Comprehensive Examination
Master’s Economic Theory
American University
Department of Economics
June 2013
Page 1 of 5
Instructions: You must answer both the microeconomic and macroeconomic sections of the
exam. Each section receives equal weight in the grading. Plan to spend about 2.5 hours on each
section. Make sure you follow the directions in each section carefully.
MICROECONOMICS SECTION
Directions: Answer 3 of 4 questions from Part A (Short Answer) and all questions from Part B
(Long Answer). Show all of your work. Make sure you label all graphs.
Part A: Answer 3 of the following 4 questions (20 minutes each – 60 minutes total).
1. True, False or Uncertain and Explain. A local factory pays its workers $10 per hour
and finds that the average product of labor is maximized when 50 workers are
employed. Therefore, when 50 workers are hired, average variable costs is minimized
and equal to $500. (Assume that labor is the only variable cost).
2. Michelle spends her weekly income of $30 on chocolate (c) and shampoo (s).
Initially, when the prices are pc=2=ps (where pc is the price of chocolate and ps is the
price of shampoo) she buys c=10 and s = 5. After the prices change to pc=1 and ps=3
she purchases c=6 and s=8. Draw her budget lines and choices in a diagram. Using
revealed preference, discuss whether or not she is maximizing her utility before and
after the price change.
3. Suppose a paper mill earns $500,000 when it pollutes a river, and that it can invest in
abatement. The more it invests, as captured in the variable A, the less pollution there
is. The effects of pollution are confined to a single farmer who earns in dollars:
200,000 400√
If bargaining is frictionless and the parties split the gains from any agreement equally,
calculate the agreement reached between the mill and farmer if the mill has the right
to pollute, as well as the post agreement profits of the mill and farmer. How does
your answer change if the farmer has the right to set the level of abatement up to
$250,000?
4. Show that a monopolist’s marginal revenue will be positive at a certain sales quantity
only if the demand for the firm’s product is elastic at that quantity.
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Part B: Answer both questions (45 minutes each – 90 minutes total).
1. Ariel’s Grotto produces burgers (q) according to the production function:
q  K  L
where K is the number of units of capital and L is the number of units of labor.
(a) What restrictions must you impose on α and β to ensure that this production function
obeys the law of diminishing marginal productivity? What restrictions must you impose
to ensure that his production function exhibits decreasing returns to scale.
(b) Assume that these restrictions hold. Define w as the price of a unit of labor, and r as the
price of a unit of capital. Calculate Ariel’s Grotto long-run cost function, C(w,r,q). What
is the firm’s marginal cost of production?
(c) If this firm operates in a perfectly competitive environment, calculate its supply function.
Illustrate the firm’s supply curve on a graph.
(d) Union contract negotiations temporarily fix the Ariel’s Grotto labor force at 10 workers.
Calculate the firm’s short-run cost function.
(e) Illustrate on an isoquant/isocost graph and explain in words the relationship between the
firm’s long-run and short-run cost function.
2. Consider a movie theater monopolist who faces the following demand curves for adults and
children, respectively:
1,600 100
800 100
The firm has a cost function of:
1
200
a. What is the monopolist’s best price if discrimination is not possible?
b. What is the monopolist’s best price(s) if discrimination is possible?
c. What is the effect of discrimination on consumer surplus?
d. Illustrate on a graph and explain how the relative elasticities of demand are related to the
relative prices in the two markets.
P
MACROECONOMICS SECTION
Directions: Answer both parts, A and B; there is some choice in each part. Points will be
proportional to the time limits indicated.
Part A – Short Answer Questions (Identifications): Choose three (3) of the following. For
each one you choose, you must give a definition and briefly discuss the significance of the
concept for macro theory or policy. You may provide examples, but note that these do not
substitute for definitions. Time limit: 10 minutes each (30 minutes total).
1.
2.
3.
4.
5.
6.
7.
8.
9.
Zero lower bound
Monetary neutrality
Natural rate of output
Speculative attack
Phillips curve
Disinflation
Wage setting equation (WS)
Golden rule level of capital
J-curve
Part B – Long Answer Questions (Problems/Models) Choose two (2) of the following. Time
limits: 60 minutes each (120 minutes total)
1. Many countries will move to monetary contraction over the next many years. Analyze the
situation of contractionary monetary policy for any three (3) of the following cases,
assuming a short-run analysis. Your analysis can be mainly graphical and must include
detailed explanations. You may include equations if you wish. Also, you must show the
changes on the central bank balance sheet where relevant.
a. Closed economy IS-LM model (with the traditional LM curve).
b. IS-MP model, closed economy, where MP is the “monetary policy” curve
assuming the central bank targets the interest rate.
c. Open economy IS-LM model, with free capital mobility (so that the interest parity
relation holds) and a flexible exchange rate. Explain in detail the role of the
interest parity condition.
d. Open economy IS-LM model, with free capital mobility (so that the interest parity
relation holds) and a fixed exchange rate. You must explain in detail the role of
the interest parity condition.
(Part B continues on the next page)
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2. Analyze the short-run and medium-run effects of each of the following on output and the
price level, using the IS-LM model and the aggregate-supply/aggregate-demand model
(AS-AD). Be sure to explain how the economy adjusts from the new short-run
equilibrium to the new medium-run equilibrium, discuss in detail the role of price
expectations, and assess whether the theoretical adjustment process is realistic or not in
each case. You may assume that the economy starts in an initial medium-run equilibrium
at the “natural” output level Yn in each situation.
a. A negative supply shock, such as a rise in the price of oil.
b. A reduction in the level of unemployment benefits.
c. A positive shock to aggregate demand, due to a rise in business confidence.
3. (a) Derive the Solow Growth model (neoclassical growth model) algebraically.
(b) Explain intuitively the steady-state equilibrium condition in the Solow Growth model.
(c) Use the graph of the Solow model to analyze the effects of each of the following
changes (considered separately) on long-run equilibrium:
(i) A fall in the growth rate of the population
(ii) A rise in the saving rate
(iii) A decline in the rate of technical progress
For each case, what is the change in the growth rate of output, output per worker, and
output per effective worker? Summarize and explain the reasoning.
(d) Finally, consider whether or not a policy to reduce the saving rate would be a good
idea (e.g. is it possible for an economy to have too much capital?).
4. (a) Derive the endogenous growth model (Y = AK model).
(b) How is this model affected by the following events, considered separately:
(i) A fall in the initial level of K.
(ii) A rise in the saving rate.
Provide a detailed graphical analysis and thorough economic explanations in each
case.
(c) In what ways is the endogenous growth model preferable to the Solow model?
5. Many countries are pursuing a policy of fiscal austerity. (a) Explain fiscal austerity. What
has been the rationale for fiscal austerity?
(b) Consider the closed economy IS-LM and AD-AS model and analyze the short run and
medium run implications of fiscal austerity for real GDP, interest rates and the price
level. Provide a detailed explanation.
(c) What are the implications for your analysis if the economy is in a liquidity trap?
Demonstrate with new graphs and a new explanation.
(d) Use the equation for the government budget constraint to discuss the potential long
run consequences for the debt/GDP ratio. Be specific.
(e) Are there any special aspects of the US economy that affect the risks presented by the
already accumulated debt? Explain.
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6. Consider the open economy with flexible exchange rates. Analyze the short run
consequences for the home economy when there is a:
(a) fiscal expansion in the foreign economy.
(b) monetary expansion in the foreign economy.
Use the open economy IS-LM model along with interest parity condition. Explain all
changes. Summarize the effects on home economy real GDP, interest rates and the
exchange rate in each case.