Tips and Sample Questions for chapter 16, Micro.

Chapter 16 is the extension of chapter 13, Price Determination in Factor Markets. Interest Rates are prices for
borrowing and lending money or compensation for Capital Goods, Economic Rents are prices of land, and
profits are residuals for an entrepreneur.
Start the chapter with the Loanable Funds Market and study the Demand and Supply sides of it. Familiarize
yourselves with the following terms:

Interest vs. Interest Rates

Positive Rate of Time Preference
Roundabout Method of Production
Interest Rates and Return on Capital Goods
Why do Interest Rates Differ? Risk, Term of the Loan, and Cost of making the Loan.
Nominal and Real Interest Rates => an important distinction.
Present Value of future income.
Renting an apartment, a car, or a movie, etc. is not the type of rent discussed in this chapter. To an
economist, rent means ECONOMIC RENT, that is the payment in excess of opportunity cost. A
subset of economic rent, called PURE ECONOMIC RENT, is a payment in excess of opportunity
costs when opportunity costs are zero. This term was first used to describe the payment to the factor
LAND, which is perfectly inelastic in supply (meaning that its supply is vertical.)
Study Exhibits 3 and 4 where demand and supply of land in two different cases are presented. Pay
attention to David Ricardos discussion of Price of Grain and Land Rent and conclude that land

rents are price determined rather than price determining!

Then note that:
economic rent also applies to other factors of productions such as labor
economic rents and baseball players, and
Competing for Artificial and Real Rents by individuals and business firms at the end.
Economic profit is the difference between total revenue and total cost (both explicit and implicit
costs) and the entrepreneur after paying to all factors of production or resources entitled to claim the
leftover or residual. => Profit is a residual that may be positive (called profit) or negative (called
loss.) and it is a sheer coincident the residual to be zero in short run. Profit or loss function as
signals.
There are different theories of profit based on (1) Uncertainty, (2) Arbitrage Opportunities, and (3)
Innovation. What an entrepreneur as claimant of profit does is closely tied to what happens in a
market:

How can the entrepreneur increase Trade?

Turning potential trades into actual trades in a way that is acceptable to consumers.
Can increasing trades in one area reduce trades in another?
Entrepreneurs and NO $10 BillS on the sidewalks.
Uncertainty and the entrepreneur.

Sample Questions for chapter 16, Micro.

Multiple Choices
Identify the choice that best completes the statement or answers the question.
____

1. Interest can be regarded as the

a. payment to entrepreneurs for incurring risk in the production of new goods.
b. rate that a lender receives for the use of the lender's loanable funds.
c. return earned by capital as an input in the production process.
d. dollar amount of loanable funds that a person borrows to invest in a capital good.

____

2. Which of the following is true?

a. Larger loans are likely to be cheaper to process (per dollar) than smaller loans; therefore,
larger loans will carry a lower interest rate than smaller loans, ceteris paribus.
b. Larger loans are likely to be more expensive to process (per dollar) than smaller loans;
therefore, larger loans will carry a higher interest rate than smaller loans, ceteris paribus.
c. Larger loans are likely to be cheaper to process (per dollar) than smaller loans; therefore,
larger loans will carry a higher interest rate than smaller loans, ceteris paribus.
d. Larger loans are likely to be more expensive to process (per dollar) than smaller loans;
therefore, larger loans will carry a lower interest rate than smaller loans, ceteris paribus.

____

3. If the nominal interest rate is 4 percent and expected inflation rate is 5 percent, the real interest rate
a. equals 1 percent.
b. equals -1 percent.
c. equals 9 percent.
d. cannot be calculated.
e. none of the above

____

4. Suppose a bank makes a $1,000 loan to you at 5 percent interest when the expected and actual inflation rate
are zero percent. Before you pay back the $1,000 principal and $50 interest, the inflation rate increases to 10
percent. Does anyone lose from this situation?
a. Nobody loses, because the terms were set before the inflation rate increased, and once the
terms are set, inflation does not affect the situation.
b. You lose, because the dollars that you have borrowed are worth more the higher the
inflation rate.
c. The banker loses, because you will be paying back the loan with dollars that are worth less
than the dollars you borrowed.
d. Both the banker and you lose, for the reasons in answers b and c.
e. There is not enough information to answer the question.

