CAPE Economics, July 2nd, Unit 1, Paper 2 suggested answer by Edward Bahaw

1. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
CAPE
ECONOMICS
nd
July 2 2008
Unit 1
Paper 2
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2. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
June 2008 – Unit 1 – Paper 2
1a)i) The production possibility is an abstract curve used to demonstrate an economy’s
production capacity from its given resources. As different quantities of resources are
devoted towards the production of each good, different output levels are attained. The
curve or frontier, maps all possible combinations of medical services and education
which can be produced, as the given resources are distributed between the productions of
each good in different quantities.
Education
A
14
B
12 G.
C
9
U.
D
5
E
O
10 18 25 30 Medical
Services
The curve shows that using all resources the following combination of education and
medical services are possible.
Possibility Education Medical Services
A 14 0
B 12 10
C 9 18
D 5 25
E 0 30
ii) Assumptions on which the PPF is based are:
1. The curve is drawn on the assumption that only two goods and services can be
produced namely, Good X and Good Y.
2. The PPF is constructed such that resources are both fully employed and utilized
efficiently.
This means that all production combinations which lie along the curve such as A, B, C, D
and E are derived when all resources are efficiently employed.
1b)i) Scarcity 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. Point G represents
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scarcity as it represents an output combination that is unattainable with the current
endowment of resources.
1b) ii) Choice
Since resources are simply insufficient to meet the unlimited human desires for goods
and services, choices are encountered. This choice would relate to the exact production
combination which the economy decides to produce. In other words only one production
combination could be chosen between A, B, C, D and E.
1b) iii) Increasing Opportunity Cost
The production possibility curves are typically concave to the origin, as shown in figure.
This shape implies that as more resources are allocated towards the production of a
particular good, opportunity cost increases. This occurs because as more resources are
diverted towards the production of medical services, producers may be forced to use
resources which were more suitable to the production of education services.
1c)i)a) Allocative Efficiency
Allocative efficiency is achieved when resources are directed to production which
generates an optimal output combination of goods and services. An optimal output
combination occurs when resources are allocated to production in such a way that the
socially optimal level of output is produced. Socially optimal means that various goods
and services are neither under produced nor over produced. If a good or a service is under
produced, then the resulting shortage would create a net loss of welfare. Similarly, if a
good or service is over produced, then the underlying surplus would also impose a net
welfare loss onto society.
1c)i)b) Production Efficiency
Production efficiency occurs when the largest quantity of goods and services is produced
from a given amount of inputs. This implies that the cost which the firm incurs in
producing a good is minimized and is achieved at the lowest point along the firm’s long
run average cost curve. This is shown to occur at the point where the marginal cost curve
intersects the average cost curve (MC = AC). This point is sometimes referred to as the
point of maximum efficiency or the productive optimum.
Production Possibility Curve
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Education
Production
Efficiency
achieved along
any point on the
Frontier
Allocative Efficiency
achieved only at one
point on the Frontier
where the socially
optimal output is
produced
Medical
Services
c ii) Production efficiency occurs when the economy is operating on the production
possibility frontier. If for some reason resources were being used inefficiently or they
were idle or under-utilized, then output produced by the economy would not be
maximized. Such output combinations would correspond to points within the production
possibility frontier.
In terms of allocative efficiency, this would refer to just one point along the frontier
where the right mix of output is produced. In other words, resources would be allocated
in such a way that the quantities of medical services and education produced maximises
social welfare.
1d) i) A decrease in the resource endowment would have the effect of shifting the
production possibility curve to the left as the quantity of output the economy can produce
will be smaller.
ii) Improvements in technology would enable the economy to produce more output and
thus the production possibility curve would shift outwards.
2a) i) The rapid expansion in China and India would lead to an increase in demand for oil
as more energy would be consumed. This is shown by a rightward shift of the demand
curve in the figure.
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Increase in Demand
P D2
D1
D2
D1
Q
2 a) ii) As the demand for oil increases, at unchanged prices, a shortage for oil would be
created. Such a shortage would lead to upward pressure on price which would lead to an
extension of supply.
Shortage Created and Extension of Supply
P D2
S
D1
E1
P1
D2
S D1
Q1 Q’ Q
Shortage
2 a) iii) As price rises in this manner there is an increase in quantity supplied, as
producers are encouraged to produce more output for the market. This is shown by the
extension of supply depicted by the yellow arrow in panel B. At the same time, the
gradual increase in prices discourages some consumers from purchasing the good or
service and thus quantity demanded declines. This is shown by the contraction of demand
represented by the green arrow in panel B. This gradual increase in prices would continue
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until a new equilibrium is established at E2. At this new equilibrium the quantity bought
and sold would be greater compared to the original equilibrium.
New Equilibrium
P D2
S
D1
E2
P2
E1
P1
D2
S D1
Q1 Q2 Q’ Q
2 a) iv) At the new equilibrium the new price has increased to P2.
2b) As oil prices increase, the cost of energy becomes more expensive. This leads to an
increase in the cost of production of all goods including food. This can be shown by a
leftward shift of supply. In addition rising oil prices may also increase the incentives for
the production of alternative energy such as ethanol. This would have the effect of
increasing the demand for agriculture land which simultaneously increases the cost of
producing food. This is shown in the figure by the leftward shift of the supply curve
from S1 to S2. Initially, this leads to the creation of a shortage in the market at the existing
market price P1. This is shown by the amount Q 1 to Q’. A shortage in the market would
compel consumers to offer higher prices as they attempt to purchase the quantity of food
they desire. As a consequence, the market price gradually increases, leading to an
extension of supply as shown by the green arrow. At the same time, the upward pressure
on prices would prompt a decrease in consumption via a contraction of demand as shown
by the yellow arrow. The gradual upward movement of prices and the associated
extension of supply and the contraction of demand would continue until the shortage is
totally eliminated. This would occur at E2 where equilibrium is re-established at a higher
price.
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Decrease in Supply of Food
P S2
D S1
P2 E2
P1 E1
S2
S1 D
Q’ Q2 Q1 Q
3 a) A comparison of Monopolistic Competition and Perfect Competition
Number of Barriers to
Type of Competition Sellers Entry and Exit Products
Perfect Competition Larger number No Product Homogeneity
Product Differentiation
Consumers benefit from
Monopolistic Competition Many No greater variety
Check class notes
3 b) A comparison of Monopolistic Competition and Perfect Competition
Type of 3 b i) Competitive 3 b ii) Output
Competition Behaviour Decision 3 b iii) Pricing Behaviour
There is a market demand and
market supply which gives a
market price. The demand
There are a very large The firms' only goal is curve which each individual
number of producers to maximize profit. firm faces is perfectly elastic.
Perfect
where each firm This is achieved where This means that the firms are
Competition
supplies a small marginal cost is price takers. That is they accept
percentage of the equated to marginal the market prices. If the firms
market. As a result revenue. Marginal set a price higher than the
firms do not compete revenue is equal to market price they would loose
on a one on one basis. average revenue. all their customers.
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In monopolistic Since there are many firms
competition, there are selling differentiated products,
many firms offering The firms' goal is also each firm has the power to set
differentiated products to maximize profit. the price of its own products.
(heterogeneous This also occurs where That is because of brand loyalty
Monopolistic products). This is marginal revenue is if the firm increase its price it
Competition different from perfect equal to marginal would not loose all of its
competition in which cost. Marginal customers. In the long run
all offer the same revenue under this though because of the freedom
product. Firms also use type of competition is of entry and exit, the price
advertising to attract less than average would be set where only
customers. revenue. normal profit is earned.
3 c) A comparison of Monopolistic Competition and Perfect Competition
Profit Efficiency
Type of
Competition Short Run Long Run Production Allocative
Perfect
Competition Any level Normal Yes Yes
Monopolistic
Competition Any level Normal No No
4 a i) Public Goods: Non- Excludability and Non-Rivalry
The consumption of public goods and services is characterised by non rivalry and non
excludability. Rivalry in consumption means that only one person can consume the good
or service at a particular point in time. A good where there is non-rivalry in consumption
on the other hand can be collectively consumed by multiple consumers at the same time.
For example there is non-rivalry in the use of a green park as this can be enjoyed by a
group of people at the same time. The term excludability means that only consumers who
pay for a good have the right to consume it. That is to say, if someone does not pay for
such a good or service, then he or she would not be able to consume it. In the case of non-
excludability, consumers who do not pay for a good or service cannot be prevented from
consuming it. In other words there is the free rider problem when non-rivalry exists as
consumers would be able to consume the good or service for free. A good example of
such a good is a street light, where individuals can use the light to see their way at night
even though they do not directly pay for it. If left to the market, no private producer
would be willing to supply goods and services which are non-excludability, as they
would be unable to charge consumers for such. As such the output of such goods would
be below the allocatively efficient output level.
4a) ii) Externalities
Externalities are spillover effects of economic activity which affect third parties. When
the external effects are negative (external marginal cost), the market would over produce
the good or service and when the external effects are positive (external marginal benefits)
the market under produces the good or service relative to the socially efficient amount.
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This is because markets only take into consideration demand and supply, which is the
same as private marginal benefits and private marginal costs respectively. Evidently,
markets do not take into consideration external marginal cost nor external marginal
benefits which means, the market’s equilibrium usually does not conform to the socially
optimal level of output. The presence of negative and positive externalities consequently
means that some goods would be over produced while others may be under produced
respectively. Both of these cases represent an inefficient allocation of resources.
4 a iii) Information Asymmetry
Asymmetric information 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 participants may not be fully aware of all the relevant
details. Asymmetric information distorts decision making and causes the allocation of
resources via markets to become inefficient. The two kinds of market failure due to
asymmetric information are moral hazard and adverse selection.
Moral hazard occurs when there are hidden actions or morally hazardous behaviour on
the part of one party in a transaction. This particularly applies to the insurance industry
where individuals who pay insurance premiums are compensated should any unfortunate
loss arise. 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. Moral hazard therefore acts to the detriment of
insurance companies as they would be faced with greater insurance claims.
Adverse selection occurs when the asymmetric information arises from a hidden attribute
about a good or service. 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.
4b) i) Natural Monopoly
A natural monopoly is defined in economics as an industry where a single firm tends to
become the only supplier of a particular kind of product or service over time because of
the fundamental cost structure of the industry. Such industries are characterized by the
existence of high fixed cost (of the capital goods especially) such that 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
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monopoly as more than one smaller scale firms would be less efficient than the natural
monopolists.
4 b) ii) If a natural monopoly is unregulated it would produce the level of output where
marginal cost is equal to marginal revenue and charge a price that consumers are willing
to pay for that output as given by the market demand curve. At this level of output both
production and allocative efficiency would not be achieved.
4 c) Government Regulation of a Natural Monopoly
Typically, governments set the price which coincides with the output level at which just
normal profits are earned. That is at this price, AR = AC. Although this output level still
does not coincide with the allocative level of output (AR = MC) it is much closer to this
output level than the profit maximise level where MR = MC.
5a) The price of a factor of production within a particular industry is determined by the
industry’s demand and supply of the factor. In the case of labour, wages are determined
by the interaction between the demand for labour and the supply of labour within the
industry. This is demonstrated in the figure.
Panel A: Labour Market Panel B: The Individual Firm
Wage Wage
Rate ($) Rate ($)
SL
E
WL Wage
Rate
Share of
Share of Income
Income going MRP
going to labour
to labour by
by firm
industry
DL
QE Quantity Q’ Quantity
of of
Labour Labour
In the figure, the industry demand for labour is shown by D L and the industry supply of
labour is shown by SL. Overall, the labour market attains equilibrium at point E where a
single wage rate WL exists throughout the industry. The share of income received by
labour from the industry as a whole is shown by the rectangle. The area of this rectangle
gives the quantity of labour times the wages rate.
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The individual firm in the industry would accept the market wage rate and hirer labour up
to point where marginal revenue product (MRP) is equal to this rate. The area of the
rectangle gives the share of income received by labour form the individual firm.
5b) 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.
Factor owners would thus transfer there factor inputs to other industries which meet the
minimum payments. Transfer earnings are depicted by the area under the supply curve as
up to the equilibrium level of output as shown in the figure.
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
Wage
Rate ($)
SL
WL Wage
Rate
Economic
Rent
Transfer
Earnings DL
Quantity of
Labour
5c) i) Factors of production are demanded by producers purely as an input in the
production process. As such, the demand for factors of production is described as a
derived demand, as indirectly it arises out of the need to fill consumers demand for final
goods and services. As firms encounter rising demand for their products, they will need
to employ more factor inputs and thus the demand for factors increases. Similarly, if the
demand for final output declines, then less production would be required and thus the
demand for factors of production used in the production process would be curtailed. In
short, the demand for factors of production depends ultimately on the demand for final
goods and services which the factors of production are used to generate.
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5c) ii) The price of land in a commercial district would have higher value than the price
in other areas because of the difference in marginal revenue product. Marginal revenue
product refers to the change in revenue from the sale of one more unit of a good or
service produced by the factor of production. Since land in a commercial area can be used
to locate a retail business or a service providing business, it would be able to generate a
lot of revenue. In other areas though, the land may not be able to generate as much
revenue since it may not be as busy with shopping consumers. As a result wiliness to pay
for land in a commercial area would be much greater which accounts for its higher price.
5d) In a medium size to large poultry farm, an increase in production can be achieved
from and increase in capital employed as well as labour. Capital in this case would refer
to the farm facilities used to house and support the chickens. An expansion in this case
would only be possible in the long run. If the farmer increases the amount of labour and
capital employed by 100 percent and output increases by 150 percent then the business
would be achieving increasing returns to scale. If the factor rewards remains the same,
then the average cost of production would fall. This represents a case of the firm
benefiting from economies of scale. If however as a result of the expansion the price of
factors of production increased by more than 50 percent, the average cost of production
would rise representing the occurrence of diseconomies of scale.
6a) 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.
Based on these definitions it is clear that someone can be classified as relatively poor but
not absolutely poor.
6b) The basic needs approach combines certain aspects of absolute and relative measures.
This is because it considers firstly the amount of income needed for long-term physical
well-being such as food, clothing and shelter which is essentially the definition of
absolute poverty. In addition it also considers the amount of income needed to afford
other goods and services which the average member of society consumes such as health
care, but also personal care, furniture, transportation, communication, laundry, and home
insurance. This is similar to looking at the average level of income earned under the
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relative poverty approach. Anyone with income below this combined income level,
would face poverty according to the basic needs approach.
The additional items included in the basic needs approach is therefore what constitutes
the difference between this approach and the poverty line approach.
6c) i) Taxes and subsidies – the government can ease poverty by lowering taxes and
providing subsidies. Lower taxes would increase the amount of disposable income
enabling consumers to afford more goods and services. This measure should be applied
on a progressive basis meaning that the individuals who earn the lowest income should
face the lowest tax percentage in order to promote greater equality. Subsidies applied on
items such as food for instance would lower its price enabling greater affordability. To
reduce inequality such subsidies should only be available to the poorest in society.
ii) Public Housing - the government can lessen through the provision of public
housing solutions. This can be in the form of houses given to the poorest
individuals in society who do not posses the means to own their own home. The
houses would also be provide on a lease basis at lower than market rates.
iii) Education and Training - Poverty reducing measures with respect to the provision
of education include: free education, book grants, public school transportation and
even school meals. These measures would enable the poorest individuals in
society to have access to education which they would otherwise be unable to
afford.
6d) Education and Training - This policy overcomes poverty at the source by improving
the skills and hence employability of workers. Education also improves labour
productivity and this result in increased wages to workers. As such this is the most
sustainable method as the individuals who receive this assistance would not require such
forever. As education milestones are achieved these individuals would be able to earn
more income and thus the government would therefore be able to redirect resources to
other areas in the economy.
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