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Economics Including Examiners Report Question Paper

Economics Including Examiners Report

Course:

Exam Year:2000

Faculty of Actuaries Institute of Actuaries
EXAMINATIONS
11 April 2000 (am)
Subject 107 — Economics
Time allowed: Three hours
INSTRUCTIONS TO THE CANDIDATE
1. Write your surname in full, the initials of your other names and your
Candidate’s Number on the front of the answer booklet.
2. Mark allocations are shown in brackets.
3. Attempt all 37 questions; answer the 26 multiple questions continuously
and then begin each answer from question 27 on a separate sheet.
Graph paper is not required for this paper.
AT THE END OF THE EXAMINATION
Hand in BOTH your answer booklet and this question paper.
In addition to this paper you should have available
Actuarial Tables and an electronic calculator.
ã Faculty of Actuaries
107—A2000 ã Institute of Actuaries
107—2
For questions 1–26 indicate in your answer booklet which one of the answers A, B, C or
D is correct.
1 A maximum price is set for Good X at £20 which happens to coincide with the
free market price. A decrease in the demand for Good X keeping the
maximum price fixed at £20 will lead to:
A no change in price and a surplus.
B a fall in price and a surplus.
C a fall in price and a shortage.
D a fall in price and a fall in the number of units sold. [1½]
2 Which one of the following is NOT a characteristic of a normal good?
A It has a positive income elasticity of demand.
B A price fall will lead to a rise in demand.
C The substitution and income effects of a price change work in opposite
directions.
D The substitution effect of a price fall has a positive effect on demand.
[1½]
3 Under what conditions should a profit maximising firm definitely keep open
its production in the short run?
A When average fixed cost is above average revenue and average fixed
costs are less than average variable costs.
B When average revenue is above average variable cost.
C When average revenue is above average fixed costs.
D When total revenue is above total fixed costs and total fixed costs are
less than total variable costs. [1½]
4 If a demand curve is described as having a price elasticity of minus unity
throughout itsentire length, this means that the demand curve is:
A a straight line and total expenditure is the same at all prices.
B not a straight line and total expenditure rises as price rises.
C not a straight line and total expenditure is the same at all prices.
D a straight line and total expenditure falls as price rises. [1½]
107—3 PLEASE TURN OVER
5 The price of good X is twice the price of good Y. A consumer spends all his
income on the two goods, the consumer is in equilibrium when which one of
the following conditions is met?
A The marginal utility of Good X is equal to the marginal utility of
Good Y.
B The ratio of the quantity of Good X to the quantity of Good Y is equal to
the ratio of the price of good X to the price of good Y.
C The marginal utility of Good X is twice the marginal utility of Good Y.
D The total utility of Good X is twice the total utility of Good Y. [1½]
6 Which one of the following is TRUE:
A Diseconomies of scale means that the ratio of inputs to outputs rises as
output rises.
B The minimum efficient scale is the point at which long run average
costs must begin to fall.
C In the long run a firm cannot alter its fixed costs of production.
D Constant returns to scale means that if a firm doubles its inputs then
output remains the same. [1½]
7 A managing director of a monopoly firm is given the following data:
Marginal revenue = £9
Marginal cost = £10
Average cost = £11
Average revenue = £15
To maximise profits the firm should:
A reduce price and increase output.
B reduce price and reduce output.
C increase price and increase output.
D increase price and reduce output. [1½]
8 A movement along a consumer’s indifference curve from left to right means
that the consumer’s
A marginal utility will rise.
B total utility will be unchanged.
C marginal utility will fall.
D money income is unchanged. [1½]
107—4
9 Which one of the following conditions indicates that a firm is operating in a
monopolistically competitive industry rather than a perfectly competitive
industry?
A Output of the firm is where marginal revenue equals marginal cost.
B The cost curves of the firm are U shaped.
C The marginal revenue of the firm is below its average revenue.
D The marginal cost curve cuts the average cost curve at its minimum
point. [1½]
10 Consider the following table:
Units of capital Units of labour Output
10 1 100
10 2 190
10 3 270
10 4 340
10 5 400
The table illustrates which one of the following:
A increasing returns to scale.
B constant returns to scale.
C decreasing returns to scale.
D diminishing marginal productivity.
[1½]
11 The principle of diminishing marginal utility of wealth implies that a risk
averse individual will be prepared to insure himself against an event:
A even though the expected return is negative.
B only if the expected return is zero.
C only if the expected return is positive.
D only if the event has a high probability of occurrence. [1½]
12 A budget line shows an individual’s expenditure constraints. If the price of
the good measured on the vertical axis goes up by a bigger percentage than the
price of the goodmeasured on the horizontal axis then the budget line will:
A not change position.
B be steeper than before.
C be flatter than before.
D shift to the right. [1½]
107—5 PLEASE TURN OVER
13 A profit maximising firm has fixed costs of £40 and the marginal costs of
production shown in the table below. The firm can sell as much of its output
as it wishes at a fixed price of £100 each. How much profit does the firm
make?
Quantity Produced Marginal Cost (£)
1 40
2 60
3 80
4 100
5 120
6 140
A £20
B £60
C £80
D £120 [1½]
14 If a country has negative net property income from abroad then:
A Gross Domestic Product is greater than Gross National Product.
B Gross Domestic Product is less than Gross National Product.
C Gross Domestic Product is the same as Gross National Product.
D we cannot say whether Gross Domestic Product differs from Gross
National Product from this information. [1½]
15 Which one of the following statements about real variables in the economy is
always TRUE?
A Real interest rates are negative if the nominal interest rate exceeds the
expected inflation rate.
B If nominal Gross Domestic Product (GDP) falls by 10 per cent and the
GDP deflator falls by 2 per cent then real GDP has risen.
C If real wages rise then this must mean that the domestic price level has
fallen.
D If the nominal money stock is constant and the general price level falls
then the real money stock will have risen. [1½]
107—6
16 The monetary base is £300 billion, the public’s cash to deposit ratio is 0.35 and
the broad money supply is £450 billion. What is the reserve to deposit ratio of
the banking system?
A 2
B 0.9
C 0.55
D 0.23 [1½]
17 Government attempts to increase the narrow money supply through open
market operations are likely to cause short term interest rates to:
A rise and reduce money demand.
B rise and raise money demand.
C fall and reduce money demand.
D fall and raise money demand. [1½]
18 Unanticipated inflation:
A increases the opportunity cost of holding money and redistributes
wealth from fixed rate borrowers to lenders.
B increases the opportunity cost of holding money and redistributes
wealth from fixed rate lenders to borrowers.
C reduces the opportunity cost of holding money and redistributes wealth
from fixed rate borrowers to lenders.
D reduces the opportunity cost of holding money and redistributes wealth
from fixed rate lenders to borrowers. [1½]
19 Assume that the actual rate of unemployment is below the natural rate of
unemployment because the expected rate of inflation is below the actual rate
of inflation. If the expected rate of inflation rises to equal the actual rate of
inflation then real wages will eventually:
A fall and real output rise.
B fall and real output will fall.
C rise and real output will rise.
D rise and real output will fall. [1½]
107—7 PLEASE TURN OVER
20 Which of the following characterises the views of a monetarist?
A In the long term unemployment can be reduced by an expansionary
fiscal policy.
B In the long term unemployment can be reduced by an expansionary
monetary policy.
C In the long term unemployment is unaffected by monetary policy.
D In the long term unemployment can be reduced but only at the cost of a
higher rate of inflation. [1½]
21 Given the following data for an economy:
Consumer expenditure £70 million
Investment £20 million
Government expenditure £40 million
Exports £10 million
Imports £30 million
Capital depreciation £20 million
Net property Income from abroad £10 million
What is the value of its Net National Product?
A £90 million
B £100 million
C £110 million
D £120 million [1½]
22 Other things being equal, an increase in the fiscal surplus will lead to a:
A rise in long term interest rates.
B increase in the money supply.
C a rise in bond prices.
D none of the above. [1½]
23 Which one of the following will increase the size of the multiplier?
A An increase in the marginal propensity to import.
B An increase in the marginal tax rate.
C A decrease in the marginal propensity to consume.
D A decrease in the marginal propensity to save. [1½]
107—8
24 If savings exceed investment by £100 million and government tax revenue
exceeds government expenditure on goods and services by £200 million then
which of the following applies to net exports?
A Net exports are £100 million.
B Net exports are - £100 million.
C Net exports are - £300 million.
D Net exports are £300 million. [1½]
25 If the current account is in surplus then which of the following applies to the
trade account?
A It must be in surplus.
B It must be in deficit.
C It must be in balance.
D It is not possible to say which of the above is applicable. [1½]
26 The current dollar ($) per pound (£) exchange rate is $1.50. The forecast for
inflation rates for the year is 6% for the United States and 4% for the United
Kingdom. What would be the forecast for the dollar-pound exchange rate one
year from now if purchasing power parity applies?
A $1.65
B $1.53
C $1.47
D $1.35 [1½]
27 Draw a diagram to illustrate each of the following:
(i) a demand curve for an inferior but non Giffen good. [1]
(ii) a demand curve for a Giffen good. [1]
(iii) a demand curve with minus unity price elasticity. [1]
(iv) a supply curve with unity price elasticity. [1]
[Total 4]
28 Read parts (i) to (iv) before answering. Answer all parts on the same diagram.
A consumer has an income of £1000 all of which is spent on a combination of
Goods X and Y. Good X costs £25 per unit and Good Y costs £20 per unit.
Good X is an inferior good and Good Y is a normal good.
(i) Draw the budget line of the consumer, labelling the quantities of Good
X and Good Y at the points where the budget line meets the Good X
and Good Y axes. Label the budget line as B1. [1]
107—9 PLEASE TURN OVER
(ii) Draw an indifference curve for Good X and Good Y at a point where the
consumer is maximising his satisfaction. Label the indifference curve
IC1. Mark the quantities of X and Y consumed as X1 and Y1
respectively. [1]
(iii) Draw a new budget line to show what would happen to the budget line
if the consumer’s income rose to £2000. Label the budget line as B2. [1]
(iv) Draw a new indifference curve for Good X and Good Y at a point where
the consumer is maximising his satisfaction following the change in
income. Label the indifference curve IC2. Mark the quantities of X and
Y consumed as X2 and Y2 respectively. [2]
[Total 5]
29 Consider the following options A to E. Each option relates to an individual
firm operating under a certain market structure.
Option Marginal Average Marginal Average
cost cost revenue revenue
A 20 20 20 20
B 24 18 24 24
C 30 36 30 40
D 18 28 28 40
E 40 40 20 40
(i) Which option indicates a short run equilibrium output for a profit
maximising monopolist? [1]
(ii) Write down ALL the options that indicate that a firm is both profit
maximising and making excess profits. [1]
(iii) Write down ALL the options that indicate that the firm could reduce its
output and increase its profits. [1]
(iv) Write down ALL the options that would be consistent with a perfectly
competitive firm in long run equilibrium. [1]
[Total 4]
30 State FOUR factors which will make the demand curve for a good more price
elastic, other things being equal. [4]
107—10
31 Read both parts (i) and (ii) before answering.
(i) Draw a diagram to show a firm in a perfectly competitive industry
making a loss sufficiently small that it pays the firm to continue to
operate in the short run. Make sure you use the following labels, AC1
for the average total cost curve, AVC1 for average variable cost curve,
MC1 for the marginal cost curve, MR1 for marginal revenue schedule,
AR1 for the average revenue schedule, P1 for price and Q1 for quantity.
[2]
(ii) Illustrate on the diagram drawn in part (i), the long run equilibrium
price and quantity of the firm assuming all the cost curves remain
unchanged. Mark the new revenue curves as MR2 and AR2, and P2 and
Q2 for the long run equilibrium price and quantity. [2]
[Total 4]
32 (i) Explain the difference between diminishing marginal productivity and
diseconomies of scale as they relate to average cost curves. [3]
(ii) State what is meant by the law of diminishing marginal utility in
consumption. [1]
[Total 4]
33 You are given the following data on an economy:
£ millions
Investment expenditure 20
Government expenditure on good and services 70
Exports 50
Notes:
(a) All tax revenues are derived from a uniform rate of income tax of
50% of income.
(b) Consumption expenditure is given by:
C = 0.8 Yd
where Yd is disposable national income (i.e. income less taxes)
C is consumption expenditure
(c) Import expenditure is given by:
Z = 0.1 Y
where Y is national income
Z is import expenditure
107—11
(i) Calculate the equilibrium value of national income. [1]
(ii) Calculate the current account balance at the equilibrium value of
national income. [1]
(iii) Calculate the fiscal surplus (+) or deficit (-) at the equilibrium value of
national income. [1]
(iv) Calculate the effect of a rise in government expenditure of £14 million
on the current account. [1]
[Total 4]
34 Briefly discuss the long run effects of lower (but still positive) domestic
inflation on the following variables, while inflation in the rest of the world is
zero.
(i) The level of nominal wages in the long term. [2]
(ii) The exchange rate of the domestic currency. [2]
[Total 4]
35 Define the following:
(i) the Public Sector Borrowing Requirement. [1]
(ii) the National Debt. [1]
(iii) Direct taxes. [1]
(iv) Progressive taxation. [1]
[Total 4]
36 (i) With the aid of a numerical example, explain briefly the concept of the
multiplier. [2]
(ii) Explain briefly the relationship between the accelerator and the
business cycle. [2]
[Total 4]
37 (i) “Inflation imposes heavy costs upon an economy and can be caused by
either cost-push or demand-pull factors.” Discuss. [10]
(ii) Explain the theory behind how monetary policy can be used to control
inflation and discuss some of the practical problems associated with
using monetary policy to control inflation. [10]
[Total 20]
Faculty of Actuaries Institute of Actuaries
EXAMINATIONS
April 2000
Subject 107 — Economics
EXAMINERS’ REPORT
Faculty of Actuaries
Institute of Actuaries
Subject 107 (Economics) — April 2000 — Examiners’ Report
Page 2
1 D
2 C
3 B
4 C
5 C
6 A
7 D
8 B
9 C
10 D
11 A
12 C
13 C
14 A
15 D
16 C
17 D
18 B
19 D
20 C
21 B
22 C
23 D
24 D
25 D
26 B
The multiple choice questions were generally well answered.
Subject 107 (Economics) — April 2000 — Examiners’ Report
Page 3
27
(i)
Subject 107 (Economics) — April 2000 — Examiners’ Report
Page 4
(ii)
Subject 107 (Economics) — April 2000 — Examiners’ Report
Page 5
(iii)
Subject 107 (Economics) — April 2000 — Examiners’ Report
Page 6
(iv)
Quite a few candidates failed to correctly answer parts (iii) and (iv).
Subject 107 (Economics) — April 2000 — Examiners’ Report
Page 7
28
It seems that a number of candidates did not read the question correctly and assumed
Good X to be a normal good, when the question states that it is an inferior good.
29 (i) c
(ii) B, C
(iii) E
(iv) A
Generally well answered.
IC2
IC1
B2
B1
X1
Subject 107 (Economics) — April 2000 — Examiners’ Report
Page 8
30 There are numerous factors that may make demand for a product more price
elastic these include:
(i) a rise in the number of substitute products available.
(ii) a lengthening of the time horizon.
(iii) the higher the proportion of income that is spent on the good.
(iv) the less necessary the good is.
Quite a few candidates could only identify 2 or 3 factors that make demand for a product
more price elastic.
31
Part (i) of this question was not well answered, with the correct placing of the AVC1 curve
being a problem. Also the gap between the average variable cost curve and average total
cost curve was not shown as narrowing as output expands by a significant number of
candidates.
Subject 107 (Economics) — April 2000 — Examiners’ Report
Page 9
32 (i) Diminishing marginal productivity is applicable only to the short run
when one has one fixed factor of production (usually capital) and one
variable factor of production (usually labour). It says that after a certain
point as you add more of the variable factor to a given amount of the fixed
factor of production then the marginal product and the average product of
the variable factor will decline, It leads to U - shaped short run costs
curves. By contrast, diseconomies of scale concerns increases in long run
average costs. Diseconomies of scale occur when output increases less
than proportionately to increases in all inputs. Diseconomies of scale will
gives upward sloping long run average cost curves and thus help to
explain U shaped long run cost curves.
(ii) The law of diminishing marginal utility in consumption states that as you
increase consumption of a good then marginal utility derived from the
good will decline.
In part (i) the distinction between the short and the long run needed to be brought out
more fully in the answers to this question.
Part (ii) was generally well answered.
33 (i) Y=C+I+G+X-Z
Y= 0.8 (Y-0.5Y) + 20 + 70 + 50 - 0. 1Y
Y= 0.3 Y + 140
0.7 Y = 140
Y = £200 million
(ii) Exports = £50m
Imports = 0.1(200) = £20m
Hence current account is in surplus of £30m
(iii) Tax revenue = 0. 5 (200) 100 million
Government expenditure = £70 million
Hence budget is in surplus of £30 million
(iv) The increase in government expenditure will increase Y to £220m.
Exports = £50m
Imports = 0.1(220) = £22m.
Hence the current account surplus will fall by £2m to £28m.
The calculations in this question seemed to present a number of candidates with problems
particularly in relation to parts (iii) and (iv).
Subject 107 (Economics) — April 2000 — Examiners’ Report
Page 10
34 (i) A lower but still positive rate of inflation will mean a higher level of
nominal wages in the long term as workers will require positive rises in
wage levels to compensate for inflation. However wages will rise by less
than they would have done had the fall in inflation not taken place.
(ii) The exchange rate of the domestic currency should depreciate as this will
help maintain purchasing power parity over the long run and maintain
the competitiveness of the currency. However the exchange rate will fall
by less than it would have done had the fall in inflation not taken place.
Lower but still positive expected rate of inflation while assuming inflation in the rest of
the world was zero means that nominal wage rates will grow more slowly than otherwise
and the exchange rate depreciate more slowly than otherwise. Too many candidates
answered this question as if it was phrased "examine the effects of inflation on wage
growth and the exchange rate of the domestic currency" rather than in the spirit of the
effects of lower inflation.
35 (i) The PSBR is the excess of the government expenditure over the income
from taxation.
(ii) The National Debt is a debt of the public sector. The debt may be owed to
citizens and organisations within the country or to overseas citizens or
organisations.
(iii) A direct tax is a tax on a payment made to a factor of production, e.g.
wages, rent, dividends, interest, profit.
(iv) A tax is said to be progressive if it takes an increasing proportion of a
persons income as income rises.
All four parts were generally well answered.
Subject 107 (Economics) — April 2000 — Examiners’ Report
Page 11
36 (i) An increase in an injection to the national income flow (e.g. an increase in
investment spending), causes an increase in the equilibrium level of
national income greater than the increase in the injection.
The multiplier is the ratio of the increase in equilibrium national income
to the original increase in the injection.
In the special case where I,G,X and Z are all exogenous and there are no
direct taxes the value of the multiplier is
1
1 MPC
Where: MPC = Marginal Propensity to consume.
If MPC = 0.8 then the multiplier = 5.
(ii) According to the accelerator principle, investment is determined by the
rate of change of national income.
The capital stock is the current amount of capital equipment available in
the economy. The capital output ratio is the amount of capital needed to
produce one unit of output. If national income falls the required capital
stock is reduced and investment demand will fall. Similarly a rise in
national income will increase the required capital stock causing a rise in
investment demand. Therefore, the demand for investment will change
when national income changes.
The combination of the accelerator principle and the multiplier can
explain the business cycle. An increase in investment will cause national
income to rise (the multiplier effect) which in turn causes a further
increase in investment (the accelerator effect) and an upward trend in the
business cycle. A fall in investment will cause national income to fall (the
multiplier effect) which in turn causes a further fall in investment (the
accelerator effect) and a downward trend in the business cycle.
Part (i) was very poorly answered with many students failing to include a simple
numerical example as the question asked.
Part (ii) few candidates were able to make a good explanation of the relationship between
the accelerator and the business cycle.
Subject 107 (Economics) — April 2000 — Examiners’ Report
Page 12
37 (i) Inflation is the annual percentage rate of change in the price of a
weighted bundle of goods and services. There are numerous harmful
effects to the economy that are caused by inflation. Inflation can
arbitrarily redistribute the national income for example, it hits those on
fixed incomes, debtors who borrow at fixed rates of interest gain while
lenders who lend at fixed rates lose. Inflation erodes the real value of
savings. In addition, inflation hits business planning and investment with
businesses finding it harder to forecast costs, revenues, interest rates etc.
Inflation will harm a country's international competitiveness especially if
the currency is part of a fixed exchange rate regime. Inflation will also
have the effect of placing upward pressure on interest rates, and long
term bond yields may have a high inflation risk premium if a country has
a poor inflation performance, this will undermine long term investment in
the economy. Finally, inflation is an average of price rises which means
that while some firms with above average price increases will be able to
meet higher wage demands other firms that raise their prices by less than
the inflation rate will not. These firms may suffer from strikes and
industrial disruption as workers seek compensation. Most economists
today recognise that there is a need to distinguish between anticipated
and unanticipated inflation. To the extent that inflation is anticipated
then it will generally speaking be less harmful than when it is
unanticipated.
Inflation is sometimes blamed on cost push factors, that is higher
production costs, which are then passed onto the consumer in the way of
higher prices. There are numerous possible causes of these cost push
pressures, excessive wage demands (wages rises not justified by
productivity increases), rises in commodity and raw material prices, a rise
in imported input costs due to a depreciation of the currency and attempts
by firms to raise their profit margins.
Demand pull pressures are where increases in aggregate demand
(consumer expenditure, government expenditure, investment and exports)
exceed the output potential of the economy resulting in upward pressure
on prices. Excess aggregate demand is especially likely to result in
inflationary pressures as the economy approaches full employment. The
causes of demand pull pressures are numerous but expansionary
monetary and fiscal policies are usually cited. On occasions excessive
domestic demand factors are reinforced by a booming world economy.
(ii) Contractionary monetary policy can prove to be a powerful weapon in
controlling inflation. According to the quantity theory of money which
assumes a stable money demand function and a fixed level of real
domestic output a fall in the rate of growth of the money supply will lead
to a similar fall in the rate of inflation. For example a 10% increase in the
money supply leads to 10% inflation whereas a 5% increase in the money
supply will lead to only 5% inflation. A contractionary fiscal policy helps
to reduce inflationary pressures in the economy by reducing aggregate
demand in the economy.
A contractionary monetary policy operates through government sales of
treasury bills and bonds which places downward pressure on bond prices
Subject 107 (Economics) — April 2000 — Examiners’ Report
Page 13
implying higher short term interest rates. A contractionary open market
operation means that the public holds more bonds and less money which
in turn will reduce the broad money supply measure associated with the
money multiplier. A lower level of money will in turn imply a reduced
demand for goods and services which will then translate into a lower
inflation rate. The higher short term interest rates will discourage
consumption and investment thereby reducing aggregate demand in the
economy. The quantity theory of money makes it clear that there is a link
between the rate of growth of the money supply and the rate of inflation,
slower monetary growth will have the effect lowering current and
expected inflation rates.
A further benefit of contractionary monetary policy is that the exchange
rate will tend to appreciate in value (sometimes quite significantly) which
will lower the cost of imports. Since most economies are fairly open this
can represent a significant contribution to inflation control especially as
lower prices for goods will in turn encourage wage moderation.
In practice, however, monetary policy is more difficult to implement than
the quantity theory of money suggests. Firstly money demand can be
unstable especially in the short run so that reductions in the money
supply might not have the intended impact if money demand is falling at
the same time. Then there is the question of defining the appropriate
monetary aggregate to target, should it be a narrow definition of the
money supply or a broad monetary aggregate? The financial sector is
always innovating and this too complicates the process of controlling the
monetary aggregates the monetary authorities might succeed in
controlling their intended monetary aggregate but find that other
monetary aggregates are not under control. There is also a problem of
time lags in the economic system. The precise time it will take for
monetary tightening to cool the economy is quite uncertain and there is a
danger that a monetary tightening will be enacted at a time when the
economy is slowing of its own accord leading to the possibility of a policy
induced recession. Finally, policy makers cannot be sure about the degree
of monetary tightening that will be required to keep inflation under
control, some economists advocate a gradual approach to the tightening of
monetary policy so that it gives economic agents time to adjust their
wages and price setting, behaviour while other economists advocate a
more hawkish approach to the implementation of monetary policy in
which a significant monetary tightening is implemented in a short period
of time as the best means of controlling inflation.
This was by the poorest section of the paper with the quality of handwriting and legibility
of some of the answers being below what can reasonably be expected.
In part (i) many candidates failed to make a distinction between anticipated and
unanticipated inflation with the latter being by far the most harmful aspect of inflation.
In part (ii) many candidates failed to make mention of the quantity theory of money. The
answers on the difficulty of implementing monetary policy is practice were often quite
weak such as the problem of defining the appropriate monetary aggregate, instability in
money demand, uncertainty and time lags often not mentioned.
Faculty of Actuaries Institute of Actuaries
EXAMINATIONS
12 September 2000 (am)
Subject 107 — Economics
Time allowed: Three hours
INSTRUCTIONS TO THE CANDIDATE
1. Write your surname in full, the initials of your other names and your
Candidate’s Number on the front of the answer booklet.
2. Mark allocations are shown in brackets.
3. Attempt all 37 questions, beginning your answer to each question on a
separate sheet.
4.
Graph paper is not required for this paper.
AT THE END OF THE EXAMINATION
Hand in BOTH your answer booklet and this question paper.
In addition to this paper you should have available Actuarial
Tables and an electronic calculator.
Faculty of Actuaries
107—S2000 Institute of Actuaries
107—2
For questions 1–26 indicate in your answer booklet which one of the answers A, B, C or D
is correct.
1 Scarcity exists if:
A prices are too high.
B economies are not perfectly competitive.
C human wants cannot be satisfied when price is zero.
D there are shortages of some goods. [1½]
2 Diseconomies of scale means:
A short run average total cost falls as output rises.
B long run average total cost falls as output rises.
C long run average total cost rises as output rises.
D short run average total cost rises as output rises. [1½]
3 Which of the following events would shift the demand curve for good X to the
left?
A An increase in the price of good X.
B An increase in the price of a substitute good.
C An increase in the price of a complementary good.
D An increase in consumer income. [1½]
4 The demand equation for good X is Qd = 15 - 0.5P and the supply equation for
good X is Qs = 3 + 2P, where P is the price. When the price is £6 there will be:
A a surplus of good X and price will rise.
B a shortage of good X and price will fall.
C a surplus of good X and price will fall.
D a shortage of good X and price will rise. [1½]
5 Individual A can choose between good X and good Y. The price of good X is £2
and the price of good Y is £5. What will be the ratio of the marginal utilty of X
over the marginal utility of Y when individual A maximises total utility?
A 5/2
B 7/2
C 1/1
D 2/5 [1½]
107—3 PLEASE TURN OVER
6 Which of the following assumptions apply when constructing a budget line?
A Consumer preferences exhibit diminishing marginal substitution.
B The consumer’s income is fixed.
C Consumers prefer more of a good to less of it.
D A consumer can rank any two bundles of goods. [1½]
7 Which of the following statements regarding the productivity of labour is
correct?
A Average product is maximised when average product equals marginal
product.
B Average product is maximised when marginal product is maximised.
C Marginal product increases when average product is above marginal
product.
D Average product increases when marginal product is below average
product. [1½]
8 If the total cost of production is £48 when output is 5 units and rises to £78
when output is 7 units, the marginal cost of production will be:
A rising and less than the average total cost of production.
B falling and less than the average total cost of production.
C rising and greater than the average total cost of production.
D falling and greater than the average total cost of production. [1½]
9 If firms in a perfectly competitive industry are making economic profit the
long run effect will be to:
A increase the output of the firms and the industry.
B reduce the output of the firms and the industry.
C reduce the output of the industry and increase the output of the firms.
D reduce the output of the firms and increase the output of the industry.
[1½]
10 In the long run, profit maximising firms operating under conditions of
monopolistic competition will produce at a level of output where:
A price equals marginal cost.
B price equals average total cost.
C price equals average variable cost.
D price equals average fixed cost. [1½]
107—4
11 If the government places an indirect tax on good X, the price of good X to
consumers will not change when:
A supply of good X is price elastic.
B supply of good X is completely price inelastic.
C demand for good X is price elastic.
D demand for good X is completely price inelastic. [1½]
12 In a country with a population of 25 million people there are 16 million in the
total workforce and 2 million unemployed. What is the rate of unemployment?
A 8%
B 11.1%
C 12.5%
D 44% [1½]
13 The need to employ workers with certain skills may decline even if the industry
as a whole is not in decline . This form of unemployment is called:
A structural.
B demand-deficient.
C regional.
D technological. [1½]
14 Which of the following costs of inflation occurs because of the possibility of
unanticipated inflation?
A “Inflation risk premium”.
B “Menu costs”.
C “Shoe-leather costs”.
D “Institutional sluggishness”. [1½]
15 Other things remaining the same, the result of an increased PSBR is:
A higher short term interest rates because the LM curve moves to the left.
B lower short term interest rates because the LM curve moves to the right.
C higher short term interest rates because the IS curve moves to the right.
D lower short term interest rates because the IS curve moves to the left.
[1½]
107—5 PLEASE TURN OVER
16 In the circular flow of income model of an economy with no government or
international trade, the flow of money is:
A from firms to households in return for goods and services provided.
and from households to firms in return for the factor services
provided.
B from households to firms in return for the factor services provided.
C from firms to households in return for the factor services provided.
and from households to firms in return for the goods and services
provided.
D from firms to households in return for goods and services provided.
[1½]
17 The macroeconomic demand schedule slopes downwards because at higher price
levels the real money supply:
A increases and national income is lower.
B increases and national income is higher.
C decreases and national income is lower.
D decreases and national income is higher. [1½]
18 The short run aggregate supply schedule tells us that an increase in the average
price level will encourage firms to:
A increase output and employment.
B reduce output and employment.
C increase output and reduce employment.
D reduce output and increase employment. [1½]
19 If consumption expenditure increases from £18,000 to £19,500 when disposable
income increases from £20,000 to £26,000, then:
A the marginal propensity to consume is 0.25 and the multiplier is 1.33.
B the marginal propensity to consume is 0.25 and the multiplier is 4.
C the marginal propensity to consume is 0.75 and the multiplier is 4.
D the marginal propensity to consume is 0.75 and the multiplier is 1.33.
[1½]
107—6
20 A fall in real Gross Domestic Product would result from an increase in all of the
following with the exception of:
A saving.
B imports.
C taxation.
D government expenditure. [1½]
21 An unexpected increase in the price level which causes a temporary reduction in
the real wage rate may:
A increase the natural rate of unemployment.
B decrease the natural rate of unemployment.
C give an actual rate of unemployment which is temporarily greater than
the natural rate.
D give an actual rate of unemployment which is temporarily lower than the
natural rate. [1½]
22 In Country A government expenditure is £360 billion, tax revenue is £375 billion,
aggregate saving is £225 billion and aggregate investment is £205 billion. The
net exports of Country A are equal to:
A deficit of £35 billion.
B surplus of £35 billion.
C deficit of £15 billion.
D surplus of £15 billion. [1½]
23 Keynesian economists support the argument that:
A the aggregate labour market will automatically move towards
equilibrium.
B changes in interest rates have little effect on aggregate investment in the
short term.
C changes in the money supply have a proportionate impact on the rate of
inflation.
D crowding out effects will seriously reduce the impact of increases in
government expenditure. [1½]
107—7 PLEASE TURN OVER
24 A fall in a country’s terms of trade index means that:
A the index of export prices has risen by a smaller percentage than the
index of import prices.
B the index of export prices has risen but the index of import prices has
remained the same.
C the index of export prices remains the same whilst the index of import
prices falls.
D the index of export prices has fallen by a smaller percentage than the
index of import prices. [1½]
25 In Country A it takes 15 hours to produce a unit of good X and 12 hours to
produce a unit of good Y. In Country B it takes 10 hours to produce a unit of
good X and 15 hours to produce a unit of good Y. Which of the following
statements is correct?
A Country B has a comparative advantage in the production of good X and
an absolute advantage in the production of good Y.
B Country B has a comparative advantage in the production of good X and
an absolute advantage in the production of good X.
C Country A has a comparative advantage in the production of good X and
an absolute advantage in the production of good Y.
D Country A has a comparative advantage in the production of good X and
an absolute advantage in the production of good X. [1½]
26 An appreciation of the domestic currency:
A reduces the foreign price of exports and increases the domestic price of
imports.
B reduces the foreign price of exports and reduces the domestic price of
imports.
C increases the foreign price of exports and reduces the domestic price of
imports.
D increases the foreign price of exports and increases the domestic price of
imports. [1½]
107—8
27 Illustrate on four separate supply and demand diagrams the effect on
equilibrium price and quantity of good X (which is a normal good) of (i) to (iv)
below. Use the labels P1 and P2 for the original and new price and Q1 and Q2
for the original and new quantity respectively.
(i) A reduction in the price of a substitute good. [1]
(ii) The introduction of an indirect tax on good X. [1]
(iii) An increase in the productivity of labour in producing good X. [1]
(iv) An increase in consumers’ incomes.[1]
[Total 4]
28 Consumer A demands 450 units of good X per year given that the price of good X
is £3.50 per unit, the price of good Y is £4.80 per unit and consumer A’s income is
£35,000 per year.
(In each case your answer should be given to two decimal places.)
(i) When the price of good X falls to £2.80 per unit, consumer A’s demand for
good X rises to 530 units per year, other things remaining the same. What
is consumer A’s price elasticity of demand for good X? [2]
(ii) When the price of good Y falls to £4.40 per unit, consumer A’s demand for
good X declines to 380 units per year, other things remaining the same.
What is consumer A’s cross price elasticity of demand for good X? [2]
(iii) When consumer A’s income increases to £38,000 per year his demand for
good X increases to 480 units per year, other things remaining the same.
What is consumer A’s income elasticity of demand for good X? [2]
[Total 6]
29 Define the following:
(i) an inferior good. [1]
(ii) a Giffen good. [1]
(iii) a normal good. [1]
[Total 3]
30 Read all parts of the question before answering.
(i) Draw a diagram to show a monopoly firm making a profit. Label your
diagram as follows: AR for average revenue, MR for marginal revenue, AC
for average total cost and MC for marginal cost. Indicate on your diagram
the profit maximising price P1 and output Q1. [2]
(ii) Indicate on the diagram drawn in part (i) the socially optimal output level
Q2. [1]
(iii) Indicate and label on the diagram drawn in part (i) the social cost of
monopoly. [1]
[Total 4]
107—9 PLEASE TURN OVER
31 Define the following:
(i) adverse selection. [2]
(ii) moral hazard. [2]
[Total 4]
32 Discuss briefly FOUR factors that would explain why economies of scale might
occur in large firms. [4]
33 A perfectly competitive firm manufactures good X which sells at £9.50 per unit.
The total output per week at each level of employment is given below.
Number of employees Total output
per week per week (units)
1 6
2 13
3 22
4 32
5 39
6 44
(i) Construct a table to provide the following information per week at each
level of employment;
(a) marginal product of labour.
(b) marginal revenue product of labour.
(c) total revenue. [3]
(ii) Determine the level of employment after which the firm begins to
experience diminishing marginal returns. [1]
[Total 4]
107—10
34 Use the following annual data for Country A to answer the questions below.
Consumer expenditure = £203 million plus 75% of disposable national income.
Government expenditure = £120 million.
Investment expenditure = £90 million.
Direct tax revenue = £100 million.
Transfer payments = £64 million
Export expenditure = £85 million
Import expenditure = £68 million
(i) What is the equilibrium value of national income? [1]
(ii) If government expenditure increased by £15 million:
(a) by how much would national income increase? [1]
(b) by how much would consumer expenditure increase? [1]
(c) by how much would saving increase? [1]
[Total 4]
35 Explain four economic benefits of international trade. [4]
36 Briefly discuss four factors which explain economic growth. [4]
37 (i) Explain what IS and LM curves show. Use an IS-LM graph to
explain how the equilibrium national income and the equilibrium level of
interest rates is determined. [5]
(ii) Discuss, with the aid of IS-LM graphs, the impact on interest rates and
national income of:
(a) an increase in injections.
(b) an increase in the money supply.
(c) an increase in the average price level. [15]
[Total 20]
Faculty of Actuaries Institute of Actuaries
EXAMINATIONS
September 2000
Subject 107 — Economics
EXAMINERS’ REPORT
Faculty of Actuaries
Institute of Actuaries
Subject 107 (Economics) — September 2000 — Examiners’ Report
Page 2
Overall comments
One comment for the next set of exams is that it is a waste of time and paper to have the
multiple choice questions answered on separate pages. The instructions for the next exams
will clearly state that for multiple choice, a new page should not be used for each question.
There was considerable evidence of poor exam technique, for example:
appearing to fail to consider all the options in multiple choice questions
not giving sufficient weight to high mark questions
disregarding the wording of questions eg ‘2 decimal places’, ‘discuss’.
Handwriting ranged from the clear to the terrible.
Diagrams, in particular, were very poor in many cases. Many diagrams were drawn freehand
(without a ruler) and therefore lacked clarity. Many diagrams were also too small for the
answers to be clear. Candidates should use rulers, and diagrams should be of a sufficient size
to show movements clearly.
Comments on individual questions appear in italics at the end of each corresponding
solution.
Subject 107 (Economics) — September 2000 — Examiners’ Report
Page 3
1 C
2 C
3 C
4 C
5 D
6 B
7 A
8 C
9 D
10 B
11 B
12 C
13 D
14 A
15 C
16 C
17 C
18 A
19 A
20 D
21 D
22 B
23 B
24 A
25 B
26 C
Q1-Q26 Generally, the multiple choice questions were well answered. The questions which caused
the main problems were numbers 7, 9, 11, 12 and 21. Of these, 11 was answered incorrectly
most often.
Subject 107 (Economics) — September 2000 — Examiners’ Report
Page 4
27 (i) Price
S
P1
P2
D2 D1
0 Q2 Q1 Quantity
(ii) Price
S2
S1
P2
P1
D
0 Q2 Q1 Quantity
(iii) Price
S1
S2
P1
P2
D
0 Q1 Q2 Quantity
(iv) Price
S
P2
P1
D1 D2
0 Q1 Q2 Quantity
Q27 Well answered by most.
Subject 107 (Economics) — September 2000 — Examiners’ Report
Page 5
28 (i) Price Elasticity of Demand =
% change in Qd(X)
% change in P(X)
= –0.89
(ii) Cross Price Elasticity of Demand =
% change in Qd(X)
% change in P(Y)
= 1.87
(iii) Income Elasticity of Demand =
% change in Qd(X)
% change in income
= 0.78
Alternative answers using arc elasticity measurement:
(i) -0.73
(ii) 1.94
(iii) 0.78
Q28 Well answered by most. Marks were given for part (i) where the minus sign was missed out,
as it explicitly states in the core reading that some economists do miss out the minus sign.
The most common error was to base the answer on the change in the quantity or price
rather than the percentage change.
29 (i) An inferior good is a good for which the income elasticity of demand is
negative. So the quantity demanded fall as income increases.
(ii) A Giffen good is a good for which the price elasticity of demand is positive.
So, as its price rises the quantity demanded increases.
(iii) A normal good is a good for which the income elasticity of demand is
positive. So the quantity demanded increases as income increases.
Q29 Very well answered.
Subject 107 (Economics) — September 2000 — Examiners’ Report
Page 6
30
Q30 Reasonably well answered by most. The most common error was not knowing the area
representing the social cost of monopoly.
31 (i) Adverse selection describes the fact that people who know that they are
particularly bad risks are more inclined to take out insurance than those
who know that they are good risks.
(ii) Moral hazard describes the fact that a policyholder may, because they
have insurance, act in a way which makes the insured event more likely.
Q31 Well answered by most, although some candidates lost marks by simply giving an example
for each rather than defining, as the question required.
Subject 107 (Economics) — September 2000 — Examiners’ Report
Page 7
32 Any four of the following factors might be discussed to explain economies of scale:
Spreading of fixed costs, e.g. administration, marketing, research and
development.
Specialisation; division of labour allows employees to specialise thus increasing
productivity. Similarly more specialist equipment is employed as output rises
Physical economies; increasing the volume of a physical object requires a less
than proportionate increase in surface area.
Finance; large firms may be seen as more credit worthy and consequently should
obtain finance more cheaply.
Bulk purchase; a larger firm is able to exert more pressure on suppliers to set
lower prices.
By-products; some production processes produce small amounts of potentially
useful by-products. It may not be worthwhile selling this unless the scale of
production (and hence the output of the by-product) is sufficiently large.
The principle of multiples; different machines needed in the production process
may have different capacities. In this case use of all machines’ capacities may
only be possible at high output levels.
Q32 Very well answered. No marks were given where candidates simply stated factors without
discussing them.
33 (i) Number of Marginal product Marginal Revenue Total
employees of Labour Product of Labour Revenue
per week (£) (£)
1 6 57 57
2 7 66.5 123.5
3 9 85.5 209
4 10 95 304
5 7 66.5 370.5
6 5 47.5 418
(ii) Diminishing Marginal Returns are experienced when the number of
employees per week exceeds 4.
Q33 Well answered by most. In part (i) full marks were given where candidates either marked
the MPL between rows recording the number of employees per week, or in the same rows.
In part (ii) full marks were given for ‘4’ or for ‘if a 5th person is added’, but no mark for ‘5’
by itself.
Subject 107 (Economics) — September 2000 — Examiners’ Report
Page 8
34 (i) Y = C + G + I + X - Z
C = 203 + 0.75( Y + 64 - 100 )
Y = 203 + 0.75( Y +64 - 100 ) + 120 + 90 + 85 - 68
Y = 403 + 0.75( Y )
Y = £1612 million.
(ii) (a) When G = £120 million, Y = £1612 million.
When G = £135 million, Y = £1672 million
The increase in Y = £60 million.
(b) When G = £120 million, C = £1385 million.
When G = £135 million , C = £1430 million.
The increase in C = £45 million.
(c) When G = £120 million, S = £191 million.
When G = £135 million, S = ££206 million.
The increase in S = £15 million.
Q34 Poorly answered. Many candidates calculated (i) incorrectly but went on to correctly derive
the increases in (ii). Conversely some candidates who calculated the first part correctly,
complicated part (ii). Many candidates neglected to take taxation into account in part (i).
35 The existence of international trade:
(a) allows countries to specialise in the production of the goods which they
can produce relatively more efficiently than other countries.
(b) increases the scope for benefits from economies of scale by increasing the
size of the available markets.
(c) increases the range of goods and services which consumers can buy.
(d) leads to lower prices through increased competition.
Q35 Not very well answered. No marks were given where candidates simply stated factors
without explaining them.
Subject 107 (Economics) — September 2000 — Examiners’ Report
Page 9
36 Economists explain economic growth in terms of increases in:
(a) capital; an increase in the stock of capital occurs when new investment
exceeds depreciation of the existing stock of capital.
(b) labour; an increase in the labour force occurs as a result of population
growth or an increase in the proportion of the population employed - that
is the participation rate or an increase in working hours. Furthermore,
the productivity of labour can be increased through education and
training and health improvements.
(c) land; increases in the availability of land and natural resources may arise
from more efficient land use and the discovery of new resources.
(d) technical knowledge; the rate of technical advance will depend on the
amount of research and development taking place giving rise to new
inventions and innovation.
(e) economic efficiency; improved utilisation of the available capital, labour,
land, and technical knowledge can lead to increased growth.
Q36 Poorly answered. Again, no marks were given where candidates simply stated factors
without discussing them.
37 (i) Points on the IS curve show combinations of interest rates and national
income at which injections equal withdrawals and consequently the total
output (national income) equals total expenditure, giving equilibrium in
the markets for goods and services.
Points on the LM curve show combinations of interest rates and national
income at which the demand for money (liquidity) equals the supply of
money, giving equilibrium in the money markets.
Interest
Rate (i)
IS LM
i1
0 Y1 National Income (Y)
The IS-LM curves are drawn on a graph with interest rates on the vertical
axis and national income on the horizontal axis. The IS curve slopes
downward from left to right showing that lower rates of interest lead to
Subject 107 (Economics) — September 2000 — Examiners’ Report
Page 10
higher levels of national income. The LM curve slopes upward from left to
right showing that in order to obtain equilibrium in the money market,
given the supply of money, higher levels of national income are associated
with higher rates of interest.
At the rate of interest and level of national income where the IS-LM
curves intersect in the graph both the money market and the market for
goods and services are in equilibrium.
(ii) (a) An increase in injections will shift the IS curve to the right giving
an increase in the equilibrium rate of interest and national income.
The rate of interest rises because the increase in national income,
brought about by the increase in injections times the multiplier,
increases the demand for money. Given a fixed money supply
interest rates must rise to choke off the excess demand for money.
The increase in interest rate will reduce investment and consumer
expenditure so that national income does not rise by the full
multiplier effect. The fall in investment and consumer expenditure
is called crowding out.
Interest
Rate (i)
IS1 IS2 LM
i2
i1
0 Y1 Y2 National Income (Y)
(b) An increase in the money supply will shift the LM curve to the right
giving a reduction in the equilibrium rate of interest and an
increase in the equilibriumnational income.
The increase in the money supply gives an excess supply of money
causing rates of interest to fall. The fall in the rate of interest
encourages higher levels of investment and consumer expenditure,
increasing injections causing the equilibrium level of national
income to rise.
Subject 107 (Economics) — September 2000 — Examiners’ Report
Page 11
Interest
Rate (i)
IS LM1
i1 LM2
i2
0 Y1 Y2 National Income (Y)
(c) An increase in the average price level will result in a reduction in
the real value of the money supply. A reduction in the money supply
will shift the LM curve to the left giving an increase in the
equilibrium rate of interest and a fall in the equilibrium level of
national income.
The reduction in the money supply gives an excess demand for
money causing rates of interest to rise. The rise in interest rates
discourages investment and consumer expenditure, reducing
injections and causing the equilibrium level of national income to
fall.
Interest LM2
Rate (i)
IS LM1
i2
i1
0 Y2 Y1 National Income (Y)
Q37 This question was particularly poorly answered. Many candidates spent too much time on
part (i) rather than part (ii), despite the clear allocation of marks between the two parts.
The standard of diagrams overall was very poor in this question. A surprisingly high
number of candidates confused the slope of the IS and LM curves.
Candidates who did well tended to have simple, accurate diagrams and short, clear
supporting text.
Faculty of Actuaries Institute of Actuaries
EXAMINATIONS
3 April 2001 (am)
Subject 107 ? Economics
Time allowed: Three hours
INSTRUCTIONS TO THE CANDIDATE
1. Write your surname in full, the initials of your other names and your
Candidate?s Number on the front of the answer booklet.
2. Mark allocations are shown in brackets.
3. Attempt all 37 questions. From question 27 onwards begin each answer on a
separate sheet.
Graph paper is not required for this paper.
AT THE END OF THE EXAMINATION
Hand in BOTH your answer booklet and this question paper.
In addition to this paper you should have available
Actuarial Tables and an electronic calculator.
Faculty of Actuaries
107?A2001 Institute of Actuaries
107 A2001?2
For questions 1?26 indicate in your answer booklet which one of the answers A, B, C or D
is correct.
1 Good X has a cross price elasticity of demand with respect to Good Y that is
negative and Good Z has a cross price elasticity of demand with respect to Good Y
that is positive. Which of the following is correct?
A Goods X and Y are substitutes.
B Goods Y and Z are complements.
C Goods X and Z are substitutes.
D Goods X and Y are complements. [1½]
2 Which of the following will result from the imposition of a 10 per cent tax on
Good X, the demand for which has a price elasticity of demand equal to -1.5?
A A rise in the price of Good X by 15 per cent.
B A rise in the price of Good X by 11.5 per cent.
C A rise in the price of Good X by 10 per cent.
D A rise in the price of Good X by less than 10 per cent. [1½]
3 A monopoly firm is able to sell 46 units of output per day when the price is £17.50
per unit and 47 units when the price is £17.25. The marginal revenue from the
47th unit sold is:
A £17.50
B £17.25
C £5.75
D 25 pence [1½]
4 Which one of the following will shift the supply curve for Good X to the right?
A A government subsidy on the production of Good X.
B A decrease in labour productivity in industry X.
C A rise in price of raw materials used to produce Good X.
D An increase in real wages in industry X. [1½]
5 A minimum price is set for Good X at £10 which happens to be below the free
market price. A decrease in the supply of Good X keeping the minimum price
fixed at £10 will result in:
A a rise in price and a surplus of Good X
B a rise in price and a shortage of Good X
C a rise in price and a balance between supply and demand for Good X
D no change in price and a shortage of Good X [1½]
107 A2001?3 PLEASE TURN OVER
6 Revenues from the sale of a good will decrease if:
A income increases and the good is normal
B its price rises and demand is price elastic
C its price rises and demand is price inelastic
D income falls and the good is inferior [1½]
7 Consider the budget line of a consumer that consumes only two Goods X and Y,
with the quantity of Good X represented on the horizontal axis and quantity of
Good Y represented on the vertical axis. If money income is held constant, a fall
in the price of Good X and a rise in the price of Good Y will:
A shift the entire budget line to the left
B shift the entire budget line to the right
C make the budget line steeper
D make the budget line less steep [1½]
8 Which one of the following statements reflects decreasing returns to scale?
A If more labour is added to a given amount of capital, the marginal and
average product of labour falls.
B If the ratio of labour to capital doubles, the output of the firm less than
doubles.
C If the input of capital and labour doubles, the output of the firm less than
doubles.
D If the input of capital and labour doubles, the ratio of inputs to output
falls. [1½]
9 Points on the LM curve show combinations of real Gross Domestic Product (GDP)
and the interest rate where:
A the product market is in equilibrium
B the money market is in equilibrium
C aggregate demand equals aggregate supply
D both the product and money markets are in equilibrium [1½]
107 A2001?4
10 A firm with fixed costs of £400 per week and constant average variable costs of £8
per unit of output, has the following information about its weekly sales:
Sales Total Revenue (£?s)
10 400
20 720
30 960
40 1,120
50 1,250
60 1,280
Which of the following levels of output yields the highest profit?
A 50
B 40
C 30
D 20 [1½]
11 Which one of the following statements correctly distinguishes monopolistic
competition from perfect competition?
A Under monopolistic competition firms can make short run supernormal
profits but this is not possible under perfect competition.
B Under monopolistic competition firms can make long run supernormal
profits but this is not possible under perfect competition.
C Under monopolistic competition a firm can unilaterally raise its price
without losing all its customers but this is not possible under perfect
competition.
D Under monopolistic competition the firm does not set its price at the point
where marginal cost equals marginal revenue but a perfectly competitive
firm does. [1½]
12 Which one of the following statements about market structure is FALSE?
A Under perfect competition, in the long run all firms make only normal
profits.
B Under oligopoly firms make decisions taking into account the possible
reactions of their competitors.
C For a monopolist facing a linear demand curve, average revenue is always
greater than marginal revenue.
D Firms under monopolistic competition have marginal revenue equal to
their average revenue. [1½]
107 A2001?5 PLEASE TURN OVER
13 Which one of the following economic statements correctly defines moral hazard in
relation to insurance?
A Moral hazard describes the fact that people who know that they are a
particularly bad risk are more inclined to take out insurance.
B Moral hazard describes the fact that a policyholder may act in a way
which makes the insured event more likely.
C Moral hazard describes the fact that people who know that they are a
particularly bad risk are less inclined to take out insurance.
D Moral hazard describes the fact that a policyholder may act in a way
which makes the insured event less likely. [1½]
14 The three injections into the circular flow of income are:
A investment, consumer expenditure and exports
B investment, consumer expenditure and government expenditure
C investment, government expenditure and exports
D investment, consumer expenditure and imports [1½]
15 If the level of real Gross Domestic Product (GDP) in an economy is greater than
the level of its planned aggregate expenditure then real GDP:
A and planned aggregate expenditure will both rise
B and planned aggregate expenditure will both fall
C will rise and planned aggregate expenditure will fall
D will fall and planned aggregate expenditure will rise [1½]
16 You are given the following data on the relationship between national income (Y)
and consumer expenditure (C) in a simple closed economy with no government
sector:
Y C
100 80
120 95
140 110
What is the value of the simple Keynesian multiplier?
A 1.25
B 1.33
C 4
D 5 [1½]
107 A2001?6
17 If a country has a positive balance of net property income from abroad then:
A Gross Domestic Product is greater than Gross National Product.
B Gross Domestic Product is less than Gross National Product.
C Gross Domestic Product is the same as Gross National Product.
D We cannot say whether Gross Domestic Product differs from Gross
National Product from this information. [1½]
18 Which of the following will decrease the value of the multiplier?
A An increase in the marginal propensity to import.
B A decrease in the marginal propensity to consume.
C A decrease in the marginal tax rate.
D A decrease in government expenditure. [1½]
19 If the level of real output is assumed to be fixed, the quantity theory of money in
its simplest form assumes that the:
A ratio of the velocity of circulation to the price level rises when the money
supply increases
B ratio of the velocity of circulation to the price level is fixed
C ratio of the money supply to the velocity of circulation is fixed
D ratio of the money supply to the price level is fixed [1½]
20 Which one of the following statements about real variables in the economy is
TRUE?
A Real interest rates are positive if the expected rate of inflation is less than
the nominal rate of interest.
B Real wages must rise if inflation is positive.
C An increase in real income will lead to a reduced demand for real money
balances.
D If nominal Gross Domestic Product (GDP) rises by 10 per cent, the GDP
deflator rises by 15 per cent and the population rises by 10%, then real
GDP per capita has fallen.
[1½]
107 A2001?7 PLEASE TURN OVER
21 Which one of the following is the most accurate description of the National Debt ?
A The annual gap between total government tax receipts and total
government expenditure.
B The total amount owed by a country to the rest of the world.
C The net accumulation of a country?s budget deficits.
D The net accumulation of a country?s current account deficits. [1½]
22 The money multiplier will be higher the:
A lower the ratio of cash held by the public to their bank deposits
B higher the banks? reserve ratio (cash to deposits)
C higher the banks? reserve ratio (cash to deposits) and the lower the ratio of
cash held by the public to their bank deposits
D lower the banks? reserve ratio (cash to deposits) and the lower the ratio of
cash held by the public to their bank deposits [1½]
23 The introduction of an expansionary monetary policy in an open economy
operating with a flexible exchange rate would most likely lead in the short run to:
A higher domestic interest rates and an exchange rate appreciation of the
domestic currency
B higher domestic interest rates and an exchange rate depreciation of the
domestic currency
C lower domestic interest rates and an exchange rate appreciation of the
domestic currency
D lower domestic interest rates and an exchange rate depreciation of the
domestic currency [1½]
24 A government policy that will decrease the number of voluntary unemployed in
an economy is:
A an increase in unemployment benefit
B an increase in income taxes
C a decrease in the minimum wage
D none of the above [1½]
107 A2001?8
25 According to purchasing power parity theory, if the British inflation rate is 4 per
cent and the European inflation rate is negative at -1 per cent then the pound
should:
A depreciate against the euro by 5 per cent
B depreciate against the euro by 3 per cent
C appreciate against the euro by 5 per cent
D appreciate against the euro by 3 per cent [1½]
26 You are given the following data on a country?s balance of payments:
£ millions
Exports of goods and services 900
Imports of goods and services 600
Interest Profit and Dividend Received from ROW 100
Interest Profit and Dividend Paid to ROW 200
Transfer payments from ROW 150
Transfer payments to ROW 50
Borrowing from ROW 500
Lending to ROW 300
Note ROW stands for rest of the world.
What are the values of the current account balance and capital account balance
respectively?
A £300 million, £200 million
B £300 million, -£200 million
C £200 million, £300 million
D £200 million, -£300 million [1½]
27 Explain briefly the accelerator principle. [4]
28 Draw a separate diagram in each case to illustrate the following:
(i) a demand curve with zero price elasticity throughout its entire length
[1]
(ii) a demand curve that would yield the same total revenue at each price
level [1]
(iii) a supply curve with infinite price elasticity throughout its entire length
[1]
(iv) a supply curve with a price elasticity of 1 throughout its entire length [1]
[Total 4]
107 A2001?9 PLEASE TURN OVER
29 You are given the following data concerning the total utility from consumption of
two Goods X and Y for a consumer. Good X costs £1 and Good Y costs £2. The
consumer has £10 of income which is spent on consumption of the two goods.
Consumption Total Utility Consumption Total Utility
of Good X from Good X of Good Y from Good Y
0 0 0 0
1 100 1 520
2 190 2 900
3 270 3 1,040
4 340 4 1,160
5 400 5 1,200
6 450 6 1,220
7 490 7 1,230
8 520 8 1,235
9 540 9 1,238
10 550 10 1,240
(i) Calculate the utility maximising combination of Good X and Good Y of the
consumer. [1]
(ii) Calculate the consumption quantities of Good X and Good Y that would
give the lowest total utility. Assume the consumer has to spend all his
income. [1]
(iii) Assume that the consumer is currently consuming 5 units of Good Y and 0
units of Good X. Calculate the increase in the consumer?s total utility
from switching to the utility maximising combination of Good X and
Good Y. [1]
(iv) Calculate the utility maximising consumption of Good X and Good Y, if
the price of Good Y was to halve to £1 and the consumer?s income was to
rise by £2 to £12. [2]
[Total 5]
30 Draw a diagram showing a monopolist making a loss in the short run that is not
sufficient to make it close down. Include the following curves; marginal revenue
(MR), average revenue (AR), average total cost (AC) and average variable cost
(AVC). Indicate the loss minimising price (P1), output (Q1), average variable cost
(AVC1) and average total cost (C1). [4]
107 A2001?10
31 You are given the following data concerning the production costs and the average
revenue of a profit maximising firm that produces Good X. The fixed costs of
production are initially £200.
Output Of Short Run Average Average
Good X Variable Cost Of X Revenue
£ £
1 220 600
2 190 500
3 160 420
4 150 360
5 162 300
6 170 240
7 180 200
8 200 180
9 220 160
10 240 140
(i) Calculate the profit maximising output of the firm. [1]
(ii) Calculate the smallest rise in total variable costs that would force the firm
to cease production in the short run. [2]
(iii) State what will happen to production in the short run if the fixed costs of
production rise from £200 to £500. [1]
[Total 4]
32 The consumption function for a closed economy with no government sector is
given by the equation:
C = £100 million + 0.7Y
Where: C is aggregate consumption
Y is national income
(i) Calculate the value of aggregate savings if the level of national income is
£1000 million. [1]
(ii) Calculate the change in national income if planned investment rose by
£100 million. [1]
(iii) Calculate the value of aggregate consumption at the equilibrium level of
national income, if the level of planned investment is £500 million. [2]
[Total 4]
33 Explain the term ?crowding out?, giving TWO examples of ?crowding out? effects.
[4]
107 A2001?11
34 (i) State what happens to the price of treasury bills and the money supply if
the authorities conduct a contractionary open market operation. [1]
(ii) Explain what is likely to happen to the long-term rate of interest and the
price of government bonds, if the conduct of monetary policy is such that it
raises the expected rate of inflation and creates additional uncertainty
concerning the conduct of monetary policy. [3]
[Total 4]
35 Define each of the following:
(i) a direct tax [1]
(ii) an indirect tax [1]
(iii) a progressive tax [1]
(iv) a regressive tax [1]
[Total 4]
36 The world consists of two countries A and B and the only factor of production is
labour. In country A it takes 50 hours to produce one unit of Good X and 25 hours
to produce one unit of Good Y. In country B it takes 40 hours to produce one unit
of Good X and 10 hours to produce one unit of Good Y.
State whether each of the following statement is true or false.
(i) Country B has an absolute advantage in the production of Good X. [1]
(ii) Country B has a comparative advantage in the production of Good X. [1]
(iii) Exchanging 3 units of Good Y for 1 unit of Good X represents terms of
trade which are mutually beneficial. [1]
(iv) Before trade is opened up Country A must have a lower level of total
production of both goods than Country B. [1]
[Total 4]
37 (i) Outline the characteristics of an oligopolistic market structure and
explain how they differ from the characteristics of a monopoly market
structure. [10]
(ii) Discuss, with the aid of a diagram, the reasons why firms in an
oligopolistic market are sometimes reluctant to raise or lower their prices.
[10]
[Total 20]
Faculty of Actuaries Institute of Actuaries
EXAMINATIONS
April 2001
Subject 107 ? Economics
EXAMINERS? REPORT
Faculty of Actuaries
Institute of Actuaries
Subject 107 (Economics) ? April 2001 ? Examiners? Report
Page 2
1 D
2 D
3 C
4 A
5 C
6 B
7 D
8 C
9 B
10 A
11 C
12 D
13 B
14 C
15 B
16 C
17 B
18 A or B
19 D
20 A or D
21 C
22 D
23 D
24 D
25 A
26 A
27 According to the acceleration principle investment is determined by changes in
national income and small changes in national income can lead to large
fluctuations in investment demand. Consequently investment is a very unstable
component of aggregate demand and a major factor contributing to trade cycle
fluctuations.
When national income is stable investment is only needed to replace machinery
and equipment that has worn-out or become obsolete. When national income is
rising firms will wish to expand their production capacity and will demand new
investment to increase their stock of capital. When national income is falling
firms will require less production capacity and investment will fall. The
relationship between investment demand and the change in national income is
determined by the desired capital-output ratio, this is the amount of capital
needed to produce 1 unit of output.
Subject 107 (Economics) ? April 2001 ? Examiners? Report
Page 3
Demand
Quantity
Price
Quantity
28
(i)
(ii)
Price
Demand
Subject 107 (Economics) ? April 2001 ? Examiners? Report
Page 4
Price
Quantity
Supply
(iii)
(iv)
Price
Quantity
Supply
Subject 107 (Economics) ? April 2001 ? Examiners? Report
Page 5
29 (i) 4 units of X and 3 units of Y
(ii) 10 units of X
(iii) 180 units of utility
(iv) 7 units of X and 5 units of Y
30
31 (i) 4 units
(ii) £840 or £841
(iii) Nothing ? there is no change in output
Price
C1
P1
AVC1
MC AC
Q1
MR
Quantity
AR
AVC
Subject 107 (Economics) ? April 2001 ? Examiners? Report
Page 6
32 (i) S = -£100m + 0.3Y
= £200 million
(ii) dY =
1
1 - MPC
£100 million
where MPC is the marginal propensity to consumer
dY =
1
1 - 0.7
£100 million
Therefore, national income would rise by £333 million
(iii) Y = 100 + 0.7 Y + 500
Y = £2000 million
Therefore, C = 100 + 0.7(2,000)
C = £1,500 million
33 Crowding out is the short run consequence of expansionary fiscal policy. An
increase in government expenditure or lower taxation will increase national
income via the multiplier. The higher level of national income will increase the
precautionary and transactions demand for money. Assuming that money supply
is unchanged the higher demand for money will force up interest rates. The
PSBR will also increase.
The fact that expansionary fiscal policy leads to higher interest rates will
adversely affect (crowd out) private consumption and investment.
Increased public borrowing and higher interest rates might lead to large capital
inflows and exchange rate appreciation which will adversely affect (crowd out)
net exports.
34 (i) If the authorities conduct a contractionary open market operation, they
will sell Treasury bills. The price of treasury bills will fall and the money
supply will fall.
(ii) If monetary policy is sufficiently expansionary as to raise the expected
rate of inflation and increase risk, then this will lead market participants
to seek a higher longer-term rate of interest to compensate them for the
increased inflation and risk. The result is that the long term rate of
interest will rise and the price of government bonds will fall.
Subject 107 (Economics) ? April 2001 ? Examiners? Report
Page 7
35 (i) A direct tax is a tax on a payment made to a factor of production, e.g.
wages, rent and interest.
(ii) An indirect tax is a tax on expenditure. An indirect tax is a tax paid when
a good is sold or a service provided, e.g. VAT, excise duty and customs
duty.
(iii) A tax is said to be progressive if it takes an increasing proportion of a
person?s income as income rises.
(iv) A tax is said to be regressive if it takes a decreasing proportion of a
person?s income as income rises.
36 (i) True
(ii) False
(iii) True
(iv) False
37 (i) In an oligopolistic market:
• There are only a small number of firms whereas in a monopoly there is
just one firm.
• There is a high degree of interdependence between firms. This means
that firms have to take into account decisions made by other firms
when making their price and output decisions. This is a problem that
a monopolist does not have to worry about although there might be
concerns about potential competition if price is set too high.
• Each firm has only a share of the market demand curve whereas for a
monopoly the market demand curve is the firm?s demand curve.
• Each firm may be selling either identical or differentiated products
and they tend to compete with each other on both price and quality. A
monopolist may also produce just one good or a variety of goods.
• There are barriers to entry in both market structures although they
tend to be stronger in the case of a monopoly. The existence of
barriers to entry means that there is the potential to make abnormal
profits in the long run in both market structures but clearly a
monopolist would have the potential to yield superior abnormal profits
compared to firms operating in an oligopolistic market structure.
[10]
Subject 107 (Economics) ? April 2001 ? Examiners? Report
Page 8
Price
P1
a
b
MR
Demand (AR)
MC
Q1 Quantity
(ii) It is sometimes observed that prices in an oligopolistic market structure
tend be sticky. This can be explained with reference to the ?kinked?
demand theory. According to this theory an oligopolistic firm may be
reluctant to raise prices from their current level because it believes that
the other firms will not raise theirs. Hence the demand curve facing the
firm is perceived to be highly elastic above the current price. Conversely,
if the firm cuts its price it believes that the other firms will retaliate and
cut theirs and so it will not gain that many extra customers. Hence the
demand curve facing the firm is perceived to be inelastic below the current
price. This is depicted in the diagram below.
The perceived demand curve is elastic above the current price P1 and is
perceived to be inelastic below that price. The kink in the demand curve
means that so long as the marginal cost (MC) fluctuates between the
region a?b where there is a discontinuity in the marginal revenue curve,
then there is no reason for the firm to change its price. This combined
with the fear of losing too many customers when raising prices and losing
revenue when cutting prices may help explain the sticky prices that are
sometimes observed under oligopoly.
Faculty of Actuaries Institute of Actuaries
EXAMINATIONS
6 September 2001 (am)
Subject 107 ? Economics
Time allowed: Three hours
INSTRUCTIONS TO THE CANDIDATE
1. Write your surname in full, the initials of your other names and your
Candidate?s Number on the front of the answer booklet.
2. Mark allocations are shown in brackets.
3. Attempt all 36 questions. From question 27 onwards begin each answer on a
separate sheet.
Graph paper is not required for this paper.
AT THE END OF THE EXAMINATION
Hand in BOTH your answer booklet and this question paper.
In addition to this paper you should have available
Actuarial Tables and an electronic calculator.
Faculty of Actuaries
107?S2001 Institute of Actuaries
107 S2001?2
For questions 1?26 indicate in your answer booklet which one of the answers A, B, C or D
is correct.
1 In a particular economy the value added by all firms is the same in 2001 as in
2000. However, consumption is £100m lower. Compared with 2000:
A GDP will be £100m lower in 2001
B expenditure on final goods and services will be lower in 2001
C incomes will be lower in 2001
D investment in inventories will be higher in 2001 [1½]
2 Assume that the actual rate of unemployment is above the natural rate of
unemployment because the expected rate of inflation is above the actual rate of
inflation. If the expected rate of inflation falls to equal the actual rate of inflation
then real wages will:
A fall and real output will rise
B fall and real output will fall
C rise and real output will rise
D rise and real output will fall [1½]
3 The top rate of income tax is cut from 50% to 45%. Other things remaining the
same, the effect on the multiplier will be:
A a rise
B a fall
C no change
D uncertain [1½]
4 The government is planning an increase of £100m in public spending on goods
and services. By choosing to finance the increase with extra taxation rather than
public borrowing, the resulting equilibrium level of national income would be:
A higher
B lower
C the same
D uncertain [1½]
5 Which of the following is not part of the measure of money supply known as
sterling M3?
A £1 held as a coin by an individual.
B £1 held in a private sector building society account.
C £1 held in a private sector sterling time deposit.
D £1 held in a private sector cheque account. [1½]
107 S2001?3 PLEASE TURN OVER
6 An increase in the money supply will have a bigger impact on real output the
more:
A interest elastic is the demand for money and the more interest elastic is
the level of investment
B interest inelastic is the demand for money and the less interest elastic is
the level of investment
C interest elastic is the demand for money and the less interest elastic is the
level of investment
D interest inelastic is the demand for money and the more interest elastic is
the level of investment [1½]
7 The relationship between planned investment and the rate of interest is:
A positive because at higher interest rates the returns to investment are
higher
B negative because at higher interest rates the returns to investment are
higher
C negative because the interest rate is the opportunity cost of capital
D positive because the interest rate is the opportunity cost of capital [1½]
8 If both government spending and the money supply are increased:
A national income and interest rates will both rise
B national income and interest rates will both fall
C the effect on both national income and interest rates is uncertain
D national income will rise but the effect on interest rates is uncertain [1½]
9 Which of the following does not cause a shift in the demand curve for Good X?
A A change in the price of Good X.
B A change in the price of a substitute Good Y.
C A change in consumer incomes.
D A change in consumer tastes. [1½]
107 S2001?4
10 Which of the following is not correct?
A A Giffen good is a good for which the income elasticity of demand is
positive.
B An inferior good is a good for which the income elasticity of demand is
negative.
C A normal good is a good for which the income elasticity of demand is
positive.
D A luxury good is a good for which the income elasticity of demand is
greater than 1. [1½]
11 A consumer can spend his or her entire income by buying either 28 units of
Good X or 35 units of Good Y. If the quantity of Good X is represented on the
vertical axis, and the quantity of Good Y is represented on the horizontal axis,
the slope of his or her indifference curve at maximum utility is:
A -1.25
B -0.80
C 1.25
D 0.80 [1½]
12 A consumer?s demand curve for Good X is represented by the equation
Qx = 50 ? 0.2Px
where Qx is the quantity of Good X demanded and Px is the price of Good X.
A producer?s supply curve for Good X is represented by the equation
Qx = 10 + 0.6Px
where Qx is the quantity of Good X supplied and Px is the price of Good X.
Demand and supply are in equilibrium when:
A Qx is 20 and Px is 150
B Qx is 30 and Px is 100
C Qx is 35 and Px is 75
D Qx is 40 and Px is 50 [1½]
107 S2001?5 PLEASE TURN OVER
13 For a profit maximising firm fixed costs are £20 and the owner?s opportunity cost
is £10. The marginal costs of production are shown in the table below. The firm
faces a horizontal demand curve where price is £50. How much supernormal
profit does the firm make?
Quantity Produced Marginal cost (£)
1 20
2 30
3 40
4 50
5 60
6 70
A £30
B £40
C £50
D £60 [1½]
14 Which of the following views will be held by a typical Keynesian?
A Markets work efficiently.
B Most individuals suffer from money illusion.
C Increased government spending will do little to influence the level of
economic growth.
D Supply side policies should be used to improve the efficiency of
markets. [1½]
15 Other things being equal, in the long run higher government expenditure:
A will reduce demand for money
B will increase net exports
C will reduce interest rates
D will increase the rate of inflation [1½]
16 The socially optimal output for a monopoly is at the point where:
A the marginal cost curve cuts the marginal revenue curve
B the marginal cost curve cuts the demand curve
C the average cost curve cuts the marginal revenue curve
D the average cost curve cuts the demand curve [1½]
107 S2001?6
17 Which of the following features is not a typical characteristic of oligopoly?
A A kinked demand curve.
B Supernormal profits.
C A belief that one firm?s actions have little influence on the actions of other
firms.
D Advertising. [1½]
18 Other things remaining the same, the effect of an increase in the Public Sector
Debt Repayment is:
A lower short term interest rates because the IS curve shifts to the left
B higher short term interest rates because the IS curve shifts to the right
C lower short term interest rates because the LM curve shifts to the right
D higher short term interest rates because the LM curve shifts to the left
[1½]
19 All other things being equal, which of the following will not increase the Public
Sector Borrowing Requirement:
A an increase in local government expenditure
B an increase in grants from central government to nationalised industries
C an increase in transfer payments
D an increase in the interest rate paid on the national debt [1½]
20 A consumer spends all her income on Good X and Good Y in such a combination
that the marginal utility of Good X is one third of the marginal utility of Good Y.
If the price of Good X is £30 and the price of Good Y is £10 then:
A the consumer cannot increase her total utility
B to maximise total utility the consumer needs to increase the consumption
of Good X so that the marginal utility from Good X is equal to the
marginal utility from Good Y
C to maximise total utility the consumer needs to decrease the consumption
of Good X so that the marginal utility from Good X is equal to the
marginal utility from Good Y
D to maximise total utility the consumer needs to rearrange consumption so
that the marginal utility from consuming Good X is three times the
marginal utility from consuming Good Y [1½]
107 S2001?7 PLEASE TURN OVER
21 When taxes on all income are regressive:
A the marginal tax rate will initially be less than but eventually be greater
than the average tax rate
B the marginal tax rate will initially be greater than but eventually be less
than the average tax rate
C the marginal tax rate will always be greater than the average tax rate
D the marginal tax rate will always be less than the average tax rate [1½]
22 Which of the following cases is true?
A Where demand is price elastic, the effect of a price change on the quantity
demanded will tend to be small.
B If demand is price inelastic, a cut in price will increase revenue.
C Demand is said to have unit elasticity when the own price elasticity of
demand is 1.
D Where demand is elastic, the own price elasticity of demand is more
negative than ?1. [1½]
23 Which of the following assumptions is usually made when drawing indifference
curves?
A It is difficult for consumers to choose between two different bundles of
goods.
B Indifference curves nearer to the origin yield higher utility.
C The prices of goods are fixed.
D Consumer preferences exhibit diminishing marginal substitution. [1½]
24 Which of the following is not a direct tax?
A A tax on interest.
B A tax on professional fees.
C A tax on rent.
D A tax on company profits. [1½]
107 S2001?8
25 The following table gives a breakdown of a firm?s average cost and average
revenue at various levels of output.
Output Average cost Average revenue
1 15 20
2 13 19
3 12 18
4 12 15
5 14 12
6 16 9
Which of the following is true?
A The marginal cost of producing the fourth item is greater than that of
producing the first item.
B The marginal cost of producing the fourth item is less than the marginal
revenue from selling the fourth item.
C The marginal revenue from selling the sixth item is negative.
D The marginal revenue from selling the fifth item is the same as that from
selling the fourth item. [1½]
26 In perfect competition:
A the price charged to customers is equal to marginal cost
B the demand curve faced by each firm is inelastic
C there may be difficulty for some firms in exiting the industry
D there are no supernormal profits in the short run [1½]
27 Explain, with the use of demand and supply curves, how a per unit subsidy on a
good will affect the price paid by consumers (the net price), the price received by
producers (the gross price) and the equilibrium quantity traded when the subsidy
is given to:
(i) consumers [3]
(ii) producers [3]
[Total 6]
28 (i) Define the marginal product of labour. [1]
(ii) State the relationship between the marginal productivity of labour and
short run marginal costs. [1]
(iii) Define the marginal revenue product of labour and explain its
relationship with the marginal productivity of labour. [2]
[Total 4]
107 S2001?9 PLEASE TURN OVER
29 Discuss, with the aid of diagrams, why monopolists may engage in price
discrimination. [6]
30 Define the following types of unemployment:
(i) structural unemployment [1]
(ii) demand-deficient unemployment [1]
(iii) technological unemployment [1]
(iv) frictional unemployment [1]
[Total 4]
31 Describe briefly five different reasons why long run average costs might fall as
output is increased. [5]
32 Explain the differences between a centrally controlled economy and a free market
economy. [4]
33 Discuss briefly, with examples, four factors which influence price elasticity of
demand. [4]
34 (i) Explain briefly, with the use of a diagram, the circular flow of income in
an open economy with a government. [4]
(ii) State three equivalent ways of defining Gross Domestic Product. [1]
[Total 5]
35 You are given the following information on an economy.
National income at factor cost £300bn
Consumption £200bn
Transfer benefits £10bn
Direct taxes £50bn
Indirect taxes £30bn
Government spending £40bn
Investment £30bn
Exports £80bn
(i) Calculate the surplus or deficit in the private sector. [1]
(ii) Calculate the surplus or deficit in the government sector. [1]
(iii) Calculate the surplus or deficit in the foreign sector. [1]
[Total 3]
107 S2001?10
36 (i) Discuss the effectiveness of monetary and fiscal policy with fixed and
floating exchange rates. [10]
(ii) Discuss the advantages and disadvantages of fixed and floating exchange
rates which a government would take into consideration when deciding
which system to operate. [10]
[Total 20]
Faculty of Actuaries Institute of Actuaries
EXAMINATIONS
September 2001
Subject 107 ? Economics
EXAMINERS? REPORT
Faculty of Actuaries
Institute of Actuaries
Subject 107 (Economics) ? September 2001 ? Examiners? Report
Page 2
Overall comments
Many candidates wasted time by writing answers which were too long and which lacked
focus. Candidates who did well tended to have short, clear text supported by simple and
accurate diagrams.
Once again the general standard of diagrams was poor. Many diagrams were drawn
freehand (without a ruler). Sloppy work can lead to deduction of marks for lack of
clarity. Many diagrams were also too small for the answers to be clear. Candidates
should use rulers, and diagrams should be of a sufficient size to show movements
clearly.
Individual comments
Q1-Q26 The multiple choice questions were generally well answered. The questions
which caused the main problems were numbers 4, 6, 18, 19 and 21. Of these, 4
was answered incorrectly most often.
Q27 Reasonably answered. Many candidates failed to give a clearly reasoned
response. Many did not distinguish between net and gross price, often only
discussing ?price?.
Q28 Reasonably answered. Most candidates defined the terms correctly (although
most students missed the assumption of all other factors remaining constant)
but few were able to answer part (iii). Some students were unable to distinguish
between marginal product and marginal revenue product.
Q29 Badly answered. The most common mistake was for candidates to waste time
talking in general about monopolies, spending too little time talking about the
question on price discrimination. While most candidates were able to describe
price discrimination, few gave a comprehensive explanation of its effects on a
monopolist?s revenue and profits.
Q30 Well answered by most. Some students just gave examples of the different
types of unemployment rather than defining.
Q31 Very well answered.
Q32 Reasonably answered. Many candidates failed to describe the free market
situation fully.
Q33 Well answered by most, though some candidates described a shift, rather than a
movement, in demand. Some candidates gave either a description of the factor,
or an example, rather than both.
Subject 107 (Economics) ? September 2001 ? Examiners? Report
Page 3
Q34 Reasonably answered. In part (i), most candidates produced a good diagram
though many failed to explain fully their abbreviations. The most common
errors were mixing up direct and indirect taxes, and the flow directions of
exports and imports. In part (ii), there were many cryptic answers and few got
the correct definitions. Reference to the domestic economy was usually missed.
Q35 While part (ii) was reasonably answered, part (i) and particularly part (iii) were
badly answered.
Q36 Poorly answered. Candidates getting high marks divided the question and gave
well thought out, structured answers. Candidates getting lower marks tended to
use more of a ?scattergun? approach. In part (i), many candidates wasted time
describing the terms used rather than discussing the effects. Part (ii) was
usually answered slightly better.
Subject 107 (Economics) ? September 2001 ? Examiners? Report
Page 4
1 D
2 A
3 A
4 B
5 B
6 D
7 C
8 D
9 A
10 A
11 B
12 D
13 A
14 B
15 D
16 B
17 C
18 C
19 B
20 D
21 D
22 D
23 D
24 B
25 C
26 A
Subject 107 (Economics) ? September 2001 ? Examiners? Report
Page 5
27 (i) A subsidy given to consumers per unit of the good purchased will
encourage consumers to increase demand. This is shown by an upward
shift in the demand curve (D1 to D2). The price paid by consumers (the
net price) will decrease (P1 to P2), the price received by producers (the
gross price) will increase (P1 to P3). The equilibrium quantity traded will
increase (Q1 to Q2).
(ii) A subsidy given to producers per unit of the good supplied will encourage
producers to increase supply. This is shown by a downward shift in the
supply curve (S1 to S2). The price paid by the consumer (net price) will
decrease (P1 to P2), the price received by the producers (gross price) will
increase (P1 to P3). The equilibrium quantity traded will increase (Q1 to
Q2).
Price
P3
P1
P2
S1
S2
Q1 Q2 Quantity
D
S
Price
P3
P1
P2
Q1 Q2 Quantity
D2
D1
Subject 107 (Economics) ? September 2001 ? Examiners? Report
Page 6
28 (i) The marginal product of labour is the increase in total output obtained by
employing one extra worker, holding the amount of other factor inputs
constant.
(ii) Assuming that labour is the only variable input, there is a direct inverse
relationship between the marginal productivity of labour and short run
marginal costs.
(iii) The marginal revenue product of labour is the change in the firm?s total
revenue when it sells the output of each extra worker.
Diminishing marginal productivity means that marginal productivity
falls. Additionally, as output rises, the price has to fall so marginal
revenue may be quite low. Therefore marginal revenue product of labour
can fall quite steeply.
29

A monopolist who cannot price discriminate will maximise profits by equating
marginal cost with marginal revenue and producing this output.
However, because monopolies face no competition, they may be able to charge
different prices to different consumers or groups of consumers. This is known as
price discrimination.
If it is possible for a firm to use price discrimination, it will be profitable for the
firm to do so. The monopoly will be able to expand its output and increase its
profits.
Price
P*
MC
AC
MR1 DD
Q1 Quantity
Subject 107 (Economics) ? September 2001 ? Examiners? Report
Page 7
Perfect price discrimination would allow a monopolist to operate at the socially
optimal point increasing output to Q2 in the diagram below. The old demand
curve now becomes the new marginal revenue curve (MR2). The perfectly price
discriminating monopolist makes additional profit on the quantity of goods he
used to sell, consisting of the triangle bounded by the area between MR1, MR2
and the vertical line going through Q1. He also makes profit from the extra
quantity now produced, from the triangle bounded by MR2, MC and the vertical
line going through Q1.

30 (i) Structural unemployment arises because of a mismatch between the skills
that employers require, and the skills that the unemployed possess. This
can be caused by the fact that at any time, some industries are in decline,
while others are growing.
(ii) Demand-deficient unemployment arises due to fluctuations in national
output that occur due to the business cycle giving temporary periods of
deficient demand.
(iii) Technological unemployment arises when the need to employ workers
with certain skills declines even if the industry as a whole is not in
decline.
(iv) Frictional unemployment refers to the level of unemployment that would
still exist in a well functioning economy in the absence of any other
problems. It will include, for example, people who have left one job to look
for another one.
Price
Q1 Q2 MR1 Quantity
DD=MR2
MC
AC
Subject 107 (Economics) ? September 2001 ? Examiners? Report
Page 8
31 Any five of the following.
Spreading of fixed costs: for example doubling output is unlikely to require
double the number of administrative staff; marketing and R&D costs are often
independent of output levels.
Specialisation: division of labour allows people to become experts at small parts
of the production process, increasing output per person. Similarly with machines.
Physical economies: these can arise because an increase in the volume of a
physical object, e.g. a storage tank, requires a less than proportionate increase in
surface area.
Finance: larger firms may be seen as being more credit worthy, and should face
lower interest costs.
Bulk purchases: a larger firm is able to exert more pressure on suppliers to set
low prices.
By-products: some production processes produce small amounts of potentially
useful by-products. It may not be worthwhile selling this unless the scale of
production is sufficiently large.
The principle of multiples: different machines needed in the production process
may have different capacities. In this case full use of all machines? capacities may
only be possible at high output levels.
32 In a centrally controlled economy, a central agency decides what is to be
produced, how it is to be produced, and for whom it is to be produced. In this
context a central agency is a government department, staffed by economists and
administrators, who will try to make sure that the decisions they make produce a
consistent plan. In practice, some local control may exist over the method of
production and consumers retain some choice as to which goods they consume.
In a free market economy there is no government intervention. The interaction of
supply and demand, driven by individuals acting in their own self interest, solves
all the allocation questions. The goods produced are those for which the amount
that consumers are willing to pay exceeds the cost of production. The methods of
production are the ones that minimise the costs of production. Consumption
patterns are determined by which goods and services consumers are willing and
able to pay for.
Subject 107 (Economics) ? September 2001 ? Examiners? Report
Page 9
33 Broadness of product definition: it is easier to find a substitute for a product
which is narrowly defined, for example the elasticity of demand will be greater
for one particular chocolate bar than it will be for chocolate as a whole.
The length of time considered: it is easier to find and make use of a substitute in
the long run than in the short run. For example, in the short run the elasticity of
demand for petrol will be less than it will be in the long run, as people can switch
to vehicles that use different fuels.
The degree of brand loyalty or addiction: if people are very loyal to a particular
brand, or are addicted to a particular product, the elasticity of demand will be
less. For example, if people are loyal to a particular type of jeans, there will be a
lower elasticity of demand.
The proportion of consumers? incomes spent on the good: if people spend a large
proportion of their income on a good the elasticity of demand will be lower than if
they spend a small proportion. For example, if somebody spends a large
proportion of their income on food the elasticity of demand will be lower than
somebody who spends a small proportion.
34 (i) The circular flow is the flow of money from firms to households (in return
for the factor services provided) and from households to firms (in return
for goods and services provided).
Firms pay income (Y) to households. Direct taxes (Td) are paid out of this
income to the government, but transfer benefits (B) are also paid from the
government to supplement households? incomes.
Households spend all their income on either consumption (C) or savings
(S). Indirect taxes (Te) are paid to the government on what they consume.
Government
Firms Households
C
G Te S
B
Td
Y
I
X Z
Subject 107 (Economics) ? September 2001 ? Examiners? Report
Page 10
Firms receive government expenditure (G) and also investment
expenditure (I) and payment for exports (X), but pay out for imports (Z).
(ii) Expenditure in the domestic economy.
The value added by all firms located in the domestic economy.
The factor incomes of all factors of production located in the domestic
economy.
35 (i) S = Y Td + B C
S = 300b 50b + 10b 200b
= 60b
I = 30b
S I = 30b
Private sector surplus = £30b
(ii) Tax revenues = Td + Te
= 50b + 30b
= 80b
Government expenditure = G + B
= 40b + 10b
= 50b
Government sector surplus = £30b
(iii) Y = C + I + G + X Z Te
300b = 200b + 30b + 40b + 80b Z 30b
Z = 20b
Z ? X = 20b 80b
= 60b
Foreign sector deficit of £60b
Subject 107 (Economics) ? September 2001 ? Examiners? Report
Page 11
36 (i) Monetary policy with floating exchange rates
A reduction in the money supply increases interest rates (by shifting the
LM curve to the left) and reduces price inflation (as explained by the
quantity theory of money).
Under floating exchange rates, higher interest rates will increase the
value of the currency.
A higher exchange rate will reduce both cost push inflation and demand
pull inflation (by reducing net exports).
Thus, floating exchange rates make monetary policy more effective at
controlling price rises.
Monetary policy with fixed exchange rates
If interest rates are higher in country A than in country B, with a fixed
exchange rate money from abroad will flood in from country B to country
A, as there is no possibility of exchange rate depreciation.
To maintain the fixed exchange rate the government will have to sell the
domestic currency to meet the demand for money.
Selling the domestic currency increases the money supply and pushes
interest rates down, towards the level in country B.
Thus, an independent monetary policy is not possible under fixed
exchange rates.
Fiscal policy with floating exchange rates
An increase in government expenditure tends to increase interest rates
(as the IS curve shifts to the right).
Under a floating exchange rate the rise in interest rates will lead to an
increase in the value of the currency.
The increase in the value of the domestic currency will reduce net exports,
worsening the effects of crowding out.
Thus fiscal policy is less effective with floating exchange rates.
Fiscal policy with fixed exchange rates
With fixed exchange rates, interest rates must be maintained at the world
level.
Subject 107 (Economics) ? September 2001 ? Examiners? Report
Page 12
Normally, when an expansionary fiscal policy is introduced, private sector
consumption and investment is crowded out by higher interest rates and
higher prices.
Under fixed exchange rates interest rates cannot be allowed to rise, which
limits the amount of crowding out that can occur.
Hence fiscal policy is more effective with fixed exchange rates.
(iii) Advantages of fixed exchange rates
Fixed exchange rates give greater certainty, and hence encourage foreign
trade, allowing the potential gains from trade to be realised.
Fixed exchange rates can lead to lower inflation when the domestic
currency is fixed relative to a low inflation currency.
Under fixed exchange rates, interest rates must stay at the world level, so
Keynesian crowding out is less likely to occur. (Although the government
could just increase money supply which would have the same effect.)
Fixed exchange rates may in some circumstances add to political, social
and economic harmonisation.
Disadvantages of fixed exchange rates
If there is a balance of payments deficit, the level of domestic aggregate
demand must be reduced, which can have serious effects in terms of
higher unemployment and lost output.
Usually a balance of payments deficit can be corrected by reducing the
value of the domestic currency, which is not an option with fixed exchange
rates.
The government may find it difficult in practice to maintain a fixed
exchange rate, as there may be a lot of money speculating in case of a
devaluation.
Fixed exchange rates can be maintained by imposing controls on capital
flows, together with quotas and tariffs. This is economically inefficient as
it prevents a globally pareto optimal allocation of resources.
Advantages of floating exchange rates
Monetary policy can be conducted independently of other countries
without the need for controls on the movement of capital.
A floating exchange rate will tend to move to automatically offset a
balance of payments deficit or surplus.
Subject 107 (Economics) ? September 2001 ? Examiners? Report
Page 13
There is no need for the central bank to hold large amounts of gold and
foreign currencies, as the government need not intervene in foreign
exchange markets.
Disadvantages of floating exchange rates
The major disadvantage of floating exchange rates is that they introduce
uncertainty into foreign trade transactions.
However, traders can alternatively use financial markets to carry out
forward exchange deals to protect themselves against unexpected
movements.
Faculty of Actuaries Institute of Actuaries
EXAMINATIONS
16 April 2002 (am)
Subject 107 ? Economics
Time allowed: Three hours
INSTRUCTIONS TO THE CANDIDATE
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
3. Mark allocations are shown in brackets.
4. Attempt all 37 questions. From question 27 onwards begin each answer on a separate
sheet.
Graph paper is not required for this paper.
AT THE END OF THE EXAMINATION
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
In addition to this paper you should have available Actuarial Tables and
your own electronic calculator.
Faculty of Actuaries
107?A2002 Institute of Actuaries
107 A2002?2
For questions 1?26 indicate in your answer booklet which one of the answers A, B, C or D is
correct.
1 Good X has a cross elasticity of demand with respect to Good Y which is equal to
minus unity (1). Good X is which of the following with respect to Good Y?
A A perfect substitute.
B An imperfect substitute.
C A perfect complement.
D An imperfect complement. [1½]
2 Which of the following will result from the imposition of a 10 per cent sales tax on
Good X, the demand for which has an own price elasticity of demand equal to ?1?
A A rise in the price of Good X by 10 per cent.
B A rise in the price of Good X by less than 10 per cent.
C A rise in the price of Good X by 20 per cent.
D No change in the price of Good X.
[1½]
3 Consider the budget line of a consumer that consumes only two Goods X and Y, with
the quantity of Good X represented on the horizontal axis and the quantity of Good Y
represented on the vertical axis. If money income is unchanged, the price of Good X
falls by 50% and the price of Good Y rises by 50% the net result will be to:
A shift the entire budget line to the left
B shift the entire budget line to the right
C make the budget line steeper
D make the budget line less steep [1½]
4 A movement along a consumer?s indifference curve from left to right means that the
consumer?s:
A utility will rise
B utility will fall
C utility will be unchanged
D money income is unchanged [1½]
5 If the income elasticity of demand for Good X is 2, a rise in all consumers? disposable
incomes from £50 million to £52 million will increase the quantity demanded of Good
X by:
A 2%
B 4%
C 6%
D 8% [1½]
107 A2002?3 PLEASE TURN OVER
6 Which one of the following statements about short run costs is FALSE?
A Marginal cost is equal to average variable cost when average variable cost is at
a minimum.
B Average fixed costs always fall as output rises.
C Average total costs exceed average variable costs by an amount that increases
with increasing output.
D Marginal costs of production can be above or below average total costs.
[1½]
7 Diseconomies of scale means:
A short run average total cost increases as output rises
B long run average total cost increases as output rises
C the price of a product increases as output rises
D the total cost of a product increases as output rises [1½]
8 A perfectly competitive firm is producing at a level of output where short run
marginal cost exceeds marginal revenue. What should the firm do to maximise its
short run profits?
A Reduce its output.
B Raise its output.
C Raise its price.
D Reduce its price. [1½]
9 A monopoly firm facing a linear demand schedule and having positive but constant
marginal costs is currently producing where its marginal cost is below its marginal
revenue. If the firm wishes to maximise profits then it should:
A lower its price and increase output
B raise its price and increase output
C lower its price and decrease output
D raise its price and decrease output [1½]
107 A2002?4
10 Which one of the following statements about market structure is TRUE?
A Perfect competition is distinguished from all other market structures because
of the assumption of no barriers to entry/exit from the industry.
B Firms under monopolistic competition face horizontal demand curves for their
products.
C A monopoly will find that its average revenue is always greater than its
average costs.
D Under perfect competition, in the long run, each firm will find that its
marginal cost is equal to its average cost of production. [1½]
11 Total Revenue from the sale of a good will decrease if:
A income increases and the good is normal
B income falls and the good is inferior
C its price rises and demand is price inelastic
D its price rises and demand is price elastic [1½]
12 Which one of the following does NOT follow from the ?kinked? demand curve theory
of oligopoly?
A The oligopolist will seek to maximise profits.
B There is a discontinuity in the marginal revenue curve of the oligopolist.
C There is a discontinuity in the average revenue curve of the oligopolist.
D There is a kink in the average revenue curve of the oligopolist. [1½]
13 If the government imposes a price ceiling on Good X which exceeds the equilibrium
price then for Good X:
A the price will rise above the equilibrium price
B the market price will prevail
C a shortage will arise
D a surplus will arise [1½]
107 A2002?5 PLEASE TURN OVER
14 You are given the following data on the relationship between national income (Y) and
consumer expenditure (C) in a closed economy with no taxes:
Y 100 120 140
C 80 96 112
What is the value of the simple Keynesian multiplier?
A 0.8
B 1.25
C 4
D none of the above [1½]
15 The accelerator principle states that:
A investment is increased when interest rates fall
B an increase in national income can lead to a more than proportionate increase
in the level of investment
C an increase in investment can lead to a more than proportionate increase in
national income
D the rate of change of investment affects the rate of change of output [1½]
16 The following table contains output and expenditure data for an economy:
£ billions
Consumption (at market prices) 300
Investment (at market prices) 90
Government spending (at market prices) 100
Net Exports (at market prices) 10
Net Property income from abroad 15
Indirect taxes 60
Gross Domestic Product at FACTOR COST and Gross National Product at MARKET
PRICES are respectively:
A 420, 495
B 480, 435
C 420, 435
D 480, 495 [1½]
107 A2002?6
17 Which of the following will decrease the size of the multiplier?
A A decrease in the marginal propensity to save.
B An increase in the marginal propensity to consume.
C An increase in the marginal rate of taxation.
D A decrease in government expenditure. [1½]
18 In an open economy with a government sector, which one of the following conditions
will ensure that national income and expenditure are equal?
Given:
S = Savings , I = Investment, T = Taxation, G = Government expenditure
B = Transfer Payments, Z = Import expenditure, X = Export receipts,
C = Consumer expenditure
A S + T + Z = I + G + C + X
B S + T + Z = I + G + B + X
C S + T + C = I + G + B + X
D None of the above. [1½]
19 The quantity theory of money in its simplest form assumes that the:
A velocity of circulation and nominal output are reasonably stable
B ratio of the velocity of circulation to the price level is reasonably stable
C ratio of the money supply to the velocity of circulation is reasonably stable
D velocity of circulation and real output are both reasonably stable [1½]
20 Which one of the following is the most accurate description of the National Debt?
A The annual gap between total government tax receipts and total government
expenditure.
B The total amount owed by a country to the rest of the world.
C The net accumulation of a country?s budget deficits.
D The net accumulation of a country?s balance of payments deficits. [1½]
21 A contractionary open market operation by the central bank will result in a fall in the
money supply and:
A a fall in the short term rate of interest and a fall in the price of treasury bills
B a fall in the short term rate of interest and a rise in the price of treasury bills
C a rise in the short term rate of interest and a fall in the price of treasury bills
D a rise in the short term rate of interest and a rise in the price of treasury bills
[1½]
107 A2002?7 PLEASE TURN OVER
22 In the event of a recession in the economy, automatic stabilisers would be expected
to:
A raise government expenditure and reduce tax revenue
B raise government expenditure and raise tax revenue
C reduce government expenditure and raise tax revenue
D reduce government expenditure and reduce tax revenue [1½]
23 Which one of the following will lead to the most crowding out after an increase of
government expenditure?
A The demand for money is interest elastic and private investment is interest
inelastic.
B The demand for money is interest inelastic and private investment is interest
elastic.
C The demand for money and private investment are both interest inelastic.
D The demand for money and private investment are both interest elastic.
[1½]
24 The nominal rate of interest is 2% and the rate of inflation is negative at 3%. Which
one of the following is TRUE?
A The real rate of interest is negative.
B The rate of inflation is greater than the real rate of interest.
C The real rate of interest is greater than the nominal rate of interest.
D The real rate of interest is 1%. [1½]
25 The current equilibrium dollar ($) per pound (£) exchange rate is $1.50/£1. The
forecast for inflation rates for the next year are 8% for the United Kingdom and 3%
for the United States. What would be the forecast for the equilibrium dollar-pound
exchange rate one year from now if purchasing power parity is used?
A $1.67/£1
B $1.58/£1
C $1.43/£1
D $1.34/£1 [1½]
107 A2002?8
26 Other things being equal, which one of the following statements is always TRUE?
A An appreciation of a country?s exchange rate will increase its import volumes
and decrease its export volumes.
B An appreciation of a country?s exchange rate will increase its import
expenditure and decrease its export revenues.
C A depreciation of country?s exchange rate will decrease its import volumes
and decrease its export volumes.
D A depreciation of a country?s exchange rate will decrease its import
expenditure and decrease its export revenues. [1½]
27 A consumer has £2.00 of income which is entirely spent on Good X and Good Y.
Good X costs 20 pence, Good Y costs 40 pence.
The relevant marginal utilities for the consumer are:
Quantity Marginal Utility Quantity Marginal Utility
of Good X of Good X of Good Y of Good Y
1 100 1 170
2 80 2 120
3 60 3 80
4 40 4 60
5 20 5 50
6 10 6 40
(i) Calculate the quantity of Good X and quantity of Good Y the utility
maximising consumer will buy. [2]
(ii) State the total utility of the consumer when he is maximising his satisfaction.
[1]
(iii) If the consumers income is doubled to £4 and the price of Good X is doubled
to 40 pence, what will be the new utility maximising quantities of Goods X
and Y purchased? [1]
[Total 4]
107 A2002?9 PLEASE TURN OVER
28 A producer has constant average total costs of production of £1 per unit of output
produced. The producer knows the following data on the weekly sales for Good X at
different price levels:
Price Quantity
(£?s) sold
3 300
4 250
5 200
6 150
(i) Draw a diagram to show the relationship between price (horizontal axis) and
total profit (vertical axis) from the above data. Indicate clearly the level of
profits at each price. [2]
(ii) Calculate the price elasticity of demand for a rise in price from £4.00 to £5.00.
[1]
(iii) Calculate the approximate marginal revenue associated with changing prices
from £5 to £6. [1]
[Total 4]
29 Draw a diagram for a profit maximising monopoly firm with constant marginal costs
at all levels of output making losses in the short run and yet finding it viable to
continue production. Use the following labels:
AR Average Revenue Curve
MR Marginal Revenue Curve
MC Marginal Cost Curve
AC Average Total Cost Curve
AVC Average Variable Cost Curve
Indicate the price (P1), quantity (Q1), average total cost (C1) and average variable
cost (AVC1) at the loss minimising level of output. [5]
30 (i) Describe the ?substitution effect? of a price change. [2]
(ii) Describe the ?income effect? of a price change. [2]
[Total 4]
31 (i) Explain briefly the problem of ?adverse selection? and how it might be dealt
with by insurance companies. [2]
(ii) Explain briefly the problem of ?moral hazard? and how it affects the price of
insurance. [2]
[Total 4]
107 A2002?10
32 Describe how the following might be taken account of in measures of national
income.
(i) a reduction in the value of assets due to wear and tear [2]
(ii) inflation [2]
[Total 4]
33 (i) Explain what the IS curve for a closed economy depicts. [2]
(ii) Explain two factors that may shift the IS curve to the right in a closed
economy. [2]
[Total 4]
34 State for each of the following whether the proposition is more likely to be Keynesian
or Monetarist.
(i) Both the short run and long run Phillips curves are vertical. [1]
(ii) Money and other financial assets are relatively close substitutes for one
another. This means that money demand is relatively elastic with respect to
changes in interest rates. [1]
(iii) Money demand can be highly unstable in both the short run and long run.
[1]
(iv) The IS curve is likely to be steep and the LM curve likely to be relatively flat.
[1]
[Total 4]
35 (i) Describe the differences between direct and indirect taxes and provide
examples of both. [2]
(ii) Describe the differences between progressive and regressive systems of
taxation and provide examples of both. [2]
[Total 4]
107 A2002?11
36 A perfectly competitive firm can sell its output of Good X for £20 per unit. Labour is
the only variable input and the daily wage rate is £100.
You are given the following information:
Quantity of Labour Output of Good X
Input (per day) (per day)
1 5
2 14
3 30
4 38
5 42
(i) Construct a table to show at each quantity of labour employed per day:
(a) the marginal product of labour
(b) the marginal revenue product of labour [2]
(ii) Determine the profit maximising quantity of labour input. [2]
[Total 4]
37 (i) Describe and discuss the various categories of unemployment that can exist in
an economy. [10]
(ii) Explain what is meant by the term ?economic growth? and discuss the various
factors that can raise the economic growth rate. [10]
[Total 20]
Faculty of Actuaries Institute of Actuaries
REPORT OF THE BOARD OF EXAMINERS ON
THE EXAMINATIONS HELD IN
April 2002
Subject 107 ? Economics
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however
given credit for any alternative approach or interpretation which they consider to be
reasonable.
K Forman
Chairman of the Board of Examiners
11 June 2002
Faculty of Actuaries
Institute of Actuaries
Subject 107 (Economics) ? April 2002 ? Examiners? Report
Page 2
1 D
2 B
3 D
4 C
5 D
6 C
7 B
8 A
9 A
10 D
11 D
12 C
13 B
14 D
15 B
16 A
17 C
18 B
19 D
20 C
21 C
22 A
23 B
24 C
25 C
26 A
Comment
The multiple-choice section was well answered by most candidates. However, a large
number of candidates answered question 1 incorrectly. Other questions that had a less than
satisfactory proportion of correct responses were questions 2, 9, 14, 18, 19 and 23.
Subject 107 (Economics) ? April 2002 ? Examiners? Report
Page 3
27 (i) 4X 3Y
(ii) 650
(iii) 4X 6Y
Comment
Generally well answered, though many candidates made numerical slips.
28 (i) Profit
(ii) The price elasticity of demand is given by:
% change in quantity demanded
% change in price
= 0.2/0.25 = 0.8
Answers of ?1 (and 1) also allowed as no change in total revenue
(iii) Marginal revenue from £5 to £6 = -£100/-50 = £2
Comment
Many diagrams were poorly drawn for part (i). Part (ii) was well answered, correct
responses of ?0.8 or ?1 (and 0.8 and 1) were allowed. Few determined the answer
to part (iii) correctly; most failed to divide the (negative) change in total revenue by
the (negative) change in the number of items sold. Answers of -2 were also allowed
in part (iii).
800
750
600
£3 £4 £5 £6
Profit
Price
Subject 107 (Economics) ? April 2002 ? Examiners? Report
Page 4
29
Comment
This question was very poorly answered with few candidates correctly deducing the
shape of the AC and AVC curves from the ?constant MC? criteria. This was despite
the fact that the word constant was written in italics on the exam paper. Most drew U
shaped AC and AVC curves, and many MC lines were increasing.
30 (i) The ?substitution effect? of a price change is the change in demand for a good
caused by the change in relative prices, holding the consumer?s level of utility
(or real income) constant.
(ii) The ?income effect? of a price change is the change in demand caused by a
change in the real income of a consumer when a price changes.
Comment
Quite well answered, though some candidates described a graphical representation,
often in complex detail, without a clear explanation of the terms requested. Maximum
marks were obtainable without the use of diagrams.
Output/Quantity
AVC1 MC/AVC
AC
Q1 MR AR
C1
P1
Price
Subject 107 (Economics) ? April 2002 ? Examiners? Report
Page 5
31 (i) Adverse selection refers to the fact that people who know that they are
particularly bad risks are more inclined to take out insurance than those who
know that they are good risks. To try to reduce the problems of adverse
selection insurance companies try and find out information about potential
policyholders. Policyholders can then be put in small, reasonably
homogeneous pools and charged appropriate premiums.
(ii) Moral hazard describes the fact that a policyholder may, because they have
insurance, act in a way which makes the insured against event more likely to
occur. Moral hazard makes insurance more expensive. It may even push the
price of insurance above the maximum premium that a person is prepared to
pay.
Comment
Very well answered
32 (i) The true reduction in the value of assets due to wear and tear is depreciation.
Depreciation must be deducted from GNP at factor cost in order to obtain the
measure of economic activity known as national income (net national product
at factor cost).
(ii) In order to take account of inflation it is necessary to convert nominal or
money values of national income, calculated using current prices, into real
values, calculated using constant prices, (prices which prevailed in some base
year). This is achieved by using the ?GNP deflator? The ?GNP deflator? takes
account of price changes in C, I, G, X and Z.
Comment
Well answered, though some candidates explained the microeconomic
issues or the effects on the economy.
33 (i) The IS curve for a closed economy shows different combinations of the rate of
interest and the level of national income for which the goods market is in
equilibrium, that is injections (investment plus government expenditure) equal
leakages (savings plus taxes).
(ii) The IS curve for a closed economy could shift to the right for a number of
reasons.
(a) a rise in investment caused by a rise in business confidence
(b) a fall in savings/rise in consumption caused by an increase in consumer
confidence
Subject 107 (Economics) ? April 2002 ? Examiners? Report
Page 6
(c) an increase in government expenditure
(d) a decrease in taxes
Comment
Part (ii) was poorly answered with many candidates describing reasons for a
movement along the IS curve, rather than a shift. Also the question specified a
closed economy and so open economy effects on the IS curve were not valid
answers.
34 (i) Monetarist
(ii) Keynesian
(iii) Keynesian
(iv) Keynesian
Comment
Most candidates answered (i) correctly but parts (ii)-(iv) were less well done.
35 (i) A direct tax is a tax on a payment made to a factor of production e.g. wages,
rent dividend/interest/company profits. Examples are: income tax, national
insurance payments, capital gains tax and corporation tax.
An indirect tax is a tax on expenditure. In other words, an indirect tax is a tax
paid whenever a good is sold, or a service provided. Examples are: value
added tax, excise duties on tobacco petrol and alcohol, licence fees for motor
cars and television, customs duties on imports.
(ii) A tax is said to be progressive if it takes an increasing proportion of a person?s
income as income rises. Examples include income tax where the rate of tax
increases with higher incomes and indirect taxes on goods and services on
which the rich spend a much higher proportion of income than do the poor.
A tax is said to be regressive if it takes a decreasing proportion of a person?s
income as income rises. Examples include indirect taxes on goods and
services on which the poor spend a much higher proportion of income than do
the rich.
Comment
Very well answered, with clear definitions given. The examples were not always
complete.
Subject 107 (Economics) ? April 2002 ? Examiners? Report
Page 7
36 (i) Quantity of Labour Marginal Product Marginal Revenue
Input (per day) of Labour Product of Labour
1 5 100
2 9 180
3 16 320
4 8 160
5 4 80
(ii) 4
Comment
Very well answered.
37 (i) There are a number of categories of unemployment including:
Frictional ? is the irreducible minimum amount of unemployment caused by
labour market turnover when new people enter the labour force and look for
jobs and existing workers change jobs. Frictional unemployment is most
easily identifiable when unemployment is low and the majority of the
workforce has been unemployed only for a short time.
Structural ? occurs because changes in the regional, occupational and
industrial structure of the demands for labour do not match changes in the
structure of the supply of labour. Changes in demand may be due to
international competition, e.g. shipping decline in UK, or new technology,
e.g. motor car industry. Many of the unemployed are from particular
declining sectors of an economy. Structural unemployment is often associated
with the decline of particular sector due to technological change. Such
unemployment is referred to as technological unemployment.
Regional ? occurs when a whole region is in decline due to closure of one or
more industries within the region. Regional unemployment is identifiable if
the unemployment in a particular region is substantially higher than other
regions of a country.
Demand Deficient/Keynesian ? is due to a lack of aggregate demand in the
economy as a whole. Affects all regions but some hit more than others. A
sign of Demand Deficient Unemployment is that the unemployment rate is
quite high across the whole country.
Real Wage Unemployment/Classical Unemployment ? occurs because real
wages are too high in relation to labour productivity. At the going real wage it
does not pay firms to employ all the labour force that is willing to work at the
real wage. A sign of real wage unemployment can be that real wages have
risen by more than can be justified by productivity increases.
Subject 107 (Economics) ? April 2002 ? Examiners? Report
Page 8
Seasonal Unemployment refers to unemployment caused by seasonal
fluctuations in the demand for labour. For example there is normally
increased unemployment in the construction industry in winter.
Modern analysis also makes a distinction between voluntary and involuntary
unemployment. Voluntarily unemployed are not willing to work at the going
real wages while the involuntary would work at the going real wage but
cannot find work. One key factor that may raise the amount of voluntary
unemployment is a rise in the net income with no work to net income when
working ratio.
(ii) The term ?economic growth? refers to increases in the real Gross Domestic
Product or real Gross National Product. The economic growth rate measure
the percentage increase in the real Gross Domestic Product from one year to
the next. Sometimes the term ?economic growth? refers to the increase in the
trend rate of real Gross Domestic Product rather than the actual increase in
output.
The economic growth rate can be raised by increases in the various inputs to
the production process (capital, labour and raw materials/land) and also by the
way that these inputs are utilised as measured by the state of technical
knowledge and economic efficiency.
Capital is a vital part of the production process and if the country increases its
capital stock through net new investment then this will tend to boost economic
growth. The capital stock will increase if the annual investment in new capital
is greater than the depreciation of the existing capital stock. Any net increase
in investment aids economic growth in two ways (i) by expanding the
productive base of the economy and (ii) the new capital is typically more
productive than the old capital which it replaces.
Labour is a vital part of the production process and increases in the quantity of
labour and improvements in its quality will tend to raise the economic growth
rate. The quantity of the labour force is determined by the size of the
population, the proportion of the population employed and working hours. In
addition improved education, training and health care improve the quality and
productivity of the labour force and so raise the economic growth rate. The
stock of ?human capital? will rise with better education and training and so
improve the economic growth rate.
Land and raw materials are also important inputs into the production process.
Increases of the input of land come about mainly through the better use of land
principally as a result of investment. Increased input of raw materials can
improve a country?s economic growth rate. To the extent that the price of
imported commodity inputs falls then this boosts the economic growth rate of
the importing country.
The state of technical knowledge is a vital determinant of economic growth.
As the state of technical knowledge increases production will increase giving a
higher rate of economic growth.
Subject 107 (Economics) ? April 2002 ? Examiners? Report
Page 9
Another determinant of the economic growth rate is the degree of economic
efficiency. An improvement in economic efficiency raises the output per unit
of input and in so doing will inevitably raise the economic growth rate.
Economic efficiency can be promoted by governments taking steps to: reduce
bureaucracy; privatise state-owned monopolies; promote competition; invest
in education and training; liberalise financial and labour markets; and
generally allow a greater role for market forces.
Comment
Most candidates made a fair attempt at this question, though not many gave a very good
answer to both parts.
Too many candidates simply described the various factors in both parts but they were also
expected to incorporate some discussion as requested in the question. The term economic
growth refers to increases in real GDP and quite a lot of candidates did not make this clear
in that they failed to distinguish between real and nominal GDP. Part (i) was generally better
answered than part (ii).
Faculty of Actuaries Institute of Actuaries
EXAMINATIONS
18 September 2002 (am)
Subject 107 ? Economics
Time allowed: Three hours
INSTRUCTIONS TO THE CANDIDATE
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
3. Mark allocations are shown in brackets.
4. Attempt all 36 questions. From question 27 onwards begin each answer on a separate
sheet.
Graph paper is not required for this paper.
AT THE END OF THE EXAMINATION
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
In addition to this paper you should have available Actuarial Tables and
your own electronic calculator.
Faculty of Actuaries
107?S2002 Institute of Actuaries
107 S2002?2
For questions 126 indicate in your answer booklet which one of the answers A, B, C or D is
correct.
1 If the own price elasticity of demand for Good X is ?0.8 and the income elasticity of
Good X is ?0.3, which of the following is correct?
A Demand for Good X is elastic.
B A cut in the price of Good X will increase revenue for a firm producing
Good X.
C Good X is a Giffen good.
D Good X is an inferior good. [1½]
2 Which of the following will NOT cause a shift in the demand curve for Good X?
A A change in the price of Good X.
B A change in the price of other goods.
C A change in consumer incomes.
D A change in consumer tastes. [1½]
3 Which of the following is TRUE?
A By making the supply of a good illegal, the supply curve for that good will
move downward to the right.
B A price ceiling set below the free market price produces excess demand.
C A binding quota will decrease prices.
D A subsidy given to consumers can be shown as a downward shift to the left of
the demand curve using the net price on the price axis. [1½]
4 If the price of Good X falls and there is a fall in the consumption of Good X then the
income effect of the price change is:
A positive and exceeds the substitution effect
B positive and reinforces the substitution effect
C negative and reinforces the substitution effect
D negative and exceeds the substitution effect [1½]
107 S2002?3 PLEASE TURN OVER
5 The budget line for a particular consumer is given as
3Qx + 2Qy = 30
where Qx is the quantity of Good X and
Qy is the quantity of Good Y.
Note that Goods X and Y can only be consumed in whole units.
Which of the following is TRUE?
A The price of Good X is 2.
B The consumption bundle consisting of 3 units of Good X and 10 units of Good
Y is on the consumer?s budget line.
C If the consumer decides to buy as many units as possible of Good X, he will
still have enough income left over to buy one unit of Good Y.
D A rational consumer will choose a consumption bundle such that his marginal
rate of substitution of Good X for Good Y is equal to ?1.5. [1½]
6 A consumer spends all her income on Good X and Good Y in such a combination that
the marginal utility of Good X is one third that of Good Y. If the price of Good X is
£10 and the price of Good Y is £30 then:
A to maximise total utility the consumer must increase her consumption of Good
X and decrease her consumption of Good Y
B to maximise total utility the consumer needs to increase her consumption of
Good Y and decrease her consumption of Good X
C to maximise total utility the consumer needs to rearrange consumption so that
the marginal utility from consuming Good X is three times the marginal utility
from consuming Good Y
D the consumer cannot increase her total utility [1½]
7 The principle of diminishing marginal utility of wealth makes:
A more people risk averse
B fewer people risk averse
C more people risk loving
D more people risk neutral [1½]
107 S2002?4
8 A lawyer operates with just one assistant.
Assume that: - she has £100,000 of her own capital tied up in her business
- the best rate of return she could get elsewhere on this capital is
6% a year
- her assistant is paid £15,000 each year
- she earns £300,000 in revenue each year
- she pays £50,000 in rent each year
- expenses of business and depreciation total £75,000 each year
- there are no taxes
If she was employed in a bigger practice, the lawyer calculates that she would earn
£100,000 a year.
Calculate her annual economic profit.
A £0
B £54,000
C £100,000
D £154,000 [1½]
9 Which of the following statements is relevant to the distinction between the short run
and the long run in the production process?
A Labour input is fixed in the short run but variable in the long run.
B Labour input is variable in the short run but fixed in the long run.
C Capital input is fixed in the short run but variable in the long run.
D Capital input is variable in the short run but fixed in the long run. [1½]
10 Which of the following does not contribute to economies of scale?
A Spreading of indivisibilities.
B The principle of multiples.
C Dilution of ownership.
D Specialisation. [1½]
11 Constant returns to scale means that as a firm?s scale of production is increased:
A long run total costs remain constant
B total output remains unchanged
C long run average costs and long run marginal costs are equal
D fixed costs remain constant [1½]
107 S2002?5 PLEASE TURN OVER
12 Which of the following statements is FALSE?
A In monopolistic competition, supernormal profits cannot be made in the long
run.
B Perfect price discrimination would allow the monopolist to produce the
socially efficient level of output.
C Collusion may occur between firms in oligopolistic competition.
D A firm in perfect competition faces a perfectly inelastic demand curve. [1½]
13 For a monopoly, price exceeds marginal revenue because:
A the firm has to charge a price higher than the marginal cost of producing the
last unit
B any decision by the monopolist to sell an additional unit of output does not
affect product price
C the firm has to reduce price on all units sold in order to sell an additional unit
D of the law of diminishing returns [1½]
14 A monopoly firm is able to sell 13 units of Good X per day when the price of Good X
is £4.50 per unit and 14 units of Good X per day when the price is £4.25 per unit.
The marginal revenue for the 14th unit of Good X sold is:
A £0.25
B £1.00
C £4.25
D £4.50 [1½]
15 When taxes on all income are progressive then as income increases:
A the marginal tax rate will be less than the average tax rate.
B the marginal tax rate will be greater than the average tax rate.
C the marginal tax rate will be equal to the average tax rate.
D the marginal tax rate will initially be less than but eventually greater than the
average tax rate. [1½]
107 S2002?6
16 The three leakages from the circular flow of income are:
A investment, government expenditure and exports
B savings, government expenditure and imports
C savings, taxes and imports
D savings, taxes and exports [1½]
17 Calculate the amount of investment in the following three sector economy:
Savings =100
Total taxes less transfer payments = 250
Net exports = 75
Government expenditure = 125
A 50
B 150
C 300
D 400 [1½]
18 If national income is £100 billion and the total level of planned expenditure is £80
billion then there will be an:
A accumulation of stock and output will rise
B accumulation of stock and output will fall
C unplanned reduction in stock and output will fall
D unplanned reduction in stock and output will rise [1½]
19 Assume that the total output of goods and services is held constant and the price level
increases. Which of the following observations concerning Gross Domestic Product
(GDP) is TRUE?
A Nominal GDP rises, real GDP falls.
B Nominal GDP falls, real GDP rises.
C Nominal GDP rises, real GDP stays the same.
D Nominal GDP stays the same, real GDP rises. [1½]
107 S2002?7 PLEASE TURN OVER
20 Which one of the following is not a ?crowding out? effect resulting from a fiscal
expansion?
A A fall in investment due to the associated rise in the interest rate.
B A fall in consumer demand due to fear of higher future taxes.
C Reduced import expenditure due to increased government demand for
domestically produced goods.
D A fall in demand for exports due to an exchange rate appreciation caused by
the associated rise in the interest rate. [1½]
21 If the ratio of cash held by the public to deposits is 0.1, and the bank?s reserve ratio is
0.07, the value of the money multiplier (to two decimal places) is:
A 5.88
B 6.17
C 6.29
D 6.47 [1½]
22 When it is said that country A has a comparative advantage in the production of a
good, this means that:
A Country A must give up less of other goods than other countries to produce 1
more unit of that good.
B The cost of raw materials to produce the good is less in country A than in
other countries.
C Country A produces the good at a lower total cost than other countries.
D Wages paid are lower in country A than in other countries. [1½]
23 Devaluation of a country?s currency will lead to the greatest improvement in the
current account of a country’s balance of payments when:
A the demand for imports is price elastic and the demand for exports is price
inelastic
B the demand for imports is price inelastic and the demand for exports is price
elastic
C the demand for both imports and exports is price inelastic
D the demand for both imports and exports is price elastic [1½]
107 S2002?8
24 Which of the following statements on economic activity data is FALSE?
A The Financial Times publishes daily indications of gilts prices and yields.
B The Retail Prices Index uses prices obtained over a few days during the
middle of each month.
C Official reserve figures are published monthly by the manufacturing industry.
D The National Average Earnings Index is constructed using a monthly sample
of representative firms. [1½]
25 A country has a total population of 15 million, 12 million of whom are in employment
and 1 million of whom are registered unemployed. What is the country?s
unemployment rate?
A 3.7%
B 6.7%
C 7.7%
D 8.3% [1½]
26 According to Keynesian analysis, the adoption of a policy to reduce the government?s
budget deficit will involve:
A an increase in aggregate demand and a reduction in real output
B an increase in aggregate demand and an increase in real output
C a reduction in aggregate demand and a reduction in real output
D a reduction in aggregate demand and an increase in real output [1½]
27 Describe and discuss the scope of economics in terms of the problems of the
allocation of scarce resources. [4]
28 Define each of the following:
(i) price elasticity of demand of Good X
(ii) price elasticity of supply of Good X
(iii) cross price elasticity of demand of Good X with respect to the price of Good Y
(iv) income elasticity of demand of Good X [4]
107 S2002?9 PLEASE TURN OVER
29 (i) The utility of any level of wealth for a particular individual is given by the
function:
U = 100 + w + 600
w
where U = utility
and w = wealth
This individual can insure against a particular event, which has a probability
of occurrence of 0.1. The individual?s initial level of wealth is £100. The loss
to the individual if the event did occur would be £150.
Calculate, to the nearest penny, the maximum premium the individual is
prepared to pay. [3]
(ii) The utility of any level of capital for a particular insurer is given by the
function:
U = 5,000 + 0.5 c
where U = utility
and c = capital
The insurer?s initial level of capital is £1,000.
Calculate the minimum premium the insurer is prepared to charge if, in the
likelihood of the event occurring, they will be wholly liable for the loss. [2]
(iii) State whether, given the answers to (i) and (ii) above, the insurance transaction
is feasible. [1]
[Total 6]
30 Describe the conditions needed for perfect competition. [5]
31 Explain the economic argument which says that under monopoly output is too low to
maximise social welfare. [6]
107 S2002?10
32 A perfectly competitive firm manufactures Good X which sells at £16 a unit. The
total costs of production for different levels of output per day are given below.
Output Total Cost (£)
0 10
1 18
2 30
3 47
4 67
5 92
(i) Construct a table to provide the following information at each level of output:
(a) Total Fixed Cost
(b) Marginal Cost
(c) Average Total Cost [3]
(ii) Determine the level of output at which profit will be maximised. [1]
[Total 4]
33 List the ways by which the government can pay for its expenditure. Separately, list
the ways by which the government can finance the Public Sector Borrowing
Requirement. Explain why the two lists are not the same. [4]
34 Discuss, with the aid of a diagram, what will happen to inflation and unemployment,
in the short run and the long run, following an increase in the growth rate of the
money supply. [6]
35 Define the following types of unemployment:
(i) structural unemployment [1]
(ii) technological unemployment [1]
[Total 2]
36 (i) (a) Explain, with the use of a worked example, how the multiplier
principle operates.
(b) Discuss how injections and leakages will affect the level of economic
activity. [10]
(ii) Discuss the accelerator principle and the claim that the accelerator-multiplier
theory can be used to explain why economies move in cycles. [10]
[Total 20]
Faculty of Actuaries Institute of Actuaries
EXAMINATIONS
September 2002
Subject 107 ? Economics
EXAMINERS? REPORT
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however
given credit for any alternative approach or interpretation which they consider to be
reasonable.
K G Forman
Chairman of the Board of Examiners
12 November 2002
Faculty of Actuaries
Institute of Actuaries
Subject 107 (Economics) ? September 2002 ? Examiners? Report
Page 2
1 D
2 A
3 B
4 D
5 D
6 D
7 A
8 B
9 C
10 C
11 C
12 D
13 C
14 B
15 B
16 C
17 B
18 B
19 C
20 C
21 D
22 A
23 D
24 C
25 C
26 C
In general the multiple choice questions were well answered by most candidates. Some
questions were answered incorrectly more frequently than others. These included questions
18, 20 and 26.
Subject 107 (Economics) ? September 2002 ? Examiners? Report
Page 3
27 Economics is the study of the allocation of scarce resources. A resource is scarce if
there would not be enough of it to satisfy all the people who would want to make use
of it if it had a zero price.
Economists usually categorise resources into three broad types:
Land ? all natural resources
Labour ? all human effort
Capital ? all man-made resources used in production.
There are three main allocation problems which have to be solved by any economic
system
Which goods and services should be produced (and in what quantities)?
How should these goods and services be produced?
Who should consume the goods and services that have been produced?
Most candidates made a fair attempt at the question. Some were tempted merely to list or
describe types of resources and the main allocation questions without discussing these in any
detail.
28 (i) % change in quantity demanded of Good X
% change in price of Good X
(ii) % change in quantity supplied of Good X
% change in price of Good X
(iii) % change in quantity demanded of Good X
% change in price of Good Y
(iv) % change in quantity demanded of Good X
% change in income
Very well answered by candidates. Full marks were given for an accurate verbal or
algebraic description. Marks were often lost where candidates failed to identify the
importance of the percentage change in prices, quantities and income.
29 (i) For maximum premium P, solve so that the utility from insuring equals the
expected utility from not insuring.
100 + 100 ? P + 600 / (100 P) = 0.1 * (100 ? 50 12) + 0.9 * (100 + 100 + 6)
200 ? P + 600 / (100 P) = 189.2
10.8 + 600 / (100 P) = P
P2 ? 110.8P + 1680 = 0
Subject 107 (Economics) ? September 2002 ? Examiners? Report
Page 4
P = (110.8 +/ root (110.82 ? 4 * 1680)) / 2
P = 92.67 or 18.13
The maximum premium is therefore £18.13.
(ii) For minimum premium Q, solve so that the expected utility from taking on the
insurance equals the utility from not taking it on.
0.1 * (5000 + 0.5 * (1000 ? 150 + Q)) + 0.9 * (5000 + 0.5 * (1000 + Q))
= 5000 + 0.5 * 1000
542.5 + 0.05 Q + 4950 + 0.45 Q = 5500
5492.50 + 0.5 Q = 5500
P = 15
The minimum premium is therefore £15.00.
(iii) As the minimum premium the insurer is prepared to accept is less than the
maximum premium the individual is prepared to pay, the transaction is
feasible.
This question caused many of the candidates a good deal of trouble. Simple arithmetic and
algebraic errors were common. Of those able to solve the quadratic equation a surprising
number chose the higher of the two roots. Where formulae were known parts (ii) and (iii)
were well answered.
30 A very large number of firms is needed. If each firm has an infinitesimally small
share of the market, an x% change in output by one firm will have (virtually) no effect
on the overall level of industry output.
Each firm must produce exactly the same product. A price raising firm could lose all
its sales. Similarly, if it dropped its price fractionally large numbers of customers
might want to buy the output from that firm.
Customers must have perfect information. If we assume that customers have perfect
information concerning the price charged by different firms, and know that all firms
are producing exactly the same product, then a price raising firm may well lose all its
sales.
Customers must act rationally. This means that, using their perfect information,
customers will choose to purchase from the cheapest suppliers.
There is free entry and exit of firms, so that collusion between firms can be ruled out.
Many candidates merely listed the conditions for perfect competition and so did not obtain
full marks. The question asked for descriptions - some of which were brief but adequate.
Credit was not given to candidates who moved away from the question to discuss imperfect
markets.
Subject 107 (Economics) ? September 2002 ? Examiners? Report
Page 5
31 The way to explain that output under monopoly is too low to maximise social welfare
is to consider the monopoly?s chosen (profit maximising) output level (q*) and weigh
up the costs and benefits to society of increasing output by one unit.
The main cost to society will be whatever it costs the monopolist to produce the one
extra unit. If there are no other costs imposed on society then the monopolist?s
marginal cost is the marginal cost to society.
The demand curve can be assumed to show the marginal benefit to society of each
extra unit produced.
So long as the demand curve exceeds the monopolist?s marginal cost curve, social
welfare can be increased by setting output at a higher level.
The socially optimal output level (q**) is thus where the marginal cost curve cuts the
demand curve.
Most candidates correctly identified the relevant diagram, but in many cases the quality of
the sketch was poor. The written explanation accompanying the diagram differentiated
between candidates. A discussion of price discrimination was not required.
32 (i)
Output Total Cost Total Fixed
Cost
Marginal
Cost
Average Total
Cost
0 10 10 ?
1 18 10 8 18
2 30 10 12 15
3 47 10 17 15.67
4 67 10 20 16.75
5 92 10 25 18.4
social cost MC
MR DD
q* q**
£
Q
Subject 107 (Economics) ? September 2002 ? Examiners? Report
Page 6
(ii) 2 units of output
A straightforward question that was generally very well answered. Some candidates failed to
identify correctly the profit maximising level of output, and some gave confusing figures for
Marginal Cost and Average Total Cost at zero output.
33 The government can pay for its expenditure in one of five ways:
taxation
profits from publicly owned companies and other income
sales of public assets
borrowing
printing money
The government can finance the PSBR by:
borrowing
printing money
The two lists are not the same because the proceeds from the sale of nationalised
industries and also their profits are treated as negative expenditure, therefore
increased proceeds from nationalised industries will reduce the PSBR, rather than
being a way of funding it. Taxation also reduces the PSBR, by definition, and,
therefore, does not fund it.
The quality of answers varied widely with some candidates having difficulty distinguishing
between the contents of the two lists.
34
The long run Phillips curve (LRPC) and the short run Phillips curve (SRPC) show the
relationship between inflation and unemployment in the long run and short run
respectively.
A
D
C
B
U1
10%
5%
Unemployment
SRPC1
SRPC2
Inflation LRPC
Subject 107 (Economics) ? September 2002 ? Examiners? Report
Page 7
Starting at point A with LRPC and SRPC1, the natural level of unemployment is U1
and the rate of money supply growth is 5% per year. Thus, actual and expected price
and wage inflation are all 5% per year as well.
If the government increases the rate of growth of the nominal money supply to, say,
10% but inflation remains at a lower level the real money supply will expand. This
causes interest rates to fall. Private sector investment and consumption will rise
leading to lower unemployment.
So long as workers expect the money supply to expand at 5% per year in the long run,
the economy stays on SRPC1. Wage claims and inflation are increased only a little
above 5% by the fall in unemployment and rise in aggregate demand. With inflation
lower than monetary growth the real money supply continues to expand.
Consequently interest rates and unemployment continue to fall. The economy moves
to the left up SRPC1, for example to point B on the diagram.
In the long run, the economy will return to LRPC either at point A or D. What
happens depends upon the government?s and workers? reactions.
If the government decides to accommodate wage rises by less than 10% by once again
expanding the money supply at 5%, the economy will move back to point A. This
happens because, while it persists, falling unemployment will keep wage rises and
thus price inflation above 5%. This means that the real money supply will be
contracting with interest rates and thus unemployment rising as a result.
If the government continues to expand the money supply at 10%, workers will
eventually come to expect 10% inflation in the long run and the economy will move
on to SRPC2 at point C. Wage inflation will be a little higher than 10% and so the
real money supply is contracting, eventually taking the economy back to LRPC at
point D as interest rates and thus unemployment rise.
Again diagrams varied in quality. Most correctly used the Phillips curve apparatus, but
some focussed instead on aggregate supply diagrams failing to cover the effects on
unemployment. A few discussed the effects of a decrease rather than an increase in the
growth rate of the money supply.
35 (i) At any point in time, the demand for the products of some industries is in long
term decline. The result is structural unemployment: a mismatch between the
skills employers require, and the skills of the unemployed.
(ii) Technological unemployment arises because the need to employ workers with
certain skills may decline even if the industry as a whole is not in decline.
Although consisting of straightforward definitions there was considerable variation in the
quality of answers.
Subject 107 (Economics) ? September 2002 ? Examiners? Report
Page 8
36 (i) (a) The multiplier principle
An increase in an injection to the national income flow (e.g. an
increase in investment expenditures) causes an increase in the
equilibrium level of national income greater than the increase in the
injection.
Explanation: The multiplier is the ratio of the increase in equilibrium
national income to the original increase in the injection. The multiplier
can be explained as follows.
Assume investment increases by 60 and the marginal propensity to
consume is 0.8.
In the first time period following the extra 60 investment expenditure,
national income will be higher by 60. But this is not an equilibrium
position.
In the next time period, the factors of production who received the
extra 60 will be able to spend more. Given that the marginal
propensity to consume is 0.8, we know that another 48 will be added to
national income.
This will, in turn, give rise to extra factor incomes of 48, and therefore
subsequent expenditure of 38.4. This 38.4 will also give rise to further
incomes and expenditure, and so on.
The total increase in national income is found by summing the increase
in each successive round of the multiplier:
60 + 0.8 * 60 + 0.82 * 60 + ?
This is a geometric progression. Its sum is:
1
a
r
where a = 60 and r = 0.8
Its value is 60 / 0.2
This is the same as 60 / MPS, or 60 / (1 ? MPC)
Where MPS is the marginal propensity to save and MPC is the
marginal propensity to consume.
In the special case where I, G, X, and Z are all exogenous and where
there are no direct taxes, the value of the multiplier is 1 / MPS or 1 /
(1 ? MPC)
Subject 107 (Economics) ? September 2002 ? Examiners? Report
Page 9
(b) An increase in an injection into the circular flow of income will
increase the equilibrium level of national income.
In each case, if it is an autonomous part of the injection / leakage that
changes, the resulting change in equilibrium national income will be:
Change in injection/leakage x multiplier
In equilibrium planned injections must equal planned leakages. An
increase in planned injections into the circular flow of income will tend
to raise the equilibrium level of national income. The equilibrium is
changed because planned withdrawals must also change (and by the
same amount) in order to maintain the equilibrium condition that
planned withdrawals equal planned injections. Planned withdrawals
are an increasing function of national income. Thus an increase in
injections / withdrawals means that equilibrium national income is
higher.
Equivalently, the effect of an increase in planned injections can be seen
by considering the multiplier. An increase in injections is an increase
in one of the components of aggregate demand. This increase in
aggregate demand will increase factor incomes. This leads to a further
increase in aggregate demand etc.
(ii) According to the accelerator principle, investment expenditure is determined
by the rate of change of national income. Small fluctuations in national
income can lead to large fluctuations in investment demand.
The capital stock is the current amount of capital equipment available in the
economy. It consists of machines, factories, offices, commercial vehicles etc.
which are all used to allow production of other goods. The capital stock is
long lasting. Unlike raw materials it is not used up in production. The capital
output ratio is the amount of capital needed to produce 1 unit of output.
If national income falls slightly, the required capital stock is reduced slightly.
However, the negative investment needed to meet the reduction in the required
capital stock may swamp the small annual replacement demand.
Similarly, a small rise in national income can lead to a very large rise in
investment demand. Therefore the demand for investment can fluctuate
greatly.
The accelerator-multiplier theory can be used to explain why economies move
in cycles. A one-off shock within a very simple model leads to a complex
cycle of economic activity. Because investment depends on the rate of change
of national income, which can change much more rapidly than its absolute
level, investment demand is particularly volatile.
Subject 107 (Economics) ? September 2002 ? Examiners? Report
Page 10
Part (i)(a) of the question was quite well answered, although some candidates were
sidetracked into a discussion of the money multiplier. For the worked example many simply
reproduced a page or more of algebra without giving a full explanation to interpret the
various mathematical expressions.
Part (i)(b) was less well handled. Very few gave a good explanation of the link between
injections and leakages and the point at which these came into equilibrium. Again others
were sidetracked by irrelevant discussions of crowding out.
Answers to Part (ii) were surprisingly brief and superficial given that half of the allocated
marks for the question were available. Turning points in the economic cycle were a source of
confusion in the accelerator-multiplier discussion.
In several instances handwriting was virtually illegible.
Faculty of Actuaries Institute of Actuaries
EXAMINATIONS
2 April 2003 (am)
Subject 107 ? Economics
Time allowed: Three hours
INSTRUCTIONS TO THE CANDIDATE
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
3. Mark allocations are shown in brackets.
4. Attempt all 37 questions. From question 27 onwards begin each answer on a separate
sheet.
Graph paper is not required for this paper.
AT THE END OF THE EXAMINATION
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
In addition to this paper you should have available Actuarial Tables and
your own electronic calculator.
Faculty of Actuaries
107?A2003 Institute of Actuaries
107 A2003?2
For questions 1?26 indicate in your answer booklet which one of the answers A, B, C or D is
correct.
1 Which one of the following is true of a negatively sloped linear demand curve?
A It becomes more elastic as price rises.
B It become more inelastic as price rises.
C It has a constant elasticity throughout its entire length.
D It switches from positive to negative elasticity as price rises. [1½]
2 If Good X is a Giffen good then an increase in income will cause a:
A rightward shift of the demand curve for Good X.
B leftward shift of the demand curve for Good X.
C movement along the demand curve for Good X from left to right.
D movement along the demand curve for Good X from right to left. [1½]
3 Consider the budget line of a consumer that consumes only two Goods X and Y, with
the quantity of Good X represented on the horizontal axis and quantity of Good Y
represented on the vertical axis. If money income is increased and there is a fall in the
price of Good X while the price of Good Y remains the same then the budget line will
shift to the:
A left and become steeper
B left and become less steep
C right and become steeper
D right and become less steep [1½]
4 A monopolist increases his sales from 7 units to 8 units by reducing the price of his
product from £20 to £18. The marginal revenue from the 8th unit sold is:
A £18
B £4
C £2
D £4 [1½]
5 Which one of the following conditions indicates that a firm is operating in a perfectly
competitive industry rather than a monopolistic industry?
A Output of the firm is where marginal revenue equals marginal cost.
B The cost curves of the firm are U-shaped.
C Marginal revenue equals average revenue.
D The marginal cost curve cuts the average cost curve at its minimum point.
[1½]
107 A2003?3 PLEASE TURN OVER
6 What will be the consequence of an increase in a firm?s fixed costs of production on
the firm?s marginal costs?
A Marginal cost will increase by more than fixed cost.
B Marginal cost will increase by the same amount as fixed cost.
C Marginal cost will increase but by less than fixed cost.
D Marginal cost will remain unchanged. [1½]
7 Which one of the following relationships between marginal product and average
product is always TRUE?
A If marginal product is greater than average product then average product must
fall.
B If marginal product is greater than average product then average product must
rise.
C If marginal product is positive then average product must rise.
D If marginal product is falling then average product must be falling. [1½]
8 If a minimum guaranteed price is set for Good X above the equilibrium price for
Good X this will result in:
A an increase in demand for Good X
B a decrease in supply of Good X
C excess supply of Good X
D excess demand for Good X [1½]
9 The price of Good X is half the price of Good Y. A consumer spends all his income
on the two goods. Which one of the following conditions is met when the consumer
maximises utility?
A The marginal utility of Good X is double the marginal utility of Good Y.
B The ratio of the quantity of Good X to the quantity of Good Y is double the
ratio of the price of Good X to the price of Good Y.
C The marginal utility of Good X is half the marginal utility of Good Y.
D The total utility of Good X is twice the total utility of Good Y. [1½]
107 A2003?4
10 Which one of the following is TRUE:
A Diseconomies of scale means that the ratio of inputs to outputs rises as output
rises.
B Economies of scale means that the ratio of inputs to outputs rises as output rises.
C In the long run a firm cannot alter its fixed costs of production.
D Constant returns to scale means that if a firm doubles its inputs then output
remains constant. [1½]
11 Which one of the following statements about market structure is FALSE?
A Under perfect competition, in the long run all firms make only normal profits.
B Firms under monopolistic competition produce homogeneous products.
C Under oligopoly, firms make decisions taking into account the possible
reactions of their competitors.
D Under monopoly, a profit maximising firm with positive marginal costs
always produces in the region of price elastic demand. [1½]
12 Which one of the following is an example of moral hazard?
A A person will not take out an insurance policy because they object to the
investment policy of the insurance company.
B A person takes out an insurance policy but lies on the insurance policy form.
C A person who is insured against theft makes a false claim.
D A person who takes out a insurance policy is more careless with the insured
goods than if they had not taken out an insurance policy. [1½]
107 A2003?5 PLEASE TURN OVER
13 Adverse selection describes the fact that people who know that they are particularly:
A bad risks are more inclined to take out insurance than those who know that
they are good risks. High premiums should be charged to all policyholders.
B good risks are more inclined to take out insurance than those who know that
they are bad risks. Appropriate premiums should be charged to all
policyholders.
C bad risks are more inclined to take out insurance than those who know that
they are good risks. Appropriate premiums should be charged to all
policyholders.
D good risks are more inclined to take out insurance than those who know
that they are bad risks. Low premiums should be charged to all
policyholders. [1½]
14 Assume that the total output of goods and services is held constant and the general
price level increases. Which one of following observations concerning Gross
Domestic Product (GDP) is FALSE?
A Nominal GDP increases.
B Real GDP remains constant.
C Nominal GDP changes by more than real GDP.
D Nominal GDP changes by less than real GDP. [1½]
15 If an economy experiences an unplanned increase in its inventories (stocks of goods)
then:
A Gross Domestic Product will have increased.
B Recorded investment will have increased.
C Producers? desired level of inventories is more than the actual level.
D Total expenditure in the economy is greater than the value of total output
produced. [1½]
107 A2003?6
16 According to Keynesian analysis, once a closed economy is in macroeconomic
equilibrium such that planned savings equals planned investment then:
A there will be no unemployment in the economy
B the marginal propensity to consume must be greater than the marginal
propensity to save
C consumption will be equal to or greater than income
D there may or may not be unemployment [1½]
17 You are given the following data for an economy:
Consumer Expenditure £80 million
Investment £20 million
Government Expenditure £40 million
Exports £20 million
Imports £30 million
Net Property Income from abroad £10 million
What is the value of its Gross Domestic Product?
A £130 million
B £140 million
C £150 million
D £160 million [1½]
18 The monetary base is £200 billion, the public?s cash to deposit ratio is 0.5 and the
broad money supply is £400 billion. This means that the reserve ratio of the banking
system (cash to deposits) is:
A 2
B 0.25
C 0.5
D 1 [1½]
19 Which one of the following statements about the demand for money is FALSE?
A The demand for money is negatively related to the interest rate.
B The demand for money is positively related to nominal income.
C The demand for money is negatively related to the general price level.
D The demand to hold money is positively related to real income. [1½]
107 A2003?7 PLEASE TURN OVER
20 An increase in the general price level with no change in the money supply will:
A Raise aggregate demand and increase real money balances.
B Raise aggregate demand and decrease real money balances.
C Lower aggregate demand and increase real money balances.
D Lower aggregate demand and decrease real money balances. [1½]
21 Which one of the following statements is NOT associated with the monetarist
argument concerning the so called ?vertical? long run Phillips curve?
A At a given rate of unemployment there will be a unique rate of inflation.
B If the actual rate of unemployment is above the natural rate, then we would
expect to observe a decrease in the rate of wage and price inflation.
C If the actual rate of unemployment is below the natural rate of unemployment,
then we would expect to observe an increase in wage and price inflation.
D In the long run, the government can influence the rate of inflation. [1½]
22 The level of consumption in a closed economy with no government sector is 80% of
national income and planned investment is £50 billion. The equilibrium level of national
income is:
A £400 billion
B £250 billion
C £40 billion
D indeterminate from the information given [1½]
23 The IS curve for a closed economy shows different combinations of the rate of
interest and level of national income for which the sum of:
A savings and taxation equals the sum of investment plus government
expenditure
B savings and taxation equals the sum of consumption plus government
expenditure
C savings and taxation equals the sum of consumption plus investment
expenditure
D savings and investment equals the sum of consumption plus government
expenditure [1½]
107 A2003?8
24 A country has a government budget deficit of £200 million, private sector investment
of £100 million and private sector savings of £150 million. The current account
position of the country is:
A £250 million in deficit
B £150 million in deficit
C £50 million in surplus
D £150 million in surplus [1½]
25 Which one of the following would constitute a ?supply side? economic policy for
reducing unemployment?
A Increasing social security benefits.
B Increasing the money supply.
C Reducing corporate and personal taxation.
D Increasing fiscal expenditure aimed at exploiting the fiscal multiplier effect.
[1½]
26 Which one of the following statements about real variables in the economy is
FALSE?
A If all else is constant, a rise in money wages is also a rise in real wages.
B Real interest rates are negative if the rate of inflation exceeds the nominal rate of
interest.
C Real interest rates are negative if the rate of inflation is negative.
D If nominal Gross Domestic Product (GDP) rises by 10 per cent and the GDP
deflator rises by 5 per cent then real GDP has risen. [1½]
27 Read all parts of the question before answering.
A consumer has an income of £200 which can be spent either on Good X or on
Good Y. Good X costs £20 per unit and Good Y costs £10 per unit. Good X is a
Giffen good and Good Y is a normal good. Draw a single diagram to show:
(i) The budget line for the consumer. Label the quantities of Good X and Good Y
at the points where the budget line meets the Good X (horizontal) and Good Y
(vertical) axes. [1]
(ii) An indifference curve for Good X and Good Y at a point where the consumer
is maximising satisfaction. Label the curve A, the quantity of X consumed as
X1 and quantity of Y consumed as Y1. [1]
107 A2003?9 PLEASE TURN OVER
(iii) The effect on the budget line of a fall in the price of Good X to £10 per unit.
Label the quantities of Good X and Good Y at the points where the budget line
meets the Good X and Good Y axes. [1]
(iv) A new indifference curve for Good X and Good Y on the new budget line
drawn in part (iii) at a point where the consumer is maximising his
satisfaction. Label this new curve B, the quantity of X consumed as X2 and
quantity of Y consumed as Y2. [1]
[Total 4]
28 Consider the following options A to E. Each option relates to an individual firm
operating under a certain market structure in the short run.
OPTION Marginal Average Average Marginal
cost cost revenue revenue
A 25 20 20 10
B 20 20 20 20
C 24 18 24 24
D 15 18 20 15
E 9 14 20 14
(i) State ALL the options that indicate the firm is not seeking to maximise its
profits nor minimise its losses. [1]
(ii) State ALL the options that indicate that the firm is making excess profits. [1]
(iii) State ALL the options that indicate that the firm could increase its output and
increase its profits. [1]
(iv) State ALL the options which could correspond to the firm operating in a long
run perfectly competitive environment. [1]
[Total 4]
29 Draw a diagram to illustrate the short run profit maximising price and output for a
monopolistic competitor firm making losses but with sufficient revenue to continue
production in the short run. Label the diagram as follows:
AC1 ? average cost curve P1 ? price
MC1 ? marginal cost curve Q1 ? quantity
AVC1 ? average variable cost curve CI ? average cost
MR1 ? marginal revenue curve C2 ? average variable cost
AR1 ? average revenue curve
[4]
107 A2003?10
30 The world consists of two countries A and B and the only factor of production is
labour. In Country A it takes 40 hours to produce one unit of Good X and 10 hours to
produce one unit of Good Y. In Country B it takes 50 hours to produce one unit of
Good X and 25 hours to produce one unit of Good Y.
(i) State which country has a comparative advantage in producing Good X. [1]
(ii) Calculate the opportunity cost of producing Good X in country A. [1]
(iii) Explain whether mutually advantageous international trade would be possible
between the two countries if the terms of trade were 3 units of Good Y for 1 unit
of Good X. [2]
[Total 4]
31 (i) Draw a diagram showing a real money supply curve (labelled MS1), a
real money demand curve (labelled MD1) and the interest rate (labelled
r1) that clears the money market. Show how an increase in the real
money supply to MS2 would affect the market rate of interest in the short
run. [3]
(ii) State how an increase in the real money supply through open market
operations will affect the price of Treasury bills. [1]
[Total 4]
32 The government in a closed economy undertakes expenditure on goods and services of
£60 billion, investment expenditure is £20 billion. The rate of direct taxation is 20
percent of all income. The consumption function is given by the equation:
C = 0.75 Yd
Where Yd is disposable income (national income less taxes)
(i) Calculate the equilibrium level of national income. [1]
(ii) Calculate the level of national income where the government has a balanced
budget. [1]
(iii) Calculate the required budget deficit to achieve the full employment level of
national income of £350 billion. [2]
[Total 4]
107 A2003?11 PLEASE TURN OVER
33 (i) Using an IS/LM diagram briefly explain the likely effects of a fiscal
contraction on both the domestic interest rate and the level of economic
activity. [2]
(ii) Using a second IS/LM diagram briefly explain the likely effects of a monetary
contraction on both the domestic interest rate and the level of economic
activity. [2]
[Total 4]
34 (i) Explain briefly the concepts of voluntary and involuntary unemployment. [2]
(ii) Outline two reasons which might explain why some people choose to be
voluntarily unemployed on a long term basis. [2]
[Total 4]
35 (i) Outline how the national debt may be linked to this year?s fiscal deficit and
how a rising national debt can impact on next year?s fiscal deficit. [2]
(ii) Outline why it is that countries with a high national debt tend to have to pay a
higher rate of interest, other things being equal, than countries with a low
national debt. [3]
[Total 5]
36 State the effects of an appreciation of the exchange rate of a country on its:
(i) import volumes [1]
(ii) inflation rate as measured by a consumer price index made up of domestic
produced and imported goods [1]
(iii) export volumes [1]
(iv) export earnings measured in the domestic currency. [1]
[Total 4]
107 A2003?12
37 (i) Discuss the differences between a market structure characterised by
monopolistic competition and one characterised by monopoly. In your
answer refer to both the short and the long run.
(No diagrams are required in your answer.) [10]
(ii) Explain the effects of a per unit sales tax on Good X on the producers of Good
X, the consumers of Good X and the government tax revenues. Discuss any
net welfare effects for society as a whole.
Illustrate your answer using a diagram and discuss the welfare implications
using the concepts of consumer and producer surplus. [10]
[Total 20]
Faculty of Actuaries Institute of Actuaries
REPORT OF THE BOARD OF EXAMINERS
April 2003
Subject 107 ? Economics
EXAMINERS? REPORT
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however
given credit for any alternative approach or interpretation which they consider to be
reasonable.
J Curtis
Chairman of the Board of Examiners
3 June 2003
Faculty of Actuaries
Institute of Actuaries
Subject 107 (Economics) ? April 2003 ? Examiners? Report
Page 2
1 A
2 B
3 D
4 B
5 C
6 D
7 B
8 C
9 C
10 A
11 B
12 D
13 C
14 D
15 B
16 D
17 A
18 B
19 C
20 D
21 A
22 B
23 A
24 B
25 C
26 C
The multiple choice part was in general well answered and many students secured high
marks. The questions which contained most incorrect responses were 7, 11, 13, 15, 16, 21,
and 24.
Subject 107 (Economics) ? April 2003 ? Examiners? Report
Page 3
27
Some candidates put x2 to the right of x1, and failed to show the impact of a Giffen good.
28 (i) A, E
(ii) C, D, E
(iii) E
(iv) B
Generally well answered.
10 20 Quantity
Of Good X
Quantity
Of Good Y
20
X2 X1
Y1
Y2
A
B
Subject 107 (Economics) ? April 2003 ? Examiners? Report
Page 4
29
Many candidates failed to place the price P1 below the average cost curve but above the
average variable cost curve. Some candidates drew the average cost curves poorly not
showing the correct relationship with the marginal cost curve.
30 (i) Country B
(ii) 4 units of Good Y
(iii) Yes, country A will be better off if less than 4Y is traded for 1X and country B
will be better off if more than 2Y is traded for 1X.
Generally well answered.
AC1
AVC1
MC1
Price/Cost
Q1 Quantity
C1
P1
C2
MR1
AR1
Subject 107 (Economics) ? April 2003 ? Examiners? Report
Page 5
31 (i)
(ii) An increase in the real money supply resulting from open market operations
will raise the price of treasury bills.
The diagrams was generally well drawn but in part (ii) many candidates failed to indicate
that a rise in the money supply will raise the price of Treasury bills.
32 (i) Y = 0.75(1 0.2)Y + 20 + 60
Y = £200 billion
(ii) Since G = £60 billion with 20% tax rate we require national income to be
£60 billion = 0.2 Y
so that Y = £60 billion/0.2 = £300 billion
(iii) The fiscal multiplier is 1 = 1 = 2.5
1 c(1 t) 1 0.75(1 0.2)
Hence to increase income from £200 billion to £350 billion requires an
increase in government expenditure of £150 billion/2.5 = £60 billion.
Hence government expenditure needs to be £120 billion while tax revenue at
£350 billion is £70 billion implying a budget deficit of £50 billion.
interest
rate
r1
r2
real money supply
MS1 MS2
MD1
Subject 107 (Economics) ? April 2003 ? Examiners? Report
Page 6
Generally well answered.
33 (i)
A fiscal contraction via either a cutback in government expenditure or a rise in
taxes will result in a shift to the left of the IS curve from IS1 to IS2. The result
will be a fall in the rate of interest from r1 to r2 and a fall in the level of
national income/output in the economy from Y1 to Y2.
(ii)
Output/income
LM
IS1
IS2
Y2 Y1
r1
r2
interest rate
Y2 Y1 Output/income
LM1
IS1
LM2
r1
r2
interest rate
Subject 107 (Economics) ? April 2003 ? Examiners? Report
Page 7
The fall in the money supply will result in a shift to the left of the LM curve
from LM1 to LM2. The result will be a rise in the rate of interest from r1 to r2
and a fall in the level of national income/output in the economy from Y1 to
Y2.
Diagrams were usually correct but many candidates failed to give good explanations of the
reasons for fiscal and monetary contractions causing interest rate and output changes.
34 (i) Voluntary unemployment. A worker who is registered as part of the labour
force but is not prepared to immediately accept a job at the going wage rate for
his skills is voluntarily unemployed.
Involuntary unemployment. A worker who is registered as unemployed and is
prepared to accept a job immediately at the going wage rate for their skills is
involuntarily unemployed.
(ii) People are more likely to choose to be voluntarily unemployed on a long term
basis if:
- high state benefits for being unemployed reduce the opportunity cost of
being unemployed
- high rates of tax on earned income reduce the incentive to work
- finding out about jobs and travelling to interviews is expensive (i.e. high
search costs)
- retraining is difficult to obtain and / or expensive.
Many incorrectly defined voluntary and involuntary unemployment.
35 (i) This year?s fiscal deficit may be financed by bond sales which will
increase the size of the national debt. A higher national debt will then impact
upon next year?s fiscal deficit because interest on the national debt is part of
the government expenditure used to calculate the fiscal deficit.
(ii) The national debt of a country is the outstanding stock of government bonds in
the market. The higher a country?s national debt the higher the stock of bonds
available on the market and, other things being equal, the higher the interest
rate. Apart from this, governments with a high national debt tend to be
distrusted by the financial markets. The markets may attach a higher risk to
countries with high national debts for fear that the government may ultimately
redeem the debt by printing money which could lead to inflation. This extra
inflation risk will tend to be priced into the rate at which the government can
borrow.
Many of the responses were weak and the majority of candidates did not demonstrate an
understanding of the link between fiscal deficits and the national debt.
Subject 107 (Economics) ? April 2003 ? Examiners? Report
Page 8
36 (i) An appreciation of the exchange rate will make imports cheaper and therefore
result in a rise in import volumes.
(ii) An appreciation of the exchange rate will make imports cheaper and therefore
help to lower the inflation rate.
(iii) An appreciation of the exchange rate will make exports more expensive in
foreign currencies and therefore result in a fall in export volumes
(iv) An appreciation of the exchange rate will make exports more expensive in
foreign currencies and therefore result in a fall in export volumes and,
therefore, lower export earnings measured in the domestic currency.
Generally well answered, but many candidates failed to give a correct response to part (ii),
an appreciation of the domestic currency by lowering the price of imports will lower the
inflation rate.
37 (i) There are significant differences between the market structures of
monopolistic competition and monopoly. With monopolistic competition there
are many competing firms whereas with monopoly there is only one firm.
Under monopolistic competition each firm sells a differentiated product
whereas a monopoly may sell either a single product or a range of
differentiated but similar products.
A crucial difference between the two structures is that with monopolistic
competition there are no barriers to entry whereas with monopoly there are
barriers to entry. The absence of barriers to entry mean that firms in a
monopolistic competition industry will only make normal profits in the long
run although super normal profits can be made in the short run. With
monopoly, the existence of barriers to entry means that in both the short and
the long run excess profits can be made.
Although both monopolistic and monopoly firms face downward sloping
demand curves, the market demand curve is the demand curve for a
monopolist whereas a monopolistic competitor firm only has a share of the
market. The presence of competition will also tend to make the demand curve
facing a monopolistic firm more price elastic than for a monopoly firm.
While both types of firm can be profit maximisers, competition means that a
monopolistic competitor firm will have to seek to minimise costs whereas a
monopoly firm can afford to some extent to be inefficient. Monopoly firms
will be better able to exploit economies of scale as their production runs will
be bigger than monopolistic competitor firms.
Subject 107 (Economics) ? April 2003 ? Examiners? Report
Page 9
(ii) The effect of a per unit sales tax is illustrated in the diagram below.
Before the introduction of the tax the supply and demand curves S1 and D1
intersect to give the equilibrium price and quantity of P1 and Q1 respectively.
If a per unit sales tax is introduced this will have the effect of shifting the
supply curve to the left by the full amount of the tax per unit from S1 to S2.
The result is a new equilibrium price and quantity given by the intersection of
the new supply curve S2 and the original demand curve D1 giving a new
equilibrium price and Quantity of P2 and Q2 respectively. It should be noted
that the rise in the price of the good is less than the amount of the tax.
The effect of the tax is to create a wedge between the price paid by the
consumer P2 and the price received by the producer P3. There is a reduction in
consumer surplus equal to area P2ABP1. There is also a reduction in producer
surplus equal to area P1BCP3 as they suffer both a lower price received from
P1 to P3 and produce a lower quantity of units Q2 than before the imposition
of the tax. There is one party that gains from the tax and that is the
government which receives a tax of P2 P3 per unit sold, hence the
government receives tax revenue equal to area P2ACP3. The gain to the
government is less than the combined losses of consumers and producers, so
that there is a net loss from the tax given by the area ABC. The net loss is
relatively easy to explain, the area ABD is the consumer surplus loss suffered
by consumers who are willing to pay between price P1 and P2 but unable to
do so at the price P2, while the area BCD is the producer surplus loss suffered
by domestic producers who are willing to produce the good between the price
P3 and P1 but who no longer do so as a result of the tax.
This section was the poorest part of the examination.
D1
S1
Price S2
Quantity
P1
P2
P3
Q2 Q1
A
B
C
Tax D
Subject 107 (Economics) ? April 2003 ? Examiners? Report
Page 10
In part (i) many defined some of the characteristics/ differences but overall there were
relatively few good explanations and too few candidates made direct comparisons of
monopoly and monopolistic competition as required by the question.
Part (ii) was not well answered, diagrams were poor and many moved the demand curve
instead of the supply curve. The analyses were generally weak with poor explanations of
producer and consumer surplus effects and many candidates were not able to explain the
welfare implications.
Faculty of Actuaries Institute of Actuaries
EXAMINATIONS
9 September 2003 (am)
Subject 107 — Economics
Time allowed: Three hours
INSTRUCTIONS TO THE CANDIDATE
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
3. Mark allocations are shown in brackets.
4. Attempt all 37 questions. From question 27 onwards begin each answer on a separate
sheet.
Graph paper is not required for this paper.
AT THE END OF THE EXAMINATION
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
In addition to this paper you should have available Actuarial Tables and
your own electronic calculator.
Faculty of Actuaries
107—S2003 Institute of Actuaries
107 S2003—2
For questions 1–26 indicate in your answer booklet which one of the answers A, B, C or D is
correct.
1 A minimum price is set for Good X at £12 which happens to coincide with the free
market price. Keeping the minimum price fixed at £12, an increase in the demand for
good X will lead to:
A no change in price and a shortage
B a rise in price and a shortage
C a rise in price and a surplus
D a rise in price and quantity sold [1½]
2 Good Y has a cross elasticity of demand with respect to Good X of 0.5 and 100 units
of Good Y are demanded when Good X costs 60 pence. A rise in the price of Good X
to 90 pence will lead to a change in the demand for Good Y to:
A 150 units
B 125 units
C 75 units
D 50 units [1½]
3 Consider the budget line of a consumer that consumes only two goods X and Y, with
the quantity of Good X represented on the horizontal axis and the quantity of Good Y
represented on the vertical axis. If real income and the price of Good Y are held
constant, a rise in the price of Good X will:
A shift the entire budget line to the left
B shift the entire budget line to the right
C make the budget line steeper
D make the budget line less steep [1½]
4 Which of the following is true for total utility and marginal utility as consumption of a
good increases?
A Total utility is increasing and marginal utility is increasing.
B Total utility is increasing and marginal utility is decreasing.
C Total utility is decreasing and marginal utility is increasing.
D Total utility is decreasing and marginal utility is decreasing. [1½]
107 S2003—3 PLEASE TURN OVER
5 Which of the following is NOT TRUE of a risk averse person?
A A risk averse person chooses a course of action designed to maximise
expected utility.
B A risk averse person will tend to reject a fair gamble.
C A risk averse person will be unwilling to pay more for insurance than the long
run average value of claims which will be made.
D A risk averse person will be willing to pay more for insurance than the long
run average value of claims which will be made. [1½]
6 Which one of the following statements about short run costs of production is FALSE?
A Marginal cost cannot exceed average total cost.
B Marginal cost is equal to average variable costs when average variable cost is
at a minimum.
C Average fixed cost always falls as output rises.
D Average total cost exceeds average variable cost by an amount that declines
with increasing output. [1½]
7 Consider the following table:
Units of Labour Units of Capital Output
1 1 100
2 2 190
3 3 270
4 4 340
5 5 400
The table illustrates which of the following?
A The law of diminishing marginal returns.
B Increasing returns to scale.
C Constant returns to scale.
D Decreasing returns to scale. [1½]
107 S2003—4
8 Each of the following is a characteristic of monopolistic competition. Which one is
NOT a characteristic of oligopoly?
A Each firm faces a downward-sloping demand curve.
B Firms are profit-maximisers.
C The sales of one firm will not have a significant effect on other firms.
D There is more than one firm in the industry. [1½]
9 All the following, except one, describe both monopoly and perfect competition.
Which does not?
A Both may make supernormal profits in the short run.
B Both determine output by equating marginal cost and marginal revenue.
C Both reduce output if marginal cost exceeds marginal revenue.
D Both face a perfectly elastic demand curve. [1½]
10 A movement along a consumer’s indifference curve from right to left implies that:
A a consumer’s utility will be unchanged
B a consumer’s money income will be unchanged
C a consumer’s utility will rise
D a consumer’s utility will fall [1½]
11 When personal income taxes are progressive then, for an individual, as income
increases:
A the marginal tax rate will be less than the average tax rate
B the marginal tax rate will be greater than the average tax rate
C the marginal tax rate will be equal to the average tax rate
D the marginal tax rate will initially be less than, but eventually greater than, the
average tax rate [1½]
12 Which of the following types of unemployment would exist even in a well
functioning economy:
A classical unemployment
B frictional unemployment
C technological unemployment
D structural unemployment [1½]
107 S2003—5 PLEASE TURN OVER
13 In the circular flow of income model:
A savings, taxes and investment are leakages
B exports, imports and government expenditure are leakages
C investment, government expenditure and exports are injections
D investment, exports and consumption are injections [1½]
14 Assume that the total output of goods and services is held constant and the price level
increases. Which one of the following observations concerning Gross Domestic
Product (GDP) is FALSE?
A Nominal GDP rises.
B Real GDP remains constant.
C Nominal GDP rises while real GDP falls.
D Nominal GDP changes by more than real GDP. [1½]
15 The accelerator principle implies that:
A investment is determined by the rate of change of national income
B national income is determined by the rate of change of investment
C investment is increased when interest rates fall
D national income is increased when interest rates fall [1½]
16 Which one of the following situations will lead to the most crowding out following an
increase in government expenditure?
A The demand for money is interest elastic and private investment is interest
inelastic.
B The demand for money is interest inelastic and private investment is interest
elastic.
C The demand for money and private investment are both interest inelastic.
D The demand for money and private investment are both interest elastic. [1½]
107 S2003—6
17 The direct impact of open market operations, where the central bank purchases
government securities is to:
A increase the cash reserves of commercial banks and increase the monetary
base
B increase the cash reserves of commercial banks and reduce the monetary base
C reduce the cash reserves of commercial banks and increase the monetary base
D reduce the cash reserves of commercial banks and reduce the monetary base
[1½]
18 Which of the following is NOT a cost of inflation?
A menu costs
B shoe-leather costs
C arbitrary redistribution of wealth from lenders to borrowers
D arbitrary redistribution of wealth from borrowers to lenders [1½]
19 Which of the following statements best characterises the views of a monetarist?
A In the long term unemployment can be reduced by an expansionary fiscal
policy.
B In the long term unemployment can be reduced by an expansionary monetary
policy.
C In the long term unemployment can be reduced by increasing efficiency and
productivity.
D In the long term unemployment can be reduced but only at the cost of a higher
rate of inflation. [1½]
20 The law of comparative advantage states that countries should specialise in producing
and exporting the goods that they produce at a lower:
A marginal cost than other countries
B absolute cost than other countries
C total cost than other countries
D opportunity cost than other countries [1½]
107 S2003—7 PLEASE TURN OVER
21 The terms of trade index may be defined as:
A the ratio of the index of import prices to the index of export prices
B the ratio of the index of export prices to the index of import prices
C the ratio of the quantity of imports to the quantity of exports
D the ratio of the quantity of exports to the quantity of imports [1½]
22 Which of the following would NOT be included in the current account of the United
Kingdom’s balance of payments?
A Property income from abroad.
B The purchase of shares in a UK company by foreign investors.
C Interest and dividends paid to the rest of the world.
D Exports of services. [1½]
23 Other things being equal, which one of the following statements is always TRUE?
A An appreciation of a country’s exchange rate will increase its import volumes
and decrease its export volumes.
B An appreciation of a country’s exchange rate will increase its import
expenditure and decrease its export revenues.
C A depreciation of a country’s exchange rate will decrease its import volumes
and decrease its export volumes.
D A depreciation of a country’s exchange rate will decrease its import
expenditure and increase its export revenues. [1½]
24 The marginal propensity to consume in an open economy with no government sector
is 0.9. Planned investment is £100 billion and exports are £15 billion. The
equilibrium level of national income is:
A £103.5 billion
B £115 billion
C £1150 billion
D indeterminable from the information given [1½]
107 S2003—8
25 Assume that the United Kingdom interest rate is 10% per annum and the United
States interest rate is 5% per annum. What is the expected annual movement in the
dollar-pound exchange rate?
A The dollar is expected to depreciate by 2%.
B The dollar is expected to appreciate by 2%.
C The dollar is expected to appreciate by 5%.
D The dollar is expected to depreciate by 5%. [1½]
26 Which of the following is least likely to lead to an increase in long run economic
growth?
A An increase in the money supply.
B An increase in capital investment expenditure.
C An increase in education expenditure.
D An increase in research and development expenditure. [1½]
27 A small manufacturing company sells cameras. At present total costs of production
vary with output as follows:
Output Total Cost (£)
0 200
10 650
20 1000
30 1300
40 1600
50 2000
60 2500
The relationship between quantity demanded and price is given by the equation:
Q = 150 2P
Where:
Q = quantity demanded
P = price
(i) For each level of output in the table, calculate the following (round all figures
to the nearest pound (£)):
(a) Average Total Cost
(b) Average Revenue
(c) Marginal Cost
(d) Marginal Revenue [4]
(ii) From the table select the profit-maximising level of output. [1]
[Total 5]
107 S2003—9 PLEASE TURN OVER
28 Read both parts (i) and (ii) of the question before answering.
(i) Draw a diagram to show a firm in a monopolistically competitive industry
making normal profits. Label the diagram as follows: AC — average cost
curve, MC — marginal cost curve, MR — marginal revenue curve, AR —
average revenue curve, P — price and Q — quantity. [2]
(ii) State, but do not show on the diagram, the short and long run effects of a fall
in the fixed costs of production facing all firms in the industry. [2]
[Total 4]
29 Workers in two countries A and B can produce shoes and computers. The annual
productivity of a worker in each country is given in the table below.
Country Computers Shoes
A 5,000 10,000
B 200 5,000
(i) State which country has a comparative advantage in the production of
computers. [1]
(ii) State which country has a comparative advantage in the production of shoes.
[1]
(iii) Explain whether international trade would take place between the two
countries if the terms of trade were 10 shoes per computer. [2]
[Total 4]
30 (i) Define the following:
(a) own price elasticity of demand
(b) cross price elasticity of demand
(c) income elasticity of demand
(d) own price elasticity of supply [2]
(ii) State two factors which affect income elasticity of demand. [2]
[Total 4]
31 Outline two difficulties encountered in placing a value on measures of national
income. [4]
32 Outline four actions a government could take to reduce an adverse trade balance. [4]
107 S2003—10
33 You are given the following data on an economy:
Consumption expenditure = £50 million + 0.8 Yd
Taxation = 0.25Y
Investment = £120 million
Government Expenditure = £280 million
Exports = £150 million
Imports = 0.2Y
where Y = national income, and Yd = disposable national income.
(i) Calculate the equilibrium level of national income. [2]
(ii) Calculate the current account deficit as a percentage of the national income at
the equilibrium level of national income. [1]
(iii) Calculate the budget deficit as a percentage of the national income at the
equilibrium level of national income. [1]
[Total 4]
34 You are given the following information:
c = the ratio of cash held by the public to their deposits
r = the bank’s reserve ratio (cash to deposits)
where:
c = 0.6
r = 0.2
(i) Calculate the value of the monetary base when the broad money supply is
£600 million. [1]
(ii) Calculate the value of the broad money supply when the monetary base is
£200 million. [1]
(iii) What would be the percentage effect on the broad money supply of an
increase in the monetary base of 10%? [1]
(iv) Calculate the value of the broad money supply if the monetary base were £200
million and the banks were to reduce their reserve ratio from 0.2 to 0.1 while
the proportion of deposits held by the public as cash fell to 0.5. [1]
[Total 4]
107 S2003—11
35 (i) Explain the difference between a fixed and a floating exchange rate regime.
[2]
(ii) List two advantages of fixed exchange rates and two advantages of floating
exchange rates. [2]
[Total 4]
36 Explain briefly:
(i) the law of diminishing marginal returns [2]
(ii) diseconomies of scale [2]
[Total 4]
37 (i) Discuss the conditions needed for a perfectly competitive market to exist.
[10]
(ii) Assess the welfare advantages of perfect competition compared with
monopoly and use this to comment on the assertion that “monopolies are bad
for society”. [10]
[Total 20]
Faculty of Actuaries Institute of Actuaries
REPORT OF THE BOARD OF EXAMINERS
September 2003
Subject 107 — Economics
EXAMINERS’ REPORT
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however
given credit for any alternative approach or interpretation which they consider to be
reasonable.
J Curtis
Chairman of the Board of Examiners
11 November 2003
© Faculty of Actuaries
© Institute of Actuaries
Faculty of Actuaries Institute of Actuaries
EXAMINATIONS
September 2003
Subject 107 — Economics
EXAMINERS’ REPORT
© Faculty of Actuaries
© Institute of Actuaries
Subject 107 (Economics) — September 2003 — Examiners’ Report
Page 3
General Comments
In several instances handwriting was virtually illegible. Diagrams were often drawn
freehand. Clarity would have been enhanced through the simple use of a ruler.
Specific comments on individual questions appear after each solution listed below.
1 D
2 B
3 C
4 B
5 C
6 A
7 D
8 C
9 D
10 A
11 B
12 B
13 C
14 C
15 A
16 B
17 A
18 D
19 C
20 D
21 B
22 B
23 A
24 D
25 C
26 A
The overall performance of candidates for multiple choice questions was good. Some
questions were answered incorrectly more frequently than others. These included questions
7, 21 and 25.
Subject 107 (Economics) — September 2003 — Examiners’ Report
Page 4
27 (i)
Output Total Cost (£) Ave
Total
Cost (£)
Ave
Rev (£)
Marg
Cost (£)
Marg
Rev (£)
0 200 - - - -
10 650 65 70 45 70
20 1000 50 65 35 60
30 1300 43 60 30 50
40 1600 40 55 30 40
50 2000 40 50 40 30
60 2500 42 45 50 20
(ii) Profit-maximising output level = 40 units
Generally well answered. Most candidates proved able to compute the figures accurately
with only minor slips. For example the fact that output steps were expressed in units of 10
caused confusion in some cases.
28 (i)
(ii) In the short run the firms in the industry will make a supernormal profit. In the
long run the entry of competitors will result in a return to normal profits.
Part (i) was well answered. In Part (ii) some were unsure of the distinction between the short
and long run.
Price
0 Quantity
AR
AC
Q
P
MC
MR
Subject 107 (Economics) — September 2003 — Examiners’ Report
Page 5
29 (i) Country A
(ii) Country B
(iii) Yes. B will trade shoes for A’s computers. Explain in terms of opportunity
cost and potential for mutually beneficial trade. The relative price must lie
between 2 shoes per computer (the A opportunity cost) and 25 shoes per
computer (the B opportunity cost).
A straightforward question. Part (iii) proved problematic for some with a limited
understanding of opportunity cost.
30 (i) (a) % change in quantity demanded of Good X / % change in the price of
Good X
(b) % change in quantity demanded of Good X / % change in the price of
Good Y
(c) % change in quantity demanded of Good X / % change in income
(d) % change in quantity supplied of Good X / % change in the price of
Good X
(ii) Explanations may include:
• the extent to which the good is preferred to possible alternatives
• how vital the good is to life support
• the proportion of consumers’ income spent on the good
Extremely well answered. Candidates recognised that the question drew on standard
material in the Core Reading.
31 The four main difficulties alluded to in the Core Reading are:
(i) Depreciation, i.e. capital consumption.
This is the true reduction in the value of assets due to wear and tear. In
practice estimates are difficult to make and are likely to be inaccurate.
(ii) Inflation.
Use of the GNP deflator to convert nominal economic activity to real
economic activity.
(iii) Exchange rates.
It is not clear which exchange rate should be used, e.g. an average exchange
rate over the year or the end year exchange rate?
(iv) Net Economic Welfare.
Subject 107 (Economics) — September 2003 — Examiners’ Report
Page 6
We should allow for other factors which affect economic welfare,
e.g. unreported market transactions, non-marketed goods and services,
externalities, leisure time.
This question proved challenging. Many candidates did not get beyond a discussion of nonreported
economic activities, i.e. non-traded / non-market goods etc. Some discussed
measurement of national income in detail (alternative approaches) – risking irrelevance.
32 (i) Reduce the value of the currency, i.e. a devaluation. Reduces demand
for imported goods and raises demand for exports.
(ii) Reduce aggregate demand. Again this will lower imports and increase
exports. A fairly drastic way of eliminating a balance of payments deficit. The
result of lower aggregate demand may be a prolonged period of mass
unemployment.
(iii) Help exporters, e.g. export credit insurance, subsidies to exporters, help with
marketing, improving infrastructure, encouragement (awards to exporters).
(iv) Discourage imports, e.g. tariffs, quotas and persuasion.
Very well answered. Again Core Reading material gave a good guide to what was required.
33 (i) Y = 50 + 0.8(1 - 0.25)Y + 120 + 280 + 150 - 0.2Y
= £1000 million
(ii) £50m/£1000m * 100 = 5%
(iii) £30m/£1000m * 100 = 3%
Well answered. Calculations were straightforward and many candidates showed their
workings clearly. Some marks were lost due to careless work.
34 N.B Broad money = money multiplier x monetary base
Money multiplier = (1 + c)/(r + c)
(i) £300 million
(ii) £400 million
(iii) a rise of 10%
(iv) £500 million
Well answered. Calculations were straightforward. Some marks were lost due to careless
work.
Subject 107 (Economics) — September 2003 — Examiners’ Report
Page 7
35 (i) A fixed exchange rate means that the government stands ready to intervene
directly in the foreign exchange markets in order to maintain a fixed level of
the domestic currency against a foreign currency or against an external
standard of value. A floating exchange rate means that the government does
not intervene directly in the foreign exchange markets. Under a floating
exchange rate the foreign exchange value of the domestic currency is
determined solely by supply and demand from current and capital account
transactions.
(ii) Advantages of fixed exchange rates:
• interest rates must stay at the world level and hence “Keynesian Crowding
Out” cannot occur
• greater certainty, hence encourage foreign trade, allowing potential gains
from trade to be realised
• can lead to lower inflation
• as a step towards a single currency may (or may not!) promote economic,
political and social harmonisation
Advantages of floating exchange rates:
• monetary policy can be conducted independently of other countries
without the need for controls on the movement of capital
• a floating exchange rate will tend to move to automatically offset a balance
of payments deficit or surplus (assuming that import and export demands
are sufficiently elastic)
• there is no need for the central bank to hold large amounts of gold and
foreign currencies
• monetary policy is more effective for controlling price rises
Well answered. Core Reading material was closely followed.
36 (i) Law of diminishing marginal returns.
A short run concept. One factor of production (often capital) is assumed fixed
and another factor (often labour) is varied. Diminishing returns at the margin
eventually occur as the input of the variable factor is increased. This implies
that short run average and marginal cost curves will eventually slope upwards.
(ii) Diseconomies of scale.
A long run concept. All factors of production are assumed to be variable in
the long run and in the presence of diseconomies of scale long run average
costs rise. Even if both factors of production are increased in equal proportion
output rises less than proportionately. Reasons offered for this phenomenon
include, managerial diseconomies, dilution of ownership, quality of resources,
and physical diseconomies of scale.
Subject 107 (Economics) — September 2003 — Examiners’ Report
Page 8
One of the most poorly answered questions on the paper. Once again it was clear that the
difference between the short run and the long run was not understood by many candidates. A
large number were unable to distinguish diminishing marginal returns from diminishing
marginal utility and diseconomies of scale.
37 (i) The following five conditions are needed to ensure that each firm faces
a horizontal demand curve:
(a) A very large number of firms.
If each firm has an infinitesimally small share of the market, an x%
change in output by one firm will have (virtually) no effect on the
overall level of industry output.
(b) Each firm produces exactly the same product.
A price raising firm could lose all its sales. Similarly, if it dropped its
price fractionally large numbers of customers might want to buy the
output from that firm.
(c) Customers have perfect information.
If we assume that customers have perfect information concerning the
price charged by different firms, and know that all firms are producing
exactly the same product, then a price raising firm may well lose all its
sales.
(d) Customers act rationally.
This means that, using their perfect information, customers will choose
to purchase from the cheapest suppliers.
(e) Free entry and exit and firms.
By assuming that there is free entry and exit of firms, collusion
between firms can be ruled out.
(ii) Under monopoly the output level is too low to maximise social welfare. So
long as the demand curve (i.e. consumers’ valuation of each extra unit of
output) exceeds the monopolist’s marginal cost curve (i.e. the marginal cost to
society), social welfare can be increased by setting output at a higher level.
Diagram: Social Cost of Monopoly
Price
Quantity
MC
DD
MR
q* q**
Social Cost
Subject 107 (Economics) — September 2003 — Examiners’ Report
Page 9
There may be an additional loss if we are prepared to make value judgements
about the effect of a monopoly’s pricing policy on social welfare.
Because monopolies do not face any competition (actual or potential) they
may be able to charge different prices to different groups of customers —
i.e. price discriminate. If it is possible for a firm to employ price
discrimination it will be profitable to do so as the monopoly will be able to
expand its output and increase its profits.
Counterintuitively price discrimination allows the monopoly to produce the
socially efficient level of output. However in the case where monopolies
provide an essential service (e.g. gas, electricity, water) governments may
establish regulatory agencies or fix rules to ensure that all sections of society
have access to these goods or services at affordable prices. They thereby
restrict the ability of monopolists to price discriminate on their own terms.
This was a straightforward question.
(i) Most candidates managed simply to state the conditions needed for a perfectly
competitive market to exist, but fewer demonstrated a clear understanding of each.
Explanations varied quite widely in length and quality.
(ii) Most candidates offered an adequate explanation of the social cost of monopoly
compared to perfect competition but few developed a well structured and reasoned
argument as to whether or not monopolies are bad for society.
Faculty of Actuaries Institute of Actuaries
EXAMINATIONS
27 April 2004 (am)
Subject 107 Economics
Time allowed: Three hours
INSTRUCTIONS TO THE CANDIDATE
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
3. Mark allocations are shown in brackets.
4. Attempt all 37 questions. From question 27 onwards begin each answer on a separate
sheet.
Graph paper is not required for this paper.
AT THE END OF THE EXAMINATION
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
In addition to this paper you should have available Actuarial Tables and
your own electronic calculator.
Faculty of Actuaries
107 A2004 Institute of Actuaries
107 A2004 2
For questions 1 26 indicate in your answer booklet which one of the answers A, B, C or D is
correct.
1 The economic problem of HOW a good shall be produced (the capital-labour mix) is
solved in capitalist societies:
A through the purchasing decisions made by consumers in the market place for
the final good produced
B by means of the profit motive which prompts producers to keep their
production costs to a minimum
C purely by comparing the cost of capital relative to the cost of labour.
D by the use of relatively capital intensive methods of production
[1½]
2 Which one of the following will shift the supply curve for good X to the right?
A A decrease in labour productivity in industry X.
B A fall in the price of raw materials used to produce good X.
C An increase in real wages in industry X.
D A government sales tax on the production of good X.
[1½]
3 A maximum price is set for good X at £30 which happens to coincide with the free
market price. An increase in the supply of good X keeping the maximum price fixed
at £30 will lead to:
A no change in price and a surplus
B no change in price and a shortage
C a fall in price and a fall in the quantity sold
D a fall in price and a rise in quantity sold
[1½]
4 Good Y has a positive cross price elasticity of demand with respect to good X of 0.5 and
100 units of good Y are demanded when good X costs 20 pence. A rise in the price of
good X to 30 pence will lead to a change in the demand for good Y to:
A 150 units
B 125 units
C 75 units
D 50 units
[1½]
107 A2004 3 PLEASE TURN OVER
5 If public transport is an inferior good, which of the following will cause its demand
curve to shift to the left?
A A rise in the price of cars.
B An increase in consumers incomes.
C An increase in the price of petrol.
D An increase in the price charged to use public transport.
[1½]
6 You have the following data on the price of good X and the quantity sold of good X.
If the market price is set at £12 what is the total value of consumer surplus?
Price of good X Quantity of good X sold
£15 1
£14 2
£13 3
£12 4
£11 5
A £48
B £4
C £5
D £6 [1½]
7 Which one of the following is NOT a characteristic of a normal good?
A It has a positive income elasticity of demand.
B A price fall will lead to an increase in demand.
C The substitution and income effects of a price change work in opposite
directions.
D The substitution effect of a price rise works to reduce demand for the good.
[1½]
8 Which one of the following characteristics applies to an oligopolistic market
structure?
A There is a large number of firms.
B The absence of barriers to entry into the market.
C Demand is infinitely price elastic.
D The output decisions of one firm may exert a significant influence on other
firms in the industry. [1½]
107 A2004 4
9 The kinked demand curve model of oligopoly is based upon the assumption that:
A a firm s competitors match both its price increases and price reductions
B one firm in the industry sets the price for all other firms
C a firm s competitors match its price reductions but not its price increases
D the price charged by the firm can either rise or fall depending on what happens
to its competitors prices
[1½]
10 Which one of the following is NOT a feature of perfect competition?
A In the long run firms make only normal profits.
B Price is equal to marginal cost.
C Price is equal to average revenue.
D Firms can unilaterally raise their price without losing all their customers.
[1½]
11 A profit maximising monopoly facing a linear demand schedule and with zero
marginal costs will set his price in the region of the demand curve where the absolute
price elasticity of demand is:
A greater than unity but finite
B equal to zero
C between zero and unity
D unity
[1½]
12 A managing director of a monopoly firm with constant marginal costs has the
following data:
Average revenue = £14
Marginal revenue = £10
Marginal cost = £8
Average variable cost = £8
Average total cost = £12
To maximise profits/minimise losses in the short run the firm should:
A reduce price and increase output
B reduce price and reduce output
C increase price and increase output
D close down
[1½]
107 A2004 5 PLEASE TURN OVER
13 Which one of the following is TRUE?
A The long run average total cost curve passes through the minimum point of all
the short run average total cost curves.
B The minimum efficient scale is the point at which long run average costs must
begin to fall.
C In the long run a firm cannot alter its fixed costs of production.
D If a firm trebles all its inputs and its output doubles then this is indicative of
diseconomies of scale. [1½]
14 The following transactions take place in a simple closed economy. A company
producing good X sells its output for £1 million. In producing good X the company
buys raw materials for £400,000, uses £100,000 worth of electricity and depreciates
capital equipment to the value of £200,000. What is the contribution of the company
to the country's Gross Domestic Product?
A £600,000
B £500,000
C £400,000
D £300,000 [1½]
15 In an open economy with a government sector, which one of the following conditions
will ensure an equilibrium level of output in the Keynesian model?
Where:
C = planned consumption, S = planned savings, I = planned investment, T = taxation,
G = government expenditure, B = transfer payments, M = import expenditure,
X = export receipts.
A S + T + M = I + G + B + X
B S + T + M = I + C + B + X
C S = I
D none of the above [1½]
107 A2004 6
16 In a simple closed economy with no government sector the consumption function
relating consumption (C) to national income (Y) is given by the expression:
C = £20 million + 0.8Y
Planned investment is constant at £50 million.
Which one of the following is TRUE?
A The multiplier has a value of 4.
B An increase in the level of national income will raise the average propensity to
consume.
C The economy is in equilibrium when national income is £300 million.
D None of the above.
[1½]
17 In a simple closed economy with no government sector which one of the following
statements about the consumption function is TRUE?
A The consumption function describes the relationship between aggregate
consumption and the price level.
B The consumption function describes all equilibrium levels of income where
planned savings and planned investment are equal.
C The consumption function has a slope equal to the average propensity to
consume.
D The consumption function has a slope equal to the marginal propensity to
consume.
[1½]
18 One way of reducing the natural level of unemployment would be to increase:
A unemployment benefit
B government consumption expenditure
C information on job availability
D the money supply
[1½]
107 A2004 7 PLEASE TURN OVER
19 If an increase in the level of the money supply results in no change in either the
nominal or real value of national income, then which of the following is TRUE?
A Interest rates must have risen.
B The velocity of circulation must have fallen.
C The price level must have risen by the same proportion as the increase in the
money supply.
D Taxes must have risen.
[1½]
20 Assuming all other variables remain constant, a decrease in the average price level
will result in a:
A fall in the real interest rate
B fall in the nominal wage rate
C rise in the real wage rate
D rise in the nominal interest rate
[1½]
21 The following table contains output and expenditure data for an economy.
£ billions
Consumption (at market prices) 260
Investment (at market prices) 70
Government spending (at market prices) 85
Net Exports (at market prices) 5
Net Property income from abroad 5
Taxes on production 60
Gross Domestic Product at market prices and Gross National Product at factor cost
are respectively:
A 415, 420
B 410, 355
C 415, 355
D 410, 415 [1½]
22 If nominal Gross National Product (GNP) per capita is £10,000 and the GNP deflator
(base year 100) is 250 then real GNP per capita is:
A £7,500
B £2,500
C £4,000
D £12,500
[1½]
107 A2004 8
23 Which one of the following statements about real variables in the economy is
FALSE?
A Real interest rates are negative if the anticipated rate of inflation exceeds the
nominal rate of interest.
B If all else is constant, a rise in money wages is also a rise in real wages.
C An increase in real income will lead to a reduced demand for real money
balances.
D None of the above.
[1½]
24 Which of the following is a possible explanation for an increase in the average price
level and a decrease in real national income?
A An increase in short run aggregate supply.
B A decrease in short run aggregate supply.
C An increase in aggregate demand.
D A decrease in aggregate demand.
[1½]
25 Which one of the following is most likely to be the best method of reducing long term
structural unemployment?
A Expansionary fiscal policy.
B Expansionary monetary policy.
C A reduction in trade union powers.
D Better education and training. [1½]
26 Which one of the following is NOT likely to lead to cost push inflation?
A An increase in trade union powers.
B An appreciation of the domestic currency s exchange rate.
C An increased budget deficit which causes interest rates to rise.
D An increase in the profit margins applied by firms.
[1½]
107 A2004 9 PLEASE TURN OVER
27 List FOUR factors that increase the price elasticity of demand for a product. [4]
28 Consider the following data for a perfectly competitive firm, where the market price
for the commodity is £30:
Output Total
per week Cost (£ s)
0 5
1 45
2 78
3 99
4 114
5 132
6 162
7 210
(i) Construct a table showing the marginal cost and average variable cost at each
level of output. [2]
(ii) State the profit maximising level of output of the firm. [1]
(iii) Calculate the profit at the profit maximising level of output. [1]
[Total 4]
29 (i) Explain the difference between the law of diminishing returns and the law of
diminishing marginal utility. [2]
(ii) Draw a marginal product curve for good X that you would expect from the
laws of increasing and diminishing returns. Clearly indicate on the curve a
region of negative marginal product. [1]
(iii) Draw a marginal utility curve for good X that you would expect from the law
of diminishing marginal utility. Indicate on the curve a region of negative
marginal utility. [1]
[Total 4]
30 Draw a diagram showing a profit maximising monopolist making supernormal profit
at its profit maximising output. Ensure that the firm has constant average costs at all
levels of output. Make sure that you include the following curves with the labels as in
the parentheses: marginal revenue (MR), average revenue (AR), marginal cost (MC)
and average cost (AC). Mark the price P1, quantity Q1 and average cost C1. [4]
107 A2004 10
31 Discuss the key factor that distinguishes monopolistic competition from perfect
competition and the implications for the demand curve facing the individual firm in
each market structure. [4]
32 Explain the meaning of the following words when used in economics.
(i) resources [2]
(ii) scarce [1]
(iii) allocation [2]
[Total 5]
33 Explain how the introduction of the following controls will affect prices, quantity
supplied and quantity demanded, and whether the outcome will be a surplus or a
shortage of goods supplied.
(i) A price ceiling set below the free market price. [2]
(ii) A price floor set above the free market price. [2]
[Total 4]
34 (i) Define economies of scale and diseconomies of scale . [2]
(ii) List FOUR reasons for economies of scale. [2]
[Total 4]
35 (i) Using the IS-LM diagram explain the effects of a contractionary open market
operation on the money supply, the short term rate of interest and the level of
national income. [2]
(ii) Using the IS-LM diagram explain the effects of an expansionary fiscal policy
financed by bond sales on the money supply, the long term rate of interest and
the level of national income. [2]
[Total 4]
107 A2004 11
36 You are given the following data on Country A s international transactions for the
year 2003 with the rest of the world (ROW):
£ millions
Exports of goods and services 180
Imports of goods and services 150
Interest, Profits, Dividends received from ROW 30
Interest, Profits and Dividends paid to ROW 50
Unilateral receipts from ROW 20
Unilateral payments to ROW 40
Capital inflows from ROW 80
Capital outflows to ROW 40
Statistical error ?
Increase in official reserves 25
(i) Calculate the current account balance indicating whether it is in surplus(+) or
deficit( ). [1]
(ii) Calculate the statistical error indicating whether it is positive(+) or
negative( ). [1]
(iii) State whether the increase in official reserves indicates that the Central Bank
has been buying or selling (a) foreign currency (b) sterling, in the foreign
exchange market. [1]
(iv) State with reasons whether or not it is possible to calculate the trade balance
amounts from the above set of figures. [1]
[Total 4]
37 (i) Discuss the view that the best way for a country to tackle a current account
deficit is to devalue its currency. In your answer, discuss what other
macroeconomic policy measures may be used to reduce a current account
deficit. [10]
(ii) Discuss the possible advantages that adherence to a fixed exchange rate
regime may have over a floating exchange rate regime. [10]
[Total 20]
END OF PAPER
Faculty of Actuaries Institute of Actuaries
EXAMINATIONS
April 2004
Subject 107 Economics
EXAMINERS REPORT
Faculty of Actuaries
Institute of Actuaries
Subject 107 (Economics) April 2004 Examiners Report
Page 2
General comment
There were a few instances where the candidates answers to some questions were totally
illegible - accordingly it was impossible to award any marks in these instances. The overall
standard was generally good with many candidates exhibiting high marks.
Multiple choice Section
Generally well answered although questions 3,6,11,13,19,23 and 24 caused most problems
for candidates.
1 B
2 B
3 D
4 B
5 B
6 D
7 C
8 D
9 C
10 D
11 D
12 A
13 D
14 B
15 A
16 D
17 D
18 C
19 B
20 C
21 B
22 C
23 C
24 B
25 D
26 B
Subject 107 (Economics) April 2004 Examiners Report
Page 3
27 (1) An increase in the number of close substitutes.
(2) An increase in the proportion of the consumer s income spent on the good.
(3) A reduction in the degree of necessity of the good.
(4) An increase in the time period under consideration.
(5) A reduction in the volatility of the price of the product.
(6) A reduction in the brand loyalty for the product.
(7) Other relevant factors correctly described.
References to broadness of product description tended to be confused. Many people stated
the general factors, but not which way in it should move to increase elasticity.
28 (i)
Output Total Marginal Average Variable
per week Cost (£ s) Cost (£ s) Cost (£ s)
0 5
1 45 40 40
2 78 33 36.5
3 99 21 31.33
4 114 15 27.25
5 132 18 25.4
6 162 30 26.16
7 210 48 29.28
(ii) 5 or 6 units
(iii) £18
Entries for marginal cost were frequently wrong.
Subject 107 (Economics) April 2004 Examiners Report
Page 4
29 (i) The law of diminishing returns applies to the short run production process. It
states that as you add increasing amounts of a variable factor of production to
a given amount of a fixed factor of production then after a certain point the
marginal product of the variable factors will decline.
By contrast the law of diminishing marginal utility applies to consumption. It
states that as a consumer consumes increasing amounts of a given product then
the marginal utility derived from the product will decline.
(ii)
Marginal product
of Good X
Quantity of variable
factor e.g. labour
Negative marginal product
Subject 107 (Economics) April 2004 Examiners Report
Page 5
(iii)
In part (i) the short run (or capital factors fixed) was rarely mentioned; relatively few
candidates correctly charted the marginal amounts. Some candidates confused marginal
product and total product. Parts (ii) and (iii) were poorly answered with
a significant number of candidates labelling the axes incorrectly.
30
Marginal utility
of Good X
Quantity of Good X
consumed
Negative marginal utility
MC=AC
P1
MR AR
Q1
C1
Price/cost
output
Subject 107 (Economics) April 2004 Examiners Report
Page 6
Despite using a constant Average Cost line, many candidates incorporated an increasing
Marginal Cost curve. Some candidates did not label axes and curves as requested in the
question.
31 The key factor that distinguishes monopolistic competition from perfect competition
is that under monopolistic competition the firms sell similar but differentiated
products whereas under perfect competition all the firms sell identical products. This
means that firms under monopolistic competition have some pricing power (e.g. brand
loyalty) and can raise their price without losing all their customers. The firm faces a
downward sloping demand curve for its product. Under perfect competition since
firms are selling identical products they have no pricing power and are price takers .
Each firm therefore faces a horizontal demand curve for its product.
Generally well answered - some candidates failed to bring out product differentiation.
32 (i) In economics resources are divided into three broad types.
Land: All natural resources
Labour: All human effort
Capital: All man-made resources used in production.
Sometimes entrepreneurs (i.e. people who own business) is added to this
list.
(ii) A resource is scarce if there would not be enough of it to satisfy all the people
who would want to make use of it if it had a zero price.
(iii) Allocation refers to how resources are used. There are three main allocation
questions:
Which goods and services should be produced?
How should the goods and services be produced?
Who should consume the goods and services which have been produced?
Generally well answered - many simply stated the elements in (i) and few candidates
mentioned entrepreneurial resource. Part (ii) was very well answered and part (iii) was also
generally well answered.
Subject 107 (Economics) April 2004 Examiners Report
Page 7
33 (i) Price will be reduced, quantity supplied will fall, quantity demanded will rise.
There will be a shortage.
(ii) Price will be increased, quantity supplied will rise, quantity demanded will
fall.
There will be a surplus.
Many used diagrams but failed to state the effects on all the factors specified in the question.
Some candidates failed to answer the question by explaining explicitly what would happen to
prices, quantity demanded and supplied.
34 (i) Economies of scale refer to the situation where long run average costs fall as
output is increased. Diseconomies of scale refer to the situation where long
run average costs rise as output is increased.
(ii) The four reasons might include:
Indivisibilities
Specialisation
Physical economies
Finance
Bulk purchases
By-products
The principle of multiples
Generally well answered. However many candidates did not the mention long run. There was
some confusion between average costs and total costs, and also confusion between
diseconomies of scale and diminishing marginal returns. Part (ii) was very well answered.
Subject 107 (Economics) April 2004 Examiners Report
Page 8
35 (i) With a contractionary open market operation the Central Bank will sell
Treasury bills in exchange for money. The result is that the price of treasury
bills falls, the short term rate of interest rises and the rise in interest rates will
reduce investment and consumption so lowering the level of national income.
This is depicted in the diagram below with the reduction in the money supply
shifting the LM curve to the left from LM1 to LM2, the interest rate rising
from r1 to r2 and the level of national income falling from Y1 to Y2.
rate of
interest
national income
LM1
LM2
IS1
r1
r2
Y2 Y1
Subject 107 (Economics) April 2004 Examiners Report
Page 9
(ii) With an expansionary fiscal policy financed by the sale of bonds, the
government sells bonds and uses the proceeds raised to finance increased
government expenditure. The effect on the money supply should be zero as the
money raised from the bond sales is spent by the government, however, the
increase in the supply of bonds for sale pushes down bond prices and raises
the interest rate. There is a multiplier effect associated with the increase in
government expenditure which is only partially offset by the effect of rising
interest rates on consumption and investment so there is a net increase in the
level of national income. This is depicted in the diagram below with the
increase in government expenditure shifting the IS curve to the right from IS1
to IS2 and the interest rate rising from r1 to r2 and the level of national income
rising from Y1 to Y2.
Part (i) was better answered than part (ii). Few mentioned the money supply in part (ii)
despite question specifically for this.
36 (i) Deficit £10 million
(ii) minus £5 million
(iii) The increase in official reserves indicates that the Central Bank has been
buying foreign currency and selling sterling in the foreign exchange market.
(iv) It is not possible to calculate the trade balance as this is the balance of exports
in goods minus imports of goods only. The above figures are for both goods
and services and we need to know the value of the services component before
we can calculate the trade balance.
Generally well answered. Although part (iv) was not particularly well answered.
rate of
interest
national income
LM1
IS2
r1
r2
Y1 Y2
IS1
Subject 107 (Economics) April 2004 Examiners Report
Page 10
37 (i) There is no easy way to tackle a current account deficit. A current account
deficit means that a country s expenditure on goods/services from the rest of
the world is greater than its revenues received from exports of goods/services
from the rest of the world.
Devaluation is certainly a useful tool in the medium to long term in helping to
correct a current account deficit. This is because a devaluation makes exports
more competitive as measured in the foreign currency and imports more
expensive as measured in the domestic currency. According to the Marshall
Lerner condition provided the sum of the elasticity of demand for exports and
imports is greater than unity then a devaluation will improve the current
account.
In the short run, devaluation is less likely to be effective in correcting a current
account deficit since elasticities of demand for imports and exports are lower
in the short run. Imports cost more in the domestic currency while import
volumes do not decline sufficiently and exports earn less with exports not
increasing sufficiently. Indeed, empirical evidence tends to suggest that the
elasticities of demand for imports and exports in the short run are so low that
the current account initially deteriorates. The idea of an initial deterioration in
the current account followed by a subsequent improvement is known as the Jcurve
effect depicted in the figure below:
The J-curve
One major problem with devaluation is that by making imports more
expensive it could spark off wage and price pressures which to some extent
will undermine the increased competitiveness one might otherwise have
expected. In addition, the effectiveness of devaluation will be undermined if
other trading competitors devalue their currencies so as maintain their
international competitiveness.
Time
current
account
surplus
0
current
account
deficit
Subject 107 (Economics) April 2004 Examiners Report
Page 11
There are other means that a government can use than devaluation to correct a
current account deficit. These include tighter fiscal and monetary policies. The
current account which ignoring transfers is given by exports minus imports
(X M) has its counterpart in either domestic investment (I) being greater than
domestic savings (S) and/or government expenditure on goods and services
(G) exceeding tax revenue (T) as given by the equation below:
(X M) = (S I) + (T G)
Introducing a tighter monetary policy by raising the domestic interest rate will
discourage consumption (encourage savings) and reduce investment so
helping to improve the first bracketed expression on the right hand side.
Tighter fiscal policy in the form of a rise in taxes or cut in government
expenditure will reduce national income and with it expenditure on imports
also helping to improve the current account.
Devaluation is by no means the only mechanism for improving the current
account and its relative effectiveness as compared to fiscal and monetary
policies will depend upon the structural parameters of the particular economy
under consideration. However, there can be little doubt that a combination of
devaluation supported by tighter fiscal and monetary policies will be the most
effective means of tackling a current account deficit although this may have
adverse consequences for employment and output.
(ii) There are numerous potential advantages that fixed exchange rates may have
over floating exchange rates.
(a) Reduction in exchange rate uncertainty fixed exchange rates
provide a degree of stability that may not be present under floating
exchange rates. As such they help to promote trade and investment.
(b) Discipline for economic policy provided the currency is pegged to a
low inflation currency then it will provide a degree of discipline for
economic policy that may not be present if the country has a floating
exchange rate. The need to keep its inflation rate in line with a low
inflation currency will mean the authorities will have to conduct
prudent fiscal and monetary policies.
(c) Fixed exchange rates promote international policy cooperation the
need to maintain fixed exchange rates means that the countries
involved in the arrangement need to coordinate their macroeconomic
policies and this may lead to better economic policies than under
floating exchange rates where the need to coordinate is less.
(d) Fixed exchange rates reduce the dangers of destabilising exchange rate
speculation, which can lead to misaligned exchange rates under
floating. It is sometimes claimed that floating exchange rates can be
characterized by bouts of destabilizing speculation which moves
exchange rates out of line with economic fundamentals which then
Subject 107 (Economics) April 2004 Examiners Report
Page 12
causes harm to the real economy and such misalignments can be
reduced by fixed exchange rates.
(e) Fixed exchange rates reduce the need to engage in hedging activity.
Under fixed exchange rates the greater certainty about the future spot
exchange rate means that there is less need for businesses to engage in
costly hedging of foreign exchange risk. By contrast, the greater
uncertainty that exists under floating exchange rates requires
businesses to engage in greater hedging activity.
The Essay questions were the least well answered part of the examination with many
candidates writing insufficient quantity and quality.
Part (i) few mentioned the 'J' curve effect and distinguished between short and long run
effects of a devaluation. Reducing aggregate demand was not given sufficient emphasis by a
significant minority of candidates.
In part (ii) many candidates found it difficult to stick to the advantages as the question asked.
Candidates need to stick to the question asked and not just talk about fixed and floating
exchange rate regimes in a general way.
END OF REPORT
Faculty of Actuaries Institute of Actuaries
EXAMINATIONS
28 September 2004 (am)
Subject 107 Economics
Time allowed: Three hours
INSTRUCTIONS TO THE CANDIDATE
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
3. Mark allocations are shown in brackets.
4. Attempt all 37 questions. From question 27 onwards begin each answer on a separate
sheet.
Graph paper is not required for this paper.
AT THE END OF THE EXAMINATION
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
In addition to this paper you should have available Actuarial Tables and
your own electronic calculator.
Faculty of Actuaries
107 S2004 Institute of Actuaries
107 S2004 2
For questions 1 26 indicate in your answer booklet which one of the answers A, B, C or D is
correct.
1 The problem of scarcity in economics:
A exists only in economies which rely on the market mechanism
B could be eliminated if we force prices to fall
C means that there are shortages of some goods
D exists because there are insufficient resources to satisfy human wants
[1½]
2 Which of the following would NOT cause an increase in demand for a normal good?
A An increase in income.
B An increase in the price of a substitute.
C A decrease in the price of a substitute.
D A decrease in the price of a complement.
[1½]
3 Revenues from the sale of a good will decrease if:
A income increases and the good is normal
B its price rises and demand is elastic
C its price rises and demand is inelastic
D income falls and the good is inferior
[1½]
4 The price elasticity of demand for a product is 3. A reduction in price from 30 pence
to 29 pence will result in an increase in demand of:
A 3.0%
B 3.3%
C 6.0%
D 10.0%
[1½]
5 If the cross elasticity of demand between goods X and Y is positive then:
A X and Y are complements
B X and Y are substitutes
C the demand for X and Y are both price elastic
D the demand for X and Y are both price inelastic
[1½]
107 S2004 3 PLEASE TURN OVER
6 The problem of moral hazard:
A describes the situation in which those who know they are particularly bad risks
are more inclined to take out insurance than those who know they are good
risks
B reduces the cost of insurance for low risk people
C describes the situation in which those with insurance act in a way which
makes the insured event more likely
D reduces the cost of insurance for high risk people
[1½]
7 A firm s marginal product of labour is positive but diminishing. In the short run, the
employment of additional units of labour will cause:
A total product to fall at an increasing rate
B total product to fall at a decreasing rate
C total product to rise at an increasing rate
D total product to rise at a decreasing rate
[1½]
8 If the price of a fixed factor of production increases by 50%, what effect would this
have on the marginal costs facing a firm?
A Marginal costs would increase by 50%.
B Marginal costs would increase by less than 50%.
C Marginal costs would increase by more than 50%.
D No effect.
[1½]
9 Which of the following DOES NOT describe both perfect competition and
monopolistic competition?
A Each firm produces an identical product.
B Normal profits are made in the long run.
C The demand curve for the industry as a whole slopes down.
D Free entry and exit of firms.
[1½]
107 S2004 4
10 Which of the following is NOT a barrier to entry in oligopoly?
A Product proliferation.
B Investment in spare capacity.
C Constant returns to scale.
D High advertising expenditure.
[1½]
11 Which of the following taxes is indirect?
A A tax on expenditure.
B A tax on earned income.
C A tax on investment income.
D A tax on rent received.
[1½]
12 If a profit maximising firm s marginal revenue is less than its marginal cost, the firm:
A must be experiencing economic losses
B must be making supernormal profits
C should decrease its output
D should increase its output
[1½]
13 A firm with fixed costs of £100 per week and a constant average variable cost of £3
per unit of output, has the following information about its weekly sales.
Quantity Total Revenue
30 240
40 280
50 300
60 310
Which of the following quantities of sales per week produces the highest level of
profits?
A 30 units.
B 40 units.
C 50 units.
D 60 units.
[1½]
107 S2004 5 PLEASE TURN OVER
14 Net National Product is defined as Gross National Product minus:
A taxes
B transfer payments
C depreciation
D retained corporate earnings
[1½]
15 Which of the following is an example of an injection into the circular flow of income?
A Investment
B Saving
C Taxation
D Imports
[1½]
16 Which of the following factors helps explain why the aggregate demand curve
has a negative slope? As the price level falls:
A domestic consumers have an incentive to purchase more of the cheaper goods
and services
B the central bank will have to increase the supply of money which will lead to
an increase in the amount purchased
C the government will have to reduce taxes which will lead to an increase
in the amount purchased
D the real balances of people holding a fixed quantity of money increases
causing them to expand their purchases
[1½]
17 If a household s disposable income increases from £15,000 to £20,000 and as a result
its consumption increases from £12,000 to £15,000, what is the household s marginal
propensity to consume?
A 0.8
B 0.75
C 0.7
D 0.6
[1½]
107 S2004 6
18 The economy cannot stay at a level of real national income above long-run aggregate
supply because wages will:
A fall, thus shifting the long-run aggregate supply curve rightward
B fall, thus shifting the short-run aggregate supply curve rightward
C rise, thus shifting the long-run aggregate supply curve leftward
D rise, thus shifting the short-run aggregate supply curve leftward
[1½]
19 Crowding out describes the:
A extent to which government expansionary policy is counteracted by lower
private spending resulting from higher interest rates
B extent to which government contractionary policy is counteracted by lower
private spending resulting from higher interest rates
C increase in interest rates caused by contractionary monetary policy
D increase in consumption expenditure caused by lower taxes
[1½]
20 The higher the reserve requirements for commercial banks:
A the higher the money multiplier
B the lower the money multiplier
C the larger the amount of total deposits that can be created from a new deposit
D the larger the amount of total money that can be created from a withdrawal
[1½]
21 Money that is held because of possible unforeseen events is held because of the:
A speculative motive for holding money
B transactions motive for holding money
C precautionary motive for holding money
D asset motive for holding money
[1½]
107 S2004 7 PLEASE TURN OVER
22 Purchasing Power Parity is the principle that:
A the exchange rate adjusts to equate the standard of living in the trading
countries
B the exchange rate adjusts to offset differences in inflation rates between
countries
C the exchange rate adjusts to equate currency values relative to gold
D the exchange rates between currencies are fixed
[1½]
23 If the hourly production of good X and good Y by individuals A and B is as follows:
Good X Good Y
Individual A 10 50
Individual B 40 800
A B has a comparative advantage in producing X and Y
B B has a comparative advantage in producing X
C A has a comparative advantage in producing X
D A has a comparative advantage in producing X and Y
[1½]
24 Under a fixed exchange rate system the following approaches might be considered by
governments to correct a balance of payments deficit.
I Discouragement of imports.
II Support for exporters.
III Increase the level of aggregate demand.
Which of the following is most likely to achieve this objective?
A I only.
B II only.
C I and II only.
D I, II and III.
[1½]
107 S2004 8
25 If unemployment is above the natural level, the long run Phillips curve would suggest
that, other things remaining the same, real wages would:
A fall and unemployment would rise
B fall and unemployment would fall
C rise and unemployment would fall
D rise and unemployment would rise
[1½]
26 Which of the following is best suited to reducing the level of structural
unemployment?
A Provision of government funds for retraining the unemployed.
B Providing higher voluntary redundancy payments for those in declining
industries.
C Increasing general government fiscal expenditure.
D Raising unemployment benefit.
[1½]
27 (i) A firm, operating in a perfectly competitive market, sells goods for £10 per
unit (the market price). The wage rate for workers is £70 each per day. As
more workers are employed, the output of the firm increases as shown in the
table below:
Number of Workers Output per Day
0 0
1 24
2 44
3 59
4 67
5 73
6 77
Construct a table to show at each level of employment (i.e. for each number
of workers) the firm s
(a) average product of labour per day
(b) marginal product of labour per day
(c) marginal revenue product of labour per day
[3]
(ii) State the profit maximising level of employment. [1]
[Total 4]
107 S2004 9 PLEASE TURN OVER
28 (i) Draw a diagram to show the profit maximising price and output of a firm with
a kinked demand curve in an oligopoly market. The curves in the diagram
should be labelled: MR for marginal revenue, AR for average revenue, MC
for marginal cost. Price and quantity should be labelled P1 and Q1
respectively. [3]
(ii) Explain why the demand curve is kinked. [2]
[Total 5]
29 (i) Define the following:
(a) the IS curve
(b) the LM curve
[2]
(ii) Using an IS/LM diagram, describe the effect of an increase in government
expenditure (fiscal expansion) on the equilibrium values of the rate of interest
and national income. [2]
[Total 4]
30 (i) Explain two potential problems caused by unanticipated inflation. [2]
(ii) Explain four potential problems caused by anticipated inflation. [2]
[Total 4]
31 (i) In each of the following cases calculate the value of the multiplier assuming
that the components of aggregate demand are exogenous and that there are no
direct taxes.
(a) The marginal propensity to save is 0.4.
(b) The marginal propensity to consume is 0.75.
[2]
(ii) Explain how direct taxes which are proportional to income will affect the
value of the multiplier. [2]
[Total 4]
32 (i) Explain the meaning of the term economic growth . [1]
(ii) Outline the factors which may lead to economic growth. [3]
[Total 4]
107 S2004 10
33 Using a Phillips curve diagram, illustrate how a reduction in the rate of growth of
money supply may lead to a reduction in the rate of inflation. Use the labels LRPC
and SRPC for long run and short run Phillips curves respectively. [4]
34 Use the following data for a hypothetical Keynesian economy to answer the questions
below.
Consumption expenditure is £425 million plus 80% of disposable national income.
The tax rate is 15% of national income.
Investment expenditure is £265 million.
Government expenditure is £210 million.
Export expenditure is £230 million.
Imports are 10% of national income.
(i) Calculate the level of consumption expenditure when GDP is £2400 million.
[1]
(ii) Calculate the surplus or deficit on the balance of trade when GDP is £2400
million. [1]
(iii) Calculate the equilibrium level of GDP. [2]
[Total 4]
35 (i) Outline the economic benefits which arise from international trade. [2]
(ii) Explain the expression the terms of trade . [2]
[Total 4]
36 (i) Describe the relationship between the marginal productivity of labour and
short run marginal costs. [2]
(ii) Describe the relationship between average long run costs of production and
(a) economies of scale
(b) diseconomies of scale
[2]
[Total 4]
37 (i) Describe an indifference curve and discuss briefly the assumptions which
underpin indifference curve analysis. [5]
(ii) Use indifference curve analysis to explain the effect of a price change on the
demand for a normal good and a Giffen good. [15]
[Total 20]
END OF PAPER
Subject 107 (Economics) September 2004 Examiners Report
Faculty of Actuaries Institute of Actuaries
EXAMINATIONS
September 2004
Subject 107 Economics
EXAMINERS REPORT
Faculty of Actuaries
Institute of Actuaries
Subject 107 (Economics) September 2004 Examiners Report
Page 3
Q1-26 Multiple Choice
The overall performance of candidates for multiple choice questions was good. Some
questions were answered incorrectly more frequently than others. These included questions
16, 18 and 23 (where answer b was the most frequent error).
Q27
Generally well answered. There were minor slips in the construction of the table and some
confusion between revenue and profit when calculating the marginal revenue product of
labour.
Q28
In some cases the diagram was poorly drawn and therefore unclear. In part (ii) many
candidates failed to mention elasticity in their answer.
Q29
Although straightforward, Part (i) was rather poorly answered. In Part (ii) many candidates
wrote essay length answers (generally of a high standard) to a part of the question worth
only 2 marks.
Q30
In some cases there was basic confusion between anticipated and unanticipated inflation.
Some candidates listed rather than explained . The length of the answers varied
considerably and it should be noted that only 2 marks were allocated to each part.
Q31
Generally well answered. In part (ii) some candidates only gave a formula for the multiplier
without a full answer to the question.
Q32
Most candidates organised their answer around a discussion of GDP or GNP, however some
failed to distinguish between nominal and real measures.
Q33
Although diagrams showing the adjustment loop were reproduced accurately in many cases,
candidates were less able to explain the mechanism by which a reduction in the rate of
growth of money supply may lead to a reduction in the rate of inflation.
Q34
Well answered. Calculations were straightforward. Some marks were lost due to careless
work.
Subject 107 (Economics) September 2004 Examiners Report
Q35
Part (i) was generally well answered. In part (ii) some candidates incorrectly identified the
terms of trade with the trade balance. Others argued that it was a contract drawn up by two
countries listing the terms under which they would trade.
Q36
One of the more poorly answered questions on the paper. It was clear that the difference
between the short run and the long run was not understood by many candidates. There was
little understanding of how marginal product would go down and marginal cost up.
Q37
The essay question was straightforward.
(i) Surprisingly the quality of answers in this part of the question varied greatly in terms
of the definitions and number of assumptions discussed. In particular diminishing
marginal rate of substitution was not well handled.
(ii) The most common pitfalls included, trying to explain both cases using one diagram
(which was unclear and confusing) and the omission of a discussion of income and
substitution effects. The most ambitious sought to analyse the effect of a price change
considering both a price increase and a price decrease. This was unnecessary.
General Comments
This was a straightforward paper. In several instances handwriting was virtually illegible.
Diagrams were often drawn freehand. Clarity would have been enhanced through the simple
use of a ruler.
Subject 107 (Economics) September 2004 Examiners Report
Page 5
1 D
2 C
3 B
4 D
5 B
6 C
7 D
8 D
9 A
10 C
11 A
12 C
13 B
14 C
15 A
16 D
17 D
18 D
19 A
20 B
21 C
22 B
23 C
24 C
25 B
26 A
Subject 107 (Economics) September 2004 Examiners Report
27 (i)
No. of Workers APL MPL MRP
0 0
1 24 24 240
2 22 20 200
3 19.7 15 150
4 16.8 8 80
5 14.6 6 60
6 12.8 4 40
(ii) 4 workers
28 (i)
Price
Quantity
AR
MR
0
P1
MC
Q1
Kinked demand curve model of Oligopoly
Subject 107 (Economics) September 2004 Examiners Report
Page 7
(ii) The demand curve is kinked at the current price because the demand curve is
more elastic above the current price and more inelastic below.
If an oligopolist cuts its price, rivals will follow suit.
If an oligopolist raises its price rivals will not follow.
29 (i) (a) The IS curve shows combinations of interest rates and national income
at which investment demand will equal savings.
(b) The LM curve shows combinations of interest rates and national
income for which the demand for liquidity equals the supply of money.
(ii)
The increase in government expenditure will move the IS curve to the right
(IS1 to IS2) and result in an increase in national income (Y1 to Y2) and the rate
of interest (R1 to R2).
30 (i) The potential problems caused by unanticipated inflation are:
Unintended and arbitrary redistribution of wealth from lenders (typically the
elderly) to borrowers (typically the young) when inflation is unexpectedly
high.
Lenders may require a higher real rate of interest to compensate them for the
risk of unexpected inflation. This is sometimes called inflation risk
premium .
R
Y
IS1
Y1
LM
0
IS2
Y2
R2
R1
Subject 107 (Economics) September 2004 Examiners Report
People who are due to receive money under any type of fixed price contract or
pension arrangement will lose out if inflation is unexpectedly high.
(ii) The potential problems caused by anticipated inflation are:
Money illusion mistake a difference in prices caused by inflation for a real
difference in price.
Menu costs scarce resources are wasted purely to cope with changes in
prices.
Shoe-leather costs more frequent financial transactions so that more
resources are required in the financial services industry; less cash is held
which may result in missed opportunities.
High inflation would be a problem if there was a desire to maintain the value
of the currency.
The possibility of leading to a situation of hyper-inflation.
31 (i) (a) 2.5
(b) 4
(ii) The introduction of a proportional tax on income will give a further leakage
from consumer expenditure as national income rises. This will reduce the
marginal propensity to consume out of national income and the value of the
multiplier will fall.
Subject 107 (Economics) September 2004 Examiners Report
Page 9
32 (i) The term economic growth is used to refer to increases in real GNP or GDP.
Sometimes, economists will consider GNP (or GDP) per capita, so that
economic growth can be used to refer to real growth in GNP per person.
(ii) Economists explain economic growth in terms of increases in the quantity and
productivity of the following factors used in production:
Capital man-made resources.
Labour all human effort.
Land all natural resources
Technical knowledge invention and innovation
33
Starting at point A with LRPC and SRPC2 the natural level of unemployment is U1
and the rate of money supply growth is 10%pa. Thus actual and expected price and
wage inflation are all 10% pa as well.
If the government cuts the rate of growth of the nominal money supply to say 5% but
inflation remains at a higher level the real money supply will contract. This causes
interest rates to rise. Private sector investment and consumption will fall leading to
higher unemployment. The economy will move right from A to B down the SRPC2
curve and unemployment will rise.
If the government continues to expand money supply at only 5% workers will
eventually come to expect 5% inflation in the long run and the economy will move
onto SRPC1 at point C. Wage inflation will be a little lower than 5% and so the real
money supply is expanding, eventually taking the economy back to LRPC at point D
as interest rates and thus unemployment fall.
Unemployment Rate
Inflation
Rate
SRPC2
SRPC1
LRPC
0
10%
5%
U1
A
B
D
C
Subject 107 (Economics) September 2004 Examiners Report
34 (i) C = 425 + 0.8(2400 0.15(2400))
C = £2057
(ii) Exports = £230 million
Imports = 0.1(2400) = £240 million
Balance = £10 million (deficit)
(iii) Y = 425 + 0.8 (Y 0.15(Y)) + 265 + 210 + 230 0.1(Y)
Y = 1130 + 0.58 (Y)
Y = £2690 million
35 (i) International trade allows the world's resources to be used in a more
economically efficient way. In particular, the existence of world trade:
Allows countries to specialise in the production of the goods which they
can produce relatively more efficiently than other countries.
Increases the scope for benefits from economies of scale by increasing the
size of the available markets.
Increases the range of goods and services which consumers can buy.
Leads to lower prices through increased competition which benefits
consumers rather than producers.
(ii) The terms of trade for a country is the quantity of domestically produced
goods that have to be sacrificed in order to obtain a unit of imported goods. In
other words, the terms of trade is the opportunity cost of imported goods in
terms of the goods that have to be exported to pay for imports.
Subject 107 (Economics) September 2004 Examiners Report
Page 11
36 (i) Since capital is fixed in the short run, the amount of capital available to each
worker declines as more workers are employed. Consequently diminishing
marginal productivity will eventually arise. If we assume that labour is the
only variable input, there is a direct inverse relationship between the marginal
productivity of labour and short run marginal costs. As more labour is
employed to increase output, marginal productivity of labour will eventually
fall and short run marginal costs will rise.
(ii) (a) Economies of scale refer to the situation where long run average costs
fall as output is increased. This will be the case when an increase in all
inputs gives a greater than proportional increase in outputs. This can
only happen in the long run when all factor inputs are variable.
(b) Diseconomies of scale refer to the situation when long run average
costs rise as output is increased. This is often explained by the
problem of efficiently managing large companies.
37 (i) An indifference curve joins all the two good consumption bundles of equal
utility. The slope of an indifference curve will depend on the consumer s
preferences and is equal to the marginal rate of substitution, (the amount of
one good that the consumer is prepared to swop for one extra unit of another
good).
The key assumptions are:
A consumer can rank any two bundles and can therefore pick a set of
consumption bundles that give the same utility.
Consumers prefer more of a good to less of it therefore indifference curves
slope downwards from left to right and indifference curves further from the
origin give higher utility.
Consumer preferences exhibit diminishing marginal rates of substitution and
are convex to the origin.
(ii) In answering the question an understanding of the substitution and income
effects of a price change is necessary.
The substitution effect of the price change is the change in demand for the
good caused by the change in relative prices, holding the level of utility (or
real income) of consumers constant. The substitution effect of a price change
is always negative, it is the opposite direction to the change in price.
The income effect of the price change is the change in demand for the good
caused by the change in the real income of consumers. It can either be
negative (when it is in the opposite direction from the change in price and the
good is a normal good), or positive (when it is in the same direction as the
change in price and the good is an inferior good or Giffen good).
Subject 107 (Economics) September 2004 Examiners Report
The examples below relate to example where a consumer has a choice
between bundles of good X and Y.
Normal Good:
Consider the case where good Y is a normal good. If the price of good Y falls
and the price of good X remains the same the budget line will pivot out from
ab1 to ab2. The consumption point changes from A1B1 to A2B2. For a
normal good the income and substitution effects will both be negative,
(demand will change in the opposite direction to the price change), and
reinforce each other. They both involve an increase in the quantity demanded
as price falls.
Good Y
0
I2
I1
A1
Good
X
B1 B2
A2
b1 b2
a
Subject 107 (Economics) September 2004 Examiners Report
Page 13
Giffen Good:
Consider the case where good Y is a Giffen good and the price of good Y
falls. In terms of the indifference curve diagram the budget line pivots from
ab1 to ab2. In the case of a Giffen Good the positive income effect, which
reduces demand as price falls, is strong enough to exceed the negative
substitution effect, which increases demand as price falls. The overall effect of
the fall in the price of good Y is to decrease the quantity of good Y demanded.
Before the price fall consumption of good X was A1 and good Y was B1.
After the price falls consumption is A2 and B2 for goods X and Y
respectively.
In both cases the diagrams can be used to separate out the income and
substitution effects of the price fall. This is achieved by drawing a
hypothetical budget line, which has the slope of the new budget line and is
tangential to the old indifference curve. The movement along the old
indifference curve from the old consumption bundle to the intermediate
bundle with the same utility is the substitution effect. The income effect is the
change from the intermediate bundle on the old indifference curve to the
point where the new budget line is tangential to the new indifference curve.
END OF EXAMINERS REPORT.

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