SUMMER TERM 2019

ECON0002: 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 ECON0002. 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 ECON0002.
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, there are three
options: TRUE, FALSE, or DON’T KNOW. Please note that at least 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 incorrect you will receive
ZERO marks. If you choose DON’T KNOW, you receive ZERO marks. The maximum score for
each question is THREE.

A1. In a competitive market if demand is Q=10-2P, and the cost of production for all firms is 2Q,
then in equilibrium:
a) Quantity is 2 and price is equal to 4.
b) Consumer surplus is 1.
c) A unit tax of 2 would raise prices less than 2 because demand is inelastic at the optimal point.

A2. Assume that a household has access to credit. Which of the following is likely to have a
significant effect on long-run consumption?

a) A temporary reduction in income.

b) A temporary rise in interest rates.
c) An unexpected promotion to a senior position.
CONTINUED

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A3. For vacation, Flora has three choices, listed in order of preference: (1) go to Baja and surf
the waves, (2) work at Fintechplus, or (3) write a novel. Her opportunity cost of going to Baja
includes which of the following:

a) The knowledge she would have acquired at Fintechplus.

b) The cost of the plane trip to Baja.
c) The electricity she does not spend at home when going away.

A4. There are two goods in the economy. One of them increased its price by 4% from 2016 to
2017. The other decreased by 2%. The weights of the first good in 2017 in GDP was 60%, the
weight of the second was 40% in the same year.

a) The Laspeyres price index from 2016 to 2017 increased by 1.6.

b) We cannot know the Paasche index change as we do not know the weights of the goods in
2016.
c) Increasing the wages of workers by using the Laspeyres index is the correct way to make sure
their standard of living is not affected by the price changes.

A5. The figure depicts indifference curves for consumption today and consumption later for
Abraham and Sarah.

Which of the following statements is correct?

a) Sarah’s indifference curve exhibits a higher degree of diminishing marginal returns to
consumption than Abraham’s.
b) Sarah is more impatient as a person than is Abraham.
c) Abraham has a larger feasible set than Sarah.

TURN OVER

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A6. The figures depict the wage-setting curve and how it is derived using the best response
function of the employees and the isocost lines for effort of the employers. U1 and U2 are
unemployment rates and are shown at the corresponding levels of employment in the lower
panel.

Which of the following statements is /are correct?

a) w2 is the reservation wage when the unemployment rate is U1.

b) w5 is the Nash equilibrium wage when the unemployment rate is U2.
c) w5 = w3.

A7. The table shows a balance sheet of a bank:

Assets Liabilities
Cash £10 million
Deposits £110 million
Loans £100 million
The interest rate charged on loans is 10%. Which of the following statements is / are correct?

a) The bank holds £110 million of base money.

b) In a year’s time, both assets and liabilities grow by £10 million.
c) The possibility that the loans will not be repaid is called the liquidity risk.
CONTINUED

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A8. An investment project costs £500,000 today, and it will generate £300,000 next year and an
additional £400,000 two years from now at which point it finishes. Which of the following is
true?
a) If the interest rate is 5% the present value of the project is bigger than £100,000.
b) The maximum interest rate for which the project should be undertaken is bigger than 40%.
c) If the investment costs £10,000 rather than £500,000, the project should be undertaken for all
positive interest rates.

A9. Consider the long-run data on real wage growth and unemployment rates in the figure and
select the correct statement(s).

a) A policymaker who values wage growth above all else would have vertical indifference
curves.
b) Positively sloped indifference curves with the most favoured point in the north-west would
reflect a policymaker's preferences who valued both real wage growth and low unemployment.
c) The preferences of a Spanish policymaker would go through the point labelled 'SPA'.

A10. Which of the following best describes the operation of ‘automatic stabilisers’?

a) When saving increases, investment increases.

b) Some components of government spending inevitably increase when output falls.
c) They are pro-cyclical. TURN OVER

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A11. The two figures below both show the long-run growth of real per capita GDP in the UK (in
logs) but for different periods.

Which of the following is/are correct?

a) Since 1950, the annual rate of growth of real GDP per capita has been more rapid than the
average rate of growth over the whole period since 1875.
b) The average rate of growth of real GDP per capita before 1950 must have been more rapid
than since 1950.
c) Since the financial crisis, the growth of real per capita GDP has fallen below the long-run
average rate from 1875. CONTINUED

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A12. Although the opinion polls suggest it has little popular support, the governing elite has been
in power for many years because the opposition is divided. The opposing party then changes its
leader and begins to look like a possible alternative government. How would the figure below
need to be modified to show the new situation facing the governing elite?

a) The cost curve for the public service provided would shift up.
b) The governing elite can increase its political rents if the greater political competition has the
effect of making the country less prone to a violent overthrow of power.
c) Whenever the duration curve shifts, the iso-rent curves drawn in the figure with the same axes
as shown have to be re-drawn.

