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Markets and Equilibrium

ECON3101
S1 2014
Revision Questions for Midterm 15 April 2014-ANSWERS
1. If markets have a high intensity of competition, we should more likely to
observe higher or lower prots?
> High intensity of competition is generally associated with lower prots.
2. What are the main ve elements/assumption of the environment for a
perfectly competitive market?
> Large number of homogenous sellers and buyers
3. If Demand > Supply at a certain price and nothing else changes, should
we expect the price to increase, decrease or remain the same? Explain
why.
>Excess demand puts upward pressure on the price since there is scarcity
in the market.
4. Consider a one good market model in which buyers are all the same and
take the market price as given. A typical buyer solves:
max ln qd
qd

s.t. pqd = I

where I is income. What is the buyers demand curve?


> From the budget constraint: qq = I=p:
5. Consider the same market as in 4. above, in which sellers are all the same,
take price as given and solve:
max pqs
qs

qs2 :

What is the supply curve for the seller?


>FoC implies p = 2qs or qs = p=2 .
6. Join your answers from 4. and 5. to solve for the equilibrium price. Show
carefully how you get it.
> qs = qd implies p=2 = I=P or p = (2I)1=2
7. Consider the two goods market with c1 and c2 . A typical buyer solves the
following problem:
maxfln c1 + ln c2 g s.t. p1 c1 + p2 c2 = I:
c1 ;c2

Solve for demands cd1 and cd2 .

p1
p2 c1

I
p2

> Use budget constraint c2 =


wrt to c1 :

then into the utility and maximize

c2
p1
=
c1
p2

or
p2 c2 = p1 c1
into the budget constraint
( + 1)p2 c2 = I or cd2 =

I
p2 (1 + )

I
Then p1 c1 = p2 ( p2 (1+
) ) or

cd1 =
Setting

I
:
p1 (1 + )

= 1 give same as in class example.

8. Remain in the same market as in 7. but now consider the supply side. In
each market, rms are perfectly competitive and take prices as given. In
market 1 rm solves:
maxfp1 q1 (q1 )2
q1

and in market 2 rm solves:


maxfp2 q2
q2

(q2 )2 :

Solve for the supply curves q1s and q2s .


> Clearly qis =

pi
2

for i = 1; 2:

9. Join your results from 7. and 8. and nd the equilibrium prices p1 and
p2 .
> We have cd1 = q1s then

I
p1 (1+ )

p1
2

2 I 1=2
or p1 = ( (1+
))

p2
I
2I
1=2
Then cd2 = q2s then p2 (1+
. Unlike in the lecture,
) = 2 or p2 = ( (1+ ) )
the two prices are dierent here because of the preference parameter .

10. Explain in the two period model how the possibility of borrowing and
lending expands the possible set for consumption c1 and c2 .

> Without borrowing the feasibility set for consumption is:


But with borrowing then it becomes:Borrowing and lending, thanks to
existence of a nancial market, allows for consumption smoothing and
expands the set of feasible allocations.
11. In the two period model, show on a well labelled graph, with indierence curve, budget constraint and income y1 and y2 , a situation where a
household is borrowing in period one and repays the debt in period two.
> It is the reverse of this one: where y1 < c1 . So endowment point (y1 ; y2 )
is to the left of point A.
12. Consider the Intertemporal Budget Constraint (IBC) of the two-period
model. What is the maximum a household could borrow in the rst period?
>The present value of future income which is
than that.

y2
R.

No one would lend more

13. If a borrowing constraint exist in the two-period model of borrowing and


lending, what could be the main reasons for this constraint?
>The lack of commitment is the problem here. In question 12. it assumes perfect commitment, no default. Because of potential for defaults,
a "bank" may lend a fraction of the present value of future income, examples yR2 where < 1.
14. What mainly determines the interest rate in the economy?
> The market for loanable funds through its supply and demand.
15. Suppose that we observe an sudden increase in interest rate and there is
a strong evidence that it is driven by changes in the demand side. What
factors could have created a shift in demand and in which direction (left
or right)?
> What shift the demand curve is investors condence and marginal productivity of capital. Since it is a increase in interest rate driven by demand
side, the deamdn curve must have shifted to the right. That is, higher investor condence or higher marginal productivity of capital or both.
16. Who are the main suppliers and demanders in the market that determines
the interest rate?
>Suppliers are mainly households via saving. Demanders are mainly rms
for investment purpose in project.
17. Suppose that we observe an sudden decrease in interest rate and there is
a strong evidence that it is driven by changes in the supply side. What
factors could have created a shift in supply and in which direction (left or
right)?

>What shift supply is time preference and income mainly. So a lower


interest rate supply driven means the supply must have shifted to the
right. This happens for increase in or increase in income y1 ; y2 or both.
18. Consider the following story: "After some market research, there is some
evidence that investorscondence is on the rise." If indeed this rise occurs,
what are the likely outcomes on the interest rate and saving? Explain
using the tools we have learned.
>We know that increase in investorscondence shift demand for loanable
funds to the right. This leads to higher interest rate. Higher interest rate
leads to higher saving from households.
19. Why is the interest rate on credit cards higher than mortgage rates? Explain.
>The probability of default on credit card is much higher than mortgages.
Moreover, mortgages loans use the house as collateral.
20. In the two-period model with prices, write down and explain the Intertemporal Budget Constraint (IBC).
>The IBC is p1 c1 +
PV of income.

p2
R c2

= y1 +

1
R y2 .

This is the PV of expenditure =

21. In the two-period model with prices and for the case of log utility we have
obtained the following demand curves for each period:
y1 + R1 y2
p1 (1 + )

cd1 =
and
cd2 =

p2 (1 + )

[Ry1 + y2 ]:

Suppose that households suddenly become more impatient and everything


else remains the same. What would happen to cd1 and cd2 ?
>More impatience means lower
use derivative to show that

. Clearly lower

increases cd1 . You can

@cd2
1
=
[Ry1 + y2 ] > 0.
@
p2 (1 + )
22. Considering the same model as in 21., how do prices change aect saving?
>We have shown in class that prices do not aect saving in the log utility
model. Here is what we found:
sd = y1

p1 y1 + p1 R1 y2
=
y1
p1 (1 + )
1+

1
1+

y2
:
R

23. In the same model as 21. again, we have derived the following equilibrium
prices:
1=2
y1 + R1 y2
p1 = 2
(1 + )
and

1=2

p2 =
Suppose that <
p2 ? Explain why.

1
R,

(1 + )

[Ry1 + y2 ]

would this imply that p1 is bigger, lower or equal to

>Here you can show:

y1 +

1=2

1=2

p1

y1 + R1 y2
2
(1 + )

1
y2
R

>

Ry1 + y2 since R < 1 and R > 1.

>

(1 + )

[Ry1 + y2 ]

= p2

This happen because household is relatively impatient compared to return


on saving. Then they want to consume more today, leading to higher
demand and higher price.
24. Consider the model with labour income. Households solve:
maxfc + ln `g s.t. pc = wh and ` + h = 1.
c;`

Find the supply of labour hours by the households, that is, hd . How does
it dier from the one found in the lecture on Week 6?
>use the constraint to solve for c = wh
p . Substitute into the utility function
and relace ` = 1 h
wh
maxf
+ ln(1 h)g
h
p
FoC give
w
1
p
=
or hs = 1
p
1 h
w
which makes sense, higher w lead to more hours of work supplied. Unlike
the example in the lecture, here the labour supply is not xed, but upward
sloping.
25. Consider again the model with labour income in 24. But now assume that
household has a non-labour income that we denote by d (dividend). The
budget constraint becomes:
pc = wh + d:
Suppose that the dividend d is a share of rms prot. If the market is
perfectly competitive and in the long run, how would this change your
answer in 24.?
>We know from the perfectly competitive framework in long run, rms
make zero economic prot. Hence, if d is a share of prot, then d = 0,
and the answer to 24. is the same.