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ECONOMICS MEMORANDUM – JULY 2008
SECTION A
QUESTION 1
1.1 B. √√
1.2 D. √√
1.3 D. √√
1.4 A. √√
1.5 C. √√
1.6 A. √√
1.7 D. √√
1.8 C. √√
1.9 D. √√
1.10 C. √√
1.11 C √√
1.12 B √√
1.13 C √√
1.14 D √√
1.15 B √√
State whether the following statements are TRUE or FALSE:
1.16 True √√
1.17 True √√
1.18 True √√
1.19 False √√
1.20 True √√
1.21 True √√
1.22 True √√
1.23 True √√
1.24 True √√
1.25 False √√
[2 x 25 = 50]
SECTION B
Answer all the questions
QUESTION 2:
2.1.1
(i) Supply means the quantity of a good a producer is willing to supply at a price during a
period of time. 2
(ii) Revenue means receipts from the sale of output. 2
(iii) Cost means expenditure incurred on producing a good including the estimated value
of the inputs supplied by the owner. 2
(6)
2.1.2 Production function is a technological relationship between physical inputs and
physical output (2)
2.1.3. Equlibrium price will fall. (2)
2.1.4 Earning of above- normal profit by the existing firms. (2)
(6)
2.1.5 In current account, transactions relating to export and import of goods and services
(3) and transfer payment are recorded. In capital account transaction relating to
international purchases and sales of assets are recorded.
Import of machinery is included under import of goods and so it is recorded under (1)
current account.
(4)
2.1.6 a)
Output per TR per
week
week
0
1
2
3
4
5
6
7
TC per
week
0
50
90
125
155
180
200
210
Profit per
week
0
10
25
45
70
100
140
200
0
40
65
80
85
80
60
10
MR
MC
50
40
35
30
25
20
10
10
15
20
25
30
40
60
[1 each +22]
b) 4 units per week (2)
c) The lump-sum tax has no effect on the profit-maximizing output choice as it is
essentially just a fixed cost (or a sunk expenditure) (4)
d) The unit tax increases marginal cost by R6 for every unit sold. Thus the fourth
unit is no longer profitable (MR (30) < MC (31). To maximize profit the firm should
produce 3 units per week (4)
[50]
2.2.1
1. Rise in the price of the substitute good.
2. Fall in the price of complementary good.
3. Rise in income (in case of a normal good)
4. Fall in income (in case of an inferior good)
5. Increase in taste for the good.
(10)
2.2.1
Labour Total
Marginal Wage rate Total Cost Average Margin
per
product
Physical per week per week Cost
al Cost
week per week Product
1
50
50
50
50
1.00
1.00
2
110
60
50
100
0.91
0.83
3
170
60
50
150
0.88
0.83
4
230
60
50
200
0.87
0.83
5
280
50
50
250
0.89
1.00
6
320
40
50
300
0.94
1.25
7
340
20
50
350
1.03
2.50
8
355
15
50
400
1.13
3.33
[1 each = 40]
[50]
2.3.1 Marginal revenue is the addition to total revenue from producing one more unit of
output (2
2.3.2
(i) MR = AR at all the output levels (1)
(ii) MR will be less than AR at all the output levels (1)
(4)
2.3.3 There are two ways of answering this question. You can just calculate the profit
level by using the definition of profits = revenue - total costs, where revenue is equal to
price times quantity produced. Alternatively you may use the profit-maximizing rule, that
is MR=MC. Both ways are shown in the table below.
Notice that you could produce 3 or 4 units of output. Both would yield R4 of profits.
Units of
Output
0
1
2
3
4
5
Total Cost
(R)
8
10
14
20
28
38
Revenue
(P*Q)
0
8
16
24
32
40
Profits (R)
-8
-2
2
4
4
2
MC (R)
MR (R)
2
4
6
8
10
8
8
8
8
8
[1 each = 22]
2.3.4
(I) Monopoly:
(1) Only one producer
(2) No freedom of entry to new firms, etc.
(3) Firm control prices
(4) One firm dominates
(Any 2 x 2 = 4)
(ii) Monopolistic Competition (1x2)
(1) Large number of sellers and buyers
(2) Firms produce differentiated products.
(3) Freedom of entry and exit to firms
(4) Perfect knowledge about market (any two) 1x2
(Any 3 x 2 = 6)
(iii) Perfect competition:
(1) Large number of sellers and buyers
(2) Firms produce homogeneous product
(3) Freedom of entry and exit to firm
(4) Perfect knowledge about market and technology.
(Any 3 x 2 = 6)
(16)
[50]
2.4.1 Inflation is a sustained rise in the general price level, measured by a price index.
(2) Its main features are a basket of goods, a base year, weighting and data
collection. (4) Data is calculated at different times to show changes in the index and
rate of inflation. (2)
(8)
2.4.2 Rapid inflation will harm all groups through reducing real values, creating
uncertainty, instability and harming the efficient operation of the market system. (2)The
level of inflation will influence the severity of any effects. (2) Those who benefit include
the government, borrowers, importers and some producers. (4) Those who suffer include
fixed income earners, lenders, exporters and some producers. (4)
(12)
2.4.3
(4)
Relation between ATC and AVC.
1. ATC is greater than AVC by the amount of AFC. (2)
2. The difference between ATC and AVC decreases as more output is produced
because AFC declines as level of output increases. (2)
(4)
2.4.3
Output
(units)
1
TC (Rs)
TFC (Rs)
(TVC) Rs
MC (Rs)
20
12
8
8
2
26
12
14
6
3
4
31
38
12
12
19
26
5
7
[1 each = 12]
2.4.4. Sources of demand for foreign exchange :
(i) Importers
(ii) Tourists going abroad
(iii) Investors who want to make investments in other countries.
Sources of supply of foreign exchange.
(i) Exporters
(ii) Foreign tourists
(iii) Remittances from abroad, etc.
(3)
(3)
2.4.5 It is the ratio of bank deposits that the commercial banks must keep with the South
African Reserve Bank
(2)
[50]
2.5.1
Qty. sold
(Units)
7
Price (Rs.
per unit)
10
. ATC
(Rs)
6
TR
(Rs)
70
TC
(Rs)
42
Profit
(TR-TC)
28
8
9
5
72
40
32
9
8
6
72
54
22
10
7
7
70)
70
0
:
[1 each = 12]
Profit maximizing output = 8 units (2)
2.5.2 Undertakes banking business of government: (2)
(i)
receipts,
(ii)
payments,
(iii)
foreign exchange transactions,
(iv)
credit to the government,
(v)
borrowing money on behalf of government,
(vi)
managing public debt, etc
2.5.3
Pvt. Income = ii – vii – iv – vi + iii + v
+ i
= 400 – 70 – 40 – 50 + 20 + (-10) + 30
= Rs 280 crores. (2)
[1 each = 6]
(6)
2.5.4 Disequilibrium involves persistent deficit or surplus problems, which are not
sustainable. (2) Switching intends to move domestic and foreign expenditure more
towards domestic production. (2) It includes tariffs, quotas and subsidies and should
mean more exports and fewer imports. (2)
Dampening involves reducing the level of total spending so reducing imports and forcing
domestic producers to export. (2) Deflationary fiscal and monetary policy would be used.
(2)
(10)
2.5.5
(i)
Capital account (2)
(ii)
financial account (2)
(iii)
errors and omissions/balancing item (2)
(iv)
individual components, e.g. investment flows (2)
(v)
transfers (2)
(10)
[50]
SECTION C
Answer ALL questions
QUESTION 3
EXTERNALITIES AND MARKET FAILURE
(i)
What are externalities? (4)
They are defined as third party (or spill-over) effects arising from the production
and/or consumption of goods and services for which no appropriate compensation is
paid. They are common in virtually every area of economic activity. (4)
(ii)
What is meant by market failure? (4)
Market failure occurs when freely functioning markets, fail to deliver an efficient
allocation of resources. The result is a loss of economic and social welfare. Market
failure exists when the competitive outcome of markets is not efficient from the point
of view of society as a whole.
(4)
(iii)
Why do externalities lead to market failure? (12)
If we assume that the producer is interested in maximising profits (1) - then they will
only take into account the private costs and private benefits (2) arising from their
supply of the product. The producer creating the externality does not take the effects of
externalities into their own calculations.
We assume that producers are only concerned with their own self interest The socially
efficient level of production would consider the external costs. (2) This leads to the
private optimum output being greater than the social optimum level of production.
(2)
The failure of the producer to take into account the negative externality effects is an
example of market failure. (2) Externalities can cause market failure if the price
mechanism does not take into account the full social costs and social benefits of
production and consumption. (3)
(12)
(iv)
Identify the negative consumption externalities and their impact on goods and
services.
(16)
Negative consumption externalities
1. Consumers can create externalities when they purchase and consume goods
and services.
