ECON1001/1001I

SUMMER TERM 2017 ANSWERS

ECON1001/1001I: ECONOMICS

TIME ALLOWANCE: 2.5 HOURS

Answer ALL the questions from Part A and ANY TWO from Part B
This exam constitutes 70 per cent of the final grade for ECON1001/1001I. Part A (multiple
choice questions) is worth 30 per cent of the final grade and Part B is worth 40 per cent of the
final grade. Each of the 20 questions in Part A is worth 3 points; each of the two questions in
Part B is worth 40 points. The total number of points in this exam is 140, which will be divided
by two to give a score out of 70, which will be added to the score (out of 30) achieved in the
January exam to give the final grade for ECON1001/1001I.
In cases where a student answers more questions than requested by the examination rubric, the
policy of the Economics Department is that the student’s first set of answers up to the required
number will be the ones that count (not the best answers). All remaining answers will be
ignored.

PART A: Answer ALL questions from this section. Each question below has THREE answer
options. More than one (or none) of these may be correct. For each answer option decide whether
it is TRUE or FALSE. If you don’t know, then choose DON’T KNOW. Please note that exactly
ONE of these options needs to be selected for each answer option.
If your choice is correct you will receive ONE mark. If your choice is wrong, ONE mark will be
subtracted from your score for this question. If you choose DON’T KNOW, you receive ZERO
marks. The maximum score for each question is +3 and the minimum score per question is -3.
The minimum overall mark for this part of the exam is set to ZERO.

A1. Ten individuals play a game where their strategies are all the real numbers between zero and
100. The winner is the person whose stated number is closest to one half the average of all the
numbers in the group. If there is more than one winner, they divide the prize (100 pounds)
equally.

(a) The strategy 50 is dominated.

(b) The strategy profile where all individuals say 25 is a Nash equilibrium.
(c) The strategy 40 is a best-response for one player if all other players choose 50

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A2. The following statements is/are true about a monopoly:.

(a) If marginal revenue is larger than marginal cost, its profits would increase if quantity
increased.
(b) A monopolist is interested in increasing demand elasticity.
(c) The deadweight loss of the monopolist depends on the difference between marginal
revenue and marginal cost at the optimal choice.

A3. In a perfectly competitive market in which the demand is Q = 30 – P and the supply is Q =
2P – 3, the government announces a per unit tax of the good of 3.

(a) The equilibrium price is now P=14.

(b) The consumer surplus is now 220.
(c) The deadweight loss of the tax is equal to 5.

A4. The government has instituted a subsidy (paid to the buyers) of 3000 pounds per electric car
bought in 2017. The electric car industry is competitive.

(a) The deadweight loss caused by the subsidy is minimal if the elasticity of supply is
infinite.
(b) Buyers gain more from the subsidy than sellers if demand is more inelastic than supply.
(c) The final price paid by consumers of electric cars will increase by 3000 if supply is
perfectly inelastic.

A5. A factory generates an external marginal cost equal to 20 pounds per unit of the good it
produces.

(a) In a competitive market without intervention the price will be 20 pounds lower than that
which would lead to the socially optimal quantity.
(b) Only government intervention can lead to the production of the socially optimal quantity.
(c) The Pigouvian tax can be less than 20 pounds per unit of good to attain the socially
optimal quantity, if demand is sufficiently elastic in a competitive market.

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A6. Clark and Oswald (2002) estimate that “the average British person would need to be
compensated £15,000 ($22,500) per month after losing their job in order to be as happy as they
were when they were employed.”

a) This evidence favours the interpretation of unemployment as voluntary.

b) This is less than the estimated loss of earnings of an average worker who became
unemployed at that time.
c) This evidence is an indicator that employment rents are non-negligible.

