Exam Quiz

The capitalist revolution 1. The GDP per capita of Greece was $22,494 in 2012 and $21,966 in 2013. Based on these figures, the growth rate of GDP between 2012 and 2013 (to two decimal places) was: -2.35% 2. If the GDP per capita of a country doubles every 100 years, the shape of its graph on a linear scale graph (the "normal" graphs where the height between 1 and 2, and 2 and 3, are the same on the y-axis) and a ratio scale graph are: Linear scale graph: An upward sloping curve with increasing slope (convex shape) Ratio scale graph: An upward sloping straight line = An upward-sloping straight line on a linear scale graph means that the GDP per capita increases by the same amount every year. = A straight horizontal line on a ratio scale graph means that the GDP per capita is constant over the years. An upward-sloping concave curve on a ratio scale graph means that the growth rate decreases each year. Here the growth rate is constant. An upward-sloping convex curve on a ratio scale graph means that the growth rate increases each year. 3. GDP per capita for the UK measures: The total output of UK economy, divided by country’s population = This is called the GNP (Gross National Product) per capita. The GNP is calculated by adding to the GDP the output of the UK nationals abroad and subtracting from it the output of the foreign nationals who reside in the UK. 4. Which of the following are examples of private property? = Computers belonging to your college A farmer’s land in the Soviet era Russia Shares in a company = A worker’s skills 5. Which of the following are examples of markets? = Wartime food rationing. The transfer of goods and services that occur in a centrally planned economy as a result of government orders is not a market. Auction websites, such as eBay Touts selling tickets outside concert halls Sale of illegal arms 6. The figure shows a graph of GDP per capita for West and East Germany, Japan and Spain between 1950 and 1990. You can enlarge the figure by clicking on it. Which of the following statements is correct? Having a much lower starting point in 1950 was the main reason for East Germany’s poor performance compared to West Germany. = Japan had even lower starting point than East Germany but yet was able to catch up with West Germany by 1990. The fact that Japan and West Germany have the highest GDP per capita in 1990 implies that they found the optimal economic system. = Different economic systems can be successful. The Japanese economy had its own particular combination of private property, markets and firms along with a strong government coordinating role which was different to the system in West Germany.

Spain was able to grow at a higher growth rate than Germany between 1950 and 1990. The difference in East and West Germany’s performance proves that capitalism always promotes rapid economic growth while central planning is a recipe for stagnation. = In economics one cannot use one piece of evidence to “prove” a theory. What we can infer here is that during the second half of the 20th century, the divergence of economic institutions mattered for the livelihoods of German people. 7. The figure shows GDP per capita for seven countries between 1928 and 2013. You can enlarge the figure by clicking on it. The Communist party rule in the former Soviet Union before 1990 was a complete failure. =Actually Former Soviet Union had growth rates much higher than Brazil’s and its GDP per capita even briefly overtook Argentina’s just before the Communist party rule ended in 1990. The contrasting performances of Botswana and Nigeria show that rich natural resources alone do not guarantee higher economic growth, but that higher quality institutions (government, markets and firms) may also be necessary. The impressive performance of South Korea’s economy implies that other countries should copy their economic system. = Korea had a system of developmental state where the government and a few very large corporations played a leading role in directing the process of development. This does not necessarily mean that this system is optimal for all countries. The evidence from the Russian Federation and the former Soviet Union after 1990 shows that the replacement of central planning by capitalism led to immediate economic growth. = GDP per capita of both countries fell after 1990. This is due to their private property not being secure, the markets not being competitive and their firms not operating as competitive firms in their newly introduced capitalist economy. 8. Select the correct statement regarding the Gini coefficient: A decreasing Gini coefficient means higher inequality. = Maximum equality occurs at 0, while the maximum inequality occurs at 1. The larger the area between the Lorenz curve and the perfect inequality line, the higher the equality. = Maximum equality occurs when the Lorenz curve is the 45-degree straight line. As inequality increases, the Lorenz curve bows downwards. The coefficient takes the value 1 when a single individual receives all the income. A lower Gini coefficient implies a wealthier nation. = Gini coefficient is a measure of income equality, not the level of income.

Technological change, population and economic growth 1. The figure is an index of average real wages of skilled workers in London between 1264 and 2001. Skilled workers were paid about £100 in 1408. = This is a graph of an index, based on the value in 1850. This means that, in real terms, the average wage was about the same in 1408 as it was in 1850. The average wage in 1850 was about the same as that in 1408 in pound terms. = The wages graphed are real wages, i.e. adjusted to take account of changes in prices. The average real wage was more or less constant between 1264 and 1850. = While the graph looks fairly constant between 1264 and 1850 compared to the rapid increase since 1850, the average real wage actually almost doubled and then halved again between 1264 and 1600. The average real wage increased by around 600% between 1850 and 2001.

2. You are renting some land from a landlord to produce crops. The economic rent is: What you pay to use the land for the economic activity (i.e. producing crops). = This is the rent as used in everyday language. Economic rent is something you would like to get and not something you have to pay. The profit level required to cover your rent. = An economic rent is what you earn above the next best alternative, which in this case may be to sublet out the land to someone else at the same rate. The extra profit you managed to earn due to a new crop producing technology you have discovered. The extra profit you managed to earn because you worked really hard for the year. = This would be the normal profit you earn on your hard work. An economic rent is what you earn over and above this normal profit. 3. You are given the technologies described in the figure to produce 100 metres of cloth. Technology D is more energy-intensive than technology C. = Technology D uses more workers and less coal, and therefore is more labour-intensive than C. Technology B dominates technology D. Technology A is the cost-minimising technology at all prices of coal and wages. = Technology A would be more costly than B, D or E if the price of coal was much higher than the wage level. Technology C can sometimes be a cheaper technology than A. = Technology C is dominated by A as it uses both more workers and more coal than A. Therefore it can never be the cheaper technology than A. 4. You are given the following three different isocost lines, MN, FG and HJ. Along isocost MN, it is more costly to produce at point N than at point B. = An isocost represents all combinations of number of workers and tonnes of coal for which the total cost of production is the same. Isocosts MN and FG represent the same price ratio (wage / coal price) but different total costs of production. Isocost HJ represents a higher wage / coal price ratio than isocost FG. = Isocost FG has slope -2 (i.e. replacing two tonnes of coal with one worker leaves the total cost of production the same), while isocost HJ has slope -0.5 (i.e. replacing one tonne of coal with two workers leaves the total cost the same). This means that labour is relatively cheaper along HJ, or isocost HJ has a lower wage/coal price ratio. Isocost HJ represents all points that can produce 100 metres of cloth at a particular price ratio. = Along isocost HJ we know that at point B (i.e. 4 workers and 2 tonnes of coal) the technology can produce 100 metres of cloth. This does not mean that all technologies along the isocost can produce 100 metres of cloth. 5. The figure depicts isocost lines for Britain in the 1600s and 1700s. The flatter isocost line HJ for the 1600s Britain indicates high wage cost relative to the coal price. = The slope of the isocost line is the negative of the price ratio = wage/coal price. A flatter isocost line indicates low wage costs relative to the coal price. The increase in the level of wages relative to the cost of energy in the 1700s is represented by the shifting out of the isocost line from HJ to the parallel isocost line going through A. = An increase in the level of wages relative to the cost of energy would lead to a steeper isocost line. Had the wage level fallen together with the falling energy costs (due for example to cheaper transportation), then the 1700s Britain would definitely have stayed with technology B. = What matters is the relative price and not the absolute level. So if wages fall less than the energy costs, such that the price ratio still increases, then technology A may still be the better choice.

The shifting in of the isocost line to FG from the parallel one going through B suggests that an innovation rent is earned by 1700s Britain as the country moves from technology B to A. 6. The figure depicts the production function of grain for farmers under average growing conditions with the currently available technology. In a year with exceptionally good weather conditions, the production function curve will be higher and parallel to the curve above. = Zero farmers means zero output. Therefore all curves must start at the origin. Hence it cannot shift upward or downward in a parallel manner. A discovery of new high-yielding crop seeds would tilt the production function curve higher anticlockwise, pivoted at the origin. In a year of bad drought the production curve can turn downward for large numbers of farmers. = A downward-sloping curve implies decreasing output as the number of farmers increases. This would only be the case if the additional labourers have negative effects on the productivity of the existing labourers, which we normally rule out. If there is an upper limit on the amount of grain that can be produced, then the curve will end up horizontal for large number of farmers. 7. In the bubonic plague of 1348 and 1351, between one quarter and one third of Europe’s population died. In the 17th and 18th centuries the wages of unskilled workers relative to the incomes of land owners were only one fifth of what they had been in the 16th century. It follows that: According to the Malthusian model, the fall in the population due to the bubonic plague would have led to an increase in the average productivity of workers, causing the observed rise in the real wage post-plague. The doubling and halving of the real wage index over 250 years from around 1350 is contrary to the Malthusian model. = According to the Malthusian model the increase in population caused by the rise in real wages would have led to a decrease in the average productivity, leading to an eventual fall in the real wage back down to the subsistent level. This seems to be what is observed in the graph. The fall in the unskilled workers’ share of total output in the 17th and 18th centuries was due to the fall in their average product of labour. = The average product of labour determines the size of the pie (the total output), but what share of this is claimed by the workers is determined by their bargaining power, which diminished over the Malthusian cycles in the graph. We can see that real wages shot up in the 19th century. The fall in the relative wages of the unskilled workers in the 17th and 18th centuries was one of the factors that led to this. = On the contrary, the wage growth happened in spite of the low wages relative to the incomes of the land owners. The key to the process was that wages remained high compared to the prices of energy and capital goods, leading to innovation for less labour-intensive technology. 8. According to Malthus, with diminishing average product of labour in production and population growth in response to increases in real wages, an increase in productivity will result in increased population but not increased real wages in the long run. Based on the information above, which of the following statements is correct? Between the 1800s and the 1860s population grows as real wages rise. This is entirely in line with Malthus’s description of the economy’s growth. There is a clear evidence of a persistent and continuous Malthusian trap between the 1280s and the 1800s. = It is true that Malthus assumes population growth in response to real wage increases. However, as population increases the average per-capita output falls, resulting in a fall of the real wage back to the subsistence level. This is not evident in the graph post-1800s. There is a clear evidence of a persistent and continuous Malthusian trap between the 1280s and the 1800s. = There are actually two periods – between the 1280s and the 1590s, and between

the 1740s and the 1800s – when a Malthusian trap is evident. There is, however, the period in between when the negative relationship between the real wage and population seems to break down (no population growth despite the wage increase). The Malthusian traps seem to occur in a cycle of 60 years. = Though the second cycle of the Malthusian trap lasted about 60 years (between the 1740s and the 1800s), the first cycle seems to have lasted around 300 years. The Malthusian model does not take into account the possibility of a persistent positive technology shock that may offset the diminishing average product of labour.

Scarcity, work and choice Currently you work for 40 hours per week at the wage rate of £20 an hour. Your free hours are defined as the number of hours not in work per week, which in this case is 24 hours × 7 days – 40 hours = 128 hours per week. Suppose now that your wage rate has increased by 25%. If you are happy to keep the total weekly income constant, then: Your total number of working hours per week will fall by 25%. = The new wage rate is 20 × 1.25 = £25. Your total weekly income is 20 × 40 hours = £800. Therefore your new total number of working hours is 800/25 = 32 hours. This represents a change of (32 – 40)/40 = -20% Your total number of working hours per week will be 30 hours. = The new wage rate is 20 × 1.25 = £25. Your total weekly income is 20 × 40 hours = £800. Therefore your new total number of working hours is 800/25 = 32 hours. Your total number of free hours per week will increase by 25%. = Then your free time is now 24 × 7 – 32 = 136 hours, an increase of (136 – 128)/128 = 6.25%. Your total number of free hours per week will increase by 6.25%. 2. The figure depicts the annual number of hours worked against GDP per capita in the US, France and the Netherlands, between 1870 and 2000. An increase in GDP per capita causes a reduction in the number of hours worked. = The negative relationship between the number of hours worked and GDP per capita does not necessarily imply that one causes the other. The GDP per capita in the Netherlands is lower than that in the US because Dutch people work fewer hours. = Lower GDP per capita in the Netherlands may be due to a number of other factors, including the possibility that the Dutch may prefer less income but more leisure time for cultural or other reasons. Between 1870 and 2000, the French have managed to increase their GDP per capita more than ten-fold while more than halving the number of hours worked. On the basis of the evidence in the graph, one day the French will be able to produce GDP per capita of over $30,000 with less than 1,000 hours of work. = That would be nice. However past performance does not necessarily mean that the trend will continue in the future. 3. The figure shows a student’s production function with the final grades (the output) related to the number of hours spent studying (the input). You can enlarge the figure by clicking on it. The marginal product and the average product are the same for the initial hour. The marginal product and the average product are both constant beyond 15 hours. = The marginal product is constant beyond 15 years, but the average product remains diminishing. The horizontal production function beyond 15 hours means that studying for more than 15 hours is detrimental to the student’s performance. = If studying for more than 15 hours has a negative effect on the student’s grade, then it means that the marginal product is negative, implying a downward-sloping curve beyond 15 hours.

The marginal product and the average product at 20 hours are both 4.5. The average product is 90/20 = 4.5. The marginal product is zero. 4. The figure shows the indifference curves of a student for the two goods, free time and final grade. You can enlarge the figure by clicking on it. The student prefers C to B because at C she has more free time. = The indifference curve through C is lower than that through B. Hence the student prefers B to C. The student is indifferent between the grade of 84 with 15 hours of free time, and the grade of 50 with 20 hours of free time. The student prefers D to C, because at D she has the same grade for more free time. = At D the student has the same amount of free time for higher grade. At G, the student is willing to give up 2 hours of free time for 10 extra grade points. = Going from G to D, the student is willing to give up 10 grade points for 2 extra hours of free time. Going from G to E, she is willing to give up 2 hours of free time for 15 extra grade points. 5. The marginal rate of substitution is:

The ratio of the numbers of the goods in a given consumption choice. = The marginal rate of substitution represents the ratio of trade-off at the margin, i.e. how many of one good is the consumer willing to sacrifice for one extra unit of the other. The number of one good the consumer is willing to trade with one unit of the other. The number of one good the consumer has to exchange with one unit of the other, given his budget. = This would be the price ratio (if one good is twice as expensive as the other, then you would swap one of the former with the two of the latter to keep expenditure constant). This is sometimes called the economic rate of substitution. The slope of the indifference curve. 6. You are a taxi driver who earns £50 for a day’s work. You have been offered a one-day ticket to watch tennis on the Centre Court at Wimbledon for £40. Being a big tennis fan, you value the day at Wimbledon at £100. Then: The opportunity cost of the day at Wimbledon is £40. = By going to Wimbledon you are foregoing the opportunity of earning £50 taxi-driving. This is your opportunity cost. The economic cost of the day at Wimbledon is £40. = The economic cost is the sum of the actual price you pay plus the opportunity cost, which in this case is £40 + £50 = £90. The economic rent of the day at Wimbledon is £10. You would have paid up to £100 for the ticket. = The maximum price you would have paid for the ticket is the price at which your economic rent is zero. In this case this is £50. 7. The figure shows a student’s production function with the final grades (the output) related to the number of hours spent studying (the input). You can enlarge the figure by clicking on it. The hours of free time per day is given by 24 hours minus the hours of study per day. Consider now the student’s feasibility set of the combinations of her final grade and the hours of free time per day. Then: To find the feasible set one needs to know the number of hours that the student sleeps per day. = The hours of free time per day is already given as 24 hours minus the hours of study per day. Therefore the number of hours spent sleeping is included in the hours of free time. The feasibility frontier is a mirror image of the production function above.

The feasibility frontier is horizontal between 0 and 10 hours of free time per day. = The production function is horizontal after 15 hours of study per day. Therefore the feasibility frontier must be horizontal for 9 hours of free time per day or less. The marginal product of labour at 10 hours of study equals the marginal rate of transformation at 14 hours of free time. 8. Study this figure, which shows a student’s feasible frontier and her indifference curves for final exam marks and the hours of free time per day. All students have the same feasible frontier, but they may differ in the slope of the indifference curves depending on their preferences. You can enlarge the figure by clicking on it. At the chosen consumption bundle the marginal rate of substitution equals the marginal rate of transformation. C is below the feasible frontier but D is on the feasible frontier. Therefore this student may choose bundle D as her optimal choice. = Along the feasible frontier, at bundle E the student is on a higher indifference curve. Therefore E will be chosen instead of D. All students with downward-sloping indifference curves, whatever the slope, would choose bundle E. = Students with flatter indifference curves (i.e. they are willing to sacrifice more hours of free time for the same number of extra marks) have lower marginal rate of substitution. Therefore they will choose bundles to the left of E (such as D) where their indifference curves are tangent to the feasible frontier. At E, the student has the highest ratio of the final exam mark per hour of free time per day. = The points along the feasible frontier to the left of E have higher ratios of final exam mark per hour of free time. The optimal bundle is determined as where marginal rate of substitution equals marginal rate of transformation. 9. The figures show a student’s production function and her corresponding feasible consumption frontier for her final exam marks and the hours of work/free time per day. They show the effect of an improvement in her studying technique, represented by the tilting up of the two curves. You can enlarge the figures by clicking on them. Consider two cases of further changes in the student’s study environment: Case A. She suddenly finds herself needing to spend 4 hours a day caring for a family member. (You may assume that her marginal product of labour is unaffected for the hours she studies.) Case B. Due to health reasons her marginal product of labour is reduced by 10%. For case A, the student’s production function shifts to the right. = With the student’s marginal product of labour unaffected, the production function remains the same. For case A, the student’s feasible frontier shifts to the left. For case A, the student’s production function shifts down in a parallel manner. = With the reduction in the student’s marginal product of labour the production function curve becomes flatter. This leads to tilting of the curve inwards, pivoted at the origin. For case B, the student’s feasible frontier tilts inwards, pivoted at the intercept with the x-axis. 10. The figure depicts the budget constraint of a consumer with the hourly wage of $15. You can enlarge the figure by clicking on it. The slope of the budget constraint is the negative of the wage rate, i.e. -15. The budget constraint is a feasible frontier with a constant marginal rate of transformation. An increase in the wage rate would make the budget constraint shift outwards. = An increase in the wage rate would make the budget constraint steeper, pivoted at the intercept on the x-axis.

A gift of $60 would make the budget constraint steeper, with the intercept on the y-axis increasing to $300. = A gift would shift the budget constraint outward in a parallel manner. 11. Consider this figure, which depicts a model of labour supply and consumption for the US in 1900 and 2013. The wage rate is shown to have increased between the two years. You can enlarge the figure by clicking on it. The substitution effect corresponds to the steepening of the budget constraint. This is represented by the move from point A to point D. = The substitution effect is the pure effect of the change in the relative price, ignoring the effect of the price change on the real income (which is the income effect). This means that it is the effect of the steepening of the budget constraint around an indifference curve, which corresponds to the move from C to D. The income effect corresponds to the shift in the budget constraint outwards due to the higher wage income. This is represented by the move from point A to C. As shown, the income effect dominates the substitution effect, leading to a reduction in the labour supply. With a different set of indifference curves or a different wage rise, the substitution effect can dominate the income effect leading to a rise in the labour supply.

Social interactions 1. In a simultaneous one-shot game: A player observes what others do before making a decision on his action. = A simultaneous game (as opposed to a sequential game) means that players all make a decision on their action simultaneously. A player takes into account what other players may do in future to decide his action today. = In a one-shot game (as opposed to a repeated game), the actions are taken only once. Players coordinate to find the actions that lead to the optimal outcome for the society. = The players take actions non-cooperatively, driven by self-interest. A player chooses his action taking into account the possible actions that other players can take. 2. Brian likes going to the cinema more than watching football. Anna, on the other hand, prefers watching football to going to the cinema. Either way, they both prefer to be together rather than spending an afternoon apart. The table represents the happiness levels (payoffs) of Anna and Brian, depending on their choice of activity - the first number is Brian’s happiness level while the second number is Anna’s. You can click on the table to enlarge it. Based on the information above, we can conclude that: The dominant strategy for both is to watch football. = For Brian, the dominant strategy is to go to the cinema. There is no dominant strategy equilibrium. = The dominant strategy equilibrium is the outcome in which each player plays his/her dominant strategy. In this game it is (Cinema, Football), with the payoff (4, 3). The dominant strategy equilibrium yields the highest possible happiness for both. = Anna would attain the highest happiness level if they could go to the cinema together. Similarly Brian would be happiest if they both watched football. Neither player would want to deviate from the dominant strategy equilibrium. 3. Dimitrios and Ameera work for an international investment bank as foreign exchange traders. They are being questioned by the police on their suspected involvement in a series of market manipulation trades. The table below shows the cost of each strategy (in terms of the length in

years of jail sentences they will receive), depending on whether they accuse each other or deny the crime. The first number is the payoff to Dimitrios, while the second number is the payoff to Ameera (negative numbers signify losses). Assume that the game is a simultaneous one shot game. You can click on the table to enlarge it. Both traders will hold out and deny their involvement. = Denying is a dominated strategy so they will choose to accuse. Both traders will accuse each other, even though they will end up being in jail for 8 years. Ameera will accuse, whatever she expects Dimitrios to do. There is a small possibility that both traders will get away with 2 years each. = There isn’t. The players will never play the dominated strategy in a one-shot game. 4. Anil has just won the lottery and has received a sum of 10,000 rupees. He is considering how much (if at all) he would like to share this sum with his friend Bala. The figure depicts the feasible payoffs set, and Anil’s indifference curves for when he is completely selfish and when he is somewhat altruistic. You can click on the figure to enlarge it. Unfortunately, before he manages to share his winnings Anil receives a tax bill for these winnings of 3,000 rupees. Based on this information, which of the following statements is true? Bala will receive 3,000 rupees if Anil is somewhat altruistic. = Without the tax Anil would have shared 3,000 rupees with Bala. With the total income now at 7,000 rupees, Anil will choose to share less than this. If Anil was somewhat altruistic and kept 7,000 rupees before the tax bill, he will still keep 7,000 rupees after the tax bill by turning completely selfish. = We assume that the consumer’s preferences are fixed. Hence he will remain somewhat altruistic. Anil will be on a lower indifference curve after the tax bill. Had Anil been completely altruistic and only cared about Bala’s share, then Bala will receive the same income before and after the tax bill. = Bala would have received 10,000 and 7,000 rupees respectively before and after the tax bill. 5. The diagram shows Anil’s preferences when he is completely selfish, and also when he is somewhat altruistic, when he and Bala participate in the prisoners' dilemma game. You can click on the figure to enlarge it. when Anil is completely selfish, using Terminator is his dominant strategy. when Anil is somewhat altruistic, using Terminator is his dominant strategy. = When Anil is somewhat altruistic, (I, I) is on a higher indifference curve than (T, I), and (I, T) is on a higher indifference curve than (T, T). So Anil would choose IPC irrespective of Bala’s choice and therefore it is his dominant strategy. when Anil is completely selfish, (T, T) is the dominant strategy equilibrium even though, for Anil, it is on a lower indifference curve than (T, I). (I, I) is attained as the dominant strategy equilibrium if both Anil and Bala are somewhat altruistic. 6. Which of the following statements is correct regarding a public good? The national army is a public good, because use by one person does not reduce its availability to others. Electricity is a public good because it is available to all members of the public. The Houses of Parliament is a public good because it is not privately owned. Pollution as a by-product of production is a public good because it affects the public.

7. Anastasia and Belinda’s favourite hobby is to go metal detecting. On this occasion Anastasia finds four Roman coins while Belinda has been unsuccessful. Both women have reciprocal preferences. From this, we can say that: If both women are altruistic, then they will definitely share the find 50-50. = It depends how altruistic Anastasia is. She is still altruistic if she gives less than a half to Belinda. If Anastasia is altruistic and Belinda is selfish, then Anastasia may not share the find. If Anastasia is selfish and Belinda is altruistic, then Anastasia will definitely not share the find. = Reciprocity means that Anastasia may still share, if she has benefitted from Belinda’s altruism in the past or hopes to benefit from it in the future. If Anastasia is altruistic and Belinda believed in fairness, then they may or may not share the find 50-50. 8. Consider an ultimatum game where the Proposer offers a proportion of $100 to the Responder, who can either accept or reject the offer. If the Responder accepts, both the Proposer and the Responder keep the agreed share, while if the Responder rejects, then both receive nothing. The figure shows the result of a study which compares the responses of US university students and Kenyan farmers. You can click on the figure to enlarge it. Kenyans are more likely to reject low offers than Americans. = Kenyan farmers are more likely to reject low offers than US students. This does not imply that all Kenyans are more likely to reject low offers than all Americans. Just over 50% of Kenyan farmers rejected the offer of the Proposer keeping 30%. = Just over 50% of Kenyan farmers rejected the offer of the Responder accepting 30%. Both groups of Responders are indifferent between accepting and rejecting an offer of receiving nothing. = Both groups of Responders 100% rejected the offer of receiving nothing. Kenyan farmers place higher weight on fairness than US students. 9. Consider the Ultimatum Game in the previous question. The table shows the percentage of the Responders who rejected the amount offered by the Proposers for Kenyan farmers and US university students. You can click on the table to enlarge it. The expected payoff of offering $30 is $4.50 for the US students. = The expected payoff is: 85% chance of keeping $70 = 0.85 × 70 = $59.5 The expected payoff of offering $40 is $6 for the US students. The expected payoff of offering $20 is $8 for the Kenyan farmers. The expected payoff of offering $10 is higher for the Kenyan farmers than for the US students. = The probability of being rejected is higher for the Kenyan farmers than for the US students. The expected payoff is therefore lower for the Kenyan farmers. 10. Consider the following game between Anil and Bala on their choice of crops, where the first and the second numbers are the payoffs to Anil and Bala, respectively. You can click on the table to enlarge it. There are two Nash equilibria: (Cassava, Rice) and (Rice, Cassava). The choice of Cassava is a dominant strategy for Anil. = When Bala chooses Cassava, Anil is better off choosing Rice. Hence Cassava is not a dominant strategy for Anil. The choice of Rice is a dominant strategy for Bala. = When Anil chooses Rice, Bala is better off choosing Cassava. Hence Rice is not a dominant strategy for Bala.

