This part of the written comprehensive exam in Economics is divided into two parts, macro and micro, which are given equal weight in your final Economics comprehensive grade.

Answer each part in a separate bluebook. Be sure to put your identification number on each bluebook. In addition, put "Micro" on the cover of the bluebook containing the micro part and "Macro" on the other bluebook.

Your answers will be graded on the basis of the CONTENT and PRESENTATION of the economic analysis. The Macro part is an ESSAY, so you should be sure to take time to organize your ideas and present them in coherent form. Your answer should include appropriate verbal, graphical, and mathematical reasoning. The Micro part is composed of a series of specific questions. Please number each answer in your bluebook and write coherently and legibly.

Remember, the Macro and Micro sections are equally weighted, so you should allocate your time efficiently.

Use the 30 minute reading period to read the entire exam carefully, underlining important information. You may write notes on the exam but we will only evaluate answers in the blue book.

You have until 12:00 PM to complete the exam. Good luck.
1996 Macroeconomics Comprehensive Exam Essay

For most of 1995, nominal GDP grew about 4.2% with real GDP growing around 2.7%. During the past six months the consumer price index has increased by less than 2% on an annual basis, which after measurement error adjustments may place the inflation rate for the CPI's bundle of goods near zero. Since 1992 the unemployment rate has trended down and has hovered around 5.5% for most of 1995. Both imports and exports showed brisk growth in 1995 with real net exports in the third quarter amounting to -$125.5 billion, much of it fueled by merchandise exports. The value of the dollar on the foreign exchange markets declined in the first part of 1995, but has since increased in value. For example, at one point the yen/$ rate was 80.63 yen per dollar and has risen to about 101 yen per dollar. Large amounts of financial capital have readily moved between countries in response to changing interest rates in various countries and changing perceptions about future exchange rates.

In late December of 1995 the Federal Reserve Open Market Committee indicated that it was reducing its target for the federal funds rate (the interest rate that one private commercial bank charges another when the second bank borrows reserves held at Federal Reserve Banks) from 5.75% to 5.5%

Assume we can characterize the economy in late December 1995 as having been in a state of full equilibrium with a real GDP of $5.5 trillion, a three month Treasury bond yield of 6.14%, unemployment rate of 5.5%, a trade-weighted exchange rate of $.8 (per unit of foreign currency).

Assuming no additional shocks to the economy, explain what the effects of the Federal Reserve's reduction in the federal funds rate is likely to be. Consider: the financial market effects, the impact on the product markets, the effects on the balance of trade, and on the balance of payments conditions. Provide a literate explanation using appropriate graphs (refer to specific points and numbers in your graphs in your essay for concreteness). Obviously the quantitative impacts of the change are unknowable at this point, but you should indicate what the causal forces at work are likely to be and the direction of changes if we are to approach an equilibrium. Indicate the factors that will motivate financial and other economic agents as events unfold. For simplicity, assume that product prices in terms of the dollar prices are to be unchanged.

Your answer will be evaluated on the clarity, coherence, and completeness of your answer as well as on the conclusions and graphs.

GCMO's cost structure per performance can be summarized by the following:

(10 pts) (a) If GCMO behaved like a profit-maximizing firm, how many tickets would it want to sell? Show your work. (Hint: If you cannot do the math, draw a picture and explain what is happening.)
The objective function of the firm can be written

max ¼ = 40Q - .01Q2 - 35,000
Q

To find the maximum, take the derivative and set it equal to zero, then solve for Q*.

This means that the firm's profits will be ¼* = 80,000 - 75,000 = $5,000.

(5 pts) (b) In what sense is this outcome optimal?
This outcome is optimal in two senses. First, it is optimal for the agent in that it is profit-maximizing: it is not possible for this firm to make more than $5,000 by producing another output level. Second, because the industry is perfectly competitive and under the assumption that there are no externalities, the outcome is optimal from society's point of view in that the marginal cost to society of serving another customer is exactly equal to the marginal value (both are $40). This maximizes net benefit for society.

2. On the other coast, the city of Metropolis also has an orchestra, the Metropolis Philharmonic. Unlike the situation in Gotham City, however, the MP faces no competitors in the provision of high-brow music to the culturati of Metropolis. The cost structure for MP is the same as that of GCMO, and inverse market demand for tickets is given by P = 120 - .05Q.

(10 pts) (a) Find the profit-maximizing price and number of tickets per performance and illustrate it graphically. (Hint: If you cannot do the math, draw a picture and explain what is happening.)
The objective for the monopolistic firm is to maximize profits. You solve for the optimal level of tickets by taking the derivative of the objective (profit) function with respect to Q, setting it equal to 0, and then solving for the optimal level of Q, Q*.

The monopolist's profits are then $70,000 - $45,000 = $25,000.

(5 pts) (b) In what sense is this outcome optimal?
This outcome is optimal in the sense that it is profit-maximizing for the monopolist.

(5 pts) (c) Is this outcome Pareto-efficient? Describe why or why not briefly, making reference to your diagram.
No, it is not Pareto-efficient. Pareto-efficiency means that it is impossible to make someone better off without making someone else worse off. Another way of describing Pareto-efficiency is by saying that net social benefit is maximized. In the above case, the monopolist sells too few tickets in order to make higher profits through the restriction of output. The loss to society is the sum of the excess of willingness to pay (marginal value or price, measured by the demand curve) and the marginal cost of production. This is called the deadweight loss due to the monopoly.

3. Let's take a closer look at the cost structure of an orchestra. The production function for an orchestral concert involves labor (various types of musicians and other support personnel) and capital equipment (in the form of instruments, chairs, and a hall). Orchestra scores call for particular numbers and combinations of instruments; these are unchanging. For example, it takes the same number of players and instruments to produce a Beethoven Fifth now as it did 10 years ago. Thus, the orchestra has a fixed proportions, Leontief production function (analogous to perfect complements in the theory of consumer behavior). If we focus on the musicians as a crucial part of the symphony's labor input, we can see that it is extremely difficult to replace a musician with machinery.

In contrast, manufacturing industries such as automobiles are much more able to substitute capital for labor when technological advances occur or when the price of labor rises. Today, General Motors makes many more cars, of much higher quality, with much less (although higher paid) labor than it did 20 years ago.

(5 pts) (a) What is the numerical value of the elasticity of substitution for the orchestra's production function? Explain.
For an orchestra, labor cannot be substituted for capital. Therefore, the elasticity of substitution is zero.

(10 pts) (b) Assume that the generic "capital" and "labor" are the only inputs into live orchestral music concerts and a representative manufactured good. Draw two separate isoquant maps which describe the production processes for these two goods. Show on each diagram the implications for the input mix (that is, the capital/labor ratio) of an increase in the price of labor. Be sure to label everything carefully!

An increase in the price of labor, other things equal, is represented by a shift inward of the isocost line. In the first case, unless labor is an inferior input, management is able to substitute capital for the more expensive labor, resulting in a higher K/L ratio (as measured by the slope of the ray from the origin that leads to the optimal input combination). You can see that the ray is getting steeper in the first case, meaning that the K/L ratio is increasing.

In the second case, because labor and capital are not substitutable, an increase in the price of labor results in management cutting back labor and capital in equal proportions. As a result, there is no change in the K/L ratio.

(10 pts) (c) As the price of labor increases, what would be your prediction about the time path of prices for the arts relative to manufactured goods? What are the implications for orchestra attendance?

As labor becomes more expensive, the orchestra is not able to substitute relatively cheaper capital, as can the manufacturing sector. As a result, costs and hence prices will rise faster for orchestral concerts than in the manufacturing sector.

(10 pts) (4) In the Edgeworth-Bowley box below, point E represents the initial endowment of labor and capital in an economy that produces only two goods: orchestral concerts and a manufactured good. Describe what will happen if labor and capital are allocated by a market system.

5. Arguments have been advanced that the arts in general have collective benefits. One example might be "national feeling benefits" which refers to the pride felt by people in the achievements of their fellow citizens, especially if those achievements are recognized internationally.

(10 pts) (a) Use a partial equilibrium analysis of the arts market that incorporates the position of those who believe in the collective benefits of the arts.
The main difference is in the concept of marginal value. With no external effects, private marginal value is equal to social marginal value. If the case described above, the value to the individual (or willingness to pay) is less than the value to society. A general picture of supply and demand for the industry would then look like the following:

(5 pts) (b) If there are collective benefits from the arts, what implications does this have for the economic efficiency of a market system for the allocation of resources to the arts?
If there are positive consumption externalities, then the private market will not lead to a social welfare or social net-benefit maximizing result. The market solution that will obtain will equate private benefit and marginal cost; this will result in too little art being produced. The social net benefit or social welfare maximizing solution equates marginal social benefit and marginal cost.

(5 pts) 6. So, what's your opinion of the recent (and proposed further) cuts in the National Endowment for the Arts, a government organization that provides subsidies to symphony orchestras (among other organizations)? (Hint: There is no right answer to this question. We are interested in how you defend your position.)
There are a number of ways you could have answered this question, but primarily your answer will depend on whether you buy the argument that the arts have important external effects. If you believe this, then the market result will be inefficient: too little art will be produced. One way of correcting for this externality is to subsidize the production of the arts, therefore shifting out the supply curve. If this happens, then the market solution will be closer to the welfare-maximizing solution.