1.      This question has three parts:

a) Suppose that  the  supply  and  demand  schedules  for  a  product  are  given  by  the information below. Using an appropriate Supply and Demand diagram, illustrate the equilibrium price and quantity of the product in this market and explain why this is the equilibrium.

This question requires that students draw an appropriate supply and demand diagram with clearly marked axes and the equilibrium point clearly labelled. Students are not expected to draw the diagram perfectly to scale but it should reflect the data points in the table. Students should draw on their knowledge of the model to explain why this is the equilibrium in the model beyond stating only that this is the point where ‘supply equals demand.’ The strongest answers will explain what equilibrium means and why there is no reason for market forces to cause the price to change from the equilibrium price and quantity.

b) Suppose that the price of a product is currently above the equilibrium level. Using an appropriate Supply and Demand diagram, illustrate and explain how the market would adjust towards the equilibrium level. (8 Marks)

The appropriate diagram would indicate a price above the equilibrium. It can be helpful for students to use a numerical example although this is not required. For example, if the current price is £100 but the equilibrium is £50, then the price is above the equilibrium level. This results in an excess supply of the product and some sellers will be unable to sell all of their quantity at the price of £100. Therefore market forces will drive the price downwards towards the equilibrium. The mechanism is that sellers who cannot sell their product at £100 would undercut the market price to make sure they sell their product. This process continues until all sellers who are willing and able to sell their quantity at the market price are exactly equal to all of the buyers who are willing and able to buy their quantity at the market price.

c)  Explain what  is meant by Price Elasticity of Demand and Price Elasticity of Supply. Illustrate the effects on Price and Quantity of a decrease in demand when the Supply curve is Perfectly Inelastic and the Demand curve is elastic (but not perfectly elastic). (9 Marks)

Definitions of  price  elasticity of demand and supply  should  be  given,  perhaps  including diagrams to indicate the different elasticities and explain how this links to the slope of the demand and/or supply curves.

A perfectly inelastic supply curve will be vertical, Implying that the product's supply will not change when the price changes. Any shift in the demand curve will only affect the price and not the quantity in the market. This should be illustrated using a fully labelled diagram, where a decrease in demand corresponds to a shift left of the demand curve. The equilibrium price will fall but the quantity will remain unchanged.

2.      Consider the model of Consumer Choice Theory with Indifference Curves and Budget Lines covered in the lectures. Suppose an individual has an income of £800 to spend on two products: A and B. The price of product A is £25 per unit and the price of product B is £100 per unit.

a)  Using a diagram, illustrate and explain the budget line for this individual. Ensure your diagram is fully labelled. (5 Marks)

The budget line should be drawn, labelled and explained fully in terms of what the budget line represents. The axes where the budget line intersects should be calculated correctly. For product A this is 800/25 = 32 and for product B this is 800/8 = 100.

b) Suppose an individual changes the combination of products A and B that they buy, but they remain on the same indifference curve. Explain whether the individual will be better off, worse off, or unchanged in terms of their utility/satisfaction. You may wish to include a diagram to help explain your answer. (5 Marks)

The  indifference curve should  be  defined  e.g. the  combination of quantities of the two products that generate the same utility/satisfaction for the consumer. One way to approach this question would be to draw an indifference curve to help explain the answer. It should be explained  that  changing  the  combination  of  the  two  products  has  no  impact  on  the satisfaction/utility of the consumer if the new point is on the same indifference curve as the original point. Only combinations of products that reach a new indifference curve to the right of the original indifference curve increase utility/satisfaction. Any combinations of products that reach a new indifference curve to the left of the original indifference curve decrease utility/satisfaction.

c)  Suppose the individual’s income increases from £800 to £1600. Draw an appropriate  diagram including the new Budget Line and Indifference Curve, and explain the effect on the equilibrium for this consumer. You can assume that this is a Normal Good.  (9 Marks)

The diagram should be presented with the new budget line to the right of the original budget line. The diagram should be fully labelled with the appropriate axes intercepts calculated as in part (a). The answer is likely to include an explanation of the impact of the increase in income on (1) the budget line and the amount of the products a consumer can afford, (2) the indifference  curve  a  consumer  can  now  achieve,  (3)  the  equilibrium  quantity  that  the consumer will buy. The definition of a normal good should also be provided. Students may explain what is meant by an inferior good to provide additional analysis.

d) Explain the terms: Sunk Cost, Marginal Cost and Average Cost. (6 Marks)

Appropriate definitions should be provided as covered in the module. Credit will always be given to  any appropriate  definition and explanation and students  may  use  diagrams  or numerical examples, or general examples (e.g. of an example of a sunk cost), to help explain their point.

3.      This question has multiple parts:

a)  Using an appropriate diagram, illustrate and explain how a monopolist will set their price optimally. (10 Marks)

Students are expected to present the diagram for the optimal  price and quantity that a monopolist would choose, consisting of (at least) Demand, Marginal Revenue and Marginal Cost curves. Axes should be labelled.

The answer should explain why this is the optimal price for a monopolist to charge.

One way to achieve this is to explain why any price above or below this level will lead to lower profit. If the price is above the optimal level, we can see that MR>MC, therefore increasing the output (which reduces the price) of the monopolist will increase profit. Similarly, if the price is below the optimal level, we can see that MC>MR, therefore reducing the output (which increases the price) will decrease profit. This means that profit is maximised at the output level where MR=MC, and the price associated with this level is found by examining the demand curve at this level of output (drawing up from the output level where MR=MC until we reach the demand curve and then drawing across to the vertical axis to find the price).

b) Using an appropriate diagram, illustrate and explain what is meant by Consumer Surplus and Producer Surplus. (6 Marks)

An appropriate diagram should be presented to explain consumer and producer surplus, as covered in the course. As part of the analysis, a credit will always be given to any relevant points or examples.

c)  Pharmaceutical  drugs often generate positive externalities beyond the patient receiving treatment. Explain what is meant by positive externalities and why the government may wish to provide financial support for pharmaceutical drugs with large positive externalities. (9 Marks)

The main idea is that pharmaceutical drugs often benefit both the patient receiving the drugs and other individuals or society as a whole. Therefore, it is optimal for the government to fund or subsidise pharmaceutical drugs to ensure individuals consume/use these.

For example, COVID vaccines benefit both the individual by reducing their risk of serious illness from COVID, and wider society by reducing transmission of the disease and reducing the demands on hospital services.

Students may choose to explain this formally using an appropriate diagram from the course, indicating that for goods with positive externalities, the private benefit of consumption is less than the total public benefit of consumption.

The credit would be given to all reasonable analyses and examples/explanations.

Additional Example Question for Section A: You will only receive three questions in Section A in the exam - This question is to provide an additional example question.

Question 4

a) Suppose two companies are choosing the quality of the products they should offer. If both firms choose low quality, they make a saving on the cost of production and earn a higher profit than if they both choose high quality. If only one firm offers high-quality products, all consumers buy from them and no consumers buy from the low-quality firm.

The payoffs for the firms are represented in the payoff matrix below.

Solve the payoff matrix for the Nash equilibrium and explain what is meant by the Nash equilibrium in this situation.

 (8 Marks)

The  Nash  equilibrium  represents  the  point  where  each  of  the  two  parties/players  is achieving the highest payoff they possibly can, in response to the choice of the other party (any relevant explanation and definition is awarded credit). Therefore, there is no incentive or reason for either player to change their decision. In this case, the Nash equilibrium is for both players to choose high quality and they each earn a payoff of 300. Students may explain  that  the  players  could  both  earn  a  higher  payoff  of   500  each   if  they coordinated/colluded on choosing low quality. However, this is not a Nash equilibrium because if both players are choosing low quality, one player could change to high quality and increase their payoff from 500 to 700. This leads both players to choose high quality where there is now  no incentive for either player to change their decision, given the decision of the other player.

b) Explain what is meant by First, Second and Third Degree Price Discrimination. Include in your answer two examples each for Second and Third Degree Price Discrimination. (7 Marks)

Appropriate  definitions  should   be  given  for   First,  Second  and  Third   Degree   Price Discrimination and credit should be awarded to any reasonable examples for Second and Third Degree Price Discrimination. These can be hypothetical examples or real examples that students are aware of.

c)  Using an appropriate diagram, illustrate and explain what is meant by a Natural Monopoly. (10 Marks)

The  Natural  Monopoly diagram  should be  presented, as covered in the  lectures. The diagram should be fully labelled. Answers should include an explanation and definition of natural monopoly, where the AC curve is always downward sloping due to economies of scale - typically found in industries where there exist high fixed costs and low variable costs. Examples may be provided.

For additional analysis should discuss that a  natural  monopoly will earn supernormal profits if they are allowed to set their price and they may require regulation, and there are challenges when regulating a natural monopoly. Entry will also be difficult into such an industry due to the scale required for entry. Credit will always be given for such points.

It is a normative statement. It expresses an opinion about the effectiveness of the market mechanism as a tool for allocating resources in an economy. This statement reflects a subjective  view  that   market-based  mechanisms  lead  to   more  efficient  outcomes compared to other mechanisms, such as government intervention or central planning. However, this statement cannot be proven or disproven through observation or empirical evidence and is therefore a normative statement.

2.      Answer the following questions:

a) What is the meaning of money to be a “legal tender”? (6 Marks)

The term "legal tender" refers to the status of money as a medium of exchange that is recognized by law and must be accepted as payment for debts, taxes, and other financial obligations. When a currency is declared as legal tender, it means that it is backed by the government and is accepted as a form of payment for all debts, public and private, within a country's jurisdiction.

Legal tender laws provide a level of certainty and stability to the monetary system, as they ensure that the currency is widely accepted and can be used to settle financial obligations. In most countries, legal tender is issued by the central bank or the government, and its value is typically regulated by monetary policy to maintain price stability and promote economic growth.

b) What are the differences between “commodity money” and “fiat money”? (6 Marks)

Commodity Money: This is a type of currency that is backed by a commodity such as gold, silver, or other precious metals. The value of commodity money is directly linked to the value of the underlying commodity, and it can be exchanged for the commodity on demand. Historically, many societies have used commodity money as a means of exchange, and it has been seen as a store of value and a hedge against inflation.

Fiat Money: This is a type of currency that is not backed by any physical commodity or asset. Fiat money derives its value from the government's decree or declaration that it has value, and it is accepted as legal tender in the economy. Fiat money can be created by the government through monetary policy, and its value is not directly linked to the value of any underlying commodity.

The key differences between commodity money and fiat money are:

•    Commodity money has intrinsic value, while fiat money has no intrinsic value and derives its value from government decree.

•    Commodity  money is limited by the supply of the underlying commodity, while fiat money supply can be expanded or contracted by the government.

•    Commodity  money  can  be  exchanged  internationally  for  the  underlying commodity, while fiat money cannot be exchanged for any commodity if the currency is not valued internationally.

•    Commodity money tends to be more stable in value, while the value of fiat money can  be affected  by changes  in government  policy and economic conditions.

c)  What are the main assumptions behind the theory of liquidity preferences? (6 Marks)

The theory of liquidity preferences is a key concept in macroeconomics that was developed by John Maynard Keynes. The theory suggests that the demand for money is not only related to the transactional needs of individuals and businesses but also to their preferences for holding liquid assets.

The main assumptions behind the theory of liquidity preferences are:

•    Money is a unique asset that is different from other types of assets, such as stocks, bonds, or real estate.

•    Individuals and businesses hold money not only for transactional purposes but also as a store of value and as a buffer against uncertainty.

•    The  demand  for  money  is  affected  by  changes  in  interest  rates,  for speculative reasons: a higher interest rate reduces the demand for money and a lower interest rate increases the demand for money.

•    The  demand  for  money  is  affected  by  changes  in  total  income,  for transactional motives: a higher income increases the demand for money and a lower income decreases the demand for money.

•    The  equilibrium  interest  rate  is  determined  by  the  intersection  of  the demand for money and the supply of money.

These assumptions suggest that the theory of liquidity preferences is a key tool for understanding how changes in monetary policy can affect the economy, including inflation, output, and employment.

d) What  are  the  main  disagreements   between  the  Verticalist  and   horizontalist approaches to the supply of money?                                                     (7 marks)

The Verticalist and Horizontalist approaches are two competing views regarding the mechanics  of  the  money  supply.  The  main  disagreements  between  the  two approaches can be summarized as follows:

.  Nature of money creation : The main point of disagreement between the two approaches is the nature of money creation. According to the Verticalist approach, the money supply is determined by the central bank, which has the power to create or destroy money through its monetary policy operations. In contrast, the Horizontalist approach argues that the money supply is created by the banking system through the process of credit creation. (Theory of endogenous money: Demand-driven credit-led money)

.  Role of reserves : The Verticalist approach emphasizes the importance of reserves, which are deposits held by banks at the central bank, as a constraint on the ability of banks to create money. According to this view, banks need reserves to make loans, and the central bank controls the supply of reserves to  limit  the  amount  of  money  that  banks  can create.  In contrast,  the Horizontalist approach argues that reserves are not a constraint on bank lending, as banks can always obtain the required reserves from the central bank through the process of interbank lending.

.  Money multiplier: The Verticalist approach relies on the money multiplier model, which suggests that changes in the supply of reserves lead to a proportional  change  in  the  money  supply.  In  contrast,  the  Horizontalist

approach argues that the money multiplier model is flawed because it does not accurately reflect the real-world mechanics of the banking system.

.  Policy implications : The different views on the mechanics of the money supply  have  important  implications  for  monetary  policy.  The  Verticalist approach suggests that the central  bank  can  control  the  money  supply through its  monetary  policy  operations, while the  Horizontalist  approach suggests that the central bank's ability to control the money supply is limited, and that  policy  should focus on  managing  interest  rates  and  promoting financial stability.

3.      A closed economy is defined by the following equations:

.    C = 85 + 0.75 Yd

.    Yd  = Y − T

.    T = 20 + 0.2 Y

.    I = 30

.    G = 40

a)  Find the equilibrium level of output.

Y = C + I + G

Substituting the given equations into this expression, we get:

Y = (85 + 0.75(Y - (20 + 0.2Y))) + 30 + 40

Simplifying this equation, we get:

Y = 140 + 0.60Y

Now, we can solve for Y by subtracting 0.55Y from both sides:

0.40Y = 140

Dividing both sides by 0.45, we get:

Y = 350. Therefore, the equilibrium level of output is 350. (6 Marks)

b) How much total  income will change if the government decides to  increase  its expenditure by 10 units? (6 Marks)

Given that the tax is a function of income, we need to adjust the multiplier formula accordingly.

The formula for the fiscal multiplier in a closed economy with taxes as a function of income is:

Multiplier = 1 / (1 - MPC(1 - t))

where MPC is the marginal propensity to consume and t is the marginal tax rate.

We know that the MPC is 0.75 and the initial tax rate (T/Y) is 20%, so the

marginal tax rate is 0.2. Substituting these values into the multiplier formula, we get:

Multiplier = 1 / (1 - 0.75(1 - 0.2)) = 2.22

This means that a 10-unit increase in government spending will lead to a 22.2-unit increase in total output (income) in the short run.

c)  After explaining the concept of crowding out, find out whether the economy is experiencing crowding out. (7 Marks)

Crowding out occurs when the government's increase in spending is financed by borrowing, which can increase interest rates and reduce private investment.

To determine whether the economy is experiencing crowding out, we need to look at the impact of the government's increase in spending on the overall level of investment in the economy.

In this case, we know that the government's increase in spending of 10 units is not being financed by an increase in taxes, so it  must  be financed  by  borrowing. However, we also know that investment is fixed at 30 units. So, there is no crowding out.

d) Find the difference between multipliers in the case that tax is lumpsum and when it is dependent on the level of total output (or income). (6 Marks)

The multiplier in the case of lump-sum taxation is larger than the multiplier when taxes are dependent on the level of total output (or income). This is because lump- sum taxes do not depend on the level of income and do not affect the marginal propensity to consume. Therefore, an increase in government spending will have a larger impact on output because it is not offset by a decrease in consumption due to increased taxation.

To see the difference in multipliers, let's first calculate the multiplier when taxes are lump-sum. Assuming the same initial conditions as in the previous question:

C = 85 + 0.75Yd Yd = Y - T I = 30 G = 40

The formula for the multiplier in the case of lump-sum taxation is: Multiplier = 1 / (1 - MPC)

where MPC is the marginal propensity to consume. We know that the MPC is 0.75, so the multiplier is:

Multiplier_lumpsum = 1 / (1 - 0.75) = 4

Now, let's calculate the multiplier when taxes are dependent on the level of total output (or income), using the formula we derived in the previous question:

Multiplier = 1 / (1 - MPC(1 - t))

where MPC is the marginal propensity to consume and t is the marginal tax rate. We know that the  initial tax  rate  (T/Y)  is  20%,  so  the  marginal  tax  rate  is  0.2. Substituting these values into the multiplier formula, we get:

Multiplier_income = 1 / (1 - 0.75(1 - 0.2)) = 2.22

The difference between the two multipliers is:

Multiplier_lumpsum - Multiplier_income = 4 - 2.22 = 1.78

Therefore, the multiplier is higher when taxes are lump-sum by 1.78 units.

Additional Example Question for Section B: You will only receive three questions in Section B in the exam - This question is to provide an additional example question.

4. The equation for equilibrium in the goods market is Y  = 1250 − 30 r  and in the money market is Y = 750 + 20 r, when C  = 100 + 0.8 Y, I = 150 − 6 r, the supply of real money balances is s   =  150 , and the demand for real money balances is d   = 0.2 Y − 4 r.    Find: