EC2040

THE UNIVERSITY OF WARWICK

Summer Examinations 2010/11

Economics II

Time Allowed: 3 Hours

Answer ALL questions from Section A, ONE question from Section B and ONE question from
Section C.

Section A carries 40 marks. Each question in Section B and Section C carries 30 marks.

Read carefully the instructions on the answer book provided and make sure that the particulars
required are entered on each answer book.

(Continued)
EC2040

Section A

1. Answer True, False or Uncertain and provide an explanation

a) If 2 individuals, A and B, have utility functions over 2 goods, x1 and x2, given by :

U A ( x1 , x2 ) = x1r x21-r U B ( x1 , x2 ) = r ln(x1) + (1-r) ln(x2)

then the indifference curves of A and B will be the same shape.

b) Moral Hazard is a problem of hidden information which can arise when we are unable to
distinguish good types from bad types in a marketplace, leading to the good types being
driven out of the market.

c) David has preferences over 2 goods (Good 1 and Good 2) as given by the indifference curves
on the below diagram. Good 2 is a private good, but Good 1 is a public good. John is also
consuming Good 1, at a level of x .

Knowing this, David will choose to free-ride on John's consumption of Good 1, and hence
spend all his money on Good 2.

d) Behavioural economics has suggested that preferences often display a reflection effect
whereby people appear risk seeking when faced with potential gains, but risk averse when
faced with potential losses, when measured with respect to a specific reference point.

(12 Marks)

2 (Continued)
EC2040

2. a) Two friends decide to play a game of Rock Paper Scissors where the winner gets 1 from
the loser, but no money changes hands if the game is drawn. They decide, however, to play
the game sequentially, so that player 1 moves first, then player 2 observes player 1's move,
and then player 2 moves.

Represent this game using a Decision Tree and identify all the subgames of this game. Using
the concept of a subgame, explain and identify the Pure Strategy Subgame-Perfect Nash
Equilibria of the game.

b) An experimental economist decides to use this game to look at the predictive power of the
Subgame-Perfect Nash Equilibrium concept by asking two different friends to play
sequential Rock Paper Scissors in a lab.

He assigns one friend to the role of player 1, and the other to the role of player 2, and asks
them to play the game 20 times, but without any money changing hands. At the end, the
experimenter pays them both 10 for their participation.

Using the concept of Induced Value Theory, and your knowledge of other experiments in
game theory, briefly discuss the validity of this specific experimental approach, and suggest
ways to improve the experiment.

(8 Marks)

3. Answer True, False or Uncertain and provide an explanation

a) In the Solow growth model, an increase in the saving rate leads to a higher growth rate of
output per worker in steady state.

b) In the matching and search model of the labour market an increase in the bargaining power
of workers lowers the unemployment rate.

c) The tax-smoothing model predicts that in response to news that government purchases as a
share of GDP have unexpectedly and permanently increased, taxes as a share of GDP will
stay constant.

d) In an open economy an increase in the domestic real interest rate implies an increase in the
economys net capital outflows.

(12 Marks)

3 (Continued)
EC2040

4. a) Explain why a downward-sloping yield curve may indicate that a recession is coming.

b) When short term nominal interest rates are near zero do you expect the slope of the yield
curve to be a better or worst predictor of the business cycle? Explain why.

(8 Marks)

Section B

5. Consider a market with an incumbent monopolist who is facing the possible entry of a new
competitor. The incumbent firm can decide to Fight the entrant or Acquiesce, and the
entrant must decide whether to Enter or Not Enter

If the entrant does not enter, the incumbent gets the monopoly profits of 500k and the entrant
gets 0, regardless of what the incumbent chooses to do. If the entrant enters, and the
incumbent decides to acquiesce, both firms get profits of 100k, but if the incumbent chooses
to fight, then both firms lose 100k.

a) Firstly assume that both firms must make their decision simultaneously. Explain why this
situation can be represented using game theory in the normal form. Explain the concept of a
Nash Equilibrium, and solve for the Pure Strategy Nash Equilibria of the game. Does this tell
us how both firms should act in this situation?

b) Another way of analysing this situation is to construct the best response functions for each
firm. Both graphically and algebraically, explain what the best response function of the
entrant can tell us about their decision (assuming both firms are able to use mixed
strategies).

c) Another concept we can use is that of dominant strategies. Explain this concept and show
whether any of the 4 pure strategies in the game are dominant or dominated (either
weakly or strictly)

d) Now assume that this market situation occurs with firms only being able to move
sequentially. Explain and use the concept of backwards induction to show how the order in
which firms move will determine the outcome in this market, and how they relate to the
PSNE found in part a). Why is the concept of an incredible threat relevant here?

(30 Marks)

4 (Continued)
EC2040

6. a) Using the concept of an Edgeworth Box, show

i) the concepts of Excess Demand and Excess Supply

ii) how a budget constraint shows us what the consumers can afford, given their
endowments

iii) the idea of Pareto Efficiency, and the Contract Curve

iv) what is meant by a Competitive Equilibrium

b) The Fundamental Welfare Theorems say there is a deep connection between the ideas
outlined in parts iii) and iv) above. Explain both theorems and the implications they have for
Government policy, specifically the role of taxes and subsidies.

c) The limitations of the welfare theorems are exposed, however, when we consider a world
which has consumption externalities. Explain what is meant by this term and why the
problem can be thought of as one of a missing market. How is this relevant to the real
world problems of air and river pollution?

d) Common solutions to the problems of externalities include a Pigouvian tax and the sale of
permits in the market, but another approach is to seek to assign property rights to one of the
agents in the marketplace. Why might a Government look to assign property rights rather
than dealing with taxes and/or permits?

(30 Marks)

7. a) Uncertainty is a problem which confronts economists when making predictions about the
choice or behaviour of agents. Explain the tools of Expected Value and Expected Utility,
and how they give us an insight into the decisions of agents faced with uncertainty.

b) When agents are making a decision under uncertainty, but with known outcomes and
associated probabilities, they are making a risky choice. Show graphically how the utility
function of an agent could explain why an agent may want to

i) Gamble for leisure

ii) Take insurance out on their car

c) Whilst classical economics has struggled to explain why the same individual may choose to
both gamble for leisure and take out insurance, behavioural economics proposes the view
point that the framing of decision under uncertainty is crucial for explaining behaviour.
Explain what is meant by the term framing, and what behavioural economists mean
when they talk about utility relative to a reference point.

(Question 7 continued overleaf)

5 (Continued)
EC2040

(Question 7 continued)

d) One model in behavioural economics which seeks to describe a wide range of experimental
evidence of decision making under uncertainty is Prospect Theory. This theory uses an S-
shaped value function in place of a utility function. Explain this value function and why
it captures many of the different experimental results. The theory also uses a subjective
probability function, to transform objective probability functions. By combining the value
function and subjective probability function, show how Prospect Theory compares to
Expected Utility Theory in the approach to analysing decision under uncertainty.

(30 Marks)

Section C

8. Consider an inflation targeting central bank whose policy function is described by the following
simple monetary policy rule:

i = (rn + *) + ( *),

where i is the nominal interest rate, rn is the natural real interest rate, is the inflation rate and
* is the central banks inflation target.

a) Is this a good monetary policy rule to represent the behaviour of the Bank of England?

b) Explain why it may be desirable to choose a positive target for inflation (*>0).

c) Explain why it is important for the good conduct of monetary policy that the policy
parameter, , be greater than one (>1).

d) Assuming adaptive expectations, so that E(t+1) = t , describe the adjustment path of output,
interest rates and inflation following a negative aggregate demand shock.

(30 Marks)

6 (Continued)
EC2040

9. Consider the following chart illustrating the labour market flows in the US between July 2009
and May 2010, for the different sectors of the economy. In particular the chart shows the number
of job vacancies (openings) and job matches (hires) in each sector.

a) Explain the importance of considering the labour market flows to understand the equilibrium
level of unemployment and describe how the search and matching model explains these
flows.

b) Assume the bargaining power of workers is the same in all sectors of the economy. Based on
the information displayed in the chart above, in which sectors of the US economy do you
think the productivity is higher? Explain.

c) Assume instead that the productivity is the same in all sectors of the economy but the
bargaining power of workers differs across sector. Based on the information displayed in the
chart above, in which sectors of the US economy do you think the bargaining power of
workers is higher? Explain.

(30 Marks)

7 (Continued)
EC2040

10. Consider the following table from the Mankiw, Romer and Weil 1992 QJE paper: it shows the
results of an estimated growth equation where the dependent variable is the growth rate of
GDP per working-age person from 1960 to 1985 and the explanatory variables are the level of
GDP per working-age person in 1960, the investment GDP ratio, and the population growth
rate.

a) Give a theoretical justification for estimating this regression equation.

b) What important variable is missing from the regression equation and what may be the
implications of omitting this variable?

c) Given the value of the R2 statistic for the sample of non-oil countries, what is your
view about the success of the neoclassical growth theory in explaining the differences in
economic growth across countries? In your view, what are the important elements
missing from the neoclassical growth theory?

(30 Marks)

8 (End)