CPA
Intermediate Leval
Economics November 2016 Suggested Solutions

Types of Price Controls:

• Price Ceilings: Maximum prices preventing prices from rising above a certain level.
• Price Floors: Minimum prices ensuring prices do not fall below a certain level.

Reasons for Price Controls in an Economy:

1. Consumer Protection: To prevent exploitation of consumers by limiting the prices of essential goods and services, ensuring affordability.
2. Inflation Control: To curb inflation by preventing rapid and uncontrolled price increases.
3. Income Stability: Price floors provide stability to producers' incomes, ensuring a reasonable return.
4. Market Stability: To avoid extreme fluctuations in prices that could disrupt the normal functioning of markets.
5. Social Equity: To promote fairness and social justice by making goods and services accessible to a broader population.
6. Emergency Situations: During crises, price controls may be imposed to prevent hoarding, profiteering, and ensure the availability of essential goods.
7. Monopoly or Market Power: To prevent monopolies or dominant market players from exploiting their position and charging excessive prices.
8. Public Goods: For goods and services deemed essential for public welfare, price controls may be implemented to ensure widespread access.
9. Externalities: To address negative externalities, such as environmental damage or health risks, by adjusting prices to reflect the true social cost.
10. Speculation: To curb speculative activities that could lead to artificial price increases and market distortions.

Advantages of a Controlled Market System:

1. Stability: A controlled market system can contribute to economic stability by preventing extreme fluctuations in prices and market conditions.
2. Consumer Protection: Regulations and controls can protect consumers from unfair practices, ensuring the availability and affordability of essential goods and services.
3. Social Equity: Controlled markets can promote social justice by addressing income inequality and ensuring access to basic necessities for a broader segment of the population.
4. Public Goods: Government intervention can ensure the provision of public goods, such as infrastructure and education, which might be underprovided by the private sector.
5. Monopoly Prevention: Regulations can prevent the emergence of monopolies or restrain the market power of dominant players, promoting fair competition.
6. Externalities Management: Controlled market systems can address externalities, such as pollution, by implementing regulations that internalize social costs and encourage responsible business practices.
7. Financial Stability: Regulatory frameworks can contribute to the stability of financial markets, preventing excessive risk-taking and speculative bubbles.
8. Long-Term Planning: Government intervention allows for long-term planning and investment in critical sectors, fostering sustainable economic development.
9. Employment Protection: Regulations can include measures to protect workers' rights and ensure fair labor practices, contributing to stable employment conditions.
10. Market Failures Mitigation: A controlled market system can address market failures, such as information asymmetry, to enhance overall market efficiency.

This concept is rooted in the economic principle of marginal utility, which measures the additional satisfaction gained from each additional unit of a good or service. The individual utility of a good or service varies among consumers based on their personal preferences. Typically, as consumers acquire more of a good or service, their willingness to spend diminishes due to diminishing marginal utility.

Diagram Description:

• Consumer Surplus:
  • The demand curve, represented by line AF, illustrates the consumer's willingness to pay and the utility gained from successive units of the commodity.
  • The market price, denoted by BC, is the amount consumers pay, leading them to purchase CE units.
  • The total utility derived by consumers from OC units is shown by the area CADC.
  • Consumers pay BCDE for this utility, resulting in the total consumer surplus, represented by the shaded area ABD.
• Producer Surplus:
  • Producer surplus is the difference between the amount a producer is willing to supply goods for and the actual amount received in the trade.
  • It serves as a measure of producer welfare.
  • In the diagram, producer surplus is represented by the region BCD above...

Factors Leading to a Rightward Shift of the Supply Curve:

1. Technological Advancements: The adoption of new technologies can enhance production efficiency, leading to increased output and a rightward shift of the supply curve.
2. Input Cost Reduction: When the costs of inputs such as labor, raw materials, or energy decrease, businesses can produce goods more affordably, causing a rightward shift in the supply curve.
3. Increased Productivity: Improvements in overall productivity, often through better management practices or employee training, can result in higher levels of output and a rightward shift in supply.
4. Favorable Weather Conditions: For industries related to agriculture or natural resources, favorable weather conditions can lead to abundant harvests, increasing the quantity supplied and shifting the supply curve to the right.
5. Government Subsidies: Subsidies or incentives provided by the government can reduce production costs for businesses, encouraging increased production and a rightward shift in the supply curve.
6. Expansion of Production Capacity: Investments in expanding manufacturing plants or facilities can increase a firm's ability to produce goods, causing a rightward shift in the supply curve.
7. Enhanced Infrastructure: Improvements in transportation, communication, and other infrastructure can facilitate smoother production processes, leading to increased supply and a rightward shift in the curve.
8. Introduction of New Suppliers: The entry of new producers or suppliers into the market can increase overall supply, contributing to a rightward shift in the supply curve.
9. Expectations of Future Prices: If producers anticipate higher future prices, they may increase current production to take advantage, causing a rightward shift in the supply curve.
10. Globalization: Access to international markets and global supply chains can provide businesses with new opportunities and resources, leading to an increase in overall supply.

1. Perfectly Competitive Labor Market: The theory assumes a perfectly competitive labor market where both employers and workers are price takers, and no individual or firm can influence the market wage rate.
2. Homogeneous Labor: It is assumed that all workers in the labor market are homogeneous, meaning they have identical skills, abilities, and productivity levels.
3. Perfect Mobility of Labor: The theory assumes perfect mobility of labor, implying that workers can easily move between different jobs or industries without incurring any costs or facing any barriers.
4. Fixed Capital Stock: The amount of capital in the production process is assumed to be fixed. Changes in the quantity of labor are the primary factor influencing changes in output.
5. Diminishing Marginal Returns: The marginal productivity theory assumes diminishing marginal returns to labor, meaning that as more units of labor are employed, the additional output produced by each additional unit of labor decreases.
6. Profit Maximization by Employers: Employers are assumed to be profit-maximizers. They will continue to hire additional units of labor as long as the marginal revenue product of labor (additional revenue generated by an additional unit of labor) equals the wage rate.
7. Full Employment: The theory assumes that the economy is operating at full employment, meaning that all available resources, including labor, are fully utilized.
8. Rational Behavior: Both employers and workers are assumed to be rational decision-makers, seeking to maximize their respective objectives, whether it be profit for employers or utility for workers.
9. Perfect Information: It is assumed that all market participants have perfect information about the productivity and wages in the labor market.
10. Static Analysis: The theory often relies on a static analysis, assuming that factors influencing productivity and wages remain constant in the short run.

1. Substitutability: The availability of close substitutes affects elasticity. If substitutes are readily available, demand tends to be more elastic as consumers can easily switch to alternatives.
2. Necessity vs. Luxury: Necessities often have inelastic demand because consumers are less responsive to price changes for essential goods. Luxuries, on the other hand, may have more elastic demand.
3. Proportion of Income Spent: The proportion of income spent on a commodity matters. Goods that represent a significant portion of a consumer's budget tend to have more elastic demand.
4. Time Horizon: Elasticity can vary over time. In the short run, demand may be inelastic, but it could become more elastic in the long run as consumers adjust their behavior and find alternatives.
5. Definition of the Market: The way the market is defined can influence elasticity. For example, demand elasticity may differ for a specific brand within a broader market.
6. Brand Loyalty: Products with strong brand loyalty often have inelastic demand as consumers are less likely to switch to alternatives, even with price changes.
7. Availability of Close Substitutes: The more substitutes available, the more elastic the demand. If there are no close substitutes, demand tends to be inelastic.
8. Elasticity along the Demand Curve: Elasticity can vary along the demand curve. Different price ranges may result in different elasticities due to changes in consumer behavior.
9. Perceived Necessity: If a commodity is perceived as a necessity, the demand may be less elastic as consumers are less responsive to price changes for essential items.
10. Habits and Preferences: Consumer habits and preferences can impact elasticity. Products integral to daily routines may have less elastic demand.

In the diagram above, the equilibrium quantity Q is established at the point where marginal cost is equal to marginal revenue (MC=MR). The firm sets the price based on the average revenue (AR) curve, reaching equilibrium at Point G. At this point, profits are maximized, with price P exceeding average cost (AC). The shaded region above represents the supernormal profits made by the monopolistic firm.

In the long run, the presence of free entry in monopolistic competition attracts new firms into the industry, eroding supernormal profits. The long-run equilibrium is depicted in the following diagram:

In the long-run equilibrium diagram, the firm still produces where marginal cost and marginal revenue are equal. However, the demand curve (MR and AR) has shifted due to increased competition from new entrants. The firm no longer sells goods above average cost and can no longer claim economic profits.

(ii) The equilibrium level of price and quantity of the product in market B.

1. Infrastructure Development: Invest in infrastructure such as transportation, energy, and communication to provide a solid foundation for industrial activities.
2. Investment Incentives: Offer tax incentives, subsidies, and other investment-friendly policies to attract both domestic and foreign investments in the industrial sector.
3. Education and Skills Development: Focus on improving the education and skills of the workforce to ensure a capable and skilled labor force that meets the needs of the industrial sector.
4. Research and Development: Encourage research and development initiatives to promote innovation, improve technology, and enhance the competitiveness of industries.
5. Trade Policies: Develop favorable trade policies to facilitate the export of manufactured goods and create market opportunities for domestic industries.
6. Access to Finance: Establish mechanisms to provide easier access to finance for industrial enterprises, particularly small and medium-sized enterprises (SMEs).
7. Regulatory Reforms: Streamline regulatory processes and reduce bureaucratic hurdles to make it easier for businesses to operate and expand in the industrial sector.
8. Cluster Development: Promote the formation of industrial clusters where related industries can benefit from shared infrastructure, resources, and knowledge.
9. Technology Transfer: Facilitate the transfer of technology from more advanced economies through partnerships, collaborations, or technology licensing agreements.
10. Environmental Sustainability: Implement policies that encourage environmentally sustainable practices within the industrial sector to ensure long-term viability and compliance with global standards.
11. Entrepreneurial Support: Provide support for entrepreneurs by offering training programs, mentorship, and access to resources to encourage the establishment of new industrial ventures.

If we connect all points of tangency, such as L, M, and N, with a line, this line is termed the expansion path or the output factor curve. The expansion path illustrates how the proportions of the two factors can be adjusted as the firm undergoes expansion.

Diagram: Expansion curve of a firm

1. Income Inequality: National income statistics may not reflect the distribution of income within a country. High levels of income inequality can skew the perception of overall standards of living.
2. Cost of Living Differences: Variations in the cost of living, including prices of goods and services, can significantly impact the purchasing power of income in different countries, affecting standards of living.
3. Non-Market Transactions: National income statistics may exclude non-market transactions, such as informal or subsistence economies, leading to an underestimation of economic activities and standards of living.
4. Quality of Life Factors: National income does not account for various quality of life factors such as healthcare, education, environmental conditions, and social amenities, which are crucial components of well-being.
5. Exchange Rate Fluctuations: Changes in exchange rates can distort the comparison of national incomes, as they impact the value of currencies and the conversion of income figures between countries.
6. Different Consumption Patterns: Variation in consumption patterns, cultural preferences, and lifestyle choices can affect how people experience their standard of living, even with similar income levels.
7. Informal Economies: National income statistics may not accurately capture economic activities in the informal sector, which is prevalent in many developing countries, leading to an incomplete picture of economic well-being.
8. Environmental Impact: Economic activities contributing to national income may have negative environmental consequences. Ignoring these impacts can result in an overestimation of the true standard of living.
9. Population Differences: Differences in population size and composition can affect the per capita calculations of national income, making it challenging to compare standards of living accurately.
10. Regional Disparities: National income statistics often mask regional disparities within a country. Concentration of wealth and development in specific regions can lead to an inaccurate representation of overall standards of living.

(ii) Interest Rates:

Brexit may influence interest rates in the UK. Central banks, such as the Bank of England, may adjust interest rates to stabilize the economy, control inflation, and support economic growth. The direction of these adjustments will depend on the overall economic conditions post-Brexit, including the performance of key sectors, inflationary pressures, and monetary policy goals.

