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

1. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
CAPE
ECONOMICS
June 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
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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
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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
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$
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
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$
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
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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
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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
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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
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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 $200 per unit.
5 a) Equilibrium Wage Rate in the Labour Market
In the figure, the construction industry’s demand for labour is shown by D L and the
industry’s supply of labour is shown by SL. Overall, the labour market attains equilibrium
at point E where a single equilibrium wage rate WL exists throughout the construction
industry. The number of workers employed is QL.
Labour Market in the Construction
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W ($) 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 ($) DL1 DL2 SL
WL2
WL1
DL2
SL DL1
QL1 QL2
Quantity of Labour in
the Construction
5 c i) Trade Union Wage Rate
Labour is Supplied Monopolistically by a Trade Union but demanded competitively
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W ($) 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.
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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
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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:
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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