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Department of Economics University of California, Berkeley

Professor Kenneth Train Fall 2009

ECONOMICS 1 FINAL EXAMINATION


December 14, 2009

INSTRUCTIONS

1. Please fill in the information below: Students Name: _____________________________________ SID #: ____________________________________________ GSIs Name: ________________________________________ Section Number (Day/Time):___________________________ 2. This exam starts at 5:00pm and ends at 8:00pm. 3. If you finish before 7:45pm, turn in your exam to your GSI and leave quietly. 4. If you finish after 7:45pm, please remain in your seat until the end of the exam so that you do not disturb others. 5. When time is called, please stop writing and turn in your exam. 6. There is a total of 200 points, 10 questions, and 14 pages (including this cover sheet) points for each question are in parenthesis. 7. NO BLUE BOOKS NEEDED. Please answer the questions in the space provided. If you need extra room to answer the questions, use the backs of the pages. 8. Calculators are not permitted. 9. Good Luck and Happy Holidays!

DO NOT TURN THE PAGE UNTIL YOU ARE TOLD TO BEGIN THE EXAM

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Question 1: TRUE, FALSE, UNCERTAIN. (32 points) For each question decide whether the statement is false, true or uncertain. Your grade is determined by your explanation; an answer without an explanation receives no credit. Use graphs when needed to complement your answer.

a) (4 points) If the government wants to minimize the effect on consumers when imposing an excise tax on a good, the government should charge producers for the tax rather than charging consumers.

b) (4 points) Absolute advantage in the production of a good exists when a country can produce more units of the good than another country can, independent of the resources used.

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c) (4 points) Consider the exchange rate Thailand Bath /US dollar. When the Thai bath depreciates, both US imports and Thai exports are going to increase.

d) (4 points) Fiscal and monetary policy are more effective in a closed economy (i.e., an economy that does not trade) than an open economy.

e) (4 points) In monopolistic competition in stage two equilibrium, it is possible for the representative firm to make positive profits at the market equilibrium price because P>min AC.

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f) (4 points) Moral hazard increases the benefits of insurance.

g) (4 points) In the prisoners dilemma all players have an incentive to deviate from the cooperative equilibrium but then end-up worst than if they have had cooperated.

h) (4 points) A $1 excise tax on any good that is sold in a competitive market hurts consumers more than $1 excise tax on any good that is sold by a monopolist.

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Question 2: Short answer (15 points) Clearly state and explain each one of the assumptions for a market to be a monopoly, and contrast it to monopolistic competition.

Question 3: (14 points) A proposition is put on the ballot to charge each person $100 and to use the money to purchase a specified public good. Assume everyone votes. (a) (7 points) What condition determines whether this ballot proposition will pass?

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(b) (7 points) What condition determines whether this ballot proposition should pass from a social perspective?

Question 4: (17 points) Two unrelated people, which we will call Adam and Beth, have the same assets and face the same risks, but have different von-Neumann Morgenstern utility functions. Each person owns a house worth $500,000 and has no other assets. The probability of a fire and total loss of the house is 0.40 (forty percent), which is the same for both people. (Assume that the land is worthless without the house.) a) (7 points) Suppose an insurance company offers these people an insurance policy that will pay the totality of the damage if their house burns down. What premium will the company need to charge to just break even?

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b) (10 points) The graph below shows the von-Neuman Morgenstern utility functions for the two people. Adams utility function is the dotted line, and Beths is the solid line. Is Adam willing to pay more than Beth for the insurance, or is Beth willing to pay more than Adam? Explain your answer.

Utility

Beth

Adam

300,000

500,000

Wealth

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Question 5: (22 points) Consider the following aggregate economy. C = 450 + 0.8*(Y-T) I = 50 +0.4*Y G = 2600 T = 400 + 0.2*Y EX=1200 IM=100 + 0.3*(Y-T) Note that investment, taxes and imports rise with income. Assume that interest rates, exchange rates and prices are fixed. a) (12 points) Calculate the equilibrium output in this economy. Show your calculations or no points will be awarded.

b) (10 points) Given that investment depends also on Y, how would you expect the multiplier in this economy to be? Higher, lower or equal to the multiplier when investment is independent of Y. No calculations needed, just make sure to explain the reasoning of your answer.

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Question 6: (18 points) Consider a closed economy (i.e., no trade), with prices and the interest rate fixed. Aggregate output is Y = 1000, and the economy is in equilibrium. Currently, the tax function is: T=200 + 0.3Y. The government wants to stimulate the economy by lowering taxes. The government has two options for lowering taxes. It can lower taxes that are not related to income, so that the new tax function is: Option 1: T=100+0.3Y Alternatively, it can lower the tax rate on income, so that the new tax function is: Option 2: T=200+0.2Y Which way of reducing taxes will have a greater effect on stimulating the economy? Explain your answer.

Question 7: (30 points) Consider an open economy in which prices, interest rates, and the exchange rates all vary. Explain briefly the effect of contractionary monetary policy on the following variables. Use a graph to complement your answers. Make sure to include the feedback effect in your analysis.

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a. (6 points) The exchange rate. Does the dollar appreciate or depreciate?

b. (6 points) The trade balance? Improve or worsen?

c. (6 points) The price level? Rise or fall?

d. (6 points) The GDP? Rise or fall?

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e. ( 6 points) The interest rate? Rise or fall?

Question 8: (23 points) Suppose there are two countries Freedonia and Homelandia. Both countries produce both leather and cotton. The only input in production is labor, and each country has 100 workers. The output per worker in each country is given by the following table, and is the same for any level of production:

Leather (yard) Cotton (ton)

Freedonia 12 4

Homelandia 15 40

a) (3 points) In a graph, draw the PPF for Freedonia.

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b) (3 points) Which country (if any) has the absolute advantage in producing leather?

c) (3 points)Which country (if any) has the absolute advantage in producing cotton?

d) (3 points)Which country (if any) has the comparative advantage in producing leather?

e) (3 points)Which country (if any) has the comparative advantage in producing cotton?

f) (8 points)Without trade, each country produces both goods. With trade, assume that ton of cotton can be exchanged for one yard of leather. Will trade at this exchange rate benefit both countries? Why or why not? Explain your answer.

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Question 9: (17 points) Natural gas and gasoline are substitutes for many uses. However, natural gas creates fewer emissions than gasoline, such that switching users from gasoline to natural gas reduces emissions. Suppose the market for natural gas is described by the following demand and supply equations. Supply of natural gas: Q=1000*Pn-600 Demand for natural gas: Q=400-200*Pn + 100*Pg where Pn is the price of natural gas and Pg is the price of gasoline. a) (5 points) Suppose the price of gasoline is $2. What is the equilibrium price for natural gas?

b) (6 points) The government wants to increase natural gas consumption 100 units by raising the price of gasoline. How much must the price of gasoline rise in order for natural gas consumption to rise by 100 units?

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c) (6 points) If the market for gasoline is perfectly competitive, what size of an excise tax on gasoline would increase natural gas consumption by 100 units?

Question 10: (12 points) The price of cigarettes is $4 per pack. Which of the following two new taxes would reduce cigarette consumption more: an excise tax equal to $1 per pack, or a sales tax equal to 25% of the price? Show your answer graphically. Assume downward sloping demand and upward sloping supply.

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