Midterm answerAugust 9th 2010

1. Which of the following is least likely to be associated with the incentive system that an economy must have as a precondition to experience economic growth?

a) Human capital that promotes the discovery of new technologies

b) Monetary exchange that facilitates the efficient exchange of goods and services

c) Property rights that govern the ownership, use, and exchange of physical and intellectual property

d) Entrepreneurial policy that promote the formation and growth of domestic production industries

e) Market policy that benefits BOTH buyers and sellers allowing flexible adjustment of demand and supply of domestic products

Answer : AThe 3 institutions that are critical to the development incentives that promote economic growth are markets, property rights, and monetary exchange. With these institutions in place, investment in human capital can lead to economic growth

2. Which of the following is least likely to be associated with the law of diminishing returns?

a) Investment in laborb) Investment in knowledge capitalc) Investment in physical capitald) Investment in infrastructuree) Investment in mutual funds

Answer : BKnowledge capital is a special type of public good that is not subject to the law of diminishing returns. Investment in labor and physical capital do exhibit diminishing returns, which are reflected in the shape of the productivity curve

3. The two economic factors that are most important to the new theory of economic growth are:

a) Population growth and real interest ratesb) Investment in new capital and real interest ratesc) The creation of knowledge capital and real interest ratesd) Population growth and relative interest ratese) Investment in new capital and new technologies

Answer : CThe new growth theory argues that productivity growth is a function of society’s ability to discover new products and methods (ex; the creation of knowledge capital) and real interest rates. A key part of new growth theory is that knowledge is not subject to the law of diminishing returns.

4. Refer to Neoclassical Growth Theory labor productivity graph, what are the most likely values for growth in real GDP per labor hour at:

Point 2 Point 3a) 3% 3%b) 3% 0%c) 0% 3%d) All of the abovee) None of the above

Answer : BThe real interest rate is greater than the target rate of return, so savings are sufficient to support an increase in the growth of capital per labor hour. When this occurs, technology will advance, new profit opportunities will be created, and investment and savings will increase further. As a result, labor productivity (real GDP per labor hour) will experience growth, so the growth rate must be greater than 0% at Point 2At Point 3, real interest rate adjust to the level of the target rate of return, capital accumulation stops, and the growth rate falls to 0%

5. Refer to New Growth Theory labor productivity graph, what are the most likely values for growth in real GDP per labor hour at:

Point 2 Point 3a) 3% 3%b) 3% 0%c) 0% 3%d) All of the abovee) None of the above

Answer : AUnder the new growth theory as depicted in Figure 4, real GDP per labor hour will grow indefinitely at a positive rate because the real interest rate is consistently above the target rate of return. Point A is consistent with a positive growth rate at both Point 2 and Point 3.

6. The two great nations of Bundy and Bandi share a border and a common language, but little else. In 2009 they signed a trade agreement to improve both economies; initially the real GDP in Bundy is four times that of Bandi. If real GDP in Bandi is growing at 10% a year, and real GDP in Bundy is growing at 3.5% a year, approximately how many years will it takes for real GDP in the two nations to match? (Hint: Use the rule of 70 and assume population growth is 0):

a) 10 yearsb) 14 yearsc) 24 yearsd) 35 yearse) 54 years

Answer : CThe rule of 70 states real GDP will double every 70 / r years. Bandi is doubling every 7 years. Bundy is doubling every 20 years. If we arbitrarily assume Bundi’s GDP is 1 unit and Bundy’s is 4, Bundy’s GDP will increase from 4 to 8 over the next 20 years. During roughly the same period, Bandi’s will increase from 1 to 2 to 4 to 8 over 21 years. Thus based on the rule of 70, it will take approximately 20 years before they are equal.

7. A regulatory commission that requires firms in the industry to charge prices that are close to the average cost of production is utilizing which of the following methods of regulation?

a) Rate-of-return regulationb) Cost-of-service regulationc) Average cost regulationd) All of the abovee) None of the above

Answer : BCost-of-service regulation established pricing policies for the industry based upon the actual average costs of the products or services

8. Which of the following is NOT considered results of government regulation?

a) Creative responseb) Feedback effectsc) Capture hypothesisd) Share-the-gains, share-the-painse) None of the above

9. Which of the following statements about international trade is least accurate? If two countries have different opportunity costs of production for two goods, by engaging in trade:

a) Each country gains by importing the good for which it has a comparative advantage

b) Each country can achieve a level of consumption outside its domestic production possibility frontier

c) The low opportunity cost producer of each good will export to the high opportunity cost producer of that good

d) The country with low opportunity cost will gain by exporting goods to the country with high opportunity, which does not gain from this trade

e) None of the above

Answer : AEach country gains by EXPORTING the good for which it has a comparative advantage

10. Which of the following is true?

a) US has an absolute advantage in computersb) Sweden has a comparative advantage in computersc) Sweden has a comparative advantage in candyd) Both (a) and (b)e) None of the above

Computer Candy

USA 20 120

Sweden 10 30

Answer : D

11. Both countries would benefit if

a) US produced both commodities and did not trade with Sweden

b) Sweden produced both commodities and did not trade with the US

c) The US exported candy and imported computersd) The US exported computers and imported candye) None of the above

Computer Candy

USA 20 120

Sweden 10 30

Answer : C

12. Countries A and B have two factors of production, capital and labor, with which they produce two goods, X and Y. Technology is the same in the two countries. Good X is capital intensive; Country A is capital abundant. An increase in A’s labor would result ina) Increase B’s terms of trade, Decrease A’s terms of tradeb) Decrease B’s terms of trade, Increase A’s terms of tradec) Increase both A and B terms of traded) Decrease both A and B terms of tradee) None of the above

Answer : BAn increase in A’s labor will induce an increase in A’s relative supply of the labor-intensive good, good Y and the price of good Y will decrease. Because A is an importer of good Y, A’s term of trade increase and B’s terms of trade MUST fall

13. Ricardian model with more than two goods. Suppose the unit labor requirements for country A and B are the following:

If the wage rate in A is five times that of B, which goods will country A export? Which goods will country B export?

a) Country A exports corn, apple, tomato; Country B exports avocado, wheat

b) Country A exports wheat, avocado, corn, apple; Country B exports cornc) Country A exports corn, avocado; Country B exports tomato, apple,

wheatd) Country A exports avocado; Country B exports corn, tomato, apple,

wheate) No trade between two countries due to high wage rate difference (A’s

wage rate is five times that of B) ; all products are cheaper to produce in Country B

Answer : C

Country A Country BCorn 2 20Avocado 6 48Tomato 5 20Apple 7 20Wheat 12 6

Consider a two country world (the US and Thailand) in which only two goods can be produced, good C (for CLEAN) or good D (for DIRTY). The two goods are produced using only one factor of production called “environmental resources” (E for short). A production process that uses a lot of E results in greater environmental deterioration. Since the US is wealthy, its citizens want environmental quality. Therefore, in the US, the “unit environmental resource requirements,” that is, the number of units of E that are required to produce one unit of a good, are small: they are equal to 1 in the production of C and 2 in the production of D. Thailand, on the other hand, spends more environmental resources producing one unit of each good. Specifically, in Thailand 3 units of E are spent producing one unit of C and 4 units of E are required to produced one unit of D

15. What is the opportunity cost of producing C in terms of D in the United States and in Thailand?

a) US: 2 and Thailand: 0.5b) US: 0.75 and Thailand: 0.5c) US: 1.33 and Thailand: 0.5d) US: 0.5 and Thailand: 0.75e) Not enough information to calculate

Answer : C

•Production of C in the US costs 1 unit of E (aEC=1). This unit of E could have been used to produce 1/aED=1/2 = 0.5 units of D. ▫The opportunity cost of C in terms of D in the

US is therefore aEC/aED= 0.5.•Production of C in the Thailand costs 3 unit

of E (a*EC=3). These three units of E could have been used to produce 3/a*ED=3/4 = 0.75 units of D. ▫The opportunity cost of C in terms of D in

Thailand is therefore a*EC/a*ED= 0.75

16. Suppose that the U.S. is endowed with 100 units of E, and Thailand with 120 units. Which of the following best represents each country’s production possibility frontier?

Answer : A

• The U.S can put all of its 100 units of E into production of the clean good and have 100/ aEC=100 units of C or it could put the 100 units into the dirty good and have 100/ aED=50 units of D. ▫ Between these extremes, the US must forego 2 unit of D for

every 1 unit of C it produces, so the slope of the PPF is simply the (negative of) the opportunity cost of C in terms of D = -1/2.

• Thailand can put all of its 200 units of E into production of the clean good and have 200/a*EC=67 units of C or it could put the 200 units into the dirty good and have 200/ a*ED=50 units of D. ▫ Between these extremes, the developing country must forego 3/4

units of D for every 1 unit of C it produces, so the slope of the PPF is simply the (negative of) the opportunity cost of C in terms of D = -3/4.

• The autarky prices are equal to the nation’s opportunity cost. ▫ In the US, PC/ PD= aEC /aED= ½▫ For Thailand, P*C/P*D=a*EC/a*ED=3/4

A free-trade equilibrium exists in a two-region, two-product world. The United States trade with the Rest-of-the-World, exporting manufacturing and importing energy. Suppose that environmental consciousness has reduced the demand for energy in the US.

17. At given international price, what is the effect in the US of this change in demand on the desired level of imports and of exports?

a) US’s energy demand remains the same; Import decreases; Export increases

b) US’s energy demand increases; Import increases; Export decreases

c) US’s energy demand decreases; Import increases; Export increases

d) US’s energy demand decreases; Import decreases; Export decreases

e) Not enough information to answer this questionAnswer : DAt any given price the relative demand of energy in the US decline. This implies a decrease in the desired level of imports, and correspondingly a decrease in the desired level of exports