Whiteknights, Reading Berkshire RG6 6AW Tel: +44 (0) 118 921 4628 Fax: +44 (0) 118

921 4681

University of Reading BSc ECONOMICS Assignment 1 Module Code: Due Date: OUTLINE ANSWER QUESTION 1a This was a reflective question about the purpose of economics as a discipline. It is often students least favourite subject, due to the weight of jargon and the abstraction of much of the analysis. However, it is concerned with some of the most important features of the way our world (globally and close to home) is organised. Occasionally, when my guilty secret of being an economist is let slip, people ask, Oh, thats about cooking isnt it?. This is because many in the UK have heard of the life skills school subject home economics and know that the preparation of food is part of that subject! The reason economics is used to describe such skills is because it involves the best use of resources. Families have limited budgets and, to run a home successfully, they need to try to maximise their home comforts with the minimum of waste (in raw materials, time and effort). This includes, among other things, cookery skills. This does not mean that I am going to ask you to prepare Thai prawns for your next assignment. The economics of your course has bigger fish to fry! It is concerned with the best use of resources in the country (or indeed the world) as a whole. This focus leads to a logical set of concerns. How should production and consumption activity be organised to best use resources? What goods and services should be produced to make the best use of resources? Which resources should be devoted to which production? Who should benefit from goods and services produced? These are the focal questions of economics. These questions are couched in prescriptive terms what choices should be made? Much of economics is, in practice, about how choices are made. However, the assumption is that we need to understand how the economy actually works to be able to recommend how it might be improved. Economics is about resource choices and you should have explained the notion of scarcity and discussed the nature of the choices necessitated by that fundamental fact of life. QUESTION 1b i. You are required to make it clear what exactly the two curves are showing. Basically, the distinction is between changes in nominal gross domestic product (GDP) (single line) and changes in real GDP at 2004 prices (double line). They would coincide if the level of prices were to remain constant (i.e. if inflation were zero). When nominal GDP changes at a faster rate than real GDP (the single line curve is higher), inflation must be positive. The level of inflation can be inferred from the vertical gap between the curves. For F101ECO 22 February 2011

QF111AV12-0

instance, in 2007 the respective values are approximately 10% and 16%, which suggests an inflation rate of (116 100/110) 100, which is 5.5%. During 20042005, growth in both measures is shown to be negative and the nominal curve is below the real curve. This implies that inflation in this period was negative. Some economists call this disinflation, while others call it deflation. The fact that the real GDP measure is based on 2004 prices should make no difference to the pattern of the curve. ii. This is a very simple question if you have coped with part i. You need to appreciate that the curves show rates of change and not actual levels. Looking at the nominal curve (single line): The highest level must be in 2010, as it was 7.5% higher than in 2009, which was 11% higher than in 2008, etc. Conversely, the lowest level was in 2001, as substantial growth occurs in the next two years prior to the modest fall in the GDP level mid-period.

iii.

It appears, from the real double line, that the year subsequent to the base date of 2004 brought 1% growth, followed by a year of 8.5% growth and then up to 2007 there was 10.0% growth. Starting from 100 this gives us 100 101 109.6 120.6. This is simply a matter of compounding (not just aggregating) all the growth rates shown for real GDP (double line again). To me they look like 6.5%, 7.5%, 7.5%, -2%, 1%, 8.5%, 10%, 8%, 7% and finally 5.5%. Obviously, a reasonable margin of error is allowable on each of these. Starting at a convenient 100 we therefore get: 100 106.5 114.5 123.1 120.6 121.8 132.2 145.4 157.0 168.0 177.3 which suggests overall growth of 77.3% (close to 6% p.a.).

iv.

QUESTION 2 The study paper wording about these Slutsky effects is to be found in Paper 3447, Demand and supply, section 3.3. However, these concepts are revisited in Paper 3448, Consumers, section 6.8, where indifference curve analysis is used. Figure 18 would be appropriate. Basically, when a price changes we respond for two distinct reasons. Firstly, there is a change in the products value for money relative to other forms of expenditure. Thus, we reallocate our spending. Secondly, even if we spent the same on the product, its price change would leave us with a different amount purchasable. Cross elasticity of demand has some relevance to the substitution effect and income elasticity of demand has relevance to the real income effect. However, it is price elasticity of demand (PED) which is most closely linked to these two effects. Figure 8 in Paper 3448 (reproduced in Figure 1, here) illustrates that all determinants of PED must relate to one, or other, or both of the effects.

FIGURE 1: The determinants of price elasticity of demand

QUESTION 3 Imperfect competition is so called because it differs from perfect competition. There are therefore many different types of imperfect competition according to the permutations of imperfections that apply. Such imperfections would include: a limited number of firms a differentiated product barriers to entry imperfect information.

Permutations of these define the various forms of monopolistic competition and oligopoly. You should examine one such form in detail. Further imperfections could be included, such as: price discrimination government intervention objectives other than profit maximisation

and each would imply a slightly different kind of imperfection competition. There is also another important sense in which competition may be called imperfect and that is in its effects, particularly on the efficiency with which resources are allocated. There are welfare losses (see Paper 3458, Competition and monopoly, section 3.6 and Figure 12 for the appropriate diagram). These losses occur in both monopolistic competition and oligopoly. Such inefficiencies (from society's viewpoint) may be the result of any of the imperfect characteristics mentioned above. For example, differentiated products will mean the firm charges a price above marginal cost and therefore there will be a range of output which would have contributed more

to consumer utility (measured by willingness to pay) than to resource costs. However, this range of output is not produced. Diagrammatic models should be used to predict behaviour and illustrate the effect on economic welfare. This imperfection of effect would suggest that competition could also be imperfect if externalities exist (e.g. pollution).

QUESTION 4a The special characteristics of land are set out in Paper 0018, Property resources, section 3. The two characteristics of significance in explaining the price volatility of land are: its low (or zero) price elasticity of supply; its residual valuation.

The former means that its average value is primarily influenced by shifts in demand, and that such shifts will have most or all of their effect on price rather than quantity in the market. This is indicated in Figure 2.

FIGURE 2: Price volatility with low PES

Price

Perfectly inelastic supply

P2 Large P variability D2 P1 D1 0 NO Q variability

Quantity of land

In the case of individual plots of land, the residual nature of their value will make them particularly sensitive to changes in the profitability of development. A simple arithmetic example would illustrate this.

Before 10% increase in income earning potential of land Income potential Non-land costs Normal profit Land residual 1m 0.5m 0.3m 0.2m

After 10% increase in income earning potential of land Income potential Non-land costs Normal profit Land residual 1.1m 0.5m 0.3m 0.3m

It can be seen that the 10% rise in the lands earning potential creates a 50% rise in its value. You could vary the other components in the calculation which is based upon Figure 10 in Paper 0018. Students may legitimately ascribe price volatility to other factors such as planning redesignations. QUESTION 4b The arguments in favour of taxing land are covered in more detail in Module F105ECO. However, the basic argument about land rent being the definitive type of economic rent can be used here (see Paper 0018, sections 3.4 and 3.6). Taxing other factors of production typically creates a disincentive to use them. High wage taxes may discourage work, high capital taxes may discourage investment and high taxes on enterprise may discourage innovation. Such negative responses would be ways of avoiding the taxes. However, taxes on land are not so easily avoided. Indeed, it is argued that such taxes may encourage fuller use of land to be able to afford the tax. Related to this is the idea that land value is created by society, so should be, at least in part, returned to society. Contrasts with the other factors can be made.