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# CAPE Economics, June 2004, Unit 1, Paper 2 suggested answer by Edward Bahaw

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CAPE Economics, June 2004, Unit 1, Paper 2 suggested answer by Edward Bahaw

CAPE Economics, June 2004, Unit 1, Paper 2 suggested answer by Edward Bahaw

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• 1. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS CAPE ECONOMICS th June 18 2004 Unit 1 Paper 2 EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 2. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS June 2004 – Unit 1 – Paper 2 1 a i) The Indifference Curve An indifference curves shows a consumer’s preference for various combinations of goods and services in the consumer choice framework. For simplicity the framework assumes that there are only two goods which the consumer consumes: Good X and Good Y. Each indifference curve shows all possible combinations of Good X and Good Y which yield the same level of satisfaction to the individual consumer. 1 a ii) Two characteristics of Indifference Curve  An indifference curve slopes downward from left to right. That is it has a negative slope. This slope measures the rate at which the consumer is willing to substitute Good X for Good Y so as to leave satisfaction unchanged. This is called the marginal rate of substitution.  There are an infinite range of indifference curves on the same set of axes which is known as an indifference map. Each curve to the right shows consumption bundles which has a higher preference by the consumer. 1 b i) The Budget Line The budget line shows all the consumption bundles or combination of Good X and Good Y which can be afforded by the consumer’s income. 1 b ii) Information needed to draw a budget line:  The consumer’s income  Price of Good X  Price of Good Y 1 c) Indifference Curve for Movies and Milk EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 3. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS Movies 40 E 16 O 12 20 Milk 1 d) Income and Substitution Effect The substitution effect from a decrease in the price of milk refers to the increase in consumption of milk and the decrease in consumption of movies as the consumer buys more of the former for less of the latter. In other words the consumer substitute more milk for less movies as the relative price of milk declines. The income effect from a decrease in the price of milk refers to the increase consumption of milk as well as movies as the purchasing power of income increases. This occurs as the decline in the price of milk enables to consumer to afford more of both goods. Movies 40 E2 18.7 E1 16 12 O 30 12 13 16 20 Milk Sub Income Effect Effect EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 4. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS In the figure, the total increase in consumption of milk is 4 liters. This can be decomposed into the increase due to the substitution effect of 1 liter and the increase due to the income effect of 3 liters. 2 a) Labour Output VC FC TC AVC ATC MC 0 0 0 25 25 ∞ ∞ na 6. 12. 1 4 25 25 50 3 5 6.25 5. 7. 2 10 50 25 75 0 5 4.17 5. 7. 3 13 75 25 100 8 7 8.33 6. 8. 4 15 100 25 125 7 3 12.50 7. 9. 5 16 125 25 150 8 4 25.00 2 b i) Average Total Cost EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 5. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS \$ ATC AVC AFC Q where ATC = average total cost AVC = average variable cost AFC = average fixed cost 2 b ii) Shape of the Average Total Cost Curve Since ATC = AFC + AVC, the shapes of both of these curves must be explained. AFC fall continuously as output increases since fixed cost are spread over a larger volume of output. AVC first decreases in the short run from increases productivity from the variable factor but eventually increases due to diminishing returns. ATC first decreases due to both declining AFC and AVC but eventually rises due to rising AVC as a result of diminishing returns. 2 b iii) Marginal Cost EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 6. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS \$ AC MC AC is Productive AC is falling as Optimum rising as MC < AC MC > AC QO Quantity 2 b iv) Relationship Between Average Total Cost and Marginal Cost Average total cost is neither rising nor falling when marginal cost is identical to average cost. This point is the minimum point on the average total cost curve. This is because average total cost would rise when marginal cost is higher than the current level of average total cost. Average total cost would fall if marginal cost is below the average total cost of all previous units of output produced. Conclusively at the point of intersection between the ATC and MC curve, average total cost is at a minimum. 2 c i) The supply curve of Shirts EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 7. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS P (\$) S \$6 \$5 S 20 25 Quantity of Shirts 2 c ii) Price Elasticity of supply 5 100 × %∆QS 20 1 25% PES = = = =1.25 %∆P 1 100 20% × 5 1 2 c iii) Increase in Supply of Shirts Every 10 percent increase in the price of shirts results in a 12.5 percent increase in quantity supplied. 3 a i) Level of output at a price of \$15 At a price of \$15, the firm would produce 35 units of output. This is because profit would be maximized at this point as marginal revenue of \$15 would be equal to marginal cost of \$15. If for some reason the firm was producing an output level below 35 then it would be able to earn more profits by increasing output as marginal revenue would be greater than marginal cost. If the firm produces any output above 35 units, then it would incur losses on such units as marginal revenue would be less than marginal costs. Thus profit would be maximized at an output level of 35. 3 a ii) Level of output at a price of \$10 At a price of \$10, the firm would produce 0 units in neither the short run nor long run. This is because at this price level, AR < AC which means a loss would be incurred. As such the firm would not produce any output at this price over the long run. In the short EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 8. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS run at a price of \$10 which is equal to AVC the firm would cease to produce as well. This is because if it produced output (25 units) or not (0 units) it would incur a loss equivalent to its fixed cost. In such a case a firm would choose to produce zero units. 3 b) Normal or Zero Economic Profit Normal profit would be earned at a price of \$15. This is because at this price level, AR = AC which means the firm would generate just enough revenue to cover all its production costs. Such production costs arise from the payments made to the four factors of production which are wages, rent, interest and normal profit. Here the firm’s total revenue would be \$525 and its total cost which includes normal profit would also be \$525. Any price above \$15 would enable the firm to earn enough revenue to more than cover is production cost leaving a surplus or abnormal profit. 3 c i) Increase in Demand under perfect Competition in the short run If demand increases, then price would rise and existing firms in the industry would earn abnormal profits in the short run. Panel A shows the increase in demand for the good from D1 to D2 which leads to an increase in price from P1 to P2. As such firms face a new AR curve as shown by AR2 = MR2 in Panel B. At this price level, abnormal profit is earned as AR>AC. 3 c ii) Increase in Demand under perfect Competition in the long run As there is freedom of entry in the long run, new firms would enter the industry and this would lead to an increase in supply. Price would fall and all abnormal profits would be eliminated which is where equilibrium in the industry is restored. Panel A: Market Price Panel B: The Individual Firm \$ \$ D2 AC MC D1 S1 S22 P2 MR2= AR2 P1 MR1= AR1 D2 S1 D1 S22 Q1 Q2 Q Q EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 9. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS This is shown by the increase in supply in Panel A from S1 to S2 which leads to a fall in price back to P1. As such the AR curve which firms face return to its initial position as shown by AR1 = MR1 in Panel B. At this price just normal profit is earned as AR = AC. 4 a i) Natural Monopoly and Average Total Cost An industry with a long run average total cost (ATC) which is falling even after demand is met is know as a "natural monopoly". Such industries are characterized by the existence of high fixed cost of the capital goods especially. This is shown in the figure by the continuous downward sloping shape of the ATC curve over the range of the market demand. Furthermore MC is consistently below ATC which also accounts for the downward slope of the ATC. ii) Natural Monopoly and Supply and Cost With natural monopolies 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 monopoly as more than one smaller scale firms would be less efficient than the natural monopolists. If two or more firms attempted to supply the product each firm would have a market share of less than 100 percent and average total cost would be higher relative to if just one firm supplies the entire market. In the figure if 1 firm supplied 2 units of output to the market, the average total cost would be \$5. If 2 firms each supplied 1 unit to the market then average total cost would be \$6. 4 b) Unregulated Output by a Natural Monopoly i) Output = 2000 units ii) Price = \$6 per unit iii) Average total cost = \$5 per unit iv) Marginal cost = \$2 v) Profit = \$2000 4 c) Natural Monopoly and Inefficiency In the absence of externalities the allocative efficient level of output occurs where P = MC which corresponds to 4000 units. Since the firm only produces 2000 units, it means the product is under produced an inefficient from society’s point of view. As such a welfare loss is incurred onto society. 4 d) Problem faced by Natural Monopoly where P = MC At the output level where price is equal to marginal cost ATC> AR. This means the firm would incur a loss and not be able to cover all of its costs. Any private firm would cease to produce in this situation. 4 e i) Unregulated Output with Negative Externality EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 10. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS Unregulated output is 250 units per month as this is where demand is equal to supply. Demand is given by marginal social benefit as there are no positive externalities. Supply is given by marginal private costs. 4 e ii) Negative Externality and Allocative Inefficiency The efficient level of output occurs where MSC = MSB which corresponds to 150 units per week. Thus the output of 250 represents overproduction which results in a welfare loss from the allocatively inefficient level of output. This occurs as the private firm does not take into consideration negative externalities as it has no obligation to pay these spills over cost. 4 e iii) Marginal Social Costs and Marginal Social Benefits MSC (marginal social cost) gives the increases in cost faced by society from the production of one more units of the product, while MSB (marginal social benefit) gives the increase in benefits derived by society from the consumption of one more unit of the product. 4 e iv) Tax to be imposed by the Environmental Protection Agency A tax of \$100 per unit. 4 e v) Output after tax is imposed Output would decline to 150 units per month. 4 e vi) Price after Tax is Imposed Price would rise to \$200 per unit. 5 a) Equilibrium Wage Rate in the Labour Market In the figure, the construction industry’s demand for labour is shown by D L and the industry’s supply of labour is shown by SL. Overall, the labour market attains equilibrium at point E where a single equilibrium wage rate WL exists throughout the construction industry. The number of workers employed is QL. Labour Market in the Construction EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 11. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS W (\$) DL SL WL SL DL QL Quantity of Labour in the Construction 5 b) Equilibrium Quantity of Labour in Construction Market 5b) All other variables held constant, as the demand for housing increases, the price of new homes would rise and this would encourage more construction. In response the demand for construction workers would rise since the demand for a factor of production is a derived demand. The figure shows the increase in the demand for construction workers from DL1 to DL2 which would result in an increase in the wages earned by construction workers from WL1 to WL2. W (\$) DL1 DL2 SL WL2 WL1 DL2 SL DL1 QL1 QL2 Quantity of Labour in the Construction 5 c i) Trade Union Wage Rate Labour is Supplied Monopolistically by a Trade Union but demanded competitively EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 12. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS W (\$) DL SL Trade WU Union Wage WL SL DL Q1 QL Q2 Quantity of Labour in the Construction In the figure the trade union wage rate is shown by Wu. 5 c ii a) Effect of Trade union wage on the demand for construction workers The quantity of construction workers demanded would decline at the higher trade union wage rate from QL to Q1. 5 c ii b) Effect of Trade union wage on the number of workers employed The number of workers employed would decline from QL to Q1. 5 c ii c) Effect of Trade union wage on the number of workers supplied The number of workers supplied at the higher trade union wage rate would increase from QL to Q2. 5 d) Before Trade Union After Trade Union i) Wage Bill Higher Lower ii) Employment Level Higher Lower iii) Unemployment Level Lower Higher 6 a i) Poverty Line In general, poverty refers to a state of deprivation by individuals. There are two ways of measuring such deprivation. The poverty line, is the minimum level of income deemed necessary to achieve an adequate standard of living. Determining the poverty line is usually done by finding the total cost of all basic goods that an average household consumes. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 13. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 6 a ii) Absolute poverty This 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 their 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. 6a iii) Relative Poverty This 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 as he falls below this relative power line. Clearly a person, who is classified as relatively poor, may not be absolutely poor. 6 b ) Influence on Household Income i) Education. The different levels of education attained by different members of household would result in individuals with more education earning a higher level of income. ii) Size of the household. A household with a large number of dependents would definitely face challenges as income earned by the parents would have to be shared to meet the needs of all members of the family. iii) Marital status. A married couple household may experience earn a higher level of income compared to unmarried couple or even single parent headed households. iv) Age. If the household is an extended family with grandparents living in the same residents then income is likely to be uneven as the elderly may rely on income from pension which may be small relative to the income earned by other members of the household. v) Location. Household located in rural areas may be faced with low income levels as there may be less job opportunities in those areas relative to the suburbs and the urban areas. 6 c i) Moral hazard This occurs when there are hidden actions or morally hazardous behaviour on the part of one party in a transaction due to asymmetric information. This particularly applies to the insurance industry. If Joan establishes a fire insurance policy then losses would be covered in the event of fire damage to her property. Moral hazard occurs in this type of transaction where the individual does not necessarily intentionally sets fire to the property but may take fewer steps to prevent fires. This is because they would have the piece of mind that all loss would be fully covered. If insurance companies were able to monitor the actions of every single insured person, then morally hazardous behaviour would be EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 14. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS prevented. Since insurance providers cannot do this, these actions remain hidden resulting in greater risk and high insurance claims and hence a misallocation of resources. 6 c ii) Adverse selection This occurs when the asymmetric information arises from a hidden attribute about a good or service results in a suboptimal decision on the part of one party. If Mark buys an expensive health insurance policy then all his medical cost would be covered. Typically people who buy insurance often have a better idea of the risks they face than do the insurance companies as they would have a better idea about the health risk they face. As a result insurance companies may be faced with greater claims which reduce profitability. In other words asymmetric information causes the insurance company to make a suboptimal decision and hence there is a misallocation of resources. 6 d i) Conclusions from the Gini - Coefficient Taxation results in a decrease in the gini-coefficient. That is taxation result in a less uneven distribution of income. This occurs when the tax structure is progressive. 6 d ii) Lorenz Curve Y (%) 100% After Tax Before tax 100% Population (%) 6 d iii) Computation of the Gini coefficient The Gini coefficient is calculated as follows: EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 15. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS A 100 Gini Coefficient = × A+ B 1 where as shown in the figure A is the area between the line of absolute equality and the Lorenz curve B is the area between the Lorenz curve and the line of absolute inequality Y (%) 100% Line of Absolute Equality A B 100% Population (%) EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS