Economics Sample Paper on Demand and supply

Final Exam

  1. Demand and supply

a). In the market for bananas, the equilibrium price would be at the point of intersection where demand (D1) meets supply (S) in figure 1 below. The initial equilibrium price will be P1 while the equilibrium quantity will be Q1.

Figure 1: Demand and Supply Curves

However, when the demand is excess, the demand curve (D1) will shift to D2, and the price will rise from P1 to P2. Quantity demanded, as well as quantity supplied will be indicated by Q2.

(b) In case of disequilibrium, high prices led to excess supply of bananas, but the demand will return to the now level, causing a reduction in the price. High prices create allocative inefficiency in the short-run. In the long-run, the price of bananas will fall to the equilibrium while the demand will rise to meet the equilibrium price.

(c) Excess demand in the market may persist due to falling of price below the equilibrium price. When the price is low, customers will respond by purchasing bananas in large quantities while suppliers may not manage to bring enough bananas in the market. An external force may create a permanent shortage, thus, preventing prices from going up. 

2. Price elasticity of demand

a) Price elasticity of demand is related to total revenue (TR) because both terms employ P and Q variables in their operation. Figure 2 below illustrates this relationship.

Figure 2: Price elasticity and Total revenue

b). When the demand is elastic, a rise in price by 1% will cause total revenue to fall. Movement from B to O in Figure 2 above represents the drop in total revenue as the price go up.

c). In case of inelastic demand, an increase in the price by 1% will result to a rise in total revenue. The movement from T to B in Figure 2 above illustrates the rise in total revenue as the price increases.

3. Understanding short-run cost curves

a) Figure 3 below represents average fixed cost, average variable cost, average total cost, and marginal cost curves

Figure 3

b) (i) A perfect competitive firm will be making normal economic profit where average cost curve meets marginal revenue curve at its lowest level as shown in figure 4

Figure 4: Firm making economic profit

(ii) Perfect competitive firm will make an economic loss if the average total cost is way above marginal revenue curve as indicated in figure 5.

Figure 5: firm making economic loss

c) A minimum efficient scale shows the lowest point that a firm can continue producing in an attempt to minimize its long-run average costs.This point is usually indicated at the point of intersection between average total cost and marginal cost, and is shown in figure 4 above.It is not possible for a firm to produce goods at any other level, as this is the lowest possible point, or opportunity cost.

4. Price and output decisions for maximizing profit

a). A perfectly competitive market usually produce at a level where the marginal costs (MC) equals to marginal revenue (MR). In the short-run, perfect competitive firms produce at a level where price is equal to marginal cost. At this level, firms can earn abnormal profits. In the long-run, perfectly competitive firms adjust their production plants, or increase capital, to achieve long-run profits. They cannot earn abnormal profits since other firms will be attracted to the industry, resulting in normal profits.

b). A monopolist maximizes his profit when he opt to produce at a point where marginal revenue crosses marginal cost at point P1 Q1, as indicated in Figure 3 below.





0                        Q1                                             Q


Figure 6: Monopolist profit maximization

c). A perfect competitive firm does not set prices while a monopoly firm is capable of setting prices. As a price taker, a perfect competitive firm has a limit of how much to bring to the market while a monopolist decides on the quantity, as well as the price level before producing. The main difference between perfect competitive firms and monopolists is the level of economic competition. Monopolists tend to enjoy lack of competition due to lack of perfect substitutes for their products. On the other hand, perfect competitive firms are quite innovative, as innovation assists them in sustaining their competitive edge.

5. Externalities

a). A negative externality happens when an economic activity creates harm to uninvolved individuals. An example of a negative externality is a factory that pollutes air. When such factory emits harmful gasses to the environment, people who live around that area may contract some diseases. Social costs of pollution increase as the level of pollution goes up. Tax can assist in addressing environmental degradation by setting a price that would discourage air pollution. The government will earn income while society will benefit from fresh air.

b). A positive externality will only occur if an action benefits uninvolved people. Example of an externality is a vaccine against communicable disease.  When people are vaccinated against communicable diseases, they prevent other people from contracting such diseases. With positive externalities, market returns are fewer than social returns. To promote social outcomes, the government should work on maximizing social returns through offering subsidies, and minimize social costs.

c). Use of tax in limiting negative externality will enlighten factories on the costs of polluting environment. However, taxation fee should match with the external cost for efficient production.  On the other hand, a subsidy will encourage health care facilities that offer vaccines to educate and convince more people to take vaccines and consequently, people will not incur much cost while treating communicable diseases. This will enhance social costs but will affect private entities.

