CPPE 4265 CEAM 4265 AMHE 4265

FIRST P U B L I C E X A M I N A T I O N

Preliminary Examination for Philosophy, Politics and Economics, and Economics and Management and for Honour Moderations for Modem History and Economics

INTRODUCTORY ECONOMICS
TRINITY TERM 2000

Monday, 26 June, 2.30 p.m. - 5.30 p.m.

P P E and M o d e r n History and Economics candidates should answer F O U R questions, of which not more than T W O may be from P A R T B.

Economics and Management candidates should answer F O U R questions, ALL from PART A.

Do not turn over until told that you may do so.

PART A

1. When will an outward shift in the supply curve for a product cause a fall in the equilibrium quantity bought and sold?

2 Why is it normally assumed that indifference curves are convex to the origin? How would you analyse the case of addictive goods?

3.

Should investors discount the prospective yields on a project using the market interest rate?

4. How likely are perfect competition and pure monopoly to exist in practice? What lessons can be learned from studying these two types of market structure?

5, Would you expect prices to be more stable under oligopoly than other forms of market structure?

6.

Under what conditions is a worker paid the value of his or her marginal product?

7. "The trouble with the concept of Pareto optimality is that an economy can be Pareto optimal yet offend common intuitions about social welfare," "A Pareto improvement always increases social welfare." Discuss.

8. "If pollution is damaging people will have an incentive to control it and wilt adjust their behaviour, so there is no need for pubfic policy." Discuss.

9. "Economic theory implies that countries benefit from fi'ee trade, so it is hard to see why anyone might oppose it". Discuss.

4265

10. What is meant by 'the natural rate of unemployment'? Is this concept useful to policy makers?

11.

How would the average propensity to save be affected by: (a) a fall in the rate of population growth; (b) more rapid productivity growth; (c) a temporary reduction in income tax?

12. "It is hard to understand how anyone could seriously believe that GNP could be converted into a meaningful indicator of total social welfare." (Okun, 1971.) Do you agree?

13. What is the 'paradox of thri~'? Will an increase in national savings lead to an increase or a decrease in national income over time?

14. Can a combination of rapid growth, low unemployment and low inflation be explained by macroeconomic theory?

15. Describe how the IS-LM framework can be extended to open economies. What are the implications for macroeconomic policy?

16. How can policy makers achieve current account balance and low unemployment at the same time?

4265

TURN OVER

PART B 1. A firm has a demand for labour (N) which depends on the wage rate (W) and its output price (P): N = 3 0 0 - 4 W + 8P Initially both labour and output markets are competitive. a) IfW = 25 and P = 10, what is the level of employment and the size of the firm's wage bill?

A trade union is formed and all the existing workers join, creating a union membership M. The union's objective is to maximise union welfare (U), where: U=WN+B(M-N) and B is the rate of unemployment benefit. The union sets the wage and the firm then chooses the level of employment.

b)

If benefit B is initially 15 and output price is unchanged, (i) what is the new level of wages in the firm? (ii) how many members of the union are employed? (iii) are union members better off?. What happens to the above results if: (i) output price rises by 50%? (ii) unemployment benefit fails by 20%? (iii) unemployed union members leave the union?

e)

4265

2.

A worker lives for two periods. Her utility function is:

U(Cl,C 2) ~-- c I + &2

where cl is consumption in the first period and c2 is consumption in the second period. There is no saving, and all income is consumed in each period. In the first period, she divides her working day between working, education and training. Her income in the first period can be written as:

Yl

=(1-e-v)w

where w is the wage per period in the first period, 0<e< 1 is the fraction of the first period spent in education and 0<v<l is the fraction of the first period spent in training. Time spent in education and training in the first period raises her income in the second period. In the second period, she only works, and her income is given by:

=(i +e +/)w
where O<a<l and 0<[3<1.

