, he will consume fewer of the good concerned as the
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good is an inferior good. If the negative income effect outweighs the

(negative) substitution effect, the quantity demanded will fall with a fall
in price. This explains why the Law of Demand cannot be derived from
indifference curve analysis.
However, if we hold real income constant (Hick’s method)or apparent real

income constant (Slutsky’s method), a fall in price of a good will only
generate the substitution effect as there is only a fall in relative price.
In this case the quantity demanded will undoubtedly rise as a result of
a fall in price. In this case the price and quantity demanded are
negatively correlated and the Law of Demand can be derived from
indifference curve analysis.
2007 Q. 2
‘The Giffen good may logically exist in a one-man world, but
not in the market.’ Defend this statement.
(6 marks)
Reference Question 1
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Is it possible for both goods to be Superior Goods?

(4 marks)
As superior good is a good which has income elasticity greater than

one, this means that when income rises by a certain percentage, the
amount spent on the good will rises by amore than a certain
percentage. If this ever occurs, the amount spent on the other good
must rises by a smaller percentage or even become smaller than
before. Hence, it is not possible for both goods to be superior goods. If
one good is a superior good, then the other good will either be a
normal good or an inferior good.
Reference Question 2
Is it possible for both Good X and Good Y to be inferior goods?
(4 marks)
A good is an inferior good if it has a negative income effect. This means

that when there is a rise in income, keeping the prices of both goods
unchanged, the quantity consumed of an inferior good will fall. Since
we assumed that an individual will spend all his income on Good X and
Good Y, if there is a fall in consumption of one good, there must be a
rise in consumption of the other good. Thus, it is not possible that both
goods are inferior goods as Good X is an inferior good, Good Y must be
a superior good, or normal good as the percentage increase in
consumption of Good Y must be greater than the percentage increase
in income.
- END -
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Unit 4 - Exchange
1. A newspaper seller buys newspaper for $3.5 each and sells them for $5.00.
Which one of the following about the transaction is TRUE?
A. The newspaper seller gets $1.50 per script that otherwise would go to the
publisher.
B. The newspaper seller’s costs in making the transaction may be higher than
$1.50.
C. With the newspaper seller, the transaction costs will be at least $1.50 per
script.
D. Without the newspaper seller, the cost of the newspaper to the consumer
would be less than
$5.00. (87-17)
2. Middlemen exist in the market because
A. both the buyers and the sellers want them to exist.

B. there is an information cost in the market.
C. society gains from having middlemen.
3. For an exchange between two individuals to take place,
A. each individual must have a surplus in one good and shortage in another
good.
B. each individual must have different consumer surpluses.
C. the transaction costs must be zero.
D. each individual must have different marginal valuations of the goods before
the exchange.
(90-
26)
4. If the marginal use valuation schedules of two persons are identical,
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A. their wealth must be the same.

B. there cannot be mutually beneficial exchange between them.
C. exchange will occur between them if their initial endowments are different.
5. Market demand for a private good is derived from the _____ summation of
individual demand curves because the private good is characterized by _____
consumption.
A. horizontal, non-exclusive
B. horizontal, exclusive
C. vertical, non-exclusive
D. vertical, exclusive (92-04)
6. The Pareto Condition is satisfied if
A. it is possible to make one individual gain without making another lose.

B. there is no way to make one individual gain.
C. there is no way to make all individuals except one gain.
7. Suppose a tax of ab per unit is imposed. The total of the consumer’s surplus
and the producer’s surplus would become
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A. eac + dbg
B. cafbd
C. cabd
D. efg – afb (94-12)
8. If the purchase of a flat through a property agent requires only the buyer to pay
a commission, then
A. the seller will benefit more from the exchange.

B. the buyer will benefit more from the exchange.
C. both the buyer and the seller would have gained more if they had not used a
property agent.
9. Under zero transaction cost, the Theorem of Exchange predicts that market
equilibrium
A. occurs when each person’s marginal use value is equal to the market price.
B. occurs when there is no transaction in the market.
C. occurs when each person possesses the same amount of the good.
D. can only occur when each person has a different marginal use value
schedule for the good.
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(95-
09)
10. Exchange occurs when
A. people have surplus of some goods.

B. people own significantly different quantities of the same good.
C. we value what we get more than what we give.
D. middlemen exist. (96-09)
11. Which of the following is NOT a transaction cost?
A. in making farming decisions, the cost incurred to forecast the weather.

B. in deciding to buy an oil filed, the cost incurred to estimate the quantity of oil
deposits.
C. in deciding to sell a stock, the cost incurred to search for the best price.
D. in buying a good, the cost incurred to find out the chance that the seller can
making the delivery on time. (96-29)
12. If two persons own the same quantity of a good,
A. exchange will occur between them if their marginal use values are different.
B. there cannot be any mutually beneficial exchange between them.
C. exchange will occur between them only if transaction costs are zero.
D. exchange will occur and their consumer surpluses will be the same.
(98-09)
13. Consider an exchange between two individuals over a fixed quantity of good
X. Which of the following statements is correct?
A. The buyer and the seller jointly determine the market demand for good X.
B. The buyer determines the market demand for the seller determines the
market supply of good X.
C. All of the good X must be traded to determine the market price.
14. The selling of products through the Internet is more common for products such
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as books and video compact discs (VCDs) than furniture. Which of the following
explains the observation?
A. Delivery costs are higher for furniture than for books and VCDs.
B. Information cost is higher for furniture than for books and VCDs.
C. The relative price of furniture is higher after adding the delivery cost.
D. Buyers of furniture and buyers of books and VCDs are different groups of
consumers which different buying habits.
(02-07)
15. Suppose the marginal use value of the last unit of a good is different to two
individuals and exchange involves a lump-sum transaction cost. Which of the
following is correct?
A. Exchange will necessarily occur.

B. If exchange occurs, the allocation of the good between the two individuals
will be the same as when there is no lump-sum transaction cost.
C. If exchange occurs, the marginal user value to the two individuals will not be
equal.
D. The gain from exchange will not be affected by the lump-sum transaction
cost. (02-11)
16. Individual A and B trade with each other through a middleman: they pay the
middleman a fee per unit of the good traded. Which of the following
statements is correct?
A. The arrangement is inefficient since the MUVs of A and B are not equal.
B. The arrangement is efficient even though the MUVs of A and B are not equal.
C. Disequilibrium results when the MUVs of A and B are not equal.
D. A and B should pay the middleman a lump sum fee in order to maximize their
utility (03-17)
17. Individuals A and B trade with each other through a middleman; they pay the
middleman a fee per unit of the good traded. Which of the following
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A. The arrangement is inefficient since the MUVs of A and B are not equal.
B. The arrangement is efficient even though the MUVs of A and B are not equal.
C. Disequilibrium results when the MUVs of A and B are not equal.
D. A and B should pay the middleman a lump sum fee in order to maximize their
utility. (03-19)
18. The Theorem of Exchange states that
A. if quantity demanded and quantity supplied of a good are not equal, there
will be a shortage or a surplus.
B. if the marginal use values of a good are not the same among individuals,
then exchange will occur.
C. if there is no exchange, the marginal use values of a good among individuals
will not be equal.
D. if a government takes away good and gives them away without using market
prices, there is no exchange. (05-10)
19. Which of the following statements about the Theorem of Exchange

INCORRECT?
A. Exchange between two individuals with the same endowment is possible.

B. Exchange between two individuals with the same preference is possible.
C. The volume of exchange between two individuals may not be affected by
transaction costs.
D. The volume of exchange between two individuals is not observable.
(06-10)
20. Suppose transaction costs are zero and two individuals have the same demand curve for a good.
Which of the following is correct?
A. exchange will not occur between them.

B. exchange may occur between them, and their gains from trade must be the same.
C. exchange may occur between them, and their final endowments must be different.
D. exchange will not occur between them if their initial endowments are the same. (07-06)
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MC Answers on Exchange
C D D C B D A D A C
A A A B B B B B D D
Exchange
1993 Q. 4
In the diagram DA is the demand schedule of individual A and
DB is the demand schedule of individual B.
(i) Add up the two demand schedules in above diagram

horizontally. (4 marks)
As the market consists of A and B only, the summation of the demand

schedules of A and B will become the market demand. The demand
curve abc shows the total quantity demanded by both A and B at
various prices. There is a kink in the demand curve because at a higher
price level only A is willing to pay for the good. Hence, A’s demand at
this price range becomes the total demand. At prices below this range,
both A and B are willing to buy the good. Thus, the total demand curve
becomes a kinked demand curve.
(ii) Explain under what situation the demand schedules should

be added up horizontally instead of vertically.
(4 marks)
A total demand curve shows the total quantity demanded at various

prices, it also reveals the highest value placed by user(s) on each
corresponding unit. If the good concerned is a private good, i.e. a unit
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used by one implies a unit less to another, consumption is exclusive by

nature. Hence, a unit of a private good can only be allocated to the
highest-valued user, not the others. Thus, the demand curve of a
private goof shows the highest price commanded by each
corresponding unit, which can be done by summing up individual
demand horizontally.
However, if the good concerned is a public good, i.e. a good which can
be consumed concurrently by many users at the same time and the
consumption by one will not reduce the amount of consumption by
others, and then the total demand can be obtained by adding up
individual demanded curves vertically. This is because the highest
value placed on a unit a public good is equal to the summation of MUVs
of all users.
1993 Q. 5
In the diagram the market demand for a good intersects the
market supply of the good at E, and all the individuals in the
market buy or sell that good at price P*. Explain why the
situation described satisfies the Pareto Condition. (8
marks)
The Pareto Condition is a state when it is impossible to reallocate

resources to make one party better off without making the other party
worse off. Resources allocation is efficient when the Pareto Condition is
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satisfied.
The Pareto Condition is satisfied when
P = MUVa = MUVb = …… = MUVn
or
P = MRSa = MRSb = …… = MRSn
From the above diagram, we can see that individuals will buy the good
at price P*. As market demand is derived from the Marginal Use
Valuation schedule, individuals will buy the good as long as their MUVs
are higher than the price paid. Thus, they will buy the good until the
price is equal to the MUV of the last unit concerned. Such requirement
is being satisfied at point E where price is equal to MUV of the last unit.
As price paid can also be expressed in terms of other goods, at point E
there will not be any further exchange as the MUV of the good
concerned is also equal to the MUV of the other good. Thus, any further
exchange will inevitably make either party worse off. So the situation
described above satisfies the Pareto Condition.
1994 Q. 7
When pop concerts face excess demand for tickets, black
markets often emerge, that is, some individuals buy up blocks
of tickets and then illegally resell them at higher black-market
prices. As a rule, if they are caught, the law will punish the
sellers in the black market but not the buyers.
What will the resale price of tickets be if the reselling is

perfectly legal (as compared to the illegal black-market price)?
And what will the illegal black-market price be if both sellers
and buyers are subject to punishment when caught?
(10 marks)
In the open market, the concert tickets are in excess demand solely
because the prevailing prices are lower than the equilibrium prices, i.e.
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prices will be determined by the interaction between demand and

supply; this means that the black-market prices will stay at the
equilibrium level. Since there is excess demand in the open market, the
prices paid in the black market will become higher. Moreover, why
black-market prices are higher is party due to the fact that the sellers
in the black market will be punished by law if caught. This raises the
sellers’ cost of reselling the tickets. Hence, they have to sell at higher
prices so as to justify their behaviour.
If the reselling is perfectly legal, the sellers’ cost of reselling the tickets
without the possibility of legal punishment will fall. With a fall in cost,
there will be more people willing to sell their tickets to others as the
reselling prices are higher than their purchase prices. With an increase
in supply, the resale price of tickets will be lower than the illegal black-
market prices.
However, if both sellers and buyers are subject to punishment when

caught, we cannot know how the resale price of tickets will be. On one
hand, as the sellers are subject to punishment when caught, their cost
of reselling the tickets will rise. This result in a fall in supply of tickets
for resale and the supply curve will shift upward to the left. On the
other hand, since the buyers are also subjected to punishment when
caught, their cost of buying the tickets also rise. This result in a fall in
demand for tickets in black market and the demand curve will shift
downward to the left. As a fall in supply will raise price while a fall in
demand will lower price, with the given information since we do not
know the extent of all in demand and supply, whether the resale price
of tickets will rise of fall becomes uncertain.
1998 Q. 2
The intersection of market demand and supply is said to
determine the equilibrium market price. Explain why this is so
without using the concepts of surplus or shortage. (Hint: Think
in terms of the Theorem of Exchange.) (10 marks)
The Theorem of Exchange states that if private property rights exist for
two goods, Good X and Good Y and if transaction costs are negligible,
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the proposition of maximization implies that trade will take place and
trade will continue so long as the marginal valuations of the good differ
between the buyer and seller.
Based on this theorem, the marginal valuations of the buyers and

sellers are reflected by the market demand and supply curves. While
the market demand curve reveals the marginal use value of
corresponding unit’s places by buyers, the market supply curve reveals
the marginal use value of corresponding units placed by sellers.
When the market demand and supply intersect, this implies that the
marginal use value of the last unit exchanged is equal for both buyer
and seller. As their marginal use value coincide, this means that the
price buyer paid and seller received will be equal to the marginal use
value of the last unit exchanged. As the marginal use values of buyers
falls when more is being possesses, by equating price with MUV buyers
can maximize their gains. On the other hand, since the marginal use
values of the previous units sold are lower than that of the last unit
sold, by equating price with MUV sellers can also maximize their gains.
Hence, by equating both parties’ MUV with price, equilibrium can be
attained. Under this condition both parties’ gains can be maximized,
any change in price will imply disequilibrium as gains will be reduced.
If market demand and supply do not intersect, this means that the
price will be either higher than or lower than the equilibrium price. If
the prevailing price is higher than the equilibrium price, the MUV of
sellers will be lower than the price. This means that sellers are willing
to sell more at higher price as further gains can be realized if more
exchange takes place. Thus, there is a tendency for price to fall until its
reaches the equilibrium level.
If the prevailing price is lower than the equilibrium price, the MUV of
buyers will be higher than the price. This means that buyers are willing
to buy more at lower price as further gains can be realized if more
exchange takes place. Thus, there is a tendency for price to raise until
its reaches the equilibrium level.
So, to conclude, with no transaction costs, only when the MUV of both
parties coincide will the market is in equilibrium. Such equilibrium will
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be attained when the market demand and supply intersect, which in

turn determines the equilibrium market price.
1999 Q. 3
Without the Law of Demand there will be no Theorem of
Exchange. Do you agree?
(7
marks)
I agree with the above statement. According to the Law of Demand, it
is asserted that with other things constant, whenever there is a fall in
price, or cost, of a good, there will be a rise in quantity demanded, vice
versa.
As for the Theorem of Exchange, it states that if private property rights

exist for two goods, Good X and Good Y and if transaction costs are
negligible, the proposition of maximization implies that trade will take
place and trade will continue so long as the marginal valuations of the
good differ between the buyer and seller. Thus, in equilibrium, the
situation will become P = MUVa = MUVb = MUVc. This means that the
last dollar spent on either good will derive the same value.
The validity of the Theorem of Exchange is based on the assumption of

diminishing marginal use valuation. With such assumption, an
individual will maximizes gains whenever P = MUVa = MUVb = MUVc.
Thus, as a maximizer, the lower the price, the greater the consumption
will be. This coincides with the assertion of the Law of Demand that the
lower the price, the greater the quantity demanded.
However, without the Law of Demand, i.e., if the demand curve is

upward sloping, this implies that the higher the price the more quantity
people would be willing to buy. If this is the case, people’s marginal use
valuation will be increasing instead of diminishing. In this case we will
not be able to obtain the market equilibrium condition of P = MUVa =
MUVb = MUVc. Hence, it is correct to say that without the Law of
Demand there will be no Theorem of Exchange.
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2002 Q. 4
DA and DB are the demand curve of a private good for individual
A and B respectively. The total quantity available, Q*, is owned
by individual B initially. Assume zero transaction costs.
(a) Draw on the above diagram the market demand curve.

Explain why it is a horizontal but not a vertical summation of
the two individual demand curves.
(3
marks)
A total demand curve shows the total quantity demanded at various
prices, it also reveals the highest value placed by users on each
corresponding unit. If the good concerned is a private good, i.e. a unit
used by one implies a unit less to another, consumption is exclusive by
nature. Hence, a unit of a private good can only be allocated to the
highest-valued user, not the others. Thus, the demand curve of a
private good shows the highest price commanded by each
corresponding unit, which can be done by summing up individual
demand horizontally.
However, if the good concerned is a public good, i.e. a good which can
be consumed concurrently by many users at the same time and the
consumption by one will not reduce the amount of consumption by
others, and then the total demand can be obtained by adding up
individual demand curves vertically. This is because the highest value
placed on a unit of a public good is equal to the summation of MUVs of
all users.
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(b) Label the market price P*. Explain why the distribution of
the good between A and B, determined by MUVa = MUVb,
satisfies the Pareto Condition. (7 marks)
By Pareto Condition, we mean a situation under which it is not possible

to reallocate resources to make one party better-off without making the
other party worse-off. Under the Pareto Condition, since resources are
allocated to the highest-valued users, any reallocation of resources
implies inefficiency. In the absence of transaction costs, as long as the
MUV of two parties on a good differs, exchange will take place until the
MUV of the exchanged parties coincide. At the market price P*, the
allocation of goods between A and B will become Qa and Qb as shown
on the diagram. From the above diagram, we can see that when MUVa
equals MUVb, the gains from exchange will be maximized. Hence, any
further exchange will lead to a fall in gains as it is impossible to make
one party better-off without making the other party worse-off. Thus, the
Pareto Condition can be satisfied when MUVa equals to MUVb which in
turn equals to price.
2004 Q. 3
‘If there is no production, an individual’s demand curve for a
certain good is also his supply curve for that good.’ Do you
agree? Explain. (8 marks)
An individual demand curve shows the quantities of a good which a

person is willing and able to buy at various prices in a period of time,
keeping other things constant. While an individual supply curve shows
the quantities of a good which a person is willing and able to sell at
various prices in a period of time, keeping other things constant.
If there is no production, it is only possible to have more of a good

through exchange. According to the Theorem of Exchange, if there is a
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difference in marginal use value between different individuals,

potential gains can be realized through exchange.
For two individuals, A and B, if MUVa is higher than that of MUVb, and if
the initial endowments are lower than B, he will be the buyer in this
case. Thus his MUV curve becomes his demand curve which shows the
maximum amount of other goods he is willing to give up to obtain an
additional unit of the good concerned.
For B, since his MUV is lower than that of A, assuming that his initial
endowments are higher than A, he will be the seller in this case. Thus
his MUV curve reveals the minimum amount of other goods he has to
receive in order to give up a unit of the good concerned. As on one
hand B’s MUV curve is his demand curve, it will also be treated as a
supply curve which represents the minimum receipt required for him to
give up that unit of the good.
As constrained maximizers, individual A will buy the good until MUV

equal to price while individual B will sell the good until MUV equal to
price, provided that transaction cost is negligible. So, in equilibrium, P
= MUVa = MUVb under single pricing arrangement. In this case both
consumer surplus and seller surplus can be maximized.
2005 Q. 5
What is Pareto Condition? Under what situation will this
condition not be met?
(8
marks)
The Pareto Condition refers to a situation under which it is no longer
possible to rearrange resource use to make one individual gain without
another losing, or no longer possible to rearrange resource use to make
all individuals gain. This condition defines economic efficiency in a
society. Under the postulate of individual constrained maximization, by
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definition, the Pareto Condition is always achieved if all constraints are

taken into consideration. This is because if the condition is violated, all
individuals may gain with no one losing by rearranging resource use,
not to do so imply the postulate of constrained maximization does not
hold.
However, if some constraints are omitted in the analysis, the Pareto

Condition may not be met. In a buffet dinner where a customer
consumes food to the point that his marginal use value is below
marginal cost, the Pareto Condition is violated, but this is only because
we have ignored the cost of monitoring how much food the customer
could take in a buffet dinner.
2006 Q. 5
What is the Pareto Condition? Illustrate and explain why this
condition is not satisfied in buffet dinners.
(8 marks)
The Pareto Condition is said to be satisfied when it is no longer possible

to reshuffle resources to make one individual gain at the loss of
another, or impossible to make all individuals gain. Since each and
every individual is postulated to maximize subject to constraints, the
Pareto Condition will always be satisfied if all relevant constraints are
specified. However, in a buffet dinner when a consumer eats until his
marginal use value reaches zero, lower than the marginal cost of
producing food, we have an inefficient situation – the Pareto Condition
is not met – because we have ignored the costs of monitoring how
much a diner may eat.
- END -
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Unit 5 – The Theory of Cost
1. The cost of any event is the
A. highest value one is willing to pay to achieve that event.

B. highest value option necessarily forsaken to achieve that event.
C. suffering which one must incur to achieve that event.
D. present value of income generated by the event. (85-08)
2. The short-run supply curve of an industry is obtained by adding the marginal

cost curves of the individual firms concerned. This requires that
A. factor price are constant.

B. the marginal cost curves of individual firms are identical.
C. the firms make no profit.
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D. the average cost curves of individual firms are identical. (85-

20)
3. Which of the following statements about cost is FALSE?
A. Cost is the highest-valued opportunity forgone.

B. Cost is a forward-looking concept because it is based on anticipations.
C. When there is a choice, there may be no cost.
D. Sunk cost is irrelevant to choice. (86-20)
4. Constant returns to scale means
A. when all factors of production are increased, output will also increase.
B. when all factors of production are increases, output will remain constant.
C. when all factors of production are increased by the same percentage, output
will increase by the same percentage.
D. when some factors of production are increased and others held constant,
output will increase at a constant rate.
(87-21)
5. Which of the following statements about cost is INCORRECT?
A. Haste does not make waste; haste makes a highest cost.

B. The more the methods of production to choose from, the lower tends to be
the unit cost.
C. The highest the interest, the highest the cost.
D. The highest the market value of a good, the highest will be its cost of
production. (88-08)
6. Which of the following would raise the cost of owning a swimming pool?
A. Neighbourhood children discover the presence of the pool and often invite
themselves in for a swim and make a mess of the house.
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B. The pool water turns out to be very dirty because of the water supply, and no
one wants to swim in it.
C. Oil, which is expected to have a high value, is discovered underground
beneath the pool.
D. After the pool is built, the owner discovers that it could have been built with
much less material.
(89-
03)
7. Which of the following statements about cost is correct?
A. The longer I have been waiting line at the bus stop, the more costly it would
be for me to quit the line.
B. For the same price, a poor haircut costs more than a good haircut.
C. John does everything faster and better than Joe, so the cost for John to do
anything is lower than it is to Joe.
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)
A. Cost is the highest value that an individual is willing to pay.

B. Cost may be a flow or a stock concept.
C. Rent is a cost.
D. Cost does not exist without choice. (89-28)
10. Which of the following would raise the average cost of production?
(1) It is necessary to speed up the rate of production at the request of buyers.

(2) There is a rise in the property value of the factory building used for
production.
(3) The market interest rate is increased.
A. (1) and (2) only
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B. (1) and (3) only

C. (2) and (3) only
D. (1), (2) and (3) (90-08)
11. In the short run, assuming one fixed factor of production and one variable
production, then,
A. when the average product of the variable factor rises, the average variable
cost falls.
B. when the average product of the variable factor falls, the average cost rises.
C. when the marginal product of the variable factor rises, the marginal cost
rises.
D. when the total product of the variable factor rises, the total cost falls.
(90-13)
12. Consider two persons, X and Y, each of whom could produce two goods: fish
and rice. When we say Mr. X has an absolute advantage over Mr. Y in producing
fish, we mean
A. the marginal cost of producing fish is lower for Mr. X than for Mr. Y.
B. Mr. X’s maximum alternative sacrifice to produce one fish is less than that of
Mr. Y.
C. Mr. X’s. fish/rice output ratio is higher than that of Mr. Y.
D. by putting in the same amount of work, Mr. X could produce more fish than
Mr. Y. (91-20)
A. Cost changes if and when the highest-valued alternative changes.