____

5. The present value of $10,000 one year in the future at a 5 percent interest rate is approximately

a.
b.
c.
d.

$9,524.
$6,250.
$9,400.
$10,500.

____

6. What is the approximate present value of $1,000 received two years from today if the interest rate is 6
percent?
a. $890
b. $720
c. $792
d. $1,120

____

7. Economists generally agree that land rents are

a. price determining, not price determined.
b. price determined, not price determining.
c. too high.
d. too low.
e. Economists generally do not agree on anything.

____

8. Uncertainty
a. is the result of economic rent seeking.
b. is the same thing as risk.
c. exists when the probability of a given event can be estimated.
d. exists when the probability of a given event cannot be estimated.
e. none of the above

____

9. In a very popular movie, the principal character wore aviator sunglasses that were given to the movie studio
by the sunglasses producer. The sunglasses suddenly became very popular, and their producer earned
significant profits. Which of the following theories on the source of profits discussed in the text best describes
the reason behind this success?
a. Uncertainty is a source of profits.
b. Profit is a reward for alertness to arbitrage opportunities.
c. Profit is the return to the entrepreneur as innovator.
d. Profit is a reward for waiting long enough for consumers to respond to your product.

____ 10. Ceteris paribus, the nominal rate of interest will increase when the
a. real rate of interest falls.
b. expected rate of inflation increases.
c. expected rate of inflation falls.
d. a and b
e. a and c
____ 11. If the nominal rate of interest is 12 percent and the expected rate of inflation is 5 percent, then the real rate of
interest is
a. 17 percent.
b. 12.6 percent.
c. 7 percent.
d. 2.4 percent.
e. 11.43 percent.
____ 12. The supply of loanable funds curve is
a. upward sloping.
b. downward sloping.

c. perfectly elastic.
d. perfectly inelastic.
____ 13. If there is an increase in the expected inflation rate, then,
a. the supply and demand for loanable funds will decrease.
b. the supply and demand for loanable funds will increase.
c. the supply of loanable funds will decrease, and the demand for loanable funds will
increase.
d. the supply of loanable funds will increase, and the demand for loanable funds will
decrease.
____ 14. If there is a decrease in the expected inflation rate, then,
a. the nominal interest rate will increase.
b. the nominal interest rate will decrease.
c. the real interest rate will increase.
d. a and c
e. b and c
____ 15. If medical research were to find that grain consumption lowers human life expectancy, agricultural land rents
would
a. increase.
b. decrease.
c. not be affected.
d. increase in the short run and decrease in the long run.
____ 16. A decrease in the expected rate of inflation will shift the demand for loanable funds curve __________, while
shifting the supply of loanable funds curve __________.
a. leftward; leftward
b. leftward; rightward
c. rightward; rightward
d. rightward; leftward
____ 17. What is a roundabout method of production?
a. It refers to an inefficient way of producing goods.
b. It refers to the production of capital goods that are used to enhance productive capabilities.
c. It refers to hiring more workers and using fewer capital goods.
d. It refers to producing more consumer goods and fewer capital goods.
e. none of the above
____ 18. If roundabout methods of production did not ultimately __________, they would probably not be employed.
a. decrease taxes
b. increase consumption
c. decrease interest rates
d. lower inflation
e. increase the number of persons working
____ 19. A firm knows that it can borrow funds at 7 percent to invest in capital. Whether or not it borrows the funds
depends upon the
a. amount of people's saving.
b. rate of time preference of consumers.
c. return on capital relative to the price of credit.
d. difference between its interest payments and the interest rate.
e. none of the above

