SUMMER TERM 2015

ECON1001: 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. 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.

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 Assume the world is described by a Malthusian model and the following phenomena are
observed: a short term increase in income per capita, followed by growth in population and in
the longer term, a return to the initial level of income per capita. This could be accounted for
by:

a) The occurrence of a plague.

b) The loss of agricultural land due to military defeat.
c) The chance development of a more productive grain.

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A2 In the ultimatum bargaining game between Pam and Larry, where Pam is the proposer,
suppose Larry has the following preferences: his utility in monetary terms is the amount of
money he gets minus 50 percent of Pam's amount. Then if the total amount of money is £100:

a) the minimum offer Larry will accept is larger than the offer he would accept if he
cared only about his own money and about nothing else.
b) the minimum offer Larry will accept is £25.
c) the minimum offer Larry will accept is smaller than the offer he would accept if his
utility in monetary terms were the amount of money he gets minus 100 percent of
Pam's amount.

A3 The graph below represents the feasible consumption set for a worker. Which, if any of
the following statements are true?

a) The marginal rate of transformation between consumption and free time when she is
working three hours is 20.
b) If the marginal rate of substitution between hours of free time and consumption is
equal to 10 when she has 21 hours of free time and 60 pounds, she should choose to
have more free time.
c) She would never choose to have 7 hours of free time if her indifference curves are
downward sloping.
Consumption (in £)

Hours of free time

A4 Bengt works 40 hours a week at his current job, getting paid $15 an hour and has a
disutility of work of $5 an hour. Suppose that if he loses his current job, he gets

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unemployment benefits of $500 a week. This benefit is available only for the first 10 weeks
of unemployment, after which he gets no benefit. If the expected duration of unemployment
is 30 weeks, what is Bengt’s expected net benefit from keeping his current job?

a) His expected net benefit from working is negative, and assuming he is eligible for
unemployment benefits if he quits, he will quit work and live off the government
benefits.
b) He expects to have a benefit of -$100 a week for the first 10 weeks.
c) He expects to have a benefit of $8000 over the full 30 weeks.

A5 The demand function for a monopolist is Q  16  P and the cost function is

C (Q)  6Q .

a) The optimal production of the monopolist is Q=5

b) The perfectly competitive price would be P=6 if all the competitors had the same
costs as the monopolist
c) The deadweight loss from monopoly is 12.5

A6 Which, if any, of the following statements are true?

a) An asset price bubble can occur when markets increase their demand for an asset after
its price rises, because they believe the price will rise further.
b) Economists who believe in the efficient markets hypothesis interpret increasing asset
prices as a response to new information about the expected stream of revenues from
the asset.
c) A house price bubble can only occur when the supply of housing is inelastic.

A7 Consider the two-period model of individual choice between consumption this period
and consumption next period. The rate of interest is the per-period rate of interest. Which, if
any, of the following statements are true?

a) The preferences of a decision-maker between consumption this period and next period
expressed in her indifference curves are independent of the rate of interest.
b) If the consumption endowment is zero this period and $100 next period, the rate of
time preference is higher than in the case where the consumption endowment is $100
this period and zero next period.
c) The number of units of future consumption the decision-maker is willing to give up
for one additional unit of consumption this period is her marginal rate of substitution
and is equal to one plus her rate of time preference.

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A8 Which, if any, of the following statements are true?

a) Two economies, A and B, are identical except that economy A has a higher share of
impatient households. A forecast of lower long term growth in the economy will
depress current consumption less in economy A than in economy B.
b) Following an increase in their income, a household's consumption barely changes.
One explanation for this observation is that the increase in income was not a surprise
to the household.
c) Recessions are more costly for credit-constrained households than for others because
the ability of the credit-constrained ones to borrow to smooth consumption is more
limited.

A9 Consider labour productivity as a function of capital intensity. Which of the following

statements are true?

a) The phenomenon of diminishing returns to capital is represented graphically by

convexity of the production function.
b) In a diagram of the function with capital intensity on the horizontal axis and labour
productivity on the vertical axis, the slope of a line from the origin to a point on the
production function is the capital to output ratio.
c) Technological progress can raise the marginal product of capital at a given level of
capital intensity.

A10 This question concerns the Beveridge curve. Which, if any, statements are true?

a) The Beveridge curve is downward sloping because a fall in vacancies causes

unemployment to go up.
b) In a recession, fewer job openings are posted and there are more people searching for
work.
c) The Beveridge curve shifts to the left in a boom because of improved matching
efficiency in the labour market.

A11 Which, if any, of the following statements are true?

a) Suppose that GDP in the first quarter of the year is 3.8bn euros and that aggregate
demand is 4.2 bn euros. This is consistent with the observation that inventories fell in
the first quarter.
b) In the multiplier model, autonomous demand is expenditure that does not depend on
the level of output.

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 c) In the two period model of intertemporal substitution, consumption 'now' depends on
the interest rate. Assuming this model applies to all households in the economy and
holding everything else constant, a rise in the interest rate necessarily reduces
aggregate consumption ‘now’ in the economy.

A12 Which, if any, of the following statements are true?

a) If the government can finance its expenditure including transfers and interest
payments by either borrowing or by using tax revenue, and this expenditure exceeds
its revenue, government debt rises.
b) Economists used the fact that recessions are deeper in Italian regions with close links
to the mafia to estimate the size of the government spending multiplier.
c) A policy of fiscal stimulus in a recession is more effective in an open economy than in
a closed economy because of the stimulus it provides to neighbouring economies.

A13 Which, if any, of the following statements are true?

a) The zero lower bound constraint on monetary policy arises because the real interest
rate cannot be negative.
b) If the number of units of foreign currency per unit of home currency increases, this is
described as an appreciation of home's exchange rate.
c) In a diagram with the quantity of Indian rupees on the horizontal axis and in which the
Indian rupee exchange rate is defined so that the rupee appreciates as one moves up
the vertical axis, a tightening of monetary policy by the Reserve Bank of India
through an increase in the interest rate is represented by a rightward shift in the
demand curve for Indian rupees.

A14 This question refers to the model with the wage curve and profit curve, in which both
curves are represented in a figure with employment on the horizontal axis and the real wage
on the vertical axis. Which, if any, statements are true?

a) The profit curve shows the highest wage consistent with firms earning zero economic
profits.
b) An increase in the opportunity cost of capital shifts the profit curve down.
c) If the wage is higher than the profit curve at a given employment level, job creation
will exceed job destruction.

A15 Which, if any, of the following statements are true?

a) Employment rents rise with the value of outside opportunities.

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 b) Employer provision of onsite childcare raises the employment rent.
c) If the expected duration of unemployment is 40 weeks, but unemployment benefit is
only paid for the first 8 weeks, then the employment rent is smaller than without the
presence of unemployment benefit.

A16 Which, if any, of the following statements are true?

a) If the nominal interest rate is 0.5% and the real interest rate is -2%, the inflation rate is
negative.
b) Inflation redistributes income to households with fixed-rate mortgages from
households relying on long-term assets with a fixed interest rate as their source of
income.
c) The following series (96, 98, 97, 98, 100, 101, 102) is observed for the consumer
price index in seven consecutive years starting in the year 2000.. The series displays
both inflation and deflation but not disinflation.

A17 Which, if any, of the following statements are true?

a) The golden age of capitalism came to an end in part as the result of an increase in
income inequality.
b) The Gini coefficient for household income in the entire world would be reduced to a
bit less than half of its current level, if everyone in the same country had the same
income and per capita income in each country remained unchanged.
c) Two divisions of a good are Pareto efficient. In one division, Ali is advantaged. In the
other, Beena has the larger share. The Gini coefficient measuring the inequality for
one division must be greater than for the other.

A18 Which, if any, of the following statements about the US economy are true?

a) In the three epochs of capitalism since 1921, inequality fell during all three sub-
periods of good economic performance (i.e. 1921-1929, 1948-1973 and 1979-2008).
b) Government debt as a percentage of GDP was higher at the end of the golden age (in
1979) than it was in 1948.
c) As a percentage of GDP, household debt fell and government debt rose in the period
from 2008, when the financial crisis began, until 2013.

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A19 Which, if any, of the following statements are true?

a) The higher is the social discount rate, the more weight is placed on the benefits in the
distant future of abating pollution today.
b) If we care about future generations as much as about the current generation, the social
discount rate should necessarily be 0%.
c) Discounting at market rates means that we do not engage in ethical judgements.

A20 Which, if any, of the following statements are true?

a) Following the collapse of the tech bubble in the US in 2001, the US economy
experienced a negative aggregate demand shock.
b) Updating inflation expectations based on the previous year's inflation explains rising
but not falling inflation.
c) Forming inflation expectations is an example of forward-looking behaviour.

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PART B

Answer ANY TWO questions from this section.

B1 In the following 3 games, the payoff matrices are shown in monetary terms. Player
A’s payoff is the first number in each entry, and Player B’s payoff the second:

Game 1

Player A/Player B Left Right

Up 2, 1 1, 2

Down 1, 2 2, 1

Game 2

Player A/Player B Left Right

Up 2, 2 7, 1

Down 1, 7 6, 6

Game 3

Player A/Player B Left Right

Up 7, 7 1, 6

Down 6, 1 3, 3

a) Define the concept of a Nash equilibrium. Identify the Nash equilibria in each of these
games.

b) Write the utility matrices for each game for the case where the utility of each player
consists of their own monetary payoff plus one half of the monetary payoff of the
other player.

c) Concentrating on Game 2, how would your answer to part a) above change if utility is
defined as it is in part b)?

d) Can you find a value of the weight a player puts on the monetary payoff of the other
player so that (Up, Left) is the only equilibrium in Game 3?

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 e) One of the games above represents a situation we called the tragedy of the commons
or the social dilemma. Another one represents a situation where two countries are in
recession and the options of each of the countries are to pursue an expansionary fiscal
policy or not to do so. Explain which of the games above represents each of the
situations and justify your answer. In particular you should explain what the strategies
up, down, left and right represent in the game, and why the pattern of monetary
payoffs are as shown.

f) Can you explain a real-life strategic situation that is well represented by the remaining
game (the one that is neither a social dilemma nor a fiscal policy game)?

g) In the three games shown, if a game has more than one equilibrium, explain whether
one of them seems more likely than the other.

B2 A government aims to benefit consumers by deciding to subsidize the purchase of a

home. You can assume that the subsidy can be represented by a per unit subsidy paid by the
government to home purchasers.

a) Explain the impact of a subsidy on the equilibrium price and quantity of houses, and
on consumer and producer surplus.

b) Explain whether the change in total surplus is larger than, smaller than, or the same as
the government’s expenditure on the subsidy.

c) Who benefits more and what determines the distribution of the benefit of the subsidy
between producers and consumers?

d) Consider a situation where land supply is inelastic (for example, in the centre of the
English town of Bath, where UNESCO heritage site status imposes strict building
rules) and demand is elastic. Does the subsidy achieve its objective of benefitting the
consumer?

e) We now illustrate the previous question with a numerical example. The demand is
D  60  P and supply is S  20 (i.e. supply is independent of price). The subsidy is
equal to 10. What are the price and quantity with and without the subsidy and the
distribution of surplus between producers and consumers with and without the
subsidy? What is the total expenditure on subsidies and how does this compare with
the change in surplus?

f) How would your answers to part e) change if supply were elastic, (i.e. S  P )?

g) Comment on the merits of the government’s subsidy policy as applied in the

situations described in e) and f).

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B3 This question relates to the data presented in Figure 1.

(a) Using Figure 1 and your knowledge of recent economic events, concisely describe the
economic performance of the US economy since 2004. Use and define the following terms:

 shock
 the ‘great moderation’
 deflation
 financial crisis.

(b) How were the lessons of the Great Depression reflected in the policy choices made in the
period shown in Figure 1? Use and define the following terms:

 aggregate demand
 monetary policy
 Fisher equation
 zero lower bound
 fiscal stimulus.
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B4 Pawn broking is one of the oldest sources of credit in the world. A pawn shop offers
loans in exchange for items such as jewellery which are held by the shop until the loan is
repaid. Such shops are mainly used by people on low incomes. In Texas, the maximum
interest rate that can be charged is 20% per month. According to a study of pawn shops in
Texas, default rates are lower when items of sentimental value such as rings rather than
items of equivalent resale value such as TV screens are held by the shop.

(Source: Carter & Skiba, Review of Banking & Financial Law, Vol. 32, 2012-13.)

(a) Provide an economic explanation for the phenomenon of pawn broking.

In answering this question,

i. define the term that is used for the items like jewellery held by the shop, and use
real world examples other than pawn broking to explain its role in the functioning
of credit markets.
ii. Use the two-period model of intertemporal substitution to illustrate the situation of
a client of a pawn shop.
iii. Suggest an explanation for the differential default rates on the type of item held by
the pawn shops. (HINT: to answer this, you may find it useful to refer to the
discussion of ‘my diet begins tomorrow’ in Unit 12.)

(b) Is there an economic case for the government to ban pawn broking? Explain your answer.

END OF EXAM

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