Download 1. a) Explain the difference between monopolistic Competition and

1. a) Explain the difference between monopolistic Competition and Monopoly!
In monopolistic competition there are many sellers of a differentiated product and in a monopoly
there is only one single seller of a product with no close substitute. The monopolistic competition
counts as imperfect competition and therefore it has some features of a competitive market, but not
all of them. Whereas in a monopoly there is absolutely no competition and the monopolistic firm is a
price maker and doesn’t need to adjust to the price changes of competitive firms as in monopolistic
competition, where price cutting and more than that advertising is necessary to keep customers
buying their product.
1. b) Explain the difference between Monopolistic Competition and Oligopoly!
Although both market structures belong to the imperfect competition (they have features of a
competitive market but not all of them) in the monopolistic competition there are many sellers of a
differentiated product and in oligopoly there are only few sellers of a standardized or differentiated
product. So since there is less competition in oligopoly and the oligopolistic firms are more of a price
maker than a price taker, compared to firms in monopolistic competition, the cost for consumers
tends to be higher in oligopoly than they do in monopolistic competition. On the other hand, the
oligopolist assumes quick price adjustments of competitive firms in case of price reductions but that
competitors will ignore price increases, whereas competitive firms in a monopolistic competition see
the prices of competitive firms as given.
1. c) Explain the difference between Perfect Competition and Monopolistic Competition!
In perfect competition there are many small sellers of a standardized product, whereas in
monopolistic competition there are many sellers of a differentiated product. That is why in
monopolistic competition each firms has to some extend an influence on the market price (the firm
has some monopolistic power due to product differentiation) and therefore the cost for consumers
tend to be higher in monopolistic competition. In perfect competition firms are simply price takers
and can produce and sell more without cutting the price, whereas in monopolistic competition
advertisement seems to be more profitable than price cutting only. So when in perfect competition
advertisement is not needed it can lead to higher sales and revenues in monopolistic competition as a
feature of differentiated products.
2. a) Give three examples of barriers, that can limit the number of producers in a particular market!
Legal: Governmental regulations, patents
Marketing: Predatory pricing (Larger companies can cut the prices dramatically whereas smaller firms
could not afford the losses coming along with such prices), advertisement
Production: Economies of scale (larger and more experienced firms can produce larger quantities at
lower costs), research and development (some specified products might need a large investment on
technology research and development beforehand only large firms have access to)
2. b) Explain the concept of “Strategic Interaction” in Oligopoly!
In an oligopoly there are only few sellers in a market. Every firm knows their competitive firms and
carefully keeps track on their actions. Strategies that can be made in terms of remaining competitive
could be for example the selling price and the output quantity. That means in an oligopoly in terms of
prices that price decreases of one firm will automatically lead to price decreases of other firms but
that does not take place when one competitor increases prices. So they are no perfect price takers,
but still pay attention to competitive firm’s actions.
3. a) Explain the relationship between the ATC curve and the MC!
The ATC curve is a measurement for the average costs of each unit produced until that point of time
when ATC is measured. MC on the other hand measures the costs that would occur only for one
additional unit produced. So these curves are directly related. As long as the Marginal Cost Curve is
below the ATC curve, it’s dragging the ATC cost curve down until the minimum of ATC, when both
curves intersect. From that point on, MC is above ATC and therefore it’s dragging the average up
again. At the minimum of ATC where both curves intersect, the cost of one additional unit produced
equals exactly the average costs of the units that have been produced until that point of time.
3. b) Explain the relationship between the ATC, AVC and the MC curve!
See 3. a) And AVC is a part of the ATC cost curve in addition to the fixed cost curve. The AVC curve
intersects the MC curve in its own minimum obviously earlier than MC intersects ATC because the
AVC are less than ATV. AVC is related to MC in the same way as ATC is related to MC. As long as it’s
above MC, MC is dragging the AVC down and it’s dragging the AVC up again, when AVC is less than
MC.
4. a) Why are the ATC and MC curve U-shaped?
If you look at ATC and MC in the short run, you could see sometimes the effect of increasing and
diminishing returns when usually only labor is a variable factor and Capital and Land is fixed. When
you make your business and the output quantity bigger, you get for example discounts on raw
materials and so on. Therefore the MC of each additional unit decreases until some point. At that
point of time (point of inflection in the production function) there are decreasing returns of scale
starting and the bigger the business gets, the steeper MC are raising because factors such as land and
machinery are too small for such big numbers of labor. That’s why the MC curve is U-shaped. And
according to the description, that MC which is lower than ATC is dragging ATC down and when it’s
above ATC it’s dragging ATC up, the ATC curve is also U shaped and has its minimum at the point of
intersection with the MC curve.
4. b) Why is it sometimes said, that AFC curve is not very interesting?
Because in the short run you cannot change the FC anyways and for the producer only the Total Costs
are of interest in terms of profitability, and AFC is only a part of that. Since the AFC in the short run
stays at the same level all the time, it’s possible to use only the varying Variable Cost as a measure of
Marginal Cost.
5. a) Assuming the supply remains constant, if any increase in demand occurs in this market, what
will happen to the equilibrium price and quantity?
The demand curve will so to say “shift” to the right, since consumers are willing to buy more at the
same price or buy the same amount at a higher price and both the equilibrium price and quantity will
increase.
5. b) When there is a decrease in the supply curve and the demand in a market remains
constant, what happens to the equilibrium price and quantity? And what policy measures
could the government take to combat this situation?
6.
A decrease in the supply curve will lead to a “shift” of the supply curve to the left and therefore it
intersects the demand curve at a higher equilibrium price and a lower equilibrium quantity than it
was before. To combat this situation the government could influence the two factors for the short-run
supply public spending and taxes (fiscal policy). By decreasing taxation and spending more money the
government could create new jobs and wages and by pumping money into the economy this would
lead to a higher disposable income and the consumer demand for goods and services increases.
5. c) If there is an increase in supply in this market, assuming the demand curve remains constant,
what happens to the equilibrium price and quantity?
The supply curve will “shift” to the right and therefore equilibrium price will decrease and quantity
will increase.
6. a) What is a “Comparative Statics” analysis?
This analysis two different states of the world “before” and “after” a change of the supply, demand or
both curves took place. It focuses on how a change in the world changes one or both of the curves
and how that affects the equilibrium price and quantity!
7. a) The data in the table below is given in billions of US dollars, RGDP chained 2005. What is the
change in the price level in 2008? What is output growth in 2008?
Year
2006
2007
2008
2009
NGDP
13,377.2
14,028.7
14,291.5
13,939.0
RGDP
12,958.5
13,206.4
13,161.9
12,703.1
Real GDP Growth: (13,161.9 – 13,206.4)/13,206.4 = - 0.337 %
Nominal GDP Growth: (14,291.5 - 14,028.7)/14,028.7 = 1.873 %
Change in the price level: for small changes %dNGDP = %dP + %dRGDP
%dNGDP - %dRGDP = %dP
1.873 + 0.337 = 2.21 %
(NGDP(2008)/RGDP(2008))/((NGDP(2007)/RGDP(2007)) – 1 = 2.218 %
7. b) Use the implicit GDP Deflator method to measure price inflation in 2008 and the real output
growth in 2008.
Year
2005
2006
2007
2008
NGDP
12,638.4
13,398.9
14,077.6
14,441.4
RGDP chained 2005
12,638.4
12,976.2
13,254.1
13,312.2
GDP Deflator 2005: 100
GDP Deflator 2008: NGDP/RGDP * 100 = 14,441.4/13,312.2 * 100 = 108.48
GDP Deflator 2007: 106.21
Price inflation 2008: (108.48/106.21) – 1 = 2.137 %
Real Output Growth: Measured with RGDP (inflation taken into account) (13,312.2 –
13,254.1)/13,254.1 = 0.438 %
7. c) Calculate the Consumer price inflation rate in 1993 and the output growth in 1992!
