Final Review questions

Final Review questions Question 1: -The demand for labour is a derived demand. Explain? Demand for labour is derived demand because labour is demanded not for itself but for the profits which it brings to the company. Figure beside shows the demand for labour which is downward-sloping because we assume that in perfect competition the firm is a price taker, the decline in MPPL means that the MRP curve is also declining. The figure also shows that the firm hires 5 labours to maximize profit where wage is equal to MRP (W = MRP); that is, where wage line intersects the MRP curve.demand for labour: the demand curve for labour in a perfectly competitive model is given by the marginal revenue product curve. Question 2: Suppose that the inflation rate in Kuwait between 2004 and 2005 was 10 percent, the nominal GDP in 2005 was 110 Billion. Calculate the GDP deflator and the real GDP in 2005 expressed in terms of 2004 prices. Nominal GDP2005 110 Real GDP2005 billion GDPdeflator 2005 110 GDP deflator 2005= 10 + 100=110 Question 3: In most countries around the world, income in the form of money is vital to people s everyday life, and the Circular Flow Model provides us with a framework for understanding changes in income at a national level. Discuss the extended circular flow of income with leakages and withdrawals and draw it and show how it differs from the basic Circular Flow Model. The circular flow (CF) model of income: - All activities of an economy (or a country) involve a set of exchanges. Economists analyze such exchanges using a circular flow model of income as in the figure below it shows: - 1) Firms pay incomes to households for supplying the factors of production (labor, capital, land) to firms. That is, firms pay incomes such as wages, dividends and interest, and rent to households for supplying those factors. 2) On the other side of the flow, households pay firms for the goods and services they consume (or buy from firms). So, there are two flows: - 1. The first is Physical flow (solid lines) of goods and services from firms to households and of the factors of production from households to firms. 2. The second is money flow (dotted lines) in the opposite direction, from firms to households in the form of income for the factors of production they supply and from households to firms in the form of consumption expenditure for the purchases of goods and services. 1

The basic CF model of income The extensions to the CF model: - The Extensions of the basic CF model is basically to add more (complete) financial or money flows, as show in the figure below there are three extensions of the basic CF model: - 1) First is to add savings by households and investment by firms. households don't consume all their income, but they save (deposit) part of their income to financial institutions (banks) and banks lend the deposited money to firms for investment. As such, in the CF model, saving is treated as withdrawal (or leakage) from household spending and investment is injection of finance to firms. 2) Second is to add financial flows of government sector. Government earns revenue (income) by imposing taxes on households and businesses, but some revenues are paid back to households in the form of pensions known as transfer payments. Thus one arrow shows money flow coming from households to government as taxes less transfers as leakage. The corresponding injection is the money government spends on defense, health, education and so on. Savings, imports and taxes less transfers are leakages or withdrawals from households. Investment, exports, and government spending are injections of finance into firms. 3) Third is to add financial flows of foreign trade sector. Goods and services that are brought into the country are known as imports, and goods and services sold to the foreign countries are known as exports. - Money payments to foreign countries for imports are leakages (withdrawals) from the CF of income. - Money payments received by home country from foreign countries are injection in the CF of income. The Extended CF Model 2

