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Intermediate Leval
Economics May 2021 Suggested Solutions

Economics
Revision Kit

QUESTION 1a

Q Evaluate four ways in which the government could influence allocation of resources in a country
A

Solution


Government Influence on Resource Allocation


1. Fiscal Policy


Fiscal policies, such as taxation and government spending, can impact the allocation of resources. Higher taxes may discourage certain activities, while targeted spending can stimulate specific sectors.

2. Monetary Policy


The government, through its central bank, can influence the allocation of resources by adjusting interest rates. Changes in interest rates affect borrowing costs and, consequently, investment and consumption patterns.


3. Regulations and Legislation


Government regulations and legislation play a crucial role in shaping the business environment. For example, environmental regulations can impact resource allocation by influencing industries to adopt sustainable practices.


4. Subsidies and Incentives


Providing subsidies and incentives to specific industries or activities can direct resources towards desired outcomes. This approach is often used to promote innovation, research, and development.


5. Public Investment


The government can directly allocate resources through public investment projects. Infrastructure development, education, and healthcare initiatives are examples of areas where public funds can shape resource allocation.


6. Trade Policies

Government trade policies, such as tariffs and

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QUESTION 1b

Q Explain using formulae, the difference between "arc elasticity" and "point elasticity" of demand.
A

Solution


Arc Elasticity of Demand


Arc elasticity measures the responsiveness of quantity demanded to a change in price over a range of prices. It calculates the percentage change in quantity demanded relative to the percentage change in price. The formula for arc elasticity (E) is given by:

E
=
ΔQ
ΔP
=
Q2 - Q1
(Q2 + Q1) ÷ 2
÷
P2 - P1
(P2 + P1) ÷ 2

Where:


  • Q1 and Q2 are the initial and final quantities demanded.
  • P1 and P2 are the initial and final prices.
  • ΔQ is the percentage change in quantity demanded.
  • ΔP is the percentage change in price.

Point Elasticity of Demand


Point elasticity measures the responsiveness of quantity demanded to a change in price at a specific point on the demand curve. The formula for point elasticity (\(E\)) is given by:


ΔQ
ΔP
x
P
Q

Where:


  • dQ / dP is the derivative of the quantity demanded with respect to the
  • P is the price at the specific point.
  • Q is the quantity demanded at the specific point.

Key Differences


  • The arc elasticity is calculated over a range of prices, taking the average of initial and final values, while point elasticity is calculated at a specific point on the demand curve.
  • Arc elasticity provides an average elasticity for a range, while point elasticity gives the elasticity at a specific price-quantity combination.
  • Point elasticity is more accurate at determining the elasticity at a specific point, but arc elasticity is often used when the exact point is unknown or when dealing with a range of prices.

These formulas are essential tools in economics to understand how changes in price affect the quantity demanded and, consequently, the elasticity of demand.

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QUESTION 1(c)

Q (i) Define the term "Consumer Sovereignty" as used in economics.

(ii) Summarise six limitations of consumer sovereignty in an economy.
A

Solution


(i) Consumer Sovereignty


Consumer Sovereignty in economics refers to the idea that consumers, through their purchasing decisions, determine what goods and services are produced in an economy. In a market-driven economy, the preferences and choices of consumers guide producers and businesses in deciding what to produce, how much to produce, and at what prices. The concept emphasizes the influence of consumers in shaping the market and allocative efficiency.

(ii) Limitations of Consumer Sovereignty


While consumer sovereignty is a fundamental concept in market economies, it has its limitations. Some of the key limitations include:


  • Information Asymmetry: Consumers may not always have complete information about products, leading to imperfect decision-making.
  • Externalities: Consumer choices may result in external costs or benefits that are not reflected in market prices, impacting overall social welfare.
  • Income Disparities: Not all consumers have equal purchasing power, leading to disparities in the ability to influence production through consumption.
  • Public Goods: Certain goods, like national defense or clean air, may not be efficiently provided based solely on consumer preferences.
  • Monopoly Power: In cases of monopolies or oligopolies, a small number of producers may have significant influence, limiting the impact of individual consumer choices.
  • Short-Term Orientation: Consumers may focus on short-term satisfaction rather than long-term sustainability or societal well-being.

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QUESTION 2(a)

Q Highlight the effects of removing interest rate capping in an economy.
A

Solution


Effects of Removing Interest Rate Capping


The removal of interest rate capping in an economy can have both positive and negative effects. It is important to consider various aspects of the financial system and the impact on different stakeholders. Here are some key effects:

Positive Effects:


  • Increased Access to Credit: Removal of interest rate caps may encourage lenders to provide loans to a broader range of borrowers, including those considered riskier. This can lead to increased access to credit for individuals and businesses.
  • Stimulated Investment: Higher interest rates can attract more investment from savers and investors, potentially stimulating economic growth and development.
  • Market Efficiency: Without interest rate caps, the financial market may operate more efficiently, allowing interest rates to respond to market forces and economic conditions.

Negative Effects:


  • Higher Borrowing Costs: The removal of interest rate caps could result in higher interest rates for borrowers, increasing the cost of borrowing for individuals and businesses.
  • Increased Financial Vulnerability: Individuals with variable-rate loans may face greater financial vulnerability due to potential fluctuations in interest rates.
  • Impact on Low-Income Borrowers: Removing interest rate caps may disproportionately affect low-income borrowers who are more sensitive to changes in interest rates.
  • Risk of Predatory Lending: Without regulation, there may be a risk of predatory lending practices, where lenders exploit borrowers with excessive interest rates and fees.

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QUESTION 2b

Q Identify four reasons why governments intervene with the operations of price mechanism
A

Solution


Reasons for Government Intervention in Price Mechanism


  • Market Failure: Governments may intervene when the market fails to allocate resources efficiently. This can occur due to externalities, public goods, information asymmetry, and other market imperfections.
  • Equity and Fairness: Governments intervene to promote social equity and fairness, ensuring that essential goods and services are accessible to all segments of the population, especially low-income groups.
  • Stabilizing Prices: Interventions can help stabilize prices to prevent extreme fluctuations and control inflation or deflation, contributing to economic stability.
  • Protecting Consumers: Government regulations may be implemented to protect consumers from exploitation, fraud, and unsafe products, ensuring the well-being and safety of the public.
  • Income Distribution: Governments may intervene to address income inequality, implementing policies that promote a more equitable distribution of wealth and resources.
  • Strategic Industries: Interventions can occur in strategic industries critical to national security or economic development to ensure their stability and sustainability.
  • Preventing Monopoly Power: Government intervention helps prevent the abuse of monopoly power, promoting competition and maintaining a level playing field for businesses.
  • External Shocks: During times of crisis or external shocks, governments may intervene to stabilize the economy, provide financial support, and prevent widespread economic downturns.
  • Environmental Concerns: Governments intervene to address environmental externalities, implementing policies to reduce pollution, promote sustainability, and protect natural resources.
  • Public Health: Interventions may be necessary to address public health crises, such as controlling the pricing and distribution of essential medical supplies or pharmaceuticals.
    •

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QUESTION 2c

Q Outline seven factors that influence the elasticity of supply of a commodity
A

Solution


Factors Influencing Elasticity of Supply


  1. Availability of Inputs: The ease with which producers can obtain necessary inputs influences supply elasticity. If inputs are readily available, supply tends to be more elastic.
  2. Time Horizon: Elasticity often varies over different time periods. In the short run, producers may be constrained by fixed resources, leading to inelastic supply. In the long run, producers can adjust production levels more easily, resulting in more elastic supply.
  3. Storage Capacity: Perishable goods or goods with limited storage options may have less elastic supply, as producers need to sell them quickly to avoid spoilage or storage costs.
  4. Technology: Technological advancements can affect production efficiency. Industries with advanced technology may have a more elastic supply as they can respond quickly to changes in demand or input prices.
  5. Government Regulations: Regulatory barriers or restrictions can impact the ability of producers to adjust their production levels, affecting supply elasticity.
  6. Number of Producers: In markets with many producers, individual producers' actions have a smaller impact on the overall market supply, resulting in a more elastic supply.
  7. Substitutability of Inputs: If producers can easily switch between different inputs in the production process, the supply is more elastic as they can adapt to changes in input prices.
  8. Production Flexibility: The ability of producers to switch production between different goods or services influences supply elasticity. More flexible production processes lead to more elastic supply.
  9. Nature of the Commodity: Commodities with unique or specialized production processes may have less elastic supply compared to standardized goods that can be produced more easily.
  10. Expectations of Producers: Producers' expectations about future prices can influence their current production decisions. If producers anticipate higher prices in the future, they may reduce supply in the short run.
    11.