A13. Assume the economy is initially characterised by stable inflation at the central bank's
inflation target. Choose the correct statement(s):

a) The inflation rate in the economy is determined by the growth rate of the money supply
chosen by the central bank.
b) Inflation would be predicted to rise above target if there is a business cycle upswing because
of the increase in wages required to get workers to work hard in a tighter labour market.
c) The central bank would be expected to respond to increased price competition among firms by
reducing the interest rate.

A14. In an economy with unutilised resources, the government stimulates aggregate demand by
increasing its spending. The effect on output and employment will be greater if:

a) The economy has a low propensity to import.

b) The spending is financed by additional taxation.
c) Its trading partners undertake a similar policy. TURN OVER

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A15. The Beveridge curve will shift downward (toward the origin) if:
a) Information about job vacancies improves.
b) As compared with the geographical distribution of the unemployed, vacancies are increasingly
concentrated in a geographical region.
c) Unemployment benefits become less closely tied to the wage and occupation of an
unemployed person's previous job.

A16. The UK performed worse than many other Western European countries in the 'catch up'
years of the 1950s and 1960s. Using the figure below as the representation of what happened in
the 'typical' catch-up economy, decide which of the following amendments for the British case
would need to be made to the diagram (note: employment is measured from left to the right
along the horizontal axis and unemployment from right to left. The unemployment rates
associated with the employment rates at A and B are labelled):

a) The price-setting curve would have shifted up less because of the weak competition faced by
British firms in protected markets in former colonies.
b) The wage-setting curve would have shifted up by less because of the fragmented nature of
British unions.
c) The price-setting curve would have shifted up by less because there was a smaller gap
between productivity in the UK and in the US than was the case elsewhere in Western Europe in
the early 1950s.

CONTINUED

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A17. The effect of automation on jobs depends on whether workers have skills that can be
substituted by machinery or are complementary to their operation. Looking at the figure below,
which statement(s) is / are true?

a) The data is consistent with the hypothesis that automation will have a stronger effect on
machine operators than on home health aides.
b) Nurse practitioners appear to be especially difficult to substitute with machines, since these
jobs are predicted to grow rapidly but are also amongst the best paid.
c) Personal financial advisors are likely to suffer more than optometrists.

A18. In a two-party political system which of the following condition/s could cause the two
parties to offer programmes that showed real differences?

a) Voters are not equally distributed across the ideological spectrum from left to right; rather,
voters on the extreme left reject both capitalism and the democratic system, and do not vote at
all.
b) Instead of all voters being equally distributed, there are few in the centre. Most voters
congregate around positions on the extreme right and the extreme left, and are not prepared to
vote for a centrist platform that they have no commitment to.
c) New party leaders are elected who care strongly about the content of their programmes
(‘politics becomes more ideological’) and are less determined to maximise votes. TURN OVER

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A19. For a country that is dependent on imports of commodities, a fall in the world price of
commodities will:

a) Shift both the price-setting and Phillips curves down.

b) Create a positive bargaining gap.
c) Reduce the unemployment rate consistent with constant inflation.

A20. The following diagram depicts a firm’s isoprofit curves and demand curve, given the
economy-wide demand. Which of the following statements is /are correct?

Output, q

a) At A, the Human Resources Department would be telling the Marketing Department to

produce less.

b) At B, the marginal rate of substitution is

c) The firm will be making a profit at C.

CONTINUED

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PART B. Answer ANY TWO questions from this section.

B1. (40 points)

A strategic situation arises between a government and a non-government organization. The
militants of the non-government organization have to decide whether to take some hostages and
ask the government for concessions or stay in hiding. If they stay in hiding, the payoffs of both
militants and governments are zero. If they take hostages, the government can decide to make the
concessions or not. If they make the concessions, the hostages are freed, and the concessions do
take place, so the payoff for the government is -2 and the payoff for the militants is 2. If the
concessions are not made, the militants must decide whether to free the hostages or to kill them.
If the hostages are killed, the payoffs are -3 to the government and to the militants. If the
hostages are released, the payoffs for both government and militants is -1.
a) Draw the game tree for this strategic interaction.
b) What is the solution of this game by backwards induction?
c) This same game can be represented in matrix form as follows:

Militants/Government Pay Do not pay

Do not take hostages 0, 0 0, 0
Take hostages and 2, -2 -3, -3
kill
Take hostages and 2, -2 -1, -1
release
.
Define a Nash equilibrium. Find all the Nash equilibria in this game, if any. (Hint: a player can
be using a best response when she is indifferent between two actions; all that is required is that
the action used is a best response, not that it is the only best-response). Can you find a game of
economic significance that is similar to this game?

d) If there is a difference in your solutions to the games in b) and c), can you explain why you
think they exist?
e) Suppose now that the militants work in an environment in which not killing the hostages when
the government does not pay is seen as a symptom of weakness and thus their payoff if the
government does not pay and it releases the hostages is -4. What is now your answer to a) and
b)?
f) Suppose now that the militants know whether they are in the original position, or in the one
described in e) but the government does not know which type of militant it is facing. What
should the government do? And what should the militants do if they are rational?
TURN OVER

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B2. (40 points)
Assume that a market has 80 firms with cost function 𝐶(𝑄) = 4𝑄 2 + 4𝑄 + 16.
a) Define the following concepts: perfectly competitive equilibrium, price-taking firm,
average costs.
b) Write down the formulae for the average costs and find the level of Q for which average
cost is minimized for each firm and what the average cost is for that value of Q.
c) What is the short-run supply curve of each firm? What is the supply curve of the entire
industry? Please specify the minimum price at which the firm starts to supply.
d) Assume that demand is Q = 760 -10P. What is the competitive equilibrium in this
market? What is the consumer surplus?
e) What is the equilibrium in the market if demand is Q = 760 - 10p and the government
decides to impose a tax per unit of £8? What is the deadweight loss created by this tax?
Why would a government want to inflict a deadweight loss like that on a population? Is
there a way to mitigate that loss?
f) What would you expect the price to be in this market if there is free entry in the industry?
What can the government do to make sure entry in the industry happens? Could the entry
rate in an industry ever be too fast?

B3. (40 marks)

Consider the following scenario. Initially, Julia has no assets but will get income of $100 next
year. Her initial situation is at point A in the figure. She goes to a payday lender for a loan to
smooth her consumption. Next, she learns of the opportunity to become a driver for a ride-
sharing company called Lyft and finds that she can borrow her brother’s car. She could use the
loan to pay for the repairs to the car she needs to make to be able to get rides through Lyft. The
payday lender charges an interest rate of 78% per annum. Assume that for every dollar spent on
repairs, Julia can make $3 more income next year.

a) Referring to the diagram, explain Julia’s feasible set when she can borrow from the payday
lender.
b) Explain why Julia is unlikely to get a conventional loan from a bank to smooth her
consumption and must go to a payday lender to get one.
c) Redraw the figure to show Julia’s new feasible set to include the investment opportunity that
is available to her. Explain what has happened to it and why. What is the rate of return Julia
makes on her investment? What is the marginal rate of transformation?
d) Assume that Julia’s choice of consumption today is $35 in the case in which she borrows
only and in the case in which she borrows and invests. Sketch and label her indifference
curves on the diagram. CONTINUED

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e) In each case of ‘borrowing only’ and ‘borrowing and investing’ in (d) above, show the
amount borrowed and the amount paid back to the pay-day lender.
f) Refer to the diagram to explain how Julia’s wellbeing is affected by access to this investment
opportunity (hint: compare consumption next year with and without the investment
opportunity).
g) Will it always be worthwhile for Julia to engage in an investment opportunity?

TURN OVER

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B4. (40 marks)

The figure below presents five-yearly unemployment rates for two countries that are members of
the European Union, Spain and Germany.

Unemployment in Spain and Germany (1960-2014).

The table below presents data for the period 1976 to 2011 for unemployment and three economic
variables.
1 2 3 4
Unemployment Generosity of Openness of the Labour
rate (%) unemployment economy to productivity in
benefits (%) global manufacturing
competition (% (2005 US$)
of GDP)
Germany 6.8 26.9 71.0 43.3
Spain 15.4 31.9 65.1 30.6

Note: Generosity of unemployment benefits is measured as Gross Unemployment Benefit

Replacement Rates. Openness of the economy to global competition is exports plus imports as a
share of GDP. Labour productivity is gross value added per hour worked, in manufacturing
sector, measured in 2005 US$. All data are averages over the period 1976-2011.
CONTINUED

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a) Using the data in the figure above, concisely compare unemployment trends in the two
countries. You should refer to any events relevant to the trends you observe.
b) Referring to the labour market model you have studied in this module, explain the
determinants of equilibrium unemployment and why it is described as a Nash equilibrium.
c) Explain how you would represent the variables in columns 2, 3 and 4 of the table above in
the labour market diagram with employment in the horizontal axis and the real wage on the
vertical axis.
d) Using the ceteris paribus assumption explain what the labour market model would predict for
the effect of each variable in columns 2, 3 and 4 for the average equilibrium rate of
unemployment in Germany relative to that of Spain.
e) Use the labour market diagram to show the predicted unemployment outcomes for Spain and
Germany.

END OF EXAM

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