WAEC SSCE - Economics - 2012 (Essay)
Question 1 Report
(a) With the aid of a diagram, explain a minimum price. [5 marks]
(b) State any five measures by which a minimum price for an agricultural produce can be made effective. [15 marks]
(a) Minimum price
A minimum price, also called a price floor, is the lowest price fixed by government below which a commodity must not be bought or sold. For it to have an effect, it must be fixed above the equilibrium price.
In the diagram, the demand curve is DD and the supply curve is SS. They intersect at E, giving the equilibrium price Pe and equilibrium quantity Qe. Government fixes the minimum price at Pmin, which is above Pe. At this price, quantity demanded falls to Qd, while quantity supplied rises to Qs. The difference, Qs − Qd, is excess supply or surplus. Government must therefore take measures to dispose of, buy up, or prevent the production of the surplus if the minimum price is to be maintained.
(b) Measures for making a minimum price of an agricultural produce effective
- Government purchase and buffer stock: Government may buy the excess output at the guaranteed minimum price and store it as buffer stock.
- Promotion of exports: Export markets may be developed to increase demand for the produce and reduce the surplus.
- Advertisement and publicity: Extensive advertising can increase consumers' awareness and demand for the agricultural produce.
- Tax on substitutes: Taxes may be imposed on close substitutes, raising their prices and shifting demand towards the protected produce.
- Restriction of output: Government may introduce quotas, acreage restrictions, or production licences to reduce supply.
- Withdrawal or reduction of production subsidies: Reducing subsidies to producers raises production costs and discourages excessive output.
- Higher taxes on producers: Appropriate taxes may discourage overproduction and reduce the quantity supplied.
- Encouragement of alternative products: Resources may be diverted to the production of other commodities by granting incentives or reducing taxes on those commodities.
Answer Details
(a) Minimum price
A minimum price, also called a price floor, is the lowest price fixed by government below which a commodity must not be bought or sold. For it to have an effect, it must be fixed above the equilibrium price.
In the diagram, the demand curve is DD and the supply curve is SS. They intersect at E, giving the equilibrium price Pe and equilibrium quantity Qe. Government fixes the minimum price at Pmin, which is above Pe. At this price, quantity demanded falls to Qd, while quantity supplied rises to Qs. The difference, Qs − Qd, is excess supply or surplus. Government must therefore take measures to dispose of, buy up, or prevent the production of the surplus if the minimum price is to be maintained.
(b) Measures for making a minimum price of an agricultural produce effective
- Government purchase and buffer stock: Government may buy the excess output at the guaranteed minimum price and store it as buffer stock.
- Promotion of exports: Export markets may be developed to increase demand for the produce and reduce the surplus.
- Advertisement and publicity: Extensive advertising can increase consumers' awareness and demand for the agricultural produce.
- Tax on substitutes: Taxes may be imposed on close substitutes, raising their prices and shifting demand towards the protected produce.
- Restriction of output: Government may introduce quotas, acreage restrictions, or production licences to reduce supply.
- Withdrawal or reduction of production subsidies: Reducing subsidies to producers raises production costs and discourages excessive output.
- Higher taxes on producers: Appropriate taxes may discourage overproduction and reduce the quantity supplied.
- Encouragement of alternative products: Resources may be diverted to the production of other commodities by granting incentives or reducing taxes on those commodities.
Question 2 Report
(a) Describe the output method of measuring the gross domestic product of a country. [6 marks]
(b) How is the net national product at factor cost obtained from gross domestic product? [8 marks]
(c) State two problems associated the output method. [6 marks]
(a) The output (product) method of measuring GDP. Under this method the gross domestic product is found by adding up the money value of all final goods and services produced by all sectors of the economy (agriculture, industry, services and so on) within the country during a year. To avoid double counting, only the value of final goods is counted, or equivalently the value added at each stage of production is summed. Value added is the difference between the value of a firm's output and the cost of the inputs it bought from other firms.
(b) Obtaining net national product at factor cost from GDP. Proceed step by step:
- Add net income from abroad to GDP to obtain gross national product: \( GNP = GDP + \text{net income from abroad} \).
- Subtract depreciation (capital consumption) to obtain net national product at market prices: \( NNP_{mp} = GNP - \text{depreciation} \).
- Subtract indirect taxes and add subsidies to obtain net national product at factor cost: \( NNP_{fc} = NNP_{mp} - \text{indirect taxes} + \text{subsidies} \).
(c) Two problems associated with the output method
- The danger of double counting: if intermediate goods are added in as well as final goods, output is overstated; care is needed to count only final goods or value added.
- Valuation of non-marketed and subsistence output: goods produced and consumed at home (for example subsistence farming and unpaid household services) have no market price and are hard to value or may be left out, understating true output.
Answer Details
(a) The output (product) method of measuring GDP. Under this method the gross domestic product is found by adding up the money value of all final goods and services produced by all sectors of the economy (agriculture, industry, services and so on) within the country during a year. To avoid double counting, only the value of final goods is counted, or equivalently the value added at each stage of production is summed. Value added is the difference between the value of a firm's output and the cost of the inputs it bought from other firms.
(b) Obtaining net national product at factor cost from GDP. Proceed step by step:
- Add net income from abroad to GDP to obtain gross national product: \( GNP = GDP + \text{net income from abroad} \).
- Subtract depreciation (capital consumption) to obtain net national product at market prices: \( NNP_{mp} = GNP - \text{depreciation} \).
- Subtract indirect taxes and add subsidies to obtain net national product at factor cost: \( NNP_{fc} = NNP_{mp} - \text{indirect taxes} + \text{subsidies} \).
(c) Two problems associated with the output method
- The danger of double counting: if intermediate goods are added in as well as final goods, output is overstated; care is needed to count only final goods or value added.
- Valuation of non-marketed and subsistence output: goods produced and consumed at home (for example subsistence farming and unpaid household services) have no market price and are hard to value or may be left out, understating true output.
Question 3 Report
Distinguish between the following:
(a) wants and effective demand; [5 marks]
(b) demand schedule and demand e; [5 marks]
(c) individual demand and market demand, [5 marks]
(d) change in demand and change in quantity demanded. [5 marks]
(a) Wants versus effective demand. A want is simply a desire for a commodity, whether or not the person can pay for it. Effective demand is a want that is backed by both the willingness and the ability to pay (purchasing power). A want becomes effective demand only when the consumer is able and ready to buy at the ruling price.
(b) Demand schedule versus demand curve. A demand schedule is a table showing the quantities of a commodity that consumers will buy at various prices. A demand curve is the graphical representation of that schedule, a line (usually sloping downward from left to right) plotting price against quantity demanded. The curve is drawn from the figures in the schedule.
(c) Individual demand versus market demand. Individual demand is the quantity of a commodity a single consumer is willing and able to buy at each price. Market demand is the total demand for the commodity by all consumers in the market, obtained by adding up the individual demands at each price.
(d) Change in demand versus change in quantity demanded. A change in quantity demanded is a movement along the same demand curve caused by a change in the good's own price. A change in demand is a shift of the whole demand curve (to the right or left) caused by changes in factors other than the good's own price, such as income, tastes, or the prices of related goods.
Answer Details
(a) Wants versus effective demand. A want is simply a desire for a commodity, whether or not the person can pay for it. Effective demand is a want that is backed by both the willingness and the ability to pay (purchasing power). A want becomes effective demand only when the consumer is able and ready to buy at the ruling price.
(b) Demand schedule versus demand curve. A demand schedule is a table showing the quantities of a commodity that consumers will buy at various prices. A demand curve is the graphical representation of that schedule, a line (usually sloping downward from left to right) plotting price against quantity demanded. The curve is drawn from the figures in the schedule.
(c) Individual demand versus market demand. Individual demand is the quantity of a commodity a single consumer is willing and able to buy at each price. Market demand is the total demand for the commodity by all consumers in the market, obtained by adding up the individual demands at each price.
(d) Change in demand versus change in quantity demanded. A change in quantity demanded is a movement along the same demand curve caused by a change in the good's own price. A change in demand is a shift of the whole demand curve (to the right or left) caused by changes in factors other than the good's own price, such as income, tastes, or the prices of related goods.
Question 4 Report
The tables below show the expected revenues and projected expenditures from the budget of a hypothetical country in 1998. Use the information in the tables to answer the questions that follow.
EXPECTED REVENUE
| ITEM | AMOUNT ($ millions) |
| Rents, royalties and profits | 75.00 |
| Company income tax | 150.00 |
| Customs and excise duties | 300.20 |
| Personal income tax | 80.00 |
| Fees specific charges | 60.80 |
| Value added tax | 100.00 |
PROJECTED EXPENDITURE
| ITEM | AMOUNT ($ millions) |
| General administration | 220.10 |
| Maintenance of foreign missions | 50.00 |
| Transfer payments | 65.00 |
| Building of schools and hospitals | 200.00 |
| Road construction | 180.90 |
(a) Calculate the total revenue from
(i) direct taxes [3 marks]
(ii) indirect taxes [3 marks]
(iii) non-tax sources [3 marks]
(b) Determine the total
(i) capital expenditure [3 marks]
(ii) recurrent expenditure [3 marks]
(c) Determine whether the budget is a surplus or deficit. [5 marks]
(a) Revenue by source
- (i) Direct taxes = Company income tax + Personal income tax \(= 150.00 + 80.00 = \$230.00\) million.
- (ii) Indirect taxes = Customs and excise duties + Value added tax \(= 300.20 + 100.00 = \$400.20\) million.
- (iii) Non-tax sources = Rents, royalties and profits + Fees and specific charges \(= 75.00 + 60.80 = \$135.80\) million.
(b) Expenditure by type
- (i) Capital expenditure = Building of schools and hospitals + Road construction \(= 200.00 + 180.90 = \$380.90\) million.
- (ii) Recurrent expenditure = General administration + Maintenance of foreign missions + Transfer payments \(= 220.10 + 50.00 + 65.00 = \$335.10\) million.
(c) Surplus or deficit
Total revenue \(= 75 + 150 + 300.20 + 80 + 60.80 + 100 = \$766.00\) million.
Total expenditure \(= 380.90 + 335.10 = \$716.00\) million.
\[766.00 - 716.00 = +\$50.00\ \text{million}\]
Revenue exceeds expenditure, so the budget is a surplus of \$50 million.
Answer Details
(a) Revenue by source
- (i) Direct taxes = Company income tax + Personal income tax \(= 150.00 + 80.00 = \$230.00\) million.
- (ii) Indirect taxes = Customs and excise duties + Value added tax \(= 300.20 + 100.00 = \$400.20\) million.
- (iii) Non-tax sources = Rents, royalties and profits + Fees and specific charges \(= 75.00 + 60.80 = \$135.80\) million.
(b) Expenditure by type
- (i) Capital expenditure = Building of schools and hospitals + Road construction \(= 200.00 + 180.90 = \$380.90\) million.
- (ii) Recurrent expenditure = General administration + Maintenance of foreign missions + Transfer payments \(= 220.10 + 50.00 + 65.00 = \$335.10\) million.
(c) Surplus or deficit
Total revenue \(= 75 + 150 + 300.20 + 80 + 60.80 + 100 = \$766.00\) million.
Total expenditure \(= 380.90 + 335.10 = \$716.00\) million.
\[766.00 - 716.00 = +\$50.00\ \text{million}\]
Revenue exceeds expenditure, so the budget is a surplus of \$50 million.
Question 5 Report
(a) Distinguish between economic activities and an economic system. [5 marks]
(b) Explain the following terms:
(i) production; [5 marks]
(ii) distribution; [5 marks]
(iii) consumption15 marks]
(a) Economic activities versus an economic system
Economic activities are the human efforts and actions directed at the production, distribution, exchange and consumption of goods and services in order to satisfy human wants (for example farming, trading, banking and manufacturing). An economic system, on the other hand, is the organised framework or method a society adopts to allocate its scarce resources and to decide what to produce, how to produce and for whom to produce (for example capitalism, socialism or a mixed economy). In short, economic activities are the individual actions people carry out, while an economic system is the overall arrangement within which those activities take place.
(b) Explanation of the terms
- (i) Production: the creation of goods and services to satisfy human wants. It adds utility (value) to resources and includes not only making goods but also providing services and moving goods closer to the consumer.
- (ii) Distribution: the process of moving and sharing produced goods and services from producers to final consumers through the chain of trade. (In another sense it also means the sharing of the national income among the factors of production as rent, wages, interest and profit.)
- (iii) Consumption: the using up of goods and services to satisfy human wants. It is the final aim of all economic activity, since goods are produced and distributed ultimately in order to be consumed.
Answer Details
(a) Economic activities versus an economic system
Economic activities are the human efforts and actions directed at the production, distribution, exchange and consumption of goods and services in order to satisfy human wants (for example farming, trading, banking and manufacturing). An economic system, on the other hand, is the organised framework or method a society adopts to allocate its scarce resources and to decide what to produce, how to produce and for whom to produce (for example capitalism, socialism or a mixed economy). In short, economic activities are the individual actions people carry out, while an economic system is the overall arrangement within which those activities take place.
(b) Explanation of the terms
- (i) Production: the creation of goods and services to satisfy human wants. It adds utility (value) to resources and includes not only making goods but also providing services and moving goods closer to the consumer.
- (ii) Distribution: the process of moving and sharing produced goods and services from producers to final consumers through the chain of trade. (In another sense it also means the sharing of the national income among the factors of production as rent, wages, interest and profit.)
- (iii) Consumption: the using up of goods and services to satisfy human wants. It is the final aim of all economic activity, since goods are produced and distributed ultimately in order to be consumed.
Question 6 Report
(a) Define money. [2 marks]
(b) State the three motives for holding money. [6 marks]
(c) Mention two determinants each of the motives for holding money. [12 marks
(a) Money is anything that is generally accepted as a medium of exchange and in the final settlement of debts.
(b) The three motives for holding money (as identified by J. M. Keynes):
- The transactionary (transactions) motive: holding money to meet day-to-day purchases and expenses.
- The precautionary motive: holding money to meet unforeseen or emergency expenses.
- The speculative motive: holding money to take advantage of expected changes in the price of bonds or other assets, that is, to speculate.
(c) Two determinants of each motive
- Transactionary motive: the level of the individual's or nation's income, and the interval or frequency of receiving income and making payments (also the general price level).
- Precautionary motive: the level of income, and the degree of uncertainty about the future together with the person's temperament or foresight.
- Speculative motive: the current rate of interest (bond prices), and people's expectations about future interest rates and bond prices.
In general, the transactionary and precautionary balances depend mainly on income, while the speculative balance depends chiefly on the rate of interest.
Answer Details
(a) Money is anything that is generally accepted as a medium of exchange and in the final settlement of debts.
(b) The three motives for holding money (as identified by J. M. Keynes):
- The transactionary (transactions) motive: holding money to meet day-to-day purchases and expenses.
- The precautionary motive: holding money to meet unforeseen or emergency expenses.
- The speculative motive: holding money to take advantage of expected changes in the price of bonds or other assets, that is, to speculate.
(c) Two determinants of each motive
- Transactionary motive: the level of the individual's or nation's income, and the interval or frequency of receiving income and making payments (also the general price level).
- Precautionary motive: the level of income, and the degree of uncertainty about the future together with the person's temperament or foresight.
- Speculative motive: the current rate of interest (bond prices), and people's expectations about future interest rates and bond prices.
In general, the transactionary and precautionary balances depend mainly on income, while the speculative balance depends chiefly on the rate of interest.
Question 7 Report
(a) What is a supply schedule? [2 marks]
(b) Using an example, show how a market supply schedule of a product is obtained from individual supply schedules. [12 marks]
(c) State three examples of exceptional demand. [6 marks]
(a) A supply schedule is a table showing the different quantities of a commodity that producers are willing and able to supply at various prices over a given period.
(b) Obtaining a market supply schedule from individual schedules. The market supply schedule is found by horizontal summation: at each price, add together the quantities that all the individual producers are willing to supply. Suppose there are two producers, A and B:
| Price ($) | Supply by A (units) | Supply by B (units) | Market supply (units) |
|---|---|---|---|
| 1 | 10 | 15 | 25 |
| 2 | 20 | 25 | 45 |
| 3 | 30 | 35 | 65 |
At each price the market quantity is simply the sum of A's and B's quantities (for example at $2, \( 20 + 25 = 45 \) units). Extending this addition to every producer in the market gives the whole market supply schedule.
(c) Three examples of exceptional (abnormal) demand, where more is bought as price rises or less as price falls, contrary to the ordinary law of demand:
- Giffen goods (basic inferior staples), for which a rise in price can raise quantity demanded.
- Goods of ostentation or prestige (Veblen goods), bought precisely because they are expensive.
- Goods bought under the expectation of future price changes, where a rising price today makes buyers rush to buy more, fearing further rises.
Answer Details
(a) A supply schedule is a table showing the different quantities of a commodity that producers are willing and able to supply at various prices over a given period.
(b) Obtaining a market supply schedule from individual schedules. The market supply schedule is found by horizontal summation: at each price, add together the quantities that all the individual producers are willing to supply. Suppose there are two producers, A and B:
| Price ($) | Supply by A (units) | Supply by B (units) | Market supply (units) |
|---|---|---|---|
| 1 | 10 | 15 | 25 |
| 2 | 20 | 25 | 45 |
| 3 | 30 | 35 | 65 |
At each price the market quantity is simply the sum of A's and B's quantities (for example at $2, \( 20 + 25 = 45 \) units). Extending this addition to every producer in the market gives the whole market supply schedule.
(c) Three examples of exceptional (abnormal) demand, where more is bought as price rises or less as price falls, contrary to the ordinary law of demand:
- Giffen goods (basic inferior staples), for which a rise in price can raise quantity demanded.
- Goods of ostentation or prestige (Veblen goods), bought precisely because they are expensive.
- Goods bought under the expectation of future price changes, where a rising price today makes buyers rush to buy more, fearing further rises.
Question 8 Report
(a) Define market in economics. [2 marks]
(b) State any three features of a monopoly. [9 marks]
(c) Outline any ee sources of monopoly power. [9 marks]
(a) A market in economics is any arrangement or system through which buyers and sellers of a commodity are brought into contact with one another to exchange goods and services at an agreed price. It need not be a particular physical place; contact may be by telephone, internet or agents.
(b) Three features of a monopoly
- Single seller: there is only one producer or seller of the commodity, who is the industry.
- No close substitutes: the product has no near alternatives, so buyers cannot easily switch away.
- Price maker with barriers to entry: the monopolist can influence price by controlling output, and new firms are prevented from entering the industry.
(c) Three sources of monopoly power
- Legal grants: patents, copyrights, licences or a government franchise that give one firm exclusive rights.
- Control of a raw material or key resource: ownership of an essential input or the sole source of supply shuts out rivals.
- Economies of scale (natural monopoly): where a single large firm can supply the whole market at lower cost than several firms, discouraging entry.
(Mergers and takeovers, and ownership of special technical knowledge, are other valid sources.)
Answer Details
(a) A market in economics is any arrangement or system through which buyers and sellers of a commodity are brought into contact with one another to exchange goods and services at an agreed price. It need not be a particular physical place; contact may be by telephone, internet or agents.
(b) Three features of a monopoly
- Single seller: there is only one producer or seller of the commodity, who is the industry.
- No close substitutes: the product has no near alternatives, so buyers cannot easily switch away.
- Price maker with barriers to entry: the monopolist can influence price by controlling output, and new firms are prevented from entering the industry.
(c) Three sources of monopoly power
- Legal grants: patents, copyrights, licences or a government franchise that give one firm exclusive rights.
- Control of a raw material or key resource: ownership of an essential input or the sole source of supply shuts out rivals.
- Economies of scale (natural monopoly): where a single large firm can supply the whole market at lower cost than several firms, discouraging entry.
(Mergers and takeovers, and ownership of special technical knowledge, are other valid sources.)
Question 9 Report
The diagram below represents the cost and revenue situation of a firm. Use the information in the diagram to
answer the questions that follow.
(a) Why would the firm not produce at (i) Q\(\_1\) (ii) Q\(\_3\) ? [6 marks]
(b) How much profit does the firm make at P\(\_1\)? [4 marks]
(c) If price falls to P\(\_1\)
(i) What quantity would the firm produce? [2 marks]
(ii) What type of profit does the firm make? [2 marks]
(iii) Explain your answer in c(ii). [4 marks]
(d) In which type of market s the firm operating?[2 marks]
Reading the diagram. The vertical axis is Cost/Revenue and the horizontal axis is Output/Sales. The MC curve (dashed) is U-shaped and rises steeply; the AC curve is U-shaped, cut by MC at its lowest point. Three horizontal revenue lines are drawn: \(AR_1=MR_1\) at price \(P_1\) (lowest), \(AR_2=MR_2\) at \(P_2\) (middle) and \(AR_3=MR_3\) at \(P_3\) (highest). The horizontal (flat) AR = MR lines tell us the firm is a price taker. Point A sits at output \(Q_1\) where the \(P_1\) line just touches the bottom of the AC curve; point E sits at \(Q_2\) on the \(P_2\) line where MC cuts \(MR_2\); output \(Q_3\) is further to the right where MC has risen to the \(P_3\) level (point H).
(a) Why the firm would not produce at:
(i) \(Q_1\). At \(Q_1\) the marginal cost (point A, at the level of \(P_1\)) is below the marginal revenue the firm receives at the ruling price \(P_2\); that is \(MC < MR\). Each extra unit beyond \(Q_1\) adds more to revenue than to cost, so profit is still rising. The firm would therefore expand output past \(Q_1\) rather than stop there.
(ii) \(Q_3\). At \(Q_3\) the marginal cost has risen to the \(P_3\) level, which is above the marginal revenue \(P_2\); that is \(MC > MR\). The last units cost more to make than they earn, so they reduce total profit. The firm would cut back from \(Q_3\). Profit is largest only where \(MC = MR\), at \(Q_2\) (point E).
(b) How much profit the firm makes at \(P_1\). The \(AR_1=MR_1\) line at \(P_1\) is exactly tangent to the AC curve at its minimum point A. There average revenue equals average cost:
\[ AR_1 = AC \;\Rightarrow\; \text{profit per unit} = AR_1 - AC = 0 \]So at \(P_1\) the firm makes only normal profit (zero supernormal/abnormal profit). Total revenue just covers total cost, including the normal return to the entrepreneur; there is no excess profit.
(c) If price falls to \(P_1\):
(i) Quantity produced. The firm equates \(MC = MR_1\) at price \(P_1\), which occurs at point A. Output \(= \mathbf{Q_1}\).
(ii) Type of profit. The firm makes normal profit only.
(iii) Explanation. At \(Q_1\) the price line \(P_1\) touches the AC curve at its lowest point, so \(AR = AC\) and total revenue equals total cost. The firm therefore just covers all its costs, including the normal profit that is counted as part of cost (the minimum reward needed to keep the entrepreneur in business). Since there is no gap between AR and AC, there is no supernormal profit and no loss. This point A is the firm's break-even point, and in the long run under perfect competition it is the equilibrium position.
(d) Type of market. The firm is operating under perfect competition. The clue is that average revenue equals marginal revenue and both are drawn as horizontal (perfectly elastic) lines (\(AR=MR\)), which means the firm is a price taker that can sell any quantity at the ruling market price.
Answer Details
Reading the diagram. The vertical axis is Cost/Revenue and the horizontal axis is Output/Sales. The MC curve (dashed) is U-shaped and rises steeply; the AC curve is U-shaped, cut by MC at its lowest point. Three horizontal revenue lines are drawn: \(AR_1=MR_1\) at price \(P_1\) (lowest), \(AR_2=MR_2\) at \(P_2\) (middle) and \(AR_3=MR_3\) at \(P_3\) (highest). The horizontal (flat) AR = MR lines tell us the firm is a price taker. Point A sits at output \(Q_1\) where the \(P_1\) line just touches the bottom of the AC curve; point E sits at \(Q_2\) on the \(P_2\) line where MC cuts \(MR_2\); output \(Q_3\) is further to the right where MC has risen to the \(P_3\) level (point H).
(a) Why the firm would not produce at:
(i) \(Q_1\). At \(Q_1\) the marginal cost (point A, at the level of \(P_1\)) is below the marginal revenue the firm receives at the ruling price \(P_2\); that is \(MC < MR\). Each extra unit beyond \(Q_1\) adds more to revenue than to cost, so profit is still rising. The firm would therefore expand output past \(Q_1\) rather than stop there.
(ii) \(Q_3\). At \(Q_3\) the marginal cost has risen to the \(P_3\) level, which is above the marginal revenue \(P_2\); that is \(MC > MR\). The last units cost more to make than they earn, so they reduce total profit. The firm would cut back from \(Q_3\). Profit is largest only where \(MC = MR\), at \(Q_2\) (point E).
(b) How much profit the firm makes at \(P_1\). The \(AR_1=MR_1\) line at \(P_1\) is exactly tangent to the AC curve at its minimum point A. There average revenue equals average cost:
\[ AR_1 = AC \;\Rightarrow\; \text{profit per unit} = AR_1 - AC = 0 \]So at \(P_1\) the firm makes only normal profit (zero supernormal/abnormal profit). Total revenue just covers total cost, including the normal return to the entrepreneur; there is no excess profit.
(c) If price falls to \(P_1\):
(i) Quantity produced. The firm equates \(MC = MR_1\) at price \(P_1\), which occurs at point A. Output \(= \mathbf{Q_1}\).
(ii) Type of profit. The firm makes normal profit only.
(iii) Explanation. At \(Q_1\) the price line \(P_1\) touches the AC curve at its lowest point, so \(AR = AC\) and total revenue equals total cost. The firm therefore just covers all its costs, including the normal profit that is counted as part of cost (the minimum reward needed to keep the entrepreneur in business). Since there is no gap between AR and AC, there is no supernormal profit and no loss. This point A is the firm's break-even point, and in the long run under perfect competition it is the equilibrium position.
(d) Type of market. The firm is operating under perfect competition. The clue is that average revenue equals marginal revenue and both are drawn as horizontal (perfectly elastic) lines (\(AR=MR\)), which means the firm is a price taker that can sell any quantity at the ruling market price.
Question 10 Report
Explain how the following factors will affect the demand for a commodity X:
(a) a decrease in the price of a implement Y; [5 marks]
(b) an increase in consumers' disposable income; [5 marks]
(c) a decrease in the apply of a substitute P; [5 marks]
(d) an increase in income tax. [5 marks] )
The demand for a good changes when the conditions of demand change. Judge each factor by whether it raises or lowers consumers' ability or willingness to buy commodity X, and whether the related good is a complement or a substitute.
(a) A decrease in the price of an implement Y (a complement used together with X). Because Y is used jointly with X, a fall in the price of Y makes the combined use cheaper, so consumers buy more of Y and therefore more of X. The demand for X rises (the demand curve for X shifts to the right).
(b) An increase in consumers' disposable income. For a normal good, higher disposable income raises purchasing power, so the demand for X increases (rightward shift). (If X were an inferior good, demand would instead fall.)
(c) A decrease in the supply of a substitute P. A fall in the supply of the substitute P pushes up P's price. As P becomes dearer, consumers switch away from P towards X, so the demand for X increases.
(d) An increase in income tax. Higher income tax reduces consumers' disposable income and therefore their purchasing power, so the demand for the normal good X falls (leftward shift).
Note that these are changes in the conditions of demand, so they shift the whole demand curve, unlike a change in the price of X itself, which would cause only a movement along the curve.
Answer Details
The demand for a good changes when the conditions of demand change. Judge each factor by whether it raises or lowers consumers' ability or willingness to buy commodity X, and whether the related good is a complement or a substitute.
(a) A decrease in the price of an implement Y (a complement used together with X). Because Y is used jointly with X, a fall in the price of Y makes the combined use cheaper, so consumers buy more of Y and therefore more of X. The demand for X rises (the demand curve for X shifts to the right).
(b) An increase in consumers' disposable income. For a normal good, higher disposable income raises purchasing power, so the demand for X increases (rightward shift). (If X were an inferior good, demand would instead fall.)
(c) A decrease in the supply of a substitute P. A fall in the supply of the substitute P pushes up P's price. As P becomes dearer, consumers switch away from P towards X, so the demand for X increases.
(d) An increase in income tax. Higher income tax reduces consumers' disposable income and therefore their purchasing power, so the demand for the normal good X falls (leftward shift).
Note that these are changes in the conditions of demand, so they shift the whole demand curve, unlike a change in the price of X itself, which would cause only a movement along the curve.
Question 11 Report
(a) Define:
(i) elasticity of demand; [2 marks]
(ii) price elasticity of demand. [2 marks]
(b) State any four determinants price elasticity of demand. [12 marks]
(c) Draw curves illustrating
(i) fairly elastic demand; [2 marks]
(ii) perfectly inelastic demand. [2 marks]
(a)
(i) Elasticity of demand is the degree of responsiveness of quantity demanded of a commodity to a change in any of the factors that influence demand, such as price, income and the prices of related goods.
(ii) Price elasticity of demand is the degree of responsiveness of quantity demanded of a commodity to a change in its own price.
(b) Determinants of price elasticity of demand
- Availability of substitutes: Demand is more elastic where close substitutes are available, but inelastic where there are no close substitutes.
- Nature of the commodity: Necessities generally have inelastic demand, whereas luxuries tend to have elastic demand.
- Proportion of income spent: Demand tends to be elastic where a large proportion of income is spent on the commodity, and inelastic where only a small proportion is spent.
- Number of uses: A commodity with many alternative uses tends to have elastic demand, while one with few uses tends to have inelastic demand.
- Habit or addiction: Goods which consumers are accustomed or addicted to using tend to have inelastic demand.
- Time period: Demand becomes more elastic over a longer period because consumers have more time to find substitutes or adjust their consumption.
- Level of price: Demand for very cheap goods tends to be inelastic, while demand for relatively expensive goods tends to be more elastic.
- Breadth of definition: Broadly defined commodities tend to have inelastic demand, while narrowly defined brands or varieties tend to have elastic demand.
(c)
(i) Fairly elastic demand curve: The demand curve slopes downward from left to right and is relatively flat.
(ii) Perfectly inelastic demand curve: Quantity demanded remains constant at all prices. The demand curve is vertical and parallel to the price axis.
Answer Details
(a)
(i) Elasticity of demand is the degree of responsiveness of quantity demanded of a commodity to a change in any of the factors that influence demand, such as price, income and the prices of related goods.
(ii) Price elasticity of demand is the degree of responsiveness of quantity demanded of a commodity to a change in its own price.
(b) Determinants of price elasticity of demand
- Availability of substitutes: Demand is more elastic where close substitutes are available, but inelastic where there are no close substitutes.
- Nature of the commodity: Necessities generally have inelastic demand, whereas luxuries tend to have elastic demand.
- Proportion of income spent: Demand tends to be elastic where a large proportion of income is spent on the commodity, and inelastic where only a small proportion is spent.
- Number of uses: A commodity with many alternative uses tends to have elastic demand, while one with few uses tends to have inelastic demand.
- Habit or addiction: Goods which consumers are accustomed or addicted to using tend to have inelastic demand.
- Time period: Demand becomes more elastic over a longer period because consumers have more time to find substitutes or adjust their consumption.
- Level of price: Demand for very cheap goods tends to be inelastic, while demand for relatively expensive goods tends to be more elastic.
- Breadth of definition: Broadly defined commodities tend to have inelastic demand, while narrowly defined brands or varieties tend to have elastic demand.
(c)
(i) Fairly elastic demand curve: The demand curve slopes downward from left to right and is relatively flat.
(ii) Perfectly inelastic demand curve: Quantity demanded remains constant at all prices. The demand curve is vertical and parallel to the price axis.
Question 12 Report
(a) State and explain the law of comparative cost advantage. [12 marks]
(b) Give two limitations of the law as a theory of international trade. [8 marks]
(a) The law of comparative cost (comparative advantage), associated with David Ricardo, states that a country should specialise in producing and exporting those goods in which it has the greatest comparative advantage (lowest opportunity cost) and import those goods in which it has a comparative disadvantage, even where it holds an absolute advantage in producing both goods. Trade will still benefit both countries because each concentrates where its opportunity cost is lowest.
The key idea is opportunity cost. Suppose two countries can each produce cloth and wine. Even if one country is more efficient at both, its advantage will be relatively greater in one good than the other. By specialising where its advantage is comparatively greatest and trading for the other good, total world output of both goods rises, and each country obtains more of both than it could by producing both itself. Thus specialisation according to comparative cost leads to mutual gains from trade.
(b) Two limitations of the law as a theory of international trade
- It ignores transport costs. The theory assumes goods move freely between countries; in reality high transport and handling costs can wipe out the comparative-cost gain.
- It assumes free trade with no barriers. In practice tariffs, quotas and other trade restrictions prevent countries from specialising and trading fully along comparative-cost lines. (Other valid limitations: it assumes constant costs and full employment, perfect factor mobility within a country but immobility between countries, and only two countries and two commodities.)
Answer Details
(a) The law of comparative cost (comparative advantage), associated with David Ricardo, states that a country should specialise in producing and exporting those goods in which it has the greatest comparative advantage (lowest opportunity cost) and import those goods in which it has a comparative disadvantage, even where it holds an absolute advantage in producing both goods. Trade will still benefit both countries because each concentrates where its opportunity cost is lowest.
The key idea is opportunity cost. Suppose two countries can each produce cloth and wine. Even if one country is more efficient at both, its advantage will be relatively greater in one good than the other. By specialising where its advantage is comparatively greatest and trading for the other good, total world output of both goods rises, and each country obtains more of both than it could by producing both itself. Thus specialisation according to comparative cost leads to mutual gains from trade.
(b) Two limitations of the law as a theory of international trade
- It ignores transport costs. The theory assumes goods move freely between countries; in reality high transport and handling costs can wipe out the comparative-cost gain.
- It assumes free trade with no barriers. In practice tariffs, quotas and other trade restrictions prevent countries from specialising and trading fully along comparative-cost lines. (Other valid limitations: it assumes constant costs and full employment, perfect factor mobility within a country but immobility between countries, and only two countries and two commodities.)
