ECON1001

SUMMER TERM 2016

ECON1001: INTRODUCTION TO 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. The following technologies are available to produce 10 metres of cloth:

Technology Number of Tonnes of coal

worker days required
A 15 3
B 10 2
C 3 4
D 4 5

(a) Technology A is preferred to technology C for any relative price of a worker days to a
tonne of coal less than 1.
(b) Technology D is preferred to technology A for any relative prices of a worker days to a
tonne of coal greater than 1, even though it is an inefficient technology.
(c) B or D can be the optimally chosen technologies depending on the relative price of coal
and workers. TURN OVER

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A2 In the following game 2 people are choosing simultaneously what to plant. The first entry
shows the row player’s payoff and the second entry, the column player’s payoff.

Anil, Bala Rice Cassava Potato

Rice 3,3 6,2 3,4

Cassava 2,6 1,1 2,1

Potato 4,3 1,2 1,1

(a) Cassava is a dominant strategy for both players.

(b) There is exactly one Nash equilibrium in this game.
(c) There are two ways this game could be played that would maximize the sum of payoffs.
but differ in the distribution of payoffs between the two players.

A3. Angela is a farmer who cares both about her free time and the amount of grain she gets and
Bruno, the owner of the land cares only about the amount of grain that he gets. If the owner
can dictate the rent and all the farmer can do is take the offer or leave it, the outcome:
(a) will be Pareto efficient.
(b) will leave her no better off than if she did not have the right to refuse the offer.
(c) will give Angela the same utility as her reservation option.

A4. Demand faced by a monopolist is Q = 20 – 0.5P. Her marginal cost is 10. Based on this
information we can say that:

(a) The optimal production of the monopolist is Q = 15.

(b) The price charged by the monopolist is equal to her marginal cost.
(c) The deadweight loss associated with the monopolist’s choice of price is less than the
product of the difference between her price and marginal cost, multiplied by her optimal
quantity.

CONTINUED

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A5 Demand in a competitive market is Q = 20 – 0.5P. The private marginal cost of all producers
in this market is 10, the social marginal cost is 5.

(a) In the absence of any interventions, production in this market is inefficiently high.
(b) The solution to the external effect present in this market is to have a cap on the amount
produced in this market and to allow producers to trade freely their quotas.
(c) The deadweight loss in the case of no intervention is larger than 100.

A6. The following diagram depicts Julia’s choice of consumption in periods 1 and 2. She has no
income in period 1 and an income of $115 in period 2. The current interest rate is 15%.

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

(a) The maximum that Julia can borrow to spend in period 1 is $91.
(b) If Julia borrows $80 to spend in period 1, she will have $23 to spend in period 2.
(c) The consumption choice of $60 in period 1 and $50 in period 2 is a feasible option.

A7. Which of the following statements is/are correct?

(a) The base rate is the rate at which the central bank lends in the money market.
(b) The base rate is determined by the supply and demand of the money market.
(c) The bank lending rate is the rate at which the central bank lends to commercial banks.
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A8. The following diagram depicts Marco’s choice of consumptions in periods 1 and 2. He has
$100 worth of grain in period 1 and no income in period 2. Marco has two choices. In scheme
1, he can store the grain that he does not consume in period 1. This results in a loss of 20% of
the grain due to pests and rotting. In scheme 2, he can sell the grain that he does not consume
and lend the money at 10%. The feasible frontiers under these two schemes are marked in the
diagram as FF.

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

(a) The substitution effect implies that Marco will consume more in period 1 under scheme 2
than under scheme 1.
(b) Marco will unambiguously consume more in period 2 under scheme 2 than in scheme 1.
(c) Marco will unambiguously consume less in period 1 under scheme 2 than in scheme 1.

A9. Which of the following statements about GDP is/are true?

(a) When output is produced and consumed in the home but no-one outside the family is
employed to do it, it is not counted as part of GDP.
(b) Nominal GDP and GDP at current prices mean the same thing.
(c) If real GDP rises from one year to the next, it must be the case that quantities have risen
and that prices have not changed.
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A10. Which of the following is/are true of consumption behaviour?

(a) In both modern and agrarian economies, co-insurance institutions helped to reduce the
impact on household welfare of shocks to income.
(b) Following an unexpected increase in their income, a household's saving goes up and
consumption barely changes. One explanation for this observation is that the household
interprets the increase in income as temporary.
(c) 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.

.A11. Assuming that there is no government spending or trade, an economy’s aggregate demand
is given by its domestic consumption C and investment I, AD = C + I = c0 + c1Y + I. In the
goods market equilibrium this equals output: AD = Y. Solving for Y this yields:

1
𝑌=( ) (𝑐0 + 𝐼 ).
1 − 𝑐1

Given this equation, which of the following statements is/are correct?

