Conceptual Questions
Answer the following questions in a few sentences:
1. Read the article “Rethinking GDP” by Diane Coyle. Give three reasons why GDP is not a perfect
measure of well-being and explain why their omission is important.
2. Read the article “We’ve become addicted to the income stagnation story. It’s probably not true.”
Explain how the article shows an example of the impact of making different choices in adjusting
variables for inflation.
3. Read the article “Say’s Law: Supply creates its own demand.” What is Say’s Law? Explain why
Say’s Law won’t always work in a monetary economy.
Analytical Questions
1. In each of the following scenarios, calculate the total increase in US GDP this year caused directly
by the given information
a. An individual purchases an old used car from their friend for $6,000. They buy a new engine
for the car for $1,000, replace the brakes for $500, and paint it for $200. They then sell the
car for $10,000. Assume all improvements were completed this year.
b. A computer manufacturer in the US buys parts for its computer from Japan. The cost of
these parts is $500. It produces and sells a computer for $700 using these parts.
c. A child is running a lemonade stand. They purchase 20 lemons for $3 each and 500 grams of
sugar for $0.01 per gram. Using these ingredients, they make and sell 50 cups of lemonade
for $2 each and at the end of the day they have 5 lemons and 100 grams of sugar remaining
(that they do not sell and eventually consume themselves).
d. A video game company prints 2 million copies of a game that sells for $60. It sells 1.8 million
of these this year and the remainder the following year.
e. A sandwich shop buys $1000 of ham, $500 of cheese, and $300 of bread. It also buys a new
meat slicer for $300. Using these, it produces and sells $2000 of sandwiches. There is no
ham or cheese remaining after production, but the meat slicer is still in perfect condition.
2. There are 800 consumers in an economy that each have the same utility function given by U(c, l) =
32c
1/2−(24−l)
2 where c is their consumption and l is the number of hours they spend for leisure. A
single firm serves the market with production function Y = 32L
1/2K1/2
. The firm cannot choose
its capital stock, which is fixed at K = 1600. You can assume the price level is equal to 1 so real
and nominal wages are equivalent.
a. Solve for an individual consumer’s labor supply as a function of the real wageb. What is the total supply of labor hours for the economy in one day as a function of the real
wage?
c. Solve for the firm’s labor demand as a function of the real wage
d. What is the equilibrium real wage and equilibrium total number of hours worked per day?
How many hours does each consumer work per day?
e. What is total output for the economy? What is consumption? (challenge: why isn’t the
consumption you calculated equal to output?)
f. The government wants to increase the equilibrium real wage, so it mandates a minimum
wage of $15 per hour. What happens to labor supply and demand? How many total hours
will be worked? What is total output?
g. Now the government gets rid of the minimum wage and tries a wage subsidy instead. For
every hour worked, they pay the consumer some benefit b. How large does b have to be
in order to reach $15/hr of total compensation (w + b)? (don’t forget that the equilibrium
wage will change with the subsidy) Now how many hours will be worked and what is total
output?
h. Bernie Sanders is worried that the wage subsidy is actually subsidizing the firm. The government passes a 100% tax paid by the firm for every dollar of benefit the firm’s employees
receive from the government (in other words, for every hour of labor the firm hires the worker,
it needs to pay the wage plus the benefit its workers receive). Solve for total compensation
received by the worker (you will not be able to solve for the wage and benefit separately,
solve for w + b). Does Sanders’s proposal help workers? Explain the intuition.
3. The manufacturing industry has a labor demand curve given by L
D
M = 1200 − 100w and the
service industry has a labor demand curve given by L
D
S = 400 − 20w. Total labor supply is given
by L
S = 400 (i.e. labor supply is perfectly inelastic – it doesn’t depend on the wage. Here assume
L is in units of workers, so there are 400 total workers)
a. Find the equilibrium wage and labor in each industry (remember the sum of labor in each
industry has to add up to total labor)
b. The manufacturing industry union renegotiates a wage of $11. If workers can freely move
between industries, what happens to wages and employment in each industry? (Hint: If
workers cannot find a job in manufacturing, they will look for a job in services)
c. Service workers complain about low wages, so the government mandates a $11 minimum
wage. What happens to employment in each industry? What is the unemployment rate?
d. Show what happened on a graph
4. Two consumers (call them A and B) have utility functions over consumption in period 1 and
consumption in period 2 given by
U(c1, c2) = ln(c1) + ln(c2)
In period 1, consumer A receives income of y
A
1 = 80 and consumer B receives y
B
1 = 120. In
period 2, the endowments are reversed, consumer A gets y
A
2 = 120 and consumer B gets y
B
2 = 80
a. First assume consumers are not allowed to save (so they just consume their income each
period). Calculate utility for each consumer.
b. Now let consumers save. They receive an interest rate r on their savings. Write out the
budget constraint for each consumer in each period and the combined two-period budget
constraint (as in the notes)
c. Find the optimal consumption for each consumer in each period as a function of the interest
rate
d. If r=0.2, calculate how much each consumer wants to save (or borrow – if optimal saving is
negative) and consumption in each period. Is this allocation feasible? In other words, given
the amount of total income in the economy in each period, is it possible to consume as much
as this allocation would suggest?
e. Find the market clearing interest rate (the interest rate where total consumption adds to
total income in each period)
f. Now assume consumer B’s income in period 2 increases to y
B
2 = 100 (everything else stays
the same). Find the new equilibrium interest rate. Is it higher or lower than the interest
rate in part e? Explain the economic intuition of this result (hint: think about what has
happened to the relative scarcity of total income in each period and how that affects desired
saving by each consumer).
g. Now assume consumers discount consumption in period 2 relative to period 1 so that their
utility function becomes
U(c1, c2) = ln(c1) + β ln(c2)
Where β is a discount factor between 0 and 1. Keeping the values from question f, what is
the equilibrium interest rate if β = 0.9? Explain the economic intuition.
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