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UNIVERSITY OF LONDON

279 0002 ZA 990 0002 ZA 996 D002 ZA

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 x when the economy produces 120 units of x? How many units of y can be efficiently produced with this quantity of x? What would be the opportunity cost of a unit of y? 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 is perceived as an inferior good. However, the income effect under Slutsky would then be smaller than that under Hicks. True or false? Explain your answer. Short run marginal costs will always intersect the long run marginal costs at the same level of output at which short run average cost equals the long run average cost. True or false? Explain your answer. If not all industries are at the long-run equilibrium of perfect competition, market prices will not reflect the true social costs. 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. An exogenous increase in the demand for commodity x in a world of two goods would necessarily lead to an increase in the equilibrium relative price of x. 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 supply of wine to a local market comes from local growers and from new and rising international suppliers. International supply is perfectly elastic and the local market is competitive. Due to good weather in other parts of the world, the price of foreign wines has fallen. (a) (b) (c) (d) Describe the initial long run equilibrium, identifying the equilibrium price and quantity, the level of imports and the level of each growers output. What will be the effects of the change on equilibrium price and quantity, imports and the number of growers in the industry in the short and in the long run? Will the change have any effect on other industries assuming that the labour market is competitive? To avoid a meltdown of local production, the government proposes to offer a lump sum subsidy to growers to prevent any one of them leaving the market. Would the average subsidy per unit (at the initial level of production) be greater or smaller than the fall in the international price? Analyse the effects of such a policy if it is pursued immediately in response to the fall in the international price of wine. Would your answer to (c) be different in this case?

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4.

A fashion house, Apple Crumbles and Fish, has a complete monopoly in the market for tight clothes. The demand for its products comes from two different groups: the young, who are willing to spend a great deal of money on these clothes (because the lead singer in the Burning Bushes band wore them), and older people who like to dress like this when no one else is around. (a) (b) Assuming that the monopolist cannot discriminate, under what conditions would the monopolist supply both groups of consumers? Another brand, Borrister, begins to sell tight clothes. Given that it is inspired by a singer whom the older people dislike, only the young are influenced by this development. How would the emergence of Borrister affect the initial equilibrium facing Apple Crumbles and Fish? Would your answer to (a) remain unchanged?

(c)

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 the government is committed to increase its expenditure with increases in national income, the balanced budget multiplier will be independent of the publics marginal propensity to consume (assume a lump-sum tax). True or false? Explain your answer. Two open economies are identical in all but the fact that economy 1 has a surplus in the capital account while economy 2 has a deficit. Therefore, domestic investment in economy 1 will be greater than that of economy 2. 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 increase in the marginal propensity to import would have no effect on domestic investment in an open economy without capital mobility and a fixed exchange rate regime. True or false? Explain your answer. An increase in demand for liquid assets would cause a recession in an open economy with perfect capital mobility and flexible exchange rates. True or false? Explain your answer. Actual investment always equals actual savings (private and government) in a closed economy, therefore the economy is always in equilibrium. 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 alleviate poverty, a government decides to increase its programme of income support for the poor. Critics of the government argue that such a policy will have no real effect and will cost the economy its future. Instead, they argue, the government should reduce taxes. Analyse the effects of the governments policy and consider the view of its critics in: (a) (b) (c) (d) (e) a closed economy with fixed wages. a closed economy with flexible wages. an open economy without capital mobility and a fixed exchange rate policy. an open economy with perfect capital mobility and a fixed exchange rate. an open economy with perfect capital mobility and a flexible exchange rate.

8.

Gasilands major export is natural gas. Due to repeated difficulties with its supply, its main trading partners moved either to new suppliers or to alternative forms of energy and the demand for its gas collapsed. Analyse the impact that this would have on Gasiland when: (a) (b) (c) there is no capital mobility and the exchange rate is fixed; what would happen to domestic investment? there is perfect capital mobility with a fixed exchange rate. there is perfect capital mobility with a flexible exchange rate.

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