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# CAPE Economics, May 22nd 2008, Unit 1, Paper 2 suggested answer by Edward Bahaw

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CAPE Economics, May 22nd 2008, Unit 1, Paper 2 suggested answer by Edward Bahaw

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### CAPE Economics, May 22nd 2008, Unit 1, Paper 2 suggested answer by Edward Bahaw

1. 1. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS CAPE ECONOMICS nd May 22 2008 Unit 1 Paper 2 EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
2. 2. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS June 2008 Non-Trinidad (Rest of Caribbean) – Unit 1 – Paper 2 1a i) Scarcity therefore 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. ii) The production possibility curve or frontier, maps all possible combinations of Good X and Good Y which can be produced, as the given resources are distributed between the productions of each good in different quantities. iii) Opportunity cost refers to the value of the best alternative forgone as a result of choosing one option among competing options. iv) The production function refers to the relationship between the quantity of inputs and quantity of output in a production process. Inputs can be divided into four sub groups: 1. Land 2. Labour 3. Capital 4. Enterprise v) Price elasticity of demand can be defined as a measure of the degree of responsiveness of the quantity demanded of a product to changes in its price. This is calculated by dividing the percentage change in quantity by the percentage change in price. 1b) 1ci) 1 cii) EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
3. 3. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 1 d i) The production possibility curve is drawn on the assumption that there were no changes in technology. As technology is improved, the quantity of output produced using a given amount of resources increases. Under this situation it might be possible to have an increase in production of one good without any decrease in output of the other good. 1 d ii) An improvement in food technology would result in an increase in food production only. This is shown by a rightward pivot of the production possibility curve. 1 d iii) An increase in all resources would result in an increase in production of all good. This is shown by a rightward shift of the entire production possibility curve. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
4. 4. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 1 e i) Opportunity cost = ∆Capital Goods / ∆Food = (10 - 18) / (4 - 3) = -8 / 1 = -8 This means the opportunity cost of increase food production 3 to 4 units is 8 units of capital goods forgone. 1 e ii) As food production increases, the slope of the production possibility curve becomes steeper. Since this slope gives the opportunity costs, then this means the opportunity cost increases as the production of food expands. This arises since the increase in food production results in the utilization of resources which are less and less suitable. This results in an increase in cost of food. 1 e iii) At point e relatively more food and less capital is production when compared to point c. This means that in future, there would be less growth compared to point c since less resources is devoted to capital formation. The production possibility curve would therefore shift less to the right. 2 a) As the relative price of chicken increases, the substitution effect refers to the change in consumption patterns where the consumer buys less chicken and substitutes other goods in place of it by purchasing more of them. The income effect of an increase in the relative price of chicken arises from the decrease in purchasing power of the consumer’s disposable income. This decrease in real income will induce the consumer to purchase a decrease quantity of all goods. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
5. 5. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 2b) Two factors which shifts the demand curve Income Decrease in preference of consumers 2 c) Two factors which shifts the supply curve Price of factors of production The price of other goods 2d i) Cross Price Elasticity %∆Q A XED A/B = %∆PB 15% XED CHICKEN/BEEF = =3 5% 2 d ii) Whether a consumer regards a good as normal or inferior depends on the relationship between the quantity consumed and the level of income. If there is a positive relationship between quantity consumed and consumers’ income then it is regarded as a normal good. If there is an inverse relationship between quantity consumed and consumers’ income then the good is an inferior good. 2 e i) Three determinants of Price Elasticity of Demand 1. Number of substitutes immediately available - the greater the number of substitutes available the higher the price elasticity of demand tends to be. Goods which are necessities tend to have an inelastic demand as they possess very few substitutes. Furthermore, goods which have multipurpose uses may tend to have a high elasticity of demand, as there may be many substitutes available. 2. Income – the higher the proportion of consumers’ income which the price of a good represents, the higher is its price elasticity of demand. 3. Addiction – the more addictive a product tends to be, the smaller is its price elasticity of demand. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
6. 6. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 2 e ii) Demand Curve of a Good with a Perfectly Elastic Demand P (\$) \$60 D \$30 O Quantity Demand Curve of a Good with a Perfectly Inelastic Demand P (\$) D \$60 \$30 O 40 Quantity EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
7. 7. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 2 e iii) In the figure, marginal revenue is positive between an output level of 0 and Q1. This means as price is lowered, an increased output is sold and total revenue increases. As such demand is price elastic in this output range. Between Q1 and Q2, marginal revenue is negative, this means that as the price is lowered an increased quantity is sold and total revenue declines. This means that demand is price inelastic between these output levels. At output level Q1, where marginal revenue is 0, price elasticity of demand is unitary. P (\$) MR AR = Demand O Q1 Q2 Q 2 f) Two impacts of time on price elasticity of demand. Following a price increase, price elasticity of demand tends to be greater as time elapses since it may be possible for substitutes to be sourced as consumers have more time to adjust. As consumers switch to these substitutes, the response to the increase in price is greater which means demand becomes more price elastic. If however as more time elapses the substitutes are found to be unsuitable then the consumers would return to consuming the original good rendering demand more inelastic. 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 EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
8. 8. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS output. 3b) Similarities Differences Barriers to Entry Short Long Number Type of and Run Run of Production Allocative Other Competition Exit Profits Profits Sellers efficiency efficiency Characteristic Only a Any Larger theoretical Perfect No level Normal number Yes Yes possibility Increased variety to cater for diverse Monopolistic Any consumer Competition No level Normal Many No No needs 3 c i) Similarities Differences Barriers Number to Entry Type of of and Short Long Other Competition Production Allocative Sellers Exit Run Run Characteristic Economies of scale might be Monopoly No No One Yes Abnormal Abnormal achieved Increased variety to cater for diverse Monopolistic consumer Competition No No Many No Any level Normal needs Market Structure Examples Mobile phone services in Trinidad and Tobago provided Monopoly by TSTT prior to 2005. Monopolistic Competition The Fast Food Industry in Trinidad and Tobago 3 d) Barriers to Entry  Patents and Licenses (legal barriers to entry). A patent is a contractual agreement which gives exclusive right to an inventor to use his or her invention. Such exclusivity may create and perpetuate monopolies by conferring on the patent holder the sole right to produce a particular commodity. A license is a legislative arrangement which limits the entry of firms into an industry to only approved license holders. Since licenses are issued and enforced by governments, this gives the state control over the number of firms which can enter an industry.  Economies of scale. The achievement of declining long run average costs by large firms can create financial obstacles for new firms to enter the market. This is because the incumbent firm may be able to pass its cost savings to customers in the form of EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
9. 9. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS lower prices. Such prices may be so low that new firms will find it difficult to compete on a price basis, and will often earn economic losses if they try to do so. The established firm may therefore retain a monopoly position through its cost advantage, because it can produce at a lower cost than could any new smaller competitor  Brand proliferation (attributed mainly to oligopoly) – the larger the number of differentiated products sold by existing oligopolists, the smaller the market available to a new firm entering with a new product and the more difficult it is for it to enter. This is because the market would be saturated with existing brands and as a result it would be difficult for new brands to compete.  Pricing and other Strategic Barriers – this accounts for aggressive price cutting, increased advertising and other actions on the part of existing firms in the market which make it difficult for an entering firm to succeed. Advertising in particular and effective brand building mean that new firms will have to advertise significantly in order to catch the public’s attention and acquire market share. This cost may be too high for new firms expecting to operate on a small scale. Furthermore, other factors attributable to longevity advantages possessed by existing firms such a well established clientele and the provision of favourable financing to long term customers can act as a potent entry barrier by increasing the set up cost of new entrants.  Production secrets – if the production of a good involves a secret ingredient or a secret recipe such as Angostura bitters for instance, then this would effectively prevent other firms from producing this good.  Control over raw materials – the exclusive ownership or control of a substantial amount of an essential raw material would considerably limit attempts by other firms to enter an industry and as such this a monopoly firm would prevail. 3 e i) Normal Profit vs Economic Profit  Normal profit – which is the minimum amount of profit which is necessary to entice the firm to continue production in the current industry. Usually this may be determined by the amount the entrepreneur could receive in his next best job.  Economic profit or Abnormal profit – any profit earned in excess of normal profit. Abnormal profit is called, economic profit, windfall profit and super normal profit. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
10. 10. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 3 e ii) Normal Profit vs Economic Profit \$ AC MC PE E MR= MC MR AR O QE Quantity 3 e iii) If abnormal profits are earned by existing firms under monopolistic competition then this would encourage new firms to enter the industry. As more and more firms enter the industry, the market share of each firm is diluted and this has the effect of reducing the abnormal profits earned by each firm. This would be shown by a leftward shift of the demand curve faced by each existing firm in the industry. The entry of new firms in the monopolistically competitive industry would continue until all abnormal profit is eliminated from the increased competition. This would occur where AR is equal to AC. 4 a i) 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. 4 a ii) The marginal cost of production represents the cost of producing an additional unit of a good or service. This marginal cost would include the payments to the factors of production utilized which covers, rent wages, interest and normal profit. As such the firm EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
11. 11. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS in a competitive market would be prepared to accept a price equal to the marginal cost of each unit of output sold. 4 a iii) When positive externalities exist a distinction is made between benefits received by consumers which are called private marginal benefits (PMB) and those received by third parties, which are referred to as external marginal benefits (EMB). The sum of PMB and EMB gives the overall level of benefits attained by society (i.e. both the consumers and third parties) from the consumption of the good or service. This is called social marginal benefit (SMB). 4 a iv) Pareto efficiency refers to the best use of the finite resources in the production of goods and services for consumer satisfaction. There are two requirements for this to be achieved: 1) Production efficiency will not be achieved if firms in a particular market produce the level of output where production efficiency is achieved. This means that resources are not being used the most efficiently to produce goods and services to cater for the wants and needs of people. As a result social welfare is not maximized and a welfare loss exists. 2) Allocative efficiency is not achieved in a market if based the benefits and cost of it to society the good is either over producer or under produced. In short these scenarios refer to cases where an incorrect allocation of resources is made towards the production of the good in the respective market. 4 b i) Public goods have two main characteristics: • Non-rivalry in consumption • Non-excludability in consumption 4 b ii) Public Goods and Services  Roadways and highways  Public savannahs, parks and promenades 4 b iii) 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 c i) When externalities exists, there additional benefits and costs apart from the benefits received by consumers and cost faced by producers. These are the benefits and costs faced by the third parties. The market however does not take into consideration these spillover cost and benefits received by third parties. 4 c ii) Positive externalities are benefits enjoyed by third parties who are not directly involved in the consumption or production of the good or service. Negative externalities are costs faced by third parties who are not directly involved in the consumption or production of the good or service. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
12. 12. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 4 c iii) When positive externalities exist a distinction is made between benefits received by consumers which are called private marginal benefits (PMB) and those received by third parties, which are referred to as external marginal benefits (EMB). The sum of PMB and EMB gives the overall level of benefits attained by society (i.e. both the consumers and third parties) from the consumption of the good or service. This is called social marginal benefit (SMB). 4 c iv) When negative externalities exist a distinction is made between cost incurred by producers which are called private marginal costs (PMC) and those faced by third parties, which are referred to as external marginal costs (EMC). The sum of PMC and EMB gives the overall cost face by society (i.e. both the producers and third parties) resulting from the production of the good or service. This is called social marginal cost (SMC). The market however does not take into consideration these spillover cost and benefits received by third parties. As a result goods and services which generate positive externalities are under produced. This means when there are external benefits, the market would under produce the good or service. This results in a loss in welfare which means allocative efficiency is not achieved. When negative externalities exist, the good or service is over produced also leading to a welfare loss. Such over production causes a loss in welfare as too many resources are being used in the production of the good or service. 4 d) Causes of Market Failure: 1. Imperfect competition 2. Insufficient provision of merit goods and services. 3. Asymmetric information 4 e) Addressing Markets Failure associated with Externalities (Sync with past paper solutions) 1. Nationalization - under this approach the government takes ownership of the production facilities and takes charge of production. As such the government chooses to produce the quantity of output which achieves allocative efficiency. This means that if positive externalities were involved and the good or service was under produced by the market, then the government would take charge of production and increase output towards the socially desirable level. If, on the other hand, negative externalities existed, then a welfare loss from over production would be created under private production. Under state production, output would be reduced to the optimal level, in order to achieve a maximization of society’s welfare. 2. Indirect Taxation and Subsidies  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 optimal 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 EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
13. 13. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS would provide an incentive for more people to consume such goods which would increase output to the socially optimal level of output. A good example of subsidies include: the recent financial assistance program in Trinidad Tobago where students who qualify for tertiary level education are granted subsidies by the government of that country. 3. Legislation • A Total Ban on the product - with this method the government would simply put a total ban on the good or service which generates the negative externality such as guns and illegal drugs. However, banning a product may involve creating a new welfare loss due to zero production. The welfare loss associated with the market output of the good or service which generates the negative externality is shown by the smaller shaded triangle. The welfare loss associated with a ban on production is shown by the larger shaded triangle. This implies that a ban on the product can only be justified if the welfare loss resulting from the ban is smaller than the original welfare loss that existed at the market equilibrium. • A ban on the negative externality. A ban on pollution for instance can be imposed by the government in an attempt to eliminate the welfare loss impact it has onto society. In such an extreme case, firms may have to be innovative to develop methods of eliminating pollution in order to continue production. • Regulation of output. The state also has the option of regulating the level of output in a market. Where a negative externality exists, firms could be prohibited by law from producing more than the socially efficient output level. In theory, the government could set a quota or a physical limit on output corresponding with the social optimum. This may require the establishment of regulatory bodies such as the Environmental Management Authority in Trinidad which monitors and enforces standards on activities which result in environmental degradation which is a negative externality. 5 a i a) These resources or factors of production are simply the inputs used in the production process to generate output. 5 a i b) The labour force participation rate is the proportion of individuals from the overall population who are in the labour force. The labour force is the number of available workers in a country. This accounts for all people 18 years and over and under 65 years who are either working or actively looking for employment. 5 a ii) Factors of Production and Factor Rewards Factor of Production Factor Reward Land Rent Labour Wages Capital Interest Enterprise Profit 5 b i a) 1 2 3 4 Units of Labour Output per Day Marginal Product Value of Marginal Product EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
