Capital and interest

Explain and comment on the following in connection with interest theory;

(1) length of the productive period; (2) underestimate of the future; (3) marginal physical productivity of waiting; (4) marginal abstinence; (5) “evening out the income stream.”

It has been argued that in as much as the demand for capital goods is a derived demand it follows that any voluntary saving will necessarily result in some degree of unemployment. That is to say, the savings will reduce the demand for consumers’ goods, thus reducing the demand for capital goods, and consequently not all the savings will be borrowed; hence unemployment. But the commercial banks, through their power to create circulating medium, make it possible for entrepreneurs to obtain the funds with which to create capital goods without the reduction in consumer demand which comes with saving. Hence the banks furnish a means of escape from the dilemma. Discuss.

Discuss the following concepts (a) the “postponement” of consumption said to be involved in saving and investment, (b) “abstinence”, (c) “time preference”, (d) the “marginal efficiency of investment”, (e) the “marginal efficiency of capital”.

Write briefly on the meaning of the capital concept and its importance in interpreting economic growth or change. Relate your discussion to the case of a Crusoe economy and state whether (and if so how) the principles are different for the competitive pecuniary social order.

Define briefly the following terms and indicate their use in economic theory:

Backward bending supply curve

Giffen effect

Composite demand

Elasticity of substitution

Exhaustion of product

Marginal value product

Sunk costs

Rent

Firm

Present value

Rate of time preference

Indicate whether each of the following statements is true (T), false (F), or uncertain (U). Give a brief explanation of your answer.

If the income elasticity of demand for a product is greater than unity, the relative price of that product will rise as real per capita incomes increase, i.e., will rise relative to products with income elasticity less than unity.

When a firm is producing in a region of rising marginal cost, that firm is in equilibrium because average costs are increasing also.

The market price of steel and iron scrap fluctuates more than the price of finished steel primarily because the scrap market is competitive while the finished steel market is in the hands of monopolists.

If automobile firms overproduce and competition forces down the price of new cars, this harms a car owner who has purchased his car on credit since his mortgaged car has suffered a decline in price.

It is frequently stated that the more disagreeable or dirty a job is the more it will be necessary to pay workers, but this is contradicted by the fact that college professors earn more than foundry workers.

Lowering the support price of wheat in the United States at present would aggravate rather than relieve the problem of surpluses, since farmers would simply produce proportionately more in order to maintain their incomes.

An increase in demand for a commodity increases its price, but an increase in price reduces demand. Increases in demand tend, therefore, to be self-compensating.

Increasing the minimum wage rate to one dollar per hour will have little or no effect outside the South, since most workers now being paid less than one dollar per hour are in the South.

In the absence of factors making for an increase in demand, and other things being equal, a new method will be introduced sooner in a competitive than in a monopolized industry.

Without collective bargaining, the workers’ market disadvantage would enable the owners of other productive agencies to appropriate income that would otherwise go to labor.

With collective bargaining, workers in general can appropriate income from the owners of other agents.

In equilibrium, it is enough to know the marginal factor cost of any one factor and its marginal physical product to know the marginal cost of the product, even though the product is produced by many factors.

The demand for a product at the market price is inelastic. It follows that the product must be produced under conditions of net internal diseconomies.

Under competition, the marginal efficiency of capital is equal to the marginal physical product of a particular kind of capital good times the price of the product.

To assert that the rate at which a consumer is willing to substitute x for y decreases as the quantity of x increases along an indifference curve is equivalent to saying that the indifference curve is concave toward the origin.

A recent court decree requires a company (The United Shoe Machinery Co.) which heretofore has only leased its machines, for which there are at present no competitors, to offer them for sale at prices which will make it neither more nor less advantageous to buy than to rent the machines. How can such prices be determined, and by what criteria can it be determined whether a given price meets the requirement?

Indicate whether each of the following statements is true (T), false (F), or uncertain (U). Explain briefly the basis for your answer.

_____. If the market elasticity of demand for peaches is -2, a peach producer whose output accounts for 1/20th of the total supply of peaches will be faced by a demand function of elasticity -40.

_____. If a constant amount of carpenters’ services is required per unit of housing constructed, and the elasticity of demand for housing is -1, the elasticity of demand for carpenters’ services used in housing must be less (in absolute value) than unity.

_____. If the production possibilities for wire can be represented by a Cobb-Douglas production function, and the wire industry is competitive, a rise of 10 per cent in the wages of wire-workers will lead to a reduction of 10 per cent in their employment.

_____. The elasticity of demand for a group of commodities with respect to the average price of the group can never be larger in absolute value than the largest of the individual price elasticities of the commodities which comprise the group.

_____. If total consumer expenditures are the same before and after a tax, then an excise tax on a consumer good of elastic demand will lead to an increase in consumer spending on other consumer goods, while an excise tax on a consumer good of inelastic demand will lead to a decline in consumer spending on other consumer goods.

