Econs 2015

~~EC2020 ZA d0
This paper is not to be removed from the Examination Halls
UNIVERSITY OF LONDON EC1002 Part I ZA

EC1002Q ZA
BSc degrees and Diplomas for Graduates in Economics, Management, Finance

and the Social Sciences, the Diplomas in Economics and Social Sciences and
Access Route
Introduction to Economics
Wednesday, 6 May 2015 : 14:30 to 16:00
This is Part I (Section A) of the examination, which consists of Multiple Choice

Questions.
You have 90 minutes and you should attempt to answer ALL the questions.
Each question has FOUR possible answers (a-d). There is only ONE correct answer to
each of the questions.
Please mark the correct answer in the special multiple choice answer sheet
provided using an HB pencil.
Part I is worth 50% of the marks for the entire examination.
PLEASE TURN OVER
University of London 2015

UL15/0193 Page 1 of 9 D1
SECTION A
1. An economy produces only agricultural products (x) and manufactured goods (y). A quarter of
the land in the country is arid and not suitable for agricultural products. Therefore, if half of the
arid land is not used at all:
(a) The economy could be productively inefficient with infinite opportunity cost for the
production of x (agricultural products);
(b) The economy could be productively inefficient with infinite opportunity cost for the
production of y (manufactured goods);
(c) The economy could be productively efficient when the opportunity cost of x (agricultural
products) is infinite;
(d) The economy could be productively efficient when the opportunity cost of y (manufactured
goods) is zero.
2. Consider the following economy:
600
A
400
B
250
300 450 600 x
If the economy is efficiently producing 500 units of y and the international price of x is 1.2 units
of y per x. The economy will:
(a) Specialise in x and move to produce at point A in the above diagram;

(b) Specialise in y and move to produce at point A in the above diagram;
(c) Specialise in x and move to produce at point B in the above diagram;
(d) Specialise in y and move to produce at point B in the above diagram.
Note: Specialisation is the production of goods not for the purpose of their direct consumption.

UL15/0193 Page 2 of 9 D1
3. In a world of two goods (say, x and y) an increase in the price of x which is accompanied by
money compensation for the income effect alone will lead to:
(a) A fall in quantity demanded of x and a fall in well-being;
(b) A fall in the quantity demanded of x and no change in well-being;
(c) No change in quantity demanded of x and no change in well-being;
(d) No change in quantity demand for x and a fall in well-being.
4. If good x is a normal good and y is its gross substitute then:

(a) Income elasticity of the demand for x must be greater than zero and so must be cross
price elasticity;
(b) Income elasticity of the demand for x is less than zero and so is the cross price
elasticity;
(c) Income elasticity of the demand for x must be greater than zero and cross price
elasticity must be less than zero;
(d) Income elasticity of the demand for x must be less than zero and cross price elasticity
greater than zero.
5. An increase in wages will lead to a long-run expansion path with:

(a) A lower capital to labour ratio;
(b) A higher capital to labour ratio;
(c) An unchanged capital to labour ratio;
(d) A changed capital to labour ratio but the nature of the change is uncertain.
6. When long-run average costs are rising, short-run and long-run marginal costs:
(a) Never intersect;
(b) Intersect below average costs;
(c) Intersect at the level of average costs;
(d) Intersect above average costs.
7. Short-run equilibrium in a perfectly competitive market (where the number of firms is not as it
would be in the long run) is consistent with:
(a) Price equals average cost, profits are normal and the outcome is efficient;
(b) Price equals marginal cost which is greater than average cost, profits are above normal
and the outcome is inefficient;
(c) Price equals marginal cost which is greater than average cost, profits are above normal
and the outcome is efficient.
(d) Price equals marginal cost which is greater than average cost, profits are normal and the
outcome is efficient.
8. In a small country, the supply of land is perfectly inelastic. A tax on the land will:
(a) Be borne by owners of land alone regardless of price elasticity of demand;
(b) Be borne by consumers alone only if price elasticity of demand is less than unity;
(c) Be shared by consumers and owners of land equally if price elasticity of demand is unity;
(d) Be shared by consumers and owners of land regardless of price elasticity of demand;

UL15/0193 Page 3 of 9 D1
9. The monopolists marginal revenue is different from the one facing a firm in perfect competition
because:
(a) The price elasticity he faces is less than unity;
(b) The price elasticity he faces is equal to unity;
(c) The price elasticity approaches infinity;
(d) The price elasticity he faces is less than infinity.
10. A lump-sum tax levied on a monopolist will:

(a) Have no effect on the choice of output or price and cannot have any effect on the
inefficiency created by the monopolist;
(b) Have no effect on the choice of output or price but could reduce the inefficiency created by
the monopolist depending on what the government is doing with the tax revenues;
(c) Cause a fall in output and an increase in price which would make the inefficiency worse;
(d) Cause a fall in output and an increase in price which would reduce the inefficiency.
11. A firm in monopolistic competition faces, in the long run, a demand with price elasticity of
-2 (, = 2) and a cost function of: () = 400 + 4 . Long run equilibrium is where:
(a) = 8; = 200 and profits are above normal;
(b) = 4; = 100 and profits are normal;
(c) = 8; = 100 and profits are normal;
(d) = 8; = 100 and profits are above normal.
12. In a market where two firms interact strategically, the total demand they face is given by:
() = 1,000 3 The cost of production is given by: () = 100
(a) Deadweight loss will be 15,000;
(b) Deadweight loss will be 20,000;
(c) Deadweight loss will be 10,000;
(d) Deadweight loss will be 5,000.
13. In a world of two goods (x and y) technological improvements in the production of x will lead
to:

(a) A fall in the relative price of x (a decrease in ) but not necessarily an expansion of the

x industry;
(b) A fall in the relative price of x with a necessary expansion of the x industry;
(c) An increase in the relative price of x with a necessary expansion of the x industry;
(d) An increase in the relative price of x but not necessarily an expansion in the x industry.
14. The contract curve is the collection of points where:

(a) Offer curves (Price-Consumption Curves) are tangent to each other;
(b) Offer curves are tangent to indifference curves;
(c) Indifference curves intersect offer curves;
(d) Indifference curves are tangent to each other.

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15. In an economy there are two goods which are produced by labour. The wage level is 10 and the
marginal product of labour in the x industry is 10 units of x; the marginal product of labour in the
y industry is 5 units of y. A unit of labour employed in x produces 2 units of a substance Z, each
unit of which destroys a unit of y. Markets are competitive.
1
(a) Market price of x in units of y is a unit of y per x ( = 2) which is the same as the

social cost;
3
(b) Market price of x in units of y is 3/5 a unit of y per x ( = 5) which is greater than the

social cost (which is units of y per x);
1
(c) Market price of x in units of y is a unit of y per x ( = 2) which is smaller than the

social cost (which is 3/5 units of y per x);
3
(d) Market price of x in units of y is 3/5 a unit of y per x ( = 5) which is the same as the

social cost.
16. An unplanned increase in stocks will occur at the following level of national income in the
diagram below:
AE
AE ( r0 )
y
y1 y0 y2
(a) At 0 because planned investment is greater than actual investment;

(b) At 2 because planned investment is lower than planned savings;
(c) At 1 because planned investment is greater than planned savings;
(d) At none of these because actual investment always equals actual savings.

UL15/0193 Page 5 of 9 D1
17. The only change which happened between the previous and the current year is that while in the
previous year, all of the 100 million worth of imports were used for consumption, now all imports
are directed exclusively to investment. Therefore this will affect the national account of the
current year by:
(a) A decrease in consumption by a 100 million and an increase in investment by 100 million;
(b) A decrease in consumption by 100 million times the multiplier and an equivalent increase
in investment;
(c) A decrease in consumption by 100 million times the multiplier and an increase in
investment by 100 million;
(d) No change at all.
18. The following information (in billions) about an economy is given: Net taxation = 600;
Government spending = 400; Private consumption = 800; Imports = 200 and private savings =
300:
(a) National income will be 1,700 and if investment equals 300, exports must be equal to 400;
(b) National income will be 1,500 and if investment equals 300, exports must be equal to 200;
(c) National income will be 2,000 and if investment equals 300, exports must be equal to 300;
(d) National income will be 1,800 and if investment equals 300, exports must be equal to 400.
19. In an economy, the marginal propensity to consume is 0.8. The government balances the
budget by adjusting the proportional tax level to the required government spending. An increase
by 10 million in government required spending will lead to an increase in equilibrium level of
national income by:
(a) 20
(b) 50
(c) 10
(d) 30
20. Eliminating all charges for the use of cash withdrawal machines will:
(a) Increase demand for liquid assets and reduce the price of bonds;
(b) Increase the supply of liquid assets and increase the price of bonds;
(c) Reduce demand for liquid assets and increase the price of bonds;
(d) Reduce the supply of liquid assets and reduce the price of bonds.
21. An increase in income will:

(a) Increase demand for liquid assets;
(b) Reduce demand for liquid assets;
(c) Have no effect on the demand for liquid assets;
(d) Only have a direct effect on the supply of liquid assets.

UL15/0193 Page 6 of 9 D1
22. The money base equals 40 billion, the total amount of loans equal 120 billion. Therefore, with a
reserve ratio of 20% the supply of liquid assets will be equal to:
(a) 120 billion
(b) 140 billion
(c) 180 billion
(d) 160 billion
23. Consider the following diagram:

LM ( M 0 , P2 ) LM ( M 0 , P1 )
r
C
r2 LM ( M 0 , P0 )
r1 B
r0 A IS (' )
IS ()
Y
p SAS ( w1 )
SAS ( w0 )
C
p2
p1 B
p0 A
AD (' )
AD ()
Y
Y0 Y1
Which of the following could have triggered on its own the changes depicted in this diagram (the
move from A to C)?
(a) An increase in the autonomous element of government spending;
(b) A reduction in the rate of a proportional tax;
(c) An increase in the supply of liquid assets;
(d) A fall in the marginal propensity to consume.
24. In an open economy with no capital mobility and a fixed exchange rate, an increase in the
marginal propensity to import will:
(a) Reduce equilibrium level of national income and reduce the interest rate;
(b) Increase equilibrium level of national income and have no effect on the interest rate;
(c) Reduce equilibrium level of national income and increase the interest rate;
(d) Reduce equilibrium level of national income and have no effect on the interest rate.

UL15/0193 Page 7 of 9 D1
25. In an open economy, if only the demand for consumption and imports are dependent on income
and the marginal propensity to consume is the same as the marginal propensity to import, the
multiplier will be:
(a) Equal to 1 if there is lump-sum tax and less than 1 if the tax is proportional;
(b) Equal to 1 if there is a proportional tax and greater than 1 if there is a lump-sum tax;
(c) Equal to 1 if there is a lump-sum tax and greater than 1 if the tax is proportional;
(d) Equal to 1 if there is a proportional tax and less than 1 if there is a lump-sum tax.
26. An increase in the rate of a proportional tax will affect the IS schedule (relative to the current
position) in the following way:
(a) Shift to the left and become flatter;
(b) Shift to the right and become steeper;
(c) Shift to the left and become steeper;
(d) Shift to the right and become flatter.
27. There is a fixed exchange rate regime. Assuming that all accounts are balanced in the balance
of payments, a sale of a local enterprise to a foreign buyer will create:
(a) A surplus in the capital account which will lead to a fall in reserves;
(b) A surplus in the capital account which will lead to an increase in reserves;
(c) A deficit in the capital account which will lead to a surplus in the current account;
(d) A deficit in the capital account which will lead to a fall in reserves.
28. When there are expectations that there will be inflation and expectations are rational, the long
run equilibrium will be:
(a) When the actual rate of inflation is the same as the expected rate;
(b) Where the actual rate of inflation is lower than the expected rate;
(c) Where the actual rate of inflation is higher than the expected rate;
(d) There cannot be equilibrium when there are expectations of inflation.

