I.

Microeconomics (questions 1-20)

1. Referring to the subject matter of research and research methods applied by
economists, discuss the specifics of economics as a discipline of science.

Economics is the social science that studies the production, distribution and consumption of goods
and services. It studies how individuals, businesses, governments and nations make choices on
allocating resources to satisfy their wants and needs, and tries to determine how these groups
should organize and coordinate efforts to achieve maximum output.

Economics study is generally broken down into two categories:

• Microeconomics focuses on how individual consumers and producers make their
decisions. This includes a single person, a household, a business or a governmental
organization. Microeconomics ranges from how these individuals trade with one another
to how prices are affected by the supply and demand of goods. Also studied are the
efficiency and costs associated with producing goods and services, how labor is divided
and allocated, uncertainty, risk, and strategic game theory.
• Macroeconomics studies the overall economy. This can include a distinct geographical
region, a country, a continent or even the whole world. Topics studied include government
fiscal and monetary policy, unemployment rates, growth as reflected by changes in the
Gross Domestic Product (GDP) and business cycles that result in expansion, booms,
recessions and depressions.

In terms of methodology, economists, like other social scientists, are not able to undertake
controlled experiments in the way that chemists and biologists are. Hence, economists have to
employ different methods, based primarily on observation and deduction and the construction of
abstract models.
• Deductive reasoning - is the process of reasoning from one or more statements (premises)
to reach a logically certain conclusion. The process of deductive reasoning looks as follow:
1. Hypothesis → 2. Observation → 3. Accepting or rejecting hypothesis.
• Inductive reasoning - is a method of reasoning in which the premises are viewed as
supplying some evidence for the truth of the conclusion. While the conclusion of a
deductive argument is certain, the truth of the conclusion of an inductive argument may be
probable, based upon the evidence given. The process of inductive reasoning looks as
follow: 1. Observation → 2. Looking for pattern → 3. Initial conclusion – Hypothesis.
Other selected methods:
• Comparative analysis method - analysis of individual cases and determination of
similarities, differences or their rank according to specific criteria.
• Economic experiment - Deliberate, artificial triggering of a specific phenomenon or its
change in order to examine its course, features and results in order to check the previous
hypothesis (e.g. pilot observations of the project of a given economic reform in a selected
region)
 2. Using the categories of consumer and producer surplus, assess market efficiency as a
mechanism of resources allocation.

Resource allocation – in economics, is the assignment of available resources to various uses.

In the context of an entire economy, resources can be allocated by various means, such as
markets or central planning.

Consumer Surplus – is defined as the difference in the market price of a good and how much an
individual or individuals would be willing to pay.

An example would be a person who is willing to spend $4 on a milk shake but the price is only $3
yielding a surplus of $1.

Producer Surplus – is defined as the difference between what it costs to produce a good and
what price the market provides.

An example would be a firm that makes milk shakes for $2 and sells them for $3 yielding a
producer surplus of $1.

Total surplus = Consumer surplus +

Producer surplus

A market is efficient when it provides the

most consumer surplus and the most
producer surplus possible. An inefficient
market creates what economists call a
deadweight loss.

Deadweight loss (zbędna strata

społeczna) - also known as excess burden
or allocative inefficiency, is a loss of
economic efficiency that can occur when
equilibrium for a good or a service is not
achieved. That can be caused by monopoly
pricing in the case of artificial scarcity, an
externality, a tax or subsidy, or a binding price ceiling or price floor such as a minimum wage.
 3. Using the market model describe the impact of concurrent demand and supply shocks
on the price and quantity of goods at the point of the market equilibrium.

Equilibrium is the state in which market supply and demand balance each other, and as a result,
prices become stable. Generally, an over-supply for goods or services causes prices to go down,
which results in higher demand. The balancing effect of supply and demand results in a state of
equilibrium.

Negative demand shock – occurs when there is a sharp drop in demand. As a result, the
aggregate demand curve moves to the left
Positive demand shock – occurs when there is a rapid increase in demand. As a result, the
aggregate demand curve moves to the right.
Causes of demand shocks:
• Changing the number of buyers
• Change in the prices of complementary days and substitutes
• Changing the amount of disposable income of buyers
• Change Customer preferences.

Negative supply shock – occurs when there is a sharp drop in supply. As a result, the aggregate
supply curve moves to the left.
Positive supply shock – it occurs when there is a rapid increase in supply. As a result, the
aggregate supply curve moves to the right.
Causes of supply Shocks:
• Changing the number of manufacturers
• Change of production technique
• Change in production factor prices
• Change of State behaviour.

While Positive Demand and supply shock:

• P ↔, q ↑ (same effect of positive demand and supply shock)
• P ↑, q ↑ (stronger effect of positive demand shock)
• P ↓, q ↑ (stronger effect of positive supply shock)

While Negative Demand and supply shock:

• P ↔, Q ↓ (same effect Negative Demand and supply shock)
• P ↓, Q ↓ (Stronger effect Negative Demand shock)
• P ↑, Q ↓ (Stronger effect Negative Supply shock)
 4. Define the price and income elasticity coefficients (simple and mixed) of demand and
supply. Indicate some applications.

Price elasticity of demand - relation of relative change in demand to relative price change. The
price elasticity of demand determines how the demand for a given good will change with changes
in the price.
ΔQ
𝑄⁄
𝐸= ΔP
𝑃
Interpretation:
E = ∞ → The demand is perfectly flexible.
E > 1 → Price elasticity of demand is elastic. A small change in the price causes a significant
increase in the value of demand.
E = 1 → Unitary price elasticity of demand. Relative price changes correspond to the same
changes in the value of demand.
E ϵ (0,1) → Inelastic price elasticity of demand. Even a significant price change only causes a
slight increase in demand.
E = 0 → Perfectly inelastic demand. There is a constant demand of good regardless of the
movement of its price.

Price elasticity of supply – relation of relative change in supply to relative price change.
Interpretation is the same as in the case of price elasticity of demand.

Income elasticity of demand – it is the relation between the percentage change in the demand
for a given good and the percentage change in the income of buyers. It tells you how much the
demand will change if the buyers' income changes by 1%.
ΔQ
𝐸 = 𝑄⁄ΔI
𝐼
E ϵ (0,1) → Normal goods.
E > 1 → Luxury goods.
E < 0 → Inferior goods.
Giffen good - is a product that people consume more of as the price rises and vice versa—violating
the basic law of demand in microeconomics.
Veblen goods - are types of luxury goods for which the quantity demanded increases as the price
increases.

Cross elasticity of demand - percentage change in the demand for good (service) x in response
to the percentage change in the price of a good (service) y.
Δ𝑄𝑥
𝑄𝑥
𝐸= ⁄Δ𝑃𝑦
𝑃𝑦
Applications:
• Determining market prices
• They facilitate market analysis and allow to set patterns of changes in demand for given
goods
• Supporting social policy - determining what goods are most often purchased by the poor
and checking how inflation will affect their situation.
• They allow to determine the point of market equilibrium and answer the question whether
the price of a given good should be raised or not.
 5. Assuming a linear demand function, describe the curve of price elasticity of demand
and firm revenues at various price levels.

Price elasticity of demand - relation of relative change in demand to relative price change. The
price elasticity of demand determines how the demand for a given good will change with changes
in the price.

When demand is inelastic – a rise in price leads to a rise in total revenue – a 20% rise in price
might cause demand to contract by only 5% (E PD = 0.25)

When demand is elastic – a fall in prices leads to a rise in total revenue – for example a 10% fall
in price might cause demand to expand by only 25% (E PD = 2.5)

When demand is perfectly inelastic (i.e. EPD = 0), a given price change will result in the same
revenue change, e.g. a 5% increase in a firm’s prices results in a 5% increase in its total revenue.

The table below gives an example of the relationships between prices; quantity demanded and
total revenue. As price falls, the total revenue initially increases, in our example the maximum
revenue occurs at a price of PLN 12 per unit when 520 units are sold giving total revenue of PLN
6240.

Price 20 18 16 14 12 10 8 6
Quantity 200 280 360 440 520 600 680 760
TR 4000 5040 5760 6160 6240 6000 5440 4560
MR ------- 13 9 5 1 -3 -7 -11
 6. Drawing upon the assumptions of the consumer choice model, define a basket of goods
corresponding to the consumer equilibrium in that model.

Consumer choice theory – the ultimate goal of analyzing consumer choices is to formulate
general conditions in which the consumer achieves optimal benefits from the consumption of
goods under given market conditions. If we assume that a person behaves rationally, then we can
assume that he will strive to achieve the optimal level of consumption of goods.

Assumptions regarding consumer:

• Sovereignty of the decision - the consumer makes a choice only on the basis of his
preferences within the limits imposed by the amount of income he has at his disposal
• Rationality of decisions - the consumer chooses such combinations of goods that
maximize its usefulness, that is, the subjective satisfaction that it derives from
consumption; he works in his own interest and on his own account
• Unlimited needs - the consumer's needs can never be fully satisfied, the consumer always
strives to achieve higher and higher levels of utility; more goods are always preferred over
fewer goods

Income of the consumer – cash at the consumer's disposal, which he can use to purchase
various combinations of goods. At a given price level in the market, the consumer's income
determines which combinations of goods are available to the consumer and which are outside the
reach of his budget.

Preferences – preferences are a reflection of the consumer's tastes. He prefers some

combinations (baskets) of goods over others - in particular, he prefers baskets of goods that
maximize his usefulness (i.e. satisfaction derived from their consumption), i.e. he prefers baskets
that are more useful than less useful ones.

Assumptions regarding preferences:

• Full information - the consumer has full information about the goods available on the
market, and also knows exactly which are more for him and which are less useful (in other
words, the consumer is not mistaken in assessing their preferences)
• The uniqueness of preferences - for each pair of baskets of goods: A and B, the
consumer is able to establish a clear relationship between the preferences between them:
U(A) > U(B) or U(B) > U(A) or U(A) = U(B)
• Transitivity - if the consumer prefers basket A over basket B and at the same time he
prefers basket B over basket C, then he always prefers basket A over basket C:
If U(A) > U(B) and U(B) > U(C) then always U(A) > U(C)

Utility - is a measure of the subjective satisfaction that the consumer derives from the
consumption of a specific basket (combination) of goods.

Law of diminishing marginal utility - with the increase in the consumption of goods for
subsequent units, utility gains are becoming smaller.
 7. Using the consumer choice model, discuss the substitution and income effect in the
situation of price increase in a standard good and Giffen good.

Substitution effect - change in the ratio of acquired goods (services) caused by a change in the
price of one of them. Together with the income effect, it describes the impact of price changes on
purchasing power and consumer decisions. The substitution effect always changes in the opposite
direction than the price change. This means that if the price of a product grows as a result of the
substitution effect, the demand for it decreases.

Income effect – in microeconomics, is the change in demand for a good or service caused by a
change in a consumer's purchasing power resulting from a change in real income. This change
can be the result of a rise in wages etc., or because existing income is freed up (or soaked up) by
a decrease (or increase) in the price of a good that money is being spent on.

Giffen good - is a product that people consume more of as the price rises and vice versa - violating
the basic law of demand in microeconomics.
 8. Discuss the criteria for firm decisions on the volume of production in the short term
and long term.

Production decisions of the company in a short term

In the short-term, the number of fixed factors does not change, the production volume determines
the equalization of short-term marginal costs with marginal revenue. With this production volume,
the company achieves a maximum profit or has minimal losses. The company then has to decide
whether it is in the short term that it still pays to run its production activity or not. Therefore, it is
necessary to check whether for a given production size the profit is positive, i.e. whether the sales
price covers the average total costs. An appropriate reference point is the SATC level (the
intersection of short-term average total costs and Q1 production). If the price exceeds SATC (total
average cost), the company achieves profits in the short term and its production should be Q1. If
the price is lower than SATC - the company incurs losses because the price does not cover the
costs. In the long run, such a situation means the need to make a decision to liquidate the
company, but in the short term it is different. Even if the production equals zero, the company must
cover fixed costs in the short term. Hence, it is important to know if the losses are greater in Q1
production or in production 0.

In the short-term, the enterprise chooses the level of production Q1 - i.e. at which the marginal
revenue is equal to the short-term marginal cost, provided that at these production volumes the
price is not lower than the short-term average variable costs. If the price is lower than the short-
term average variable costs, the company's production is zero.

Production decision of the company in a long term

In the long-term, the enterprise selects the production sizes specified in the point of balancing the
marginal cost with marginal revenue. The level of production ensuring maximum profit or minimum
losses can be found at this point. The task of the company is to check whether it achieves profits
or incurs losses at this production volume. If losses are of a lasting nature - continuing business
operations is pointless.

The total profit of an enterprise is equal to the product of the average profit (per unit of product)
and the volume (number of units) of production. Therefore, the total profit is positive only when
the average profit is greater than zero. Average profit is the average revenue per unit of product,
less the average cost. The average income equals the price at which individual product units are
sold. If, therefore, the long-term average costs at the point of offsetting the marginal cost with the
final sale exceed the price - the enterprise incurs losses; in the long term, this production should
be liquidated. If the price is equal to the average cost for the same production, the company covers
only its costs and reaches the break-even point. However, if the price for Q1 production exceeds
the long-term average costs, then the company is profitable in the long run and should continue
its operations.
 9. Define the production function of a firm and explain differences between the
technically and economically efficient techniques as well as the work and capital
intensive one.

Production function - in economics, the function by which the dependencies between inputs and
production resources and production effects are examined. One of the most popular example is
the Cobb-Douglas function which is a particular functional form of the production function, widely
used to represent the technological relationship between the amounts of two or more inputs
(particularly physical capital and labor) and the amount of output that can be produced by those
inputs.

Technical efficiency vs. Economic efficiency

A technically efficient company aims to be productive while using the minimum quantity of inputs.
In other words, the company wants to be as efficient as possible with as few inputs as possible, while
still hitting its production goal.

Economic efficiency is a related but distinct concept. Technical efficiency aims to minimize
inputs, but economic efficiency aims to minimize costs, which might or might not require fewer
inputs. In other words, the business aims to lower costs as much as possible while still hitting a
production goal.

Work and Capital intensive techniques

Labor intensive is used to describe any production process that requires higher labor input than
capital input in terms of cost. The production of goods and services requires labor and capital in
varying amounts, depending on the product. If the labor cost outweighs the capital cost, it indicates
that the production process is labor intensive. For example, mining is considered labor intensive
because a majority of production costs are related to paying workers. Other industries considered
labor intensive include hospitality (hotels and restaurants) and construction.

Capital intensive refers to business processes or industries that require large amounts of
investment to produce a good or service, and therefore have a high percentage of fixed assets,
which are also known as property, plant, and equipment (PP&E). Companies in capital-intensive
industries are often marked by high levels of depreciation. Examples: automobile
manufacturing, refining, steel production, telecommunications.
 10. Define the concepts of economics of scale and economies of scope and discuss their
sources

Economies of scale refer to reduced costs per unit that arise from increased total output of a
product. For example, a larger factory will produce power hand tools at a lower unit price, and a
larger medical system will reduce cost per medical procedure.

Graphic interpretation:

→As quantity of production increases from Q to Q2, the

average cost of each unit decreases from C to C1.
LRAC is the long run average cost.

Economies of scope are economic factors that make

the simultaneous manufacturing of different products
more cost-effective than manufacturing them on their
own. Economies of scope describe situations in which the long-run average and marginal cost of
a company, organization or economy decreases, due to the production of similar complementary
goods and services. The output of item A, therefore, reduces the price of producing item B. For
example, McDonald's can produce both hamburgers and French fries at a lower average expense
than what it would cost two separate firms to produce each of the goods separately. This is
because McDonald's hamburgers and French fries can share the use of food storage, preparation
facilities and so forth during production.

Whereas economies of scale for a firm involve reductions in the average cost (cost per unit) arising
from increasing the scale of production for a single product type, economies of scope involve
lowering average cost by producing more types of products.

Sources:
Depending on the type of economies, these factors can be internal to an organization or present
in its external environment:

Internal:
• Mass production through manufacturing capability improved by process improvements or
application of technology and innovation
• Discounts received from bulk purchases of supplies or raw materials used as inputs in
production or from special agreements with suppliers
• Multiple production or delivery of different goods or services using similar production
processes resulting in higher collective output and profitability
• Specialization of tasks made possible from financial capability used in hiring a larger
workforce or using better tools resulting in better productivity
• Spreading the fixed cost association in the management or administration of an
organization across a higher level of output or large production volume
• Inexpensive or cost efficiency advertising and marketing expenditures relative to profits
from high profitability from large production volume
External:
• Expansion of an industry or sector leading to an increase in marginal returns although
involved organizations individual produce under constant returns to scale
• Government intervention such as tax breaks or discounts to attract organization, thus
resulting in lesser cost in doing business to a particular location
• Effective transportation networks that make the movement of supplies or distribution of
outputs time and cost effective and efficient
• Availability of highly competent individuals in the labor market of a particular location, thus
leading to lower hiring and retention cost
• Geographic locations with favorable characteristics such as transportation networks,
competent labor market, and infrastructures or public services
 11. Enumerate and discuss the significance of basic criteria used by economists to classify
market forms.

In ordinary sense, market means a place where goods are bought and sold. In economics, market
refers to a group of buyers and sellers dealing in a particular commodity (e.g., gold market, oil
market, car market, fruit market, etc.). Kotler defines market as an area or atmosphere of potential
exchange.

The Market Structure refers to the characteristics of the market either organizational or
competitive, that describes the nature of competition and the pricing policy followed in the market.

There are few basic criteria that economists use to identify market structure. The most important
of them are:
• Number of firms in the market – extremely important one. For example if we have
information that there is only one firm one the market, we can easily state that it is a
monopolistic structure.
• Nature of product – here we can see if product on the market is homogenous, differentiated
or if there is only one type of the product available.
• Entry of firms – difficulties in entering the market by the new firm indicate which form of
market is it. Of course there may be no barriers of entry as in perfect competition or
monopolistic competition. This is another criterion which clarifies the division of market
structures.
• Degree of monopoly power – express the influence that one firm has on the market in a
given structure.
• Price policy of firm – describe if the firm is a price-taker or a price-maker
• Market knowledge – indicate a degree of knowledge that a single company has about the
market
• Elasticity of demand – knowing how elasticity of demand look in each structure we can
easily differentiate them.

Those criteria are crucial for classifying market structures. Economists Economists, basing on
them, distinguished 4 basic market forms – Perfect competition, Monopoly, Monopolistic
competition and Oligopoly. Table below shows how each of above mentioned criteria look for
these 4 market forms.
 12. Using the method of comparative statics, discuss the impact of production cost
increases on the equilibrium in a perfectly competitive industry in the short and long
term

The assumptions of a perfectly competitive market:

- A large number of small companies on the market (many buyers and many sellers operate on
the market)
- The good produced is homogeneous (the goods produced are basically the same),
- Every producer is a price-taker (he cannot influence the price level).
- Enterprises are free to enter and leave the market (in the long run)

For simplicity, it considers the case when all enterprises have the same costs, and the curve of
the long-term supply of branches runs horizontally. The figure shows that the demand curve for
DD products for the entire branch has a negative slope. At the starting point, the long-term supply
curve is the LRSS1 curve, the price ensuring the balance is P 1, and the production is Q1, the short-
term branch supply curve is SRSS1. The market presented in the figure is in a state of equilibrium,
both short-term and long-term.

The picture on the left shows the situation for each company in the branch under analysis. Each
company produces q1*, which is at the lowest point of the long-term cost curve of the average
LAC1. This point must also be the lowest point on the SATC curve (short-term total costs), so it
must also lie on the SMC curve (this is not shown in the chart). If there is N 1 companies in the
branch, production Q1 is equal to the production of q1 and N1.

Let us assume that the increase in the prices of production factors results in the increase of
production costs in all enterprises. LAC2 is a new curve of long-term costs of the average
enterprise. In the short term, some production factors in the enterprise are permanent. SATC 2 and
SAVC2 are average total costs and average variable costs at given quantities of fixed production
factors. The short-term marginal cost curve of SMC2 passes through the lowest point of both
curves. Part SMC2, which lies above SAVC2, is the company's supply curve in the short term. The
number of enterprises in the branch in the short-term does not change.
By adding horizontally curves of short-term supply for a given number of enterprises, we will
receive a new curve of short-term supply of SRSS2 branches. The new state of short-term
equilibrium sets the price of equilibrium at the level P 2, at the point where SRSS2 intersects the
demand curve. Each of the companies equates P 2 with short-term marginal costs of SMC2,
producing q2 production. In total, N1 companies produce Q2. At P2 prices, companies cover
variable costs, but do not cover fixed costs. This means that they incur losses.

When switching from a short period to a long period, two limiting conditions disappear: fixed
production factors are no longer fixed and enterprises can leave the branch. Long-term
equilibrium is set at price P2*, because the new curve of the long-term supply of branches LRSS2
is horizontal at the price of P 2*, which covers only the minimal long-term average costs. Each
company produces q2*. The number of enterprises is N2, which means that Q2 is equal to the
product of q2* * N2.

The drawing draws attention to two issues concerning changes in the long-term balance:
• The increase in average costs is finally passed on to the consumer in the form of
higher prices. In the state of long-term equilibrium, the marginal enterprise (in the
analyzed case the enterprises are identical) can only achieve a normal profit. This
means no incentive to continue entering and leaving the branch. In order to achieve
normal profits, prices increase, covering the increase of minimum average costs.
• Higher prices cause a decrease in demand, so production must decrease
 13. Comparing the economic outcomes in the circumstances of perfect competition and a
monopoly, outline the social cost of monopolization

The result of having a monopolistic market as opposed to a competitive market is restricted

output and a higher price. Monopoly creates a social cost, called a deadweight loss, because
some consumers who would be willing to pay for the product up to its marginal cost (MC), are not
served.

In a monopoly, there is no supply curve because monopolists

are price makers and not price takers.

In a competitive market, firms have to passively take the

market price as given. The supply curve describes the
quantities they will put on the market at any given price.

If the firm is a monopoly it does not need that information

because it is setting the price.

In a competitive market, marginal cost tells us the social cost

of producing a product, and the demand curve tells us the
social benefit of producing the product. The competitive price
/ output is determined where marginal cost intersects the
demand curve (PCQC). At the competitive price / output
combination social value is maximized

A monopolist restricts the output to the point at which MC =

MR and increases the price to what the market will bear

The result of a monopoly is restricted output and higher price.

Because of the monopolist’s restriction of output, you can see

that there are people who would be willing to pay up the
marginal cost who are not being served. The reduced output
is the difference between QC – Qm. The shaded area in the
graph on the left represents the loss of economic value from
a monopoly. The loss is called deadweight loss.
 14. Using the category of extraordinary profit, discuss characteristics of a firm
equilibrium in the conditions of monopolistic competition in the short and long term

Monopolistic competition is another type of imperfect competition other than monopoly. It refers
to a market situation in which there are large numbers of firms which sell closely related but
differentiated products. Markets of products like soap, toothpaste are examples of monopolistic
competition.

Features of monopolistic competition similar to perfect competition:

• A large number of sellers and buyers – in a monopolistic market, there are large number
of sellers who individually have a small share in the market.
• Free entry and exit
Different features from perfect competition:
• Imperfect information of the market
• The goods sold are heterogeneous
• Non price competition – in addition to price competition, non-price competition also exists
under monopolistic competition. Non price competition refers to competing with other firms
by offering free gifts, making favorable credit terms etc. without changing prices of their
own products
• Pricing Decisions – a firm under monopolistic competition is neither a price-taker nor a
price-maker. However, by producing a unique product or establishing a particular
reputation, each firm has partial control over the price. The extent of power to control price
depends upon how strongly the buyers are attached to his brand.

Supernatural profit (extraordinary profit) - is all the excess profit a firm makes above the minimum
return necessary to keep a firm in business.

Short-term and long-term equilibrium in monopolistic competition

In the short term, a company operating under monopolistic competition that has some small
influence on the market supply and price, also achieves a small extraordinary profit (area ABCD).
In the long run, the entry of competitors means that the extraordinary profit disappears and there
will be a balance at the point of contact of T. In the short term, the total surplus deficit is the BFE
area, and in the long term the TAE area.
 15. Drawing upon the prisoner’s dilemma, discuss mutual interrelations between firms in
an oligopoly.

Let’s start with a short definition of oligopoly. One can describe it as competition among the few.
An oligopoly is a market structure in which a few firm dominate. When a market is shared between
a few firms, it is said to be highly concentrated. Although only a few firms dominate, it is possible
that many small firms may also operate in the market. An oligopoly is similar to a monopoly except
that rather than one firm, two or more firms dominate the market. There is no precise upper limit
to the number of firms in an oligopoly, but the number must be low enough that the actions of one
firm significantly impact and influence the others.

Prisoner’s dilemma

Sometimes firms fail to cooperate with each other, even when cooperation would bring about a
better collective outcome. The prisoner’s dilemma is a canonical example of a game analyzed in
game theory that shows why two individuals might not cooperate, even if it appears that it is in
their best interest to do so.

In the game, two members of a criminal gang are arrested and imprisoned. Each prisoner is in
solitary confinement with no means of speaking to or exchanging messages with the other. The
police offer each prisoner a bargain:

Betrayal in the dominant strategy for both players, as it provides for

a better individual outcome regardless of what the other player does.
This set of strategies is thus a Nash equilibrium in the game – no
player would be better off by changing his or her strategy However,
the resulting outcome is not Pareto-optimal. Both players would
clearly have been better off if they had cooperated.

Similarly to the prisoner’s dilemma scenario, cooperation is difficult to maintain in an oligopoly

because cooperation is not in the best interest of the individual players. However, the collective
outcome would be improved if firms cooperated, and were thus able to maintain low production,
high prices, and monopoly profits.

One traditional example of game theory and the prisoner’s dilemma in practice involves soft drinks.
Coca-Cola and Pepsi compete in an oligopoly, and thus are highly competitive against one another
(as they have limited other competitive threats). Considering the similarity of their products in the
soft drink industry (i.e. varying types of soda), any price deviation on part of one competitor is seen
as an act of non-conformity or betrayal of an established status quo.

In such a scenario, there are a number of plausible reactions and outcomes. If Coca-Cola reduces
their prices, Pepsi may follow to ensure they do not lose market share. In this situation, defection
results in a lose-lose. Which is to say that, due to the initial price reduction by Coca-Cola (betrayal
of status quo), both companies likely see reduced profit margins. On the other hand, Pepsi could
uphold the price point despite Coca-Cola’s deviation, sacrificing market share to Coca-Cola but
maintaining the established price point. Prisoner dilemma scenarios are difficult strategic choices,
as any deviation from established competitive practice may result in less profits and/or market
share.
 16. Discuss the model of a kinked demand curve in an oligopoly and explain the impact
of the adopted assumptions on company decisions concerning the volume of
production and level of prices of the goods.

The kinked demand curve model assumes that a business might face a dual demand curve for its
product based on the likely reactions of other firms to a change in its price or another variable.

What are the assumptions of likely behavior of firms in this model?

• The assumption is that firms in an oligopoly are looking to protect and maintain their market
share and that rival firms are unlikely to match another's price increase but may match a
price fall. I.e. rival firms within an oligopoly react asymmetrically to a change in the price of
another firm.
• If a business raises price and others leave their prices constant, then we can expect quite
a large substitution effect making demand relatively price elastic. The business would then
lose market share and expect to see a fall in its total revenue.
• If a business reduces its price but other firms follow suit, the relative price change is smaller
and demand would be inelastic. Cutting prices when demand is inelastic leads to a fall in
revenue with little or no effect on market share.

Is there a stable profit maximizing equilibrium in this model?

The kinked demand curve model makes a prediction that a business might reach a stable profit-
maximizing equilibrium at price P1 and output Q1 and have little incentive to alter prices.
• The kinked demand curve model predicts there will be periods of relative price stability
under an oligopoly with businesses focusing on non-price competition as a means of
reinforcing their market position and increasing their supernormal profits.
• Short-lived price wars between rival firms can still happen under the kinked demand curve
model. During a price war, firms in the market are seeking to snatch a short term advantage
and win over some extra market share.

Changes in costs using the kinked demand curve analysis

• One prediction of the kinked demand curve model is that changes in variable costs might
not lead to a rise or fall in the profit maximising price and output.
 • This is shown in the next diagram where it is assumed that a rise in costs such as energy
and raw material prices leads to an upward shift in the marginal cost curve from MC1 to
MC2.
• Despite this shift, the equilibrium price and output remains at Q1.
• It would take another hike in costs to MC3 for the price to alter.

Overview

• There is limited real-world evidence for the kinked demand curve model.
• The theory can be criticised for not explaining why firms start out at the equilibrium
price and quantity.
• That said it is one possible model of how firms in an oligopoly might behave if they
have to consider the responses of their rivals.
 17. Compare economic outcomes in the oligopoly models by Bertrand and Cournot.

An oligopoly is a market structure in which a few firm dominate. When a market is shared between
a few firms, it is said to be highly concentrated. Although only a few firms dominate, it is possible
that many small firms may also operate in the market. An oligopoly is similar to a monopoly except
that rather than one firm, two or more firms dominate the market. There is no precise upper limit
to the number of firms in an oligopoly, but the number must be low enough that the actions of one
firm significantly impact and influence the others.

Duopoly Cournot model – a form of oligopoly in which only two companies operate, but none of
them has a dominant position on the market. Additionally:
• The goods produced by the companies are homogeneous and have the same price
• Both competitors are driven by maximizing profit
• Production takes place at identical marginal costs (MC A = MCB)
• Competition takes place only in terms of quantity (Consumers specify prices and firms
adjust production to them)
• Both companies decide at the same time the production volumes. They must predict the
choice of the competitor
• Both competitors maximizes profit depending on the different production volumes of a
competitor. This is represented by reaction function.
• At the Cournot equilibrium point each company maximizes its profit with belief that they
both made the best decision in term of quantity of production. This is an example of Nash
equilibrium
• The market price is lower than in the monopoly
• Production is higher than in the monopoly
• Cournot competition leads to an inefficient equilibrium i.e. a price above the price in perfect
competition and economic profits for the firms

Duopoly Bertrand model – a form of oligopoly, in which the decision-making variable is only price.
• The goods are produced by the companies are homogeneous
• Production takes place at identical marginal costs (MC A = MCB)
• Each company sets the price at which they will sell their goods, assuming a certain price
level set by the competitor. The market demand at this price (lower) then determines
quantity supplied.
• The company that chooses the lowest price can serve the entire market.
• Companies strive to minimize product prices – equilibrium is achieved by setting the price
at marginal cost level. Long-term equilibrium is an example of Nash equilibrium. This
means that the prices in the Bertrand model are the same as for the excellent competition.
• In a state of Bertrand equilibrium, the companies will earn normal economic profit.

Comparison:
• In Bertrand model companies sell good at minimum price level, therefore the price is lower
than in the Cournot model
• Due to the low price in Bertrand model, the quantity of goods produced will be higher than
in the Cournot model.
• Companies in Bertrand model earn normal economic profit, while in Cournot model they
gain positive economic profit
• From the point of view of total surplus, the Bertrand model is more efficient but less realistic
 18. Discuss the way of company decision making on the level of employment in the
conditions of perfect competition and a monopoly on the goods market and perfect
competition and a monopsony on the job market.

I. Competitive labor market

The demand for labor – marginal productivity

The demand for labor will vary inversely with the wage rate. To understand this we need to
consider the law of diminishing returns. This states that if a firm employs more of a variable
factor, such as labor, assuming one factor remains fixed, the additional return to extra workers will
begin to diminish. To explore this process, we need to consider the total physical product (output)
produced by a series of workers, which will enable us to measure the individual output from each
additional worker – the marginal physical product (MPP).

Demand is based on the value to the firm of the

marginal physical product produced by each worker.
For example, if candles are £2 each, the firm can
calculate the revenue derived from each worker's
physical output. The value of the extra output is
called marginal revenue product (MRP), and this is
calculated by multiplying MPP and price, as follows:

Deriving a demand curve

We can now find the number of workers that would

be employed by a profit maximising firm at various
wage rates. The profit maximising firm will employ
workers up the point where the marginal benefit,
in terms of the MRP, equals the marginal cost of
labor (MCL), which in this case is the wage rate
(W).

For example, at a wage rate of £1,200, the firm will

employ 5 workers, because at 5 workers, MRP =
MCL. At a lower wage of £800, the firm will employ 7
workers, and so on. This means that a demand curve
can be derived. In labor market theory, the demand
for labor is identified as MRP=D.

II. Monopsony labor market

A monopsony occurs when a firm has market power in employing factors of production (e.g.
labour). A monopsony means there is one buyer and many sellers. It often refers to a monopsony
employer – who has market power in hiring workers. This is a similar concept to monopoly where
there is one seller and many buyers.

An example of a monopsony occurs when there is one major employer and many workers seeking
to gain employment. If there is only one main employer of labour, then they have market power in
setting wages and choosing how many workers to employ.
Examples of monopsony in labour markets:
• Coal mine owner in town where coal mining is the primary source of employment.
• Government in employment of civil servants, nurses, police

In a competitive labour market, the equilibrium will be where

D=S at Q1, W1. However, a monopsony can pay lower wages
(W2) and employ fewer workers (Q2). The marginal cost of
employing one more worker will be higher than the average
cost because to employ one extra worker the firm has to
increase the wages of all workers. To maximise the level of
profit, the firm employs Q2 of workers where the marginal cost
of labour equals the marginal revenue product MRP = D. In a
competitive labour market, the firm would be a wage taker. If
they tried to pay only W2, workers would go to other firms
willing to pay a higher wage.

III. Demand for labour under monopoly in product markets

Monopolist on the market of goods has an influence on the

price of manufactured products, therefore the price
exceeds the marginal revenue. This also affects the
manufacturer’s decision on the number of employees and
the level of wages. In the case of monopoly on the market
of goods, the valuation of the labour’s marginal physical
product (VMPL) is greater than the marginal revenue
product (MRPL)

Monopolist employs fewer workers than a perfectly

competitive company, which proves its inefficiency.

More info: http://www.yourarticlelibrary.com/economics/theory-of-distribution/concepts-of-factor-

productivity-marginal-revenue-and-value-of-marginal-product/37425
 19. Discuss the concept and examples of market failure and indicate ways of government
intervention in the economy designed to mitigate negative consequences of such a
market failure.

Market failure occurs when the price mechanism fails to account for all of the costs and benefits
necessary to provide and consume a good. The market will fail by not supplying the socially
optimal amount of the good. Prior to market failure, the supply and demand within the market do
not produce quantities of the goods where the price reflects the marginal benefit of consumption.
The imbalance causes allocative inefficiency, which is the over- or under-consumption of the good.

Reasons for market failure include:

• Positive and negative externalities: an externality is an effect on a third party that is
caused by the consumption or production of a good or service. A positive externality is a
positive spillover that results from the consumption or production of a good or service. For
example, although public education may only directly affect students and schools, an
educated population may provide positive effects on society as a whole. A negative
externality is a negative spillover effect on third parties. For example, secondhand smoke
may negatively impact the health of people, even if they do not directly engage in smoking.
• Environmental concerns: effects on the environment as important considerations as well
as sustainable development.
• Lack of public goods: public goods are goods where the total cost of production does not
increase with the number of consumers. As an example of a public good, a lighthouse has
a fixed cost of production that is the same, whether one ship or one hundred ships use its
light. Public goods can be underproduced; there is little incentive, from a private standpoint,
to provide a lighthouse because one can wait for someone else to provide it, and then use
its light without incurring a cost. This problem – someone benefiting from resources or
goods and services without paying for the cost of the benefit – is known as the free rider
problem.
• Underproduction of merit goods: a merit good is a private good that society believes is
under consumed, often with positive externalities. For example, education, healthcare, and
sports centers are considered merit goods.
• Overprovision of demerit goods: a demerit good is a private good that society believes
is over consumed, often with negative externalities. For example, cigarettes, alcohol, and
prostitution are considered demerit goods.
• Abuse of monopoly power: imperfect markets restrict output in an attempt to maximize
profit.

During the market failures the government usually responds to varying degrees. Possible
government responses include:
• Legislation – enacting specific law. For example, banning smoking in restaurant or making
high school attendance mandatory
• Direct provisions of merit and public goods – governments control the supply of goods
that have positive externalities. For example, by supplying high amounts of education,
parks.
• Taxation – placing taxes on certain goods to discourage use and internalize external
costs. For example, placing a ‘sin-tax’ on tobacco products, and subsequently increasing
the cost of tobacco consumption
• Subsidies – reducing the price of a good based on the public benefit that is gained. For
example, lowering college tuition because society benefits from more educated workers.
Subsidies are most appropriate to encourage behavior that has positive externalities.
• Tradable permits – permits that allow firms to produce a certain amount of something,
commonly pollution. Firms can trade permits with other firms to increase or decrease what
they can produce. This is the basis behind cap-and-trade, an attempt to reduce of pollution.
• Extension of property rights – creates privatization for certain non-private goods like
lakes, rivers, and beaches to create a market for pollution. Then, individuals get fined for
polluting certain areas.
• Advertising – encourages or discourages consumption.
• International cooperation among governments – governments work together on issues
that affect the future of the environment.
 20. Drawing upon the market model, explain the Pareto-efficient allocation of resources
in the economy.

Pareto efficiency – or pareto optimality is a formally defined concept used to determine when an
allocation is optimal. An allocation is not Pareto optimal if there is an alternative allocation where
improvements can be made to at least one participant's well-being without reducing any other
participant's well-being. If there is a transfer that satisfies this condition, the reallocation is called
a "Pareto improvement." When no further Pareto improvements are possible, the allocation is a
"Pareto optimum."

In principle, a change from a generally inefficient economic

allocation to an efficient one is not necessarily considered to be
a Pareto improvement. Even when there are overall gains in the
economy, if a single agent is disadvantaged by the reallocation,
the allocation is not Pareto optimal. For instance, if a change in
economic policy eliminates a monopoly and that market
subsequently becomes competitive, the gain to others may be
large. However, since the monopolist is disadvantaged, this is
not a Pareto improvement. In theory, if the gains to the economy
are larger than the loss to the monopolist, the monopolist could
be compensated for its loss while still leaving a net gain for
others in the economy, allowing for a Pareto improvement.

Under the idealized conditions of the first welfare theorem, a system of free markets, also called
a "competitive equilibrium," leads to a Pareto-efficient outcome. However, the result only holds
under the restrictive assumptions necessary for the proof:
• markets exist for all possible goods, so there are no externalities;
• all markets are in full equilibrium;
• markets are perfectly competitive;
• transaction costs are negligible;
• market participants have perfect information

In the absence of perfect information or complete markets, outcomes will generally be Pareto
inefficient.
II. Macroeconomics (questions 21-41)
21. Enumerate and discuss ways of measuring production value in the economy derived
from the circular movement scheme.

The circular-flow diagram (or circular-flow model) is a graphical representation of the flows of
goods and money between two distinct parts of the economy:
• market for goods and services, where households purchase goods and services from firms
in exchange for money;
• market for factors of production (such as labour or capital), where firms purchase factors
of production from households in exchange for money.

Basic measure of production value derived from the circular-flow diagram is GDP indicator.

Gross domestic product (GDP) is the market value of all final goods and services produced
within an economy in a given period of time. This means that we take into account the market
value of products of a given country, including nationals and foreigners working in that country.
This is the main difference with the gross national product (GNP), which considers goods
produced only by nationals of a country, without considering their residence.

We can estimate it using one of three methods. The income approach considers all wages,
interests paid, rent and other sources of income to estimate GDP. The production approach
estimates gross value and then subtracts intermediate consumption, considered as goods and
services used in the making of final goods and services. Finally, there is the expenditure approach,
which looks at the demand side.

The expenditure approach considers total expenditure, considering everyone in the economy,
such as households, firms and government. GDP (also denoted as Y, production) can be
disaggregated into four big components that classify the nature of the expenditure. These
components are consumption (C), investment (I), government spending (G) and net exports
(NX = export – import). With all these variables we can define the following identity:

Y = C + I + G + NX

Any amount of money spent in an economy can be classify into one of the four components of the
identity, taking into account the nature of the product, the buyer and the purpose of the spending.
 22. Discuss advantages and disadvantages of the Gross Domestic Product (and its
derivative measures) as tools for wealth measurement.

GDP Gross Domestic Product

Cons:
• GDP does not take into account the "gray area" (at least a dozen or so percent of Polish
citizens perform unregistered work)
• GDP does not include production for own household needs
• GDP does not take into account the value of free time (free time is not only an element of
well-being, but can be understood as a component of broadly understood consumption)
• GDP omits 'external effects' – e.g. environmental degradation associated with production
growth, pollution of water, air and land, increase in noise.
• Does not provide information on the level of well-being of the average citizen.
• Not taking into account foreign property income.
Pros:
• Relatively simple to calculate and easy to understand indicator design.
• Possibility to compare the indicator between countries.
• Availability of data from many years (long time series of data)

Gross National Income (GNI)

Pros:
• Includes the net income of citizens from foreign ownership
• Relatively simple to calculate and easy to understand indicator design.
• Possibility to compare the indicator between countries.
• Availability of data from many years (long time series of data)
Cons:
• GNI does not take into account the "gray area" (at least a dozen or so percent of Polish
citizens perform unregistered work)
• GNI does not include production for own household needs
• GNI does not take into account the value of free time (free time is not only an element of
well-being, but can be understood as a component of broadly understood consumption)
• GNI ignores 'external effects' – e.g. environmental degradation associated with production
growth, water, air and land pollution, increase in noise.
• Does not provide information on the level of well-being of the average citizen.

GDP per capita:

Cons:
• does not take into account social stratification (for example in oil and Norway countries:
both have high per capita GDP, but where one lives better).
Pros:
• covers all the advantages of GDP,
• additionally includes the population,
• helps in assessing an individual citizen.
GDP Purchasing Power Parity (PPP):

Cons:
• does not take into account purchasing power on international markets (PPP includes
purchase prices of goods and services only in a given country, excluding prices in other
countries).
Pros:
• takes into account the actual purchasing power of a given currency,
• facilitates international GDP comparison,
• takes into account the purchasing power of the population.
 23. Enumerate and discuss factors determining equilibrium on the goods market in a
demand model of an open economy

Keynes Model (demand model) - developed to explain the reasons for the high level of
unemployment and low production levels observed in the 1930s (the period of the Great
Depression). It is a short-term model, and thus tries to answer the question why, in the short-term,
actual production differs from the potential one:
actual production - actual production volume in a given period
potential production - production volume of a given economy, assuming full use of all production
factors (when all markets in the economy are in a state of equilibrium)

Model assumptions:
• the model assumes that it is possible to operate an economy whose actual production is
lower than the potential one
• we assume stiffness of wages and prices (they do not change)
• with existing wages and prices there are unused production capacities (eg there are
unemployed people who would like to work), so there are no factors limiting production on
the supply side, i.e. you can freely increase production
• factors limiting production are on the demand side

Definition of equilibrium on the goods market:

Y = C + I + G + NX
Where:
• consumption (C),
• investment (I),
• government spending (G)
• net exports (NX = export – import.

These are the factors determining aggregate

expenses, and hence the balance on the goods
market.

In the Keynes model, the economy is in a state of equilibrium when aggregated planned
expenditures are equal to the actual production value.

What changes the product's height in equilibrium?

Production grows if:
• any autonomous expense grows
• the marginal propenity to consume is growing
• tax rate decreases
• the marginal propensity to import decreases
• nominal exchange rate increases
• the price level abroad is rising
• the price level in the country is falling
• The balance of foreign trade in relation to the real exchange rate is growing
Determinants of consumption:

In the Keynesian model, we assume that consumer spending is function of disposable income.
The factor directly related to disposable income is the extreme propensity to consume (MPC),
which indicates how much of the disposable income households spend on expenses, and how
much on savings. The higher the MPC value, the higher the level of aggregated expenses. At the
same time, it is dependent on other factors, including inclination to import.

Determinants of investments:

The investment expenditures of enterprises are connected with the planned increase of capital
and inventories. The demand model assumes that investments (I) are autonomous and do not
depend on current production and income

Determinants of government spending

In the Keynes model, government expenditures (G) are exogenous variables determined outside
the model. The fiscal policy of the state concerns, therefore, the determination of the amount of
budget revenues (indirect and direct taxes, T) and the method of their distribution for expenditure
on goods and services (G). In the case of the demand model, their ratio is irrelevant, ie the impact
on the budget deficit.

In the demand model, it is assumed that if the government expenditure is increased at the expense
of increased taxes by the same amount, the aggregate expenditure will increase. It results from
the assumption that, unlike consumers who spend a certain part of their income on savings, the
government spends all of it on the purchase of goods and services in the economy.

Determinants of net exports

Net exports (NX = X-Z), i.e. the difference between the export demand reported by the rest of the
world and the demand for imports reported by the country) depends on:

• marginal propensity to import - the higher the inclination to import, the lower the national
aggregate expenditure. The extreme propensity to import determines what part of the
disposable income households spend on buying goods from abroad
• disposable income
• real exchange rate (only in more advanced, extended models, in the basic version of the
model trade exchange is independent of factors such as nominal exchange rate and real
price levels in economies)

In the demand model (the basic version), it is assumed that export is an autonomous value,
determined outside the model.
 24. Using the concept of an autonomous expenditures’ multiplier, compare the efficiency
of fiscal policy as a tool for influencing the level of production and employment in a
demand model of an open and closed economy.

Description of the Keynes model in question 23.

State fiscal policy

Controlling the size of planned aggregated expenditures by changing expenditures and budget
inflows. The goal is efficiency and justice.
• Expansive fiscal policy - when the planned aggregate expenses in the economy are
small, the actual production is smaller than the potential production and people do not have
a job. Lowering net taxes or increasing state expenditure may be a remedy for recession
and unemployment. The increase in planned aggregate expenses will in this case increase
production and reduce unemployment.
• Restrictive fiscal policy - when planned aggregate expenses exceed the ability of the
economy to produce goods and reduce spending by the state can prevent inflation.

Multiplier of autonomous expenditures - this is the ratio of the change in production to the
change in autonomous expenditure that causes it.

I. Multiplier in a closed economy without a government, so-called investment multiplier:

Beacuse Y = C + I and C = a + by so Y = a + bY + I,

Therefore Y - bY = a + I ⇒ Y = (a + I)/1 - b = (1/1-b)(a + I),

We know that a + I are autonomous expenses,

so 1/(1 – b) is kensyan multiplier, we can write it as:

1/(1 – MPC)

MPC (Marginal Propensity to Consume) - informs what part of the additional portion of income
available, households decide to spend on increasing consumption.

The change in autonomous expenses causes an additional change in income caused by a change
in the level of consumption and thus an additional change in the level of production.

II. Multiplier in a closed economy with the government, so-called government spending
multiplier

Yd = Y – NT (netto taxes) = Y - tY = Y(1-t) →

disposable income

C = a + b(1-t)Y the introduction of taxes

changes the slope of the function

AD = C + I + G government spendings are

autonomous
The introduction of taxes causes that our income decreases and then the multiplier takes the
form:
1/(1 – KSK’), where KSK’ = KSK x (1-t), therefore 1/(1-KSK(1-t))

KSK’<KSK, so multiplier deacreases

The state's expenses are shifting the line of aggregated expenditures up. Its slope is decreasing.
As a result, the aggregate demand and production levels in the economy change. The level of
aggregate expenditures and the production volume corresponding to the balance increase if the
change in the production volume ΔY from part (a) of the figure turns out to be greater than the
change in the production volume ΔY'' from its part (b).

Balanced budget multiplier - describes the situation when the increase in state expenditure
combined with the same tax increase results in increased production.

As can be seen in the graph, the increase in government spending combined

with an identical increase in quota taxes shifts the AD curve up.

The effects of increasing state expenditure (G) - an increase in state

expenditure at a given tax rate results in an increase in production at the
balance point and an increase in the budget deficit.

The effects of tax increase (t) - an increase in the tax rate for given government expenditure
results in a decrease in production at the balance point and a reduction in the budget deficit.

III. Multiplier in the open economy, the so-called multiplier of the open economy:

AD = C + I + G + X - Z export is autonomous
Z = cY = MPI*Y import depends on income (MPI – marginal propensity to import)

The impact of exports on the production volume is similar to the impact of private investment (I)
and state expenditure (G). The emergence of exports causes a parallel shift of the planned upward
expenditure line and triggers a multiplier process. As a result, the change in the production volume
corresponding to the balance is relatively high.

Because the marginal propensity to import reduces the marginal propensity to consume domestic
goods, the multiplier in the open economy takes the form:

Multiplier = 1 / (1 - MPI '+ MPI), where the MPI-marginal propensity to import

 25. Discuss differences between automatic stabilizers and active (discretionary) fiscal
policy and indicate limitations to its efficiency.

Passive fiscal policy - involves the use of automatic stabilizers, that is, such instruments that
automatically, without state interference, affect changes in the level of national income and other
economic variables (e,g. demand, employment). Thanks to them, the economy stabilizes itself on
the level of national income ensuring high employment, and this happens without wasting time
and without government intervention. Automatic stabilizers include: income tax, value added tax
(VAT), unemployment benefit and other forms of social benefits.

The advantage of automatic stabilizers is their relatively quick reaction to changing the income
situation of entities, and more importantly, no one has to decide on their launch. In addition, they
reduce the vulnerability of the economy to shocks, causing economic activity not to drop to a
catastrophic level.

The most often discussed disadvantage of automatic stabilizers is the fact that they stabilize the
existing situation, do not create premises for change, act short-term, may hinder the growth
process. They lead to budget deficits during periods of recession and surpluses during expansion
periods. They are effective in stabilizing small cyclical fluctuations.

Active (discretionary) fiscal policy is based on Keynesian theory. According to it, the state, and
not the market itself, should stimulate demand through investment expenditure (G), thus ensuring
overall well-being. It can be divided into:
• expansive policy - stimulating expenditure growth, tax reduction or both instruments
• restrictive policy - reducing expenditures, increasing net taxes or both

Active fiscal policy therefore consists in conscious state intervention, requiring, among others,
decision about:
• Change in budget expenses for specific purposes
• Changes in the amount and rules of taxation (regulation of budget revenues)
• A change in the rules for subsidizing entities

The disadvantage of the active method of influencing the economy is that the use of its
instruments takes time and is associated with a long and arduous legislative process concerning,
for example, the introduction of new taxes or changes to existing taxes. There may be so-called
the effect of delays, in which between the diagnosis of the state of the economy and the
preparation of specific economic policy measures, so much time passes that at the moment when
these tools are ready, the economy has changed so much that these tools are not enough or not
at all effective
 26. Characterise factors determining demand for money and Central Bank’s tools for
controlling the money supply.

I. Demand for money - the demand for money from various business entities (outside the banking
sector) or individual consumers.

Two main factors determining the demand for money:

• Number of transactions (demand transaction element), which can be approximated by
the value of GDP: 𝑷𝒀 (we assume unit elasticity of demand here, in accordance with
empirical results).
• The opportunity cost of holding money, measured by the nominal interest rate.

According to the theory of money demand J.M. Keynes, the reasons for wanting to possess and
hold money are as follows:
• the transactional reason results in transactional demand, which results from the
necessity to have money in order to conduct commercial operations,
• Precautionary cause of precautionary demand, which results from uncertainty about
future income and expenses and striving for security,
• speculative reason raises speculative demand, which consists in striving to have money
making profit in the future,
• the portfolio reason generates portfolio demand, which is a consequence of the tendency
to have money in a situation of unwillingness to take risks.

II. Tools for controlling the money supply by the central bank

Money supply - the amount of money in circulation. Includes cash, savings deposits, term
deposits and highly liquid financial assets. The central bank's duty is to control the money supply,
because not only CB plays an important role in the creation of money, but also other banks
operating in a given country.

Instruments of the central bank's influence on the money supply:

• Open market operations
• Change in the reserve requirement
• Change of the rediscount rate

To increase the supply:

• lowering the rediscount rate to increase loans to commercial banks; the rediscount rate
determines the price at which the central bank grants loans to commercial banks
• purchase of government securities on the open market,
• lowering the level of the required reserve rate; the minimum reserve ratio is the
minimum ratio of cash reserves to contributions that commercial banks must maintain
under a central bank's decision

To reduce the supply:

• increase of the rediscount rate to reduce loans to commercial banks,
• sale of government securities held,
• raising the level of the required reserve rate.
 27. Using the conception of the money multiplier, discuss the role of commercial banks in
the process of creating money in the economy.

Money multiplier - is one of various closely related ratios of commercial bank money to central
bank money under a fractional-reserve banking system. Most often, it measures an estimate of
the maximum amount of commercial bank money that can be created, given a certain amount of
central bank money.

kp = M1/M0, M1
where
M1 - basic measure of money supply;
M0 - monetary base (sum of cash in circulation and reserves of commercial banks on accounts
with the central bank, i.e. the total amount of money directly issued by the central bank)

Primary creation takes place in the central bank, which grants loans to commercial banks. In
modern banking systems, the issue of banknotes is regulated by the monetary base, the sum of
cash in circulation and reserves of commercial banks on the accounts in the central bank, ie the
total amount of money directly issued by the central bank.

Secondary creation is carried out by commercial banks that provide loans to their clients. In
the process of money creation by commercial banks, we can distinguish:
• primary contribution - let us assume that the client pays PLN 1000 to the bank. The bank
opens a bill for the amount that this customer can dispose of. The contribution made is the
original contribution. As a result of this operation, cash (banknotes) are transformed into
non-cash money, which is the customer's contribution to the bank account. This change
does not affect the amount of money in circulation, because only the form of money has
changed. This contribution has full coverage in the bank's cash reserve.
• derived contribution - a transaction consisting in granting a loan to a customer from this
part of the contributions, which does not have to be kept in the form of a mandatory reserve.
The loan is made available to the customer by opening to him the account with the
contribution at his disposal.

We deal with the secondary creation of money when commercial banks grant loans to their clients.
This creation determines the size of the money supply (the amount of money in circulation, the
concept includes both cash, savings deposits, term deposits and highly liquid financial assets).
Clients make deposits and withdrawals alternately and only a relatively small cash reserve of a
given bank is enough to fulfill all their commitments. The rest of the funds may be used by banks
granting loans to enterprises or individuals, earning on this transaction. Borrowed sums return to
banks, in the form of payments on bills and can be used to grant another loan, and so on, and so
on. In this way, a much larger sum of bank money in the form of loans was created from a certain
amount of deposits accepted at the beginning. Banks usually try to give as much credit as possible
to increase their profits. A commercial bank can only grant loans to a certain size. The creation of
bank money proceeds until the relation between the primary contribution and the sum of derivative
contributions reaches the limit below which it cannot go down due to the need to keep the minimum
of payment liquidity.

The creation of bank money by commercial banks occurs through the increase in the volume of
loans granted by these banks, as well as by increasing the purchase of foreign currencies. Both
of these operations increase the means of payment in a given bank or in another bank whose
account received funds in the form of a loan.
 28. Discuss the importance of Central Bank’s interest rates as a transmission mechanism
of the monetary policy.

The central bank bases its monetary policy on controlling the money supply. This is done using a
range of instruments. The most important are:
• Changes in the reserve requirement ratio,
• Changes in central bank interest rates,
• Open market operations.

The interest rate policy of the central bank consists in lowering, raising or maintaining at the current
level of these rates. These are the central bank interest rates, such as the rediscount rate, the
lombard rate or the refinancing rate. These rates are used when granting loans or credits by the
central bank to commercial banks. Due to the fact that these interest rates are one of the three
determinants shaping costs in commercial banks, changes in these rates usually lead to changes
in interest rates in commercial banks going in the same direction.

Lowering the interest rates of the central bank leads to interest rate cuts by commercial banks,
which usually results in increased loans in commercial banks, reduced propensity to invest savings
in banks, increased demand for commodities and increased production of goods.
On the other hand, raising central bank interest rates has the opposite effect: raising interest
rates in commercial banks, limiting borrowings, increased propensity to invest savings in banks,
reduced demand for commodities and limited production of goods.

In summary, the monetary policy transmission mechanism is a process in which the following path
of influence is maintained:
I. The central bank's decision on official interest rates,
II. A. Central bank interest rates through open market operations, affect commercial banks and
affect market interest rates, are transferred to interest rates on debt securities and, consequently,
also to prices of other financial assets,
II. B. The decisions of the central bank also affect the expectations of monetary policy in the future
and, consequently, affect the expectations regarding the level of inflation,
II. C. Differences in the level of interest rates between different countries also affect exchange
rates.
III. The above factors have an impact on global demand, which increases or decreases inflationary
pressure,
IV. Inflationary pressure combined with a change in the prices of foreign goods, in turn, affects the
level of inflation.
 29. Drawing upon IS-LM model, discuss the importance of the right fiscal and monetary
policy mix for setting the level of production and interest rates in a situation of a short
term equilibrium on the goods and money market.

The IS-LM model assumes that there is a short-term balance on the goods and money markets.
The model assumes a constant level of prices, the money supply is exogenous (given from
outside) and investments are dependent on the interest rate (and not autonomously). This model
can be used to describe the stabilization policy used by the state, i.e. a combination of expansive,
neutral and restrictive monetary policy and fiscal policy.

• Expansive policy aims to increase aggregate expenditure in the economy.

• The restrictive policy aims to reduce aggregate expenditure in the economy.
• A neutral policy means that the state does not try to change the level of aggregate
expenditures in the economy.

• Expansive monetary policy shifts the LM line to the right. At the same interest rate, the
level of production at which the money market is in equilibrium increases (LM’).
• Restrictive monetary policy shifts the LM line to the left. For particular interest rate
levels, the production volume at which the market is in equilibrium decreases (LM’’).
• Expansive fiscal policy shifts the IS line to the right. At the same interest rate, the level
of production at which the money market is in equilibrium increases (IS’)
• Restrictive fiscal policy shifts the IS line to the left. For particular interest rate levels,
the production volume at which the market is in equilibrium decreases (IS’’)

Where i = interest rate and Y = production

The economy is initially in a short-term equilibrium at point E. Using a combination of fiscal and
monetary policy, you can receive 8 different points, which are marked on the graph with black
dots. For example:
• E1 shows the state of the market in which an expansionary fiscal policy was applied
(increase in government expenditure, tax reduction) and restrictive monetary policy
(reduction of the money supply on the market by the Central Bank). As a result, the level
of interest rates increased and production remained at the same level.
• E2 shows the state of the market using neutral monetary policy and expansive fiscal policy.
As a result, both the production and the level of interest rates increased.
 30. Present the characteristic of a macroeconomics equilibrium on the goods, money and
job market in the long-term in a (neo)classical model.

Classical Model definition: An analysis of the economy in which wages and prices are perfectly
flexible (well-elastic) and the economy is always at the level of potential production-ensuring full
utilization of manufacturing factors (full employment).

Interdependence of goods, money and labour market

• The magnitude and changes in global demand are the result of the interdependence
between commodities and money markets;
• Global supply defines the interdependence between goods and labour markets;
• The markets for goods and money are linked by price and interest rate, while the markets
for goods and employment and production through wages and prices.

Equilibrium in the classic model, or the analysis of supply, employment, production and prices:

• In the classic model there is always a full

employment, i.e. No forced unemployment
occurs. If there are no disturbances in the labour
market, price changes are not affected by the level
of employment.
• Full employment, in combination with a given
resource for tangible capital, determines the level
of potential production, i.e. production in full
employment.
• In the classic model, companies always produce
at the level of potential production; This level does
not affect price changes.
• The global supply curve as in the classic model
runs vertically (it is independent of the prices).

Conclusions:
• In the classic model, the economy always takes full advantage of production capacity – i.e.
actual production is equal to potential production,
• Any deviation from the potential production results in the adjustment of prices and wages
which result in the elimination of such deviation,
• Fiscal and monetary policies in the classic model affect the level of global demand-so they
are able to change price levels, but are not able to alter the volume of production (which is
always equal to the potential output).
 31. Drawing upon well-known macroeconomics models, compare the efficiency of
monetary policy in a closed economy in the short and long term

Monetary policy consists in making changes in the money supply.

Expansive monetary policy means increasing the money supply at a faster pace than economic
growth. This is to reduce interest rates, increase investment and, consequently, increase
production and employment.

This kind of policy was not recommended by any of the main trends in macroeconomics.
Keynesians believed that monetary policy is less effective than fiscal policy, due to the possibility
of a liquidity trap. On the other hand, they allowed supplementing the expansive fiscal policy with
an expansive monetary policy to limit the effect of pushing out. For monetarists, it was an
extremely harmful policy leading to inflation. The new classics are convinced that no announced
changes in the money supply have an impact on the economic situation, as economic entities are
characterized by rational expectations.

Restrictive monetary policy consists in reducing the money supply growth rate. Its main purpose
is to reduce inflation. It can also be used to reduce the trade balance deficit (current account
balance). As a rule, this is a policy enforced by the need to limit high inflation or high deficits in
foreign trade. Politicians reach for it as a last resort, because it causes a reduction in production
and an increase in unemployment.

I. IS-LM model

Model assumptions:
• short-term balance,
• wages and prices are rigid (sticky), i.e. they are lagging behind, adapting to changes in
demand
• and supply,
• balance on the market of goods and money,
• investments are not autonomous and depend on the interest
rate level,
• the money supply is exogenous, i.e. given from the outside.