There are two dominant strategy equilibria: (Cassava, Rice) and (Rice, Cassava). = There are no dominant strategies. Hence there are no dominant strategy equilibria. The firm and its customers 1. Consider a firm whose cost of producing each unit of its output is the same at all output levels. Which of the following statements is correct regarding its isoprofit curves? Each isoprofit curve depicts the firm’s profit for different outputs for a given price of the output good. = An isoprofit curve joins all combinations of price and output for which the firm’s profit is the same. The isoprofit curves are upward-sloping. = For a higher output, the price has to be lower to keep the profit level constant. Therefore isoprofit curves are generally downward-sloping. (It can be horizontal if the price equals the unit cost of production.) The isoprofit curves cannot cross. The higher isoprofit curves represent higher price levels. = Isoprofit curves represent different profit levels and not price levels. 2. A firm’s unit cost of production is £12 per output good. Let P be the unit price of the output good and Q be the total output level. Which of the following statements is correct? Point (Q, P) = (2,000, 20) is on the isoprofit curve representing the profit level £20,000. = At (Q, P) = (2,000, 20), profit = (20 – 12) × 2,000 = £16,000. Point (Q, P) = (2,000, 20) is on a lower isoprofit curve than point (Q, P) = (1,200, 24). = At (Q, P) = (1,200, 24), profit = (24 – 12) × 1,200 = £14,400. Therefore (2,000, 20) is on a higher isoprofit curve. Points (Q, P) = (2,000, 20) and (4,000, 16) are on the same isoprofit curve. Point (Q, P) = (5,000, 12) is not on any isoprofit curve. = At P = 12 the firm makes no profit. Therefore (5,000, 12) will be on a horizontal isoprofit curve representing zero profit. 3. The table represents market demand Q of good at different prices P. Click on the table to enlarge it. The firm’s unit cost of production is £60. Based on this information, which of the following is correct? At Q = 100, the firm’s profit is £20,000. = At Q = 100, profit = (270 – 60) × 100 = £21,000. The profit-maximising output is Q = 400. The maximum profit that can be attained is £50,000. = The maximum profit is attained at Q = 400, where profit = (180 – 60) × 400 = £48,000. The firm will make a loss at all outputs of 800 and above. = The firm will make a loss of all outputs above 800. At 800, though, the profit and loss = 0.

4. Which of the following statements are correct? A firm’s production is said to exhibit constant returns to scale if doubling the inputs level leads to doubling of the output level. A firm’s production is said to exhibit decreasing returns to scale if doubling the inputs level leads to more than doubling of the output level. A firm is said to have economies of scale if it is able to produce goods cheaper as the firm expands its production. = Usually a falling average cost would be associated with economies of scale. However it is possible that average costs fall even if there are diseconomies of scale, for

example when there are large fixed costs of production that are spread over a large number of units. A firm is said to have diseconomies of scale if doubling the inputs level leads to less than doubling of the output level. 5. Consider a firm with fixed costs of production. Which of the following statements is correct regarding average cost (AC) and marginal cost (MC) of the firm? When AC = MC, the AC curve has a zero slope. When AC > MC, the MC curve is downward-sloping. When AC < MC, the AC curve is downward-sloping. The MC curve cannot be horizontal. 6. Suppose that the unit cost of producing a pound of cereal is $2, irrespective of the level of output. Which of the following statements is correct? The total cost curve is a horizontal straight line. = The total cost = 2Q, where Q is the output. This is an upward-sloping straight line through the origin. The average cost curve is downward-sloping. The marginal cost curve is upward-sloping. The average cost and the marginal cost curves coincide. 7. The following diagram depicts two demand curves, D and D’, for a product. On demand curve D, for the price £5,000 the firm is able to sell 15 of the product. On demand curve D’, for the output of 70 the firm is able to charge the price £3,000. The firm is able to sell 40 more of the product at price £1,000 on D’ than on D. The firm is able to charge £2,000 more for the product at output 30 on D’ than on D. 8. The following diagram depicts the marginal cost curve (MC), the average cost curve (AC) and the isoprofit curves of a firm. The profit level at A is 1,000. = The profit along the AC curve is zero (as the price equals the average cost). The profit level at B is 2,400. = The profit level for Isoprofit 1 can be calculated at Q = 100, where the average cost is 20. Here on Isoprofit 1 the price is 40, and therefore the corresponding profit is (40 – 20) × 100 = 2,000. The price at C is 50. The profit margin at B is 8. = The profit level at B is 2,000. We can see from the AC curve that at output Q = 200, the average cost is 25. Therefore the price at B is given by (p – 25) × 200 = 2,000, or p = 35. Profit margin = 35 – 25 = 10. 9. The figure depicts the demand curve for Beautiful Cars, and the marginal cost and isoprofit curves of the car manufacturer. You can click on the figure to enlarge it.

The quantity and price at point E are (Q*, P*) = (32, 5,440). Suppose now that the firm keeps the price at P = $5,440 but produces 50 cars instead of 32. You may assume that the average cost of producing 32 cars and 50 cars are the same. Based on this information, which of the following is correct? The firm will now sell all 50 cars at $5,440. = The demand curve states that at $5,440, the maximum demand for the car is 32.

The firm’s profit is now increased. = The firm’s profit is reduced by the cost of producing the extra 18 cars that now remain unsold. The firm’s profit remains the same. = The firm’s profit is reduced by the cost of producing the extra 18 cars that now remain unsold. The firm’s profit is now reduced. 10. This question uses the same figure as previously. You can click on the figure to enlarge it. Suppose instead the firm chooses to produce Q = 32 cars and sets the price at P = $5,400. You are also given that the profit at point E is $63,360. Based on this information, which of the following statements is correct? The profit remains the same at $63,360. = At Q* = 32, if the profit at E is $63,360 then the average cost at this output must be AC such that (5,440 – AC) × 32 = 63,360, or AC = $3,460. Therefore at the new price, the profit is now (5,400 – 3,460) × 32 = $62,080. The profit is reduced to $62,080. The average cost of production is $3,400. = At Q* = 32, if the profit at E is $63,360 then the average cost at this output must be AC such that (5,440 – AC) × 32 = 63,360, or AC = $3,460. This is the same irrespective of the price charged. The firm is unable to sell all the cars. = At the lower price the market demand is higher than 32, so the firm will have no problem selling all 32 cars at the new price. 11. This question uses the same figure as previously. You can click on the figure to enlarge it. Suppose now that the firm decides to switch from P* = $5,440 and Q* = 32 to a higher price. Assuming that the firm will choose the profit-maximising level of output at the new price, which of the following statements is correct? The quantity of cars produced is reduced. The marginal cost of producing an extra car is higher. = The marginal cost curve is upwardsloping. Therefore at a lower output the marginal cost is lower. The total cost of production is higher. = The marginal cost of producing the cars is lower at all Q < 32 than at E. Therefore the total cost is also unambiguously lower at Q < 32 than at Q* = 32. The profit is increased due to the new higher price. = Moving higher up to the left of point E means that the firm will move to a lower isoprofit curve. Hence its profit is reduced. 12. The figure shows the demand curve and the marginal revenue curve of the Beautiful Cars market, and the marginal cost curve and the profit function curve of the manufacturing firm. That table gives data on the market demand. You can enlarge the figure and table by clicking on the image. The marginal revenue at C is $2,000. The marginal cost at E is $2,960. At A, the firm’s marginal revenue exceeds its marginal cost. Therefore the firm should reduce its output. At B, the firm’s marginal profit is $4,880. 13. Which of the following statements is correct? Consumer surplus is the difference between the consumers’ willingness-to-pay and the price actually paid. Producer surplus equals the firm’s profit. = Producer surplus is the difference between the firm’s revenue and its marginal cost. Additional to its marginal cost the firm incurs fixed costs of production which is not accounted for in producer surplus. The profit is the producer surplus minus the fixed costs.

