AMERICAN UNIVERSITY
Department of Economics
Comprehensive Examination
Political Economy I
Comprehensive Examination in Political Economy I
Directions: Please answer all six questions.
January 2005
Page Count = 3
1. Define and briefly explain the significance of each of the following terms. Limit your answers to no more than 200 words (or approximately ¾ of a page) per term :
Coase’s Theorem
Government Debt Neutrality
Moral Hazard
Rational Expectations
2. Explain each of the following puzzles using economic reasoning. Limit your explanation to each to no more than 300 words:
(i) Why do drive-up ATM machine key pads have braille dots (for the blind)? Blind persons do not drive nor should they walk up to machines where cars can go by.
(ii) Why does neoclassical growth theory predict that poorer economies grow faster ?
(iii) Why do firms mail discount coupons (e.g. 10 cents off toothpaste) to households rather than give discounts directly at the store?
(iv) Why should stock prices follow a random walk if markets are efficient?
3. Itchy and Scratchy are two people who met at a party. They got along well, but unfortunately they forgot to exchange phone numbers. Fortunately, each remembers that they spoke of attending an
Oscar party that night. However, there are two such parties. One party is small. If each attends this party, they will certainly meet. The other party is large. If each attends this one, there is a chance that they will not meet because of the huge crowd. Of course, they will definitely not meet if they attend separate parties. Payoffs to each, depending on the combined choice of parties, are shown below, with Itchy’s payoffs listed first:
Scratchy
Go to
Small Party
Go to Small Party (1000, 1000)
Go to
Large Party
(0, 0)
Itchy
Go to Large Party (0, 0) (500, 500)
(i) Identify the Nash equilibria for this problem if any. Explain briefly.
(ii) Which outcome is Pareto-optimal? Explain briefly.
(iii) What would be the mixed strategy equilibrium to this game?

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4. Let = sy - (n + g + d )k, where k is the capital stock per unit of effective labor, s the savings rate, y output per effective unit of labor, n the growth rate of labor, g the growth rate of technology, and d the depreciation rate. Let c = (1 - s)y be consumption per effective unit of labor. Assume the production function is Cobb-Douglas: y = k
" where 0 < " < 1
(i) Find the steady-state k*, y*, and c* as functions of the model’s parameters (s, n, d , g, and
).
(ii) Find the golden rule capital stock.
(iii) What savings rate would yield the golden rule capital stock? Interpret this savings rate.
5. Consider the following beach were “Jaws” was filmed. The beach is linear and L yards in length:
0 A E B L
________________________________________________
<------------ a ----------- > <-- x --> <---- y ----> <----- b ----> where 0 (origin) marks the beginning of the beach property and L marks the end of the property.
There are two ice cream stands: one of them is located at point A (which is “a” yards from 0) and the other at point B (which is “b” yards from L). Assume sunbathers (i.e. consumers) are located uniformly along the beach, one at each unit of length, and that each buys exactly one ice cream cone per period. Assume that ice cream cones are costless to produce. However, consumers incur a transportation cost of t per unit of distance traveled (due to the fact that ice cream melts). Let p
A
denote the price charged by stand A and p
B
the price charged by stand B.
(i) Let the consumer located at point E be indifferent between purchasing ice cream from stand
A and purchasing from stand B. (Note that E is x yards from A and y yards from B.) What condition must be true for location E to be a point of indifference?
(ii) Note that a + x + y + b = L. Using your condition in part (i), solve for x and y as functions of p
A
, p
B
, a, b, and t .
(iii) Given your solutions for x and y, write down the profit functions for the two firms also as functions of p
A
, p
B
, a, b, and t . [Hint: Remember that profits are the difference between revenues and costs, and here there are no production costs. Revenues equal price times quantity demanded.]
(iv) Using your profit functions from part (iii), derive the profit maximizing prices. Under what condition will p
A
> p
B
?
(v) At what locations of the two firms would consumer welfare be maximized? [Hint: at what locations would the total costs of walking be minimized? You can show this quantitatively or argue qualitatively, but convincingly.]

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6. Consider the following closed-economy macro model:
Y = C + I + G
C = C(Y),
I = I(r),
(M/P) = L(r, Y),
0 < C
Y
< 1
I r
< 0
L r
< 0, L
Y
> 0 where Y denotes output, C consumption, I investment, L liquidity preference, and r the interest rate. Government spending G, money supply M, and the price level P are exogenously given.
(i) Derive the IS curve and LM curve
(ii) Totally differentiate (or linearize) the IS & LM curves. Why is the IS curve downward sloping, and LM curve upward sloping, in (Y, r) space?
(iii) Rewrite the system you derived in part (ii) in 2 x 2 matrix form; namely, AX = B, where X is a vector of endogenous variables, A matrix of coefficients, and B vector of exogenous terms.
(iv) Using Cramer’s rule, derive the following comparative static effects (holding other factors constant): M Y/ M G, M Y/ M M, M r/ M G, and M r/ M M. Discuss how the efficacy of monetary and fiscal policies depends on the interest elasticities of investment and money demand. Illustrate graphically.
(v) Derive the aggregate demand curve (relating output to the price level).
(vi) Suppose the aggregate supply function is Y = Y(W/P) where (W/P) is the real wage and the partial derivative Y ’ is negative. Re-derive M Y/ M G and discuss the efficacy of fiscal policy with an endogenous price level.