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CPA
Intermediate Leval
Economics November 2020 Suggested Solutions

Economics
Revision Kit

QUESTION 1a

Q Explain four methods used by the government to stabilise agricultural prices. (4 marks)
A

Solution


Methods used by the government to stabilise agricultural prices

i) Increasing and stabilizing agricultural production;

ii) Regulating imports;

iii) Regulating exports;

iv) Encouraging agro-processing industries;

v) Building up buffer stocks;

vi) Ensuring procurement and public distribution;

vii) Regulating inter-regional movement of commodities;

viii) Rationing

ix) Expanding infrastructure

x) Improving the efficiency of the marketing system

xi) Fixation of maximum or ceiling price;

xii) Fixation of minimum floor price

xiii) Fixation of both maximum and minimum price

xiv) Fixation of an administered price

xv) Trainings about future shocks: This will enable farmers and producers to anticipate other potential shocks and respond quickly.

xvi) Diversification: To reduce the uncertainty in the livehood of the farmer.

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QUESTION 1b

Q Using sumable examples, differentiate between the following terms as used in economics

(i) "Basic human wants" and "secondary human wants". (4 marks)

(ii) Public good" and "merit good". (4 marks)

(iii) "Stable equilibrium" and unstable equilibrium". (4 marks)
A

Solution


(i) "Basic human wants" and "secondary human wants".

Basic human needs are essential needs in life and cannot be eliminated. This includes food, shelter and clothing. They have the following characteristics: they cannot be postponed, they feel needs, .... they are met before secondary needs, and they cannot be omitted.

Secondary needs are a prerequisite for a comfortable and luxurious life. Comfort is not only about survival, but also about needs such as education, medical care, and security. Luxury items include far more extravagant needs such as luxury cars, mansions, and study abroad.

(ii) "Public good" and "merit good".

A public good is a product for which consumption by additional consumers does not reduce consumption by existing customers for a given product i.e Laws, parks, streetlights, defense.

Merit goods are goods and services that the government considers to be under-consumed and are either subsidized or , must be provided free of charge at the time of use. i.e education and healthcare.

(iii) "Stable equilibrium" and unstable equilibrium".

Equilibrium is a point whereby forces of demand and supply are equal.

Stable equilibrium is the equilibrium that is restored when disturbed by external forces. Most economic models have a stable equilibrium, reflecting the observation that the real world adapts to change and maintains a reasonable degree of stability.

Unstable equilibrium refers to equilibrium where a slight disturbance evokes further disturbance so that the original position is never restored. In this case, there is a tendency for the object to assume newer and newer positions once there is a departure from the original position i.e cobweb model.

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QUESTION 1c

Q With the aid of a well labelled diagram, illustrate the effect of a simultaneous increase in the income of the consumer rease in fuel prices. (4 marks)
A

Solution




Effects

1. An increase in consumer's income(demand factor) increases demand for product due to increase in purchasing power of consumer denoted by shift of demand Curve from DoDo to D1D1

2. An increase in fuel prices(supply factor) will lead to shift of supply Curve to S1S1, from SoSo

3. All above will lead to an increase in equilibrium price from Po to P1

4. As regards equilibrium quantity, it's change depends on magnitude of change in price and income


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QUESTION 2a

Q (a) With the help of a diagram, discuss the concept of an individual engel curve as applied in the theory of consumer behaviour (5 marks)
A

Solution


Concept of an individual engel curve as applied in the theory of consumer behaviour.

➢ The engel curve for a good describes the relationship between income and the amount consumed holding everything else constant (including prices and their consumer's preferences)

➢ To graph an engel curve, measure income on the vertical axis and the amount consumed on the horizontal axis.

➢ For goods normal, an increase in income raises consumption, so the engel curve slopes upwards.



➢ For inferior goods, an increase in income reduces consumption, so the engel curve slopes downwards



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QUESTION 2b

Q Citing four examples, explain the significance of mobility of factors of production. (8 marks)
A

Solution


Significance of mobility of factors of production

Factor mobility refers to the ability to move production factors (labor, capital, or land) from one production process to another. Mobility may involve moving elements between companies within an industry. Movement of factors between sectors within a country and within liquidity may include movement of factors between countries within sectors or between sectors.

It has the following significance:

1. Mobility of labour helps improve work efficiency and as workers move to the occupations that best suit them..

2. Mobility of labour also makes Workers earn more as they move from low-paying jobs to high-paying jobs.

3. Labour mobility reduces unemployment problem when workers move to where they are wanted. When migrating from Dubai in search of greener pastures. 4.Labor mobility contributes to economic development as the unemployed move to public works such as dams, roads, canals and factories.

5 Mobility may also be deemed to be significant in that workers are occasionally allowed to perform various tasks and are capable of performing them, then they are less likely to experience the monotony often associated with specialisation attributed by its accompanying negative effects.

6 Mobility of factors of production enables the benefits of economic growth of a country to be spread evenly throughout.Many industries are located in urban areas primarily because of the urban market and economies of scale. If industries can be located in rural areas through incentives, then the benefits of industrial development in a particular country can be spread evenly.

7 Mobility enables different factor combinations to be made into use. For instances, more capital and labour can only be used if either of these factors is mobile to facilitate a change in the production techniques. This enables the producers to search for aleast cost method of production

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QUESTION 2c

Q A firm uses two factors of production, labour and capital in the long-run. The price per unit of labour is Sh.1,200 while the price per unit of capital is Sh.900. The firm has a budget of Sh.72,000 which it uses entirely on labour and capital to produce an output level of 500,000 tons

Required:
i) With the help of a diagram, derive the optimal point of the firm. (4 marks)

ii) Determine the firm's marginal rate of technical substition (MRTS) (3 marks)


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QUESTION 3a

Q three sources of monopoly power. (6 marks)
A

Solution


Sources of monopoly power

i). Exclusive Ownership and Control of Factor Submissions

ii). Market franchise: Refers to the exclusive legal right to deliver products or goods e.g. Kenya airways service before the coming of other commercial flights in kenya.

iii). Patent rights i.e. soft drinks like Coca-Cola, beer brands like guiness

iv). Natural monopoly which results from a minimum average cost of production.

v). Unrecoverable costs: The greater the cost of establishing a new business in an industry the more difficult it is to enter that industry. That cost will, in turn, be greater if the outlays required to start a business are unlikely to be recovered if the business. The potential for high sunk cost will contribute to the monopoly power of an existing firm by making entry by other firms more difficult.

vi). Location: Sometimes monopoly power is the result of location. For example, sellers in markets isolated by distance from their nearest rivals have a degree of monopoly power i.e Doctors,mechanics & professionals in isolated towns also be monopolists.

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QUESTION 3b

Q With the aid of a well labelled diagram, explain the equilibrium level of a firm operating under monopolistic market the long run. (6 marka)
A

Solution


Monopolistic competition is a type of imperfect competition in which many manufacturers sell differentiated products.



In the long run, a firm in a monopolistically competitive market produces a quantity of goods whose long-term marginal cost (LMRC) curve intersects marginal revenue (MR). Price (PL ) is set while the quantity produced (QL) falls on the average revenue curve (AR) hence the company break even over the long term.


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QUESTION 3c

Q Required: Determine the level of output and price to be charged for

(i) Domestic market (4 marks)

(ii) Foreign market. (4 marks)


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QUESTION 4a

Q (i) Determine the marginal propensity to save (2 marics)

(ii) Derive the equilibrium level of income and taxes. (6 marks)


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QUESTION 4b

Q Differentiate between "seasonal unemployment and frictional unemployment (4 marks)
A

Solution


Difference between "seasonal unemployment" and "frictional unemployment"

Seasonal unemployment occurs when factors such as deadlines or climate limit the need for one type of job during certain periods of the year. For example, in Kenya tourism workers are in high demand during the high season from July to September, after which most people are unemployed.

Frictional unemployment is the result of job migration within the economy. Frictional unemployment means that workers voluntarily lose their jobs while looking for a better job or moving for other reasons..

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QUESTION 4c-d

Q (c) Explain the term "economic planning".(2 marks)

(d) Highlight six characteristics of a good economic plan (6 marks))
A

Solution


(c) Explain the term "economic planning"

Economic planning is the process by which major economic decisions are made or influenced by a central government.

(d) Highlight six characteristics of a good economic plan

Characteristics of a good economic plan

• Definite objective: The most important feature of economic planning is having specific goals. Planning means conscious and considered action for a specific goal. For example, economic plans aim to accelerate the pace of growth, eliminate wheel cycles, create stability, and achieve full employment in the economy.

• Central planning authority: -The existence of a central planning authority is another feature of economic planning. This central planning authority is responsible for preparing various development plans and coordinating various activities. The central planning authority makes all decisions regarding production and consumption in the economy.

• Democratic behaviour: Another pioneering feature is its democratic character. The different plans are undoubtedly created by professionals, but at the same time they give ample opportunity for people to actively participate at different levels. As a federal structure in the Constitution of kenya, the federal government only uses its financial, monetary and physical controls to direct the Five Year Plan.

• Advisory function of the planning committee:The distributed structure of the plan, the planning committee is the top body. it provide the perspective, guidance, and alignment needed. In addition, it serves as a close link between various authorities to ensure smooth functioning. The Planning Committee is of an advisory nature.

• Comprehensiveness: Another key feature of the plan is its comprehensive scope. A central planning authority makes all decisions regarding production, consumption and distribution and therefore must have comprehensive coverage of the entire economy. In other words, planning must be effective so that planning in one sector is not invalidated by lack of planning in other sectors.

• Planned consumption: A centrally planned economy is not only limited to production, but must cover distribution and consumption at the same time. In other words, planning authorities shouldn't decide what to produce and how, but they should track it and decide accordingly who to distribute it to.

• Rational allocation of resources: Developing countries generally lack available resources and these resources are allocated in a way that maximizes social welfare. We need to set priorities in terms of economic development. In other words, resources should be distributed according to the priorities set. These scarce resources are used to eliminate waste in order to maximize social welfare, coordinate intersectoral and international planning into a single, unified entity, and promote the economic development of the economy. is also assigned.

• Feasible policies and targets: A good plan is based on the country's initial ability interms of resources to achieve its goals. Thus, domestic resources are planned to achieve economic stability.

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QUESTION 5a

Q (a) Enumerate four factors that determine the velocity of money in circulation(4 marks)
A

Solution


Factors that determine the velocity of money in circulation

Velocity of money refers to the average number of times a single unit of money changes hand in an economy during a given period of time

Factors affecting velocity of circulation include;

➢ Payment system: Affected by the frequency with which labour is paid (weekly, monthly,Quarterly) and how fast the bills for various goods are settled.

➢ Income regularity : The regularity of income enables people to spend their money more freely leading to a rise in velocity of circulation

➢ Frequency of transactions: As the number of transactions increases so does the velocity of money

➢ Money supply: and velocity of money are inversely proportional. If the money supply in an economy rises, then the velocity of money will fall short and vice versa

➢ Value of money

➢ Volume of trade

➢ Credit facilities available in the economy

➢Business conditions

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QUESTION 5b

Q (i) Explain the relationship between the multiplier and the accelerator. (4 marks)

(ii) Evaluate four benefits that might accrue to an economy as a result of accelerator effect (8 marks)
A

Solution


(i) Relationship between the multiplier and the accelerator.

The multiplier is a numerical factor that indicates how much your income increases with each increase in investment. It is the ratio of income change to investment change.

Multiplier = Change in income /Change in investment

The Accelerator show the response (impact) to changes in investment consumption. The idea behind accelerator is the functional relationship between consumer demand for commodities and demand for the machines that produce them. The acceleration factor is the ratio between induced investment and a certain net change in consumption.

(ii) Benefits that might accrue to an economy as a result of accelerator effect.

The accelerator interaction has profoundly increased our understanding of business cycles.

The accelerator principle indicates how changes in the level of current income will have an accelerated impact on the level of investment and is therefore one explanation of economic instability and the upward and downward swings of the trade cycle.

The Accelerator Interaction allows you to shine a light on one of the most important functions of your business cycle. A characteristic of this is that the capital goods industry is more volatile than the consumer goods industry. It helped show that small changes in demand in the consumer goods industry can lead to big, big changes in the industrial goods industry.

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QUESTION 5c

Q (c) Summarise four factors that might lead to an inward shift in the optimal point of a firm. (4-marks)
A

Solution


Optimal point of a firm
An optimum firm is one which operates at the lowest point of the long run average cost curve. Production at minimum point is considered optimum because society's resources are efficiently deployed at that point.

Factors that might lead to an inward shift in the optimal point of a firm

• Decrease in firm size

• Poor deterioration of technology used by firm

• Poor economic performance

• Subsidy cuts and taxation increases by the government

• Entrepreneur Inefficiency

• Decrease in quantity of factors of production like land and labour.

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QUESTION 6a

Q (a) Justify five reasons for differential interest rates in an economy. (5 marks)
A

Solution


Reasons for differential interest rates in an economy

• Market imperfection

• Risk differences

• Variation in demand and Sopply of money

• Loan duration

• Loan amount

• Financial position of the borrower

• Nature of security

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QUESTION 6b

Q With the aid of a diagram, describe the concept of liquidity trap. (4 marks)
A

Solution


Concept of liquidity trap



A liquidity trap is a situation in which expansionary monetary policy (increasing the money supply) fails to raise interest rates and stimulate economic growth. This is a situation where the general public is willing to hold any amount at any interest rate. They do this for fear of negative consequences such as deflation and war. In such cases, monetary policy cannot influence interest rates. There is a liquidity trap with short-term zero percent interest rates. When interest rates are zero, people don't want to hold bonds. This is because money has the advantage that it can be used for transactions even if the interest rate is zero.


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QUESTION 6c

Q Using suitable examples, provide three reasons for interest rate decontrol in an economy.(6 marks)
A

Solution


Reasons for interest rate decontrol in an economy.

• Leads to local currency appreciation.

• Higher interest rates discourage borrowing,this the money supply and help keep inflation under control.

• Governments generate tax revenue from increased investment and employment. This is because interest controls increase investment and employment hence interest rates increase investment and promotes job creation.

• It will lead to increased foreign investment which is an important source of foreign exchange in the economy.

• It will lead to an improvement in the country's balance of payments.

• Encourage investment in the banking industry.

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QUESTION 6d

Q Summarise five reasons that make it possible for commercial banks to create credit. (5 marks)
A

Solution


Reasons that make it possible for commercial banks to create credit.

• Market forces; Availability of profitable lending opportunities increase creation.

• Regulatory policies i.e. capital reserve requirements. A low reserve ratio means banks can loan out more.

• Availability of securities; refers to securities against which banks grant loan. Thus, availability of collateral is necessary for granting loan Otherwise, no credit creation takes place.

• Monetary Policy: Level of policy interest rates influence the aggregate demand for loans.

• Customer deposits: Deposits made by customers make credit available

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QUESTION 7a

Q Summarise six corrective measures that developing countries should institute to correct the persistent deficits in their balance of payments position.(6 marks)
A

Solution


Corrective measures that developing countries should institute to correct the persistent deficits in their balance of payments position

Investment in modern critical infrastructure to support companies and industries operating in international markets.

Investments in education and healthcare strengthen human capital, increase competitiveness in high-growth and high-value industries such as biotechnology, engineering, finance and health policy, thus help drive business creation and Successful SMEs with export potential.

Application of protectionist measures such as import quotas and tariffs.

Devaluation of a currency:the central bank may lower the exchange rate which helps improve competitiveness and making imports more expensive

Measures to boost productivity: Measures to promote innovation and encourage investment in industries with export potential and also aim to improve export performance and compete more effectively with imports. It is a measure on the supply side.

Cuts in government spending through demand management, interest rate hikes and tax hikes could all weaken consumer demand and reduce import demand. This increases free production capacity, which can be allocated for export .

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QUESTION 7b

Q (b) Discuss four policy recommendations that developing countries should institute to reduce regional imbalances in their economics.(8 marks)
A

Solution


Policy recommendations that developing countries should institute to reduce regional imbalances in their economies

• Transfer of resources from central government to county government, etc.

• Policies for development of irrigation, agriculture and related activities

• Measures for industrialization of underdeveloped areas through industrial location policies in which large-scale industrial parks are set up near small towns in underdeveloped areas, and all initial facilities are provided by the relevant national and local governments.

• Policies aimed at providing infrastructural facilities such as transport,communications, banking etc in underdeveloped areas.

• Special programs for the development of underdeveloped areas. Each region requires a separate development program, based on the region's social,cultural & techno-economic status .

• Security, law and order i.e. the influx of refugees in areas such as the northern parts of Kenya.

• Factor rewards,differentials i.e. different in wage compensation between different regions,hardship allowance for those working in designated hardship area etc.

• Comprehensive development plan and strategy.

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QUESTION 7c

Q Justify six reasons why external debt problems is a major policy issue in developing countries. (6 marks)
A

Solution


Reasons why external debt problems is a major policy issue in developing countries

• Local countries may suffer a downgrade of their original credit rating. For example, many sub-Saharan African countries are experiencing rising external debt ratios, making investors reluctant to lend at low interest rates.

• Rising debt may discourage foreign and private investment amid concerns that debt is unsustainable.

• Demand-side shocks that reduce GDP For example, conflicts and global recessions that affect demand and GDP.

• When a country struggles to pay interest, it may be tempting to borrow to make interest payments, but the problem can get worse and worse

• Unexpected exchange rate devaluation boosts real value of foreign currency debt interest

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