14. 14. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 0 0 1 2 2 10 2 6 4 20 3 12 6 30 4 19 7 35 5 25 6 30 6 29 4 20 7 32 3 15 5 b i b) If the wage rate is \$20 then 6 units of labour would be employed 5 b i c) At this level of employment the MRP of labour is equal to the wage rate. The firm is able to maximise profit from the employment of labour at this point. 5 b ii) 5 b iii) If the wage rate is \$15 then 6 units of labour would be employed. 5 b iv) The MRP curve constitutes the firm’s demand curve for a factor of production, since it shows how many units of a factor of production a firm is willing to employ at different factor prices. If the MRP of a factor of production is greater than its price then the firm can profitably hire more that factor. If a firm discovered that the MRP from the last unit of a factor employed is less than the price then it would have to lay off that unit as a loss would be incurred. Conclusively if MRP is equal to price then the firm would employ neither more nor less of the factor. In other words the firm employs the optimal quantity of the factor when MRP is equated to price (MRP = Price). 5 c) Factors of production are demanded by producers purely as an input in the production process. In short, the demand for factors of production depends ultimately on EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
15. 15. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS the demand for final goods and services which the factors of production are used to generate. 5 d i) The labour force is the number of available workers in a country. This accounts for all people 18 years and over and under 65 years who are either working or actively looking for employment. 5 d ii) In this case the labour force is 110 (130 – 20). EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
16. 16. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 5 d iii) Labour Force Labour force Participation rate = × 100 Population 110 = × 100 = 85.4% 130 5e i) In panel A, as more workers supply their labour to the high wage labour market the supply curve shifts to the right from SH1 to SH2 causing wages to fall from WH to W. 5 e ii) Panel B shows the low wage labour market where workers are leaving and thus the supply of labour decreases from SL1 to SL2. As a consequence, wages increase to W thus leading to an equalization of wages across both industries. 6 a) The size distribution of income was mentioned in the preceding section as a cause of poverty. This refers to how income earned throughout the economy is distributed among the population of an economy. 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. 6 b i) The Lorenz curve traces how the total income of an economy is shared among the overall population. This is constructed with income shown on the vertical axis and population represented on the horizontal axis. If income is perfectly evenly distributed then there is an even spread between the amount of income and the individuals who make the population. Such a Lorenz curve is a straight line which forms a 45 degree angle at the origin and is referred to as the line of absolute equality. Since income is usually unevenly distributed then the actual Lorenz curve would be below the line of absolute equality. The bigger the area between the Lorenz curve and the line of absolute equality, the more unequal would be the distribution of income. From the Lorenz curve, a quantitative measure of the distribution of income can be derived. This is known as the Gini coefficient which is calculated as follows: A 100 Gini Coefficient = × A+ B 1 where as shown in figure 16-5 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 EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
17. 17. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 6 b ii) If there is an absolutely, uneven distribution of income then area B would be zero. As such the Gini coefficient would correspond to 100 percent. The closer the Gini coefficient is to 0, the more even the distribution of income and the closer it is to 100 percent, the more uneven the distribution of income. 6 c i) 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. 6 c ii ) Underlying Causes of Poverty • Unemployment – one of the leading causes of poverty is unemployed. Those who do not have jobs would not have a source of income to support themselves and their families. There are many cause of unemployment. • Education – low education attainments is also a cause of poverty as it typically denies employment opportunities to individuals who are not sufficiently educated. Furthermore, lack of education also perpetuates the cycle of poverty as individuals who are not educated may not be able to educate their children. As such future generations also face the challenge of poverty. • Health – poor health and lack of access to healthcare is also a contributor to poverty. This is because as individuals face health problems their productive abilities would be impaired. This can be exacerbated if the individual is unable to access healthcare treatment as prolonged health problems are encountered. As such the individual’s earnings ability suffers in the long run which exposes them to a life of poverty. 6 d) Social Welfare Programs A welfare programme 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. In Trinidad and Tobago there is the Chronic Disease Assistance Programme (CDAP) which provides free prescription drugs and other pharmaceutical items for a number of health conditions such as diabetes and asthma etc. 6 e) 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 EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
18. 18. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 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 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. 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. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS