Examiners' Commentaries 2019: EC1002 Introduction To Economics

Examiners’ commentaries 2019


EC1002 Introduction to economics
Important note

This commentary reflects the examination and assessment arrangements for this course in the
academic year 2018–19. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).
Information about the subject guide and the Essential reading

references
Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2018).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.
General remarks
Learning outcomes
At the end of this course and having completed the Essential reading and activities you should be
able to:
• define the main concepts and describe the models and methods used in economic analysis
• formulate the real world in the language of economic modelling
• apply and use the economic models to analyse these issues
• assess the potential and limitations of the models and methods used in economic analysis.
Format of the examination
This paper consists of three sections:
• Section A (40 marks): Ten multiple choice questions, each worth four marks. Candidates
must answer all questions. No explanation is needed.
• Section B (30 marks): Candidates must answer one of two questions on microeconomics. It
is essential that candidates explain their answers.
• Section C (30 marks): Candidates must answer one of two questions on macroeconomics. It
is essential that candidates explain their answers.
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Textbook
The answers make extensive reference to the textbook for the course, referred to as BVFD. The
textbook is:
• Begg, D., G. Vernasca, D. Fischer, and R. Dornbusch, Economics (2014) McGraw–Hill (11th
edition).
Key steps to improvement
When answering the long questions (Sections B and C), some candidates had problems because they
were not familiar with the material. The examiners look for clear and logical arguments which
explain the material and answer the precise question asked – putting in irrelevant material makes for
a less clear answer. Some candidates found this difficult, and it was obvious that they had not fully
understood the material.
Examination strategy
Make the most of what you know in the examination room.
• Read the wording of the questions very carefully and answer the exact question asked.
• Explain your answer.
• Answer the right number of questions.
• Plan your time. Do not spend too much time on any question. If you get stuck on part of a
question move on to the next question you answer and come back to the original question if
you have time.
• Start each answer on a new double page. Arrange your answer so that you do not have to
turn over a page to see a diagram you are discussing.
• Practise drawing diagrams when you are studying. Draw your diagrams large enough and
carefully enough that the examiner can easily see what you are doing.
Examination revision strategy
Many candidates are disappointed to find that their examination performance is poorer than they
expected. This may be due to a number of reasons, but one particular failing is ‘question
spotting’, that is, confining your examination preparation to a few questions and/or topics which
have come up in past papers for the course. This can have serious consequences.
We recognise that candidates might not cover all topics in the syllabus in the same depth, but you
need to be aware that examiners are free to set questions on any aspect of the syllabus. This
means that you need to study enough of the syllabus to enable you to answer the required number of
examination questions.
The syllabus can be found in the Course information sheet available on the VLE. You should read
the syllabus carefully and ensure that you cover sufficient material in preparation for the
examination. Examiners will vary the topics and questions from year to year and may well set
questions that have not appeared in past papers. Examination papers may legitimately include
questions on any topic in the syllabus. So, although past papers can be helpful during your revision,
you cannot assume that topics or specific questions that have come up in past examinations will
occur again.
If you rely on a question-spotting strategy, it is likely you will find yourself in difficulties
when you sit the examination. We strongly advise you not to adopt this strategy.
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Important note

references
section.
Comments on specific questions – Zone A
This paper consists of THREE sections:
Section A (40 marks): TEN multiple choice questions, each worth FOUR marks. Candidates must
answer ALL questions. No explanation is needed.
Section B (30 marks): Candidates must answer ONE of TWO questions on microeconomics. It is
essential that candidates explain their answers.
Section C (30 marks): Candidates must answer ONE of TWO questions on macroeconomics. It is
Section A: Multiple choice questions
Candidates should answer ALL questions from this section.
Choose one answer for each question: no explanation is needed.
Note that some questions ask you to choose which statement IS correct and other questions ask you
to choose which statement IS NOT correct.
Question 1
5
Consider a market where the demand is given by QD = 120 − P and supply is
3
1
given by QS = P . What are the consumer and producer surplus?
3
3
(a) Consumer surplus is 120 and producer surplus is 600.

(b) Consumer surplus is 600 and producer surplus is 1200.
(c) Consumer surplus is 240 and producer surplus is 300.
(d) Consumer surplus is 1200 and producer surplus is 240.
Reading for this question
See BVFD Section 3.8 and concept 3.1 on consumer and producer surplus.
Approaching the question
(a) is correct.
Here we need to first compute the equilibrium – this occurs when demand equals supply. Setting:
5 1
120 − P = P
3 3
we obtain P = 60 and Q = 20. Now we think about the gains from trade and find the consumer
surplus (the area between the demand curve and the price) is:
(72 − 60) × 20
CS = = 120
2
and producer surplus (the area below the price but above the supply curve) is:
60 × 20
PS = = 600.
2
Question 2
Assume that movie tickets and popcorn are complements. Which of the following
statements IS correct?
(a) If the price of movie tickets goes down the quantity of popcorn demanded will
decrease.
(b) If the price of movie tickets goes down the quantity of popcorn demanded will
not change.
(c) If the price of movie tickets goes up the quantity of popcorn demanded will
decrease.
(d) If the price of movie tickets goes up the quantity of popcorn demanded will not
change.
See BVFD Chapter 5.
(c) is correct.
If the price of a complement good goes up the demand for the other good decreases, as the
consumer only wants to consume these goods together. The idea behind it is simple: if the
consumer wants to consume two goods in a fixed proportion (for example, popcorn and movies)
and the price of one of the two (this time movies) increases, the consumer will also demand less
of the complement good (popcorn).
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Question 3
Which of the following statements IS NOT correct?
(a) A tax does not always lead to the inefficient output.

