ECONOMICS 108
Spring, 1994
Second Midterm
There are 60 points on this exam; the number of points appears in parentheses after each question.
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Soc. Sec. # Recitation Day/Time
Part 1 -- (1/2 point each)
1. World food production per person has ________ in the past several decades.
(a) increased (b) stayed about the same (c) decreased
2. On average, there is ______ income inequality in richer countries than poorer countries.
(a) more (b) about the same (c) less
3. Each year in the United States, households in the top fifth of the income distribution (the 20 percent with the highest incomes) get about ______________ of all the income in the economy.
(a) one-third (b) one-half (c) three-quarters
4. Households in the bottom fifth get about ______________ of all the income in the economy.
(a) 1 percent (b) 5 percent (c) 10 percent
Part 2 -- (1 point each)
5. Over the last 200-300 years, economic growth has become
(a) slowed down (b) stayed about the same (c) become faster
6. Nominal GDP per person in the United States is about $24000. (Answer with a number.)
7. Nominal GDP person in the world is about $6000. (Answer with a number.)
8. What is the connection between the real interest rate and the nominal interest rate?
nominal rate = real rate + inflation or i = r inflation
9. What is a subgame perfect Nash equilibrium?
A subgame perfect Nash equilibrium is a Nash equilibrium in which every player's strategy is credible (no player makes incredible threats).
10. Suppose the nominal money supply rises by 10 percent. If the velocity of money does not change and real GDP does not change, how much does the price level change?
it rises 10 percent
Part 3 -- (points indicated by each question)
11. Comment: "Committing yourself to a future action is never a good idea because it takes away your flexibility to respond to a situation in whatever way is best at the time." (2)
false: People can benefit from being able to limit their future actions so that they cannot do what they would want to do in the future -- because commitments can change the way other people act in a way that is good for you. Examples include committing not to deal with terrorists or burning bridges behind you.
12. If the real interest rises, do goods now become cheaper or more expensive compared to goods in the future? Explain why. (2 points)
Goods now become relatively more expensive compared to future goods when the real interest rate rises: people get a higher return on their savings, meaning they can afford more future goods for each good they sacrifice now.
13. Explain the tragedy of the commons and why private property rights can prevent the tragedy of the commons. (3 points)
The tragedy of the commons refers to the overuse of common resources (resources that are not owned) -- relative to their economically-efficient use. Private ownership of a resource gives the owner an incentive to preserve its value, so it prevents overuse.
14. Draw the basic supply-demand diagram with a negative externality. Show (for 6 points)
(a) the marginal private cost and marginal social cost of the good,
(b) the marginal cost to others from the good,
(c) the marginal private benefit and marginal social benefit of the good,
(d) the economically efficient amount of output of the good,
(e) the perfect-competition equilibrium quantity and price of the good,
(f) the deadweight social loss from the externality.
15. Explain and discuss (with some PRO and CON arguments on) two of the following ideas of fairness or justice in assessing the distribution of income in an economy. (6 points)
(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."
see chapter 18:
Egalitarianism is the view that fairness requires equal results.
A simple version is that fairness requires everyone to have 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: perhaps a handicapped person or a person with greater medical needs should get more income than other people. Perhaps a person who is physically unattractive should get more income than a popular, good-looking person. Perhaps a person whose job is unpleasant should get more income than a person with a personally-satisfying job (such as an artist). Another version of egalitarianism, "From each according to his abilities, to each according to his needs," was advocated by Karl Marx.
Egalitarianism in some form has obvious appeal to many people. (That is, after all, one reason for giving every person one vote in an election.) But problems arise when one tries to decide which version of egalitarianism is best, or to design policies that would create an egalitarian society. The main problem is that egalitarian policies reduce incentives to work. If egalitarianism is desirable for its own sake, it may be worth sacrificing some economic efficiency to achieve a more equal distribution (according to whichever version of egalitarianism one chooses).
Many questions of policy arise from egalitarianism. What is the best tradeoff between equality and efficiency? 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? Is it just to punish a poor person who robs from a rich person? Or does the robbery contribute to justice? Should socially valuable behavior -- such as curing a disease, or producing a good that people want -- be rewarded with extra income? Should esteem (bestowed by other people) be equally distributed like income? Can it be? Should people with more esteem get less income? Can people give material (or physical) tokens of esteem in an egalitarian world, or do these tokens count as income?
Another set of issues arises when people become unequal through their actions. Suppose two people have the same wealth at age 20, but one saves more than the other. In later years, the saver will have investment income that the other person does not. Is this just? Is it consistent with egalitarianism?
One need not be an egalitarian to believe that a more equal distribution of wealth would be desirable. Nor need one be an egalitarian to believe that, regardless of the degree of income inequality, government policies to reduce poverty (defined in some way) are good. These views can be deduced from other views of justice that we now consider.
Utilitarianism is the view that justice consists of maximizing the total amount of human happiness.
Only total happiness matters to a utilitarian, not who is happy and who does not. In this sense, utilitarianism is very different from egalitarianism, which argues that distribution is important and should be equal.
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. The marginal utility (benefit) of the money is larger for the poor person than for the rich person, so redistributing income from the rich to the poor raises total utility (happiness). Critics of this argument say that it requires an impossible interpersonal comparison of utility -- that we cannot compare one person's happiness with another person's. For all we know, according to this criticism, redistributing income from the rich to the poor might actually reduce total happiness. A utilitarian might reply that while we can never be sure of these comparisons, it seems reasonable that poor people gain more happiness from an extra $10 than rich people lose when the government takes away $10, and that people make interpersonal comparisons of utility regularly when they decide to give money to charities.
There are many criticisms of utilitarianism. Many people find it objectionable because it 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 1 unit to a situation in which Jeremy and John each have 5 units of happiness; an egalitarian would prefer the latter situation.
A second criticism of utilitarianism is that it ignores peoples' fundamental rights. If someone needs an emergency kidney transplant to stay alive and no one offers to donate a kidney, a utilitarian might say that the government should force someone to donate (because the gain in happiness to the person who needs the transplant exceeds the loss in happiness to the donor, who can live with her remaining kidney). Some critics of utilitarianism say that, while the situation is unfortunate, forcing someone to donate a body part is a violation of her rights. Many philosophers believe utilitarianism has "morally monstrous" implications.
Justice as an Implicit Contract
Before you play a game with a friend, you agree on rules. Football teams agree on rules before they know the outcome of the "toss of the coin" which determines which team will receive the first kickoff.
Suppose people could meet with each other and agree on the rules of life before the "toss of the coin" (that is, luck) turns them into unique individuals living in diverse circumstances around the world. We can imagine that people meet together before they are born -- before they find out 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 the legal rules and government policies that will affect their lives. 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 do not (yet) know their own individual circumstances when they make these decisions, they would not be able to make rules to give special benefits to themselves. Instead, they would presumably choose rules that benefit, in a sense, the whole society. In this sense the rules they choose would be fair and would give meaning to the concept of justice.
According to this view, only rules can be fair or just, not outcomes like who wins a game or how equally income is distributed. Rules are fair or just if everyone would agree to them at this magical meeting behind the veil of ignorance. But because this meeting is impossible to arrange, no one knows for sure what rules people would agree on. John Rawls, in his book A Theory of Justice, guessed that people would choose a system that involves considerable redistribution from the lucky to the unlucky -- from the rich to the poor -- to make certain that no one falls below a certain level of income. He argued that people in the original position would agree to redistribute income from whoever turns out to be rich, to those who turn out to be poor. Justice is then the enforcement of this agreement. Other proponents of the idea that justice is an implicit contract have other guesses about what rules people would choose.
16. Will the finite quantity of natural resources cause economic growth to slow down and stop in
the future? Present arguments on both sides of the issue. (8 points)
ECONOMICS AND SOCIAL ISSUES
Will the Finite Quantity of Natural ResourcesCause Economic Growth to Slow Down and Stop?
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YES: There is a finite amount of many important natural resources. Some of these -- like total land area -- don't change over time but population growth reduces the amount available per person. Many others -- such as fossil fuels (like oil and natural gas) and metals -- are actually being used up. Future generations will have less available even if the population stops growing. And there is no indication that the world population will stop growing anytime soon. Most experts expect it to increase massively over the next century. Population growth is already outstripping the world's supplies of fresh water, food, and minerals. The fact that people have warned of doom in the past is irrelevant. They were, of course, wrong at the time. But now is different. These finite natural resources will soon get more expensive, because they are being used up. The fact that some commodities have become cheaper in the past proves nothing, because we were not near the point of running out; now we are near that point.
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NO: We haven't run out yet, and there is a reason. When resources become scarce, people respond with innovations and substitutes. This has happened throughout history. The Greeks' transition from the Bronze Age to the Iron Age 3000 years ago was caused by wars in the eastern Mediterranean that disrupted trade and reduced the supply of tin needed to make bronze. The Greeks responded to the bronze crisis by starting to use iron instead. Timber shortages in 16th-century Britain led to the use of coal as a substitute. People find alternative ways to produce the services that the scarce resources previously produced, and the alternatives usually turn out to be better. There is an unlimited supply of human ingenuity -- the most important natural resource -- to produce these new ideas. As a result, neither the finite physical quantities of natural resources nor population growth will limit economic growth. An increase in population growth causes short-term problems because children do not produce. But it does not create long-term problems because as adults people produce both goods and new ideas. Serious people have claimed many times in the past -- wrongly -- that the world was about to run out of some natural resource. The current claims are wrong for the same reason similar people were wrong in the past. Many physically finite natural resources have become cheaper rather than more expensive over time because of new discoveries that raise their supplies or the development of substitutes that reduce their demand.
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17. Rebecca produces unique artwork at a cost (including the opportunity cost of her time) of $40 each. (Her marginal and average cost are each $40.) She faces the demand schedule in the table below. (5 points)
(a) How much should she produce and what price should she charge to maximize her profit? Explain why.
(b) How big is her profit and how much consumer surplus do her customers get?
(d) Repeat parts (a)-(c) for the case in which Rebecca can perfectly price discriminate.
quantity
price demanded
$200 1
$180 2
$160 3
$140 4
$120 5
$100 6
$80 7
$60 8
$40 9
$20 10
MC=MR at Q=5, so she produces 4 or 5 to max profit at $400. P = 120.
Consumer surplus is then 80+60+40+20+0 = 200.
If she can perfectly price discriminate, she produces 10 and earns a profit of 160+140+120+100+80+60+40+20+0 = $720 by selling 9; consumer surplus is then zero.
18. Explain in detail the controversy regarding the effects of government budget deficits on interest rates. (5 points)
19. What are the effects on consumption, savings, investment, the real interest rate, and real GNP of an increase in consumer patience? (Use a diagram to explain your answer.) (5 points)
Suppose people become more patient: they become more concerned about the future and decide to spend less money on current consumption and save more for the future. (This kind of change is sometimes called a fall in consumer confidence: people spend less on consumption and save more.) This raises the supply of loans as in Figure 25.2, which reduces the real interest rate and raises the equilibrium quantity of loans. Equilibrium savings rises (because the equilibrium quantity of loans is the same as equilibrium savings) and equilibrium consumption falls. (Consumption equals GDP minus investment and minus government, and investment rises while GDP and government spending stay the same, so consumption must fall.) Equilibrium investment rises -- because the quantity of loans equals investment plus the government budget deficit (and that deficit does not change). Firms invest more because the lower real interest rate raises the quantity of investment demanded: more investment projects become profitable.
20. Fred and Wilma can each choose "action 1" or "action 2." They each must choose without knowing what the other person will choose. The table below shows their payoffs from each possible combination of actions. (6 points)
Fred
Action 1 Action 2
Action 1 Fred gains 5 Fred gains 2
and Wilma gains 5 and Wilma gains 13
Wilma
Action 2 Fred gains 13 Fred gains 10
and Wilma gains 2 and Wilma gains 10
(a) Find the Nash equilibrium of this game.
the unique Nash equilibrium is for Fred and Wilma both to take action 1.
(b) Comment briefly on the Nash equilbrium of this game.
this is a Prisoner's dilemma game. Fred and Wilma would each gain if they both took action 2 instead of action 1.
21. The table below shows a sequential game between a monopoly and a new firm. The new firm must decide whether to enter an industry and compete with the monopoly. The monopoly can then decide whether to charge a high price or a low price. (4)
New Firm (N)
enter do not enter
keep p high Monopoly gets 3, Monopoly gets 5,
New Firm gets 2 New Firm gets 0
Monopoly
cut price Monopoly gets 0, Monopoly gets 2,
New Firm gets -1 New Firm gets 0
Find a Nash equilibrium of this game.
One Nash equilibrium is for the monopoly to play the strategy, "high price regardless of whether the new firm enters," and the new firm enters. Then the monopoly gets 3 and the new firm gets 2.