June 2009 unit 1 paper 2 answer

EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS

CAPE
ECONOMICS
st
May 21 2009
Unit 1
Paper 2



June 2009 – Unit 1 – Paper 2

1 a i) A market is defined as a group of buyers and sellers who interact with each other
for the purpose of buying and selling a particular good or service.

1 a ii) The demand curve shows the price consumers are willing to pay per unit for
different quantities of a good or service. The supply curve gives the prices would
producers are willing to accepts for different quantities of a good or service.

Market Equilibrium

P ($) D
S

PE E

S
D

QE Quantity

Point E shows where the demand and supply curves intersect. This is market equilibrium,
since at this point the quantity which consumers wish to purchase is equal to the quantity
which producers are willing to offer for sale. The associated price at which this occurs is
known as the equilibrium price, or the market price which is shown by PE in the figure.
The equality between demand and supply at the market equilibrium means that scare
resources are being efficiently allocated towards the production of the good or service in
question.

Market Disequilibrium
A disequilibrium is said to exist when there is inequality between quantity demanded by
consumers and quantity supplied by producers. This tends to occur when the existing
price does not correspond with the equilibrium price. There are two types of market
disequilibriums. These are:
 Surpluses or excess supply occurs where the price in the market is such that
quantity supplied by producers exceeds quantity demanded by consumers. This
occurs if the price is above the equilibrium price of PE in the figure. In this case an



excess amount of resources are being allocated to the production of the good or
service in question.
 Shortages or excess demand occurs where price in the market is such that quantity
demanded by consumers is greater that quantity supplied by producers. This occurs
if the price is below the equilibrium price of PE in the figure.. In this case an
insufficient amount of resources are being allocated to the production of the good or
service in question.

Decrease in Demand
If demand decreases, then a new equilibrium would be established at a lower price. This
would encourage producers to decrease the quantity supplied and less resources would be
allocated towards the production of the good or service in question. In other words the
market ensures that as demand decreases, amount of resources allocated towards the
production of the good or service would automatically decrease.

1 b i)
A price floor is implemented to ensure that producers receive a sufficient price for the
good or service which they supply to the market. The aim in this case is to enable
suppliers to earn an adequate level of income. As such the prise floor is usually
implemented above the equilibrium price.

Wage
D S
$15
Price
0
Floor

$10 E

S D

400 1000 Quantity of milk
Surplus of milk

Although a price floor usually enables greater affordability to consumers, it tends to
result in a situation where a surplus exists, which means that suppliers would be left with
unsold goods. Such a surplus represents an inefficient allocation of resources.

1 c) The government may implement a price floor despite the negative side effect of
creating a surplus since the increase in price might benefit the suppliers to a greater
extent than the decrease in quantity sold. This can occur if the product has an inelastic
demand which enables the suppliers to earn a higher level of income when the price floor



is implemented. Such a measure can be essential for the eradication of poverty even
though it causes a misallocation of resources.

2 a i) Supply can be defined as the total quantity of a good or service which producer
offer for sale at a particular price.

2 a ii) This first law of supply states that as the price of a good or service is increased,
producers would supply a larger quantity as long as all other variables are held constant.
That is to say, there is an observed positive relationship between the price of final output
and the quantity produced by suppliers.

2 a iii)
As price changes, quantity demanded changes giving rise to a movement along the
demand curve. A fall in price resulting in an increased quantity demanded which is
termed an extension of demand. An increase in price resulting in a decreased quantity
demanded which is termed a contraction of demand.

An increase or decrease in demand, which results in a shift of the demand curve, is
brought about by a factor other than a change in price of the good or service under
consideration. These factors are called the conditions of demand. A rightward shift
indicates that an increased quantity is demanded at all price levels and is termed an
increase in demand. Leftward shifts, on the other hand, indicate that a decreased quantity
is demanded at all price levels and are termed a decrease in demand.

2 bi) The conditions of supply which:
1) Price of factors of production
2) Indirect taxes
3) Subsidies
4) The price of other goods (production substitute)
5) Technology
6) Exogenous factors – such as weather, crime, vehicular traffic congestion etc.

2 b ii) Effects of changes in the conditions of supply:
1) Price of factors of production – as factor prices increase, supply decreases and vice
versa.
2) Indirect taxes - as indirect taxes are imposed, supply decreases and vice versa.
3) Subsidies - as subsidies are applied, supply increases and vice versa.
4) The price of other goods (production substitute) – the supply of a good would
decrease as the price of a production substitute increases and vice versa.
5) Technology – as technology improves, supply increases and vice versa.
6) Exogenous factors – the occurrence of adverse exogenous factors such as bad weather
causes supply to decrease and vice versa.

2 c) Reasons for change in supply:
1 Price of factors of production – as factor prices increase, cost of production increases
and the firm would be able to produce a smaller output level. As a result supply



would shift to the left.
2 Indirect taxes - as indirect taxes are imposed, the firm faces additional costs and the
production declines as a result. This is shown by a leftward shift of the supply curve.
3 Subsidies - as subsidies are applied, this helps the firm to reduce its costs as a result
production increases. This is shown by a rightward shift of the supply curve.
4 The price of other goods (production substitute) – Supply of one good would
decrease as the price of a production substitute increases since firms would be
encouraged to use its resources to product this good instead as more profits can be
earned.
5 Technology – as technology improves, the firm would be able to produce more
output from its given resources and as a result supply increases.
6 Exogenous factors – the occurrence of adverse exogenous factors such as bad
weather causes supply to decrease since production would be disrupted. As a result
supply would shift to the left.

3 a i) Market structure refers to the type of competition which exists among firms in a
particular industry.

3 a ii) In one extreme, there can be immense competition which is a state of perfect
competition. At the other extreme, there can be no competition at all which occurs under
monopoly. In between these two extremes are: oligopoly and monopolistic competition
which refers to imperfect competition.

3 a iii) Characteristics of Perfect Competition
1. The market is large, meaning that there are a large number of consumers
2. There are a large number of suppliers where each individual firm contributes a small
proportion of the overall market supply.
3. The market is liberal in the sense that any buyer and seller could freely conduct
business in the market without any barriers to entry or exit.
4. The output supplied by each firm in the market is identical. That is, there is product
homogeneity throughout the market.
5. Buyers and sellers have perfect knowledge of all market variables. As such, market
participants are able to make well informed decisions and take full advantage of all
opportunities in the market.

3 b i)
Number of Barriers to Product
Type of Competition
Sellers Entry and Exit Characteristic

Perfect Competition Larger number No Homogeneous

Monopoly One Yes No close substitute



Heterogeneous –
Substitutable apart from
Oligopoly Few Yes
perceived differences
through branding

Heterogeneous – Not easily
Monopolistic substitutable due to real
Many No
Competition differences through product
differentiation

3 b ii)
Type of Short Run Long Run Production Allocative
Pricing
Competition Profit Profit Efficiency Efficiency

Perfect Price
Any level Normal Yes Yes
Competition Taker

Price
Monopoly Abnormal Abnormal No No
Setter

Price
Oligopoly Abnormal Abnormal No No
Setter

Monopolistic Price
Any level Normal No No
Competition Setter

4 a i) Private cost refers to the costs incurred by the producers directly involved in
production, which basically comprises the costs of factor inputs employed which covers,
rent wages, interest and normal profit. In addition to private cost the production and
consumption of goods may create additional costs which are faced by other individuals in
society who are neither consumers nor producers of the good or service in question.
These third parties are said to face external cost or negative externalities. The cost
incurred by firms is referred to as private cost and that borne by third parties is termed
external cost. The private costs and external costs sum to form social costs.

4 a ii) The consumption of public goods and services is characterised by non rivalry and
non excludability. Non-rivalry means that the good can be collectively consumed by
multiple consumers at the same time. Non-excludability means that 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. Merit goods and services are those which are
provided by the state to individuals in society on the basis of merit or need. This occurs
because merit goods and services generate significant spill over benefits or positive
externalities.

4 a iii) 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.

4 a iv) 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. Adverse selection refers to a suboptimal decision by one party in a
transaction when there is a hidden attribute about a good or service which the other party
is aware off.

4 b i) If left to the market, no private producer would be willing to supply goods and
services which are non-excludable. This is because no consumer would be willing to pay
for the goods and services and producers would therefore not get any revenue. The free
rider problem is the term often used to describe this situation. Since output would be zero
in the market, these goods would be under produced and allocative inefficiency would
exist.

4b) ii) When externalities exist, there are additional benefits and costs apart from the
benefits received by consumers (PMB) and the cost faced by producers (PMC). These are
the external 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.
This means when there are external benefits, the market would under produce the good or
service and this results in a loss in welfare. When negative externalities exist, the good or
service is over produced also leading to a welfare loss. The existence of welfare losses
means that allocative efficiency is not achieved by the market in the presence of
externalities.

4 b iii) Moral hazard causes market failure because the hidden actions by one party cause
other parties to face unwarranted costs. E.g. Irresponsible behaviour of those insured
causes insurance companies to face excessive claims.

4 c ) 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. The state would therefore produces the allocatively efficient level of output and
distributes it freely to the public.



5 a i a) MPP = ΔTPP/ΔQL

5 a i b) APP = TPP/QL

5 a i c) VMPP = P × MPP

5 a ii)
Marginal Average Value of
Units of Units of Physical Physical Marginal Wage Rate
Labour (L) Output (Q) Product of Product of Product (W)
Labour (MPP) Labour (APP) (VMP)
0 0 $200
1 8 8 8.00 $800 $200
2 21 13 11.50 $1300 $200
3 27 6 9.00 $600 $200
4 31 4 7.75 $400 $200
5 33 2 6.60 $200 $200
6 34 1 5.66 $100 $200

5 b i)

5 b ii) The firm would employ 5 workers as this is the level of employment at which
MVP or MRP is equal to the wage rate. If the firm employs less than 5 units of labour
then profits can be increase by employing more workers. If the firm employs more than 5
units of labour then it would incur a loss on all workers in excess of the 5 th employee. The
firm therefore maximizes profits when the quantity of labour is 5.

5 b iii) 4 workers



6a) Poverty refers to a state of deprivation by individuals. This usually occurs when an
individual has little or no means to support to his or her family. As a result living
standards are significantly depressed. E.g. Beggars and vagrants face a life of extreme
poverty and experience very poor living standards.

6 a ii )
Absolute poverty - this measures the actual number of people or headcount within qn
economy who are unable to afford certain basic goods and services such as food and
shelter.

Relative Poverty - this measures the extent to which a household's financial resources
falls below the average income level of the economy.

6 b i) 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 essentially defines 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 furniture,
transportation, communication, entertainment and health care and home insurance. This
is similar to looking at the average level of income earned under the relative poverty
approach. Anyone with income below this combined income level, would face poverty
according to the basic need approach. There may however be some difficulties using this
approach for cross country comparisons as clearly the goods and services consumed by
the average member of society in different countries would definitely vary.

6 b ii) 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
amount of money that is required to afford the basic goods and services needed by each
household. According to the United Nations Development Program (UNDP), the poverty
line is US$1 per day based on 1985 prices. All individuals with an income below this
threshold are absolutely poor. This approach also suffers from the difficulty that the
poverty line in country may not be the same for others.

6 b iii) The United Nations Development Program computes such a measure which is
known as the human development index (HDI). This is a socio-economic measure which
focuses on three of the factors which affects poverty. These factors are:
• GDP per capita – average income per person;
• Longevity – Life expectancy;
• Knowledge – Access to education and literacy rates.
This method may be more appropriate since it incorporate more variables apart from just
income alone.


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