(iii) Inflation Rate:

The impact on the inflation rate post-Brexit will be multifaceted. Changes in exchange rates, trade policies, and supply chain disruptions can contribute to inflationary pressures. Conversely, economic uncertainties and potential declines in consumer spending may act as deflationary factors. The overall effect on inflation will depend on how these opposing forces play out in the post-Brexit economic landscape.

(iv) Securities Exchange Market:

The securities exchange market, including stock markets, can experience fluctuations in response to Brexit-related developments. Changes in investor sentiment, trade agreements, and economic policies can influence stock prices. Industries particularly sensitive to trade relationships and regulatory changes may see more pronounced effects. Investors will closely monitor government policies, trade negotiations, and economic indicators for signals on the future direction of the securities exchange market.

It's important to note that the economic effects of Brexit are complex and depend on various factors, including the negotiated trade deals, regulatory frameworks, and the ability of the UK to adapt to its new economic environment.

(ii) The marginal cost of producing each level of output.

(iii) The maximum attainable profit.

• Interest Rates: Differentials in interest rates between countries can influence exchange rates. Higher interest rates in a country may attract foreign capital, increasing demand for its currency and raising its exchange rate.
• Inflation Rates: Countries with lower inflation rates often see appreciation in their currency value. Lower inflation preserves the purchasing power of the currency, making it more attractive to investors.
• Economic Indicators: Economic indicators such as GDP growth, employment rates, and industrial production can impact exchange rates. Strong economic performance tends to attract foreign investment and may lead to currency appreciation.
• Political Stability: Political stability and a predictable political environment attract foreign investors. Countries with stable political conditions are likely to have a more favorable exchange rate.
• Current Account Deficit/Surplus: The balance of payments, particularly the current account, influences exchange rates. A country with a surplus in its current account may experience currency appreciation, while a deficit may lead to depreciation.
• Government Debt: High levels of government debt may lead to concerns about a country's ability to meet its financial obligations, resulting in a depreciation of its currency.
• Speculation: Market speculation and expectations about future economic conditions can drive short-term fluctuations in exchange rates. Traders may buy or sell currencies based on anticipated movements in value.
• Trade Balances: Trade balances, including exports and imports, impact the demand for a country's currency. A trade surplus may strengthen the currency, while a deficit may lead to depreciation.
• Central Bank Interventions: Central banks may intervene in the foreign exchange market to influence their currency's value. Actions such as buying or selling currency can impact exchange rates.
• Market Sentiment: Overall market sentiment and perceptions of risk can influence currency values. Events such as geopolitical tensions or financial crises may lead to shifts in investor preferences and currency values.

1. Monetary Policy: The central bank formulates and implements monetary policies to regulate the money supply, interest rates, and credit availability to achieve economic objectives such as price stability and full employment.
2. Banker to the Government: The central bank serves as the government's banker by managing its accounts, facilitating transactions, and helping in debt management through the issuance and redemption of government securities.
3. Banker to Commercial Banks: Central banks act as a lender of last resort, providing financial support to commercial banks facing liquidity crises. They also regulate and supervise commercial banks to ensure stability in the financial system.
4. Control of Foreign Exchange Reserves: Central banks manage a country's foreign exchange reserves, intervening in the foreign exchange market to stabilize the currency's value and support international trade.
5. Issuance and Regulation of Currency: Central banks are responsible for issuing and regulating the country's currency. They ensure the security and integrity of banknotes and coins in circulation.
6. Conducting Open Market Operations: Central banks conduct open market operations, buying or selling government securities in the open market to influence the money supply and interest rates.
7. Financial Stability: Central banks play a crucial role in maintaining financial stability by monitoring and addressing systemic risks, ensuring the soundness of financial institutions, and implementing measures to prevent financial crises.
8. Implementation of Exchange Rate Policies: Central banks may be involved in managing the country's exchange rate, either through direct interventions in the foreign exchange market or through the adoption of specific exchange rate regimes.
9. Collection of Economic Data: Central banks gather and analyze economic data, including inflation rates, employment figures, and GDP growth, to make informed decisions and assess the overall health of the economy.
10. Consumer Protection and Financial Inclusion: Central banks may work to protect consumers by regulating financial products and services. They also promote financial inclusion, ensuring that a broad segment of the population has access to banking services.

1. Economic Diversification: Encourage economic diversification by supporting the growth of various sectors, reducing dependence on a single industry, and creating a more resilient job market.
2. Investment in Infrastructure: Implement infrastructure projects to stimulate economic activity, create jobs in construction and related industries, and enhance the overall competitiveness of the country.
3. Education and Skill Development: Invest in education and vocational training programs to equip the workforce with the skills demanded by the labor market, reducing the skills gap and improving employability.
4. Small and Medium-sized Enterprises (SMEs) Support: Provide support for SMEs, which are often major contributors to employment. This includes access to finance, training, and initiatives to foster entrepreneurship.
5. Labor Market Reforms: Implement reforms that enhance flexibility in the labor market, making it easier for businesses to hire and adapt to changing economic conditions.
6. Public Works Programs: Introduce public works programs to create temporary employment opportunities, particularly during economic downturns. This could include infrastructure maintenance, environmental projects, or community development initiatives.
7. Foreign Direct Investment (FDI) Promotion: Attract foreign direct investment by creating a favorable investment climate, offering incentives, and establishing policies that encourage multinational corporations to set up operations and create jobs locally.
8. Entrepreneurship and Innovation Support: Foster entrepreneurship and innovation through incentives, incubators, and support for research and development. Start-ups and innovative enterprises can contribute to job creation and economic growth.
9. Social Protection Programs: Implement social protection programs to provide a safety net for vulnerable populations, including unemployment benefits, to mitigate the impact of job losses and reduce poverty levels.
10. Trade Policies: Develop trade policies that promote export-oriented industries, as increased international trade can lead to the creation of new jobs and economic growth.

MV = PQ

• M: Money Supply
• V: Velocity of Money (the rate at which money circulates in the economy)
• P: Price Level
• Q: Quantity of Goods and Services

The Quantity Theory of Money suggests that, in the long run, changes in the money supply will lead to proportional changes in the price level. Here's how the relationship works:

1. Increased Money Supply: If the central bank increases the money supply without a corresponding increase in the demand for goods and services, individuals and businesses will have more money. This excess money can lead to an increase in spending.
2. Higher Spending: With more money in circulation, people may increase their spending on goods and services. This increased demand can, in turn, lead to higher prices for those goods and services.
3. Inflationary Pressure: The increased demand and spending, without a proportional increase in the supply of goods and services, create inflationary pressure. As prices rise, the purchasing power of money decreases, and inflation occurs.
4. Decreased Money Supply: Conversely, a decrease in the money supply, without a corresponding decrease in the demand for goods and services, can lead to reduced spending. This can result in deflationary pressures, with falling prices and decreased economic activity.
5. Central Bank Role: The central bank plays a crucial role in managing the money supply through monetary policy tools. By adjusting interest rates, open market operations, and reserve requirements, central banks aim to achieve price stability and control inflation.

This relationship emphasizes the importance of a well-managed money supply to maintain price stability and avoid excessive inflation or deflation in an economy.

Advantages of a Floating Exchange Rate System:

• 1. Automatic Adjustment: Floating exchange rates allow for automatic adjustments to changes in supply and demand for currencies. Market forces determine the exchange rate, facilitating equilibrium without the need for constant government intervention.
• 2. Absence of Speculative Attacks: In a floating system, there is less susceptibility to speculative attacks compared to fixed exchange rate systems. Speculators are less likely to target a currency when its value is determined by market forces.
• 3. Independent Monetary Policy: Countries with floating exchange rates have more flexibility in implementing independent monetary policies. Central banks can adjust interest rates to address domestic economic conditions without being constrained by the need to defend a fixed exchange rate.
• 4. Economic Stability: Floating exchange rates can contribute to economic stability by allowing countries to adapt to external shocks. Adjustments in the exchange rate act as a shock absorber, helping the economy absorb and recover from external disruptions more smoothly.
• 5. Trade Balance Adjustment: Floating exchange rates facilitate adjustments in a country's trade balance. If a country experiences a trade deficit, its currency may depreciate, making exports more competitive and imports more expensive, which can help correct the trade imbalance.
• 6. Market-Driven Efficiency: The market-driven nature of floating exchange rates encourages efficiency in resource allocation. Exchange rates reflect market conditions and information, guiding resources to areas where they are most needed and can be utilized most effectively.
• 7. Reduced Need for Foreign Exchange Reserves: Countries with floating exchange rates may have reduced dependence on maintaining large foreign exchange reserves to defend a fixed exchange rate. This can free up resources for other productive uses.
• 8. Market Discipline: Floating exchange rates subject countries to market discipline. Governments and policymakers are incentivized to adopt sound economic policies as deviations may lead to currency depreciation, impacting inflation and economic performance.
• 9. Hedging Opportunities: Participants in the foreign exchange market have opportunities to hedge against currency risk using financial instruments. This helps businesses and investors manage the uncertainties associated with currency fluctuations.
• 10. Avoiding Boom-Bust Cycles: A floating exchange rate system can help avoid boom-bust cycles that may be associated with fixed exchange rates. The flexibility allows for a more gradual adjustment to economic shocks, reducing the likelihood of severe downturns.

Key Characteristics:

• Market Determination: The exchange rate is primarily determined by the interactions of buyers and sellers in the foreign exchange market. Government or central bank interventions are limited, and the rate is allowed to adjust naturally.
• Absence of Fixed Peg: Unlike a fixed exchange rate system, where a country may peg its currency to another currency or a basket of currencies, a floating exchange rate system does not have a fixed value or target.
• Flexibility: The exchange rate can adjust in response to various factors, such as changes in economic conditions, inflation rates, interest rates, and trade balances. This flexibility allows for automatic adjustments to external shocks.
• Limited Central Bank Intervention: While central banks may intervene in the foreign exchange market from time to time to stabilize or influence the currency, such interventions are generally less frequent compared to fixed exchange rate systems.

Examples of Countries with Floating Exchange Rates:

Several countries around the world operate under a floating exchange rate system. Examples include:

1. United States (USD)
2. United Kingdom (GBP)
3. Japan (JPY)
4. Australia (AUD)
5. Canada (CAD)
6. Switzerland (CHF)

• Economic Instability: Developing countries often face economic instability due to factors such as high inflation, fluctuating exchange rates, and inadequate fiscal management, which can impede progress towards development goals.
• Poverty and Inequality: Widespread poverty and inequality pose significant challenges. Limited access to resources and opportunities for marginalized populations can hinder inclusive development and socioeconomic progress.
• Corruption: Corruption in both public and private sectors can divert resources away from development projects. It undermines effective governance, erodes public trust, and impedes the successful implementation of development plans.
• Political Instability: Political instability, including conflicts, civil unrest, and frequent changes in leadership, can disrupt development initiatives and create an unfavorable environment for sustained economic growth.
• Insufficient Infrastructure: Inadequate infrastructure, such as transportation, energy, and communication networks, can hinder economic activities and limit the potential for growth in various sectors.
• Education and Skill Gaps: Lack of access to quality education and skill development opportunities can result in a mismatch between the workforce's capabilities and the demands of a modern economy, limiting productivity and innovation.
• Health Challenges: Health issues, including high disease prevalence and inadequate healthcare infrastructure, can negatively impact workforce productivity and strain resources that could otherwise be allocated to development projects.
• Environmental Degradation: Unsustainable exploitation of natural resources and environmental degradation can have long-term consequences for development. Climate change and ecological imbalances pose additional challenges.
• Debt Burden: High levels of external debt can constrain fiscal space for investment in development projects. Repayment obligations may divert funds from essential services and infrastructure development.
• Global Economic Factors: Developing countries are often vulnerable to global economic trends, including commodity price fluctuations, trade barriers, and economic downturns in major economies, which can impact their economic stability and development efforts.

(ii) Net Domestic Product at Market Price

(iii) Net domestic product af factor cost