_____. A tax of 10 per cent per year on the rental value (actual or imputed) of all land will in the long run lead to a lowering of the marginal productivity of labor in agriculture.

_____. A technological advance opening up widespread possibilities for new investment in the electronics industry at very high rates of return will tend to lower the real value of the existing stock of residential housing in the United States.

_____. A supply curve passing through the origin has an elasticity equal to unity.

_____. Given certainty, no firm would hold inventories.

_____. A negatively sloping supply curve of labor implies a positively sloping demand curve for leisure.

_____. It is impossible to derive a supply function for a monopolist.

_____. A legally enforced minimum wage for a particular occupation may increase employment in that occupation.

_____. Wage rates rise while interest rates remain the same. It follows that the ratio of capital to labor will increase.

_____. Engel’s laws are due to Friedrich Engels.

“The interest rate measures the rate of time-preference. Therefore, in a community, the members of which are as anxious to provide for the future as for the present, the rate of interest will be zero. But the rate of interest also equals the marginal productivity of capital. It follows that in such a community the marginal productivity will be zero”.

Discuss the validity of this argument.

The U.S. government currently guarantees a large fraction of mortgages on newly-constructed houses through the Federal Housing Administration and the Veteran’s Administration. The government guarantee naturally makes these more attractive than non-guaranteed mortgages and so leads to their being available at a lower rate of interest. Recently there has been a decline in residential building. Representatives of the industry have suggested that one means of stimulating building would be to extend the government guarantee to mortgages on existing houses. They claim that the higher cost of mortgages on such houses inhibits their sale and thus prevents individuals currently owning houses from coming into the market for new houses.

Analyze the effect that the enactment of this proposal would have on the rate of construction of residential housing. Do not discuss the desirability as a matter of public policy of either the existing guarantees or the proposed extension.

Discuss the problem of the relationship of the rate of physical productivity of capital goods to the rate of interest; or

Discuss the supply curve of saving.

The margin in stock trading is the fraction of the price of the stock which the trader must supply and the balance is lent to the trader by the broker. Hence the margin represents the trader’s equity and is analogous to a down payment. Assume there is no government regulation of the margin and that brokers are free to set any margin they please and to charge any interest rate they please on the loan they extend to traders. Assume there is perfect competition in the brokerage industry.

Would you expect margins to be higher during periods of “active” speculation?

Would you expect higher margins when stock prices are rising then when they are falling?

Would a rise in the interest compensate for or be equivalent to a rise in the margin?

In the theory of the household demand for perishable goods, for a given money income there is a fall in real income if the price of some good rises. The pure substitution effect is the effect on quantity demanded of a price change for constant real income. In the case of durables households own stocks of durables. Hence a rise in the price of durables causes the value of the stock of consumer owned durables to appreciate. Hence a price rise of perishable reduces the demand for perishables if money income is given and the income elasticity is positive while a price rise of durables increases the demand because it implies a rise in consumer wealth if the wealth elasticity of demand is positive.

What are appropriate budget constraints for the demand for durables?

Is the last statement beginning with “HENCE …” correct?

Would it make a difference if the durable good had a fixed life or if it lasted forever?

What are the counterparts of constant real income in the demand for durables?

Jones lives in a rented house for which he pays $150 a month. He has the opportunity of buying an identical house for $25,000, of which $15,000 will be paid in cash and $10,000 can be borrowed on a mortgage. He has figured that his monthly expenses would be $100 if he bought: $50 for interest on the mortgage, $20 for local taxes, and $30 for maintenance and depreciation. His income tax and expenses for fuel and utilities will not be affected by the purchase. He argues that it will cost him less to live if he buy the house; his wife argues that it will not.

Under what conditions is Jones right? Under what conditions is Mrs. Jones right?

Is there any divergence between the “right answer” to this problem from the private standpoint of the Jones family and from the standpoint of society? Explain.

Briefly discuss the Ricardian conception of capital, specifically in relation to his theory of wages. Argue the question whether wages are paid out of (pre-existing) capital or out of (current) product.

Can you find any relation between the Böhm-Bawerk production-period theory of interest and the Ricardian theory of capital and profit? What is the crucial assumption about the nature and source of capital which underlies the production-period theory, and is it sound? How does diminishing returns to investment enter into Ricardo’s and Böhm-Bawerk’s theories?

“From the preceding considerations it would be seen, even if it were not otherwise evident, how great an error it is to imagine that the rate of interest bears any necessary relation to the quantity or value of the money in circulation. An increase in the currency has in itself no effect, and is incapable of having any effect, on the rate of interest.” (J.S. Mill)

“We can sum up the above in the proposition that in any given state of expectation there is in the minds of the public a certain potentiality towards holding cash beyond what is required by the transactions-motive or the precautionary-motive, which will realize itself in actual cash holding in a degree which depends on the terms on which the monetary authority is willing to create cash…Corresponding to the quantity of money created by the monetary authority, there will, therefore be set. par. a determinate rate of interest.” (J. M. Keynes)

“The saving schedule tells us what part of income the community desires to save. The technical conditions…expressed by the marginal-efficiency-of-investment function, determine the marginal efficiency of the amount of investment that the giving up of consumption permits undertaking. (The intersection of the two schedules determines) the equilibrium rate of interest.” (F. Modigliani).

Can you reconcile these opinions concerning the determinants of the interest rate? Explain fully, making and stating any assumption you like as to the conditions of production, the time period under consideration, and the flexibility of prices and costs.

We frequently hear it said that labor is cheap and capital dear in a country like the U.S. Such statements seem reasonable, yet it is not clear how one can compare the price of labor (rupees or dollars per hour) with the price of capital (percent per year). Can you suggest a way to interpret the statements so that they make sense?

Comment briefly on each of the following passages (explanation, justification, disproof, qualification, as may be appropriate).

“It is not the case that an increased demand for mutton must in the long run necessarily operate to lower the price of wool. An increased demand for mutton will stimulate sheep farming, but it will also stimulate the substitution of crossbred [mutton type] for merino [wool type] breeds; and the resultant of these two opposite tendencies is logically indeterminate.”

“When Consols are at 93½ , and business in in a tranquil state, it matters not how many buyers of these securities there are at 93, or sellers at 94. They are really off the market. Those only are operative who may be made to buy or sell by a rise or a fall of an eighth. The question is, whether the price shall remain at 93½, or rise to 93 5/8, or fall to 93 3/8. This is determined by a very few persons and by the sale or purchase of very small amounts.”

“The degree of monopoly control by a seller equals the degree by which price exceeds marginal revenue.”

“The degree of monopoly control by an employer as employer equals the degree by which the value of the marginal product of labor exceeds the marginal supply price of labor.”

“Where it is the case that people would not give as large a total sum for a larger quantity of an article than for a smaller, this would be expressed geometrically by saying that the demand curve would cut negatively a rectangular hyperbola.” [negatively means cut from above]

“The fact that supplying labor with better or more instruments results in an increase in output has sometimes led to the conclusion that capital is productive, a phrase which must be used with care. The strictly accurate statement is that labor applied in some ways is more productive than labor applied in other ways. Tools and machinery, buildings and materials, are themselves made by labor, and represent an intermediate stage in the application of labor. Capital as such is not an independent factor in production, and there is no separate productiveness of capital.”

A demand schedule for labor shows the amount of labor in physical units that will be taken at each wage. A demand schedule for capital shows the amount of capital in physical units that will be taken at each interest rate.

The rate of interest in a stationary state would be zero.

Define the following terms precisely and indicate briefly the use made of each in economics:

Demand

Supply

Equilibrium

Indifference Curve

Marginal

Rate of Substitution

Marginal value product

Marginal efficiency of capital

Production function

Time preference

Profit

Rent

Run

Net advantages

Variable Costs

The following quotation is from an article on the illicit gold traffic:

“Traffic on the Asian gold-smuggling trails has doubled since Korea…Meanwhile savings which could be productively invested by banks lie idle; paper money is snubbed for gold, depreciates with every rise in the gold price, and becomes a weaker and weaker factor in national economies.” (H.R. Reinhardt, The Reporter, July 22, 1952, p.21).

Analyze this quotation. Precisely what effect would the willingness of people to hold bank deposits instead of gold have on productivity or productive investment, and through what channels? What of sense and what of nonsense is there in the statements after the semi-colon?

Define the following terms precisely and indicate briefly the use made of each in economics:

Demand

Supply

Indifference Curve

Rate of Substitution

Marginal value product

Marginal efficiency of capital

Production function

Time preference

Assume that Crusoe is interested in economizing the use of his resources and that during the period in question there is no change in his knowledge of production techniques. How does capital and interest theory aid in explaining the following observations?

(a) After several years, Crusoe begins to obtain berries by planting and cultivation rather than simply by picking them as he had done previously.

(b) After an additional number of years, he reverts to picking wild berries.

A part of the nation’s productive capacity is destroyed, say by a war. Ignoring any possible expectational and distributive effects, how will this affect: (a) the division of the national income between consumption and investment? and (b) the income-velocity of money. How, if at all, does your answer depend on whether wealth is a variable which influences behavior?

In calculating whether the government ought to undertake certain investment projects, a rate of interest is frequently used. How in principle would you determine what rate of interest is appropriate?

(60 points) Indicate whether you believe each of the following statements to be true, false, or uncertain. In each case write a few sentences explaining your answer. Your grade will depend heavily on your explanation.

If the rate of obsolescence is constant over time for each type of capital equipment, a rise in the rate of interest will shorten the optimal life of capital equipment.

