ECON0002: Economics UCL 2022/23

ECON0002: Final Coursework – Written Component (35% of Overall Mark)

Please read these instructions carefully before you start. DO NOT include your name
anywhere on the submission document!
Use the template on the next page for your submission. You must answer all of the questions
listed. The total mark for each question is indicated in the question text.
The deadline for submission is Tuesday, May 9th 2023 at 12 noon (London time). We
expect that once you have done all your revision/prep, it should take you no more than 3
hours to write the answer.
The word limit is 1200 words across all six questions (A – F).
The word limit rules are similar to those for the Individual Writing Assignment: text in
graphs, tables, equations, headings or titles, sources, references and in-text citations do not
count. If your submission is longer than the permitted length, it will be subject to length
penalties set by UCL.
Please also make sure that you understand and abide by UCL’s academic integrity policy. If
you refer to material from The Economy or any other citation, please provide a full
bibliography (reference list) as indicated at the end of the template (preferably Harvard style).
When you are drawing graphical models or writing equations, please produce these yourself
by hand rather than copying and pasting from somewhere else. Include your candidate
number with the drawing/ hand-written equation and paste this into the submission
document in the appropriate place where you are discussing the diagram/equation. If you do
not do this, this may be reviewed as possible academic misconduct (with reference to UCL’s
academic integrity regulations).
Those with SORAs registered with the department will automatically get the extra time they
are registered for. If you need to submit an Extenuating Circumstance instance, please read
the information on the Student Support Moodle page and complete this form.
If your work is submitted late and you do not have a SORA or an EC, it will be subject to late
submission penalties which will be applied by the Departmental Tutor in line with UCL
regulations.

Due date for submission: Tuesday, May 9th 2023 at 12 noon BST Instructions
ECON0002: Economics UCL 2022/23

ECON0002 Summer Coursework Submission Template

Use the models taught in this module to answer the following questions. You will need to draw
diagrams and use equations where appropriate. A complete verbal explanation will also always
be required. You are required to use this template to submit your coursework (through the
appropriate Turnitin link on the module’s Moodle page). You can extend the size of the answer
box to fit your answer. You are required to answer ALL six questions.

The word limit for your answer is 1200 words. That is, the sum of words for your answers
to all six questions A-F cannot exceed 1200 words.

A) [15 marks] The Simran family household chooses between energy usage per day (𝑥1) and
consumption of all other goods per day (𝑥2). As a result of the UK energy crisis, the unit price of
energy has surged to 𝑝1 = £4. Given that the price of all other goods is 𝑝2 = £1, the household
expenditure on all other goods is the share of household income, 𝑚, not spent on energy.

The Simran family’s daily disposable income to spend on energy and all other goods is
𝑚 = £27. The family’s preferences over bundles of energy and all other goods are represented
by the following utility function:
2𝑥1𝑥2
( )
𝑢 𝑥1, 𝑥2 = 𝑥1+𝑥2
*
Derive analytically the Simran family’s optimal energy usage 𝑥1 and consumption of all other
*
goods 𝑥2. Explain your reasoning and illustrate your findings by completing the figure below:

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ECON0002: Economics UCL 2022/23

Write your answer to part A) here:

Based on the utility function and the MRS can be found as

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ECON0002: Economics UCL 2022/23

This is the rate at which the household is willing to exchange x1 for x2 while keeping the level
of utility constant and the absolute value of the slope of the indifference curve (IC1) at that point
The MRT can be found as

This rate is equal to the relative price of the two goods and is the absolute value of the slope of
the feasibility curve.
By finding MRS = MRT this where the rate the simran household is willing to trade x1 for x2 is
the same rate as they can exchange them in the market, which means they are maximising their
utility subject to their budget constraint. This is where the indifference curve is tangential to the
feasible frontier.

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ECON0002: Economics UCL 2022/23

B) [15 marks] Suppose now that the government wants to support struggling families like the
Simrans by imposing an energy price cap. Instead of a unit price of 𝑝1 = £4, the Simran family
now has to pay only 𝑝1 = £25/9 per unit of energy (this is approx. £2. 78). The price 𝑝2 of all
𝑐
other goods remains unchanged. Compute the Simran family’s optimal energy usage 𝑥1 and
𝑐
consumption of all other goods 𝑥2 under the energy price cap. Illustrate these choices by building
on – and completing – the following figure, which shows the family’s optimal choices from part
(A).

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ECON0002: Economics UCL 2022/23

As a way of measuring the value of the energy price cap to the Simran family, compute how
𝑐
many other goods the family could buy before and after the price cap. In particular, if 𝑥1 denotes
the amount of energy the family consumes under the energy price cap as per your calculations
0
above, compute now the expenditure 𝑒2 on all other goods that the family would have been able
𝑐
to make with an energy usage of 𝑥1 under the original (i.e. uncapped) energy price 𝑝1 = £4.
𝑐
Subtract this hypothetical expenditure from the family’s actual expenditure 𝑒2 on all other goods
𝑐 0
under the energy price cap. The difference 𝑒2 − 𝑒 represents the value to the family of the
2
energy price cap. Comment briefly on your findings.

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ECON0002: Economics UCL 2022/23

𝑐 𝑐
The simran family optimal energy usage 𝑥1 and consumption of all other goods 𝑥2 can be found
as….

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ECON0002: Economics UCL 2022/23

As the MRS is the same the shape of the indifference curve is the same as without a price
cap on energy, however as the MRT has changed the slope of the feasible frontier has
become less steep illustrated on the graph. Under the price cap the new optimal point can
be seen where MRS = MRT or IC2 is tangential to the new feasible frontier.

Calculating the value of the price cap as follows:

This suggests the price cap is very effective for struggling families as it has allowed the
Simran family to increase expenditure on all other goods by 7.425 or 28% of their budget
whilst also increasing energy usage, we can see the new optimal point under the price cap
lies past the original feasible frontier which suggests this level of energy usage and
consumption of goods is unattainable without the price cap

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ECON0002: Economics UCL 2022/23

C) [20 marks] Suppose now that instead of the energy price cap above, the Simran family
𝑐 0
receives a lump-sum payment of 𝑒2 − 𝑒 from the government to support it through the energy
2
**
crisis. Compute the Simran family’s optimal energy usage 𝑥1 and consumption of all other
**
goods 𝑥2 under the lump-sum payment. Once again, illustrate these choices by building on – and
completing – the following figure:

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ECON0002: Economics UCL 2022/23

( **
Explain carefully whether – and if so, why – the Simran family’s choices 𝑥1 , 𝑥2 under the )
**

0
𝑐
( 𝑐 𝑐
)
lump-sum payment 𝑒2 − 𝑒 differ from their choices 𝑥1, 𝑥2 under the price cap.
2

𝑐 0
For a given level of government expenditure 𝑒2 − 𝑒 , does a per-unit energy price cap or a
2
lump-sum subsidy provide greater benefit to the Simran family and why? Which of these two
options increases demand for energy by more and why?

The UK government has adopted in September 2022 (and has now extended until the end of June
2023) an Energy Price Guarantee scheme which limits “[…] the amount suppliers can charge per
unit of energy used.”1 In light of your findings in part (B) and those above in part (C), draw on
any relevant academic research on this topic to explore reasons why the UK government may
have opted for a price cap instead of a lump-sum income subsidy.

(Please list any references you have used as previously instructed at the end of this document)

https://www.gov.uk/government/publications/energy-bills-support/energy-bills-support-factsheet-8-septembe
r-2022

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ECON0002: Economics UCL 2022/23

** **
The Simran family’s optimal energy usage 𝑥1 and consumption of all other goods 𝑥2 is:

𝑐 ** ** 𝑐
From the graph we can see that 𝑥1 > 𝑥1 and 𝑥2 > 𝑥2 . The optimal choice differs when there
is a price cap compared to when there is a lump sum as after receiving a lump sum the
budget constraint increases to 34.425 therefore the optimal allocation of energy
and other goods and services will be different from when the budget constraint is 27.
𝑐 0
For government expenditure = 𝑒2 − 𝑒 ; a price cap adds the most added benefit to the simran
2
family, as this allows them to consume on IC2 which is the indifference curve furthest away
from the origin and therefore represents a greater level of satisfaction.

The price cap on energy increased the demand for energy of the simran family by more as
low-income households have a relatively high price elasticity of demand for energy.*

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ECON0002: Economics UCL 2022/23

Therefore, a price cap lowering the price of energy would greatly increase the quantity
demanded by households like the Simrans, as they are more sensitive to changes in energy
prices.

The government likely introduced a price cap as research has shown that low income
households will likely use a lump sum payment to pay off debt or spend on necessities such
as food, on the other hand a price cap on energy greatly increases the welfare of low
income households by protecting them from large decreases in living standards when
energy firms pass on rising costs to consumers.

*David Osmon, (2018), The case for a cap on the standing charge in energy bills. Report
prepared for OFGEM at
https://www.ofgem.gov.uk/sites/default/files/docs/2018/10/ideal_economics_-_response
_2_0.pdf

D) [20 marks] In popular discussion, one often hears that inflation can be caused by
i. ‘too high’ aggregate demand.
ii. ‘too high’ wage claims.
Provide an economic interpretation of each statement using the models you have studied in this
module. To answer this part of the question, ignore inflation expectations and assume that
inflation is equal to zero initially. You will need to use the WS/PS, multiplier and Phillips curve
models and to produce appropriate diagrams.

Using your interpretation of either (i) or (ii), now explain how a process of rising inflation can
occur. If you want to use a diagram in your answer, draw a new one and do not add to the
diagram used in the first part of this question.

i)”Too high” aggregate demand can be interpreted as an increase in general spending on

domestic goods and services leads to a fall in unemployment as labour is a derived demand
therefore firms increase wages to compete and attract a smaller talent pool. This increased cost
of wages is passed on to the consumers in the form of price increases that lead to upward
pressure on prices, which can contribute to inflation. Indicated in the phillips curve as the

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ECON0002: Economics UCL 2022/23

economy transitions from A to B.

ii) “Too high” wage claims can be interpreted as workers bargaining power increasing, leading to
the minimum wage required for workers to put adequate effort increases at all employment
levels. This leads to a rise in the wage setting curve and price setting curve as initially inflation is

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ECON0002: Economics UCL 2022/23

0,this increase in costs due to increased wages would likely lead to cost push inflation

Rising inflation can occur from “too high” wage claims as if workers have the bargaining power
demand excessively high wages, it can lead to a shift in the wage-setting curve upward, meaning
that firms must pay higher real wages to incentivize workers to provide sufficient effort.When
workers receive these higher wages, they may increase their consumption of goods and services,
leading to an increase in aggregate demand. If the economy is operating at full capacity, this
increase in demand can lead to upward pressure on prices, which can contribute to inflation.

E) [15 marks] Suppose that inflation is above the central bank’s target. Is a recession necessary
to reduce the rate of inflation? Explain your reasoning.

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ECON0002: Economics UCL 2022/23

Write your answer to part E) here:

A recession is highly unlikely to be necessary to reduce the rate of inflation as in most scenarios
a sufficient increase in the base rate would lead to credit being constrained across the economy.
Therefore as variable rate mortgage owners see a fall in disposable income and firms see large
increases in costs AD in the economy will fall leading to a fall in demand-pull inflationary
pressure.The only time a recession may be necessary is in a scenario where there is an economic
boom causing inflation. Workers would expect prices to rise by the inflation rate and therefore
nominal wages would have to rise. However workers would naturally expect a natural pay
increase, for example 2% rise to give them an expected real wage rise on the wage-setting curve,
so wages increase by 2% plus inflation. With their costs rising b, firms will increase prices in
line with these rising costs. This gives a Phillips curve like below,

In this case increasing interest rates would simply add to firms costs which would further push
up cost-push inflationary pressure. Therefore a recession would be a viable inflation
management strategy as a reduction in employment would lead to lower prices.

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ECON0002: Economics UCL 2022/23

F) [15 marks] In the case of an energy price shock, what is the predicted effect on inflation and
real wages? Define how you are measuring inflation and real wages. Provide a data chart to back
up your predictions (use UK data). You don’t have to construct this chart yourself, but you must
provide the full citation of the source.

Using the models you have used in Sections (D) and (E), suggest an appropriate policy response
to an energy price shock. Relate your answer to policies implemented in the UK in the recent
episode of an energy price shock, including those discussed in Sections (B) and (C).

(Please list any references you have used as previously instructed at the end of this
document)

Defining inflation as the rate at which the overall price level of goods and services in an
economy increases, and real wages as the purchasing power of wages after adjusting for
inflation. An energy price shock would lead to inflation rising, as an increase in cost-push
inflationary pressure causes firms' cost of production to increase due to energy costs increasing.
This would cause the price of many goods and services to increase as firms pass the cost on to
consumers in order to raise the rise in prices. This is seen here as the CPIH rises Real wages fall.

A price cap such as the Energy Price Guarantee would be an appropriate response to an energy
price shock as this would be an appropriate response as it would limit the extent to which firms
could pass on the increased cost of production to consumers. This would mean that the increase
in firms markup would be less causing the price setting curve to not fall to a great extent. This

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ECON0002: Economics UCL 2022/23

would lead to the economy ending up at a point where employment has fallen however real
wages in the economy stay roughly the same

Bibliography (provide a full list of references used in all parts of your answer here)
Monthly Wages and Salaries Survey from the Office for National
Statistics,https://www.ons.gov.uk/employmentandlabourmarket/peopleinwork/employmentande
mployeetypes/bulletins/averageweeklyearningsingreatbritain/april2023

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