UL15/0193 Page 8 of 9 D1
29. The possible effects of a fall in the international interest rate are depicted in the diagram below
for an open economy with perfect capital mobility:
r
LM ()
LM (' )
A
r0 r0 * BOP
B C
r1 * BOP
IS ()
IS (' )
Y
Y1 Y0
If the economy has a flexible exchange rate, the economy will end up at point:
(a) A
(b) B
(c) C
(d) D
30. An increase in international prices in an open economy with perfect capital mobility and a
flexible exchange rate will:
(a) Lead to an increase in long-run output without a long-run change to the interest rate;
(b) Lead to a fall in long-run output without a long-run change to the interest rate;
(c) Lead to no change in long run output but a long run increase in the interest rate;
(d) Lead to no change in output or interest rate in the long run.
END OF PART I

UL15/0193 Page 9 of 9 D1
~~EC2020 ZA d0
UNIVERSITY OF LONDON EC1002 Part II ZA

Access Route
Wednesday, 6 May 2015 : 16:00 to 17:30
This is Part II (Sections B and C) of the examination.
Candidates should answer TWO of the following SIX questions: ONE question from
Section B and ONE from Section C.
Part II is worth 50 marks and each of the questions in Sections B and C is worth 25
marks.
PLEASE TURN OVER

UL15/0195 Page 1 of 4 D1
SECTION B
Answer ONE question from this section.
1. A referendum in Love-Thy-Neighbour forces the government of the country to use its tax
revenues to provide every citizen regardless of whether he or she is working with a basic
income (B). This is calculated on the basis of the market value of an essential bundle made
up of units of x and units of y (which are the only two goods in the economy).
(a) Describe the choice that will now be made by an individual who does not work and
therefore, has no other source of income.
(b) Describe how the introduction of the programme will affect the choices and well-being
of those individuals who normally work (and so earn a regular income).
(c) To help fund the scheme, the government levies a tax on commodity x (the less
essential of the two goods). How will the tax affect the choices and well-being of
individuals who rely entirely on their basic income (B)? Analyse the income and
substitution effects for an individual who at first chose to consume the essential bundle.
Will one of the goods necessarily be inferior?
(d) How will the introduction of the tax affect those who work as well as receive their basic
income? Will they be able to continue consuming the same bundle as before? Will their
well-being change? If so, how?
(e) If the purpose of the policy is to introduce greater equity, will it work?
2. The production of Organic Fig-based wine (called Fine) attracts two types of buyers:
environmentally conscious individuals with low price elasticity and carefree individuals (with high
price elasticity). The market is competitive and the government wishes to enlarge the circle of
people who buy organic-based products. To do so, the government proposes to offer a lump-
sum subsidy to the producers.
(a) Draw the initial equilibrium in the market.
(b) Analyse the effects of the lump-sum subsidy on price, output, the distribution of
consumption between the two groups and spending by each group;
(c) Critics of the government have argued against this proposal and suggested considering a
subsidy targeted at the carefree population. Analyse the effects of each of these
proposals;
(d) Assess the implications of the two policies for the welfare of the two groups of consumers.

UL15/0195 Page 2 of 4 D1
3. Consider a monopolist who faces a linear demand. The price elasticity of demand at the
profit maximising quantity is given as -2. The marginal cost is constant at 20, the average
cost at that point is 30 and the profits are 1,000.
(a) What will be the equilibrium price?
(b) What will be the equilibrium quantity?
(c) What will be the deadweight loss created by the monopolist?
(d) If there were two firms in the market, what would be their respective reaction functions?
Would a Nash equilibrium be viable?
SECTION C
4. A vicious civil war in a neighbouring country created an unprecedented influx of refugees into a
country. To deal with the refugees who arrived penniless, the government has had to increase
its transfer payments. Suppose that the country in question is a closed economy (though with
open borders).
(a) Describe the initial equilibrium in the economy before the influx of refugees.
(b) How will the influx of refugees affect the economy in the short run? What will happen to
output, prices, wages and domestic investment?
(c) What will happen to all these variables in the long run? What will be the distributional
consequences if only a few people in the economy have access to income from capital?
(d) How will your answer to (b) and (c) change if the refugees brought skills with them?

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5. A new government came to power in a country with corrupt institutions which stifled
investment. Using sweeping powers, the government managed to cleanse the country from
corruption and in so doing removed a considerable number of bureaucratic obstacles to
investment.
(a) Analyse the effect of this change on a closed economy with flexible prices and wages;
(b) Analyse the effect of this change on an open economy without capital mobility but with
a fixed exchange rate policy;
(c) Analyse the effects of this change on an open economy with perfect capital mobility and
a flexible exchange rate policy;
(d) Would your answer to (c) be different if the exchange rate had been fixed?
6. The aggregate demand for imported goods has a price elasticity which is less than unity.
Analyse the effects of an increase in international prices on:
(a) An open economy without capital mobility and a fixed exchange rate.
(b) An open economy with capital mobility and a flexible exchange rate.
(c) An open economy with capital mobility and a fixed exchange rate.
(d) How would your answers to (a)-(c) change if the price elasticity of demand for imported
goods had been greater than unity?
END OF PAPER

UL15/0195 Page 4 of 4 D1
~~EC2020 ZA d0
UNIVERSITY OF LONDON EC1002 Part I ZB

EC1002Q ZB

Access Route
Wednesday, 6 May 2015 : 14:30 to 16:00
This is Part I (Section A) of the examination, which consists of Multiple Choice

Questions.
Each question has FOUR possible answers (a-d). There is only ONE correct answer to
each of the questions.
Please mark the correct answer in the special multiple choice answer sheet
provided using an HB pencil.
Part I is worth 50% of the marks for the entire examination.
PLEASE TURN OVER

UL15/0194 Page 1 of 9 D1
SECTION A
1. An economy produces only agricultural products (x) and manufactured goods (y). A quarter of
the land in the country is arid and not suitable for agricultural products. Therefore, if half of the
arid land is not used at all:
(a) The economy could be productively efficient when the opportunity cost of x (agricultural
products) is infinite;
(b) The economy could be productively efficient when the opportunity cost of y (manufactured
goods) is zero;
(c) The economy could be productively inefficient with infinite opportunity cost for the
production of x (agricultural products);
(d) The economy could be productively inefficient with infinite opportunity cost for the
production of y (manufactured goods).
2. Consider the following economy:
600
A
400
B
250
300 450 600 x
If the economy is producing efficiently 500 units of y and the international price of x is 1.2 units
of y per x. The economy will:
(a) Specialise in x and move to produce at point B in the above diagram;

(b) Specialise in y and move to produce at point B in the above diagram;
(c) Specialise in x and move to produce at point A in the above diagram;
(d) Specialise in y and move to produce at point A in the above diagram.
Note: Specialisation is the production of goods not for the purpose of their direct consumption.

UL15/0194 Page 2 of 9 D1
3. In a world of two goods (say, x and y) an increase in the price of x which is accompanied by
money compensation for the income effect alone will lead to:
(a) A fall in quantity demanded of x and a fall in well-being;
(b) A fall in the quantity demanded of x and no change in well-being;
(c) No change in quantity demanded of x and no change in well-being;
(d) No change in quantity demand for x and a fall in well-being.
4. If good x is a normal good and y is its gross substitute then:

(a) Income elasticity of the demand for x is less than zero and so is the cross price
elasticity;
(b) Income elasticity of the demand for x must be greater than zero and cross price
elasticity must be less than zero;
(c) Income elasticity of the demand for x must be less than zero and cross price elasticity
greater than zero;
(d) Income elasticity of the demand for x must be greater than zero and so must be the cross
price elasticity.
5. An increase in wages will lead to a long-run expansion path with:

(a) A lower capital to labour ratio;
(b) An unchanged capital to labour ratio;
(c) A higher capital to labour ratio;
(d) A changed capital to labour ratio but the nature of the change is uncertain..
6. When long-run average costs are rising, short-run and long-run marginal costs:
(a) Intersect above average costs;
(b) Intersect below average costs;
(c) Intersect at the level of average costs;
(d) Never intersect.
7. Short-run equilibrium in a perfectly competitive market (where the number of firms is not as it
would be in the long run) is consistent with:
(a) Price equals average cost, profits are normal and the outcome is efficient;
(b) Price equals marginal cost which is greater than average cost, profits are above normal
and the outcome is inefficient;
(c) Price equals marginal cost which is greater than average cost, profits are normal and the
outcome is efficient;
(d) Price equals marginal cost which is greater than average cost, profits are above normal
and the outcome is efficient.
8. In a small country, the supply of land is perfectly inelastic. A tax on the land will:
(a) Be borne by consumers alone only if price elasticity of demand is less than unity;
(b) Be borne by owners of land alone regardless of price elasticity of demand;
(c) Be shared by consumers and owners of land equally if price elasticity of demand is unity;
(d) Be shared by consumers and owners of land regardless of price elasticity of demand.

UL15/0194 Page 3 of 9 D1
9. The monopolists marginal revenue is different from the one facing a firm in perfect competition
because:
(a) The price elasticity he faces is less than unity;
(b) The price elasticity he faces is equal to unity;
(c) The price elasticity he faces is less than infinity;
(d) The price elasticity approaches infinity.
10. A lump-sum tax levied on a monopolist will:

(a) Have no effect on the choice of output or price but could reduce the inefficiency created by
the monopolist depending on what the government is doing with the tax revenues;
(b) Have no effect on the choice of output or price and cannot have any effect on the
inefficiency created by the monopolist;
(c) Cause a fall in output and an increase in price which would make the inefficiency worse;
(d) Cause a fall in output and an increase in price which would reduce the inefficiency.
11. A firm in monopolistic competition faces, in the long run, a demand with price elasticity of
-2 (, = 2) and a cost function of: () = 400 + 4 . Long-run equilibrium is where:
(a) = 8; = 200 and profits are above normal;
(b) = 4; = 100 and profits are normal;
(c) = 8; = 100 and profits are normal;
(d) = 8; = 100 and profits are above normal.
12. In a market where two firms interact strategically, the total demand they face is given by:
() = 1,000 3 The cost of production is given by: () = 100
(a) Deadweight loss will be 20,000;
(b) Deadweight loss will be 10,000;
(c) Deadweight loss will be 5,000;
(d) Deadweight loss will be 15,000.
13. In a world of two goods (x and y) technological improvements in the production of x will lead
to:

(a) A fall in the relative price of x (a decrease in ) but not necessarily an expansion of the

x industry;
(b) A fall in the relative price of x with a necessary expansion of the x industry;
(c) An increase in the relative price of x with a necessary expansion of the x industry;
(d) An increase in the relative price of x but not necessarily an expansion in the x industry.
14. The contract curve is the collection of points where:

(a) Offer curves (Price-Consumption Curves) are tangent to each other;
(b) Indifference curves are tangent to each other;
(c) Offer curves are tangent to indifference curves;
(d) Indifference curves intersect offer curves.

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15. In an economy there are two goods which are produced by labour. The wage level is 10 and the
marginal product of labour in the x industry is 10 units of x; the marginal product of labour in the
y industry is 5 units of y. A unit of labour employed in x produces 2 units of a substance Z, each
unit of which destroys a unit of y. Markets are competitive.
1
(a) Market price of x in units of y is a unit of y per x ( = 2) which is the same as the

social cost;
3
(b) Market price of x in units of y is 3/5 a unit of y per x ( = 5) which is greater than the

social cost (which is units of y per x);
1
(c) Market price of x in units of y is a unit of y per x ( = 2) which is smaller than the

social cost (which is 3/5 units of y per x);
3
(d) Market price of x in units of y is 3/5 a unit of y per x ( = 5) which is the same as the

social cost.
16. An unplanned increase in stocks will occur at the following level of national income in the
diagram below:
AE
AE ( r0 )
y
y1 y0 y2
(a) At 0 because planned investment is greater than actual investment;

(b) At 1 because planned investment is greater than planned savings;
(c) At 2 because planned investment is lower than planned savings;
(d) At none of these because actual investment always equals actual savings.

UL15/0194 Page 5 of 9 D1
17. The only change which happened between the previous and the current year is that while in the
previous year all of the 100 million worth of imports were used for consumption, now all imports
are directed exclusively to investment . Therefore this will affect the national account of the
current year by:
(a) A decrease in consumption by a 100 million and an increase in investment by 100 million;
(b) A decrease in consumption by 100 million times the multiplier and an equivalent increase
in investment;
(c) A decrease in consumption by 100 million times the multiplier and an increase in
investment by 100 million;
(d) No change at all.
18. The following information (in billions) about an economy is given: Net taxation = 600;
Government spending = 400; Private consumption = 800; Imports = 200 and
private savings = 300:
(a) National income will be 1,500 and if investment equals 300, exports must be equal to 200;
(b) National income will be 1,700 and if investment equals 300, exports must be equal to 400;
(c) National income will be 2,000 and if investment equals 300, exports must be equal to 300;
(d) National income will be 1,800 and if investment equals 300, exports must be equal to 400.
19. In an economy, the marginal propensity to consume is 0.8. The government balances the
budget by adjusting the proportional tax level to the required government spending. An increase
by 10 million in government required spending will lead to an increase in equilibrium level of
national income by:
(a) 10
(b) 50
(c) 20
(d) 30
20. Eliminating all charges for the use of cash withdrawal machines will:
(a) Increase demand for liquid assets and reduce the price of bonds;
(b) Reduce demand for liquid assets and increase the price of bonds;
(c) Reduce the supply of liquid assets and reduce the price of bonds;
(d) Increase the supply of liquid assets and increase the price of bonds.
21. An increase in income will:

(a) Reduce demand for liquid assets;
(b) Increase demand for liquid assets;
(c) Have no effect on the demand for liquid assets;
(d) Only have a direct effect on the supply of liquid assets.

UL15/0194 Page 6 of 9 D1
22. The money base is equal to 40 billion, the total amount of loans equals to 120 billion. Therefore,
with a reserve ratio of 20% the supply of liquid assets will be equal to:
(a) 160 billion
(b) 140 billion
(c) 180 billion
(d) 120 billion
23. Consider the following diagram:
LM ( M 0 , P2 ) LM ( M 0 , P1 )
r
C
r2 LM ( M 0 , P0 )
r1 B
r0 A IS (' )
IS ()
Y
p SAS ( w1 )
SAS ( w0 )
C
p2
p1 B
p0 A
AD (' )
AD ()
Y
Y0 Y1
Which of the following could have triggered on its own the changes depicted in this diagram (the
move from A to C)?
(a) An increase in the autonomous element of government spending;
(b) An increase in the supply of liquid assets;
(c) A reduction in the rate of a proportional tax;
(d) A fall in the marginal propensity to consume.
24. In an open economy with no capital mobility and a fixed exchange rate, an increase in the
marginal propensity to import will:
(a) Reduce equilibrium level of national income and reduce the interest rate;
(b) Increase equilibrium level of national income and have no effect on the interest rate;
(c) Reduce equilibrium level of national income and have no effect on the interest rate;
(d) Reduce equilibrium level of national income and increase the interest rate.

