Kasneb Economics revision questions and answers

This revision questions applies to:

Certified Public Accountants (CPA)
Certified Secretaries (CS)
Certified Credit Professionals (CCP)
Certified Investment and Financial Analysts (CIFA)

Question one

The following economic functions have been derived by the Finance Manager of the Kenya Tea Limited:
Qa = 3p2 – 4p and
Qb = 24 – p2; where p represents price and Q is quantity

Required:
a) i) Which of the two functions represents a demand curve, supply curve and why? (4 marks)

Answer

 

ii) At what values of price and quantity is the market in equilibrium? (6 marks)

Because of the exponential nature of the functions, the 1st step of distinction is to find the 1st order derivatives of the functions such that:

NB: There are four approaches/alternatives of distinction:-

1) Direction of change between Q & P given by the signs of the coefficient of the  independent variable (P): Its positive for supply functions since supply is an increasing function of price; negative for demand functions since demand is a decreasing function of price. Therefore since the co-efficient of the independent variable (P) in function Qa = 3p– 4P given by its derivative (dQa/dP = -4 + 6P) is positive (i.e. +6) then this function (Qa = 3P2– 4P) represents a supply curve. Similarly, dQb/dP = – 2P with – 2 being the
coefficient of P thus function Qb = 24 – Prepresents the demand curve.

2) X & Y intercepts: For supply functions the Y intercept is negative and X intercept is positive; for demand functions its positive for the Y intercept and negative for the X intercept.

3)

Random(P): 1 2 3 4 5
Qa = 3P–4P -1 4 15 32 55
Qb = 24 –P2 23 20 15 8 -1

 

b) Explaining with the aid of diagrams the effect on the demand and supply  functions indicated in (a) above of a simultaneous fall in costs of production and an increase in the price of a complementary good.  Complementary goods are goods which are used jointly (eg cars and petrol) such that the demand for one is a decreasing function of the price of another implying that the cross elasticity of demand (for complementary goods) is negative.

Decrease (fall) in cost of production has an effect of reducing the final product prices by increasing supply represented by a downward and to the right shift of the supply curve (from S0S0  to S1 S1 )

Quantity of petrol

An increase in price of a complementary good has an effect reducing demand represented by a downward shift of the demand curve from D0 D0 to D1 D1

Quantity (petrol)

In this case, however, the fall in cost of production is accompanied by an increase in price implying that the ultimate equilibrium will depend on the magnitude (proportion) of the fall in production costs and the increase in price of the complementary good. (In any case, price will have to fall but the level of output is subject to the magnitude of change).

Case 1: Where the magnitude of a fall in production cost is greater than that of an increase in price of a complementary good.

A fall in cost of production has an effect of increasing supply thereby creating a downward pressure on price. Overall, quantity increases from Q0  to Q1 and price falls from P0  to P1  represented by the movement of the equilibrium from e0  to e1

Question two

a) i. Give the meaning of the term ‘ Price Control’  (2 marks)

Answer

price Control- deliberate government intervention to artificially determine price.

ii. Explain the circumstances under which price control is considered necessary. (4 marks)

Answer

The government controls prices in order to:

  • Stabilize prices and supplies of essential commodities
  • Reduce income inequalities by balancing welfare through imposition of minimum wages
  • Control the exploitative/ unscrupulous practices of natural  monopolies and or those created by government policies.
  • Promote self-sufficiency in domestic production of goods and  services.
  • Direct investment by increasing relative profitability while  restricting competitors because any prices, other than the legislated
    prices, are not allowed.
  • Protect the purchasing power of consumers especially the low income earners.
  • Protect domestic industries against the highly competitive foreign influence-the infant industry argument.
  • Generate a conducive and selective political support base- industrial peace, minimal or absence of food riots and other forms of insecurity.

b) i. With the aid of well-labeled diagrams, distinguish between price floors and price ceilings.(6 marks)

Price control takes two forms: Maximum price (price ceiling) and minimum price (price floor).  Price ceiling involves fixing prices below the market price aimed at protecting the low-income consumers against excessively high market prices. It’s therefore the price above which the government does not allow. Price floor is where prices are fixed/set above the market prices to protect producers of certain commodities (against low and unstable income) and low-paid workers (from unscrupulous employers). Minimum price is thus
the price below which the government does not allow.

