ECON 100 Tutorial: Week 25

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ECON 100 Tutorial Week 25

• Shane Murphy
• s.murphy5_at_lancaster.ac.uk
• Last Office Hour Monday 300 PM 400 PM LUMS
  C85

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Outline for the Last Tutorial

• Go over any questions from Exam 4
• Students not taking the exam are free to go
  have a nice summer!
• Prep for Final Exam Review of Past Micro Essay
  Question
• Best way to prepare for Essay Exam

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2012 Past Exam Essay Questions

• Note Some of these solutions/suggested answers
  were provided for revision last year by last
  years Professors, so Ive included them in this
  years slides.

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Microeconomics essay 2012 Q41

• 2012 Q1) Governments are often concerned that by
  providing financial support for individuals with
  low incomes they undermine the incentive to work
  hard. Following the steps below explain the basis
  for this concern and explain how an in-work
  welfare policy might be used to overcome this
  problem.
• A) Using an appropriate diagram, explain the
  economic theory of labour supply where
  individuals have preferences defined over c
  (consumption) and l (leisure) and face a budget
  constraint defined by c w.h m where w is the
  hourly wage, hours of work are given by h24-l,
  and m is unearned income. Show how you can
  characterise the equilibrium optimal level of
  hours of work, h, in this theory.

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Microeconomics Essay 2012 Q41(A)

• U U(c, l) where U increasing in c and in l
• l T-h where h is work hours and T is total
  hours available.
• Hence UU(c, T-h) where U is increasing in c and
  decreasing in h.
• So there is a trade-off between c and l.
• So the indifference map is given by

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Microeconomics Essay 2012 Q41(A)

• Next, we draw the budget constraint c wh m
• If h 0, then c m (ie the vertical part of the
  blue line below).
• If hgt0 then earnings can finance c as well
• ie c rises with h along the sloping part of the
  blue constraint below.
• So, in general the budget constraint is defined
  by
• c m wh.
• Hence the budget constraint is given by

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Microeconomics Essay 2012 Q41(A)

• In this step, we put the indifference curves and
  the budget constraint together to find the
  equilibrium.
• If the individual does the best she can (ie max
  utility) subject to the constraint she faces (ie
  cmw.h), then equilibrium will defined by
• a tangency where slope IC slope BC.
• That is, MRShc w .
• This equation defines the optimal labour supply
  h which depends on w and m, ie hh(w,m).
• And if h is chosen then the max utility is U.

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Microeconomics Essay 2012 Q41(B)
Show how a change in w might affect the
equilibrium labour supply, h.

• A rise in w, from w0 to w1, holding m constant at
  m0, implies that h increases.
• Having two values for w and two hs, we can
  begin to plot a labour supply curve, hh(w,m0)
  as in the bottom panel.

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Microeconomics Essay 2012 Q41(C)

• It is often the case that governments provide
  welfare payments to individuals who have incomes
  below a certain level such that if mwh is less
  than this level, S, then the government pays the
  individual an amount that raises their income to
  S. Show, in a diagram, what this does to the
  budget constraint and use this diagram to explain
  how this adversely affects work incentives.

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Microeconomics Essay 2012 Q41(C)

• Suppose for simplicity that m0, and w is such
  that the budget contraint then looks like the
  blue sloped line.
• If the government decides to top up the income of
  those people whose income is below S then the BC
  would have the red lines for low hours worked and
  the blue line for higher h.
• With the red line, someone is better off not
  working and receiving the higher green utility
  curve than working and receiving the lower green
  curve.
• A small loss in income gives a large increase in
  the amount of leisure enjoyed.
• Thus, there is an adverse effect on the incentive
  to work for a wide rang of h. Many countries have
  welfare programmes that have such a feature.