Question 4: - a) Table (1) shows output, Total Fixed Cost (TFC), Total Variable Cost (TVC) for a firm operating in a perfectly competitive market. Rewrite the table in your answer book and complete the columns: Total Cost (TC), Total Variable Cost (TVC), Average Cost (AC) and Marginal Cost (MC). (Round the figures of costs to the nearest 1$.) Table (1) A firm s Total and Marginal Costs Q TFC TVC TC AC MC 0 400 1 450 2 495 3 530 4 550 5 180 6 225 7 290 Q TFC TVC TC AC MC 0 400 0 400 0-1 400 50 450 450 50 2 400 95 495 247.5 45 3 400 130 530 176.67 35 4 400 150 550 137.5 20 5 400 180 580 116 30 6 400 225 625 104.17 45 7 400 290 690 98.57 65 ثابت TFC TVC TC- TFC TC TVC TFC TC AC Q TC MC Q b) If the market price is $20, what is the level of quantity that will maximize the profit for this firm? Show how your calculation? (10 marks) The level of quantity that will maximize the profit for this firm = 4, were MC=MR=P=20 TR at Q4= P x Q= 20 x 4=80 Profit at Q4= TC-TR= 550-80=470 Question 5: A production activity that generates a social cost is an example of a negative externality. Discuss the effects of the negative externality, as a source of pollution, on the market efficiency. What is the rationale for government intervention? Use diagrams to illustrate your answer. Externality: an externality happen when one person s action affects the welfare of another in ways that the first need not take into account. An externality therefore arises in a market when producer, seller s or buyers actions influence the welfare of others in ways not reflected in market prices. For example: Pollution. A good example of a negative externality is water pollution because firms don t have to pay for its costs to others. government intervention because for public goods (externalities) there are no markets where you can buy and sell those public goods (or externalities) so as a result there is market failure for such goods, and government needs to deal with the polluters. Market failure: is a market in which competition doesn t bring about a pareto optimal outcome is said to exhibit market failure. Figure below shows the effect o f externalities on efficiency. MPC=S is the supply curve of the firm derived from the marginal private cost of the firm which producing the output that is producing externality. 3

The MPC curve only include those costs that firm actually has to pay. The private market equilibrium is at A, where firm s supply curve equals demand curve (MPC=MR=D) at price Pp and output Qp. But this is not an efficient market equilibrium; because by producing Qp it causes damage to other people who are not consumers of the good. So the firm should include external cost (EC) in their action and in that case society s cost is marginal social cost (MSC). (MSC = MPC + EC) And in that case the efficient market outcome is output Qs and price Ps at point B. Thus efficient allocation requires (MSC = D = P). Externalities therefore imply market failure. A market failure identifies an opportunity for intervention to improve market outcomes, consumers don t want pollution reduced to zero rather the efficient or optimal outcome (Qs) is less output and less pollution. So government can achieve a market efficient equilibrium at point B with output equal to Qs by two methods. Government have 2 methods to force the firms to reduce output and pollution down: - 1) Governments can impose a tax that internalizes the externality, that is increases firms costs to include full costs of output including social costs which will make production up to optimal level Qs. 2) Government can create incentives for firms to find new technology and to clean up their emissions. Figure below shows the use of a specific tax to force down output of the polluting industry to the optimum level. The tax rate is the vertical distance between the supply curves S and (S + t), equal to the distance BC. The market equilibrium without the tax is at A, at price Pp and output Qp. The tax shifts the firm s supply curve to (S + t), and the market equilibrium to B with price Ps and quantity Qs. The firm s supply curve (S + t) is drawn at precisely the level to force output down to the market optimum level QS. Achieving that in practice wouldn t be easy government need to calculate what the market optimum should be, and the precise tax needed to achieve it. The effect of taxes 4