If oranges are substitutes for apples, apples are complementary to cheese, and cheese is a substitute for butter, oranges and butter are complements.

If a certain commodity is rationed and subject to price control, and there is a black market price for it, the black market price is the equilibrium price of the commodity in the absence of price control.

Let ${\sum }_i{p}_{i1}{x}_{i1}$ and ${\sum }_i{p}_{i2}{x}_{i2}$ be the expenditure of a firm on factors of production per unit of output at two points in time. If ${\sum }_i{p}_{i1}{x}_{i2}>{\sum }_i{p}_{i1}{x}_{i1}$ and ${\sum }_i{p}_{i2}{x}_{i1}<{\sum }_i{p}_{i2}{x}_{i2}$, the production function of the firm has changed between the two points of time.

A company cannot have a monopoly if its shareholders receive only the normal rate of earnings on their stock in it.

If the production function of an Industry is subject to constant returns to scale, the industry supply curve will be horizontal.

If it were possible to travel backwards as well as forwards in time, everyone would be a millionaire.

The development of better fertilizer will increase the value of farm land.

Manufacturers frequently advertise that their products contain extra ingredients, and they generally succeed in selling “extra-ingredient” products (e.g. Bufferin) at higher prices than “similar” single-ingredient products (e.g. aspirin). This implies that consumers have a diminishing marginal rate of substitution between the ingredients.

The removal of a barrier to competition anywhere in the economy must make society better off.

Given:

a three-product world,

the cross-elasticity of demand of x with respect to the price of z is zero,

the own-price elasticity of demand for x is -1,

y and z are substitutes,

expenditures on X occupy half of consumers’ budgets, expenditures on Y one quarter of consumers’ budgets in the initial situation,

it follows that the own-price elasticity of demand for y is greater than 1.5 in absolute value. (For this question consider all price-elasticities defined to include the substitution effect only.)

The price-elasticity of demand on the part of a competitive industry for a factor of production will be greater, the smaller is the share of that factor of production in the total costs of the industry in question.

If production in industry X (assumed to be competitive) is governed by a Cobb-Douglas production function, then no wage set by the trade union in that industry will produce greater total labor income than any other wage.

A tax of a fixed amount per unit of output, placed upon the product of an industry with constant costs, will necessarily result in a smaller rise in price if that industry is organized (and behaves) as a monopoly than if the industry is competitive.

In an industry employing just two factors of production, the elasticity of demand on the part of that industry for either factor must be less in absolute value than the elasticity of substitution between the two factors in that industry.

Comment briefly on the following statements:

“If labor has effective occupational mobility, the prices of all commodities under competitive conditions will tend to equal their marginal labor costs.”

“Labor is paid out of current product, and if advances are made, they are made by laborer to employer, rather than vice versa.”

“Saving is necessary only in an expanding economy. No one need wait for the product of his labor or property in a stationary economy.”

“Any increase in investment lengthens the production period, and the production period cannot be lengthened unless more investment takes place.”

Indicate whether statement is true, false, or uncertain, and briefly give your reason.

A firm has a monopoly in its home market and also sells in a perfectly competitive world market; if its home-market price is 50% above the world market price, the elasticity of demand in the home market must be 3.

If a multiplant firm has to produce a given quantity of output, it will never pay it to produce in more than one of its plants if that plant has decreasing marginal costs.

The development of more rapid urban transport will inevitably raise the aggregate rental value of urban residential property.

If the number of acceptable applicants for admission to medical schools is less than the number that could be accepted, the medical profession cannot be raising its earnings by artificially restricting entry.

The rate of interest is determined by the marginal productivity of capital.

If a particular commodity is subject to a special tax not imposed on other commodities, removal of that tax will always increase economic welfare.

If the supply curve of a competitive industry has a positive slope, it means that the industry is subject to decreasing returns to scale.

If wage rates, on the average, increase at the same rate as average product per worker, this means that the marginal return on investment declines over time.

Entrepreneurs in a competitive industry may realize short term gains or profit as a result of an increase in the price of an input (due to a shift in the supply function for the input), even if the demand curve for the industry remains unchanged.

Discuss the relation between forward (and/or futures) prices and spot prices on commodity markets and foreign exchange markets and the role of “speculators” and “hedgers” in these markets. State some of the leading theories about this relationship and discuss the kinds of evidence used in testing them.

(30 minutes) The stock market break of May 28 elicited many explanations. Comment upon the relevance of each of the following explanations.

Stock prices had previously been too high.

There was a holding back by big buyers.

Inflation was no longer feared.

Sellers became panic-stricken.

The gold outflow, it was feared, would lead to exchange controls.

Remember that you are writing an examination in economic theory.

(30 minutes) Capital formation may be defined as the use of current resources in such a way as to increase future income, and on this definition capital formation includes investments in equipment, human beings, and discovery of new knowledge. Discuss the problem of the meaning of the marginal product of capital, and whether capital as defined is subject to diminishing returns.

“A central planning authority may or may not decide to weight equally the welfare of the future generation and the welfare of the present generation. This is essentially an ethical question. But if equal weights are to be applied, the appropriate rate of discount (interest) to use in comparing the costs and benefits from alternative public investments is a zero rate.”

“Exploration for natural gas or oil is a form of investment. As such, like all investments, it depends on the expected level of future output (demand). Thus, a rise in the governmentally fixed (regulated) price of natural gas will decrease consumption and hence curb exploration. Conversely, lowering the price of gas will stimulate both consumption and exploration.” Appraise.

Part I

The income of farmers from the sale of their products depends on the prices at which the products sell. The general level of agricultural prices, in turn, depends primarily on the income of nonfarm population. But the income of the nonfarm population depends on the prices of nonfarm products which, in turn, depends partly on the income of farmers.

This kind of analysis is often criticized as circular reasoning and hence as incapable of leading to any useful conclusions. Is this criticism valid? Explain your answer.

Discuss the following quotation from Marshall:

"A useful history of the opposition to machinery is given in Industrial Democracy (by Sidney and Beatrice Webb)…It is combined with the advice (to trade unions) not generally to resist the introduction of machinery, but not to accept lower wages for working on the old methods in order to meet its competition. This is good advice for young men. But it cannot be followed by men who have reached their prime."

How would you expect prices in local, neighborhood, stores in large cities to compare with prices in the central shopping district (in Chicago, the "loop")? In your answer, distinguish among different products, and include an evaluation of the statement so often made by neighborhood stores that they can charge lower prices because they pay lower rents.

Part II

There are 100 each of A and B farms. The product schedules of one farm are

Number of laborers / Total Product (A Farm / B Farm): 1: 40 / 40 2: 90 / 80 3: 140 / 115 4: 185 / 145 5: 225 / 170 6: 260 / 190 7: 290 / 205 8: 315 / 215 9: 335 / 220

a) Determine wages, rents, and employment on both types of farms

(i) if there are 900 laborers and full competition

(ii) if with 900 laborers, the laborers on the A farms organize and succeed in setting a wage rate of 40,

(iii) if, with 900 laborers, the laborers on the A farms organize and succeed in raising the standard wage rate to 47.

b) State briefly the general economic principles illustrated by each part of the above problem.

Consider a hypothetical society in which there is no investment, either net or gross. All capital is completely permanent, not subject to change in form but capable of being used for different purposes. There is no lending or borrowing, no selling or buying of capital goods: whoever owns the capital goods is forced by the laws or conventions of society to hold them and is permitted only to rent them out (i.e., all capital is subject to the conventions that now govern human capital). Hence there is no market interest rate that matters, and all saving takes the form of hoarding of cash. The total amount of money in society is fixed in nominal units (say dollars). Wages are initially rigid (by law or otherwise) and the society is in a state of Keynesian unemployment equilibrium, unemployment keeping the real income down to a level at which dissaving equals saving, so total net saving is zero. Now wages are made flexible. Describe the process of adjustment to a new equilibrium position. Does this new position involve unemployment? What is the equilibrium condition on total net saving? What forces operate to bring about the satisfaction of this equilibrium condition?

5. “In conversations with gold mining engineers a phrase glibly and frequently repeated is ‘sweetening the ore.’ By this phrase reference is made to the practice of diverting production in profitable periods to the poorer ores and perhaps restricting output in the richer fields. Under this practice the better ores are preserved for periods in which mining costs have risen so that over a long period of time output can be held more steady. Contributing also to a policy of sweetening the ores is the reluctance of producers to install capital equipment in a period in which the tendency is for mining expenses to increase with the general advance of wages and living costs. By the time the equipment is installed it might be expected that wages and price levels would be adjusted to the increased price of gold.”

Discuss the wisdom of the policy described in this quotation from the point of view of the individual producer. Assume that the individual producer seeks to maximize the present net capital value of his mining properties. Discuss separately (a) the alleged policy of “diverting production in profitable periods to the poorer ores and perhaps restricting output in the richer fields”; (b) the alleged policy of postponing the installation of capital equipment.

6. Assume a change in the laws so that less stringent conditions are imposed for bankruptcy and reorganization in a particular field (say the production of steel). As a consequence, a number of steel firms reorganize, wiping out a large part of their bonded debt. What would you expect to be the short- and long-run effects of these events on (a) the output and prices of the reorganized firms; (b) the amount of investment in the industry; (c) the rate of interest paid by the industry for new loans; (d) the output and prices of the industry? In each case, give the basis for your answer.

Consider a hypothetical society in which there is no investment, either net or gross. All capital is completely permanent, not subject to change in form but capable of being used for different purposes. There is no selling or buying of capital goods: whoever owns the capital goods is forced by the laws or conventions of society to hold them and is permitted only to read them out (i.e., all capital is subject to the conventions that now govern human capital). Lending or borrowing is prohibited, so that there is no market rate of interest that matters, and all saving takes the form of hoarding of cash. The total amount of money in society is fixed in nominal units (say dollars).

