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# CAPE Economics, June 2005, Unit 1, Paper 2 suggested answer by Edward Bahaw

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CAPE Economics, June 2005, Unit 1, Paper 2 suggested answer by Edward Bahaw

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### CAPE Economics, June 2005, Unit 1, Paper 2 suggested answer by Edward Bahaw

1. 1. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS CAPE ECONOMICS th May 26 2005 Unit 1 Paper 2 EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
2. 2. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS June 2005 – Unit 1 – Paper 2 1 a) Labour Output APP MPP VC FC TC AVC MC 0 0 0 0 0 1 30 30 30 10000 0 10000 333 333 2 70 35 40 20000 0 20000 286 250 3 120 40 50 30000 0 30000 250 200 4 200 50 80 40000 0 40000 200 125 5 260 52 60 50000 0 50000 192 167 6 300 50 40 60000 0 60000 200 250 1 b i) Average Physical Product (APP) refers to the amount of output produced per unit of the factor of production employed. This is calculated by dividing the total physical produced by the quantity of factor input used. APP = Total Physical Product/Quantity of the Variable Factor 1 b ii) Marginal Physical Product (MPP) refers to the addition to output from hiring one more unit of the variable factor of production. This is calculated by dividing the change in total physical produced by the change in the quantity of factor input used. MPP = Change in Total Physical Product/Change in Quantity of the Variable Factor 1 b iii) Average variable cost (AVC) gives the variable cost per unit of output produced. This is calculated by dividing the average variable cost by the number of units of output produced. AVC = VC/Q. 1 b iv) Marginal cost (MC) refers to the additional cost as a result of producing one more unit of output. This is calculated by dividing the change in total cost by the change in the quantity of output produced. MC = TC/ Q. where TC is the change in total cost Q is the change in the quantity of output produced. 1 c) As output expands APP and MPP eventually declines. This occurs because of the law of diminishing returns which applies to the short run. 1 d) AVC and MC eventually increase in the short run as output increases. This also occurs because of the law of diminishing returns. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
3. 3. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 1 e i) In the short run, when one factor input is fixed in supply and successive units of a variable factor are added to it, then after some time, the extra output derived from the employment of each successive unit of the variable factor must diminish. The law of diminishing returns implies that if more units of labour are employed along with a fixed amount of capital, the marginal physical product of labour will, after some time, decrease. 1 e ii) Due to diminishing returns marginal costs and average cost will rise as output increases in the short run. In the long run marginal costs and average cost will first fall as output increases due to economies of scale but eventually diseconomies would set in and cause these costs to rise. 1 f) Marginal Cost Diagram 1 g) Given a fixed price, then MR = AR = price. The firm maximises profit where MR = MC. The corresponding output level is about 280 units. 2 a i) Demand can be defined as the total quantity of a good or service purchased over a specific period of time at a particular price. 2 a ii) Supply can be defined as the total quantity of a good or service that suppliers wish to produce and offer for sale at a particular price over a specific period of time. 2 b) A change in demand can be an increase or decrease in demand, which results in a shift of the demand curve and is brought about by a factor other than a change in price of the good or service under consideration. Changes in quantity demanded are shown by movements along the demand curve. This can be a contraction or an extension of demand and are brought about by a change in price of the good or service under consideration and by nothing else. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
4. 4. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 2 c i) Digital Cameras Market 220 200 180 Demand 160 Price 140 Supply 120 100 80 0 10 20 30 40 50 60 Quantity 2 c ii) Equilibrium price = \$150 per camera Equilibrium quantity of cameras traded = 30 cameras 2 d i) Five factors influencing the demand for digital cameras. 1) Changes in income; 2) Price of other goods (substitutes or compliments); 3) Changes in population; 4) Seasonal factors affecting demand; 5) Advertising by producers 2 d ii) Four factors influencing the demand for digital cameras.  An increase in income would lead to an increase in demand for digital cameras as consumers would purchase more of all goods and services. This is shown by a rightward shift of the demand curve.  If the price of film cameras which are a substitute increases then this would encourage consumers to buy more digital cameras leading to an increase in demand. This is shown by a rightward shift of the demand curve.  A rise in the population level would increase the demand for digital cameras as more consumers would be buying such goods. This is shown by a rightward shift of the demand curve.  During shopping seasons such as Christmas the demand for digital cameras would rise as consumers spend more money on such goods. This is shown by a rightward shift of the demand curve. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
5. 5. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 2 e) An increase in Demand due to an increase in the population size P (\$) D2 D1 D2 D1 O Quantity of Digital Cameras An increase in population size leads to an increase in quantity demanded of digital cameras at all prices. This is shown by the rightward shift of the demand curve from D1 to D2. 2 f i) Five Factors influencing Supply 1) Price of the digital cameras 2) Price of factors of production (including the imposition or removal of a sales tax or subsidy) 3) Technological changes 4) Changes in the tastes of producers 5) Exogenous factors 2 f ii) Four Factors influencing Supply  As the price of digital cameras changes this would lead to a change in the quantity which producers are willing to supply to the market. This is shown by movements along the supply curve.  As the price of factors of production increases, cost of production would increase and there would be a decrease in supply of the digital cameras. This is shown by a leftward shift of the supply curve.  Improvements in technology which enable digital cameras to be produced more efficiently would lead to an increase in the supply. This is shown by a rightward shift of the supply curve.  Exogenous factors such as weather conditions or political turbulence which affect international shipping could affect the supply of digital cameras. This is shown by a leftward shift of the supply curve. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
6. 6. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 3 a ) Market structure refers to the type of competition which exists among firms in a particular industry. The type of competition is distinguished by the characteristics of the industry which gives an indication of how firms would operate in terms of price and output. 3 b) Type of Market Structure Example Perfect No pure forms – shares on a stock exchange of a large company is close Monopoly Angostura Bitters Oligopoly Commercial and newspapers Banks in Trinidad and Tobago Monopolistic Competition Clothing retailers 3c) Barriers Market Power Profit in Type of to Entry Number Nature of Goods and control the Long Competition and Exit of Sellers produced over prices Run Larger Homogenous output Perfect No number sold by all firms Yes Normal No substitutes exist for the output of the Monopoly Yes One monopolist No Abnormal Branding – goods are essentially identical with perceived Oligopoly Yes Few differences No Abnormal Non homogenous - A great deal of variety with regards to the output Monopolistic produced by Competition No Many difference firms No Normal 3 d i a )There are two type of efficiency  Productive efficiency – can be defined the as extent to which the amount of resources used in the production process are minimised. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
7. 7. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS  Allocative efficiency – can be defined as the extent to which resources used in the production process are allocated towards the production of those goods and services which maximise economic welfare. 3 d i b) Consumer surplus can be defined as the difference between what consumer pays for a good and the price they were willing to pay for it. 3 d i c) Producer surplus can be defined as the difference between what producers received from the sale of a good and the price they were willing to pay for it. 3 d ii a ) In the absence of externalities allocative efficiency occurs where the price of a good is equal to the marginal cost of producing it (P = MC). Under monopoly, the firm producers where P > MC. This means the firm is allocatively inefficient. Productively efficiency is achieve where average cost is equal to marginal cost (AC = MC). Under monopoly the firm producers where AC > MC. This means the firm is productively inefficient. In the figure the monopolists output is shown by QE. Monopoly \$ MC AC PM AC=MC P=MC E MR AR QE QO Q 3 d ii b) Under Perfect Competition the firm is allocatively efficient as it produces where P = MC. The firm is also productively efficient as AC = MC. this is why perfect competition refers to the theoretical optimal performance of a firm in a free market economy. In the figure the perfectly competitive firm’s output is shown by QE. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
8. 8. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS Perfect Competition \$ AC MC E MR=AR AC=MC P=MC QE Q 4 a) Market failure occurs whenever the quantity of a good or and service produced in a market does not occur at the productive and allocative efficient level. In other words as long as a welfare loss exists at the quantity of output produced by the market then market failure exists. This can occur as a result of: 1. Imperfect competition 2. Externalities 3. Insufficient provision of merit goods and services. 4. Non provision of public goods and services 4 b) Political instability affects the supply of oil. The market responds to this situation via an automatic increase in the price of oil. At this new price consumers would choose a new quantity of oil to consume and at this new equilibrium the quantity chosen would result in welfare maximisation subject to the new price for oil as private marginal benefit would be equal to private marginal cost. As such this not an indication of market failure. 4 c i) Market Failure due to Monopoly Market failure means that the output produced in the market does not maximise society’s output. This occurs under a monopoly environment for two reasons. In the first case monopolies do not utilises resources efficiently. That is the monopolist’s output does not conform the level where unit cost is minimised (MC = AC). This means the market fails because of production inefficiency. In addition, monopolies also produce below the level of output where P = MC. This means there is market failure due to allocative efficiency. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
9. 9. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS These two conditions are shown in the figure. The monopolist’s output is given by QE. This represents market failure as the level of output at which society’s welfare is maximized is at QO. Monopoly \$ MC AC PM AC=MC P=MC E MR AR QE QO Q 4 c ii) Market Failure due to Externalities Externalities occur when there are third parties who enjoy spill over benefits or face spill over costs as a result of production and consumption of a particular good or service. Spill over benefits are referred to as positive externalities and spill over costs are called negative externalities. When externalities exist the level of output at which society’s welfare is maximized occurs where social marginal benefits (the sum of private marginal benefits by consumers and external marginal benefits by third parties) and equal to social marginal cost (the sum of private marginal cost by producers and external marginal cost faced by third parties. When there are positive externalities the market would ignore this as it produces where demand (private marginal benefit) = supply (private marginal cost). As such output would be below the allocative efficient level of output and welfare is not maximised. In figure the socially optimal output level occurs where SMB = SMC which corresponds with Qs. However, the market equilibrium is at QE, which is less than QA. As a result a welfare loss triangle exists and there is market failure Positive Externalities and Under Production EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
