Document 253257

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SESSION 2013/2014
This assignment is to be handed in to Room 5B.209 BEFORE 12.00 NOON on MONDAY
25th November, 2013. You will receive an electronic receipt. You should NOT hand in
assignments to your class teacher. Please note that the University has a zero tolerance policy
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Please make sure that your NAME and that of your CLASS TEACHER are printed clearly
on the front page of your assignment.
This assignment is divided into two sections. Each is worth 50% of the marks. You should
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but take this only as a rough guide: you may find that your own answer is longer or shorter
than this.
Please write your answers CLEARLY.
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SECTION A (5 marks per question)
State whether each statement is TRUE, FALSE or UNCERTAIN, giving a brief explanation
in the space provided. Use diagrams where appropriate. Your marks will depend entirely on
the quality of this explanation: e.g., even if it is correct, putting “TRUE” will get no marks
unless you explain your answer.
1. Two countries, A and B, produce two goods, 1 and 2, using only labour. With one unit of
labour, country A can produce 4 units of good 1 and 5 units of good 2; while country B can
produce 6 units of good 1 and 8 units of good 2. Country B has a comparative advantage in
good 1 and an absolute advantage in good 2.
2. When the price of a good in a market falls, consumer surplus in that market must rise.
3. Indifference curves cannot intersect.
4. If two goods are perfect substitutes in consumption, the marginal rate of substitution of one
good for the other will be constant.
5. Laurel has the choice between purchasing insurance for £1000 but incurring no losses if
her car, which is worth £10000 to her, is damaged or purchasing no insurance but facing the
possibility of damage equalling £5000. Laurel thinks that there is a 10% chance of her
receiving damage to her car. If Laurel purchases insurance, this is evidence that she is risk
6. The short run total cost may be greater than, less than, or equal to the long run total cost.
7. Variable costs are non-sunk costs; fixed costs are sunk costs.
8. Imposing a binding minimum wage in an industry must cause employment in that
industry to fall.
9. Monopoly leaves no surplus to consumers, but the profit it generates can make the total
welfare benefit of monopoly higher, taking both consumer and producer well-being into
account, than the benefit of perfect competition.
10. It is possible for all goods to be luxury goods.
Section B (25 marks per question)
1. In 2011, George Osborne announced an increase in the tax on cigarettes in the UK, saying
that “this will reduce smoking…”. This question investigates cigarette taxation.
Suppose for simplicity that we have only two neighbouring countries, A and B, in
Europe. Cigarettes are sold in both countries, but the taxes and prices in each country
may differ. Assume that current cigarette prices are the same in countries A and B. You
can assume that demand is linear for your analysis.
An economist has conducted a study of the demand for cigarettes and has estimated the
following elasticities for you. You can assume these values apply to both countries.
Regulations are measured as index variables (so that a higher index value corresponds to
more stringent regulation on where and when one can smoke) and education is measured
in years of schooling. These are based on the most recent available data:
Education Regulatory
elasticity elasticity
of demand
The own price elasticity in the above calculation assumes that all prices in all countries
are equal and change prices in step with each other (so a 2p rise in price in country A
would be accompanied by the same rise in country B). The own price elasticity in
country A when country B’s price stays constant is -1.2 for adults and -1.5 for teenagers,
in 2010. The regulatory and education elasticity, similarly, refers to changes in regulation
that are in step with each other across countries.
State the formula for own price elasticity of demand. How do you interpret a zero
value for own price elasticity of demand for adults in 1980? Why do you think
that teenagers’ own price elasticity is more negative?
State the formula for cross price elasticity of demand. How do you interpret a
positive value for price elasticity of demand across countries?
State the formula for income elasticity of demand. How do you interpret the
change in sign of this elasticity over time?
State the formula for education and regulatory elasticity of demand and interpret
the sign and magnitude of their values in the tables.
b. Suppose that the price in country B is constant. Illustrate the demand for cigarettes in
country A in 2010. Now, assume that state B’s prices always equal those of state A and
illustrate the demand for cigarettes in country A in 2010. Justify how you have drawn the
diagram using the data on elasticities, above.
c. Suppose that a European-wide tax of £t per pack is imposed. Assume that this tax is fully
reflected in the retail price of cigarettes. Using your diagram in (b), illustrate the effect of
this tax on consumption in country A. Illustrate the revenue earned from cigarette
consumption in A and explain your findings. How does your answer change if only A
raises its tax?
d. Country A’s retail price for a pack of cigarettes in 2010 was £6 per pack, and 2.3Bn packs
were sold. Out of that total price, the 2010 tax was £5 per pack. Should country A expect
to earn more revenue from a £.1 tax hike in this case if it is the sole country to raise taxes,
again assuming that any tax is fully reflected in the retail price of cigarettes? Why?
Should Country A instead consider changes in education to raise the number of years of
schooling from 16 to 17 years? Why?
e. Despite recent tax hikes in certain countries, the number of smokers in those countries has
not fallen in recent years even when we take away the effect of population increases.
Using the numbers in the table, above, how would you explain this?
2. One common way to distribute food benefits to citizens is by vouchers. One current system used
in the United States, for example, distributes electronic cards that recipients can use to purchase
food, but not non-food items such as tobacco, alcohol, or paper good. A similar voucher system
has been introduced selectively in Germany.
Another common way to distribute benefits is cash assistance, where the cash can be used for any
purpose. The German voucher system, in fact, is replacing a cash benefits system. Under the
new universal benefit system, the UK system includes elements of both vouchers and cash. This
question investigates the effects of different methods to supporting -- or taxing -- consumption in
the context of current reductions in cash and in-kind benefits.
Ms. Smith currently receives a cash benefit of £1000 per month, which she allocates only to food
and housing. Food currently costs £10 per “unit”. You can, for example, think of a “unit” as a
shopping trip, but consider food a homogeneous and completely divisible good for the purposes
of this question. Housing costs vary directly with the quality and size of apartment: Ms Smith
currently spends £600 per month to rent a 600 square foot apartment. Housing currently is priced
at £1 per square foot, with a maximum square footage in Ms. Smith’s local area of 1000. You can
assume that Ms. Smith’s preferences satisfy all the usual axioms and that Ms. Smith’s subsistence
needs are met by all relevant bundles.
a. Illustrate Ms. Smith’s budget constraint and her current consumption bundle. Explain your
diagram carefully, giving an economic interpretation of Ms. Smith’s current consumption
b. The government introduces a new “bedroom tax”. For Ms. Smith’s needs, any apartment
with less than 400 square feet would not incur the tax. If she uses any more than 400 square
feet, however, assume that she will incur a tax per square foot on any footage above 400. The
effect of the tax would be to raise her housing cost to £2 per square foot at any size above 400
square feet. Do you agree with Raquel Rolnik, special rapporteur to the UN on housing, that
the UK’s “bedroom tax” could force tenants to cut down on their spending on food? Why?
c. Consider Ms. Smith’s situation without the bedroom tax. This year’s food prices are likely to
fall, as it has been a bumper year for many crops, so that Ms. Smith can purchase the same
items of food now for only £8 per “unit”. At the same time, the UK government is attempting
to reduce its deficit. As a result, the government has proposed a cut in cash benefits to £800
per month. Illustrate the change in Ms. Smith’s choice problem. Will she continue to live at
the same address and reduce her food shopping? Why? Is she better or worse off with the
change? Why?
d. Consider again the case of food at £8 per unit and no bedroom tax. Instead of the cut in cash
benefits proposed in (c), the government instead proposes to cut cash benefits to £600 and
provide food vouchers that allow 40 units of food to be bought. Hence, Ms. Smith can
purchase forty units of food regardless of the market price of food. Illustrate this proposal
and compare it to the cash benefit system proposed in (b). If you were Ms. Smith, which
proposal would you vote for: the cut in cash benefits in (c) or the voucher and cut system in