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Microeconomics Essay 2012 Q41(D)

• To overcome the adverse effects of such a welfare
  scheme governments sometimes use in-work welfare
  payments.
• The UK has such a scheme which provides
  additional income for individuals whose incomes
  are less than some level, F, but who are working
  at least some given level of hours, hF.
• Such welfare payments are means-tested so that
  the amount paid is reduced until it falls to zero
  when mwhF.
• Explain in a diagram how this affects the budget
  constraint. Using this diagram and the previous
  one show how this in-work welfare scheme might
  overcome the adverse incentive effects of the low
  income welfare scheme.

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Microeconomics Essay 2012 Q41(D)

• This graph shows our old welfare program.
• The new UK working tax credit requires 24 hours
  of work a week.
• So for hgt24 hours a week the in-work welfare
  payment will move the agent to a higher utility
  curve.

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Microeconomics Essay 2012 Q41(D)

• So for hgt24 hours a week the in-work welfare
  payment will move the agent to a higher utility
  curve. The new payment scheme is shown in purple.
  
• Note for someone at h0 and receiving S, there is
  now an incentive to work 24 hours because you get
  24w in earnings and this gets topped up by the
  in-work welfare programme to such an extent
  that working now becomes attractive.

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Microeconomics Essay 2012 Q41(E)

• Explain the weaknesses of such an in-work welfare
  policy
• There a number of problems with a policy like
  this in work welfare programme.
• One is stigma - the government has found that
  people are reluctant to take up their entitlement
  to such programmes - the forms are difficult,
  you need to get your employer to sign that you
  work 24 hours, and you might feel that people on
  welfare are looked down on by others.
• A second problem is that while it incentivises
  non workers to work, it disincentivizes those
  that already work, or they would tend to work
  less so as to generate an entitlement (or bigger
  entitlement) to this welfare payment.

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Microeconomics Essay 2012 Q42

• An oligopolistic market structure is often
  thought to lead to collusion between firms. But
  collusion is often said to be unstable.
• Following the steps below, explain these
  propositions, using a Cournot duopoly model of
  two identical profit maximising firms selling
  identical products facing a linear market demand
  curve.
• In the Cournot model each firm is assumed to
  maximise their own profits by taking the output
  of the rival firm as given. Explain, using the
  idea of an iso-profit function, how this leads to
  the reaction curve for one of the firms.
• If both firms have linear reaction curves use an
  appropriate diagram to explain where the Nash
  equilibrium occurs.
• Using an appropriate diagram examine whether, if
  we started away from equilibrium, the model would
  tend towards the equilibrium.
• Explain, using an appropriate diagram, why there
  is an incentive to depart from the Nash
  equilibrium through agreeing to collude. Show
  what the collusive equilibrium looks like.

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Microeconomics Essay 2012 Q42(A)

• A) In the Cournot model each firm is assumed to
  maximise their own profits by taking the output
  of the rival firm as given. Explain, using the
  idea of an iso-profit function, how this leads to
  the reaction curve for one of the firms.
• Cournot model Same good produced by 2 firms
  (could be 3, 4..). Cost to firm i depends on qi,
  ie Ci(qi), where i1,2.
• If cost functions are the same across i, C1(q1)
  C2(q2) Ci (qi).
• If total output is q1q2 then market price is
  P(q1q2) ie price depends on INDUSTRY output.
• Note that profit of firm 1 depends on the firm
  2s output (as well as its own), and vice versa
  ie p1(q1,q2) q1.P(q1q2) C(q1) and p2(q1,q2)
  q2.P(q1q2) C(q2).
• Strategic game between firm 1 and firm 2 each
  firms action is its output each firms
  preferences (payoffs) is represented by its
  profits.

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Microeconomics Essay 2012 Q42(A) ctd.

