University of Warwick

Student name and ID number: Robert Butoi-Radoslav, 1421712

Section A

Question 1
Define the following:
i.
ii.

Non-satiation represents the notion that more of any good is, ceteris paribus,
preferred to less of that good. In other words greater quantities will provide
greater levels of satisfaction to a consumer.
The marginal rate of substitution is the rate at which a consumer is ready to give
up one good in exchange for another good while maintaining the same level of
utility.
An indifference map is the group of all of an individuals indifference curves,
where each indifference curve represents the group of points at which, by
consuming different quantities of two or more goods, the consumer gets the same
level of utility. Under the assumption of non-satiation, indifference curves are
convex to the origin, and are moving on to a higher indifference curve, which,
means the consumer enjoys a higher level of utility.

iii.

Question 2
Examine the following statement:
An increase in non-labour income must lead a worker to reduce leisure taken (i.e.
increase labour supply)
An increase in non-labour income means that the opportunity cost of working
increases given that the time an individual can allocate between leisure and work is
limited. The individual already has a certain amount of income for which he would
have been required to spend additional time in a different situation. Since the wage
rate does not increase, the individual has no incentive to perform more work because
he benefits from the new freely-earned income. In this case, we are making the
assumption that Leisure is a normal good for which demand increases as income
increases.
Diagram (a).

Income

I1
N1
I0

IC2

A1
IC1

A0

N0

L0

L1

Tmax Leisure

In the diagram above, when non-labour income increases from N0 to N1, the
individual reaches a higher indifference curve. Following the reasoning above, the
point A1 (the point at which the individual optimizes between the amount of money he
earns and the leisure time he is taking) will not only lie above point A0, but also to the
right of it. Therefore, L1 > L0 (the individual increases the amount of leisure taken).
Question 3
Examine the following statement:
Trade enables countries to achieve outcomes which are superior to those attainable
under autarky.
In the diagram below, the blue and the red line represent the Production Possibility
Curve (PPC) of two different countries. Because the Red country line is flatter than
the the Blue one, Red country needs to sacrifice less Y than the Blue country in order
to produce an extra unit of X. Correspondingly, Blue country needs to sacrifice less
X in order to produce an extra unit of Y. Thus, it could be said that Red country has
comparative advantage in the production of X and Blue country has comparative
advantage in the production of Y. This means that through specialisation and trade, the
countries can achieve superior outcomes. This situation can be illustrated as follows:
Blue country starts at at B1 and moves to B2. It has to give up 1.5 units of X and
obtains 2 extra units of Y. The Red Country starts at R1 and moves to R2. It has to
give up 0.5 units of Y and obtains 2.5 extra units of X. By trade, the Blue country sells
1 unit of Y to the Red country and the Red country sells 2 units of X to the Blue
country. As a result, Blue country has an extra unit of Y and 0.5 extra units of X,
whereas Red country has 0.5 extra units of X and 0.5 extra units of Y, Both countries
are therefore better-off, and the statement above is proven to be true. However, in the
real economy, other factors come into action, such as the prices of X and Y or how
necessary they are to the two countries respectively.
Y
Diagram (b).
B2
y=2

B1

x=1.5
R1
y=
-0.5
0

R2
x=2.5
X

Question 4.
Comment on the following statements:
When the firm breaks even, total revenue covers total costs, which include the firms
opportunity cost.
i.

The break even notion refers to the firm earning Normal Profit, that is Total
Costs (TC) = Total Revenue (TR). The firm therefore is neither operating at a loss
(TC>TR) nor is it obtaining Super-Normal Profit (TC<TR). Must be remembered,
however, that Economic Total Costs Accounting Total Costs since the former
includes the Opportunity Costs of the Firm operating in another market or
producing a different type of goods.
Indifference curves cannot cross.

ii.

There are two properties which characterise the preferences of an individual: nonsatiation as defined above and transitivity
.

(if A B and B C, then A C)

Suppose indifference curves could cross, as shown in the following diagram.

Since A IC1 and B IC1 , by definition it follows that A B. Similarly, if B

IC2 and C

IC2 , by definition it follows that B

first two conditions it follows that A

C.

By transitivity, from the

C. Because bundle C has the same amount

of X as bundle A, but a greater amount of Y, under the assumption of nonsatiation, it follows that C A .

Diagram (c).

Y
IC2
IC1
YC
YA

C
A

XA=XC

Section B
Question 5
An increase in the rate of interest must lead a borrower to reduce current
consumption, assuming consumption in any period is a normal good. Analogously,
a decrease in the interest rate must lead the saver to raise current consumption.
Examine this statement.
In order to consider the statement, the case of a borrower must be differentiated from
the case of a saver. It must be mentioned that in both cases the increase of the interest
rate will be represented by the inter-temporal constraint line becoming steeper and
rotating clockwise about the endowment point E. The differentiation between
Substitution and Income effects can be done by shifting the new inter-temporal
constraint line to the right in the case of the borrower and to the left in the case of the
saver and then analysing the points at which both the new line and the hypothetical
one formed by shifting.
A rise in the rate of interest in the case of a borrower has two effects on its behaviour.
First, the relative price of borrowing with respect to saving has increased. This means
that the individual will choose to reduce the amount borrowed, substituting part of
what he is currently borrowing for future income (this is the Substitution Effect the
movement from A to B). Second, because the the amount of money he has to pay for
the sum he has borrowed has increased, the economic agent is also worse-off in terms
of real income. Therefore, he will reduce the level of borrowing even further (Income
Effect the movement from B to B). Given that the the effects act in the same
direction, the current consumption of the borrower will be reduced, as presented in the
next diagram (the two effects combined determine a reduction of C, from C0 to C0*).

I1, C1

I1
C1*

Diagram (d).

C1

I0 C0*

C0

I0, C0

Similarly, a saver is also influenced by the income and substitution effects. However,
in this case it is unclear whether the rise in the interest rate will generate a decrease or
an increase in current consumption. Since the opportunity cost of not saving has
increased, the individual has an incentive to lend even more of his money, thus
reducing current consumption. On the other hand, since the interest rate has risen, the
economic agent is now better-off, and since we assume that spending is a normal
good, the income effect pushes the individual to increase the current consumption.
Depending on which one of these effects is stronger, the current consumption can
either increase or decrease. If the Income Effect overrides the Substitution Effect
current consumption is higher than the initial one (C0*>C0) and B lies to the right of
A, whereas if Substitution Effect offsets the Income Effect B lies to the left of A and
current consumption lower than before (C0*<C0).
Diagram (e).

I1, C1

Diagram (f).

I1, C1

B
C1
C1*
I1

C1*
C1

B
E

C0 C0*I0

I1

I0, C0

C0*C0

I0

I0, C0