This distinction can clearly be demonstrated by way of diagrams as shown below:

NB: Fig. 1: Maximum Price Control   Fig.6.2: Minimum Price control

Where:
P: equilibrium price
Q: equilibrium quantity
Pmax: Maximum price
Pmin: Minimum price
PBM : Black Market price
E: Equilibrium point
QS : quantity supplied
Qd : quantity demanded
SS: Supply curve
DD: Demand curve

ii. What are the major consequences of each of the price control measures? (8 marks)

Answer

The consequences of price control measures are largely linked to changes in the level of output and the elasticities of supply and demand. Moreover, the  imposition of statutory prices has not been much effective in achieving the  intended objectives and the following explanations are supportive of this argument:

Maximum price Control (Price ceilings):

  • Institutionalized excess demand over supply of a commodity, which  largely translates into inflation and structural unemployment. In the diagram 1 above, excess demand is given by Qd-Qs.
  • Scope for a black market- this involves selling a product at a price other than the legislated/statutory price (in an illegal market) preferably to those willing to pay higher prices e.g. out put Qs at price P BM as shown in Fig 6.1 above.
  • Hoarding and smuggling of products to other countries where prices are relatively high. This will further create artificial shortages
  • Disincentive to investment as producers are not allowed to maximize their profits and may opt to invest in industries whose product prices are not controlled, usually non-essential commodities could be produced in place of necessities.
  • Waste of resources by the government through policing efforts in trying to ensure adherence to statutory prices.
  • Loss of foreign exchange arising from importation of essential commodities whose domestic supply is insufficient. This foreign
    exchange could otherwise be used to import capital inputs necessary for economic growth and development.
  • Sale by discrimination and rationing of the scarcely available commodities-selling to relatives/ close associates or even subjecting consumers to unnecessary purchase of non-essentials as a pre-requisite to getting essential commodities. This practice is largely among retailers especially in rural areas where market information is inadequate. Rationing implies consumption of less than the amount required. It could also mean going without, a situation, which may lead to such events as
    food riots and starvation.

Minimum price control (price floors):

  •  Institutionalized excess supply over demand for a commodity. In Fig. 2, the quantity supplied is Qs while the amount demanded is Qd. Thus the excess supply is represented by Qs – Qd
  • Increase or distortion on government spending programmes arising form establishment of buying agencies such as the NCPB, which may not be efficient/cost-effective. It may also require the setting up of costly storage facilities in the name of buffer stocks so that goods are released to the public at subsidized prices in the event of a shortage.
  • Dumping – a kind of price discrimination whereby the government buys and exports the surplus of a commodity at lower prices. This is done especially where the cost of storage is prohibitively high. Since the acquisition price (minimum price) is relatively higher than the dumping price, the government is in effect making a ‘loss’

Black marketing also arises due to demand deficiency resulting from higher prices (minimum price) and the inability of the government to buy the whole amount of excess output. This coupled with the perishable nature of products makes producers resort to prices lower than the statutory minimum price, such as PBMin figure 2.

As we have seen, both maximum and minimum price controls produce  problematic consequences and may result in a less efficient allocation of resources than might be expected to arise from the operation of a free market. However, where there are specific problems affecting particular groups in the economy, such controls might be justified on equitable grounds.

 

Question three

(a) (i) What is an indifference curve? (2 marks)

Answer

An indifference curve is the locus of all possible combinations of two commodities their consumption from which the consumer derives the same level of satisfaction.

(ii) Explain the main characteristics of indifference curves (6 marks)

Answer

Negatively sloped: Indifference curves slope downwards from left to right implying that more of one commodity is consumed by reducing the consumption of the other commodity while deriving the same level of satisfaction, that is, marginal rate of substitution (MRS).

Do not intersect: Indifference curves do not intersect because an intersection would contradict the principles of consistency and transitivity. Intersection implies that different levels of satisfaction can be derived on the same indifference curve (which is not in accordance with the definition of indifference curves). The intersection point would also mean that two indifference curves have the same level of utility which is also not true.

(b) (i) Briefly explain two exceptions to the definition of an indifference curve.(4 marks)

Fig 15.2: Intersection and the principle of transitivity

Similarly, intersection would mean that the consumer is indifferent between points A, B and C assuming that A = C, B = C and therefore A = B. However, this is NOT the case since point B is on a higher indifference curve representing more units of X (i.e. X2) than point A (i.e. X1) meaning that a rational consumer would prefer more than less thereby choosing to consume at B than at A (preferring point B to point A). This then contradicts the principles of transitivity and consistency which state that if A = C and B = C then A = B because in this case A ≠ B.

It also contradicts the aspect of indifference since the satisfaction at B is greater than the satisfaction at A which makes the consumer prefer B to A. Moreover, since the consumer prefers B to A, then he should also prefer B to C since A = C which is NOT the case with an intersection since B and C are on the same indifference curve implying that B = C. Therefore, as a condition underlying the indifference curve analysis approach to consumer behavior, indifference curves do not intersect.

NB: Consistency and transitivity of choice: It’s assumed that given preferences, a consumer should be consistent in such a way that once A is chosen or preferred to B in one period he should not choose bundle B over A in another period when both A and B are available. Similarly, it’s assumed that consumer’s choice is characterized by transitivity, that is, if A is preferred to B and B to C then A should be preferred to C. : Consistency and transitivity of choice: It’s assumed that given preferences, a consumer should be consistent in such a way that once A is chosen or preferred to B in one period he should not choose bundle B over A in another
period when both A and B are available. Similarly, it’s assumed that consumer’s choice is characterized by transitivity, that is, if A is preferred to B and B to C then A should be preferred to C.

Convex to the origin: Indifference curves are convex to the origin denoting diminishing marginal rate of substitution of one commodity for another since commodities are close but not perfect substitutes such that as more of one commodity is consumed it becomes increasingly difficult to give up more units.

of the other while deriving the same level of satisfaction. Marginal rate of substitution is the amount of one commodity that the consumer is just willing and able to give up for an additional unit of another commodity while deriving the same level of satisfaction.

Fig.4: Diminishing Marginal rate of Substitution

Indifference map:- the distance from the origin of indifference curves represents different levels of satisfaction; those further awa from the origin

represent higher levels of satisfaction.

(b)(i) There are two exceptions to the definition of an indifference curve:

  • The case of perfect substitutes: For perfect substitutes the nature of the indifference curve is such that it’s a straight line with a constant slope implying that the marginal rate of substitution is constant i.e. MRS = 1. In this case, the goods being consumed are mutually exclusive in consumption such that either of them can be exclusively consumed (without the other) while the consumer derives the same level of satisfaction.

MRSxy = 1 implying that the quantity of Commodity Y the consumer would give up for additional units of commodity X would be constant (the same), while deriving the same level of  satisfaction. eg. Petrol from Caltex and petrol from Total.

It’s possible for the consumer to spend all his income on either X or Y without any change in satisfaction; at point A it’s I/Py and at B it’s I/Px i.e. at A it’s (I/Py) units of Y and at B it’s (I/Px) units of X without X and Y respectively.

The case of complementary goods:
Complementary goods are those goods used together or jointly such that no satisfaction can be derived by exclusively consuming either of them, that is, satisfaction can only be obtained by way of combination. Examples of such goods include: Watch and Battery, vehicle and tyres, guns and bullets, film and camera, car and petrol etc; such goods are related in such a way that an increase in price of one (e.g. vehicles) causes a decrease in the quantity demanded of the other (e.g.tyres).

The indifference curves for complementary goods are L-shaped (right-angled) since marginal rate of substitution is equal to zero, that is, marginal rate of substitution is equal to zero implying that there is no possibility of substitution.

Answer

(ii) Explain any four uses of indifference curve analysis. (8 marks)

The leisure-income trade-off and the need for overtime rates higher than the normal wage rate

Indifference-curves analysis may be used to explain why firms must pay higher rate for overtime work.  We first derive the income-leisure curve of an individual consumer. This curve shows different combinations of income, earned by working, and leisure time.
Assume that we measure money income on the vertical axis and leisure time on the horizontal axis. Assume further that the maximum time available for either leisure or work is 0Z hours a day. The individual can either use all the 0Z houfor leisure, in which case he earns zero income, or he can choose to work all the 0Z hours and earn a maximum money income 0M (given the current market wage rate w) or he can use part of the 0Z hours for leisure (e.g. 0A) and the remaining (AZ) hours for work, in which case he would earn 0M1 income.

Evaluation of alternative government policies using indifference-curves analysis

Indifference curves may be used to evaluate the effects of alternative government policies. For example, assume that the government considers either the adoption of a food subsidization policy for pensioners or granting a supplementary income
to them.

Which of these measures costs less to the government (and hence to the tax payer)? What are the effects of these policies on the demand patterns of a pensioner? Such questions may be answered by using indifference-curves analysis. We will illustrate the way in which the above information may be obtained, assuming for simplicity that there is a single pensioner and two commodities, x(food) and y(money income).

The initial equilibrium of the pensioner is at point ewhere his budget line, AB is tangent to indifference curve I1: he consumes 0X1
units of food, paying ZA of his income and have OZ income left over to spend on other commodities. The goal of the government is to make it possible for the pensioner to move to the higher level of welfare (satisfaction) denoted by the indifference curve I2

Which of these measures costs less to the government (and hence to the tax payer)?  What are the effects of these policies on the demand patterns of a pensioner? Such questions may be answered by using indifference-curves analysis. We will  illustrate the way in which the above information may be obtained, assuming for simplicity that there is a single pensioner and two commodities, x(food) and y(money income).

The initial equilibrium of the pensioner is at point e1 where his budget line, AB is tangent to indifference curve I1: he consumes 0X1
units of food, paying ZA of his income and have OZ income left over to spend on other commodities. The goal of the government is to make it possible for the pensioner to move to the higher level of welfare (satisfaction) denoted by the indifference curve I2
.

The effects of the food subsidy. Assume that the government gives food coupons to the pensioner which allow him to buy food at half the market price. Following this measure the budget line of the pensioner shifts to ABwhich is tangent to Iat point e. At his new equilibrium position the pensioner buys OXunits of food, paying for this quantity AL of his income. If there was no food subsidy the
pensioner would have to spend AK of his income to buy OXunits of food. Since he pays only AL, the difference LK = (AK – AL) must be paid to the food producers by the government. Thus, if the government adopts the food subsidy policy we have the following effects:

(a) the cost to the government (and to the taxpayer) is LK.

(b) the market price of food is not affected by this policy, so that other consumers continue to pay the original price.

(c) the government is certain that the pensioners will consume more food. This effect may be particularly desirable (as a subsidiary goal of the government) if there are surpluses of food.  Actually it is often the case that food subsidies are designed in such a way as to benefit not only the consumers but also the producers of foodstuffs.

(d) the assistance to pensioners via the food subsidy imposes a certain pattern of consumption, a certain choice of spending their income.

The effects of a supplementary income policy. Assume that the government considers granting to the pensioner a supplementary income which will enable him to reach the higher welfare level implied by indifference curve I2. To find the
amount of such a supplementary income we simply draw a budget line (CD), parallel to the original budget line (AB) and tangent to I2
(at point e3 ). The pensioner will now buy OXunits of food. The cost to the government of the supplementary income policy is equal to CA, which (in our example) is smaller than the cost of the food subsidy policy. Furthermore the quantity of food in this case (OX3) is smaller than the quantity which would be bought under a food subsidy programme (OX2).

Comparing the two alternative policies we observe that both policies achieve the government’s goal of enabling the pensioner to reach the higher welfare state implied by I. But the food subsidy programme is more costly (in our example)
than the supplementary income policy. In fact if the government were to give to the pensioner the cost of the subsidy in the form of supplementary income, the pensioner would attain a higher level of satisfaction (an indifference curve above I2). However, the consumption of food will be greater in the case of the food subsidy policy.

Which one of these alternative policies the government will adopt depends not only on the above considerations, but also on the other goals of the government and the indirect effects of each policy. For example, if there is a surplus food production the government may adopt the more costly subsidization policy which apart from increasing the welfare of the consumer, also benefits the producers by reducing or even eliminating the surplus. Furthermore, supplementary incomes policies are in general more inflationary than price subsidies to specific individuals (especially if there is a surplus of the subsidized commodities). Increasing the
incomes of some groups of ‘needy’ consumers may lead to increases of the market prices of commodities for all consumers, thus decreasing their welfare.

The above discussion illustrates how indifference-curves analysis may give insight into the implications of selective government measures, and thus help efficient policy formulation.

Indifference – curve analysis and the theory of exchange

Indifference-curve analysis and the theory of revealed preference can be used to establish whether, over a period of time during which both money incomes and prices have been changing, the consumer is better or worse off. The assumption underlying the discussion is that the consumer spends all his money

Classification of goods income in all time periods, that is, he chooses a point on his budget line in any
particular period.

Classification of goods

Perhaps the most important theoretical contribution of the indifference curve analysis approach is the establishment of a better criterion for the classification of goods into substitutes and complements. Hicks suggested measuring the cross elasticity after compensating for changes in real income. Thus, according to Hicks, goods X and Y are substitutes if, after compensating for the change in real income (arising from the change in the price of X) a decrease in the price of X leads to a decrease in the quantity
demanded of Y. Although this criterion is theoretically correct, it still requires knowledge of the individual preference functions which cannot be statistically estimated.

Use of indifference comes also allows for the classification of goods into normal, inferior or giffen. For normal goods both income and substitution effects of a price change are positive such that the total price effect is positive. For inferior goods, the income effect is negative but the substitution effect is positive and relatively greater than the negative income effect such that the total price effect remains positive. However, for giffen goods the negative income effect is overwhelming on the positive substitution effect such that the total price effect is negative. This is the source of regression of the demand curve.

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