• Firm 1 for any value of q2, there is a best
  response level of q1 that maximises p1.
• The lower is q2, the higher will be q1, and thus
  p1. This defines reaction function R1, which is
  the dashed line.
• The closer the isoprofit curve to the q1 axis,
  the higher p1
• Firm 2 for each q1, there is a best response q2
  that max p2 The lower is q1, the higher is p2.
  This defines reaction function R2

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Microeconomics Essay 2012 Q42(B)

• If both firms have linear reaction curves, use an
  appropriate diagram to explain where the Nash
  equilibrium occurs.
• The NE is a pair (q1, q2) such that each firms
  action is a best response to the other firms
  action.
• This is q1 R1(q2) and q2 R2(q1). In
  other words this pair of outputs is a mutual best
  response.
• (the curved red and blue lines are iso-profit
  functions)

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Microeconomics Essay 2012 Q42(C)

• Using an appropriate diagram examine whether, if
  we started away from equilibrium, the model would
  tend towards the equilibrium.
• Suppose, Firm 1 chooses q1a.
• Then Firm 2s best response is q2aR2(q1a).
• Then Firm 1s best response to that is
  q1bR1(q2a).
• Then Firm 2s best response to that is
  q2bR2(q1b). Etc.
• This NE is STABLE
• ie we converge towards the NE, even if we
• start away from it.

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Microeconomics Essay 2012 Q42(D)

• Explain, using an appropriate diagram, why there
  is an incentive to depart from the Nash
  equilibrium through agreeing to collude. Show
  what the collusive equilibrium looks like.
• Suppose the Nash Equilibrium is at point A.
• Note that each firm could get higher p than at A
  if they agreed to reduce their outputs. For
  example, each could agree to produce ½qM (ie at
  B).
• (The green line represents production at
  monopoly quantity.)
• How do we know profit is higher at point B than
  at point A?
• It is on an iso-profit curve that is closer to
  the axis (see part A of this question)

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Microeconomics Essay 2012 Q42(E)

• Explain, using a diagram, why each firm has an
  incentive to cheat on such a collusive agreement.
  
• From Point B, each firm has incentive to cheat -
  to get higher profits.
• For example firm 2 would look at its reaction
  function and, if firm 1s output stays at ½qM ,
  then firm 2 would decide that producing more
  would yield higher profit (better iso-profit
  curve).
• Similarly for firm 1.
• So cheating is the dominant strategy. So both
  cheat. Both end up worse off.
• This is a Prisoners dilemma problem. So a
  collusive agreement is likely to be unstable.

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Microeconomics Essay 2012 Q43

•  

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Microeconomics Essay 2012 Q43

•  

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Microeconomics Essay 2012 Q43

• C) Consider the negative non-pecuniary
  externalities drivers are exerting on each other
  in the Nash-equilibrium you found in (b)
• i) What is the negative externality a rush-hour
  driver exerts on all other drivers (in minutes)?
• ii) How much is that driver herself delayed by
  all other drivers? (If you know of a shortcut to
  answer these last two questions, dont hesitate
  to use it).
• A driver delays all others just by the same
  amount as she is delayed by all the others,
  therefore the answer for the two questions is the
  same. If there is no other driver, then the
  driver needs 10.01min. During rush hour with
  x5000 her travel time is 60min. Thus she delays
  all others, and is delayed by all others about
  50min.

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Microeconomics Essay 2012 Q43

• iii) What is the negative externality an
  early-bird driver exerts on all other drivers (in
  minutes)?
• iv) How much is that early-bird driver herself
  delayed by all other drivers?
• By the same logic as above Since there are
  7k-5k2k drivers on the road, he needs 30 min,
  almost 20min more than an all empty road would
  take. Therefore the answer is 20min to both
  questions.

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Microeconomics Essay 2012 Q43

•  

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Microeconomics Essay 2012 Q44

• Consider streetlights as an example of a
  non-rival good. The reservation price or benefit
  of a certain number of streetlights is as given
  in the table. Streetlights have a price of 100
  each that is, the marginal cost of a streetlight
  is 100.

