CAPE Economics, May 22nd 2008, Unit 1, Paper 2 suggested answer by Edward Bahaw

EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS

CAPE
ECONOMICS
nd
May 22 2008
Unit 1
Paper 2



June 2008 Non-Trinidad (Rest of Caribbean) – Unit 1 – Paper 2

1a i) Scarcity therefore arises out of the inequality between limited resources and the
unlimited wants of man. That is, it may be literally impossible to satisfy all human wants
as the resources or factors of production available are simply insufficient.

ii) The production possibility curve or frontier, maps all possible combinations of Good
X and Good Y which can be produced, as the given resources are distributed between the
productions of each good in different quantities.

iii) Opportunity cost refers to the value of the best alternative forgone as a result of
choosing one option among competing options.

iv) The production function refers to the relationship between the quantity of inputs and
quantity of output in a production process. Inputs can be divided into four sub groups:
1. Land
2. Labour
3. Capital
4. Enterprise

v) Price elasticity of demand can be defined as a measure of the degree of responsiveness
of the quantity demanded of a product to changes in its price. This is calculated by
dividing the percentage change in quantity by the percentage change in price.

1b) 1ci) 1 cii)



1 d i) The production possibility curve is drawn on the assumption that there were no
changes in technology. As technology is improved, the quantity of output produced using
a given amount of resources increases. Under this situation it might be possible to have
an increase in production of one good without any decrease in output of the other good.

1 d ii) An improvement in food technology would result in an increase in food production
only. This is shown by a rightward pivot of the production possibility curve.

1 d iii) An increase in all resources would result in an increase in production of all good.
This is shown by a rightward shift of the entire production possibility curve.



1 e i) Opportunity cost = ∆Capital Goods / ∆Food
= (10 - 18) / (4 - 3)
= -8 / 1
= -8

This means the opportunity cost of increase food production 3 to 4 units is 8 units of
capital goods forgone.

1 e ii) As food production increases, the slope of the production possibility curve
becomes steeper. Since this slope gives the opportunity costs, then this means the
opportunity cost increases as the production of food expands. This arises since the
increase in food production results in the utilization of resources which are less and less
suitable. This results in an increase in cost of food.

1 e iii) At point e relatively more food and less capital is production when compared to
point c. This means that in future, there would be less growth compared to point c since
less resources is devoted to capital formation. The production possibility curve would
therefore shift less to the right.

2 a) As the relative price of chicken increases, the substitution effect refers to the change
in consumption patterns where the consumer buys less chicken and substitutes other
goods in place of it by purchasing more of them. The income effect of an increase in the
relative price of chicken arises from the decrease in purchasing power of the consumer’s
disposable income. This decrease in real income will induce the consumer to purchase a
decrease quantity of all goods.



2b) Two factors which shifts the demand curve
Income
Decrease in preference of consumers

2 c) Two factors which shifts the supply curve
Price of factors of production
The price of other goods

2d i) Cross Price Elasticity
%∆Q A
XED A/B =
%∆PB

15%
XED CHICKEN/BEEF = =3
5%

2 d ii) Whether a consumer regards a good as normal or inferior depends on the
relationship between the quantity consumed and the level of income. If there is a positive
relationship between quantity consumed and consumers’ income then it is regarded as a
normal good. If there is an inverse relationship between quantity consumed and
consumers’ income then the good is an inferior good.

2 e i) Three determinants of Price Elasticity of Demand
1. Number of substitutes immediately available - the greater the number of substitutes
available the higher the price elasticity of demand tends to be. Goods which are
necessities tend to have an inelastic demand as they possess very few substitutes.
Furthermore, goods which have multipurpose uses may tend to have a high elasticity of
demand, as there may be many substitutes available.
2. Income – the higher the proportion of consumers’ income which the price of a good
represents, the higher is its price elasticity of demand.
3. Addiction – the more addictive a product tends to be, the smaller is its price elasticity
of demand.



2 e ii) Demand Curve of a Good with a Perfectly Elastic Demand

P ($)

$60 D

$30

O
Quantity

Demand Curve of a Good with a Perfectly Inelastic Demand

P ($) D

$60

$30

O
40 Quantity



2 e iii) In the figure, marginal revenue is positive between an output level of 0 and Q1.
This means as price is lowered, an increased output is sold and total revenue increases.
As such demand is price elastic in this output range. Between Q1 and Q2, marginal
revenue is negative, this means that as the price is lowered an increased quantity is sold
and total revenue declines. This means that demand is price inelastic between these
output levels. At output level Q1, where marginal revenue is 0, price elasticity of demand
is unitary.

P
($)

MR AR = Demand
O Q1 Q2 Q

2 f) Two impacts of time on price elasticity of demand.
Following a price increase, price elasticity of demand tends to be greater as time elapses
since it may be possible for substitutes to be sourced as consumers have more time to
adjust. As consumers switch to these substitutes, the response to the increase in price is
greater which means demand becomes more price elastic.
If however as more time elapses the substitutes are found to be unsuitable then the
consumers would return to consuming the original good rendering demand more
inelastic.

3 a) Market structure refers to the type of competition which exists among firms in a
particular industry. The type of competition is distinguished by the characteristics of the
industry which gives an indication of how firms would operate in terms of price and



output.

3b)
Similarities Differences
Barriers
to Entry Short Long Number
Type of and Run Run of Production Allocative Other
Competition Exit Profits Profits Sellers efficiency efficiency Characteristic
Only a
Any Larger theoretical
Perfect No level Normal number Yes Yes possibility
Increased
variety to cater
for diverse
Monopolistic Any consumer
Competition No level Normal Many No No needs

3 c i)
Similarities Differences
Barriers
Number to Entry
Type of of and Short Long Other
Competition Production Allocative Sellers Exit Run Run Characteristic
Economies of
scale might be
Monopoly No No One Yes Abnormal Abnormal achieved
Increased
variety to cater
for diverse
Monopolistic consumer
Competition No No Many No Any level Normal needs

Market Structure Examples
Mobile phone services in Trinidad and Tobago provided
Monopoly by TSTT prior to 2005.

Monopolistic Competition
The Fast Food Industry in Trinidad and Tobago

3 d) Barriers to Entry
 Patents and Licenses (legal barriers to entry). A patent is a contractual agreement
which gives exclusive right to an inventor to use his or her invention. Such
exclusivity may create and perpetuate monopolies by conferring on the patent holder
the sole right to produce a particular commodity. A license is a legislative
arrangement which limits the entry of firms into an industry to only approved license
holders. Since licenses are issued and enforced by governments, this gives the state
control over the number of firms which can enter an industry.
 Economies of scale. The achievement of declining long run average costs by large
firms can create financial obstacles for new firms to enter the market. This is because
the incumbent firm may be able to pass its cost savings to customers in the form of



lower prices. Such prices may be so low that new firms will find it difficult to
compete on a price basis, and will often earn economic losses if they try to do so. The
established firm may therefore retain a monopoly position through its cost advantage,
because it can produce at a lower cost than could any new smaller competitor
 Brand proliferation (attributed mainly to oligopoly) – the larger the number of
differentiated products sold by existing oligopolists, the smaller the market available
to a new firm entering with a new product and the more difficult it is for it to enter.
This is because the market would be saturated with existing brands and as a result it
would be difficult for new brands to compete.
 Pricing and other Strategic Barriers – this accounts for aggressive price cutting,
increased advertising and other actions on the part of existing firms in the market
which make it difficult for an entering firm to succeed. Advertising in particular and
effective brand building mean that new firms will have to advertise significantly in
order to catch the public’s attention and acquire market share. This cost may be too
high for new firms expecting to operate on a small scale. Furthermore, other factors
attributable to longevity advantages possessed by existing firms such a well
established clientele and the provision of favourable financing to long term customers
can act as a potent entry barrier by increasing the set up cost of new entrants.
 Production secrets – if the production of a good involves a secret ingredient or a
secret recipe such as Angostura bitters for instance, then this would effectively
prevent other firms from producing this good.
 Control over raw materials – the exclusive ownership or control of a substantial
amount of an essential raw material would considerably limit attempts by other firms
to enter an industry and as such this a monopoly firm would prevail.

3 e i) Normal Profit vs Economic Profit
 Normal profit – which is the minimum amount of profit which is necessary to entice
the firm to continue production in the current industry. Usually this may be
determined by the amount the entrepreneur could receive in his next best job.
 Economic profit or Abnormal profit – any profit earned in excess of normal profit.
Abnormal profit is called, economic profit, windfall profit and super normal profit.