UL15/0194 Page 7 of 9 D1
25. In an open economy, if only the demand for consumption and imports are dependent on income
and the marginal propensity to consume is the same as the marginal propensity to import, the
multiplier will be:
(a) Equal to 1 if there is lump-sum tax and less than 1 if the tax is proportional;
(b) Equal to 1 if there is a proportional tax and greater than 1 if there is a lump-sum tax;
(c) Equal to 1 if there is a lump-sum tax and greater than 1 if the tax is proportional;
(d) Equal to 1 if there is a proportional tax and less than 1 if there is a lump-sum tax.
26. An increase in the rate of a proportional tax will affect the IS schedule (relative to the current
position) in the following way:
(a) Shift to the left and become flatter;
(b) Shift to the left and become steeper;
(c) Shift to the right and become steeper;
(d) Shift to the right and become flatter.
27. There is a fixed exchange rate regime. Assuming that all accounts are balanced in the balance
of payments, a sale of a local enterprise to a foreign buyer will create:
(a) A surplus in the capital account which will lead to an increase in reserves;
(b) A surplus in the capital account which will lead to a fall in reserves;
(c) A deficit in the capital account which will lead to a surplus in the current account;
(d) A deficit in the capital account which will lead to a fall in reserves.
28. When there are expectations that there will be inflation and expectations are rational, the long-
run equilibrium will be:
(a) Where the actual rate of inflation is lower than the expected rate;
(b) Where the actual rate of inflation is higher than the expected rate;
(c) When the actual rate of inflation is the same as the expected rate;
(d) There cannot be equilibrium when there are expectations of inflation.

UL15/0194 Page 8 of 9 D1
29. The possible effects of a fall in the international interest rate are depicted in the diagram below
for an open economy with perfect capital mobility:
r
LM ()
LM (' )
A
r0 r0 * BOP
B C
r1 * BOP
IS ()
IS (' )
Y
Y1 Y0
If the economy has a flexible exchange rate, the economy will end up at point:
(a) A
(b) B
(c) C
(d) D
30. An increase in international prices in an open economy with perfect capital mobility and a
flexible exchange rate will:
(a) Lead to an increase in long-run output without a long run change to the interest rate;
(b) Lead to a fall in long-run output without a long run change to the interest rate;
(c) Lead to no change in output or interest rate in the long run;
(d) Lead to no change in long-run output but a long run increase in interest rate.
END OF PART I

UL15/0194 Page 9 of 9 D1
~~EC2020 ZA d0
UNIVERSITY OF LONDON EC1002 Part II ZB

Access Route
Wednesday, 6 May 2015 : 16:00 to 17:30
This is Part II (Sections B and C) of the examination.
Candidates should answer TWO of the following SIX questions: ONE question from
Section B and ONE from Section C.
Part II is worth 50 marks and each of the questions in Sections B and C is worth 25
marks.
PLEASE TURN OVER

UL15/0196 Page 1 of 4 D1
SECTION B
1. To encourage the use of educational products (like books, software etc. which we shall call y)
the government both offers a certain number of educational products (say, ) for free and
subsidises the price of these goods for those who want to buy more. Critics argue that it is
because of this subsidy that people have too much disposable income to use on football
goods (x). The government considers three options: (i) to tax football goods; (ii) to remove
the subsidy from educational goods (but to keep the free offer of ); (iii) to levy a fixed tax on
income to help fund the free offer of educational goods while raising it from to as well as
to remove the subsidy for the remaining educational products.
(a) Describe the initial choice an individual makes between football goods (x) and
educational products (y).
(b) How would proposal (i) affect an individuals choice and well-being? Would the
government achieve its objectives better if it had offered to compensate individuals for
the income effect resulting from the change?
(c) How would proposal (ii) affect an individuals choice and well-being? Would the
government achieve its objectives better if it had offered to compensate individuals for
the income effect resulting from the change?
(d) Along similar lines examine now proposal (iii) and form a judgement about which of
these proposals better serves the governments objectives.
2. The new UR-Phone has reached the market. The device is so advanced that it answers all the
text messages for you. The demand for UR-Phones is comprised of two large groups: the
young (for whom it has become a status symbol) and the rest of the adult population. The price
elasticity of the youngs demand is inelastic. For the rest of the population who value the
development but would still like to participate in their own lives, the price elasticity of their
demand is greater than unity. The market is perfectly competitive but the government is
concerned about the effects that this device will have on the development of cognitive skills in
the young. It considers two options: (i) Levy a unit tax on sales to youngsters; (ii) Levy a lump-
sum tax on producers.
(a) Draw the initial set-up of the market.
(b) Analyse the short-run effects of the two options on price, output, the distribution of
consumption amongst the two groups and the spending by each group.
(c) Analyse the long-run effects of the two schemes.
(d) If the two schemes lead to the same quantity of UR-Phones supplied in the market, in
which of them will the tax per unit be greater?

UL15/0196 Page 2 of 4 D1
3. Consider a monopolist who faces a linear demand. The price elasticity of demand at the
profit maximising quantity is given as -2. The marginal cost is constant at 20, the average
cost at that point is 30 and the profits are 1,000.
(d) If there were two firms in the market, what would be their respective reaction functions?
Would a Nash equilibrium be viable?
SECTION C
4. A vicious civil war in a neighbouring country created an unprecedented influx of refugees into a
country. To deal with the refugees who arrived penniless, the government had to increase its
transfer payments. Suppose that the country in question is a closed economy (though with open
border).
(a) Describe the initial equilibrium in the economy before the influx of refugees;
(b) How will the influx of refugees affect the economy in the short run? What will happen to
output, prices, wages and domestic investment?
(c) What will happen to all these variables in the long run? What will be the distributional
consequences if only a few people in the economy have access to income from capital?
(d) How will your answer to (b) and (c) change if the refugees brought skills with them?

UL15/0196 Page 3 of 4 D1
5. The fraction of national income constitutes retained profits which are entirely directed at
domestic investment. However, unease developed around the quality of the workforce in the
economy. As a result, a fraction (say, ) of the retained profits has been directed toward the
purchase of imported goods. The economy is an open economy with a proportional income
tax (no corporation tax) and a fixed exchange rate regime.
(a) What will be the multiplier of the economy?
(b) Show the initial equilibrium in the economy.
(c) How will the change in the use of retained profits affect the economy?
(d) How would your answer change if the economy had perfect capital mobility and a fixed
exchange rate?
(e) How would your answer to (d) change if the exchange rate had been flexible?
6. An open economy with perfect capital mobility is in long-run equilibrium with a chronic surplus in
its balance of payments and a large deficit in the budget.
(a) Why might a government wish to do something to alter the situation?
(b) Suppose now that the government decides that to combat the situation it must cut its
spending as well as direct part of government purchases to imports. What will be the effect
of such a policy in the case of a flexible exchange rate?
(c) Would your answer be different had there been a fixed exchange rate?
(d) What will happen to actual domestic investment if government spending and net transfers
are independent of income, in case (b) and in case (c)?
(e) How would your answer in (d) change if transfers had been dependent on the level of
income?
END OF PAPER

UL15/0196 Page 4 of 4 D1
Examiners commentaries 2015
EC1002 Introduction to economics
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 201415. The format and structure of the examination may change in future
years, and any such changes will be publicised on the virtual learning environment (VLE).
Information about the subject guide and the Essential reading references
Unless otherwise stated, all cross-references will be to the latest version of the subject guide
(2011). You should always attempt to use the most recent edition of any Essential reading
textbook, even if the commentary and/or online reading list and/or subject guide refer to an
earlier edition. If different editions of Essential reading are listed, please check the VLE for
reading supplements if none are available, please use the contents list and index of the new
edition to find the relevant section.
General remarks
Learning outcomes
At the end of this course and having completed the Essential reading and activities, you should be
able to:
define the main concepts and describe the models and methods used in economic analysis
formulate problems described in everyday language in the language of economic modelling
apply and use the main economic models used in economic analysis to solve these problems
assess the potential and limitations of the models and methods used in economic analysis.
What the examiners are looking for
This year was the second year in which we used the new format of examination where Part I, which
is made up of multiple choice questions (MCQ), constitutes 50 per cent of the total mark, and Part II,
made up of two long questions, the rest. The overall pass rate in this years examination stayed more
or less the same as that of last year which was a significant improvement on the previous year
(2013). It stood at around 60 per cent of candidates passing the examination. It should be noted that
among those who sat the paper for the first time, the pass rate was slightly higher at 62 per cent.
We are, of course, pleased that the change in the format of the examination has allowed us to
detect in a more refined manner the various levels of knowledge achieved by candidates in their
study. There is also evidence that the novelty of the new format is not an issue as there has been
improvement in candidates performance in Part I. In general, candidates perform better in Part I
than they do in Part II. The reason for this, in our view, is the fact that Part I is mainly devoted to the
first and more basic level of knowledge, which requires material recognition. Part II, on the other
hand, requires that candidates demonstrate not only that they know what the concepts and models
mean but are also able to use them. This is clearly a more demanding level of expectation and
candidates tend to do worse in it than they do in the first part. Nevertheless, there is evidence for
correlation between the performance in the two parts of the examination which is, for us, further
confirmation that the design of the examination is both helping uncover a greater breadth of
achievement as well as maintain the high standards which one should expect from a course like this
at the University of London.
Having said this we would like to reiterate that there is a difference between the level of our
expectations and the way in which the examinations are marked. Even in the second part of the
examination, where we expect candidates to demonstrate a deeper understanding of the models in
the sense that they can use them to analyse specific and well defined problems, the marking of the
answers rewards candidates on all aspects of their knowledge. This means that candidates who
choose the correct analytical framework and present it correctly are awarded points even before
they get down to the business of introducing the specifics of the question into the answer. It is
important to emphasise that candidates who fail this paper usually show very little of the first level
of knowledge (material recognition) and they do not fail because they got the details of the answers
wrong.
General advice
You may want to consider now your study process in stages. First, you must understand each section
of the material as is presented in the basic textbooks. Secondly, you must study the subject guide. If
you manage to work your way through it, you are bound to have properly understood that which is
in the textbook. Last, but not least, you should try to answer questions from the self-study sections
in the subject guide as well as from past examination papers all by yourself, without looking at the
provided answers. Once you had done this, you should carefully compare your answer with the
provided answer in the subject guide and the Examiners commentaries. Always try to reproduce the
full and correct answer by yourself.
It was very clear from the examination papers that those who failed could not have properly gone
through the first phase of the study process. At the same time, it was abundantly clear that the
candidates who did well have followed all three stages of the study process. It was clear that they
were familiar with the subject guide as well as with previous years Examiners commentaries and
that their analytical skills have been considerably enhanced in the process. Consequently, it seems
that those who have done well, have done really well.
A possible explanation of candidates failure to absorb the subject guide at the basic descriptive level
could be the false perception of its mathematical nature. There is, in fact, very little mathematics in
the subject guide and those issues, which are essential to the understanding of the guides
exposition, are discussed at length in the Mathematical preface. Please make sure that you read it
carefully before you embark on the study of economics. There is, we are afraid, no way around it.
Economics is an abstract discipline and as such it requires the use of logical tools. Without those
tools, our ability to make sense of the vast complex world of social interactions is considerably
reduced. For the very same reason a candidate is required to take a quantitative paper in his or her
first year, he or she must have a reasonable command of those very basic tools, which lie at the
foundation of human knowledge.
This, of course, should not be misread as a call for mathematical competence. Of course, things
would be easier had we all had good mathematical skills. Given that most people do not have those
skills, we must be sure not to abandon mathematical tools altogether. It is important that candidates
recognise that the guides exposition is using very basic mathematical tools, all of which are within
anyones grasp. Instead of being stifled by fear, one should recognise that candidates without any
mathematical background could meet our requirements fairly quickly. A bit more effort on this front
will guarantee that at least the descriptive standards of the course will be met.
You might have noticed that in recent years, the course became much more focused. This means
that instead of getting acquainted with a little bit of a lot of things, we now wish that you gain some
command on fewer things. The key difference here is between getting acquainted and gaining
command. For the former, one normally needs to know about economic concepts. Now, we want
candidates to know the concepts.
The essay-type or discursive writing is a method of exposition becoming the getting acquainted
approach. In such a format, one tends to write about things and to describe them. For the other
approach the active understanding approach one would need to resort to a more analytical form
of discourse. A form of discourse where the candidate is making a point or, to use a more
traditional word from rhetoric, where one is trying to persuade.
To think about writing in this way will help a great deal. It forces the candidate first to establish what
it is that he, or she, wishes to say. Once this has been established, the writer must find a way of
arguing the point. To make a point, as one may put it, basically means to know the answer to the
question before one starts writing. It is my impression that many candidates try to answer the
question while writing. A question normally triggers a memory of something which one had read in
the textbook. It somehow opens the floodgates and candidates tend to write about the subject
everything they know with little reference to what the question is really about. This is not what this
course is all about. We want the candidate to identify the tools of analysis that are relevant in each
question; we want them to show us that they know what these tools are; and, lastly, we want
candidates to be able to use the tools. Examination questions, in this course, are written in a
problem form which then requires that the candidate will be able to establish which framework of
analysis is more appropriate to deal with different problems. In their exposition, candidates are then
expected to properly present this framework. Only then are they expected to solve the problem
within this framework. All of these are now clearly marked in the breaking up of each question into
sub-questions. Although some questions may have a general appeal, we do not seek general
answers. You must think of the examination as an exercise rather than a survey.
Examination revision strategy
Many candidates are disappointed to find that their examination performance is poorer than
they expected. This may be due to a number of reasons. The Examiners commentaries suggest
ways of addressing common problems and improving your performance. One particular failing is
question spotting, that is, confining your examination preparation to a few questions and/or
topics which have come up in past papers for the course. This can have serious consequences.
We recognise that candidates may not cover all topics in the syllabus in the same depth, but you
need to be aware that examiners are free to set questions on any aspect of the syllabus. This
means that you need to study enough of the syllabus to enable you to answer the required
number of examination questions.
The syllabus can be found in the Course information sheet in the section of the VLE dedicated to
each course. You should read the syllabus carefully and ensure that you cover sufficient material
in preparation for the examination. Examiners will vary the topics and questions from year to
year and may well set questions that have not appeared in past papers. Examination papers may
legitimately include questions on any topic in the syllabus. So, although past papers can be
helpful during your revision, you cannot assume that topics or specific questions that have come
up in past examinations will occur again.
If you rely on a question-spotting strategy, it is likely you will find yourself in difficulties when
you sit the examination. We strongly advise you not to adopt this strategy.
EC1002 Introduction to economics Zone A
Important note
PART I
Section A
Each question has FOUR possible answers (ad). There is only ONE correct answer to each
of the questions.
In the multiple-choice section, this year candidates in Zone A scored a mean mark of 53.8
per cent (out of the 50 points available for this Part) which is a clear improvement on last
years mean of 49.8 per cent.
We will not reproduce here the multiple-choice questions with their right answers. There
are enough questions on the VLE with which to practise your learning interactively.
PART II
Section B
1
Question 1
A referendum in Love-Thy-Neighbour forces the government of the country to use its

