The Difference between the Income Effect and the Substitution Effect - Assignment Example

? Session Take Home Examination FACULTY OF BUSINESS SESSION TAKE HOME EXAMINATION ECO501 Business Economics PART A MULTIPLE CHOICE QUESTIONS (2 marks per question, 40 marks) Answer ALL questions Select the letter corresponding to the best answer under each of the following questions and indicate it by fully shading the circle that contains the chosen letter on the answer sheet provided. 1) A single-price monopolist's demand curve A) Is the same as the market demand curve? B) Is its marginal revenue curve. C) Shows that demand for the good is perfectly inelastic. D) is horizontal. E) Shows that demand for the good is perfectly elastic. 2) Expenditures on advertising A) Are variable costs so do not affect the average total cost. B) Can lower average total cost if the advertising increases the quantity sold by a large enough amount. C) Cannot lower average total cost because when a firm advertises it increases its costs. D) Always lower average total cost because whenever a firm advertises, it increases the quantity sold. E) Lower total cost if the advertising increases the quantity sold by a large enough amount. 3) A monopoly arises for two key reasons, which are ________. A) Franchises and barriers to entry B) Natural and legal C) Barriers to entry and close substitutes D) Close substitutes and no barriers to entry E) Barriers to entry and no close substitutes 4) Dole Co. operates in a monopolistically competitive market. Which of the following characterizes Dole Co.'s market? A) Dole Co. faced no barrier to entry when it decided to enter its market. B) Dole Co. supplies a small portion of the market's output. C) Dole Co. is unable to collude with other firms in the market. D) Dole Co.'s product is slightly different from its competitors. E) All of the above describe Dole Co.'s market. 5)A market in which firms can enter and leave so easily that firms in the market face competition from potential entrants is called a A) Contestable market. B) Natural oligopoly C) Limit pricing market. D) Monopolistic competition market. E) Cartel. 6) If the demand for its good or service is inelastic, a monopoly's A) Total revenue increases when the firm lowers its price. B) Marginal revenue is positive. C) Total revenue is unchanged when the firm lowers its price. D) Marginal revenue is negative. E) Marginal revenue is equal to zero. 7) In monopolistic competition, firms compete on the basis of A) Quality and marketing, but not price. B) Price, quality, and marketing. C) Price only. D) Quality only. E) Marketing only. 8) Rent seeking is best defined as attempts A) By individuals to avoid paying taxes. B) By owners of a monopoly to sell the firm. C) To achieve monopoly power and the resulting economic profit. D) By landlords to get tenants. E) None of the above. 9) In the long-run, a firm in monopolistic competition produces at an output level where A) P = ATC and MR > MC. B) P = ATC and MR = MC. C) P > ATC and MR > MC. D) P > ATC and MR = MC. E) P > ATC and MC > ATC. 10) Some unemployment is unavoidable because ________. A) Many part-time workers would like to have full-time work B) There is always some cyclical unemployment C) Often people become discouraged workers D) Many people in the working-age population attend school and are unemployed E) People are making transitions through the stages of life and businesses are making transitions 11) Approximately, the real interest rate ________ the inflation rate ________ the nominal interest rate. A) Equals; minus B) Plus; equals C) Times; divided by 100 equals D) Minus; equals E) Equals; plus 12) Which of the following exchange rate policies uses a target exchange rate, but allows the target to change? A) Crawling peg B) Fixed exchange rate C) Moving target D) Flexible exchange rate E) None of the above 13) An increase in the tax on capital income ________ the supply of loan able funds and ________ investment. A) Decreases; increases B) Decreases the demand for loanable funds; decreases or increases C) Decreases; decreases D) Increases; decreases E) Increases; increases 14)When the Reserve Bank of Australia fights recession by implementing an open market operation, the supply of reserves curve shifts ________ and the supply of money curve shifts ________. A) Rightward; rightward B) Leftward; rightward C) Leftward; leftward D) Rightward; rightward, and the demand for loanable funds increases E) Rightward; leftward 15) The commodity substitution bias is that A) National saving and foreign borrowing are interchangeable. B) Consumers decrease the quantity they buy of goods whose relative prices rise and increase the quantity of goods whose relative price falls. C) Government spending is a good substitute for investment expenditures. D) Consumers substitute more expensive goods for less expensive goods when technology advances. E) Consumers substitute high-quality goods for low-quality goods. 16) Labour productivity is A) The rate of change in real GDP per hour of labour. B) Real GDP per hour of labour times the hours of work. C) The quantity of real GDP produced by an hour of labour. D) Real GDP per hour of labour times the population. E) None of the above. 17) If the government begins to run a larger budget deficit, the demand for loanable funds ________ and the real interest rate ________. A) Increases; falls B) Increases; rises C) Decreases; rises D) Decreases; falls E) Increases; rises or falls depending on the change in the supply of loanable funds 18) The effect of a change in taxes is less than the same sized change in government expenditure because A) Tax rates are the same regardless of income levels. B) Some people do not pay their taxes. C) The amount by which consumption initially changes is equal to MPC times the tax change. D) Changes in government expenditure do not directly affect consumption. E) None of the above. 19) The business cycle is defined as the A) Regular fluctuations of real GDP below potential GDP. B) Irregular fluctuations of prices around real GDP. C) Regular growth rate of the real GDP. D) Periodic and regular up-and-down movement of total production. E) Irregular fluctuations of real GDP around potential GDP. 20) The decreasing slope of the aggregate production function reflects A) Diminishing returns. B) Rising unemployment. C) A decrease in potential GDP. D) Increasing aggregate demand. E) Decreasing costs. PART B Question 1 For a normal good, explain the difference between the income effect and the substitution effect using an appropriate diagram (10 marks) A normal good is economically defined as the type of good or service whose demand from consumers changes with a change in the income level. That is, whenever there is a raise in the real income of a consumer, the demand for the good or service increases. This means that the income elasticity for the normal good would be positive. On the other hand, a decrease in the real income of the end user leads to a corresponding decrease in the demand for the same good or service (Baumol & Blinder, 2012). In economics, the impact of price on normal goods are usually separated into two components namely the substitution effect and the income effect. The substitution effect entails the substitution of good X for good Y or the substitution of good Y for good X due to a change in relative prices of the two goods. On the other hand, the income effect results from the change in the consumer’s real income or the purchasing power as a result of the changes in prices. The sum of the income effect and the substitution effect is known as the total effect. We will employ indifference curves to illustrate and explain both the income effect and the substitution effects of a normal good (Carbaugh, 2010). Suppose the price of good X increases. This creates a substitution effect and an income effect. Consumption Good Y BC2 BC1 Consumption Good X The substitution effect results from the comparative price alterations. In this case, good X becomes more expensive than good Y after the price change. This causes the slope of the budget constraint to become steeper. This is because the slope of the budget is determined by px/py thus an increase in price of good X leads to steepening of the curve. When the budget constraint’s graph increases the value of its gradient, it indicates that the prices of the goods have changed. Consequently, the opportunity cost of consuming good X increases (Taylor & Weerapana, 2011). On the other hand, the income effect is caused by the changes in the real income of the consumer. An increase in the price of good X leads to a decrease in the consumer’s real income since the nominal income did not increase. This causes the possible combination of utilization bundles to decrease. Consumption Good Y Ya a Yb b c U2 U1 BC1 BC2 Xa Xc Xb Consumption Good X The above graph illustrates the substitution and the income effects of goods X and Y. When the price of good X decreases, the budget constraint pivots outwards along the axis showing the change in the amount of consumption of the good. Therefore, the consumer shifts from the utility maximizing consumption bundle a to utility maximizing consumption bundle b. This characterizes the entire effect of the price decrease. The dotted line on the graph is introduced in order to identify the income and the substitution effects. It is tangential to the original budget constraint and point c. However, the dotted line maintains an identical slope to that of the newly formed budget constraint BC2. The purpose of the dotted line is to show the adequate income that the end user would require getting back to the initial indifference curve. That is, the original level of utility before the price decreases. However, it maintains the slope of the original budget constraint to show the new relative prices. Therefore, the consumer’s income is accustomed to maintain utility in the same level from points A to C after the new relative prices. Points a to c corresponds to the substitution effect. It also shows that the effect is positive. To explain this, we remind ourselves that the slope of the budget constraint is given by the ratio of the relative prices of good X and good Y. That is, px/py gives the gradient of the budget constraint. Flattening of the graph shows that there is a price decrease of good X. The substitution effect thus dictates that the consumer will substitute the expensive good with the less expensive one while maintaining the same levels of utility (Gans, 2011). Eventually, the consumer prefers consuming more of good X represented by the positive substitution effect a to c. Points c to b represents the positive income effect. From the graph, we can see that the dotted line is parallel to the new budget constraint. This symbolizes the raise in real income of a consumer when the prices decrease. The increase in consumer’s income leads to an increased purchasing supremacy thus the consumer results to buying more of all normal goods, thus a positive income effect. Question 4 How does an increase in disposable income affect the consumption function? How does an increase in expected future income affect the consumption function? (10 marks) Disposable income can be defined as the amount of income an individual retains after all the required deductions are levied against it by the government. That is, the income that is actually received by households from all sources and is available for use as the individual wishes. It is obtained after deduction the direct taxes. The consumption function on the other hand is a graphical representation of the connection between a consumer’s consumption and disposable income. It can also be referred to as the propensity to consume. The Keynesian theory considers the total of consumption by all individuals in an economy. When considering the disposable income, we shall not involve the government, thus the real income will be considered as equal to the disposable income. Y = YD. The consumption function shows the positively sloped correlation graph between real consumption and disposable income. Therefore, consumption is represented as a function of disposable income as shown: C = f(Y). Thus, C = a +b Y where ‘a’ is referred to as autonomous consumption and ‘b’ represents the slope referred to as the marginal propensity to consume (MPC). Autonomous consumption ‘a’ is independent of a consumer’s income. The MPC = ?C/?Y, that is, the marginal propensity to consume represents the ratio between the change in consumption and the adjustment in disposable income (Sexton, 2012). From this equation, it is evident that an increase in disposable income Y, directly leads to the steepening of the consumption function graph due to the resulting increase in the MPC. Consumption (C) ?C/?Y = MPC Income (Y) The above graph shows that an increase in the income leads to an increase in the consumption function represented by the graph (MPC). Expected income affects the consumption behaviour of a consumer. An increase in expected income may lead to an increase in the consumption activity and the pattern of an individual. This takes place either in current or future consumption. If we consider the future consumption, an individual with an expected increase in income may prefer to forego current consumption for a better future consumption (McEachern, 2012). Therefore, an expected income causes the consumption function to positively decrease its gradient. The graph becomes less steeper showing that expected income increases the potential for the consumption by individuals. Part C Question 1 (Total 20 marks) Using appropriate diagrams, explain the following concepts. a) Economies of scale (5 marks) In an economy, businesses grow as their output increases and the average costs of production decreases. However, under normal circumstances, the total costs of productions are always expected to go up with increase in output. However, the cost of a unit of production falls with an increase in output. Therefore, the decrease in average production costs gives well established firms a competitive advantage above the less established firms. Overall, the decrease in the average costs of production of a single unit (Marginal cost) as output increases is referred to as economies of scale. The economies of scale can also be described as the condition where an increase in inputs results to a greater increase in output. The economies of scale are a good indicator of the efficiency in production of a given firm in large scale production (Dollery, Crase & Johnson, 2006). Fixed cost per unit Units produced. b) Constant returns to scale (5 marks) Constant returns to scale is related to the production of a firm where the changes in the output results from a corresponding equal changes in inputs. This means that during production, the factor to which the inputs are changed affects the output produced with the same value of the input factor. Therefore, a proportionate change in resources in the long-run leads to a proportionate change in production. This normally takes place when a firm increases all the factors of production by a given constant margin and utilizes them to attain an increase in output by the same margin. Fixed cost per unit Units produced c) Diseconomies of scale (5 marks) During operations, firms are also susceptible to diseconomies of scale. The diseconomies of scale occur when the average cost of production rise with the amount of output produced. This means that a production firm incurs increasing costs in each unit with the corresponding increase in output produced. In addition, the diseconomies of scale may also occur when the production of two units together costs more that the cost of producing the same goods or services separately. The graph below is a simple illustration of diseconomies of scale. Fixed cost per unit. Units produced d) The minimum efficient scale (5 marks) The minimum efficient scale (MSE) can be defined as the scale of production where the internal economies of scale have been fully exploited. That is, the level of output that diminishes the long-run average cost. In addition, the MSE is described as a non-single output level because it comprises of a range of outputs in which a production firm achieves constant returns to scale where the firm experiences the lowest practicable cost per unit in the long-run (Mankiw, 2011). Costs long-run average cost curve. Increasing returns decreasing returns to scale To scale MSE Q Output Key: MSE- Minimum efficient scale. Question 2 (Total 20 marks) Explain how the equilibrium position of a monopolistically competitive firm is achieved in the long run and how it may differ from the equilibrium position of the firm in the short run. A monopolistically competitive firm attains a long-run equilibrium when it operates at a situation where the price equals the average total costs of output. This means that in the long-run, the firm makes zero economic revenue. This is because in the firms that experience long-run operations are dependent on the entry and exit of several other firms in the market. The monopolistically competitive market is defined by many small firms that compete against each other (Tucker, 2011). The firms have differentiated products where the only difference in the competition is price. Therefore, whenever a firm experiences short-run losses, it tends to leave the market. This leads to an increase in the prices of the firms that are left in the market. Therefore, these firms raise prices and restore the expected gains (Besanko, 2010). However, an increase in the prices attracts other firms that target the short run profits. A large entry of these firms results to an increase in supply of the products to the market causing a reduction in prices. This gets rid of the economic profit. The dynamism in the market causes the monopolistically competitive markets to experience a downward sloping curve. The short-run equilibrium of a monopolistically competitive market shows that firms earn an economic profit in the market. These profits exceed the prospect of the firms’ operators. However, the gains experienced in the market attract other new firms. The new firms compete for consumers in the market by providing substitute goods to the existing consumers. This decreases the demand for products from the existing firms. This causes a shift in the demand curve for the old firms that result to a shift in the marginal revenue curve as well. As more firms enter the market the demand curves continues to shift to the left leading to a position where the old firms cease to make any economic profits. This point of zero economic profits experienced by the firms occur where the demand curves of the old firms are tangent to their average total cost curves. At the long-run equilibrium in the monopolistically market, the firms sustain their operations at zero profits. Thus, there is no motivation for any firm to enter the market (Baumol & Blinder, 2012). References Baumol, W. J., & Blinder, A. S. (2012). Economics: Principles and policy. Mason, OH: South- Western Cengage Learning. Besanko, D. (2010). Economics of strategy. Hoboken, NJ: John Wiley & Sons. Carbaugh, R. J. (2010). Contemporary Economics: An applications approach. Armonk: Sharpe. Dollery, B., Crase, L., & Johnson, A. (2006). Australian local government economics. Sydney: UNSW Press. Gans, J. (2011). Principles of economics. South Melbourne, Vic: Cengage Learning. Mankiw, N. G. (2011). Principles of economics. Mason, Ohio: Thomson South-Western. McEachern, W. A. (2012). Microeconomics: A contemporary introduction. Mason, OH: South- Western Cengage Learning. Sexton, R. L. (2013). Exploring economics. Australia: South-Western Cengage Learning. Taylor, John B., & Weerapana, Akila. (2011). Economics. South-Western Pub. Tucker, I. B. (2011). Survey of economics. Mason, OH: South-Western Cengage Learning. Read More