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QUESTION 3a

Q Using indifference curve analysis, demonstrate how an individual's equilibrium point is attained.
A

Solution


Indifference Curve Analysis: Attaining Consumer Equilibrium


Indifference curve analysis: Consider three indifference curves, IC1, IC2, and IC3, along with a budget line AB. The budget line represents the consumer's monetary constraint when choosing between two commodities, 'X' and 'Y'.
Indifference Curve Diagram

With the budget line as a constraint, the highest attainable indifference curve is IC2. At the point where the budget line is tangent to indifference curve IC2, denoted as 'E', the consumer achieves equilibrium. This implies that the consumer, given the budget constraint, maximizes satisfaction at point 'E' on the indifference curve IC2.


At this equilibrium point 'E', the consumer opts to purchase a quantity of 'X' represented by OM and a quantity of 'Y' represented by ON. It's crucial to note that any other point on the budget line, whether to the left or right of point 'E', corresponds to lower indifference curves, indicating a lower level of satisfaction for the consumer.


The concept of tangency between the budget line and an indifference curve is fundamental. As the budget line can be tangent to only one indifference curve, the consumer optimizes satisfaction at the equilibrium point 'E', meeting both conditions for consumer equilibrium.



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QUESTION 3b

Q With particular interest on inferior goods, use the indifference curve analysis to demonstrate and explain the income and substitution effect of a fall in price.
A

Solution


The diagram below illustrates both the substitution and income effects associated with an inferior good.


The shift from point Y1 to Y2 indicates the positive substitution effect. Conversely, the transition from Y2 to Y3 reflects the adverse income effect.

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QUESTION 3c

Q Kenya, which is currently ranked as a developing country, came up with an economic blueprint geared towards realising economic development by the year 2030.

Required:
(i) Describe five factors that might hinder Kenya from realising the above objective.

(ii) Outline measures that might be put in place in order to overcome the impediments in (c) (i) above.
A

Solution


Factors Hindering Kenya's Economic Development


  • Corruption: Widespread corruption can divert resources away from productive activities and undermine economic development efforts.
  • Political Instability: Frequent political instability can create an uncertain business environment, discouraging investment and economic growth.
  • Infrastructure Challenges: Inadequate infrastructure, such as poor roads and limited access to electricity, can impede economic activities and development.
  • High Unemployment: High levels of unemployment can lead to social unrest and reduce the overall productivity of the economy.
  • Income Inequality: Unequal distribution of income can hinder inclusive economic growth and exacerbate social disparities.
  • Education Gaps: Insufficient education and skill gaps in the workforce can hinder innovation and technological advancement.
  • Access to Finance: Limited access to financial resources can constrain businesses and individuals from pursuing economic opportunities.

Measures to Overcome Impediments


  • Anti-Corruption Measures: Implement and enforce strong anti-corruption measures to promote transparency and accountability.
  • Political Stability: Foster a stable political environment through effective governance and conflict resolution mechanisms.
  • Infrastructure Development: Invest in infrastructure projects to improve transportation, energy, and communication networks.
  • Job Creation Programs: Implement policies and programs aimed at creating employment opportunities for the population.
  • Income Redistribution: Develop policies that promote more equitable distribution of income and reduce socio-economic disparities.
  • Education and Skill Development: Invest in education and skill development programs to enhance the capabilities of the workforce.
  • Financial Inclusion: Promote financial inclusion and provide access to capital for small and medium-sized enterprises (SMEs).
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QUESTION 4a

Q Examine six causes of a deflationary gap in an economy
A

Solution


Deflationary gap

A deflationary gap, also known as a recessionary gap, refers to a situation in an economy where the aggregate demand for goods and services falls short of the aggregate supply, leading to deflationary pressures. In simpler terms, it represents an imbalance where the economy is producing below its potential, resulting in unused resources and downward pressure on prices.

Causes of a Deflationary Gap in an Economy


  • Decrease in Aggregate Demand: A significant drop in consumer and investment spending can lead to a decrease in aggregate demand, causing a deflationary gap.
  • High Unemployment: Elevated levels of unemployment can result in lower consumer incomes, reducing overall spending and contributing to a deflationary situation.
  • Excessive Saving: If households and businesses save more and spend less, it can lead to reduced demand for goods and services, contributing to a deflationary gap.
  • Financial Crises: Banking and financial crises can erode confidence, leading to reduced lending and spending, exacerbating a deflationary gap.
  • Technological Disruptions: Rapid technological advancements can lead to structural unemployment and reduce demand for certain goods and services, contributing to deflationary pressures.
  • Global Economic Downturns: Economic downturns in major trading partners can reduce demand for a country's exports, impacting domestic production and contributing to a deflationary gap.
  • Government Austerity: Implementing austerity measures, such as cutting government spending or raising taxes during an economic downturn, can worsen deflationary pressures.
  • Debt Deflation: High levels of debt burden can lead to debt deflation, where individuals and businesses focus on debt reduction rather than spending, contributing to a deflationary gap.
  • Fear of Future Economic Uncertainty: When consumers and businesses are uncertain about the economic future, they may reduce spending and investment, contributing to a deflationary environment.
  • Overproduction: Excessive production capacity and oversupply of goods in the market can lead to falling prices and reduced profit margins, contributing to deflationary pressures.


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QUESTION 4b

Q (i) Define the term "monetary policy".

(ii) Explain five objectives of monetary policy in an economy.
A

Solution


(i) Definition of Monetary Policy


Monetary policy refers to the set of actions and measures adopted by a country's central bank to control and regulate the money supply and interest rates in the economy. The primary goal is to achieve specific macroeconomic objectives, such as price stability, full employment, and economic growth.

(ii) Objectives of Monetary Policy in an Economy


Monetary policy aims to achieve the following key objectives in an economy:


  • Price Stability: Maintain stable and low inflation levels to ensure the purchasing power of the currency remains relatively constant over time.
  • Full Employment: Strive for a level of employment that maximizes the utilization of labor resources without causing excessive inflation.
  • Economic Growth: Support sustainable economic growth by influencing interest rates and, consequently, investment and consumption levels.
  • Interest Rate Stability: Manage interest rates to promote stability in financial markets and encourage borrowing and lending activities.
  • Exchange Rate Stability: Ensure stability in the exchange rate to facilitate international trade and economic relationships.
  • Financial Market Stability: Prevent financial crises and maintain stability in financial markets to support overall economic stability.
  • Control Inflation: Control inflationary pressures by adjusting interest rates and influencing the money supply.
  • Enhance Economic Efficiency: Contribute to the efficient allocation of resources by influencing spending, investment, and consumption patterns in the economy.

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QUESTION 4(c)

Q Assess seven reasons why developing countries are concerned about the high rate of unemployment in their countries.
A

Solution


Reasons Why Developing Countries Are Concerned About High Unemployment


  • Economic Instability: High unemployment can lead to economic instability, as a significant portion of the population may struggle with poverty and a lack of income, impacting overall economic growth.
  • Social Unrest: Persistent unemployment can contribute to social unrest and dissatisfaction, as individuals facing joblessness may become frustrated, leading to protests and potential political instability.
  • Income Inequality: High unemployment exacerbates income inequality, with a smaller portion of the population controlling a disproportionate share of resources, leading to social disparities.
  • Human Capital Loss: Prolonged unemployment results in a loss of human capital, as skills and expertise deteriorate over time, reducing the overall productivity and competitiveness of the workforce.
  • Demographic Challenges: Unemployment can have long-term demographic consequences, such as delayed family formation and a decline in the overall quality of life for affected individuals and their families.
  • Public Health Impact: High unemployment can contribute to public health challenges, including increased stress, mental health issues, and reduced access to healthcare, impacting the well-being of the population.
  • Underutilization of Resources: Unemployment represents an underutilization of human resources, limiting a country's ability to leverage its full labor potential for economic development.
  • Economic Productivity: A large pool of unemployed individuals means a loss of potential economic output, as these individuals are not actively contributing to the production and growth of the economy.
  • Reduced Consumer Spending: High unemployment leads to reduced consumer spending, as unemployed individuals have limited purchasing power, negatively affecting businesses and overall economic demand.
  • Education and Skill Mismatch: The mismatch between the skills possessed by the workforce and the skills demanded by employers can result in structural unemployment, hindering economic development.
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QUESTION 5a

Q The total cost and demand functions of a firm operating under monopolistic competition are represented as follows:

TC = 850 - 8Q - 10Q2

P = 200

Where:

TC = Total costs

Q = Output

P = Price

Required:

(i) Fixed cost function.

(ii) Variable cost function.

(iii) Average cost function.

(iv) Marginal cost function.

(v) Marginal revenue function.

(vi) The level of output at which the firm breaks-even.
A

Solution


(i) Fixed cost function


F.C = 850

(ii) Variable cost function.


VC = -8Q + 10Q2

(iii) Average cost function.


A.C = TC / Q

(850 - 8Q + 10Q2) ÷ Q

10Q + 850 / Q - 8

(iv) Marginal cost function.


MC = -8 + 20Q

(v). Marginal revenue function.


TR = PQ

Q(200) = 200Q

MR = 200

(vi) The level of output at which the firm breaks-even.


Firms break even at a point where total cost equals to total revenue

200Q = 850 - 8Q + 10Q2

0 = 10Q2 - 8Q - 200Q + 850

0 = 10Q2 - 208Q + 850

Using quadratic formula

a = 10

b = -208

c = 850

Q
=
-b ± √b² - 4ac
2a


Q
=
208 ± √-208² - 4 x 10 x 850
2 x 10


Q
=
208 + 96.25
20
=
15.21 Units

Or

Q
=
208 - 96.25
20
=
5.59 Units

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QUESTION 5b

Q Examine five reasons for deteriorating terms of trade for developing countries.
A

Solution


Reasons for Deteriorating Terms of Trade in Developing Countries


  • Declining Commodity Prices: Developing countries often heavily rely on the export of primary commodities. Fluctuations and declines in global commodity prices can lead to a deterioration in the terms of trade.
  • Volatility in Global Markets: Developing countries may face challenges due to the unpredictable nature of global markets, leading to uncertainties in export earnings and terms of trade.
  • Dependency on a Few Exports: Countries overly dependent on a narrow range of exports are vulnerable to price fluctuations in those specific commodities, impacting the terms of trade negatively.
  • Terms of Trade Shocks: Sudden changes in the terms of trade, driven by factors such as geopolitical events, natural disasters, or changes in global demand, can adversely affect developing countries.
  • High Import Costs: Developing countries may face increasing costs for imported goods, including capital goods and technology, leading to a deterioration in the terms of trade as the prices of imports rise more than export prices.
  • Technological Disparities: Disparities in technological advancements between developing and developed countries can hinder the productivity and competitiveness of developing countries in the global market.
  • Debt Burden: High levels of external debt can exert pressure on developing countries, as they may need to allocate a significant portion of their export earnings to debt servicing, impacting the terms of trade.
  • Currency Fluctuations: Exchange rate fluctuations can affect the competitiveness of exports. Depreciation of the currency may improve terms of trade momentarily, but it can also lead to increased import costs.
  • Trade Barriers: Tariffs and non-tariff barriers imposed by developed countries can restrict market access for developing countries, limiting their ability to improve terms of trade through increased exports.
  • Global Economic Cycles: Deteriorating terms of trade can be linked to broader economic cycles, such as recessions or economic downturns in major trading partners, affecting demand for exports.
    •

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QUESTION 6a

Q (i) Describe the term "economic integration".

(ii) Highlight six factors that limit successful economic integration in developing countries.
A

Solution


(i) Definition of Economic Integration


Economic integration refers to the process by which different economies are unified or linked together through various means, such as trade, investment, and coordination of economic policies. It involves the removal or reduction of barriers to the free flow of goods, services, capital, and labor among participating countries.

(ii) Factors Limiting Successful Economic Integration in Developing Countries


  • Infrastructure Gaps: Insufficient infrastructure, including transportation, communication, and energy systems, can impede the smooth flow of goods and services, hindering economic integration.
  • Trade Barriers: Tariffs, non-tariff barriers, and restrictive trade policies can limit market access and hinder the free movement of goods among developing countries, reducing the effectiveness of economic integration.
  • Policy Misalignment: Divergent economic policies and regulatory frameworks among participating countries can create challenges in harmonizing strategies and hinder the success of economic integration initiatives.
  • Political Instability: Political instability and conflicts can disrupt economic activities, create uncertainties, and negatively impact the willingness of countries to engage in economic integration efforts.
  • Unequal Development: Disparities in economic development levels among participating countries may lead to unequal benefits from economic integration, potentially causing dissatisfaction and resistance.
  • Dependency on Few Exports: Countries overly dependent on a limited range of exports may face risks if those key exports are subject to market fluctuations, affecting the success of economic integration.
  • Exchange Rate Volatility: Fluctuations in exchange rates can create uncertainties for businesses engaged in cross-border trade and investment, impacting the stability of economic integration.
  • Limited Financial Resources: Insufficient financial resources and funding constraints may hinder the implementation of necessary infrastructure projects and collaborative initiatives, limiting economic integration.
  • Inadequate Institutional Frameworks: Weak institutional frameworks, including legal systems, regulatory bodies, and enforcement mechanisms, can create challenges in ensuring compliance and coordination within an integrated economic system.
  • Social and Cultural Differences: Social and cultural differences among participating countries may lead to challenges in achieving a shared vision, coordination, and cooperation in economic integration efforts.

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QUESTION 6b

Q Examine four advantages of currency devaluation to a country's economy.
A

Solution


Advantages of Currency Devaluation to a Country's Economy


  • Export Competitiveness: Currency devaluation can make a country's exports more competitive in the international market by lowering the prices of domestically produced goods and services in terms of foreign currencies.
  • Boost to Export Revenue: Increased competitiveness often leads to higher export volumes and revenues, as foreign buyers find the country's goods and services more attractive due to lower prices resulting from devaluation.
  • Trade Balance Improvement: A positive impact on the trade balance can be achieved as the increase in exports and the decrease in imports (due to higher import costs) contribute to a more favorable balance of trade.
  • Economic Growth: Enhanced export performance and a positive trade balance can contribute to overall economic growth by stimulating production, creating jobs, and attracting foreign investment in export-oriented industries.
  • Reduction in Trade Deficit: Currency devaluation can help reduce a country's trade deficit by making imports more expensive and curbing domestic demand for foreign goods, thereby narrowing the trade gap.
  • Debt Repayment Advantage: For countries with significant foreign debt, devaluation can make it easier to repay debt denominated in foreign currencies using the proceeds from increased export earnings in local currency terms.
  • Encouragement of Domestic Industries: Devaluation can provide a competitive advantage to domestic industries, fostering the growth of local businesses as consumers and businesses prefer domestically produced goods and services.
  • Employment Generation: The expansion of export-oriented industries and overall economic growth resulting from devaluation can lead to increased employment opportunities, reducing unemployment rates.
  • Boost to Tourism: A devalued currency can make a country more affordable for foreign tourists, potentially boosting the tourism sector and increasing revenues from tourism-related activities.
  • Adjustment in Current Account: Currency devaluation facilitates adjustments in the current account by making exports more competitive and imports relatively more expensive, helping to rebalance the external accounts.
    •

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QUESTION 6(c)

Q With the use of a diagram, illustrate the optimal point of a firm.
A

Solution


This diagram depicts the optimal point of a firm, which represents the level of output where total profit is maximized. This optimal point signifies the most efficient size for the firm, achieved when the long-run average cost is at its minimum.

At this point, there is no incentive for further expansion, as any deviation from this size, either larger or smaller, results in decreased efficiency. The firm's cost of production is illustrated to be at its minimum at this optimal point.


In the diagram below, OL represents a situation where total cost exceeds total revenue, indicating a loss for the firm. Point EL signifies the break-even point (BEP), where total revenue equals total cost, resulting in neither profit nor loss. The same applies to point EN.


Optimal Point Diagram

The maximum profit occurs where the vertical distance between total revenue and total cost is greatest. In the figure, point M represents the maximum profit, where AA is the largest vertical distance.

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QUESTION 7(a)

Q Enumerate seven roles of commercial banks in an economy
A

Solution


Roles of Commercial Banks in an Economy


  • Deposit Mobilization: Commercial banks mobilize deposits from individuals, businesses, and other entities, providing a safe place for people to store their money.
  • Loans and Credit: Banks extend loans and credit to individuals and businesses, facilitating economic activities such as investments, expansion, and consumption.
  • Payment Services: Banks offer various payment services, including checking accounts, savings accounts, and electronic fund transfers, facilitating transactions within the economy.
  • Financial Intermediation: Commercial banks act as intermediaries between depositors and borrowers, channeling funds from savers to those in need of capital for various purposes.
  • Interest Rate Determination: Banks play a crucial role in determining interest rates by setting rates on loans and deposits, influencing the overall cost of capital in the economy.
  • Creation of Money: Through the process of fractional reserve banking, commercial banks contribute to the creation of money by lending more than the actual reserves held.
  • Investment Banking: Some commercial banks engage in investment banking activities, including underwriting securities, facilitating mergers and acquisitions, and providing advisory services to businesses.
  • Safekeeping of Valuables: Banks offer safe deposit boxes and vaults for individuals and businesses to store valuable items such as documents, jewelry, and other assets securely.
  • Foreign Exchange Services: Commercial banks facilitate international trade by providing foreign exchange services, allowing businesses to engage in cross-border transactions.
  • Electronic Banking: Banks offer electronic banking services, including online banking, mobile banking, and ATM services, providing convenient and efficient ways for customers to manage their finances.
  • Financial Advice: Some commercial banks provide financial advisory services to clients, offering guidance on investments, retirement planning, and other financial matters.
  • Government Banking: Commercial banks often serve as bankers to the government, helping manage public finances, process payments, and participate in government debt issuance.
    •

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QUESTION 7b

Q (i) With a well labelled diagram, illustrate the concept of economic rent.

(ii) Explain how economic rent might be used as a good base for taxation
A

Solution


(i) Concept of Economic Rent - Diagram


Referring to the surplus income earned by factors of production owners beyond their anticipated or justifiable earnings according to market forces. Economic rent denotes an excess over the market price of the factor and is calculated as the the agreed price minus the free market price.

Economic Rent Diagram

(Note: This is a simplified representation)


(ii) Economic Rent as a Basis for Taxation


Economic rent refers to the surplus income earned by a factor of production (e.g., land, labor, or capital) that exceeds the minimum amount required to keep it in its current use. It is the payment for a resource above its opportunity cost.


Using economic rent as a basis for taxation: Economic rent represents income earned without the need for additional effort or cost. Taxing economic rent is considered efficient as it does not discourage productive activities or create distortions in the allocation of resources. It can be implemented through measures such as land value taxation, where the tax is levied on the unimproved value of land.


Land, being a fixed and inelastic factor, often generates economic rent. Taxing this rent can have several advantages:

  • Efficiency: Taxing economic rent does not distort incentives for production or investment since it represents surplus income beyond what is necessary to maintain the current use of the resource.
  • Equity: Taxing economic rent is often perceived as fair because it targets unearned income derived from natural resources or monopolistic advantages.
  • Land Use Optimization: Land value taxation encourages efficient use of land and discourages speculative holding of land without development, promoting optimal land utilization.
  • Stability: Economic rent is relatively stable and less sensitive to market fluctuations, providing a stable source of government revenue.

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QUESTION 7(c)

Q With the aid of a diagram distinguish between "actual economic growth" and "potential economic growth
A

Solution


Economic growth can be classified into "actual economic growth" and "potential economic growth." Actual economic growth represents the real increase in a country's output of goods and services over time, whereas potential economic growth is the maximum sustainable economic growth that an economy can achieve without causing inflation.

Actual vs Potential Economic Growth


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