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Examiners commentaries 2017

Examiners commentary 2017


EC1002 Introduction to Economics

Mock examination paper

Section A: Multiple choice questions

Answer all questions. Each question is worth 4 marks.

Choose one answer for each question; no explanation is required.

Question 1

Which of the following is a correct description of the short-run supply curve of a


perfectly competitive firm?

(a) The part of the short-run marginal cost curve above short-run average fixed
cost.
(b) The part of the short-run marginal cost curve above short-run average variable
cost.
(c) The part of the short-run marginal cost curve about short-run average total
cost.
(d) The whole short-run marginal cost curve.

The answer is (b).

Statement (a) is incorrect. Fixed costs cannot be avoided in the short run, so these should not
affect the firms decision to produce or not.

Statement (b) is correct. First, if the firm produces output, the profit-maximizing supply of
output is where price is equal to marginal cost because the firm is perfectly competitive and takes
the market price as given. Second, for it to be in the interests of the firm to operate in the short
run, the price it receives must at least cover its short-run average variable cost because these
costs could be avoided by shutting down production. Therefore, the supply curve of the firm is
the portion of the short-run marginal cost curve above the short-run average variable cost curve.

Statement (c) is incorrect. Total costs include fixed costs, which cannot be avoided in the short
run. Only variable costs affect supply decisions in the short run.

Statement (d) is incorrect. The firm has the option of shutting down production and reducing
variable costs to zero. If it produces, it must therefore receive a price in excess of its short-run
average variable costs to justify producing any output. Its supply curve cannot therefore be the
whole of the short-run marginal cost curve.

Question 2

A specific tax is imposed on a commodity. Which of the following statements about


the incidence of the tax is correct?

(a) If demand is perfectly price elastic then the demand price rises and the tax
burden falls only on the seller.

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EC1002 Introduction to Economics

(b) If supply is perfectly price elastic then the supply price is unchanged and the
tax burden falls only on the buyer.
(c) If demand is perfectly price elastic then the supply price rises and tax burden
falls only on the seller.
(d) If supply is perfectly price elastic then the supply price falls and the tax burden
falls only on the buyer.

The answer is (b).

Statement (a) is incorrect. If the demand curve is perfectly price elastic (horizontal) then the
demand price will not adjust when the tax is introduced.

Statement (b) is correct. Suppose the supply curve is perfectly price elastic (horizontal). This
shifts upwards by an amount equal to the tax. The demand price rises by exactly as much as the
tax, and since the difference between the demand price and supply price is the tax, it follows that
the supply price is unchanged. With no change in the supply price and a rise in the demand
price, the burden of the tax (the incidence) falls only on the buyer.

Statement (c) is incorrect. If the demand curve is perfectly price elastic (horizontal) then the
supply price will fall when the tax is introduced. The supply curve shifts upwards because of the
tax. The difference between the demand price and supply price is equal to the tax. Since the
demand price does not change owing to the demand curve being horizontal, the supply price
must fall.

Statement (d) is incorrect. If the supply curve is perfectly price elastic (horizontal) then the
supply price will not change following the imposition of the tax.

Question 3

Which of the following statements is correct?

(a) A public good is non-excludable, but rivalrous.


(b) A public good is efficiently provided when everyones marginal utility from the
good is equal to the marginal cost of the good.
(c) A public good is non-rivalrous, but excludable.
(d) A public good is efficiently provided when the sum of everyones marginal
utilities from the good is equal to the marginal cost of the good.

The answer is (d).

Statement (a) is incorrect. A public good is both non-rivalrous and non-excludable.


Non-rivalrous means that one persons enjoyment of the good is not affected by others
benefitting from the good.

Statement (b) is incorrect. Since a public good is non-rivalrous, the marginal social benefit is
greater than the marginal benefit any individual derives from the good. Equating an individuals
marginal benefit to the marginal cost would lead to underprovision of the public good.

Statement (c) is incorrect. A public good is both non-excludable and non-rivalrous. It is not
practical to exclude any particular individual or individuals from being able to enjoy the
provision of the public good.

Statement (d) is correct. Since the public good is non-rivalrous, the marginal social benefit is the
sum of everyones marginal utility from the good (as each individuals enjoyment of the good
does not detract from that of others). Efficiency requires that this sum is equated to the
marginal cost of providing the good.

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Examiners commentaries 2017

Question 4

Which of the following statements about a labour market with a monopsonist firm is
not correct?

(a) Less labour is hired than if the firm were perfectly competitive and took the
wage as given.
(b) Workers would like to supply more labour at the monopsony wage.
(c) The firm pays a wage below the marginal product of labour.
(d) The marginal product of labour is diminishing for the firm.

The answer is (b).

Statement (a) is correct. The monopsonist hires labour up to the point where the marginal cost
of labour (MCL) is equal to the marginal product of labour (assuming it is perfectly competitive
in the goods market). But the MCL is greater than the wage, so a firm that were perfectly
competitive in the labour market (taking the wage as given) would hire a greater amount of
labour up to the point where the wage is equal to the marginal product of labour.

Statement (b) is incorrect. Workers choose how much labour to supply for each wage, and the
monopsonist takes this into account when choosing how much labour to hire. But workers are
happy with the amount of labour they are supplying at the prevailing wage.

Statement (c) is correct. Since the firm takes into account that more hiring requires higher
wages, the marginal cost of labour is greater than the wage. Profit maximization requires the
marginal cost of labour is equal to the marginal product of labour, hence the wage is below the
marginal product of labour.

Statement (d) is correct. The marginal product of labour is diminishing, though this is not
special to the case of monopsony.

Question 5

Which of the following statements is correct?

(a) A natural monopoly is a market with barriers to entry that cannot be overcome
by potential entrants.
(b) A natural monopoly produces a product for which there are no substitutes.
(c) A natural monopoly has a long-run average cost curve that is always
diminishing.
(d) A natural monopoly produces where marginal revenue is greater than marginal
cost.

The answer is (c).

Statement (a) is incorrect. A natural monopoly does not require explicit barriers to entry to be
in place. The cost advantage enjoyed by a larger firm in a natural monopoly situation is itself a
deterrent to new entry.

Statement (b) is incorrect. The downward-sloping demand curve faced by the natural monopolist
may reflect consumers substituting towards other goods. This has nothing to do with the concept
of natural monopoly.

Statement (c) is correct. In this case, the larger the firm, the lower its average costs. The more a
firm expands, the greater its cost advantage becomes, and thus it is not possible to sustain
competition in the market.

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EC1002 Introduction to Economics

Statement (d) is incorrect. The condition for profit maximization for a natural monopolist
remains the usual marginal revenue equal to marginal cost for monopolists.

Question 6

A car maker produces 10,000 cars in a year, which have price $10,000, though 2000
of these cars remain unsold at the end of the year. The car maker pays its workers
$40m and spends a total of $30m on buying parts needed to make the cars from
other firms. It spends $5m on new robots to use next year, and must pay interest
$2m on its debts. Which of the following statements is correct?

(a) The car makers value added is $40m.


(b) The car makers value added is $65m.
(c) The car makers value added is $70m.
(d) The car makers value added is $23m.

The answer is (c).

Statement (a) is incorrect. This number might be obtained by subtracting wages $40m from
actual sales of $80m. This is wrong because value of the unsold cars should be included (this is
inventory investment, which counts as part of final demand). It is also wrong because wages are
subtracted. Payments to factors of production are part of value added and should not be
subtracted.

Statement (b) is incorrect. This number might be obtained by subtracting the $30m cost of the
car parts and the $5m cost of the new robots from the value of the cars produced ($100m). This
is wrong because the spending on robots is part of investment (a component of final demand). It
is not an intermediate input, and should not be subtracted when calculating value added.

Statement (c) is correct. The sales of the car maker are $80m, and the value of the unsold cars is
$20m. The value of the goods produced is thus $100m. Value added is obtained by subtracting
spending of $30m on intermediate goods (car parts) to leave $70m.

Statement (d) is incorrect. This number might be obtained by subtracting wages of $40m, the
$30m cost of the car parts, the $5m cost of the new robots, and the $2m of interest from the
$100m value of output produced. This is wrong because only the cost of the intermediate inputs
(the car parts) should be subtracted to obtain value added.

Question 7

The government increases its spending by $1bn and raises taxes by $1bn. According
to the IS/LM model, which of the following statements is correct?

(a) Output rises by exactly $1bn and the interest rate is higher.
(b) Output rises by less than $1bn and the interest rate is higher.
(c) Output rises by more than $1bn and the interest rate is higher.
(d) There is no effect on either output or the interest rate.

The answer is (b).

Statement (a) is incorrect. If the interest rate was higher, investment demand would fall. If
income increased by $1bn and taxes increased by the same amount, there would be no change in
disposable income and therefore no change in consumption. As government spending is $1bn
higher, investment is lower, and consumption is unchanged, aggregate demand and output must
have risen by less than $1bn.

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Examiners commentaries 2017

Statement (b) is correct. The balanced-budget increase in government spending shifts the IS
curve to right by exactly $1bn (with no multiplier effect because taxes rise with government
spending, so disposable income does not increase). The intersection with the LM curve is at a
higher interest rate, and the increase in output must be smaller than the horizontal shift of the
IS curve (equal to $1bn). This is because of the crowding out of investment spending by the
higher interest rate.