Number of street lights Lisa Josh Andrey
Reservation Price Reservation Price Reservation Price
1 150 150 150
2 180 180 500
3 200 200 590
4 210 210 610
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Microeconomics Essay 2012 Q44

• A) Suppose each person lives by themselves on a
  street. How many lights does Lisa buy? How many
  lights does Josh buy? How many lights does Andrey
  buy?
• In the table, reservation price really means
  total benefit. So you just buy while marginal
  benefit gt marginal cost.
• Lisa buys 1 light, Josh buys 1 light, Andrey buys
  2 lights.

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Microeconomics Essay 2012 Q44

• In (b) to (d), suppose all three live on the same
  street, and streetlights are a perfectly
  non-rival good.
• B) Suppose by majority vote they decide how many
  streetlights to install. Suppose the cost is
  shared equally. What is the Condorcet-winner
  (recall that a Condorcet winner is an option that
  wins a pairwise vote against any other
  alternative)? Can you explain why the
  median-voter theorem predicts that in a situation
  such as the one given there will be a
  Condorcet-winner?
• The Condorcet winner is 1 streetlight. This is
  predicted by the median-voter theorem since the
  preferences are single-peaked in the ordering as
  given. The peak is 1 for Lisa, 1 for Josh, and 3
  for Andrey. Thus a Condorcet winner exists, and
  moreover the Condorcet winner is 1, the median
  voters (Josh/Lisa) peak (most preferred
  alternative).

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Microeconomics Essay 2012 Q44

• C) Suppose the three individuals install the
  streetlights by non-cooperative, simultaneous
  provision. That is, in a simultaneous-move game,
  what is the number of streetlights Lisa, Josh and
  Andrey each buy?
• Lisa only installs one streetlight if zero are
  installed by the others. The same is true for
  Josh. Andrey installs 2 streetlights if zero are
  installed by the others, and installs one if one
  is installed by the others, and zero if two or
  more are installed by the others. Therefore the
  Nash-equilibrium is Lisa installs zero, Josh
  installs zero, Andrey installs 2.

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Microeconomics Essay 2012 Q44

• D) What is the Pareto-efficient number of
  streetlights? What rule or condition tells you
  that amount? Compare your solutions in the
  cost-sharing scenario and in the non-cooperative
  provision scenario with the Pareto-efficient
  amount.
• A necessary condition for an allocation to be
  Pareto-efficient is the Samuelson which states
  for the special case of reservation prices (i.e.
  quasi-linear preferences or no income effects)
  that for a non-rival good the sum of individual
  marginal benefits equals (if continuous, else
  integer problem) the marginal cost.In this
  example thus the Pareto-efficient amount of
  streetlights is 3.Here democracy/cost-sharing is
  furthest from the Pareto-efficient amount, the
  non-cooperative solution is closer but still
  underprovides the non-rival good.

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Microeconomics Essay 2012 Q44

• E) Briefly comment on whether excludability of
  streetlights (such as by automatic sensors that
  turn the lights on and off) could help achieve
  the Pareto-efficient amount of lighting. You can
  assume that government or one of the three
  persons operate the system, whichever you find
  easier/better.
• Suppose Andrey (for example, government or any
  other person same logic) could install as many
  streetlights as he wants and exclude others from
  use. He could and would then install the
  Pareto-efficient amount of 3 streetlights and
  charge Josh and Lisa, say 190 each. Thus
  excludability would get us the Pareto-efficient
  solutions. (extra information/bonus credit this
  works only since we have perfect information and
  know everyones reservation prices).

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Macroeconomics Essay 2012 Q 45

• The motives for holding money are often
  classified as transactions precautionary
  speculative. How do these motives relate to the
  liquidity preference function? How does the
  liquidity preference function help us understand
  the determination of equilibrium in the market
  for money?