____ 20. The return on capital is greater than the price of a loanable fund. It follows that firms will
a. borrow funds, the capital stock will rise, and eventually the return on capital will fall.
b. borrow funds, the capital stock will fall, and eventually the return on capital will rise.
c. not borrow funds and, as a result, the price of credit will rise.
d. not borrow funds and eventually the capital stock will decrease and the return on capital
will fall.
e. none of the above
____ 21. Which of the following statements is false?
a. Capital depreciates over time.
b. As the capital stock decreases, the marginal physical product of capital rises.
c. If the return on capital is less than the price of credit, a firm will not borrow funds to
invest in capital.
d. If the return on capital is greater than the price of credit, then the price of credit must be
greater than the price for loanable funds.
____ 22. The current nominal interest rate is 9 percent. If the expected inflation rate changes from 2 to 3 percent
(ceteris paribus), it follows that the demand for loanable funds will
a. rise by more than the supply of loanable funds will rise.
b. will rise by less than the supply of loanable funds will fall.
c. will fall by more than the supply of loanable funds will rise.
d. rise by the same amount that the supply of loanable funds will rise.
e. none of the above
____ 23. When the expected inflation rate is zero, then it follows that the
a. real interest rate is greater than the nominal interest rate.
b. demand for loanable funds is equal to the supply of loanable funds.
c. demand for loanable funds is greater than the supply of loanable funds.
d. real interest rate is less than the nominal interest rate.
e. none of the above
____ 24. Which of the following is true?
a. The real interest rate matters more to borrowers than the nominal interest rate.
b. The nominal interest rate is equal to the real interest rate minus the expected inflation rate.
c. If there is expected deflation (expected decline in the price level), instead of expected
inflation, the nominal interest rate will be greater than the real interest rate.
d. The nominal interest rate is determined by the demand for credit and the supply of credit,
or by the demand for loanable funds and the supply of loanable funds.
e. If there is expected deflation, the nominal interest rate will necessarily be negative.
____ 25. The higher the cost of processing a loan, the __________ the interest rate charged for the loan; the lower the
expected inflation rate, the __________ the nominal interest rate.
a. higher; lower
b. lower; higher
c. higher; higher
d. lower; lower

Tips and sample questions for chapter 16, Micro

Answer Section
MULTIPLE CHOICES
1. ANS:
LOC:
2. ANS:
LOC:
3. ANS:
LOC:
4. ANS:
LOC:
5. ANS:
LOC:
6. ANS:
LOC:
7. ANS:
LOC:
8. ANS:
LOC:
9. ANS:
LOC:
10. ANS:
LOC:
11. ANS:
LOC:
12. ANS:
LOC:
13. ANS:
LOC:
14. ANS:
LOC:
15. ANS:
LOC:
16. ANS:
LOC:
17. ANS:
LOC:
18. ANS:
LOC:
19. ANS:
LOC:
20. ANS:
LOC:
21. ANS:
LOC:
22. ANS:

PTS: 1

DIF: Moderate

NAT: Analytic

PTS: 1

DIF: Moderate

NAT: Analytic

PTS: 1

DIF: Easy

NAT: Analytic

PTS: 1

DIF: Difficult

NAT: Analytic

PTS: 1

DIF: Moderate

NAT: Analytic

PTS: 1

DIF: Moderate

NAT: Analytic

PTS: 1

DIF: Moderate

NAT: Analytic

PTS: 1

DIF: Easy

NAT: Analytic

PTS: 1

DIF: Moderate

NAT: Analytic

PTS: 1

DIF: Moderate

NAT: Analytic

PTS: 1

DIF: Easy

NAT: Analytic

PTS: 1

DIF: Easy

NAT: Analytic

PTS: 1

DIF: Moderate

NAT: Analytic

PTS: 1

DIF: Moderate

NAT: Analytic

PTS: 1

DIF: Easy

NAT: Analytic

PTS: 1

DIF: Moderate

NAT: Analytic

PTS: 1

DIF: Moderate

NAT: Analytic

PTS: 1

DIF: Moderate

NAT: Analytic

PTS: 1

DIF: Moderate

NAT: Analytic

PTS: 1

DIF: Moderate

NAT: Analytic

PTS: 1

DIF: Difficult

NAT: Analytic

PTS: 1

DIF: Moderate

NAT: Analytic

LOC:
23. ANS: E
LOC:
24. ANS: D
LOC:
25. ANS: A
LOC:

PTS: 1

DIF: Moderate

NAT: Analytic

PTS: 1

DIF: Moderate

NAT: Analytic

PTS: 1

DIF: Moderate

NAT: Analytic