2Mock Exam Class Discussion This week: Discuss the Mock Exam.Mock Exam is structured very similar to typical final examinations.
3Section A: Question 1Consider a perfectly competitive market with a downward sloping demand curve and an upward sloping supply curve and the price at the market-clearing level. Now suppose the government introduces a tax on the sale of the good which is paid by the buyer.On a diagram where the vertical axis is the price received by sellers, and the horizontal axis is the quantity, show how the tax affects the demand and supply curves? [3 marks]What happens to the quantity traded in the market? [3 marks]What happens to the price received by sellers? [2 marks]And what happens to the price paid by buyers? [2 marks]
6Section A: Question 2 aFirst, define absolute advantage. A country/individual has an absolute advantage if they are more productive in producing a good (ignoring all other goods).Equivalently, they are the lowest cost producer.Who has absolute advantage here?
7Section A: Question 2 bDefine comparative advantage. A country/individual has comparative advantage if they are relatively/comparatively more productive (i.e. relative to other goods).Key point: have comparative advantage if you have the lowest opportunity cost.Comparative Advantage:worker A’s trade off: 1 loave = 125 g butter.Worker B’s trade off: 1 loave = 50 g butter.So Worker B has a comparative advantage in producing bread. Has lower opportunity cost.A has a comparative advantage in butter. (Can check opportunity costs of butter).
8Section A: Question 2 c Remember law of comparative advantage: countries should specialize in production of the good(s) for which they have a comparative advantage.So B specialises in bread, A specializes in butter.B sells bread to AA sells butter to B
9Section A: Question 3 Suppose the price of energy rises. What will be the income and substitution effect of this change on the demand for energy by consumers? Show the income and substitution effect on a graph. [4 marks]Suppose the alternative to keeping warm by heating your house is to wear lots of clothes. What will be the income and substitution effect of the change in the price of energy on the demand for clothing? Explain your answer [3 marks]Who do you think is most hurt by rising energy prices? Give reasons for your answer. [3 marks]
10Section A: Question 3 aFirst, write some explanation of income and substitution effects.Will be marks for it, and will help you if you get the diagrams wrong.If energy becomes more expensive, consumers will substitute away from it and demand less energy. This is the substitution effect.However, as energy becomes more expensive, consumer’s are poorer. This induces them to change their consumption of energy further. This is the income effect. The direction of the income effect depends on whether the good is an inferior good or a normal good.Could add: if the good is an inferior good, a drop in income induces consumers to consume more of that good. This income effect may even offset the substitution effect; we call such goods “Giffen goods”.The total effect on consumption is the sum of income and substitution effects.
11Both Effects togetherAll other goodsEnergyOld Budget Constraint
12Highlighting Substitution / Income Effect All other goodsEnergyOld Budget ConstraintIE SE
13Section A: Question 3 bClothes are a substitute for (domestic) energy.As price of energy rises, people substitute into buying more clothes.May expect substitution effect to be strong because substitutes (clothes) are readily available. Consumers will cut back their consumption of energy significantly.Income effect: income has fallen, so demand for clothes depend on whether they are normal or inferior. If normal, clothes consumption will fall.
14Section A: Question 3 cWho do you think is most hurt by rising energy prices? Give reasons for your answer. [3 marks]Energy demand is a classical example of a commodity whose demand is very inelastic; i.e. consumers find it very hard to substitute away from consuming energy.This implies that there will be only a small change in quantity.If the quantity demanded does not change a lot, high energy cost means that consumers have less money to spend on other goods.Hence, consumers have to start cutting back on other expenditures just to keep warm.Clearly, the hardest hid individuals are ones whose expenditure shares on energy in their current budget is very high.This applies especially to low income households and the elderly.High energy prices have strong redistributive effects, the poor are hit a lot harder than the rich.
15Section A: Question 4If a technology has increasing returns to scale how doMarginal and average costs vary with the level of output [3 marks]Marginal and average costs compare [3 marks]Why is an industry with increasing returns to scale unlikely to be perfectly competitive? [2 marks]Explain why a mobile phone system is likely to have increasing returns to scale. [2 marks]
16Section A: Question 4 aIf a technology has increasing returns to scale how do Marginal and average costs vary with the level of output [3 marks]Give definitions from lectures.A Firm Has Increasing Returns to Scale if a 1% increase in output leads to less than a 1% increase in total costsFalling AC means IRSSo MC below AC, both falling
17Section A: Question 4 aIf a technology has increasing returns to scale how do Marginal and average costs vary with the level of output [3 marks]Increasing returns to scale means that increasing all inputs by, say, 1% increases output by more than 1%.This implies that, with given input prices, the cost of each additional unit of output decreases. So the marginal cost curve is downward sloping.The average cost is the total cost divided by quantity.Since the cost of producing the marginal unit is decreasing, the average cost per unit will also decrease. However, the average cost curve will lie above the marginal cost curve, since the first unit was more expensive to produce than the 10th unit.Only for the first unit is the average cost = marginal cost.
18Section A: Question 4 a / b If a technology has increasing returns to scale how do Marginal and average costs vary with the level of output [3 marks]Graphically:Average and Marginal CostsAverage CostMarginal CostOutput
19Section A: Question 4 c / d Why is an industry with increasing returns to scale unlikely to be perfectly competitive? [2 marks]Larger firms will always be able to outbid their competitors by offering a lower priceCase of natural monopolyExplain why a mobile phone system is likely to have IRS [2 marks]Network industries usually have IRS because the fixed costs are very high (building antennas etc.) and marginal costs very low.The more dense a phone network, the higher is the value of adding one additional phone mast to the network
20Section A: Question 5Explain why free healthcare paid for by a tax on income is likely to be a redistribution from rich to poor. What is the Gini coefficient and what is it used for? Show, using a graph, how you would expect the effect of the introduction of free health care to affect the Lorenz curve. What will be the effect on the Gini coefficient?
21Section A: Question 5Explain why free healthcare paid for by a tax on income is likely to be a redistribution from rich to poor.The rich have higher income (by definition). So a 40% tax on the rich contributes more money than a 40% tax on the poor.So the rich pay more, yet everyone gets the same good (free healthcare).
22Section A: Question 5What is the Gini coefficient and what is it used for?Gini coefficient is a common measure of inequality.It ranges between 0 (complete equality) and 1 (complete inequality)It is calculated using the Lorenz curve (next slide). It is area A divided by area (A+B)
24Section A: Question 5Because free health care reduces inequality, the Lorenz curve moves towards the 45 degree line(Being on 45 degree line is complete equality)This reduces the Gini coefficient
25Section A: Question 6Why is monopoly bad –make sure your answer uses some relevant graphs? What are the reasons why monopolies might occur?Reasons for monopoly. Recall (and explain!) 3 reasons for monopoly given in lectures:Natural monopoly (IRS)Firms actions (buying other firms, cornering market) e.g. ram manGovernment actions (create monopolies, give patents)
26Section A: Question 6Why is monopoly bad –make sure your answer uses some relevant graphs? What are the reasons why monopolies might occur?Price is higher and quantity lower compared to perfect competition. There is deadweight loss (DWL) relative to perfect competition.Some CS has been transferred to profits. The rest has gone.So overall welfare is lower.So board for diagram.Under perfect competition, the price paid by consumers equals marginal cost. This is socially efficient (as long as no externalities).Price is what people are willing to pay.MC is the social cost of providing it.Hence, socially optimal point is where P=MC.If P>MC society benefits from producing more. Hence monopoly is not socially efficient.
28Section A: Question 7Street lighting in many countries is provided by government. Why do you think this is?Goods can be categorised in a simple matrix:
29Section A: Question 7Most goods, e.g. ipads, guitars are rival and excludableA competitive market does a good job at providing these goods (it is Pareto efficient as long as no externalities)Street lighting is non-rival and non-excludable. It is a public good.The market will provide too little.It is very difficult to charge for using it (non-excludable)Purchasing good would have positive externalities for others (non-rival)
30Section A: Question 7It is most likely that no private enterprise would offer street lighting, since they can not discriminate people into “paying customers” and “non paying customers” due to the non-excludability.Nobody would pay
31Section A: Question 8What is moral hazard? Give an example of moral hazard from real life. What could be done to reduce the extent of moral hazard in your example?Moral Hazard arises in situations of asymmetric information. A classical example is (health) insurance. In case you are insured, you may take up some risky activities (such as skiing), that you would otherwise not take up. Without insurance, you would have to pay the cost that arise in case of accidents. Once you are insured, the health care system pays your bills.Another example is unemployment insurance: knowing that you are insured, you may shirk at work or work less hard.The extent of moral hazard can be reduced by providing adequate incentives. In the health care example, insurers may want to charge higher insurance premiums for consumers, who engage in risky activities (smoking, skiing,…). They also charge an excess for claims (so you have to pay something yourself).
32Section B : Question 9Consider a firm that is a price-taker in both product and labour markets and has a production function with diminishing returns to labour:Explain why the demand for labour will be decreasing in the wage. [4 marks]Suppose that no workers want to work if the wage is below £250 per week but everyone wants to work at a wage higher than that. Draw this supply curve. [4 marks]Suppose the marginal product of labour when everyone is employed is above £250 per week. Draw the equilibrium in this market. Identify the producer and consumer surplus. [4 marks]Now suppose that immigration increases the supply of labour in the economy. What happens to the wage and employment? What happens to consumer and producer surplus? [4 marks]What does this analysis tell you about the groups likely to support and oppose immigration? [4 marks]
33Section B : Question 9 aExplain why the demand for labour will be decreasing in the wage. [4 marks]Each additional worker increases the firm’s output by her marginal product (MP). The additional revenue that this gives the firm is MRP = MP * p.The cost of hiring an additional worker is the wage w.Hence: A firm will continue hiring workers wheneverMRP = MP * p > w, since this will increase profits.The firm will stop hiring workers when MRP = wSince there are decreasing returns to scale, the marginal product falls as the firm increases workers. If w is higher, MRP also must be higher to satisfy the equation MRP>w. And MRP is higher when there are less workers! So with higher wages, the firm hires less workers. With lower wages, it hires more.
34Section B : Question 9 b / c Suppose that no workers want to work if the wage is below £250 per week but everyone wants to work at a wage higher than that. Draw this supply curve. [4 marks]This is an example of a perfectly inelastic supply curve. No worker wants to work at wages below 250, and everybody works at wages above that.(In the graph, the vertical part of supply curve is at the total number of workers in the economy)
35Section B : Question 9 b/c WageWorkersSupply CurveDemand CurveW=250
36Section B : Question 9 b/c WageWorkersLabour supplyLabour Demandw=250CSw*PSThe worker is the producer (supplier) and the firm is the consumer (demander of the good, which is labour)
37Section B : Question 9 d/e Now suppose that immigration increases the supply of labour in the economy. What happens to the wage and employment? What happens to consumer and producer surplus? [4 marks]What does this analysis tell you about the groups likely to support and oppose immigration? [4 marks]
38Section B : Question 9 d/e Continue to assume that workers work only if wage >= 250. Influx of migrants shifts the supply curve to the right.WageWorkersLabour Demandw=250w*
39Section B : Question 9 d/e We see that the equilibrium wage falls. We see that the consumer surplus increases, while the producer surplus of initial residents falls [for this one uses the old labour supply curve].Native workers are worse off, since their wages have fallen.So existing workers are likely to oppose immigration and firms support it.Does this ring some bells considering the current political debate about Bulgarians/ Romanians in the EU?
40Section B : Question 10The government imposes a tax on cigarettes. Using graphs as well as text:What is likely to happen to the demand for cigarettes? [5 marks]Explain how it is possible that an increase in the tax on cigarettes can lead to a fall in total tax revenue for the government. [5 marks]How does the price elasticity of demand for cigarettes affect the impact of the tax on total tax revenue? [5 marks]Suppose the government thinks that cigarettes are so bad that they ban them completely. Do you think this a good idea? [5 marks]
41Section B : Question 10 aWhat is likely to happen to the demand for cigarettes? [5 marks]Standard tax diagramSee classDemand curve shifts downOR can shift supply curve upDon’t move bothQuantity falls
42Section B : Question 10 bExplain how it is possible that an increase in the tax on cigarettes can lead to a fall in total tax revenue for the government. [5 marks]The tax revenue is given as TR = t x QAn increase in taxes increases t but reduces Q (see diagram in a)If the fall in Q is large enough, tax revenues may actually fall.
43Section B : Question 10 cHow does the price elasticity of demand for cigarettes affect the impact of the tax on total tax revenue? [5 marks]First, define price elasticity of demand: % change in demand for a good divided by % change in price of the good.i.e. by what % does demand change if price changes by 1%If demand is very inelastic, quantity does not change much when prices increaseIf demand is perfectly inelastic, quantity does not change at allIf demand is perfectly elastic, quantity collapses to 0Always consider the extreme cases first.If demand is perfectly inelastic (vertical demand curve), the quantity demanded does not change if taxes go up. So tax revenues increase.If demand is perfectly elastic (horizontal demand curve), an increase in prices leads to a collapse in the market (quantity demand = 0), so tax revenue falls (to zero).In reality, it is somewhere in between, but at the more inelastic side. The quantity reaction is there, but it is small. So tax revenues are likely to increase if the tax rate goes up.Should draw diagram too.
44Section B : Question 10 dSuppose the government thinks that cigarettes are so bad that they ban them completely. Do you think this a good idea? [5 marks]Here you need to argue beyond the constraints of the question and argue along normative dimensions, using positive arguments in the background.Partly depends on whether consumers are “rational” or make wrong choicesGood idea:Positive: smoking has negative externalities on non-smokers due to passive smoking; this has very high social costs that can’t be paid for by the smokers for any price.Normative: should protect the smokers from harm they are inflicting on themselves.Bad idea:Positive: consumers are rational and so banning cigarettes makes them worse off.But smoking has negative externalitites (e.g. second-hand smoke) so there is still a case for reducing smokingNormative: could trigger smuggeling crime, etc…
45Section B : Question 11Suppose that there is a monopoly supplier of electricity.What is the optimal price that the monopolist should charge to maximize its profits? [4 marks]On a diagram compare the price the monopolist will charge with the price that would prevail if the market was perfectly competitive. [4 marks]Explain why the monopoly outcome is inefficient? [4 marks]Suppose the government caps the price that the monopolist can charge? What will be the effect on the quantity of electricity consumed? Explain your answer. [4 marks]Should the government impose a price cap on the monopolist? If so, what price? [4 marks]
46Section B : Question 11 a Chooses quantity by setting MR = MC (why?) What is the optimal price that the monopolist should charge to maximize its profits? [4 marks]Chooses quantity by setting MR = MC (why?)Uses demand curve to find price at that quantityDraw diagram and explain
47Section B : Question 11 a Price, P Quantity, Q Pm P* Qm Q* Marginal RevenueDemand Curve (Average Revenue)PmQmMarginal CostP*Q*
48Section B : Question 11 bOn a diagram compare the price the monopolist will charge with the price that would prevail if the market was perfectly competitive. [4 marks]In perfect competition, each firm sets P=MC to maximise profitsSo for the industry, the MC curve is the supply curveAs always in perfect competition, equilibrium is whereDemand = SupplyD = SHence under PC, price is lower and quantity is higher compared to monopoly
49Section B : Question 11 b Price, P Quantity, Q Pm P* Qm Marginal RevenueDemand Curve (Average Revenue)PmQmMarginal Cost= S curve under perfect competitionP*Q* (perfect competition)
50Section B : Question 11 cQuantity is lower. There is deadweight loss (DWL) relative to perfect competition.Some CS has been transferred to profits. The rest has gone.Show this on a graph.So overall welfare is lower.Under perfect competition, the price paid by consumers equals marginal cost. This is socially efficient (as long as no externalities).Price is what people are willing to pay.MC is the social cost of providing it.If P>MC society benefits from producing more.since the price reflects the valuation of consumers and the marginal costs reflects the social costs of providing electricity.As a monopolist charges prices above marginal cost, there is a welfare loss as too little electricity is being produced.
51Section B : Question 11 dSuppose the government caps the price that the monopolist can charge? What will be the effect on the quantity of electricity consumed? Explain your answer. [4 marks]The monopolist still sets MR=MC to get Q.But the MR curve has changed. It is flat at the price ceiling, then downward sloping.Easiest to draw diagram using upward sloping MC curve.Quantity of electricity may fall as a result of the price cap. But price will be lower.
52Section B : Question 11 e(e) Should the government impose a price cap on the monopolist? If so, what price? [4 marks] If the government sets pcap = p*, then the efficient outcome can be achieved. The problem with markets with a natural monopoly is, that we will never know what p* would be, since it will never be observed. Hence regulators tend to study a monopolists cost structure with a lot of caution, because the monopolists marginal cost MC tells us what p* should be. If the price cap is too low, the quantity will fall. There are possibly better policies the government could use. e.g. try to introduce competition, regulate both price and quantity, nationalise (?) etc (see “public policies towards monopolies in lecture”)
53Section B : Question 12Suppose the government has a welfare state that taxes some people (those with high levels of market income) and provides benefits to others (those with low levels of market income).Define the marginal and average tax rate [4 marks]Would you expect people with low incomes to have low or high average tax rates? [4 marks]How do you think average and marginal tax rates affect the incentives to work? [4 marks]Why are marginal tax rates often highest amongst the lowest earners? [4 marks]Suppose the government is inefficient so that for every £1 it raises in taxation it only manages to distribute 75p in benefits. Does this inefficiency mean we should redistribute more or less? [4 marks]
54Section B : Question 12(a) Define the marginal and average tax rate [4 marks]Intuition (not definition):Average tax rate is the tax rate you pay (on average) across all your earnings…lost benefits included in this tax rate!Marginal tax rate is the tax rate you pay on an additional dollar of earnings…lost benefits included in tax rate!For definition, need to distinguish between final income and market income.final income = market income – tax + benefits
55With no welfare state (no redistribution) Final income45oMarket Income
57Section B : Question 12 (a) Average Tax RateMarginal Tax Rate
58Section B : Question 12(b) Would you expect people with low incomes to have low or high average tax rates? [4 marks]People with low income tend to have low average tax rates, since they often receive high benefitsIf final income > market income you have a negative average tax ratePeople with high income tend to have high average tax rates, since their final income < market income.However, marginal tax rates will be quite different.Low income individuals often have very high marginal tax rates
59Higher average tax rate reduces final income (c) How do you think average and marginal tax rates affect the incentives to work? [4 marks]Higher average tax rate reduces final incomeAs leisure usually considered a normal good, this reduces demand for leisureThis means people want to work moreHigher average tax rate increases work
60Incentives to WorkHigher marginal tax rate reduces payoff to an extra hour of workThe price of leisure effectively fallsThis increases demand for leisure and reduces the demand for workWorks like a substitution effectHence a higher marginal tax rate reduces incentives to work
61(d) Why are marginal tax rates often highest amongst the lowest earners? [4 marks] Because (many) benefits are reduced as you begin to workAnd low earners have low wages – so an extra hour of work makes less difference to market income… low pay and rapid withdrawal of benefits makes marginal tax rates very high!(So why do governments design welfare schemes in this way?! See Iron Triangle discussion and previous class…)
63Fraser Nelson in The Spectator: “The biggest scandal of Benefits Street…is that Dee is behaving rationally in deciding not to work…were she to earn, say, £90 a week as a cleaner, then the system would reduce her benefits by £70 – an effective [marginal] tax rate of 78 per cent… this is nothing to do with indolence. Which of us would work at a 91 per cent tax rate?”
64Section B : Question 12 (e) Suppose the government is inefficient so that for every £1 it raises in taxation it only manages to distribute 75p in benefits. Does this inefficiency mean we should redistribute more or less? [4 marks]If the government is very inefficient, it “wastes” lots of the money it gathers in taxSpends this money on administration, or possibly on corrupt paymentsHere, 25% of all taxes raised are wasted in this wayThe more taxation, the higher the wasteHence could argue for less redistributionAlso, because of the waste, to achieve a given amount of redistribution (e.g. to build a new school), the government will have to raise taxes even further. This may further deteriorate incentives to work.But perhaps the government could invent a better way to redistributeE.g. by lowering the tax rate on charitable donations!