CPA
Intermediate Leval
Economics May 2017 Suggested Solutions

Opportunity cost is a fundamental concept in economics and decision theory, emphasizing the trade-offs inherent in decision-making. When resources are scarce, individuals and organizations must make choices about how to allocate those resources, and in doing so, they incur opportunity costs by forgoing the benefits of the next best alternative.

1. Resource Allocation:

• Opportunity cost helps in allocating scarce resources efficiently by considering trade-offs.

2. Investment Decisions:

• Opportunity cost is crucial in evaluating investment options and choosing those with the highest potential returns.

3. Time Management:

• Opportunity cost assists in prioritizing tasks and activities, leading to efficient time management.

4. Education Choices:

• Opportunity cost helps individuals assess the benefits and drawbacks of different education or training options.

5. Career Decisions:

• Opportunity cost factors into decisions regarding potential income, job satisfaction, and work-life balance in choosing a career.

6. Production Choices:

• Opportunity cost is crucial in production decisions, guiding companies in allocating resources to produce goods or services.

7. Government Policy Decisions:

• Opportunity cost is applied by governments in allocating budgets and making policy decisions.

8. Environmental Decision-Making:

• Opportunity cost is used to evaluate trade-offs between conservation efforts and economic development in environmental management.

9. Entrepreneurial Choices:

• Entrepreneurs use opportunity cost to assess potential profits, costs, and risks when deciding which projects to pursue.

10. Personal Finance:

• Opportunity cost guides decisions in personal finance, involving trade-offs between immediate consumption and future financial well-being.

Explanation:

A disturbance in the market, often initiated by a supply side shock, triggers a period of instability. For instance, a poor harvest in period 1 results in a supply reduction to Q₁ causing prices to surge to P₁. If producers, anticipating a continuation of these high prices, plan their period 2 production accordingly, the supply in period 2 is higher, reaching Q₂. Consequently, prices fall to P₂ as producers strive to sell their increased output.

This cyclical process repeats, creating a spiral pattern. The economy gradually converges towards equilibrium, where supply and demand intersect, as indicated in the figure. It is crucial to note that this convergence occurs because demand proves to be more elastic than supply, influencing the cyclicality of the market.

While the model typically converges, it's essential to recognize that under certain conditions, such as when the supply curve is more elastic than the demand curve, the process can lead to divergence, resulting in persistent market fluctuations.

(i) Increasing Returns to Scale:

1. Specialization and Division of Labor: Increasing returns to scale can arise from enhanced specialization and the division of labor. As the scale of production expands, workers can focus on specific tasks, leading to increased efficiency.

2. Utilization of Specialized Capital: Larger production scales often allow for the efficient utilization of specialized machinery and equipment. This can result in higher productivity and lower average costs.

3. Economies in Input Purchases: Bulk purchasing discounts and better negotiation power with suppliers become feasible at larger production scales. This leads to cost savings on input purchases, contributing to increasing returns.

4. Efficient Use of Technology: Larger-scale production allows for the implementation of advanced technologies and production methods. This can lead to higher efficiency and increased output without proportional increases in input costs.

5. Managerial Efficiencies: With increasing scale, there can be better utilization of managerial resources and expertise, leading to more effective coordination and decision-making.

(ii) Decreasing Returns to Scale:

1. Coordination Challenges: As production scales increase, coordinating and managing a larger workforce and more extensive operations become challenging. This may lead to inefficiencies and decreasing returns.

2. Diseconomies of Scale: Diseconomies of scale refer to the point where the cost per unit of output starts increasing as the scale of production grows. Factors such as communication challenges, bureaucracy, and difficulties in maintaining a cohesive organizational culture can contribute to diseconomies of scale.

3. Resource Scarcity: In some cases, the availability of certain critical resources may become scarce as production scales increase. This scarcity can lead to inefficiencies and decreased returns.

4. Increased Input Costs: Larger production scales might result in increased costs for certain inputs. For example, hiring more labor might lead to higher wage costs, especially if the labor market is tight.

5. Technological Inefficiencies: Implementing and managing advanced technologies at a larger scale may not always result in proportional increases in output. Technical difficulties and inefficiencies can contribute to decreasing returns.

The result can be positive, negative, or zero:

Positive Cross Elasticity (Substitutes): If the cross elasticity is positive, it indicates that the two goods are substitutes. An increase in the price of one good leads to an increase in the quantity demanded of the other, and vice versa.

Negative Cross Elasticity (Complements): If the cross elasticity is negative, it suggests that the two goods are complements. An increase in the price of one good results in a decrease in the quantity demanded of the other, and vice versa.

Zero Cross Elasticity (Independent Goods): If the cross elasticity is zero, the goods are considered independent or unrelated. A change in the price of one good does not affect the quantity demanded of the other.

Cross elasticity of demand provides valuable insights for businesses and policymakers, helping them understand how changes in the price of one product may influence the demand for another.

(ii) The cross elasticity of demand and comment on the relationship between commodity x and commodity y

Pecuniary Economies of Scale:

Pecuniary economies of scale involve cost reductions associated with the firm's increased purchasing power or market influence, rather than improvements in production efficiency. These cost advantages arise from the firm's ability to negotiate better terms with suppliers, secure favorable financing, or gain pricing advantages due to its increased market share. Pecuniary economies of scale are more related to the external economic environment and the firm's position within the market rather than internal production processes. While pecuniary economies can result in cost savings, they may not necessarily lead to increased operational efficiency or lower production costs per unit.

1. Subjectivity of Utility: Utility is a subjective concept, and assigning cardinal numbers to it assumes that individuals can accurately quantify their preferences. People's preferences and satisfaction are inherently subjective and may not be precisely measurable. Different individuals might assign different utility values to the same goods or services.

2. Inconsistencies in Measurement: Measurement of utility is not consistent across individuals or even for the same individual over time. The assignment of numerical values to utility lacks standardization, making it challenging to compare utility measurements between different people or even for the same person in different circumstances.

3. Assumption of Independence: The cardinal approach assumes that the utility derived from different goods is independent of each other. In reality, the satisfaction derived from one good may depend on the consumption of other goods. The assumption of independence oversimplifies the complexity of consumer preferences.

4. Difficulty in Interpersonal Comparisons: The cardinal approach implies that utility numbers can be compared across individuals to make interpersonal utility comparisons. Comparing utility between individuals is problematic because utility is a highly personal and subjective experience. What might have high utility for one person may not hold the same value for another.

5. Cardinal Numbers Lack Economic Significance: Cardinal numbers used in the utility function lack economic significance beyond indicating preferences. While the cardinal approach helps in understanding preferences, the actual numerical values assigned to utility lack real-world economic meaning. Economic decisions are often more concerned with relative preferences than precise numerical values.

6. Difficulty in Measuring Marginal Utility: The concept of marginal utility, central to the cardinal approach, is difficult to measure accurately in practice. Obtaining precise information about the change in satisfaction with each additional unit of a good consumed is challenging. This hinders the practical application of the cardinal approach.

7. Ignores Behavioral Economics Insights: The cardinal approach may ignore insights from behavioral economics that highlight the role of psychological biases and heuristics in consumer decision-making. Human behavior is influenced by cognitive biases and emotions, which the cardinal approach tends to overlook. Behavioral economics provides a more nuanced understanding of consumer behavior.

8. Utility as a Black Box: The cardinal approach treats utility as a black box, providing no insight into the underlying psychological and social factors influencing preferences. Understanding consumer behavior requires insights into the factors shaping preferences, and the cardinal approach does not offer a detailed understanding of the psychological aspects involved.

9. Limited Predictive Power: The cardinal approach may have limited predictive power in explaining actual consumer choices. Consumer choices are influenced by various factors, including psychological, social, and contextual elements. The simplistic assumption of utility maximization may not always align with observed behavior.

10. Assumes Rationality: The cardinal approach assumes that consumers are rational decision-makers seeking to maximize utility. In reality, consumers may deviate from strict rationality due to bounded rationality, emotional influences, and other factors. The assumption of perfect rationality oversimplifies consumer decision-making.

1. Substitution Effect: As the price of a good decreases, it becomes more attractive relative to other goods, leading to an increase in quantity demanded as consumers substitute the cheaper good.

2. Income Effect: A decrease in the price of a good increases the real purchasing power of consumers' income, allowing them to afford more of the good, resulting in an increase in quantity demanded.

3. Law of Diminishing Marginal Utility: Consumers are willing to pay a lower price for additional units of a good as the satisfaction derived from each additional unit decreases, contributing to an increase in quantity demanded.

4. Consumer Expectations: Anticipation of future price decreases may lead consumers to delay purchases until prices are lower, resulting in an increase in quantity demanded when prices do decrease.

