NOTE:

1. These are revision and preparatory mid-term test questions;

2. Students are encouraged to draw and understand their own diagrams in cases where the solution does not show them. This is to encourage you to research and think through the issues rather than rote learn.

Question 1:

Assume that a country is presently located on its production possibilities frontier. Explain what impact (if any) the following events will have on its production possibilities frontier.

(a) The general level of workforce training increases;

This represents an increase in the quality of a resource such as labour, and will cause the frontier to shift outwards. (2.5 marks)

(b) An economic downturn results in underutilisation of capital equipment; This will result in production being located inside the frontier. The position of the frontier will be unchanged. (2.5 marks) (c) The marketing skills of the managers are improved through special training programs;One way to accelerate economic growth is to gain additional resources. Any increase in resources will shift the production possibilities frontier outward. Similar to part (a), the frontier will shift outwards. (2.5 marks)

(d) Manufacturing firms are made to pay for cleaning up the pollution that they cause.

This represents a decrease or redirection of resources towards the cleaning up the pollution. As firms are forced to pay this cost they will internalise it resulting in increased production costs and their own outputs will decrease with a leftward shift in the supply curves. On the aggregate level this would transpose of an inward shift of the production possibility frontier. (2.5 marks)

Question 2: The marketing department of your business have informed you that the price of one of your products should be reduced so you meet with them to discuss the implications of this. What are these implications (i.e. what matters should the meeting discuss)?

This question deals with the relationship between price elasticity of demand and total revenue.

It does matter whether demand is elastic or not. If you raise prices, total revenue will increase if demand is price inelastic but decreases if demand is price elastic. It is possible for demand to be price inelastic in the short-run but price elastic when a longer time period is considered.

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Illustrate this using a diagram and table relating price elasticity of demand to revenue raised by the firm (or consumer expenditure) similar to exhibit 5.6 p.126 of Layton or section 3.2 of Sloman and Norris.

(10 marks)

Question 3:

Use a single diagram to explain and show the combined effect of the following two events on the market equilibrium price and quantity for train travel: (a) A large increase in the price of petrol; (b) An increase in motor vehicle engine price parts.

Assuming that automobile travel and train travel are substitutes and that trains do not run on petrol; than an increase in the price of petrol will cause people to use cars less and rail travel more. Consequently the demand curve for rail travel will shift to the right from D0 to D1 on diagram 1 as travellers switch to the less expensive rail travel. (4 marks).

An increase in the price of automobile engine parts will cause the manufacturing costs and hence the price of automobiles to increase and their supply curve to shift to the left. Consequently the demand curve for rail travel will shift to the right from D1 to D2 on diagram 1 as travellers switch to the less expensive rail travel. (4 marks).

In each rightward shift of the demand curve the equilibrium price and quantity will increase and the substitution will go on as long as train travel is perceived by consumers to be the cheaper alternative. (2 marks)

Question 4:

Illustrate and explain with diagrams using an example, the factor(s) which result in:

(a) An increase in quantity demanded:

An increase in the quantity demanded comprises of movement down and along a downward sloping demand curve from point A to point B on diagram 2, assuming that all other influences have been held constant. This is reflected in a decrease in the price from P0 to P1 which corresponds to an increase in the quantity demanded from Q0 to Q1. (4 marks)

(b) A decrease in demand.

A decrease in demand from D0 to D1 on diagram 3 is a leftward shift of the whole demand curve and this will result from:

1. Decrease in the price of a substitute;1. Increase in the price of a complement;2. A decrease in incomes and the good is a normal good;

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3. An increase in incomes and the good is an inferior good;4. Change in tastes – a decrease in the desire to purchase;5. Expectations of lower prices in the future.

Question 5:

Suppose the income elasticity of demand for furniture is +4.0 and the income elasticity of demand for doctors’ services is + 0.4. Compare the impact on furniture and doctors’ services of a recession that reduces consumer income by 10 per cent.

Furniture is a normal good and income elastic since єY = + 4.0, which is > 1.0; (3 marks)

Doctor’s services is a normal good and income inelastic since єY = + 0.4, which is < 1.0; (3 marks)

In a recession the demand for furniture will fall by 40 % and the demand for doctor’s services will fall by 4%. The impact on furniture is greater than that of doctor’s services as furniture would be considered a luxury good, whereas doctor’s services are still considered a necessity even during a recession.(4 marks)

Question 6:

Illustrate and explain with diagrams using an example, the difference between (a) a decrease in the quantity supplied and (b) a decrease in supply.

(a) A decrease in the quantity supplied comprises a movement down an upward sloping supply curve from point A to point B on diagram 4, which corresponds to a decrease in quantity from Q0 to Q1 on the horizontal axis and a decrease in price from P0 to P1 on the vertical axis, with all other influences being held constant (2 marks for the diagram and 3 marks for the written explanation);

(b) A decrease in supply constitutes a leftward shift of the upward sloping supply curve on diagram 5. This results when production and supply costs have increased or another good appears more profitable in supply (2 marks for the diagram and 3 marks for the written explanation).