Year
NGDP
5,803.1
5,995.9
RGDP chained
2000
7,112.5
7,100.5
CPI 1982 – 84 =
100
130.7
136.2
Unemployment
rate
5.6
6.9
1990
1991
1992
1993
6,337.7
6,657.4
7,336.6
7,532.7
140.3
144.5
7.5
6.9
Consumer price inflation rate: (144.4 – 140.3)/140.3 = 2.92 %
Output growth 1992: RGDP growth (7,336.6 – 7,100.5)/7,100.5 = 3.33 %
NGDP growth (6,337.7 – 5,995.9)/5,995.9 = 5.7 %
7. d) Calculate the growth rate of output in 2007, the price inflation in 2007 measured using implicit
GDP deflator and the price inflation in 2007 using the CPI.
Year
2006
2007
2008
2009
NGDP
13,398.9
14,061.8
14,369.1
14,119.0
RGDP (2000)
12,976.2
13,228.9
13,228.8
12,880.6
CPI 1982 = 100
201.823
210.036
210.228
215.949
Growth rate of output 2007: (13,228.9 – 12,976.2)/12,976.2 = 1.947 %
Price inflation in 2007: D2007 = 14,061.8/13,228.9 * 100 = 106.296
D2006 = 13,398.9/12,976.2 *100 = 103.258
Price inflation: (106.296/103.258) – 1 = 2.942 %
Price inflation: (210.036 – 201.823)/201.823 = 4.069 % (for base year 1982)
8. a) In Chile a Big Mac costs Peso 1,850, which would seem to be a bit cheaper to an American
tourist. Explain this statement in terms of the actual and PPP exchange rate!
The American tourist thinks that the Big Mac in Chile is cheaper, because the actual exchange rate is
higher than the PPP exchange rate, which would lead to an equal purchasing power in both Chile and
the US. For the 4.07 Dollars which an American would need to purchase a Big Mac in the US, he
would get due to the real exchange rate 1,884.41 Peso and therefore would get 1.0186 units of Big
Mac in Chile. Implied PPP of 455 (Peso/Dollar) – actually 454.54, means, that if this was the actual
exchange rate there would be Purchasing Power Parity and for the price of one BM in the US I would
get exactly one BM in Chile.
Calculation: 4.07 Dollar * 454.54 Peso/Dollar = 1850 Peso (equals selling price in Chile)
9. a) Explain the concept of the real exchange rate. What is the relationship between the real
exchange rate and the PPP exchange rate?
The Real Exchange Rate measures the physical ratio by which one country’s goods trade for another
country’s goods. For example, for one Big Mac in the US I would get 1.0186 units of Big Mac in Chile.
So that would make a real exchange rate of 1.0186 Chilean Big Mac/American Big Mac or 0.98174
American Big Mac/Chilean Big Mac. The mathematical relationship between the real exchange rate
and the PPP exchange rate is e(PPP)=nominal/real  463/1.0186 = 454.54.
9. b) How is the concept of real exchange rate related to the law of one price?
The law of one price says that in the long term a nation’s exchange rate (real exchange rates) will
equalize the cost of buying traded goods at home with the cost of buying them abroad.
In this case that implies, that the real exchange rate was 1 (in terms of equality in the purchasing
power in different countries) and therefore that the actual interest rate at that point equals the PPP
exchange rate.
10. a) Fisher Equation: What are the two components of the nominal interest rate and what does
the equation tell us about the nominal interest rate?
The two components of the nominal interest rate are due to the Fisher equation real interest rate and
inflation rate. For small values of the real interest and the inflation rate, their sum is the nominal
interest rate. For example if the nominal interest rate of 8% a year and we had inflation of 5%, the
nominal interest rate of 8% will not buy us 8% more stuff, but only 3% (8 – 5). These 3% are then the
real interest rate. So when nominal and inflation rate are the same we will have a real interest rate of
0% and therefore we do not have a return in terms of purchasing power. But in general this effect
might only appear in the long run because interest rates don’t jump with inflation rates because
mostly interest rates have a fixed percentage number. So with unexpected inflation the real interest
rate will can drop in the short run.
The Fisher effects states in general, that nominal interest rate adjusts to changes in expected inflation
in the long run.
10. b) Explain in detail why the nominal interest rate measures the monetary cost per unit of
holding money per unit of time!
Nominal interest rate is the real interest rate subtracted by inflation. By holding money in a bank
account for example you get a nominal interest rate. This is because the interest rate is supposed to
cover the costs of holding money. Which means while you do not spend your money but rather keep
it, it loses its value due to inflation over time (inflation) and you cannot use this money for spending
over a period of time (real interest rate). So if you have 100€ in a bank account where you get
annually 4% nominal interest rate you will have 104% after one year. Assuming that inflation was 2%
you only have left a real interest rate of 2%, which you then on the other hand cannot spend while
you keep it on your bank account (that is why the real interest rate is included in the costs of holding
money as well).
11. a) Explain how open market operations are conducted by a central bank and how this affects
the money supply!
The central bank can 1) buy Government securities and 2) sell them. When central bank purchases
government securities from the commercial banks, those will receive cash for the bonds they sell. For
that reason their cash reserves increase. When there is less need to borrow, the federal funds rate
decreases (0%) and there is more available money in the economy and interest rates fall.
When the central bank sells government securities to commercial banks, those will give up their cash
and their reserves decline. Now they need to borrow reserves and the federal funds rate increases.
Then there will be less money for loans in the economy, less money supply and the interest rates will
rise.
11. b) What is the Federal Funds Rate and how is it used in the conduct of monetary policy?
The federal funds rate is the interest rates that commercial banks need to pay for the use of their
excess reserves. This rate must always be below the discount rate to make sure that commercial
banks do not profit from borrowing from the central bank and then loaning in the federal funds
market. It is set by the FOMC at a certain level which is believed to achieve its monetary policy
objectives. It is meant to control the interest rate banks charge for loans and pay for deposits. Open
market operations such as buying and selling government securities are used to push the rate to its
target.
12. a) If a country is experiencing a rather severe increase in inflation, how can monetary policy be
used to combat this problem?
A higher federal funds rate for example will make banks less able to borrow money to keep their
reserves at the necessary level and they will lend less money out at higher rates. Businesses and
private people will therefore be less willing to borrow money. So in case of inflation (economy
speeding up) economy can be slowed down by a higher federal funds rate and therefore higher
interest rates. At the same time reserve requirements could be raised in order to make it even more
uninteresting for banks to lend money to strengthen the effect of slowing down economy.
12. b) If a country is experiencing a rather severe inflation, explain the practical aspects to consider
when suggesting the use of fiscal policy. How would each of these two macroeconomic policy
instruments be applied?
In that case the government needs to adjust their taxations and spending levels to slow the economy
in times of severe inflation down. Increasing taxes is an instrument that can be used to suck
invaluable money out of the economy. A decrease in government spending would at the same time
also lead to less money in circulation. Aspects to consider are that fiscal policy only is a risky
instrument to use. Higher taxes and lower government spending might lead to a weak economy and
high unemployment. It must also be considered, for which part of the population an increase in
taxation would lead to higher strains (e.g. sometimes only middle class highly affected). The same is
true for the use of government spending which might only affect a certain group of the population.
So the government might only spend money for projects that will actually lead to a higher wellbeing
for a larger group of people than for only one specific group.
12. c) How can open market operations be used to improve a situation of severe inflation?
Selling government securities: When securities are sold to the open market commercial banks will
buy then and therefore give up some of their cash reserves. Their cash reserves decline and in
combination with higher reserve requirements they will need to borrow the money at a higher
federal funds rate which also leads to an increase in interest rates since there is less money to lend in
the economy which slows the economy down.
By buying less government securities at the same time the commercial banks will receive less cash
and their level of cash reserves decreases by time. Then they need to borrow the money again at a
higher federal funds rate and the whole story of a slowdown in economy happens as well.
13. a) Calculate the expenditure and tax multipliers when MPC=0.85
When MPC=0.85, MPS=0.15
Expenditure/Spending Multiplier=1/MPS=1/0.15=6.67
Increase in savings=tax cut * MPS
Increase in spending=tax cut * MPC
Tax Multiplier=-MPC/MPS=-5.67
Total Change in Spending=Initial Tax Change * Tax Multiplier
100=-17.64*-5.67
14. a) Derive the balanced budget multiplier and explain why it is equal to 1.0?
A balanced budget exists, when the change in Taxes equals the change in governmental expenditures.
So the balanced budget multiplier is the sum of the expenditure multiplier 1/MPS and the tax
multiplier –MPC/MPS which would then be 6.67 + (-5.67) = 1.0
15. a) What is the difference between GDP and GNP?
GDP is the total value of outputs of firms using inputs within a country. Nationality of the ownership
of these firms is not taken into account. GNP on the other hand is the total value of output produced
by firms owned by the citizens of a country, wherever the production location might be.
15. b) What is the difference between GNP and NNP?
NNP is the net national product and so to speak the net of the GNP. It is Gross National Product minus
the Capital Consumption Allowance. That means in the NNP the amount of capital stock that is worn
out during the production process is subtracted from the gross product.
15. c) What is NNP and how is it calculated?
NNP is GDP subtracted with the capital stock that is worn out during the production process (Capital
Consumption Allowance). It is so to speak the net value of the gross national product value.
15. d) What is included in Gross Private Domestic Investment, I?
The GPDI is the amount of private business capital which is invested in domestic production either
though the purchase of fixed property or inventory. It includes Nonresidential investment, residential
investment and change in inventories.
16. a) Explain law of diminishing returns in terms of the input labor!
In the short-term, land and machinery of a firm for example is fixed. So when this firm hires more
workers this strategy will only be efficient until some point, when each worker starts to produce less
output then each worker would have done before one additional unit of labor was hired. Because
land and machinery is fixed there cannot be made adjustments in the short term to delay that point
of time of some point of time in the future. So the marginal product of labor will rise until that point
(which marks at the same time the minimum point of marginal cost and the point of inflection in the
total cost curve) and then start to fall again as diminishing returns of labor set it (when hiring an
additional unit of labor becomes a less cost effective solution.
16. b) Explain returns to scale using the production function!
Decreasing: When sum of exponents is less than 1, Production curve is downward sloping because
when you double all input factors you get less than twice the output before
Increasing: When sum of exponents is more than 1, Production curve is upward sloping because
when you double for example all input factors you get more than twice the output before
Constant: When sum of exponents is exactly one, the production function is a linear one because
when you double all input factors you get exactly twice the output before.
(Just include some numbers in the function for proof, e.g. 1. K=1, L=1, 2. K=2, L=2, then Q2/Q1
17. a) The Solow Growth model predicts: In the long run the economy enters an equilibrium steady
state in which the capital stock fails to grow. Explain this statement!
The Solow growth model explains that if economic growth only consists of accumulating capital
through replicating factories with existing methods of production the standard of living will eventually
stop rising. In his model technology, labor and material remain constant. Only capital is a variable
number. He assumes there will only be economic growth as long as there is a positive change in
capital which only occurs until that point of time when depreciation of the Capital Stock is lower than
the investment in that time period. From that point on economy will stagnate at that equilibrium
capital stock
17. b) Professor Paul Romer developed the new growth theory. How does it differ from the original
Solow Growth model?
The new growth theory does not treat technology as a public good but as a subject to private control.
17. c) Many economists today are questioning whether GDP per person is in fact an adequate
measure of the wellbeing of the citizens in a society. Explain why this might be the case.
GDP is only a measurement for the production performance of a nation, and not for happiness,
quality of education, wellbeing or the overall national health in a society. So GDP is more a
measurement for productivity and progress than for wellbeing. GDP does not value to leisure, does
not capture non-paid sector, GDP does not take assets into account.
18. a) State the law of demand!
The law of demand states that if prices increase, the quantity demanded decreases and the opposite
is true when prices decrease. This can only be applied when all other factors influencing quantity
demanded are held equal.
18. b) Define the concept of the supply curve. Why is the supply curve upward sloping?
The supply curve shows the relationship between the market price of a product and the quantity
demanded of that product in the market. Since the price is on the vertical axis and the quantity
supplied is on the horizontal axis, the supply curve is upward sloping. The higher the market price,
the more producers are willing to produce and sell within the market.