B. When cost changes, the individual’s behaviour changes.
C. The cost of buying a car rises when the road conditions are such as to make
driving unpleasant.
D. The more methods of production there are to choose from, the lower the unit
cost of production tends to be. (91-27)
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14. If the fixed cost is positive and the average variable cost is constant, which of
the following statements is true?
A. The average total cost deceases with expansion in output.

B. The marginal cost is equal to the average total cost.
C. The firm’s average total cost is a straight line.
D. The average fixed cost is constant. (92-01)
15. The opportunity cost of Good X in terms of Good Y is
A. the amount of Good Y which has to be given up to obtain a unit of Good X.

B. the slope of the production possibility curve, with the amount of Good X on
the X-axis and the amount of Good Y on the Y-axis.
C. The price of Good X divided by the price of Good Y.
16. Which of the following statements about cost is true?
A. Cost changes if and when the highest-valued alternative changes.

B. When the highest-valued alternative changes, the individual’s demand also
changes.
C. The cost of buying a car rises when the road conditions are such as to make
driving unpleasant.
17. If the average variable costs are constant, the firm’s cost short run supply
curve is
A. a horizontal.
B. the rising portion of the marginal cost curve.
C. the rising portion of the average cost curve.
D. the rising portion of the marginal cost curve above the minimum point of the
average cost curve.
(93-
23)
18. Which of the following statements concerning the relationship among total
product (TP), average product (AP), and marginal product (MP) is NOT correct?
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A. AP continues to rise so long as TP is rising.

B. TP is at a maximum when MP is zero.
C. The slope of the TP curve is MP.
D. The MP curve cuts the AP curve at the maximum of the AP curve.
(94-28)
19. Which of the following statements is FALSE?
A. The slope of the total cost curve is marginal cost.

B. The slope of the total variable cost curve is marginal cost.
C. The slope of an all-or-nothing demand curve is marginal use value.
D. The slope of the budget line is relative price. (95-30)
20. Consider two individuals, A and B. Each could produce two commodities,
shoes can clothes. When we say A has a comparative advantage over B in
producing shoes, we mean the following EXCEPT:
A. The marginal cost of producing shoes is lower for A than for B.

B. A’s maximum alternative sacrifice to produce a pair of shoes is less than that
of B.
C. A’s shoes/clothes output ratio per unit of labour is higher than that of B.
D. Putting in the same amount of work, A could produce more shoes than B.
(96-27)
21. 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)
22. 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
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increase.
D. Output will increase at a decreasing rate, when all inputs increase at
declining proportions.
(97-
26)
23. Which of the following statements concerning the relationship among total
product, average product and marginal product is correct?
A. When marginal product reaches a maximum, marginal product equals

average product.
B. Average product will continue to increase as long as total product is
increasing.
C. Total product will continue to increase even when marginal product becomes
negative.
D. Marginal product is measured by the ratio of a change in output to a change
in input. (98-02)
24. 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.
25. The average cost of production will definitely decrease when the volume of
output _____ and the rate of output _____.
A. increase ... decrease

B. increase ... increase
C. decrease ... increase
D. decrease ... decrease (01-22)
26. Which of the following about costs is correct?
A. The marginal cost curve will cut the average cost curve at its lowest point
when the marginal cost is the lowest.
B. If fixed cost is not zero and marginal cost is constant, then the marginal cost
curve and the average cost curve are the same.
C. When the marginal cost is falling, the average cost may be rising.
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27. Which of the following statements about marginal product is correct?
A. When total product reaches a maximum, marginal product equals total

product.
B. When total product reaches a maximum, marginal product equals average
product.
C. When average product reaches a maximum, marginal product equals
average product.
D. When average product reaches a maximum, marginal product equals total
product. (03-15)
28. One important difference between the law of demand and the law of
diminishing marginal productivity lies in that
A. Whereas a product is consumable, a factor of production is never

consumable.
B. In principle quantity demanded is not observable but marginal product is
observable.
C. Quantity demanded may be flow or a stock while marginal productivity is
always a flow.
29. Which of the following statements concerning the relationship between
average cost and marginal cost is correct?
A. When marginal cost reaches its minimum, marginal cost equals average cost.
B. When marginal cost is rising, the average cost must be rising.
C. When average cost is falling, it must be higher than marginal cost.
D. A firm’s average cost cannot always equal its marginal cost.
(06-15)
30. When average product is rising, marginal product
A. may be rising or falling.

B. may be lower than the average product.
C. must be rising at a decreasing rate.
D. must be rising at an increasing rate. (07-12)
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31. 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 Theory of Cost

B A C C D C D B A D
A D C A D A A A C D
B A D C A D C B C A
B
The Theory of Cost
1986 Q. 2
Why is there no such thing as a free lunch? (8
marks)
In Economics, a good is ‘free’ only if its existence does not require the
use of scarce resources. This means that no cost is incurred for the
existence of a free good. Thus, as long as resources are being used in
the production of a good, it is no longer a ‘free’ good.
Therefore, it is true to say that there is no such thing as a free lunch.

Although the recipient may receive the lunch free of charge, i.e.
without paying any, the provision of the lunch still requires the use of
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scarce resources, e.g. labour and food. Hence, as long as the

opportunity cost is positive, a free lunch will not exist.
1987 Q. 2
‘Whenever there is no choice, there is no cost.’ Do you agree
with this statement? Why or why not?
(8 marks)
I agree with this statement. It is because in Economics, cost is being

defined as the ‘highest-valued option forgone.’ To decide whether cost
exist in an activity, we must first consider whether option exists for an
activity or not. As long as another option exists, one has to incur
sacrifice as his decision implies that he has to forgo the other option.
Hence, as long as more that one option exists, there is cost.
Hence, whenever there is no choice, this implies that there is no option

for an individual’s activity. Thus, he does not need to sacrifice anything
in performing his acts and so no cost is incurred.
1988 Q. 2
‘The maximum one is willing to pay is value; the maximum one
will have to sacrifice is cost.’ Why is the word maximum
associated with both value and cost? (8 marks)
For a maximizing individual, he will not pay more than he is willing to

pay for a good. Thus, his marginal valuation of a good determines the
maximum amount of other goods he is willing to pay in order to obtain
an additional unit of the good concerned. As long as his marginal
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valuation is higher than the actual amount paid, he will continue to buy
the good concerned. At the margin, he will pay the maximum of what
he is willing to pay; otherwise his behaviour would be inconsistent with
maximization. Hence, what he pays at the margin his marginal
valuation.
In deciding how to allocate one’s scarce resources, one has to incur

cost no matter what his decision will be. By cost, it is defined as the
‘highest-valued option forgone.’ Thus, whenever there is option, there
will be cost. However, since one’s resources can only be allocated to
one use at one time, though there may be many options available, the
cost of one’s activity is not equal to the sum of the options forgone.
Thus, in deciding the cost of one’s action, only the highest-valued
option forgone is considered as the cost of one’s action. This is because
only this option is relevant in one’s decision making process. Anything
less than this highest sacrifice is irrelevant for decision making as even
one does not choose the prevailing option, he will not choose an option
which is not the highest-valued one.
1988 Q. 5
Explain why the marginal cost curve always cuts the lowest
point of the average cost curve.
(8 marks)
It is because the slope of an average cost curve is affected by the

marginal cost of an additional unit produced. As long as marginal cost
of an additional unit is smaller than the average cost of the previous
units produced, the average cost will become lower when more units
are being produced. Hence, whenever marginal cost is falling, average
cost will be falling.
Moreover, even when marginal cost is rising, as long as it is lower than

the average cost of the previous units produced, average cost will still
be falling.
However, if the marginal cost is higher than the average cost of the
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previous units produced, the average cost will be pulled up whenever

more is being produced.
Hence, whenever marginal cost curve lies below average cost curve,
average cost curve is downward sloping. While whenever marginal cost
curve lies above average cost curve, average cost curve is upward
sloping. Thus, the marginal cost curve will only cut the average cost
curve at its lowest point.
1989 Q. 2
‘Cost will not be affected unless the highest-valued option is
affected.’ Do you agree? Use one example to illustrate your
view. (8 marks)
Yes, because cost is the highest-valued option forgone, so there is no

way cost will change if the value of this option remains unchanged.
For example, a hair cut poorer than anticipated only reduced its value,
but does not increase its cost. The cost of the hair cut rises if the time
involved in getting it done increases in value. Similarly, one who lives
in his own house and does not have to pay rent faces a rising cost of
housing if the rental value or the market value of his house increases.
Annual report: This was not a difficult question. Low-scorers were poor in their
elaboration of the empirical application of the cost concept. The majority of them simply
gave a definition of cost, but failed to relate the definition to the question.
1992 Q. 1
The cost of an action is defined as the highest-value option
necessarily forsaken. Why is the word ‘highest’ essential in
this definition? (12 marks)
In deciding how to allocate one’s scarce resources, one has to incur

cost no matter what his decision will be. By cost, it is defined as the
‘highest-valued option forgone.’ Thus, whenever there is option, there
will be cost. However, since one’s resources can only be allocated to
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one use at one time, though there may be many options available; the
cost of one’s activity is not equal to the sum of the options forgone.
Thus, in deciding the cost of one’s action, only the highest-valued

option forgone is considered as the cost of one’s action. This is because
only this option is relevant in one’s decision making process. Anything
less that this highest sacrifice is irrelevant for decision making as even
one does not choose the prevailing option, he will not choose an option
which is not the highest valued one.
Hence, the word ‘highest’ is essential in this definition. Without the

word ‘highest’, the cost of an action will be misinterpreted as the sum
of the options forgone and it will become totally ridiculous.
1994 Q. 2
Why is historical cost not cost at all? Under what situation will
an individual use historical cost data in decision making?
(8 marks)
By historical cost, we mean a cost which is incurred in a past decision.

Thus, it is only relevant in one’s past act. Since bygones are bygones, it
is no longer relevant in one’s current act. As the cost of one’s act is
only the highest-valued option currently forsaken, historical cost has
nothing to do with the available options and is therefore not relevant
for current decision making, thus it is not a cost at all.
However, in decision-making complicated by information cost, an

individual may rely on historical cost data as a measure of his option
alternative, although in so doing he may be misinformed and commit
errors.
‘Bygones are bygones and should have no influence in deciding what is currently the
most profitable thing to do.’
1999 Q. 2
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The cost of an event is the highest-valued option necessarily

forsaken.
Why
highest?
(6
marks)
With the presence of constraints, such as budget constraints, an
individual has to decide how to allocate his limited budget among
various options available. Since one can only allocate his resources to a
specific purpose at a time, once he makes a decision, he has to forgo
the opportunity of choosing others. However, among the options
forsaken, only the highest-valued option forsaken is the cost of his
decision. This is because among the options forsaken, only the highest-
valued option forsaken is relevant to his choice.
By comparing the value of his choice with the highest-valued
alternative, he can decide whether his choice is justified. Any options
generating valuation lower than the highest-valued alternative is
irrelevant to his choice. Thus, the cost of an event will change only
when there is a change in the highest-values alternative.
1999 Q. 4
The law of comparative advantage, it is said, explains why
people specialize in production. If we are all born with identical
genes so we all have equal advantages, will we still specialize
in production? (7 marks)
Yes. Specialization refers to the separation of production processes into

a number of sub-processes, each of which is performed by different
persons. This means each worker concentrates on a particular task.
Since they tend to specialize in what they can do better, such a
situation is also known as specialization.
To the producer, he adopts division of labour in the production

processes because such practice can raise the efficiency of production,
i.e. it can raise the level of output. This is because of the following
reasons:
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- Time is saved: When a production process is divided into a number

of sub-processes, the sub-processes will become simpler. In this
case, people can learn the job easily and become more skilful.
- Practice makes perfect: Since the workers do the jobs continuously, productivity can
also be improved and greater output results.
- Possibility of mechanization: Machines can be used when production is divided into

sub-processes. This results in greater output as mass production can be carried out.
- Economy of time: As each worker specializes in only one job, time can be saved as
the workers do not need to change their jobs and more time can be used in production.
- Economy of capital: As each worker needs only one tool instead of the full set of
tools, capital can be saved. Moreover, specialization also enables the tools to be fully
utilized.
- Choose the best person to do the job: Since workers are usually assigned to the jobs
suit them most, choosing the best person to particular jobs result in higher
productivity.
- More leisure: Increased productivity of workers and the substitution of labour by

machines mean that people can work a shorter time to earn a given income. Hence,
they can have more leisure if they like. Since leisure also yields utility, the standard of
living of workers would rise.
2000 Q. 4
The completion of a construction project is postponed. Explain
whether each of the following is a cost to the developer:
(a) money already spent on the project plus interest

(4 marks)
As cost is defined as the highest-valued option forgone, it exists only if

option exists. As money already spent is a cost incurred in the past and
the interest that could have been derived from it cannot be recovered,
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they are only historical costs which have nothing to do with current
behaviour. Thus such an amount plus interest is not a cost to the
developer.
‘Bygones are bygones and should have no influence in deciding what is currently the
most profitable thing to do.’
(b) the developer’s delayed receipt of the remaining portion of

income from the project
(4 marks)
Since cost only concerns with the current sacrifice, the developer’s
delayed receipt of the remaining portion of income due to the
postponed completion of the project is a cost to the developer. It is
because the receipt can be used in other aspects such as earning
interests from bank or investing in other projects. This implies that
there is option forgone for not receiving the income on time. Thus the
delayed receipt is a cost to the developer as there is option forgone.
2001 Q. 2
What is cost? If someone purchased a flat (an apartment) and
after a year the market value of that flat fell by half, does this
means that the cost of living in that flat has gone up, gone
down, or remained the same? (7 marks)
Cost is the defined as the highest-valued option forgone for an action.

Cost exists whenever options exist for an action. As there are many
options available but one can only be choose one option at a time, only
the highest-valued option forgone will be his cost of choosing the
option. Once an option is chosen, the cost of choosing such option will
change only if there is a change in the value of the highest-valued
option forgone.
If someone lives in his own flat, his cost of living in that flat will be
equal to the implied rental value of the flat. It is because he can
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receive rental income for letting the flat to others. If the value of that
flat fell by half, the rental value for letting the flat will also fall by half.
Hence, his cost of living in that flat has gone down.
2001 Q. 3
If the market price of a haircut charged by barber shops rises
during holidays because customers have more free time to get
their hair cut, does this mean that to customers haircuts are
really more expensive during holidays because of an increase
in market demand? (7 marks)
The cost of time falls for customers taking haircut during holidays. The
price of a haircut is the price charged by a barber plus the time cost, so
during holidays the full price of a haircut falls.
2004 Q. 6
During the SARS period, restaurant business dropped sharply.
In Hong Kong, many restaurants closed down, and a few closed
temporarily for renovation. In Shanghai, many restaurants
closed temporarily for renovation, and a few closed down.
(a) Why would restaurants choose to close temporarily for

renovation during the SARS period?
(5 marks)
Because of the sharp decline in restaurant business at that time, the
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cost of renovation declined.
(b) Why was the pattern of restaurants closing down and

closing temporarily for renovation in Hong Kong different
from Shanghai during the SARS period?
(5 marks)
In Hong Kong many restaurants were on the verge of closing down and
the future looks bleak, so SARS pushed them over the cliff. In Shanghai
the outlook of restaurant business remains good, and with lower
opportunity cost during SARS, they go renovation.
2005 Q. 8
It has been said that if a train going from City A to City B has
one seat vacant; the marginal cost of serving one extra
traveler is zero or nearly zero. According to the marginal-cost
pricing, economic efficiency will be achieved if price is set to
equal marginal cost. Therefore on the grounds of efficiency the
train ticket price should be set at zero.
(a) In a restaurant with one table vacant, the marginal cost of

serving that table is lower than the average cost. Assume
customers at each and every table order the same food.
Does marginal cost pricing based on table count imply that
the restaurant will lose money? If so, under what pricing
arrangement will marginal cost pricing, again based on the
table count, make money for this restaurant?
(5 marks)
Since by table count the marginal cost of serving an extra table is
below the average cost, pricing according to marginal table cost will
result in the restaurant losing money. Therefore, even under
competition, a restaurant owner will not assess marginal cost by the
table count. If a restaurant must use the table count and must use
marginal cost pricing, price discrimination is essential to stay afloat in
business.
(b) In a cross-harbour tunnel with no traffic congestion, the

marginal cost of serving an extra car is close to zero. The
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Western Harbour Crossing almost never experiences traffic

congestion. Is the $40 fee per car the tunnel company
charges the marginal cost, the average cost, or none of
these? Explain. (6 marks)
The best answer is that the $40 fee per car is the average cost. The
average cost per car of operating the tunnel may indeed be very low,
so the $40 fee per car includes the rent that tunnel owner is entitled to
receive. The cost incurred in constructing the tunnel is a historical cost
and no longer relevant. Whatever fee the tunnel owner charges, the
part in excess of the average cost of operation, is, by definition, a rent
collected, and this rent is a part of cost.
(c) The government is considering reducing the class size of

primary schools from 40 to 25 students. If this policy is
carried out, will the average cost per student increase? Will
the marginal cost per student increase? Explain. (4
marks)
If the class size of elementary schools is reduced from 40 to 25, the

average cost per student will increase because teaching services per
class tend to remain roughly the same. However, so long as the
capacity of taking in one more students into a classroom remains the
same before and after the change in class size, the marginal cost per
student remains the same.
- END -
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Unit 6 – Price-taking Model, Price-searching Model and Price

Discrimination
(i) Price-taking Model
1. When economists say that a competitive firm faces a perfectly elastic demand
curve, they mean,
A. the firm will sell an infinite quantity of output at the going price.
B. the law of demand is rejected.
C. all variations in output the firm can make will leave the price unaffected.
D. the good is not a necessity because the quantity demanded will be zero at a
higher price. (87-05)
2. The long-run equilibrium of a price-takers’ market is characterized by
A. no price fluctuation from time to time.

B. a lower price at the margin than under a price-searchers’ market, irrespective
of the pricing structure.
C. no entry of new firms into the market.
3. In a price-takers’ market,
A. a firm will produce at an output level when its marginal revenue is greater
than its price.
B. a firm faces a perfectly elastic demand curve at a price determined in the
market.
C. the wealth maximization output for a firm occurs when the total revenue and
the total cost curves intersect.
D. all firms are selling homogeneous products. (91-06)
4. The imposition of a lump-sum tax on each firm in a price-takers’ market will
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A. decrease the number of firms in the market.

B. increase the output of each firm that remains in the market.
C. increase the market price of the output.
5. If the average variable costs are constant, the firm’s cost short run supply
curve is
A. a horizontal.
B. the rising portion of the marginal cost curve.
C. the rising portion of the average cost curve.
D. the rising portion of the marginal cost curve above the minimum point of the
average cost curve.
(93-
23)
6. Under competitive market equilibrium, all firms will have the same
A. marginal cost of production.

B. total cost of production.
C. imputed rent.
D. level of output. (95-10)
7. When all markets are perfectly competitive, resource allocation is said to be

efficient because
A. the marginal use value equals the marginal rate of substitution.

B. the marginal use value equals the marginal cost of production.
C. the marginal use value for the last dollar spent on each good is equal for all
consumers.
D. the economy is producing on its production possibility frontier.
(95-14)
8. An increase in demand for a product in a price-takers’ market will lead to
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A. the expansion of production of existing firms.

B. an increase in the number of firms in the industry.
C. a higher market price in an increasing-cost industry.
9. The demand curve facing a price-taker is perfectly elastic. This implies that
A. the market price will not change.

B. the Law of Demand cannot be applied in the price-takers’ industry.
C. the market price will not decrease even when a seller increases his output.
10. For a constant-cost industry in a long-run competitive equilibrium, an increase

in the market demand for its product
A. increases only the quantity supplied.

B. increases only the market price.
C. increases both the market price and quantity supplied.
D. decreases the market price but increases the quantity supplied.
(99-13)
11. If the marginal cost curve of a firm is upward sloping, then under perfect
competition the long-run industry supply curve must be
A. upward sloping.
B. horizontal.
C. downward sloping.
12. A firm is said to be a price-taker if
A. it has the same cost curves as other competing firms.

B. it cannot alone decide on its output level.
C. it cannot ask a price higher than the market price and expect to survive.
D. it receives no rent. (04-12)
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13. In long run competitive equilibrium, each and every firm is an industry is
making no return over cost. When the market demand for the product of this
industry falls, some firms will go out of business. Which of the following is
correct?
A. The exit of firms is a random process.

B. Firms with higher average cost curves will exit earlier.
C. Firms that had been earning rents may remain in business.
D. New firms will exit earlier than old firms. (05-13)
14. In long run competitive equilibrium where not all firms are identical, none of
the firms in an industry will be earning anything above cost. This is because
A. some firms are earning rents, and rent is a part of cost.

B. some intramarginal firms are making profits.
C. the supply curve of the industry is horizontal.
15. Which of the following statements is correct?
A. A price taker stays in the market so long as price equals marginal cost.
B. A price taker may earn a positive rent.
C. A price searcher earns a monopoly rent as long as it produces at the inelastic region of the market
demand curve.
D. A price searcher tends to make more money than a price taker. (07-14)
MC Answers on Price-taking Model

C C B D A A B D C A
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A B D C A
Price-taking Model
1987 Q. 4
Under long-run competitive equilibrium, a marginal firm operates at a point when the
price of the product equals the average cost. Why does this firm stay in business?
(8 marks)
Under long-run competitive equilibrium, a marginal firm will produce a
level of output at which price (average revenue) equals average cost.
This implies that what the firm earns is just enough to cover the total
cost of operation.
Among the total cost, both explicit costs and implicit costs are
included. For explicit costs, they are costs paid by the entrepreneur to
factor owners who contribute their efforts to the firm. As for implicit
costs, they are the incomes earned by factors owned by the firm itself.
Since the entrepreneur performs the production himself, he forgoes the

opportunity to earn income by putting his factors to other uses. Thus
such sacrifice is also part of the cost to the firm. Hence, as long as the
firm can cover the total cost, this means that the entrepreneur can
earn an income which is equal to the highest amount he can earn in his
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highest-valued alternative use. Since he is just as well off in this

business as in his highest-valued alternative use, there is no incentive
for him and other self-owned factors of the firm to leave the business.
1991 Q. 8 (b)
Say whether the following is True, False or Uncertain. You must
explain your choice; otherwise you will receive no mark at all.
If at a prevailing equilibrium price every firm in a competitive

industry is earning zero profit, then a fall of this price means
that all firms will go out of business. (8 marks)
The answer may be FLASE.
It is because if the cost curves of the firms in a competitive industry are

not identical, some intra-marginal firms will be earning imputed rent.
This may be due to the fact that some entrepreneurs’ earnings in their
best alternative forgone are lower than the others. Thus, a fall in price
will first eliminate the marginal firms as they can only cover their costs
before. This will lead to a fall in supply but the intra-marginal firms
which had been earning imputed rents will survive and they only
experience a fall in imputed rents. They will stay in the business as
they cannot do better elsewhere.
Even if the cost curves are identical, only some firms will leave while
others will stay. Which firms will go out of business will be a random
selection. This is because when some firms disappear, the market
supply will fall. This will push the price up again and existing firms will
be able to cover their costs again.
Only if the cost curves of all firms are identical and their costs curves
are all run horizontal from the vertical axis before rising. In this case a
fall in this price will make all firms going out of business as they can
obtain the same earnings in other fields of production.
2001 Q. 9
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Hong Kong businessman Jimmy Lai operated adM@rt, which

sold and delivered goods to customers after they placed orders
by telephone or through the Internet. After experiencing heavy
losses, adM@rt tried to cut losses by reducing the level of
operation, and was faced with the following paradox: the total
loss roughly equaled the total revenue regardless of the level
of sales. What is paradoxical here is not than total loss
equaled total revenue, but the ratio of loss to revenue, i.e., the
loss ratio, remained roughly constant over a wide range of
sales volume: adM@rt lost $1.00 of revenue, and another
major similar operator in the United States lost 40 cents on the
dollar, also at varying levels of sales.
(a) Grouping together the goods adM@rt sold or treating them

as one good, draws its average and marginal cost curves,
and the demand curve and the marginal revenue curve
facing adM@rt to show the constant loss ratio as described.
(4 marks)
The simplest way is to draw a horizontal average (and marginal) cost

curve twice the height of a horizontal demand (average and marginal
revenue) curve. Of course, in all likelihood these curves will not remain
horizontal throughout, but for the relevant range they appear to be so.
To show a constant loss ratio, one curve need not be twice the height of
another (which happened to be Jimmy Lai’s case). If either the demand
curve or the average cost curve is not horizontal, the drawing a
constant loss ratio will be more complicated, with considerable
difficulty depicting a situation in the real world.
(b) Did adM@rt come closer to being a competitive firm than a

monopolistic firm? Why? What was the nature of the
products adM@rt was selling? (3 marks)
Closer to a competitive firm, as the case when the demand curve

facing the firm is roughly horizontal. The products adM@rt was selling
were popularly available in supermarkets and other stores.
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(c)In its range of sales volume, was adM@rt operating at

constant, increasing, or decreasing cost? Why?
(3 marks)
At the relevant range of sales, roughly constant cost. Given constant

cost and a roughly horizontal demand curve facing the firm, if the cost
curve lies higher, a constant loss ratio is implied.
2004 Q. 1
In a long-run competitive equilibrium no firms of an industry
will be earning anything above costs. Why should any of these
firms stay in business? (6 marks)
Cost is the highest-valued option forgone. Firms stay in business

because it is the best they can do, with their highest-valued options
equaling the incomes form the business they are already in.
- END -
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(ii) Price-searching Model
1. In a simple monopoly model, wealth maximization implies
A. average cost is at a minimum.
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B. marginal revenue is zero.

C. the marginal value of the good to consumers exceeds the marginal cost.
D. the monopolist earns a return on his capital at a rate higher than the rate of
interest. (86-17)
2. A firm is a price searcher if
A. the firm earns a profit.

B. it produces a level of output where price exceeds marginal cost.
C. the demand curve facing the firm is downward sloping.
D. there is actually only one firm selling a given product in the market.
(86-17)
3. A monopolist producing a level of output at MC = MR is said to be inefficient

because
A. the price of the output equals the marginal revenue.

B. the marginal use value of the output to consumers exceeds the marginal cost
of production.
C. the marginal use value of the output is not equal to the price of the output.
D. the average revenue exceeds the marginal revenue. (86-
28)
4. A price-taking firm differs from a price-searcher in that
A. the price-searcher tends to make a greater profit.

B. the price-taker’s marginal revenue curve lies below its average revenue
curve.
C. the demand curve facing the price-searcher is downward sloping.
D. the price-taking firm earns zero profit in the short-run. (87-
19)
5. A monopolist producing an output at which MC = MR is said to be inefficient to

society because
A. individuals capture more consumer’s surplus in a competitive market than in

a monopolistic market.
B. the maximum value of an additional unit of output to society is higher than
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the maximum sacrifice the society will have to make to produce that unit.
C. the monopolist tends to produce output of lower quality than a competitive
producer.
D. in restraining competition, idle or unemployed resources will occur.
(88-19)
6. A monopolist
A. earns a higher rate of profit than a competitive firm.

B. is always protected by government.
C. is a price searcher.
D. is necessarily an inefficient producer. (89-13)
7. The following diagram shows a rise in demand from D1 to D2 in a price-

searcher’s market. If the marginal cost is constant, then
A. the price will rise.

B. the price will fall.
C. the price will remain unchanged.
D. the price cannot be determined. (90-14)
8. If the marginal cost of production is zero, the producer of a good will
A. sell at the highest possible price.

B. produce the largest possible quantity.
C. sell at the price where the elasticity of demand equals one.
D. sell at the price where the elasticity of demand is greater than one.
(91-19)
9. When a monopolist charges a price at the inelastic range of the demand

schedule,
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A. his average revenue will be negative.

B. his marginal revenue will be negative.
C. his marginal revenue will be negative although his total revenue will be at a
maximum.
D. he can raise his total revenue by lowering his price. (92-
17)
10. Which of the following about a price-searcher is correct?
A. He chooses the price and quantity independently.

B. The demand curve facing him is downward sloping.
C. He always causes efficiency loss.
D. He sets the price as high as the market will bear. (93-27)
11. With zero marginal cost of production, a price searcher will charge a price
A. which corresponds to the mid-point of the market demand curve if that curve
is consistently convex to the origin.
B. which corresponds to the mid-point of the market demand curve if that curve
is a straight line.
C. on the inelastic range of the demand curve.
D. on the elastic range of the demand curve. (95-17)
12. A price searching monopolist producing output at which MC = MR is said to be

allocating resources inefficiently because:
A. The monopolist is not maximizing wealth.

B. The monopolist is not operating at the lowest point of the average cost curve.
C. At this level of output, the price is higher than marginal revenue.
D. At this level of output, the marginal use value of an additional unit of output
is greater than the marginal cost of producing it.
(96-20)
13. If the government imposes a lump-sum tax on a monopolists to extract its

monopoly rent,
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A. the monopolists will increase the price of its product to cover part of this tax.
B. the monopolist will reduce output.
C. the monopolist will increase output.
14. The Hong Kong and China Gas Company Limited is a monopolist of coal gas
supply in Hong Kong. Which of the following statements about the Company is
correct?
A. It faces no competition because it is the only supplier of coal gas.

B. It is always less efficient than price-taking firms.
C. It faces a downward sloping demand curve for its product.
D. Its product pricing should be regulated by the government.
(97-22)
15. Which of the following statements comparing a price-taking industry and a
price-searching industry is correct?
A. A price-searching industry is as efficient as a price-taking industry when all

relevant constraints are specified.
B. A price-searching industry will earn a higher rent than a price-taking industry.
C. Both industries will produce at the lowest point of the average cost curve.
D. Both industries will produce at an output level where the market demand is
elastic. (99-12)
16. A monopolist
A. always produces at an output level where the price is higher than the
marginal cost.
B. will produce more if it succeeds in extracting consumer surplus.
C. always enjoys a monopoly rent.
D. can stay in business more easily because it has less competition.
(02-13)
17. A monopolist practicing uniform pricing with rising marginal cost will produce
at an output level where
A. average cost equals marginal revenue.

B. total revenue is maximized.
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C. average revenue equals marginal cost.

18. If the marginal cost curve of a monopolist is upward sloping, its supply curve
will be
A. the marginal cost curve.

B. horizontal.
C. downward sloping.
19. Suppose the traffic flow inside a tunnel is so low that there is no congestion
and that the cost of serving an extra car is zero. If the total revenue of the
tunnel company is not maximized, at what price elasticity of demand is the
company charging the toll?
A. It may be less than 1.

B. It must be less than 1.
C. It may be equal to1.
D. It must be greater than 1. (03-09)
20. In production, resource allocation is said to be efficient when
A. the marginal cost of production equals the marginal use value.

B. the marginal use value equals the product price.
C. the marginal cost of production equals the marginal revenue.
D. the marginal cost of production equals the average cost of production.
(03-11)
21. When a monopolist charges a price at the elastic region of the demand curve.
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A. his marginal cost of production is positive.

B. his average cost of production must be rising.
C. his marginal revenue is negative.
D. his total revenue is at a maximum. (04-13)
22. Monopoly pricing is said to result in economic waste because
A. price as an average value is higher than the marginal cost production.

B. a monopolist is not producing at the lowest point of the average cost curve.
C. a monopolist earns a rent, whereas a competitor earns no rent.
D. the maximum amount a consumer is willing to pay for one more unit is
higher than the maximum value of the opportunity forgone required to
produce that unit. (05-14)
23. The following diagram shows a fall in demand from D1 to D2 in a price-

searcher’s market.
If the price-searcher produces only to maximize total revenue,
A. the price will rise.

B. the price will fall.
C. the price will rise or fall.
D. the price will remain unchanged. (06-17)
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24. Which of the following statements is correct?
A. A price taker stays in the market so long as price equals marginal cost.
B. A price taker may earn a positive rent.
C. A price searcher earns a monopoly rent as long as it produces at the inelastic region of the market
demand curve.
D. A price searcher tends to make more money than a price taker. (07-14)
25. A wealth-maximizing monopolist who produces a good at a fixed cost only and practises simple
monopoly pricing will
A. charge a price along the demand curve where the price elasticity of demand equals one.
B. produce at an output level where marginal revenue equals marginal use value.
C. charge a price where marginal cost and marginal revenue are not equal.
D. earn a rent equal to his total revenue. (07-16)
MC Answers on Price-searching Model

C C B C B C C C B B
B D D C A B D D A A
A D D B A
Price-searching Model
1986 Q. 4
‘From the social standpoint, a monopolist is a more efficient
producer if he extracts consumer surplus than if he does not
do so.’ Do you agree? Explain. (8 marks)
Yes. Extraction of consumer surplus, either through a lump-sum charge

or all-or-nothing arrangement or a sliding price scale (perfect price
discrimination), tends to bring the quantity of output close to P = MC,
when P is a marginal price or a measure of marginal use value.
1987 Q. 3
Is monopoly rent a profit? Why or why not? (8 marks)
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Monopoly rent is not a profit. Because of the monopoly right, the rent is anticipated and is
therefore discounted into the capital value of the monopoly.
(The above answer is enough to obtain full credit. However, a good answer will also
include the following: Rent as such becomes part of cost because the monopoly can be
sold as an option to capture the capital value.)
1990 Q. 5
What is competition? In what sense does competition exist
under a monopoly?
(10
marks)
Competition is defined as a situation under which two or more
individuals each wants more of the same economic good. As a society
consists of more than one individual, therefore competition always
exists in society.
A monopoly implies that a certain producer possesses a particular

right, e.g. patent, franchise, etc., which enables him to bar competition
in the production and sale of a certain good or service.
Although restrictions exist which enable a monopolist to be the sole

seller of a certain good with no close substitutes, competition still
exists. This may exist when his rivals try to produce substitutes of his
good. Besides, as resources are scarce, he has to compete with other
producers for scarce resources as well as the factors of production.
Moreover, other producers may also want to be the sole seller. Hence,
they may try their very best to obtain the monopoly right. Thus, a
monopolist has also to compete with others so as to preserve his
monopoly right.
1991 Q. 8 (a)
Say whether the following is True, False or Uncertain. You must
explain your choice; otherwise you will receive no mark at all.
If a monopolist produces a smaller quantity of a product than a
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competitive industry would, then by the same logic the

monopolist would tend to produce a product of lower quality.
(9 marks)
The answer is Uncertain.
It is because a monopolist may acquire his monopoly right through

competition. This implies that he succeeds in driving out his rivals. In
order to out-compete his rivals, he must possess some special skills or
talents which others fail to obtain. Such specialties must enable him to
produce better or higher quality goods. Thus, a monopolist should be a
producer of higher quality goods.
However, if the monopolist concerned is a government-protected

monopoly, it may produce lower quality product. This is because of the
lack of competition. As there is little or no competition, it has little
incentive to improve and even it suffers loss, the loss may be covered
by funds from other sources such as tax revenue. Thus, this type of
monopolist would tend to produce lower quality product.
1997 Q. 5
‘A monopolist is a necessarily an inefficient producer.’ Do you
agree? Explain.
(8
marks)
Monopolists pricing is said to be inefficient because the price of the
product is set above the marginal cost of product. On one hand, price is
measure of marginal value which represents the maximum a consumer
is willing to pay to acquire his last incremental unit.
On the other hand, marginal cost means the maximum value of the
opportunity forgone to produce the last incremental unit. If, at the
margin, what a consumer is willing to pay exceeds the cost of
production, then society will gain if the marginal unit is produced. Since
a monopolist stops production when marginal value is still greater than
marginal cost, this implies that some potential gains will not be
realized. Thus, inefficiency results.
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If this is the case, by practicing first-degree price discrimination, the

monopolist can produce at an output level where P = MC and allocative
efficiency can be achieved. Since we assume that the monopolist is a
wealth maximizer, by practicing perfect price discrimination he can
extract all the consumer surplus. This implies that he can increase his
wealth as well as attain allocative efficiency. If this is the case, there is
no doubt that he will choose such practice instead of uniform pricing.
However, since we assume that the monopolist is a wealth maximizer,

under the postulate of constrained maximization, he must try his very
best to maximize wealth subject to the constraints he faces. Hence, his
practice of uniform pricing must be consistent with such postulate.
Thus, if the practice of price discrimination incurs transaction costs, i.e.
costs incurred in knowing the MUV of various buyers, extra costs for
serving different buyers, and such costs exceed the extra gains (the
area of the deadweight loss), the monopolist will choose not to
discriminate. In this case allocative efficiency occurs in a simple
monopoly.
1997 Q. 9
In late 1995 and early 1996, there was a price-cutting war in the newspaper industry in
Hong Kong. This is a case of predatory price cutting, in which one (or more) seller is
trying to eliminate competition by selling a product below cost. Apparently, this type of
price-cutting behaviour is based on the belief that whoever has money to lose and to
outlast competitors will eventually win it all.
The predatory price cutting in the Hong Kong newspaper industry has failed. As a
matter of fact, in the United States and elsewhere, predatory price cutting in various
industries has seldom if ever succeeded.
Why does predatory price cutting seldom succeed? (You are asked to consider predatory
price cutting – i.e. selling below cost – in general, and to reason in light of different
aspect of competition.) (10 marks)
No one can keep on losing money indefinitely, and if through predatory price cutting one
manages to eliminate competitors, when he raises price again competitors – old or new –
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will again enter the market to compete with him.

It is generally the case that if a producer wants to eliminate competitors, it would be
cheaper for him to buy them out than to cut price below cost over a long period of time.
However, buying out existing major competitors tends to invite new competitors entering
the market.
Competition may take the form of improving product quality instead of cutting price
below cost. Of these two options quality improvement generally will emerge as the
winner, because for every dollar spent on improving quality the producer is getting
something worthwhile in return. Cutting price below cost, however, is all lost.
The general lesson is that unless a monopoly is protected by government or by trade

secrets or patent rights, competition will prevail in the market, even in the case of only
one surviving producer.
2000 Q. 9
At present, most doctors in Hong Kong provide consultation as
well as medicine to patients and charge each patient a lump-
sum payment. However, in many western countries, doctors
usually provide consultation alone; patients have to buy
medicines from pharmacists or drugstores. It has been
suggested that Hong Kong should follow the practice of these
western countries.
(a) If the western practice is adopted, will there be any

difference in a patient’s total medical expense on both
doctor’s consultation and medicine (12 marks)
(1) If doctors are price-takers?
There should not be any change in the doctor’s incomes, whether they
are price-takers or price-searchers.
If they are price-takers, they are earning a competitive return on their

medical service. And unless they have monopoly rights on the drugs,
they cannot earn more by selling the drugs themselves.
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(2) If doctors are price-searchers?
If they are price-searchers, they will be able to earn a monopoly rent on

the basis of their own medical service. The tying of a drug cannot
increase their monopoly rent.
If a monopoly drug is tied-in, the doctors will have to pay a monopoly
rent to the drug supplier. The total gross income of doctor will increase
in either case (price-takers and price-searchers), but their income, net
of the drug cost and the cost of selling drugs, will not increase.
(b) How would you explain why most doctors in Hong Kong
choose to provide both consultation and medicine?
If there are information problems in the medical profession, a doctor

may hide from his patients about their illness and about the nature of
the drugs prescribed, and then charge an amount in excess of the
previous sources of rent. This is the same as dishonest behaviour in
any industries.
Concealing information sometimes pays, as in all other markets. On the

other hand, a doctor may be truly honest and still want to sell the
drugs himself if his business adversely affected by the lack of
professional pharmacists in most drugstores, and if the selling of fake
drugs is not uncommon.
2002 Q. 6
The Western Harbour Tunnel cost $7 billion to build. After
several years of operation the traffic flow remains far less than
anticipated. Since the cost of serving an extra car is zero, in
order to maximize wealth, the tunnel company simply charges
a toll per car to maximize total revenue.
(a) At what price elasticity of demand will the tunnel company

set the toll? Greater than one, equal to one, or less than
one? How will your answer change if there is a constant
lump-sum cost to operate the tunnel as long as it is open for
business?
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(10
marks)
To maximize total revenue, the company should charge a price at
which marginal cost equals marginal revenue. Since the cost of serving
an extra car is zero, this means that the marginal cost of serving an
extra car is zero. Thus, to maximize wealth, the company should
charge a toll at which marginal revenue will also be maximized. To
reach maximum marginal revenue, the price elasticity of demand will
be equal to one at which marginal revenue equals to zero implying that
a change in price will lead to a no change in total revenue.
If there is a constant lump-sum cost to operate the tunnel as long as it

is open for business, the answer will not change. It is because the price
charged is based on the level where marginal cost equals marginal
revenue. As the constant lump-sum cost has no effect on marginal
cost, the marginal cost will still be zero and the price charged will stay
at the original level. The tunnel company will still maximize revenue
where the elasticity of demand equals one. It is because the lump-sum
cost will only increase the total cost (TC) and the average cost (AC) but
it does not lead to a change in marginal cost (MC). Since there is no
change in MC, the answer does not change. The price will be set at
where TR - TC = 0, or, at where MC = MR.
However, the company would close the tunnel if the lump-sum cost
(Tax on Monopoly Rent) were greater than the total revenue generated
by the toll.
2003 Q. 6
Show geometrically the standard case of simple monopoly
pricing resulting in the product price being higher than the
marginal cost of production and indicate which area represents
economic waste, explaining why it is economic waste. What is
wrong with this analysis? (10
marks)
Use the demand curve to represent the marginal-use-value curve and
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the marginal-cost curve to represent marginal social cost, and then

show the triangular deadweight loss area of economic waste.
The problem of this analysis is that both the monopolist and the
consumers will gain if the monopolist produces up to the point where
the marginal use value equals the marginal cost. The only reason that
this traditional measure of efficiency is not achieved is because
transaction costs are not zero. Yet in the traditional analysis transaction
costs are implicitly presumed to be zero.
2007 Q. 4
A monopolist is not necessarily inefficient. Defend the
monopolist on the grounds of efficiency in two ways.
(7 marks)
- END -
(iii) Price Discrimination
1. Price discrimination does NOT require
A. different markets or different customers to be separated.

B. the price elasticities of demand to be efficient.
C. the seller to be able to distinguish between rich and poor customers.
D. the good to be the same in all markets and produced at the same cost.
(85-21)
2. Which of the following is an example of price discrimination?
A. land with a view being more expansive than land without a view.
B. workers demanding higher wages on holidays.
C. a theatre charging lower prices for students.
D. life insurance companies charging higher premiums for older people.
(85-26)
3. Consumer surplus is extracted by a monopolistic seller when
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A. the seller increases the price of his product during a period of peak demand.
B. members of a club are required to pay membership fees before they are
allowed to dine in that club.
C. consumers are prohibited by the seller from buying more than a stipulated
quantity.
4. Third degree price discrimination is conducted by charging different prices to

different customers or to customers in different markets. One of the following is
NOT price discrimination of this type:
A. Taxi drivers in Guangzhou collect Renminbi (RMB) from local residents and
Foreign Exchange Certificates (FEC) from foreigners according to the same
nominal meter fee, although dollar for dollar FECs are worth more than RMB
in the black market.
B. Medical doctors charge different prices to different patients for the same
treatment.
C. Dollar for dollar, shops in Shenzhen charge a lower price if a customer pays
in FECs instead of RMB.
D. The MTR in Hong Kong charges students lower rates. (86-05)
5. Which one of the following statements about price discrimination is

INCORRECT?
A. Price discrimination allows a producer to capture some or all of the consumer

surplus.
B. A monopolist tends to produce a larger output when practicing price
discrimination than that when he is using only one price.
C. When the market demand facing monopolist lies entirely below the average
cost curve, price discrimination may provide sufficient revenue to cover the
cost of production.
D. Price discrimination can only occur if there is only one seller of the good.
(87-12)
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6. Which one of the following statements about monopoly is TRUE?
A. A monopolist may suffer losses.

B. Price discrimination is always less efficient than the use of one single price.
C. A monopolist always produces a smaller output than if the dame good is
produced under competition.
D. Monopoly will not exist without government protection. (87-
13)
7. Which of the following is NOT an example of price discrimination?
A. For the same treatments, doctors charge rich patients more than poor ones.
B. Given the same show, a theatre offers discounts for students.
C. Airlines offer discounts for group tickets.
D. In a private school, scholarships are given to students with better grades.
(88-25)
8. Which of the following statements about price discrimination is FALSE?
A. Perfect price discrimination is more efficient than simple monopoly pricing.

B. Price discrimination always results in a higher level of sales.
C. Price discrimination may occur in one single market if consumers have
different information costs.
D. Price discrimination tends to be more common in the sale of services than it
is in the sale of manufactured goods. (89-
25)
9. Which of the following is NOT a case of price discrimination?
A. Free tuition is awarded to some students in a private college.

B. A theatre offers lower ticket price to students than to non-students for the
same seats.
C. The price per orange is cheaper by the dozen.
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D. Tourists in China are charged more for train or airlines fares than local
people. (89-27)
10. A monopolist practicing perfect price discrimination is said to be economically

efficient because
A. output is increased and sold at a lower marginal price.

B. the consumer surplus is fully extracted.
C. the marginal use value of the output equals its marginal cost of production.
D. the average cost of production is at a minimum. (90-15)
A. A university charges over-aged students higher tuition fees.

B. An electric power company charges more for electricity used during peak
hours.
C. The Mass Transit Railway sells tickets to students at a discount.
D. A dentist charges different patients different fees for the same treatment.
(90-28)
A. The Mass Transit Railway in Hong Kong charges higher fares at peak hours.
B. For the same treatment, a doctor charges different fees for different patients.
C. A private university in the United States grants different amounts of
scholarship funds to different students.
D. The Kowloon-Canton Railway in Hong Kong charges lower fares for students
than for non-students. (91-28)
13. When a monopolist practices perfect price discrimination,
A. the marginal revenue curve will become a horizontal straight line.

B. the demand curve will become the marginal revenue curve.
C. the marginal revenue curve will shift to a position below the demand curve.
D. the marginal revenue curve and the average revenue curve will coincide.
(92-19)
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14. Which of the following statements about price discrimination is true?
A. Price discrimination is less efficient than simple monopoly pricing.

B. Price discrimination tends to result in an average price similar to that of
monopoly pricing.
C. Price discrimination will not occur in one single market, even if consumers
have different information costs.
15. Under monopoly pricing or price searching,
A. output will be higher if perfect price discrimination is adopted.

B. average cost is at a minimum.
C. the marginal value of the good to consumers always exceeds the marginal
cost of production.
D. the monopolist earns a return on his capital at a rate higher than the rate of
interest. (93-17)
16. A monopolist practicing perfect price discrimination is
A. inefficient because it extracts all consumer’s surplus.

B. efficient because the total cost of production is minimized.
C. inefficient because there exists a divergence between private and social
costs.
D. efficient because the marginal use value to the consumer is equal to the
marginal cost of production. (94-13)
17. Economic inefficiency
A. arises due to the inefficiency of the public sector.

B. arises due to the existence of monopolists.
C. does not exist if all constraints are fully specified.
D. exists even if all constraints are fully specified. (94-24)
18. In a market where information cost exists, which of the following is a

necessary condition for price discrimination to be practiced?
A. Reselling among buyers is prevented.
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B. Different buyers have different demand elasticities.

C. There is no competition among sellers.
A. The Mass Transit Railway Corporation charges lower fares for senior citizens.
B. The bank charges civil servants lower interest rates on mortgage loans.
C. The per-litre price of a larger carton of milk is lower than that of smaller one.
D. A can of soft drinks is sold at a higher price in a tutorial centre than in
grocery store.
(95-
20)
20. A simple means of price discrimination whereby the same type of product is
sold at different prices is to give the various products some such distinguishing
label as economy, standard and deluxe. This is particularly useful where the
items cater to different income classes. (Davidson and Ranlett, Microeconomic
Theory)
A. The argument is incorrect because income has nothing to do with demand.

B. The argument is correct. It is a case of third-degree price discrimination.
C. The argument is incorrect. The products are not the same, the market is not
separated, and a poor consumer may buy the deluxe model.
D. The argument is correct. A case in point is the various classes of seats
offered by airlines. (96-15)
21. Which of the following is NOT price discrimination?
A. Medical doctors charge different prices on different patients for the same
treatment.
B. In the United States, first-run movies are priced higher than when the same
movies are shown later as second runs.
C. A private college charges a $20 000 tuition fee, but gives almost ever
student a scholarship of varying amounts depending upon needs.
D. The Star Ferry in Hong Kong does not charge senior citizens any fares.
(96-30)
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A. Taxi drivers raise their fares during typhoons and rainstorms.

B. The charge per journey for passengers using MTR stored-value ticket is lower
than that for passengers using one-way tickets.
C. A supermarket offers a higher discount to customers who buy cup noodles in
bulk.
D. A physician charges wealthy patients more than poor patients for the same
medical treatment.
(97-23)
23. A price searcher practicing perfect price discrimination will produce at an

output level where
A. total revenue is maximized.

B. the average cost curve cuts the marginal cost curve.
C. the rate of return on investment is greater than the market interest rate.
D. marginal use value equals marginal cost. (98-21)
24. Consider a seller with a constant marginal cost of production as shown in the
following diagram. Under simple monopoly pricing, the equilibrium price and
quantity are P1 and Q1. If the seller adopts all-or-nothing pricing, the extra gain
to him is
A. area I
B. area III
C. area I and III
D. area I, II and III (98-23)
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A. Property agents charge the sellers of flats commission but do not charge the
buyers.
B. A fitness centre offers certain free services to members only.
C. The telephone company charges more for international direct dialing (IDD)
calls during rush hours.
D. The Mass Transit Railway Corporation charges students lower fares.
(99-15)
26. Under perfect price discrimination,
A. a price searchers’ marginal cost curve may be regarded as its supply curve.
B. the marginal use value is higher than the marginal cost.
C. the gain from trade is zero at the margin.
D. the marginal revenue curve lies below the marginal use value curve.
(99-15)
27. With sufficiently low transaction costs, a monopolist facing an upward sloping
marginal cost curve changes from simple monopoly pricing to perfect price
discrimination. For the last unit of output, the monopolist will produce at a
_____ marginal revenue and charge a _____ price.
A. higher ... higher

B. higher ... lower
C. lower ... higher
D. lower ... lower (00-13)
28. Which of the following constitutes price discrimination?
A. Some private doctors charge senior citizens less for the same treatment.
B. A bus company charges different prices for different bus routes to the same
destination.
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C. Newspapers are sold at a lower price in the evening than in the morning.
D. A restaurant charges higher prices for the same dishes during Chinese New
Year holidays.(02-21)
29. Which of the following constitutes price discrimination?
A. A hotel with vacant charges different customers different rates for a similar
or comparable room.
B. An airline charges first class seats a price four times the price of economy
class seats.
C. A restaurant customer pays a lower price per dish if he orders from a set
menu than ordering each dish separately.
D. A cup of coffee is produced at the same cost as a cup of tea, but the former
is often sold at a higher price than the latter.
(03-12)
30. Under perfect price discrimination,
A. the marginal revenue curve is the same as the demand curve.

B. the marginal use value equals the marginal cost for the last unit produced.
C. there is no consumer surplus.
31. Which of the following is definitely NOT perfect price discrimination?
A. A seller extracts consumer surplus fully from each and every customer.
B. A uniform all-or-nothing price is charged by a seller.
C. Many all-or-nothing prices are charged by a seller.
D. Different club members pay different membership fees. (04-
14)
32. Which of the following is NOT a case of price discrimination?
A. One may bargain with taxi drivers to get the taxi fare down.
B. Barber shops double the price of a haircut several days before the Chinese
New Year holiday.
C. Senior citizens pay half fares for subway transportation.
D. Some private universities in the United States give certain selected students
partial refunds on their tuition fees already paid.
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(04-15)
A. A restaurant sells a chicken for $1.00, which is below cost, and adds the cost
of the chicken to the prices of other dishes. Not all customers order chicken
in this restaurant.
B. All customers bargain when shopping in the same store, with the result that
different customers paying significantly different prices for the same item.
C. Movie theatres cut the ticket price to half on Tuesdays for the same movie.
D. Hotel room rates are higher during holiday seasons. (05-
11)
34. Which of the following pricing practices in movie theatres constitutes price
discrimination?
A. Tickets for the same movie are charged at different prices in different
theatres.
B. Students and senior citizens are charged lower ticket prices than regular
customers.
C. The ticket price for the first show on each day is lower than later shows.
35. All-or-nothing pricing may be regarded as a form of perfect price

discrimination if
A. the average costs for all customers are equal.

B. the marginal costs for all customers are equal.
C. different all-or-nothing prices are charged by a seller to different customers.
D. the marginal receipts from each and all customers are equal.
(06-19)
36. Consumer surplus is necessarily extracted when
A. the same price is charged to all customers.

B. different customers are charged different prices.
C. customers bargain at the same shop.
D. an entrance fee is required before buying. (07-15)
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MC Answers on Price Discrimination

C C B C D A C A C C
B A B D A D C D A C
B D D C D C B A A D
B B B B C B
Price Discrimination
1991 Q. 4
It is often said that monopoly pricing leads to inefficiency in
production. Why is this so? It is also argued that monopoly
pricing would be efficient if the cost of pricing (transacting) is
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zero. Do you agree? Explain. (10 marks)
Monopolists pricing is said to be inefficient because the price of the

product is set above the marginal cost of product. On one hand, price is
measure of marginal value which represents the maximum a consumer
is willing to pay to acquire his last incremental unit.
On the other hand, marginal cost means the maximum value of the
opportunity forgone to produce the last incremental unit. If, at the
margin, what a consumer is willing to pay exceeds the cost of
production, then society will gain if the marginal unit is produced. Since
a monopolist stops production when marginal value is still greater than
marginal cost, this implies that some potential gains will not be
realized. Thus, inefficiency results.
However, if transaction costs are zero, then in attempting to maximize

wealth by extracting consumers’ surplus, a monopolist will adopt a
scheme of perfect price discrimination. In this case the marginal value
will become the monopolist’s marginal revenue. Hence, in maximizing
his wealth by equating marginal revenue with marginal cost, marginal
value will also be equal to marginal cost. As a result, all potential gains
will be realized. Thus, a perfectly-price-discriminating monopolist is
also an efficient producer.
1992 Q. 4
State and explain the necessary conditions for price
discrimination. (12 marks)
Price discrimination is defined as the selling of homogeneous goods to

different buyers at different prices. In order to practise price
discrimination, sellers must be able to
1. Distinguish between buyers with different elasticities. By knowing

their elasticities, sellers can charge higher prices from buyers with
smaller elasticities, vice versa.
2. Distinguish between buyers with different information. Since their
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information costs are different, sellers can charge higher prices from
buyers with higher information costs, vice versa.
3. Prevent resale among buyers. If not, lower-prices buyers will sell the
goods to higher-priced buyers and price discrimination will become
non-existent.
When a product is produced at different marginal costs, or when it is

not exactly produced by the same producer, but sold at different
prices, it is not price discrimination.
1993 Q. 6
Many retail stores offer ‘quantity discounts’. For example,
large boxes of laundry detergent are frequently offered at
lower prices ounce than smaller boxes. It is sometimes argued
that this pricing arrangement is a form of price discrimination.
(a) What is price discrimination? (3

marks)
Price discrimination is defined as for the same good, different

customers are charged different prices, including different price options
or price structures, e.g. all-or-nothing pricing or packaging sales.
(b) Given an explanation of the above discount practice other

than price
discrimination. (7 marks)
The above discount practice is not price discrimination. It is because

the services concerned for large boxes and smaller boxes are different.
As the quantities are different, there will be differences in the cost of
exchange. Besides, the costs of packaging the goods are also different.
Moreover, the costs of keeping inventories also differ. Since the per unit
costs of the above processes are lower for large boxes, the lower price
offers are not price discrimination.
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1994 Q. 5
‘Even if the price elasticities of demand for a good in different
markets are the same, price discrimination may still emerge
because different customers have different information costs.’
Do you agree? Explain. (8 marks)
I agree with the statement. If different customers have different

information costs about prices, in the search for bargains or negotiation
for prices they may end up paying different prices for the same good.
For buyers with higher information costs, this implies that their time
costs are high in searching for better bargains. Hence, in order to save
their time for more valuable use, they will spend less time in finding for
better offers. Thus, they will tend to end up paying higher prices for the
same good.
For buyers with lower information costs, as their time does not much
valuable alternative uses, they can afford more search for cheaper
offers. Hence, they will tend to end up paying lower prices for the same
good. Moreover, there is no systematic relation established to date
which reveals that a buyer with higher information cost with have a
lower elasticity of demand.
1997 Q. 4
Do the following cases constitute price discrimination? Explain.
(a) Young drivers are charged more for motor insurance than
are older drivers.
(4
marks)
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This is not price discrimination because young people are usually more
risky drivers, thus there is a greater possibility of traffic accidents. As
more accidents means greater compensation made by the insurance
companies, this means that the insurance companies incur higher cost
of providing insurance to the young drivers.
(b) Standby fares of airlines are much lower than regular fares.
(4 marks)
This is not price discrimination because the airlines do not provide the
same services to these two groups of buyers. Those purchasing
standby ticket-holders need to go the airport and wait for their turns to
go on board. They spend more time to wait than those buying regular-
fare air tickets. Once the air tickets are booked, those paying regular
fares are sure of getting on board at the time of the flight. In other
words, those paying standby fares purchase service which is not as
good as those paying regular fares. Thus this is not price
discrimination.
1998 Q. 5
Book publishers in the United States often reprint textbooks
for the Asian market, selling them at significantly lower prices
in Asia than in the U.S. Suppose the U.S. and the Asian editions
are truly identical (although actually the Asian version uses
cheaper paper), this practice constitutes a clear case of price
discrimination of the third degree.
(a) What are the necessary conditions to practice this type of

price
discrimina
tion?
(6
marks)
- Monopoly Power: This means that he must face a downward
sloping demand curve and he has control over the supply.
- Resale is Impossible: Prevent resale among buyers. If not, lower-

priced buyers will sell the goods to higher-priced buyers and price
discrimination will become non-existent.
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- Different Elasticity of Demand: Distinguish between buyers with

different elasticities. By knowing their elasticities, sellers can
charge higher prices from buyers with smaller elasticities, vice
versa.
- Different Information Costs: Distinguish between buyers with

different information cost. Since their information costs are
different, sellers can charge higher prices from buyers with higher
information costs, vice versa.
When a product is produced at different marginal costs, or when it is

not exactly produced by the same producer, but sold at different
prices, it is not price discrimination.
(b) It has been pointed out (correctly) that the introduction of

the significantly cheaper Asian edition is due to the fact that
copyrights are more costly to enforce in Asia than in the
U.S. How will this higher cost of enforcing copyrights affect
the price elasticity of demand for textbooks? Explain.
(8 marks)
As the major determinant of elasticity of demand for textbooks with

copyrights is the number of close substitutes available, illegal printing
of a book or photocopying of a book produces close substitutes for the
textbook with copyright protection.
If the cost of enforcing copyrights is high, more illegal printing or

photocopying of a book will be done. In this case, as demand for
textbooks with copyrights will become more elastic as a result of more
close substitutes available.
Hence, in order to compete with illegal printing or photocopying with

U.S. books, low prices are set for Asian editions.
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1999 Q. 7
Airline companies often overbook flight – they accept more
reservations for a flight than there are available seats on the
airplane. This sometimes results in a situation where too many
passengers arrive at the airport for the same flight.
In the United States, if this occurs, the airline must make a

public announcement that the flight is overbooked and that it
is necessary for some passengers to volunteer to change their
reservations for later flights. Compensation will be given to
any volunteers – usually money or a coupon for an additional
free flight at a later date. If this does not result in enough
volunteers, then the airline should make another call for
willing passengers and announce an increase in the
compensation level.
A prominent politician criticized this scheme by saying, ‘It

hurts the interests of the low-income passengers because,
more often than not, wealthy passengers will get the seats.’
(a) Who will gain from this overbooking scheme, the low-
income or the wealthy passengers?
(5 marks)
The low-income passengers, because the wealthy passengers tend to

have a higher time cost and it would cost them more to wait. The low-
income passengers who prefer to wait for another flight are, in general,
compensated by a reward more than their waiting costs.
(b) Will the wealthy passengers tend to get seats more often
than the low-income passengers? Why or why not?
(7 marks)
Yes. Again because they have a higher time cost.
2000 Q. 7
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Reputable stores with big names (i.e. anchor stores) often pay
considerably lower rentals per square foot than other stores in
a large shopping mall. Is this price discrimination? Explain.
Does a lower rental from an anchor store reflect a lower
income received by the landlord? (10
marks)
This is not a case of price discrimination. In view of the landlord, the

cost per square foot incurred in renting to large shopping mall is lower.
For the same area, higher transaction costs will be incurred if renting to
other stores. Costs include advertising, bargaining as well as legal
charges. Thus, since landlord incurs lower transaction costs in renting
to reputable stores, charging them lower rent per square foot is not
price discrimination.
Charging lower rental from anchor stores does not reflect a lower rental
income received by landlord. Since the anchor stores will attract more
people to the shopping mall, the other non-anchor stores in the mall
will get more business. Thus, more people will be attracted to open
stores in the mall. As a result the landlord can ask for higher rental
from other non-anchor stores. This may result in a higher income
received by the landlord. As the higher rent for the non-anchor stores
will fully or even more than fully compensate the landlord’s reduction
in income as a result of charging a lower rent to the anchor store, a
lower rental from an anchor store does not reflect a lower income
received by the landlord.
2001 Q. 6
A first-class airplane ticket to the United States is selling at
four times the price of an economy-class ticket. Is this price
discrimination? Movie theatres in Hong Kong sell tickets at
much lower prices on Tuesday than on other weekdays. Is this
price discrimination? (6 marks)
A first-class plane seat has about three to four times the seating area
of that of the economy class, and with much better services. So this is
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not price discrimination.
The lower movie thicket prices on Tuesday are price discrimination,

because other comparable weekdays have higher prices. This should
have more to do with different income elasticities of demand than with
the price elasticities of demand.
An alternative answer is not price discrimination. The reason is that

customers are not separated, they can decide by themselves on which
day they would go to see movies and that everyone is charged the
same price on Tuesdays, and that tickets on different weekdays are
different goods, etc.
2002 Q. 5
Explain whether the following cases constitute price
discrimination.
(a) A restaurant offers a set meal that includes several dishes.

The price of the set meal is lower than the total amount a
customer has to pay if he orders the same dishes
separately. (3 marks)
Not price discrimination because all customers have the same options
of choosing a set meal or ordering the dishes separately, with each
customer facing the same prices.
Besides, the set meal may entail a quantity discount.
(b) A bank charges all its credit card holders an annual fee
except for those who are also its deposit account holders.
(5 marks)
Not price discrimination because the deposit account holders are

letting the bank make money in another way. The account holders may
be viewed as having paid the annual credit card fees in a disguised
form.
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2003 Q. 7
Airlines providing flights from Hong Kong to Shanghai and
from Shenzhen to Shanghai charges very different fares. The
places, services and distances are comparable, but fares are
different. However, there are fewer airlines providing flights
from Hong Kong to Shanghai than from Shenzhen to Shanghai.
(a) Flying from Hong Kong to Shanghai commands a much

higher airfare than from Shenzhen to Shanghai. Is this price
discrimination? If yes, why? If not, why is there a large price
discrepancy? (5 marks)
This is not price discrimination because the locations are not the same,
airplanes may not be the same and Hong Kong passengers are free to
choose their point of departure. The airfares departing from Hong Kong
are far higher because airlines serving flights from Hong Kong to
Shanghai are more monopolistic, and/ or because the costs of workers
serving airplanes are far higher in Hong Kong.
(b) An airline operating inside China may charge widely varying

fare for the same flight when the vacancy rate is high. Is this
price discrimination? Explain. If this is price discrimination,
does it have anything to do with different price elasticities of
demand? Explain. (5 marks)
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With vacancy the opportunity cost of serving an extra passenger is

lower; however, this opportunity cost may be the same for all
passengers. If at any moment in time the opportunity cost for serving
each and every passenger is the same, and if at the same moment in
time, as a result of vacancy different passengers are paying different
fares, the case is price discrimination. However, if with the same
vacancy each and every passenger is paying the same fares, but with
different vacancy rates passengers pays different fares, a higher fare
for lower vacancy, the case is not price discrimination - it is peak-load
pricing.
Price discrimination arising from vacancy, as the seller is eager to fill

the vacant seats by charging different prices for different customers,
may not entail different price elasticities of demand.
2005 Q. 3
What is perfect price discrimination? Could a wealth
maximizing monopolist produce up to the point where marginal
cost equals marginal use value if the consumer surplus of each
consume is not fully extracted? Explain. (8
marks)
Perfect price discrimination means each and every buyer’s consumer

surplus is fully extracted by the seller, and that each buyer pays a
different all-or-nothing price, or pays according to a different price
schedule.
There are several ways in practicing of perfect price discrimination.

First of all, when transaction costs are negligible, sellers may charge
customers along their MUV curves. Also, products can be sold on an all-
or-nothing pricing. In addition, monopolist may restrict the sale of a
good with a membership system. In other words, the collection of
membership can help extracting consumer surplus.
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Nevertheless, a wealth maximizing monopolist could produce to the point where marginal
cost equals marginal use value if the consumer surplus of each consumer is not fully
extracted.
Consider a case at which the monopolist set a new uniform price or the price is regulated
by the government to be not higher than P1, the horizontal price line is just the new MR
curve for the firm. As a wealth-maximizing firm, the monopolists will produce at a point
where MR equals the MC. At the last unit, the output level will satisfy the condition at
which MUV = MC. At a result, consumers’ surplus of each consumer is not fully
extracted.
2005 Q. 6
Huang Shan is a famous mountain attracting many visitors
every year. Nearly all visitors reach the peak of the mountain
by riding cable cars. During weekdays a fee of RMB 80 per
person is charged. During holidays the crowd is so large that it
usually takes several hours waiting in line before a visitor can
get on the cable car. Under the operation of the local
government, the following dual-fee scheme is adopted on
holidays. For visitors willing to pay 120 per person (RMB 40
more), they can go to a separate waiting room with a much
shorter queue. All visitors will reach the peak the same day,
but because the capacity of cable cars is fixed, those paying
the lower fee of RMB 80 will be pushed further back to wait
longer. There has been no riot. Assume all visitors knew about
this dual-fee and perfectly anticipated their waiting time in
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advance.
(a) Will the total revenue received by the operator be higher or

lower with the dual-fee scheme? Explain.
(4 marks)
The total revenue will be higher. Since (or on the assumption) the
marginal waiter pays RMB 80 and his waiting time is unchanged, the
total number of visitors also remains unchanged. The total revenue
rises because some intramarginal waiters pay the higher fee of RMB
120.
(c) Is the dual-fee scheme a case of price discrimination?

Explain. (3 marks)
The dual-fee scheme is not a case of price discrimination because with

different waiting times the products are not the same.
2006 Q. 6
In a store where customers bargain for lower prices, some
customers end up paying higher prices than others for the
same goods. Is this price discrimination? If not, why not? If
yes, does this reflect different price elasticities of demand? If
it does not reflect different price elasticities of demand, what
explains why different customers pay different prices?
(10 marks)
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It is price discrimination if the hours of operation are equally busy when

the same goods are sold. The price elasticities of demand may or may
not be the same among customers, and the ones paying higher prices
may not be the ones who have lower price elasticities of demand. This
price discrimination occurs because information costs, or bargaining
abilities, differ among different customers, with those having higher
information costs or higher search costs tend to pay higher prices.
2007 Q. 5
‘Price discrimination is the result of different price elasticities
of demand in different market.’ What does this mean? Offer
another reason for price discrimination. (6 marks)
- END -
Unit 7 – Factor Income Determination
(i) The Determination of Wage
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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.
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,
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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.
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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.
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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
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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.
22. Assume that leisure is a normal good. Which of the following is implied by an
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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
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)
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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.
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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.
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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
37. The factor demand curve of a price-taking firm is
A. horizontal.
B. downward sloping.
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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)
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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
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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
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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.
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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)
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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
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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
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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.
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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 -
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(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
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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.
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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
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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
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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)
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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.
- END -
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(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)
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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.
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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)
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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
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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
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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
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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.
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.
- END -
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(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.
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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.
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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)
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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)
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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,
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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.
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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.
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(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.
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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)
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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
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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)
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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.
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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.
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.
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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
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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
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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)
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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
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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
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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
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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.
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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
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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
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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
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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.
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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.
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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)
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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?
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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.
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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.
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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.
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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
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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
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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.
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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
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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.
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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
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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)
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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
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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)
- END -
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Unit 8 – The Nature of the Firm
1. The presence of transaction costs implies
A. the price mechanism is always the most efficient allocative device.

B. the firm will emerge to organize production.
C. the product market and the factor market are not separable.
D. some resources will be misallocated. (90-10)
2. A communist state may be regarded as a super firm because
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A. the use of resources is directed by central authorities, not by market prices.

B. its productivity is low compared to that of a capitalist economy.
C. private property rights do not exist.
D. the market there are imperfect. (91-05)
3. Which of the following statements about firm is INCORRECT?
A. Firms exist when more than one factor input is required to produce a given
good.
B. Firms emerge to reduce the number of market transactions.
C. A firm ceases to expand when the cost of managerial coordination outweighs
that of market coordination.
D. Within a firm, the determination of the highest-valued uses of factors is less
dependent on
pricing. (91-30)
4. Which of the following statements about firm is FALSE?
A. The choice of using the market or using the firm will be indeterminate when
transaction costs are zero.
B. A socialist state is a firm.
C. Whenever a contract exists, a firm exists.
D. When a firm emerges, productive activities are no longer directly directed by
market prices.
(92-
30)
5. A communist state resembles a firm in that
A. both are directed by central planning instead of by market prices in allocating

resources.
B. both entail lower transaction costs than the market.
C. both have higher productivity than the market.
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D. both are governed by a dictatorship. (94-11)
6. Firms emerge to co-ordinate production because
A. they reduce transaction costs.

B. only firms have the clear objective of maximizing wealth.
C. team production increases total output.
D. they can hire managers to monitor production. (94-16)
7. In a world with zero transaction costs,
A. there would not be any firm.

B. there would not be any middleman.
C. there would not be any market.
8. Firms emerge because
A. people tend to shirk their duties in team work.

B. output levels are usually higher in team work.
C. it is more costly to use the price mechanism to coordinate economic
activities.
D. entrepreneurs have a comparative advantage in bearing risk and
coordinating the factors of production.
(95-15)
9. A firm exists when
A. teachers’ salaries are paid by the month in a private school.

B. a barber cuts hair of customers in a street corner.
C. Mrs. Chan employers a private tutor for her daughter and pays for the tutor’s
service.
10. The existence of transaction costs of discovering prices implies that
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A. resources are allocated inefficiently.

B. firms may emerge to organize production.
C. the choice between the market and the firm will be indeterminate.
D. it will be more costly to coordinate production by the price mechanism than
by a command system. (98-17)
11. Which of the following statements about a firm is correct?
A. Input owners are not paid by directly measuring their contributions.

B. Input owners and consumers do not trade with one another.
C. The existence of an entrepreneur inside a firm implies a separation of the
product market from the factor market.
12. A shoe-shine boy working for himself received a payment of $20 for shining a
pair of shoes. In this case,
A. the $20 is paid in the product market but not in the factor market.
B. the $20 is paid in the factor market but not in the product market.
C. the $20 is neither paid in the factor market nor in the product market.
D. the product market and the factor market are not separable.
(99-18)
13. Inside a firm, a manager directs the workers because
A. it is too costly to determine a price for every activity performed.

B. there are more than one type of workers.
C. the manager has a higher productivity than the workers.
D. the manager alone can determine the wage rates of the workers.
(99-25)
14. If all costs of information are zero,
A. there will be no searching in the market.

B. the same product will be sold at the same price everywhere.
C. the number of products sold in the market will be reduced.
D. there will be more firms in society. (01-12)
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15. A firm exists
A. when there is a visible hand directing resource use.

B. when the wage paid to a worker does not directly measure his output.
C. when a dictator controls the entire economy.
D. All of the above may be correct. (01-21)
16. In the absence of transaction costs,
A. there will be no firm.

B. there will be no exchange.
C. there will be no society.
D. there will be no specialization. (02-16)
17. How does a firm differ from a market?
A. there is an entrepreneur to direct production in a firm but not in a market.

B. the activities performed by input owners in a firm are more standardized than
those in a market.
C. there is no division of labour in a firm but not in a market.
D. input owners in a firm are paid according to their contributions but not in a
market. (02-25)
18. A firm exists because
A. it serves the function of a middleman.

B. it is too costly to use the price mechanism to direct resource use.
C. a business license is required by the government.
D. there is no market. (03-16)
19. A self-employed beauty specialist is paid $1800 for a package of her skin care
service. In this case,
A. economic efficiency is not attained because the service is not priced by

separate items.
B. the product market and factor market are not separable.
C. only the product market exists.
D. only the factor market exists. (03-18)
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A. transaction costs may be positive when there is imperfect information.

B. there is no economic institution.
C. economic analysis of the individual’s behaviour is useless.
D. there is no competition and therefore no scarcity. (03-20)
21. Which of the following statements about a firm is correct?
A. A firm’s size is determined by the number of contracts it holds.

B. A firm must have a visible hand directing resource use.
C. Pricing is not used within a firm.
D. There is no market within a firm. (04-18)
22. If all markets operate as smoothly as can be imagined,
A. there will be no firms.

B. there will be no monopoly.
C. there must be regulations directing the markets.
D. there must be good managers. (04-19)
23. A government
A. may be viewed as a firm.

B. is a legal entity that operated under a constitution.
C. is always established by the use of threat of force.
24. Which of the following descriptions about a firm and a market is correct?
A. If there are no transaction costs, there are only markets and no firms.
B. If there are transaction costs, there must be firms but not necessarily a
market.
C. If the transaction cost of determining prices for production contributions are
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high enough, a firm will emerge.

D. If transaction costs are very high, there will be neither firms nor markets.
(05-18)
25. Which of the following constitutes an institution or an organization?
A. a firm.
B. a market.
C. a government.
26. Which of the following statements about a firm and a market is correct?
A. Factors of production are transacted in a firm but not in a market.

B. Input owners are paid by measuring their contributions in both a firm and a
market.
C. Resource use is directed by visible hands in a firm and by price signals in a
market.
D. The choice between a firm and a market is a random choice.
(06-22)
27. A government may be regarded as a firm because
A. it always reduces transaction costs.

B. it direct activities through visible hands.
C. it provides services to citizens.
D. it separated consumers from input owners. (06-27)
28. Firms emerge because
A. production decisions are not made by the market.

B. information about production is costly.
C. it is costly to measure each employee’s contributions to a product.
D. supervision is required as employees tend to shirk. (07-21)
29. A private piano teacher is paid by the hour. Which of the following is the best description of the
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situation?
A. A product market does not exist.

B. A factor market does not exist.
C. The product market and factor market are not separable.
D. A firm supersedes as employees tend to shirk. (07-21)
30. Standard textbooks assume that the coordination of economic activities in the market involves no
transaction costs. Such an assumption
A. is appropriate because price signals transmit information without cost.

B. explains why it is difficult to identify a firm.
C. contradicts the existence of markets because without transaction costs markets will not exist.
D. explains why market economies are always wealthier than planned economies. (07-23)
MC Answers on The Nature of the Firm

B A A C A A D C A D
D D A A D A A B B B
B A A C D C B C C C
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(ii) Contractual Arrangements
1. In a certain garment factory, workers are paid by piece rates while the foreman
is paid a salary. This is because
A. for different performances, there are different costs associated with

monitoring inputs and outputs.
B. garment workers have a greater tendency to shirk working than workers in
other industries.
C. a higher-ranking post is typically paid by time rates.
2. When piece rates instead of time rates are paid to workers, which of the
following will be FALSE?
A. The factor market replaces the product market.

B. The cost of checking idleness is lower with piece rates than with time rates.
C. The cost of quality control is higher with piece rates than with time rates.
D. Worker on piece rates tend to use their assigned machinery more intensively.
(91-30)
3. Which of the following is NOT a means to reduce the cost of monitoring the
quality of performance?
A. gratuities paid to hairdressers at the discretion of customers.

B. bonuses paid to managers at the discretion of business owners.
C. a compulsory 10% service charge kept by a restaurant owner.
D. a profit-sharing scheme for workers in a factory. (95-28)
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4. Drivers of franchised (green) mini-buses are employed by mini-bus companies

and are paid at time rate. However, taxi-drivers pay a fixed rent to taxi
companies and take the residual income. There is such a difference because
A. the cost of pricing of mini-bus driving services is lower.

B. it is less costly for the government to contract with the mini-bus companies
than with mini-bus drivers.
C. the cost of monitoring mini-bus drivers is lower as the buses have fixed
schedules and routes.
D. it is costly to count the number of passengers taking mini-buses.
(96-17)
5. A firm may change its system of payment to labour inputs from piece rate to
time rate when
A. there is an increase in the cost of measuring inputs.

B. the output becomes more standardized.
C. the employer is unwilling to bear risks.
D. the quality of the output varies a lot. (97-10)
6. Inside a firm, paying workers by the hour is chosen because
A. workers are not honest.

B. workers have different levels of productivity.
C. the activities performed by workers are not easily standardized.
D. the monitoring cost is low. (00-16)
7. When a firm chooses to pay labour by time rate instead of piece rate, it may be
because
A. workers are lazy if not supervised.

B. there is a large variation in the types of work performed by the same worker.
C. the workers refuse to work on a piece-rate basis.
D. the volume of output is so large that it is too costly to count the output by
the piece rate. (03-23)
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8. In Hong Kong, singers singing long-term contracts with entertainment

companies tend to share their incomes with the companies instead of receiving
fixed salaries. Which of the following is correct?
A. The money invested by the entertainment companies to promote the singers

generally has no effect on the incomes generated by the signers.
B. If the incomes generated by the singers are always certain, then it makes no
difference whether they are paid by sharing or by fixed salaried.
C. The choice of contracts will not affect the singers’ performance.
9. Some tourist guides receive zero income from the travel agents they work for. This implies that
A. The tourist guides offer services free of charge.

B. The tourist guides receive zero rent.
C. The travel agents exploit the tourist guides.
D. The tourist guides receive commissions from shops and gratuities from tourists. (07-20)
MC Answers on Contractual Arrangements

B A C C D C B B D
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The Nature of the Firm
1986 Q. 6
‘Whenever there is an employee, there is a firm.’ Do you agree? Explain. (8 marks)
When production is conducted through an employer who employs workers to work for
him, the customers do not pay the workers directly. Instead they are paid by the employer
who arbitrarily sets the wages. In this case the workers are therefore directed by the
employer and not by direct price signals. Hence, we can say that the workers are working
in a firm. Thus, whenever there is an employee, there is a firm.
However, even when customers do not pay the workers or the resource owners who
produce the goods directly, an employer may not be present. This can be explained by the
various forms of contractual arrangements such as share contract or in various forms of
subcontracting. In this case their payments are still directed by price signals. Thus,
whenever there is an employee, firm may not exist.
1988 Q. 9
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Wage and workers may be paid by the hour, by piece rates, by

gratuities (tips), or by still other forms.
(a) Of workers are not monitored or supervised at all, how they

behave under the hourly-rate system as against the piece-
rate system? (6 marks)
If paid by the hour, a worker tends to be ‘lazy’ or to reduce his working

intensity in order to have more leisurely working hours. If paid by
piece-rate, he tends to increase the output units buy pay less attention
to the product quality. In other words, in either system a worker to
behave in a way to maximize the ‘property’ for which he is getting
paid.
(b) What do you think are the general characteristics of work

that determine the choice of piece-rate versus hourly-rates?
Explain. (6 marks)
Products, or components of a product, which tend to repeat with

regularity and which can be standardized are more likely to go on a
piece-rate system. This is because it would be easier both to set a
piece-rate and to monitor the product quality.
On the other hand, when a worker engages in a variety of different works, when the
product could not be conveniently standardized, or when the product itself changes often,
then the costs of determining piece-rates and of monitoring the quality of different pieces
would be so high as to render the hourly rate a preferable choice.
(c)Why are gratuities (tips) popular in the service sector but

not in the sector producing physical goods or commodities?
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(6 marks)
When a worker provides a service to a customer, the employer or the

manager is often not as effective of the service quality as the customer
himself. ‘Tips’ have the function of letting the customer participate in
monitoring performance.
On the other hand, in the production of physical goods, since their

qualities can be standardized more easily, the employer is in a better
position to monitor the qualities of the goods. Thus, using other means
of payment, such as piece-rate or time-rate, enable the employer to
have better control over the workers.
(d) What do you think is the general reason that explains the
adoption of different forms of payments to workers?
(6 marks)
The presence of transaction costs, whether in monitoring performance,

in accessing quality, in determining prices, or in measuring inputs or
outputs, all contribute to explain why different forms of payments are
chosen. Each form of payment is chosen to reduce these costs.
1990 Q. 3
It is sometimes said that the firm replaces the market. If there is such a replacement,
explain its nature. If there is not, why not? (10 marks)
As the market is defined as an institution in which consumers buy directly from and pay
directly to input owners who contributed to the product to them, then the presence of an
agent or a firm which pays the input owners, i.e., the factor market, on the one hand and
sells the finished products to consumers on the other hand, is in fact replacing or
substituting for market transactions.
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However, since the increase in factor market transactions will reduce product market
transactions, we can see that there is a replacement effect. As all kinds of transactions
involve contractual arrangements, instead of saying that the firm replaces the market, it is
more accurate for us to say that one type of contracts is being employed to replace
another type of contracts.
1991 Q. 9
In Hong Kong, taxi drivers typically rent taxis from taxi owners.
In the 1960s, the taxi rental arrangements were routinely on a
share basis; for example, the taxi owner took 55 percent of the
daily gross income while the drive took the remaining 45
percent. However, since the mid-1970s until the present day,
taxi rental has typically been on a fixed-rent basis, i.e., the
driver pays the owner a fixed sum of rent per day, and the
driver keeps the difference between the gross income and the
fixed rent.
Under the earlier share-rent arrangement, the taxi owner paid

for the cost of fuel; under the present fixed-rent arrangement,
the driver pays for the cost of fuel. In either case, maintenance
expenses are paid by the taxi owner.
(a) Why was the fuel cost paid by the owner under the share-
rent arrangement, but it is now paid by the leasing driver
under the fixed-rent arrangement? (Hint: the taxi driver
would often have to drive around in an empty taxi looking
for customers.)
(9
marks)
Driving around with an empty taxi to search for customers is costly in
fuel consumption, but this searching tactics is essential to maximize
the net worth of the taxi. In principle, the marginal cost of the search
should equal to the marginal expected gain from getting the
prospective customers.
If under the fixed-rent arrangement the fuel cost was borne by the taxi
owners, the leasing drivers would search for customers ‘excessively’, in
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the sense that the marginal cost of fuel exceeds the expected marginal
gain. This is so because the drivers could keep all the incremental
income while the owners bear the fuel cost. If under the share-rent
arrangement the fuel cost is borne by the leasing drivers, then they
might not search enough because for whatever the expected gain of
the search, the drivers could keep only a fraction.
(b) The cost of fuel rose sharply after 1973. Could this explain
the change in taxi rentals from a share-rent basis to a fixed-
rent basis? Explain. (8 marks)
With fuel cost increased sharply after 1973, driving around with an
empty taxi became more mostly. If under a share-rent basis the net
gains of taxi owners will fall. Hence, let the driver pays for the fuel and
decides how much searching he would conduct would be preferred
solution as the receipts of the taxi owner will be more certain.
Therefore, the fixed-rent practice was adopted.
(c)Why are maintenance expenses paid by the taxi owners and

by the leasing drivers?
(8
marks)
There are several reasons. One is that the turnover rate of taxi drivers
is high, and it would be difficult to make a short-term driver responsible
for maintenance. Another is that the leasing driver would have less
incentive to carry out maintenance in an honest way as compared with
the owner of the taxi.
In other words, the costs of enforcement, or the cost of transactions, to

attain an efficient level of maintenance is higher if the maintenance
expenses are paid by the leasing driver.
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1993 Q. 3
A firm is often regarded as an organization which supersedes the market. What does
this mean? (Note: You are not asked to explain here why the firm emerges, but to
explain the nature of the supersession.) (8 marks)
A firm exists whenever the cost of using the market is too high, this means that the costs
incurred in the direct interaction between input owners and customers are too high. In this
case the customers do not pay the input owners directly for the services they provided.
Instead it is the employer, or agent, who pays workers for the services provided on one
hand, and he charges customers for the goods and services purchased. In this case there is
a replacement effect, i.e., the earnings received by factor owners no longer directly
directed by market signals. Thus, the market is being superseded, or replaced by firm.
However, solely saying that firm supersedes market is not the best conclusion as we
ignore that all means of resource allocation involves a choice of contractual
arrangements. Thus, previously contracts are being made between input owners and
customers. However, with the existence of firm, one contract is being made between input
owners and employer and the other contract is being made between employer and
customers. Thus, instead of saying that firm supersedes market, we can draw a more
accurate conclusion, i.e. one type of contract supersedes another. In this case it is the
contract of hiring factor inputs supersedes contracts of selling product outputs.
1996 Q. 5
‘When we pay a shoe-shine a pair of shoes for $10, the product
market (the shine) and the factor market (the boy’s labour) are
not separate markets and the firm does not exist.’ Do you
agree? Explain your answer by using what you know about the
nature of the firm. (8 marks)
A firm is generally regarded as an organization superseding the

market; or factor market transactions superseding product market
transactions. However, these interpretations have missed the most
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important nature of firm as a choice of contractual arrangements.
If the shoe-shine boy runs his own business, the $10 paid to the shoe-
shine boy is either for the shine or for the boy’s labour; hence it would
be redundant to speak of a product market and a factor market. In this
simple example we can have either the product market or the factor
market, not both. There is no firm and there is just one market, but not
both.
However, if the boy is hired by an employer or agent and paid a wage,

a factor market transaction is involved. On the other hand, when the
employer charges a customer $10 per pair of shoes shined, a product
market transaction is involved. In this case the two markets become
separate and the agent’s organization becomes a firm.
1996 Q. 7
In Hong Kong, the number of supermarket outlets has grown
from less than 50 in 1993, and the range of products carried by
a single large outlet reaches 8000 items. This development
contrasts sharply with the earlier period (say in the 1950’s),
when small grocery stores each carrying and specializing in a
few dozen items had been the popular practice.
(a) How would you explain the growth of supermarkets as a

result of a change in the wage rate of domestic servants?
(5 marks)
The time cost of shopping is reduced by the supermarket. With sharply

rising wages of domestic servants, this reduction of shopping time
worth more.
(b) Why do fresh meat, fresh poultry, live fish and fresh
vegetables continue to be sold in centralized markets other
than supermarkets? (5 marks)
Fresh items delivered daily, or living creatures slaughtered on the spot,

would make a mess in a supermarket, the freshness of these items
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deteriorates if they are trucked to each and many supermarket outlets;

furthermore, truly fresh items lack standardization, and in the
bargaining (give and take) process the costs of transaction are lower in
centralized markets, where sop owners deal directly with customers.
1997 Q. 3
What is a firm? (8 marks)
A firm is an agent which pays input owners it employs for the services
provided on one hand and charges customers or the goods or services
purchased. In this case the behaviour of input owners are not directly
directed by market signals.
The existence of a firm is because the cost of using the market is too
high, this means that the costs incurred in the direct interaction
between the input owners and customers are too high. In this case the
customers do not pay the input owners directly for the services they
provided. Instead it is the employer, or agent, who pays workers for the
services provided on one hand, and he charges customers for the
goods or services purchased. In this case there is a replacement effect,
i.e., the earnings received by factor owners no longer directly directed
by the market signals. Thus, the market is being superseded, or
replaced by firm.
However, solely saying that firm supersedes market is not the best
conclusions as we ignore that all means of resource allocation involves
a choice of contractual arrangements. Thus, previously contracts are
being made between input owners and customers. However, with the
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existence of firm, one contract is being made between input owners

and employer and the other contract is being made between employer
and customers. Thus, instead of saying that firm supersedes market,
we can draw a more accurate conclusion, i.e. one type of contract
supersedes another. In this case it is the contracts of hiring factor
inputs supersede contracts of selling product outputs.
1998 Q. 4
It is sometimes said that transaction costs are similar to or the
same as transportation costs. Yet the presence of transaction
costs may give rise to an institutional arrangement known as a
firm, whereas transportation costs will have no such effect.
Why?
(10
marks)
Transportation costs exist even in a one-man economy; transaction
costs arise as a result of more than one man. Under different
contractual or institutional arrangements subject to which competition
take place in a society, transaction costs will differ. Hence, am
arrangement known as the firm may emerge to reduce transaction
costs.
Firstly, since firm exists because the costs of using the market are too
high, it can economize or limit the costs of market transactions.
Secondly, since market transactions are costly, firm save up cost by

reducing the number of transactions.
Thirdly, information costs can be saved as it is less costly for a firm to

do the price negotiation with the input owners than an ordinary
consumer.
Fourthly, the measurement of a factor’s contribution costs can be

saved as it is less costly for a firm to specify the criteria of
measurement.
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Finally, the pricing costs can be saved as it is less costly for a firm to
price the contribution in team work. So, to conclude, the presence of
the above transaction costs may give rise to an institutional
arrangement known as a firm, whereas transportation costs will have
no such effect.
2000 Q. 3
Consider a middleman who buys a good from a producer and
resells it to a consumer. Does the contractual relationship
between the producer and the middleman constitute a firm?
(8 marks)
A firm is an agent which pays input owners it employs for the services
provided on one hand and charges customers or the goods or services
purchased. In this case the behaviour of input owners are not directly
directed by market signals.
As firms are coordinated by entrepreneurs, with the contractual

relationship between various production factors and themselves, they
have the right to combine and coordinate factors of production so as to
lower the transaction cost of using the market mechanism to allocate
resources. Hence, whenever a firm exists, factor owners in a firm are
paid according to the entrepreneurs’ discretion rather than their
marginal revenue product.
However, if there exists a middleman who pays a good from a producer

and resells it to a consumer, whether the contractual relationship
between the producer and the middleman constitute a firm depends on
their contractual content.
If the middleman does nothing more than charging a commission

between producer and consumer, then the producer receives a price
and the customer pays a price plus the commission, then the
contractual relationship does not constitute a firm.
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However, if the middleman uses his discretion to measure the

producers’ contribution, e.g. according to the number of hours, and the
consumer pays a price for the product, then the middleman has the
right to coordinate and monitor the performance of the producer. In this
case the contractual relationship constitutes a firm.
2002 Q. 1
What is an invisible hand? What is a visible hand? Explain why
the invisible hand is sometimes superseded or replaced by a
visible hand? (6 marks)
An invisible hand means resource allocation and income distribution

are guided by market prices, or though the mechanism of the market.
A visible hand means the same activities are directed by a director, as
in the case of firm, or by planners as in the case of a planned economy.
When transaction costs are so high that market prices cannot be

determined, a firm may emerge to direct the use of resources and
replace or supersede the market. On the other hand, on political
grounds, a government with sufficient power may assume the
responsibility of directing resource use. The presence of the
government may be the result of reducing transaction costs, or the
result of having power to control for its own benefit.
2002 Q. 8
Employees promoting business are often provided with the
entertainment expenses to serve potential customers, in
addition to monthly salaries and commissions (as a certain
percentage of their sales revenue).
(a) Why are entertainment expenses provided to the

employees? (5 marks)
If entertaining customers is an effective way to generate more

business, then an employee will entertain more with entertainment
expenses than if the same amount of money is given to the employee
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in the form of an increase in salary.
(b) Suppose these employees are paid only monthly salaries,

with neither commissions nor entertainment expenses.
However, their salaries may be adjusted from time to time.
Under this situation,
(i) Could the total sales revenue of the firm be the same as
when commissions and entertainment expenses were
provided? (5 marks)
Yes. If an employee gets increases in salary with increases in sales,

then he will use some of his salary to entertain customers. At high
enough salary increases he will entertain as much as when
entertainment expenses were provided.
(ii) Could the net income (i.e. total sales revenue minus all
expenses including salaries) of the firm be the same as
when commissions and entertainment expenses were
provided? (5 marks)
No. If the total sales revenue is the same in both arrangements, under
the provision of commissions, all entertainment expenses will go to
entertainment. Whereas with an increase in salary only a part of which
will go to entertainment. Hence, the net income of the firm will be
higher through an increase in salary due to greater sale than provision
of entertainment expenses.
2003 Q. 3
What is firm? What is the difference between a firm and a
market? (8 marks)
A firm is a way of organizing production activities without using market

prices for every contribution produced. For example, a manager or a
visible hand directs the production activities of workers while paying
the latter wages measured by time, not according to their contributions
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or outputs. A firm therefore differs from the market in that different

contracts are used: a firm uses proxy measure contracts and a market
uses piece rate contracts.
2004 Q. 4
‘If there are no transaction costs of any kind, there would be
neither firms nor market.’
Do you agree? (10 marks)
If there are no transaction costs of any kind, the preferences of all

individuals are known, and so are their comparative advantages. A
central agent would then be able to costlessly assign people to their
proper jobs, collect their outputs, and distribute their outputs according
to their marginal productivities and preferences. There will be no
market and no market prices, but just a central agent whose services
are available free of charge. There will be no firm because there is no
need of contractual arrangements of any kind.
2006 Q. 3
If an orchard owner employs a beekeeper to pollinate his fruit
trees, is there one firm or two firms? If you don’t know the
answer, explain why you don’t know. (8 marks)
Don’t know the answer. The orchard owner may employ the beekeeper
through hiring him on a wage contract, or through a share contract, or
through a contract renting beehives, or even lease the orchard to the
beekeeper. All these are different contractual arrangements, and there
is no guideline for us to tell when or why a change in contractual
arrangements will alter the number of firms.
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2006 Q. 8
It is common practice in China for workers to obtain bonuses at
the year end, payable only when the company employing the
workers makes money. Does this bonus system imply a higher
or a lower rate of unemployment? Would a piece-rate system
interfere with the operation of the bonus system? Would
minimum wage laws interfere with the operation of the bonus
system? (10 marks)
Under the bonus system unemployment tends to be less because the

bonus provides an automatic adjustment in the wage rate, i.e., as
business falls the bonus is reduced and the workers’ income is reduced.
The piece-rate system would not interfere with the bonus system
because the piece rate is determined by orders received, or is a price
normally covered by the price of the product. Under the piece-rate
arrangement, bonuses are awarded to the more productive workers on
piece counts, unrelated to the ‘profit’ of the firm. Obviously, minimum
wage laws interfere with the bonus system.
- END -
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Unit 9 – Government Regulations and Dissipation of Rent
1. Under which of the following conditions will consumers bear the largest tax
A. an elastic market demand and an inelastic supply.

B. an elastic market demand and an elastic supply.
C. an inelastic market demand and an inelastic supply.
D. an inelastic market demand and an elastic supply. (85-18)
2. An excise tax raises costs, but price rises only because the supply decreases.
The burden of this tax will fall entirely on the consumers of
A. the market supply is perfectly elastic.

B. the market demand had unitary elasticity.
C. the market supply is upward sloping.
D. the market is perfectly elastic. (86-15)
3. ‘Shortages’ are generally the result of
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A. price controls.
B. unexpected decreases in supply caused by natural disasters.
C. unexpected increases in demand leading to situations where increases in
supply could respond with sufficient speed.
4. Price controls
A. reduce competition.
B. bring about other forms of non-price competition.
C. result in a more equitable distribution of income.
D. help to stabilize supplies. (87-03)
5. Some private housing developers in Hong Kong try to sell private housing
estates by ballot, in addition to their asking prices. This indicates that
A. non-price competition is chosen to complement the market solution.

B. the listed price of that particular private housing is set below the market-
clearing price.
C. a shortage is resolved by the ballot.
6. If the government maintains farm prices by buying up surpluses or selling to fill

shortages, then farmers would
A. have a stable income.

B. face a perfectly elastic demand schedule.
C. increase output because of the price stabilization programme.
D. face a unitarily elastic demand schedule. (88-13)
7. A sales tax tends to lead to an increase in price. But the price will NOT increase
if
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A. the market demand is unitarily elastic.

B. the market demand is perfectly elastic.
C. the market supply curve is upward rising.
D. the market supply is perfectly elastic. (88-27)
8. The long waiting time required to use the congested Cross Harbour Tunnel
implies that
A. waiting line is not a cost of using the tunnel.

B. the higher the toll charged, the shorter will be the waiting time.
C. the use of a monetary price cannot solve the congestion problem.
D. non-price competition is a fairer means of competition because the lower
income group cannot afford to pay. (89-
10)
9. An excise tax will raise the market price of a good by the greatest amount if
A. both demand and supply are price elastic.

B. both demand and supply are price inelastic.
C. demand is price elastic and supply is price inelastic.
D. demand is price inelastic and supply is price elastic. (89-
17)
10. The prohibition of blood sales in the free market
A. ensures a higher quality of blood for use in transfusions.

B. tends to reduce the variation in the quality of blood for use to transfusions.
C. restrains the monopoly power of doctors.
D. implies that poor people will be protected from exploitation in the sale of
their blood. (90-17)
11. Which of the following describe(s) a shortage?
A. A shortage exists whenever the price is fixed by the government.

B. A shortage exists when a queue is found.
C. A shortage exists when, at the given price, the quantity demanded exceeds
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12. Under which of the following conditions will consumers bear the smallest tax
A. an elastic demand curve and an inelastic supply curve.

B. an elastic demand curve and an elastic supply curve.
C. an inelastic demand curve and an inelastic supply curve.
D. an inelastic demand curve and an elastic supply curve. (91-
10)
13. The imposition of a lump-sum tax on a firm will
A. decrease the wealth of the firm.

B. decrease the output level.
C. increase the selling price of the good.
14. Recently, some housing developers in Hong Kong have begun selling housing
units by lottery. That is, at their asking price, there are too many buyers
queuing up to buy the flats. So, in addition to the purchase price, a buyer must
be the winner in the lottery. This implies.
A. competition for private flats is reduced since buyers no longer to line up for
days.
B. efficiency is improved.
C. a change in the form of competition.
D. the Hong Kong government is imposing a control on the price of flats.
(92-09)
15. An effective price ceiling imposed on a good by the government will lead to
A. an increase in production as producers respond to higher consumer demand

at the lower price.
B. a more even distribution of income.
C. a dissipation of the value of the good.
D. a decline in its demand. (92-12)
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16. Experts complain that voluntary water conservation programs are not working
and water shortages will continue to occur in Hong Kong. Which of the
following conclusions is most consistent with economic theory?
A. Water shortages are unavoidable as Hong Kong’s population has grown

rapidly in recent years.
B. There will be no water shortages in Hong Kong if the price is determined in
the market.
C. Water conservation programs will be more effective if the government
imposes a price ceiling on water.
D. The demand for water is always inelastic because water is vital to human life.
(92-15)
17. The imposition of a lump-sum tax on each firm in a price-takers’ market will
A. decrease the number of firms in the market.

B. increase the output of each firm that remains in business.
C. increase the market price of the output.
18. A per unit tax on an inferior good is
A. regressive.
B. proportional.
C. progressive.
D. There is not information to answer the question. (92-27)
19. Price control
A. encourages allocation on a non-price basis.

B. promotes a more equal distribution of income.
C. generates a condition of disequilibrium.
D. has no wealth redistribution effect. (93-10)
20. The Home Ownership Scheme (HOS) usually attracts 10 units more
applications than the number of flats available for sale. At present, selection is
done randomly by computer, and the flats are not transferable within ten years
of purchase. If new HOS flats are freely transferable,
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A. less applications would be expected.

B. even more applications would be expected.
C. the poor will sell their HOS flats to the rich.
D. the rich will sell their HOS flats to the poor. (94-18)
21. Currently, with no entrance fee, the flow of visitors to the Hong Kong Park
does not reach its full capacity. If the government now charges an entrance
fee,
A. the consumers’ surplus will rise.

B. the total use value will decline.
C. the marginal use value will fall.
D. the cost of maintenance will rise. (95-03)
22. If a regulated public utility such as electricity supply is allowed to earn only a
rate of return equal to some regulated percentage of the value of its assets,
then,
A. the electricity firm tends to overstate its asset value.

B. the electricity firm tends to increase the scale of its plants.
C. the price of electricity tends to be under government control.
23. If the Hong Kong government does not restrict the number of taxi licences
issued,
A. taxi fares will decline.

B. the average income of taxi drivers will rise.
C. the service of taxi drivers will improve.
24. Non-price competition arises when
A. the market price is below the equilibrium price.

B. transaction costs are positive and significant.
C. property rights are not well-defined.
D. All of the above are correct. (96-06)
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25. Price control results in a
A. change in the form of competition.

B. disequilibrium in the market.
C. decrease in the cost of getting the good at the margin.
D. decrease in the value of the good at the margin. (96-14)
26. For an unit tax, the tax incidence of consumers is greater than that of seller if
A. demand is elastic and supply is elastic.

B. demand is inelastic and supply is inelastic.
C. demand is elastic but supply is inelastic.
D. demand is inelastic but supply is elastic. (96-18)
27. In Hong Kong, the earnings of bus companies are regulated to a maximum
rate of 16% of their capital values. If a bus company is able to earn 20%
without such regulation, this company will tend to
A. increase the labour/capital ratio.

B. increase bus fares without changing the labour/capital ratio.
C. decrease the labour/capital ratio.
D. decrease bus fares without changing the labour/capital ratio.
(96-23)
28. A per-unit tax imposed on cigarettes will tend to generate which of the
following effects?
A. The quality of cigarettes will improve.

B. The length of cigarettes will increase.
C. Cigarettes will sold by piece, not by package.
D. Both A and B. (97-08)
29. Which of the following government measures will NOT increase the wealth of
an economy?
A. subsidizing health care.

B. privatizing state-owned enterprises.
C. allowing the transfer of quota rights.
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D. allowing monopolists to practice perfect price discrimination.

(97-09)
30. If the price of housing in the Home Ownership Scheme, though always lower
than the market price of private housing, is adjusted up or down by the same
amounts as the changes in the market price of private housing, which of the
following statements is correct?
A. Housing in the Scheme becomes a private property.

B. The rents dissipated under competition then to stay constant.
C. The postulate of constrained maximization no longer applies.
31. Suppose the government imposes rent controls restricting the rent of a flat
below the market rent. In addition, a law is passed such that once the flat is
rented, the landlord cannot evict a tenant, i.e. the tenant has a right to the
tenancy in perpetuity. This implies that with this rent control scheme
A. the turnover rate will be lower.

B. the landlord will spend less in maintaining the flat.
C. the effect on vacancy rate is indeterminate.
32. Price control will result in
A. dissipation of rent.
B. non-price competition.
C. a reduction in the volume of trade.
33. An effective price ceiling imposed on a good
A. leads to shortage.
B. reduces competition.
C. encourages the use of non-price competition.
D. increases consumer surplus. (00-12)
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34. Market price
A. must be measured in money terms.

B. of a good is determined by its total use value.
C. is the only feasible competitive criterion.
D. is the only competitive criterion that does not lead to dissipation of rent.
(00-15)
35. If a uniform per-unit tax on wine is removed, then
A. the price of high-quality wine will decrease.

B. the price of low-quality wine will decrease.
C. the relative price of high-quality wine will increase.
36. If the government charges the same lump-sum tax to each and every
customer going to eat in restaurants,
A. the price of food in restaurants will be reduced.

B. a customer will eat less each time he goes to a restaurant and he will go less
often.
C. a customer will go to restaurants less often, but he will go the higher-class
restaurants.
37. If the government imposes a rent control on domestic flats and sets rental
ceilings substantially below the market rents,
A. repair and maintenance of the rent-controlled flats will not be affected.

B. the reconstruction of domestic flats will not be affected.
C. a tenant may be required to pay a large amount to buy the key to the flat he
rents from the landlord.
38. Which of the following activities entails dissipation of rent?
A. With gasoline price control in the United States in the early 1970’s,
automobiles had to wait in line for an hour to buy gasoline.
B. When the housing market in Hong Kong was strong, developers sold flats by
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drawing lotteries with buyers queuing up and buying deposits to developers.

C. In the Olympic Games, participants train very hard to compete for medals.
D. In supermarkets, customers wait in lines to pay the cashiers during the rush
hours. (01-11)
39. A unit sales tax imposed in cigarettes implies that
A. the cigarettes produced will be longer.

B. more smokers will buy cigarettes by the carton.
C. the quantity of tobacco consumed will not be affected.
D. the age distribution of smokers will net be affected. (01-
20)
40. If an effective price ceiling is imposed on a good, there will be shortage. This
statement constitutes disequilibrium because
A. the government will increase the supply.

B. the quantity demanded is larger than the quantity supplied.
C. some people who are willing to pay the price may not be able to obtain the
good.
D. no testable implication can be derived. (02-06)
41. Quota rent
A. can be captured if quotas are transferable.

B. may be dissipated if non-price criteria are used to allocate the quotas.
C. exists because the government restricts the quantity of quota.
42. If a sales tax of 8% is introduced in Hong Kong,
A. the rent of shops in Hong Kong will rise.

B. the rents of shops in Shenzhen will fall.
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C. many shops in Hong Kong will close down.

D. The tax revenue of the Hong Kong government must rise.
(02-20)
43. Rent dissipation occurs when
A. The right to receive income is not exclusive.

B. A monopoly right is sold by auction.
C. A common property is privatized.
D. A public good is privately produced. (02-26)
44. A large lake subject to unrestrained common exploitation
A. has no fish.
B. has no owner.
C. yields no rent for the marginal fisherman.
D. yields no income. (03-26)
45. A government
A. may be viewed as a firm.

B. is a legal entity that operates under a constitution.
C. is always established by the use or threat of force.
46. 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)
47. Which of the following statements about Hongkong Post, the only government-
run post office in Hong Kong, is correct?
A. It must be inefficient because it is not a private enterprise.
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B. Its supply curve may be its marginal cost curve because there are many
private postal services competing with it.
C. It may be inefficient because price discrimination is not practiced.
D. The price it charges must be at the inelastic range of the market demand
curve. (04-25)
48. In economics, disequilibrium refers to a situation
A. where a stationary state is impossible.

B. when economic activities keep changing.
C. where no testable implications can be obtained.
D. where price instability is observed. (05-16)
49. Under effective maximum price control,
A. a shortage will occur.

B. some criteria other than the market price will be used to determine winners.
C. the winners and losers of the good will remain unchanged.
D. the consumer surplus of at least one buyer will rise. (06-
20)
50. A fishing ground subject to unrestrained common exploitation
A. may yield some rents for some fishermen.

B. is inconsistent with the postulate of constrained maximization.
C. may yield rent for the marginal fisherman.
D. will have no effect on the average size of the fish caught. (06-
21)
51. In a one-man economy, there is no
A. scarcity.
B. income.
C. information cost.
D. inefficiency. (07-18)
52. Which of the following statements about advertising must be correct?
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A. It provides authentic information.

B. It is useless in a world with zero information cost.
C. It is always successful in attracting buyers.
D. The cost of advertising is always less than the cost of information. (07-19)
53. An effective price ceiling imposed on a good
A. redistributes income randomly.

B. changes the form of competition.
C. results in disequilibrium.
D. increases scarcity. (07-24)
54. Non-price competition implies
A. surplus.
B. shortage.
C. scarcity.
D. monopoly. (07-25)
55. If a piece of privately-owned land is made available for common exploitation,
A. the price of the land may be positive.

B. the price of the land will be zero.
C. land use will be unaffected.
D. zero rent will be earned by all users. (07-28)
MC Answers on Government Regulations and Dissipation of

Rent
D A D B D C B B D B
C A A C C B D A A B
B D D D A D C D C B
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D D C D D C C A A D
D C A C A D B C B A
D B B C B
(i) Government Regulations
1991 Q. 6 (c)
What will be the effects of the following changes upon price? Explain your answers.
A price ceiling is imposed by the government on butter; i.e., the price of butter is
forcibly controlled to a level significantly below its market price. What would you
expect to be upon the price of margarine? (8 marks)
If the price of butter is set below its market price, an excess demand in butter will arise.
Since the price is lower than before, the quantity supplied of butter will fall. Thus, the
quantity transacted of butter will fall also.
As butter and margarine are substitutes, whenever there is a fall in quantity of butter
available, the demand for margarine will rise as people will shift to buy margarine. With
an increase in demand for margarine, the price of margarine will rise as a result.
1992 Q. 6
In the State of Washington, one who wishes to hunt for
mountain goats must obtain a special goat permit. Each year
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approximately 8,000 people apply for goat permits. A draw is

held to select 1,000 ‘winners’. Each winner may then purchase
a goat permit for US$20, entitling him to kill a maximum of one
goat over a one-year period. Permits are not legally
transferable, nor can they be resold, in any form. Each year
about 250 permit holders succeed in killing a goat.
If the goat permits are allowed to be resold in a free market,

would the new price be higher or lower? And would more goats
be killed? Explain. (15 marks)
If the goat permits are allowed to be resold in a free market, the

market price of the permits will definitely be higher than $20 (the
previously controlled price). It is because the presence of the ‘draw’
implies that there is ‘excess demand’. Thus people are willing to pay
additional cost so as to obtain the permit. If free market exists, the
criterion of drawing lottery will not be used; in this case the market
price can measure fully the value of the permit.
With the permits now going to those who offer the highest prices in the
resale market, more goats will likely be killed. This is because the
higher permit value implies that either the permit holders are better
hunters, or more enthusiastic hunters. Thus, they will tend to hunt
more intensively or more frequently.
1992 Q. 8
Currently in Japan, restrictions on agricultural imports keep
the price of agricultural products at about ten times the world
level. Suppose the Japanese government decides to remove all
import restrictions on agricultural products.
What impact do you think the removal of these import

restrictions would have on the price of housing in Japan?
Explain. (15 marks)
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The price of housing in Japan may rise, fall or remain constant because:
On the supply side, the price of agricultural products in Japan will fall.
This will reduce the demand for agricultural land and thus reduce the
value of agricultural uses of land relative to other uses. Housing prices
will fall as more agricultural lands are released and reallocated for
housing construction, and this increase in hosing land supply will
reduce the price of housing, assuming the demand for housing does
not change.
On the demand side, although agricultural income will fall, the real
income of the rest of population will rise as a result of sharply falling
prices of agricultural products. If the quantity of agricultural land
released for housing construction is very small, it is possible that the
increase in demand for housing as a result of the rise in real income
will lead to a rise in the price of housing in Japan.
1992 Q. 9
‘The provision of a per unit subsidy to the sellers of lunch
boxes will cause their total revenue (excluding the subsidy) to
rise.’
Explain whether this statement is True, False or Uncertain.

(8 marks)
The answer is uncertain. The provision of per unit subsidy leads to a

rightward shift of the supply curve and thus a decrease in the
equilibrium price. How the total revenue will change depends on the
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elasticity of demand for lunch boxes.
If the price elasticity of demand is larger than 1, the demand for lunch
boxes is elastic; the percentage decrease in price will be smaller than
the percentage increase in quantity demanded. The total revenue will
rise, because the gain in revenue due to the increase in quantity
demanded outweighs the loss in revenue due to the decrease in price.
If the price elasticity of demand is less than 1, the demand for lunch
boxes is inelastic. The percentage decrease in price will be greater than
the percentage increase in the quantity demanded. The loss in revenue
will outweigh the gain in revenue, and thus the total revenue will fall.
If the price elasticity of demand is equal to 1, the demand for lunch

boxes is unitarily elastic. The percentage decrease in price is equal to
the increase in quantity demanded. The demand curve will be in a
shape of a rectangular hyperbola and the loss in revenue will be equal
to the gain in revenue. Total revenue remains unchanged.
If the supply curve is perfectly inelastic, the decrease in price will lead
to no increase in quantity demanded. There will be no gain in revenue
and total revenue must fall.
1993 Q. 8
In Hong Kong, during the week before the Chinese New Year,
many flower bazaars are organized by the government to let
vendors sell their New Year commodities to the public. The
government allocates the right to operate each stall by tender
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or bids and the right to operate a stall goes to the vendor who
bids the highest price for it. The bidding is usually held a
month in advance. Therefore, events that happen after the
bidding which would affect the income from operating a stall
would not be reflected in the bid. The right to operate a stall is
not transferable. If the right to operate a stall was
transferable, would the government receive higher bids for the
stalls? Explain.
(10
marks)
At the time of auction, the future is not certain. Events may happen
which would affect the value of the bid. If the bids transferable, a bid
winner may transfer his rights to another operator if adverse happen
that are particularly harmful to him. Therefore, bidders are willing to
offer higher bids in the case where the bid is transferable.
Moreover, even if no unexpected events were to follow, the bids may

still be higher with transferable rights because the bidders must be
aware at the time of the bidding that their decisions might be mistakes,
given positive information costs. Hence, instead of incurring higher
information costs in finding the value of the bid, they may choose to
pay a higher bid so as to save information costs.
1995 Q. 6
Suppose the Hong Kong government decides to limit the
number of private cars to its present level. This is done by
issuing to each existing vehicle a quota permit without which a
vehicle will not be allowed to operate on the road. This quota
permit is freely transferable (saleable) in the market. In order
to drive a new car on the road, therefore, it is necessary to
obtain a quota permit in the market.
Assuming the demand for private cars is rising, what will the
effects of the quota system be upon (a) the market value of an
existing old vehicle, (b) the intensity of vehicle utilization, and
(c) the average quality of vehicles operating on the roads?
Explain.
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(15
marks)
With increasing demand for vehicles and the supply fixed by the quota,
the market value of an existing old vehicle will rise, as reflected by the
positive market price of the quota. This is because the price paid for an
existing old vehicle includes the purchase of the right to obtain a quota
permit which commands a positive value.
As the demand for private cars is rising, this means that the demand
for transportation is also rising continuously. Since the number of
vehicles remains constant, the intensity of vehicle utilization will rise as
a result. A person intending to possess more than one car may only be
able to possess one under the quota system, this the intensity of his
vehicle utilization will inevitably rise.
Since the price of a quota permit is a lump-sum which will remain the
same regardless of the market value of the new car purchased, people
will tend to use the permits to buy more expensive and higher quality
vehicles. This is because the share of the price of a quota permit is
smaller for higher quality vehicles than for lower quality ones. Thus,
with the quota permits, the prices of higher quality vehicles imported
will fall relative to lower quality vehicles. As a result, relatively higher
quality vehicles will be imported relative to lower quality vehicles. So
the average quality of vehicles operating on the roads will rise.
1995 Q. 8
State-operated enterprises in China are in general not
performing well, and nearly one half of them are losing so
much that they are on the verge of declaring bankruptcy.
Government subsidy in one form of another has been essential
in keeping many of these enterprises afloat. One of the
reasons which explain the poor performance of state
enterprises in China is that workers and managers alike are
stealing from these enterprises, and the government simply
does not have enough resources to guard against this stealing
practice.
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Suppose, only hypothetically, that in the state-operated

enterprises it is literally free to steal. What will the equilibrium
results be in the event of (a) the government not subsidizing
the enterprises at all, but allowing them to do whatever they
want to decide their own fate, and (b) the government
continuing to subsidize their survival for as long as possible?
Explain. (10 marks)
If the government truly lets the enterprises alone to decide their own
fate, then a great many of them will try to convert the state-operated
enterprises into private enterprises, through the issuance of stocks or
other meant. Alternatively, officials in charge of some enterprises may
sell out the enterprises to outside private parties (including foreign
parties), grab the money and run; other officials may take over a state
enterprise and declare to be their own property. In any event, a change
in property right structure will likely take place.
There will be either sharply rising taxes, or rising inflation through

printing money as a form of indirect taxation, to finance the subsidies.
The continuation of this development will eventually bankrupt the
government or the government may be overthrown. Therefore, the
present subsidization of state-operated enterprise will not persist
indefinitely: some thing would have to give up sustaining the
government’s own survival. If the state-operated enterprises are
relatively few in number, they may persist forever under subsidization,
but a present there are simply for too many of them to sustain lone-
term subsidization.
1996 Q. 6
Beginning in the early 70’s, countries in Asia have all been
enforced to meet quota requirements when they export
garments to the United States. This export quota is imposed
on a unit basis, that is, the garments exported are counted by
unit, not by their quality or market value. For many years after
the introduction of this system, the quotas held by Hong Kong
garment manufactures were freely transferable (saleable) at
uncontrolled market prices; indeed, for many years Hong Kong
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was the only place in Asia which allowed a free market for
quota transactions.
Use the Law of Demand to explain (a) why there had been a
significant improvement in the quality of Hong Kong garments
exported to the United States under the quota system; and (b)
why this improvement in garment quality was far more
significant in Hong Kong than in other Asian countries.
(10 marks)
Because one unit of quota must be used for one unit of garment
regardless of garment quality, and because the quota has a positive
value, the price of higher quality garment fell relative to lower quality
garments under the quota system. Hence according to the Law of
Demand the quantity of higher quality garments demanded by the
United States rose relative to that of lower quality garments.
Because Hong Kong had long been the only place in Asia to allow a free
market for quota transactions, the value of the quota was higher and
therefore the relative price of higher quality garments fell further.
This explains why Hong Kong became the leading exporter of higher
quality garments and why the quota system, designed to protect the
garment industry in the U.S., ended up hurting that industry far more
than without the quota system – Hong Kong garments before the quota
were generally of such low qualities that they competed with those
produced in Mexico or the Philippines, but hardly competed with those
produced in the U.S..
1996 Q. 9
Chinese paintings by grand masters of earlier dynasties are valuable collectors’ items.
These antique art works are found both inside and outside mainland China today. The
Chinese government prohibits the export of these art works from China, but not their
import into China. The result is that at public auctions today, similar antique art works
now command lower prices in China than in Hong Kong or New York.
What would you expect to happen to the price levels of antique art works inside and
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outside China, and to import/ export direction of these art works, if China’s export
restriction is lifted? Explain. (10 marks)
The simple level is that if China lifted the export restriction, the price level of antique
artworks inside China will rise (because of effective demand from the outside world), and
the price level outside will fall (because of increasing supply from China). The merged
price level will be higher than the earlier level inside China but lower than that outside.
Therefore there will be a net export of antique artworks from China.
A better (full mark) answer is that antique artworks in China will rise in price if the
export restriction is lifted, regardless of outside effective demand, only because artworks
worth more if they can be enjoyed in more localities. With this consideration, the price
level of the antique artworks inside China may well be higher than the earlier outside
price level if the restriction is lifted. That is, the merged price level may be higher than
the earlier price level. If this is the case, there will be a net import of artworks into China
after the export restriction is lifted.
1997 Q. 6
To obtain public medical service, just like obtaining other
below-market-price public services, a customer has to wait in
line for a long time before getting served. Since all waiting
customers will eventually get served, it is argued that the
government should greatly increase the supply of service for a
given period (say, for one month) to clear all waiting
customers. Then it could return to the original practice and
there would be no waiting at all for the customers.
(a) What is wrong with this argument? (5

marks)
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Firstly, we should be clear with the reason why there are queues of
customers. Since the basic problem is that the price is set below the
market-clearing price, there is excess demand for medical service as at
the lower price level, the quantity supplied falls while the quantity
demanded increases.
The above argument is wrong in the sense that it is impossible to clear

all waiting customers. It is because the existence of the waiting
customers is due to the fact that the price is below than the market-
clearing price. As long as the price is set below the market price,
excess demand will exist and there will still be long line of waiting
customers.
(b) In supply-demand analysis, what method will guarantee no

waiting time for customers?
(5 marks)
Since the reason for the existence of waiting time is that the price is
set below the market-clearing level so that other non-price means have
to be used, i.e. waiting in line, in order to get the service, the basic
solution is to eliminate the excess demand.
In supply-demand analysis, the method we can use is to raise the price
to the market-clearing level. With a rise in price, the quantity
demanded for medical services will fall while the quantity supplied of
medical services will rise. As a result, the excess demand will no longer
exist. As a result, anyone who is willing to pay the price, i.e. the
market-clearing price, will be served immediately and no waiting time
is needed.
2000 Q. 6
Currently households pay rates to cover the disposal charge
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for their garbage (rubbish) and the rates depend on the value
of their flats. Will there be any change in the amount of
garbage disposed of by each household if the disposal charge
is calculated according to
(a) the number of people per household instead?

(4 marks)
If the disposal charge is calculated according to the number of people

per household, the charge will become a lump-sum charge. It would
have no direct relationships with the amount of garbage disposed. In
other words, the amount of garbage disposed would not be affected.
If one argues that by reducing the number of people in a household,

the disposal charge will be reduced, we should be aware of the fact
that a reduction in the number of people in one household means an
increase in the number of people in another household. Thus, there will
be no change in the aggregate expenditure on rates. Hence, the
number of people per household would not be affected.
(b) the number of standard garbage bags used by each

household instead? (4 marks)
If the disposal charge is calculated according to the number of

standard garbage bags used by each household, total expenditure on
rates would be directly affected by the amount of garbage disposed. In
other words, the marginal cost of disposing garbage will increase, and
the amount of garbage disposed will decrease then.
However, if all the garbage is filled into one big bag before and after
the change, there will be no change in the amount of garbage disposed
by each household as there is no change in cost.
On the other hand, if more than one bag is originally used, the number
of garbage bags will drop, with each bag squeezed more tightly. Since
there are limits as to how tight the bag can be squeezed, the amount
of garbage will also drop. In other words, the percentage reduction of
garbage bags disposed will be less than the percentage reduction of
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garbage.
2002 Q. 6
(b) Some economists argue that if the cost of serving an extra

car is zero, as it will be if the tunnel has no traffic
congestion, then, to maximize social benefit, no toll should
be charged. The counter argument to this is that if no toll is
charges, no private enterprise will build the tunnel. Now the
tunnel is already built, and sunk cost is sunk. Will social
benefit increase if the government purchases the tunnel and
lets all cars use if free of charge? (5
marks)
The answer is uncertain. The purchase of the tunnel incurs a cost to

society, regardless of who pays for it. If the government purchases the
tunnel and let all cars use it free of charge, it is taxpayers who pay for
the use of the tunnel. As we cannot know whether the total value to
the users will cover the purchasing cost of the tunnel, even if we ignore
the cost of operation, we cannot know whether social benefit will
increase or not. Even if there is congestion the answer will be the same
as we have no clear information about the total value of users.
2003 Q. 8
In the United States public schools (primary and secondary)
funded by local governments cost twice as much per student
as private schools, and yet it is generally agreed that the
quality of educations is higher in private schools than in public
schools. In the 1950’s, economist Milton Friedman proposed
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the use of school vouchers to convert public schools into

private ones. That is, the dollar figure of government
subsidization per student would be printed on a voucher, a
student holding this voucher could apply to any school he saw
fit, and upon admission the school would give the voucher to
the government to obtain the subsidy. Any school under this
voucher system could, at the school’s discretion, charge a
student an additional tuition fee over and above the voucher
money.
(a) Spending on public schools in the U.S. is funded by taxes

paid by house owners. Most schools are publicly funded,
although there are private ones. On several occasions, the
proposal of implementing the voucher system was put to
the vote, and each time the proposal was defeated by a
large margin. Why? (6 marks)
Special or vested interests would lobby strongly against the voucher

system. Public school teachers earning salaries higher than what they
could earn in the free market, public education administrative bodies
making a living because of public schooling, citizens who do not own
houses and therefore not paying school taxes but who may have
children later, would all tend to vote against the voucher. There is also
a concern of parents whose children attending public schools that the
voucher system will hurt their benefits because private schools are
likely to join the voucher system and take a share of the tax money.
(b) Suppose all secondary schools in Hong Kong adopt the

voucher system, with the voucher money exactly equaling
the public funding per student at present. Suppose also all
secondary schools turn private and are allowed to do
whatever they see fit. What would you expect as regards
the change in quality of Hong Kong’s secondary-school
education under such a voucher system? Explain. (6
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marks)
Lower quality teachers will get pay cuts and good teachers may get
pay increases; political activities will decline; the curriculum will be
tailored more to meet the education demands of parents and students;
some schools may charge additional tuition fees to upgrade the
facilities and the quality of teaching. All these tend to improve the
quality of education.
(c) Following (b) above, could all Hong Kong secondary schools
gain in net income? Which type of secondary schools will
have a larger gain in net income? Who will be the losers
within a school and which groups in the Hong Kong
education system as a whole will lose?
(6 marks)
All secondary schools may gain in net income, but those schools with a
better reputation will gain more because they will draw more students
and they may impose more tuition fees over and above the voucher
system.
Lower quality teachers, administrators politically inclined, government

bodies and legislators with vested interests in public educations, will all
tend to lose as a result of the voucher system.
2004 Q. 7
hunting equally.
(b) As property rights to the deer in the wild are not assigned
to any individual or a group of individuals by law or by
customs, are there any private property right to the deer in
the wild? Explain. (Hint: Imagine an extreme case where
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only one of the participants knows how to hunt.)

(6 marks)
Yes. There are, property rights to the deer in the wild are delineated by
the know-how or special skills of the less-than-10-per-cent superior
hunters. This is just like a strong man occupying a piece of land without
legal assignment will have an implicit claim to the land if no competitor
can take it away or infringe upon his use rights.
2006 Q. 4
The market prices of a good are moving up and down sharply
one day and become relatively stable the next day. On which of
these two days are the market prices of that good closer to
equilibrium? How can you tell that equilibrium prices exist in
the
market? (8 marks)
On either say the prices may be said to be equilibrium prices if we are

able to explain why they move sharply up and down or become
relatively stable. If we could not specify enough constraints to explain
or interpret the fluctuation or stability of prices, we have a
disequilibrium situation. If the constraints specified are sufficient to
yield a predictable outcome on price movements, however violent,
equilibrium prices exist by definition.
2007 Q. 8
The school voucher system is a way to subsidize education
while allowing students a free choice of schools. At the same
time, upon receiving vouchers and turning them into cash from
the government, public schools may become private and turn
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into money-making enterprises.
(a) The proposed school voucher system in Hong Kong

kindergartens prohibits the schools receiving vouchers from
turning into money-making organizations, i.e. schools
receiving vouchers must be non-profit organizations. What
would you expect the key differences in kindergarten
performance to be, whether or not money-making is
allowed?
(b) The government has said that the voucher system is not
meant to help school owners make money for themselves.
Could schools make profit through the case-convertible
vouchers under competition, if money-making is allowed?
Could they earn rent?
(c)Suppose, instead of subsidizing education through the

voucher system, the government passes a law, forcing
parents to pay fully for their children’s schooling. Would you
expect better or worse students to be produced when the
schooling is fully financed by parents, as compared with
that of the voucher system? (13 marks)
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(ii) Dissipation of Rent
1994 Q. 6
The following is extracted from the South China Morning Post,
December 28, 1993: ‘China’s Executive Vice-Premier, Zhu
Rongji, warned that prompt action must be taken to stop the
trend of runaway grain prices and push grain prices back to a
reasonable level. He said that all localities across the nation
must act in unison, coordinate their efforts and take
immediate and forceful measures …… He called on state-
owned shops to lower their present grain prices to the fixes
state grain prices for 1994.’
Will Mr. Zhu Rongji succeed in lowering the prices of grain?

Explain. (10 marks)
Mr. Zhu will not succeed in lowering the prices of grains as the prices
include both pecuniary (monetary) and non-pecuniary (non-monetary)
components. Since what we concern are the full prices people pay for
grains, they are not simply the monetary prices paid. Thus, by lowering
the present grain prices, Mr. Zhu may succeed in reducing or
suppressing the monetary prices, but if and when he so succeeds,
there will excess demand in the market. Hence, other criteria of
rationing grains, such as waiting in line, politicking, and the like, will
necessarily emerge to supplement the reduction in the pecuniary
prices. However, a criterion such as waiting in line, or any other non-
pecuniary criterion, is also a price which the buyers of grains will have
to bear. Thus, the full prices paid will not be lower than before.
Indeed, it is certain that the described action of Mr. Zhu, to the extent
he is successful in reducing the pecuniary prices of grains, will result in
higher full prices of grains for consumers. This is because suppressing
the pecuniary prices will lead to a fall in the quantity of grains supplied.
Thus, the full prices (pecuniary and non-pecuniary) that clear the
market must therefore be higher than the uncontrolled full market
prices.
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1994 Q. 9
Consider the case when the government has two options to
allocate a valuable monopoly licence (say, an exclusive
franchise to operate a television station). Option 1 is to
allocate the licence to the highest bidder in a public auction;
option 2 is to charge a zero price, but for government officials
to allocate the licence to whoever they see fit. With the latter
option, of course, bribery will in all likelihood occur. With either
option, therefore, the licence winner may well be the same
party, with the amount of the bribe approximating the winning
bid in the public auction.
In comparison with Option 1, what are the implications of

Option 2 with respect to (a) income distribution, and (b)
economic waste? (10 marks)
With respect to the distribution of income, one thing we can say for
certain is that taxpayers will lose out under Option 2, since government
revenue available for public expenditure will fall. If the public
expenditure is to be kept at the same level, then tax may be increased.
However, it is not certain that government officials receiving bribe will

gain under Option 2, because this would depend on the intensity of
competition of the officials and whether some officials have cost
advantage in corruption over other officials.
Nevertheless, officials will compete to receive bribes and they will work
or buy themselves into corruptible positions. Hence, some rent will
necessarily be dissipated, resulting in economic waste. It is possible to
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have a situation where the entire rent of the licence value be

dissipated, resulting in no gain for government officials as a whole.
1997 Q. 2
‘The allocation of resources by market price is the only known
criteria which entails no rent dissipation.’ Do you agree?
Explain. (8 marks)
If the exchange price is below the market clearing level, then there will
exist excess demand. In this case price cannot determine who can get
what. Since the price paid is lower than the equilibrium level, those
who can get hold of the good can realize some extra gains. As a result
some non-price means will arise to supplement the inadequacy of price
as the only criteria to allocate resources.
With the presence of the non-price means, some extra costs will be
incurred. As the costs incurred during the processes imply sacrifice of
scarce resources, no one can realize gains from such sacrifice. Thus,
some resources are being wasted in the process of competition. Such
waste is known as dissipation of rent.
Hence, if allocation of resources is done by market price, there will be

no need to employ non-price means as the market price can determine
how the resources will be allocated, i.e. to the highest-valued users.
Thus, since there exists no extra costs in the process of resource
allocation, there will be no wastes and no rent will be dissipated. So I
agree with the above statement.
2000 Q. 2
‘Even under price control, market always clear.’ Why?
(8 marks)
A market clears in the sense that any and all consumers are able to get
all they want if they are willing to pay high enough price. Without price
control, the market price is at the equilibrium level implying that a
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consumer of a good is able to obtain what he is willing to pay at the

margin. Hence, under perfect competition, if price is not at equilibrium
level, price adjustment will take place so as to clear the market.
However, with price control, price adjustment is no longer possible and

excess demand or excess supply will arise as a result. As price
competition cannot only be used, suppliers and customers will use non-
price competition to sell out the remaining goods and compete for
those scare goods respectively. As these reveal that under price
control, non-price competition arises, with the use of other criterion or
criteria in addition to the pecuniary price, the combination of the two
components will become high enough so as to clear the market.
2002 Q. 3
Under price control, when a non-price criterion is adopted to
partly replace the market price, quantity demanded will equal
quantity supplied. Explain. (8 marks)
Competition for a scarce good must be resolved in one way or another,

i.e. under competition, winners or losers must be determined. If
monetary price is controlled to a level below the market price, other
non-price criteria, such as waiting in line, will be used to fill the
difference. In equilibrium, the controlled price plus the cost of waiting
time will equal the marginal use value of the good, producing a
situation where quantity demanded again equals quantity supplied.
If supply is reduced as a result of the price control, then the waiting

time will be longer. If the supply of a good is reduced to zero as a result
of the control, then the situation is similar to that when a good is not
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produced because the cost of producing it is so high that no one is

willing to pay for it.
2005 Q. 1
What is dissipation of rent? Explain how and why this
dissipation takes place.
(8
marks)
When rent or income has no exclusive claimant, or when price is not
used as a criteria 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 resource or for getting the
good, not by producing something of value to exchange in return.
For example, a public beach open to unrestrained common use will

cause such crowding that the rental value of the beach will be
competed away, or close to zero, as compared to a private beach
where the owner may charge a user fee (rent), resulting in a smaller
crowd. For another example, if the government offers free dinners on a
wait-in-line basis, the cost of the time spent waiting in line, at the
margin, will equal the value of the dinner. Hence the value of the
dinner is dissipated by the waiting cost.
2005 Q. 6
Huang Shan is a famous mountain attracting many visitors
every year. Nearly all visitors reach the peak of the mountain
by riding cable cars. During weekdays a fee of RMB 80 per
person is charged. During holidays the crowd is so large that it
usually takes several hours waiting in line before a visitor can
get on the cable car. Under the operation of the local
government, the following dual-fee scheme is adopted on
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holidays. For visitors willing to pay 120 per person (RMB 40

more), they can go to a separate waiting room with a much
shorter queue. All visitors will reach the peak the same day,
but because the capacity of cable cars is fixed, those paying
the lower fee of RMB 80 will be pushed further back to wait
longer. There has been no riot. Assume all visitors knew about
this dual-fee and perfectly anticipated their waiting time in
advance.
(b) Will economic efficiency be improved under the dual-fee

scheme? Explain.
(4
marks)
Visitors with higher time costs are willing to pay the higher fee, and by
paying the higher fee the cost of the waiting time is reduced, thereby
reducing the dissipation of rent. Economic efficiency is therefore
improved.
- END -
Unit 10 – The Problems of Social Cost
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1. Suppose a factory pollutes the environment. If the right to pollute is well-

defined and transferable,
A. the level of pollution is subject to market contracting.

B. pollution will be eliminated.
C. the factory will necessarily increase its production.
D. then, on efficiency grounds, the government should intervene when the right
to pollute is not transacted. (90-25)
2. A divergence between private and social costs is NOT wasteful if
A. the majority of people benefit from the divergence.

B. the cost of eliminating the divergence is greater than the cost of the
divergence itself.
C. people who suffer from the divergence choose not to complain to the
government.
D. the divergence is not expected to last for a long time. (90-
30)
3. A divergence between private and social costs
A. occurs when one person’s action inflicts damage on another person.

B. cannot be resolved without government intervention.
C. may be eliminated by market transactions if the action that causes the
damage is a private property right.
D. means inefficient allocation of resources. (91-01)
4. Which of the following implies a divergence between private and social costs?
A. A factory pollutes the neighbouring housing for workers, and this housing is
owned by the factory.
B. Increasing textile exports to the USA leads to higher clothing prices in Hong
Kong.
C. Mr. Smith plays the piano which his neighbour loves to hear, but he plays it so
often that the marginal benefit of his music to the neighbour is exactly zero.
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5. Suppose the construction of a flyover causes the value of nearby properties to

fall. To attain economic efficiency,
A. the flyover builder should compensate the nearby property owners.

B. the flyover builder should install a noise reduction device.
C. the nearby building should be relocated.
D. There is not enough information to answer the question. (92-
23)
6. Non-price competition arises when
A. the market price is below the equilibrium price.

B. transaction costs are positive and significant.
C. property rights are not well defined.
D. All of the above are correct. (96-06)
A. means the Pareto Condition is not satisfied.

B. is the consequence of the market failure.
C. is due to the presence of transaction costs.
D. is due to the lack of government intervention. (96-08)
8. Given that people have well-defined rights to enjoy fresh air, which of the
following justifies the government prohibiting smoking in public areas?
A. Smokers inflict harm on non-smokers.

B. The cost of contracting between smokers and non-smokers is prohibitive.
C. The rights of non-smokers must be protected at all costs.
D. It is impossible to find a tax schedule to correct the external effects of smoke
pollution. (96-21)
9. Which of the following statements about property rights is FALSE?
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A. Property rights restrain behaviour.

B. Property rights exist only when the market is used for resource allocation.
C. Property rights do not matter if all costs of transaction are truly zero.
D. A system of property rights is determined by the nature of transaction costs.
(96-28)
10. The Diaoyu Islands issue shows that
A. there is a cost in defining and enforcing property rights.

B. exchange is impossible without private property rights.
C. demonstrators dissipate rents.
11. A common property
A. has no market price.

B. always implies allocative inefficiency.
C. always has a zero consumer surplus.
D. is more commonly found in a communist system. (97-19)
12. The Coase Theorem states that;
A. there is no such thing as a divergence between private and social costs.

B. a private property rights system is the best economic system.
C. a divergence between private and social costs will not exist if property rights
are private and if transaction costs are sufficiently low.
D. a divergence between private and social costs will necessarily exist without a
clear delineation of property rights. (97-
25)
13. A pianist plays the piano. His neighbour enjoys the music but the pianist
receives no payment from the neighbour. A divergence between private and
social costs occurs in the following situations EXCEPT:
A. The more music the pianist plays, the more the neighbour enjoys the music.
B. The more music the pianist plays, the less the neighbour enjoys the music.
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C. The neighbour feels that the last minute of the music has a zero value.
D. Although the neighbour loves the music, he feels that it would be better if the
pianist plays a little less. (97-27)
14. A factory dumps waste into a farmer’s water supply, causing significant
damage to the farmer. With prohibitive transaction costs in making contracts,
A. the situation may be efficient and no government intervention is needed.

B. the situation is inefficient and the factory should not be allowed to produce.
C. the farmer should have the right to demand compensation from the factory.
D. the situation is inefficient and government regulation is the only way to
improve efficiency.
(98-
13)
15. A divergence between private cost and social cost
A. will not exist if transaction costs are zero.

B. cannot be resolved without private contracting.
C. implies that income distribution is unequal.
D. means that the market is inefficient and requires government regulation.
(98-19)
16. The new airport in Hong Kong relieves the people living under the old flight
path from noise pollution, but causes noise pollution to those under the new
flight path. After the opening of the new airport,
A. the value of properties under the new flight path will fall if the noise pollution
is fully anticipated.
B. the value of properties under the new flight path will rise if the noise pollution
is fully anticipated.
C. the respective property values will change if changes in the levels of noise
pollution are not correctly anticipated.
D. the respective property values will not change under any circumstances.
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(99-19)
17. In the ocean where fishing is subject to common exploitation, the dissipation
of rent
A. will be reduced if all fishermen have equal opportunity costs.

B. will rise with the requirement of fishing licenses.
C. will not be reduced by introducing fishing regulations.
D. will not exist in the total absence of transaction cost. (99-
20)
18. Which of the following implies a divergence between private and social costs?
A. Male students contribute money towards buying perfumes for female

students.
B. A student accidentally pours coffee on a professor’s jacket and says sorry.
C. A husband complains about his wife all the time but refuses to get a divorce.
D. A piano player who never receives any payment for his music from his
neighbour always plays the piano that the marginal value of his piano play to
his neighbour is zero. (99-27)
19. Which of the following statements is INCORRECT?
If information is a free good,
A. examinations would be less useful.

B. there would be less price dispersion.
C. the demand for insurance would decrease.
D. middlemen such as property agents would be able to earn more.
(99-30)
A. there is no interest.
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B. there is information cost.

C. there is no transportation cost.
D. rent is part of cost. (00-09)
21. The Pareto Condition is violated when
A. certain constraints are neglected in explaining behaviour.

B. transaction costs are prohibitively high for market transactions.
C. property rights are not well-defined.
D. there is non-price competition. (00-17)
22. Which of the following statements about transaction costs is correct?
A. There may be transaction costs even if there is no market transaction.

B. Transaction Costs can only exist in a society.
C. The existence of institutions implies the existence of transaction costs.
23. Newspaper and magazine publishers often increase their sales and incomes
by reporting personal information about famous movie stars who usually do not
receive any financial return from the publishers. However, theses movie stars
often benefit from theses reports which serve as a kind of publicity for them.
Which of the following statements is correct regarding this situation?
A. There must be a divergence between private and social costs.

B. To attain economic efficiency, the government should force the party who
benefits more from these reports to compensate the other party.
C. The marginal benefits of theses reports to the two parties must be the same
since neither party pays the other.
D. The costs of making and enforcing contracts are prohibitively high.
(00-19)
24. When a pianist plays the piano up to a point where the marginal value of the
unpaid music to his/her neighbour is zero,
A. private marginal benefit diverges from social marginal benefit.

B. the total gain to the pianist and his neighbour is maximized.
C. the property rights to the music has to be defined for economic efficiency.
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D. the time spent on playing the piano is indeterminate. (00-

20)
25. A common property
A. induces non-price competition.

B. is a free good because it has no market price.
C. is a good that can be consumed concurrently by more than one individual.
D. is a good owned collectively by more than one individual. (00-
28)
26. If transaction costs are zero,
A. there will be no division of labour.

B. there will not be any consumption and production activities.
C. the choice of contractual arrangements will be indeterminate.
D. there is no risk. (00-29)
27. The presence of transaction costs implies that
A. a planned economy is more efficient than a market economy.

B. a planned economy is less efficient than a market economy.
C. the world is always efficient if all costs of transactions are taken into
consideration.
D. a society always evolves to reduce transaction costs. (01-
17)
28. The Coase Theorem implies that
A. when a factory pollutes a neighbourhood, the society may gain if the

residents in the neighbourhood are required to pay the factory to reduce the
pollution.
B. under private property rights, resource allocation is always the same.
C. there will be no market if all costs of transactions are zero.
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D. a system of private property rights is the most efficient system.

(01-18)
29. The postulate of constrained maximization
A. implies the Pareto Condition is always satisfied if all constraints are specified.
B. is not a hypotheses.
C. is not an observable fact.
30. A large lake subject to unrestrained common exploitation
A. has no fish.
B. has no owner.
C. yields no rent for the marginal fisherman.
D. yields no income. (03-26)
31. The construction of a new airport generates unpleasant noise for nearby
residents, and yet the value of nearby properties increases as a result of the
new airport. Which of the following is correct?
A. There may be no divergence between private and social costs.

B. The existence of both noise damage and increases in property value calls for
a tax on the one hand and a subsidy on the other.
C. There must be a divergence between private and social costs.
D. There is definitely no divergence between private and social costs.
(03-27)
32. The Coase Theorem suggests that
A. there is no divergence between private and social costs in a market economy.

B. government interventions, such as taxation and subsidy, are ineffective in
correcting any divergence between private and social costs.
C. resource allocation will be inefficient if private property rights are not clearly
defined.
33. Property rights arise whenever
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A. there is scarcity.
B. there is a society.
C. there is a society with scarcity.
D. production is subject to the law of diminishing returns. (04-
26)
34. The Coase Theorem assumes the existence of private property rights and the
non-existence of transaction costs. Which of the following statements is
correct?
A. This theorem is useless because transaction costs always exist.

B. This theorem is useful because it describes the nature of the market.
C. Private property rights will always be formed when there are no transaction
costs.
D. If there are no transaction costs, the assumption of private property rights is
not necessary.(04-27)
35. Transaction Costs
A. do not exist without market transactions.

B. do not exist without specialization in production.
C. are the same as transportation costs.
D. do not exist in a one-man economy. (04-28)
A. is always the result of government regulations.

B. may still exist if all costs of transactions are zero.
C. will not exist if markets direct the use of all resources.
D. may be interpreted as a divergence between private and social products.
(04-29)
37. Which of the following exists in a one man economy?
A. shortage.
B. pareto condition.
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C. institution.
38. The introduction of a new airport near a city as a rule creates noise and
pollution that affect the market value of the property nearby. Also as a rule, the
market value of the nearby property rises because of a substantial increase in
business activities. Which of the following is correct?
A. There is a divergence between private and social costs, and taxes imposed
on airplane take-offs and landings will reduce this divergence.
B. There is a divergence between private and social costs, and subsidies
awarded to airplane take-offs and landings will reduce this divergence.
C. So long as the market value of nearby property continues to rise with
divergence between private and social costs declines.
D. There is no divergence between private and social costs as long as the
market value of nearby property rises.
(05-29)
39. The Coase Theorem states that
A. if property rights are clearly defined, the divergence between private and
social costs will be eliminated.
B. if property rights are clearly defined and the transaction cost is zero, the
divergence between private and social costs will be eliminated.
C. if all costs of transaction are zero, there may be a divergence between
private and social costs.
D. if property rights are not clearly defined, there will always be a divergence
between private and social costs. (05-
30)
40. Both elephants and cows are animals which have commercial value. However,
elephants face the threat of extinction while cows do not. This is because
A. the price of elephants tusks, compounded by international prohibition of the

trade, is not high enough.
B. elephants are usually wild animals while cows are raised by people.
C. being large in size, elephants are easy targets for hunters.
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41. The presence of transaction costs implies that
A. some resources will be allocated inefficiently.

B. institution will emerge to organize resource allocation.
C. there will be no competition.
D. there will be no equilibrium. (06-25)
42. Which of the following statements about transaction costs is correct?
A. Transaction Costs are not measurable because it is not possible measure

transaction costs in dollar and cents.
B. It is not necessary to measure transaction costs because they are not
observable.
C. To measure transaction costs only a ranking of theses costs under different
situations is required.
D. Whether or not transaction costs are measurable has nothing to do with
deriving testable implications. (06-26)
43. Two adjacent houses have trees extending into each other’s garden area. Both
owners clear the fallen leaves in their own lawns without saying anything to
one another. Which of the following statements is correct?
A. There may be no divergence between private and social costs.

B. The marginal damage of these trees to each party must be the same since no
compensation is given.
C. There must be a divergence between private and social costs.
D. The cost of negotiation between the two parties is irrelevant.
(06-29)
A. may not exist even in the absence of private property rights.

B. will never exist with private property rights.
C. will never exist with government intervention.
D. may still exist even if transaction costs are zero. (06-30)
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45. Transaction costs will not exist
A. if everyone is truly honest.

B. if a dictator decides on the allocation of resources.
C. in the absence of production.
46. Building a highway creates a nuisance for the environment nearby. Land prices near the highway
often increase after the announcement of the route. This implies that
A. The government has selected the location of the highway accurately.

B. The benefits derives from the highway outweigh the nuisance created.
C. Pollution is inevitable when the economy develops.
D. There is necessarily a divergence between private and social costs. (07-30)
MC Answers on The Problem of Social Cost

A B C D D D C B B D
A C C A A C D B D B
A D D B A C C A D C
A D C D D D C C B D
B D A A D B
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The Problem of Social Cost
1999 Q. 9
Imports of goods such as cameras, computers, video tapes,
and VCDs that do not pass though authorized Hong Kong
distributors are known as parallel imports. Parallel imports are
not pirated goods. The qualities of authorized imports and
parallel imports are the same. While the Hong Kong
government has long prohibited the import and the sale of
pirated goods, it has only recently passed regulations which
make the parallel imports of video tapes and VCDs illegal.
(a) Assuming the new regulations are strictly enforced, who

gains and who lose?
(7
marks)
Authorized Hong Kong distributors will gain, at the expense of
customers and unauthorized distributors. The producers and the Hong
Kong government (tax collecting agent), however, may gain or lose. If
pirated goods are ignored and if the producers will not be able to
charge higher prices under the new regulations, the producers will lose.
The government’s tax revenue based on profits may rise or fall. Not
surprisingly, the parties who will likely gain the most are those fighting
against pirated goods, because pirated goods are mainly handled by
unauthorized distributors.
(b) How would you explain the fact that other parallel imports
such as cameras and computers are not included in the new
regulations? (7 marks)
Because items such as cameras are seldom pirated goods. The new
regulations are apparently enacted under the recent wave of
anticipated-goods movement, to protect the interest of artists and
producers. If there is no pirated goods at all, the new regulations may
hurt the producers. But with the abundance of pirated goods, the
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Prepared by A.Chow
prohibition of parallel imports will benefit the producers because

pirated goods will be reduced. Pirate producers, however, will be
harmed by the new regulations.
2002 Q. 6
(b) Some economists argue that if the cost of serving an extra

car is zero, as it will be if the tunnel has no traffic
congestion, then, to maximize social benefit, no toll should
be charged. The counter argument to this is that if no toll is
charges, no private enterprise will build the tunnel. Now the
tunnel is already built, and sunk cost is sunk. Will social
benefit increase if the government purchases the tunnel and
lets all cars use it free of charge? (5
marks)
The answer is Uncertain. The purchase of the tunnel incurs a cost to

society, regardless of who pays for it. If the government purchases the
tunnel and let all cars use it free of charge, it is taxpayers who pay for
the use of the tunnel. As we cannot know whether the total value to
the users will cover the purchasing cost of the tunnel, even if we ignore
the cost of operation, we cannot know whether social benefit will
increase or not. Even if there is congestion the answer will be the same
as we have no clear information about the total value of users.
297
Prepared by A.Chow
2004 Q. 7
hunting equally.
(b) As property rights to the deer in the wild are not assigned
to any individual or a group of individuals by law or by
customs, are there any private property right to the deer in
the wild? Explain. (Hint: Imagine an extreme case where
only one of the participants knows how to hunt.)
(6 marks)
Yes. There are, property rights to the deer in the wild are delineated by
the know-how or special skills of the less-than-10-per-cent superior
hunters. This is just like a strong man occupying a piece of land without
legal assignment will have an implicit claim to the land if no competitor
can take it away or infringe upon his use rights.
2004 Q. 8
Super-highways for motor vehicles have been constructed at a
very fast pace in mainland China. The quality standards of
these highways are comparable to those in the United States.
Fees or tolls are routinely charged for their use, with private
cars paying lower tolls than trucks or lorries, and lorries are
divided into two or three weight categories with different toll
charges. The tolls are high. Generally speaking, the price (toll)
for using the highways is about the same as the cost of fuel.
(a) Why have super-highways constructed at such a fast pace

in mainland China, faster in fact than what has been
observed in most other countries? (6 marks)
Firstly, with the growing demand to support the charge of substantial or

high tolls, the source of funding is no longer a serious problem. While in
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other places, even with tax surpluses, competing or alternative usages

of funds always take a lengthy procedure to sort out the options.
Secondly, there is in China no democratic voting of the type observed

in most other countries, hence there is less political delay.
Thirdly, as most lands are not privately owned, the reclamation of land
for highway uses is more straightforward and routine.
(b) It has been reported that in spite of the relatively new

super-highways in China built to international standards, the
highways often require repairs. Why? (Hint: What does
damage have to do with high toll charges?) (6
marks)
With a substantial road toll charged per lorry, there is a tendency to

load each lorry to maximum weight. It is also reported that with
infrequent installation of weighting stations, many lorries carry loads
exceeding the maximum allowed. The routine heavy weights of lorries
using the super-highways, prompted by high toll charges, increase the
frequency of road damage.
In 1920, A.C. Pigou of Cambridge advanced the argument that, with a

superior road and an inferior road, car drivers flock to use the
superior road and cause traffic congestion, each driver considers his
own driving time and ignores the damage which he inflicts upon other
drivers by slowing them down. Hence, there is a divergence between
private and social costs. Pigou proposed that the government, by
imposing a
tax on using the superior road, could induce some drivers to use the
inferior road that no congestion and society would gain as a result.
In 1924, F.H. Knight of Chicago rebutted Pigou’s theses, arguing that

the social cost problem that exists actually arises from the fact that
the superior road has no private owner. If the superior road was
privately owned, Knight argued, a toll would be charged for its use,
exactly the same as Pigou’s road-use tax, and the divergence
between private and social costs would disappear.
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Prepared by A.Chow
In 2003, it was observed that with very substantial tolls charged for
the use of super-highways in China, congestion on these highways
often occurred. Traffic congestion means drivers are inflicting driving-
time damage upon each other, and this may occur even when
substantial tolls are charged.
(c) The question is: When congestion occurs with toll charges,
does it means a divergence between private and social cost
must remain? Or, to eliminate the divergence, is it necessary
to raise the tolls to a level that will eliminate congestion?
(8
marks)
Eliminate of the divergence does not imply the absence of traffic
congestion, i.e., drivers inflicting damage upon each other and without
transactions among themselves does not necessarily imply any
divergence between private and social costs. When road tolls are
increased, congestion will decline. The divergence will fall to zero when
the benefit of a reduction in congestion to each driver is equal to the
cost of an increase in toll at the margin.
Annual Report: There are complications to this answer, such as drivers

are not equal in the values of their driving time, or that toll-free slower
roads may or may not be available as alternatives. These
complications and the simplifying assumptions one may make is too
advanced for this level. The important point is for a student to see that
the elimination of the traditional divergence does not require the
elimination of inter-personal damage, just like the factory pollution
case the elimination of the divergence does not require market
transactions among drivers, who inflict damage upon each other, as
the Coase Theorem would so require. A convenient substitute between
drivers and toll collectors, and it the tolls are properly priced, the
divergence will be eliminated.
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Prepared by A.Chow
2007 Q. 7
The Hong Kong government has imposed a strict and severe
no-smoking law, prohibiting smoking in most public areas.
Milton Friedman said that each and every individual should
have the freedom to harm himself, including committing
suicide; however, in doing so he may inflict damage on others
and create a social cost problem. One who smokes cigarettes
enjoys smoking, but may inflict damage on the health of others
nearby.
(a) How would you assess the social gains and costs of our new
no-smoking law? Can anyone be certain that the social gains
are greater than the social costs?
(b) What is the relevance of the Coase Theorem here? In what

sense is this theorem not operative in the no-smoking case?
(c)Emissions from automobile engines are said to inflict far

more damage on health than smoke from cigarettes. Why
does the Hong Kong government not impose a no-driving
rule? (13 marks)
2007 Q. 9
In China, fees are almost routinely charged for facilities, such
as highways, tourist attractions, public parks, and even public
toilets, subject to public usage. Such a fee-charging practice is
seldom used in the United States, where these public facilities
are well-maintained and provided to the public free of charge
by the government.
(a) Would you expect such public facilities to be constructed/

provided more quickly or more slowly in China than in the
United States?
(b) Would you expect the quality and maintenance of these

facilities, say public parks, to vary more greatly in China
than in the United States?
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(c)Would you expect there to be more or less tourist guides

serving tourist attractions in China than in the United
States? (14 marks)
- END -
Unit 11 – Public Goods and Economic Efficiency
(i) Public Goods
4. Subscription (fee-paying) television programme broadcast by the Cable TV in

Hong Kong is evidence of the fact that
A. a public good is produced by a private enterprise.

B. government action is necessary for reducing the divergence between private
and social costs.
C. free riders can be identified without cost.
D. a public good becomes a private good whenever a fee is charged.
(96-04)
5. A public good is
A. a free good which can be consumed by an unlimited number of consumers.

B. a common property because no one can exclude others from using it.
C. a good for which the marginal cost of serving an additional consumer is zero.
D. a good for which the marginal cost of producing an additional unit is zero.
(96-16)
6. A public good
A. cannot be produced efficiently by private firms.

B. is free of charge.
C. can be consumed by many individual at the same time.
D. is the same as a free good. (97-05)
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7. A public good is
A. a free good.
B. owned by the public.
C. produced by the government.
D. amenable for consumption by many individuals at the same time.
(98-25)
8. Which of the following statements about a public good is correct?
A. A public toilet (water closet) is an example of a public good.

B. When the marginal cost of serving a good to an extra consumer is zero, that
good is a public good.
C. A public good is characterized by the fact that one person’s use of the good
does not reduce the amount available for himself in the future.
9. A public good is
A. a good provided by the government but a price is charged.

B. a good that must be produced by the government because it is too costly for
a private producer to sell and collect payments.
C. a good that can be consumed by many individuals at the same time.
D. a good that may be used by the public free of charge. (01-
15)
10. Which of the following is an example of a public good?
A. books in a public library.

B. a public beach.
C. the music of Mozart.
D. a piece of abandoned land. (02-28)
11. A public good
A. is a free good.
B. may be consumed by many individuals at the same time.
C. is a good produced by a public agent.
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D. is a good provided free of charge by the government. (03-

17)
12. Basketball star Yao Ming is expected to earn a higher income than any other
active professional basketball player because
A. his basketball skills are so good that his salary income will be the highest
among all professional basketball players.
B. television broadcasts and advertisements of sports are public goods and
there are more than 1.3 billion Chinese on earth.
C. Chinese are particularly fond of watching professional basketball matches,
and no matter where Yao Ming plays, it is always full house because many
Chinese go to watch him play.
13. Which of the following comes closest to a public good?
A. A public telephone in booth in Central.

B. The singing of Teresa Tang.
C. The City Hall Library.
D. The public beach at the repulse Bay. (05-28)
16. Which of the following is a public good?
A. The music of Mozart.

B. A public toilet.
C. A box of candies shared by many people.
D. A lighthouse serving only one boat. (07-29)
MC Answers on Public Goods

A C C D B C C B B B
A A
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(ii) Economic Efficiency
1. The Pareto Condition states that
A. all marginal value are equalized.

B. resource reallocation cannot make someone gain without making someone
else lose.
C. there is no divergence between private and social costs.
D. the distribution of wealth satisfies each person in the economy.
(91-02)
2. When the Pareto Condition is satisfied, it means
A. wealth is evenly distributed.

B. the society’s welfare is maximized.
C. there is no transaction costs.
3. The Pareto Condition is satisfied if
A. it is possible to make one individual gain without making another lose.

B. there is no way to make one individual gain.
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C. there is no way to make all individuals except one gain.

4. Satisfaction of the Pareto Condition implies that
A. marginal use value must always equal marginal cost.

B. there is no scarcity of resources.
C. the value of all resources is maximized.
D. all costs of transactions are zero. (06-23)
5. Economic efficiency
A. is a result of maximization subject to all relevant constraints.

B. implies rapid economic growth.
C. implies maximum welfare for an economy.
D. requires government intervention when there is a monopoly in a market. (07-27)
MC Answers on Economic Efficiency
B D D C A
Public Goods and Economic Efficiency
1991 Q. 8 (c)
‘Because of the difficulty of collecting payments from
consumers, a public good (i.e., a good that can be consumed
by many individuals at the same time) cannot be produced by
a private enterprise.’ Say whether it is True, False, or
Uncertain. You must explain your choice; otherwise you will
receive no mark at all. (8 marks)
This statement is FALSE.
It is because as long as payments can be collected from the users and

the non-paying group can be excluded, a public good can be produced
by a private enterprise.
For example, a movie shown in a theatre is a public good because it is

amenable to concurrent consumption by many individuals, yet this
show privately produced because payments can be collected. In this
case only the paying consumers can obtain the service can obtain the
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service and the non-paying public are being excluded.
1994 Q. 8
Compact discs of popular songs are now being reproduced in a
massive scale in China. This reproduction is illegal, and the
reproduced discs are sold in the market at significantly lower
prices than the original discs.
From the standpoint of maximizing social gains, should the

illegal practice of reproducing discs be firmly suppressed so
that only the higher-priced original discs can be found on the
market? Explain. (10 marks)
With the reproduction of compact discs, this will result in lower prices
which come closer to the marginal cost of production. With the increase
in consumption, as long as the marginal use value is positive, this will
lead to a rise in total use value. Moreover, such a fall in prices will bring
the marginal use value of consumers closer to the marginal cost.
Hence, from the standpoint of maximizing social gains, the illegal
practice of reproducing discs should not be firmly suppressed.
However, if the illegal practice of reproducing discs are not be firmly

suppressed, the patent rights of the original discs will not be protected.
If the resulting income received by the original producers becomes too
low, the discs may not have been produced at all. As the total use
value of the potential users is higher than the cost of producing the
discs, there will be a fall in social gains if the discs are not produced.
Hence, from the standpoint of maximizing social gains, whether the
illegal practice of reproducing discs should or should not be firmly
suppressed depends on whether such illegal practice will end the
production of the original discs.
1998 Q. 7
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Advertisements provide correct information as well as false

information; advertisements may be boring or they may be
entertaining. All advertisements are costly to place.
(a) Commercial television programmes are supported by

advertising sponsors and, expect for cable TV, the viewers
do not have to pay any fees. Is it really true that viewers do
not have to pay any cost at all? Explain. (7
marks)
By cost, we have to consider the full cost borne by viewers in watching

TV commercials. Since full cost consists of monetary cost as well as
non-monetary cost, though viewers do not need to pay monetary cost,
they pay non-monetary cost in terms of the amount of time spent on
watching TV commercials. As the amount of time spent can be used in
other uses, there is always a cost of watching TV, i.e. time cost.
Moreover, since after watching the TV commercials, the MUV of viewers

on the advertised products will usually rise, the prices of the products
concerned will also rise. Thus, viewers will have to pay higher prices for
the advertised products.
So, to conclude, though viewers do not have to pay any fees for TV
commercials, they actually pay by their time costs of watching the
commercials and by paying higher prices for the advertised products.
(b) Most advertisements in the newspapers are placed and

paid for by the sellers of products. However, in the labour
market the advertisements are almost always placed and
paid for by the employers or buyers. Why is it differing so
sharply between product and labour markets with regard to
who, the buyer or the seller, places advertisements?
(7 marks)
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In the product market, since the number of sellers are far fewer than
the number of buyers, so it is the sellers who put up advertisements as
it can save transaction costs. As fewer advertisements will be posted, it
is easier for buyers to find what they want. However, if advertisements
are being posted buyers, the advertisements will be so numerous and it
is difficult for sellers to find out who want their products. Hence, in
order to save transaction costs, whether the buyers or sellers who put
up the advertisements depends on the number of buyers and sellers in
the market.
In the labour market, buyers are the firms hiring workers, i.e.
employers. They buy advertisements because it can save transaction
costs. Since the sellers in the labour market are the workers, if
advertisements are made by them, the transaction costs involved will
become much higher than if they are paid by employers. It is because
there are so many workers in the labour market, if each of them
advertises his service; there will be so many advertisements that the
total cost will be extremely high. Furthermore, each buyer will also
have to spend a lot of time reading all these advertisements for
suitable workers.
As the number of buyers are typically fewer than sellers,

advertisements put up by them can become fewer and this in turn
saves transaction costs. Moreover, sellers can find it easier to search
for the information suitable for them.
So, to conclude, in order to save searching and information costs, it is

the buyers of labour services who put up the advertisements instead of
the sellers of labour services.
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2005 Q. 7
The Chinese government subsidizes the training of promising
athletes. When some of the athletes become sports stars, such
as winners of Olympic gold medals, the government is entitled
to a share of the income (including advertising income) earned
by the star athletes through pre-arranged contracts between
the government and the athletes. The Chinese government has
been losing money in this subsidization business.
On the other hand, in the United States, private professional

training centres (such as those for professional tennis players)
exist and they are making money, by charging relatively low
training fees plus contracted shares of the athletes’ future
incomes from the sport.
(a) Why does the Chinese government lose money in training

athletes? On what economic ground could this subsidization
be justified? (5 marks)
The government loses money in training athletes because she trains

too many of them, including the less talented athletes as well as those
specializing in sports that have little or no commercial value. The
presence of external effects, such as national pride of glory, may yield
values to citizens at large, as most if not all Chinese in some measure
enjoy a greater number of gold medals won in the Olympic Games. It
would be highly difficult to collect payments for this type of external
beneficial effects from all those enjoying the results of the training.
(Transaction Costs may be mentioned here.) Does national pride worth
something to the citizens? Of course. But since payments are not
enforced there is no way we can assess actually how much the citizens
would be willing to pay.
(b) On a voluntary training basis (although sometimes under

pressure), Chinese athletes today have won far more gold
medals in the Olympic Games than the earlier period when
the training of promising athletes was compulsory. Why?
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Prepared by A.Chow
(4
marks)
Because monetary rewards are far higher today (direct monetary
rewards from state and local governments, as well as from private
donors, plus indirect commercial rewards), talented athletes voluntarily
come forward without much forcing, and because of the higher rewards
they train themselves harder.
(c) Do you anticipate the training of professional athletes be

conducted through private funding in China in the future? If
so, which professional sports are most likely to be so
funded? Explain. (5 marks)
Yes, but it is mainly in individual sports (not team sports) with high
commercial values. There are tennis, golf, figure skating, diving even
some track and field events spectators love to watch or that are good
to advertisement purposes.
- END -
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2008-AL-ECON-I Past Questions on Microeconomics

Unit 1 – The Scope of Economic Analysis

(i) Basic Economic Problems

A. there is no such thing as a free good.

2. Which one of the following statements about economic goods is FALSE?

3. Which of the following statements about competition is FALSE?

A. Waiting in line is a form of competition.

A. First come, first served.

5. Which of the following describe(s) a ‘shortage’?

A. A shortage exists whenever the price is fixed by the government.

A. is implied by the existence of price.

7. Which of the following statements about scarcity is FALSE?

A. Scarcity implies competition.

8. Which of the following about shortage is correct?

A. Shortage is the same as scarcity.

A. is provided by the government free of charge.

C. is a good the supply of which is so abundant that more of it is not preferred.

10. In a one-man economy,

11. For a resource to be a good,

A. the resource must be limited in quantity.

A. safety is not a good for these drivers.

A. Scarcity implies shortage.

A. is the same as shortage.

15. Scarcity implies

A. everything is not enough.

16. Competition will NOT arise if

A. all individual are identical.

A. scarcity and shortage.

18. Which of the following exists in a one-man economy?

19. In a one-man economy, there will still be

20. Scarcity implies

A. the market is the most efficient place for allocating resources.

MC Answers on Basic Economic Problems

(ii) Economic Theory

1. An economic theory is useful or testable if

A. it is potentially refutable by facts.

2. Which of the following statements about economic theory is correct?

A. A theory should be abandoned when its assumption are found to be

3. A government official said, ‘Our unemployment problem will be solved if the

4. Selfishness and scarcity

A. imply constrained maximization.

6. Which of the following statements about an economic theory is correct?

A. A useful theory must contain hypotheses that are refutable by facts.

7. Which of the following statements about an economic theory is INCORRECT?

A. A useful theory must have refutable implications.

8. Economic theory is useful because

9. Which of the following is NOT an attribute of a useful economic theory?

A. The theory is always true.

10. A useful theory should

11. Which of the following is a tautology?

A. The area of Victoria Park is greater than that of Kowloon Park.

12. The explanatory power of an economic theory will be weaken if

A. the theory is consistent with maximizing behaviour.

13. Which of the following is a refutable statement?

A. When an individual’s preference changes, his consumption behaviour also

14. Which of the following statements is NOT refutable?

A. If price falls, the quantity transacted will fall.

15. A theory with an indefinite number of possible outcomes

A. is more general in application.

16. Which of the following statements is testable?

A. An increase in the available quantity of a good will lead to a reduction in its

17. A useful theory