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CPA
Intermediate Leval
Economics November 2018 Suggested Solutions

Economics
Revision Kit

QUESTION 1a

Q Differentiate between "economic resources" and "non economic resources".
A

Solution


Economic Resources:

Economic resources, also known as scarce resources or productive resources, are the inputs or factors of production that have economic value and are used in the production of goods and services. These resources are limited in supply and have alternative uses.

The three main types of economic resources are:

a. Natural Resources:

These include all the resources that occur naturally and are used in the production process. Examples include land, water, minerals, forests, and oil. Natural resources can be renewable (e.g., solar energy) or non-renewable (e.g., fossil fuels).

b. Human Resources:

Human resources refer to the human capital available for economic activities. This includes the skills, knowledge, abilities, and labor of individuals involved in production. Human resources contribute to the production process by providing intellectual and physical efforts.

c. Capital Resources:

Capital resources, also known as physical capital, are man-made goods that are used in the production of other goods and services. They are produced through previous human efforts and include tools, machinery, buildings, infrastructure, and technology. Capital resources are used to enhance the efficiency and productivity of labor and natural resources.

Non-Economic Resources:

Non-economic resources, also known as free resources or free goods, are resources that are abundant and do not have economic value because they are not scarce and have no opportunity cost. These resources are not involved in economic activities or production. Some examples of non-economic resources include air, sunlight, gravity, and love.

Unlike economic resources, non-economic resources are not allocated through the price mechanism or considered in economic decision-making because their availability is not limited, and their use does not require trade-offs. While they may have value in other contexts, they are not considered economic resources in the traditional sense.

Summary

➦ Economic resources are scarce inputs used in production, including natural resources, human resources, and capital resources, while non-economic resources are abundant and do not have economic value as they are not scarce and have no opportunity cost.

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QUESTION 1b

Q (i) Explain the term "consumer sovereignty" as used in economics.

(ii) Outline eight factors that hinder consumers' sovereignty,
A

Solution


(i) Consumer sovereignty

Consumer sovereignty refers to the principle in economics that asserts that consumers have the ultimate power and control over what goods and services are produced in an economy. It emphasizes that consumer preferences and choices determine the demand for products, which in turn influences producers' decisions on what to produce and how to allocate resources. In a market economy, where consumer sovereignty is considered crucial, producers and businesses respond to consumer demand and strive to satisfy consumer preferences in order to maximize their profits.

Consumer sovereignty implies that consumers have the freedom to make independent choices based on their preferences, needs, and budgets. They have the power to determine the success or failure of products in the market by deciding whether to purchase or not. The concept recognizes that consumers, collectively, drive the market economy through their purchasing decisions and exert influence over the allocation of resources and the production of goods and services.

(ii) Factors that can hinder consumer sovereignty include:

➧ Limited Information:

Consumers may lack access to complete and accurate information about products and their qualities. Lack of information can impede consumers' ability to make well-informed decisions, limiting their sovereignty.

➧ Market Power and Monopoly:

When a few large companies dominate the market, they may have significant control over pricing, supply, and product offerings. This reduces consumer choice and can limit their sovereignty.

➧ Advertising and Manipulation:

Misleading or deceptive advertising practices can influence consumer choices by distorting preferences or providing biased information. Manipulative tactics can hinder consumers' ability to exercise true sovereignty.

➧ Externalities:

External factors, such as environmental or social costs, may not be reflected in the price of goods and services. This can limit consumers' ability to make choices that align with their values and preferences.

➧ Income Inequality:

Unequal distribution of income can restrict consumer choices by limiting purchasing power. When a significant portion of the population has limited resources, their options may be constrained.

➧ Cultural and Social Factors:

Societal norms, cultural influences, and peer pressure can influence consumer choices and limit their sovereignty by shaping preferences and behavior.

➧ Lack of Competition:

In markets with limited competition, producers may have less incentive to respond to consumer demands and innovate. This can restrict consumer choice and limit their sovereignty.

➧ Government Regulations:

Excessive or unnecessary regulations can limit consumer choices by imposing restrictions on certain products or services, reducing the range of options available.

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QUESTION 1c

Q Enumerate factors that determine the price elasticity of demand of a commodity.
A

Solution


The price elasticity of demand measures the responsiveness of the quantity demanded of a commodity to changes in its price. Several factors influence the price elasticity of demand of a commodity.

Some key determinants include:

➧ Availability of Substitutes:

The availability of close substitutes for a commodity affects its price elasticity of demand. If there are many substitutes available, consumers can easily switch to alternative products when prices change, making demand more elastic. On the other hand, if there are no close substitutes, demand tends to be inelastic.

➧ Necessity vs. Luxury:

The necessity or luxury status of a commodity influences its price elasticity. Necessities like food, medicine, and utilities tend to have inelastic demand because consumers need them regardless of price changes. Luxuries, such as high-end electronics or vacations, tend to have more elastic demand as consumers can easily reduce or eliminate their consumption when prices rise.

➧ Time Horizon:

The time available for consumers to adjust their behavior in response to price changes affects elasticity. In the short run, demand tends to be inelastic as consumers may have limited options to change their consumption patterns quickly. In the long run, demand becomes more elastic as consumers can adjust their habits, find substitutes, or change their preferences.

➧ Proportion of Income Spent:

The proportion of income spent on a commodity influences its price elasticity. Commodities that represent a small portion of consumers' budgets tend to have inelastic demand because even large price changes have a relatively small impact on purchasing decisions. Commodities that represent a significant portion of income tend to have more elastic demand as consumers are more sensitive to price fluctuations.

➧ Durability of the Commodity:

The durability of a commodity affects its price elasticity. Goods with a longer lifespan, such as furniture or appliances, tend to have more elastic demand as consumers can delay purchases when prices are high. Goods with shorter lifespans, such as perishable goods, may have inelastic demand as consumers need them regardless of price changes.

➧ Brand Loyalty:

The presence of strong brand loyalty can affect the price elasticity of demand. Consumers who are loyal to a particular brand may be less responsive to price changes and exhibit inelastic demand. In contrast, consumers who are not brand loyal may be more price-sensitive and exhibit more elastic demand.

➧ Income Level:

The income level of consumers can influence price elasticity. Low-income individuals tend to have more elastic demand as they have limited resources and are more price-sensitive. High-income individuals may have more inelastic demand as they can afford to pay higher prices without significantly changing their consumption patterns.

➧ Market Definition:

The way the market is defined can affect price elasticity. A narrow market definition, such as a specific brand or product variant, may have more elastic demand as consumers can easily switch to alternatives. A broader market definition may have less elastic demand as it includes a wider range of options with varying degrees of substitutability.

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QUESTION 1d

Q Highlight barriers to occupational mobility of labour.
A

Solution


Barriers to occupational mobility of labor refer to factors that impede or limit individuals' ability to transition from one occupation to another. These barriers can vary in nature and severity, but they generally hinder workers' flexibility and mobility in the labor market.

Below are some common barriers to occupational mobility:

➧ Lack of Skills or Education:

Inadequate skills or education can be a significant barrier to occupational mobility. If individuals do not possess the necessary qualifications or knowledge required for a different occupation, they may face challenges in transitioning to new roles.

➧ Occupational Licensing and Certification:

Some occupations require specific licenses or certifications, which can act as barriers to entry for individuals looking to switch careers. Obtaining these credentials may involve time, financial resources, and fulfilling specific requirements, making it difficult for workers to make a smooth transition.

➧ Industry-Specific Experience:

Certain industries value industry-specific experience, making it challenging for individuals without relevant experience to transition to new sectors. This can limit workers' options and force them to remain within their current industry.

➧ Geographic Constraints:

Geographic constraints can hinder occupational mobility. Limited job opportunities in a specific region or a lack of job openings in desired locations can make it difficult for workers to pursue new occupations.

➧ Age and Experience:

Age and experience can act as barriers to occupational mobility, particularly for older workers. Some employers may prefer younger or less-experienced individuals, perceiving them as more adaptable or less expensive to hire and train.

➧ Income Considerations:

Significant disparities in income between occupations can deter workers from switching to lower-paying jobs, even if they desire a career change. Financial obligations and the need to maintain a certain standard of living can restrict occupational mobility.

➧ Social and Cultural Factors:

Social and cultural factors, such as societal norms and expectations, can influence occupational mobility. Stigmas associated with certain occupations or pressure to conform to familial or community expectations can deter individuals from pursuing alternative careers.

➧ Lack of Information and Networks:

Limited access to information about different occupations and inadequate professional networks can impede workers' ability to explore and transition to new career paths. Networking and access to job opportunities play a crucial role in occupational mobility.

➧ Emotional and Psychological Factors:

Fear of the unknown, risk aversion, and personal attachments to a particular occupation can create emotional and psychological barriers to occupational mobility. Workers may be hesitant to leave their comfort zones or face uncertainty associated with a new career.

➧ Discrimination and Bias:

Discrimination based on factors such as race, gender, age, or ethnicity can create significant barriers to occupational mobility. Bias in hiring practices or unequal opportunities for advancement can limit workers' ability to switch occupations freely.

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QUESTION 2a

Q With the aid of an appropriate diagram, explain the concept of "shortage" as used in market equilibrium.
A

Solution


To explain the concept of "shortage" as used in market equilibrium, we can utilize a supply and demand diagram. The diagram illustrates the interaction between the quantity of a good or service that consumers demand and the quantity that producers are willing to supply at various price levels.



Shortage:

➦ If the price in the market is set below the equilibrium price (P1), it creates excess demand or a shortage. This means that at the prevailing price, the quantity demanded (Qd1) exceeds the quantity supplied (Qs1).

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QUESTION 2b

Q Discuss effects of price decontrol in an economy.
A

Solution


Price decontrol, also known as price liberalization or deregulation, refers to the removal of government-imposed price controls or restrictions on certain goods or services in an economy. This policy change can have various effects on the economy.

Effects of price decontrol:

➧ Increased Competition:

Price decontrol promotes market competition by allowing prices to be determined by supply and demand forces. In a deregulated environment, producers have more flexibility to set prices based on costs, market conditions, and consumer preferences. Increased competition can lead to improved efficiency, innovation, and better allocation of resources.

➧ Efficient Resource Allocation:

Price decontrol allows prices to adjust freely, enabling resources to flow to sectors and industries with higher demand and profitability. It encourages the reallocation of resources from less efficient or declining industries to more productive sectors, promoting economic growth and development.

➧ Enhanced Productivity and Investment:

Price decontrol provides incentives for producers to improve productivity and invest in new technologies, processes, and quality enhancements. With the potential for higher profits, businesses are motivated to innovate, reduce costs, and offer improved products or services to attract customers in a competitive market.

➧ Consumer Choice and Welfare:

Price decontrol expands consumer choice by enabling a wider range of products and services at varying price levels. It allows consumers to select from a more diverse array of options based on their preferences, quality requirements, and budget constraints. This increased choice can enhance consumer welfare and satisfaction.

➧ Market Stability:

Price decontrol can contribute to market stability by reducing price distortions and imbalances caused by government interventions. Market forces of supply and demand can more effectively adjust prices, leading to a smoother and more stable market environment. However, in certain cases, price decontrol may lead to short-term price volatility until the market reaches a new equilibrium.

➧ Efficient Allocation of Government Resources:

Price decontrol reduces the need for government resources and administrative efforts to enforce and manage price controls. The government can allocate its resources to other priority areas such as infrastructure development, public services, or social welfare programs.

➧ Potential Inflationary Pressures:

Price decontrol may introduce inflationary pressures in the short term, especially if prices were previously regulated below their market equilibrium levels. Removal of price controls can cause prices to rise as they adjust to market conditions. However, in the long run, market forces tend to regulate prices efficiently, and the impact on inflation should be temporary.

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QUESTION 2c

Q (i) The equilibrium price and quantity of commodity x.

(ii) The equilibrium price and quantity of commodity y.

(iii) Explain the nature of relationship between commodity x and commodity y.
A

Solution


(i) The equilibrium price and quantity of commodity x.

Equilibrium exists when quantity demand equals to quantity supplied

4 - Px + 0.5Py = -3 + 4Px

10 + Px - Py = -18 + 4Py

4Px + Px - 0.5Py = 7

5Px - 0.5Py = 7..............x 10

-Px + 5Py = 28..............x 1

50Px - 5Py = 70

-Px + 5Py = 28

49Px / 49 = 98 / 49

Px = sh 2,000

Therefore,

(50 x 2) - 5Py = 70

100 - 5Py = 70

5Py / 5 = 30 / 5

Py = sh 6,000

Equilibrium quantity commodity X

(-3 + 4 × 2) × 1000 =(-3 + 8) x 1000

5,000 units

(ii) The equilibrium price and quantity of commodity y

Equilibrium price Y sh. 6000

Equilibrium quantity Y

(-18 + 4 × 6) × 1000 =(-18 + 24) x 1000 6000 units

(ii) nature of relationship between commodity's and commodity y

Partial derivative Qdy with regard to Px

Qdy = 10 + Px - Py

ΔQdy / ΔPx = +1

Therefore commodity X and Y are substitutes due to positive slope

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QUESTION 3a

Q Summarise characteristics of capital as a factor of production.
A

Solution


Capital, as a factor of production, refers to the physical and financial resources used in the production of goods and services. It includes man-made inputs such as machinery, equipment, buildings, infrastructure, and financial assets.

Key characteristics of capital:

➧ Physical Form:

Capital is tangible and has a physical presence. It comprises physical assets that are utilized in the production process, such as machinery, tools, vehicles, buildings, and infrastructure.

➧ Human-Created:

Unlike natural resources, capital is created by human effort and is not naturally available. It is the result of previous production activities and investment in various forms of productive assets.

➧ Long-lasting and Durable:

Capital goods are generally durable and have a longer lifespan compared to other factors of production. They are intended to be used repeatedly over an extended period, contributing to the production process over time.

➧ Complementary to Labor:

Capital and labor are complementary factors of production. Capital goods are utilized alongside human labor to enhance productivity, efficiency, and output. Capital investments often aim to augment the capabilities and productivity of the workforce.

➧ Productive Capacity:

Capital represents the productive capacity of an economy. It enables the transformation of raw materials and inputs into finished goods and services, facilitating the production process and economic activity.

➧ Subject to Depreciation:

Capital goods experience depreciation or wear and tear over time due to usage and obsolescence. Depreciation represents the reduction in the value of capital assets over their useful life, reflecting the need for ongoing maintenance, repair, and replacement.

➧ Heterogeneous:

Capital is diverse and can take various forms depending on the industry, sector, or type of production. It includes both physical capital (machinery, equipment) and financial capital (money, stocks, bonds), which serve different roles in the production process.

➧ Investment Requirement:

Capital is typically acquired through investment. Businesses and individuals allocate financial resources to purchase or create capital goods, aiming to generate income, increase productivity, and enhance future production capabilities.

➧ Scalability and Accumulation:

Capital can be accumulated and scaled up over time. Through investment and savings, capital accumulation occurs, leading to increased production capacity and potential economic growth.

➧ Transferability:

Capital can be transferred between different uses and sectors of the economy. Capital mobility allows for reallocation to more productive areas and sectors based on changes in demand, technological advancements, or market conditions.

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QUESTION 3b

Q Examine applications of indifference curve analysis in an economy.
A

Solution


Indifference curve analysis is a graphical tool used in economics to analyze consumer preferences and choices. It provides insights into how individuals make decisions based on their preferences for different combinations of goods and services. While the primary application of indifference curve analysis lies in consumer theory, it has broader implications for various aspects of an economy.

Applications of indifference curve analysis:

➧ Consumer Behavior:

Indifference curves help economists understand how consumers make choices between different goods and services. By analyzing the shape, slope, and intersection of indifference curves, economists can determine consumer preferences, the trade-offs they are willing to make, and their willingness to pay for various goods. This analysis is fundamental to studying consumer demand, elasticity, and decision-making.

➧ Consumer Surplus:

Indifference curves assist in measuring consumer surplus, which represents the difference between what consumers are willing to pay for a good and the price they actually pay. By examining the area between the demand curve and the price line, economists can quantify the benefit consumers receive from purchasing goods at a lower price, thus estimating consumer surplus.

➧ Welfare Economics:

Indifference curve analysis is crucial in welfare economics, particularly when studying income distribution and equity. By comparing indifference curves of individuals with different income levels or social groups, economists can assess the impact of policies or interventions on their well-being. Indifference curves can help identify potential winners and losers and guide policymakers in designing equitable measures.

➧ Optimal Resource Allocation:

Indifference curves are used to analyze optimal resource allocation in the production process. By examining the marginal rate of substitution (MRS) between inputs, firms can determine the most efficient combination of inputs that minimizes costs while maximizing output. This analysis is essential for firms to achieve production efficiency and minimize wastage of resources.

➧ International Trade:

Indifference curve analysis plays a role in understanding international trade patterns and gains from trade. By comparing indifference curves of different countries, economists can examine the relative preferences and comparative advantages of each country in producing specific goods. This analysis helps determine the basis for trade and the potential benefits from specialization and exchange.