Government Intervention in Market Dynamics: - Government can create other incentives to reduce pollution but not by reducing output. For example: - 1) Use regulation that firms must buy machines to clean the gases (wastes) before emitting to environment. Or they won t stay in the business. 2) In perfect competition firms might be taxed, not on output, but on measured pollution. Less pollution, less tax, hence an incentive to install the clean-up equipment. 3) In imperfectly competitive low pollution can be advantage for innovation firms allowing them to: 1) operate profitably at a regulated environment. 2) and to sell on innovative solutions. So then government can: 1) offer firms incentives and opportunities to innovate. 2) increase market power for the leaders. It remains possible that if government imposes restrictions, firms may move to other areas with less restrictions and keep on polluting. So this restriction should be done worldwide because moving of firms will decrease the GDP of the country. Question6: Consider the following information for a perfectly competitive hats manufacturing firm that can sell as many hats as it wants for $5 per hat. a. Fill in all the blanks in the table(10 marks; 3 marks for each column and 1 mark for the second column) Number of Workers Q MPPL L Number of hats Produced per day (TP) Marginal Product of Labour (MPL) Price of hat (P) 0 0 5 1 50 5 2 90 5 3 125 5 4 150 5 5 20 5 6 185 5 7 195 5 Number of Workers MRP MPPL P TR P Q Number of hats Produced per day (TP) (Q) Marginal Product of Labour (MPL) Price of hat (P) Marginal Revenue Product (MRP) Marginal Revenue Product (MRP) Total Revenue (TR) Total Revenue (TR) 0 0-5 - 0 1 50 50 5 250 250 2 90 40 5 200 450 3 125 35 5 175 625 4 150 25 5 125 750 5 150+20=170 20 5 100 850 6 185 15 5 75 925 7 195 10 5 50 975 b. If this firm must pay a wage rate of $75 per worker per day, how many workers should it hire in order to maximize its profits? Briefly explain why.(5 marks) Under perfect competition, the profit maximizing level is (W=MRP=75) when the number of employee = 6 5

c. Suppose the market wage rate rises to $105 per worker. How many workers should be hired now? Why? (5 marks) Number of workers should be hired = 4(MRP < W), because if the firm hire more workers wages will be greater than MRP which means profit will minimized. d. Discuss what is meant by diminishing returns to a factor of marginal product of labour? Show how the table indicates a situation of diminishing returns. (5 marks) diminishing returns of labour means that the marginal product of labour decreases as units of labour hired increases. In the table it shows that all marginal product of labour starts to decrease after hiring 2 units of labour. Question 7: - a) What is the definition of National Income? Suppose that money (nominal) GDP at market prices for a certain country in year 2009 was equivalent to $110 million. In 2010, the money GDP increased to $115 million. Assume that the inflation rate between 2009 and 2010 was 5 percent. Calculate the real GDP in year 2010 expressed in terms of year 2009 prices. National income: is the value of the goods and services available in a national economy over a given period of time, usually a year. Inflation index 2010 = 100+5=105 money GDP2010 Real GDP2010 inflation index 2010 115 105 109.52million b) Draw the extended circular Flow of income. By referring to your diagram, explain the financial flows that happen in the economy. The Extensions of the basic CF model is basically to add more (complete) financial or money flows, as show in the figure below there are three extensions of the basic CF model: - 1) First is to add savings by households and investment by firms. households don't consume all their income, but they save (deposit) part of their income to financial institutions (banks) and banks lend the deposited money to firms for investment. As such, in the CF model, saving is treated as withdrawal (or leakage) from household spending and investment is injection of finance to firms. 2) Second is to add financial flows of government sector. Government earns revenue (income) by imposing taxes on households and businesses, but some revenues are paid back to households in the form of pensions known as transfer payments. Thus one arrow shows money flow coming from households to government as taxes less transfers as leakage. The corresponding injection is the money government spends on defense, health, education and so on. Savings, imports and taxes less transfers are leakages or withdrawals from households. Investment, exports, and government spending are injections of finance into firms. 3) Third is to add financial flows of foreign trade sector. Goods and services that are brought into the country are known as imports, and goods and services sold to the foreign countries are known as exports. - Money payments to foreign countries for imports are leakages (withdrawals) from the CF of income. - Money payments received by home country from foreign countries are injection in the CF of income. 6

