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CAPE Economics, July 2nd, Unit 1, Paper 2 suggested answer by Edward Bahaw
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CAPE Economics, July 2nd, Unit 1, Paper 2 suggested answer by Edward Bahaw

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CAPE Economics, July 2nd, Unit 1, Paper 2 suggested answer by Edward Bahaw

CAPE Economics, July 2nd, Unit 1, Paper 2 suggested answer by Edward Bahaw

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  • 2. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS June 2008 – Unit 1 – Paper 2 1a)i) The production possibility is an abstract curve used to demonstrate an economy’s production capacity from its given resources. As different quantities of resources are devoted towards the production of each good, different output levels are attained. The curve or frontier, maps all possible combinations of medical services and education which can be produced, as the given resources are distributed between the productions of each good in different quantities. Education A 14 B 12 G. C 9 U. D 5 E O 10 18 25 30 Medical Services The curve shows that using all resources the following combination of education and medical services are possible. Possibility Education Medical Services A 14 0 B 12 10 C 9 18 D 5 25 E 0 30 ii) Assumptions on which the PPF is based are: 1. The curve is drawn on the assumption that only two goods and services can be produced namely, Good X and Good Y. 2. The PPF is constructed such that resources are both fully employed and utilized efficiently. This means that all production combinations which lie along the curve such as A, B, C, D and E are derived when all resources are efficiently employed. 1b)i) Scarcity arises out of the inequality between limited resources and the unlimited wants of man. That is, it may be literally impossible to satisfy all human wants as the resources or factors of production available are simply insufficient. Point G represents EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  • 3. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS scarcity as it represents an output combination that is unattainable with the current endowment of resources. 1b) ii) Choice Since resources are simply insufficient to meet the unlimited human desires for goods and services, choices are encountered. This choice would relate to the exact production combination which the economy decides to produce. In other words only one production combination could be chosen between A, B, C, D and E. 1b) iii) Increasing Opportunity Cost The production possibility curves are typically concave to the origin, as shown in figure. This shape implies that as more resources are allocated towards the production of a particular good, opportunity cost increases. This occurs because as more resources are diverted towards the production of medical services, producers may be forced to use resources which were more suitable to the production of education services. 1c)i)a) Allocative Efficiency Allocative efficiency is achieved when resources are directed to production which generates an optimal output combination of goods and services. An optimal output combination occurs when resources are allocated to production in such a way that the socially optimal level of output is produced. Socially optimal means that various goods and services are neither under produced nor over produced. If a good or a service is under produced, then the resulting shortage would create a net loss of welfare. Similarly, if a good or service is over produced, then the underlying surplus would also impose a net welfare loss onto society. 1c)i)b) Production Efficiency Production efficiency occurs when the largest quantity of goods and services is produced from a given amount of inputs. This implies that the cost which the firm incurs in producing a good is minimized and is achieved at the lowest point along the firm’s long run average cost curve. This is shown to occur at the point where the marginal cost curve intersects the average cost curve (MC = AC). This point is sometimes referred to as the point of maximum efficiency or the productive optimum. Production Possibility Curve EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  • 4. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS Education Production Efficiency achieved along any point on the Frontier Allocative Efficiency achieved only at one point on the Frontier where the socially optimal output is produced Medical Services c ii) Production efficiency occurs when the economy is operating on the production possibility frontier. If for some reason resources were being used inefficiently or they were idle or under-utilized, then output produced by the economy would not be maximized. Such output combinations would correspond to points within the production possibility frontier. In terms of allocative efficiency, this would refer to just one point along the frontier where the right mix of output is produced. In other words, resources would be allocated in such a way that the quantities of medical services and education produced maximises social welfare. 1d) i) A decrease in the resource endowment would have the effect of shifting the production possibility curve to the left as the quantity of output the economy can produce will be smaller. ii) Improvements in technology would enable the economy to produce more output and thus the production possibility curve would shift outwards. 2a) i) The rapid expansion in China and India would lead to an increase in demand for oil as more energy would be consumed. This is shown by a rightward shift of the demand curve in the figure. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  • 5. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS Increase in Demand P D2 D1 D2 D1 Q 2 a) ii) As the demand for oil increases, at unchanged prices, a shortage for oil would be created. Such a shortage would lead to upward pressure on price which would lead to an extension of supply. Shortage Created and Extension of Supply P D2 S D1 E1 P1 D2 S D1 Q1 Q’ Q Shortage 2 a) iii) As price rises in this manner there is an increase in quantity supplied, as producers are encouraged to produce more output for the market. This is shown by the extension of supply depicted by the yellow arrow in panel B. At the same time, the gradual increase in prices discourages some consumers from purchasing the good or service and thus quantity demanded declines. This is shown by the contraction of demand represented by the green arrow in panel B. This gradual increase in prices would continue EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  • 6. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS until a new equilibrium is established at E2. At this new equilibrium the quantity bought and sold would be greater compared to the original equilibrium. New Equilibrium P D2 S D1 E2 P2 E1 P1 D2 S D1 Q1 Q2 Q’ Q 2 a) iv) At the new equilibrium the new price has increased to P2. 2b) As oil prices increase, the cost of energy becomes more expensive. This leads to an increase in the cost of production of all goods including food. This can be shown by a leftward shift of supply. In addition rising oil prices may also increase the incentives for the production of alternative energy such as ethanol. This would have the effect of increasing the demand for agriculture land which simultaneously increases the cost of producing food. This is shown in the figure by the leftward shift of the supply curve from S1 to S2. Initially, this leads to the creation of a shortage in the market at the existing market price P1. This is shown by the amount Q 1 to Q’. A shortage in the market would compel consumers to offer higher prices as they attempt to purchase the quantity of food they desire. As a consequence, the market price gradually increases, leading to an extension of supply as shown by the green arrow. At the same time, the upward pressure on prices would prompt a decrease in consumption via a contraction of demand as shown by the yellow arrow. The gradual upward movement of prices and the associated extension of supply and the contraction of demand would continue until the shortage is totally eliminated. This would occur at E2 where equilibrium is re-established at a higher price. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  • 7. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS Decrease in Supply of Food P S2 D S1 P2 E2 P1 E1 S2 S1 D Q’ Q2 Q1 Q 3 a) A comparison of Monopolistic Competition and Perfect Competition Number of Barriers to Type of Competition Sellers Entry and Exit Products Perfect Competition Larger number No Product Homogeneity Product Differentiation Consumers benefit from Monopolistic Competition Many No greater variety Check class notes 3 b) A comparison of Monopolistic Competition and Perfect Competition Type of 3 b i) Competitive 3 b ii) Output Competition Behaviour Decision 3 b iii) Pricing Behaviour There is a market demand and market supply which gives a market price. The demand There are a very large The firms' only goal is curve which each individual number of producers to maximize profit. firm faces is perfectly elastic. Perfect where each firm This is achieved where This means that the firms are Competition supplies a small marginal cost is price takers. That is they accept percentage of the equated to marginal the market prices. If the firms market. As a result revenue. Marginal set a price higher than the firms do not compete revenue is equal to market price they would loose on a one on one basis. average revenue. all their customers. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  • 8. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS In monopolistic Since there are many firms competition, there are selling differentiated products, many firms offering The firms' goal is also each firm has the power to set differentiated products to maximize profit. the price of its own products. (heterogeneous This also occurs where That is because of brand loyalty Monopolistic products). This is marginal revenue is if the firm increase its price it Competition different from perfect equal to marginal would not loose all of its competition in which cost. Marginal customers. In the long run all offer the same revenue under this though because of the freedom product. Firms also use type of competition is of entry and exit, the price advertising to attract less than average would be set where only customers. revenue. normal profit is earned. 3 c) A comparison of Monopolistic Competition and Perfect Competition Profit Efficiency Type of Competition Short Run Long Run Production Allocative Perfect Competition Any level Normal Yes Yes Monopolistic Competition Any level Normal No No 4 a i) Public Goods: Non- Excludability and Non-Rivalry The consumption of public goods and services is characterised by non rivalry and non excludability. Rivalry in consumption means that only one person can consume the good or service at a particular point in time. A good where there is non-rivalry in consumption on the other hand can be collectively consumed by multiple consumers at the same time. For example there is non-rivalry in the use of a green park as this can be enjoyed by a group of people at the same time. The term excludability means that only consumers who pay for a good have the right to consume it. That is to say, if someone does not pay for such a good or service, then he or she would not be able to consume it. In the case of non- excludability, consumers who do not pay for a good or service cannot be prevented from consuming it. In other words there is the free rider problem when non-rivalry exists as consumers would be able to consume the good or service for free. A good example of such a good is a street light, where individuals can use the light to see their way at night even though they do not directly pay for it. If left to the market, no private producer would be willing to supply goods and services which are non-excludability, as they would be unable to charge consumers for such. As such the output of such goods would be below the allocatively efficient output level. 4a) ii) Externalities Externalities are spillover effects of economic activity which affect third parties. When the external effects are negative (external marginal cost), the market would over produce the good or service and when the external effects are positive (external marginal benefits) the market under produces the good or service relative to the socially efficient amount. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  • 9. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS This is because markets only take into consideration demand and supply, which is the same as private marginal benefits and private marginal costs respectively. Evidently, markets do not take into consideration external marginal cost nor external marginal benefits which means, the market’s equilibrium usually does not conform to the socially optimal level of output. The presence of negative and positive externalities consequently means that some goods would be over produced while others may be under produced respectively. Both of these cases represent an inefficient allocation of resources. 4 a iii) Information Asymmetry Asymmetric information is defined as a difference in access to relevant information by different participants of a transaction. That is to say, certain participants may have all the relevant information, while other participants may not be fully aware of all the relevant details. Asymmetric information distorts decision making and causes the allocation of resources via markets to become inefficient. The two kinds of market failure due to asymmetric information are moral hazard and adverse selection. Moral hazard occurs when there are hidden actions or morally hazardous behaviour on the part of one party in a transaction. This particularly applies to the insurance industry where individuals who pay insurance premiums are compensated should any unfortunate loss arise. Moral hazard occurs in this type of transaction where the insured individual takes more risk by driving recklessly. This occurs as there is comfort that all expense would be covered should an accident occur. If the individual did not have an insurance policy, then he or she would drive more carefully in order to avoid having to pay for costly damages from an accident. Moral hazard therefore acts to the detriment of insurance companies as they would be faced with greater insurance claims. Adverse selection occurs when the asymmetric information arises from a hidden attribute about a good or service. In the used car market for instance, the car salesman may be aware of the servicing records of the motor vehicle. The buyer on the other hand, may not be privy to such information. As a result of these hidden attributes the buyer would not be certain about the reliability of the vehicle and may refrain from purchasing a used car simply because of the information asymmetry. This decision may be sub optimal if in reality the car was properly maintained and in perfect working condition. In other words, the individual gave up a good opportunity simply because of the information asymmetry or hidden attribute in this case. 4b) i) Natural Monopoly A natural monopoly is defined in economics as an industry where a single firm tends to become the only supplier of a particular kind of product or service over time because of the fundamental cost structure of the industry. Such industries are characterized by the existence of high fixed cost (of the capital goods especially) such that it is feasible for one firm only to supply the entire market in order to spread the fixed cost over a large volume of output. In other words, there is a natural reason for this industry being a EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  • 10. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS monopoly as more than one smaller scale firms would be less efficient than the natural monopolists. 4 b) ii) If a natural monopoly is unregulated it would produce the level of output where marginal cost is equal to marginal revenue and charge a price that consumers are willing to pay for that output as given by the market demand curve. At this level of output both production and allocative efficiency would not be achieved. 4 c) Government Regulation of a Natural Monopoly Typically, governments set the price which coincides with the output level at which just normal profits are earned. That is at this price, AR = AC. Although this output level still does not coincide with the allocative level of output (AR = MC) it is much closer to this output level than the profit maximise level where MR = MC. 5a) The price of a factor of production within a particular industry is determined by the industry’s demand and supply of the factor. In the case of labour, wages are determined by the interaction between the demand for labour and the supply of labour within the industry. This is demonstrated in the figure. Panel A: Labour Market Panel B: The Individual Firm Wage Wage Rate ($) Rate ($) SL E WL Wage Rate Share of Share of Income Income going MRP going to labour to labour by by firm industry DL QE Quantity Q’ Quantity of of Labour Labour In the figure, the industry demand for labour is shown by D L and the industry supply of labour is shown by SL. Overall, the labour market attains equilibrium at point E where a single wage rate WL exists throughout the industry. The share of income received by labour from the industry as a whole is shown by the rectangle. The area of this rectangle gives the quantity of labour times the wages rate. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  • 11. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS The individual firm in the industry would accept the market wage rate and hirer labour up to point where marginal revenue product (MRP) is equal to this rate. The area of the rectangle gives the share of income received by labour form the individual firm. 5b) Transfer earnings are the minimum payments to a factor which is just adequate to compensate the owner for providing productive resources to firms. If the owner does not receive this payment, no productive resources would be supplied to firms in that industry. Factor owners would thus transfer there factor inputs to other industries which meet the minimum payments. Transfer earnings are depicted by the area under the supply curve as up to the equilibrium level of output as shown in the figure. Economic Rent on the other hand, accounts for payments made to any factor of production in excess of the minimum payments required by the factor owner. This is therefore the difference between the total amount paid to a factor of production and its level of transfer earnings. Economic rent is therefore represented by the area above the supply curve but under the price line as shown in the figure. Transfer Earnings and Economic Rent Wage Rate ($) SL WL Wage Rate Economic Rent Transfer Earnings DL Quantity of Labour 5c) i) Factors of production are demanded by producers purely as an input in the production process. As such, the demand for factors of production is described as a derived demand, as indirectly it arises out of the need to fill consumers demand for final goods and services. As firms encounter rising demand for their products, they will need to employ more factor inputs and thus the demand for factors increases. Similarly, if the demand for final output declines, then less production would be required and thus the demand for factors of production used in the production process would be curtailed. In short, the demand for factors of production depends ultimately on the demand for final goods and services which the factors of production are used to generate. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  • 12. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 5c) ii) The price of land in a commercial district would have higher value than the price in other areas because of the difference in marginal revenue product. Marginal revenue product refers to the change in revenue from the sale of one more unit of a good or service produced by the factor of production. Since land in a commercial area can be used to locate a retail business or a service providing business, it would be able to generate a lot of revenue. In other areas though, the land may not be able to generate as much revenue since it may not be as busy with shopping consumers. As a result wiliness to pay for land in a commercial area would be much greater which accounts for its higher price. 5d) In a medium size to large poultry farm, an increase in production can be achieved from and increase in capital employed as well as labour. Capital in this case would refer to the farm facilities used to house and support the chickens. An expansion in this case would only be possible in the long run. If the farmer increases the amount of labour and capital employed by 100 percent and output increases by 150 percent then the business would be achieving increasing returns to scale. If the factor rewards remains the same, then the average cost of production would fall. This represents a case of the firm benefiting from economies of scale. If however as a result of the expansion the price of factors of production increased by more than 50 percent, the average cost of production would rise representing the occurrence of diseconomies of scale. 6a) Absolute poverty - Absolute poverty measures the actual number of people within an economy who are unable to afford certain basic goods and services such as food and shelter. This occurs simply because there income is below the poverty threshold, or poverty line. According to the United Nations development program, the poverty line is US$2 per day and all individuals with an income below this threshold are absolutely poor. Relative Poverty - Relative poverty measures the extent to which a household's financial resources falls below the average income level of the economy. For instance, if the average level of income in a country is US$10,000 per annum then an individual who earns $US6,000 per annum would be classified as relatively poor. Clearly a person, who is classified as relatively poor, may not be absolutely poor. Based on these definitions it is clear that someone can be classified as relatively poor but not absolutely poor. 6b) The basic needs approach combines certain aspects of absolute and relative measures. This is because it considers firstly the amount of income needed for long-term physical well-being such as food, clothing and shelter which is essentially the definition of absolute poverty. In addition it also considers the amount of income needed to afford other goods and services which the average member of society consumes such as health care, but also personal care, furniture, transportation, communication, laundry, and home insurance. This is similar to looking at the average level of income earned under the EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  • 13. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS relative poverty approach. Anyone with income below this combined income level, would face poverty according to the basic needs approach. The additional items included in the basic needs approach is therefore what constitutes the difference between this approach and the poverty line approach. 6c) i) Taxes and subsidies – the government can ease poverty by lowering taxes and providing subsidies. Lower taxes would increase the amount of disposable income enabling consumers to afford more goods and services. This measure should be applied on a progressive basis meaning that the individuals who earn the lowest income should face the lowest tax percentage in order to promote greater equality. Subsidies applied on items such as food for instance would lower its price enabling greater affordability. To reduce inequality such subsidies should only be available to the poorest in society. ii) Public Housing - the government can lessen through the provision of public housing solutions. This can be in the form of houses given to the poorest individuals in society who do not posses the means to own their own home. The houses would also be provide on a lease basis at lower than market rates. iii) Education and Training - Poverty reducing measures with respect to the provision of education include: free education, book grants, public school transportation and even school meals. These measures would enable the poorest individuals in society to have access to education which they would otherwise be unable to afford. 6d) Education and Training - This policy overcomes poverty at the source by improving the skills and hence employability of workers. Education also improves labour productivity and this result in increased wages to workers. As such this is the most sustainable method as the individuals who receive this assistance would not require such forever. As education milestones are achieved these individuals would be able to earn more income and thus the government would therefore be able to redirect resources to other areas in the economy. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS