Robots The assumptions are: Full employment Productive efficiency Fixed supplies of resources Fixed technology

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1 Refrigerators Question No. 2 SUGGESTED SOLUTIONS/ ANSWERS SPRING 2016 EXAMINATIONS 1 of 7 (a) (i) Production Possibilities Curve: 03 Robots The assumptions are: Full employment Productive efficiency Fixed supplies of resources Fixed technology (ii) Cost of one more refrigerator and one more robot: Cost of refrigerator (million) = 2 12 = Cost of robot (million) = 15 2 = Increasing opportunity costs: Increasing opportunity costs are reflected in the concave-from-the-origin shape of the curve. This means the economy must give up larger and larger amounts of robots to get constant added amounts of refrigerators and vice versa. 02 (b) Mrs. Saira is not buying the utility-maximizing combination of bread and milk since the marginal utility per rupee spent on each good is not equal. The marginal utility per rupee of bread is 0.8 (80 utils Rs.100); the utility per rupee of milk is 1.75 (70 utils Rs.40). Mrs. Saira should buy more milk and less bread. 04

2 Question No. 3 SUGGESTED SOLUTIONS/ ANSWERS SPRING 2016 EXAMINATIONS 2 of 7 (a) Factors that can influence a company s share price: General influences on share prices: These influences on share price themselves result from the interplay of a large number of factors; these factors can be divided into two categories: 01 Internal factors are heavily influenced by management policy and action and include such things as rate of new product development, marketing activity, financial management and control of costs. 01 External factors include wider developments such as economic recession and demographic change; and events and forces specific to the industry concerned, such as the degree of competition in the market and the behaviour of suppliers and customers. 01 Financial influences on share price: The causes of share price variation can be analysed as changes in reported profits, changes in forecast profits, and changes in required rate of return. 01 If the expected cash flows increase, predictably enough, the current market value will increase and vice versa. Changes in the immediate future will have a larger effect than those in the more distant future. 01 An increase in the cost of equity will reduce the current market value and vice versa. 01 (b) Though it is true that all firms compete for the rupees of consumers it is playing on words to hold that pure monopoly does not exist. For example, the pure monopoly enjoyed by the local electricity company in any town. If you wish electric lights, you have to deal with the single company. It is a pure monopoly in that regard, even though you can switch to oil or natural gas for heating. Of course, you can use oil, natural gas, or kerosene for lighting too but these are hardly convenient options. 03 The concept of cross elasticity of demand can be used to measure the presence of close substitutes for the product of a monopoly firm. If the cross elasticity of demand is greater than one, then the demand that the monopoly faces is elastic with respect to substitute products, and the firm has less control over its product price than if the cross elasticity of demand were inelastic. In other words, the monopoly faces competition from producers of substitute products. 03

3 SUGGESTED SOLUTIONS/ ANSWERS SPRING 2016 EXAMINATIONS 3 of 7 Question No. 4 (a) Types of internal economies: Economies of scale are those cost-saving advantages which firms get due to large-scale production. The advantages which a single firm gets from the expansion of business are called Internal economies. Internal economies are classified under five types: 1. Technical economies arise when it is possible to use larger or more efficient machinery. Like; (i) Increased specialization and division of labour (ii) Large scale producers can also use specialized machinery and reduce unit cost (iii) The initial cost and the operating costs of one large machine may be lower than two or more small machines doing the same work (iv) Production on large scale means less wastage of materials and energy 2. Managerial: In large-scale production, management can be split into specialized jobs, employing an expert for each one. There are production manager, marketing manager, purchase manager, sales manager, accounts manager etc. In this way, per unit cost is lower. 3. Commercial (or Marketing economies): A large firm buys from cheaper market and sells in dearer market. When a firm buys raw materials in bulk, it gets concessional rate. 4. Financial: Large firms can get easy credit from banks on more favourable terms. So, it is easier and cheaper for UNILEVER to get a bank loan of Rs.500 million than for a small soap factory to get a loan of Rs.50, Risk Bearing: Large firms do not put all eggs in one basket. Often they produce a whole variety of goods to eliminate the risk. Any four (4) 1.5 marks each = 06 (b) (i) With the same costs, the pure monopolist will charge a higher price, have a smaller output, and have higher economic profits in both the short-run and the long-run than the pure competitor. As a matter of fact, the pure competitor will have no economic profits in the long-run even though it might have some in the short-run. Because the monopolist does not produce at the point of minimum ATC and does not equate price and MC, its allocation of resources is inferior to that of the pure competitor. Specifically, resources are under allocated to monopolistic industries. Since a pure monopolist is more likely than the pure competitor to make economic profits in the short-run and is, moreover, the only one of the two able to make economic profits in the long-run, the distribution of income is more unequal with monopoly than with pure competition. 04 (ii) In pure competition, MR = P because the firm s supply is so insignificant that its output has no effect on price. It can sell all that it wishes to at the price established by demand and the total industry supply. The firm cannot force the price up by holding back part or all of its supply. 01

4 SUGGESTED SOLUTIONS/ ANSWERS SPRING 2016 EXAMINATIONS 4 of 7 The monopolist, on the other hand, is the industry. When it increases the quantity it produces, price drops. When it decreases the quantity it produces, price rises. In these circumstances, MR is always less than price for the monopolist; to sell more it must lower the price on all units, including those it could have sold at the higher price had it not put more on the market. When the monopolist equates MR and MC, it is not selling at that price: The monopolist s selling price is on the demand curve, vertically above the point of intersection of MR and MC. Thus, the monopolist s price will be higher than the pure competitor s. 02 (iii) Economies of scale may be such as to ensure that one large firm can produce at lower cost than a multitude of small firms. This is certainly the case with most public utilities. And in such industries as basic steelmaking and car manufacturing, pure competition would involve a very high cost. On the other hand, monopolies may suffer from X-inefficiency, the inefficiency that a lack of competition allows. Monopolies may also incur non-productive costs through rent-seeking expenditures. For example, they may try to influence legislation that protects their monopoly powers. 02 The implications of the lower costs that economies of scale may give a monopolist not only produce at a lower cost than pure competitors but, in some cases, may also sell at a lower price. If such is the case, the misallocation of resources is reduced. 01 Question No. 5 (a) Completion of consumption and saving table: Level of Output and Income (GDP = DI) [Rs. 000 ] Consumption [Rs. 000 ] Saving [Rs. 000 ] Average to Consume (APC) Average to Save (APS) Marginal to Consume (MPC) Marginal to Save (MPS) OR = 09

5 Saving Consumption SUGGESTED SOLUTIONS/ ANSWERS SPRING 2016 EXAMINATIONS 5 of 7 (b) (i) Graphical schedules of consumption and saving: C Real GDP S Real GDP (ii) Break-even Level of Income: Break-even income = Rs.330, Households dissave borrowing or using past savings. 01 Question No. 6 (a) Quantity Theory of Money asserts that the value of money depends largely on the quantity of money. If the quantity of money is increased without corresponding increase in volume of production, the value of money will decrease and vice-versa. 01 According to Irwin Fisher, the function of money primarily is to serve as a medium of exchange. It has an indirect or derived demand because it is demanded for its purchasing power and not for its own sake. Therefore, the value of money entirely depends upon its quantity in circulation within the country. It is also called Cash Transactions Approach or Fisher's Approach. 02 According to Irwin Fisher, Other things remaining the same, value of money falls in proportion to increase in quantity of money in circulation." 01 It means if the quantity of money is increased by 25%, whereas other things remain unchanged, the value of money will fall by 25%, and vice versa. Thus, the quantity of money and its value are inversely related. 01 Irwin Fisher explained the relationship between the quantity of money and its value in the form of an equation of exchange.

6 SUGGESTED SOLUTIONS/ ANSWERS SPRING 2016 EXAMINATIONS 6 of 7 Where, P stands for general price level, or P = the value of money. T stands for total transactions (total amount of goods and services) exchanged for M stands for actual money M' stands for credit money V stands for velocity (rate of exchanging hands) of actual money V' stands for velocity of credit money Fisher contends that, in the short period, T, V, and V remains constant. Likewise, the proportion of M to M' also remains constant. Thus, P varies directly with M. In other words; P or value of money varies inversely with M or quantity of money. Fisher s Quantity Theory of Money can also be explained with the help of a simple example. Suppose, the supply of actual money (M) issued by the government and the Central Bank, in circulation in the country at certain time is Rs. 1,000 and its velocity (V) is 10. The amount of credit money (M ) in circulation is Rs. 2,000 and its velocity (V') is 5. The total volume of transaction (T) is 500. The equation of exchange will be as under: 01 02

7 SUGGESTED SOLUTIONS/ ANSWERS SPRING 2016 EXAMINATIONS 7 of 7 (b) Consequences of balance of payments deficits: A current account deficit is the excess of expenditure abroad over earnings from abroad. It leads to three possible consequences. (i) A country may borrow more and more from abroad, to build up external liabilities which match the deficit on its current account, for example encouraging foreign investor to lend more by purchasing the government s bonds. 01 (ii) A country may sell more and more of its assets. 01 (iii) Reserves of foreign currency held by the central bank may be run down. 01 Consequences of a balance of payments surplus: If a country has a surplus on current account year after year, it might invest the surplus abroad or add it to official reserves. The balance of payments position would be strong. There is the problem, however, that if one country which is a major trading nation has a continuous surplus on its balance of payments current account, other countries must be in continual deficit. These other countries can run down their official reserves, perhaps to nothing, and borrow as they can to meet the payments overseas, but eventually, they will run out of money entirely and be unable even to pay their debts. Political pressure might therefore build up within the importing countries to impose tariffs or import quotas or calls on the country with the surplus to raise its exchange rate and/or buy more imports. 03 THE END