A7. Assume an economy comprises only two firms, Firm A and Firm B. The following table
shows the profits (or losses if negative) when the firms invest or do not invest (the first entry in
each box represents Firm A):

Firm B Firm B does

invests not invest
Firm A
400 , 60 -100 , 50
invests
Firm A
does not 310 , -10 55 , 45
invest

Based on this information, which of the following statements is/are correct?

(a) Investing is a dominant strategy for at least one firm.

(b) The Pareto-efficient outcome is a Nash equilibrium.
(c) Firm B is more dependent on investment by Firm A than the converse.

A8. The following table shows the real interest rate and the annual inflation rate (using the CPI)
of Australia in the period 1971-19955 (Source: OECD):

1971-75 1976-80 1981-85 1986-90 1991-95

Inflation rate (%) 10.4 10.6 8.3 7.9 2.5
Real interest rate (%) -2.2 -0.4 6.1 7.1 4.5

Based on this information, which of the following statements are correct?

(a) Monetary policy was looser in the 5-year period following the peak of inflation.
(b) The nominal interest rate was more than halved between the first half of the 1980s and
the first half of the 1990s.
(c) The nominal interest rate was lower in the periods in which inflation was lower.

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A9. The following is a table of the Sterling exchange rates against South African Rand and US
dollars (source, Bank of England):

22 December 22 December
2015 2016
Rand/GBP 22.53 17.29
USD/GBP 1.48 1.23

In this table from the Bank of England database, the exchange rates are defined as the number
of South African Rand USD or Euro per 1 GBP. Based on this information, which of the
following statements are correct?
(a) Rand depreciated against USD over the year.
(b) GBP depreciated against USD and Rand over the year.
(c) Imports of goods and services from Britain were cheaper in South Africa in December
2016 than a year before.

A10. Suppose a fall in inflation is forecast. Which of the following statements is /are true?

(a) This is consistent with the fact that inflation fell last period.
(b) This is inconsistent with a strengthening of competition in markets for goods and
services.
(c) This is consistent with the introduction of policies to make it more difficult for unions to
organize strikes.

A11. Consider an individual whose endowment consists of $100 now and zero in the future.
There are two periods. Which of the following statements is /are true?

(a) The slope of the feasible frontier at the endowment point is steeper than the slope of the
indifference curve at that point.
(b) The horizontal intercept of the feasible frontier shifts to the right if the individual is able to
invest in a profitable project.
(c) The individual will never choose an option with a negative real interest rate.

A12. Which of the following are correct ways of completing this sentence?

The market failure associated with credit rationing …

(a) would not arise if there was no conflict of interest between the borrower and lender.
(b) would not occur if the borrower could be forced to repay even if the project failed, e.g.
out of future earnings or other assets.
(c) means that good projects proposed by the less wealthy will not be funded while inferior
ones of the wealthy will be funded CONTINUED

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A13. Which of the following statements about liquidity and solvency is / are true?

(a) The relevant items on the balance sheet to assess solvency are total liabilities and total
assets.
(b) Allowing banks to borrow from the central bank at a penalty rate of interest can deal with
a bank’s solvency but not liquidity problem.
(c) If a bank admits that many of its loans are ‘non-performing’ and unlikely to be repaid,
this increases its liabilities.

A14. Consider an economy with GDP growing at a trend rate of 2% p.a. The population is
growing at 1% p.a. A recession occurs in which output falls for two consecutive quarters. Which
of the following statements is /are true?

(a) In a graph with time on the horizontal axis and the log of GDP per capita on the vertical
axis, the trend growth rate would be shown by a positively sloped line.
(b) If output is plotted on a ratio scale and growth returns to the previous trend line, there
must be a period after the recession during which the economy grows faster than 2% p.a.
(c) If output grows at 2% per annum after the recession but does not return to trend, the
economy suffers no permanent loss

A15. In the multiplier model,

(a) A higher share of credit-constrained households increases the impact on output of any
change in autonomous aggregate demand.
(b) The paradox of thrift means that adopting a policy of austerity in a recession (by reducing
government expenditure) will worsen the public finances as compared with a policy that
keeps government expenditure unchanged.
(c) A rise in household wealth relative to target will ceteris paribus shift the AD curve
upwards and raise output.

A16. Which of the following statements is/are true?

(a) The Beveridge curve shifts outward as the economy moves from a boom to a recession.
(b) The Phillips curve shifts down as the economy moves from a boom to a recession.
(c) Okun’s coefficient varies over time but not across countries.

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A17. In the 2006 Stern Review, Professor Nicholas Stern used the discount rate of 1.4% (1.3%
due to technological progress plus 0.1% for the possibility of extinction). Professor William
Nordhaus argued that the impatience of citizens should be additionally considered, estimated to
be around 3.0% per annum, and suggested an overall discount rate of 4.3%. The following table
shows the present values of a $100 payment in future, discounted at the two rates. Based on this
information, which of the following statements is /are true?

(a) Nordhaus would approve a project that saves the generation in 50 years’ time $100 in
environmental damages if it costs less than $12.18 today.
(b) Both Stern and Nordhaus consider future generations as less worthy of our concern than
the current generation.
(c) Nordhaus’s estimation of the discount rate is more correct than Stern’s.

A18. Herbert Hoover was the US President between 1929 and 1933. During this time:
President Hoover advocated a balanced budget which remained within the range of -0.6%
to +0.8% of GNP in 1929-31.
Output was 20% below the full employment level in 1931.
The short-term nominal interest rate fell from 5.8% in 1929 to 1.7% in 1933.
The CPI decreased from -2.7% in 1930 to -10.3% in 1932.
The US remained on the gold standard while the UK abandoned the regime in 1931.

Which of the following statements is / are true regarding this period?

(a) Despite the cut in the nominal interest rate, monetary policy was contractionary during
this period.
(b) The cut in the nominal interest rate was possible due to the US remaining in the gold
standard.
(c) The fact that the UK left the gold standard made it harder for the US to remain in the gold
standard.

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A19. Based on the data studied in this course, which of the statements below is / are correct?

a) Income inequality between countries has decreased over the last half century.
b) The rate of growth of GDP per capita over the past four decades has been greater in
countries with greater inequality in disposable income than in more equal countries.
c) Economic research in the UK and the US has shown that raising the minimum wage
reduces the number of people hired by a substantial amount.

A20. Using the following figure, which of the statements below is / are correct?

(a) An inequality-averse citizen does not care about his own income or wealth.
(b) Point E would never be chosen no matter how inequality-averse the citizen is.
(c) The philosopher favoured point R because it is consistent with the lowest Gini
coefficient.

CONTINUED

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PART B. Answer ANY TWO questions from this section.

B1. (40 points)

Angela works the land for Bruno. She can get 𝑔 = 1 bushel of grain for free from the
government if she is unemployed. Her preferences between hours of leisure h and grain g can be
represented as 𝑈(𝑔, ℎ) = 𝑔 + 2ℎ0.5 . The feasible production frontier can be represented in terms
of Angela’s hours of leisure as 𝑔 = 2(24 − ℎ)0.5 . Suppose Bruno is purely self-interested and
only wants to maximize the bushels of grain he gets from Angela, subject to her accepting the
deal. And suppose that Angela is also purely self-interested and has the utility function described
above. When answering each question below, please explain any maths you use, and when
possible draw diagrams to explain the answer.

(a) What is the constraint facing Bruno so that Angela accepts his proposal?
(b) Given that constraint what is the maximization problem that Bruno has to solve?
(c) Derive and explain in economic terms the first order conditions of the problem you just
wrote. Are the second order conditions satisfied for this problem?
(d) What is the optimal solution to the problem of Bruno? What is the utility of Angela?
(e) Suppose the government issues a regulation limiting the maximum number of work hours
to 8. What is the optimal solution of this problem now? Does Angela have a higher
utility? Why?
(f) Is there a way for both Angela and Bruno to increase their utility from the one they obtain
in part (e) by changing the regulation?
Answer:

(a) It is 𝟏 + 𝟐(𝟐𝟒)𝟎.𝟓 = 𝒈 + 𝟐𝒉𝟎.𝟓 If Angela rejects, she can have 1 bushel of government
grain and 24 hours of leisure.
(b) 𝒎𝒂𝒙𝒉 𝟐(𝟐𝟒 − 𝒉)𝟎.𝟓 − ( 𝟏 + 𝟐(𝟐𝟒)𝟎.𝟓 − 𝟐𝒉𝟎.𝟓 ) Maximizing the grain Bruno can retain
after Angela is given the utility corresponding to her rejecting the offer.
𝟏 𝟏
(c) = (𝟐𝟒−𝒉)𝟎.𝟓 This is simply equating the marginal rate of transformation of hours
𝒉𝟎.𝟓
into grain to the marginal rate of substitution for Angela. The second order conditions
are satisfied as the second derivative is negative.
(d) 𝒉 = 𝟏𝟐, total grain 𝒈 = 𝟔. 𝟗𝟑, for Angela the grain is 3.87, for Bruno 3.06. Angela’s
utility is the same as in autarky 𝑼 = 𝟏𝟎. 𝟖.
(e) 𝒉 = 𝟏𝟔, total grain 𝒈 = 𝟓. 𝟔𝟔, for Angela the grain is 2.870, for Bruno 2.86. Angela’s
utility is the same as in autarky 𝑼 = 𝟏𝟎. 𝟖. Angela does not improve because Bruno
still maximizes subject to her utility constraint, and now the constraint that hours
worked cannot be higher than 8.
(f) Yes, at the point described in part (e) the MRS of Angela does not equal the MRT of
transformation of hours into bushels of grain. She would be happy to increase her

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hours of work beyond the legal mandate in exchange for a bit more grain and Bruno
could keep part of the extra grain while she accepted.

B2. (40 points)

The demand for hard drives is given by Q = 24 – 4P and the marginal cost (and average) of
production is 4. Please answer this question graphically and also analytically whenever possible,
and explain your derivations in words.

(a) What is the equilibrium price, quantity, producer and consumer surplus in equilibrium if
the good is supplied in a perfectly competitive fashion?
(b) What is the equilibrium price, quantity, producer and consumer surplus in equilibrium if
the good is supplied by a monopolist?
(c) The production of hard drives uses cobalt, which is found out to produce an external
marginal cost amounting to 1 per unit produced, in addition to the private marginal cost
of 4. What would be the socially optimal quantity produced in the market under this
assumption?
(d) If there is no government intervention, would total social welfare be lower under
competition or under monopoly when the externality from cobalt is taken into account?
Why is that true?
(e) How could we obtain the socially optimal quantity using a Pigouvian tax under perfect
competition?
(f) How would you evaluate the equity of the situation obtained under monopoly? Is a
Pigouvian tax a good instrument to improve that situation?

Answer:

(a) Supply is constant at P=4 in a competitive market, so that is the competitive price, and
Q = 24-4×4 = 8. Producer surplus is zero, because price equal marginal cost for all
units, and consumer surplus is the area under the demand, but above the price (6-
4)×8/2 = 8.
𝟏 𝟏
(b) The total revenue is (𝟔 − 𝟒 𝑸) 𝑸 so the marginal revenue in this case is 𝟔 − 𝟐 𝑸. If we
𝟏
equate this to the marginal cost, we get 𝟔 − 𝟐 𝑸 = 𝟒, so that Q = 4. Price is then P = 5.
Consumer surplus is now (6-5)×4/2 = 2. Producer surplus, in this case equals profit as
there is no fixed cost, and it is equal to (5-4)×4 = 4.
(c) The socially optimal quantity is the one that equates demand (marginal willingness to
pay) to the total marginal cost (Private + Social) which is 4+2 =6, so that Q = 24-4×5 =
4.
(d) Without government intervention, the monopolist produces the socially optimal
quantity, whereas the competitive market produces an excessive amount of the good.
Thus total social welfare is higher under monopoly. The reason is that the monopolist

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reduces production to increase profits which has the unintended effect of achieving the
socially desirable quantity.
(e) A tax of 1 per unit of production would internalize the externality.
(f) Under monopoly the producer clearly obtains more surplus than under competition
and the consumer less, but it is not a good idea to look at the equity problem from a
single market perspective, the monopolist could employ poor people and the consumers
could be rich. Pigouvian taxes are not necessary because they are intended to obtain
efficiency, not equity, and in this case they are not needed because the monopolist
produces the socially optimal outcome.

B3. (40 points)

S1. “Technological progress destroys jobs.”
S2. “Technological progress was rapid in the 1920s and 1930s, and again in the 1950s and
1960s. In the first period, the Great Depression occurred and the second period was called
capitalism’s Golden Age.”

(a) Use a model or models you have learned in this course to explain what is meant by
technological progress and whether you agree or disagree with the first statement. In the course
of your answer, use and define the following terms:
short-run, long-run, exogenous, endogenous, wage curve, profit curve, innovation rents.

(b) Referring to these and other models, provide your own interpretation of the second statement.

Answer:
(a) Should include the following elements.
Technological progress: a change in technology that reduces the amount of resources
(labour, machines, land, energy) required to produce a given amount of output.
Use the wage curve and profit curve model in Figure 15.10b to explain the short and long-run
effects of a new technology on jobs and unemployment.
In the short run, employment falls. High profits (innovation rents) encourage new entry in the
long run. In the short run, the number of firms (capital stock) is held constant (exogenous to
the short run model) but is allowed to vary (endogenous) in the long-run model.
According to the model, the unemployment rate will be lower in the new long-run equilibrium
than in the initial equilibrium: compare point B with point A.
Jobs are destroyed initially when the new technology is introduced (can refer back to Unit 2
and the Industrial Revolution) but the innovation rents (profits in excess of economic profits

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that and lead to job creation in new activities.

(b) A good answer would demonstrate knowledge of the difference in policy environment
between the first and second period. Growth expectations and the incentives for firms to invest
to introduce new technologies were supported in the second but not the first period by
aggregate demand policies, trade openness and institutions that allowed the benefits of
technological progress to be widely shared (in the high income countries).

B4. (40 points)

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Explain (a) what is meant by an austerity policy, (b) why such policies are often introduced after
a deep recession, especially one associated with a financial crisis and (c) how you would
evaluate their use in a country and period of your choice.

Refer to Figure 1 and use and define the following terms in your answer:
government debt, government bond, automatic stabiliser, fiscal stabilisation policy, paradox of
thrift, primary budget deficit

Answer (a) Austerity policy = policy where the government tries to improve its budgetary
position in a recession by increasing its saving
(b) Deep recession - automatic stabilisers are insufficient to ensure a recovery and
governments use policies to manage aggregate demand.
Why austerity?

Weak monetary policy. If the economy is at the ZLB or they are in a fixed exchange
rate regime, standard monetary policy response of reducing the interest rate is not
possible.
Effective fiscal policy. Multiplier is higher in a deep recession (higher share of credit
constrained households).
Fiscal stimulus raises government debt ratio. Government debt is the sum of the bonds
issued to finance its deficits minus the ones that have matured: it sells additional bonds
to finance the additional spending. The government deficit is equal to the primary
deficit plus interest payments on the outstanding debt. The debt ratio will rise if there is
a primary deficit unless the growth rate exceeds the real interest rate.
Post financial crisis recession is accompanied by the increased debt associated with
bank bailouts.

(c) Reward sensible comments – could use UK, US, Eurozone country as the example.

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