Although this economy is stationary in the aggregate, it is not static. Explain the meaning of the sentence and its bearing on the willingness of people to hold money.

Wages are initially rigid (by law or otherwise) and the society is in the state of Keynesian unemployment equilibrium. Explain. What is it that assures that the aggregate amount actually saved is equal to zero? What is it that assures that the aggregate amount people wish to save is equal to zero?

Wages are now made flexible. Describe the process of adjustment to a new equilibrium position. Does this new position involve unemployment? What is the equilibrium condition on saving? What forces operate to bring about the satisfaction of this condition?

Discuss the factors that determine the rent of capital goods and the wages of labor at equilibrium when both are flexible.

Lending and borrowing is [sic] now introduced, but all other assumptions are retained, so that all loans are in essence “consumption loans”. What determines the equilibrium rate of interest? What effect, if any, would the introduction of lending and borrowing have on the price level?

Assume there is an exhaustible resource that can be extracted at a constant marginal cost c. Assume there is a competitive industry that extracts this resource. Derive the behavior of the equilibrium price over time if the demand schedule for the product remains constant over time.

Under the same demand and cost conditions, derive the equilibrium price if the resource is controlled by a single firm.

Indicate whether each of the following statements is true (T), false (F), or uncertain (U), and state briefly the reason for your answer. It is to be understood that in each question the appropriate “other things” are to be held constant.

1. The imposition of a minimum wage for labor of type X higher than the preceding wage leads to an increase in the number of laborers of type X employed. It follows that labor of type X is hired under monopsonistic conditions.

2. Under both competition and monopoly in the product market, marginal value product of a factor to a firm is equal to marginal physical product of the firm times marginal revenue to the firm from the sale of the product.

3. Marginal productivity analysis shows that, in the absence of monopsony, a laborer gets as a wage his marginal value product. If this analysis is correct, it follows that unions can raise wages in the absence of monopsony only if they either make each worker more efficient, or increase demand for the product, or make the demand for the product more elastic.

4. The law of variable proportions (or diminishing returns) is contradicted by the fact that agricultural output of this country has increased tremendously despite a decrease in the proportion of the working population on farms.

5. The rate of interest is equal to the rate of time preference of consumers.

6. At present levels of operation, three quarters of the total cost of the XYZ railroad is overhead cost that does not vary with traffic, only one quarter is variable cost. It follows that marginal cost is much less than average cost.

7. The demand curve of an individual firm for a factor of production is identical with its marginal value productivity curve for the same factor of production.

8. The demand curve of a firm for a factor of production is a meaningless concept if the firm is a monopsonistic purchaser of that factor.

9. A declining long run supply curve is impossible in a competitive industry.

10. Marginal factor cost is equal to the price per unit of a factor whenever the product market is competitive.

11. According to the theory of joint demand, the absolute value of the elasticity of derived demand for a factor of production will be smaller the more inelastic the supply of that factor.

12. The fact that individuals do not choose occupations solely on the basis of their pecuniary attractiveness helps explain why the supply curve of labor for a particular occupation has an elasticity greater than zero.

13. If all types of services were used only in fixed proportions, a marginal-productivity theory would be neither necessary nor possible.

14. Our society is often described as a “profit” economy or “profit-maximizing” economy. The word “profit” is here used in the same sense as in the uncertainty theory of “profit.”

15. “Profit” as defined in the uncertainty theory of profit is the expected return to any factor assuming uncertainty over and above the guaranteed expected income it can obtain if it assumes no uncertainty.

16. If one income is higher than another before income tax it will also be higher after a progressive income tax, provided only that the marginal tax never exceeds 100%. It follows that if one accepts the theory that individuals act as if they sought to maximize their income, he must also accept the conclusion that such taxes do not alter individual's actions and hence are not shifted.

17 and 18. A minimum wage law is repealed. The wage rate of a class of workers hired under competitive conditions was equal to the minimum before repeal and falls after repeal. It follows that:

17. The total wage bill for this class of labor will rise, remain constant, or fall, according as the elasticity of demand for labor of this class is greater than, equal to, or less than unity in absolute value.

18. The quantity of labor of this class employed will fall, remain constant, or rise according as the elasticity of supply of labor of this class is positive, zero, or negative.

19. The great technological improvements in the past few decades in the production of synthetic fibers (rayon, nylon, etc.) and associated decline in their relative price has, among other effects, tended to raise the price of meat in general, especially of lamb and mutton.

20. At the same time, stringent rationing of meat consumption in Great Britain, by tending to offset this effect, has improved the competitive position of the synthetic fiber industry, and so enabled it to expand more than otherwise.

(a) What is the Pigou effect? What relevance does it have to the theory of the rate of interest?

(b) List some economic decisions that would be affected by a change in the rate of interest. Indicate why they would be affected and if possible the direction of the effect.

In an economy using fiduciary money, it costs nothing to create additional cash balances. Hence, it is desirable to encourage wealth-holders to hold additional cash balances so long as they get any additional non-pecuniary return from them. One way to do so is through a deliberate policy of announced deflation.

For individuals, additions to cash balances are a substitute for real saving in the form of direct investment or loans to finance direct investment; hence, the larger the additions to cash balances, the lower will tend to be the volume of real capital formation. Since economic growth depends on the volume of real capital formation, it is desirable to discourage the hoarding of cash. One way to do so is through a deliberate policy of announced inflation.

Both statements offer plausible, yet they lead to precisely opposite policy conclusions. Can you reconcile them? If not, which, in your opinion, is in error? What is the source of the mistake?

An earthquake destroys half the physical capital in a country but miraculously there is negligible loss of life. The earthquake was most unusual, was unexpected and no one expects a repetition.

Show graphically the effect on (1) the stock demand and supply for capital; (2) the flow demand and supply curves.

Assuming flexible prices and full employment throughout, what, if anything, can you say about the initial effects on (1) rental rate on capital goods; (2) sales price of capital goods; (3) interest rate [i.e., ratio of (1) to (2)]; (4) real wage rate; (5) fraction of income consumed; (6) absolute level of investment.

What about ultimate effects on these variables?

Assuming initially rigid wages and underemployment, what, if anything, can you say about initial effects on items listed in (b)?

Consider a hypothetical economy in which initially, government expenditures (G) are 100, private investment (I) is 50, and private consumption (C) is 350, so that national product (Y) is 100 + 50 + 350 = 500, and tax receipts (T) are 90. Assume that G and T are both reduced by 10 to 90 and 80 respectively, and that wage rates are rigid.

If you neglect any effects on the rate of interest, what would be the resulting values of C, I, and Y? Prove your answer in general by a simple algebraic analysis.

Would you expect any effects on the interest rate if nominal quantity of money is constant? If so, what effect? How would this in turn affect I, C, and Y? Give hypothetical numbers that might correspond to final outcome.

Again, prove your answer.

What additional complications, if any, are relevant in generalizing these effects of a balanced budget change to actual circumstances?

MONETARY vs. FISCAL POLICY

Define fiscal policy as deliberate changes in the government tax structure or expenditure structure for a given behavior of the quantity of money; monetary policy as a change in the rate of change of the quantity of money for a given tax and expenditure structure.

Using the standard income-expenditure model, and assuming prices are rigid, analyze the effect on real income and interest rates of an increase in taxes which would raise the full-employment surplus (or lower the full-employment deficit) by X billion dollars. Specify the parameters on which the result depends and indicate limiting cases.

Using the same model, indicate how to determine the change in monetary policy that would have the same effect on real income. How would other effects of the two policies differ?

The standard model is in terms of comparative statics, so (1) and (2) would be analyzed in terms of a comparison of two alternative positions at a single date. In addition, the only stock variable in the standard model is the quantity of money. Modify the analysis in (1) in both respects. That is, indicate the time path of adjustment you might expect and why, taking into account any effects on such stock variables as total holdings of government and private securities.

Similarly, analyze the time path of the effect of a decline in the rate of monetary growth by, say, X percentage points, again allowing for effect on stocks.

Demonstrate the solution for the standard Fisherian 2-period model for the individual with both productive and credit market exchange opportunities. The individual here is assumed to have an interior endowment which does not coincide with his productive and consumptive optima. Carefully label your graph to show the amounts consumed, produced, borrowed or lent (if applicable), invested or disinvested, and wealth. Having shown the foregoing, show the effects of a fall in the interest rate. Briefly account for your results.

Construct a model of an individual who has an interior endowment of intertemporal receipts and an associated intertemporal consumption plan. Imagine that there is a fall in the interest rate.

(1) Under what conditions will the person’s planned consumption rise?

(2) Under what conditions will planned savings rise?

(3) Is it possible for both to rise? Explain.

b. Explain how the following imply that a change in the rate of interest may have occurred and note the direction of change.

(1) A rise in the price of raisins relative to the price of grapes.

(2) An increase in the “spot” price of soybeans on the Chicago futures market.

(3) Young people are better off relative to old people.

Evaluate the following: The way to get people to keep future generations in mind as they make current decision concerning the use of scarce natural resources is to allow them to hold private property rights over these resources which they can transfer. How would your answer differ if transfer rights were denied?

Suppose you were in a country where the charging of interest was prohibited by law. How could you tell whether the present price of future goods changed? What kind of evidence would you look for. Justify your choice of evidence and indicate the direction of the change in the present price of future goods.

“A rise in the rate of interest will generally tend to make young people better off and old people worse off.” Would you regard this as a decent generalization? Discuss. Explain what assumptions are relevant to appraising the statement.

“A rise in the interest rate tends to moderate aggregate demand and so is anti-inflationary. But interest is a cost of business and the increase in cost tends to raise prices. Hence on balance it is not clear whether w rise in the interest rates tends to counter inflation.” Analyze.

It is sometimes argued that since future generations are not in any position to cast dollar votes (or for that matter any other vote) in influencing the saving-investment decisions of the current generation, there will be under-provision of the needs of the future because of “selfishness” on the part of the current generation. The rapid exploitation and even destruction of may of our natural resources are often cited as evidence for this contention. On the other hand, there is the indisputable evidence from modern history that each successive generation had been left richer than its predecessor. Comment and include the reason why present generations enrich future generations; what is the quid pro quo? (Remember that in this exchange future generations have not done anything for present generations.)

Give short, but complete, answers to the following:

(a) “Automation is destroying 300,000 jobs a month.” Is destroying jobs socially good or bad? Does automation mean that people will be left without jobs. Why?

(b) If in some town the minimum wage rate for taxi-driver employees were raised to $5.00 an hour, what would happen to the ratio of cabs driven by the owners to cabs driven by employees of cab owners? Why?

(c) If you were a visitor in some underdeveloped country in which all lending and borrowing are effectively prohibited, is there an interest rate; if so, where could you get date to compute it; how could you tell when it changes?

(d) Why do you think that the commandments: “Thou shalt have no other Gods before me” and “Thou shalt not make unto thee any graven image. . . .” are the two most important among the Ten Commandments, in the eyes of God?

Evaluate the following: The most effective way to get people to keep future users of scarce natural resources in mind as they make their current decisions on use is to allow them to hold private property rights over these resources which they can transfer. How would your answer differ if transfer rights were denied?

Write brief answers explaining each of the following:

(a) Explain what Hayek might mean when he asserts that: “The most significant fact about the price system is the economy of knowledge with which it operates.”

(b) Why does specialization lead to a larger output? What is meant by specialization in this context?

(c) If two people work jointly in production, it is impossible to tell who produced how much. What then is the meaning of the statement that each gets paid according to what he produces?

(d) Give at least three reasons why the observation of a negative rate of interest is highly improbable.

Briefly analyze the following:

(a) The price of cheese falls relative to the price of milk. What is implied about the rate of interest? Why?

(b) Usually there are cheaper prices for matinee performances than evening performances. Why?

(c) “Allowing the price of goods to rise in period when none of the good is being produced is immoral, because the higher prices do not induce a larger output. They merely give unwarranted profits to those who are lucky enough to own the goods. Either prices should be prevented from rising, or the government should take over ownership in order to prevent unjust enrichment.” Evaluate this statement using economic analysis.

(d) Give the definition of interest rates.

Assume that you are a member of a minority group in some country and have reason to doubt that your property rights would be enforced and respected in the community.

(a) What forms of capital would you invest in?

(b) What kinds of skills would you encourage for your children?

(c) Do you know of any evidence of such actual behavior by minority groups?

“Debtors are exploited by creditors because a person who has to borrow is usually in distress and is willing to pay a very high price to get the loan. Unless laws were passed controlling the rate of interest, debtors would be forced to pay unreasonable rates of interest.” Is the analysis correct? Explain why or why not.

How is interest rate defined? Why is there a lower present value of goods to be delivered in the future? If in New York, state bonds paying $1,000.00 at maturity (one year hence) are selling for $650.00, and in New Jersey sell for $800.00, what are their respective interest rates? Describe the adjustments that you think will ensue.

If the price of prunes relative to the price of plums fell, what could you infer about the interest rate?

Evaluate: “A bird in the hand is worth six in the bush.”

Evaluate the following: The way to get people to keep future generations in mind as they make current decisions concerning scarce natural resources is to allow them to hold private property rights over these resources, which they can transfer at death to their heirs.

Why do market rates of interest rise whenever people expect increasing inflation in the future?

(a) Why will a person who has transferable (saleable) property rights in a business for which he is making decisions, be more influenced by the longer run effect of his decisions than if he did not have transferable property rights in the business?

(b) Explain the influence that transferable property rights versus non-transferable property rights, has on individual decision making.

Suppose you are contemplating the purchase of a mini computer at a cost of $1,000.00. The expected lifetime of the asset is three years. You expect to lease the asset to a business for $400.00 annually (payable at the end of each year) for three years. If you can borrow (and lend) money at an interest rate of 8 percent, will the investment be a profitable undertaking? Is the project profitable at an interest rate of 12 per cent? Provide numerical calculations in support of your answers.

A television newscaster said, “Janet Jones is $20 million richer today. She just won the Florida lottery, which will pay her $1 million per year for each of the next twenty years.” Is she really $20 million richer?