Question 7:

Illustrate and explain with diagrams using an example, the difference between a decrease in the quantity supplied and a decrease in supply.

(a) On the upward sloping supply curve a fall in the price from P0 to P1 will result in a decrease in the quantity supplied from Q0 to Q1 all other things being held constant.

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There will be movement backwards / downwards along the supply curve from point A to point B

(b) A decrease in supply from means a complete leftward shift in the supply curve from S0 to S1.

This occurs because of:

An increase in the goods production costs:

A substitute good becomes more profitable in supply.

Question 8:

(a) Interpret the following Income Elasticities of Demand (YED) values for the following and state if the good is normal or inferior;

YED= +0.5

The demand response as income changes (i.e. the proportionate change in demand divided by the proportionate change in income);Inelastic because < 1.0;This is a normal good because the demand increases with income as indicated by the positive sign. (2.5 marks)

YED= -2.5

The demand response as income changes (i.e. the proportionate change in demand divided by the proportionate change in income);Elastic because > 1.0;This is an inferior good because the demand decreases with income as indicated by the negative sign. (2.5 marks)

(b) Interpret the following Cross-Price Elasticities of Demand (XED) and state if the goods are substitutes or compliments.

XED= + 0.6

The demand response of this good as the price of the other good changes (i.e. the proportionate change in demand divided by the proportionate change in price of the other good);This good is inelastic because the real absolute value is < 1.0; and a Substitute good because the demand increases as the price of the other good increases. (2.5 marks)

XED= -2.2

The demand response as income changes (i.e. the proportionate change in demand divided by the proportionate change in income);Elastic because the real absolute value is > 1.0;

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Complementary good because the demand for the good decreases as the price of the other good increases. (2.5 marks)

Question 9:

With the ‘global recession’ in current times, should governments continue with law of ‘minimum wages?’ Why /Why Not? Explain and illustrate with diagrams in the light of economic concepts of a ‘price ceiling’ or ‘floor’.

Consider the labour market equilibrium diagram below with upward sloping supply and downward sloping demand curves. (2.5 marks)

The market equilibrium wage rate and corresponding employment levels can be found where the demand and supply curves intersect. This can only occur if the market is allowed to clear via market forces. (2.5 marks)

If a minimum wage is imposed which is > the equilibrium wage rate say at W1 then the supply of labour will exceed the demand for labour causing an oversupply and consequently unemployment. (2.5 marks)

If a minimum wage is imposed which is < the equilibrium wage rate say at W1 then the demand for labour will be exceed the supply demand for labour causing a skills shortage and problems filling vacancies. (2.5 marks) Question 10:

“There is no such thing as free Lunch.” Explain with the aid of a suitable diagram.

In an economy of scarce resources choices must be made as to what to produce using the limited available resources.

The cost of making a choice is the opportunity cost, otherwise known as the next best alternative choice or investment.

Using the simple Production Possibility Frontier or Indifference Curve approach it can be shown that the opportunity cost of increasing the use or production of good or commodity A is what we forgo in the use or production of commodity B.

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Question 11:

Revision Questions – Cross Price and Income Elasticity of Demand:

Assume that portable ear phone model PE313 is sold by Laing’s electrical and your business sells the MP3 player that uses these ear phones.

Unfortunately, you have had to increase the price of the MP3 players from $65 to $75 and as a result, the quantity demanded for the portable ear phones has decreased from 230 to 190.

At a latter stage your sales staff tell you that the price of Laing’s portable ear phones has increased from $15 to $20 per set and as a result the MP3 player demand has fallen from 250 to 205.

(a) Calculate the cross-price elasticity of demand for the ear phones, and is it elastic or inelastic?

Proportionate change in ear phone demand / Proportionate change in MP3 player price= [(190 – 230) / 230] / [(75 – 65) / 65] = - 0.173913043 / 0.153846153 = -1.13;

This is > - 1.00 and therefore elastic;

(b) Calculate the cross-price elasticity of demand for the MP3 players, and is it elastic or inelastic?

Proportionate change in MP3 demand / Proportionate change in portable ear phone price= [(205 – 250) / 250] / [(20 – 15) / 15] = - 0.18 / 0.33 = -0.55;

This is < - 1.00 and therefore inelastic.

(c) Interpret the values calculated in (a) and (b) i.e. are the :

Both cross-price elasticity of demand values are negative meaning that this pair of goods are complements.

If the sign of the cross-price elasticity of demand coefficient is positive the pair of goods are substitutes. The bigger the positive coefficient, then the more they are substitutes. If the sign of the cross-price elasticity coefficients are zero then there is no relationship between the goods.

(d) Are these cross price elasticities elastic or inelastic measures?

For portable ear phones it is elastic because it is greater than -1.00 which means that you get a more than proportionate change (decrease) in the demand for portable ear phones in response to the proportionate increase in the price of the MP3 players.

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For MP3 players it is inelastic because it is < -0.55 which means that you get a less than proportionate change (decrease) in the demand for portable ear phones in response to the proportionate increase in the price of the MP3 players.

(e) Assuming that a 10% increase in income will cause a 5% increase in sales of MP3 players, what is the income elasticity of demand for the MP3 players and is this good a necessity or luxury good?

Proportionate increase in MP3 player demand / Proportionate increase in income = (5% / 10%) = 0.5;

This income elasticity of demand is inelastic (i.e. < 1.0)

(f) Is this income elasticity of demand elastic or inelastic and interpret its value?

Inelastic because it is less than 1.00 and this means that there is a less than proportionate increase in MP3 player demand for the proportionate income increase.

If the sign is positive and the value is < 1.0 but greater than zero the good is a normal good and is a necessity. This means that it has a downward sloping demand curve and is not a luxury item. If the coefficient is > 1.0 the good is a normal good and also a luxury good.

If the value is negative then the good is an inferior good meaning that its demand decreases with an increase in income. In this case it is likely to be replaced by a better quality good.

(g) How will the above 10% increase in income affect portable ear phone sales commencing with an initial equilibrium quantity demanded of 230?

From question (e) we have calculated that a 10 per cent income increase will cause a 5 per cent increase in the demand for MP3 players. If we assume that there is one set of ear phones only for every MP3 player the sale of portable ear phones will increase by 5 per cent (from 230 to 242 rounded).

(h) How will the 10% increase in income affect the price of the MP3 players?

We know from (f) that a 10% increase in income causes a 5% increase in demand for ear phones from 230 plus 11.5 = to 242 rounded;

We know from (a) that the cross price elasticity of demand is -1.13;

Hence, -1.13 = (proportionate change in ear phone demand / proportionate change in MP3 player price);so that -1.13 = (5% / X%)Hence X% = (5% / -1.13) = -4.424778761 = -4.42, or a fall in the price of MP3 players by 4.42% (from $65.00 to $62.13 rounded).

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Question 12:

Through appropriate diagrams, show the effect of each on the equilibrium price of laptops for each of the following:

(a) Fall in income level due to Global Recession – Demand curve will shift to the left

(b) Scientists develop cheaper softwares and hard wares – Supply curve will shift to the right

Question 13:

7) Publishing house X has a price elasticity of demand for its publications (majority core text books at schools) as 0.7 %. Publishing house X intends to revise its prices of the books. If you were the firm manager what pricing strategy (increase or decrease of price) would you advise and why? Explain with the help of suitable diagrams.

The important concept here is the relationship between price elasticity of demand and revenue raised – you should revise and thoroughly understand these concepts

Question 1:

Suppose the income elasticity of demand for furniture is +4.0 and the income elasticity of demand for doctors’ services is + 0.4. Compare the impact on furniture and doctors’ services of a recession that reduces consumer income by 10 per cent.

Furniture is a normal good and income elastic since єY = + 4.0, which is > 1.0; (3 marks)

Doctor’s services is a normal good and income inelastic since єY = + 0.4, which is < 1.0; (3 marks)

The impact on furniture is greater than that of doctor’s services as furniture as furniture would be considered a luxury good, whereas doctor’s services are still considered a necessity even during a recession. (4 marks)

Question 2:

(a) Interpret the following Income Elasticities of Demand (YED) values for the following and state if the good is normal or inferior;

YED= +0.5

The demand response as income changes (i.e. the proportionate change in demand divided by the proportionate change in income);Inelastic because < 1.0;Normal good because the demand increases with income as indicated by the positive sign. (2.5 marks)

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YED= -2.5

The demand response as income changes (i.e. the proportionate change in demand divided by the proportionate change in income);Elastic because > 1.0;Inferior good because the demand decreases with income as indicated by the negative sign. (2.5 marks)

(b) Interpret the following Cross-Price Elasticities of Demand (XED) and state if the goods are substitutes or compliments.

XED= + 0.6

The demand response of this good as the price of the other good changes (i.e. the proportionate change in demand divided by the proportionate change in price of the other good);Inelastic because the real absolute value is < 1.0;Substitute good because the demand increases as the price of the other good increases. (2.5 marks)XED= -2.2

The demand response as income changes (i.e. the proportionate change in demand divided by the proportionate change in income);Elastic because the real absolute value is > 1.0;Complementary good because the demand for the good decreases as the price of the other good increases. (2.5 marks)

Price Ceilings and Floors:

Studenst are advsied to draw the diagrams and think through the issue:

What is the effect of the following on the maket if the following are imposed:

(a) If a price ceiling is placed below the equilibrium price, what is the effect (i.e. will the market clear)?

No because we cannot charge a price above the ceiling so we will not reach the equilibrium price.

(b) If a price ceiling is placed only above the equilibrium price, what is the the market clear?

Yes because we can charge only below the ceiling and the equilibrium price is in this range

(c) If a price floor is placed below the equilibrium price, will the market clear?

Yes, because we can charge only above the floor and the equilibrium price is in this range.

(d) If a floor is placed above the equilibrium price, will the market clear?

No, because we cannot charge a price below the floor where the equilibrium price is.

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