(b) Monopolies do not always create a deadweight loss.
(c) If two firms compete in prices (Bertrand competition) they will set a higher
price than if they compete in quantities (Cournot competition).
(d) A monopolist chooses the price based on the elasticity of demand with respect
to price (PED).
See BVFD Section 8.5 and Section 9.3.
(c) is not correct.
Firms competing in prices will set a price equal to marginal cost, whereas firms competing in
quantity will set a higher price. This is because firms which compete in quantity will retain some
market power.
Question 4
A farm is located next to a steel mill. The cows are free to go into the field but are
hurt by the pollution created by the steel mill, which creates a negative externality.
The profit function for the farmer is π F = 4C − C 2 − 2S where C is the number of
cows the farmer has and S is the amount of mills the steel mill has. The profit
function for the steel mill is π S = 6S − S 2 . The two firms merge to internalise the
externality. What are the outputs they end up producing as one merged firm?
(a) C = 2 and S = 3.
(b) C = 4 and S = 2.
(c) C = 2 and S = 2.
(d) C = 4 and S = 3.
See BVFD Section 3.5.
(c) is correct.
The joint firm maximises:

π M = 4C − C 2 − 2S + 6S − S 2 .
Maximising this function means finding a partial derivative with respect to C and setting it equal
to zero and doing the same for S. Doing so yields C = 2 and S = 2.
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Question 5
Choose the correct statement. The labour supply curve IS:
(a) Always downward sloping.

(b) Always upward sloping.
(c) Upward sloping for monopsonies.
(d) Perfectly elastic.
(c) is correct.
The labour supply curve is upward-sloping for monopsonies, since more workers will be willing to
work more when the wage is high. This is not a result we can apply to all other types of markets.
Question 6
Choose the correct statement. Potential output IS:
(a) The output demanded by households as consumption and by firms as

investment.
(b) The output obtained when there is no unemployment.
(c) The output obtained by trading with other countries.
(d) The output obtained when all inputs are fully employed.
(d) is correct.
The potential output is a measure of the economy’s output when all inputs are fully employed –
this is the standard definition of it.
Question 7
Although investors in a given economy take into consideration the nominal interest
rates when they make investment decisions, in the IS–LM model we express the
level of investment (and so the IS curve) as depending on the real interest rate.
Why is this the case?
(a) Because the nominal interest rates are less volatile than the real ones.
(b) Because nominal interest rates are determined by the Central Bank.
(c) Because prices are fixed in the short-run and so the nominal interest rate is the
same as the real one.
(d) Because we focus on policy tools that affect the real (non-monetary) side of the
economy.
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See BVFD Sections 20.1 and 22.2.
(c) is correct.
We express the level of investment (and so the IS curve) as depending on the real interest rate
because prices are fixed in the short run and so the nominal interest rate is the same as the real
one. This is the standard Fisher equation.
Question 8
In a time of political instability investments fall because of lack of confidence from

consumers. With no change in fiscal policy and no change in the interest rate the
IS–LM model still predicts some adjustments. Assume that this is a closed economy.
(a) Investments will be lower for any given interest rate.

(b) Income will fall because of a rightward shift in the IS curve.
(c) The new interest rate will be lower.
(d) The LM curve will not shift.
(b) is not correct.
If investment falls because of lack of confidence from consumers we will have a leftward shift of
the IS curve and hence lower income. This means that out of the statements given the only
incorrect one was (b) which considered a rightward shift of the IS curve – this happens whenever
investment increases.
Question 9
Which of the following statements IS correct?
(a) The real exchange rate cannot be equal to the nominal exchange rate.
(b) The real exchange rate depends only on the rates of inflation in the two
countries.
(c) The purchasing power parity exchange rate is the path of the nominal exchange
rate that maintains a constant real exchange rate.
(d) The purchasing power parity exchange rate can be computed by looking at the
market for one good.
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(c) is correct.
The purchasing power parity exchange rate is computed based on the idea that regardless of the
currency they are expressed in, real prices should be the same. This means maintaining a
constant real exchange rate through nominal prices.
Question 10
What does the convergence theory in the Solow model imply?
(a) Rich nations will stop growing.

