Download Chapter 1 Practice Exam Solutions

Chapter 1: The Market Economy
Short Answer Questions
For the following questions assume an economy in which consumers can use their
income to purchase two goods, tea and coffee.
1. Explain the factors that influence a consumer’s decision to consume.
Answer: The reader should discuss at least the role of these factors on a consumer’s
demand: prices, income, prices of related goods (substitutes and complements) and
consumer preferences (tastes). [For a full discussion see chapter 1, p.12.]
2. What is a demand curve, and how could it be used to summarize factors you
identified in question 1?
Price of coffee
Answer: A demand curve shows the relationship between the market price of a good
and the quantity of a good that a consumer are willing and able to buy, holding other
things that may affect demand constant. According to the law of demand, the
relationship between price and quantity demanded is negative.
D1
1
Quantity for coffee
3. Explain what will be the impact on the demand for coffee if the price of tea
increases permanently. Use a diagram to illustrate your answer.
Answer: Assuming that tea and coffee are substitutes for the consumer, if the price of
tea increases, the demand curve for coffee will shift outwards.
Price of coffee
D2
D1
1
1
Quantity for coffee
4. Identify the factors that may influence the supply of each good.
Answer: The reader should discuss how a change in these following factors affects the
quantity supplied of a commodity: price, input prices and conditions of production.
[For a full discussion see chapter 1, p.14.]
5. What is a supply curve, and how could it be used to summarize factors you
identified in question 4?
Answer: A supply curve shows the relationship between the market price of a good
and the quantity of a good that a producer are willing and able to supply, holding
other things that may affect supply constant. According to the law of supply, the
relationship between price and quantity demanded is positive.
S1
Price of coffee
1
Quantity for coffee
6. Explain what will be the impact on the supply for coffee if the unit cost of
coffee production increases permanently. Use a diagram to illustrate your
answer.
Answer: An increase in the cost of production will shift the supply curves inwards
because producers are now willing to sell less at any given price.
S2
1
S1
Price of coffee
1
Quantity for coffee
7. Define the concept of equilibrium.
Answer: Equilibrium occurs when the demand curve intersects with the supply curve
in the market. At that point, quantity demanded equals to quantity supplied at the
particular price, and no one has any incentive to change his/her behaviour.
8. Use a diagram to show the equilibrium in the coffee market, before the
increase in the price of tea.
Answer: The equilibrium, point E, before an increase in the price of tea is shown
below.
S1
Price of coffee
1
E
D1
1
Quantity for coffee
9. Derive the new equilibrium after the increase in the price of tea.
Answer: Assuming that tea and coffee are substitutes for the consumer, if the price of
tea increases, the demand curve for coffee will shift outwards. This will result in the
new equilibrium, point E1, where the supply curve intersects with the shifted demand
curve. At this point, we observe an increase in both quantity and price of coffee.
S1
1
E1
Price of coffee
E
D2
D1
1
Quantity for coffee
10. Following question 8, derive the new equilibrium after the increase in the unit
cost of production of coffee.
Answer: An increase in the cost of production will shift the supply curves inwards
because producers are now willing to sell less at any given price. This will result in
the new equilibrium, point E1, where the demand curve intersects with the shifted
supply curve. At this point, we observe an increase in price of coffee and a decrease in
quantity of coffee.
S2
1
S1
1
Price of coffee
E1
E
D1
1
Quantity for coffee
Essay questions
1. Discuss how the demand and supply model can be used to explain the
allocation of resources in a market economy
Brief answer: The demand and supply model show how co-ordination in the market is
accomplished in a decentralized fashion by prices. If “too much” of a commodity is
being produced in a market system, its price falls; If “too little” is being produced, its
price increases. The price remains stable only when a balance has been achieved
between what producers are willing and able to produce and what consumers are
willing and able to consume. That is, at the equilibrium in the demand and supply
model, the quantity demanded equals the quantity supplied at the particular price.
2. Using a simplified demand and supply framework, explain why the price of
goods under war conditions (everything else being equal) is bound to increase.
Brief answer: Assuming that the market is initially at the equilibrium, at point E1.
Under the war conditions, it is likely that the production process may be interrupted
and as a result the supply curve shifts leftwards from S1 to S2 – the quantity supplied
decreases at any given price. The new equilibrium, point E2 shows lower level of
quantity and higher level of price.
S2
Prices per unit of output
1
S1
1
P2
E2
E1
P1
D1
1
Q2
Q1
Quantity of output
3. Discuss how the supply and demand curves for inputs can be used to explain
the returns to the production factors.
Brief answer: The demand and supply model can also be applied to the market for
inputs where the households are the suppliers of the input (labour) and the firms are
the demanders. The demand for labour is downward sloping, showing the assumption
that as labours become more expensive (wage increases), firms hire fewer labours. In
contrast, the supply of labour is upward sloping, showing the assumption that as wage
increases, more households enter into the labour market. Hence, the equilibrium in the
labour (input) market occurs where the demand curve intersect with the supply curve.
The equilibrium point, point E in the below figure, determine the return to the
production factors (labour), We, and the number of labours employed by firms, Le.
S1
Wage rate per labour
1
E
We
D1
1
Le
The number of labour
4. Discuss the general mechanics of the Circular Flow Model. What are its
implications for exchange markets?
Brief answer: The circular flow model shows how markets regulate the physical and
monetary flows between the two sectors, households and businesses. In other words,
the circular flow model shows how a market economy answers the three fundamental
questions posed by the existence of scarcity The two sectors “meet” in the goods
market; the outcome determines what goods are produced. And they “meet” again in
the factor market; the outcome determines how things are produced. In addition, the
factor market determines how much income households get for supplying their inputs;
hence, it also determines who gets the outputs (goods/services) that are produced.
5. Discuss the role of prices in a supply/demand model.
Brief answer: The discussion should cover the following issues: how prices convey
information to consumers and producers in the market, how prices ration scare
resources in the economy and how prices determine money income. [For a full
discussion see chapter 1, p.18-19.]