tax revenues to provide every citizen regardless of whether he or she is working with
a basic income (B). This is calculated on the basis of the market value of an essential
bundle made up of units of x and units of y (which are the only two goods in the
economy).
(a) Describe the choice that will now be made by an individual who does not work and
therefore, has no other source of income.
(b) Describe how the introduction of the programme will affect the choices and well-
being of those individuals who normally work (and so earn a regular income).
(c) To help fund the scheme, the government levies a tax on commodity x (the less
essential of the two goods). How will the tax affect the choices and well-being of
individuals who rely entirely on their basic income (B)? Analyse the income and
substitution effects for an individual who at first chose to consume the essential
bundle. Will one of the goods necessarily be inferior?
(d) How will the introduction of the tax affect those who work as well as receive their
basic income? Will they be able to continue consuming the same bundle as before?
Will their well-being change? If so, how?
(e) If the purpose of the policy is to introduce greater equity, will it work?
Approaching the question
The subject of this question is the well-being of individuals who receive a basic income but
who may or may not work. The relevant analytical framework for this question is therefore
that of consumer choice.
The question states that all individuals in society will now receive a basic income which is
calculated on the basis of the market value of an essential bundle of consumption. There are
two goods in the economy, x and y, and the essential bundle ( consists of units of
commodity x and units of commodity y. Therefore, the basic income would be:
(a) We begin by examining the choices of an individual who does not normally work. Such
an individual would have no income without B and would therefore, in principle, not be
able to consume any of either x or y. Such an individual, before the change, would
probably live off charity which may provide him with the actual quantities of the
essential goods but s/he would not be able to trade them. With the basic income, s/he
would now make the following choice:
2
Even if we assume that the individual had access to the essential bundle through
charity, it is clear that at point A s/he would be better off than if s/he were at a point
like or without any income at all.
(b) We now look at individuals who are normally working and earn an income which
augments the basic income they now receive from the government:
Let represent the income derived from work. Without the basic income, the budget
line would have gone through point which would have generated a much lower
utility. A working individual will also be made better off (see point A).
3
(c) In order to fund the scheme, the government levies a tax on commodity x (the less
essential good). We now begin by looking at an individual who relies entirely on B and
who, upon receiving B, chooses to consume the essential bundle ( :
B
0
py
A
U0
0
px
0
py
x
B
0
px
Taxing commodity x means that the price of x will increase to . But as x is one of
the essential goods, it also means an increase in the basic income B:
So it is clear here that in terms of commodity y, real income will increase as .But in
terms of commodity x, real income will fall:
As the individual was consuming the essential bundle at point A and the value of B is based
on this essential bundle, it is clear that the new budget line will have to go through point
4
y
B1
0
py
X-normal
B
0
py
yc B
C A
U0
IE
0
px
SE 0
py
xc x
B1 B
1 0
px px
The individual was initially at point B and the new budget line cuts through it. It is clear that
the individual will be made better off. The substitution effect will take the agent to point C
and the move from the broken to the heavy red line is equivalent to an increase in income
which means that if the individual perceives both goods as normal goods, s/he would move
from C to a point like B. The fact that substitution and income effects work in opposite
directions does not mean that x is an inferior good.
(d) We now look at the effect which the tax will have on individuals who benefit from the
basic income but who are also working and have other earnings. For them too, there
will now be an increase in their money income as the basic income increased in value.
So it is clear here that in terms of commodity y, their real income will increase as
. But in terms of commodity x, real income will fall:
So the question now is whether the new budget line will go through their initial choice
at point A:
5
y
B I0
0
py
A
y0
U0
0
px
0
py x
x0 B I0
0
px
To find out we must calculate the income needed to be at point A. Before the tax was
levied on commodity x, the following held for point A:
We can re-write this as follows:
Now, the new budget line going through A would have to be:
Which, again, can be written as:
This means that the new budget constraint cannot go through A as the income the
individual would have to earn to be at that point, with the higher price and the increased
benefits, is much higher. Therefore, we can conclude that point A is no longer within
the reach of the individual who in addition to the benefits, has other sources of income.
But will he necessarily be made worse off? The answer depends on the level of the tax
and it is quite possible that the individual will stay as well off as s/he was before by
moving to point B in the diagram below:
6
y
B1 I 0
0
py
B I0
0
py
B
A
y0
U0
0
px
0
py x
x0 B1 I 0 B I0
1 0
px px
(e) If the purpose of the tax was to introduce greater equity the answer is, in principle, yes.
The poor agents who rely entirely on the basic income will definitely become better off
if they adhere to the governments view on what constitutes an essential bundle of
consumption. The wealthier individuals will most likely become worse off or at least be
no better off than they were before.
Question 2
The production of Organic Fig-based wine (called Fine) attracts two types of buyers:
environmentally conscious individuals with low price elasticity and carefree individuals
(with high price elasticity). The market is competitive and the government wishes to
enlarge the circle of people who buy organic-based products. To do so, the government
proposes to offer a lump-sum subsidy to the producers.
(a) Draw the initial equilibrium in the market.
(b) Analyse the effects of the lump-sum subsidy on price, output, the distribution of
consumption between the two groups and spending by each group;
(c) Critics of the government have argued against this proposal and suggested
considering a subsidy targeted at the carefree population. Analyse the effects of each of
these proposals;
(d) Assess the implications of the two policies for the welfare of the two groups of
consumers.
7
This is a question about a competitive market where there are two types of consumers. The
market is for Organic-Fig-Based-Wine (FINE) and the demand is made up of consumers who
are environmentally conscious (EC), who like the organic nature of the good, and therefore
have a low price elasticity of demand (which means that they are willing to pay more for the
good). The other group is that of carefree individuals (CF) who do not care much for the
organic nature of the product and so have a much higher price elasticity of demand.
(a) The initial set-up is the following:
A 0 A
0
px px
D EC () D CF ()
EC
x EC 0 x x CF
0 x CF
n MCi ( w0 , r0 )
S MCi
i 1
ACi ( w0 , r0 )
A A
0
px
DT
x0 xi
X xi0
(b) The effect of a lump-sum subsidy given to producers in order to encourage organic
consumption will be as follows. In the short run:
8
A 0 A
0
px px
D EC () D CF ()
EC
x EC 0 x x CF
0 x CF
n MCi ( w0 , r0 )
S MCi
i 1
ACi ( w0 , r0 )
A A ACi ( w0 , r0 )
S
0
px xi
DT
x0 xi
X xi0
The lump sum subsidy will only affect the average costs of the producers as it is
independent of how much they produce. As the marginal cost has not changed,
producers will not feel the need to adjust the profit maximising level of output and we
will stay at A where the producers make the profits depicted in the yellow rectangle
In the long run, however, if the subsidy is available to everyone, new producers will
enter the industry as profits above the normal can be made. This will increase the
supply of FINE and lead to a new equilibrium at point B below:
A 0 A
0
px px
px
1 B px
1 B
D EC () D CF ()
EC
EC
x EC 0 x 1 x x CF 0 x CF 1 x CF
n MCi ( w0 , r0 )
S MCi
i 1
nK ACi ( w0 , r0 )
A
S MC i
S
0
i 1
A ACi ( w0 , r0 )
px xi
px
1 B B
DT
x0 x1 xi
X x i1 xi0
9
Price will fall and everyone will consume more. Given the respective price elasticity of
their demands, the carefree individuals will respond with a greater increase in the
consumption of the organic wine. The government will achieve its objective of
enlarging the circle of people consuming organic products. The total spending by EC
consumers will decrease (as they have a low price elasticity) and that of carefree
consumers will increase. Inevitable, the carefree consumers will have much less income
available to spend on non-organic products.
(c) The proposal by the critics is to give a subsidy only to those who are currently not
committed to organic products: the carefree individuals. This will cause an increase in
their effective demand because for any given quantity the maximum per unit price that
they are willing to pay will have increased due to the subsidy. The short run effects are
given below:
px
1
B px
1
B
0 0
px px s
A A
B
D CF () s
D EC () D CF ()
EC
x EC1 x EC 0 x x CF 0 x CF 1 x CF
n MCi ( w0 , r0 )
S MCi
i 1
ACi ( w0 , r0 )
px
1 B B
0
px
A A
T
D
DT
x0 x1 i
xi
X xi0 x 1
We start at point A. The subsidy given to the CF people will shift their effective
demand to the right. Subsequently, the total demand will shift to the right too. The
magnitude of this shift depends on the share of the CF individuals in the market. The
increase in effective demand will cause excess demand in the market at the current
price. This will lead to an increase in the price which would lead firms to adjust their
sales to the profit maximising level of output (point B). Firms will now make profits
(the shaded (yellow) area) in the bottom right diagram.
The increase in price will cause the environmentally conscious (EC) individuals to buy
less of the good but as their price elasticity is less than unity, they will end up spending
more on the good. The carefree individuals (CF) will now face a lower price (
(point B) where they buy more of the good and spend more on it as well (their price
elasticity is greater than unity). The shaded area (green) is the total amount of subsidy
which the government will have to pay.
10
In the long run, however, the following will occur:
px
1
B px
1
B
0
px
0
px C
A=C A
0
px s B s
C D CF () s
D EC () D CF ()
EC
x EC1 x EC 0 x x CF 0 x CF 1 x CF 2 x CF
n
S MCi MCi ( w0 , r0 )
i 1
nK
S MC i ACi ( w0 , r0 )
px
1 B i 1 B
0
C
px
A A=C
T
D
DT
x0 x1 x2 i
xi
X xi0 x 1
As there are profits above the normal in the industry, more firms will move into the
market and create excess supply (at point B). This will lead to a fall in the equilibrium
price to its original level (if we assume the industry not to have an effect on factor
prices). But now, more firms will produce as much as each firm produced before the
change (point A=C in the bottom right diagram) and profits will return to their normal
level. As the price falls back to its original level, there will be no impact on EC
individuals but the carefree individuals will now move to point C where they buy more
of the good and their spending increases even further (the move from B to C).
(d) Clearly, in the lump-sum case, the subsidy brought about an increase in the
consumption of the organic wine by all individuals. Equally, all of them became better
off (larger consumer surplus).
In the case of the subsidy to carefree individuals, they are the only group to benefit from the
subsidy in the long run. As the entire increase in consumption of organic wine came from this
group, which was the target of the government policy, this policy seems to be better targeted
and most likely costs less than the lump sum subsidy.
11
Question 3
Consider a monopolist who faces a linear demand. The price elasticity of demand at the
profit maximising quantity is given as -2. The marginal cost is constant at 20, the
average cost at that point is 30 and the profits are 1,000.
(d) If there were two firms in the market, what would be their respective reaction
functions? Would a Nash equilibrium be viable?
This is a fairly simple question which requires some calculation which would reflect the
candidates understanding of the Monopolist model. Before we launch into the details, here is
the general picture we face:
px
M
0
px
AC(x0 )
AC
MC ( x0 ) MC
MR( x0 )
MR D
x0 x
From the information given in the question we know the following things:
1. demand is linear
2. marginal costs are constant at 20
3. the average costs at the optimal level of output is 30
4. price elasticity at the optimal level of output is -2
5. profits are 1000.
12
The above picture depicts the kind of set-up we may face. We know that this is not a case of
CRS where MC=AC in the long run as we are told that AC=30>MC=20.
(a) We must calculate now the equilibrium price. To do this we remind ourselves of the
conditions of optimisation:
1
1
| |
We know that MC=20 and | |=2. Therefore:
20
40
1 1
1 1
| | 2
(b) To find the equilibrium level of output we must resort to the profit function:
40 30 1000
Therefore,
100
(c) We now need to calculate the deadweight loss. To do this, we need to find the quantity
of the good which would have been supplied had the market been competitive.
There is a simple way of calculating this point as we know that when demand is linear
and the marginal cost constant, the MR intersects the MC at exactly half of the market
(which is the competitive level of output where price=MC). This means that the
competitive level of output would be 200:
px
M
0
px 40 40-20=20
AC( x0 ) 30
AC
1

