June 2010 unit 1 paper 2 suggested answer by Edward Bahaw

1. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
CAPE
ECONOMICS
th
May 19 2010
Unit 1
Paper 2
EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS

2. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
June 2010 – Unit 1 – Paper 2
Units of Good X Consumed Total Utility Marginal Utility
0 0
1 150 150
2 250 100
3 330 80
4 380 50
5 400 20
1 a i) )Total utility refers to the total level of satisfaction derived from the consumption of
a given quantity of a good or a service. As shown in the table, if an individual consumes
0 units, then 0 utils of satisfaction is derived. As 1 unit is consumed, 150 units of
satisfaction are gained and if 2 units are consumed, total satisfaction increases to 250
utils. As the table shows, by the time 5 units are consumed, total utility rises to 400 utils.
1 a ii) Marginal utility gives the change in satisfaction derived from the consumption of
each additional unit of a good or service. The third column of the table shows this. As
consumption rises from 0 to 1 unit, total utility changes from 0 to 150, this means that
marginal utility is 150. As consumption increases further from 1 to 2 units, total utility
rises from 150 to 250, thus, marginal utility is 100.
1 a iii) The law of diminishing marginal utility states, that as a consumer increases
consumption of a good or a service, the marginal utility will diminish. As can be seen,
marginal utility in the table declines as consumption increases, thus demonstrating the
law of diminishing marginal utility.
1 b i)
Total Marginal Marginal
Utility per Dollar
Quantity Utility Utility (MU/Price)
Bread Buns Bread Buns Bread Buns
0 0 0
1 6 5 6 5 6 5
2 11 9 5 4 5 4
3 15 12 4 3 4 3
4 18 14 3 2 3 2
5 20 15 2 1 2 1
1 bii)
3 bread @ $1 each = $3
2 bag of buns @ $1each = $2
Total Expenditure = $5
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3. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
P ($) D
$2
$1
D
2 3 Quantity of
Bread
1 biii)
2 bread @ $2 each = $4
1 bag of buns @ $1each = $1
Total Expenditure = $5
1b iv)
Total Marginal Marginal
Quantity Utility Utility Utility per Dollar (MU/Price)
Bread Buns Bread Buns Bread Buns
0 0 0
1 6 5 6 5 2.5 2
2 11 9 5 4 2 1.5
3 15 12 4 3 1.5 1
4 18 14 3 2 1 0.5
5 20 15 2 1 3 5
2 a i) Consumer demand can be defined as the total quantity of a good or service
purchased over a specific period of time at a particular price.
2 a ii) This first law of demand states that as the price of a good or service is lowered,
consumers would demand a larger quantity as long as all other variables are held
constant. That is to say, there is an observed inverse relationship between the price of
final output and the quantity purchased by consumers.
2 a iii)
As price changes, quantity demanded changes giving rise to a movement along the
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4. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
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 b i) Factors influencing the demand for beef.
1) Changes in income;
2) Price of other goods (substitutes or compliments);
3) Seasonal factors affecting demand;
2 b ii) Four factors influencing the demand for beef
 An increase in income would lead to an increase in demand for normal goods. The
consumers of beef may regard this meat as a normal good and as their income
increases consumers would purchase more. This is shown by a rightward shift of the
demand curve.
 If the price of a substitute such as chicken increases then this would encourage
consumers to buy more beef and less chicken. This is shown by a rightward shift of
the demand curve for beef.
 During festive seasons such as Christmas the demand for beef would rise as
consumers increase consumption of food. This is shown by a rightward shift of the
demand curve.
3a i)
Number of Barriers to
Type of Competition Nature of Product
Firms Entry and Exit
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
3a ii) Although, firms under monopolistic competition sell differentiated products,
consumers can substitute output from one firm with the output produced by other firms.
Firms therefore attempt to create customer loyalty though advertising which builds the
brand image of their products. Advertising therefore reduces the cross elasticity of
demand between the output of firm and other producer in a monopolistically competitive
industry. Firms therefore gain some degree of market control as consumers would regard
the output of each firm less substitutable.
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5. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
3b)The firm can earn abnormal profits in the short run if AR is greater than AC. This is
shown in the figure, where at the quantity where MR = MC, (QE) AR is greater than AC,
thus the shaded region represents abnormal profits.
Short Run Abnormal Profits earned by the firm under Monopolistic Competition
Price ($)
AC
MC
PE
MR= MC
MR AR
O QE Quantity
Such abnormal profits earned by existing firms 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. The entry of new firms in the
monopolistically competitive industry would continue until all abnormal profit is
eliminated from the increased competition. This is shown in figure, where the AR curve
has shifted until it becomes tangential to the AC curve.
Long Run Normal Profit earned by the firm under Monopolistic Competition
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Price ($)
AC
MC
AC = MC
PE
MR = MC MR AR
O QE QO
Quantity
Excess Capacity
In the figure, at the output level where MR = MC, normal profits is earned, that is AR =
AC. This implies that no additional firms would be motivated to enter the industry as any
further dilution of market share and hence a further leftward shift of the demand curve
would lead to losses. This situation where all abnormal profits are competed away and all
firms earn just normal profits, is the long run equilibrium under monopolistic
competition.
4a i) Market failure occurs whenever the quantity of a good or service produced in a
market does not occur at the productive and allocative efficient level. When production
efficiency and allocative efficiency are simultaneously achieved, it means that resources
are being efficiently used and allocated towards the production of goods and services
which generate the highest level of economic well-being. In other words, when market
failure exists the welfare of society is not maximized as welfare losses exist.
4bi) Public goods have two main characteristics:
• Non-rivalry in consumption
• Non-excludability in consumption
Non-rivalry in consumption means the good or service can be consumed by a group of
consumers at the same time. Non-excludability in consumption means that consumers can
make use of the good or service even though they do not pay for it. The producer cannot
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7. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
prevent anyone from consuming such goods and services. The non-excludability feature
of public goods means that people who use public goods and services do not pay for
them. 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. Public goods would
therefore be under-produced if produced by private producers. As a result, welfare would
not be maximized and a welfare loss would exist.
4b ii) Monopoly firms do not produce at the level of output where production efficiency
is achieved. This means that resources are not used efficiently to produce goods and
services to cater for the wants and needs of people. As a result, welfare is not maximized
and a welfare loss exists. Also under monopoly, allocative efficient is not achieved. This
is because the firm maximizes profits where MR = MC. Allocative efficiency occurs
where P = MC. Since under monopoly MR ≠ P, at the level of output where MR=MC, P
≠ MC. As a result, the good is under producers and a welfare loss exists.
4c) Solutions to Market Failure due to Monopoly and Public Goods
1. Nationalization
Under this approach, the government takes ownership of the production facilities and
takes charge of production. As such, the government would choose to produce the
quantity of output which achieves allocative efficiency. This means in the case public
goods and monopolies, the government would take charge of production and ensure that
allocative efficiency is achieved. Of course public goods would be provided free to the
public as the state would not be able to directly charge price for them. Instead the
government would use its taxation revenue to cover the cost of providing these goods.
2. Regulation
The state also has this option of regulating the level of output produced by the private
producers. In theory, the government could set a quota on output corresponding with the
allocative. This cannot be applied to public goods but to monopolies. This may require
the establishment of regulatory bodies to monitor the producers.
5 a)
5 a ii) Value of
Units of Labour Total Product 5 a i) Marginal Product
Marginal Product ($)
0 1
1 10 9 13.5
2 30 20 30
3 60 30 45
4 100 40 60
5 136 36 54
6 146 10 15
7 150 4 6
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5b i) Value of Marginal Product and Wage Rate
5b ii) The firm would employ 6 workers as this is the level of employment at which MRP
is equal to the wage rate. If the firm employs less than 6 units of labour then profits can
be increase by employing more workers. If the firm employs more than 6 units of labour
then it would incur a loss on all workers in excess of the 6th employee. The firm therefore
maximizes profits when the quantity of labour is 6.
6a) In a competitive labour market the wage rate is determined by MRP theory. In this
theory, the wage rate is determined by the interaction between the industry’s demand and
the industry’s supply of labour. This gives rise to an equilibrium wage which all firms in
the industry accept as they are price takers. In panel A of the figure, the industry’s
demand curve intersects the industry’s supply at point E. At this point, equilibrium is
achieved, as the quantity of labour which firms are willing to employ, coincides with that
being supplied by workers. As such, the equilibrium wage established in the market is W E
and each firm must accept this price as firms are price takers in a competitive labour
market. This is shown in panel B of the figure, where, at the wage rate of W E, the
individual firm employs 10 units of the labour.
Factor Price Determination
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9. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
Panel A: Labour Market Panel B: The Individual Firm
Wage Wage
Rate ($) Rate ($)
S
E
WE Equilibrium
Wage Rate
D
500 Quantity 10 Quantity
of of
Labour Labour
If demand increases, then the equilibrium wage rate would increase and firms would have
to adopt this increase. Also, if the supply of labour shifts to the right, then the wage rate
in the competitive labour market would decrease and firms would take this new lower
wage rate.
b i) Government – the state can have an impact on wage determination especially in the
unskilled labour market through the implementation of minimum wages. These enable
workers to earn a minimum acceptable level of income to ensure that they can afford to
cover their basic needs. These wages are usually higher than what would exist under the
market equilibrium for unskilled labour.
b ii) Trade Union - trade union enables workers to act collectively bargain for higher
wages. As group workers would have more negotiating power as oppose to if they
attempted to negotiate individually. Labour markets with trade unions usually have high
wages than those without.
b iii) Employers Association - this is an organisation that represents a group of employers
in a particular industry. These groups exist to promote the interest of their members and
would negotiate on their behalf with trade unions. Employers’ associations therefore
reduce the bargaining power of trade unions and this restricts wage increases.
EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS