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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 Thursday, 13 May 2010 : 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) In an economy there are two goods, x and y, which are produced with capital and labour. The technological requirements are as follows: 1/2 a unit of labour and 1/3 a unit of capital will produce one unit of x; 1/4 a unit of labour and 1/2 a unit of capital will produce a unit of y. There are 100 units of labour and 150 units of capital. If the economy produces 100 units of y efficiently and the international price of y is 1/3 of a unit of x, the economy will fully specialise in producing y. True or false? Explain. A rational agent will never respond to a fall in the price of a commodity by reducing the quantity demanded of that commodity unless it is an inferior good. True or false? Explain. When there are decreasing returns to scale throughout, there will be no U-shaped average cost curve in either the long or the short run. True or false? Explain. A decision has been taken to offer a higher wage per hour for anyone working beyond a certain number of hours ( l ). A worker who used to work more than l hours before the change now works less and is better off. This could only be possible if the worker treats leisure as an inferior good. True or false? Explain. A unit tax on firms in monopolistic competition will not affect the long-run equilibrium level of output. True or false? Explain. A competitive equilibrium of an exchange economy is Pareto-efficient. True or false? Explain.

(b) (c) (d)

(e) (f) 2.

In a drought-ridden economy, the government considers ways to reduce the waste in the use of water. 0 Up to now, consumers (all of whom had water meters in their homes) paid ( p x ) per cubic meter. Now, the government proposes to charge an annual lump sum (say, W), which allows the consumption of what the government deems as essential (say, up to x cubic meter of water). For each extra cubic 1 meter of water, consumers will now have to pay a higher price ( p x ) per cubic meter. Assuming that x measures the use of water and y all other goods: (a) (b) Describe the initial set-up diagrammatically. Analyse the effect of the governments proposal on those who initially consumed more than x . Is it possible that the government may succeed in not affecting their well being yet bring down their consumption of water? Critics of the government say that one must also deal with those who initially use less than x cubic meters and give them an incentive to consume even less. They suggest that for each cubic meter not consumed below x , consumers should receive a rebate of b per cubic meter not used (up to x ). Will such a scheme help further reduce the use of water even when consumers treat the use of water as a normal good? Would your answer be different if consumers who consume less than x treat water as an inferior good?

(c)

(d)

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3.

A remote region in Megaland is the sole producer of a special kind of cheese (Caprice de Chevre). As the uniqueness of this goat-cheese emanates from special minerals in the land of that region, it cannot be produced elsewhere. Nevertheless, the region is sufficiently big to allow competition to thrive. Producers sell their cheese both locally and in the large city centre which is, however, far from the region. Naturally, sales to the city are subject to considerable transportation costs. (a) (b) (c) (d) Show the initial long run equilibrium and the distribution of sales between local consumers and the big city dwellers. Who would bear the burden of the transportation costs? Analyse the short run and long run implications of an increase in transportation costs for the equilibrium price, distribution of sales, consumers expenditures and profits of producers. To counter the effects of the increase in transportation costs, the government offers local industry a lump-sum subsidy. Who will benefit from such a move? Will it be worthwhile for producers in the city to transport soil from the region to compete with local producers for the citys market? Examine the development of the city market when city producers enter the frame.

4.

Consider a monopolist who is producing a unique type of Talking Teddy-Bears (TTB). The demand for TTBs is linear. The production technology is such that if one produces less than, say, x TTBs, the main machine can produce each TTB at a constant marginal cost of c0 . For quantities beyond x it is worthwhile to use the more complex machine which has higher maintenance costs but where the marginal cost of an extra TTB is constant at a lower level of d 0 ( c0 d 0 ). Suppose that the level of output where the switch occurs ( x ) is such that marginal cost intersects marginal revenue twice. (a) (b) (c) (d) Draw the monopolists set-up. Draw the average cost curve facing the monopolist. At what level of output would profits be maximised? How does your answer to (c) affect the inefficiency created by the monopolist?

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SECTION B Answer question 5 and one further question from this section. 5. Answer THREE of the following questions. (a) (b) (c) (d) (e) (f) Derive the multiplier of a closed economy where the government is committed to increase its spending as output increases but maintains a balanced budget with a proportional tax system. Why are more investment projects being abandoned when there is a rise in interest rates? In a closed economy with flexible prices and wages, a reduction in the reserve ratio will have no real effect and will only cause a rise in nominal wages. True or false? Explain. There is no 'paradox of thrift' in an open economy without capital mobility and a fixed exchange rate policy. True or false? Explain. Derive the deposit multiplier. In an open economy, when the governments deficit equals private savings, there will not be any domestic investment unless the current account is in deficit. True or false? Explain.

6.

In an efficiency drive, the government orders the out-sourcing of a large number of services to the private sector. Assume that there is a proportional tax system and that private profits, which constitute a constant proportion of national income, are directed in their entirety to investment. (a) (b) (c) Analyse the effects of the change on a closed economy with fixed prices and wages. How would your answer change if prices and wages are flexible? How would your answer change if there is a corporate tax and not all of the remaining profits are invested?

7.

In the wake of a financial crisis, bankers decide to limit the amount of loans that they issue. To counter the effect of this and to stimulate the economy, the government orders all its agencies to refrain from importing goods. Critics of the government argue that this policy will only make things worse and that the government will do better if it does nothing at all. (a) (b) (c) Analyse the short run and long run effects of the bankers behaviour on the equilibrium income and interest rate in an open economy without capital mobility and a fixed exchange rate. What is the effect of the government policy? Are the critics right? How would your answer change if the exchange rate is flexible?

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8.

The government wishes to combat the excesses of boardroom payments by increasing the level of corporate tax. Let represent the share of profits in national income. Assume that corporations invest their retained profits and that there is a proportional income tax system. Assume an open economy. (a) (b) (c) (d) What is the economys multiplier? How would the increase in corporate tax affect the economy if there is no capital mobility and the exchange rate is fixed? How would your answer change if there is perfect capital mobility and the exchange rate is fixed? Would a flexible exchange rate change your answer in (c)?

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