MC ( x0 ) 5 C
MC
MR ( x0 ) 20
MR D
x0 100 xc 200 x
13
But we can also do this through the discovery of the slope of the demand schedule. If
the slope of the demand is, in absolute value, , then the following holds:
40 20
100
We can find the slope of the demand schedule by examining the price elasticity at the
optimal level of output:
Hence,
We know that 2 2.5. Therefore, 5 and . It is then

easy to see that the value of must be 200.
So the deadweight loss would be:
40 20 200 100 20 100

1000
2 2
which is represented by the faint blue triangle in the above diagram.
(d) What would happen if we had two firms in the markets? This is the case where we will
have strategic behaviour.
When firms behave strategically, each one will behave as a monopolist relative to what
remains from the market. In our case, with linear demand and constant marginal costs,
this will always happen at half of the market. This means that we will face the
following reaction functions:
1 1
200
2 2
1 1
200
2 2
Solving these two equations simultaneously to find the Nash equilibrium, we get that
each firm will produce 1/3 of the market which is 66.6. Together, they will produce
133.33. To make life easy we can round this to 133.
To answer the question of whether this Nash Equilibrium will be viable we need to
know something about the level of fixed costs. We know from the beginning that at
14
100, AC=30 and profits = 1000. Given that the price is 40, total revenue will be = (40 x
100) = 4000. The total variable costs (the area under the MC) will be = (20 x 100) =
2000 and total cost will be = (30 x 100) = 3000. Therefore, Fixed costs are equal to
1000 (FC = C - VC):
px
M
0
px 40
AC( xi ) 35
N
px 33.4
N
AC( x0 ) 30
AC
1

MC ( x0 ) 5 C
MC
MR ( x0 ) 20
MR D
xi 66.6 x0 100 xN 133 xc 200 x
The equilibrium price for producing 133 units of x can be calculated through the slope
of the demand schedule between points N and C. Clearly:
1 1 1

5 5 5
1
200 133 20 33.4
5
If only one firm produced the quantity of 133 units of x, the average fixed costs would
have been (AFC=1000/133=7.5) and the total average costs would have been
AC(133) 27.5 which is clearly less than the price of 33.4 and so profits would be
positive.. However, each firm will produce only 66.6 and have fixed costs of 1000. This
means that the AFC for each firm is 1000/66.6 15 which has to be added to the AVC
(which is 20). Therefore, AC(66.6) 35 which is greater than the price of 33.4. This
means that equilibrium here will not be viable: one of the firms will have to withdraw
and this market will be that of a monopolist.
15
Section C
Question 4
A vicious civil war in a neighbouring country created an unprecedented influx of

refugees into a country. To deal with the refugees who arrived penniless, the
government has had to increase its transfer payments. Suppose that the country in
question is a closed economy (though with open borders).
(a) Describe the initial equilibrium in the economy before the influx of refugees.
(b) How will the influx of refugees affect the economy in the short run? What will
happen to output, prices, wages and domestic investment?
(c) What will happen to all these variables in the long run? What will be the
distributional consequences if only a few people in the economy have access to
income from capital?
(d) How will your answer to (b) and (c) change if the refugees brought skills with
them?
This is a question about a closed economy where there is an increase in the supply of labour
due to an influx of refugees.
(a) The initial set-up which allows us to take into consideration the influence of an increase
in the labour supply would necessarily include the economys labour market:
r LM ( M 0 , P0 )
r0
IS ( G 0 , T 0 )
Y
P
SAS ( w0 )
P0
A
AD ( G 0 , T 0 , M 0 )
Y0 Y
16
And the labour market:
SL
Returns to Capital
w0 A
p0
Total Wages
MP L ( K 0 )
L
L0
The shaded area under the labour demand corresponds to in the IS-LM-AD-AS
framework and also provides the information about the distribution of income between
wages and capital.
(b) We now move to examine the effects of the influx of labour in the short run. It is clear
from the story that the influx of refugees will have two immediate effects. Firstly, it
will increase the demand for consumption (at first, the autonomous element) and
secondly, it will increase the supply of labour and therefore will change the level of
potential output as well as create pressure on real wages.
r
LM ( M 0 , P1 )
B LM ( M 0 , P0 )
r1
A
r0
IS ( G 0 , T 0 )
IS ( G 0 , T 0 )
Y
P
SAS ( w0 )
p1 B
p0 A
AD ( G 0 , T 0 , M 0 )
AD ( G 0 , T 0 , M 0 )
Y0 Y
Y1
17
SL SL
w0 Returns to Capital
p0 A
B
w0
p1
Total Wages
MPL
L
L0 L1 L2
The increase in the supply of labour will create excess supply in the labour market but
as the nominal wages are fixed in the short run, the only change will come from the
goods market and the change in price level. As demand for consumption increased, the
IS and the AD schedules will shift to the right. This, in turn, will lead to an increase in
price which will reduce the level of real wages. At lower real wages, there will be more
employment and more output (points B in the labour market and in the IS-LM-AD-AS
framework). The increase in prices will reduce the supply of liquid assets and shift the
LM schedule upwards as there will now be equilibrium at a higher level of interest rates
for any given level of income. The economy will move from A to B. Output would
increase but so would interest rates which will reduce domestic investment. Nominal
wages will stay the same but real wages will fall.
(c) In the long run, the pressures of excess supply in the labour market will lead to a fall in
nominal wages to the new equilibrium at point C. The fall in nominal wages will be
accompanied by a fall in prices:
r LM ( M 0 , P1 )
LM ( M 0 , P 2 )
r1 B
r2 LM ( M 0 , P0 )
A C
r0
IS ( G 0 , T 0 )
IS ( G 0 , T 0 )
Y
P
SAS ( w0 )
p1 B SAS ( w1 )
p2 C
p0 A
AD ( G 0 , T 0 , M 0 )
AD ( G 0 , T 0 , M 0 )
Y0 Y1 Y2 Y
18
SL SL
p0 A
w0 B
p1 w1 C
p2
Total Wages
MPL ( K 0 )
L
L0 L1 L2
The fall in wages will lead to a fall in prices which will shift the LM schedule
downwards until the new equilibrium is reached at point C where real wages have gone
down (as well as the share of wages in national income) and prices are higher than
before the influx but lower than in the short run. Interest rates will be higher than before
the change but lower than in the short run.
(d) How would the answers to (b) and (c) change had the refugees brought capital with
them? In this case, there is only a need to look at what happened in the labour market
which is the key to the rest of the changes:
SL SL
w0 p 0 A B
p1 w
1 C
p2
Total Wages
MPL ( K 1 )
MPL ( K 0 )
L1 L2 L
L0
We started at A. The influx of refugees will increase the supply of labour but as they
also brought capital with them, the general demand for labour will increase (the red line
in the above diagram). The rest of the story is exactly the same as before except that the
magnitude of the changes will be much greater. As we go from A to B nominal wages
are constant but prices will increase due to the increase in demand for consumption
which will also reduce the supply of liquid assets and shift the LM schedule upwards to
a point like B as in the previous case. In the long run the economy will shift towards
point C in exactly the same manner as before.
The story we tell, however, depends on the magnitude of changes in the supply and
demand for labour. If the flow of capital was so great (which is very unlikely when we
19
talk about refugees) then the demand for labour could have shifted such that in the long
run there would be increase in real wages. But as this is highly unlikely, we will not
examine this possibility here.
Question 5
A new government came to power in a country with corrupt institutions which stifled
investment. Using sweeping powers, the government managed to cleanse the country
from corruption and in so doing removed a considerable number of bureaucratic
obstacles to investment.
(a) Analyse the effect of this change on a closed economy with flexible prices and
wages;
(b) Analyse the effect of this change on an open economy without capital mobility but
with a fixed exchange rate policy;
(c) Analyse the effects of this change on an open economy with perfect capital
mobility and a flexible exchange rate policy;
(d) Would your answer to (c) be different if the exchange rate had been fixed?
In this question, candidates were expected to analyse the effect of a change which is
institutional rather than a specific change in one of the models parameters.
The preamble of the question suggests that due to corruption there were bureaucratic
obstacles to investment which would discourage people from being willing to invest or,
alternatively, make the effective demand for investment in each period smaller than
otherwise. Removing these obstacles can only mean an increase in demand for investment.
So this is a question about an exogenous increase in demand for investment.
(a) At first, we analyse this change in a closed economy with flexible prices and wages:
20
r LM ( M 0 , P2 ) LM ( M , P )
0 1
r2
C LM ( M 0 , P0 )
r1 B
r0
A
IS ( G 0 , T 0 )
IS ( G 0 , T 0 )
Y
P SAS ( w1 )
SAS ( w0 )
C
p2
p1 B
p0 A
AD ( G 0 , T 0 , M 0 )
AD ( G 0 , T 0 , M 0 )
Y0 Y1 Y
We start at point A where there is now an increase in demand for goods because the
demand for investment increases. This means that both the IS and AD schedules shift to
the right as there is greater demand for domestic product at each level of price or
interest rate. At first, the excess demand for goods will lead to a slow increase in prices
which will work towards the reduction in real wages. This will lead to employers being
willing to pay for additional work hours and also an increase in the supply of goods. At
the same time, the increase in price level will reduce the supply of liquid assets. This
means that any level of income, there will now be equilibrium in the liquid asset market
at a higher level of interest rates. The LM schedule will therefore shift upwards and the
new short run equilibrium will be achieved at point B with higher prices and a higher
level of interest rates. While the increase in interest rates will reduce the demand for
investment, it will not offset the initial increase in the autonomous component of the
demand for investment.
In the long run, there is still an excess demand for labour at the lower level of real
wages. Wage negotiations will lead to an increase in wages which will take into
account the anticipated increase in prices which will be induced by this increase in
wages. This will lead to a fall in output and a further increase in price which will shift
the LM schedule further upwards. The new equilibrium will be obtained at point C
where prices and wages are higher but the real wages i unchanged. Interest rates will be
higher too and output will return to the original level. This means that there will be no
change in actual investment as the autonomous increase in investment will be offset by
the increase in interest rates.
(b) We now examine the same change in an open economy without capital mobility and a
fixed exchange rate regime:
21
The initial increase in demand for investment will shift the IS schedule to the right.
This will lead to an expansion of output in response to the excess demand for goods
(point B). However, the subsequent increase in income will also trigger an increase in
the demand for imports. With a fixed exchange rate regime this means that there will be
an excess demand for foreign currency. As the Central Bank sells foreign currency
from its reserves in return for local currency, the supply of liquid assets in the economy
will fall which will cause the LM schedule to shift upwards until equilibrium is
obtained at point C. Here, too, there will be no real change in the economy except for
an increase in interest rates which will offset the initial increase in the demand for
investment.
(c) and (d) We now look at the case of an open economy with perfect capital mobility:
22
The initial change will be the same as before. An exogenous increase in the demand for
investment will shift the IS schedule to the right. This will lead to an excess demand for
domestic goods which will induce an increase in production and output. Therefore
income increases as does the demand for liquid assets. The equilibrium level of interest
rates will increase (the move from A to B). The return on local assets is now greater
than the return on foreign assets. This will cause an increase in the supply of foreign
currency.
With a flexible exchange rate (section (c)), the excess supply will translate into a fall in
the nominal exchange rate (measured here in units of domestic currency per unit of
foreign currency, or the local price of foreign currency). As the nominal exchange rate
falls, the attractiveness of exports diminishes at the same time as imported goods
become cheaper. The demand for net-exports (NX) will therefore fall which means that
for any given level of interest rates, there will now be less demand for domestic output.
The IS schedule will now shift to the left and the economy will return to equilibrium at
point A=C. As neither output nor interest rates changed in the long run, the increase in
demand for investment will be funded by a fall in the demand for net exports (NX).
Section (d) is about the same situation but with a fixed exchange rate policy. So we
start at point B where a gap is opening in the balance of payments due to the excess
supply of foreign currency emanating from the higher return on domestic assets relative
to foreign assets. This time, as the exchange rate is fixed, the Central Bank will be
buying the excess supply of foreign currency in return for domestic currency. This will
increase the supply of liquid assets and shift the LM schedule downwards as now, for
any given level of income, there will be an equilibrium at a lower level of interest rates.
We move to equilibrium at point D. Here, the increase in demand for investment will be
funded by an increase in output.
Question 6
The aggregate demand for imported goods has a price elasticity which is less than unity.
Analyse the effects of an increase in international prices on:
(a) An open economy without capital mobility and a fixed exchange rate.
(b) An open economy with capital mobility and a flexible exchange rate.
(c) An open economy with capital mobility and a fixed exchange rate.
(d) How would your answers to (a)-(c) change if the price elasticity of demand for
imported goods had been greater than unity?
This is a question about the effect of an increase in the international price. This will be
immediately connected to the ambiguous effect which a change in the international price has
on the demand for foreign currency emanating from the demand for imports. Therefore, the
23
temptation to launch into the IS-LM framework has to be tempered here as the analysis
depends on how the demand for foreign currency might be affected by the price elasticity of
the demand for imports (this point is elaborated in the subject guide, pp.39295). The first
thing which we must clarify is that there will be an increase in the supply of foreign currency
as exports will now increase. As far as demand for foreign currency is concerned, we
expected to find the following analysis:
We can see from this diagram how the demand for foreign currency may be influenced by the
price elasticity of the demand for imported goods. The top part of the diagram describes the
demand for imports while the bottom part captures the quantity of foreign currency
demanded which would always be . Hence, A at the bottom part of the
diagram, denotes the rectangular area which is the quantity of foreign currency demanded. As
the international price increases we move from A to B (we assume a small economy and
hence a perfectly elastic international supply). This means that in terms of the quantity of
foreign currency demanded we lose the K area in the bottom diagram but we have to add the
V area (the area T is common to both the quantity of foreign currency demanded before and
after the change). Whether or not V is greater or smaller than K depends on the price
elasticity of demand. If it is greater than unity it means that while we buy less imports, we
pay, proportionately, more for them and the total demand for foreign currency would
increase. We can see this in the diagram below:
24
E
x
S FC ( p0 , p *0 )
IM 1
IM 1 x
S FC ( p0 , p *1 )
A B
E0
IM
DFC ( p0 , p *1 , y0 )
IM
IM
DFC ( p0 , p *1 , y0 ) DFC ( p0 , p *0 , y0 )
QFC
If the price elasticity is less than unity, which is the case in this question, the increase in
international prices will lead to an increase in the supply of foreign currency due to the
greater demand for exports. The demand for foreign currency will increase too, due to the
low price elasticity of demand for imports. This means that we will move from point A to
point B. The reason why we assume that there will still be an excess supply of foreign
currency is associated with the real side of the economy. We know that there is be an increase
in the demand and supply of foreign currency but, at the same time, we saw that the real
demand for imports will fall while it is clear that the real demand for exports will increase.
Therefore, at B, we will definitely be in a situation of positive NX and therefore, an excess
supply of foreign currency.
(a) The analysis of the real effects on an open economy without capital mobility and a
fixed exchange rate regime.
As we said, assuming no nominal effects, the move from A to B in the foreign currency
market will not alter the existence of more unambiguous real changes. For this, we will
need to turn to the framework which analyses this world, the IS-LM model. As we have
an open economy with a fixed exchange rate, the following picture must emerge:
25
E0 p *0
NX ( )0
p0
r LM ( M 0 , P0 )
LM ( M 1 , P0 )
E 0 p *1
NX ( ) 0
p0
B
r1 LM ( M 2 , P0 )
A D
r0
r2 C
E 0 p *1
IS ( G , t , )
p0
E0 p *0
IS (G , t , )
p0
Y
Y0 Y1 YD Y2
Irrespective of what happens to the demand for or supply of foreign currency, the
increase in international prices which increased the real exchange rate would bring
about an increase, in real terms, of the demand for net exports (NX). This means that
both the NX and IS schedules would shift to the right. As there is now a gap in the
market for foreign currency, there will be an excess supply of foreign currency which
will lead to an increase in the supply of liquid assets and an initial shift downwards of
the LM schedule.
As both the IS and NX=0 schedules shift to the right, there is an additional element in
this question which has to do with the position of point C relative to point A. This
should clearly be at a lower level of interest rates. If we move to the right from A until
we meet the IS schedule again (point D), we know that the demand for investment has
not changed. Only in equilibrium in the goods market (on the IS schedule) would the
planned investment be equal to planned savings, T-G plus NX. At A we had
(as at A, originally, NX=0). For simplicity`s sake, we suppose that T-
G=0. Hence, at A, we had . Now, at D, we have as
.Therefore NX must be >0 for the equation to hold.
So the economy will move from A to B in the short run where the increase in income
will increase the real demand for imports but not enough to offset the real increase in
exports. This additional change will cause an excess supply of foreign currency and an
increase in the supply of liquid assets. This will shift the LM schedule downwards until
the new equilibrium is achieved at point C.
26
(b) An open economy with perfect capital mobility and a flexible exchange rate regime.
In the case of a flexible exchange rate (section (b)), the increase in the international
price will cause an increase in the demand for net-exports in real terms as well as an
excess demand for foreign currency even when the price elasticity of demand for
imports is less than unity. The initial change (depicted in the diagram of the market for
foreign currency) suggests that there will also be an initial fall in the nominal exchange
rate. The new IS schedule which takes the economy to point B already includes the
slight offsetting in the increase in demand for NX due to the fall in the nominal
exchange rate. At B, the return on local assets is higher than that on foreign assets. This
will trigger a capital inflow and an excess supply of foreign currency which will cause
the nominal exchange rate to fall further until the IS schedule returns to its original
level at point C and where output remains as it was at the beginning.
(c) In the case of a fixed exchange rate regime:
27
The initial change will be the same as we had in the answer to (a). IS will shift to the
right due to the increase in real demand for NX but, as there will be an initial excess
supply of foreign currency (depicted in the diagram of the foreign currency market
above), there will be an immediate adjustment through the increase in the supply of
liquid assets which takes the economy from A to B. This will trigger a capital inflow
which, in the presence of a fixed exchange rate regime, will lead to a further increase in
the supply of liquid assets until a new equilibrium is reached at point C.
(d) How will the answer change if the price elasticity of demand for imports was greater
than unity?
E
x
S FC ( p 0 , p * 0 )
IM 1
IM
1 x
S FC ( p 0 , p *1 )
A B
E0
IM
D FC ( p 0 , p *1 , y 0 )
IM
D FC
IM
( p 0 , p *1 , y 0 ) D FC ( p 0 , p *0 , y 0 )
Q FC
As we saw at the beginning of the discussion, in such a case, area V (in the first
diagram in this answer) will be smaller than area K. This means that the fall in demand
for real imports will lead to a fall in demand for foreign currency. This is depicted by
the shift to the left of the demand for foreign currency schedule in the above diagram.
The meaning of it is that the excess supply created by the increase in international
prices will be much greater and will therefore lead to a much greater shift downwards
of the LM schedule in all the previous answers. In other words, the impact on output
will be much greater in all the cases, except the one in section (b) where there is a
flexible exchange rate.
28
EC1002 Introduction to economics Zone B
Important note
PART I
Section A
Each question has FOUR possible answers (ad). There is only ONE correct answer to each
of the questions.
In the multiple choice section, this year candidates in Zone B scored a mean mark of 47.4
per cent (out of the 50 points available for this Part) which is a clear improvement on last
years mean of 43 per cent.
We will not reproduce here the multiple-choice questions with their right answers. There
are enough questions on the VLE with which to practise your learning interactively.
PART II
Section B
1
Question 1
To encourage the use of educational products (like books, software etc. which we shall
call y) the government both offers a certain number of educational products (say, ) for
free and subsidises the price of these goods for those who want to buy more. Critics
argue that it is because of this subsidy that people have too much disposable income to
use on football goods (x). The government considers three options: (i) to tax football
goods; (ii) to remove the subsidy from educational goods (but to keep the free offer of
); (iii) to levy a fixed tax on income to help fund the free offer of educational goods
while raising it from to as well as to remove the subsidy for the remaining
educational products.
(a) Describe the initial choice an individual makes between football goods (x) and
educational products (y).
(b) How would proposal (i) affect an individuals choice and well-being? Would the
government achieve its objectives better if it had offered to compensate individuals
for the income effect resulting from the change?
(c) How would proposal (ii) affect an individuals choice and well-being? Would the
government achieve its objectives better if it had offered to compensate individuals
for the income effect resulting from the change?
(d) Along similar lines examine now proposal (iii) and form a judgement about which
of these proposals better serves the governments objectives.
This is a question about a government which is trying to direct individuals choice towards a
consumption bundle which it deems more appropriate. The right analytical framework for
this is, of course, the model of consumer choice.
We have two goods in this story: educational products (y) and football goods (x). At the
beginning of our story, the government is offering units of educational products for free
and the price of these goods for further consumption ( is a subsidised price.
(a) The initial set-up, therefore, will be the following one:
2
(b) Critics of the government accuse it of funding the wrong type of activities (football
goods) because of the subsidy given to the price of educational products.
The proposal to tax football goods means that the price of good x will now increase to:
The effects that this will have on a typical consumer will be:
3
The tax on commodity x will increase the price. This will change the budget constraint
into the heavy line. The individual will therefore move from point A to point B. At
point B it is clear that the individual will consume considerably less football goods (x)
if x is normal but this may also affect his, or her, consumption of educational products
(y). However, we cannot be sure of whether point B will be where the individual
consumes more, or less, or the same as at A. The individual will clearly be worse off at
point B.
If now the government chooses to compensate the individual for the loss of utility, it
will pay him C so that his new budget constraint will be tangent to the original
indifference curve. This will lead the individual to a point like C where he will, indeed,
be as well off as he was before. Here he will definitely increase the consumption of
educational products at the expense of football goods. However, the scheme is even
more costly for the government than the original situation where it funded the free
provisions of educational products and subsidised their price.
(c) Removing the subsidy from educational products means an increase in the price of y (it
is equivalent to a tax on educational product):

Which will have the following effect:
Without compensation, the individual will become worse off as he moves from point A
to point B. The objectives of the government would also be undermined at this point as
he will definitely buy less education products and may even end up buying more
football goods though this is not a certain outcome.
4
With compensation, he will end up at point C where he is as well off as he was before
except that he will now substitute football goods for education products. This is exactly
the opposite outcome to the governments objectives.
(d) Here you were asked to examine the effects of proposal (iii) and to form a judgement
about all three proposals in terms of achieving the government`s objectives
According to proposal (iii), the government levies a fixed tax on income (lump-sum)
(T) to fund the provision of free educational products and subsidies the price of these
products for those who purchase more. At the same time, the government also increases
the provision of free educational products. There are two possible outcomes here:
5
The two effects of the proposals are:
1. a shift upwards of to
2. a shift to the left of the budget constraint.
Both the above diagrams depict such changes but, as we can see in the top diagram, the
magnitude of the tax was greater than the increase in free provision which led to a fall
in well-being and in the consumption of both types of goods. In the bottom diagram the
government is more generous with the free provision and the tax is lower. This leads to
an improvement in agents well-being and an increase in the consumption of both
goods.
Evaluating the three schemes will therefore lead to the following conclusions:
Proposal (i) will definitely reduce the consumption of football goods but may or may
not increase the consumption of educational products. Well-being, however, will fall.
Proposal (ii) will not only lead to a decline in the consumption of educational products
but will definitely increase the consumption of football goods.
Proposal (iii) could increase or decrease well-being, improve the funding of the
provisions of educational products but may increase or decrease the consumption of
both goods.
In terms of the objective of shifting people from Football goods to educational

products, the only scheme which seems to point in this direction is scheme (i) and even
there, it is uncertain. After that is scheme (iii) that, if well planned, can lead to an
increase in well-being as well as to an increase in the consumption of both goods.
6
However, the funding situation will be much improved. Option (ii) should not be
considered at all.
Question 2
The new UR-Phone has reached the market. The device is so advanced that it answers
all the text messages for you. The demand for UR-Phones is comprised of two large
groups: the young (for whom it has become a status symbol) and the rest of the adult
population. The price elasticity of the youngs demand is inelastic. For the rest of the
population who value the development but would still like to participate in their own
lives, the price elasticity of their demand is greater than unity. The market is perfectly
competitive but the government is concerned about the effects that this device will have
on the development of cognitive skills in the young. It considers two options: (i) Levy a
unit tax on sales to youngsters; (ii) Levy a lump-sum tax on producers.
(a) Draw the initial set-up of the market.
(b) Analyse the short-run effects of the two options on price, output, the distribution
of consumption amongst the two groups and the spending by each group.
(c) Analyse the long-run effects of the two schemes.
(d) If the two schemes lead to the same quantity of UR-Phones supplied in the
market, in which of them will the tax per unit be greater?
In this question candidates were expected to realise that while this is indeed a question about
a perfectly competitive industry, there is a particular feature here which is that the demand for
the good is made up of two distinct groups of consumers. On the one hand we have the
impatient-technology-drunk young people with a very low price elasticity of demand and the
rest of the adult population with a greater than unity price elasticity.
7
(a) The initial set-up, therefore, will be the following one:
where point A denotes the initial long-run equilibrium.
(b) The government would like to reduce the use of phones by the young so that their
cognitive abilities will not be too damaged. It considers two options: (i) levy a unit tax
on sales to the young or (ii) levy a lump-sum tax on producers. In this section,
candidates were expected to analyse the short run effects of both proposals.
(i) We begin with scheme (i) which is a unit tax levied on sales to the young:
The tax on a unit sold to the young would mean that the effective demand by the
young is now smaller (the broken line in the left diagram). It means that at any
given market price, the young will face a higher price (which includes the tax)
and would therefore wish to buy less at this price. This, in turn, will lead to a fall
in total demand. The degree to which the fall in the youngs demand will
influence the total demand in the market depends on their share in the market.
Therefore, the shift of the aggregate demand schedule will be smaller relative to
the shift of the demand for the young.
8
If we start at A, this will now lead to an excess supply in the market which will
push the market price down to . At this lower price, firms will adjust their
production to the profit maximising level of output (where price equals marginal
cost: point B in the right hand diagram). They will therefore produce less and at a
level where the average cost is higher and, therefore, the red area depicts the
losses that they will make.
The price for consumers will fall. This means that the adult population will
consume more and will be spending more on UR-Phones as their price elasticity
is greater than unity. The young will consume much less and their spending will
increase as they will now have to pay the price + the tax (B in the left hand
diagram). As their price elasticity is less than unity, they will be spending more
even though they consume less.
(ii) We are now looking at the short-run effects of the second option in which the
government proposes to levy a lump sum tax on producers.
In this case, as the lump-sum tax only affects the average costs of the firms, they
will not change their choice of output in the short run but they will incur losses
which are captured by the yellow area in the right hand diagram.
(c) We are now looking at the long-run effects of each of these schemes. We begin with
scheme (i):
(i) This is the case of the tax per unit of sales to the young:
9
In the long run, firms will begin to leave the market according to their ability to
sustain the losses which we identified in the short-run analysis. As they leave,
supply will fall and will shift to the left. This will cause excess demand in the
market which will push prices up. The process will continue until we get to point
C where the price returns to its original level. Each firm, now, will produce as
much as it did before the introduction of the policy but as there are fewer firms,
overall output will be lower.
As price returns to its original level, the adult population will be in exactly the
same position as they were before the change. The young, on the other hand, will
further reduce their consumption and increase their spending on UR-Phones
(point C in the left hand diagram).
(ii) In the case of the lump-sum tax on producers, the long run effect will be as
follows:
As firms begin to leave the market, supply will fall which will cause price to
increase. This will lead each firm to produce more (point B in the right hand
diagram) but as there are fewer firms, the overall output will fall.
10
The increase in price will reduce the quantity demanded by both groups. The
quantity demanded by the adults will fall by more than the quantity demanded by
the young due to their greater price elasticity. For the very same reason, spending
by the adults will fall while spending by the young will increase.
(d) Here candidates were expected to compare the long-run equilibrium between the two
schemes when the equilibrium level of output is the same:
Point B in the above diagram depicts the long-run equilibrium with the lump-sum tax
on producers. Point C (and C) depicts the long-run equilibrium with a unit tax on sales
to the young. In both cases the long-rum equilibrium is at the level . To get to this
level of output, equilibrium in B suggests that the price rose by dp. Looking at the right
hand diagram and noting the shape of the AC curves, it is clear that: . So the
difference between points B and C in the market diagram represents a change in price
which is greater than the average tax per unit. But the difference between A and C
(which is equal to dp and denoted by the heavy blue line in the market diagram) is also
the effect of the unit tax on the young on total demand. As the young are only part of
the market, it is clear that the shift in the market demand will be only a fraction of the
magnitude of the tax (which shifts the youngs demand, see left hand diagram).
Therefore, the unit tax (t) is greater than dp which is greater than the average tax per
unit in the case of the lump sum tax.
11
Question 3
Consider a monopolist who faces a linear demand. The price elasticity of demand at the
profit maximising quantity is given as -2. The marginal cost is constant at 20, the
average cost at that point is 30 and the profits are 1,000.
(d) If there were two firms in the market, what would be their respective reaction
functions? Would a Nash equilibrium be viable?
This is a fairly simple question which requires some calculation which would reflect the
candidates understanding of the Monopolist model. Before we launch into the details, here is
the general picture we face:
px
M
0
px
AC(x0 )
AC
MC ( x0 ) MC
MR( x0 )
MR D
x0 x
From the information given in the question we know the following things:
1. demand is linear
2. marginal costs are constant at 20
3. the average costs at the optimal level of output is 30
4. price elasticity at the optimal level of output is -2
5. profits are 1000.
12
The above picture depicts the kind of set-up we may face. We know that this is not a case of
CRS where MC=AC in the long run as we are told that AC=30>MC=20.
(a) We must calculate now the equilibrium price. To do this we remind ourselves of the
conditions of optimisation:
1
1
| |
We know that MC=20 and | |=2. Therefore:
20
40
1 1
1 1
| | 2
(b) To find the equilibrium level of output we must resort to the profit function:
40 30 1000
Therefore,
100
(c) We now need to calculate the deadweight loss. To do this, we need to find the quantity
of the good which would have been supplied had the market been competitive.
There is a simple way of calculating this point as we know that when demand is linear
and the marginal cost constant, the MR intersects the MC at exactly half of the market
(which is the competitive level of output where price=MC). This means that the
competitive level of output would be 200:
px
M
0
px 40 40-20=20
AC( x0 ) 30
AC
1

MC ( x0 ) 5 C
MC
MR ( x0 ) 20
MR D
x0 100 xc 200 x
13
But we can also do this through the discovery of the slope of the demand schedule. If
the slope of the demand is, in absolute values, , then the following holds:
40 20

100
We can find the slope of the demand schedule by examining the price elasticity at the
optimal level of output:
Hence,
We know that 2 2.5. Therefore, 5 and . It is then

easy to see that the value of must be 200.
So the deadweight loss would be:
40 20 200 100 20 100

1000
2 2
which is the faint blue triangle in the above diagram.
(d) What would happen if we had two firms in the markets? This is clearly the case where
we will have strategic behaviour.
When firms behave strategically, each one will behave as a monopolist relative to what
remains from the market. In our case, with linear demand and constant marginal costs,
this will always happen at half of the market. This means that we will face the
following reaction functions:
1 1
200
2 2
1 1
200
2 2
Solving these two equations simultaneously to find the Nash equilibrium, we get that
each firm will produce 1/3 of the markets which is 66.6. Together, they will produce
133.33. To make life easy we can round this to 133.
To answer the question of whether this Nash Equilibrium will be a viable we need to
know something about the level of fixed costs. We know from the beginning that at
100, AC=30 and profits=1000. Given that the price is 40, total revenue will be = (40 x
100) = 4000. The total variable costs (the area under the MC) will be = (20 x 100) =
14
2000 and total cost will be = (30 x 100) = 3000. Therefore, Fixed costs are equal to
1000 (FC = C - VC):
px
M
0
px 40
AC( xi ) 35
N
px 33.4
N
AC( x0 ) 30
AC
1

MC ( x0 ) 5 C
MC
MR ( x0 ) 20
MR D
xi 66.6 x0 100 xN 133 xc 200 x
The equilibrium price for producing 133 units of x can be calculated through the slope
of the demand schedule between points N and C. Clearly:
1 1 1

5 5 5
1
200 133 20 33.4
5
If only one firm produced the quantity of 133 units of x, the average fixed costs would
have been (AFC=1000/133=7.5) and the total average costs would have been
AC(133) 27.5 which is clearly less than the price of 33.4 and so profits would be
positive. However, each firm will produce only 66.6 and have fixed costs of 1000. This
means that the AFC for each firm is 1000/66.6 15 which has to be added to the AVC
(which is 20). Therefore, AC(66.6) 35 which is greater than the price of 33.4. This
means that equilibrium here will not be viable: one of the firms will have to withdraw
and this market will be that of a monopolist.
15
Section C
Question 4
A vicious civil war in a neighbouring country created an unprecedented influx of

refugees into a country. To deal with the refugees who arrived penniless, the
government had to increase its transfer payments. Suppose that the country in question
is a closed economy (though with open border).
(a) Describe the initial equilibrium in the economy before the influx of refugees;
(b) How will the influx of refugees affect the economy in the short run? What will
happen to output, prices, wages and domestic investment?
(c) What will happen to all these variables in the long run? What will be the
distributional consequences if only a few people in the economy have access to
income from capital?
(d) How will your answer to (b) and (c) change if the refugees brought skills with
them?
This is a question about a closed economy where there is an increase in the supply of labour
due to an influx of refugees.
(a) The initial set-up which allows us to take into consideration the influence of an increase
in the labour supply would necessarily include the economys labour market:
r LM ( M 0 , P0 )
r0
IS ( G 0 , T 0 )
Y
P
SAS ( w0 )
P0
A
AD ( G 0 , T 0 , M 0 )
Y0 Y
16
And the labour market:
SL
Returns to Capital
w0 A
p0
Total Wages
MP L ( K 0 )
L
L0
The shaded area under the labour demand corresponds to in the IS-LM-AD-AS
framework and also provides the information about the distribution of income between
wages and capital.
(b) We now move to examine the effects of the influx of labour in the short run. It is clear
from the story that the influx of refugees will have two immediate effects. Firstly, it
will increase the demand for consumption (at first, the autonomous element) and
secondly, it will increase the supply of labour and therefore will change the level of
potential output as well as create pressure on real wages.
r
LM ( M 0 , P1 )
B LM ( M 0 , P0 )
r1
A
r0
IS ( G 0 , T 0 )
IS ( G 0 , T 0 )
Y
P
SAS ( w0 )
p1 B
p0 A
AD ( G 0 , T 0 , M 0 )
AD ( G 0 , T 0 , M 0 )
Y0 Y
Y1
17
SL SL
p0 A
B
w0
p1
Total Wages
MPL
L
L0 L1 L2
The increase in the supply of labour will create excess supply in the labour market but
as the nominal wages are fixed in the short run, the only change will come from the
goods market and the change in price level. As demand for consumption increased, the
IS and the AD schedules will shift to the right. This, in turn, will lead to an increase in
price which will reduce the level of real wages. At lower real wages, there will be more
employment and more output (points B in the labour market and in the IS-LM-AD-AS
framework). The increase in prices will reduce the supply of liquid assets and shift the
LM schedule upwards as there will now be equilibrium at a higher level of interest rates
for any given level of income. The economy will move from A to B. Output would
increase but so would interest rates which will reduce domestic investment. Nominal
wages will stay the same but real wages will fall.
(c) In the long run, the pressures of excess supply in the labour market will lead to a fall in
nominal wages to the new equilibrium at point C. The fall in nominal wages will be
accompanied by a fall in prices:
18
r LM ( M 0 , P1 )
LM ( M 0 , P 2 )
r1 B
r2 LM ( M 0 , P0 )
A C
r0
IS ( G 0 , T 0 )
IS ( G 0 , T 0 )
Y
P
SAS ( w0 )
p1 B SAS ( w1 )
p2 C
p0 A
AD ( G 0 , T 0 , M 0 )
AD ( G 0 , T 0 , M 0 )
Y0 Y1 Y2 Y
SL SL
p0 A
w0 B
p1 w1 C
p2
Total Wages
MPL ( K 0 )
L
L0 L1 L2
The fall in wages will lead to a fall in prices which will shift the LM schedule
downwards until the new equilibrium is reached at point C where real wages have gone
down (as well as the share of wages in national income) and prices are higher than
before the influx but lower than in the short run. Interest rates will be higher than before
the change but lower than in the short run.
(d) How would the answers to (b) and (c) change had the refugees brought capital with
them? In this case, there is only a need to look at what happened in the labour market
which is the key to the rest of the changes:
19
SL SL
w0 p 0 A B
p1 w
1 C
p2
Total Wages
MPL ( K 1 )
MPL ( K 0 )
L1 L2 L
L0
We started at A. The influx of refugees will increase the supply of labour but as they
also brought capital with them, the general demand for labour will increase (the red line
in the above diagram). The rest of the story is exactly the same as before except that the
magnitude of the changes will be much greater. As we go from A to B nominal wages
are constant but prices will increase due to the increase in demand for consumption
which will also reduce the supply of liquid assets and shift the LM schedule upwards to
a point like B as in the previous case. In the long run the economy will shift towards
point C in exactly the same manner as before.
The story we tell, however, depends on the magnitude of changes in the supply and
demand for labour. If the flow of capital was so great (which is very unlikely when we
talk about refugees) then the demand for labour could have shifted such that in the long
run there would be increase in real wages. But as this is highly unlikely, we will not
examine this possibility here.
Question 5
The faction of national income constitutes retained profits which are entirely directed
at domestic investment. However, unease developed around the quality of the workforce
in the economy. As a result, a fraction (say, ) of the retained profits has been directed
toward the purchase of imported goods. The economy is an open economy with a
proportional income tax (no corporation tax) and a fixed exchange rate regime.
(a) What will be the multiplier of the economy?
(b) Show the initial equilibrium in the economy.
(c) How will the change in the use of retained profits affect the economy?
(d) How would your answer change if the economy had perfect capital mobility and a
fixed exchange rate?
(e) How would your answer to (d) change if the exchange rate had been flexible?
20
There is an economy where a fraction of national income is kept as retained profits. This
means it does not become part of the income which is used to generate the demand for
consumption and all the retained profits are directed at domestic investment. In the question
we are told that a certain disaffection with the quality of the local workforce leads to the
direction of some of the retained profits towards imports. There is a proportional tax system
and there is no corporate tax. We begin the story with an open economy without capital
mobility and a fixed exchange rate regime.
(a) In the initial stage, we are presenting the economy as it is before the disaffection from
the local workforce changes the direction of the retained profits.
C ( y ) c0 c1 (1 t ) (1 ) y
I ( r, y ) I 0 I r r y
G ( y ) G0
EP * EP*
X( ) x0 ( 0 0 )
P P0
EP * EP*
IM ( , y ) im0 ( 0 0 ) m1 y
P P0
EP * EP*
AE ( y, r, ) [c0 I 0 I r r ( x0 im0 )( 0 0 )] [c1 (1 t )(1 ) m1 ] y
P P0
EP * 1 EP * 1
y A( r, ) A( r, )
P 1 [c1 (1 t )(1 ) m1 ] P 1 M
(b) The initial set-up would be as follows:
E0 p *0
NX ( )0
p0
r LM ( M 0 , P0 )
r0 A
E0 p *0
IS (G, t0 , , )
p0
Y
Y0
21
(c) Here you were expected to examine the effect of the change in the use of retained
profits on the economy. Namely, the fraction of the retained profits (y) is now
directed to imports. This means that the demand for investment will now be:
, 1
and the demand for imports will be:

,
Therefore, the entire economy will now be represented by the following set of
equations:
C ( y ) c0 c1 (1 t ) (1 ) y
I ( r, y ) I 0 I r r (1 ) y
G ( y ) G0
EP * EP*
X( ) x0 ( 0 0 )
P P0
EP * EP*
IM ( , y ) im0 ( 0 0 ) ( m1 ) y
P P0
EP * EP*
AE ( y, r, ) [c0 I 0 I r r ( x0 im0 )( 0 0 )] [c1 (1 t )(1 ) ( m1 )] y
P P0
EP * 1 EP * 1
y A( r, ) A( r, )
P 1 [c1 (1 t )(1 ) (m1 )] P 1 M '
This means that the change will have no effect on the autonomous component but will
affect the multiplier. Intuitively, the answer is fairly straightforward. The fact that part
of the demand which up to now was directed at local products and is now directed at
imported goods suggests that the multiplier will become smaller.
We need to compare: with . We know that the answer will depend on whether
M is greater or smaller than M:
1 1
1 1 1
Therefore:
1 0
Therefore, M>M which means that the multiplier became smaller.
22
This means that for any given level of interest rates, there will now be less demand for
domestic products and, as the multiplier is smaller, the slope of the IS schedule will
become steeper:
E0 p *0
NX ( )0
p0
r LM ( M 0 , P0 )
LM ( M 1 , P0 )
r0 A
r1 B
E0 p *0
E0 p *0 IS (G, t0 , , )
IS (G, t0 , , ) p0
p0
Y
Y1 Y0
The fall in demand for domestic products will lead to a fall in income which will result
in a lower interest rate which will, to some extent, offset the initial fall in the demand
for domestic investment. We move from point A to point B. The fall in national income
reduced demand for imported goods (by consumers and producers alike) which creates
a deficit in the current account and an excess supply of foreign currency. The Central
Bank buy the excess to keep the nominal exchange rate fixed and, in so doing, increases
the supply of liquid assets which will lead to the LM schedule shifting downwards and
a further fall in interest rates which would keep raising the demand for investment until
we are at point C with the same level of output but an increased demand for investment
which replaces the fall in demand for it due to the re-direction of retained profits
towards imports.
23
(d) and (e) We now look at the case where the economy has perfect capital mobility:
r
LM ( M 1 , P0 ) LM ( M 0 , P0 )
C A=D
r0 r0 * BOP
B
r1
E1 p *0
IS (G, t0 , , , )
p0
E0 p *0
IS (G, t0 , , , ) E0 p *0
p0 IS (G, t0 , , )
p0
Y
Y2 Y1 Y0
The initial effect on the IS schedule will be exactly the same as before. However, the move
from A to B will induce an outflow of capital as the return on local assets is now lower than
the return on foreign assets. This outflow of capital triggers a deficit in the capital account on
top of the deficit in the current account. The Central Bank will need to sell a great deal of
foreign currency from its reserves and thus reduce the supply of liquid assets in the economy.
This will lead to an increase in the equilibrium level of interest rates for any given level of
income (a shift upwards of the LM schedule) until a new equilibrium is achieved at point C
with a much lower level of domestic product.
In the case of a flexible exchange rate (e), the deficits in the current and capital accounts will
lead to an increase in the nominal exchange rate which will make imports more expensive
and exports more profitable. As demand for NX increases, the IS schedule will shift to the
right and the economy will return to point D in the above diagram.
24
Question 6
An open economy with perfect capital mobility is in long-run equilibrium with a chronic
surplus in its balance of payments and a large deficit in the budget.
(a) Why might a government wish to do something to alter the situation?

(b) Suppose now that the government decides that to combat the situation it must cut
its spending as well as direct part of government purchases to imports. What will
be the effect of such a policy in the case of a flexible exchange rate?
(c) Would your answer be different had there been a fixed exchange rate?
(d) What will happen to actual domestic investment if government spending and net
transfers are independent of income, in case (b) and in case (c)?
(e) How would your answer in (d) change if transfers had been dependent on the level
of income?
An open economy has a chronic surplus in the Balance of Payments and a large deficit in the
budget. It is an open economy with perfect capital mobility and the first question which you
must ask yourselves is why must the analytical framework be that of an open economy with
perfect capital mobility?
The answer to this question, though not part of the expected answer, is that if there were no
capital mobility, there would not have been a capital account in the balance of payments.
Without such an account, the economy could not have been in equilibrium with a chronic
surplus in the balance of payments. The latter is always balanced and when we say that there
is a surplus in the balance of payments we mean that there is a surplus in the current account.
Without a capital account there would be an excess supply of foreign currency which would
lead to either a fall in the nominal exchange rate, which would lead to an equilibrium in the
current account, or an increase in the supply of liquid assets which would lead to an increase
in income and an increase in demand until the surplus is eliminated.
So, to be in a chronic state of surplus in the current account, the Balance of Payments must be
balanced in another way: the deficit in the capital account. This would mean that the demand
for foreign currency will be equal to the supply of foreign currency as illustrated below:
25
E
x
S FC ( p0 , p *0 )
T
S FC ( p0 , p *0 )
Surplus
Current account
A
E0
Deficit
Cap. Acc.
T
DFC ( p0 , p *0 , y0 )
IM
DFC ( p0 , p *0 , y0 )
QFC
(a) The question which follows is why should such a situation be a source of concern given
that there is clearly an equilibrium at point A?
To answer this question we must revert back to the national accounts. In an open
economy, we know that the capital formation equation is as follows:
A surplus in the Balance of Payment which means a surplus in the current account is
the case where NX>0. Hence, for any given level of interest rates and budgetary
regime, the level of domestic investment will be lower. If we add to this the large
budgetary deficit (T-G<0) then the reduction in actual domestic investment is very high
for any given level of interest rates. This could jeopardise growth as the stock of capital
may be diminishing and the economy could shrink because we know that:
where is the rate of depreciation. Hence, for any given rate of depreciation, the lower
I is, the more likely it is for the stock of capital (and hence the PPF) to shrink.
(b) The government decides to act by cutting its spending (dG<0) and by directing a
greater part of its purchases to imports. We examine the effects of this on the economy
assuming a flexible exchange rate:
26
The fall in G will reduce demand for domestic product and therefore shift the IS to the
left. The instruction to direct a greater part of its purchase to imports would result in a
fall in demand for NX. How it affects the IS schedule depends on whether the change is
coming through a reduction in the autonomous element of the demand for NX or from
an increase in the marginal propensity to import. If it is the latter then this would reduce
the multiplier and imply a steeper slope of the IS schedule. If the change came through
the autonomous component, then the IS schedule will shift downwards and parallel to
the left. Both elements of the policy work in the same direction: a reduction in the
demand for domestic product. Therefore, in the short run, output will fall and so will
the equilibrium level of domestic interest rates (the move from A to B).
As the return on domestic assets is now lower than the return on foreign assets, this will
trigger an increase in the demand for foreign assets and therefore for foreign currency
(capital outflow). The excess demand for foreign currency will cause the nominal
exchange rate to increase and the demand for net exports (NX) to increase with it. This
process will continue until we get back to point C. Now, the level of the deficit will be
less (as a result of reduced government spending (G)) but the level of NX will probably
not change much as the increase in NX will merely compensate for its decrease due to
the governments increased demand for imports.
27
(c) In the case of a fixed exchange rate, the following will happen:
The initial change from A to B will be the same as before. However, the effects of the
capital outflow in the case of a fixed exchange rate will be very different. The excess
demand for foreign currency will lead the Central Bank to sell currency from the
reserves which will reduce the supply of liquid assets in the economy (a shift upwards
of the LM schedule). This will push domestic interest rates up and reduce the demand
for investment until we get to point C at a lower level of output. In this case, the fall in
income will offset the increase in demand for imports by government agencies and
leave NX unaffected. The fall in the deficit (only if there were lump-sum taxes) will be
accompanied by a fall in private savings. The government will not achieve its
objectives and the economy will be worse off.
(d) and (e) In these two sub-questions you were expected to examine the effects of the
two set-ups on investment according to whether G and T are dependent or
independent of income.
If G and T are independent of income, we know that in equilibrium (at point A) the
following was true:
where

In the case of a flexible exchange rate (sub-question (b)) we ended up at point C which
is at the same level of income as before. Therefore the new NX will be:
28

As and we cannot be sure what
will happen to NX at point C. The first element increases it (as a result of the increase
in the nominal exchange rate) but the increase in the marginal propensity to import will
reduce it. For simplicity`s sake, we can assume that NX at point C will be the same as it
was at point A.
Therefore, at C, the following will have to hold true:
Clearly, and as NX has not changed, then the level of domestic

investment will now be greater. The policy will be effective.
If the exchange rate were fixed (sub-question (c)) then at point C, the following will
hold true:
In this case the new NX will be as follows:
Which means that the increase in the marginal propensity to import (the effect of
government policy) will reduce the demand for NX. Hence, in this case, .
This will push investment up. So will the cut in government spending (
. However, as income fell, the level of private savings will fall with it
( ). This may, or may not, offset the increase in investment due to the fall
in NX and in the government deficit. So we cannot be sure whether the government
will be equally successful in rescuing domestic investment but we can be sure that the
price of these policies in terms of lost income will be much greater.
In the case of G and T being dependent on income (sub-question (e)), the following will
hold at point A:
Where NX is:

Now, at C (in the case of flexible exchange rate), we have the same level of income but
a lower level of g: . But the level of net transfer will not change so that:
29

As for NX, we now have:
which, for the reasons cited above, we will assume to remain unchanged.
Consequently, the effect will be the same as in the case where G and T were both
independent of income. For the comparison to be meaningful we assume that
.
For the case when the exchange rate is fixed (sub-question (c)) the story is slightly
different. Now, the following has to hold:
Clearly, the NX will now change like this:

We know that . But what about
versus ? While it is clear that the marginal propensity to import increased, the
fall in income suggests that it is more likely that . Therefore,
.
This means that there will be an increase in the surplus in the current account which
will reduce domestic investment. As for the deficit, we know that both net transfers and
government spending fell. Therefore, again,
As ( it means that . The policy will not meet its objectives

and will cost dearly in terms of lost income.
30

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~~EC2020 ZA d0

This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON EC1002 Part I ZA

BSc degrees and Diplomas for Graduates in Economics, Management, Finance

Wednesday, 6 May 2015 : 14:30 to 16:00

This is Part I (Section A) of the examination, which consists of Multiple Choice

Part I is worth 50% of the marks for the entire examination.

PLEASE TURN OVER

University of London 2015

2. Consider the following economy:

300 450 600 x

(a) Specialise in x and move to produce at point A in the above diagram;

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4. If good x is a normal good and y is its gross substitute then:

5. An increase in wages will lead to a long-run expansion path with:

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10. A lump-sum tax levied on a monopolist will:

14. The contract curve is the collection of points where:

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(a) At 0 because planned investment is greater than actual investment;

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21. An increase in income will:

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23. Consider the following diagram:

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University of London 2015

This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON EC1002 Part II ZA

BSc degrees and Diplomas for Graduates in Economics, Management, Finance

Wednesday, 6 May 2015 : 16:00 to 17:30

This is Part II (Sections B and C) of the examination.

PLEASE TURN OVER

University of London 2015

Answer ONE question from this section.

(a) Draw the initial equilibrium in the market.

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(a) What will be the equilibrium price?

(b) What will be the equilibrium quantity?

(c) What will be the deadweight loss created by the monopolist?

Answer ONE question from this section.

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University of London 2015

This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON EC1002 Part I ZB

BSc degrees and Diplomas for Graduates in Economics, Management, Finance

Wednesday, 6 May 2015 : 14:30 to 16:00

This is Part I (Section A) of the examination, which consists of Multiple Choice

Part I is worth 50% of the marks for the entire examination.

PLEASE TURN OVER

University of London 2015

2. Consider the following economy:

300 450 600 x

(a) Specialise in x and move to produce at point B in the above diagram;

University of London 2015

4. If good x is a normal good and y is its gross substitute then:

5. An increase in wages will lead to a long-run expansion path with:

University of London 2015

10. A lump-sum tax levied on a monopolist will:

14. The contract curve is the collection of points where:

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(a) At 0 because planned investment is greater than actual investment;

University of London 2015