Price of Good Y 1 c) Indifference Curve for Movies and Milk EDWARD BAHAW CAPE

ECONOMICS PAST PAPER SOLUTIONS Price of Good X The consumers income There are
an infinite range of indifference curves on the same set of axes which is known as an indifference
map. Each curve to the right shows consumption bundles which has a higher preference by the
consumer. 1 b i) The Budget Line The budget line shows all the consumption bundles or combination
of Good X and Good Y which can be afforded by the consumers income. 1 b ii) Information needed
to draw a budget line: An indifference curve slopes downward from left to right. That is it has a
negative slope. This slope measures the rate at which the consumer is willing to substitute Good X
for Good Y so as to leave satisfaction unchanged. This is called the marginal rate of substitution.
June 2004 Unit 1 Paper 2 1 a i) The Indifference Curve An indifference curves shows a
consumers preference for various combinations of goods and services in the consumer choice
framework. For simplicity the framework assumes that there are only two goods which the consumer
consumes: Good X and Good Y. Each indifference curve shows all possible combinations of Good X
and Good Y which yield the same level of satisfaction to the individual consumer. 1 a ii) Two
characteristics of Indifference Curve

3. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS Movies 40 E 16 O 12

20 Milk 1 d) Income and Substitution Effect The substitution effect from a decrease in the price of
milk refers to the increase in consumption of milk and the decrease in consumption of movies as the
consumer buys more of the former for less of the latter. In other words the consumer substitute more
milk for less movies as the relative price of milk declines. The income effect from a decrease in the
price of milk refers to the increase consumption of milk as well as movies as the purchasing power of
income increases. This occurs as the decline in the price of milk enables to consumer to afford more
of both goods. Movies 40 E2 18.7 E1 16 12 O 30 12 13 16 20 Milk Sub Income Effect Effect
EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS

4. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS In the figure, the total
increase in consumption of milk is 4 liters. This can be decomposed into the increase due to the
substitution effect of 1 liter and the increase due to the income effect of 3 liters. 2 a) Labour Output
VC FC TC AVC ATC MC 0 0 0 25 25 na 6. 12. 1 4 25 25 50 3 5 6.25 5. 7. 2 10 50 25 75 0 5 4.17
5. 7. 3 13 75 25 100 8 7 8.33 6. 8. 4 15 100 25 125 7 3 12.50 7. 9. 5 16 125 25 150 8 4 25.00 2 b i)
Average Total Cost EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS

5. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS $ ATC AVC AFC Q
where ATC = average total cost AVC = average variable cost AFC = average fixed cost 2 b ii) Shape
of the Average Total Cost Curve Since ATC = AFC + AVC, the shapes of both of these curves must
be explained. AFC fall continuously as output increases since fixed cost are spread over a larger
volume of output. AVC first decreases in the short run from increases productivity from the variable
factor but eventually increases due to diminishing returns. ATC first decreases due to both declining
AFC and AVC but eventually rises due to rising AVC as a result of diminishing returns. 2 b iii)
Marginal Cost EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS

6. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS $ AC MC AC is

Productive AC is falling as Optimum rising as MC < AC MC > AC QO Quantity 2 b iv) Relationship

Between Average Total Cost and Marginal Cost Average total cost is neither rising nor falling when
marginal cost is identical to average cost. This point is the minimum point on the average total cost
curve. This is because average total cost would rise when marginal cost is higher than the current
level of average total cost. Average total cost would fall if marginal cost is below the average total
cost of all previous units of output produced. Conclusively at the point of intersection between the
ATC and MC curve, average total cost is at a minimum. 2 c i) The supply curve of Shirts EDWARD
BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS

7. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS P ($) S $6 $5 S 20 25

Quantity of Shirts 2 c ii) Price Elasticity of supply 5 100 %QS 20 1 25% PES = = = =1.25 %P 1
100 20% 5 1 2 c iii) Increase in Supply of Shirts Every 10 percent increase in the price of shirts
results in a 12.5 percent increase in quantity supplied. 3 a i) Level of output at a price of $15 At a
price of $15, the firm would produce 35 units of output. This is because profit would be maximized at
this point as marginal revenue of $15 would be equal to marginal cost of $15. If for some reason the
firm was producing an output level below 35 then it would be able to earn more profits by increasing
output as marginal revenue would be greater than marginal cost. If the firm produces any output
above 35 units, then it would incur losses on such units as marginal revenue would be less than
marginal costs. Thus profit would be maximized at an output level of 35. 3 a ii) Level of output at a
price of $10 At a price of $10, the firm would produce 0 units in neither the short run nor long run.
This is because at this price level, AR < AC which means a loss would be incurred. As such the firm
would not produce any output at this price over the long run. In the short EDWARD BAHAW CAPE
ECONOMICS PAST PAPER SOLUTIONS

8. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS run at a price of $10
which is equal to AVC the firm would cease to produce as well. This is because if it produced output
(25 units) or not (0 units) it would incur a loss equivalent to its fixed cost. In such a case a firm would
choose to produce zero units. 3 b) Normal or Zero Economic Profit Normal profit would be earned at
a price of $15. This is because at this price level, AR = AC which means the firm would generate just
enough revenue to cover all its production costs. Such production costs arise from the payments
made to the four factors of production which are wages, rent, interest and normal profit. Here the
firms total revenue would be $525 and its total cost which includes normal profit would also be $525.
Any price above $15 would enable the firm to earn enough revenue to more than cover is production
cost leaving a surplus or abnormal profit. 3 c i) Increase in Demand under perfect Competition in the
short run If demand increases, then price would rise and existing firms in the industry would earn
abnormal profits in the short run. Panel A shows the increase in demand for the good from D1 to D2
which leads to an increase in price from P1 to P2. As such firms face a new AR curve as shown by
AR2 = MR2 in Panel B. At this price level, abnormal profit is earned as AR>AC. 3 c ii) Increase in
Demand under perfect Competition in the long run As there is freedom of entry in the long run, new
firms would enter the industry and this would lead to an increase in supply. Price would fall and all
abnormal profits would be eliminated which is where equilibrium in the industry is restored. Panel A:
Market Price Panel B: The Individual Firm $ $ D2 AC MC D1 S1 S22 P2 MR2= AR2 P1 MR1= AR1
D2 S1 D1 S22 Q1 Q2 Q Q EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS

9. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS This is shown by the
increase in supply in Panel A from S1 to S2 which leads to a fall in price back to P1. As such the AR
curve which firms face return to its initial position as shown by AR1 = MR1 in Panel B. At this price
just normal profit is earned as AR = AC. 4 a i) Natural Monopoly and Average Total Cost An industry
with a long run average total cost (ATC) which is falling even after demand is met is know as a
"natural monopoly". Such industries are characterized by the existence of high fixed cost of the
capital goods especially. This is shown in the figure by the continuous downward sloping shape of
the ATC curve over the range of the market demand. Furthermore MC is consistently below ATC
which also accounts for the downward slope of the ATC. ii) Natural Monopoly and Supply and Cost
With natural monopolies 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 monopoly as more than one smaller scale firms would be less efficient than the natural
monopolists. If two or more firms attempted to supply the product each firm would have a market
share of less than 100 percent and average total cost would be higher relative to if just one firm
supplies the entire market. In the figure if 1 firm supplied 2 units of output to the market, the average
total cost would be $5. If 2 firms each supplied 1 unit to the market then average total cost would be
$6. 4 b) Unregulated Output by a Natural Monopoly i) Output = 2000 units ii) Price = $6 per unit iii)
Average total cost = $5 per unit iv) Marginal cost = $2 v) Profit = $2000 4 c) Natural Monopoly and
Inefficiency In the absence of externalities the allocative efficient level of output occurs where P =
MC which corresponds to 4000 units. Since the firm only produces 2000 units, it means the product
is under produced an inefficient from societys point of view. As such a welfare loss is incurred onto
society. 4 d) Problem faced by Natural Monopoly where P = MC At the output level where price is
equal to marginal cost ATC> AR. This means the firm would incur a loss and not be able to cover all
of its costs. Any private firm would cease to produce in this situation. 4 e i) Unregulated Output with
Negative Externality EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS

10. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS Unregulated output
is 250 units per month as this is where demand is equal to supply. Demand is given by marginal
social benefit as there are no positive externalities. Supply is given by marginal private costs. 4 e ii)
Negative Externality and Allocative Inefficiency The efficient level of output occurs where MSC =
MSB which corresponds to 150 units per week. Thus the output of 250 represents overproduction
which results in a welfare loss from the allocatively inefficient level of output. This occurs as the
private firm does not take into consideration negative externalities as it has no obligation to pay these
spills over cost. 4 e iii) Marginal Social Costs and Marginal Social Benefits MSC (marginal social
cost) gives the increases in cost faced by society from the production of one more units of the
product, while MSB (marginal social benefit) gives the increase in benefits derived by society from
the consumption of one more unit of the product. 4 e iv) Tax to be imposed by the Environmental
Protection Agency A tax of $100 per unit. 4 e v) Output after tax is imposed Output would decline to
150 units per month. 4 e vi) Price after Tax is Imposed Price would rise to $200 per unit. 5 a)
Equilibrium Wage Rate in the Labour Market In the figure, the construction industrys demand for
labour is shown by D L and the industrys supply of labour is shown by SL. Overall, the labour market
attains equilibrium at point E where a single equilibrium wage rate WL exists throughout the

construction industry. The number of workers employed is QL. Labour Market in the Construction
EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS

11. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS W ($) DL SL WL SL

DL QL Quantity of Labour in the Construction 5 b) Equilibrium Quantity of Labour in Construction
Market 5b) All other variables held constant, as the demand for housing increases, the price of new
homes would rise and this would encourage more construction. In response the demand for
construction workers would rise since the demand for a factor of production is a derived demand.
The figure shows the increase in the demand for construction workers from DL1 to DL2 which would
result in an increase in the wages earned by construction workers from WL1 to WL2. W ($) DL1 DL2
SL WL2 WL1 DL2 SL DL1 QL1 QL2 Quantity of Labour in the Construction 5 c i) Trade Union Wage
Rate Labour is Supplied Monopolistically by a Trade Union but demanded competitively EDWARD
BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS

12. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS W ($) DL SL Trade
WU Union Wage WL SL DL Q1 QL Q2 Quantity of Labour in the Construction In the figure the trade
union wage rate is shown by Wu. 5 c ii a) Effect of Trade union wage on the demand for construction
workers The quantity of construction workers demanded would decline at the higher trade union
wage rate from QL to Q1. 5 c ii b) Effect of Trade union wage on the number of workers employed
The number of workers employed would decline from QL to Q1. 5 c ii c) Effect of Trade union wage
on the number of workers supplied The number of workers supplied at the higher trade union wage
rate would increase from QL to Q2. 5 d) Before Trade Union After Trade Union i) Wage Bill Higher
Lower ii) Employment Level Higher Lower iii) Unemployment Level Lower Higher 6 a i) Poverty Line
In general, poverty refers to a state of deprivation by individuals. There are two ways of measuring
such deprivation. 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 total cost of
all basic goods that an average household consumes. EDWARD BAHAW CAPE ECONOMICS PAST
PAPER SOLUTIONS

13. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 6 a ii) Absolute
poverty This 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 their 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. 6a iii) Relative Poverty This 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 as he falls below this relative power line. Clearly a person, who
is classified as relatively poor, may not be absolutely poor. 6 b ) Influence on Household Income i)
Education. The different levels of education attained by different members of household would result
in individuals with more education earning a higher level of income. ii) Size of the household. A
household with a large number of dependents would definitely face challenges as income earned by
the parents would have to be shared to meet the needs of all members of the family. iii) Marital

status. A married couple household may experience earn a higher level of income compared to
unmarried couple or even single parent headed households. iv) Age. If the household is an extended
family with grandparents living in the same residents then income is likely to be uneven as the elderly
may rely on income from pension which may be small relative to the income earned by other
members of the household. v) Location. Household located in rural areas may be faced with low
income levels as there may be less job opportunities in those areas relative to the suburbs and the
urban areas. 6 c i) Moral hazard This occurs when there are hidden actions or morally hazardous
behaviour on the part of one party in a transaction due to asymmetric information. This particularly
applies to the insurance industry. If Joan establishes a fire insurance policy then losses would be
covered in the event of fire damage to her property. Moral hazard occurs in this type of transaction
where the individual does not necessarily intentionally sets fire to the property but may take fewer
steps to prevent fires. This is because they would have the piece of mind that all loss would be fully
covered. If insurance companies were able to monitor the actions of every single insured person,
then morally hazardous behaviour would be EDWARD BAHAW CAPE ECONOMICS PAST PAPER
SOLUTIONS

14. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS prevented. Since
insurance providers cannot do this, these actions remain hidden resulting in greater risk and high
insurance claims and hence a misallocation of resources. 6 c ii) Adverse selection This occurs when
the asymmetric information arises from a hidden attribute about a good or service results in a
suboptimal decision on the part of one party. If Mark buys an expensive health insurance policy then
all his medical cost would be covered. Typically people who buy insurance often have a better idea of
the risks they face than do the insurance companies as they would have a better idea about the
health risk they face. As a result insurance companies may be faced with greater claims which
reduce profitability. In other words asymmetric information causes the insurance company to make a
suboptimal decision and hence there is a misallocation of resources. 6 d i) Conclusions from the Gini
- Coefficient Taxation results in a decrease in the gini-coefficient. That is taxation result in a less
uneven distribution of income. This occurs when the tax structure is progressive. 6 d ii) Lorenz Curve
Y (%) 100% After Tax Before tax 100% Population (%) 6 d iii) Computation of the Gini coefficient The
Gini coefficient is calculated as follows: EDWARD BAHAW CAPE ECONOMICS PAST PAPER
SOLUTIONS

15. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS A 100 Gini
Coefficient = A+ B 1 where as shown in the figure A is the area between the line of absolute
equality and the Lorenz curve B is the area between the Lorenz curve and the line of absolute
inequality Y (%) 100% Line of Absolute Equality A B 100% Population (%)