Expansive monetary policy:

• the increase in the money supply causes the LM curve to move to the right,
• in the new short-term equilibrium there was an increase in production and a decrease in
the interest rate = an increase in demand and income at a lower level of the interest rate

Expansive monetary policy is effective when:

- The sensitivity of interest rate investments is high (flat IS curve)
- Big interest rate changes are necessary to balance the market (steep
LM curve)

Restrictive fiscal policy:

• reducing the money supply causes the LM curve to move to the left,
• in the new short-term equilibrium there was a drop in production and an increase in the
interest rate.
II. AS-AD model

Assumptions:
• analysis of the economy in the short and long run;
• prices may change (inflation may occur).

The aggregate demand curve shows the total amount of

goods and services purchased by households, enterprises
and the state at different price levels. This curve has a
negative slope, because there is:
• asset effect - when the prices fall, the real value of
the property increases, which increases the consumption expenditures that are part of the
aggregate demand;
• interest rate effect - the price level is a factor determining the demand for money
(transaction motive). The lower the price level, the less money you need to buy goods and
services. Households will therefore increase purchases of assets, which increases the
supply of loan funds in the economy, affecting the reduction of the interest rate. It
stimulates growth of investments
• the effect of the exchange rate: the drop in prices affects the reduction of interest rates,
and this in turn leads to the depreciation of the national currency, which increases net
(exports are more profitable, imports less)

Short-term supply curve - reasons for the transfers:

• Change in production costs
• Change in the level of nominal wages
• Change in the expectations of business entities

Aggregate demand curve (AD) - Curve movement

Monetary policy (change in the money supply) -> shifting the AD curve and changing its slope
• Expansive policy: moving to the right and increasing the slope
• Restrictive policy: shift to the left and slope decrease

+ Model Keynsowski i klasyczny (trzeba dorobić rysunki na podstawie materiałów)

 32. Compare (in the IS-LM/IS-LM-BP models, in the short term) the efficiency of fiscal
policy in the three situations:
a) closed economy
b) open economy with a fixed exchange rate and full capital mobility
c) open economy with a fluctuating exchange rate and full capital mobility

a. Closed Economy

Expansive fiscal policy:

• an increase in government spending [G] and / or a fall
in taxes causes the IS curve to move to the right,
• relatively low share of private sector expenditure [C+I]
• in the new short-term equilibrium there was an
increase in both production and interest rate.

Expansive fiscal policy, the expression of which is increasing

government spending, causes both an increase in production
and an increase in the interest rate, which in turn results in a
reduction in investment outlays. This is called the push effect, which causes that the expansive
fiscal policy increasing the Y level may, in an extreme case, lead to a reduction in the investment
rate. The displacement effect is the stronger (fiscal policy is less effective) the steeper the LM
curve is. in a situation where LM is vertical, fiscal policy does not affect the change of Y, but only
the change i. In this case, we are dealing with the full effect of pushing out investments as a result
of an increase in the interest rate

Restrictive fiscal policy:

• a fall in government spending and / or an increase in
taxes causes the IS curve to move to the left,
• less crowding out of the private sector,
• in the new short-term equilibrium there was a drop in
both production and interest rate

Fiscal policy is more effective as LM is flatter (bigger Y increase). When LM is horizontal, then
fiscal policy is maximally effective and we observe the full multiplier effect.

The IS-LM-BP model is a version of the IS-LM model in the open economy. Thus, it shows how
the economy behaves in the short term, as a result of activities undertaken in the framework of
fiscal and monetary policy. The BP curve shows the relationship between the current account
balance and capital turnover and is a combination of all points for which the balance of payments
is balanced. With full capital mobility, the BP curve is horizontal. One of the most important
conclusions to which this model leads is that the state of the economy depends to a large extent
on which exchange rate system (fixed or liquid) is in force in a given country.

b. Open economy with a fixed exchange rate and full capital mobility

Expansive fiscal policy

• Expansive fiscal policy will cause an increase in the interest rate, a surplus in the balance
of payments and an inflow of capital.
• The increase in demand for the domestic currency will not cause appreciation. It will force
the central bank to increase the domestic money supply by buying foreign currency.
 • Foreign exchange reserves will increase. The growing
money supply will move the LM curve to the right.
• Conclusion: fiscal policy very effective.

c. Open economy with a fluctuating exchange rate and full

capital mobility

Expansive fiscal policy:

• Expansive fiscal policy shifts the IS curve to the right IS0
to IS1.
• The interest rate grows and capital flows from abroad.
• As a result, the domestic interest rate exceeds the global one, and thus the inflow of capital
will take place
• A surplus of BP will occur and the domestic
currency will appreciate.
• the appreciation of the domestic currency causes
an increase in imports and a drop in exports, IS1
shifts back to the left to IS0

Demand for the domestic currency is growing, it is

appreciating, export is pushed out and the situation
returns to the starting point. The end result: Y and i
remain unchanged. Conclusion - fiscal policy is
ineffective.

Conclusion: fiscal policy in the system of liquid

exchange rates with perfectly mobile capital is ineffective.
It does not change real values, in particular GDP.
 33. Drawing upon Keynesian model of aggregated demand and the classical model,
discuss the types of unemployment and their reasons as well as possible ways of
mitigating this phenomenon.

Supply-side unemployment (the

natural rate of unemployment). These
are usually microeconomic imbalances in
labour markets.
Demand-side unemployment
(Unemployment caused by lack of
aggregate demand in the economy). In
recessions, we can expect demand
deficient unemployment (sometimes
called cyclical unemployment) to
increase significantly.

Cyclical unemployment (demand-deficient)

• Cyclical unemployment exists when individuals lose their jobs as a result of a downturn in
aggregate demand (AD). If the decline in aggregate demand is persistent, and the
unemployment long-term, it is called either demand deficient, general, or Keynesian
unemployment.
• Classical economists reject the conception of cyclical unemployment and alternatively
suggest that the invisible hand of free markets will respond quickly to unemployment and
underutilization of resources by a fall in wages followed by a rise in employment.
• Keynesian economists on the other hand see the lack of demand for jobs as potentially
resolvable by government intervention. One suggested interventions involves deficit
spending to boost employment and demand. Another intervention involves an
expansionary monetary policy that increases the demand of money which should reduce
interest rates which should lead to an increase in non-governmental spending.

Solution: Government has to increase public spending &

reduce taxes. Increase in G will jump-start the economy
since it’s part of the component of AD. Hopefully through
the multiplier effect, will lead to a secondary increase in
AD. Cut in direct tax will induce more people into work
since it increase the level of disposable income.

Structural unemployment
Structural unemployment occurs when certain industries decline because of long term changes in
market conditions. For example, over the last 20 years UK motor vehicle production has declined
while car production in the Far East has increased, creating structurally unemployed car workers.
Globalisation is an increasingly significant cause of structural unemployment in many countries.

Solutions: Government provides incentives to firms to train these employees to make them more
marketable for other jobs & also incentives for those unemployed to join the training scheme
Geographical unemployment
This occurs when unemployment is concentrated in certain areas. Jobs may be available in some
prosperous areas (e.g. London) however, there may be difficulties for the unemployed to move to
these areas (e.g. difficulty in finding accommodation, children in schools, e.t.c.) Note, geographical
unemployment is often considered part of structural unemployment.
Solutions: Government can consider giving incentives to firms e.g. tax breaks, investment tax
credit etc to set up businesses in areas with high unemployment. Also, they can actually reduce
barriers to free movement.

Seasonal unemployment
Seasonal unemployment exists because certain industries only produce or distribute their
products at certain times of the year. Industries where seasonal unemployment is common include
farming, tourism, and construction.

Solution: Try to diversify the economy. This could be hard to do in touristy areas. Regulations
which involve paying workers throughout the year, even if work is temporary. Government creating
jobs in the off-season to improve infrastructure.

Frictional unemployment
Frictional unemployment, also called search unemployment, occurs when workers lose their
current job and are in the process of finding another one. There may be little that can be done to
reduce this type of unemployment, other than provide better information to reduce the search time.
This suggests that full employment is impossible at any one time because some workers will
always be in the process of changing jobs.
Solution: The government can cut unemployment benefits, to increase the opportunity costs of
staying idle

Voluntary unemployment
Voluntary unemployment is defined as a situation when workers choose not to work at the current
equilibrium wage rate. For one reason or another, workers may elect not to participate in the labour
market. There are several reasons for the existence of voluntary unemployment including
excessively generous welfare benefits and high rates of income tax. Voluntary unemployment is
likely to occur when the equilibrium wage rate is below the wage necessary to encourage
individuals to supply their labour.

Real wage unemployment.

Unemployment that is caused due to high wages in the economy. It could be caused by any of the
combinations such as strong trade unions, wage rigidity & minimum wage. Strong trade unions
can cripple the whole economy. Secondly, there are some wages that could be difficult to be
adjusted downwards, e.g. workers with long term contract. Lastly, high NMW (national minimum
wage) can lead to unemployment as firms will demand for lesser workers if per hour pay is high
Solutions: The US government can follow the stance adopted by Margaret Thatcher in paralysing
the strong labour union. However it is very politically unpopular.
 34. Drawing upon Philips Curve, discuss the relation between the level of unemployment
and inflation in the short and long term.

BASED ON THE MODEL AD-AS

Phillips noted that there is inversely proportional relationship between unemployment and
changes in money wages. Wages grow with low unemployment, because employees can exert
pressure to raise them, because they have bargaining power.

Short term Phillips Curve

Phillips curve (short-term) developed by A.W. Phillips (in 1958) for a useful way of presenting the
inflation process. Phillips proved that there is a strong statistical inversely proportional relationship
between the level of inflation and unemployment, i.e. wages tend to increase with low
unemployment and vice versa.
negatively inclined - rising inflation together with falling unemployment

In the AD-AS model as a result of expansive fiscal or monetary policy aggregate demand
increases and prices increase (inflation) - this reflects the shift of the AD0 curve to AD1. The new
point of short-term equilibrium is at point A, where production is higher, but also prices have risen.
The relationship between price increase and unemployment rate is shown in Figure b). The vertical
axis shows the inflation rate and the horizontal unemployment. SPC - this is a short-term Phillips
curve. As the inflation rate increases, unemployment decreases.

Long term Phillips Curve

As the rate of increase in the amount of money

increases, the short-term Phillips curve moves up along
the line we call the long-term Phillips curve. The vertical
course of the long-term Phillips curve means that after
the end of the demand shock the unemployment rate
returns to its natural level. In the long run, regardless of
the inflation rate, the unemployment rate is U*.

In the long run, inflation is determined by the supply of

money. Each increase in money will in the long run lead
to a proportional change in all nominal values in the
economy, leaving real values (such as the
unemployment rate) unchanged.
 35. Using the existing theorical approaches, discuss the causes and costs of inflation.

Monetary theory of inflation – monetarists argue that inflation is caused by an excess of money
in relation to the amount of goods on the market.

Demand pull theory – occurs when the total amount of planned expenditures (i.e. demand)
increases faster than the total amount of production directed to the market (i.e. supply). This
means that people want to buy more than the economy produces, and then the “pulling prices up”
occurs.

Cost push theory – appears when restrictions are imposed on the supply of one or several
resources, then the price of these resources increases. In this situation, the costs of manufacturing
and the prices of products increase. If the initial price increase concerns the so-called strategic
raw material, for example crude oil, it will cause an increase in production costs in basically all
areas of production and thus increase in prices of products on the scale of the entire economy.

Structural inflation theory – occurs when the structure of demand for goods and services does
not correspond to the structure of production in the economy, while producers have not adjusted
their production to new needs at the time, which in turn leads to higher prices.

Actual inflation costs depend on two elements. First of all, whether entrepreneurs and
consumers expect inflation or whether it is a surprise for them. Second, the ability of the
government and the tax system to create rules that allow market participants to adjust to
inflation.

Inflation costs increase significantly when it appears unexpectedly or when its size increases
sharply. If prices rise unexpectedly, losses are borne by receivers with a nominal value only, and
debtors (who have liabilities) benefit. This means that unexpected inflation causes the
redistribution of monetary resources between creditors and debtors, and this may reduce the
overall economic efficiency of resource allocation.

There are many costs associated with inflation; for the economy, the volatility and uncertainty can
lead to lower levels of investment and lower economic growth. For individuals, inflation can lead
to a fall in the value of their savings and redistribute income in society from savers to lenders and
those with assets. At extreme levels, inflation can destabilize society and destroy confidence in
the economic system.
• Reduced international competitiveness - if a country has a relatively higher inflation rate
than its trading partners, then its exports will become less competitive, leading to a fall in
exports.
• Confusion and uncertainty - when inflation is high, people are more uncertain about what
to spend their money on. Also, when inflation is high, firms are usually less willing to invest
– because they are uncertain about future prices, profits and costs. This uncertainty and
confusion can lead to lower rates of economic growth over the long term.
• Boom and bust economic cycles - high inflationary growth is unsustainable and is
usually followed by a recession.
• Menu costs - this is the cost of changing price lists. When inflation is high, prices need
frequently changing which incurs a cost.
• Fiscal drag - the amount of tax we pay increases if there is inflation. This is because with
rising wages more people will slip into the top income tax brackets.
• Cost of reducing inflation - high inflation is deemed unacceptable therefore governments
/ Central Bank feel it is best to reduce it. This will involve higher interest rates to reduce
spending and investment. This reduction in Aggregate Demand (AD) will lead to a decline
in economic growth and unemployment
• Income redistribution - Inflation will typically make borrowers better off and lenders worse
off. Inflation reduces the value of savings, especially if the savings are in the form of cash
or bank account with a very low-interest rate. Inflation tends to hit older people more. Often
retired people rely on the interest from savings. High inflation can reduce the real value of
their saving and real incomes.
• Shoe leather costs - to save on losing interest in a bank people will hold less cash and
make more trips to the bank.
 36. Discuss the most important legal institutions and economic policy tools used for
mitigating inflation.

Inflation is generally controlled by the Central Bank and/or the government.

The anti-inflation policy can be implemented by government activities carried out under monetary,
fiscal and structural policies:
• Monetary policy
• Fiscal policy
• Structural policy - activities that aim to change the structure of production from ineffective
to pro-efficiency.

Additional policy tools to control inflation include:

• Control of money supply – Monetarists argue there is a close link between the money
supply and inflation, therefore controlling money supply can control inflation.
• Supply-side policies – policies to increase competitiveness and efficiency of the
economy, putting downward pressure on long-term costs.
• Wage controls - Trying to control wages could, in theory, help to reduce inflationary
pressures. However, apart from the 1970s, rarely used.

Monetary Policy

In a period of rapid economic growth, demand in the economy could be growing faster than its
capacity can grow to meet it. This leads to inflationary pressures as firms respond to shortages by
putting up the price. We can term this demand-pull inflation. Therefore, reducing the growth of
aggregate demand (AD) should reduce inflationary pressures.

The Central bank could increase interest rates. Higher rates make borrowing more expensive
and saving more attractive. This should lead to lower growth in consumer spending and
investment. See more on higher interest rates

A higher interest rate should also lead to higher exchange rate, which helps to reduce inflationary
pressure by
• Making imports cheaper.
• Reducing demand for exports and
• Increasing incentive for exporters to cut costs.

Inflation target

As part of monetary policy, many countries have an inflation target (e.g. UK inflation target of 2%).
The argument is that if people believe the inflation target is credible, then it will help to lower
inflation expectations. If inflation expectations are low, it becomes easier to control inflation.

Countries have also made Central Bank independent in setting monetary policy. The argument is
that an independent Central Bank will be free from political pressures to set low-interest rates
before an election.
Fiscal Policy

The government can increase taxes (such as income tax and VAT) and cut spending. This
improves the budget situation and helps to reduce demand in the economy.

