# .SECTION A: MICROECONOMICS

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1 Solution 1.SECTION A: MICROECONOMICS a) The concept of equilibrium under demand and supply analysis refers to a situation where at a price the quantity demanded equals the quantity supplied. Graphically, given normal demand and supply curves when the demand and supply curves intersect. The point of intersection defines the equilibrium point. The equilibrium point invariably defines the equilibrium price and quantity. a) i. An increase in the price of cocoa beans will affect the cost of producing Milo. This will reduce the supply of Milo. This is illustrated in Figure 1 below. Price Figure 1: The Market for Milo S 2 P 2 B S 1 P 1 A D 1 0 Q 2 Q 1 Quantity Demanded/Supplied In Figure 1, the increase in cost of production reduces supply from S 1 to S 2. Given D 1, the equilibrium price rises to P 2 and the equilibrium quantity declines to Q 2. ii. Milo and Bournvita are substitutes. A decrease in the price of Bournvita makes Bournvita relatively cheap and increases its quantity demanded. In this vein, some consumers of Milo will move to Bournvita reducing the demand for Milo in the process. The effect of this on equilibrium price and quantity is illustrated in Figure 2 below 1

2 Figure 2: The Market for Milo Price S 1 P 1 P 2 B A D 2 D 1 0 Q 2 Q 1 Quantity Demanded/Supplied Initially the market attains equilibrium at point A with equilibrium price and quantity as 0P 1 and 0Q 1 respectively. A decrease in the price of Bournvita increases the quantity demanded of Bournvita which invariably decreases the demand for Milo. This shifts the demand curve for Milo from D 1 to D 2 reducing the equilibrium price and quantity from 0P 1, 0Q 1 to 0P 2, 0Q 2. 2

3 Solution 2 i. Large numbers of buyers and sellers: The industry or market includes a larger number of firms (and buyers), so that each individual firm, however large, supplies only a small part of total quantity offered in the market. The buyers are also numerous so that no individual buyer can affect the working of the market. Under these conditions, each firm alone cannot affect the price in the market by changing output. ii. Product Homogeneity: The Industry is defined as a group of firms producing a homogeneous product or standardized product. The assumptions of a large number of sellers and product homogeneity imply that the individual firm in perfect competition is a Price Taker rather than a price maker. In Perfect Competition price is set by industry - wide supply and demand; the perfect competitor can take it or leave it. iii. iv. NOTE: Consider Price Taker as a point only if points (i) and (ii) are not mentioned. Free entry and exit of firms (Perfect Mobility of Firms): Under perfect competition, there is perfect mobility, and none of these barriers exist. In other words, there is no barrier to entry or exit from the industry. Entry or exit may take time, but firms have freedom of movement in and out of the industry or market. Perfect mobility of factors of production: The factors of production are free to move from one firm to another throughout the economy. It is also assumed that workers can move between different jobs, which imply that skills can be learned easily. Finally, raw materials and other factors are not monopolized and labour is not unionized. In short, there is perfect competition in the market of factors of production. v. Perfect Knowledge: It is assumed that all sellers and buyers have complete knowledge of the conditions in the market. Everyone knows about every possible economic opportunity. 3

4 b) Figure A: Short-run Competitive Equilibrium with a Loss C, R and P A B MC AVC ATC P 1 K MR 1 = AR 1 = D 1 0 Q 1 Qty. Produced /Sold P = MR In the Figure A, the demand curve is D 1 = AR 1 = MR 1. At the equilibrium output Q 1, unit cost of production (ATC) exceeds price (P = AR) but AR > AVC. There is no way by which the firm can earn profit. In spite of the loss, the competitive firm is in equilibrium with an equilibrium output of Q 1. In this case the loss is smaller than the total fixed cost that the firm will have incurred as losses if it stops production. In conclusion, the statement is FALSE. A profit-maximising perfect competitor will NOT cease production in the short-run if its average revenue is greater than its average variable cost but less than average total cost. 4

5 Solution 3 a) Returns to variable proportions explain the behaviour of output in the short-run. The short-run is a period of production with fixed and variable inputs. When the variable input is varied holding the fixed input constant, then the proportion between the fixed and variable input changes. The resulting output displays among others: increasing returns to variable proportions, constant returns to variable proportion and diminishing returns to variable proportions. b) Returns to scale on the other hand explain the behaviour of output in the long-run. In the long-run all factors of production are variable. When all factors are varied in the same proportion in the long-run then the scale of production is changed. The resulting output displays the following phases: increasing returns to scale, constant returns to scale and decreasing returns to scale. Increasing Returns to Scale: This means total product rises more than in proportion to inputs. For example, if capital and labour units are increased from 1 and 2 units to 2 and 4 units respectively output increases from 1000 to 2500 units. This shows that a 100% increase in inputs leads to a 150% increase in output. The production function shows increasing returns to scale. Constant Returns to Scale: The output mounts in proportion to, or at the same rate as the rise in inputs. Suppose that the capital - labour combination was doubled from 4 is to 8 to 8 is to 16, and output increases by 100%. This implies a 100% increase in inputs leads to a 100% increase in output. The Production Function depicts Constant Returns to Scale. Decreasing Returns to Scale: As the scale is changed, the total product indeed becomes larger but does so at a lower rate than the rate of growth of all the inputs used in production. Assume that the scale is changed from 8 and 16 units to 16 and 32 units of capital and labour respectively and output increases from units to units. This shows that 100% rise in scale has increased output by 80%. 5

6 SOLUTION 4 (a) i. A production function describes the technical relationship between the maximum quantity of a good that can be obtained from different combinations of factors production given state of technology and in a socio-cultural environment.. A Production Possibilities Curve, on the other hand, describes the various combinations of two commodities that can be produced in a given period of time with available resources and technology. ii. Private cost of production relates to all costs incurred by the firm in the course of production. These include payments individual producers make for hiring or purchasing factors of production as well as cost of resources owned and used by the producer. It is important to note that to determine the private cost of production, it is essential to consider both explicit and implicit costs incurred. Social cost of production refers to the cost society incurs when its resources are used to produce a given commodity. When the society's resources are used to produce a given commodity the production of other commodities are sacrificed. The cost of this sacrifice is the social cost also termed the opportunity cost of production. (b) (i) The table shows the production possibilities of a nation. The nation can choose to produce a maximum of 15 tons of foods if it allocates all of its resources to the production of food, i.e. alternative A. Choosing alternative A means no resources would be available for producing cloth. Or it can choose production alternative F to produce 5 bales of cloth and zero amount of food. The nation s choice or decision about what to produce is not limited to the extremes alternatives of A and F. Alternative B, C, D, and E can equally be produced. This shows that nation has alternatives to choose from. (ii) The table also depicts the opportunity cost the nation faces. This can be illustrated in two ways: - Suppose the nation settles for alternative A. This gives the nation 15 tons of food and 0 bale of cloth. There is an element of opportunity cost here. The opportunity cost of 15 tons of food is 5 bales of cloth that are sacrificed. - Assume the nation first settles for alternative A but now desires alternative B which contains 14 tons of food and 1 bale of cloth. This means the nation cannot have 15 tons of food again. Choosing 6

7 alternative B now over A, the nation has to sacrifice 1 ton of food to shift some resources to produce 1 bale of cloth. The opportunity cost of 1 bale of cloth is 1 ton of food forgone. In the same way if alternative F is chosen now over A, the opportunity cost of the 5 bales of cloth are the 15 tons of food that cannot be produced. Any productive alternative that the nation chooses involves an opportunity cost because the nation s resources are scarce. SECTION B: MACROECONOMICS Solution 5 a) (i) The 100m shows the autonomous consumption that is consumption expenditure at zero (0) disposable income. The 0.75 is the marginal propensity to consume. The fraction or percentage of any additional income spent on consumption. (ii) The complementary saving function is (iii) 1. If Yd = 500m, C C S 100m Y d 100m m 2. The average propensity to consume APC) is APC = Consumption Expenditure Disposable Income APC APC 475m 500m In equilibrium Y equals Aggregate Expenditure (AE). Therefore, 7

8 Y AE( C I) Y 100m 0.75Y I Y 0.75Y 100m 150m 0.25Y 250m 1 Y 250m 0.25 Y 1000m The expenditure multiplier (K) is K 4 1 MPC 0.25 b) (i) The level of disposable income: The level of income is the basic determinant of how much households will consume. If disposable income increases, households consumption and/or saving increases. (ii) Stock of durable goods on hand: If the economy has enjoyed an extended period of prosperity, consumers may find themselves well supplied with various durable goods, e.g. cars, televisions, etc. all worthy of years of service. Hence, for sometime, many households will be out of the market for such products with the result that consumers will be willing to spend less and save more at each level of disposable income. (iii)wealth: This is a stock of accumulated purchasing power stored up from the past. For example, if you have a fat savings account accumulated from your past earnings, your current spending may be greater than your current income. This implies that what actually determines consumption is not nominal wealth but real wealth, which takes the price level into account. (iv) Expectations: Households expectations concerning future prices, money income and the availability of goods may have a significant impact on their current spending. Expectations of rising prices and product shortages tend to trigger more spending and less saving, that is, it shifts the consumption function upward and the saving function downward. (v) Aggregate household indebtedness: This is the purchasing power of the sum of money outstanding that households have borrowed and are currently obligated to repay. If households are in debt to the degree that part of their current incomes are committed to installment payments on previous purchases, they may well be obliged to reduce current consumption as well as savings. 8

9 Solution 6 a) Monetary policy is the deliberate manipulation of changes in money supply and bank credit on the premise that the control of these variables is an effective way of controlling the macro-economy. Or Monetary Policy is deliberate regulation of supply of money and credit in the economy to achieve macro economic targets. b) (i) The discount rate (d): The discount rate also known as Bank of Ghana policy rate is the rate at which the central bank is prepared to lend to commercial banks. Alternatively, it is the interest charged by the central bank on loans it makes to the commercial banks. The discount rate is also the basic short-term interest rate in an economy. Changes in the discount rate are expected to lead to changes in all other short-term interest rates e.g. bank deposit rates, interest charged by banks on advances, etc. (ii) Open Market Operations (OMO): Open Market Operations involve the sale of government securities by a central bank when it desires/intends to reduce money supply, and purchase of securities by a central bank when it desires to increase money supply. It also encompasses the activities of a central bank in buying or selling governments bonds to influence bank reserves, the money supply and interest rates. If securities are bought, the money paid out by the Central Bank increases commercial bank reserves, and money supply increases. If securities are sold, the money supply contracts as part of the money in circulation finds its way back to the central bank. (iii) The Required Reserve Ratio or the cash ratio: The portion of deposits that a bank sets aside in the form of vault cash or non-interest earning deposits with the central bank is called the required reserve ratio. The required reserve ratio may be used to increase or decrease money supply. If the required reserve ratio were increased, it would affect the excess reserve of the commercial banks negatively. For example, if someone deposits say 1,000 and the required reserve ratio is increased from 10% to 20%, the minimum required reserve would be 20% of 1,000, that is, 200 and the credit multiplier will be five instead of ten as calculated earlier. (iv) Selective Credit Control: These are used by the Central Bank to influence specific types of credit for particular purposes or sectors of the economy. (v) Credit ceiling: Imposition of a limit to which the commercial banks can grant credit. 9

10 (vi) Moral suasion: Persuading commercial banks to take specific steps that are consistent with the central bank s macroeconomic objectives. (vii) Special Deposit: Instructing commercial banks to make specified amount of deposit to reduce their lending capacity. Solution 7 10

11 a) Direct taxes are taxes imposed on the incomes or the earnings of a person or a corporate body and are paid directly to the government through public authorities such as the Internal Revenue Service or the local authority. Indirect taxes are taxes imposed on goods and services and are paid only when these goods and services are bought. Under direct taxes each individual s tax liability is assessed separately. People who pay direct taxes cannot shift the incidence or burden of payment to some other individuals. For indirect taxes the incidence or the burden of payment can be passed to others to pay. b) Ad valorem tax is levied in percentages, that is, a fixed percentage of the total value of the good is taken as tax. For instance, a 15% tax levied on the total values of a good is ad valorem. Specific tax is a fixed amount charged or levied on each physical unit of a good irrespective of its value. For example, a tax of GH 1 may be levied on each unit of a good irrespective of the value of that good. Suppose that the government levies a tax of GH 200 on every vehicle. This tax is indirect and specific. c) A tax is proportional when every taxpayer pays the same proportion of his income or wealth as tax. The wealthier taxpayer pays more in absolute terms but in relative terms he pays the same percentage of his income as any other person. For example, if 20% of all incomes is taken as tax then the tax structure is proportional. A progressive tax provides that a taxpayer with a higher income should not only pay a larger absolute amount in tax, but also his tax liability should represent a larger proportion of his income. The tax is graduated, that is, the tax rate increases as the level of income rises. d) i. Revenue: The most obvious aims of taxation is to raise revenue so as to pay for government expenditure in the form of education, construction of roads, pipe-borne water, etc. ii. Redistribution of Income: The government may then impose taxes to redistribute income and bridge the gap between the higher income earners and the lower income earners. 11

12 iii. Discouraging the consumption of certain commodities: Taxes may be used to prevent and reduce the production and consumption of some commodities in an economy. iv. Protection of infant industries: Infant industries are newly established industries to produce goods that were formally imported. To protect them the government imposes taxes on these imported substitutes that the infant industries produce so as to discourage their consumption and importation. v. To stabilize the economy: Taxes can be imposed or cut to stabilize the economy and achieve internal or external balances. During inflation taxes are imposed on income. This has the effect of reducing disposable income, aggregate demand may fall and pressure on price may decrease. vi. To control resource movement: The government tax policy can be used to control and direct resource movement. 12

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