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SOLUTION 24/01/03 INTRODUCTION TO ECONOMIC ANALYSIS 1. a) Agree. The competitive equilibrium price and/or quantity lead to a maximum consumer’s and producer’s surplus. Any deviation from that equlibrium will disminish these two surpluses. b) Agree. This is a just a straight application of the definition of the concept of elasticity of demand. In this case, the corresponding elasticity is 1.5, so demand curve is elastic. c) Disagree. The supply curve is the segment of the marginal curve above the average variable costs curve. Not above the average fixed costs curve, as the statement says. 2. i) ii) iii) The drawing is straighforward: a straight line with an intersection of 20 in both the Y and X axis. If the price of X increases to 10 €, the Y intersection stays put and the X intersection moves inwards to 10 units of X. The budget line does not move. The change considered is just a neutral nominal change that does not alter at all real values. Since consumption theory is ab out relative prices and about the real value of money, it is natural that real opportunities for this consumer have not changed. At the new prices the consumer can still buy the old bundle of goods. The price change is a “compensated” price change. 3. Among the reasons that may justifythe exisytence of a monopoly, we can cite the follonwing: a) exclusive ownership of key resources (e.g. possession of a mine of diamonds); b) licence or exclusive rights given by government (e.g. patents,copyrights); and c) efficiency advantage over potential competitors (lower costs) that leads to natural monopoly (e.g. utilities such as gas, elictricity, etc.). The equilibrium of the monopolist includes, first, the consideration of the difference between average and marginal revenue that a monopolist faces. This is a fact that differenciates the monopolist from the price-taking firm. 4) a) Disagree. GDP is not the product obtained anywhere by nationals of a country, but the product achieved by nationals and others within the geographical boundaries of a given country. The reference to nationals gives in fact, the definition of Gross National Product (GNP) rather than Gross Domestic product (GDP). b) Agree. If the economy is closed, then Y = C+I+G. Or Y– C – G=I, or S=I. c) Disagree. In general, the statement is wrong because an increase in money supply, for given conditions of money demand, will lower the interest rate, and this will increase investment. 5) i) Nominal GDP First, we calculate nominal GDP: 1995 Nominal GDP = 1 x 100 + 1 x 100 + 1 x 100 = 300 2000 Nominal GDP = 1.20 x 120 + 1.4 x 150 + 0.8 x 110 = 442 Real GDP Second, we calculate real GDP: Real GDP 1995 is the same a nominal GDP 1995, for the base year (1995), always, both nominal and real are the same, so real GDP = 300. Real GDP 2000: 1995 prices x 2000 quantities: 1 x 120 + 1 x 150 + 1 x 110 = 380, GDP deflator = ( Nominal GDP/ Real GDP ) 100 Then GDP deflator will be: (442/380) 100 = 116.32 Growth of GDP deflator between 1995 and 2000: [(116.32 – 100)/100] 100 = 16.3% ii) CPI base1995 1995 = 100 2000 (base 1995) = 2000 prices x shares A,B, C. 1.2 x40 + 1.4 x 30 + 0.8 x30 = 114 Growth of CPI between 1995 and 2000: [(114 – 100)/100] 100 = 14% iii) None is better than the other. The two are good depending on the purpose for which they are to be used. The GDP deflator is the adequate index to correct nominal figures of output, in order to isolate real growth of this output. The CPI is good to identify the evolution of the prices of the goods and services we consume. The main differences between the two indices are: a) The GDP deflator is an index of prices with variable weights (the extent of production of each year), the CPI, on the other hand, is an index with fixed weights (the consumption shares of the base year) and it is a Laspeyres index. b) CPI includes the price of imports and excludes the prices of exports. GDP deflator, on the other hand, includes the price of exports and excludes the price of imports. 6. The price of money is (1/P). Therefore, if there is an increase in the money supply, for given conditions of demand, there will be a fall in the price of money. A fall in (1/P) and thus an increase in P. This is the basic relation between money supply and the price level. The quantity equation puts forward this relationship by means of the definition of the Velocity of Money. According to this definition, Velocity of money = Nominal value of output/Money supply V= (PY)/M From this definition we derive the following identity: MV=PY In rates of growth, this read, % M + %V = %P + %Y Or, % P = %M + %V - %Y This expression gives a theory of inflationn in the sense that it establishes a relationship between inflation and three factors: the rates of growth of money, velocity and output. Put like this, this is a tautology. The tautology gets transformed into a theory when we say that velocity is a parameter that, given its estructural nature, is likely to remain constant, and that in the lon run output (abstracting from the growth of resources or productivity) is likely to be constant at its potential level. If this is so, then % M = %P which says that in the long run inflation will be exclusively determined by the growth of the money supply.