3 e ii) Normal Profit vs Economic Profit

$

AC

MC
PE

E

MR= MC
MR AR
O QE Quantity

3 e iii) If abnormal profits are earned by existing firms under monopolistic competition
then this would encourage new firms to enter the industry. As more and more firms enter
the industry, the market share of each firm is diluted and this has the effect of reducing
the abnormal profits earned by each firm. This would be shown by a leftward shift of the
demand curve faced by each existing firm in the industry. The entry of new firms in the
monopolistically competitive industry would continue until all abnormal profit is
eliminated from the increased competition. This would occur where AR is equal to AC.

4 a i) Market failure occurs whenever the quantity of a good or and service produced in
a market does not occur at the productive and allocative efficient level. In other
words as long as a welfare loss exists at the quantity of output produced by the market
then market failure exists.

4 a ii) The marginal cost of production represents the cost of producing an additional
unit of a good or service. This marginal cost would include the payments to the factors of
production utilized which covers, rent wages, interest and normal profit. As such the firm



in a competitive market would be prepared to accept a price equal to the marginal cost of
each unit of output sold.

4 a iii) When positive externalities exist a distinction is made between benefits received
by consumers which are called private marginal benefits (PMB) and those received by
third parties, which are referred to as external marginal benefits (EMB). The sum of PMB
and EMB gives the overall level of benefits attained by society (i.e. both the consumers
and third parties) from the consumption of the good or service. This is called social
marginal benefit (SMB).

4 a iv) Pareto efficiency refers to the best use of the finite resources in the production of
goods and services for consumer satisfaction. There are two requirements for this to be
achieved: 1) Production efficiency will not be achieved if firms in a particular market
produce the level of output where production efficiency is achieved. This means that
resources are not being used the most efficiently to produce goods and services to cater
for the wants and needs of people. As a result social welfare is not maximized and a
welfare loss exists. 2) Allocative efficiency is not achieved in a market if based the
benefits and cost of it to society the good is either over producer or under produced. In
short these scenarios refer to cases where an incorrect allocation of resources is made
towards the production of the good in the respective market.

4 b i) Public goods have two main characteristics:
• Non-rivalry in consumption
• Non-excludability in consumption

4 b ii) Public Goods and Services
 Roadways and highways
 Public savannahs, parks and promenades

4 b iii) Examples of public goods are roads are street lighting. These are provided by the
government since if left to the market private producers will not provide them. This is
because the non-excludability feature of public goods means that people who use public
goods and services do not pay for them. As such the market would fail to produce these
goods and as a result a welfare loss would exist.

4 c i) When externalities exists, there additional benefits and costs apart from the benefits
received by consumers and cost faced by producers. These are the benefits and costs
faced by the third parties. The market however does not take into consideration these
spillover cost and benefits received by third parties.

4 c ii) Positive externalities are benefits enjoyed by third parties who are not directly
involved in the consumption or production of the good or service. Negative externalities
are costs faced by third parties who are not directly involved in the consumption or
production of the good or service.



4 c iii) When positive externalities exist a distinction is made between benefits received
by consumers which are called private marginal benefits (PMB) and those received by
third parties, which are referred to as external marginal benefits (EMB). The sum of PMB
and EMB gives the overall level of benefits attained by society (i.e. both the consumers
and third parties) from the consumption of the good or service. This is called social
marginal benefit (SMB).

4 c iv) When negative externalities exist a distinction is made between cost incurred by
producers which are called private marginal costs (PMC) and those faced by third parties,
which are referred to as external marginal costs (EMC). The sum of PMC and EMB gives
the overall cost face by society (i.e. both the producers and third parties) resulting from
the production of the good or service. This is called social marginal cost (SMC). The
market however does not take into consideration these spillover cost and benefits
received by third parties. As a result goods and services which generate positive
externalities are under produced. This means when there are external benefits, the
market would under produce the good or service. This results in a loss in welfare which
means allocative efficiency is not achieved. When negative externalities exist, the good
or service is over produced also leading to a welfare loss. Such over production causes a
loss in welfare as too many resources are being used in the production of the good or
service.

4 d) Causes of Market Failure:
1. Imperfect competition
2. Insufficient provision of merit goods and services.
3. Asymmetric information

4 e) Addressing Markets Failure associated with Externalities
(Sync with past paper solutions)
1. Nationalization - under this approach the government takes ownership of the
production facilities and takes charge of production. As such the government chooses
to produce the quantity of output which achieves allocative efficiency. This means
that if positive externalities were involved and the good or service was under
produced by the market, then the government would take charge of production and
increase output towards the socially desirable level. If, on the other hand, negative
externalities existed, then a welfare loss from over production would be created under
private production. Under state production, output would be reduced to the optimal
level, in order to achieve a maximization of society’s welfare.
2. Indirect Taxation and Subsidies
 Indirect Taxation - This is applied in cases where there are negative externalities
and the good or service is over produced. Here the government can impose a tax on
each unit of output, where the amount of tax corresponds to the external cost. The
main aim of such indirect taxes is to increase the firm’s private marginal cost (PMC)
until it equates with social marginal cost curve (SMC). As a result production of the
good or service would decline to the optimal level.
 Subsidies - activities that generate positive externalities can be subsidized. The aim
of a subsidy is to reduce the private marginal cost (PMC) of consuming a good. This



would provide an incentive for more people to consume such goods which would
increase output to the socially optimal level of output. A good example of subsidies
include: the recent financial assistance program in Trinidad Tobago where students
who qualify for tertiary level education are granted subsidies by the government of
that country.
3. Legislation
• A Total Ban on the product - with this method the government would simply put a
total ban on the good or service which generates the negative externality such as guns
and illegal drugs. However, banning a product may involve creating a new welfare
loss due to zero production. The welfare loss associated with the market output of the
good or service which generates the negative externality is shown by the smaller
shaded triangle. The welfare loss associated with a ban on production is shown by the
larger shaded triangle. This implies that a ban on the product can only be justified if
the welfare loss resulting from the ban is smaller than the original welfare loss that
existed at the market equilibrium.
• A ban on the negative externality. A ban on pollution for instance can be imposed
by the government in an attempt to eliminate the welfare loss impact it has onto
society. In such an extreme case, firms may have to be innovative to develop methods
of eliminating pollution in order to continue production.
• Regulation of output. The state also has the option of regulating the level of output
in a market. Where a negative externality exists, firms could be prohibited by law
from producing more than the socially efficient output level. In theory, the
government could set a quota or a physical limit on output corresponding with the
social optimum. This may require the establishment of regulatory bodies such as the
Environmental Management Authority in Trinidad which monitors and enforces
standards on activities which result in environmental degradation which is a negative
externality.

5 a i a) These resources or factors of production are simply the inputs used in the
production process to generate output.

5 a i b) The labour force participation rate is the proportion of individuals from the
overall population who are in the labour force. The labour force is the number of
available workers in a country. This accounts for all people 18 years and over and under
65 years who are either working or actively looking for employment.

5 a ii) Factors of Production and Factor Rewards
Factor of Production Factor Reward
Land Rent
Labour Wages
Capital Interest
Enterprise Profit

5 b i a)
1 2 3 4
Units of Labour Output per Day Marginal Product Value of Marginal Product



0 0
1 2 2 10
2 6 4 20
3 12 6 30
4 19 7 35
5 25 6 30
6 29 4 20
7 32 3 15

5 b i b) If the wage rate is $20 then 6 units of labour would be employed

5 b i c) At this level of employment the MRP of labour is equal to the wage rate. The firm
is able to maximise profit from the employment of labour at this point.

5 b ii)

5 b iii) If the wage rate is $15 then 6 units of labour would be employed.

5 b iv) The MRP curve constitutes the firm’s demand curve for a factor of production,
since it shows how many units of a factor of production a firm is willing to employ at
different factor prices. If the MRP of a factor of production is greater than its price then
the firm can profitably hire more that factor. If a firm discovered that the MRP from the
last unit of a factor employed is less than the price then it would have to lay off that unit
as a loss would be incurred. Conclusively if MRP is equal to price then the firm would
employ neither more nor less of the factor. In other words the firm employs the optimal
quantity of the factor when MRP is equated to price (MRP = Price).

5 c) Factors of production are demanded by producers purely as an input in the
production process. In short, the demand for factors of production depends ultimately on



the demand for final goods and services which the factors of production are used to
generate.

5 d i) The labour force is the number of available workers in a country. This accounts for
all people 18 years and over and under 65 years who are either working or actively
looking for employment.

5 d ii) In this case the labour force is 110 (130 – 20).



5 d iii)
Labour Force
Labour force Participation rate = × 100
Population

110
= × 100 = 85.4%
130

5e i) In panel A, as more workers supply their labour to the high wage labour market the
supply curve shifts to the right from SH1 to SH2 causing wages to fall from WH to W.

5 e ii) Panel B shows the low wage labour market where workers are leaving and thus the
supply of labour decreases from SL1 to SL2. As a consequence, wages increase to W thus
leading to an equalization of wages across both industries.

6 a) The size distribution of income was mentioned in the preceding section as a cause of
poverty. This refers to how income earned throughout the economy is distributed among
the population of an economy. The functional distribution of income captures the
proportion of income going to the owners of different factors of production. That is, it
measures the amount of income received by landowners, labourers, owners of capital and
entrepreneurs in the form of: rents, wages, interest and profit respectively.

6 b i) The Lorenz curve traces how the total income of an economy is shared among the
overall population. This is constructed with income shown on the vertical axis and
population represented on the horizontal axis. If income is perfectly evenly distributed
then there is an even spread between the amount of income and the individuals who make
the population. Such a Lorenz curve is a straight line which forms a 45 degree angle at
the origin and is referred to as the line of absolute equality. Since income is usually
unevenly distributed then the actual Lorenz curve would be below the line of absolute
equality. The bigger the area between the Lorenz curve and the line of absolute equality,
the more unequal would be the distribution of income.

From the Lorenz curve, a quantitative measure of the distribution of income can be
derived. This is known as the Gini coefficient which is calculated as follows:

A 100
Gini Coefficient = ×
A+ B 1

where as shown in figure 16-5

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



6 b ii) If there is an absolutely, uneven distribution of income then area B would be zero.
As such the Gini coefficient would correspond to 100 percent. The closer the Gini
coefficient is to 0, the more even the distribution of income and the closer it is to 100
percent, the more uneven the distribution of income.

6 c i) Absolute poverty - Absolute poverty 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 there 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. Relative Poverty - Relative poverty 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. Clearly a person, who
is classified as relatively poor, may not be absolutely poor.

6 c ii ) Underlying Causes of Poverty
• Unemployment – one of the leading causes of poverty is unemployed. Those who do
not have jobs would not have a source of income to support themselves and their
families. There are many cause of unemployment.
• Education – low education attainments is also a cause of poverty as it typically denies
employment opportunities to individuals who are not sufficiently educated.
Furthermore, lack of education also perpetuates the cycle of poverty as individuals
who are not educated may not be able to educate their children. As such future
generations also face the challenge of poverty.
• Health – poor health and lack of access to healthcare is also a contributor to poverty.
This is because as individuals face health problems their productive abilities would be
impaired. This can be exacerbated if the individual is unable to access healthcare
treatment as prolonged health problems are encountered. As such the individual’s
earnings ability suffers in the long run which exposes them to a life of poverty.

6 d) Social Welfare Programs
A welfare programme refers to any government initiative which seeks to provide a
minimum level of income or financial aid as well as other support such as access to free
services for underprivileged or deprived peoples such as the poor, elderly and the
disabled. Such programs are financed by government taxation revenue. In Trinidad and
Tobago there is the Chronic Disease Assistance Programme (CDAP) which provides free
prescription drugs and other pharmaceutical items for a number of health conditions such
as diabetes and asthma etc.

6 e) Moral harzard occurs when an individual makes a suboptimal decision or undertakes
a hidden action if the other party in the transaction cannot monitor his or her behaviour
all the time. This particularly applies to the insurance industry where individuals who pay
insurance premiums are compensated should any unfortunate loss arise. Insurance is
therefore a service which gives peace of mind to individuals who face the risk of
unfortunate losses. For instance, a driver may establish an automobile insurance policy



which covers all damages in the event that he or she is involved an accident. Moral
hazard occurs in this type of transaction where the insured individual takes more risk by
driving recklessly. This occurs as there is comfort that all expense would be covered
should an accident occur. If the individual did not have an insurance policy, then he or
she would drive more carefully in order to avoid having to pay for costly damages from
an accident.

Adverse selection refers to a suboptimal decision by one party in a transaction when there
a is a hidden attribute about a good or service which the other party is aware off. In the
used car market for instance, the car salesman may be aware of the servicing records of
the motor vehicle. The buyer on the other hand, may not be privy to such information. As
a result of these hidden attributes the buyer would not be certain about the reliability of
the vehicle and may refrain from purchasing a used car simply because of the information
asymmetry. This decision may be sub optimal if in reality the car was properly
maintained and in perfect working condition. In other words, the individual gave up a
good opportunity simply because of the information asymmetry or hidden attribute in this
case.


CAPE Economics, May 22nd 2008, Unit 1, Paper 2 suggested answer by Edward Bahaw

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