➧ Public Policy Analysis:

Indifference curve analysis provides insights into evaluating public policies and their impact on consumer welfare. It helps assess the consequences of price controls, taxes, subsidies, or regulations on consumer choices, market efficiency, and social welfare. Policymakers can use indifference curve analysis to make informed decisions about policy interventions.

➧ Economic Welfare Analysis:

Indifference curves are utilized to assess changes in economic welfare resulting from shifts in prices, incomes, or policies. By comparing pre- and post-intervention indifference curves, economists can quantify the gains or losses in consumer welfare and societal well-being. This analysis aids in evaluating the efficiency and equity implications of economic changes.

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QUESTION 3c

Q Discuss cases advanced by trade unions for increase in the wages of their members.
A

Solution


➧ Cost of Living:

Trade unions argue that wage increases are necessary to keep up with the cost of living. Inflation and rising prices erode the purchasing power of workers' wages over time. Unions may push for wage adjustments to ensure that their members' wages maintain their real value and allow them to meet their basic needs.

➧ Productivity Gains:

Trade unions often argue that if workers contribute to increased productivity, they should share in the benefits. When employees become more efficient or when technological advancements enhance productivity, unions advocate for higher wages as a fair reward for their members' efforts.

➧ Wage Parity:

Trade unions strive for wage parity or equity among workers in similar occupations or industries. They may demand wage increases to bridge wage gaps between different job categories or to address gender, racial, or other forms of wage discrimination. Unions advocate for fair and equal pay for comparable work.

➧ Labor Market Conditions:

Trade unions consider labor market conditions when demanding higher wages. If the demand for labor exceeds the supply, unions argue that higher wages are necessary to attract and retain skilled workers. They use the concept of supply and demand in the labor market to support their case for increased wages.

➧ Profitability of the Employer:

Unions may examine the financial health and profitability of the employer to justify wage increases. If a company is earning substantial profits or experiencing growth, trade unions argue that workers should share in the success by receiving higher wages. They believe that workers' wages should be commensurate with the company's financial performance.

➧ Fairness and Social Justice:

Trade unions often make arguments based on fairness and social justice. They highlight the disparity between the wages of workers and top executives or shareholders, pointing out income inequality. Unions advocate for a fair distribution of wealth and a living wage that allows workers to support themselves and their families.

➧ Minimum Wage:

Trade unions play a significant role in advocating for increases in the minimum wage set by the government. They argue that a higher minimum wage provides a decent standard of living and helps to reduce poverty among low-wage workers. Unions may engage in campaigns and negotiations to push for higher minimum wage rates.



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QUESTION 4a

Q Highlight characteristics of a mixed economic system.
A

Solution


A mixed economic system refers to an economic system that combines elements of both a market economy and a planned or command economy. It incorporates features of both capitalism and socialism, creating a hybrid system with a blend of market forces and government intervention.

Characteristics of a mixed economic system:

➧ Coexistence of Private and Public Sectors:

In a mixed economy, both the private sector and the public sector play significant roles. The private sector comprises privately owned businesses and industries that operate for profit, while the public sector consists of government-owned enterprises and services. This coexistence allows for a combination of market-driven activities and government intervention.

➧ Market-Based Allocation of Resources:

A mixed economy relies on market mechanisms to allocate resources and determine prices for goods and services. Supply and demand forces influence production decisions, consumer choices, and resource allocation to a considerable extent. The price system and competition play a vital role in guiding economic decisions.

➧ Government Regulation and Intervention:

In a mixed economic system, the government exercises regulatory powers to ensure fair competition, consumer protection, and the provision of public goods and services. The government enacts and enforces laws and regulations related to labor, environment, safety, and market conduct. It intervenes to correct market failures, address externalities, and promote social welfare.

➧ Income Redistribution and Social Welfare Programs:

One characteristic of a mixed economy is the presence of income redistribution programs aimed at reducing income inequality and providing social safety nets. The government implements policies such as progressive taxation, social security, healthcare, and public assistance programs to promote social equity and alleviate poverty.

➧ Public Ownership and Control:

The mixed economy includes public ownership and control of certain industries or sectors considered vital for the public interest, such as infrastructure, defense, utilities, and healthcare. These sectors are typically operated by government-owned enterprises or subject to significant government regulation.

➧ Private Property Rights and Entrepreneurship:

A mixed economic system recognizes the importance of private property rights and allows individuals and businesses to own and control productive assets. It encourages entrepreneurship, innovation, and risk-taking by providing a framework that protects property rights and enables individuals to reap the rewards of their efforts and investments.

➧ Economic Planning and Intervention:

Although market forces prevail, a mixed economy also involves some level of economic planning and intervention by the government. This may include macroeconomic policies to manage inflation, unemployment, and stabilize the economy. The government may also engage in strategic planning, infrastructure development, and industrial policies to guide and shape the direction of economic growth.

➧ Mixed Provision of Public Goods and Services:

A mixed economy combines both public and private provision of goods and services. While the private sector delivers most consumer goods and services, the government plays a role in providing public goods such as defense, education, healthcare, transportation infrastructure, and social services.

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QUESTION 4b

Q State advantages and disadvantages of a monopoly market structure in an economy.
A

Solution


A monopoly market structure refers to a situation where a single firm or entity has exclusive control over the supply of a particular product or service in a given market. While monopolies can offer certain advantages, they also come with several disadvantages.

Advantages of a Monopoly:

➧ Lack of Competitors:

A monopoly eliminates competition since it is the sole provider of a product or service in the market. This can provide the company with significant market power and the ability to set prices and control the market without worrying about rival firms.

➧ Potential for Economies of Scale:

A monopolistic firm can achieve economies of scale by operating on a large scale and exploiting efficiencies in production, distribution, and marketing. This can lead to lower average costs per unit of output, which may translate into lower prices for consumers.

➧ Research and Development (R&D):

Monopolies often have more resources and financial capacity to invest in research and development activities. With no immediate threat from competitors, they can allocate funds towards innovation, leading to the development of new and improved products or technologies.

➧ Stability and Long-Term Planning:

Monopolies can benefit from stability and predictability in the market. Without intense competition, they can focus on long-term planning, investment, and strategic decision-making, leading to more consistent operations and financial performance.

Disadvantages of a Monopoly:

➧ Higher Prices:

Monopolies have the power to set prices independently due to the lack of competition. In the absence of competitive pressure, they may charge higher prices for their products or services, leading to decreased consumer welfare and potential exploitation of consumers.

➧ Limited Consumer Choice:

Monopolies restrict consumer choice by offering a single option for a product or service. Consumers may have limited alternatives and may be forced to accept the monopolistic firm's offerings, even if they are dissatisfied with quality or pricing.

➧ Inefficiency and Lack of Innovation:

Without competitive pressure, monopolies may lack the incentive to operate efficiently or innovate. There is a decreased drive to reduce costs, improve quality, or develop new products since there is no immediate threat to their market dominance.

➧ Reduced Consumer Surplus:

Consumer surplus, which represents the difference between what consumers are willing to pay and what they actually pay, is often reduced in a monopoly. With higher prices and limited choices, consumers may experience lower overall satisfaction and a decrease in their surplus.

➧ Potential for Rent Seeking and Abuse of Market Power:

Monopolies can engage in rent-seeking behavior, using their market power to extract excessive profits or engage in anticompetitive practices. This can include predatory pricing, limiting supply, blocking entry of new competitors, or engaging in unfair trade practices.

➧ Lack of Market Innovation and Dynamism:

The absence of competition in a monopoly market structure can stifle market innovation and dynamism. Without the pressure to adapt and improve, monopolies may resist change, hindering progress and advancements in the industry.

➧ Socioeconomic Inequality:

Monopolies can contribute to socioeconomic inequality by concentrating wealth and power in the hands of a few individuals or companies. This can lead to unequal distribution of resources, reduced social mobility, and limited opportunities for smaller businesses or entrepreneurs.

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QUESTION 4c

Q The marginal propensity to save of a certain hypothetical economy is given as 0.25

Required:

The change in the equilibrium level of national income, if the level of investments for the economy increases by Sh.300 million.
A

Solution


To determine the change in the equilibrium level of national income, we need to use the concept of the multiplier. The multiplier represents the ratio by which a change in autonomous expenditure (such as investment) affects the equilibrium level of national income.

The formula for the multiplier is:

Multiplier = 1 / (1 - Marginal Propensity to Save)

Given that the marginal propensity to save is 0.25, the marginal propensity to consume (MPC) can be calculated as:

MPC = 1 - Marginal Propensity to Save
MPC = 1 - 0.25
MPC = 0.75

Using the formula for the multiplier, we can calculate:

Multiplier = 1 / (1 - 0.25)
Multiplier = 1 / 0.75
Multiplier = 1.3333 (rounded to four decimal places)

Now, to determine the change in the equilibrium level of national income, we multiply the change in investment by the multiplier:

Change in Equilibrium National Income = Change in Investment * Multiplier

Given that the change in investment is Sh.300 million, we can calculate the change in equilibrium national income:

Change in Equilibrium National Income = Sh.300 million * 1.3333
Change in Equilibrium National Income ≈ Sh.399.99 million (rounded to two decimal places)

Therefore, if the level of investments in the economy increases by Sh.300 million, the change in the equilibrium level of national income will be approximately Sh.399.99 million.

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QUESTION 4d

Q The maximum level of profit of the firm.
A

Solution


Total revenue TR = PQ

Q(140 - 2Q) = 140Q - 2Q²

Profit (π) = TR - TC

140Q² - 2Q² - (10 + 5Q²)

140Q - 5Q² - 2Q² - 10 = 140Q - 7Q² - 10

Δπ / ΔΟ = 140 - 14Q ................ (i)

140 - 14Q = 0

140Q / 14 = 140 / 14

Q = 10

Profit function = 140Q - 7Q² - 10

(140 x 10) - (7 x 10²) - 10

1400 - 700 - 10

690 x 1000 = Sh.690,000

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QUESTION 5a

Q Explain negative effects of a contractionary monetary policy in an economy.
A

Solution


A contractionary monetary policy is implemented by a central bank to slow down economic growth and control inflationary pressures. While its primary goal is to curb rising prices, there can be negative effects on the economy.

Potential negative effects of a contractionary monetary policy:

➧ Reduced Investment and Business Activity:

Contractionary monetary policy often leads to higher interest rates, which increases borrowing costs for businesses and individuals. Higher interest rates can discourage investment, as it becomes more expensive for businesses to finance new projects or expansions. This reduction in investment can result in decreased business activity, lower productivity, and slower economic growth.

➧ Lower Consumer Spending:

Higher interest rates resulting from a contractionary monetary policy can reduce consumer borrowing and increase the cost of borrowing for households. This leads to decreased consumer spending on items such as homes, cars, and other durable goods. Lower consumer spending can negatively impact businesses, leading to lower profits, job cuts, and economic slowdown.

➧ Decline in Housing Market:

Contractionary monetary policy can have a dampening effect on the housing market. Higher interest rates make mortgage loans more expensive, reducing affordability and dampening demand for housing. This can lead to a decline in home sales, a decrease in housing prices, and potential instability in the real estate sector.

➧ Negative Impact on Stock Market:

Contractionary monetary policy can affect the stock market negatively. Higher interest rates can make fixed-income investments, such as bonds, more attractive relative to stocks. This can lead to a shift in investor preference away from stocks, resulting in a decline in stock prices. A decrease in stock market values can impact investor confidence, reduce wealth, and affect consumer spending and business investment.

