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UNIVERSITY OF LONDON

279 0002 ZB 990 0002 ZB 996 D002 ZB

BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the Social Sciences, the Diploma in Economics and Access Route for Students in the External Programme

Introduction to Economics Friday, 15th May 2009 : 2.30pm to 5.30pm

Candidates should answer FOUR of the following EIGHT questions: QUESTION 1 and ONE further question from Section A, and QUESTION 5 and ONE further question from Section B. All questions carry equal marks.

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SECTION A Answer question 1 and one further question from this section.

1.

Answer THREE of the following questions: (a) There are two goods produced in an economy: food (x) and Robots (y). A unit of x requires a unit of labour and a of a unit of capital. In addition to this, there is a need to preserve food by adding one unit of the natural ingredient Stabilus to each unit of the good x. To produce one Robot, there is a need for a of a unit of labour and a unit of capital. Robots, however, need to be stored. Each Robot requires one unit of storage. There are 100 units of labour and 100 units of capital in the economy. There are also 80 units of the substance Stabilus and 80 storage spaces. What would be the opportunity cost of producing a unit of y when the economy produces 100 units of y? How many units of x can be efficiently produced with this quantity of y? What would be the opportunity cost of a unit of x? Explain your answer. Consider a world of two goods (x and y). The price elasticity of the demand for x would have to be greater than unity if good y (notice that here we refer to y) is perceived as an inferior good. However, the substitution effect under Slutsky would then be smaller than that under Hicks. True or false? Explain your answer. The capital to labour ratio in the short run would decrease when we produce less output as we do not need sophisticated technologies to produce lower quantities of output. Moreover, for the very same reason the short run cost would be lower than the long run cost of producing the same quantity. True or false? Explain your answer. In a competitive industry, an increase in the price of a gross substitute would leave the long run level of production by each firm the same as before the change. True or false? Explain your answer. The offer curves in an exchange economy do not necessarily intersect on the contract curve and therefore, competitive equilibria are not always efficient. True or false? Explain your answer. Optimal provision of public goods requires that the total sum of willingness to pay should be greater than the marginal costs. True or false? Explain your answer.

(b)

(c)

(d)

(e)

(f)

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2.

Mr and Mrs Marmalade own a house, which is next to a ski resort. They use one of the bedrooms in the house to cater for their hobby of making a special jam called Mountain Peel (which we would call, imaginatively, x). It costs c to make one jar of Mountain Peel and, given the fact that one of them works and earns ( I 0 ), the other can produce up to x
0 jars. The price of a Mountain Peel jar in the market is p x while the price of all other goods

is p 0 y . Suppose too that they can only produce Mountain Peel for domestic consumption as the costs of setting up a commercial business are prohibitive (i.e. they cannot sell their produce in the market). (a) Describe the initial choice the Marmalades make distinguishing between a situation where they rely only on their own jams and that when they also purchase some jam in the market. A shrewd estate agent persuaded the Marmalades to consider the option of renting their room - the one in which they were making jam - to ski holiday makers and mountaineers. Let R be the rent paid for the entire period. Analyse the effects of offering the room for a fraction of the time (say, ) which means that they will be able only to produce the fraction (1-) of their jam. Will the Marmalades always prefer to rent out the room? Suppose that the Marmalades were not buying any Mountain Peel in the markets, would they necessarily wish to rent out the room for the entire period? Is it possible for the Marmalades to become better off yet consume less Mountain Peel? Does this mean that Mountain Peel is an inferior good? How would your answers change had the Marmalades been able to sell their products in the market. Are they likely to prefer not to sell some of their product?

(b)

(c) (d) (e)

3.