(b) Poor nations will grow slower than rich nations.
(c) Growth will only arise if a nation is not in steady state.
(d) Poor countries will grow faster than rich countries.
(d) is correct.
The convergence theory postulates that countries will eventually reach the same steady state
output, i.e. there is convergence. This is true regardless of where countries start from as Solow
assumes that growth is a concave function of income. Countries which start with higher incomes
will grow less than countries which start at lower levels of income. Hence countries which start at
lower incomes will grow faster and catch up with those which started with higher ones.
Section B: Microeconomics
Candidates should answer ONE of the following long questions. It is essential that you explain your
answers.
Question 11
(a) What is the difference between a normal and an inferior good? Is leisure a
normal good? What about hours worked (i.e. labour)?
(4 marks)
(b) Why is the slope of the demand for inferior good steeper than for a normal
good? What happens to a normal and an inferior good when the price goes up?
Show this graphically and explain.
(6 marks)
(c) What is the effect of a wage rise on consumption and labour supplied? Show
this on an indifference curve graph and explain.
(8 marks)
(d) How does labour mobility affect the slope of the industry’s labour supply curve?
List at least one type of labour mobility.
(6 marks)
(e) Does a minimum wage always create unemployment? Explain.
(6 marks)
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See BVFD Sections 5.3, 10.4, 10.5 and 10.7.
(a) A good is normal if an increase in income increases demand, and is inferior if an increase in
income decreases demand.
The standard assumption is that leisure is a normal good. This implies that hours worked is
an inferior good. Any reasonable explanation of why this might not be the case would have
also been correct – for example, people may like their work.
A lot of candidates here defined goods based on their price, or at best their own-price
elasticity. This is wrong, the definition of normal and inferior goods relies only on whether
the quantity demanded goes up or down when the income of the consumer increases.
(b) Note that for normal goods the income and substitution effects work in the same direction.
When the price rises both effects imply a decrease in demand. For inferior goods the
substitution effect decreases demand and the income effect increases demand when the price
rises.
Only partial credit was given to candidates who claimed that all inferior goods are Giffen
goods, i.e. when the price goes up demand increases.
The demand curve diagram was expected and a comment that as demand for a normal good
is more responsive to price (more elastic) than demand for an inferior good, the demand
curve is flatter for a normal good. See Figure 1.
Figure 1: Demand curves for normal and inferior goods.
(There is an implicit assumption here that we are comparing two goods which have the
same-sized substitution effects. Candidates who did not point this out were not penalised.)
Alternatively, candidates could have worked with indifference curve diagrams, such as
Figures 2 and 3. This approach was equally valid, but the graph for the inferior good case is
quite hard to draw.
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Figure 2: Indifference curves for a normal good.
Figure 3: Indifference curves for an inferior good.
Quite a lot of candidates did not attempt to draw a graph here and lost marks as a
consequence.
(c) BVFD Section 10.4 gives an intuitive verbal discussion of income and substitution effects on
labour supply, without a diagram. The argument is that a higher real wage makes working
an extra hour more attractive which tends to increase the number of hours worked. This is
the substitution effect. The income effect is discussed in terms of having a target
consumption, so if the real wage increases you work fewer hours. The standard assumption
is that ‘leisure’, i.e. the time spent not in paid employment, is a normal good, so labour
supply is inferior.
The substitution effect would lead to more work being supplied (leisure is more expensive),
but the income effect would predict a lower labour supply. The overall effect depends on
which effect dominates.
Figure 4, which is based on BVFD, shows the situation in which the substitution effect
dominates going from A to B, so leisure decreases and consumption increases. B to D shows
the situation in which the income effect dominates, so leisure increases and consumption
increases.
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Figure 4: Labour supply changes as the wage increases.
Figure 5 further breaks down the income and substitution effects.
Figure 5: Income and substitution effects on labour supply.
(d) The more mobile labour is, the flatter (more elastic) is industry supply. In the extreme,
supply is perfectly elastic and the labour supply curve facing a firm, or industry, is flat.
Labour mobility may be between firms within an industry, between industries, and between
different places, both within and between countries. Additional credit was given for a
sensible discussion, even if it did not cover the same points as here.
Labour mobility between firms and industries is determined in the short term by how far
firm-specific and industry-specific skills are required, and how easy the skills are to acquire –
for example, training a doctor is lengthy and many of the skills are specific to medicine.
Long-term supply is more elastic, as people decide to train for the jobs.
Labour mobility is a crucially important determinant of a country’s economic efficiency,
both in static terms, ensuring labour is allocated to its most productive uses and in dynamic
terms, facilitating the emergence of new activities and industries while allowing for the
orderly decline of some existing activities and industries where output demand is falling.
(e) No, if the minimum wage is set below the market-clearing one it will not affect the
equilibrium and will not create unemployment.
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Figure 6, based on BVFD Section 10.7, assumes a perfectly competitive labour market. If
the minimum wage is above the market clearing level w1 (for example, w2 ) employment N2
is below its market-clearing level N1 . If the wage is set at or below w1 there is no effect on
employment.
Figure 6: Labour supply and demand in a perfectly competitive labour market.
Figure 7, also based on BVFD Section 10.7, shows the situation in which the employer is not
a price-taker in the labour market. In this situation the employer has monopsony power and
has to increase the wage rate in order to attract more workers. This pushes the marginal
cost of employing another worker above the wage rate. The quantity of labour employed,
N1 , is determined by the intersection of the marginal revenue product of labour curve and
the marginal cost of labour curve. The wage w1 is determined by the labour supply curve at
this level of employment. With a minimum wage set at the competitive market-clearing
level w2 the employer becomes a price-taker, and employment is higher at N2 . (This was
quite advanced and candidates not mentioning what happens in a monopsony could still get
full marks.)
Figure 7: A monopsonistic labour market.
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Question 12
(a) Define a dominant strategy and Nash equilibrium. Can two firms interacting
with each other have no Nash equilibria if both have a dominant strategy?
(4 marks)
(b) Consider two phone producers: Orange and Star. They have two possible
strategies, improving cameras (IC) or improving battery life (BL). The profits
that each firm makes from those strategies are reported in the following table:
Players Star
Orange IC BL
IC −200, −200 200, 300
BL 300, 200 −100, −100
Is there a dominant strategy for any of the firms? Find all the Nash equilibria
in the game.
(6 marks)
(c) Now consider a market with the same two firms, Orange and Star, competing in
quantity to maximise their individual profits. The market demand is
P = 200 − 9(Q1 + Q2 ), where Q1 is the quantity produced by Orange and Q2 is
the quantity produced by Star. The total cost for Orange (firm 1) is
TC 1 = 92Q1 , while the total cost for firm 2 is TC 2 = 92Q2 . What are the firms’
reaction functions? What are the Cournot–Nash outputs, price and profits?
(12 marks)
(d) Orange and Star now decide to merge as they realise that profits will be higher
if they do. What will be the output, price and profit if they do?
(8 marks)
See BVFD Sections 8.6, 9.1 and 9.4.
(a) A player has a dominant strategy if one strategy is their best response, regardless of what
the other player does. A Nash equilibrium is a situation where no player has an incentive to
change their strategy, since they are doing as well as they can, given the strategies chosen by
the other players.
If both firms have a dominant strategy the intersection of those strategies will be a Nash
equilibrium so, no, there cannot be a situation where players have a dominant strategy but
there is no Nash equilibrium.
(b) There is no dominant strategy here. The equilibria are (IC, BL) and (BL, IC).
(c) We have to set up the right profit maximisation problem and solve for the correct quantities,
then find the price and profits.
For firm 1, its profit function is:
π1 = P Q1 − C(Q1 ) = (200 − 9(Q1 + Q2 ))Q1 − 92Q1 = 108Q1 − 9Q21 − 9Q1 Q2
with first-order condition:

∂π1
= 108 − 18Q1 − 9Q2 = 0.
∂Q1
Hence:
108 − 9Q2
Q∗1 = .
18
13
Because the firms are symmetric Q∗1 = Q∗2 (and the reaction functions are the same).
108 = 27Q∗1 ⇒ Q∗1 = Q∗2 = 4.
As a consequence:
P ∗ = 200 − 9(Q1 + Q2 ) = 128
and:
π1∗ = π2∗ = (P − 92)Q∗1 = (128 − 92) × 4 = 144.
(d) Here Q is industry output. We have:
max = P Q − C(Q) = (200 − 9Q)Q − 92Q = 108Q − 9Q2

π
with first-order condition:

∂π
= 108 − 18Q = 0.
∂Q
Hence:
QM = 6, PM = 200 − 9Q = 146 and πM = (146 − 92) × 6 = 324.
Here some candidates said that the quantity produced by the merged firm is half of the
quantity produced in the Cournot–Nash equilibrium, which is not necessarily the case.
Candidates needed to re-do the profit maximisation.
Section C: Macroeconomics
Candidates should answer ONE of the two following long questions. It is essential that you explain
your answers.
Question 13
(a) There is some consensus that following Brexit house prices will drop in London.
If prices do fall, how are banks’ balance sheets affected? Why? How do you
expect this to affect the ability of banks to borrow from each other, depositors
and financial markets?
(8 marks)
(b) Does the fall in house prices affect only house owners and banks? Discuss the
impact of the price decrease on the economy.
(6 marks)
(c) Now assume that the Central Bank would like to foster investments by lowering
interest rates. What happens if interest rates are already very low? Will the
policy be effective?
(6 marks)
(d) Some analysts suggest that there might be a bubble in the financial market.
They suggest using a policy mix to reduce the impact of the bubble. Explain
why this might work and show the appropriate shifts in the IS–LM model. Does
the effectiveness of the policy mix depend on the exchange rate regime?
(10 marks)
This question is quite open-ended. Credit was given for sensible discussions, even if they did not
match the answers below.
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(a) See BVFD Section 18.6 for a detailed discussion of the 2008–09 financial crisis which started
with difficulties with high-risk loans to people buying houses in the US. The key points are
the following.
Many banks have mortgages (loans to buy houses) on their balance sheets as an asset. This
is a major problem with a situation such as Brexit, or the start of the 2008–09 crisis when
many borrowers are subject to the same risks. The banks faced difficulties with many loans,
with borrowers becoming unable to make their repayments, and the value of mortgages,
which are secured on the houses, falling as house prices fell.
When these mortgages become less valuable banks are less willing and able to lend to each
other, households and firms. Banks borrow and lend extensively to each other and the
financial markets. Many of these loans have very short durations (overnight), so a bank can
develop problems very rapidly.
Additional marks were given for answers which expanded sensibly on these points. For
example, candidates could point out that in the run-up to the 2008–09 crisis banks issuing
mortgages shared risks by securitisation, packaging loans and selling them onto other banks.
Securitisation does not eliminate the risk, but does extend the risk to banks which buy the
securities, even if they do not directly sell mortgages.
(b) This is open-ended and credit was given for sensible answers. Some of the points candidates
might make are below. Full marks did not require that candidates made all these points.
Firms are likely to reduce investment, both due to difficulties in borrowing, and also due to
fears that the wider economy will be adversely affected by the difficulties in the banking
system. House builders may be particularly badly affected.
Households, including those who do not own houses, may become more anxious about their
financial situation, and spend less with a further impact on firms. In particular, potential
first-time house buyers become less willing to buy and existing homeowners become less
willing to move, with a further impact on the housing market.
The fall in house prices may make people more willing to buy houses. However, part of the
reward to home-owning comes from the expected capital gains (i.e. the increase in the price
of houses); people may be less inclined to buy houses because they fear that prices will fall
further.
An exceptional answer might recognise the economy-wide effects of bank failures because of
their central role in the economy. This is partly about the role of banks in the payments
system. However, investment banks such as Lehman Brothers had no such role, but its
collapse in September 2008 when there was already a major crisis triggered a worldwide
panic.
Governments became involved in managing the crisis, in some cases putting substantial
funds into rescuing banks. In 2008–09 one result was a huge increase in government debt.
(c) The major issue is that there is a zero lower bound on interest rates, banks do not force
people to pay to deposit money in them. In this situation central banks cannot cut interest
rates further.
The major policy response has been quantitative easing, see BVFD Section 19.5 where it is
discussed at some length. Quantitative easing is the purchase by central banks of
government bonds, and other financial securities, which has had the effect of maintaining or
increasing the price of these assets, thereby making their owners more willing to spend.
Many candidates did not attempt this question or just said yes/no. Here the key was trying
to understand what happens when the interest rate is already very low.
(d) A discussion of monetary policy and the exchange rate was required. In these circumstances
there may be little time to act, so the immediate response has to be contractionary
monetary policy, which can be implemented more rapidly than fiscal policy and has a more
rapid effect. If monetary policy is conducted by an interest rate-setting central bank it will
raise the interest rate.
However, in the absence of any change in fiscal policy the increase in the interest rate is
likely to reduce investment, thereby risking a recession and reducing output. Expansionary
fiscal policy can be used to stop this happening. With the right balance of fiscal and
15
monetary policy it is possible to push up the interest rate to a level which reduces or
eliminates the bubble, without affecting output.
See Figure 8 for the curves. The economy starts at A. In order to reduce the impact of the
bubble, policy needs to push up the interest rate. This can be done by contractionary
monetary policy shifting the LM curve from LM0 to LM1 . For an interest rate-setting
central bank, it can simply set a higher interest rate. In the absence of any change in fiscal
policy this moves the economy from A to B, reducing the level of output; in particular the
higher interest rate decreases investment. In order to get output back to its target level,
fiscal policy can be relaxed – for example, by increasing government expenditure, which
moves the IS curve from IS0 to IS1 and brings the economy to C which has the same level of
output as before but a higher interest rate.
Figure 8: The policy mix.
Monetary policy cannot be used in this way in a fixed exchange rate regime because the
interest rate has to be set at the level necessary to maintain the exchange rate given beliefs
about the future of the economy. In a flexible exchange rate regime the effect of the interest
rate increase is an inflow of funds from abroad, which has the effect of causing the exchange
rate to appreciate in the short term. The appreciation in the exchange rate decreases
exports by making exporting less profitable, having a further contractionary effect. This
makes monetary policy more effective in an open economy than a closed economy.
Question 14
(a) What does the Phillips curve represent? Is there a difference between the
Phillips curve in the short-run and long-run? Explain and show it in a diagram.
(6 marks)
(b) What is the impact of a short-term negative shock on output, unemployment
and inflation? Explain and draw a diagram.
(6 marks)
(c) What is the relationship between the current and capital accounts in a flexible
exchange rate regime?
(4 marks)
(d) What is Okun’s law?
(4 marks)
(e) Assume that we are in a floating exchange rate regime. The price of oil went
up, driving the economy to a much higher unemployment rate. Use a standard
IS–LM–BP model to explain what happens to income, interest rates and the
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balance of payment if the central bank uses monetary policy to stabilise the
economy at potential output.
(10 marks)
(a) The Phillips curve suggests that there is a trade-off between inflation and unemployment. If
inflation is high, unemployment is relatively low and vice versa. In the model, short-term
aggregate supply is upward-sloping in a graph with output on the horizontal axis and
inflation on the vertical axis. In the long run, aggregate supply is a vertical straight line –
there is no impact of inflation on long-run aggregate supply. In the short run, the nominal
(money) wage rate is assumed to be fixed. It depends on how much inflation was expected
at the time the wage was fixed. If inflation is higher than expected then the real wage
(money wage/price of output) is lower than expected, and employment and output are
relatively high.
(b) Candidates may address this in a variety of ways. Full marks were given for a coherent
answer, well explained, with a diagram. Candidates may assume either a supply shock or a
demand shock. They are not expected to look at both cases.
The question can be answered working with the Phillips curve alone, Figure 9, or working
with both the Phillips curve and aggregate demand and supply. Intuitively the short-term
outcome will be to decrease output and increase unemployment. In the long run, output and
unemployment will return to their original level. What happens to inflation in the short and
long run depends on the nature of the shock, the policy response and expectations.
Candidates did not need to go into detail on this.
Figure 9: Effects of a short-term negative supply shock.
Intuitively, a short-term negative supply shock can be expected to decrease output, increase
unemployment and increase inflation. The Phillips curve diagram in Figure 10 illustrates
this. The economy starts at E. The Phillips curve shifts out from PC1 to PC2 . In the short
term the economy moves to a point such as G with higher inflation. Given the vertical
long-run Phillips curve, output eventually returns in to its original level. What happens to
inflation in the long run depends on the policy response and how expectations change.
17
Figure 10: Effects of a short-term negative demand shock.
(c) The balance of payments is typically formed of two parts – the current account (the
profit/loss from day-to-day transactions) and the capital account (capital flows related to
capital items in the form of assets, such as firms purchasing machinery). The capital
account and current account have to net out to zero. If a country has a capital surplus (for
example, foreigners are net investors of capital into the country), then it will run a current
account deficit.
(d) Okun’s law is an empirically observed relationship between unemployment and losses in a
country’s production. For every increase in the unemployment rate, a country’s GDP will be
lower than its potential GDP.
(e) Under a flexible exchange rate, monetary policy is the most effective policy response. The
fall in consumer spending shifts the IS curve to the left. Expansionary monetary policy
shifts the LM curve to the right. This restores output at a lower interest rate than originally.
For the curves see, Figure 11. The oil price shock with no change in monetary policy pushes
the IS curve to the left from IS0 to IS1 moving the economy from A to B, with a lower
interest rate and below target income. Expansionary monetary policy shifts the LM curve
from LM0 to LM1 . For an interest rate-setting central bank, it can simply set a lower
interest rate r2 . This moves the economy from B to C, returning output to its original level
Y ∗ , but with a lower interest rate.
Figure 11: IS–LM with an oil price shock.
In a flexible exchange rate regime the decrease in the interest rate results in an outflow of
funds from the country, which has the effect of causing the exchange rate to depreciate in
the short term. The depreciation in the exchange rate increases exports by making
exporting more profitable, having a further expansionary effect. This makes monetary policy
more effective in an open economy than a closed economy.
18

Important note

references
section.
Comments on specific questions – Zone B
This paper consists of THREE sections:
Section A (40 marks): TEN multiple choice questions, each worth FOUR marks. Candidates must
answer ALL questions. No explanation is needed.
Section B (30 marks): Candidates must answer ONE of TWO questions on microeconomics. It is
Section C (30 marks): Candidates must answer ONE of TWO questions on macroeconomics. It is
Section A: Multiple choice questions
Candidates should answer ALL questions from this section.
Choose one answer for each question: no explanation is needed.
Note that some questions ask you to choose which statement IS correct and other questions ask you
to choose which statement IS NOT correct.
Question 1
4
Consider a market where the demand is given by QD = 80 − P and supply is given
5
1
by QS = P . What are the consumer and producer surplus?
5
19
(a) Consumer surplus is 240 and producer surplus is 450.

(b) Consumer surplus is 160 and producer surplus is 640.
(c) Consumer surplus is 800 and producer surplus is 1280.
(d) Consumer surplus is 1600 and producer surplus is 980.
See BVFD Section 3.8 and concept 3.1 on consumer and producer surplus.
(b) is correct.
Here we need to first compute the equilibrium – this occurs when demand equals supply. Setting:
4 1
180 − P = P
5 5
we obtain P = 80 and Q = 16. Now we think about the gains from trade and find the consumer
surplus (the area between the demand curve and the price) is:
(100 − 80) × 16
CS = = 160
2
and producer surplus (the area below the price but above the supply curve) is:
16 × 80
PS = = 640.
2
Question 2
Assume that festival tickets and all-inclusive holidays are substitutes. Which of the
following statements IS correct?
(a) If the price of festival tickets goes down the quantity of all-inclusive holidays
demanded will decrease.
(b) If the price of festival tickets goes down the quantity of all-inclusive holidays
demanded will not change.
(c) If the price of festival tickets goes up the quantity of all-inclusive holidays
demanded will decrease.
(d) If the price of festival tickets goes up the quantity of all-inclusive holidays
demanded will not change.
See BVFD Chapter 5.
(a) is correct.
If the price of a substitute good goes down the demand for the other good increases, as the
consumer only wants to consume one of these goods. The idea behind it is simple: if the
consumer wants to consume one leisure good (either festivals or all-inclusive holidays) and the
price of one of the two (this time festival tickets) decreases, the consumer will demand more of
this good and less of its substitute.
20
Question 3
(a) A tax does not always lead to the inefficient output.

(b) Monopolies do not always create a deadweight loss.
(c) If two firms compete in prices (Bertrand competition) they will set a higher
price than if they compete in quantities (Cournot competition).
(d) A monopolist chooses the price based on the elasticity of demand with respect
to price (PED).
See BVFD Section 8.5 and Section 9.3.
(c) is not correct.
Firms competing in prices will set a price equal to marginal cost, whereas firms competing in
quantity will set a higher price. This is because firms which compete in quantity will retain some
market power.
Question 4
A winery is located next to a farm. The grapes are cultivated out in the open and
benefit from the fertiliser used for the crops cultivated by the farm. The profit
function for the farmer is π W = 6W − W 2 + 4F where W is the bottles of wine the
winery produces and F is the animals the farm has. The profit function for the farm
is π F = 12F − F 2 . The two firms merge to internalise the externality. What are the
outputs they end up producing as one merged firm?
(a) W = 3 and F = 6.
(b) W = 6 and F = 8.
(c) W = 6 and F = 6.
(d) W = 3 and F = 8.
(d) is correct.
The joint firm maximises:
π M = 6W − W 2 + 4F + 12F − F 2 .
Maximising this function means finding a partial derivative with respect to W and setting it
equal to zero and doing the same for F . Doing so yields W = 3 and F = 8.
21
Question 5
Choose the correct statement. The labour supply curve IS:
(a) Always downward sloping.

(b) Always upward sloping.
(c) Upward sloping for monopsonies.
(d) Perfectly elastic.
(c) is correct.
The labour supply curve is upward-sloping for monopsonies, since more workers will be willing to
work more when the wage is high. This is not a result we can apply to all other types of markets.
Question 6
Choose the correct statement. Potential output IS:
(a) The output demanded by households as consumption and by firms as

investment.
(b) The output obtained when there is no unemployment.
(c) The output obtained by trading with other countries.
(d) The output obtained when all inputs are fully employed.
(d) is correct.
The potential output is a measure of the economy’s output when all inputs are fully employed –
this is the standard definition of it.
Question 7
The Fisher equation tells us that:
(a) Nominal interest rates are less volatile than the real ones.
(b) Real interest rates are always higher than nominal ones.
(c) Nominal interest rates can be the same as the real ones.
(d) Inflation is always positive.
22
See BVFD Sections 20.1 and 22.2.
(c) is correct.
This is the standard Fisher equation when inflation is equal to zero so that the nominal and real
interest rates are the same.
Question 8
In a time of political stability demand for financial assets may increase and create a
bubble. In the context of the IS–LM model which of the following statements IS
NOT correct?
(a) Decreasing government spending might be an appropriate response.

(b) Income will fall because of a rightward shift in the IS curve.
(c) If there is no intervention the interest rate will be higher.
(d) The central bank can raise the interest rate to slow investments.
(b) is not correct.
If demand for financial assets increases, there will be a rightward shift of the IS curve and hence
higher income. This means that out of the statements given the only incorrect one was (b) which
considered a fall in income – this happens whenever the IS curve shifts to the left.
Question 9
Which of the following statements IS correct?
(a) The real exchange rate cannot be equal to the nominal exchange rate.
(b) The real exchange rate depends only on the rates of inflation in the two
countries.
(c) The purchasing power parity exchange rate is the path of the nominal exchange
rate that maintains a constant real exchange rate.
(d) The purchasing power parity exchange rate can be computed by looking at the
market for one good.
23
(c) is correct.
The purchasing power parity exchange rate is computed based on the idea that regardless of the
currency they are expressed in, real prices should be the same. This means maintaining a
constant real exchange rate through nominal prices.
Question 10
What does the convergence theory in the Solow model imply?
(a) Rich nations will stop growing.

(b) Poor nations will grow slower than rich nations.
(c) Growth will only arise if a nation is not in steady state.
(d) Poor countries will grow faster than rich countries.
(d) is correct.
The convergence theory postulates that countries will eventually reach the same steady state
output, i.e. there is convergence. This is true regardless of where countries start from as Solow
assumes that growth is a concave function of income. Countries which start with higher incomes
will grow less than countries which start at lower levels of income. Hence countries which start at
lower incomes will grow faster and catch up with those which started with higher ones.
Section B: Microeconomics
Candidates should answer ONE of the following long questions. It is essential that you explain your
answers.
Question 11
(a) Define the concept of ‘externality’. Why do economists care about externalities?
(4 marks)
(b) A wind farm is built in a seaside town that earns most of its profits from
tourism. Assume that the profits for the town depend on the number of tourists
T and the number of windmills W and are given by the expression
π T = 100 + 16T − T 2 − 4W and the profits for the wind farm, which depend on
the number of windmills W , are π W = 16W − W 2 . What would the profits and
quantities be if the town cannot stop the wind farm from expanding? What are
the efficient amounts and the associated profits? If the quantities differ explain
why.
(12 marks)
(c) Now consider the externality cars impose on pedestrians by creating pollution.
Can this externality be fixed with a Pigouvian tax? If so, what should be its
value? Show this on a graph.
(8 marks)
24
(d) There are a number of international agreements aimed at reducing pollution.

Can you explain how the free-rider problem applies to countries who decide not
to sign these agreements?
(6 marks)
(a) An externality is the cost or benefit which affects a party who did not choose to incur that
cost or benefit. Economists typically care about externalities because they lead to
inefficiencies and affect welfare – for example, pollution.
(b) If the two cannot interact the town maximises:
max π T = 100 + 16T − T 2 − 4W
yielding the first-order condition:
16 − 2T = 0 ⇒ T = 8.
The wind farm maximises:
π W = 16W − W 2
yielding the first-order condition:
16 − 2W = 0 ⇒ W = 8.
The corresponding profits are:
π T = 100 + 16T − T 2 − 4W = 132 and π W = 16W − W 2 = 64.
To calculate the efficient amount we are assuming that the wind farm is internalising the
externality. The efficient amounts are given by the social planner’s maximisation of:
max π = 100 + 16T − T 2 − 4W + 16W − W 2 .
The production of T is unaffected, but W = 6. π T = 140 and π W = 60. The difference is
due to the externality.
(c) A Pigouvian tax is a per-unit tax set so that the producers (in this case car owners) will
produce the efficient amount. The value should be the marginal damage imposed by the
externality, that is the difference between social and private marginal cost. The graph
should show the deadweight loss due to the externality and point out that the efficient tax
would be equal to the marginal loss in welfare. See Figure 1.
Figure 1: A Pigouvian tax.
25
(d) One country reducing pollution benefits both that country and other countries. Countries
who decide not to sign the agreement benefit because of lower pollution and potentially
higher growth because they are less restrictive. This could also induce firms to move to the
non-signatory countries.
Question 12
(a) The market for videogames has a downward sloping demand given by the
equation QD = 126 − 7P and an upward sloping supply curve given by the
equation QS = 14P . What are the equilibrium price and quantity? Use a
supply and demand diagram to show the equilibrium in the perfectly
competitive market for videogames. On the same graph show the consumer and
producer surplus.
(8 marks)
(b) If a tax is set on consumers who will bear the burden of the tax? Show
graphically the effect of setting a tax in this market.
(6 marks)
(c) The government has introduced a tax of £3 on suppliers for every videogame
sold. What will be the new quantity sold? What are producer and consumer
surpluses after the tax is introduced? How much will the government obtain in
tax revenues? Is there a deadweight loss? If so compute its value.
(10 marks)
(d) The government realises that raising a tax has damaged consumers and
producers. Because of this it allows all producers of videogames to merge and
become a cartel. The cartel is free to offer the same videogame at different
prices, so that the cartel can first-price discriminate. What does this imply? Is
there still a deadweight loss?
(6 marks)
(a) Equating supply and demand gives:
126 − 7P = 14P
so P = 6 and Q = 84.
This should be shown on a downward-sloping demand curve and an upward-sloping supply
curve. The area bounded by the demand curve and above the price is the consumer surplus.
The area bounded by the price and above the supply curve is the producer surplus.
The equilibrium quantity is 84, and the price in the market is 6. The consumer surplus is
504, and the producer surplus is 252. See Figure 2.
26
Figure 2: Supply and demand.
(b) Figure 3 shows the correct lines. This can be done by showing a demand curve with the tax
a distance t below the demand curve with no tax, but this is not essential so long as it is
shown that the difference between the price p + t paid by consumers is greater than the
price received by suppliers is t, and the changes in price and quantity. Candidates could get
credit by doing one of the following:
• showing the areas as in Figure 4 (but not at this stage getting the numbers asked for in
part (c)), and noting that suppliers bear more of a burden with a flat demand curve and
a steep supply curve
• showing the areas as in Figure 3 and noting that in this case demand is more elastic than
supply and more of the tax burden falls on suppliers (or the equivalent for more elastic
supply).
Figure 3: The loss of consumer surplus and producer surplus caused by a tax.
Figure 4: Tax revenue, consumer surplus, producer surplus and deadweight loss
with a tax.
27
(c) The new equilibrium is determined to be:
126 − 7P = 14(P − 3) ⇒ P d = 8, P s = 5 and Q = 70.
The government gets tax revenue of 70 × 3 = 210, consumer surplus is now (70 × (18 − 8))/2
= 350 and producer surplus is (5 × 70)/2 = 175. There is a deadweight loss from taxation
and it is (8 − 5)(84 − 70)/2 = 21.
Figure 5: The welfare effects of a tax, with numbers.
Here a lot of candidates lost marks because they interpreted the tax as just increasing the
price by 3 from the equilibrium price above. This leads to the wrong changes in consumer
and producer surplus and the wrong numbers for government revenues and deadweight loss.
(d) Half marks were awarded to candidates who talked about standard monopoly. Under
uniform pricing the monopolist charges a price above the competitive price, so there is a
deadweight loss due to being below the market-clearing quantity.
A better answer would treat this as third-degree price discrimination (charging different
groups different prices). Here there would still be a deadweight loss, although smaller than
under uniform pricing.
First-degree price discrimination allows the monopolist to set a price equal to the willingness
to pay of each consumer. This eliminates any deadweight loss, but also drives the consumer
surplus to zero.
Section C: Macroeconomics
Candidates should answer ONE of the two following long questions. It is essential that you explain
your answers.
Question 13
(a) How can we represent the Solow model graphically?

(6 marks)
(b) How does the Solow model show that the process of capital accumulation can
generate economic growth? Can growth be indefinite if savings keep increasing
and there is no technological growth and a constant population growth?
(8 marks)
(c) Discuss the effects of an improvement in technology in the Solow model. Focus
on its effects on living standards in the short run and in the long run. Show this
graphically.
(8 marks)
28
(d) How does the Solow model differ from Romer’s model? What is the long-run
growth rate of output per worker in each of the models? What does this imply
in terms of policy?
(8 marks)
(a) We can think of a production function and the income per capita. This is the standard
graph for growth. The graph should be clearly labelled and show output y, savings sy being
a proportion of output, steady state k1 at the point where the line nk crosses the curve sy.
(Here n is the rate of growth of labour, and s is the savings rate.) See Figure 6.
Figure 6: The Solow growth model.

(b) A higher savings rate s shifts up the savings curve sy. Starting at k1∗ in the short run,
increasing savings results in growth of capital and output per person. In the long run,
however, capital per person converges to its new steady state level k2∗ and capital and
output per person stop growing. As savings cannot be more than output, output per person
cannot grow indefinitely. See Figure 7.
Figure 7: An increase in the savings rate.