Statement (c) is incorrect. Output cannot rise by more than $1bn using the logic above.

Statement (d) is incorrect. The IS curve shifts to the right, so there must be some effect on
output and the interest rate.

Question 8

Which of the following statements about the paradox of thrift is correct?

(a) There is a paradox of thrift because an increase in desired saving leads to lower
income and lower consumption.
(b) There is a paradox of thrift because an increase in desired saving leads to higher
income and lower consumption.
(c) There is a paradox of thrift because saving is not equal to investment.
(d) There is a paradox of thrift because lending to the government does not boost
investment.

The answer is (a).

Statement (a) is correct. Saving more (thrift) can be have a paradoxical effect because a
reduction in aggregate demand from less consumption can reduce income (see the IS-LM model).
This is paradoxical because saving is usually thought to improve the financial position of a
household, but if it leads to lower income for the economy as a whole, this might not be the case.

Statement (b) is incorrect. What is described in this case is not paradoxical. Instead, this might
describe the process through which greater saving leads to greater capital accumulation and
higher income in the long run, with consumption falling in the short run.

Statement (c) is incorrect. In equilibrium in a closed economy, national saving must always be
equal to investment.

Statement (d) is incorrect. Lending more to the government may not boost investment (the
government might be borrowing to pay for public services today, rather than to finance
infrastructure investment), but this has nothing to do with the paradox of thrift.

Question 9

Which of the following statements is correct?

(a) The central bank can increase the money supply by selling bonds.
(b) The central bank can decrease the money supply by lowering its discount rate.
(c) The central bank can decrease the monetary base by increasing reserve
requirements.
(d) The central bank can increase the money supply by an unsterilized purchase of
foreign exchange reserves.

The answer is (d).

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EC1002 Introduction to Economics

Statement (a) is incorrect because an open-market sale of bonds by the central bank would
actually reduce the money supply (athe payment of money from commercial banks to the central
bank reduces the amount of money in circulation).

Statement (b) is incorrect because a lower discount rate encourages commercial banks to seek
greater discount-window loans from the central bank. When commercial banks borrow more
from the central bank, this increases the money supply.

Statement (c) is incorrect because changing reserve requirements does not itself change the
monetary base (the sum of currency and reserves). Reserve requirements may change the money
multiplier (the ratio of the broad money supply to the monetary base) if they are binding.

Statement (d) is correct. When the central bank buys foreign assets (reserves), it pays using
domestic currency, which increase the supply of money in circulation. If the purchase is
unsterilized, the central bank does not offset its effects on the money supply by selling bonds and
absorbing the extra money created.

Question 10

Which of the following statements about perfect capital mobility is correct?

(a) If the domestic interest rate is equal to the foreign interest rate then the
financial account of the balance of payments must be zero.

(b) If the domestic interest rate is above the foreign interest rate then the financial
account of the balance of payments must be negative.

(c) If the domestic interest rate is different from the foreign interest rate then the
financial account of the balance of payments is zero.

(d) If the domestic interest rate is equal to the foreign interest rate then the
financial account of the balance of payments might be negative.

The answer is (d).

Statement (a) is incorrect because investors would be indifferent between domestic and foreign
assets if the interest rates are same, but this does not mean that the financial account of the
balance of payments must be zero. If a positive or negative financial account is needed to finance
a negative or positive current account balance then this is consistent with perfect capital
mobility because investors do not mind whether they obtain domestic or foreign assets.

Statement (b) is incorrect because if the domestic interest rate is higher than the foreign interest
rate, investors prefer to hold domestic rather than foreign assets. Purchases of domestic assets by
foreigner or sales of foreign assets by domestic residents contribute to a positive financial
account. With perfect capital mobility, these capital flows would be large, so the financial
account would be unambiguously positive.

Statement (c) is incorrect because if there is a difference between the domestic and foreign
interest rates, there will be large capital flows in one direction under perfect capital mobility.
The financial account cannot be zero in this case.

Statement (d) is correct for the reasons explained above. With domestic and foreign interest
rates the same, investors are indifferent between domestic and foreign assets, so the financial
account might be negative (but being positive or zero would also be consistent with perfect
capital mobility).

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Examiners commentaries 2017

Section B: Microeconomics long questions

Answer one of the following two long questions (30 marks each). It is essential that you explain your
answers.

Question 11

A consumer has preferences over two goods, coconuts and fish. The consumer
prefers more of each good to less, and has a diminishing marginal rate of
substitution between the two goods.

(a) [4 marks] Draw a diagram showing indifference curves and the budget
constraint of the consumer (with coconuts on the horizontal axis and fish on the
vertical axis). Show how the consumers optimal consumption choice is found in
the diagram.
(b) [12 marks] The price of coconuts rises. Draw diagrams showing how the change
in consumption of coconuts can be broken down into income and substitution
effects in each of the following three cases:
i. Coconuts are a normal good;
ii. Coconuts are a Giffen good;
iii. Coconuts are an inferior good, but not a Giffen good.
(c) [8 marks] Now suppose the consumer is a farmer whose income comes only from
selling a fixed supply of coconuts. This means that when the price of coconuts
increases by x%, the consumers income also increases by x%. Assuming that
coconuts are a normal good, will the consumer necessarily consume fewer
coconuts? Explain your answer by illustrating income and substitution effects in
a diagram.
(d) [6 marks] The theory of labour supply is based on a trade-off between two
goods, leisure and consumption. Explain the similarity between this decision
and the consumption choice problem in part (c). What is the role of income and
substitution effects in understanding the effect of higher wages on labour
supply?

(a) The indifference curves are downward sloping because the consumer prefers more of each
good to less. The indifference curves have a concave shape because the marginal rate of
substitution between the goods (the absolute value of the gradient of an indifference curve)
is diminishing [1 mark for drawing indifference curves correctly].
Fish

Indifference curves

Budget constraint

Coconuts
C
The consumers choices are limited by a budget constraint. This is a downward-sloping
straight line, and the absolute value of the gradient is equal to the relative price of the two
goods [1 mark for drawing budget constraint correctly]. The optimal consumption
choice for the consumer is on the highest indifference curve that can be reached along the
budget constraint. Geometrically, this is where an indifference curve is tangent to the

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EC1002 Introduction to Economics

budget constraint, because the indifference curve does not cut the budget line in this case (if
it did, there must be a higher indifference curve that can be reached along the budget line)
[2 marks for correctly illustrating optimal choice].

(b) An increase in the price of coconuts makes the budget line steeper [1 mark] and pivots it
around the point where it intersects the vertical axis (the consumer could continue to buy
the same amount of fish if no coconuts were consumed before) [1 mark].

The response of the consumer can be broken down into substitution and income effects. The
substitution effect is the response to the relative price change were the consumer also to face
a hypothetical lump-sum transfer that leaves the consumer as well off as before. This
captures the incentives provided by the relative price change to adjust the chosen
consumption bundle. The income effect is the response to removing the hypothetical
transfer, holding constant the relative price. This captures the effect of the price change
making the consumer worse off or better off.

The substitution effect is found by considering a hypothetical budget line with the same
higher gradient as the new budget line, but tangent to the original indifference curve. This
is parallel to the new budget line, but not in the same position owing to the presence of a
hypothetical transfer of income [1 mark for drawing this budget line correctly]. The
tangency point would be the optimal consumption choice when faced with this budget line.
Consumption of coconuts must be lower, so the substitution effect is unambiguously
negative [1 mark].

The income effect is found by removing the hypothetical transfer, which means considering
the parallel shift of the hypothetical budget line to its true position. This is an inward shift
[1 mark]. The consumers response to this depends on whether coconuts are a normal or an
inferior good [1 mark].

i. If coconuts are a normal good, the income effect of a inward shift of the budget line is
negative [1 mark]. Both substitution and income effects point to a reduction in
consumption of coconuts, so demand for coconuts is unambiguously lower [1 mark].

Coconuts are a normal good


Fish

SE

IE
Coconuts

ii. Now suppose coconuts are a Giffen good. This requires that coconuts are also an inferior
good. For an inferior good, an inwards shift of the budget line leads to an increase in
consumption of that good. The income effect is positive in this case, which goes against
the substitution effect. The case of a Giffen good is where the income effect actually
outweighs the substitution effect and demand for coconuts rises [2 marks].

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Examiners commentaries 2017

Coconuts are a Giffen good


Fish

SE

IE
Coconuts
iii. The final case is where coconuts are an inferior good, but not a Giffen good. The income
effect is positive, but does not outweigh the substitution effect [1 mark]. The demand
for coconuts declines, but not by as much when coconuts were a normal good [1 mark].
Coconuts are an inferior good
Fish

SE

IE
Coconuts

(c) In this case, the consumer is a farmer who derives income from selling a fixed supply of
coconuts. When the price of coconuts rises by x%, the income of the farmer rises by the
same percentage. The effect of the price increase is to raise the gradient of the budget line
as before [1 mark]. But now, the associated rise in income shifts the budget line outwards
[1 mark]. Since income increases in proportion to the price of coconuts, the amount of
coconuts that can be consumed if no fish is bought is unaffected by the price increase. The
new budget line is effectively a pivot of the old budget line around the point where it
intersects the horizontal axis [1 mark]. The horizontal coordinate of this point is the
supply of coconuts available to the farmer.

Fish

SE

IE
Coconuts

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EC1002 Introduction to Economics

The substitution effect is obtained using the same method as before. The rise in the price of
coconuts implies a negative substitution effect on consumption of coconuts [1 mark].
Differently from before, the new budget line is reached by an outward shift of the budget
line used to calculate the substitution effect [1 mark]. This is because a rise in the price of
coconuts puts a seller of coconuts in a better position. Assuming coconuts are a normal
good, this positive income effect increases consumption of coconuts and goes against the
substitution effect [1 mark]. It is possible that the farmers consumption of coconuts rises
when the price increases, even though coconuts are a normal good [2 marks].
(d) The theory of labour supply has the consumer choosing leisure and consumption of a general
basket of goods [1 mark]. This choice can be analysed using the indifference curve and
budget constraint diagram. Suppose that leisure is on the horizontal axis and consumption
on the vertical axis. The consumer has a certain amount of time that can be used either for
leisure or for work. Each unit of time spent working results in the consumer earning wage
income. The resulting budget constraint is a downward-sloping line with gradient equal to
the (real) wage (in absolute value) [1 mark]. The budget line meets the horizontal axis at
the total amount of time the consumer has available [1 mark].
A change in the wage has an exactly analogous effect on the budget line as in the analysis of
the coconut-producing farmer from part (c) [1 mark]. The higher wage has a negative
substitution effect on leisure and a positive income effect (assuming leisure is a normal
good) [1 mark]. The wage is essentially the market price of leisure, and a rise in the wage
can be analysed in the same way as the rise in the price of the good produced by the farmer
[1 mark].

Question 12

A monopolist can produce a good with a constant marginal cost of 1. There are two
groups of customers. The first group would buy an amount Q = 7 P at price P .
The second group would buy an amount Q = 6.5 0.5P at price P .

(a) [6 marks] Suppose the monopolist can set a price paid only by those in the first
group of customers. Find the profit-maximizing value of this price and the
quantity sold to the first group.
(b) [7 marks] Suppose the monopolist can practise price discrimination and charge a
different price to the customers in the second group. Find the profit-maximizing
value of this price and the quantity sold to the second group.
(c) [10 marks] Now suppose the monopolist cannot practise price discrimination
and must charge one price for all customers. Write down the total demand
function faced by the monopolist and calculate the profit-maximizing price and
total quantity sold.
(d) [7 marks] How much extra profit does the monopolist gain by being able to
practise price discrimination? Explain why it is in the interests of the
monopolist to charge different prices to the two groups of customers.

In this question, marginal costs are constant, M C = 1, which implies total costs are T C = Q.

(a) The first group of customers has demand function Q1 = 7 P1 if they are charged a price
P1 . The inverse demand function is P1 = 7 Q1 , which gives the price P1 that must be
charged if the monopolist is to sell an amount Q1 to this group. Total revenue is therefore
equal to T R1 = P1 Q1 = (7 Q1 )Q1 , and the total costs of producing output to be sold to
the first group is T C1 = Q1 . The monopolists profits from selling to the first group of
customers (as a function of the quantity sold Q1 ) are [3 marks]:
1 = (7 Q1 )Q1 Q1 = 6Q1 Q21
The profit-maximizing quantity is obtained by differentiating profits 1 with respect to Q1
and setting this to zero [2 marks]:
1 6
= 6 2Q1 = 0 Q1 = =3
Q1 2

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Examiners commentaries 2017

The profit-maximizing price is found by substituting this quantity into the inverse demand
function: P1 = 7 3 = 4 [1 mark].
(b) It is assumed the monopolist can charge a different price P2 to the second group of
customers without affecting demand from the first group (because the market can be
segmented) [1 mark]. The demand function of the second group is Q2 = 6.5 0.5P2 .
Multiplying both sides by 2 yields 2Q2 = 13 P2 , and hence the inverse demand function is
P2 = 13 2Q2 . Total revenue from selling to the second group is therefore
T R2 = P2 Q2 = (13 2Q2 )Q2 , and total costs are T C2 = Q2 . The monopolists profits from
selling to the second group of customers are [3 marks]:
2 = (13 2Q2 )Q2 Q2 = 12Q2 2Q22
The profit-maximizing quantity is obtained by differentiating profits 2 with respect to Q2
and setting this to zero [2 marks]:
2 12
= 12 4Q1 = 0 Q1 = =3
Q2 4
The profit-maximizing price is found by substituting this quantity into the inverse demand
function: P1 = 13 2 3 = 7 [1 mark]. This price is greater than the profit-maximizing
price for the first group of customers.
(c) If the markets cannot be segmented then the monopolist can only charge one price P to all
customers. The total amount Q sold is the sum of demand from the two groups, that is,
Q = Q1 + Q2 . The total demand function is [4 marks]:
Q = (7 P ) + (6.5 0.5P ) = 13.5 1.5P
Multiplying both sides by 2 yields 2Q = 27 3P , and hence 3P = 27 2Q. The inverse
demand function is thus P = 9 2Q/3. Total revenue and total costs are
T R = (9 2Q/3)Q and T C = Q, which imply that profits from selling to both groups at a
common price are [3 marks]:
2Q2
= (9 2Q/3)Q Q = 8Q
3
The profit-maximizing quantity is obtained by differentiating profits with respect to Q
and setting this to zero [2 marks]:
4Q 83 24
=8 =0 Q= = =6
Q 3 4 4
The profit-maximizing price is found by substituting this quantity into the inverse demand
function: P = 9 2 6/3 = 9 4 = 5 [1 mark]. This price lies between the prices 4 and 7
charged to the two groups of customers separately in parts (a) and (b).
(d) The monopolists total sales when it practises price discrimination are the sum of Q1 and Q2
from parts (a) and (b), thus Q = 3 + 3 = 6. It turns out that this is the same as the total
quantity sold Q = 6 when a common price must be charged to both groups. Total costs are
therefore the same in both cases, and any difference in profits comes from differences in total
revenue. Total revenue with a common price is T R = 5 6 = 30. Total revenues from the
two groups charged the different prices from parts (a) and (b) are T R1 = 4 3 = 12 and
T R2 = 7 3 = 21, that is, 12 + 21 = 33 in total. The difference in total revenues, and thus
in profits, is 33 30 = 3 [4 marks]. This is the gain to the monopolist from being able to
practise (third-degree) price discrimination between the two groups of customers.
Intuitively, the gains from price discrimination come from the two groups of customers
having different price sensitivities. A unit increase in price lowers demand from the first
group by one unit, but only by half a unit for the second group. Therefore, it is possible to
sell an extra unit to the first group with a smaller price reduction and what would be
required to sell this extra unit to the second group. This means that if the prices paid by
the two groups were the same, the first group would have a higher marginal revenue than
the second group. It then makes sense to sell more to the first group at a lower price and
less to the second group at a higher price [3 marks].

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EC1002 Introduction to Economics

Section C: Macroeconomics long questions

Answer one of the following two long questions (30 marks each). It is essential that you explain your
answers.

Question 13

(a) [6 marks] Explain why inflation has a positive effect on aggregate supply in the
short run, and a negative effect on aggregate demand.

(b) [8 marks] Suppose the economy is hit by a negative demand shock and the
central bank would like to stabilize both output and inflation. What is the best
action the central bank can take, and what are the consequences for the
nominal and real interest rates?

(c) [8 marks] Alternatively, suppose the economy is hit by a temporary negative


supply shock and the central bank would like to stabilize output. What action
should the central bank take, and what are the consequences for the nominal
and real interest rates? Can the central bank also stabilize inflation? Explain.

(d) [8 marks] If the negative supply shock is permanent, would loosening monetary
policy help to stabilize output in the long run? What would be the
consequences of the shock and the policy response for inflation and for nominal
and real interest rates?

(a) In the short run, the growth rate of nominal wages has already been set and will not be
revised until the next round of wage negotiations. Any increase in the inflation rate
therefore results in a real wage which is lower than it otherwise would be. A lower real wage
provides an incentive for firms to increase demand for labour (it is optimal to demand labour
up to the point where the real wage is equal to the diminishing marginal product of labour).
If wages have been set such that desired labour supply is greater than labour demand then
workers will be willing to supply additional labour at the new lower real wage. This increase
in employment leads firms to produce more output, increasing aggregate supply [3 marks].

SAS

AD
Y

On the demand side, an increase in inflation is assumed to lead the central bank to raise the
nominal interest rate more than one-for-one with the rise in inflation. The Fisher equation
(real interest rate equals nominal interest rate minus inflation) implies that this action
should raise the real interest rate, which has a negative effect on investment demand. This
demonstrates a negative relationship between inflation and aggregate demand [3 marks].

(b) The occurrence of a negative demand shock shifts the AD curve to the left [1 mark]. This
would reduce both output and inflation in the absence of any shift in the monetary policy
stance.

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Examiners commentaries 2017

SAS

AD1
AD2
Y
Y1

Suppose the central bank cares about both output and inflation. Loosening the stance of
monetary policy would shift the AD curve back to the right, raising both output and
inflation. Therefore, the central bank achieves its goals of stabilizing both output and
inflation if it loosens its policy stance to the point where this completely offsets the shock to
aggregate demand and returns the AD curve to its original position [3 marks]. Note that
monetary policy is able to stabilize both output and inflation when the economy is hit by
demand shocks [1 mark].
If monetary policy is to maintain an unchanged level of demand following a negative shock,
it must reduce the real interest rate to compensate [2 marks]. Since there is no change in
inflation if this stabilization policy is effective, the nominal interest rate must also fall by the
same amount because inflation remains unchanged [1 mark].
(c) A temporary negative supply shock shifts the SAS curve to the left [1 mark]. Since it is
temporary, it does not affect inflation expectations. In the absence of a change in the
monetary policy stance, output would fall and inflation would rise. If the central bank
would like to stabilize output then a looser monetary policy stance is needed. This shifts the
AD curve to the right, and it is possible to offset the effects of the shock on output if the
size of the AD shift to the right is equal to the size of the SAS shift to the left [2 marks].


SAS2

2 SAS1

AD2
AD1
Y
Y1

Since output remains the same and there has been no demand shock, the real interest rate
must remain unchanged [2 marks]. The rise in inflation and the stable real rate mean that
the nominal interest rate must rise [1 marks]. Although monetary policy has been
loosened, the rise in inflation triggers an increase in the nominal interest rate. But alongside
the initial monetary easing, this is only sufficient to match the increase in inflation, leaving
the real interest rate unchanged.
Note that it is impossible to use monetary policy to stabilize both inflation and output in
this case. The aggregate supply curve has shifted, but monetary policy only directly affects
demand. Consequently, a better performance for inflation can only be obtained at the cost
of a worse performance for output [2 marks].

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EC1002 Introduction to Economics

(d) The aggregate supply curve is vertical in the long run [1 mark]. This is because errors in
forecasting inflation should not persist in the long run, which means that the actual real
wage is determined through wage negotiations rather than the realized rate of inflation.
Since the aggregate supply curve is vertical, a looser monetary policy does not help to
stabilize output [2 marks], which is independent of monetary policy in the long run. The
only effect of the looser monetary policy is a further rise in inflation [2 marks].

AS2 AS1

AD2
AD1
Y
Y2 Y1
Since the level of output falls with supply, demand must also be lower in equilibrium. This
requires a higher real interest rate [2 marks]. With a rise in both inflation and the real
interest rate, the nominal interest rate must rise unambiguously [1 mark].

Question 14

Output Y is produced using capital K and labour L with constant returns to scale
and diminishing returns to capital and labour individually. The production function
is Y = f (K, L), capital depreciates at rate , the population grows at rate n, and the
saving rate is s.

(a) [6 marks] Use a diagram to show the economy has a steady state for capital per
person k and output per person y. Explain.
(b) [8 marks] There is an increase in the saving rate. Explain why this does not lead
to permanently higher growth in output per person. If there is no permanent
effect on growth, would it ever make sense for an economy to save more?
(c) [8 marks] There is an increase in population growth. Since the marginal product
of labour is diminishing, will there be a permanent decline in the growth rate of
output per person? Explain.
(d) [8 marks] The economy now experiences permanent (labour-augmenting)
technical progress at rate t. What will be the steady-state growth rates of
capital per person and output per person in this case? Since capital per person
is increasing, is the marginal product of capital declining over time? Explain.

(a) The change in the capital stock is K = I K, where I = sY is investment. This implies
the growth rate of the capital stock is:
K Y
=s
K K
Capital per worker and output per worker are defined by k = K/L and y = Y /L, and hence
Y = yL and K = kL. It follows that Y /K = y/k. Using the constant returns to scale
property of the production function Y = f (K, L):
 
f (K, L) K L
y= =f , = f (k, 1) = F (k)
L L L

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Examiners commentaries 2017

The growth rate of the capital stock is therefore:


K F (k)
=s
K k
There is a steady state for capital per person k = K/L when K and L are growing at the
same rate. The growth rate of L is n, therefore a steady state is reached when:
F (k)
s =n
k
which is equivalent to sF (k) = ( + n)k. The left-hand side is investment per person
i = sy = sF (k). The right-hand side is the amount that needs to be invested per person to
ensure capital per person remains stable (both to replace worn-out capital and to add new
capital to keep up with growth in the population). When the left-hand side is greater than
the right-hand side, k is growing, when the right-hand side is greater, k is declining, and
when the equation holds exactly, k is stable.

y

y

( + n)k

i = sy

k
k
Geometrically, the right-hand side is an upward-sloping straight line with gradient + n
passing through the origin [1 mark for depreciation line]. The left-hand side scales down
the per-worker production function F (k) using the saving rate s. Since the marginal
product of capital is positive but diminishing, this function is increasing and concave [2
marks for saving line]. The two lines cross at some positive level of capital per person,
and this is the steady state for k. Since y = F (k), once k reaches a steady state, so does
output per person y [3 marks for steady state].
(b) An increase in the saving rate shifts the investment per person line upwards [1 mark]. This
now intersects ( + n)k at a higher value of capital per person k2 [1 mark]. At the initial
value of capital per person k1 , investment per person exceeds the amount needed to
maintain a stable value of the ratio k, which now begins to rise over time. However, this
process comes to a halt once k2 is reached, and this point constitutes the new steady state
of the economy [1 mark]. Corresponding to this is a new higher steady state for output per
person y2 . This is greater than the initial y1 , so there is growth, but that growth does not
continue once the new steady state is reached [1 mark]. There is no effect on long-run
growth in output per person, which is zero.

y2 y
y1

( + n)k
i = s2 y
i = s1 y

k
k1 k2

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EC1002 Introduction to Economics

Intuitively, diminishing marginal returns to capital place a limit on how long growth can
continue through capital accumulation. A higher saving rate allows for more capital
accumulation, but eventually the extra capital adds so little to output and thus investment
that the extra investment is just sufficient to cover what is needed to maintain a stable level
of capital per person. This why a steady state is eventually reached and why increasing the
saving rate has no effect on long-run growth [2 marks].
Even though the saving rate does not affect long-run growth, this does not mean that there
is nothing to be gained by saving more. The new steady state features a permanently higher
level of output per person. While some of this extra output will be needed to maintain the
higher capital stock, the amount available for consumption might increase. If permanently
higher consumption can be sustained by saving more, this might be argument for increasing
the saving rate [2 marks], though it would depend on whether the short-to-medium term
sacrifice is worth the long-run benefit. Note that it is possible even long-run consumption
might decline if too much is saved.

(c) A rise in population growth n increases the gradient of the line ( + n)k [1 mark]. The
pivoting of this line to the left results in a new intersection point with the investment per
person line at a lower level of capital per person. This, and the corresponding lower level of
output per person, is the new steady state of the economy [2 marks].

y1 y
y2 ( + n2 )k

( + n1 )k
i = sy

k
k2 k1

There is negative growth in output per person for a transitional period until the new steady
state is reached. However, once that steady state is reached, output per person is stable, so
its growth rate has returned to its initial value: zero [2 marks].
Intuitively, the diminishing marginal product of labour combined with faster population
growth might suggest output per person (the average product of labour) is continually
falling. This does not happen because the capital stock grows at a faster rate in the new
steady state. As capital and labour are increasing at the same rate in the steady state, the
diminishing marginal product of labour is not relevant. Instead, constant returns to scale
applies, and output also rises at the same rate as capital and labour, leaving output per
person stable. How is it possible to increase the growth rate of the capital stock without a
higher saving rate? This is achieved by having a lower level of capital per worker, which
means that during the transitional period, capital grows at a slower rate than the
population. Consequently, the marginal product of capital increases, which means that the
marginal unit of capital produces more output. With no increase in the depreciation rate,
this extra output can be used to invest in new capital for the additional workers [3 marks].

(d) In this case, the production function is Y = f (K, LE), where E is labour-augmenting
technology, which grows at rate t. Defining k = K/LE and y = Y /LE to be capital and
output per efficiency units of labour [1 mark], the argument for the existence of a steady
state for k and y works in the same way as part (a). The only difference is that LE grows at
rate n + t, rather than n (the growth rate of L alone), so n must be replaced by n + t [1
mark]. This increases the gradient of the straight line representing the amount of
investment needed to ensure a stable value of capital per efficiency unit of labour, but
otherwise the diagram from part (a) is the same [1 mark].

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Examiners commentaries 2017

y

y

( + n + t)k

i = sy

k
k
Capital per person K/L is equal to E multiplied by capital per efficiency units of labour
k = K/LE, and output per person Y /L is equal to E multiplied by y = Y /LE. Since there
is a steady state for k and y, it follows that capital and output per person must grow at the
same rate as E, that is, at rate t [2 marks].
In the absence of labour-augmenting technological progress, an increase in capital per
person would lead to a decline in the marginal product of capital. However, with
labour-augmenting technological progress, the marginal product of capital is equal to F 0 (k),
where k = K/LE. As capital per efficiency units of labour is stable, the marginal product of
capital does not decline. Intuitively, growth in technology boosts the marginal product of
capital, and offsets the decline resulting from growth in capital per person [3 marks].

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