The demand for the local product of Fine Schmaekers Smoked Mountain Goat Cheese (FSSMGC) comes from locals for whom it is a traditional dish and international snobs. The cheese is produced in a competitive market where the local demand is fairly inelastic but the international demand is perfectly elastic (there is no end to world snobbery). Due to a sharp deterioration of the local currency, the local price of international snobbery goods has gone up. (a) (b) Show the initial equilibrium in the market identifying the equilibrium price and output as well as the level of local consumption and export. What will be the effects of the change on equilibrium price and quantity, exports, and the number of FSSMGC producers in the industry in the short and in the long run? Assuming that the labour market is competitive, how would the long-run equilibrium in the FSSMGC industry affect an importing industry? To contain the effects of the change, the government proposes to levy a lump sum tax that would leave the number of firms in the industry unchanged. Would the average tax per unit - at the original level of production - be greater or smaller than the change in the market price? How would your answer to (c) change?

(c) (d)

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4.

The demand facing a monopolist is given by the following function: x( p) = Ap . Suppose too that the cost function is given by C ( x ) = cx . (a) (b) (c) Describe graphically the initial equilibrium. How would an increase in demand (an increase in A) affect the equilibrium price? If a unit tax is levied on this monopolist what would happen to equilibrium price and quantity? Will such a tax rectify the monopolists inefficiency? Would the burden of tax be shared by consumers and producers? How sensitive would your reply be to the price elasticity of demand?

(d)

SECTION B Answer question 5 and one further question from this section.

5.

Answer THREE of the following questions. (a) In a closed economy where a government is committed to increase its expenditure as national income grows, the balanced budget multiplier will be independent of the public's marginal propensity to consume (assume a lump-sum tax). True or false? Explain your answer. An increase in domestic investment which is accompanied by an increase in the economys net exports must mean an increase in private savings. True or false? Explain your answer. A decrease of 10% in the reserve ratio which is followed by a decrease of 10% of money held in banks would have no effect on a closed economy with flexible prices and wages. True or false? Explain your answer. An exogenous decrease in export would have no effect on an open economy without capital mobility and a fixed exchange rate. True or false? Explain your answer. An increase in transfer payments will cause a recession in an open economy with perfect capital mobility and a flexible exchange rate. True or false? Explain your answer. An increase in international prices, in a world without capital mobility, would necessarily increase the demand for foreign currency. True or false? Explain your answer.

(b)

(c)

(d)

(e)

(f)

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6.

In Futuritania, technological progress means that the share of labour in national income is declining at the expense of the share of capital. Suppose, for simplicitys sake, that people draw their income either from labour or from capital. Suppose too that the marginal propensity to consume of those who derive their income from labour is higher than that of those who derive their income from capital. Let denote the share of national income which is not held as retained profit, and assume that firms invest all the retained profits. Let denote the share of income derived by labour. The government of Futuritania maintains a balanced budget and there are proportional taxes on both consumption and retained profits. This is a closed economy with flexible prices and wages. (a) (b) (c) (d) (e) Describe the initial equilibrium (before the decline in the share of labour). What will be the economys multiplier? How would the fall in the share of labour in national income affect the economy? What would happen to investment? What would happen if, in addition to the above changes, firms opted to distribute a greater share of their profits? If the government wished to offset the short-term effects of such changes, what should be its tax policy?

7.

To avert recession, a countrys main trading partner has reduced its interest rate. Analyse the effects that this will have on the home country: (a) (b) (c) (d) when there is no capital mobility and exchange rates are fixed. when there is no capital mobility and exchange rates are flexible. when there is perfect capital mobility and exchange rates are fixed. when there is perfect capital mobility and exchange rates are flexible.

8.

In a remote country, Terra Terminus, a large stock of natural gas has been found. A foreign company Global Gold Digger is getting the license to extract and sell the gas. The terms of the contract are that GGD must use local means of production and pay the government an annual fee. Analyse the effect of this development on Terra Terminus when: (a) (b) (c) (d) there is no capital mobility and the exchanged rate is fixed. there is perfect capital mobility and the exchange rate is flexible. there is perfect capital mobility and the exchange rate in flexible. What would happen to another economy where individuals rush to buy shares in GGD which is not a local company? Analyse this in the set-up of (b) and (c) above.

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