(c) Solow believed technology to be the main driver of growth. Technology is interpreted as
efficiency per worker and shifts the line nk up to (t + n)k, where t is the rate of technical
progress.
29
In steady state, capital and output per worker equivalent are constant. However, output per
actual worker increases indefinitely. In the long run this means a new and higher steady
state. Note that if technology keeps improving here we can get indefinite growth in output
per worker. See Figure 8.
Figure 8: The effect of an improvement in technology.
(d) Romer introduces endogenous growth, with a model of the technical change. Romer assumes
that technical progress by one firm benefits other firms. He argues that this makes constant
returns to capital possible. (Solow assumes diminishing returns to capital instead.) In Romer’s
model indefinite growth is easier to achieve, and output per worker grows.
Question 14
(a) What does the Phillips curve represent? Is there a difference between the
Phillips curve in the short-run and long-run? Explain and show it in a diagram.
(6 marks)
(b) What is the impact of a short-term negative shock on output, unemployment
and inflation? Explain and draw a diagram.
(6 marks)
(c) What is the relationship between the current and capital accounts in a flexible
exchange rate regime?
(4 marks)
(d) What is Okun’s law?
(4 marks)
(e) Assume that we are in a floating exchange rate regime. The price of oil went
up, driving the economy to a much higher unemployment rate. Use a standard
IS–LM–BP model to explain what happens to income, interest rates and the
balance of payment if the central bank uses monetary policy to stabilise the
economy at potential output.
(10 marks)
30
(a) The Phillips curve suggests that there is a trade-off between inflation and unemployment. If
inflation is high, unemployment is relatively low and vice versa. In the model, short-term
aggregate supply is upward-sloping in a graph with output on the horizontal axis and
inflation on the vertical axis. In the long run, aggregate supply is a vertical straight line –
there is no impact of inflation on long-run aggregate supply. In the short run, the nominal
(money) wage rate is assumed to be fixed. It depends on how much inflation was expected
at the time the wage was fixed. If inflation is higher than expected then the real wage
(money wage/price of output) is lower than expected, and employment and output are
relatively high.
(b) Candidates may address this in a variety of ways. Full marks were given for a coherent
answer, well explained, with a diagram. Candidates may assume either a supply shock or a
demand shock. They are not expected to look at both cases.
The question can be answered working with the Phillips curve alone, Figure 9, or working
with both the Phillips curve and aggregate demand and supply. Intuitively the short-term
outcome will be to decrease output and increase unemployment. In the long run, output and
unemployment will return to their original level. What happens to inflation in the short and
long run depends on the nature of the shock, the policy response and expectations.
Candidates did not need to go into detail on this.
Figure 9: Effects of a short-term negative supply shock.

Intuitively, a short-term negative supply shock can be expected to decrease output, increase
unemployment and increase inflation. The Phillips curve diagram in Figure 10 illustrates
this. The economy starts at E. The Phillips curve shifts out from PC1 to PC2 . In the short
term the economy moves to a point such as G with higher inflation. Given the vertical
long-run Phillips curve, output eventually returns in to its original level. What happens to
inflation in the long run depends on the policy response and how expectations change.
31
Figure 10: Effects of a short-term negative demand shock.
(c) The balance of payments is typically formed of two parts – the current account (the
profit/loss from day-to-day transactions) and the capital account (capital flows related to
capital items in the form of assets, such as firms purchasing machinery). The capital
account and current account have to net out to zero. If a country has a capital surplus (for
example, foreigners are net investors of capital into the country), then it will run a current
account deficit.
(d) Okun’s law is an empirically observed relationship between unemployment and losses in a
country’s production. For every increase in the unemployment rate, a country’s GDP will be
lower than its potential GDP.
(e) Under a flexible exchange rate, monetary policy is the most effective policy response. The
fall in consumer spending shifts the IS curve to the left. Expansionary monetary policy
shifts the LM curve to the right. This restores output at a lower interest rate than originally.
For the curves see, Figure 11. The oil price shock with no change in monetary policy pushes
the IS curve to the left from IS0 to IS1 moving the economy from A to B, with a lower
interest rate and below target income. Expansionary monetary policy shifts the LM curve
from LM0 to LM1 . For an interest rate-setting central bank, it can simply set a lower
interest rate r2 . This moves the economy from B to C, returning output to its original level
Y ∗ , but with a lower interest rate.
Figure 11: IS–LM with an oil price shock.
In a flexible exchange rate regime the decrease in the interest rate results in an outflow of
funds from the country, which has the effect of causing the exchange rate to depreciate in
the short term. The depreciation in the exchange rate increases exports by making
exporting more profitable, having a further expansionary effect. This makes monetary policy
more effective in an open economy than a closed economy.
32

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Examiners’ commentaries 2019

Examiners’ commentaries 2019

Information about the subject guide and the Essential reading

Format of the examination

This paper consists of three sections:

Key steps to improvement

Make the most of what you know in the examination room.

Examination revision strategy

Examiners’ commentaries 2019

Information about the subject guide and the Essential reading

Comments on specific questions – Zone A

This paper consists of THREE sections:

Section A: Multiple choice questions

Candidates should answer ALL questions from this section.

Choose one answer for each question: no explanation is needed.

(a) Consumer surplus is 120 and producer surplus is 600.

Reading for this question

Approaching the question

Reading for this question

See BVFD Chapter 5.

Approaching the question

Which of the following statements IS NOT correct?

(a) A tax does not always lead to the inefficient output.

Reading for this question

See BVFD Section 8.5 and Section 9.3.

Approaching the question

(c) is not correct.

Reading for this question

See BVFD Section 3.5.

Approaching the question

The joint firm maximises:

Choose the correct statement. The labour supply curve IS:

(a) Always downward sloping.

Reading for this question

See BVFD Section 10.1.

Approaching the question

Choose the correct statement. Potential output IS:

(a) The output demanded by households as consumption and by firms as

Reading for this question

See BVFD Section 16.3.

Approaching the question

Reading for this question

See BVFD Sections 20.1 and 22.2.

Approaching the question

In a time of political instability investments fall because of lack of confidence from

(a) Investments will be lower for any given interest rate.

Reading for this question

See BVFD Section 20.1.

Approaching the question

(b) is not correct.

Which of the following statements IS correct?

Reading for this question

See BVFD Section 24.3.

Approaching the question

What does the convergence theory in the Solow model imply?

(a) Rich nations will stop growing.

Reading for this question

See BVFD Section 28.7.

Approaching the question