(i)

Show that the worker's utility can be written as

(1-e-v)w+6(l+e +/)w
(ii) By differentiating the above expression for utility, fred the worker's optimal choices for time spent in education (e) and time spent in training (v). (iii) Explain why the time allocated to education and training depends on the parameter & If a>13 does the worker allocate more time to education than training, or vice (iv) versa? (v) Finally consider a new case, where income in the second period is given by: Y2

=(1 +e%P)w

where ~>0, 13>0 and ct+13<1. Derive the worker's optimal choices for time spent in education (e) and time spent in training (v) in this new case.

4265

TURN OVER

3. Consider a closed economy in which there are N individuals who all earn the same income. Aggregate consumption is the following function of aggregate disposable income:
C = co +

where 0<cl<l is the marginal propensity to consume out of disposable income yD. Individuals are taxed in two ways. First, all income is taxed at a proportional rate t where 0<t<l; and second all individuals pay a fixed charge P that is independent of income. Hence total tax revenue is given by:
T = NP+ tY

where Y is total income. Government spending is denoted by G; investment is exogenously fixed. (i) Derive the multiplier for a change in government spending of AG, in terms of c~ andt. (ii) Derive the multiplier for a change in the fixed charge of AP, in terms of Cl, t and N. (iii) A policy-maker proposes to increase government spending by AG, funding this increase entirely through an increase in the fixed charge. Using your answers to parts (i) and (ii), derive the multiplier associated with this policy change. (iv) Explain why the 'balanced budget' expansion of part (iii) has a positive effect on income. Show that the policy proposal will ultimately improve the government's fiscal position (T-G). (v) Show that the size of the improvement in the fiscal position is increasing in the income tax rate (t) and decreasing in the marginal propensity to consume (cl).

4265

4. A certain model of video cassette recorder (VCR) is worth 230 to Polly. She knows that different retailers offer different prices. Specifically, every price between 200 and 240 is equally probable. The only way Polly can find out a retailer's price is by travelling to the shop, and each trip to a shop costs her c. After visiting a shop she can complete a purchase by telephoning from home at no further cost. She is risk neutral. (i) Polly has not yet visited any shops and is considering visiting one. What probability does she attach to finding a VCR worth buying? What is the expected value of the price at the first shop? (ii) Suppose Polly decides to make just one trip, and buy a VCR if and only if she finds a price of 230 or less. On the hypothesis that she does find such a price, what is her expected gain? (iii) What must be true of c for this plan to be rational?

(iv) Suppose the first shop Polly goes to asks pi<230. Polly considers trying one more shop. Explain why, if she does so, the expected value of the price she pays is

Pl Pr(Pz-> P,)+
(v)

E(p2IP2< Pl) Pr(Pz < Pl)

where p2 is the price at the second shop. Show that the expression for expected value in part (iv) is equal to:

6pl P12 500

80
and that, if c = 5, it is rational to buy from the first shop rather than try one more if p1<220. (vi) Is it a better plan to visit one shop and then to decide whether to visit a second, or to visit two shops and then to decide whether to buy from one of them?

4265 7

TURN OVER

5. The following data have been collected on the weekly income (W) of six students, and their weekly spending on clothes (C). C -- Weekly spending on clothes (pounds) 13 17 2I 19 21 25 W -- Weekly income (pounds) 45 55 65 75 85 95

The mean of C is 19.333 and the mean of W is 70. The following sums may also be useful:

~c}

=83.333

~ wzi =

1750

Y'.qw,

= 350

where ci is the deviation from the mean of Ci and wi is the deviation from the mean of Wi. A researcher suggests that spending on clothes is a linear function of income. She recommends estimating the regression:

Ci = a + b W i +u,
(i) Estimate the parameters a and b, showing your working.

(ii) The researcher suggests that income explains over 80% of the variation in spending on clothes. Can you confirm this finding?

