Problem Set # 2 Questions: 1. Why is a choice made when resources are allocated? 2.

What is the difference between a need and a want? 3. What role does government play in a market economy? 4. What are the main production decisions which have to be made? 5. What does a production possibility curve show? 6. What are the main justifications for the entrepreneurs profit? 7. Which factor of production is least mobile? 8. Are the following positive or normative statements? (a) Raising unemployment should cut the rate of inflation. (b) Policies to reduce unemployment should favor the young rather than the old. Answers: 1. There are alternative uses to which resources can be allocated, thus a choice has to be made between these competing uses. This choice is made by any economic agent, whether it is an individual or the government. 2. A need is a necessity, such as food, clothing. In contrast, wants are not indispensable because people can do without them. They are luxury goods and services. 3. The governments role is minimal, because most decisions on the allocation of resources are made in the private sector. Thus market forces are paramount and the government takes a back seat apart from providing basic services such as roads, law and order, defence, etc. 4. The main production decisions are what, where, how and for whom to produce. 5. A production possibility curve is a simple idea which shows the maximum of all possible combinations of two types of output (usually consumer and capital goods) that can be produced with existing resources. 6. The entrepreneurs profit is the reward for organisation, risk-bearing and decisionmaking. 7. Land is the least mobile factor. 8. (a) Positive (b) Normative Questions: 1. Describe the shape of a typical demand curve. 2. What are inferior goods? 3. How does a consumer surplus arise? 4. What is the price elasticity of demand? 5. The price of a good falls by 10 per cent but the quantity demanded increases from 100 to 120 units. Calculate the price elasticity of demand. 6. List four factors that influence elasticity. 7. How would you classify a good with a high positive income elasticity? 8. What value would you expect from a cross-elasticity calculation where the two goods are complements? 9. What is the difference between a shift in demand and an expansion of demand? Answers: 1. Downward sloping from top left to bottom right is the shape of a typical demand curve. 2. Goods are inferior where demand for them falls as their price lowers. This is because people substitute other seemingly better products from the extra income that the price fall generates. 3. A consumer surplus is the aggregated total amount of utility which consumers of a good gain because the market price was less than they were prepared to pay. 4. Price elasticity of demand shows the responsiveness of demand to a change in price. 5. 20%=10% 2. Elastic. 6. Income, substitutes, necessities, time, definition of the market. 7. A superior good has a high positive income elasticity of demand, for example, luxury services. 8. A minus (_) value. 9. A shift in demand occurs when the conditions of demand change, whereas an expansion of demand is the result of a fall in price. Questions: 1. Describe the shape of the short-run supply curve. 2. What is the shape of the supply curve called?

3. Which factors affect the elasticity of supply? 4. What effect will higher wages have on the supply curve? Answers: 1. The short-run supply curve is a straight line from bottom left to top right. 2. The short-run supply curve is the marginal cost curve in the traditional theory of the firm. With cost-plus pricing, the supply curve is the price (average revenue) line. 3. The elasticity of supply is determined by time, the factors of production, stock levels and the number of firms in the industry. 4. Higher wages will cause the supply curve to shift upwards and parallel to the original supply. Questions: 1. What is the difference between a real price and a normal price? 2. When does excess supply occur? 3. What mainly causes the price instability of agricultural goods? 4. How can producers attempt to overcome the problems that the cobweb theory illustrates? 5. What does the operation of the CAP and similar schemes tend to cause? Answers: 1. A real price allows for inflation whereas a normal price is the present face value. 2. Excess supply occurs when the amount supplied is greater than the amount demanded at a given price. 3. The price instability of agricultural goods is caused by wide variations in the supply, which is naturally inelastic in the short run. 4. Producers can overcome the fluctuations in agricultural goods prices by price-fixing within a narrow range. This requires them to co-operate through a cartel and storing surplus stocks, which are then released on to the market if there is insufficiency. 5. The operation of the CAP causes higher prices, excess supplies and storage costs, but it does stabilize farm prices. Case Study: British cod the staple of fish and chips is on the verge of becoming an endangered species, according to the Worldwide Fund for Nature (WWF), the conservation group. It stressed that the crisis in the fishing industry was due to poor management and to over-fishing. The total weight of cod caught in the North Sea had halved since the 1960s. Similar falls in catches had occurred for other types of fish. The WWF proposes the establishment of fishing free zones to protect areas where young fish grow and develop. The WWF said that such a strategy would lead to increased fish stocks and a larger fishing catch for fisherman within five years. However, the problem may become less urgent as consumer demand for this type of fish may decline in the long run. Higher prices themselves may discourage consumers and some observers believe that for many consumers fish and chips may be an inferior good and, in many cases, faces a growing number of alternatives. Requirements: Using both your knowledge of economic theory and material contained in the above passage: (a) State whether each of the following would lead to a shift in the demand curve for fish or a movement along the demand curve for fish. (I) An increase in the number of substitutes for fish. (ii) A rise in the price of fish. (iii) An outward shift in the supply curve of fish. (iv) A rise in income of fish consumers. (b) State whether each of the following is true or false. (i) If the demand for fish is very price elastic a fall in supply will raise prices a great deal. (1 mark) (ii) If the supply of fish is price inelastic, a reduction in supply will have a smaller effect on price than if the supply were price elastic. (1 mark) (iii) Price changes affect demand by leading to a shift in the demand curve for the product. (1 mark) (iv) Effective advertising might raise sales by shifting the demand curve to the right. (1 mark) (v) If the demand for fish was perfectly price inelastic, a change in income would have no effect on demand. (1 mark) (vi) The longer the time period considered, the greater becomes the price elasticity of demand for goods. (1 mark)