5. Real-Balance Effect: A decrease in the price of a good increases consumers' real wealth, encouraging higher spending and leading to an increase in quantity demanded.

6. Law of Supply: Interaction with the law of supply, where producers are willing to supply more of a good at higher prices, contributes to the downward slope of the demand curve in market equilibrium.

7. Market Dynamics: Price competition in a competitive market may lead firms to lower prices, stimulating demand and resulting in an increase in quantity demanded.

8. Psychological Factors: Lower prices create a perception of a good deal, influencing consumer behavior and encouraging them to buy more of the product.

(ii) Using year 2011 as the base year ,determine the inflation rate for the economy.

To illustrate, consider the diagram where the market price remains constant, aligning with the average revenue (AR) and marginal revenue (MR) curves for a firm in perfect competition. Should there be an increase in demand from Q1 to Q2, the price elevates to P2, leading to the firm experiencing supernormal profits. This profit margin is represented by the shaded area above the equilibrium points A, B, C, and D.

Importantly, due to the absence of barriers to entry in perfect competition, news of supernormal profits will attract new firms to enter the market. This influx of new entrants continues until the increased competition forces the price back down to P1. As a consequence, the firm's profit returns to the normal level, eliminating the temporary supernormal profits.

In essence, the diagram captures the dynamic nature of perfect competition, emphasizing that in the long run, economic forces drive the market towards a state where all firms earn only normal profits. This concept underscores the competitive nature of perfect competition, where short-term opportunities for supernormal profits attract new entrants, eventually restoring the market to a state of normal profit equilibrium.

• Large Number of Sellers: There are many firms operating in the market, each producing a slightly differentiated product.

• Product Differentiation: Products offered by firms are differentiated in terms of brand, quality, features, or other non-price factors.

• Free Entry and Exit: Firms can enter and exit the market relatively easily. There are no significant barriers to entry.

• Independent Decision-Making: Each firm makes independent decisions about pricing and production levels.

• Non-Price Competition: Firms compete on factors other than price, such as product quality, branding, advertising, and customer service.

• Downward-Sloping Demand Curve: Each firm faces a downward-sloping demand curve for its product due to product differentiation.

• Some Control Over Price: Firms have some control over the price of their products due to product differentiation.

• Perceived Monopoly Elements: Consumers may perceive a sense of monopoly power due to product differentiation.

• Excess Capacity: Firms may operate with excess capacity to maintain product differentiation.

• Advertising and Marketing: Firms invest in advertising and marketing to create brand loyalty and differentiate their products.

• Normal Profits in the Long Run: In the long run, firms earn normal profits, and the market reaches equilibrium.

• Consumer Freedom of Choice: Consumers have a wide range of choices due to the variety of differentiated products available.

• Limited Scope for Collusion: Due to a large number of firms and product differentiation, collusion is difficult to achieve.

• Elastic Demand Curve: The demand curve faced by each firm is relatively elastic, depending on the level of product differentiation.

• Waste of Resources: There is a certain degree of wastage of resources in advertising and marketing efforts.

• M is the money supply,
• V is the velocity of money (the number of times money changes hands in a given period),
• P is the price level, and
• Y is the real output or real GDP.

1. Quantity Equation and the Quantity Theory:

Monetarists argue that changes in the money supply (M) lead to proportional changes in the nominal GDP (PY). The velocity of money (V) is considered relatively stable in the short run, and real output (Y) is determined by non-monetary factors in the long run.

2. Velocity of Money:

Monetarists contend that changes in the velocity of money are relatively stable over short periods, and significant fluctuations are typically due to changes in institutional factors or financial innovations. In the long run, they assume a constant velocity.

3. Money Supply Growth and Inflation:

According to monetarists, sustained increases in the money supply will result in a proportional increase in nominal GDP. In the long run, changes in the money supply primarily affect the price level (P), leading to inflation.

4. Neutrality of Money:

Monetarists believe in the neutrality of money in the long run. This means that changes in the money supply do not affect real variables like output, employment, or productivity. Instead, monetary changes primarily impact nominal variables, such as prices.

5. Role of Central Bank:

Monetarists advocate for a stable and predictable growth rate of the money supply, often arguing that central banks should follow a rule-based approach. By controlling the money supply growth, central banks can help maintain price stability and reduce the uncertainty that can arise from unpredictable monetary policy.

6. Short-Run vs. Long-Run Effects:

In the short run, monetarists acknowledge that changes in the money supply can impact real output and employment due to nominal rigidities. However, in the long run, these effects diminish, and monetary policy primarily influences the price level.

7. Critique of Active Discretionary Policy:

Monetarists are often critical of active discretionary monetary policy, advocating for a more rule-based approach. They argue that attempts to fine-tune the economy through discretionary policy can lead to unintended consequences, such as destabilizing inflation.

8. Policy Implications:

Monetarists generally support a stable and predictable monetary policy that aims to control the growth rate of the money supply. They emphasize the importance of maintaining price stability to foster long-term economic growth.

1. Perishable Goods: For highly perishable goods, suppliers may not be able to respond immediately to changes in price.

2. Supply Constraints: If there are physical or logistical constraints on production, the law of supply may not hold.

3. Government Intervention: Government policies, such as price controls or regulations, can disrupt the normal operation of the law of supply.

4. Natural Disasters: Natural disasters can disrupt the production process and lead to a temporary decrease in the supply of goods.

5. Technological Changes: Rapid technological changes can affect the supply of goods, potentially rendering certain goods obsolete.

6. Expectations of Future Prices: Suppliers may withhold some of their current supply if they expect prices to increase in the future.

7. Supply Lags: Some industries may experience lags in responding to price changes.

8. Unique Goods: For unique or specialized goods, the supply may not respond quickly to price changes.

9. Incomplete Information: Suppliers with incomplete or inaccurate information may not respond optimally to price changes.

10. Artificial Scarcity: Suppliers may intentionally limit the supply of a good to create a sense of scarcity and drive up prices.

Accelerator: The accelerator, on the other hand, refers to the relationship between changes in the level of real output (national income) and the corresponding changes in the level of investment. The accelerator theory suggests that changes in investment are induced by changes in the rate of growth of national income. If the economy is growing rapidly, businesses are more likely to invest in additional capacity, while a slowdown in economic growth may lead to reduced investment.

(ii) Factors that could limit the application of the multiplier in developing countries:

1. Leakages: Developing countries often experience high levels of leakages from the spending cycle, including imports, savings, and taxes. These leakages reduce the effectiveness of the multiplier as a significant portion of the initial injection does not circulate within the domestic economy.

2. Import Dependency: Developing economies may heavily rely on imported goods and services. If a significant portion of the initial spending goes towards imports, it diminishes the impact on the domestic economy, as the multiplier effect is not fully realized within the country.

3. Low Marginal Propensity to Consume: In some developing countries, households may have a low marginal propensity to consume, meaning they save a larger portion of their income. This reduces the effectiveness of the multiplier, as a smaller proportion of the initial injection is spent and circulated in the economy.

4. Informal Economy: Developing countries often have large informal sectors that may not be fully captured by official economic statistics. The multiplier's impact may be limited if a significant portion of economic activities occurs in the informal economy, where the flow of money is less visible and traceable.

5. Structural Issues: Structural issues, such as inadequate infrastructure, bureaucratic inefficiencies, and regulatory hurdles, can impede the smooth operation of the multiplier. These factors may hinder the effective implementation of projects and limit the overall impact on the economy.

6. External Shocks: Developing countries are often more susceptible to external shocks, such as changes in global commodity prices, geopolitical events, or economic downturns in major trading partners. These external factors can disrupt the multiplier process and limit its effectiveness.

7. Limited Access to Credit: In some developing economies, limited access to credit may constrain businesses and households from taking full advantage of increased economic activity. This can dampen the multiplier effect as the expansion of credit is crucial for investment and consumption.

2. Economies of Scale: Integration enables the pooling of resources and production capacities among member countries, leading to economies of scale. This can result in cost efficiencies, lower production costs, and increased competitiveness on the global stage.

3. Enhanced Foreign Direct Investment (FDI): A unified market is often more attractive to foreign investors. Regional economic integration can attract higher levels of FDI, bringing in capital, technology, and expertise that can contribute to the economic development of member countries.

4. Infrastructure Development: Integration may stimulate cross-border infrastructure development projects. Improved transportation and communication networks can facilitate the movement of goods, services, and people, enhancing economic connectivity within the region.

5. Coordination of Policies: Member countries can coordinate economic policies, harmonize regulations, and align standards. This coordination can create a more conducive environment for trade and investment, reducing uncertainties for businesses operating in the integrated region.

Case Against Regional Economic Integration:

1. Unequal Distribution of Benefits: Regional integration may lead to an unequal distribution of benefits among member countries. Larger and more developed economies may disproportionately benefit, leaving smaller and less developed economies at a disadvantage.

2. Loss of National Sovereignty: Some argue that regional integration can lead to a loss of national sovereignty as member countries may need to cede decision-making authority to regional institutions. This can be a concern for countries wanting to maintain control over their economic policies.

3. Trade Diversion: Integration may result in trade diversion, where member countries start trading more with each other at the expense of non-member countries. This can be inefficient if the integrated region is not the most cost-effective source of goods and services.

4. Dependency and Vulnerability: Developing countries heavily reliant on a few key partners within the integrated region may become vulnerable to economic downturns or geopolitical tensions within that region. Overreliance on regional markets can expose countries to external shocks.

5. Implementation Challenges: Integrating economies involves overcoming various challenges, such as differences in economic structures, regulatory frameworks, and political systems. Implementation difficulties can slow down the integration process and hinder the realization of anticipated benefits.

6. Impact on Non-Members: Non-member countries may face increased trade barriers or disadvantages compared to integrated countries. This can lead to economic exclusion and trade imbalances, potentially exacerbating global economic disparities.

(ii) The level of output that would minimise costs

1. Trade Imbalances: Developing countries may experience trade imbalances, where the value of imports exceeds the value of exports. This can result from a lack of competitiveness in export industries, dependence on imported goods, or unfavorable terms of trade.

2. High Import Dependency: Reliance on imported goods, especially essential items or capital goods, can contribute to balance of payment deficits. Countries that heavily depend on imports for consumption and investment may face challenges in maintaining a trade surplus.

3. External Debt Servicing: Developing countries often carry significant external debt burdens. The need to service debt through interest and principal repayments can lead to outflows of foreign exchange, contributing to balance of payment deficits.

4. Volatility in Commodity Prices: Many developing countries rely heavily on commodity exports. Fluctuations in global commodity prices can affect export earnings, leading to uncertainties in the balance of payments. Dependence on a few key commodities can expose countries to external shocks.

5. Weakness in Export Diversification: Lack of diversification in export products and markets can make developing countries vulnerable to external shocks. Overreliance on a narrow range of exports may limit income sources and hinder the ability to offset trade deficits.

6. Macroeconomic Instability: Factors such as high inflation, fiscal deficits, and volatile exchange rates can contribute to macroeconomic instability. Uncertainties in the economic environment can affect investor confidence, leading to capital outflows and exacerbating balance of payment deficits.

7. Overvalued Exchange Rates: An overvalued domestic currency can make exports more expensive for foreign buyers and imports cheaper for domestic consumers. This can lead to a decline in export competitiveness and contribute to trade imbalances.

8. Political and Economic Mismanagement: Poor governance, corruption, and economic mismanagement can hinder economic growth and contribute to balance of payment deficits. Lack of effective policies and institutions may discourage foreign investment and exacerbate economic challenges.

9. Global Economic Conditions: Developments in the global economy, such as recessions in major trading partners or changes in interest rates, can impact the trade and financial flows of developing countries. External factors beyond their control can contribute to balance of payment challenges.

1. Assumption of Full Employment: The theory assumes full employment in all participating countries, which may not reflect the real-world employment conditions.

2. Immobility of Factors of Production: The assumption of perfect mobility of factors of production within a country may not hold true in the presence of legal or cultural barriers.

3. Constant Opportunity Costs: The theory assumes constant opportunity costs, but in reality, technological advancements or resource depletion can change opportunity costs.

4. Ignoring Transportation Costs: Transportation costs associated with moving goods between countries are often overlooked, impacting the theory's applicability.

5. Neglect of Non-Economic Factors: Non-economic factors like political considerations or national security concerns are not considered in the theory.

6. Short-Term Focus: The theory primarily addresses long-term trends, neglecting short-term challenges such as sudden market changes or geopolitical events.

7. Assumption of Perfect Competition: Perfect competition is assumed in markets, but real-world markets may be imperfect with monopolies or government interventions.

8. Failure to Consider Income Distribution: The theory does not explicitly consider the distribution of gains from trade within countries, potentially leading to income inequality.

9. Environmental and Ethical Considerations: The theory does not account for environmental or ethical considerations related to production processes.

10. Dynamic Changes in Comparative Advantage: The theory assumes static comparative advantage, but technological advancements and shifts in global demand can lead to dynamic changes.