CPA
Intermediate Leval
Economics November 2019 Suggested Solutions

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Limitations of a planned economic system
A planned economic system is a system in which all major economic decisions are made by government ministries and planning agencies.

Limitations of planned economic system are:

• Consumers have no choice, only goods and services determined by the government are produced.

• Aggressive change may completely ignore society's needs hence compelling the development of ..... black markets and other coping strategies.

• The task of assessing available resources and deciding what to produce and how much to produce and how to produce and distribute may be too much for the Central Planning Commission.

• Maintenance of such a committee can be costly

• Lack of profit motive can lead to corporate inefficiency

• A lot of time and money is spent on communicating instructions from the government to companies.

• A command economy stifles innovation and rewards businesses who follows the policy. This does not allow companies to take the risks necessary to create new solutions.

• Commodity production does not always match demand, and poor planning often leads to rationing

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(i) Giving reasons, identify the demand function and the supply function.

Q = -10+6P... (i)

ΔQ/AP =6

Since the slope is positive, then the equation above is a supply function.......

Q = 20-4p ... (ii)

ΔQ/ΔP = 4

Since the slope is negative, then the equation above is a demand function

ii) (ii) Determine the equilibrium price and quantity.

Equilibrium arises where the quantity demanded equals to quantity supplied. -10+6=20-4P

6P+4P = 20+ 20

10P/10 = 30/10

P = Sh.3

Equilibrium quantity

Q = -10+6P Q-10+(6 x 3) =-10+18 = 8 units

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Fundamental economic issues that a society has to address to minimize the problem of scarcity of resources

• Economic growth is an increase in the ability to produce goods and services. The more ..... resources a society has, the more goods and services it produces and the more needs it can meet. This reduces scarcity and brings more happiness (more goods and services).

• Reducing Wants: If the society wants are limited then there would be less scarcity. Reducing wants is an option that societies have when dealing with scarcity.

• Using existing resources wisely: Societies can reduce scarcity by using the resources they have wisely

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Factors that lead to external economies of scale in an economy

• Economies of innovation: Many companies prefer to locate facilities near centers engaged in research and development of efficient production processes. Companies can quickly adapt to innovations developed at these centers to increase production efficiency and reduce costs. ......

• Supportive legislation: In politics, as an industry grows and becomes important to the region, it gains political bargaining power and local politicians seek favorable terms for local industries in the form of subsidies/tariffs.

• Transport links: If mining is concentrated in a particular region, better transport links will be developed to bring goods to market. So when a new company joins or an existing company expands, the existing infrastructure can be used to lower the average cost.

•Economies of concentration/Cluster effect. Suppliers can meet more buyers more efficiently if businesses are located in similar regions. For example, if you set up a phone company in the phone city area of china, you already have supplier and transportation links to trade with relevant aspects of the industry.

• Skilled labor: If similar businesses are established in a particular area, qualified workers are encouraged to seek jobs in that area. For example, Silicon Valley, a suburb of San Francisco, has become a hotspot for IT-related industry. That's what attracts IT professionals. Therefore, companies will spend less on hiring skilled IT workers

• Tax breaks: When a country's government cuts taxes on the production of a particular product or provides subsidies for the purchase of a particular raw material, it lowers production costs for all firms in that particular industry. This is another source of external economies of scale.

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Assumptions of law of variable proportions

States that as the quantity of a factor is increased while keeping other factors constant, the Total Product (TP) first rises at an incremental rate, then at a decremental rate and finaly the total production begins to fall.

The assumptions of law of variable proportions are:

....... 1. It is assumed that labor is a single variable factor

2. The various factors should not be used in strictly fixed proportions, but the law is based on the possibilities of various proportions - also called the law of proportionality.

3. It operates in the short run because in the long run, fixed inputs become variable.

4. It is assumed that all units of variable factors of production are homogenous in amount and quality

5. Some inputs must be kept constant

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Assumptions of consumer rationality

Consumer rationality theory assumes that consumers are rational. This means that consumers preference satisfies the following properties:

• They are continuous: No big jumps in the ranking of alternatives

• They are reflexive: This means each bundle is at least as good as itself .....

• They are transitive: This means that if bundle A takes precedence over bundle B and bundle B takes precedence over a third bundle C, the first bundle A will take precedence over bundle.

• They are complete:That is, given any set of possible bundles of goods, consumers can always decide which one they prefer over the other, and rank them in terms of preference.

• Preferences are monotonic, or "more is preferred to less", This is a set of two bundles, one of which contains at least all the products, and one contains more products than the other, the first bundle will outperform the second and also take precedence..

• Preferences are convex: That is, any combination of two equally preferred bundles is preferred over these bundles.

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(i) The revenue function of product "R"

Linear revenue function

Q=a-bq

20 = a - 600q... (i)
70 = a - 500q... (ii) ......

100Q/100 = 50/100

Q = 0.5

20 = a - (600 x 0.5)

20 = 3-300

a= 320

∴ Price Function
P = a-bq

Total revenue = PQ

Q(320-0.5Q)

Q(320-0.5Q)

= 320Q -0.5Q²

ii) The profit earned at equilibrium

Equilibrium will occur at a point where marginal revenue equals to marginal cost

Marginal revenue (MR) = ΔTR/ΔQ = 320-Q

Marginal cost (MC) = ΔTC/ΔQ = 320-Q 1.8Q - +30

320-Q = 1.8Q +30

1.8Q+ a = 320-30

2.8Q/2.8 = 290/2.8

a = 103.57 units

Profit function = TR-TC

320Q-0.5Q² -(0.9Q² +30Q+1000)

=320Q-30Q-0.5Q -0.9Q²-1000

2900-1.40-1000 Profit made at equilibrium point (290 x 103.57)-1.4 x 103.572) - 1000

=Sh. 14,017.9

iii) The equilibrium price

P = 320 - 0.5Q

320 -(0.5 x 103.57) = Sh. 268.215

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• An increase in per capita income can lead to a decrease in overall quality of life. Working conditions may be deteriorating. The environment can suffer in the form of pollution. These non-monetary aspects are not taken into account in gross national product estimates ......

• National income may be growing, but that says nothing about the distribution of that income. Other groups may have static living standards or even worse circumstances.

• The composition of production may change. i.e. more military products will be produced, less spending on social services, more capital goods will be produced, less consumer goods, and there may be an export surplus on imports representing foreign investment . Living standards depend on the amount of consumer goods consumed.

• Prices change over time. The retail price index can be used to represent real gross domestic product, but there are problems with using such a method.

• National income increases when people pay for services they used to provide themselves. If a full-time housewife gets a clerical job and has someone else do the housework, the national income will be increased by the income of both people. Similarly, if a man painted his own house instead of paying a professional painter to make the same type of alterations above, there could be a reduction in national income.

• Regional differences in income and spending: National data can hide regional differences in output, employment and per capita income.

• Changes in life expectancy: Improvements in life expectancy are not always reflected in GDP accounts. The benefits of longevity are difficult to quantify in monetary terms.

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Methods that could be used to measure the national income of a country

• Income method: This method measures national income at the distribution stage, and is shown as the income paid or received by individuals in the country. With this method, national income is ....... derived from the sum of the incomes of all people in the country. Individuals earn income by donating their own services and the services of property such as land and capital to the country's production.

• Value added approach. This is also called the output method. Total contributions from different economic sectors are summed up.

• Expenditure approach:This approach focuses on the components of final demand that produce output. In other words, it measures Gross Domestic Product. As the total expenditure on final goods and services produced in the economy.

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Aggregate spending at equilibrium level

Y = C+I+G+X-M

Where: C - consumption

I - Investment expenditure

G - Government expenditure .......

X-M = Net exports

Therefore, Aggregate spending at equilibrium level

Y = 200+ 0.8Y+ 400

Y = 600+ 0.8Y

Y -0.8Y = 600

0.2Y/0.2 = 600/ 0.2

Y = Sh 3000 billion

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Benefits of a contractionary monetary policy to an economy

• The main purpose is to slow economy. inflation that accompanies a booming economy ......

• Stabilizing prices: Inflation causes prices to rise, which can adversely affect consumers' purchasing power. These price fluctuations can make consumer spending behavior unsettling and unpredictable. Tight monetary policy stabilizes market prices when inflation falls. This surge in consumer confidence is keeping the economy in balance and supporting government spending patterns.

• Conflicting monetary policies cause bond prices to fall and interest rates to rise. Demand for domestic borrowing increases lending to foreign capital inflows as higher interest rates make domestic borrowing more attractive.

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Factors that determine the level of induced investments in an economy

Determinants of induced investment in an economy ......

Population growth

Inventions and innovations

Political stability

Consumer demand

Existing stock of capital

Initial cost of capital goods and its useful life.

Government.

Rate of interest:

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Positive economic effects of a prolonged fall in the value of money in an economy

Inflation and lower real expected returns also weakens the currency, potentially helping trade.......

Inflation provides governments a mean of diminishing the value of historically issued long-term government debt, reducing debt/GDP.

To the extent that tax bracket don't keep up with inflation (they generally lag), inflation also increases government inflows, as people "creep" into higher tax rates due to inflation despite the fact their purchasing power may be unchanged.

Inflation diminishes the real value and returns of long-term fixed income assets, which are generally held by the wealthy and institutions. However employees and borrowers get increases in nominal wealth, which if they keep pace with inflation hold workers flat. So inflation, reduces wealth inequality to some extent

During inflation, businesses have an opportunity to earn good profits Therefore, people who invest in shares during inflation tend to gaia the businesses earn higher profits, they usually distribute the profit among investors and shareholders too.

It helps prevent deflation: deflation can cause an increase in the real debt burden and discourage spending and investment. Deflation was a factor in the great depression of the 1930's in the U.S.A. better investment returns: during, inflation, investors and entrepreneurs receive added incentives for investing in productive activities. Therefore, they receive better returns.

Increase in production: once the producers receive the right investment, they create more goods and services. Hence inflation leads to an in production of products/services.

More employment and better income since production increases, there is an increased demand for the various factors of production, including man power. Therefore, employment and income increases during inflation.

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Reasons against international trade restrictions

- Restrictions on international trade lead to the creation of monopoly power among the few firms in the industry. This is likely to come at an exorbitant price........

- Restrictions on international trade can affect healthy competition among companies within the industry. Only a few companies are allowed to produce goods.

- International trade restrictions could face resistance from unprotected businesses who feel economically marginalized

- In the short term, restrictions on international trade may encourage low levels of production, leading to shortages of goods in markets.

- Restrictions on international trade limit the range of products consumers can choose from in the market, thus limiting consumer sovereignty or choice.

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Functions of World Trade Organisation (WTO)

The world trade organization is an intergovernmental organization dealing with the rules of trade between nations.........

Its main functions include:

• Administering WTO trade agreements

• Providing a forum for trade negotiation

• Handling trade disputes

• Monitoring trade policies

• Providing technical assistance and training for developing countries

• Ensuring cooperation with other international organizations

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i) Case for foreign directs investment

➢ Foreign direct investment facilitates risk-taking for entrepreneurs in less developing countries(LDCS) as they become interested in investing in LDCS...........

➢ Increased productivity in companies run by foreign entrepreneurs and managers also means higher wages for workers. Foreign direct investment therefore helps raise the real wages or real purchasing power of the host country's working class.

➢ Rise in real wages: A situation in which new businesses, through foreign investment, increase demand for skilled and other categories of workers, leading to higher real wages. Foreign investors may secure the services of special categories of workers from their home country. Without exception, they receive higher wages. Local workers acquire similar skills and training, and can earn higher wages.

➢ Job Creation: The establishment of new companies and the diversification of activities by foreign investors are contributing to the creation of more and more employment opportunities in the LDCS. This will increase income and alleviate poverty.

Greater Tax Revenues: In LDCS, foreign investor activity leads to production and profit generation through taxation of profits, production and exports, allowing governments to generate greater tax revenues that can be diverted to implement development program.

➢ Risk borne by foreigners: investment activity in LCDS is still restrained due to the high risk ratio. Because local capitalists are risk averse. The investment process remains blocked. Foreign investors will take risks and contribute significantly to the further industrialization of LCDS.

➢ Higher social benefits. The value added from foreign direct investment will always be higher than the return on foreign investment. This means that the social returns of FDI are greater than the personal returns.

➢ Efficient control and Management: In the case of foreign direct investment, the control and management of the company is assumed by the foreign investor. Our expertise in foreign investor management and policy making persists in both domestic and external economies. A large influx of foreign direct investment can indeed greatly improve industrial efficiency.

➢ Reinvestment of Profits: A portion of the foreign investors' profits will be reinvested to fund the expansion of the modernization programme. In this way, the country can sustain higher investment rates and capital formation.

ii) Case against FDI

➢ An emergency against monopolies: Companies founded by foreign investors drive local competitors out of the market.they also obtain patent rights for products and processes. They slowly develop into powerful monopolies and exploit the host country.

➢ Political control: Foreign investors, after controlling several key sectors of LCDS, begin to interfere in their economic and political decision-making. They determine the terms that may benefit the home country more than the host country.

➢ Domestic capital and corporate dismay: Foreign direct investment has a disheartening effect on domestic capital and businesses as more profitable investment opportunities are seized by foreign investors and domestic entrepreneurs are severely demoralized. Already shy domestic capital cannot find suitable investment opportunities.

➢ No technology transfer. LDCS hopes that foreign investment will transfer the latest production techniques and technical know-how to host countries. In fact, the production techniques used by foreign companies are closely guarded by them. They do not allow indigenous entrepreneurs access there. Obsolete plants and equipment are sometimes transferred to LDCS in the form of turnkey projects.

➢ No skill development. FDI aims to help workers upskill by providing training opportunities in advanced and modern technologies , however foreign companies have shown little interest in providing training opportunities for local workers. Some junior and intermediate level routine posts are offered to local workers. All managerial and technical positions are reserved for home country personnel.

➢ Economic Exploitation: FDI is responsible for the exploitation of LDCS human and natural resources and markets. Manufactured goods are exported by foreign investors to their home countries at very low prices. These products, with or without processing, are re-exported to third countries at very favorable prices. In addition, there are regular repatriations of capital and transfers of profits to the home country by foreign investors.

➢ High costs: To attract foreign investors to large-scale investments, host countries have to bear high costs in terms of providing land, hydropower, transportation and communication facilities. In addition, concessions such as development rebates, undistributed earnings rebates, additional depreciation concessions, subsidized working capital supplies, and tax exemptions for certain periods are permitted. Therefore, the cost of foreign direct investment in LDCS will undoubtedly be higher.

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Reasons of inequalities in the distribution of income and wealth in an economy

Inequality can arise from differences in:-

➢ employment.........

➢ Pension rights

➢ Skills and training

➢ Education, school, college, degree

➢ Inheritance

➢ Experience/age

➢ Ownership of financial assets

➢ Type of job

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Benefits of development planning in an economy

A development plan is defined as the government's use of a coordinated set of policy instruments to achieve a desired goal within a specified time frame.
The advantages of development plans are:.........

➢ Discussion of resource mobilization and allocation means the plan assists in selecting and coordinating investment projects and investing in more profitable ventures.

➢ Attitudes or physiological arguments,development plans help governments identify sectors in national campaigns to eradicate poverty. Ignorance and disease among social groups, races, tribes and religious groups.. .

➢ Foreign aid argument:The existence of detailed development plans is used by governments to persuade and persuade donors to provide assistance.

➢ Market failures make a big difference between public and private valuations of alternative investment projects. The development plan thus results in the optimal allocation of resources in the country.

➢ Due to disrupted commodity and factor markets that can contribute to poor resource allocation. But the development plan avoids all these discrepancies.

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Distinction between "depreciation of a currency" and "demonetization of the currency"

➢ In a system with floating exchange rates, depreciation ...... refers to a decline in a currency's value. Economic fundamentals, interest rate differences, political unpredictability, or investor risk aversion are a few examples of the causes of currency depreciation.

➢ Demonetization is the process of robbing a currency of its status as legal tender. It happens each time the national currency is changed. The current form of money is removed from use and retired, frequently to be replaced with new bills or coins.

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Effects of demonetization of the currency:

➢ Decrease in money supply in the short run

➢ As there won't be any investments, the rate of capital form action growth will...... decrease.

➢ It will increase taxation business.

➢ Short-term downturn in the real estate, building materials, textile industries etc.

➢ It produces a more favorable business climate, less corruption, and transparency.

➢ Less currency in circulation will reduce inflation in the short run

➢ The reduction in consumption demand will have an impact on GDP formation.

➢ Employment growth and tax revenue from production.

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