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Macroeconomics Essay 2012 Q 45

• The transactions motive implies that the demand
  for real balances is positively related to
  income, since a higher value of transactions is
  undertaken as income rises.
• Extra transactions demand only exists because of
  the lack of synchronisation between incomes and
  expenditures.
• The speculative motive implies that the demand
  for real balances is negatively related to the
  interest rate, since the interest rate is the
  opportunity cost of holding assets in the form of
  money.
• Extra consider a bond market interpretation
  where demand for bonds increases when price of
  bonds is low, so interest high, and this increase
  in demand for bonds implies a decrease in the
  demand for money.
• A demand curve for money can be drawn in (r,M)
  space, and the demand curve shifts out as income
  rises.
• Superimposing onto this a supply curve (typically
  vertical) shows that money market equilibrium can
  be obtained either at low r-low Y or high r-high
  Y combinations.
• Extra derive the LM curve.
• Extra note how the interest rate moves in
  response to excess supply or demand in the money
  market.

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Macroeconomics Essay 2012 Q 46

• In simple models, the Keynesian income multiplier
  is calculated as the inverse of the marginal
  propensity to withdraw. Why then in real world
  applications, does the true value of the
  multiplier often turn out to be less than one?

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Macroeconomics Essay 2012 Q 46

• The simple answer is because of crowding out. A
  full answer is to look at how the multiplier is
  obtained in both a simple model (where there is
  no crowding out) and in a full ISLM model (where
  there is).
• The former can be achieved either by way of a
  Keynesian cross (45 degree) model or by way of an
  ISLM model with a flat LM curve.
• The latter requires the ISLM analysis.
• For a good answer, describe the mechanism of the
  multiplier process particularly clearly, or have
  a particularly good explanation of crowding out
  (eg increase in G raises income which raises
  transactions demand for money given money supply
  this means that speculative demand must fall, and
  that requires an increase in the interest rate.
  This increase in the interest rate chokes off
  private sector investment.)
• Extra comment on real world estimates of the
  multiplier.

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Macroeconomics Essay 2012 Q 47

• Use the credit counterparts of broad money to
  show the inter-dependence of shifts in Keynesian
  IS and LM loci.

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Macroeconomics Essay 2012 Q 47

• Statement of the CCBM
•  
• M bank lending to the state bank lending to
  the non-state
• M PSBR non-bank lending to the state bank
  lending to the non-state
• Monetary policy (LM) fiscal policy (IS)
  interest rate policy credit controls
• The above is sufficient for a comfortable pass
  other relevant details determine marks in the
  range 50-100-
•  
• CCBM
• is an identity
• can be stated as levels or changes in levels
• n 1 degrees of freedom in policy instruments
• can be adjusted for an open economy ( external
  effects)

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Macroeconomics Essay 2012 Q 48

• An economy is in recession and the central bank
  cuts interest rates. Contrast the emphasis given
  respectively by
• Keynesian analysis and
• (ii) Austrian School analysis.

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Macroeconomics Essay 2012 Q 48

• To write an answer this question, discuss the
  following topics 
• Keynesian analysis
• Liquidity trap doubts the effectiveness of a
  monetary stimulus when confidence is low
• Quantitative easing to lower long-term rates when
  short-term rates are at the lower zero bound
• Fiscal expenditure (e.g., infer-structure
  investments) given greater emphasis
• Austrian analysis
• Prices are best set by market forces
• Interest rates are inter-temporal prices
• Cutting interest rates below their market levels
  corrupts inter-temporal resource allocations 

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Final Exam Info

• May 31st Check your timetable for time
  location
• Bring a pencil, eraser, calculator and Student ID
  
• 40 Multiple Choice Questions
• 20 Micro
• 20 Macro
• Choose 1 Micro Essay Question 1 Macro Essay
  Question (from 3 micro questions and 3
  macro)

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Best ways to revise for the Final Exam

• Review anything your Professors tell you to
  review.
• Review Tutorial Questions
• A lot of exam questions from these.
• There will be a mix of Theory, Definitions, and
  Application Problems.
• At least 5 David Peel-type math problems
• Review Tests 1-4 from this year.
• Review Past exams 2013 and 2012, etc.
• Note The course materials change slightly from
  year to year, that is why I think revising this
  years tutorials and tests is better preparation
  than revising past years exams.

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Some MICRO topics you should definitely revise

• Supply Demand (finding equilibrium, what causes
  shifts in S D)
• Consumer Surplus Producer Surplus
• Normal, inferior, complementary, substitute goods
• Competitive markets, monopoly
• Elasticities (i.e. price elasticity of demand,
  elastic vs. inelastic)
• Average product of Labor, marginal product of
  Labor
• Effects of taxes and subsidies
• Be able to find equilibrium (and CS, PS, DWL,
  etc.) both graphically AND algebraically
• Game theory concepts and applications Nash
  equilibrium, Cournot duopoly, Prisoners dilemma,
  how to solve normal form extensive form games
• David Peels math questions exponents,
  logarithms, Cobb Douglass production function,
  derivatives (as in marginal means take the
  derivative)

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Some MACRO topics you should definitely revise

• David Peeles math questions
• derivatives, partial derivatives, exponents,
  logarithms
• Coskeran
• National Income Accounts, GDP, GNP, etc. How to
  calculate these
• Life cycle hypothesis/Permanent Income hypothesis
• IS-LM model
• Aggregate Demand/Aggregate Supply model
• Steele
• Phillips curve Expectations augmented Phillips
  curve
• Goodharts law
• Taylor Rule
• Lucas Critique
• Quantitative easing and bonds

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Good luck and have a nice summer!
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Essay/Short Answer Questions from Week 24
Tutorial Worksheet
47
Question 1

• Loanable funds. Liquidity preference. Two
  theories of interest rate determination? Why?
• We covered this in Week 20, Question 10.

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From Week 20

• Loanable funds Loanable funds refers to a market
  that brings borrowers and savers together,
  determining interest rates by finding where the
  demand for borrowing and the supply of savings
  are equal.

49
From Week 20

• Liquidity preference Liquidity preference refers
  to a market where the demand for money is in
  equilibrium with the supply of money set by a
  central bank.

50
From Week 20

• Loanable funds. Liquidity preference. Two
  theories of interest rate determination? Why?
• In contrast with liquidity preference, loanable
  funds shows how interest rates can be determined
  on an open market, without a central bank.
• In IS-LM, the LM curve is derived from Liquidity
  Preference. The IS curve can be derived from
  multiple sources. We derived it from the
  Keynesian Cross, but it can also be derived from
  Loanable Funds analysis.
• See Khan academy video

51
Question 2

• Strictly speaking, there is no more sense in
  speaking of an economic systems total or
  aggregate demand that there is in speaking of
  the weight of the solar system taken as a hole
  (Joseph Schumpter).
• What do you suppose Schumpeter has in mind?

52
Question 3

• An attempt at fine tuning the economy in the way
  described by the simplest economic models would
  be like trying to drive a car with unreliable
  steering and only partially effective breaks by
  looking in the rear-view mirror (Economic
  Briefing, H.M. Treasury, 1993).
• So why are we teaching you IS-LM?

53
Question 4

• We used to think that you could spend your way
  out of recession .. I tell you in all candour
  that option no longer exists, and that in so far
  as it ever did exist, it only worked .. by
  injecting a bigger dose of inflation into the
  economy, followed by a higher level of
  unemployment ..That is the history of the last
  twenty years. (Rt. Hon. James Callaghan,
  Prime-Minister, 1976)
• What evidence is there (thirty plus-years on)
  that anything has changed?
• Fiscal policy is no longer recognisable as an
  instrument of demand management. Monetary policy
  (where the remit is to achieve upon price
  stability, not unemployment) is administered an
  independent group of ever-changing economists who
  decide upon the short-term discount rate and,
  with quantitative easing, the long-term rates are
  a macroeconomic instrument.

54
Question 5

• Monetarism and Supply supply side economics
  were once embarrassingly confused by a former
  Prime-Minister (Sir Edward Heath).
• How would you have explained his error?