The Extended CF Model Question 8: - a) The perfect competition model is primarily an analysis of a spot market in which an amount of labor in the present is sold for wages. The price of labor wage rate- and the level of employment are determined by the intersection of supply and demand, just as in many commodity markets. A number of assumptions form the starting point of this model. Discuss these assumptions? Assumptions of a perfectly competitive labor (service) market: - 1) Buyers and sellers of labor are price takers: they can t individually change wages. 2) All participants are perfectly informed: workers know the available job and wage opportunities, while firms know the potential workers in the labor market. 3) Workers can move freely between jobs or in and out of work. 4) Labor hours, once purchased from the workers, are used without problems to produce output. 5) Firms aim to maximize profits. b) Define and discuss the demand for labor and the supply of labor. demand for labor: the demand curve for labour in a perfectly competitive model is given by the MRP curve. A graph that illustrate the amount of labour that firms want to employ at each given wage. The demand curve is downward sloping, when the price of wages decrease the quantity demanded of labour will decrease this input will be replaced by another cheaper unit. supply of labor: represents the decision on how much labour to supply at each point of the labour supply curve represents the amount of labour households want to supply at each given labour (wage) rate. The supply curve in a graph that illustrates the amount of labor that households want to supply at each given wage rate. The supply curve is upward sloping. Were the price of labour(wages) increases, the quantity supplied will increase. 7

c) Suppose that an increase in the demand for labour will happen in the country. Use diagrams to explain the impact of this market change and describe in words what will happen on the graph. If an increase in demand for labour will happen in the country,the demand curve will shift to the right from L D1 to L D2 (and it creates as excess demand for labour at initial wage) and wage rate increases from W 1 to W 2, and the quantity of labour supplied will also increased shows as a movement along the supply curve. Question 9: - a) In most countries, income is in the form of money and is vital to people s everyday life. What is a national income?. Explain, using graphics, a simple model that can provide a framework for understanding changes in income at a national level. National income is the value of the goods and services available in a national economy over a given period of time, usually a year. The circular flow (CF) model of income: - All activities of an economy (or a country) involve a set of exchanges. Economists analyze such exchanges using a circular flow model of income as in the figure below it shows: - 3) Firms pay incomes to households for supplying the factors of production (labor, capital, land) to firms. That is, firms pay incomes such as wages, dividends and interest, and rent to households for supplying those factors. 4) On the other side of the flow, households pay firms for the goods and services they consume (or buy from firms). So, there are two flows: - 3. The first is Physical flow (solid lines) of goods and services from firms to households and of the factors of production from households to firms. 4. The second is money flow (dotted lines) in the opposite direction, from firms to households in the form of income for the factors of production they supply and from households to firms in the form of consumption expenditure for the purchases of goods and services. W 2 W 1 L 1 L 2 L D2 1 The basic CF model of income 8

b) Suppose that money (nominal) GDP at market prices for a certain country in year 2010 was equivalent to $120 million. In 2011, the money GDP increased to $126 million. Assume that the inflation rate between 2010 and 2011 was 6%. Calculate the real GDP in year 2011 expressed in terms of year 2010 prices. (5 marks) Inflation index 2011 = 100+6=106 money GDP2011 Real GDP2011 inflation index 2011 126 106 118.87million c) Economists believe that the demand for labour is the demand for a factor of production. Discuss what is meant by this showing, using graphs, how the demand for labour is determined for a firm. Demand for labour is derived demand because labour is demanded not for itself but for the profits which it brings to the company. Because we assume that in perfect competition the firm is a price taker, the decline in MPPL means that the MRP curve is also declining. As in the figure 2. Figure below shows that if MRP > W, as in point A, firm will hire more labour that will increase profit. and when MRP < W, as in point B, firm will decrease labour that will reduce loss (or increase profit). and when MRP = W, as in point E, firm s profit is maximized, and LE amount of labour hours hired. افضل نقطة (E MRP = W) So firm that maximizes profits will demand labor up to the point at which W=MRP The firm s MRP curve is the firm s demand curve for labour (LD). This is because increase or decrease in wage rate will intersect different points in MRP curve which will give profit maximizing labour demand by the firm. That is, MRP curve traces out the demand for labour curve (LD). Demand for labour: the demand curve for labour in a perfectly competitive model is given by the marginal revenue product curve. 9