2. Pollution from cars and motorbikes
3. Litter on streets and in public places
4. Noise pollution from using car stereos or ghetto-blasters
5. Negative externalities created by smoking and alcohol abuse
6. Externalities created through the mis-treatment of animals
7. Vandalism of public property
8. Negative externalities arising from crime
[1 each = 8]
In these situations the marginal social benefit of consumption will be less than the
marginal private benefit of consumption. (2) This leads to the good or service being
over-consumed relative to the social optimum. (2)
Without government intervention the good or service will be under-priced and the
negative externalities will not be taken into account. (2) Again there will be a deadweight
loss of economic welfare. (2)
(8)
(v)
Give the causes of market failure
1. Negative externalities (2) (e.g. the effects of environmental pollution) causing the
social cost of production to exceed the private cost.
2. Positive (or beneficial) externalities (2) (e.g. the provision of education and
health care) causing the social benefit of consumption to exceed the private benefit
3. Imperfect information (2) means merit goods are under-produced while demerit
goods are over-produced or over-consumed
4. The private sector in free-markets cannot profitably supply to consumers pure
public goods and quasi-public goods (2) that are needed to meet people’s needs
and wants
5. Market dominance by monopolies (2) can lead to under-production and higher
prices than would exist under conditions of competition
6. Factor immobility (2) causes unemployment hence productive inefficiency
7. Equity (fairness) issues. (2) Markets can generate an ‘unacceptable’ distribution of
income and consequent social exclusion which the government may choose to
change
(14)
[50]
QUESTION 4
INTERNATIONAL ECONOMICS
Free trade and protectionism
Definition of free trade
Free trade means a lack of obstacles such as tariffs and quotas. Free trade is thought to
bring benefits of higher living standards, more employment and greater choice at lower
cost. The world’s factors of production should be employed more efficiently. This is
based on the principle of comparative advantage. (3)
Protectionism
Free trade can be contrasted with protectionism. Protectionism is the economic policy
of restraining trade between nations, through methods such as tariffs on imported goods,
restrictive quotas, and a variety of other restrictive (3)
1.
2.
3.
4.
5.
6.
7.
8.
Types of protectionism
Tariffs
Quotas
Subsidies
Voluntary Export Restraints (VERs)
Administrative obstacles
Health and safety standards
Environmental standards
[Any 5 x 1 = 5]
Arguments for protectionism
1.
2.
3.
4.
5.
6.
7.
Infant industry argument
Efforts of a developing country to diversify
Protection of employment
Source of government revenue
Strategic arguments
Means to overcome balance of payments disequilibrium
Anti-dumping
[[Any 5 x 1 = 5]
Arguments against protectionism
1.
2.
3.
4.
Inefficiency of resource allocation
Costs of long-run reliance on protectionist methods
Increased prices of goods and services to consumers
The cost effect of protected imports on export competitiveness
[2 Each = 8]
Balance of payments
the balance of payments, measures the payments that flow between any individual
country and all other countries. It is used to summarize all international economic
transactions for that country during a specific time period, usually a year. (4)
The components of balance of payment:
1. Current account
2. balance of trade
3. invisible balance
4. Capital account
[1 Each = 4]
Balance of payment problems
1.
2.
3.
4.
5.
6.
7.
Consequences of a current account deficit or surplus
Methods of correction
managed changes in exchange rates
reduction in aggregate demand/expenditure-reducing policies
change in supply-side policies to increase competitiveness
protectionism/expenditure-switching policies
Consequences of a capital account deficit or surplus
[Any 4 x 2 = 8]
The effects of exchange rates on a country
The exchange rates/ foreign-exchange rate between two currencies specifies how
much one currency is worth in terms of the other. For example an exchange rate of the
South African R7.60 to the United States Dollar. (2)
1. Fixed exchange rates
2. Floating exchange rates
3. Managed exchange rates
4. Distinction between
5. depreciation and devaluation
6. appreciation and revaluation
7. Effects on exchange rates of
8. trade flow
9. capital flows/interest rate changes
10. inflation
11. speculation
12. use of foreign currency reserves
[Any 4 x 1 = 4]
Conclusion
In reality free trade may also have harmful effects in some circumstances and this may
apply particularly to developing economies. Unequal bargaining strength may prevent a
fair sharing of the benefits, unfair trading practices such as dumping may undermine a
country’s industries, dominant market positions may prevent the growth of infant
industries and there may be high short-term costs in terms of unemployment and
disruption.
(4)
[50]
QUESTION 5
MULTIPLIER
What does multiplier in economics mean? Use the scenario above to illustrate the
meaning
(i) In economics, the multiplier effect refers to the idea that an initial spending rise can
lead to even greater increase in national income. (4) In other words, an initial change
in aggregate demand can cause a further change in aggregate output for the economy.
(2)
For example: Renault-Nissan will spend R1-billion in upgrading Nissan's manufacturing
plant in Rosslyn. The money does not disappear, but rather becomes wages to
constructors of the plant, revenue to suppliers etc. (4) The constructors will have higher
disposable income as a result, so consumption, hence aggregate demand will rise as
well. (4) Say that all of thee workers combined spend R2-billion in total, since there was
an initial R1-billion input which created a R2-billion output, the multiplier is 2. (4)
(ii)
Use multiplier analysis to explain what effect this investment might have on the
South African national income.
The National Income Multiplier says that an initial increase in spending can cause
further rounds of spending. (2) Therefore, the final increase in National Income is greater
than the initial spending (or injection of Money) (2) e.g if Government increase spending
on the wages of workers by R2million. (2) That means National Income increases by
R2million. (2)
However, if workers spend part of their extra wages, additional output and incomes will
be generated. (2)The final increase in National Income may be R3million. (2) Therefore,
there is a multiplier effect of 3/2 = 1.5 (4)
(iii) What Determines size of Multiplier?
a. The size of the multiplier depends on withdrawals and the marginal propensity to
consume (2)
b. If Renault-Nissan workers spend 90% of their extra income, the multiplier effect will
be high. (2) If they spend only 10% of extra income the multiplier effect will be low.
(2)
c. A cut in income tax means that people keep a high % of their gross income.
Therefore the multiplier effect will be higher. (2) A cut in income tax is a withdrawal leading to less spending and therefore it reduces the size of the multiplier. (2)
d. Multiplier Formula = 1 / 1-mpc (4)
e. As income tax increases the marginal propensity to consume will fall. (2)
[50]
QUESTION 6
INFLATION
(i) Meaning of inflation
1. Inflation measures the increase in cost of living. It is the percentage change in a
specific cost-of-living index at various points in time.
2. Basically it refers to the annual percentage increase in the general price level.
3. Inflation means that the value of money decreases. Basically, if prices increase it
means that R10 will buy less goods than previously.
4. It is the “overall” price level computed for a “basket of goods”
5. Inflation is measured in the SA using the CPI - Consumer Price Index.
6. The South African government has an inflation target of CPI 3 -6%.
[2 each =12]
(ii) Causes of inflation or factors that might initiate and sustain a period of persistent
inflation.
1. Cost push inflation. This occurs when firms have an increase in costs and then
pass these costs on to the consumer in the form of higher prices. This could
occur due to various reasons such as: (2)
a.
Wage push inflation. Wages are one of the biggest costs of firms
therefore if wages increase this is likely to cause inflation. Rising wages
will also cause increased AD. (2)
b. Increased price of raw materials. If input prices increase firms will either
have to increase their prices or reduce their profit margins. When OPEC
recently increased the price of oil all transport costs were increased, this
led to an increase in the general price level. (2)
2. Demand-Pull – where aggregate demand (AD) rises at a faster rate than
aggregate supply (AS) (2)
3. Inflation is caused when the monetary authorities allow the money supply to
increase at a faster rate than the growth in national income. (2)
4. Therefore increased consumer confidence, rising house prices and rising wages
would all cause higher C and therefore AD would increase. IF the economy was
close to full capacity and AD increases faster than AS this will cause inflation. (2)
5. If consumer spending rise rapidly causing a very fast rate of growth and this is
unsustainable, inflation will rise. (2)
6. If the economy is in a recession an increase in AD will not cause inflation.
7. A devaluation in the exchange rate is also likely to cause inflation: (2)
a. Firstly this will cause an increase in the price of imports which will be passed
onto the consumers. (2)
b. Secondly there will be an increase in Exports and therefore higher AD. Also
firms may have less incentive to cut costs because exports become cheaper
ithout them trying. (2)
(20)
Economic Costs of Inflation
1. Menu costs.
2. Inflation creates uncertainty and confusion.
3. Lower Competitiveness
4. Inflationary growth is unsustainable.
5. Inflation reduces the value of savings.
6. Shoe leather costs.
7. Relative price variability
8. Tax distortions
9. Arbitrary redistribution of wealth
[Any 5 x 2 = 10]
High inflation is considered harmful to the economy (2) because:
1. It creates uncertainty amongst firms and consumers. This leads to lower
investment and economic growth. (2)
2. High inflation is associated with unsustainable economic growth. This leads to
the boom and bust situation. (2)
3. High inflation reduces the country’s international competitiveness. (2)
[50]
[300