(a) The boost in the economy’s output is the same whether the aggregate demand shock
comes from an increase in investment I or in autonomous consumption c0.
(b) The larger the marginal propensity to consume c1, the larger the multiplier.
(c) If c1 = 1/3, then a £1 million increase in investment would result in a £1.5 million
increase in the output.

A12. In the US and the UK, home equity loans are widely available. Additionally, unlike in
France and Germany where large down-payments (as a per cent of the house price) are
required, in the US and the UK only small down-payments are required for house purchases.
On the basis of this information, which of the following statements is/are correct for the US
and the UK when there is a rise in the house price?

(a) There would be no effect on the consumption of the existing homeowners who are not
credit-constrained.
(b) Would-be homeowners would increase saving and reduce their consumption more than
they would in France and Germany.
(c) A rise in house price is likely to dampen aggregate consumption in the US and the UK.

A13. Which of the following statements regarding inflation and deflation is/are correct?
(a) Borrowers benefit from deflation as the value of their debt decreases in real terms.
(b) Inflation transfers wealth from lenders to borrowers.
(c) Falling prices benefit consumers and are therefore always good for the economy.

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A14. Consider a scenario where the Bank of England views the UK economy to be overheating
and is attempting to slow it down using monetary policy. Which of the following statements
is/are correct regarding the effects of an interest rate rise?
(a) It leads to lower bond prices, which results in higher demand for UK bonds.
(b) It leads to higher demand for British pounds (GBP), which results in an appreciation of
GBP.
(c) It has opposing effects on the UK’s aggregate demand (AD) of discouraging investment,
which lowers AD, and cheaper imports, which boosts AD.

A15. The following diagram depicts the Phillips curve and the indifference curves of a policy
maker in the economy. This economy has an independent central bank with an inflation-target of
2%.

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

(a) The shape of the indifference curves indicates that the central bank is willing to trade off
higher inflation against lower unemployment at all times.
(b) Consider an aggregate demand shock that increases unemployment. Without monetary or
fiscal policy to counter the negative bargaining gap, the Phillips curve would shift down.
(c) Consider an aggregate demand shock that increases unemployment. The central bank
would raise the interest rate to put downward pressure on inflation, in order to bring it
back to the target rate.

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A16. Which of the following is/are true of the Beveridge curve?

(a) A flat Beveridge curve means that the vacancy rate fluctuates little over the business
cycle, which is a sign of efficient matching in the labour market.
(b) When there is a recession, the Beveridge curve shifts out.
(c) A policy that increases the cost of job loss by reducing the duration of unemployment
benefits shifts the Beveridge curve in.

A17. This question refers to the profit curve as represented in a figure with employment on the
horizontal axis and the real wage on the vertical axis. Which statements is/are true?
(a) The profit curve refers to the demand side of the labour market.
(b) If the wage is on the profit curve, firms will neither enter nor exit the economy.
(c) If the wage is higher than the profit curve, job creation will exceed job destruction.

A18. Use the wage curve and profit curve model to decide whether the following statements are
true:
(a) The opportunities for introducing new technologies in the post-war period are represented
by a move along the profit curve to the right to lower unemployment.
(b) The growth of the welfare state following the World War II is represented by an upward
shift in the wage curve. Ceteris paribus, this would lead to higher unemployment.
(c) A postwar accord between employers and workers is represented by a lower wage curve
than the workers could achieve given their bargaining power.

A19. Which of the following is/are true?

(a) A tax to impose a socially optimal level of pollution would add to the firm’s average
costs of production an amount equal to the cost imposed on everyone affected.
(b) If the government regulates the industry using a cap-and-trade scheme and distributes
pollution permits equally between the two firms, the one which finds abatement less
costly will sell pollution permits to the other firm.
(c) To achieve the socially desirable level of pollution, it will always be more efficient to
impose a tax per unit of pollution than to regulate the quantity of pollution emitted by
each firm.

A20. Which of the following is/are true?

(a) While the Lorenz curve cannot slope downwards, under conditions of severe inequality it
can become less steep for higher fractions of the population (movements to the right in
the standard figure).
(b) If the Lorenz curve of one country is always above that of another country, then the
distribution is more equal in the first country than the second.
(c) It is not possible for the Lorenz curves of two countries to intersect.

CONTINUED

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PART B. Answer ANY TWO questions from this section.

B.1. Suppose that there are 20 price-taking firms in a market. Each firm’s cost function
is 𝐶1 (𝑄) = 𝑄2 + 25. The minimum average cost for these firms occurs when Q = 5 and it is then
equal to 10.

In each step, from (b) to (f), explain verbally how you worked out your answer. Use complete
sentences.

(a) Define: perfectly competitive equilibrium, price-taking firm, average costs.

(b) What is the short-run supply curve of each firm? What is the supply curve of the entire
industry? Be particularly careful to specify the minimum price at which the firm starts to
supply.
(c) What is the equilibrium in the market if demand is Q = 560 - 10p? What would be the
equilibrium if demand were Q = 150 - 10p? What is the consumer surplus?
(d) What is the equilibrium in the market if demand is Q = 560 - 10p and the government
decides to impose a tax per unit of 4 pounds? What is the deadweight loss created by this
tax?
(e) What would be the price and quantity sold in the market if the government forbids any
sales at a price higher than 9? What if it forbids sales at prices higher than 15? And for
prices higher than 30?
(f) Suppose now that the technology of production is available to any firm in the long run.
Demand is still Q = 560 - 10p. What will be the competitive price, quantity, profits, and
consumer surplus in the long run? How many firms will there be in the market?

B.2. The Paris protocol for climate change establishes that 195 countries in the world should
announce “legally binding” emissions targets to mitigate climate change. Let us think of some
models for the behaviour of a few countries to understand the possible implications.
Suppose that the game is played by 2 countries, each of which behaves as if it were a single
individual. Call the amount of emissions of country 𝑖, 𝐸𝑖 , the amount of emissions of both
countries together 𝐸 and the legally binding maximum a country can emit is 𝐸𝑖 = 5.

The payoffs of country 𝑖 have the following form 𝜋𝑖 (𝐸 ) = 100 + 1.5𝐸𝑖 − (𝐸1 + 𝐸2 ). That is,
every unit of a country’s own emissions has a private benefit of 1.5 but it costs each and every
country (including your own) 1 unit.
In each step, from (b) to (g), explain verbally how you worked out your answer. Use complete
sentences.

(a) Define: social dilemma, public good, Nash equilibrium

(b) Countries care only about their own payoffs. The game is such that countries announce
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once and for all an emissions’ target, simultaneously and independently. Define the term strictly
dominated strategy and indicate whether there are any in this game, and if so, what they are. Do
the same thing for strictly dominant strategy and Nash equilibria. If there is a Nash equilibrium,
is the outcome of the equilibrium Pareto efficient? Remember to define the terms in italic font.

(c) Suppose that the game is as described in the question, but rather than caring only about
themselves, each country’s payoff is her own plus that of the other country. Answer again
the questions posed in part (b): is there a strictly dominated strategy (explain); a strictly
dominant strategy (explain); a Nash equilibrium (explain); is the outcome Pareto efficient
(explain)?
(d) Suppose that the game is as described in the question, but the payoffs are different.
𝐸 𝑖𝑓 𝐸1 + 𝐸2 ≤ 4
𝜋𝑖 (𝐸 ) = { 𝑖
0 𝑖𝑓 𝐸1 + 𝐸2 > 4

That is, everyone has 100 if total emissions are below 4 and 0 if total emissions are strictly
above 4. Answer again the questions posed in part (b): is there a strictly dominated strategy
(explain); a strictly dominant strategy (explain); a Nash equilibrium (explain); is the outcome
Pareto efficient (explain)?

(e) If the equilibria in any of the previous cases are inefficient, can you think of different
rules of the game which may yield efficient outcomes, given what we learnt in class, and
how one could implement these rules in reality? Discuss also circumstances where these
changes in rules could backfire.
(f) Imagine that the game is as in part (b) but now it is played in sequence, first, country 1
makes her irrevocable pledge and then country 2. Please solve by backward induction.
(g) How would the answer to the previous question change if the payoff of both players were
his own monetary payoff plus one half that of the other player? Is there a way to make the
equilibrium of the previous game fair?

B3 (40 points)

Suppose the government proposes a policy of ‘supply-side’ reform of cutting unemployment

benefits as a means of reducing unemployment in a sustainable way.

(a) Briefly describe a situation where a policy like this has been introduced.

Use the model of the wage curve and profit curve to provide an economic justification for this
proposal. In answering this question, explain how a fall in unemployment benefits affects:

(b) the worker’s best response function and the wage set by the firm;
(c) the wage curve; and
(d) the inflation-stabilizing rate of unemployment.
(e) Who are the winners and the losers from such a policy? CONTINUED

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B4 (40 points)

(a) Explain the business model of a commercial bank: how does it make profits and how
does it ‘create money’?
(b) What is the difference between base and bank money? Which kind of money do banks
create? What is the relative importance of each type of money in a modern economy?
(c) Give an example of circumstances under which households distinguish between base and
bank money.
(d) Suppose the central bank wishes to restrict the level of economic activity in the economy
because it is afraid that inflation will increase. How does it implement its decision? What
role do households, firms and banks in the home country and abroad play in this process?

END OF PAPER

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