Fundamentals of Economics. 25 November Marking Scheme

Transcription

1 Fundamentals of Economics 25 November 2015 Marking Scheme This marking scheme has been prepared as a guide only to markers. This is not a set of model answers, or the exclusive answers to the questions, and there will frequently be alternative responses which will provide a valid answer. Markers are advised that, unless a question specifies that an answer be provided in a particular form, then an answer that is correct (factually or in practical terms) must be given the available marks. If there is doubt as to the correctness of an answer, the relevant NCC Education materials should be the first authority. Throughout the marking, please credit any valid alternative point. Where markers award half marks in any part of a question, they should ensure that the total mark recorded for the question is rounded up to a whole mark.

2 Section A Answer ALL questions from this section Question 1 a) Explain what is regarded as the fundamental problem of economics; support your answer with two examples. Scarcity (1 mark) and resource allocation, choices (1 mark) Examples of scarce resources, e.g. petrol, palm oil, etc. (2 marks) 4 b) Explain in economic terms why there is no such thing as a free lunch. 2 The cost involved is an opportunity cost (1 mark), the benefit forgone by not choosing the next best alternative (1 mark). c) Identify the main four factors of production. 4 Land, labour, capital and enterprise (1 mark for each) Total 10 Page 2 of 16

3 Question 2 a) In economic theory what is the difference between the short run and the long run? The short run is a period of time in which one factor of production is fixed. (1 mark) In the long run it is assumed that all factors of production are variable. (1 mark) b) In the example of a firm wishing to increase output in the economic short run, by adding a variable input, such as labour, to a fixed amount of capital, explain what is meant by diminishing marginal returns to labour setting in. An extra worker will add less to total output than the previous worker. c) In terms of long run average costs distinguish between economies of scale and diseconomies of scale. Economies of scale exist where an increase in all the inputs or factors of production results in falling long run average cost curves (2 marks) Diseconomies of scale set in where the long run average total cost curve begins to rise (1 mark) d) Define the following terms: i) Price elasticity of demand. 2 Price elasticity of demand measures the responsiveness of demand after a change in price (percentage change in quantity demanded/percentage change in price). ii) Income elasticity of demand. 2 Income elasticity of demand measures the responsiveness of the demand for a good to a change in the income of the people demanding the good (percentage change in quantity demanded/ percentage change in income). Total 10 Page 3 of 16

4 Question 3 a) List three factors that would define the market structure known as perfect competition. Award 1 mark for each correct point (to a maximum of 3) from any of the following: (1) large number of buyers and sellers, (2) no buyers or sellers can influence the ruling market price by their own action, (3) all buyers and sellers can trade as much as they wish at the ruling market price, (4) all buyers and sellers possess perfect market information, (5) a uniform product, (6) free entry and exit in the long run. b) Describe the demand curve faced by a firm in the short run in perfect competition. This is infinitely elastic, i.e. horizontal 3 1 c) Describe and distinguish between the following abstract terms: 1 i) Normal profit The minimum level of profit required to keep existing firms in production, yet being insufficient to attract new firms into the industry (1 mark) ii) Abnormal profit 1 Any extra profit over and above normal profit (1 mark). d) In imperfect competition of an oligopoly explain why the demand curve is described as being kinked. The oligopolist perceives that demand will be relatively elastic in response to an increase in price, because he expects his rivals to react to the price rise by keeping their prices stable, thereby gaining customers at his expense (2 marks). Conversely he expects his rivals to react to a decrease in price by cutting their prices by an equivalent amount, he therefore expects demand to be relatively inelastic in response to a price fall, since he cannot hope to lure many customers away from his rivals (2 marks). 4 Total 10 Page 4 of 16

5 Question 4 a) Define the term money. 2 Award 2 marks for some form of logical definition, examples include: Money is as money does, anything that performs the functions of money is money. A current medium of exchange in the form of coins and banknotes. b) Outline three functions of money. 3 A medium of exchange, a store of value, a unit of account. c) In a barter system, what does the term double coincidence of wants mean? 1 In order to obtain a particular good or service from a supplier, one has to possess a good or service of equal value, which the supplier also desires. d) What is credit creation? Using an example explain the risk of credit creation. 4 It relates to how banks can extend loans to their customers in excess of the cash or other assets retained on deposit, since the depositors will normally only withdraw a proportion of the funds that they have placed with the bank at any one time.(2 marks) The risk is that if depositors want their funds back in full and quickly, the banks will experience a liquidity crisis (1 mark) Northern Rock or any run on a bank would be a suitable example (1 mark) Total 10 Page 5 of 16

6 Question 5 a) Define the following terms i) Microeconomics 2 This focuses upon the detailed workings of individual markets ignoring wider factors like interactions with other markets. ii) Macroeconomics 2 This looks at the interaction of different parts of the overall economy; it simplifies in a different way from microeconomics i.e. by focusing just on broad economic aggregates like inflation, unemployment or economic growth. b) In the context of Equilibrium National Income explain what is meant by the term paradox of thrift. Keynes believed that deficient demand was either caused in the first place or certainly reinforced, by a collapse of private sector consumption and investment demand. The tendency of households to save too much becomes a vice in the economy as a whole if unemployment is caused by too little consumption. 2 c) Explain the term monetary transmission mechanism. 2 This refers to the process by which a central bank s monetary policy decisions are passed on, through financial markets, to businesses and households. d) Explain the term crowding out by (a) a government raising taxes and (b) a government funding certain activities. In terms of a government raising taxes, it leaves less discretionary income for individuals and businesses spend (1 mark). When a government funds certain activities there is little incentive for businesses and individuals to spend on those same things. (1 mark). 2 Total 10 Page 6 of 16

7 Section B Answer any TWO (2) questions from this section Question 6 a) The law of demand states that the price of a product will inversely influence the demand for that product, other things remaining equal. i) Identify four variables which influence the household s demand for a product. 4 Market price, level of household income, prices of other goods, tastes and preferences of the household, expectations about future events. (1 mark for each up to a total of four marks) ii) Explain what is meant by the income effect and the substitution effect when a price falls. Award up to 3 mark for explaining each effect. Income effect is felt because the household budget now goes further, it has more purchasing power. The household is likely to buy more of the good that has fallen in price, assuming it is a normal good. The inverse will occur where the good is inferior. (3 marks) Substitution effect arises because the good in question is now relatively cheaper than it was compared with other goods. So it makes sense for expenditure to be switched away from other goods towards this good. (3 marks) 6 iii) Explain what is meant by an inferior good and give an example of such a good. There are some goods, such as basic foods, for which consumption will fall as family income increases. White bread is an example where consumption has fallen steadily over the past decade. 3 b) Define each of the following, giving an example for each: i) A substitute good 3 Products that meet similar wants in the eyes of the buyer. An example would be ham and chicken that may be used as the filling for a sandwich. ii) A complement good. 3 Products that are often consumed together. An example would be DVD player and DVDs. Page 7 of 16

8 c) In looking at market demand, explain the difference between a movement along 6 a demand curve compared to a shift of the demand curve. Award up to 6 marks for a developed explanation, giving a clear distinction. Here is it important to distinguish between the price of the product and the other determinants known as the conditions of demand. A change in price results in a movement along a demand curve. A change in one of the conditions of demand (income, the price of other goods, tastes, price expectations or population) will lead to a shift of the demand curve. Question 7 Total 25 a) Explain the concepts of : i) Moral hazard, and outline two ways that travel insurers could try to reduce it. 4 Moral Hazard is a concept that expresses the higher likelihood of engaging in risky behaviour because of increased protection. (2 marks) Ways to reduce it include: (1 mark each up to a maximum of 2 marks) Introducing an excess Lower premiums linked to accident free periods Exclusions that resulted from risky behaviour ii) Adverse selection. 3 The increased likelihood of having those facing a higher risk taking up voluntary insurance due to asymmetric information. (3 marks) iii) Asymmetric information. 3 A situation in which one party in a transaction has more or superior information compared to another. (1 mark) This often happens in transactions where the seller knows more than the buyer, although the reverse can happen as well. (1 mark) This asymmetry is a direct consequence of efficient information search, because the acquisition of information, like the production of any good, uses scarce resources and incurs an opportunity cost (1 mark). b) Outline two strategies insurance companies might adopt in addressing the issue of adverse selection in health related insurance. Ways to protect against it include: (3 marks for each up to a maximum of 6 marks) Increase selection criteria Charge differential premiums according to risk Exclude some risks 6 Page 8 of 16

9 c) Describe the principal-agent problem and explain why it is a problem. 3 Conflicts of interest and moral hazard issues (1 mark) that arise when a principal hires an agent to perform specific duties that are in the best interest of the principal but may be costly, or not in the best interests of the agent. (1 mark). The principal faces information asymmetry and risk with regards to whether the agent has effectively completed a contract (1 mark). d) Describe three ways of coping with the principal-agent problem. 6 Award 2 marks each up to a maximum of 6 Provide incentives so that agents behave in the way that principals wish Reduce costs of removing agents or disciplining them Improve monitoring of the behaviour of agents Improve information transparency to better understand the performance of agents Total 25 Page 9 of 16

10 Question 8 a) Consider a closed economy with no government sector where national income is 16,000, and households save 20% of their income. Illustrate this economy using a circular flow diagram which includes the value of investment ( I ) by firms. 4 Y National Income = 16,000 Households Firms S Savings 3,200 I Investment 3,200 C Consumption = 12,800 Mark breakdown Award up to 2 marks for the correct diagram and up to 2 marks for the correct figures. b) A world recession provides a shock to this economy. National Income is unchanged at 16,000 but household consumption falls by 25%. Assuming Say s Law: i) What impact will the fall in consumption have on the level of investment by firms? C before shock = 12,800 25% = 3,200 So C after shock = 9,600 (1 mark) Since S=Y-C it follows that we have a new S= 16,000-9,600= 6,400 (1 mark) Under Say s Law this new higher volume of savings is transformed into investment, with I=S (1 mark) 3 ii) Describe the economic mechanism that could bring about this investment response. Award up to 2 marks for a detailed description. This is flexible interest rates. The increase in flow of savings to the investment market induces a fall in interest rates. Firms can borrow more, so investment increases. 2 Page 10 of 16

11 c) Now consider the addition of a government sector to the circular flow model for this closed economy. From a demand-side perspective, as advocated by Keynes: i) Explain how a fall in consumption might reduce national income. 4 A reduction in consumption reduces the flow of income to firms (1 mark). This reduces national income directly (1) and may increase uncertainty about the future, in which case firm might cut investment. This will also reduce national income (1 mark). This may cause households to save more, further reducing national income (1 mark). ii) Give two examples of fiscal policy measures that might be used to counteract this fall by stimulating growth in national income. Increased government spending (1 mark) Reduction in taxes (1 mark) Other examples such as research and development grants are also acceptable. 2 iii) Explain how a rise in the government deficit could affect investors holding government bonds (gilts). To finance the deficit the government needs to sell more bonds (1 mark). It will have to offer a higher interest rate to attract buyers (1 mark). The price of existing stock will tend to fall to bring returns into line with the new issue of bonds (1 mark). This means existing holders will make reduced gains or even losses if they have to sell before redemption. (1 mark) d) Now assume an open economy buying imports and selling exports. Identify three advantages or disadvantages of this economy maintaining a fixed exchange rate. Advantages: Fixed exchange rates ensure price of imports is stable and this helps in controlling inflation (2 marks). Fixed exchange rates temper uncertainty of markets. It reduces speculation in currencies (2 marks). Disadvantages: Fixed exchange rates are inflexible. A falling exchange rate makes exports cheaper (2 marks). Fixed exchange rates may lead to more speculation in currencies (2 marks). 4 6 Total 25 Page 11 of 16

12 Question 9 a) Using a Phillips curve diagram, explain why and how policy makers use the output gap (the gap between equilibrium and actual output) to target inflation. Answers need to be based around the following: The output gap: Definition of the output gap (the difference between equilibrium and actual output) (1 mark) The role of unions and firms (price setters and wage setters) is setting price and wage inflation. Workers bargain on the basis of lagged inflation and firms employ a price mark-up (1 mark) The role of lagged expectations and the output gap in determining prices (1 mark) How positive and negative output gaps lead to unstable inflation, spiralling inflation or deflation. Thus to target inflation the central banks will seek to achieve a zero output gap (1 mark) The bank of England tries to look ahead on the future planning horizon to see what the output gap is likely to be (1 mark) The VPC shows all combinations of output and inflation which keep inflation constant. This happens for all levels of output and the inflation rate as long as the output gap is zero (1 mark) The diagram also shows what happens with a positive output gap, with output above the equilibrium level. (1 mark) Initially workers are able to bargain for an increase in wages and as a result inflation increases. (1 mark) But this increase in the inflation rate results in a subsequent increase in expected inflation. The Phillips Curve shifts from SRAS1 to SRAS2. (1 mark) At the positive output gap, ever increasing, and mutually reinforcing, price inflation and expected inflation will shift the Phillips curve continually upwards as shown in the diagram below. (1 mark) 15 (Diagram 5 marks deduct 1 mark per error) Page 12 of 16

13 b) Briefly describe five types of unemployment. 5 Award 1 mark each for any of the following: (i)real wage or classical -caused by real wages being too high (ii)frictional results from the time lag involved in the move from one job to another, related to the immobility of labour. (iii) Casual Unemployment occurs where labour is employed on a shortterm basis and is seasonal in nature (iv) Structural unemployment arises where a firm or industry suffers a structural decline (v) Technological unemployment where automation reduces employment (vi) Demand deficient caused by a lack of demand in the downswing of the business cycle (vii) Residual unemployment covers any other type such as work-shy and the unemployable. c) Briefly describe five types of inflation 5 Award 1 mark for each type: (i)suppressed inflation - can divert the inflationary process into quantity shortages, queues, waiting lists and black markets (ii)creeping inflation fairly stable from year to year but creeping upwards (iii) Strato-inflation ranges from around 10% to several hundred percent, hard to anticipate and prevalent in developing countries (iv)hyper-inflation usually short-lived and occurs in severe political crisis where a government creates money to pay its debts. Can be several thousand percent. (v)stagflation high inflation and increasing unemployment. Typically stagnation in the economy with price inflation. (1 mark for each) Total 25 Page 13 of 16

14 Question 10 a) Describe the main features and use of the income statement. 5 Award 1 mark for each correct feature, for example: An income statement presents the results of a company's operations for a given period a quarter, a year, etc. (1 mark) The income statement presents a summary of the revenues, gains, expenses, losses, and net income or net loss of an entity for the period. (1 mark) This statement is similar to a moving picture of the entity's operations during the time period specified. Along with the balance sheet, the statement of cash flows, and the statement of changes in owners' equity, the income statement is one of the primary means of financial reporting. (1 mark) The key item listed on the income statement is the net income or loss. (1 mark) A company's net income for an accounting period is measured as follows: Net income = Revenues - Expenses + Gains Losses. (1 mark) b) Describe the main features and use of the balance sheet (statement of financial position). The balance sheet is a financial statement that shows what the business is worth at one point in time. (2 marks) A standard company balance sheet has three parts, assets, (1 mark) liabilities (1 mark) and ownership equity or capital (1 mark). 5 c) Describe the main features and use of the cash flow statement. 5 A cash flow statement is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents (1 mark), and breaks the analysis down to operating, investing and financing activities. (1 mark) Essentially, the cash flow statement is concerned with the flow of cash in and out of the business. (1 mark) The statement captures both the current operating results and the accompanying changes in the balance sheet. (1 mark) As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills (1 mark). d) Describe the following types of cost, giving an example for each: i) Fixed 2 Independent of the volume of activity, examples include staff costs, rates. ii) Variable 2 Costs that vary in relation to a chosen measure of activity. Examples include metered water, electricity and gas. iii) Sunk cost 2 A sunk cost is a cost that has already been incurred and cannot be recovered, for example, 10 million has been spent on building a factory but this will now cost too much to complete. Page 14 of 16

15 e) Identify four characteristics of good financial information. 4 These could include the following, one mark for each up to a maximum of four marks. Relevance directly useful in the context of any decisions Reliability free from any deliberate error Comparability helpful in making valid comparisons Understandability comprehensible to well informed users Timeliness available when needed Materiality the information needs to be significant Total 25 End of paper Page 15 of 16

16 Learning Outcomes matrix Question Learning Outcomes assessed 1 1 Yes 2 1 Yes 3 1,2 Yes 4 3,4 Yes 5 1,3,4 Yes 6 1 Yes 7 1,2 Yes 8 3,4 Yes 9 3,4 Yes 10 1,4 Yes Grade descriptors Marker can differentiate between varying levels of achievement Learning Outcome Pass Merit Distinction Apply the basic tools of microeconomics and the theories of demand and supply Demonstrate adequate and appropriate application Demonstrate sound and consistently appropriate application Analyse the various forms of market structure Analyse the key components of macroeconomics Examine the monetary policy and its effect on the economy Demonstrate adequate ability to analyse Demonstrate adequate ability to analyse Provide examination of the subject with some suitable examples and references Demonstrate ability to provide detailed and coherent analysis Demonstrate ability to provide detailed and coherent analysis Provide detailed examination of the subject with adequate use of appropriate references and examples Demonstrate detailed and highly appropriate application Demonstrate ability to provide comprehensive, lucid analysis Demonstrate ability to provide comprehensive, lucid analysis Provide consistently critical and detailed examination of the subject with innovative use of highly appropriate references Page 16 of 16