6. GDP

a). GDP (Gross Domestic Product) is normally used to measure the value of economic activities in a country. GDP is computed by adding the total output of all products and services in a given country in the formula Y = C + I + G + NX, where Y represents GDP (or national income), C represents consumer spending, I represents investment, G represents government spending, and NX  represents net export (exports- imports).

b). GDP is not an appropriate measure of well-being because it only focus on market values, leaving out externalities, such as environmental degradation. GDP measures depreciation, which is a negative part of well-being. Although GDP measures income that a country produces, it does not account for illegal production and underground businesses. Economists should consider per capita GDP for comparing economic well-being because numerous economic activities a country will raise the GDP level and, consequently, the living standards.

c). The key difference between real GDP and nominal GDP is that real GDP values are adjusted during inflation while nominal GDP is not adjustable. This explains why real GDP is always lower than nominal GDP. Savings contribute in economic growth because the more the people saves, the more they invest, hence, raising their living standards. Growth models usually emphasize on capital accumulation because it encourages economic growth through innovation. Government taxes and budgetary decisions affects capital accumulation, therefore, government should create policies that favors capital accumulation.

7. Unemployment

a). There are three major classes of unemployment: namely, frictional, structural, and cyclical. Natural Rate of Unemployment can be defines as the equilibrium level of unemployment. At the natural rate, involuntary unemployment doe not exists, as everyone who desire to work at a given real wage rate is employed. Hence, the Natural Rate of Unemployment incorporates frictional, as well as structural unemployment.

b) Cyclical unemployment happens when an economy is unable to provide jobs to everyone who is willing to work. In figure 7 below, point a represents Natural Rate of Unemployment (NRU) while point b shows cyclical unemployment.

Figure 7:NRU

c). Sometimes, the government may create policies that cause high unemployment. When the government reduces the money supply through monetary policy, a shock may result in economic factors, leading to a fall in aggregate demand from AD2 to AD1, as shown in figure 8

Figure 8

When the government opts to replace labor with capital, people will be rendered jobless even when the economy is growing.

8. The AD-AS model

a) Aggregate-supply (AS) curve signifies the total quantity of products and services that a firm produces and sells at various price levels. Thus, the aggregate-supply curve follows the price levels. The general law of supply indicates that firms will expand their production capacity to supply more goods at higher price levels. In the short-run, the aggregate-supply curve slopes upward due to misperception theory, which indicates that overall price levels are likely to misled suppliers on what is really happening, and respond by increasing output leading to an upward-sloping AS curve. 

b) In long-run, the economy will settle P*2 due to increase in government spending that causes a shift in AD, and a rise in nominal wages that causes a shift in SRAS1 to SRAS2, as shown in figure 9.

Figure 9: Long-run AS and AD curves

c). Stagflation occurs when a country experiences high inflation and low economic growth. A sudden reduction in supply or poor macroeconomic policies can lead to stagflation. AS curve will assume a vertical shape in the long-run, since the prices will rise while the quantity remain the same as shown below in figure 10.

Figure 10

9. Fiscal policy and monetary policy

a). Fiscal policy is the government’s idea of using taxation and spending strategies, which are determined by Congress. Monetary policy is the actions taken by central banks to control economy to attain macroeconomic policy goals. These actions include price stability, stable economic growth, and full employment.

b). A multiplier effect is the additional shift that occur on aggregate demand, which results when an expansionary fiscal policy causes an increase in income, and thus, an increase in consumer spending. A crowding-out effect occurs when a reduction in the investment demand results when a fiscal expansion causes a rise in interest rate. The crowding-out effect is likely to dampen the impacts of fiscal policy that occur on aggregate demand.

c). Monetary policy can be utilized to eliminate the recessionary gap

10. International trade and finance

a). People engage in trade with each other to acquire goods or services that they lack and may desire to have, and cannot produce in their area. People can also trade to obtain cheaper products that can save them time and money, if they had initially opted to produce them. The effect of trade is that every participant would be better off. Trade is perceived as the hallmark of success.

b). Countries engage in trade because they do not possess all resources they need to be satisfied. Countries import products from other countries because they may be cheaper, or have better quality, than those they produce domestically. A country that engages in international trade is better off economically, as it creates market for its surplus products and services. Its citizens are able to enjoy goods that their country cannot produce while exporting goods creates more wealth for the country.

c) Assuming that A$1 = US$0.70, when the Australia dollar depreciates, it would take less US cents to buy the Australia dollar, and the equation could be A$1 = US$0.40. When the Australia dollar depreciates, Americans would benefit from any exchange with Australians, as they would spend less than what they would have spent earlier. Australian net export would increase, as goods will be relatively cheaper to Americans. A change in net exports will cause the aggregate demand curve shift rightwards.