➧ Increased Unemployment:

The contractionary monetary policy can contribute to higher unemployment rates. When businesses reduce investment and decrease production due to higher borrowing costs, they may also reduce their workforce. This can lead to layoffs, job cuts, and increased unemployment. A contractionary policy that slows down economic growth can exacerbate the employment situation in the short run.

➧ Potential for Economic Recession:

If a contractionary monetary policy is too aggressive or implemented during a period of economic weakness, it can push an economy into a recession. The combination of reduced investment, lower consumer spending, declining housing market, and increased unemployment can create a downward spiral of economic activity, resulting in a recessionary environment.

➧ Impact on Government Budget:

Contractionary monetary policy can also have implications for government budgets. Lower economic growth, reduced tax revenue, and increased government spending on unemployment benefits can strain government finances. This can lead to challenges in managing fiscal deficits and meeting public expenditure commitments.

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QUESTION 5b

Q Outline limitations of adopting export promotion strategy in developing countries.
A

Solution


➧ Dependence on External Demand:

Export promotion strategies rely heavily on external demand for the country's goods and services. Developing countries may face challenges in accessing and maintaining export markets due to competition, changing global demand patterns, and trade barriers imposed by other countries. External factors beyond the control of the country can significantly impact export performance.

➧ Vulnerability to External Shocks:

Developing countries heavily reliant on exports can be vulnerable to external shocks and market fluctuations. Changes in global economic conditions, exchange rates, commodity prices, or geopolitical factors can have adverse effects on export revenues. Dependence on a narrow range of export products or markets can amplify the vulnerability to such shocks.

➧ Limited Diversification:

Export promotion strategies may result in limited diversification of the economy. Developing countries often focus on a few sectors or industries that have a comparative advantage in international markets. Over-reliance on a limited range of products can lead to risks, as a decline in demand or prices for those products can negatively impact the economy. Diversification is crucial to reduce vulnerability and promote long-term sustainable growth.

➧ Insufficient Domestic Market Development:

Overemphasis on export promotion can sometimes lead to neglect of the domestic market. While exports are important for economic growth, a strong domestic market is also essential for sustainable development. Neglecting domestic industries and consumer demand can create imbalances and hinder overall economic stability and social welfare.

➧ Negative Effects on Income Distribution:

Export-oriented industries in developing countries are often characterized by low-skilled labor and lower wages compared to other sectors. This can lead to unequal income distribution and contribute to income disparities within the country. The benefits of export promotion strategies may not trickle down to all segments of society, exacerbating social and economic inequalities.

➧ Infrastructure and Capacity Constraints:

Export promotion requires adequate infrastructure, logistics networks, and skilled human resources. Developing countries may face challenges in developing and maintaining the necessary infrastructure and building the capacity to compete effectively in global markets. Insufficient infrastructure can hinder export competitiveness and limit the potential benefits of export-oriented strategies.

➧ Environmental Concerns:

Export promotion strategies can put additional strain on natural resources and contribute to environmental degradation. Increased production for exports, particularly in resource-intensive sectors, may lead to unsustainable extraction or production practices. Developing countries need to balance economic growth with environmental sustainability and consider the long-term implications for natural resources and ecosystems.

➧ Trade Imbalances and Current Account Deficits:

While export promotion aims to generate export revenues, it can also contribute to trade imbalances and current account deficits. Developing countries heavily reliant on exports may experience a significant outflow of foreign currency to pay for imports, leading to imbalances in trade and the need for foreign borrowing. Sustained current account deficits can create challenges for macroeconomic stability and debt sustainability.

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QUESTION 5c

Q Using appropriate diagrams, analyse the following levels of output of a monopolist firm in the short-run period:

(i) The profit maximising level of output.

(ii) The loss making level of output.
A

Solution


(i) Profit-Maximizing Level of Output:

In the short run, a monopolist aims to maximize its profits by producing at a level where marginal revenue (MR) equals marginal cost (MC). The diagram below illustrates this situation:



In the diagram, the monopolist maximizes profit by producing the quantity where marginal revenue (MR) is equal to marginal cost (MC),taht is point Mp. This occurs at the output level where the MC curve intersects the MR curve. The corresponding price on the demand curve determines the price charged to consumers.The shaded region above, where the price (Pm) charged by the monopolist exceeds the average cost (AC), represents the area of supernormal profits earned by the monopolist firm.

(ii) Loss-Making Level of Output:

In some cases, a monopolist may face a situation where its average total cost (ATC) exceeds the price it can charge, resulting in a loss. The diagram below illustrates this scenario:



In the diagram, the monopolist is operating at a level of output where the average total cost (ATC) exceeds the price (P). As a result, the firm incurs losses. Shaded region represents the loss made by monopolist firm. The price charges is P which is less than the average cost (AC). In this case, the monopolist may continue producing in the short run as long as the price covers the variable costs (which includes the marginal cost). However, the firm is operating below its breakeven point and is making losses.

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QUESTION 6a

Q Suggest measures that developing countries could adopt to curb against high levels of urban unemployment.
A

Solution


➧ Promote Entrepreneurship and Small Business Development:

Encourage entrepreneurship by providing support and incentives for individuals to start their own businesses. This could include access to affordable credit, business development services, and simplified regulations and licensing processes. Small and medium-sized enterprises (SMEs) can be a significant source of job creation and economic growth.

➧ Enhance Skills Development and Training:

Invest in skill development and vocational training programs that align with the needs of the labor market. This can help equip individuals with the necessary skills and competencies to meet the demands of potential employers. Collaboration between educational institutions, private sector employers, and government agencies is crucial to ensure that training programs are relevant and effective.

➧ Improve Education System and Access:

Strengthen the education system by improving the quality of education and increasing access to education for all. This includes investing in primary, secondary, and tertiary education, ensuring that education is affordable and accessible to marginalized groups. A well-educated workforce is more likely to find employment and contribute to economic growth.

➧ Foster Investment in Labor-Intensive Industries: Encourage investment in labor-intensive industries that have the potential to create a significant number of jobs. This could involve providing incentives for companies to establish operations in sectors such as manufacturing, construction, agribusiness, and tourism. Targeted investment policies and infrastructure development can attract investors and promote job creation.

➧ Enhance Access to Finance:

Facilitate access to finance for individuals and small businesses to start or expand their ventures. This could involve establishing microfinance institutions, promoting financial inclusion, and creating special loan programs with affordable interest rates and flexible repayment terms. Access to finance can enable individuals to start their own businesses and generate employment opportunities.

➧ Strengthen Social Safety Nets:

Implement social safety net programs to provide support and protection for vulnerable individuals and families affected by unemployment. This can include unemployment benefits, cash transfer programs, job placement services, and training opportunities. Social safety nets can help mitigate the negative impacts of unemployment and provide a safety net for those in need.

➧ Promote Regional Development and Urban-Rural Linkages:

Encourage balanced regional development by promoting economic activities in rural areas and connecting them to urban centers. This can involve investing in rural infrastructure, agricultural development, and supporting rural enterprises. By creating opportunities and improving living conditions in rural areas, migration to urban areas for employment can be reduced, easing the pressure on urban labor markets.

➧ Strengthen Labor Market Institutions:

Develop and strengthen labor market institutions to ensure fair and transparent labor practices. This includes enforcing labor laws, promoting collective bargaining, and protecting workers' rights. Well-functioning labor market institutions can provide stability and security for workers, attract investment, and promote job creation.

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QUESTION 6b

Q Examine determinants of the level of national income of a country.
A

Solution


➧ Consumption:

Consumption expenditure by households is a significant determinant of national income. Higher levels of consumption generally lead to increased demand for goods and services, which drives economic activity and stimulates production. Factors influencing consumption include disposable income, consumer confidence, household debt levels, and cultural and social factors.

➧ Investment:

Investment expenditure, both by businesses and the government, plays a crucial role in determining national income. Investment involves spending on capital goods, infrastructure, research and development, and other productive assets. Increased investment leads to higher production capacity, technological advancements, and job creation, resulting in economic growth.

➧ Government Spending:

Government expenditure, particularly on public goods and services, has a direct impact on national income. Government spending on areas such as education, healthcare, infrastructure, and defense can generate economic activity and create employment opportunities. Expansionary fiscal policies, such as increased government spending, can stimulate aggregate demand and boost national income.

➧ Net Exports:

Net exports represent the difference between a country's exports and imports. The level of national income is influenced by international trade flows. Higher exports contribute positively to national income, while higher imports can reduce national income. Factors affecting net exports include exchange rates, trade policies, global economic conditions, and the competitiveness of domestic industries.

➧ Labor Market:

The state of the labor market, including employment levels, wages, and productivity, has a significant impact on national income. High employment rates indicate a productive workforce, contributing to increased output and national income. Factors affecting the labor market include labor market regulations, skills and education levels, technological advancements, and demographic factors.

➧ Productivity and Technology:

The level of productivity, determined by factors such as technological advancements, innovation, and efficiency, affects the overall level of national income. Higher productivity enables firms to produce more output with the same amount of resources, leading to economic growth and higher incomes. Investments in research and development, infrastructure, and human capital can enhance productivity levels.

➧ Macroeconomic Stability:

Macroeconomic stability, including factors such as low inflation, stable exchange rates, and sound fiscal and monetary policies, provides a conducive environment for economic growth and higher national income. Stable macroeconomic conditions reduce uncertainty, encourage investment, and promote business and consumer confidence.

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QUESTION 6c

Q Discuss disadvantages of adopting an import substitution strategy to control unfavourable balance of payments in a developing country.
A

Solution


Import substitution refers to a strategy adopted by developing countries to reduce their reliance on imported goods and promote domestic industries. While this approach aims to address unfavorable balance of payments, it also has several disadvantages.

Potential drawbacks of adopting an import substitution strategy:

➧ Reduced access to international markets:

Import substitution often involves implementing trade barriers such as tariffs and quotas to protect domestic industries. These protectionist measures can lead to retaliatory actions by other countries, reducing the developing country's access to international markets. This can result in reduced export opportunities and limit the growth of the domestic economy.

➧ Lack of competition and efficiency:

Protectionist policies can shield domestic industries from foreign competition. While this may initially protect local businesses, it can also reduce incentives for innovation, efficiency, and competitiveness. Without external competition, domestic industries may become complacent, leading to lower-quality goods and higher prices for consumers.

➧ Limited product variety and innovation:

By focusing on domestic production, import substitution strategies may limit the availability of imported goods. This can result in reduced product variety for consumers, limiting their choices and potentially stifling innovation. Without exposure to foreign products and ideas, domestic industries may struggle to keep up with global trends and advancements.

➧ Higher production costs:

Domestic industries may face higher production costs compared to foreign competitors due to factors such as limited economies of scale, higher input costs, and less advanced technology. This can make domestically produced goods more expensive, reducing their competitiveness in international markets and potentially leading to reduced exports.

➧ Resource misallocation:

Import substitution strategies often require significant government intervention, including subsidies, tax incentives, and protectionist measures. These policies can lead to resource misallocation, as the government may artificially support industries that are not economically viable or sustainable in the long term. This misallocation can hinder overall economic development and hinder the growth of more productive sectors.

➧ Dependence on domestic production:

Relying heavily on domestic production can make a developing country vulnerable to supply chain disruptions and shortages. If domestic industries fail to meet consumer demand or face production challenges, there may not be alternative sources of supply readily available. This dependency on domestic production can lead to higher prices, reduced product availability, and potential market inefficiencies.

➧ Potential for corruption and rent-seeking:

Import substitution strategies often involve significant government intervention, which can create opportunities for corruption and rent-seeking behavior. Industries may lobby for preferential treatment or seek to influence policy decisions to gain advantages over competitors. This can result in market distortions, reduced efficiency, and hindered economic development.

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QUESTION 7a

Q (i) Explain the term "hyperinflation" as used in economics. (ii) With the help of a diagram, describe demand pull inflation. (iii) Highlight causes of demand pull inflation in an economy.
A

Solution


(i) Hyperinflation

Hyperinflation refers to a rapid and uncontrollable increase in the general price level of goods and services in an economy. It is an extreme form of inflation characterized by extremely high and accelerating inflation rates, often exceeding 50% per month. In hyperinflationary conditions, the value of the currency rapidly declines, causing a loss of confidence in the currency and leading to a breakdown of the monetary system.

Hyperinflation is typically caused by a combination of factors, including excessive money supply growth, government deficits financed by money creation, loss of confidence in the currency, and supply-side shocks. It can have severe economic and social consequences, such as erosion of purchasing power, redistribution of wealth, hoarding of goods, distorted economic decision-making, and economic instability.

(ii) Demand-pull inflation

Demand-pull inflation occurs when the overall price level in an economy rises due to excessive aggregate demand. It is caused by an increase in consumer spending, investment, or government expenditure, which exceeds the economy's ability to produce goods and services.

The diagram below illustrates the demand-pull inflation process:



In the diagram, the aggregate demand (AD) curve shifts to the right from AD1 to AD2. This shift indicates an increase in total spending in the economy. As a result, the price level (represented on the vertical axis) increases from P1 to P2. The increased demand for goods and services puts pressure on prices, leading to inflation.

(iii) Several factors can contribute to demand-pull inflation in an economy:

➧ Increase in consumer spending:

When consumers have more disposable income or access to credit, they tend to increase their spending on goods and services. This increased consumption can drive up demand and result in inflationary pressures.

➧ Expansionary fiscal policy:

Government policies that increase government spending, reduce taxes, or implement welfare programs can boost aggregate demand. If the increase in government spending is not accompanied by a corresponding increase in production, it can lead to demand-pull inflation.

➧ Expansionary monetary policy:

When the central bank increases the money supply through measures like lowering interest rates or conducting open market operations, it stimulates borrowing and investment. This expansionary monetary policy can increase aggregate demand and potentially lead to demand-pull inflation.

➧ Investment and business optimism:

If businesses anticipate higher future profits or expect an economic boom, they may increase investment and expand production. This can generate additional demand for resources and put upward pressure on prices.

➧ Increase in exports or foreign investment:

A rise in exports or inflow of foreign investment can increase foreign demand for a country's goods and services. This external demand can boost overall aggregate demand and potentially lead to demand-pull inflation.

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QUESTION 7b

Q Analyse obstacles to industrial development in developing countries.
A

Solution


➧ Limited infrastructure:

Insufficient infrastructure, such as transportation networks, reliable power supply, and communication systems, can impede industrial development. Inadequate infrastructure increases production costs, reduces efficiency, and hampers the movement of goods and services.

➧ Lack of capital and investment:

Limited access to capital and investment is a significant obstacle for industrial development in developing countries. Insufficient funding restricts the establishment and expansion of industries, as well as investment in research and development, technology, and modernization of production processes.

➧ Limited human capital and skills:

Developing countries often face challenges related to education and skills development. A lack of skilled workforce, technical expertise, and managerial talent can hamper industrial growth and hinder the adoption of advanced technologies and innovation.

➧ Weak institutional framework:

Inadequate legal and regulatory frameworks, corruption, and bureaucratic inefficiencies can pose obstacles to industrial development. Unstable or unpredictable business environments, lack of intellectual property protection, and difficulties in contract enforcement deter investment and hinder the growth of industries.

➧ Market challenges and competition:

Developing countries may face limited market size and low purchasing power, which can make it challenging to achieve economies of scale. Additionally, competition from established industries in developed countries and emerging economies can pose significant challenges for local industries, particularly in global markets.

➧ Lack of technology and innovation capacity:

Limited access to advanced technologies, research and development capabilities, and innovation ecosystems can hinder industrial development. Without access to modern technologies, industries may struggle to improve productivity, upgrade production processes, and develop competitive advantages.

➧ Weak supply chains and logistics:

Developing countries often face challenges in building efficient and reliable supply chains. Issues such as poor transportation networks, inadequate storage facilities, and limited access to inputs and raw materials can disrupt production and increase costs.

➧ Environmental and sustainability concerns:

Industrial development can have adverse environmental impacts, such as pollution, deforestation, and depletion of natural resources. Balancing economic growth with environmental sustainability is crucial for long-term industrial development, but it can pose challenges in terms of regulatory compliance and the adoption of cleaner technologies.

➧ Lack of market diversification and over-reliance on primary sectors:

Many developing countries heavily rely on the export of primary products, such as agricultural commodities or raw materials, which can be subject to price volatility and external shocks. Diversifying into higher value-added manufacturing and service sectors can be challenging due to the aforementioned obstacles.

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QUESTION 7c

Q (i) The Gross National Product using the value added approach. (ii) Net Domestic Product at market price. (iii) Net Domestic Product at factor cost.
A

Solution


(i) The Gross National Product using the value added approach.

Sector Total output Intermediate purchases(Billions) Value added(Billions)
Agriculture
Manufacturing
Service
Gross national product		 55,000
96,000
71,000

 24,000
63,000
42,000

 34,000
33,000
29,000
93,000


Therefore GNP is sh. 93,000 billion

(ii) Net domestic product at market price

NDP = GNP - Depreciation

93,000 - 26,000 = sh. 67,000 billion

(iii) Net domestic product at factor cost

NDP at factor cost = GNP - Depreciation - Indirect tax

93,000 - 26,000 - 22,000 = 45,000 billion


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