ECONOMICS 336Y5Y Fall/Spring 2014/15. PUBLIC ECONOMICS Spring Term Test February 26, 2015

Transcription

1 UNIVERSITY OF TORONTO MISSISSAUGA DEPARTMENT OF ECONOMICS ECONOMICS 336Y5Y Fall/Spring 2014/15 PUBLIC ECONOMICS Spring Term Test February 26, 2015 Please fill in your full name and student number in the spaces below. NAME: STUDENT NUMBER: You have 1 hour and 40 minutes to complete this closed-book test. When the invigilator asks everyone to stop, you must stop writing. This should be entirely your own work no conferring please. No calculators are allowed. (None are needed.) The test is worth 92 points. Please attempt all the questions, and be sure to read each question carefully. The number of points each question is worth is indicated in brackets. You should answer the test directly on this booklet, in the spaces provided. Please write legibly, and answer in proper, clear sentences. If you need additional space, indicate clearly which question you are answering, and write on the reverse side of the page. [Approximate guidelines as to the length of the perfect answer are given in square brackets, where necessary.] 1

2 Question 1: the Financial System (worth 9 points) The financial sector plays a very important role in the economy indeed, in the global economy. Not least, it is one of the few sectors that can lead to a global recession if things go wrong, as they certainly did following the collapse of Lehman Brothers in a) What is the rationale behind a policy of too big to fail in the context of the banking sector? [One sentence.] (2 points) b) What sort of problem does a policy of too big to fail in the banking sector create? [Two words.] [Hint: the second word begins with h.] (1 point) c) Suppose you were tasked with redesigning the financial system in such a way that bankers were given incentives not to take excessive risks with investors money. What remuneration scheme (that is, pay scheme) for bankers might help reduce their desire to gamble in the short term? [Hint: we discussed one in class.] (3 points) d) In response to the financial crisis, no bank bondholders in North America lost any money. Suppose banks were forced to hold a certain amount of capital that they would lose in the event of bankruptcy. What effects might this have? [Two sentences.] (3 points) Question 2: Deflation (worth 6 points) Deflation occurs when prices fall. Currently, deflation in the Eurozone is thought to be a major threat to the global economy. 2

3 a) Why might deflation be a problem in an economy that had large amounts of nominal government debt outstanding? [One relevant sentence.] (3 points) b) Would deflation be a problem in an economy whose entire debt was in indexed form? Please explain. (3 points) Question 3: Interest Rates (worth 8 points) a) What is the relationship between the real interest rate (r), the expected inflation rate (π E ), and the nominal interest rate (i)? Please write down a relevant formula. (2 points) b) Following on from a), if the nominal interest rate (i) was 0.5 percent, and the expected inflation rate (π E ) was 1 percent, what would the real interest rate (r) be, exactly? (2 points) c) Can the real interest rate ever be negative? (2 points) d) Suppose you have $1000 to invest, and a bank offered you a negative nominal interest rate of 0.5 percent. Would you take it? (2 points) 3

4 Question 4: Debt (worth 11 points) a) Define the nominal yield on a T-year nominal bond. [Hint: it is a formula.] (3 points) b) As an investor, suppose you are considering either to invest in a two-year nominal bond today (with yield i 2,t ) or two one-year nominal bonds (with yields i 1,t+1 and i 1,t+1 respectively). Suppose you are convinced that market expectations about short-term rates are too high. Specifically, you think the market s one-year nominal rate, i 1,t+1 E, in one year s time is too high. How might you gain a lot if you turn out to be correct. Please explain precisely. (4 points) c) Suppose you are considering investing in indexed versus nominal bonds. If your expectation about the break-even inflation rate (BEIR) is lower than that of the market, which type of financial instrument should you invest in? [Two words.] (2 points) d) Suppose that the government objective can be represented by the following simplified payoff function: R = a G + (1 a) S, where R measures overall government utility, G is the private payoff to the government, S represents the welfare of the general public, and a is a parameter measuring how much weight the government attaches to its private interest, ranging between 0 and 1. Consider two alternative options: i. Option 1 involves the government issuing nominal debt, then subsequently inflating the economy a lot. The government has a great deal of outstanding debt, so this option yields especially high private payoffs to the government of G 1 = 8 and a payoff to society of S 1 = -4; ii. Option 2 involves the government issuing indexed debt, then subsequently keeping inflation low. This yields a private payoff to the government of G 2 = 4 and a payoff to society of S 2 = 4. 4

5 Under what conditions would the government choose Option 2? Please be precise. (2 points) Question 5: Neo-Classical Economics (worth 5 points) a) Consider the following Edgeworth box, with two goods, A and B, and two consumers, with the origin for Person 1 being in the bottom left-hand corner and the origin for Person 2 in the top-right corner of the box. O 2 Good B U 2 U 1 O 1 Good A Does the above figure depict a market-clearing allocation? Please explain. (3 points) 5

6 b) In the standard theory of the firm, firms produce output (y) at a total cost C(y) and sell it at the given market price (P). Suppose there are two types of good, A and B, and firms have the options of producing both. What condition must hold true if firms are choosing both output levels optimally, taking prices as given? [Hint: the answer is an equation.] (2 points) Question 6: Welfare Economics (worth 16 points) a) Define competitive equilibrium in an economy in which there are firms. (3 points) b) State the First Welfare Theorem. [One sentence.] (2 points) c) Demonstrate the First Welfare Theorem in the pure exchange economy (in which there are no firms). [Hint: use formulae and mathematical reasoning, not a diagram.] (3 points) d) Suppose firms have some market power. Will the First Welfare Theorem hold? Please explain your answer. (3 points) 6

7 e) Why is Adam Smith s notion of the invisible hand highly relevant from the point of view of thinking about methods of allocating resources in society? [Hints: You might draw a contrast with central planning. You might also mention Hayek.] (3 points) f) Why is the Second Welfare Theorem important? [Hint: equity goals.] [One Sentence.] (2 points) Question 7: Welfare Economics Part II (worth 7 points) Suppose we are willing to specify a social welfare function, which we can derive social indifference curves from. Assume that the social welfare function is utilitarian, given by S = w 1 U 1 + w 2 U 2, where w 1 and w 2 are non-negative person-specific welfare weights, for persons 1 and 2 respectively. Consider the following utility possibilities frontier (or UPF ), made up of three straightline segments: relatively flat along AB, steeper along BC, and steepest along CD. Specifically, suppose the slope along BC = - 8/9. Along CD, it is -4. 7

8 U 2 A UPF B C Slope of line along segment BC = - 8/9 D U 1 a) In a completely egalitarian society, w 1 = w 2. Where would the socially optimal allocation be located in the figure? Please explain clearly. (4 points) b) Suppose, in general, you do not know your welfare weight in advance. Which would your preferred point for society in the above figure be? (3 points) Question 8: Monopoly (worth 6 points) 8

9 Consider a monopolist facing a downward-sloping demand curve (this is implied by having market power), which we can write in general as P = P(Q), with first derivative P (Q) < 0, meaning that demand, Q, increases as price, P, falls. Let the total cost of producing output Q be given by C(Q), where the marginal cost C (Q) is positive. a) When the firm has market power, demonstrate that AR(Q) > MR(Q) for Q > 0. (3 points) b) Denote the profit-maximizing output chosen by the monopolist by Q M. Will this coincide with the socially efficient level, Q*? Please explain. (3 points) Question 9: Industry Regulation (worth 16 points) Consider an industry characterized by the following total cost curve: TC(Q) = 6 + Q. Further, the demand curve faced by the industry is given by P(Q) = 9 Q. a) What is the optimal number of firms in this industry from a cost minimization perspective? Why? [One sentence.] (2 points) b) In this instance, what output level, Q M, would a monopolist choose? Please show your calculations. (4 points) 9

10 c) At the output level you calculated in part b), would the monopolist make positive profits? Please verify. (2 points) d) Suppose a regulator were to insist that the monopolist produced the socially efficient output level, Q*. What exact amount would the firm earn in profit from producing Q*? (4 points) e) Generally speaking, the regulator knows less about the firm s costs than the firm does, a point emphasized by Jean Tirole. Suppose the regulator wished to regulate the output and pricing in the industry described in this question. What means could the regulator use in response to this information asymmetry? Please describe your proposed solution briefly. (4 points) Question 10: Externalities (worth 8 points) Firms in an industry produce an aggregate output Q, yielding marginal social benefits according to the marginal benefit schedule MB(Q), which is downward-sloping. (Think of this as the demand curve facing the industry.) Assume that the marginal private cost ( MPC ) schedule of firms is positive and upward-sloping for all output levels Q 0. In the process of production, firms pollute the environment, where these pollution damages are captured by the industry marginal damage ( MD ) schedule. Consider a specific instance in which the industry s MPC schedule is given by: 10

11 MPC(Q) = 2 + Q. Further, the industry MD schedule is given by: MD(Q) = 2Q, and the benefit schedule is given by: MB(Q) = 6 Q. a) Solve for the aggregate output level, Q 1, that firms would choose in the absence of regulation. (2 points) b) Solve for the socially efficient output level, Q*, numerically. (2 points) c) Compute the efficiency loss, relative to the efficient level, associated with the aggregate output Q 1. (As a guide, you might also sketch the diagram and indicate the relevant triangle.)] (4 points) Question 11: Responses to Externalities (worth 9 points) a) In general, how should a regulator set a Pigouvian tax? Please give the precise general rule. (2 points) 11

12 b) Calculate the total amount of the tax paid by firms operating in the following specific setting. Let the MPC schedule be given by: MPC(Q) = 4. The industry MD schedule is given by: MD(Q) = 2Q. And the marginal benefit (or demand) schedule is given by: MB(Q) = 12 Q. Please show your calculations clearly. [Hint: you will need to calculate the firm s quantity choice in the absence of regulation as part of your answer.] (4 points) c) Suppose an alternative variant of the tax is introduced (compared to part b)), whereby t = MD(Q) for all Q. Would firms prefer this tax to a standard Pigouvian tax? Please explain. (3 points) Question 12: Shark-fin soup (worth 5 points) Sharks are very sophisticated creatures that perform a vital function, helping ensure that other creatures in the sea are fit. If they are not, they go (as it were) While it is hard to measure precisely, an estimated 100 million sharks are fished out of the sea each year, to the detriment of the health of the oceans. Many restaurants in Toronto serve shark-fin soup, and the price does not reflect the external damage involved. a) Based on principles discussed in ECO336, why might some form of intervention be desirable? [One sentence.] (2 points) b) What intervention would you propose, again based on policies we have discussed? (3 points) 12