Download (a) State clearly whether the following statement is TRUE

SOLUTION: ECONOMICS MAY 2013
.SECTION A: MICROECONOMICS
Solution 1
a) The concept of equilibrium under demand and supply analysis refers to a
situation where at a price the quantity demanded equals the quantity supplied.
Graphically, given normal demand and supply curves when the demand and
supply curves intersect. The point of intersection defines the equilibrium point.
The equilibrium point invariably defines the equilibrium price and quantity.
a)
i. An increase in the price of cocoa beans will affect the cost of producing
Milo. This will reduce the supply of Milo. This is illustrated in Figure 1
below.
Figure 1: The Market for Milo
Price
S2
P2
S1
B
A
P1
D1
0
Q1
Q2
Quantity Demanded/Supplied
In Figure 1, the increase in cost of production reduces supply from S 1 to
S2. Given D1, the equilibrium price rises to P2 and the equilibrium quantity
declines to Q2.
ii. Milo and Bournvita are substitutes. A decrease in the price of Bournvita
makes Bournvita relatively cheap and increases its quantity demanded. In
this vein, some consumers of Milo will move to Bournvita reducing the
demand for Milo in the process. The effect of this on equilibrium price and
quantity is illustrated in Figure 2 below
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SOLUTION: ECONOMICS MAY 2013
Figure 2: The Market for Milo
Price
S1
A
P1
P2
B
D2
0
Q2
Q1
D1
Quantity
Demanded/Supplied
Initially the market attains equilibrium at point A with equilibrium price and
quantity as 0P1 and 0Q1 respectively. A decrease in the price of Bournvita
increases the quantity demanded of Bournvita which invariably decreases
the demand for Milo. This shifts the demand curve for Milo from D 1 to D2
reducing the equilibrium price and quantity from 0P1, 0Q1 to 0P2, 0Q2.
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SOLUTION: ECONOMICS MAY 2013
Solution 2
i.
Large numbers of buyers and sellers: The industry or market includes
a larger number of firms (and buyers), so that each individual firm,
however large, supplies only a small part of total quantity offered in the
market. The buyers are also numerous so that no individual buyer can
affect the working of the market. Under these conditions, each firm
alone cannot affect the price in the market by changing output.
ii.
Product Homogeneity: The Industry is defined as a group of firms
producing a homogeneous product or standardized product.
The assumptions of a large number of sellers and product
homogeneity imply that the individual firm in perfect competition is a
Price Taker rather than a price maker. In Perfect Competition price is
set by industry - wide supply and demand; the perfect competitor can
take it or leave it.
NOTE: Consider “Price Taker” as a point only if points (i) and (ii)
are not mentioned.
iii.
Free entry and exit of firms (Perfect Mobility of Firms): Under perfect
competition, there is perfect mobility, and none of these barriers exist.
In other words, there is no barrier to entry or exit from the industry.
Entry or exit may take time, but firms have freedom of movement in
and out of the industry or market.
iv.
Perfect mobility of factors of production: The factors of production are
free to move from one firm to another throughout the economy. It is
also assumed that workers can move between different jobs, which
imply that skills can be learned easily. Finally, raw materials and other
factors are not monopolized and labour is not unionized. In short,
there is perfect competition in the market of factors of production.
v.
Perfect Knowledge: It is assumed that all sellers and buyers have
complete knowledge of the conditions in the market. Everyone knows
about every possible economic opportunity.
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SOLUTION: ECONOMICS MAY 2013
b)
Figure A: Short-run Competitive Equilibrium with a Loss
C, R and P
MC
AVC
B
A
P1
MR1 = AR1 = D1
K
0
ATC
Q1
Qty. Produced /Sold
P = MR
In the Figure A, the demand curve is D1= AR1= MR1. At the equilibrium output
Q1, unit cost of production (ATC) exceeds price (P = AR) but AR > AVC.
There is no way by which the firm can earn profit. In spite of the loss, the
competitive firm is in equilibrium with an equilibrium output of Q 1. In this case
the loss is smaller than the total fixed cost that the firm will have incurred
as losses if it stops production.
In conclusion, the statement is FALSE. A profit-maximising perfect competitor
will NOT cease production in the short-run if its average revenue is greater than
its average variable cost but less than average total cost.
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SOLUTION: ECONOMICS MAY 2013
Solution 3
a) Returns to variable proportions explain the behaviour of output in the
short-run. The short-run is a period of production with fixed and variable
inputs. When the variable input is varied holding the fixed input constant,
then the proportion between the fixed and variable input changes. The
resulting output displays among others: increasing returns to variable
proportions, constant returns to variable proportion and diminishing
returns to variable proportions.
Returns to scale on the other hand explain the behaviour of output in the
long-run. In the long-run all factors of production are variable. When all
factors are varied in the same proportion in the long-run then the scale of
production is changed. The resulting output displays the following phases:
increasing returns to scale, constant returns to scale and decreasing
returns to scale.
b)
Increasing Returns to Scale: This means total product rises more than in
proportion to inputs. For example, if capital and labour units are increased
from 1 and 2 units to 2 and 4 units respectively output increases from 1000
to 2500 units. This shows that a 100% increase in inputs leads to a 150%
increase in output. The production function shows increasing returns to
scale.
Constant Returns to Scale: The output mounts in proportion to, or at the
same rate as the rise in inputs. Suppose that the capital - labour combination
was doubled from 4 is to 8 to 8 is to 16, and output increases by 100%. This
implies a 100% increase in inputs leads to a 100% increase in output. The
Production Function depicts Constant Returns to Scale.
Decreasing Returns to Scale: As the scale is changed, the total product
indeed becomes larger but does so at a lower rate than the rate of growth of
all the inputs used in production. Assume that the scale is changed from 8
and 16 units to 16 and 32 units of capital and labour respectively and output
increases from 12000 units to 21600 units. This shows that 100% rise in
scale has increased output by 80%.
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SOLUTION: ECONOMICS MAY 2013
SOLUTION 4
(a)
i.
A production function describes the technical relationship between the
maximum quantity of a good that can be obtained from different
combinations of factors production given state of technology and in a
socio-cultural environment.. A Production Possibilities Curve, on the other
hand, describes the various combinations of two commodities that can be
produced in a given period of time with available resources and
technology.
ii. Private cost of production relates to all costs incurred by the firm in the
course of production. These include payments individual producers make for
hiring or purchasing factors of production as well as cost of resources owned
and used by the producer. It is important to note that to determine the private
cost of production, it is essential to consider both explicit and implicit costs
incurred.
Social cost of production refers to the cost society incurs when its resources
are used to produce a given commodity. When the society's resources are
used to produce a given commodity the production of other commodities are
sacrificed. The cost of this sacrifice is the social cost also termed the
opportunity cost of production.
(b)
(i) The table shows the production possibilities of a nation. The nation can
choose to produce a maximum of 15 tons of foods if it allocates all of its
resources to the production of food, i.e. alternative A. Choosing alternative
A means no resources would be available for producing cloth. Or it can
choose production alternative F to produce 5 bales of cloth and zero
amount of food. The nation’s choice or decision about what to produce is
not limited to the extremes alternatives of A and F. Alternative B, C, D,
and E can equally be produced. This shows that nation has alternatives to
choose from.
(ii) The table also depicts the opportunity cost the nation faces. This can
be illustrated in two ways:
- Suppose the nation settles for alternative A. This gives the nation
15 tons of food and 0 bale of cloth. There is an element of
opportunity cost here. The opportunity cost of 15 tons of food is 5
bales of cloth that are sacrificed.
- Assume the nation first settles for alternative A but now desires
alternative B which contains 14 tons of food and 1 bale of cloth.
This means the nation cannot have 15 tons of food again. Choosing
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SOLUTION: ECONOMICS MAY 2013
alternative B now over A, the nation has to sacrifice 1 ton of food to
shift some resources to produce 1 bale of cloth. The opportunity
cost of 1 bale of cloth is 1 ton of food forgone.
In the same way if alternative F is chosen now over A, the
opportunity cost of the 5 bales of cloth are the 15 tons of food that
cannot be produced.
Any productive alternative that the nation chooses involves an
opportunity cost because the nation’s resources are scarce.
SECTION B: MACROECONOMICS
Solution 5
a) (i) The 100m shows the autonomous consumption that is consumption
expenditure at zero (0) disposable income.
The 0.75 is the marginal propensity to consume. The fraction or
percentage of any additional income spent on consumption.
(ii) The complementary saving function is
S  100m  0.25Yd
(iii)
1. If Yd = 500m,
C  100m  0.75500
C  475m
2. The average propensity to consume APC) is
APC = Consumption Expenditure
Disposable Income
475m
500m
APC  0.95
APC 
3. In equilibrium Y equals Aggregate Expenditure (AE). Therefore,
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SOLUTION: ECONOMICS MAY 2013
Y  AE (C  I )
Y  100m  0.75Y  I
Y  0.75Y  100m  150m
0.25Y  250m
1
250m
Y
0.25
Y  1000m
4. The expenditure multiplier (K) is K 
1
1

4
1  MPC 0.25
b) (i) The level of disposable income: The level of income is the basic
determinant of how much households will consume. If disposable income
increases, households’ consumption and/or saving increases.
(ii) Stock of durable goods on hand: If the economy has enjoyed an
extended period of prosperity, consumers may find themselves well supplied
with various durable goods, e.g. cars, televisions, etc. all worthy of years of
service. Hence, for sometime, many households will be out of the market for
such products with the result that consumers will be willing to spend less and
save more at each level of disposable income.
(iii)Wealth: This is a stock of accumulated purchasing power stored up from
the past. For example, if you have a fat savings account accumulated from
your past earnings, your current spending may be greater than your current
income. This implies that what actually determines consumption is not
nominal wealth but real wealth, which takes the price level into account.
(iv) Expectations: Households’ expectations concerning future prices, money
income and the availability of goods may have a significant impact on their
current spending. Expectations of rising prices and product shortages tend
to trigger more spending and less saving, that is, it shifts the consumption
function upward and the saving function downward.
(v) Aggregate household indebtedness: This is the purchasing power of
the sum of money outstanding that households have borrowed and are
currently obligated to repay. If households are in debt to the degree that
part of their current incomes are committed to installment payments on
previous purchases, they may well be obliged to reduce current
consumption as well as savings.
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SOLUTION: ECONOMICS MAY 2013
Solution 6
a) Monetary policy is the deliberate manipulation of changes in money supply
and bank credit on the premise that the control of these variables is an
effective way of controlling the macro-economy. Or Monetary Policy is
deliberate regulation of supply of money and credit in the economy to
achieve macro economic targets.
b) (i) The discount rate (d): The discount rate also known as Bank of Ghana
policy rate is the rate at which the central bank is prepared to lend to
commercial banks. Alternatively, it is the interest charged by the central
bank on loans it makes to the commercial banks. The discount rate is also
the basic short-term interest rate in an economy. Changes in the discount
rate are expected to lead to changes in all other short-term interest rates
e.g. bank deposit rates, interest charged by banks on advances, etc.
(ii) Open Market Operations (OMO): Open Market Operations involve the
sale of government securities by a central bank when it desires/intends to
reduce money supply, and purchase of securities by a central bank when
it desires to increase money supply. It also encompasses the activities of
a central bank in buying or selling governments bonds to influence bank
reserves, the money supply and interest rates. If securities are bought, the
money paid out by the Central Bank increases commercial bank reserves,
and money supply increases. If securities are sold, the money supply
contracts as part of the money in circulation finds its way back to the
central bank.
(iii) The Required Reserve Ratio or the cash ratio: The portion of deposits
that a bank sets aside in the form of vault cash or non-interest–earning
deposits with the central bank is called the required reserve ratio. The
required reserve ratio may be used to increase or decrease money supply.
If the required reserve ratio were increased, it would affect the excess
reserve of the commercial banks negatively. For example, if someone
deposits say ¢1,000 and the required reserve ratio is increased from 10%
to 20%, the minimum required reserve would be 20% of ¢1,000, that is,
¢200 and the credit multiplier will be five instead of ten as calculated
earlier.
(iv) Selective Credit Control: These are used by the Central Bank to
influence specific types of credit for particular purposes or sectors of the
economy.
(v) Credit ceiling: Imposition of a limit to which the commercial banks can
grant credit.
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SOLUTION: ECONOMICS MAY 2013
(vi) Moral suasion: Persuading commercial banks to take specific steps
that are consistent with the central bank’s macroeconomic objectives.
(vii) Special Deposit: Instructing commercial banks to make specified
amount of deposit to reduce their lending capacity.
Solution 7
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SOLUTION: ECONOMICS MAY 2013
a) Direct taxes are taxes imposed on the incomes or the earnings of a
person or a corporate body and are paid directly to the government
through public authorities such as the Internal Revenue Service or the
local authority.
Indirect taxes are taxes imposed on goods and services and are paid only
when these goods and services are bought.
Under direct taxes each individual’s tax liability is assessed separately.
People who pay direct taxes cannot shift the incidence or burden of
payment to some other individuals. For indirect taxes the incidence or the
burden of payment can be passed to others to pay.
b) Ad valorem tax is levied in percentages, that is, a fixed percentage of the
total value of the good is taken as tax. For instance, a 15% tax levied on
the total values of a good is ad valorem.
Specific tax is a fixed amount charged or levied on each physical unit of a
good irrespective of its value. For example, a tax of GH¢1 may be levied
on each unit of a good irrespective of the value of that good. Suppose that
the government levies a tax of GH¢200 on every vehicle. This tax is
indirect and specific.
c) A tax is proportional when every taxpayer pays the same proportion of his
income or wealth as tax. The wealthier taxpayer pays more in absolute
terms but in relative terms he pays the same percentage of his income as
any other person. For example, if 20% of all incomes is taken as tax then
the tax structure is proportional.
A progressive tax provides that a taxpayer with a higher income should
not only pay a larger absolute amount in tax, but also his tax liability
should represent a larger proportion of his income. The tax is graduated,
that is, the tax rate increases as the level of income rises.
d) i. Revenue: The most obvious aims of taxation is to raise revenue so as to
pay for government expenditure in the form of education, construction of
roads, pipe-borne water, etc.
ii. Redistribution of Income: The government may then impose taxes to
redistribute income and bridge the gap between the higher income
earners and the lower income earners.
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SOLUTION: ECONOMICS MAY 2013
iii. Discouraging the consumption of certain commodities: Taxes may be
used to prevent and reduce the production and consumption of some
commodities in an economy.
iv. Protection of infant industries: Infant industries are newly established
industries to produce goods that were formally imported. To protect them
the government imposes taxes on these imported substitutes that the
infant industries produce so as to discourage their consumption and
importation.
v. To stabilize the economy: Taxes can be imposed or cut to stabilize the
economy and achieve internal or external balances. During inflation taxes
are imposed on income. This has the effect of reducing disposable
income, aggregate demand may fall and pressure on price may decrease.
vi. To control resource movement: The government tax policy can be used
to control and direct resource movement.
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