Fundamentals of Economics. 3 June Marking Scheme

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1 Fundamentals of Economics 3 June 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) Briefly explain what is meant by an economic model or theory. 2 These are frameworks which help one think about economic issues (1); to do so they simplify reality by making certain assumptions.(1) 2 marks for this or other suitable definition. b) i) State the simple rule for identifying a profit maximising level of output. 2 Profits are maximised at the level of output at which marginal cost equals marginal revenue.(2) ii) Explain what is meant by the term equilibrium price. 2 Equilibrium price is the price in a market at which supply equals demand.(2) c) When economists consider the effect that a change in price may have upon demand, they tend to assume that other factors that might also affect demand remain constant and can therefore be ignored. 4 According to simple economic theory, what are the other main factors that can have a direct effect on the demand for a product? The price of substitutes (1) The price of complements (1) Income of consumers (1) Consumer tastes or preferences (1) Total 10 Page 2 of 15

3 Question 2 a) Draw and label a monopolistically competitive firm in its short run equilibrium position. 5 5 marks for correct, fully labelled diagram; deduct 1 mark for each substantive error or omission. Note: for full marks the MC curve should clearly intersect the AC curve at the latter s minimum point. b) Explain how and why this position differs from the long run equilibrium position of a monopolistically competitive firm. In short run equilibrium, the firm is able to earn supernormal profits, shown by average revenue being higher than average cost. (2) However, in the long run the firm can only earn normal profit. (1) This is because free entry in the long run allows firms to enter and compete away any supernormal profits. (2) 5 Total 10 Page 3 of 15

4 Question 3 a) Define the following terms: i) fiscal policy 2 Fiscal policy refers to government policy on government expenditure (1) and taxation (1). ii) government budget deficit 2 A government budget deficit is a shortfall between its spending levels (1) and tax revenue (1). iii) the stock of government debt 3 This is the accumulated, past borrowing of the government (1) on which it pays interest (1) and normally needs to pay back the principal (1). b) The circular flow of income model generates three flows that can be used as measures of overall economic activity in an economy. Identify these THREE (3) flows of activity. The value of the goods and services produced (1) The level of income earned by households (1) The value spent by households when buying them (1) 3 Total 10 marks Question 4 a) What is meant by the term liquid asset? 1 An asset that can be converted quickly and easily into cash. b) In what ways can a Central Bank contribute to the stability of the banking system? 4 Acting as lender of last resort (1), the Central Bank will always make funds available to banks which are short of liquidity (1). Engaging in prudential regulation (1) e.g. setting capital adequacy ratios to ensure banks have enough funds to overcome crises (1). c) Explain what is meant by open market operations by a Central Bank. 5 Use of central bank money to buy bonds in the market (2) and thus increasing the stock of money (1), similarly by selling bonds (1) it can reduce the stock of money (1). Total 10 marks Page 4 of 15

5 Question 5 a) Define inelastic demand. 2 Inelastic demand is where a given % change in price leads to a lower % change in quantity demanded. (2) b) What is the economic problem? 4 The economic problem is that all societies need to prioritise in the face of scarcity (1) and decide exactly WHAT (1), HOW (1) and FOR WHOM (1) goods and services are to be produced. c) Explain briefly the difference between a free market economy model and a command economy model. The free market economy model is where all economic decisions are made in markets with no government intervention. (2) The command economy model is where administrators take all decisions concerning production and there is no role for markets. (2) 4 Total 10 Page 5 of 15

6 Section B Answer any TWO (2) questions from this section Question 6 a) Economists analyse costs and other economic issues in the short run and the long run. Define the terms short run and long run. The long run refers to a period which is long enough to allow a firm to adjust all of its inputs as it changes its level of output. (2) 3 The short run is a period in which a firm can only adjust some of its inputs. (1) b) Define the following terms: i) economies of scale 2 Economies of scale occur when long run average costs fall as output increases (2) ii) diseconomies of scale 2 Diseconomies of scale occur when long run average costs rise as output increases (2) iii) minimum efficient scale 2 Minimum efficient scale is the level of output at which the long run average cost curve first hits it lowest point (2) Page 6 of 15

7 c) With reference to the three terms defined in part (b), explain why economists 10 believe that a firm s long run average cost curve is often U-shaped. At relatively low levels of output economies of scale occur (1). The causes of economies of scale are principally: indivisibilities or fixed costs (1) a minimum quantity of inputs required to be in business at all (1) e.g. manager (1), as output grows these are spread over more and more units of output thus driving down average cost (1) specialisation (1) as output grows a firm can justify hiring specialist labour or machines (1) which can operate more efficiently than the more general labour or less sophisticated machines used at lower levels of output (1). Once the minimum efficient scale has been reached economies of scale cease and diseconomies of scale begin. (1) The main causes of diseconomies of scale are: managerial diseconomies of scale (1) in large bureaucratic organisations as coordination of large organisations becomes more difficult (1) technical difficulty as scale increases (1) e.g. coal extraction becomes more difficult (1) Please note, not all points above are required for full marks. However, for high marks (7 or above) all three terms defined in part (b) need to have been used correctly. d) Using an appropriate diagram, explain the relationship that will always exist between a short run marginal cost curve and an average cost curve. 6 2 marks for correct, fully labelled diagram, deduct 0.5 mark for each substantive error or omission. Basically the marginal cost (MC) curve always cuts the average cost (AC) curve at the latter s minimum point (1) because when MC is less than AC, AC is falling (1) when MC is more than AC, AC is rising (1) when MC=AC, AC is constant (1) Total 25 Page 7 of 15

8 Question 7 a) Using appropriate symbols, identify the elements of aggregate demand in a four-sector Keynesian model of the economy. C household consumption (2) I firms investment (2) G government expenditure (2) (X-M) net exports (2) 8 b) In simple terms, explain the Keynesian view of the relationship between aggregate demand and inflation. The simple Keynesian view is that inflation is caused by excess demand in the economy (1); i.e. that inflation occurs if the level of equilibrium aggregate demand is above the level of output consistent with full employment (2). This excess demand drives up both wages and prices. (1) 4 c) Defining the key terms involved, state the quantity theory of money. 5 MV = PY (1) where: M = supply of money (1) V = its velocity of circulation (1) P = average price level (1) Y = output (1) d) i) How would monetarist economists interpret the quantity theory of money equation? The monetarist interpretation of the equation assumes that: V remains stable (1) Y remains stable at the level of potential output (1) Consequently growth in the money supply causes inflation (1) 3 ii) How might other economists, particularly Keynesian economists, interpret the equation differently? Such economists may challenge the assumption that V is stable, e.g. as they see it varying with changes in interest rates, which affect how much money people wish to hold. (2) Keynesian economists would see Y as less than Y* (potential output) in the short-run at least so would expect increases in M to lead to some increase in Y. (2) Even if these economists accept that M and P move together, they question the direction of causation. (1) 5 Total 25 Page 8 of 15

9 Question 8 a) i) Draw and label a diagram of the circular flow of income in a simple two-sector model of the economy. 6 ii) 6 marks for correct, fully labelled diagram, deduct 1 mark for each substantive error or omission. In the context of the above question, what are leakages and injections and how do each impact the level of economic activity? Savings are a leakage from the circular flow in a two-sector model (1), as savings occur purchasing power leaks from the economy (1), other things being equal this would depress the overall level of economic activity (1). Investment is an injection into the circular flow in a two-sector model (1), as investment occurs purchasing power is injected into the economy and sets off a multilpier process (1), other things being equal this would increase the overall level of economic activity (1). 6 Page 9 of 15

10 b) To a considerable extent it is the case that monetary policy has become more important in recent decades as the significance given to fiscal policy has declined. Explain the main problems and difficulties associated with relying on fiscal policy to manage an economy. Fiscal policy faces the following constraints/problems in its operation: Time lags (1) - e.g. gathering data on output levels (1) Making changes to policy (1) Allowing people to react fully to the policy change (1) Uncertainty (1) caused by the fact that policy has to be based on projections of the future (1) Budget deficits(1); experience has shown active fiscal policy leads to almost continuous budget deficits (1) can have side-effects on the monetary conditions of the economy (1) e.g. on interest rates or on inflation (1) Not all points required for full marks. Award marks for all valid responses. 9 c) Define the terms macro-economics and micro-economics, highlighting the differences between them. Microeconomics focuses upon the detailed workings of individual markets (1) ignoring wider factors like interactions with other markets (1). Macroeconomics looks at the interaction of different parts of the overall economy (1), it focuses just on broad economic aggregates (1) like unemployment (1). 4 Not all points needed for full marks. Maximum of 2 marks available for each term. Total 25 Page 10 of 15

11 Question 9 a) The market structure models of perfect competition and monopoly are often considered to represent two ends of a spectrum or continuum of market structures. i) Outline the assumptions that underpin the model of perfect competition. 4 Many firms in the industry each of trivial size (1) A homogeneous (identical) product (1) Perfect knowledge by customers (1) Free entry and exit into and out of the industry (1) ii) Define the term monopoly. 1 There is only one firm comprising the industry (1) b) Explain how the long run equilibrium profitability of a perfectly competitive firm and a monopoly firm differ and explain the main reason for this difference. A perfectly competitive firm can earn only normal profits in long run equilibrium, while a monopoly firm can earn supernormal profits. (2). The difference exists primarily because entry barriers persist into the long run for a monopoly firm whereas there are no barriers to entry in the long run to a perfectly competitive industry. (2) c) Draw a fully labelled diagram of a monopoly firm in its long run equilibrium position and comment on how it reflects any of the points you made in your answer to part (b) marks available for a correct, fully labelled diagram; deduct 1 marks for each error or omission. At the profit maximising output OQ1 (1), the AC curve is below the demand curve (1), signifying that supernormal profits are being earned.(1) Page 11 of 15

12 d) Discuss the advantages and disadvantages of a monopoly structure compared to 8 a perfectly competitive structure from the point of view of society as a whole. Monopoly restricts output (1) and drives up price (1) compared to a perfectly competitive industry. Therefore it can be argued it offers less value for money to the customer and results in allocative inefficiency. (2) However, large monopoly firms may have more resources and incentive (as profits are protected because of the lack of a threat of entry) to carry out research and development to reduce costs. (3) They are more likely to be large and therefore benefit from economies of scale. (2) Innovation and scale by monopolists may reduce costs and be reflected in lower prices and higher outputs than perfectly competitive industries. (2) Not all points required for full marks. Award marks for any acceptable points. Total 25 Page 12 of 15

13 Question 10 a) Explain the terms price ceiling and price floor. 3 These occur when government tries to control prices in a market (1), a price ceiling is a maximum price (1) and a price floor a minimum price (1). b) Draw a fully labelled diagram, including a key showing key terms, for the imposition of a price ceiling below the equilibrium price in the market. 10 An appropriate key to the diagram as follows: Pe equilibrium price Qe equilibrium quantity Pc ceiling price Dc quantity demanded at ceiling price Sc quantity supplied at ceiling price 10 marks available for fully labelled diagram plus key, deduct 1 mark for each error or omission. Page 13 of 15

14 c) With reference to your diagram from part (b), discuss how far the ceiling price 12 established there is likely to help the poor. A ceiling price is intended to keep prices low and thus affordable by the poor. (1) While Pc is lower than Pe (1) in fact the lower price discourages supply (1) and less is supplied at Pc compared to Pe (1). Excess demand exists at Pc equal to Dc Sc (2), the ceiling price prevents price rising to an equilibrium price (1), consequently a lot of unsatisfied demand exists and the low price gives no encouragement to increase supply to meet it (2). While the price is lower as a result of the ceiling price than it would have been had the market been left alone to reach an equilibrium price (1), less is actually traded (Sc) under the price ceiling arrangements than is at the free market equilibrium price (1). Thus efforts to assist the poor can be argued to lead to less being produced. (1) Total 25 End of paper Page 14 of 15

15 Learning Outcomes matrix Question Learning Outcomes assessed 1 1 Yes 2 2 Yes 3 3 Yes 4 4 Yes 5 1 Yes 6 2 Yes 7 4 Yes 8 3 Yes 9 2 Yes 10 1 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 15 of 15

Fundamentals of Economics. 3 June Examination Paper. Time: 2.5 hours

Fundamentals of Economics. 3 June Examination Paper. Time: 2.5 hours Fundamentals of Economics 3 June 2015 Examination Paper Section A Section B Answer ALL questions from this section. Answer any TWO (2) questions from this section. Clearly cross out surplus answers. Failure