Deadweight loss is the loss incurred by the producer for not selling more cars. = The deadweight loss is the loss of potential surplus that arises due to the firm producing at the output level below the socially optimal level. It is the sum of the surplus losses of both the consumers and the producer. All possible gains from trade are attained when the producer firm chooses its profit maximising output level. = When a firm has market power (i.e. the demand curve is downward-sloping) and it chooses its profit maximising output level, it restricts its output to a level below the socially optimal level (the level that maximises the gains from trade) in order to maximise its surplus. 14. The figure depicts the market demand for Beautiful Cars. You can enlarge the figure by clicking on it. The slope of the demand curve is -80. Based on this information, which of the following calculated elasticities ε is correct? ε = 100 at Q = 0. ε = 0.25 at Q = 20 (point A). ε = 0.5 at Q = 70 (point D). ε = 0 at Q = 100. 15. The figure depicts two demand curves. You can click on the figure to enlarge it. Demand curve D1 is highly elastic. Demand curve D2 is less elastic than demand curve D1. The elasticity is higher at A than at B. The elasticity is the same at A and C. 16. Suppose that in a small town a multinational retailer is planning to build a new superstore. Which of the following arguments are correct? The local protestors argue that the close substitutability of some of the goods sold between the new and the existing retailers means inelastic demand for those goods, leading to the new retailer attaining excessive market power. = The availability of close substitutes implies elastic demands for those goods. The new retailer argues that the close substitutability of some of the goods implies their high elasticity of demand, which leads to healthy competition resulting in lower prices for consumers. The local protestors argue that once they are driven out, there will be no competition giving the multinational retailer the market power. This would drive up prices. The new retailer argues that there are enough differentiability in most of the goods sold between them and the existing retailers. This means sufficiently elastic demand for those goods which would protect the local retailers. = High differential (i.e. low substitutability) implies inelastic demand.

Supply and demand: Price-taking and competitive markets 1. As a student representative, one of your roles is to organise a second-hand textbook market between the current and former year 1 students. After a survey you estimate the demand and supply curves for the textbooks. The figure shows the result. You can click on the figure to enlarge it.

For example, you estimate that pricing the book at $7 would lead to a supply of 20 books and a demand of 26 books. Based on this information, which of the following statements is correct? A rumour that the textbook may be required again in Year 2 would shift the supply curve upwards. You can double the supply by doubling the price to $14. = Doubling the supply to 40 requires increasing the price along the supply curve to $12. A rumour that the textbook may no longer be on the reading list for the new Year 1 students would shift the demand curve upwards. = The rumour would shift the demand curve downwards. You can double the demand by reducing the price sufficiently along the demand curve. = The maximum demand attainable is 40 at zero price. 2. You have now combined the demand and supply curves from question 1. You can click in the figure to enlarge it. As a result, you find that the curves intersect at (Q, P) = (24, 8). Based on this information, which of the following is correct? At price $10, there is an excess demand for the textbook. = At $10 the price is above the equilibrium price of $8, and there is an excess supply of books. At $8, some of the sellers have an incentive to increase their selling price. = At $8, all buyers with willingness-to-pay at $8 or above have been matched with sellers with willingness-to-accept of $8 or less. So increasing the price will lead to the loss of the sale. At $8, the market clears. 40 books will be sold in total. = The maximum level of demand is 40, but 16 of these will be unfulfilled as their willingness-to-pay is below the market clearing price of $8. 3. A price taking firm’s marginal and average cost curves, and its isoprofit curves are depicted in this figure. You can click on the figure to enlarge it. Also in the diagram, the market price for the bread is given at €2.35. Which of the following statements is correct regarding the firm’s supply? The firm’s supply curve is horizontal. = The firm’s demand curve is horizontal. Its supply curve is upward-sloping. At the market price of €2.35, the firm will supply 62 loaves where the firm makes zero profit. = At €2.35 the firm will supply 120 loaves where the firm’s profit is maximised. At different market prices, the firm will choose to supply where the isoprofit curve is above the marginal cost curve. = A profit-maximising firm will choose the point on the highest isoprofit attainable. With horizontal demand curves, the point will always be at the bottom of the Ushaped isoprofit curves, where the slope is zero. This is also where the marginal cost curve intersects with the isoprofit curves. The marginal cost curve equals the supply curve. 4. There are two different types of producers of a good in an industry where firms are pricetakers. The marginal cost curves of the two types are shown in the figure. You can click on the figure to enlarge it. Type A is more efficient than Type B: for example, as shown, at the output of 20 goods, the Type A firms have the marginal cost of £2, as opposed to the marginal cost of £3 for the Type B firms. There are 20 Type A firms and 15 Type B firms in the market. Based on this information, which of the following statements is correct? At price £2, the market supply is 400. = At £2, the market supply is 20 × 20 firms + 15 × 15 firms = 625. The market will supply 1000 of the good at price £3.

At price £2, the market marginal cost of supplying one extra unit of the good will depend on the type of the firm which produces it. = Both types will be producing at the marginal cost of £2. Therefore the market marginal cost is £2, irrespective of which firm produces the extra unit. With different types of firms, the market marginal cost curve cannot be estimated. = The market marginal cost curve is its supply curve. 5. The diagram shows the market equilibrium of the bread market in 2015 to be 5,000 loaves per day at price €2. you can click on the figure to enlarge it. In 2016, you find that the market equilibrium price has fallen to €1.50. The fall in the price must have been caused by a downward shift in the demand curve. = The price fall can be caused by a downward shift in the supply curve as well. If we know additionally that the market output has also decreased, then we can conclude that the demand curve has shifted down. The fall in the price must have been caused by a downward shift in the supply curve. = The price fall can be caused by a downward shift in the demand curve as well. If we know additionally that the market output has increased, then we can conclude that the supply curve has shifted down. It is not certain which curve has shifted to cause the price fall. At €1.50 there will be an excess demand of bread. 6. In the following diagram, the market equilibrium output and price of the bread market is shown to be at (Q*, P*) = (5,000, €2). Suppose now that the bakeries produce 6,000 loaves instead and sell them at €2 each. Assuming that all loaves are sold, which of the following statements is correct? The consumer and producer surpluses are both increased. = The 1,000 extra loaves are sold at €2, above the willingness-to-pay of the consumers and below the marginal cost of the producers. Therefore both surpluses are reduced. The producer surplus is increased but the consumer surplus is decreased. The consumer surplus is increased but the producer surplus is decreased. The deadweight loss is given by a triangle on the right of the market equilibrium, between outputs 5,000 and 6,000. 7. Which of the following statements are correct about Pareto efficiency? Pareto efficiency is attained when the production is at its efficient level. = Pareto efficiency is attained when there is no alternative feasible allocation in which at least one person would be better off without making anyone else worse off. When the market equilibrium is Pareto efficient, then there is no deadweight loss. The perfectly competitive market equilibrium is always Pareto efficient. At the Pareto efficient outcome the surplus from trade is maximised. 8. Which of the following statements are correct regarding shifts in demand and supply curves? A fall in the mortgage rate would shift the demand curve of new houses up. A launch of a new Sony smart phone would shift the demand curve of the existing iPhones up. A fall in the oil price would shift the demand curve of petrol up. = This is the market moving down the demand curve to a new equilibrium. The demand curve is not shifting. A fall in the oil price would shift the supply curve of a manufactured good down. 9. The figure shows the market for bread in the short run and the long run. You can click on the figure to enlarge it. All bakeries are identical.

