EC282: Economics for Business
Outline Solutions (May/June 2014)
Question 1 Answer
(a)
If the goods are perfect complements, the consumer’s indifference curves are L-shaped
(rectangular). The optimal combination is then given where the kink of the highest achievable
indifference curve touches the budget line. If goods are perfect substitutes, indifference
curves are downward sloping straight line. Depending on the relation between the (constant)
relative price and the (constant) marginal rate of substitution, the optimum is given by one or
the other possible corner solution or the consumer is indifferent between all points on the
budget line.
(b)
If the goods are imperfect substitutes, indifference curves have the usual convex shape.
Consumer’s optimum is given by the point of tangency between the budget line and the
highest achievable indifference curve.
(c)
To separate the substitution and the income (budget) effect, a hypothetical budget line has to
be drawn that is parallel to the new budget line (after the price change) but tangent to the
original indifference curve. The movement along this indifference curve is the SE. The
income effect is then just the remaining movement to the new optimum.
Question 2 Answer
(a)
Excludability and rivalry are the two dimensions used to identify different types of goods. A
public good is one where there is non-excludability and non-rivalry.
(b)
The lighthouse problem can be conceptualised by a simple prisoners’ dilemma game
between two players. The free-rider problem becomes obvious which leads to the lighthouse
not being built.
(c)
The solution is some kind of authority that has the power to levy taxes on all that benefit from
the existence of the lighthouse.
Page 1 of 2
EC161/EC282: Economics for Business (MS)
(May/June 2014)
Question 3 Answer
a)
According to the classical view, aggregate supply is irresponsive to nominal price changes,
giving a vertical aggregate supply curve. Only real variables – the quantity and productivity of
factors – influence the ability of producers to supply. Nominal variables (prices) do not. A key
assumption is that markets (in particular factor markets) adjust quickly to shocks, ensuring all
resources are fully utilised and the economy always operates at full potential. Thus, if there is
a negative shock to aggregate demand, any resulting surpluses drive prices down quickly
until a new equilibrium is reached where all resources are fully employed, but at a lower
price. The key policy implication is that demand-side policies are futile for achieving output
objectives, and should only be used for price level objectives. Supply-side policies should be
the focus for achieving output objectives. Examples may be given.
b)
If the aggregate supply curve slopes upwards to the right (at least in the short run) the effects
of a fall in aggregate demand on output, and thus the implications for policy, are very
different. An upwards sloping AS curve may exist if the classical assumption of immediate
price adjustments does not hold. For example, wages are often assumed to be ‘sticky’ in the
short-run, due to infrequent negotiation of contracts, motivational considerations, etc. Firms
may thus respond to a fall in aggregate demand, not by lowering wages and prices, but by
reducing employment and output. The key policy implication, in contrast to the classical view,
is that demand-side policies may be necessary to achieve output objectives. Examples may
be given.
c)
A good answer will incorporate empirical observations to support the argument. For example,
it could be argued that recent experiences in the UK can be better explained by Keynesian
theory due to the large and sustained drop in output experienced (yet to be recovered), high
and sustained unemployment, a rise in saving whilst investment has simultaneously fallen,
etc.
Question 4 Answer
a)
The quantity theory of money should be explained with reference to the equation of
exchange: MV=PQ. The key policy implication – that the money supply growth should be
restrained for the sake of price stability – should be discussed.
b)
A good answer will include a suitable diagram (showing a short-run Phillips curve sloping
downwards to the right) with a brief explanation, and an explanation of why this relationship
may exist in the short-run.
c)
A good answer will include a suitable diagram (showing a vertical long-run Phillips curve and
a number of short-run Phillips curves at differing expected inflation rates), and an explanation
of why no relationship may exist between inflation and unemployment in the long run due to
adaptive expectations.
Question 5 Answer
Briefly define the terms given.
Page 2 of 2
EC161/EC282: Economics for Business (MS)
(May/June 2014)