Both these policies reduce inflation by reducing the growth of Aggregate Demand. If economic
growth is rapid, reducing growth of AD can reduce inflationary pressures without causing a
recession.

If a country had high inflation and negative growth, then reducing aggregate demand would be
more unpalatable as reducing inflation would lead to lower output and higher unemployment. They
could still reduce inflation, but, it would be much more damaging to the economy.
 37. Discuss the factors determining labour demand and supply in the economy and define
the notion of unemployment referring to the situation of equilibrium on the labour
market.

Factors determining labour supply:

• Participation Rate as Labour Force
• Number of Hours the Employees is Willing to Work
• Speed or Intensity of Work - Speed of work controls the quantity of labour. One labour who
works at a double speed completes the supply of other labourer. This speed depends on
various factors. Education, health, climate and others put impact on this tendency of work.
We can change the speed knowingly.
• Efficiency or Skill of Work - skill of work is related with the kind of work that how much
wastage is done, how many accidents are committed and many other factors are
considered to know the efficiency of work.

Factors determining labour demand:

CHANGES IN THE USE OF OTHER FACTORS OF PRODUCTION - as a firm changes the

quantities of different factors of production it uses, the marginal product of labour may change.
CHANGES IN TECHNOLOGY - technological changes can increase the demand for some
workers and reduce the demand for others. The production of a more powerful computer chip, for
example, may increase the demand for software engineers. It may also allow other production
processes to be computerized and thus reduce the demand for workers who had been employed
in those processes.
CHANGES IN PRODUCT DEMAND - a change in demand for a final product changes its price,
at least in the short run. An increase in the demand for a product increases its price and increases
the demand for factors that produce the product. A reduction in demand for a product reduces its
price and reduces the demand for the factors used in producing it
CHANGES IN THE NUMBER OF FIRMS - we can determine the demand curve for any factor by
adding the demand for that factor by each of the firms using it. If more firms employ the factor, the
demand curve shifts to the right. A reduction in the number of firms shifts the demand curve to the
left. For example, if the number of restaurants in an area increases, the demand for waiters and
waitresses in the area goes up. We expect to see local wages for these workers rise as a result.

Unemployment: Supply of labor > demand of labor

 38. Discuss the way of reaching equilibrium on the currency market in the systems of
fixed and fluctuating exchange rates.

Fixed exchange rates

A fixed exchange rate system is one where the value of the exchange rate is fixed to another
currency. This means that the government have to intervene in the foreign exchange market to
maintain the fixed rate. The equilibrium exchange rate may be either above or below the fixed
rate. In Figure 1 below, the equilibrium is above the fixed rate. There is a shortage of the national
currency at the fixed rate. This would normally force the equilibrium exchange rate upwards, but
the rate is fixed and so cannot be allowed to move. To keep the exchange rate at the fixed rate
the government will need to intervene. They will need to sell their own currency from their foreign
exchange reserves and buy overseas currencies instead. This has the effect of shifting the supply
curve to S2 and as a result, their foreign currency holdings will rise.

In Figure 2, the opposite is true - the equilibrium rate is below the fixed rate. This means that there
is a surplus of the national currency. The government will need to buy this surplus if they are to
prevent the currency from falling - in other words keep it at the fixed rate. When they buy the
currency they will be selling from their foreign currency reserves and so these will fall, but the
demand for domestic currency will rise.

Fluctuating exchange rates

Demand for złoty

The people who demand złoty are those who have bought goods and services from Poland and
need to pay in złoty. To do this they need to sell (supply) their currency and buy (demand) złoty in
exchange. So, the demand for złoty is partly determined by the level of exports - the higher the
level of exports, the higher the demand for złoty. However, people may also demand złoty simply
because they want to invest in Poland or because they are speculating to make a profit, as they
believe that exchange rates will change. So the demand for złoty arises from:
• Exports
• Inflows of funds into Poland
• Speculation

Supply of złoty

The supply of złoty comes from people who are selling złoty to buy other currencies. We all do
that when we travel overseas - we sell złoty and buy Euros, $, Yen or whatever. However, we, as
tourists, are only a very small part of overall supply of złoty. Much of it will come from firms who
buy goods and services from overseas (imports), but there may also be outflows of funds and
perhaps speculative flows as well. So, the supply of złoty arises from:

• Imports
• Outflows of funds from Poland
• Speculation

Equilibrium in the market for złoty will therefore look as in Figure 1 below.

If exports were to rise significantly, then this would cause an increase in demand for złoty and
would shift the demand curve to the right as shown in Figure 2. The exchange rate has appreciated
from $0.25 to the złoty to $0.35 to the złoty. This could also be caused by an increase in Thai
interest rates attracting higher demand for złoty.

If imports rose, this would shift the supply curve for

złoty as more złoty would be sold to enable the
importers to buy the required foreign exchange. This
would shift the supply curve to the right as shown in
Figure 3 on the left. This could also be caused by an
outflow of funds due perhaps to a loss of confidence in
złoty.

Governments can use exchange rates to affect economic performance. A rising exchange rate,
which is often linked to an increase in base interest rates, leads to exports becoming more
expensive but imports falling in price. This would reduce part of the inflationary pressure within an
economy. A fall in the exchange rate would lead to the reverse and might help domestic
businesses export more.
 39. Explain the concept of the business cycle and discuss its stages

The business cycle is the fluctuation of economic growth around its long-term trend. Another
definition: The business cycle is defined as fluctuations in economic activity, manifested mainly in
fluctuations in production and employment. The most common for the study of the business cycle
are such measures of economic activity as:
• GDP dynamics,
• industrial production
• employment level,
• unemployment,
• change in prices,
• export, import,
• stock market indices (treated as
• leading indicator).
• expenditure and income of the population
• interest rate.

Attention is drawn to the cyclical nature of business fluctuations, but the only element of
repeatability in business fluctuations is the phase sequence, i.e. crisis, depression, recovery, and
prosperity.

Description of each phase:

Crisis / recession / breakdown - high intensification of production decline; weakening of

economic activity; rising unemployment; decrease in employment, investment and consumption
level; falling prices; lowering interest rates, starting at the upper turning point.

Depression - production and other measures remain low or slightly changed.

Recovery - production begins to rise; unemployment is slowly falling; consumption and investment
spending are increasing; interest rates are rising; labor productivity is increasing (at the end of this
phase, productivity is slowing down).

Prosperity - the phase immediately before the crisis, the above-mentioned measures (except for
unemployment, which is anti-cyclical) remain at a high level. Although many macro variables
fluctuate in a similar way (GDP, income, investments, production, employment, etc.), the scale of
these fluctuations varies. For example, investment expenditures are subject to major changes
during the cycle - the investment size is on average 1/7 of GDP, while during the recession their
fall reaches 2/3 of GDP decline. These fluctuations are usually the medium-term process - about
5 years.
 40. Drawing upon various models of economic growth, discuss the most significant
economic growth factors.

Selected models of economic growth:

• Neoclassical (exogeneous) models:
o Solow model
o Ramsey model
• New models of economic growth (endogenous) :
o Romer learning-by-doing model
o Lucas model

I. Solow model

The condition determined in the Solow model is stable. This means that regardless of the initial
level of capital, the economy will always reach a steady state. The Solow model confirms the
occurrence of conditional convergence (convergence) (type β). Convergence (type β) means that
less developed countries (with a lower level of GDP per capita) show a faster rate of economic
growth than the more developed countries. The convergence confirmed by the Solow model is
conditional because it occurs only when the economies strive for the same long-term equilibrium.

The condition determined in the Solow model is stable. This means that regardless of the initial
level of capital, the economy will always reach a steady state. The Solow model confirms the
occurrence of conditional convergence (convergence) (type β). Convergence (type β) means that
less developed countries (with a lower level of GDP per capita) show a faster rate of economic
growth than the more developed countries. The convergence confirmed by the Solow model is
conditional because it occurs only when the economies strive for the same long-term equilibrium.

In the steady state, the rate of economic growth is equal to the sum of the pace of technical
progress and the pace of population growth, which implies that these two variables are
determinants of long-term economic growth. The increase in the savings rate (equal to the
investment rate) causes the economy to enter the trajectory of the transition period and results in
a temporary acceleration of the economic growth rate. This means that changes in the
investment rate are a factor of short-term economic growth.

II. Ramsey model

The main difference between the Ramsey model and the Solow model concerns the shaping of
the savings rate. The rate of savings, which in Solow's theory was exogenous, in Ramsey's
approach is shaped endogenously on the basis of optimization decisions taken by the maximizing
utility of households.

In a long-term equilibrium, capital, consumption and production per unit of effective work are
permanent. This means that the GDP growth rate is equal to the sum of technical progress
and the rate of population growth (i.e. exogenously shaped variables), and the rate of GDP
growth per capita is equal to technical progress. Ramsey's model is optimal in the sense
of Pareto. Endogenous savings rate prevents excessive accumulation of capital and thus
prevents the occurrence of dynamic inefficiency. The Ramsey model confirms the occurrence
of the conditional convergence phenomenon.
III. Romer learning-by-doing model

The Romer model differs from neoclassical models in that it does not assume the occurrence of
declining revenues from reproducible production factors. On the contrary, knowledge, as the only
reproducible factor of production, shows growing revenues at the level of the entire economy. The
rationale for adopting this assumption is that the knowledge that arises from the investments of
individual enterprises can spread unlimitedly across the entire economy and thus can be used by
all enterprises without additional costs. The above mechanism of spreading knowledge is defined
by the English term "learning-by-doing", which means learning (or acquiring knowledge) through
practice.

The perfectly competitive economy in the Romer model is not optimal in the sense of Pareta. It
results from the fact that investments in knowledge made by one enterprise contribute to the
increase of the general level of knowledge in the economy, which is a common factor of
production. However, a single enterprise in its investment decisions does not take into account
these positive externalities.

The dynamics of the economy in Romer's learning-by-doing model differs from the dynamics of
the economy in neoclassical models, primarily because there is no steady state in the Romer
model.

The Romer model does not confirm the occurrence of convergence between countries. What's
more, this model indicates the existence of divergent tendencies. In the Romer concept, the pace
of economic growth increases with the income level, which means that highly developed countries
develop faster than less developed countries. Although the pace of economic growth tends to be
asymptotic to the same upper limit, poor countries will develop at a slower pace, because they will
have less knowledge at the time. Therefore, the differences in the level of income between
countries will increase permanently.

IV. Lucas growth model

The Lucas model belongs to the group of two-sector models of economic growth, which include -
in addition to physical capital - also human capital. Lucas' model does not explain the phenomenon
of convergence - both on the basis of comparison of long-term equilibrium of various economies,
and on the basis of ownership of the transition period of economies striving for the same steady
state. In the first case, it turns out that in a long-term equilibrium the rate of economic growth does
not depend on the level of capital and production. This means that countries are developing in the
same way, regardless of the level of income they have achieved. In the second case, when we
consider a transition period of economies striving for the same long-term equilibrium, it turns out
that less developed countries can develop faster or more slowly than developed countries. It
depends on whether the low level of development results from the lack of physical capital (then
the underdeveloped countries will develop faster) or human capital (then the underdeveloped
countries will show slower growth).
 41. Discuss the theoretical and empirical aspects of the real convergence model (the Solow
model)

The economic model by Robert Solow attempts to explain economic growth based on capital
accumulation towards a long-term balance of investments and depreciation, i.e. the convergence
to a steady state.

According to the model, an economy, that initially has a low level of capital, will accumulate it and
grow respectively. In the beginning, the growth rate is increasing, but it will level out until the long-
term steady state is reached, i.e. the growth rate will eventually equal ‘0’. Any further growth is
only possible by technological development, which is an exogenous factor that is not explained in
the Solow-Model.

In its most basic form, the Solow-Model makes the following assumptions and refers to the
following equations:

1. As it is a closed economy without any government activity, income and output must be
equal, i.e. output can either be used for consumption or investments:
𝑌𝑡 = 𝐶𝑡 + 𝐼𝑡
t: time period
Y: output (total production)
C: consumption
I: investment

2. As the gross investments must be equal to the savings of the economy:

𝑆𝑡 ≡ 𝐼𝑡
S: savings
the savings in a closed economy are thus:
𝑆𝑡 = 𝑌𝑡 − 𝐶𝑡

3. Often the output is based on a type of Cobb-Douglas production function: 𝑌𝑡 = 𝐾𝑡𝛼 ∗

(𝐴𝑡 𝐿𝑡 )1−𝛼
K: capital
L: labor (or number of population)
A: labor-augmenting technology (or knowledge)
AL: effective labor
0 < α < 1: output elasticity with respect to capital

4. For comparability, the model items are expressed per capita (instead of absolute terms).
Therefore, small letters are used (instead of capital letters):
𝑌𝑡 𝐹(𝐾𝑡 , 𝐴𝑡 𝐿) 𝐾𝑡
𝑦𝑡 = = = 𝐹( , 𝐴𝑡 )
𝐿 𝐿 𝐿
As technology A is constant, the per capita income is only depending on per capita capital:
𝐾𝑡
𝑓(𝑘𝑡 ) = 𝐹( , 𝐴𝑡 )
𝐿
 5. There is a constant savings rate “s”, which is between 0 and 1. So every period, the
economy saves up (=invests) a certain percentage of its overall output:
𝑆𝑡 = 𝑠 ∗ 𝑌𝑡

and accordingly also part of its per capita income:

𝑠𝑦𝑡 = 𝑠𝑓(𝑘𝑡 )

6. There is a certain constant depreciation of the capital “𝛿”, which is between 0 and 1. So
every period, a certain percentage of the existing per capita capital renders useless.
There is also a certain working population growth rate “n”, which grows exponentially. In
order to keep the per capita capital constant, more and more workers must be equipped
with capital. Thus, the depreciation per capita is:

(𝑛 + 𝛿)𝑘𝑡

7. Based on that, the change of the capital stock per capita in every period is given as:
𝛥𝑘𝑡 = 𝑠𝑓(𝑘𝑡 ) − (𝑛 + 𝛿)𝑘𝑡
i. Thus, if the investments per capita are higher than the depreciation per capita, the
capital stock per capita increases:
𝑠𝑓(𝑘𝑡 ) > (𝑛 + 𝛿)𝑘𝑡 ⇒ 𝛥𝑘𝑡 > 0
ii. On the contrary, if the investments per capita are lower than the depreciation per
capita, the capital stock per capita decreases:
𝑠𝑓(𝑘𝑡 ) < (𝑛 + 𝛿)𝑘𝑡 ⇒ 𝛥𝑘𝑡 < 0

8. The capital stock increases or decreases until the long-term steady state of the economy
is reached, if investments per capita and depreciation per capita are in balance. This
process is called convergence. At the steady state the capital stock per capita is not
changing anymore (i.e. it is constant over time).
𝑠𝑓(𝑘𝑡 ) − (𝑛 + 𝛿)𝑘𝑡 = 0 ⇔ 𝑠𝑓(𝑘𝑡∗ ) = (𝑛 + 𝛿)𝑘𝑡∗

These functions of the Solow-Model can be

illustrated graphically. The horizontal axis
depicts the capital per capita 𝑘𝑡 , and the
vertical axis plots the output (= income) per
capita 𝑓(𝑘𝑡 ).

In empirical terms, the Solow-Model explains

the convergence of national economies. If
there are two national economies both having
the exact same technologies, depreciation
rate, savings (investment) rate and population
growth rate, they also have the same long-term steady state. However, if they are still below the
steady state and differ in their initial per capita capital stock, the model predicts that the poorer
national economy is going to grow faster than the richer national economy. Thus, due to a higher
growth rate, the poor economy will eventually catch up with the rich economy. With increasing
capital accumulation, the growth rate declines and the nations will reach the same steady state.
This process is known as convergence (or catch-up effect).
III. History of economic thought (questions 42-50)
42. Using the knowledge of selected economic approaches outline possible difficulties in
defining capitalism and socialism.

Generally - the concepts of capitalism and socialism have for years been marked by many
stereotypes in the general consciousness of society: capitalism is associated with exploitation and
social inequalities; socialism with limited market freedom and communism. Both of these concepts
are taken puristically, but should not be considered in black and white.

Capitalism - an economic system in which means of production and resources are in private
hands. There is a so-called class in it - capitalists, relatively small, in whose possession there is
the majority of capital available on the market. Consequently, most of the workforce works for the
capitalists for the remuneration received.

Socialism - an economic system in which the means of production are in public hands,
popularizing social benefits and social control of the economy. In the assumption of socialism
there are no different classes of citizens - everyone is equal.

Problems with defining:

1. Problems with defining capitalism. Capitalism is considered to be:
a) a system based on private property - in socialism we also deal with private
property: for example, houses or sites belong to private owners;
b) a system based on processes related to the use of capital - in this case
everything is capitalism, because capital is the foundation of every economic
system. Both Bolshevism and anarchist communism can in this sense be called
capitalism;
c) a system based on free competition - under capitalism, the state also interferes
in the economy, through subsidies or participation in economic planning. One of
the postulates of Keynesians was state interventionism;
d) a system based on freedom of decision on basic issues such as education
(paid), healthcare (voluntary), which allow the lowest possible taxes - in
socialism, thanks to taxes, citizens have access to free health care and education.
In capitalist Poland and the US we pay contributions to pension funds and health
services, so we are not capitalist purists.
2. In turn, socialism is recognized as:
a) a system based on shared ownership - under capitalism we also deal with
shared property. There are state treasury companies in the capitalist countries. In
addition, both in one and in the other system we have a small private enterprise.
b) a system that rejects democracy - there are socialist parties postulating the
democratic shape of the state, just as the Labor Party in the UK has existed since
1900

It is worth mentioning that the current market system in force in Poland is the social market
economy system, which is a combination of a market economy with a social security guarantee.
Its goal is to provide full employment, protection of the employment relationship, and activities for
the fair distribution of national income, taking into account the need to maintain adequate
economic growth. The state using instruments such as minimum wage, social insurance, subsidies
interferes in the economy, in which most of the property remains in private hands. This is a kind
of combination of capitalism and socialism.

Important issues:

Both socialism and capitalism rely on the concept of work value, used both by Karl Marx and Adam
Smith. According to Marx, socialism is a corollary of capitalism.

Conclusion:

Capitalism and socialism, although they are two different economic systems, have many common
points. Therefore, despite being in the general consciousness of society as completely opposite
systems, there are many similarities between them that blur the boundaries that allow them to be
distinguished. In the present reality, capitalism has elements of socialism as well as the socialism
of capitalism, and therefore both concepts are difficult to define.
 43. Conduct a comparative analysis of fundamental differences and similarities between
the orthodox and heterodox approaches in economics.

Heterodox economics - directions in economics not included in the mainstream economics due
to the difference of the research method and the subject of the analysis.
• Heterodox authors use a descriptive and historical research method. They reject the
concept of homo oeconomicus. According to them, the entity makes decisions not only on
the basis of the profit and loss account and trying to maximize usability and pleasure,
because there are social limitations and / or coercion.
• The heterodox economics are: historical school, institutionalism with its contemporary
varieties, evolutionary economy, neo-Austrian school and the theory of public choice of
James M. Buchanan, as well as socialist, anarchist, Marxist, ecological, etc.
• One analysis suggests four main factors in the economic studies of a heterodox economist:
history, natural systems, uncertainty and power.

Orthodox economics - it includes economic schools that rigorously adhere to their model
theories and assumptions adopted by school creators for them. Orthodox economics is associated
with neoclassical economics and with neoclassical synthesis that combines neoclassical methods
and Keynesian approach to macroeconomics. Orthodox economics can be defined, unlike other
economic schools, using various criteria, in particular through its assumptions, methods and
topics.
• In a classical school it is an assumption of price and wage volatility, achieving balance in
conditions of economic freedom and state non-interference;
• In a neoclassical school in economics - full use of resources, maximization of utility and
profit, theory of rational choice;
• In Keynesism - stability of wages and prices, balance in conditions of underutilized
resources (unemployment), necessity of state intervention that restores balance;
• The unit is the starting point of orthodox economic analysis. People are generally defined
as individuals with a common goal: maximization through rational behavior. The only
difference lies in the specific goal of maximization (individuals strive to maximize usability,
enterprise - profits); and the limitations encountered in the maximization process
(individuals can be limited by limited income or commodity prices, and companies can be
limited by technology or the availability of funds);
• Orthodox economics is defined methodologically as such that economists develop using
mathematical models, including calculus, optimization and comparative statistics;
• Modern orthodox schools focus on 4 problems: allocation, division, stability and economic
growth.

Similarities:
• Orthodox and heterodox economics are not opposed - the ideas of both economists are
largely complementary;
• It is often the case that orthodox economists explain what heterodox economists take for
granted and vice versa;
• Both allow the construction of large economic theories and none of them should be
excluded or ignored.
Differences:

• Orthodox approach - focuses on technical analysis and the problem of allocation and
economic growth; heterodox approach - focuses on sociological, psychological and
anthropological factors.
• Methodology of research: orthodox economics - mathematical models, statistics,
differential calculus; heterodox economics - descriptive and historical research methods.
• Heterodox economics rejects the homo oeconomicus paradigm (making decisions based
on the maximization of utility and pleasure) and the theory of rational choice that forms the
basis of orthodox economics.
• Heterodox economics rejects the model of market equilibrium and optimization, while in
orthodox economics it is one of the main concepts
• In orthodox economics, complex social factors do not affect the law of supply and demand;
it is different in the case of heterodox economics, which emphasizes the importance of the
social context in economics.
 44. In your opinion, what are the relations between economic systems and freedom.

The issue of the relationship between economic and political freedom and socialism and capitalism
is outside the normal scope of mainstream economics, but has been considered by many authors.
The way of thinking that planning is incompatible with freedom, and there is compatibility between
capitalism and freedom, has found many supporters among economists. The most famous are
Frank Knight, Henry C. Simons, Milton Friedman and Henry Wallich. And of course F.A.Hayek in
his “Road to serfdom”.

Friedrich August von Hayek was one of the most influential economists of the Austrian School of
Economics. The great publicity of Hayek's writings is particularly evident from the book “Road to
serfdom” (1944), in which he argued that socialism inevitably leads to the loss of freedom. In the
socialist system, Hayek saw the denial of freedom of an individual whose activity is
restrained by the strict framework established by the state. These frameworks are not the
result of the free activity of people who create certain forms of market behavior, but top-down,
authoritarily imposed by officials in the interest of a specifically understood public. In socialism,
any free activity is contrary to the interest of the state, which is why private property is
abolished or significantly reduced. In this case, free market mechanisms are liquidated and
are replaced by planning decisions.

Milton Friedman, an American economist and Nobel laureate in economics (1976), shared similar
views on socialism and freedom. His approach resulted from the axiological basis, where the most
important value was the individual's freedom, understood as the lack of compulsion from any side
and as much as possible. The central place of freedom in Friedman's concept grew out of the
individualistic model of man, whose motive of action became the pursuit of his own interests. It
was an entity that was able to plan, anticipate and implement its plans in a rational way. Using
reason allowed her to adapt to changing conditions and some flexibility, but such an individual
needed above all the freedom of action to be able to optimize them. According to Friedman,
freedom is realized both in the political and economic fields. An important element of economic
freedom is not only the possibility of taking free economic initiatives, but also the right to private
property. Only in such a system are individuals motivated to take actions that create the greatest
profit at the lowest cost.

Everything depends on the system, each of them is guided by different rules. As far as socialism
is concerned, I think that despite typical attacks on this system one should take into account the
opinions of economists like Hayek. According to him, socialism can not be reconciled with
freedom. The implementers of the economic plan are not able to know the preferences of everyone
in this system, so they simply create their own scale of social preferences, which is simply imposed
on the society. A socialist prescription suggesting that market socialism would allow freedom of
choice of consumption and profession within a planned economy is therefore false because
planning and freedom of choice are incompatible. Besides, if we look deeper at the socialist
system itself, then we notice that it is difficult to guarantee in it both freedom of choice of
consumption and profession.

The situation is different in the case of capitalism, where there is compliance with freedom -
however, it should be strived to ensure that all guaranteed freedoms are respected - both personal
and those related to running a business. An example of such freedom is, among others free
competition including anti-monopoly. Nevertheless, minimizing the role of government is the most
important factor in ensuring freedom in any economic system.
 45. In a historical perspective, there have been four mechanisms used to mitigate the
problem of scarcity of goods. What are they? Which economic approach has been the
most successful in dealing with this issue?

Scarcity refers to the limited availability of a commodity, which may be in demand in the market.
The concept of scarcity also includes an individual capacity to buy all or some of the commodities
as per the available resources with that individual.

From historical perspective there are 4 ways to counter the problem of scarcity:
• Power - allocation of goods as a result of physical or military strength of units of some
societies in the face of the weakness of other societies. Violence as a means to achieving
goals accompanies humanity from the beginning. Currently, highly developed countries
lead to a decline in criminal phenomena;
• Tradition - from generation to generation, the transmission of cultural content, which over
time are considered by society to be significant for the present and future;
• Institutions
o Church - before secularization - numerous church goods - religious authority as
much as church authority.
o State - fiscal and monetary policy measures affecting aggregate demand and
redistribution.
• Market - trade exchange between units.

Modern societies now use: power, tradition and markets. The transition from traditional-state-church
economies to market economies did not proceed in a linear manner and involving all societies.

The four basic methods used to alleviate the scarcity problem are: violence, tradition, institutions
(government / church) and the market. They do not occur in any particular hierarchy, and despite
the fact that market solutions dominate today, all of the mechanisms described are still found in
various areas of the world. Naturally, mechanisms such as violence or tradition do not necessarily
have to be referenced in economic sciences. But also market / institutional solutions are often
influenced by social and political factors. In addition, many of the old economic ideas have their
sources in philosophical and ethical reflections, which is why the problem of resource allocation is
not always solved in an "economic" way.

In my opinion, the directions that best deal with this problem are a combination of two ways - a
roar and an institution. Market as the dominant form of deciding on the method of distribution of
goods, with the supporting role of formal and informal institutions give the best results.
 46. Discuss the implications of the Keynesian revolution for the economic thought

The Keynesian Revolution marked the end of the laissez-faire doctrine and the rejection of Saya
market law (supply creates demand for goods of the same value as the product).

The macroeconomic model of Keynes describes a market economy that operates with incomplete
use of capital resources and underemployment. The analysis is carried out in conditions of flexible
supply of industrial goods, with low-elastic, sticky prices (flexibility of prices and wages). This
corresponds to the contemporary realities of oligopolistic competition. The assumption of price
stability is one of the foundations of Keynesian macroeconomics.

Keynes's main thesis is that economy is limited by the size of demand, not by the size of resources.
The investment demand is the most important because the driving force triggering changes in the
size of the product (national income) is investment expenditure, not savings.

Model: AD = C + I (demand = consumption + investments)

C = Co + c* Y
(Consumption. = Autonomous consumption + Consumption from income, small c – marginal
propensity to consume)

Instead of starting the analysis traditionally with the tendency of society to save and then showing
how the investments adjust to savings through the interest rate, Keynes adopted an autonomous
stream of investment expenditures. He showed how the savings needed to finance this level of
investment will be generated using the investment multiplier mechanism.

Investment expenditures are not determined by savings, but depend on various factors shaping
investment decisions of entrepreneurs; generally - from predictions, i.e. from the expected
profitability of the intended investments, as well as from the current interest rate. The risk of
investing is the main force limiting decisions, making the investor cautious. That is why Keynes
exposes incomplete reinvesting of savings, as well as - as its counterpart - the lack of effective
demand. Keynes's analysis resulted in three main conclusions:
• unemployment is not the effect of voluntary employee decisions;
• it is not the result of the lack of flexibility of nominal wages "down";
• government spending can increase employment.

All this contradicted the thesis of the orthodox theory, according to which unemployment was
caused by too high wages. What is needed is a "visible hand" - state intervention, encouraging
entrepreneurs to make investments and complementing private investments with public
investments. Budget deficits (budget deficit) can be used to supply the economy with additional
purchasing power, and thus to stimulate production and employment growth. That is why the
budget deficit is acceptable, and even - under certain conditions - desirable.

Keynes proved that in an economy limited by demand, the total savings depend on investment
expenditures, the budget deficit and the export surplus. His theory, born of the deficiencies of the
neoclassical theory, which could not cope with the level of employment, transferred the economic
analysis from the unsettled time, risk and uncertainty of statistical balance states closer to reality.
Demand theory is treated as the first school of rational thinking about indirect forms of state
influence on the economy. Keynes's theory has had a strong impact on the development of
economics, as well as on economic policy in countries with a mature market economy.

Summarizing:
• Keynes questioned the Say's markets rights, which caused a revolution in economics.
Keynes reverses the perspective, says that the effective demand is how much we produce.
If there is an effective demand in the market, supply will immediately come;
• According to Keynes, savings result from investment and not vice versa;
• future unknown, entrepreneurs do not know what will happen if they guess that it will be
good - they will invest, and vice versa, that's why the economy does not strive for balance
by itself;
• The marginal capital productivity decreases - investment strikes down, entrepreneurs'
moods are worse (because lower profits) and so crises are inevitable.
 47. Present arguments of the critics of capitalism as an economic system. Assess their
accuracy.

Capitalism - a socio-economic system based on private property, personal freedom and the
freedom to conclude contracts; Capitalism is an economic system that is characterized by the
dominance of private property and the free market, i.e. the lack or relatively small intervention of
the state in market mechanisms. Important features of capitalism are also such properties as
unrestricted competition, free trade in services, goods, finances and means of production and, as
a consequence, profit from them. That is why the capitalist economy is also called free market
economy.

Criticism of capitalism ranges from expressing disagreement with the principles of capitalism in its
entirety, to expressing disagreement with particular outcomes of capitalism.

For instance, Marx and Weber perceive capitalism as a system where "the individuals are ruled
by abstractions (Marx), where the impersonal and "thing-like" relations replace the personal
relations of dependence, and where the accumulation of capital becomes an end in itself, largely
irrational. Prominent among their critiques of capitalism are accusations that capitalism is
inherently exploitative, that it is unsustainable, that it creates economic inequality, that it
is anti-democratic and leads to an erosion of human rights and that it incentivizes
imperialist expansion and war.

Anti-Democratic and erosion of human rights (Branko Horvat, F.D. Roosevelt, Thomas
Jefferson): Critics argue that capitalism leads to a significant loss of political, democratic and
economic power for the vast majority of the global human population. The reason for this is they
believe capitalism creates very large concentrations of money and property in the hands of a
relatively small minority of the global human population (the “elite”), leading, they say, to very large
and increasing, wealth and income inequalities between the elite and the majority of the population

Exploitation of workers (Marx, Ricardo, Smith): Critics of capitalism view the system as
inherently exploitative. By using the labor theory of value, Marxists see a connection between
labor and exchange value, in that commodities are exchanged depending on the socially
necessary labor time needed to produce them. However, due to the productive forces of industrial
organization, laborers are seen as creating more exchange value during the course of the working
day than the cost of their survival (e.g. food, shelter, clothing). Marxists argue that capitalists are
thus able to pay for this cost of survival while expropriating the excess labor (i.e. surplus value).

Imperialism and political oppression (Lenin): Critics of capitalism argue that the system is
responsible for not only economic exploitation, but also imperialist, colonial and counter-
revolutionary wars and repression of workers and trade unionists.

Inefficiency: Some economists, most notably Marxian economists, argue that the system of
perpetual capital accumulation leads to irrational outcomes and a mis-allocation of resources as
industries and jobs are created for the sake of making money as opposed to satisfying actual
demands and needs.

Inequality: One criticism is that it can lead to inequality in society. There will be people who have
lots of money and access to resources while there will be other people who will be poor with very
little access to resources. Capitalism can also lead to disdain for those who aren’t doing well.
People may feel it is an inefficient use of resources to help people who are struggling.
Market instability: Critics of capitalism, particularly Marxists, identify market instability as a
permanent feature of capitalist economy

Property: In discussions of the sensitive issue of property, it is critical to make a clear distinction
between private property and public property. While the critics of capitalism listed/discussed below
are calling for the abolition of private property and its transformation into the commons or public
property, they nonetheless retain respect for personal property rights.
 48. Discuss key aspects of the economic theory of Karl Marx.

Marx studied capitalism and together with Engels created the Communist Manifesto, describing
the characteristics of this system (expropriation of property, progressive tax, forced labor,
confiscation of property of emigrants and rebels, etc.)

Marx’s economic theories

The Marx system is a mixture of philosophical, sociological and economic analysis. He was
convinced of the inevitable fall of capitalism.

Marx's methodology -> The whole determines the parts: Marx started the analysis at the level of
the entire society and the economy by examining them in terms of the influence exerted on their
component parts.

Goods and classes

The existence of two classes between which there is an exchange: the owners of the means of
production - the capitalists and the proletariat selling their work on the market one of the
characteristic features of capitalism is the separation of labor from the ownership of the means of
production.

Commodity prices represent two types of relations - quantitative and qualitative

• quantitative relations between commodities (2 apples for 1 banana)
• social, or qualitative relations between individuals in the economy

Wages, as prices in the economy, represent both the quantitative and qualitative relation between
the capitalists and the proletariat. Marx was interested in prices as much as they revealed social
relations, he was secondarily interested in prices as a reflection of the quantitative relation
between goods.

Value based on work

Goods reveal certain quantitative ratios through their prices. According to Marx, this means that
all goods must contain one common element, which must exist in them in certain measurable
quantities - work. He concluded that the factor that governs the relative prices of goods is the
amount of time needed to produce them, that is, the only social cost of producing goods was work.

Marx’s algebra:

The value of the good can be divided into parts.

VALUE = C (fixed capital) + V (variable capital) + S (additional value)

C - fixed capital - capitalists' expenses on purchases of raw materials and depreciation write-offs
from fixed capital

V- variable capital - expenditure on wages and salaries

S - additional value - the rest after deduction of fixed capital and variable capital expenditure on
the capitalist gross income.
According to Marx, fixed capital expenditures give capitalists revenues in total equal to these
expenditures. Variable capital expenditures in cases where economic activity is profitable
generate revenues higher than expenditures. In this way, Marx embodied his fundamental
assumption that only work creates value. The additional value is a source of property income.

According to Marx, goods used in the production process, i.e. manpower, allow to produce a value
greater than that which is paid for the goods. The long-term competitive price of the workforce
balance is the equivalent of the necessary working time required to produce a real wage of the
workforce. Marx called the relation of surplus value to the capital of variable capital with the rate
of surplus value.

Marx's analysis of capitalism - Marx applied his theory of history to the detection of the laws of
movement under capitalism and to identify contradictions between the factors of production and
the relations of production in this system.

Marx laws:
• reserve army of the unemployed (existence of long-term unemployment),
• a decline in the profit margin (accumulation of capital leads to an increase in demand for
labor, causing an increase in wages and shrinking of the army of the unemployed),
• economic crises (periodic depression as an inherent feature of capitalism),
• the concentration of industry in a declining number of enterprises,
• he impoverishment of the proletariat.

Crisis of disproportionality
From the moment of entering the economy to a high level of specialization of work and using
money, problems may arise with the coordination of production levels in particular branches. Marx
questioned the ability of markets to make changes in the allocation of resources. According to the
classics, the increase in demand in branch A and the fall in demand in branch B will cause shifting
of resources to the branch subject to expansion and the imbalance will be short-lived. According
to Marx's theory, unemployment in a given industry can spread to the entire economy and cause
a general decline in economic activity.
 49. Present key reasons for the existing differences in the views of contemporary
economists.

In the history of development of macroeconomics, we observe numerous and intensifying over

time - along with the change in the course of economic processes - the radical undermining and
rejection of "old" theories and the creation of new paradigms. The most important allegations
concern the essence of economics as science.

Contemporary philosophy of science has questioned the ideal of obvious knowledge based on the
indisputable evidence of empirical data, observations, inductions, and possibilities that have been
sustained for many centuries in scientific research as a model. Increasingly, it is claimed that
economics is useless in terms of a correct and objective diagnosis of economic processes, and
the descriptions or real-world interpretations provided by it are incorrect or pass the actual or
expected state of the economy. The utilitarian (useful) role of economics - especially
macroeconomics - for drastic economic entities is drastically decreasing. Critics are also subjected
to the methodological foundations of economics.

Some have made allegations that the economy is excessively theoretical (too abstract), while
others are excessively empirical. In this context, criticizes the "departure" of economics from the
methodology of research proper to the humanities and giving priority to mathematical models.
There are also accusations of returning to the ideologization of economics. Among many
objections related to the subject and area of research, attention should first be paid to narrowing
research shots.

Behind the main reason for the differences of views among contemporary economists, the
invariably changing reality is assumed. It may be that it is impossible to obtain sufficient time series
that give a faithful image of today's world and enable the final empirical verification of competing
theories. In striving to understand the differences between views, four basic problems should be
taken into account: the pace at which the labor market equilibrates, the way expectations are
formed, the hysteresis potential and the relative weight attributed to the short and long-term
analysis.
New classical macroeconomics:
• the market achieves equilibrium in an almost immediate way
• full employment is halted by previously concluded contracts
• the rationality of expectations assumes that any foreseeable changes are already included
in the variables
• the appearance of "pure surprises" (unpredictable changes) can only disrupt full
employment
The theory of the real business cycle
• status quo of full market equilibrium (negation of any deviations)
• a detailed analysis of inter-period decisions of farms, enterprises and the state allows
short-term fluctuations to be interpreted as changes in potential output
Moderate monetarists:
• the return to the level of potential production is not immediate, but ALE only takes a few
years
• the government should only deal with the long-term inflation policy and supply policy in
order to increase potential production
Moderate Keynesians:
• a return to the level of potential production can take many years
• the government should actively interfere
 50. Outline the most crucial assumptions of Adam Smith’s classical economics

Adam Smith: Often called “the father of economics”, because he was able to synthesize his and
previous achievements into one coherent, integrated system explaining:
• how markets function (price determination),
• how economic growth operates,
• what policies accelerate economic growth,
• how domestic economy interacts with others (international trade),
• what is the appropriate role for the state in the economy, etc.
Classical Economics: is a school of thought in economics that flourished, primarily in Britain, in
the late 18th and early-to-mid 19th century. Its main thinkers are held to be Adam Smith, Jean-
Baptiste Say, David Ricardo, Thomas Robert Malthus, and John Stuart Mill. These economists
produced a theory of market economies as largely self-regulating systems, governed by natural
laws of production and exchange (famously captured by Adam Smith's metaphor of the invisible
hand). → Begin with “The Wealth of Nations” By Adam Smith in 1776.

Assumptions:

The concept of "homo oeconomicus"

An economic man lived in a world in which there was a shortage of goods. It was characterized
by: a tendency to exchange and a tendency to specialize. It resulted from the desire to have as
much material goods as possible. The unit was characterized by the principle of minimum effort -
maximum benefit. Homo oeconomicus (economic man, economic entity), according to Smith, was
a vain, lazy, greedy, capable of dishonest behavior in achieving its goals. These negative selfish
traits consequently lead to specialization, and thus to greater labor productivity, serving the good
of the whole society.

The philosophy of utilitarianism

The philosophy of the classics was utilitarianism. According to his assumptions, there was no
predetermined social order. The laws were made by people, so they were not natural and eternal.
The rule of utilitarianism was the greatest happiness of the largest number of people, interpreted
in the interests of industrialists and merchants.

Economic liberalism

The condition of proper economic development was the principle of economic liberalism - not
interfering with the state in economic matters. The private initiative and entrepreneurship could
then develop. Each business unit works in such a way as to achieve the greatest benefits for itself,
even at the expense of others. Thus, the interests of individuals were contradictory and could lead
to chaos. In order for this to happen, an invisible hand of the market, restoring order in the
economy, was watching over everything.

The concept of wealth

The wealth of nations is a national income. In contrast to previous views, Smith claimed that the
source of wealth is work in general. Neither circulation (mercantilism) nor only farming
(physiocratism) is a source of wealth. "The annual work of every nation is a fund that provides it
with all necessary and useful things in life that this nation consumes, and which always constitute
a direct product of this work, or what it acquires for this product from other nations."
Wealth, or income, depends on two factors:
• on skills, efficiency and the understanding of work (performance)
• on the number of employees in material production (employment).

The labor productivity factor was decisive. The main way to increase wealth was to increase the
division of labor. Smith, however, warned against excessive specialization that could dull the
worker. The division of labor led people out of the tendency to exchange.

Theory of value
In value theory Smith wanted to explain three problems:
• what is the real measure of exchange value,
• what are the price components,
• what factors shape price fluctuations, i.e. what causes the market price to deviate from the
natural price.
Smith distinguished between two meanings of values:
• utility value - usefulness of the object, ability to meet specific needs,
• exchange value - exchange ratio, ability to exchange goods.
Smith did not deal with utility value because he thought he was not part of the science of
economics. He focused his attention on exchange value, formulating five concepts of value - two
valuable, two quantitative and one cost. These concepts were mutually exclusive, which was a
weak point in Smith's theory.

Concepts of values:
• valuable:
o The value of the commodity is determined by the amount of work involved in its
production
o The value of the commodity is determined by the amount of work that can be
procured for a given product
• quantitative:
o The value of goods is determined by the amount of other goods, e.g. wages
o The value of goods is determined by the amount of money on the market
• cost:
o The value of the commodity is determined by the production costs, hence the value
= production costs = price

The price consists of income and falls into income. Income is: pay, profit and pension, which are
components of the price. This is called Smith's dogma. The identification of value with the cost of
production and price has led Smith to equate national income with a global product. He did not
include in the last reproduction of capital contained in fixed assets. An important achievement of
Smith was the rejection of the theory that it is one kind of work that creates wealth. According to
him, work generates income in general. Among the Smithy concepts of value, the quantitative
concepts proved to be the weakest, because it was the easiest to prove their assumption was
wrong.
IV. Managerial Economics (questions 51-75)
51. Discuss the role of marginal analysis in making optimal decisions in a firm

Marginal analysis is an examination of the additional benefits of an activity compared to the

additional costs incurred by that same activity. Companies use marginal analysis as a decision-
making tool to help them maximize their potential profits.

When a manufacturer wishes to expand its operations, either by adding new product lines or
increasing the volume of goods produced from the current product line, a marginal analysis of the
costs and benefits is necessary. Some of the costs to be examined include, but are not limited to,
the cost of additional manufacturing equipment, any additional employees needed to support an
increase in output, large facilities for manufacturing or storage of completed products, and as the
cost of additional raw materials to produce the goods.

Once all of the costs are identified and estimated, these amounts are compared to the estimated
increase in sales attributed to the additional production. This analysis takes the estimated increase
in income and subtracts the estimated increase in costs. If the increase in income outweighs the
increase in cost, the expansion may be a wise investment.

Marginal analysis can also help in the decision-making process when two potential investments
exist, but there are only enough available funds for one. By analyzing the associated costs and
estimated benefits, it can be determined if one option will result in higher profits than another.

Example:

We say allocative efficiency occurs at an output

where the marginal utility of consumption equals
the marginal cost. At this point society is
maximising welfare.

Why is this?

Suppose, we have a good where only 40 units are

consumed. But, at this output the marginal utility
(15) is much greater than marginal cost (6).

A company would benefit from increasing output – because the utility gained will be greater than
the cost.

The optimal result would be to increase output to 70 – where marginal cost = marginal utility.
 52. Is profit maximization identical with revenue maximization? In your answer account
for various market structures and various aspects of decision-making (including the
pure-selling problem). Use numerical data in your argument.

Profit is the amount of value that remains after you subtract the expenses your business incurs
during the year from the amount of revenue it produces. In addition to additional cash, profit could
be defined as a decrease in liabilities, an increase in assets, or an increase in the owners’ value
in the company.

Profit maximization describes when a business can sell a product so that the marginal
revenue equals the marginal cost when the value of marginal cost is increasing. What this
means is that the production and sale of the business’s product reach a point that if the business
were to sell one more unit, it would begin to lose money because the costs of producing that unit
would exceed the unit’s price on the market. Achieving this goal with precision in the real world is
difficult, but it illustrates the overall strategy of maximizing the owners’ annual return, even if that
means not making sales that could have been made if the business produced more.

Revenue is essentially another word for sales, or how much of the good or service that your
business produces is sold to consumers. Revenue does not take into consideration the costs
necessary to produce or market your business’s product, so it does not reflect what the owners
ultimately receive. A revenue maximization strategy dictates that a business should do
whatever is required to sell as much of its product as possible.

The long-term strategy of any business is to maximize profits because maximizing personal profit
is why people start businesses. However, when a small business begins, it may choose to
maximize revenue to the detriment of short-term profits so it can build market share and a
reputation in the market. Market share is the portion of total sales volume a company controls in
a given market.

After a business generates a reputation in the market, it can then shift to profit maximization. Part
of this strategy will invariably involve decreasing expenses, which more established and
experienced businesses can do by acting on the lessons they have learned in their earlier years
and improving bargaining positions with their suppliers. But another part may involve raising the
price, which will probably alienate some customers, decreasing revenue. However, profit would
still increase.

The monopolist's profit maximizing level of output

is found by equating its marginal revenue with its
marginal cost, which is the same profit maximizing
condition that a perfectly competitive firm uses to
determine its equilibrium level of output. Indeed,
the condition that marginal revenue equal
marginal cost is used to determine the profit
maximizing level of output of every firm,
regardless of the market structure in which the firm
is operating.
 Figure illustrates the monopolist's profit maximizing
decision using the data given in Table . Note that the
market demand curve, which represents the price the
monopolist can expect to receive at every level of output,
lies above the marginal revenue curve.

The monopoly in the preceding example made profits of

$12. These profits are illustrated in Figure as the shaded
rectangle labeled abcd.

In order to maximize profits in a perfectly competitive market,

firms set marginal revenue equal to marginal cost (MR=MC). MR
is the slope of the revenue curve, which is also equal to the
demand curve (D) and price (P). In the short-term, it is possible
for economic profits to be positive, zero, or negative. When price
is greater than average total cost, the firm is making a profit.
When price is less than average total cost, the firm is making a
loss in the market.

Over the long-run, if firms in a perfectly competitive market are

earning positive economic profits, more firms will enter the
market, which will shift the supply curve to the right. As the supply
curve shifts to the right, the equilibrium price will go down. As the
price goes down, economic profits will decrease until they become
zero.