The supply curve of each bakery shifts as more bakeries enter the market. = The supply curve of each bakery remains the same. It is the market supply curve that shifts down. A and B are short-run equilibria as the bakeries are making a positive economic rent and therefore we expect new entrants. C is the long-run equilibrium as the market demand is filled. = The long-run equilibrium occurs when the bakeries are no longer making a positive economic rent. The market supply curve is more inelastic in the long run than in the short run. = The market supply curve is flatter in the long-run, i.e. it is more elastic. 10. The figure depicts the demand and supply curves in the salt market. It also depicts the shift in the supply curve due to the implementation of 30% tax on the price of salt. You can click on the figure to enlarge it. In the post-tax equilibrium, the consumers pay P1 and the producers receive P*, where P1 = 1.3P*. = In the post-tax equilibrium, the consumers pay P1 and the producers receive P0, where P1 = 1.3P0. The government’s tax revenue is given by (P* – P0)Q1. = The government’s tax revenue = (P1 – P0) × Q1. The deadweight loss is given by ½(P1 – P0)(Q* – Q1). As a result of the tax, the consumer surplus is reduced by ½(Q1 + Q*)(P1 – P*). 11. The figure shows the effect of a fat tax on the consumer and producer surpluses for butter. The before-tax equilibrium is at A = (2.0kg, 45kr) and the after-tax equilibrium is at B = (1.6kg, 54kr). The tax imposed is 10kr per kg of butter. You can click on the figure to enlarge it. The producers receive the price 45kr per kg of butter. = The producers receive the price 54 – 10 = 44kr per kg. The very elastic supply curve implies low tax revenue. Therefore we can conclude that the government policy is less effective than if the supply curve was less elastic. = The aim of the tax is to reduce the consumption of butter. The very elastic nature of the supply curve means that the policy was very effective in achieving this aim. The very elastic supply curve implies that the proportion of the tax borne by the producers is very small compared to that by the consumers. The amount of consumer surplus lost due to tax is ½(54 – 45)(2.0 – 1.6) = 2.0. = As well as the area of the triangle calculated, the consumers also lose their share of the tax burden given by (54 – 45) × 1.6 = 14.4. Therefore the total reduction in the consumer surplus is 16.4. 12. The figure on the left shows the market for Choccos, which is produced by one firm. The wider market for chocolate bars, with many close substitutes, is shown in the right-hand figure. You can click on the figure to enlarge it. The firm chooses to produce at the bottom of the U-shaped isoprofit curve. = The firm chooses to produce where the isoprofit curve is tangent to the firm’s demand curve. As the demand curve is not quite horizontal, this point will be close to, but not at, the bottom of the U-shape. All chocolate bars will be sold at the same price P*. = The chocolate bars are not perfect substitutes. They will be sold at similar but not exactly the same prices. The existence of many competitors means that the firm makes zero economic rent. = As depicted in the left hand diagram, the firm produces at a point where P* > MC ≥ AC. The firm will therefore be making a positive economic rent. The market marginal cost (MC) curve is approximately the sum of the MC curves of all the producers of the chocolate bars.

Markets, contracts and information A factory is situated next to a dormitory for nurses who work nightshifts. The factory produces 120 units of humanoid robots a day. The production process is noisy, and the nurses often complain that their sleep is disturbed. Based on this information, which of the following statements is correct? The marginal private cost is the factory’s total cost of producing 120 units a day. = The MPC is the factory’s cost of producing one additional robot and not the total cost. The marginal social cost is the noise cost incurred by the nurses of producing an additional robot. = The MSC is the total cost, incurred by the factory and the nurses, of producing the additional robot, MSC = MPC + MEC. The marginal external cost is the total cost of producing an additional robot, including the noise cost incurred by the nurses. = The MEC is the noise cost incurred by the nurses of producing an additional robot. Hence MEC = MSC – MPC. The total external cost is the total costs imposed on the nurses by the factory’s production a day. 2. The figure depicts the MPC and MSC of the robot factory production in Question 1. You can click on the figure to enlarge it. The robot market is competitive and the market price is £340. Currently the factory is producing an output of 120. Based on this information, which of the following statements is correct? In order to induce the factory to reduce the output to 80, their minimum acceptable payment from the nurses is £1,600. The maximum that the nurse is willing to pay to induce the factory to reduce the output to 80 is £2,400. = The maximum that the nurse would pay is the total gain (of reduction in noise cost) associated with the fall in output. This is the total area of the shaded shape, which is (80 + 120) × 40/2 = £4,000. The factory would reduce its output to 80 only if they receive £4,000. = £4,000 is the maximum the nurses would pay. The minimum acceptable payment is £1,600. Any payment between these two values would be Pareto-improving. The net social gain from the output reduction to 80 depends on the amount paid by the nurses to the factory. = The net social gain is the difference between the nurses’ reduction in the noise cost and the loss of profit for the factory. This is 4,000 – 1,600 = £2,400. This is independent of the level of payment, which determines the distribution of the net social gain. 3. Consider a situation where the noise of a factory’s production affects nurses in the dormitory next door. Which of the following statements is correct regarding Coasian bargaining? (Assume no transaction costs.) The final output level depends on who has the property right (to produce goods or to have undisturbed sleep). = The final output level is the same irrespective of whether the factory has the right to produce or the nurses have the right for undisturbed sleep. This is the main result of Coasian bargaining. The final wealth distribution depends on who has the property right (to produce goods or to have undisturbed sleep). The final output level is the same even if the property rights are not defined. = Without property rights bargaining cannot take place. Therefore property rights must be well defined for Coasian bargaining to reach the Pareto-efficient outcome. Whether the final output level is Pareto efficient or not depends on the chosen output level. = There is a unique outcome from Coasian bargaining, which is the Pareto-efficient outcome.

4. A factory is situated next to a dormitory for nurses who work nightshifts. The production process is noisy and the nurses complain that their sleep is disturbed. The figure depicts the MPC and MSC of the factory production. You can click on the figure to enlarge it. The market for the output good is competitive and the market price is £340. The current output is 120 but the government wishes to reduce this to the efficient outcome of 80. It decides to introduce a Pigouvian tax rather than encourage Coasian bargaining to achieve this. Based on this information, which of the following statements is correct? The Pigouvian tax required to attain the efficient outcome is £120 per unit of good. = The Pigouvian tax should lower the after-tax price from £340 to £260 so that the efficient output level of 80 is attained. Hence the per-unit tax is £80. The Pareto efficient outcome is the factory’s profit-maximising outcome. The nurses are unambiguously worse off than would be under Coasian bargaining. = The best outcome for the nurses under Coasian bargaining is to have the efficient outcome and gain the full net social gain. The Pigouvian taxation attains this exact outcome. The net social gain is reduced by the amount of tax raised than would be under Coasian bargaining. = The net social gain is the same, but the final wealth distribution is not. The factory’s profit is decreased by the tax amount which the government gains. 5. Which of the following statements is correct? A good that is available to all at no additional cost is called non-rival. A public good may not be non-rival. = By definition, if a public good is available to one person it has to be available to all at no additional cost. Therefore a public good must be non-rival. A public good must be non-excludable. = For some public goods it is possible to exclude additional users even though the cost of use is zero, e.g. subscription TV. These are called artificially scarce goods. A good cannot be rival and non-excludable. = For example common grazing land is rival but nonexcludable. These goods are called common-pool resources. 6. Which of the following statements is correct regarding patents? Without patents, there would be no innovation. = There may still be innovation if there is delay in followers copying the new innovation and the innovator can earn innovation rents in excess of the cost. The patent period should be indefinitely long. = Only from the point of view of the innovators. The society benefits from the diffusion of innovation which occurs after the expiry of patent. Patents address the negative externality problem of new innovation. = Patent resolves the public good problem of new innovation, where the knowledge of the new process or product can easily be copied by others while the cost of innovation is solely incurred by the innovator. Patents convert public goods into private goods for the duration of the patent. 7. Which of the following statements is correct regarding positional goods and Veblen effect? Airline tickets are positional goods as they determine which seats you have on an airplane. = Positional goods are those that demonstrate your wealth or status, i.e. your position in the society. According to Veblen, buying chocolate in front of your friends is conspicuous consumption. = According to Veblen, conspicuous consumption is buying of luxury items, such as an expensive car, as a public display of social and economic status. Consumption of positional goods creates negative externality.

The altruistic behaviour of consumers to restrain conspicuous consumption is called a Veblen effect. = A Veblen effect is the “keeping up with the Joneses” problem that arises because consumers care not only about what they have but also what they have relative to what other people have. 8. Phil and Grant are brothers who are both getting married next summer. They have to buy wedding rings for their fiancées. The table shows the payoffs to both of buying modest or expensive rings. You can click on the table to enlarge it. Both buying the expensive ring is the Pareto efficient outcome. = Both buying expensive ring is not Pareto efficient, as the payoffs can be improved without making the other brother worse off by both agreeing to buy the modest ring. Both buying the expensive ring is the Nash equilibrium. Choosing the modest ring is the dominant strategy. = Irrespective of what the other brother does, one always has a higher payoff by buying the expensive ring. Therefore choosing the expensive ring is the dominant strategy. The inefficiency of the outcome arises from the negative externality associated with buying the modest ring. = The negative externality arises from buying the expensive ring, which causes the payoff of the other brother to fall.

9. Which of the following markets suffer from an adverse selection problem? The motor insurance market when the insurers do not know the behaviour of the drivers. = This is a hidden action (moral hazard) problem. The health insurance market when the insurers do not know who are smokers and who are not. The capital market when the investors do not know the performance of the firms raising capital. Within a firm when the managers do not know the effort levels exerted by their workers. = This is a hidden action (principal-agent) problem. 10. Imagine there are two kinds of cars: good quality cars which are worth £9,000, and lemons which are worth zero. Ten cars come on the market daily, of which six are good and the rest are lemons. The buyers do not know the quality of the cars they are buying, but they know the proportion that is good quality. All sellers are happy to accept a price at least half the value of their car. Based on this information, which of the following statements is correct? The buyers are willing to pay at most £4,500. = The average price is (9,000×6 + 0×4)/10 = £5,400. This is the highest price that the buyers are willing to pay. The good quality car sellers are happy to sell their cars at any price at or above £4,500. The lemon sellers are happy to receive any price for their cars. The buyers are happy to pay at most £5,400, which is the average quality of the cars. Therefore all cars will be traded if the price is set anywhere between £4,500 and £5,400. Only the lemons will be sold in this market. All cars will be sold if the price is set at £5,400. There is a unique equilibrium price at which all cars will be sold. = Therefore there is a continuum of equilibrium prices between £4,500 and £5,400. 11. The figure depicts the average number of late-coming parents per week in daycare centres, where a fine was introduced in some centres and not in others. The fines were eventually abolished, as indicated on the graph. You can click on the figure to enlarge it.

The introduction of the fine successfully reduced the number of late-coming parents. = This is clearly not the case from the graph, where the number of late-coming parents is seen to more than double in the centres where the fine was introduced. The parents’ tendency to be late stopped after the fine was abolished. The fine can be considered as the "price" for being late. The crowding out of the social preference is evident in the centres where the fine was introduced in periods 9, 14 and 19. = The crowding out of the social preference occurs when the moral obligation of not being late is replaced by the market-like incentive of purchasing the right to be late without ethical qualms. This is evident in the graph immediately after the introduction of the fines.

The nation in the world economy 1. The diagram depicts the supply curve in the exporting country and the demand curve in the importing country in a market for a traded good. Assume that none of the good is consumed in the exporting country and none of the good is produced in the importing country. You can click on the figure to enlarge it. At quantity 4,000, the price received by the producers is 7.25. = The price received by the producers is the price paid minus the trade costs. At quantity 4,000 this is 2.75. At quantity 6,000, the price paid by the consumer is 4. = The price paid by the consumers at quantity 6,000 is 6. The price gap represents the trade costs, such as transportation costs and trade taxes. By increasing the quantity to 6,000, the price gap is reduced to 2. = The causality is the other way round: if the trade costs were 2 the quantity traded would be 6,000. 2. The figure shows an index representing impediments to trade in the commodity market. A higher index represents more impediments - in other words less globalisation. You can click on the figure to enlarge it. The graph suggests a consistent decline in trade costs since 1870. = There is a period between the two world wars when the trade costs seem to have increased. Attempts by countries to address their unemployment problems after the 1929 Great Depression seem to have led to a decline in globalisation. There does not seem to be any evidence of increased globalisation after the second world war. = There is a downward trend in the impediments to trade index after the second world war. The graph suggests that commodity market integration over the past 150 years was one of interrupted integration. 3. Which of the following statements is correct regarding current accounts? An increase in the trade surplus would lead to a decrease in a country’s current account. = An increase in the trade surplus means a larger export–import gap. The country would then be receiving more international payments resulting in an increase in its current account. A country with zero trade balance but historically high foreign direct investment would always have a current account deficit. = A country with historically high FDI may have high dividend receipts from these investments. When the net earnings are positive the current account would be in surplus. An increase in remittance by a country’s nationals abroad would lead to a lower current account. = Remittance is where migrant nationals send money back to their families at home. This would increase the country’s current account.

An increase in the official aid payment means a lower current account. 4. The diagram depicts the level of immigration into the US as a percentage of the change in the US population. You can click on the figure to enlarge it. In the decade prior to the first world war, the number of immigrants was higher than the number of births minus the number of deaths. Wars cause permanent declines in the level of migration. = There was a sharp rise in the immigration level for a short period after the first world war. As with trade in goods and capital flows, there is evidence of a continued trend of "reglobalisation" in migration since the end of the second world war. = Since the restrictive immigration law in 1923, the level of immigration has not recovered to the levels seen before it, suggesting that national boundaries continue to be barriers to the global integration of labour markets. The trend in the graph suggests that with high migration over the past 150 years the wages in different countries around the world should now be similar. = With restricted migration this is not true. Whilst the wages in the manufacturing sector in many European countries as well as Japan have converged (and in many cases overtaken) the level in the US since 1975, the wages in Mexico have actually fallen relative to the US. 5. The diagram shows Carlos’s and Greta’s feasible production frontiers and their utilitymaximising choices of consumption between wheat and apples under autarky (no trade). You can click on the figure to enlarge it. Carlos will choose to consume 10,000 apples. = Carlos will choose point D where he consumes 3,750 apples and 2,500 bushels of wheat. Greta can consume 3,750 apples and 2,500 bushels of wheat but will choose not to do so. Greta has an absolute advantage in the production of wheat, while Carlos has an absolute advantage in the production of apples. = Greta has the absolute advantage in the production of both goods. Irrespective of the shape of the indifference curves (not necessarily the same as depicted in the diagram), Greta will always choose to consume more of both goods than Carlos. = It is entirely possible that with different shapes of indifference curves that Greta will choose to consume less of one of the goods than Carlos. For example, if her indifference curve was much flatter she would consume fewer apples. 6. The figure depicts the feasible frontier and the consumption frontier of Carlos and Greta if they specialise and trade. The resulting relative price of wheat is assumed to be 2. You can click on the figure to enlarge it. Let the resulting consumption be at A and B, respectively, for Greta and Carlos. Then which of the following statements is correct? As Greta has the absolute advantage in production of both goods, she will produce both apples and wheat. = The point is that they both specialise in the good with comparative advantage and trade. Therefore Carlos produces all the apples while Greta produces all the wheat. Carlos produces 6,000 apples and 2,000 bushels of wheat, while Greta produces 4,000 apples and 8,000 bushels of wheat. = Those are their consumption choices as a result of trade. The two specialise and produce just one of the goods. Carlos trades 4,000 of his apples for 2,000 bushels of Greta’s wheat. Greta is better off while Carlos is worse off as a result of the trade. = As a result of the trade they are both able to achieve a point on a higher indifference curve. Therefore they both benefit from the trade.

7. The diagram shows Alex’s and Jose’s feasible production frontiers for oranges and melons. You can click on the figure to enlarge it. Jose has the absolute advantage in the production of both melons and oranges. Jose has the comparative advantage in the production of melons. = Jose can produce twice as many oranges as melons. On the other hand Alex can produce 1.5 times as many oranges as melons. Therefore Jose has the comparative advantage in the production of oranges. Jose will specialise in the production of oranges while Alex will specialise in the production of melons. The relative price of melons after trade will be 1.75. = Jose can produce twice as many oranges as melons. On the other hand Alex can produce 1.5 times as many oranges as melons. Therefore Jose has the comparative advantage in the production of oranges. The relative price after trade will depend on the bargaining power of the two, which may or may not be 1.75. 8. The diagram describes the effects of trade on the capitalists and the workers in Germany and China. You can click on the figure to enlarge it. The initial size of the economies are normalised to one. Germany has the comparative advantage in the capital-intensive goods, while China has the comparative advantage in the labour-intensive goods. As a result of the trade Germany’s economy is assumed to grow by 30% and that of China by 40%. Specialisation means that China will produce all the capital-intensive goods. = Specialisation means that Germany will produce all the capital-intensive goods, in which it has the comparative advantage. Germany has the stronger bargaining power in the determination of the relative price after trade. = The fact that China’s economy grew by a larger percentage suggests that it has the stronger bargaining power. In Germany, the capitalists are better off while the workers are worse off as a result of the trade. In China, the workers are better off while the capitalists are worse off as a result of the trade. = In China, while the share of the pie claimed by the capitalists is smaller after the trade, its absolute size is still increased. Therefore both the workers and the capitalists are better off. 9. The figure shows the long-run labour market model for Germany as a result of specialisation according to its comparative advantage. You can click on the figure to enlarge it.

Germany has the comparative advantage in the production of capital-intensive machine tools, while China, its trade partner, has the comparative advantage in the production of labourintensive consumer electronics. Before trade, the German labour market equilibrium is at A. Which of the following statements are correct? As a result of specialisation, both worker productivity and the total employment level rise. = The productivity rises as production shifts to more capital-intensive good. However this means that fewer workers are employed per unit capital, resulting in a fall in the total unemployment. On the diagram the economy moves from A to B. With the rise in productivity, the firms expand employment resulting in a lower unemployment rate. With lower unemployment, workers demand higher wages for high effort, resulting in a higher profit curve. The wage curve rises if workers demand unemployment insurance as a result of globalisation. Then the long-run employment level is unambiguously lower than at A. = If the rise in the wage curve is modest then the long-run employment level may be higher than at A (for example at F).

10. The figure shows a labour market model describing short-run and long-run impacts of immigration on the domestic labour market. You can click on the figure to enlarge it. The labour market pre-immigration is at A, with the number of employed and unemployed at 4 million and 1 million, respectively. Immigration increases the total labour force to 5.5 million. According to this model, which of the following statements is correct? If none of the immigrants have a job or are entrepreneurs with plans to start a business, there is a short-run loss of employment after immigration. = The labour market moves from A to B where the number of employed remains the same. The real wage is reduced to $13 per hour in the long run. = The firms’ profits rise after the initial fall in the real wage to $13. This leads to expansion of their business. The associated rise in labour demand leads to an increase in the real wage back up to $20 per hour. In the long run the incumbent workers are worse off. = In this model the incumbent workers do not lose employment. They suffer an initial fall in their real wage (due to the fall in the wage curve) but in the long run they are no worse off than pre-immigration. If all immigrants are entrepreneurs with plans to start a business, then there may not be any short-term impact on the incumbent workers.

Economic inequality 1. The figure shows income distribution in the world. You can click on the figure to enlarge it. Norway is the country with the highest income inequality. = Norway has the highest gross domestic income per capita, but its skyscraper is hidden behind that of the US. The US is the country with the highest income inequality. The richest 10% of Botswana has gross domestic income per capita at a similar level to that of the richest 10% of Japan. Renfu, who is in the richest 10% in China, has higher gross domestic income than Mark, a relatively poor person in the US. = The graph shows that Mark has a higher gross domestic income than Renfu. The poorest 10% in Japan have a higher gross domestic income per capita on average than the poorest 10% in the US. 2. Which of the following statements are correct regarding endowments? Endowments are facts about an individual that may affect his or her income. Getting a university degree is an individual’s choice. Therefore having or not having a degree does not constitute a difference in endowments. = Whether one has a degree or not affects the income of the individuals. Therefore one with a degree and one without have different endowments. All individuals have the same reservation option, irrespective of their endowments. = Reservation options depend on the individuals’ endowments. For example a firm owner’s reservation option is to hire another employee; an employee’s reservation option is receiving an unemployment benefit. Different endowments lead to citizens engaging in asymmetric economic interactions, creating different classes of citizens. 3. In an economy with population 100, there are u unemployed, n employees and 100 – u – n owners of firms. Each firm has one owner. The firms are identical, so they employ the same number of workers and they pay the same wage. The diagram shows the Lorenz curve of the economy. You can click on the figure to enlarge it.

The number of unemployed (u) is 12 and they receive an unemployment benefit equal to 50% of the wage of the employed. = The number of unemployed (u) is 12, but according to the Lorenz curve they receive no unemployment benefit. There are 8 firms, each employing 8 workers. = There are 100 – 92 = 8 owners and therefore 8 firms. However they each employ (92 – 12)/8 = 10 workers. The workers each receive 0.8% of the aggregate income as the wage. The Gini coefficient is 0.40. = The area under the Lorenz curve is ½(92-12)×64 + ½(64+100)×(100-92) = 3216. The area of the blue shaded shape is then 5000 – 3216 = 1784. Therefore the Gini coefficient is 1784 / 5000 = 0.36 (2 decimal places). 4. In the economy described in the previous question, a new labour-saving technology is introduced. This results in: Higher wage rate and higher Gini coefficient in the short run. = The labour-saving technology leads to higher unemployment. This means that the reservation position of the remaining workers deteriorates. Therefore the firms are able to lower the wage rate. Lower wage rate and higher Gini coefficient in the short run. Lower wage rate and lower Gini coefficient in the short run. Higher unemployment, lower wage rate and higher Gini coefficient in the long run. = In the long run improvements in technology result in job creation too, leading to lower unemployment. 5. In an economy with a population of 100, there are 80 farmers and 20 lenders. The farmers use the funds to finance the planting and tending of their crops. The rate of profit for the harvest is 12.5%, while the interest rate charged is 10%. Compare the following two cases: Case A: all farmers are able to borrow. Case B: only 50 farmers are able to borrow. The share of total output received by the farmers who can borrow is 25%. = The farmers keep 12.5 – 10 = 2.5% of the 12.5% profit rate. This is a 2.5/12.5 = 20% share. The Gini coefficient for Case A is 0.5. = The Gini coefficient for Case A is 0.6. The Gini coefficient for Case B is 0.6. = The Gini coefficient for Case B is 0.66. There is a 10% increase in the Gini coefficient in Case B compared to Case A. 6. The graph shows the inequality in wealth, earnings and disposable income in the US, Sweden and Japan using the Gini coefficient. You can click on the figure to enlarge it. Wealth is much more unequally distributed than earnings in all three countries. Sweden is an unambiguously more unequal society than Japan. = Sweden is more unequal than Japan in terms of wealth, but is more equal in terms of disposable income. Of the three countries, the US is the most unequal society. = True in terms of earnings and disposable income; however Sweden is more unequal in terms of wealth. Sweden attains its relatively equal disposable income distribution through its system of taxes and transfers. 7. In his Economist in action video, which of the following were NOT among the reasons that Piketty gave for the fall in the incomes of the very rich during the 20th century? The first world war. The Great depression. The Russian revolution.

The second world war. 8. Which of the following statements are correct regarding a segmented labour market? A segmented labour market exists when there are barriers preventing free movement of workers between different sections of the labour market. Workers in the secondary labour market are better paid than those in the primary labour market. = Workers in the primary labour market enjoy higher wages and job security, while those in the secondary labour market have lower wages and limited job security. Workers in the secondary labour market are typically represented by trade unions. = Workers in the secondary labour market tend not be in a trade union; rather their jobs are short-term with high levels of labour turnover. In certain countries, men and women can be in different sectors of a segmented labour market. 9. The diagrams show the proportion of children in earnings quantiles, conditional on their father’s earnings quantile in the US and Denmark, respectively. You can click on the figure to enlarge it. Select one answer. In the US, 40% of the poorest 20% in the children’s generation had their father in the poorest 20% quantile. = The diagram is the proportion of children in earnings quantile conditional on their father’s earnings quantile. Therefore it shows that of those in the poorest 20% in the fathers’ generation, 40% of their children remained as the poorest 20% in the children’s generation. In the US, of those from the poorest 20% of families, 7.4% managed to move up to become part of the richest 20%. In Denmark, it is far more difficult for the richest families to preserve their status to the next generation than in the US. = The numbers for the richest 20% fathers having their children also in the richest 20% are comparable in Denmark and the US: 33.7% compared to 36%. The diagrams suggest that there is very little governments can do to reduce intergenerational transmission of economic status = The diagrams show that in Denmark, the advantage of being born in a rich family is relatively smaller and the disadvantage of being born poor is certainly smaller than in the US. This may be attributed to Denmark’s attempt to improve intergenerational mobility by, for example, providing equal opportunities for high-quality education and reducing the importance of inherited wealth. 10. The diagram depicts the feasible frontier of the incomes of the rich and the poor. You can click on the figure to enlarge it. E is the point where both the rich and the poor have an equal income. Based on this information, which of the following statements is correct? E, the point of maximum equality, is Pareto efficient. = Point E is not Pareto efficient as, at point R, both the rich and the poor are better off than at E. This reflects the belief that complete equality in the society would remove incentives for its citizens to work, study and take risks, so at least a little inequality could actually be better for all. The marginal rate of transformation of the income feasible frontier is the highest at F. = The marginal rate of transformation, when negative, measures how much more income the rich receives per unit income loss for the poor. This is the steepest at R. If you had a 50:50 chance of being rich or poor, then your expected income is maximised at point B. = If you had a 50:50 chance of being rich or poor, then the average income is maximised at the point where the MRT = -1, that is one unit loss of income for rich/poor leads to an exactly the same amount of gain for poor/rich (otherwise you would be able to increase the total income by choosing another point). This is point A. Between D and F, less income for the poor leads also to less income for the rich.

11. According to James Heckamn's Economist in action video, which of the following individual attributes are NOT among the reasons for persistent poverty in a family from generation to generation? Inherited IQ. Limited schooling. Race. Social behaviour. 12. Which of the following statements is correct regarding policies on inequality? Japan has a more equal society compared to the US, due to the equalising effect of taxes and transfers. = Japan is a more equal society than the US in terms of wealth or earnings even before taxes and transfers. Providing high-quality education to citizens is a way of raising the endowments of less well-off people. An increase in the minimum wage increases unemployment, leading to higher inequality unambiguously. = The evidence so far suggests otherwise; the benefit of a wage increase more than offsets the cost of possible (if any) decrease in employment by a wide margin. Non-compete contracts mean that workers can demand higher wages, leading to reduced inequality. = Non-compete contracts prohibit workers from leaving their firm for a competitor. This reduces their bargaining power leading to lower wages.