(iii)

The income elasticity of demand for clothes can be defined as:

W dC C dW

Use this definition and your answer to part (i) to estimate the income elasticity of demand for clothes, for a student with a weekly income of 40 pounds. What does the regression specification imply about the relationship between the income elasticity and the level of income? (iv) Another researcher estimates an equation of the same form for a much larger data set (200 students). Her estimate of the parameter b is 0.22, with an estimated standard error of 0.01. Show how to construct a 95% confidence interval for the parameter. (Continue...) 4265

(v) The second researcher argues that in practice, her larger data set potentially supports an alternative model for spending on clothes:
C = kW p

Show that the income elasticity of demand for clothes is equal to 13. Could the least squares method be used to obtain an estimate of this elasticity? (vi) Describe briefly how you might discriminate between the two models.

6. (a) A sample of 36 weekly observations of the FTSE 100 index returns has a mean of 0.005 (0.5%) and a standard deviation of 0.02 (2%). (i) (ii) (iii) Calculate a 95% confidence interval for the mean weekly return. How large a sample is required to estimate the mean weekly return so that the 95% confidence interval is given by the estimate plus or minus 0.004 (0.4%)? Do we need to assume that the weekly returns follow a normal distribution?

(b) In 1976, 50 people reported the number of hours they spent at work. The mean of the sample was 38.5 hours, and the standard deviation was 5.3 hours. In 1996, 65 people reported the number of hours they spent at work. The mean of this sample was 41.2 hours, and the standard deviation was 7.0 hours.

(i)
(ii)

Perform a test to establish whether the population means differ in 1976 and 1996 at the 5% level. What is the approximate p-value associated with this hypothesis test? How do you interpret the p-value?

NOTE: For the comparison ofmeans in two large samples, the standard error ofthe test statistic is

F/!

/'12

4265 9

TURN OVER

CRITICAL VALUES OF THE t-DISTRIBUTION

v

indicates the number of degrees of freedom indicatcs thc probability that the t statisticis greater than the entry in the table
, a=O.lO

v
1

w~0.05 6,314 1720

g-0.025
12.706 4.303 3.182 2.776 2.571 2.447 2.365 2.306 2.262 2.228 2.2O 1 2.179 2.160

~--0.01

a"0.005
63.657 9.925 5.84 I 4.604 4.032 3.707 3.499 3.355 3,250 3.169 3.106 1 2 3 4 5 6 7 8 9 10 I1 12 13 14 15 I6 17 18 19 20 21 22 23 24 25 26 27 2g 29 inf.

3.078
t,886 1,638 ~

31,821 6.965 4,541 3.747 3.365 3.143 2.998 2.896 2.8"21 2.764 2.718 2.681 2.650 2.624 2.602
2.583 2.567 2.552 2.539

2 3 4 5 6 7 8 9 I0 II 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 inf.

2.353 2.132 2.015 1.943

I

L.533 1.476
L ,440 1.4L5 L.397

1.895 1.860
1.833 1.812 1.796 1.782

1.383

1.372 1.363
1.356 1.350

3.055
3.012 2.977 2.947 2.92 [ 2,895 2.878 2.861

1.771 i.76 L 1353 1.746 1.740

1.734 13"29 1,725
1.72L

1.345 1.341 1.337

1.333 1.330

2.145 2.131 2.120 2.110 2.101

2.093 2.0S6

1.32&
1.325

2.528
2.518

2.845 2.831 2.g19 2.S07

2,797 2.787 2.779 2.771

1.323 1.321

2.080 2.074
2.069 2.064
2.060

1.717 ,1,714 1.711 Ifl0g

1.706 1,703

2.508 7_500
2.492 2.485 2.479 2.473 2.467 2.462 2.326

1,319
1.318 1.316

1.315
1.314 1.313

2.056

2.052 2.048 2.045 1.960

1.701
'l L,699

2.763 2.756 2.576

1.311 1.232

1.645

4265

I.AST PAGE

10