EC2040

UNIVERSITY OF WARWICK

Summer Examinations 2018/19

Economics 2

Time Allowed: 3 hours.

Answer ALL FOUR questions from Section A (40 marks total), ONE question from Section B
(30 marks total) and ONE question from Section C (30 marks total). Answer Section A
questions in one booklet, Section B questions in a separate booklet; and Section C questions
in a separate booklet.

Approved pocket calculators are allowed.

Read carefully the instructions on the answer book provided and make sure that the
particulars required are entered on each answer book. If you answer more questions than
are required and do not indicate which answers should be ignored, we will mark the
requisite number of answers in the order in which they appear in the answer book(s):
answers beyond that number will not be considered.

Section A: Answer ALL FOUR questions

1. Answer true, false or uncertain and provide an explanation.

(a) If not all goods are essential, a consumer will end up optimizing at a corner solution.
(3 marks)

(b) In an Edgeworth Box, if two individuals’ indifference curves through their

(c) Suppose two Bertrand price competitors have different constant marginal costs. In
any simultaneous move Nash equilibrium, only the higher cost firm will produce.
(3 marks)

(d) If the government contributes to a public good, private contributions will fall.
(3 marks)

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2. Consider the following sequential move game, where Player 1 decides between going L
or R in stages 1 and 3 of the game. Player 2 decides between going and r in stage 2 of
the game.

(a) Identify the 4 Nash equilibria in this game (ensuring that you consider each player’s
action at all nodes, i.e. your Nash equilibria should be written in the form:
{( , ), ( , )}, where ( , ) represents player 1 choosing at stage 1 and at stage
3; and ( , ) represents player 2 choosing when making a decision at the left hand
node and when making a decision at the right hand node.) Which one of them is
subgame perfect? (4 marks)

(b) Of the 4 Nash equilibria identified in part (a), only one was subgame perfect. Explain
what makes the other 3 Nash equilibria non-credible. (4 marks)

3. Answer true, false or uncertain and provide an explanation.

(a) An adverse change in the terms of trade is the same as a fall in price
competitiveness. (4 marks)

(b) A small open economy can maintain a higher inflation rate than the rest of the
world but this requires a continuously depreciating exchange rate. (4 marks)

(c) The typical negative slope of the Beveridge curve shows that, for employment to be
in flow equilibrium, vacancies must be low when unemployment is high. (4 marks)

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4. Answer the following two questions:

(a) Draw the Uncovered Interest Parity (UIP) curve. What explains the slope of this
curve, and what roles do arbitrage and rational expectations play? Show on your
graph the case of a one-period rise in home country interest rate above world level,
using this as appropriate in your explanations. Throughout, assume that the foreign
interest rate and expected future exchange rate are held fixed. (4 marks)

(b) Consider the small open economy shown in Figure 1, which has flexible exchange
rates and a vertical ERU curve. Explain why, after the pictured inflation shock and
monetary policy response, the economy will be off the AD curve during adjustment
back to medium run equilibrium. (4 marks)

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Section B: Answer ONE question.

5. Suppose Coke and Pepsi are perfect substitutes for me, whilst right and left shoes are
perfect complements. Assume I allocate £100 per month to spend on Coke/Pepsi
consumption and £100 per month to spend on Right/Left shoe consumption.

(a) Suppose Coke currently costs 50p per can and Pepsi costs 75p per can, but then the
price of Coke rises to £1 per can. With Coke on the horizontal axis, illustrate my
original and my new optimal bundles and explain the intuition behind them.
(6 marks)

(b) Assume that right and left shoes are sold separately and both are initially priced at
£1. With right shoes on the horizontal axis, illustrate my original bundle and my
new optimal bundle when the price of left shoes increases to £2. Explain the
intuition behind the optimal bundles. (6 marks)

(c) Explain why the Lagrange method cannot be applied to (or doesn’t seem to work)
when calculating the optimal consumption bundle when goods are perfect
complements or perfect substitutes. (4 marks)

(d) Suppose a consumer’s tastes are given by:

( , )= with = 2; = 10; = 180.

Find the optimal bundle, assuming the consumer is maximizing utility. If the price of
good 1 now increases to £4, find the change in demand due to the Hicksian
substitution effect. Would the change in demand based on the Slutsky substitution
effect be larger or smaller? (10 marks)

(e) The tastes given in part (d) are homothetic. Explain or provide a proof as to how we
know this. (4 marks)

6. Consider a person who is thinking about whether to engage in a life of crime. He knows
that, if he gets caught, he will be in jail and his consumption will be low, , but if he
does not get caught, he will be able to consume an amount that is considerably
above .

(a) Suppose that = 20; = 80 (where both are expressed in thousands of

4 (Question 6 continued overleaf)

(b) Suppose the potential criminal’s tastes over gambles can be expressed using the
following utility function ( ) = ln ( ). Calculate the person’s expected utility from
a life of crime. How does it compare with the utility of the expected value of
consumption? Based on your answer, explain this individual’s attitude towards risk
and draw the consumption/utility relationship. (8 marks)

(c) Consider the level of consumption this person could attain by not engaging in a life
of crime. What level of consumption from an honest living would make the person
indifferent between a life of crime and an honest living? Denote this consumption
level ̅ and show it on your diagram. (5 marks)

The Minister for Crime proposes an increased deterrence policy, but no extra spending
on law enforcement. This policy increases the penalties for committing crimes, which
thus reduces , the consumption level of an individual who gets caught.

(d) Suppose, therefore, that the expected consumption level (found in part (a)) for a
person engaged in a life of crime remains unchanged under this policy. Using a
diagram, illustrate what will happen and with reference to the certainty equivalent,
explain whether the person who was previously indifferent between an honest
living and a life of crime, will still be indifferent. Does this therefore mean that the
policy is successful? (8 marks)

(e) If criminals were able to take out insurance against getting caught, what conditions
would have to exist to make private insurance feasible? Are these conditions likely
to exist? (6 marks)

7. Consider a two-person exchange economy in which I own 200 units of and 100 units
of and you own 200 units of and 100 units of and that this endowment is not
Pareto efficient. Assume that we both have homothetic tastes, with MRS = -1 when
= and goods and are not perfect substitutes for each other.

(a) Draw the Edgeworth Box, with my consumption of measured on the lower
horizontal axis and identify the initial endowment point. You should clearly label
your diagram, identifying the dimensions of the box. (6 marks)

(b) In your diagram, where does the region of mutually beneficial trades lie? Explain
your answer and identify the Pareto efficient allocations. (4 marks)

(c) If the prices of and are set equal to each other, illustrate the competitive
equilibrium in your Edgeworth Box and explain why that point must be the
competitive equilibrium. (6 marks)

5 (Question 7 continued overleaf)

(d) Suppose a per unit tax t (paid in terms of ) is now imposed on all units of that
are traded. This introduces a difference of t between the price received by sellers
and the price paid by buyers. How does the tax result in kinked budget constraints
for both of us? Illustrate and explain the new shape of both budget constraints.
(You don’t need to re-draw the whole Edgeworth Box accurately, but simply need
to show the positions and shapes of these new budget constraints). (6 marks)

(e) In government policy making, taxes are often used to change market signals. If a tax
is being used, does this create a more efficient outcome in the affected market?
(You do not need to consider this in the context of the Edgeworth Box above, but
should just consider the idea of a tax being imposed and how this might affect the
market outcomes.) (8 marks)

Section C: Answer ONE question.

8.
(a) Explain how in an open economy macroeconomic model, the curve known as “ERU”
represents the supply side of the economy. (10 marks)

(b) Assume the ERU curve is vertical. In a small open economy, is a negative supply
shock or a negative demand shock more damaging for medium-run output? Explain
in words and use AD-ERU diagrams to back up your argument. (10 marks)

(c) Assume the ERU curve is vertical. Using diagrams to help explain your answers,
compare the effects on the real exchange rate, unemployment and real wages in
medium-run equilibrium of:
(i) a negative demand shock stemming from a reduction in autonomous
consumption. (5 marks)
(ii) a negative supply shock in the form of the withdrawal of new technology due
to environmental concerns. (5 marks)

9.
(a) Use the three equation model to show how fiscal policy can be used to stabilise the
economy after an inflation shock to a particular country that is a member of a
Common Currency Area (CCA). (12 marks)

(b) What effect does this use of fiscal stabilisation policy have on that country’s budget
balance? (8 marks)

(c) Why might it be important that a principle similar to a Taylor rule can be applied to
a member of a Common Currency Area (CCA)? (10 marks)

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10.
(a) In the Shapiro-Stiglitz efficiency wage model, why is it important that the employee
receives a rent – that is, a wage greater than their opportunity cost of working?
(10 marks)

(b) Why are imperfect monitoring of shirking behaviour and the existence of
unemployment in equilibrium important to ensure that the wage paid embodies a
rent? (10 marks)

(c) How, if at all, would a worsening of working conditions affect the efficiency wage
and equilibrium unemployment? (10 marks)

5 (End)