Universidad Carlos III de Madrid – Department of Economics

Principles of Economics - Course 2020-2021 - Problem Set 1

Conceptual Questions

Write down a short and concise answer. When you are asked to solve the question in class,
explain the concept clearly and give examples or pieces of evidence.

1. While campaigning for the US presidency on 18 March 1968, Senator Robert Kennedy
gave a famous speech questioning ‘the mere accumulation of material things’ in
American society. He said that GDP “counts the destruction of the redwood and the
loss of our natural wonder in chaotic sprawl. It counts napalm and counts nuclear
warheads and armoured cars for the police to fight the riots in our cities. It counts
Whitman's rifle and Speck's knife, and the television programs which glorify violence
in order to sell toys to our children. Yet the gross national product does not allow for
the health of our children, the quality of their education or the joy of their play. It does
not include the beauty of our poetry or the strength of our marriages, the intelligence
of our public debate or the integrity of our public officials. It measures neither our wit
nor our courage, neither our wisdom nor our learning, neither our compassion nor our
devotion to our country, it measures everything in short, except that which makes life
worthwhile. And it can tell us everything about America except why we are proud that
we are Americans.” (Underline has been added). Please read the full text available in
https://www.jfklibrary.org/learn/about-jfk/the-kennedy-family/robert-f-kennedy/robert-
f-kennedy-speeches/remarks-at-the-university-of-kansas-march-18-1968.

What statements of Robert Kennedy do you agree with and what statements you don’t
agree with? For instance, do you think that GDP “counts the destruction of the
redwood and the loss of our natural wonder…” and that GDP “…does not allow for the
health of our children, the quality of their education or the joy of their play”?

Many of the things Kennedy mentions are manufactured goods. Such goods make up a
considerable share of GDP in most countries. However, such goods may come with a
negative impact on society (like pollution resulting from their production or use),
which is typically not measured (such negative so-called external effects are introduced
in unit 12). So the question may not only be what IS measured (as JFK remarks) but
also what IS NOT measured (that he suggests should be). These are all the things that
Kennedy feels make (should make) US citizens ‘proud to be American’. Although such
aspects are of great benefit and promote the development of a more just and fair society
for all, they cannot be as easily quantified in monetary terms.

2. Use one of the following figures to answer the questions:

Figure 1.1a: https://ourworldindata.org/grapher/historys-hockey-stick-worldwide-

historical-gross-domestic-product-percapita-1990 (linear scale and ratio scale or
logarithmic)
Figure 1.1b: https://ourworldindata.org/grapher/historys-hockey-stick-gross-domestic-
product-per-capita-using-the-ratio-scale-1990?yScale=linear (linear scale and ratio
scale or logarithmic)

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 1) For Britain, identify a period of time when its growth rate was increasing and
another period in which its growth rate was roughly constant. Which figure did you
use, and why?
2) Identify a period during which GDP per capita was shrinking (a negative growth
rate) faster than in India. Which figure did you use and why?

See spreadsheet (Exercises_Week1_English.xlsx in Aula Global) for data.

1) In Figure 1.1b, you can see that Britain’s growth rate was increasing between 1700 and
2000 (the blue series becomes steeper), and roughly constant after that (the blue series
is a straight line).
2) A negative growth rate would be indicated in both the first (1.1a) and the second (1.1b)
figures by a downward-sloping line. In the second one (1.1b) you can easily see that
from around 1600 until around 1900, in China, income per capita was shrinking faster
than in India (its line is more steeply downward-sloping). In the same sense, in the
period corresponding to the WWII (1939-1945) the real GDP per capita of the UK,
Italy and Japan shrank faster than the GDP of India, because this last territory remained
less involved in the conflict.

3. Suppose you build a model of the market for umbrellas, in which the predicted number
of umbrellas sold by a shop depends on their colour and price, ceteris paribus.
1) The colour and the price are variables used to predict sales. Which other variables
are being held constant? Which of the following questions do you think this model
might be able to answer? In each case, suggest improvements to the model that
might help you to answer the question.
2) Why are annual umbrella sales higher in the capital city than in other towns?
3) Why are annual umbrella sales higher in some shops in the capital city than others?
4) Why have weekly umbrella sales in the capital city risen over the last six months?

1) In the example in this exercise, all variables apart from colour and price are held
constant. For example, weather, location and quality are held constant.
2) It depends. It seems unlikely that differences in price will provide a full
explanation. It will also be necessary to include other factors such as the population
in the regional area, regional weather, average regional income, and so on.
3) As above, only in so far as differences in sales are due to differences in price and
colour. Ideally, we would want to include a range of seller characteristics to better
understand the differences between shops.
4) As above. The key factors to include here are time-varying, such as weekly rainfall

Problems

1. Download the spreadsheet data used to create Figure 1.2 that is in the text
(https://jackblun.github.io/Globalinc/html/fig_2014.html). Choose five countries to
calculate their 90/10 ratio for income in 1980, 1990 and 2014. Describe the differences
between countries and the changes over time that you find. Can you think of any
explanations for observed changes or patterns?

See spreadsheet (Exercises_Week1_English.xlsx in Aula Global) for the data set.

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 The main aim of this question is to familiarise students with how to work with income
data and the 90/10 ratio inequality measure. The questions provide a self-led mini
research exercise. Students can follow their own interests and engage in some
independent research on the economic performance of some countries of their choice.

1. We have chosen the following 5 countries as an example:

90/10
country year ratio

Bangladesh 1980 8

Bangladesh 1990 12.06

Bangladesh 2014 17.69

Canada 1980 8.99

Canada 1990 7.93

Canada 2014 9.24

Ethiopia 1980 33.89

Ethiopia 1990 29.36

Ethiopia 2014 44.97

Germany 1980 5.61

Germany 1990 6.54

Germany 2014 7.31

Sweden 1980 4.89

Sweden 1990 5

Sweden 2014 6.28

2. Inequality in 2014 has been higher than in 1980 and 1990 in all countries. It is
particularly high in low income countries such as Bangladesh and even more
Ethiopia. In both countries this may indicate that economic growth may have
benefitted different parts of society in different ways. Canada, Germany and
Sweden look similar, with Sweden having lowest inequality characterized by the
90:10 ratio.
3. Students may use historical events suggest possible explanations for this evolution,
but should be careful to not suggest causality.

2. Suppose the price of one unit of labour (the wage) is 10 euros and the price of one unit
of coal is 5 euros.
1) What is the relative price of labour?

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 2) Using the method explained in the text, write down the equation of the isocost line
for a cost of 60 euros, and write it in the standard form, y = a + b x.
3) Write down the isocost line in both forms when the cost is 30 euros and when the
cost is 90 euros. Represent all the isocost lines in a graph. What happens to the
isocost line when the price of coal rises to 20 euros and the wage remains equal to
10 euros? Compare the initial isocost line and the new isocost line using the same
diagram for a total cost of 60 euros.

See spreadsheet (Exercises_Week1_English.xlsx in Aula Global) for graphs.

1) If the firm hires one additional unit of labour, the relative price of labour indicates
how many units of coal the firm must reduce to keep total cost constant. The
relative price of labour is shown by the slope of the isocost line: -(w/p) = -(10/5) = -
2. For instance, at this relative price of labour, if the firm spends 10 euros by hiring
an extra worker, it needs to reduce coal purchases by 2 units (tonnes) in order to
keep total cost the same.

2) We can follow the steps in the text to write and simplify the isocost line.
c=wL+pR
60 = 10 L + 5 R
5R = 60 - 10 L
R = 12 - 2 L

3) If c = 30, the isocost line becomes R = 6 - 2 L and if c = 90, the line becomes R =
18 - 2 L. The graph looks as follows. Students should note, that only positive
values of L are economically sensible and that the new isocost lines are much
steeper than under the previous relative prices.

Other Questions

1. The following table shows the nominal GDP (in 2015 US dollars) and the population
of Japan in 2013 and 2014 (source: The World Bank). Based on this information,
which of the following statements regarding GDP per capita is correct?

a. Japan’s GDP per capita in 2013 was $36,194.42.

b. Japan’s GDP per capita fell by 6.74% between 2013 and 2014.
c. The fall in the population was enough to offset the fall in GDP, for an overall
growth in GDP per capita between 2013 and 2014.
d. Japan’s GDP per capita fell by 6.31% between 2013 and 2014.

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 a. The GDP per capita in 2013 was $4,919,563,108,372.50 / 127,338,621 =
$38,633.71. $36,194.42 is for the GDP per capita in 2014.
b. The GDP per capita was $38,633.71 in 2013 and $36,194.42 in 2014. Therefore it
changed by (36,194.42 – 38,633.71) / 38,633.71 = -6.31%.
c. The population fell by 0.16%. This was not enough to offset the fall in GDP of
6.47%.
d. The GDP per capita was $38,633.72 in 2013 and $36,194.42 in 2014. Therefore it
changed by (36,194.42 – 38,633.71) / 38,633.71 = -6.31%.

2. Capitalism is an economic system in which private property, markets, and firms

play an important role. Which of the following statements related to the terms in this
definition is correct?
a. An economic system is a way of organising the production and distribution of
goods and services in an entire economy.
b. The knowledge you attain from the CORE programme is considered private
property.
c. Forced labour where the workers receive some daily allowance is an example of a
market.
d. Employee-owned cooperatives are firms.

a. This is the definition of economic system (see Unit 1.6).

b. Human capital is something that you can use in the way that you choose and can
exclude others from using. However, it is still not considered private property as
you cannot give or sell it directly to others for them to become the owners.
c. Forced labour is not a market, as the exchange of labour and allowance is not
voluntary.
d. Employee-owned cooperatives are productive organisations but are not firms
because the owners are not private individuals who own the assets of the firm and
employ others to work there.

3. The following diagram depicts the production function of the farmers, where
diminishing average product of labour is assumed. At A the average product of labour
is 500,000/800 = 625 kg of grain per farmer. At B the average product of labour is
732,000/1,600 = 458 kg of grain per farmer. If you know that the grain output for
2,800 farmers is 894,000kg, then which of the following statements is correct?

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 See spreadsheet (Exercises_Week1_English.xlsx in Aula Global) for table and graph.

a. When the labour input is 2,800, the average product of labour is 300 kg.
b. The slopes of the rays from the origin to the production function increase along the
curve, indicating that the average product of labour is decreasing.
c. If the production function curve is an upward-sloping straight line, then there is no
diminishing average product of labour.
d. It is possible that initially there are economies of scale (for example, when there are
two farmers instead of one, the average output increases as they efficiently share
the workload).

a. The average product of labour is 894,000 / 2,800 = 319 kg.

b. The slope of the ray from the origin is the average product of labour, so if the slope
decreases as in the graph when moving along the production function, not increases
as the statement says incorrectly, the average product of labour decreases.
c. If the production curve is an upward-sloping straight line, the average product of
labour is constant.
d. The assumption of diminishing average product of labour rules out this possibility.

4. The following figures show the real wage index in England from 1750 to 2000, and
the explanation of how England escaped the Malthusian trap in the period up to 1900.
Based on this information, which of the following statements are correct
a. These figures show evidence that increased productivity of labour increases wages
immediately.
b. Throughout the 1800s, political developments led to a fall in the workers’
bargaining power, keeping the real wage low.
c. England was able to escape from the Malthusian trap after the 1780s by being able
to increase the workers’ share of the rising output, due to an increase in the
workers’ bargaining power.

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 d. These figures demonstrate that the size of pie (the total output) does not determine
the wage rate, but it merely sets a limit on how high the wage could possibly be.

a. The increase in output per worker due to the invention of the spinning jenny and the
steam engine in 1760s to 1780s did not immediately lead to a rise in wages. In fact,
these technological improvements kept wages low by increasing unemployment, which
reduced workers’ bargaining power.
b. The expansion of voting rights and the development of the trade unions meant that the
workers’ bargaining power increased in the 1800s, leading to a rise in the real wage
(though not as steeply as in the 1900s).
c. Increases in workers’ bargaining power which started in the 1830s, not the 1780s,
meant that wages rose, allowing workers to benefit from the permanent technological
revolution (see Unit 2.10).
d. Bargaining power determines the wage rate, but the range of possible wages depends
on the size of the pie.