ECONOMICS 108

Spring, 1992

Second Midterm

There are 60 points on this exam; the number of points appears in parentheses after each question.

Print your name AND sign your name in the spaces provided below. Also write your social security (University ID) number.

PRINT NAME

SIGN NAME

Soc. Sec. # Recitation Day/Time

1. If the interest rate is 10 percent per year, what is the discounted present value of $200 paid one year from now? (1)

$200/1.1 (which is about $181.82)

2. (a) Explain the circular flow of economic activity and use it to derive the quantity equation of money. (2)

The circular flow shows money flowing from people to firms as people buy goods, and then money flowing from firms to people as people are paid for inputs such as labor. It also shows goods flowing from firms to people (who buy the goods) and inputs from people to firms (which buy labor services and other inputs from people). Suppose y goods flow each period (year or month) from firms to people (i.e. firms produce and sell y goods per period). Also suppose there are M dollars in the economy, and people spend each of these M dollars V times per period. Then total spending each period is MV dollars, which buys y goods. So the price level P is MV/y, i.e. MV=Py, which is the quantity equation.

(b) Use your equation from part (a) to derive an equation for the rate of inflation. (1)

Take percentage changes of MV=Py and get %D M + %D V = %D P + %D y, or

inflation = %D P = %D M + %D V - %D y. (Another way to write this is inflation = %D P = %D M - %D k - %D y.

note: give credit for either way of writing it

3. The price level in the United States roughly quadrupled from 1968 to 1992 (it roughly doubled twice over that period). Use the rule of 72 to calculate the (approximate) average inflation rate per year from 1968 to 1992. (1) Since it doubled twice in 24 years, on average it doubled each time in 12 years. So 72/12 = 6, which means the inflation rate averaged about 6 percent per year.

4. Suppose that in some year the nominal money supply rises by 6 percent, velocity falls by 1 percent, and real GNP rises by 3 percent. What would inflation be that year? (1)

2 percent

5. What is statistical discrimination? Why might it reduce the wages of married women relative to wages of married men? (2)

Statistical discrimination occurs when people use information about a person's sex (or race, etc.) to help predict important individual characteristics. For example, insurance companies practice statistical discrimination when they charge higher prices for life insurance to older people than to younger people because on average younger people are less likely to die soon than older people. If women on average are more likely than men to leave a job for some years to raise children, then employers may be less willing, on average, to hire women and invest in training them. This may explain part of the difference between the average wages of men and women.

6. Explain the equation

Y = C + I + G + EX - IM.

(2)

On the left, Y is the amount of goods the economy produces. C shows how many of these goods go for consumption (by people), I shows how many of these goods go for investment (by firms and people), G shows how many of the goods are purchased by the government, and EX-IM shows the trade balance (how many more goods are exported than imported).

7. (a) About how large is GNP in the United States? about $6 trillion

(GIVE CREDIT FOR ANY NUMBER BETWEEN $3 trillion and $10 trillion)

(b) About how large is per capita GNP in the United States? about $24,000 per person

(GIVE CREDIT FOR ANY NUMBER BETWEEN $18,000 and $30,000)

(GIVE CREDIT FOR ANY NUMBER BETWEEN $3,000 and $12,000)

(d) Roughly what has been the average growth rate of real GNP per capita in the United States since the year 1900? 1.8 percent per year

(4) GIVE CREDIT FOR ANY ANSWER BETWEEN 1 percent and 3 percent)

8. What is the connection between the real interest rate and the nominal interest rate? (1)

i = r + p (give credit for the answer in words: nominal rate is real rate plus inflation)

9. If the real interest rises, do goods now become cheaper or more expensive compared to goods in the future? Explain why. (2)

1 point: they become more expensive

second point: when the real interest rises, you sacrifice more future goods for each good you consume now (today), so the opportunity cost rises

10. Explain the majority view and the Ricardian view on the effects of tax cuts that cause budget deficits. (6)

(1 point:) According to the majority view, the increase in the government budget deficit by X dollars raises the demand for loans by X dollars, which shifts the demand for loans to the right by X dollars. (Second point:) This raises the equilibrium real interest rate and (third point:) reduces investment.

(4^th point:) According to the Ricardian view, people save the money from the tax cut. So (5^th point:) the supply of loans shifts to the right by X dollars, which is the same amount the demand for loans shifted to the right. (6^th point:) So the tax cut does NOT affect the real interest rate or investment.

You may also give points for discussions of:

(a) the Ricardian-view idea that it doesn't matter when the government takes money from you, only the discounted presented valule of what they take matters;

or (b) the Ricardian-view idea that rational people would save the tax cut because they can use the interest and principal on that savings to pay the higher future taxes.

11. (a) Draw the basic supply-demand diagram with a negative externality. Use it to discuss why the economically efficient amount of output of the good differs from the perfect-competition equilibrium amount of output, and show the deadweight social loss from the externality. (4)

(b) Explain the Coase theorem. (3)

The Coase Theorem summarizes two conclusions about externalities. First, if transactions costs are low, the equilibrium is economically efficient regardless of how property rights are assigned, e.g. whether or not the law allows a firm to pollute. People can make side payments to reach the same economically efficient solution regardless of whow has which property rights (though the distribution of income depends on how property rights are assigned because it affects who might make side payments to whom). If transactions costs are high, side payments may not be possible, so the equilibrium might not be economically efficient. With high transactions costs, the equilibrium depends on who has which legal rights.

12. Explain: "Prejudice is free, but discrimination has costs." What determines the price a prejudiced person must pay in order to discriminate? (4)

A person who discriminates pay a price to do so. Suppose you own a business and you are prejudiced against blacks and women. You want to make profits, but you also want to hire white males. If many other businesses discriminate against women and blacks, then white men earn higher wages than equally-skilled women and blacks. You can discriminate by hiring white males, but you would earn higher profits by hiring the lower-wage women and blacks with equally-good skills. You lose profits if you discriminate: this is the price of discrimination. Sometimes customers are prejudiced and want to buy from a seller who does not employ blacks. When blacks earn lower wages than whites, firms that employ only whites have higher marginal costs. So buyers must pay higher prices to buy from these firms. The higher product prices represent a price of discrimination to buyers. The price of discriminating is higher when other people discriminate more: the more other firms discriminate against blacks, for example, the higher the relative wages of whites and the more a firm sacrifices if it hires whites (at the higher wage) instead of blacks.

13. Use diagrams to help explain the effects on

* consumption

* savings

* investment

* the real interest rate

and * real GNP

of: (a) an increase in consumer patience (increased willingness to save), (5)

and (b) an increase in the rate of return on investments (marginal efficiency of investment). (5)

14. Explain and discuss the problems with the following ideas of fairness (or justice) in assessing the distribution of income in a society:

(a) egalitarianism,

(b) utiliarianism,

(c) the idea that fairness is a set of rules that people would agree upon in an "original position," behind the "veil of ignorance."

(10)

(a) Egalitarianism is the view that fairness requires equal results. On simple version of egalitarianism is that fairness requires everyone to get the same income. Another version of egalitarianism says that fairness requires that some people get more income than others to compensate them for other differences. Many questions of policy arise from egalitarianism. What is the best tradeoff between equality and efficiency (by providing incentives)? Is it better to have a society in which half the people have 100 and half the people have 200, or a (more egalitarian) society in which everyone has 100? Another set of issues arise when people become unequal by their actions. For example, suppose two people start out with the same wealth, and one saves more than the other. In later years, the saver will have investment income that the other person does not. Is this just?

(b) Utilitarianism is the view that justice consists of maximizing the total amount of human happiness. Only the total matters, not who has the happiness and who does not. In this sense, utilitarianism is very different from egalitarianism, since utilitarianism asserts that the distribution of happiness across people does not matter, only the total. Despite its concentration on total happiness, utilitarianism provides an argument for redistributing income from the rich to the poor. The argument is that if you take a dollar from a rich person and give it to a poor person, the loss in happiness to the rich person is smaller than the gain in happiness to the poor person. The poor person, according to this argument, values money more than the rich person because he has less of it. Critics of this argument say that it is impossible to know how much happiness one person has, or how much he gains or loses as his income changes. There are many criticisms of utilitarianism. First, many people find it objectionable that utilitarianism does not consider the distribution of happiness important. A utilitarian would prefer a situation in which Jeremy has 10 units of happiness and John has 2 units to a situation in which Jeremy and John each have 5 units of happiness. A second criticism of utilitarianism is that it ignores peoples' fundamental rights. If someone needs an emergency kidney transplant and no one offers to donate a kidney, a utilitarian might say the government should force someone to donate, because the gain in happiness to the patient exceeds the loss in happiness to the donor. Some critics of utilitarianism say that forcing someone to donate a kidney violates her rights, and that this is an example of the morally monstrous implications of utilitarianism.

(c) Suppose people could meet and agree on the rules of life before they are born and before knowing if they will be smart or dumb, beautiful or ugly, lucky or unlucky, whether they will have rich or poor parents, tastes for material goods or for spiritual fulfillment, and so on. This is called meeting in the original position or behind the veil of ignorance. At this meeting, people would choose legal rules and government policies. They would decide whether the government should redistribute income from rich people to poor people, and how much they should transfer. They would decide what rights and obligations people have. Because people would not (yet) know their own individual circumstances when they make these decisions, they cannot make rules that give special benefits to themselves. Instead, they would choose rules that benefit the whole society. In this sense, the rules they would choose are fair. Justice, according to this idea, is a set of rules. Rules are fair or just if everyone would agree to them at this magical meeting behind the veil of ignorance. Since this meeting is impossible to arrange, we don't know what rules people would agree on; we can only guess.

15. (a) Explain the tragedy of the commons and what it has to do with externalities.

(b) Explain why private property rights prevent the tragedy of the commons.

(6)

(a) When everyone has the right to use a resource, no one person has a strong incentive to protect it. Each person wants to be a free rider and let other people do the work to protect the resource. This causes many important externalities. The tragedy of the commons is the result of common ownership rather than private property rights. It is the overuse or destruction of the common resource. (THREE POINTS for this part)

(b) GIVE UP TO THREE POINTS FOR ANY BRIEF DISCUSSION OF HOW THE COMMON-RESOURCE PROBLEM RELATES TO PROPERTY RIGHTS, e.g. mentioning the fishing example in class: when the lake is not owned, it is overfished, but if it is owned, the owner has an incentive to maintain the value of his resource by limiting its use -- by chargin people to fish. Ownership of the lake leads to the economically efficient use of the lake. (The Turkey-Island problem from the homework assigmnent is similar.) OR UP TO THREE POINTS FOR ANY GENERAL DISCUSSION OF THIS RESULT