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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.