CAPE Economics, June 2007, Unit 1, Paper 2 suggested answer by Edward Bahaw

1. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
CAPE
ECONOMICS
th
May 24 2007
Unit 1
Paper 2
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2. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
June 2007 – Unit 1 – Paper 2
1 a i) Utility refers to a numerical measurement of satisfaction derived from the
consumption of a good or service. Marginal utility is the change in total utility whenever
an additional unit of a good or service is consumed.
1 a ii)
Marginal Utility
Utility from Video Utility from
Quantity Games Novels Video Games Novels
0 0 0
1 30 30 30 30
2 40 38 10 8
3 48 44 8 6
4 54 46 6 2
5 58 47 4 1
1 b)
Video
Games
5
5 Novels
1 c i)
Marginal Utility per
Marginal Utility Dollar
Utility from Video Utility from Video Video
Quantity Games Novels Games Novels Games Novels
0 0 0
1 30 30 30 30 1.50 1.50
2 40 38 10 8 0.50 0.40
3 48 44 8 6 0.40 0.30
4 54 46 6 2 0.30 0.10
5 58 47 4 1 0.20 0.05
1 c ii) Optimal number of video games and novels Abina will consume in a month is 3
and 2 respectively. This is the combination which meets the equi-marginal utility
condition and utilizes the entire $100 available for spending.
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1 d i) In general an increase in income would lead to an increase in consumption of both
goods as the consumer has more purchasing power. In this case an increase in income of
just $20 would allow Abina to purchase just one more of either good.
1 d ii) An increase in the price of one good would result in a decrease in the quantity
consumed of it via the substitution effect and possibly a decrease in the consumption of
the other good via the income effect.
1 e ia) and 1 e ib) and 1 e iia)
Rental Housing Market
Price 150
140
Quantity
Demanded
130
E quilibrium 120
P ric e Quantity
Supplied
110
100 Price Ceiling
90
80
15 20 25 30 35 40 45 50
E quilibrium
Qua ntity Quantity of Rental Housing in '000s
1e ii b i) As the price ceiling of $110 is introduced, the demand for rental housing would
rise to 35,000 units but the supply would contract to 25,000. As a result the policy would
lead to a shortage of rental housing.
1 e ii b ii) Effect on Producer Surplus and Consumer Surplus.
• Producer surplus would decrease by $55,000.
• Consumer surplus would fall by $25,000 on account of the decrease in quantity
available and increase by $50,000 on account of the lower price. The overall change
in consumer surplus is therefore is a net increase of $25,000.
2 a i) Average physical product (APP) is the total physical product (TPP) per unit of
variable factor. Average physical product is derived by dividing the total physical product
by units of the variable factor used.
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Total Physical Product
Average Physical Product =
Units of Labour
Marginal Physical Product (MPP) can be defined as the additional output resulting from
employing an additional unit of variable factor. It is calculated as:
Change in Total Physical Product
Marginal Physical Product =
Change in Units of Labour
2 a ii)
Labour Output Average Physical Product Marginal Physical Product
0 0 na na
1 5 5.0 5
2 12 6.0 7
3 22 7.3 10
4 30 7.5 8
5 36 7.2 6
6 40 6.7 4
2b i) Average and Marginal Physical Product Curves
2 b ii) Relationship between Average and Marginal Physical Product - Both the average
and marginal physical product curves are upward sloping but then after become
downward sloping. When marginal physical product is higher than average physical
product, the average physical product curve is upward sloping. When marginal physical
product is lower then average physical product, average physical product is downward
sloping. The point at which the marginal physical product is equal to average physical
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product, average physical product is neither upward sloping nor downward sloping but at
its maximum point.
2 b iii) Reason why marginal physical product is first upward sloping and then becomes
downward sloping. In the short run, when one factor is fixed in supply and successive
units of labour is employed marginal physical product would first rise due to increased
productivity owing to the specialization and the division of labour.
After some time, marginal physical product would decline though due to the law of
diminishing returns. As more and more workers are employed with a fixed amount of
labour, the capital to labour ratio declines and this causes a reduction in labour
productivity as shown by the decrease in marginal physical product.
2 c)
Fixed Variable Total Average Average Marginal
Output Cost Costs Costs Variable Costs Total Costs Costs
0 30 0 30
5 30 20 50 4.0 10.0 20
12 30 40 70 3.3 5.8 20
22 30 60 90 2.7 4.1 20
30 30 80 110 2.7 3.7 20
36 30 100 130 2.8 3.6 20
40 30 120 150 3.0 3.8 20
2 d i) 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.
%∆Q A
PED = − (coefficient of price elasticity of demand)
%∆PA
(30 − 25) / 30 × 100 / 1 1/ 6
2 d ii) PED = − =− = 0.67
(4 − 5) / 4 × 100 / 1 − 1/ 4
This coefficient means that demand is price inelastic as it is less than 1. In this case as
price is increased, the quantity demanded would fall less than proportionately and total
revenue would rise.
3 a i) 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. Two other types of market structure which exist in Trinidad and Tobago are:
1. Monopolistic Competition
2. Oligopoly
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3 a ii) Four assumptions of perfect competition:
1. The market is large, meaning that there are a large number of consumers and there are
a large number of suppliers where each individual firm contributes a small proportion
of the overall market supply.
2. The market is liberal in the sense that any buyer and seller could freely conduct
business in the market.
3. The output supplied by each firm in the market is identical. That is, there is product
homogeneity throughout the market.
4. Buyers and sellers have perfect knowledge of all market variables. As such, market
participants are able to make well informed decisions and thus rational individuals are
able to take full advantage of all opportunities in the market.
The closest industry is the poultry in Trinidad and Tobago.
3 a iii) A comparison of Monopoly and Perfect Competition
Profit Efficiency
Barriers
Number to Entry
Type of of and Short Long Other
Competition Sellers Exit Run Run Production Allocative Characteristic
Larger Only a theoretical
Perfect number No Any level Normal Yes Yes possibility
Economies of
scale might be
Monopoly One Yes Abnormal Abnormal No No achieved
The figures below shows the price and output under each type of competition
Perfect Competition
$
Monopoly
AC $
MC
MC
AC
E
PE MR=AR
PE
AC=MC
P=MC AC=MC
QE Q P=MC
E
MR AR
QE
Q
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3 b i) Effect of Imposition of Indirect Taxes on Cigarettes
P ($)
S2
D S1
TAX
E2
P2
P1 E1
S2
S1 D
Q2 Q1 Quantity of Cigarettes
3 b ii a) The tax would result in a decrease in the quantity of cigarettes bought and sold.
3 b ii b) The tax would result in an increase in the price of cigarettes paid by the buyer.
3 b ii c) The net price received by the seller after tax would fall but it is likely that the
decrease would be less than the full tax. This is because since cigarettes are addictive the
demand is likely to be price inelastic in which case a greater burden of the tax would be
passed onto the consumer with the lesser amount absorbed by the seller.
3 c i ) Deadweight loss from the imposition of a unit tax on cigarettes
P ($)
S2
D S1
TAX
E2
P2
P1 E1
S2
S1 D
Q2 Q1 Quantity of Cigarettes
Deadweight loss is the loss in welfare caused by, for example, a tax or monopoly pricing.
In this case the government earns revenue at the expense of producers and consumers
who face a decrease in producers and consumers surpluses respectively. Usually the
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decrease in producers’ and consumers’ surpluses is bigger than the increase in
government revenue and the difference gives the magnitude of the net decrease in
economic welfare. This is shown by the shaded triangle.
3 c ii) Consumers’ surplus can be defined as the difference between the maximum price
that consumers would be willing to pay for a good and what they actually pay. This is
measured by the vertical distance between the demand curve and the price line which
gives a monetary valuation of the excess or surplus satisfaction which consumers derive
freely from consuming the good or service. The decrease in consumer surplus as a result
of the tax is shaded in green.
Producers’ surplus can be defined as the difference between the prices that suppliers
would be willing to sell their output for what they actually receive. This is measured by
the vertical distance between the supply curve and the price line which gives a monetary
valuation of the excess or surplus revenue which producers derive freely from sale of
their output. The decrease in producer surplus is shaded in yellow.
P ($)
S2
D S1
TAX
E2
P2
P1 E1
S2
S1 D
Q2 Q1 Quantity of Cigarettes
4 a) Market failure refers to cases where the market output occurs at a level which does
not coincide with welfare maximization. That is to say, the output set by the interaction
between consumers and producers in the market is not socially optimal. This can occur if
either productive of allocative efficiency is not achieved by a market.
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.
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.
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4 b) Causes of Market Failure
1. Imperfect competition and Monopoly - firms which operate under imperfect
competition and monopoly maximizes profit at a level of output below productive
efficient or allocative efficient level of output. As a result social welfare is not
maximized and a welfare loss exists.
2. Externalities - Goods and services which generate positive externalities are under
produced. This results in a loss in welfare which means allocative efficiency is not
achieved. Merit goods a special category of goods with positive externalities where in
particular the spill over benefits are quite significant. In this case the market output of
merit goods is significantly below the allocative efficient output level. When negative
externalities exist, the good or service is overproduced. Such over production causes a
loss in welfare as too much resources allocated towards the production of the good or
service. This implies that allocative efficiency is not achieved.
3. Non Provision of Public Goods – Public goods have two characteristics. Non-rivalry
in consumption which means the good or service can be consumed by a group of
consumers at the same time and Non-excludability in consumption which means that
consumers can make use of the good or service even though they do not pay it. This
includes goods such as public roads and street lighting which are provided by the
government since if left to private producers, they will not be provided. This is
because the non-excludability feature of public goods means that people who use
public goods and services do not pay for them. That is the market fails to produce
these goods and services which are needed by citizens of a county. As a result a
welfare loss would exist which means social welfare is not maximized.
4. Asymmetric Information – this is defined as a difference in access to relevant
information by different participants of a transaction. That is to say, certain
participants may have all the relevant information, while other participant may not be
fully aware of all the relevant details. Asymmetric information distorts decision
making and causes markets to become allocatively inefficient. The two kinds of
market failure due to asymmetric information are moral hazard and adverse selection.
4 c) Government Measures for Correcting Markets Failure
1. 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.
Negative Externalities and Indirect Taxes
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P ($)
S = SMC
D = SMB
PMC
Tax
E2
P2
P1 E1
S = SMC PMC D = SMB
Q2 Q1 Quantity
In the figure, a tax equal to the level of external cost would be set. This corresponds to
the vertical distance between SMC and PMC.
 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 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 (GATE) where
students who qualify for tertiary level education are granted subsidies by the
government of that country.
Positive Externalities and Subsidies
SMB
P ($) SMB = SMC
S1
D = PMB
Subsidy
S2
E1
P1
P2 E2
SMB
S1 D = PMB
S2
Q1 Q2 Quantity
In the figure the subsidy shifts the supply curve downwards, from S 1 to S2, moving the
market equilibrium from E1 to E2. At E2 the associated output corresponds with the
socially efficient level of output which occurs where SMB = SMC.
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2. Nationalization - under this approach the government takes ownership of the firm
and produces the level of output at which social marginal cost and social marginal
benefits are equal. This means that if positive externalities were involved and the
good or service was under produced by the market, then the government would take
charge of production and increase output towards the socially desirable level. If, on
the other hand, negative externalities existed, then a welfare loss from over
production would be created under private production. In the case where production
is controlled by the state output would be reduced to the optimal level, in order to
achieve a maximization of society’s welfare.
3. A Total Ban on the product - with this method the government would simply put a
total ban on the good or service which generates the negative externality such as guns
and illegal drugs. However, banning a product may involve creating a new welfare
loss due to zero production as shown in the figure.
Welfare Loss from a Ban on a product
P ($)
S = SMC
PMC
Large Small
Welfare Welfare
Loss Loss
PE E
S = SMC PMC D = SMB
QA Quantity
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.
4. Regulation or Legislation - 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
alloative efficient level. 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.
4 c) Effectiveness of Two Government Measures for Correcting Markets Failure
• Indirect taxes and subsidies can be very effective in correcting market failure due
to externalities as it results in an adjustment of market output towards the
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achievement of allocative efficiency. Like all measures to address market failure
the determination of the optimal output in reality and the magnitude of the taxes
and subsidies to apply may be difficult to calculate.
• The banning of a good or service which generates negative externalities may not
be very effective since as it was demonstrated, this might lead to the creation of
another welfare loss associated with zero output. Instead a more effective measure
might be the banning of the negative externality in stead. In this way firms may be
very innovative and find novel ways of eliminating the spill over costs in order to
continue production.
5 a i ) The diagonal represents the line of absolute equality where income is perfectly
evenly distributed throughout the economy.
5 a ii) The vertical axis gives the cumulative percentage of income earned within the
economy in ascending order from the lowest income earner to the highest income earner.
5 a iii) The horizontal axis gives the cumulative percentage of the population within the
economy in ascending order from the lowest income earning to the highest income
earner.
5 a iv) Curve (b) gives the distribution of income earned by individuals before taxes are
paid and subsidies are collected by members of the population.
5 a v) Curve (b) gives the distribution of income earned by individuals after taxes are
paid and subsidies are collected by members of the population.
5 b i) The diagonal line traces out an equal distribution of income amongst the
populations. Along this line, the cumulative percentage of income is equal to the
cumulative percentage of the population. As such on this line the first 25 percent of the
population earn exactly 25 percent of income, 50 percent of the population earns 50
percent of income and so on. In other words there is an even spread between the amount
of income and the individuals who make the population.
5 b ii) Lorenz curve (b) indicates that top 20 percent of the population earns about 40
percent of total income while the lowest 20 percent of the population earns about 10
percent of total income. Lorenz curve (c) indicates that top 20 percent of the population
earns about 50 percent of total income while the lowest 20 percent of the population
earns about 5 percent of total income.
5 b iii) The area between Lorenz curve (b) and Lorenz curve (c) shows the effect of taxes
and subsidies on the distribution of income among households in the economy.
5 b iv) The Gini coefficient is calculated as follows:
A 100
Gini Coefficient = ×
A+ B 1
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where 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
Area A in Lorenz curve (c) is greater than that of Lorenz curve (b). This means Lorenz
curve (c) has the greater gini coefficient.
5 c) Difference between absolute and 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.
5d) 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. Government
subsidization of education will improve social welfare by improving the skills and hence
employability of workers. Education also improves labour productivity and this result in
increased wages to workers. 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.
Poverty reducing measures with respect to the provision of education include: free
education, book grants, public school transportation and even school meals. In Trinidad
and Tobago for instance, there is universal free provision of primary and secondary
education by the state. Tertiary education is also fully subsidized to those who need
financial aid. In Barbados, Tertiary education is also provided free to all persons who
undertake such academic training.
6 a) The marginal physical product (MPP) – this refers to the increase in output in the
short run as the firm employs one more unit of a variable factor of production. This
increase in output is subject to the law of diminishing returns.
6 b) 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. A person is not considered as part of the labour force if he has
retired before the age of 65 years, or if he is permanently incapacitated and unable to
work. Persons who are institutionalized by attending an educational institution on a full-
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time basis or incarcerated in prison, or hospitalized are also not considered as being part
of the labour force. In the schematic diagram as shown by the figure the labour force
comprise sections C and D.
U: Population
A: Working Age B: Non – Working Age
D: Unemployed E: F: Not working and
C: not in search of a
but in search of Institutionalized
Employed job
a job
Labour
Force
The Potential Labour Force accounts for all those individuals in the economy who are of
working age who are not institutionalized. In the schematic diagram shown in the figure
this would comprise sections C, D and F which cover those individuals of working age
who are employed, unemployed and in search of a job as well as unemployed and not in
search of a job.
6 c) The size distribution of income refers to how income earned throughout the economy
is distributed among the population of an economy. The distribution of income among the
population is said to be even when every individual earns roughly the same level of
income. If in the economy income varies among individuals, meaning that there are
individuals who earn high income along with those who earn low income, then the
distribution of income is said to be uneven. The greater the divergence in income earned
by different individuals the more uneven the distribution of income.
The functional distribution of income captures the proportion of income going to the
owners of the four 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.
6d i) 6d ii) 6 d iii)
Factor of production Factor Payment Factor Reward Percentage Revenue
Land $49,000 Rent 5%
Labour $588,000 Wages 60%
Capital $147,000 Interest 15%
Enterprise $196,000 Profit 20%
$980,000 100%
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6 e i) Transfer earnings are the minimum payments to a factor which is just adequate to
compensate the owner for providing productive resources to firms. If the owner does not
receive this payment, no productive resources would be supplied to firms in that industry.
Transfer earnings are depicted by the area under the supply curve as shown in the figure
as this represents the minimum amounts factors owners are willing to accept in order to
offer their productive resources to firms.
Economic Rent on the other hand, accounts for payments made to any factor of
production in excess of the minimum payments required by the factor owner. This is
therefore the difference between the total amount paid to a factor of production and its
level of transfer earnings. Economic rent is therefore represented by the area above the
supply curve but under the price line as shown in the figure.
Transfer Earnings and Economic Rent
Factor
Price ($)
S
PE Market
Price
Economic
Rent
Transfer
Earnings D
Quantity
6 e ii) Calculation of Economic Rent
Transfer earnings to the entrepreneur (normal profit) of 18% amounts to $176,400
Total earnings to the entrepreneur of 20% amounts to $196,000
Economic Rent to the entrepreneur (abnormal profit) of 20% - 18% amounts to $196,000
- $176,400 = $19,600.
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