10. 10. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS SMB P (\$) S = SMC D PE E EMB SMB S = SMC D QE QA Quantity When negative externalities exist, the market would ignore this as it produces where demand (private marginal benefit) = supply (private marginal cost). As such output would be above the allocative efficient level of output and welfare is not maximised. In figure the socially optimal output level occurs where SMB = SMC which corresponds with Qs. However, the market equilibrium is at QE, which is more than QA. As a result a welfare loss triangle exists and there is market failure Negative Externalities and Over Production SMC P (\$) D S EMC E PE SMC S D = SMB QA QE Quantity EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
11. 11. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 4 c iii) Market Failure due to Non Provision of Public Goods Public goods have two main characteristics: • Non-rivalry in consumption • Non-excludability in consumption Non-rivalry in consumption means the good or service can be consumed by a group of consumers at the same time. Non-excludability in consumption means that consumers can make use of the good or service even though they do not pay it. Examples of public goods are roads are street lighting. These are provided by the government since if left to the market private producers will not provide them. This is because the non-excludability feature of public goods means that people who use public goods and services do not pay for them. As such the market would fail to produce these goods and as a result a welfare loss would exist. 4 d i) Regulation to remove the effect of monopoly power. 1. Price ceiling – the government can regulate monopoly power by imposing a price ceiling in the market which prohibits the firm from charging high prices and remove and therefore removes the effect of monopoly power. 2. Regulations to promote competition – the government can liberalise the monopoly markets by granting license to new producers. This would enable new firms to enter the industry which would encourage greater competition and remove the effects of monopoly power. 3. Nationalization - under this approach the government can take partial or full ownership of the production facilities and take charge of production. As such the government would be able to control the quantity of output produced and remove the effects of monopoly power. 4 d ii) Indirect Taxation and Subsidies to remove the effect of externalities.  Indirect Taxation - This is applied in cases where there are negative externalities and the good or service is over produced. Here the government can impose a tax on each unit of output, where the amount of tax corresponds to the external cost. The main aim of such indirect taxes is to increase the firm’s private marginal cost (PMC) until it equates with social marginal cost curve (SMC). As a result production of the good or service would decline to the allocative efficient level.  Subsidies - activities that generate positive externalities can be subsidized. The aim of a subsidy is to reduce the private marginal cost (PMC) of consuming a good. This would provide an incentive for more people to consume more of such goods. As a result the market output should increase towards the allocative efficient level. 4 d iii) Government intervention to ensure optimal production of public goods. To determine the socially desirable level of output, social marginal benefits are estimated and compared with social marginal costs. The social marginal benefit curve for a public good or service is derived by a vertical summation of each individual consumer’s demand EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
12. 12. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS curve. This differs from private goods and services where a horizontal summation is applied instead. The process of vertical summation comes about because of the non- rivalry characteristic of public goods. That is to say, since a public good simultaneously benefits a group of consumers, then the aggregate benefit by all consumers would be the sum of the benefits received by all individual consumers. The social marginal benefits derived in this way can be used in conjunction with the social marginal cost of providing the public good or service to determine the socially optimal level of output. The state would therefore provide this level of output freely to public. Although members of the public do not pay for public goods directly, they still pay for them indirectly. This is because the government would finance the provision of public goods and services using its resources which are primarily derived from the proceeds of taxes. In other words public goods and indirectly paid for by individuals who pay taxes to the state. 5 a i) The functional distribution of income captures the proportion of income going to the owners of different factors of production. That is, it measures the amount of income received by landowners, labourers, owners of capital and entrepreneurs in the form of: rents, wages, interest and profit respectively. 5 a ii) Inequality is defined as uneven distribution of income among the population throughout the economy. That is income varies among different individuals in society. If there are some individuals who earn high income along with those who earn low income, then the distribution of income is said to be uneven. 5 a iii) The gini coefficient is a measure of income inequality based on the distribution of income. The greater the gini coefficient the more unequal the distribution of income. 5 a iv) The Lorenz is a graph which gives the relationship between the cumulative income percentage in an economy and the cumulative population percentage who earn such income in ascending order of earnings. This can be used to determine the extent to which income is unevenly distributed. 5 bi) The gini coefficient ranges from 0 to 1. 5 bii) The closer the gini coefficient is to 0 the more even the distribution of income whereas the closer it is to gini coefficient is 1 the more uneven the distribution of income. 5 c i) Measures to Achieve Equality  Progressive taxes  Social welfare programs  Minimum wages 5 c ii) Measures to Achieve Equality EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
13. 13. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS If the percentage of income taken in tax increases as income rises, then the tax is progressive. This can help reduce inequality as low income earners face a lower tax rate than high income earners. A social welfare program refers to any government initiative which seeks to provide a minimum level of income or financial aid as well as other support such as access to free services for underprivileged or deprived peoples such as the poor, elderly and the disabled. Such programs are financed by government taxation revenue. A minimum wage is a government imposed wage rate which is set above the market rate in the low pay labour market. The intension of this artificial price is to enable workers to earn sufficient income to afford basic standard of living and therefore promote greater equality in society. 5 d i) Poverty refers to a state of deprivation by individuals in terms of access to basic goods and services. Individual who are faced with poverty experience a low standard of living. 5 d ii) Absolute versus relative poverty  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. 5 e) An unequal distribution of income means that living standards would be variable among the population. The high income earners would enjoy a high standard or living while the low income households would face a life of poverty. The middle class would be able to afford to buy more goods and services than the low income earners but less than that of the high income earners. Overall they would enjoy a medium quality of life. 5 f) Education has a very significant role in the elimination of poverty. This policy overcomes poverty at the source by improving the skills and hence employability of workers. In addition labour productivity is improved and this result in increased wages to workers. Poverty reducing measures with respect to the provision of education include: free education, book grants, public school transportation and even school meals. Furthermore education can also stem the poverty cycle where children born in poverty do not have access to proper education and become adults and have children who born in poverty. As individuals attain a meaningful education they can earn enough income to ensure that their children are properly educated as well. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
14. 14. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 6 a) Social welfare or welfare of society refers to the net benefits society enjoys from the use of its resources in the production and consumption of goods and services. The output combination of goods and services at which social welfare is maximized occurs where resources are allocated towards the best possible uses in face of the fundamental problem of economics which is scarcity. 6 b) Four Government Services  Health and Sanitation Services  Transportation Services  National Defence and Polices Services  Education Services 6 c i) Vote getting would encourage government to provide goods and services at the lowest possible cost to the greatest number of voting constituencies as this would help build political support needed for success at elections. 6 c ii) Welfare equity means that the provision of public services would be done on an equitable basis. This requires that as far as possible the services provided should benefit every single person in society. 6 c iii) The government would implement measures to increase the provision of services with beneficial externalities. This is because such services would be under produced by private producers in the market. In some cases, subsidies would be granted to assist private produces while in other cases full subsidization and distribution by the state would implemented. The later would be done in the case of merit services. 6 d i) Asymmetric information refers differences in access to relevant information by different participants of a transaction. That is to say, either certain participants (such as the buyer or seller of a good, service, or factor of production) 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 markets to become allocatively inefficient. Take the case of an individual who offers a very old for sale at an extremely low price. If the interested buyer is aware that the car is a limited edition antique while the seller does not know this then this is an example of asymmetric information. 6 d ii) Moral harzard occurs when an individual makes a suboptimal decision or undertakes a hidden action if the other party in the transaction cannot monitor his or her behaviour all the time. This particularly applies to the insurance industry where individuals who pay insurance premiums are compensated should any unfortunate loss arise. Insurance is therefore a service which gives peace of mind to individuals who face the risk of unfortunate losses. For instance, a driver may establish an automobile insurance policy which covers all damages in the event that he or she is involved an accident. 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 EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
15. 15. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 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. 6 d iii) Adverse selection refers to a suboptimal decision by one party in a transaction when there a is a hidden attribute about a good or service which the other party is aware off. 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. 6 e i) A minimum wage refers to a legally enforced wage rate stipulated by the government of a country which prevents employers from paying workers a wage rate below the set rate. 6 e ii) In the figure the equilibrium wage rate in the labour market is \$5 but a minimum wage of \$8 is imposed by the government. Price Floors or Minimum Wage Wage D S \$8 Price Increase in Floor Wages E \$5 S D 30 50 Quantity of Labour Decrease in Employment Two effects of the Minimum Wage on Welfare of Workers 1. As the figure shows 30 workers would be able to earn a higher wage. This would increase their welfare. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
16. 16. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 2. The figure also shows that total employment falls from 50 to 30 workers. This therefore results in a decrease in welfare of these 20 individuals. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS