The Income Effect - Assignment Example

Q You have already paid £50 for a ticket to a Wimbledon tennis final. But now your boss has called and offered you some work on that day; she pays £50 per day. Furthermore, tickets for the tennis final are now selling on ebay for £100. If you now decide to go to the show, then how much does it really cost you? Explain your answer. If I decide to go to the show, the cost of my ticket is still £50 even though the real value of the same ticket has already increased to £100. However, if I decide not to go, then there will be an opportunity loss of £100 because of the amount of money I have spent for the ticket plus the price increase at the time of the show. Q.2 Carefully distinguish between income and substitution effects for an inferior good and a normal good. Particularly the changes in the relative price of a good have both income and substitution effects. Either the income or substitution effect is dominant depends on the magnitude of the price change and on the nature of the good. For example: In the case of a normal or superior goods, the ‘income effect’ remains positive and more than the substitution effect; whereas in the case of an inferior good, the ‘substitution effect’ remains positive and more than the income effect. (See Figure I – IV below) Figure I – Price Increase on Normal/Superior Goods Figure II – Price Decrease on Normal/Superior Goods Figure III – Price Decrease on Inferior Goods Figure IV – Price Decrease on Inferior Goods Q.3 Are vouchers better than cash for essential items for the less well off? Even though there is a minimal cost attached with the use of vouchers, the less well off could still benefit from using it instead of cash. First, the business could trace back all their accumulated expenses over time. By having a n accurate documentation on the business’ cash out, the accountant could easily monitor its monthly budget. Q.4 Given an example of the ‘hurdle’ model of price discrimination and explain how it works. A price discrimination normally exist when a company has the ability to price above the marginal cost; when the company can prevent or limit arbitrage; or when the consumers’ demand on goods and services differ from each other. For example: Company A and B sell a homogenous product in the market. Since company A is able to capture the interest of its target consumers more than company B, company A is able to sell its product line at a much higher price than company B. Q.5 What is the compensated demand curve? Why isn’t it perfectly inelastic? A compensated demand curve is a curve that represents the quantity demanded for each price when consumers were income compensated for all price changes. This compensated demand curve is elastic because of the constant changes in the percent change in consumption which usually results from a given percentage change in price. Q.6 Use a long-run marginal cost curve to illustrate increasing returns to scale for a natural monopoly. Explain why it is best not to have competition when natural monopoly exists. The long-run marginal costs and average costs of a company that is a natural monopoly would generally decline when its production increases. In this case, the company is able to dominate the entire production for the market. Therefore, the long-run marginal cost curve of a natural monopoly will continue to fall even though the company is experiencing increasing returns to scale. (See Figure V below) Figure V – Long-run Average Cost Curve Slopes Down when Production Increases It is best not to promote competition when a natural monopoly exists because the operational costs and fixed costs of a company that is natural monopoly is huge. If competition is present in the market, it is likely that the market price of goods and service would fall below the normal average costs of goods. If this happens, the business condition of the company that is natural monopoly would greatly suffer. Thus, greatly affects the supply over the market’s demand. Q.7 Use the prisoner’s dilemma to explain why it can benefit a firm to make a strategic commitment. A prisoner’s dilemma is “a type of a non-zero –sum game wherein two or more players within or outside the same industry either ‘cooperate with’ or ‘betray’ the other party.” When a company makes a strategic move within the industry, being able to win the trust of another party could unconsciously loosen up their defence over the company. Thus, makes it easier for the company to implement their strategic plans in order to win more of the market share over its rivals. For example, company A (a medium-size telecommunication company) and B (a small company that has the capabilities of offering a cheaper international call rate via Voice-Over-Internet-Protocol) decided to enter into a special contract for a 40-60 profit sharing respectively. Company A’s main goal is to be able to compete with other bigger telecom company by offering a cheaper international call rates to the local consumers whereas company B’s hidden agenda is to be able to easily acquire a license to sell its services to the same target consumers via company A’s license. Eventually, company B could slowly grab the market share of company A by being able to personally get hold to its common target consumers. In case company B is able to successfully make its strategic plan work, then company B wins the game. The same goes with company A. In case both company A & B failed to achieve their plan, then it would be a win-win situation for both of them. Q.8 Show, using the intertemporal choice model, the effect of a change in the interest rate on a patient person. ‘Intertemporal Choice Model’ is a sociological theory of capital which studies the relative value that a person assigns to two or more payoffs within a different time frame. Basically, this model assumes that: (1) the consumer’s income is constant; (2) the maximization of the utility is evident; (3) anything that goes above the line remains unexplainable; (4) investments are generators of savings; and (5) all properties are indivisible and unchangeable. In general, a consumer takes into account all of his previous consumptions when making a major decision between his present and future consumption. For example: he decides to spend 40% of his entire bank savings today, it would only mean that he only have the 60% of his current savings available for future use. Instead of being able to enjoy a bigger interest on his entire savings, he could now only enjoy the interest of his remaining savings for future use. The revenue is always in the form of interest rate wherein the real interest rate can be computed by deducting inflation from the nominal interest rate: Real Interest Rate = Nominal Interest Rate – Inflation Therefore, when the nominal interest rate changes; then the real interest rate will also change. EC2013C – January 2006 – 2007 Q.1 Consider whether the structure of industries within a country provide an accurate indicator of the level of its economic development. The structure of the local industries within a country should never be considered as an accurate indicator of the level economic development because it the structure of industries is only a description on how the market within certain industries looks like. For example: monopoly, oligopoly, etc. The best way to measure the level of a country’s economic development is by looking at the annual gross domestic product (GDP). GDP measures the size of a country’s economy by getting the total market value of final goods and services that has been produced within the country within a year. GDP = consumption + investment + (government spending) + (export – imports) - or - GDP = C + I = G (X – M) Q.2 Briefly describe the Soviet development model and assess its relevance, if any, to contemporary developing countries. In general, a country could choose two forms of economic development either a ‘free enterprise, market capitalism’ or a ‘modern state capitalism’ which could eventually lead to socialism. In the case of Soviet Union, they use Soviet Development Model that follows ‘socialism’ more than capitalism. The government under socialism has the power to rule a country as a regulator. Therefore, the State is expected to positively mould the society slowly converting a capitalist society into a socialist society. The problem with most capitalist developing countries is the fact that capitalism contributes a lot to a huge gap between the rich and the poor. By removing capitalism within the developing countries, it is possible for the government to change the state policy in such a way that they could minimize the socio-economic gap among its people. Thus, eliminating social inequality and production exploitation. Q.3 Explain the concept of a ‘neo-Malthusian population trap’. Consider if contemporary sub-Saharan countries are in such a situation. The ‘Neo-Malthusian Population Trap’ claims that population growth and economic development are related in the sense that the population of a country grows at a geometric rate whereas thee per capita income grows at an arithmetic rate. It means that it is possible for any country that is not able to lower its population growth to reach a level where it would barely be able to live above subsistence level. It is safe to conclude that the modern Sub-Saharan countries such as Nigeria, Ethiopia, Congo, South Africa, Kenya, Sudan, Tanzania, and Uganda all have a population between 20 – 30 million and is considered to be the fastest group population all over the world. In line with the huge increase in its population, the economy of Sub-Saharan countries are also rapidly urbanizing as compared to other developing countries. Q.4 Why has China, in its industrialisation drive, rejected the development and use of ‘intermediate technology’? China rejected the development and use of intermediate technology in order to avoid economic problems related to inflation, high unemployment rate, and socio-economic inequalities. High inflation rate can be controlled by increasing the country’s interest rate. Considering that the Chinese economy is new, it is expected that a lot of these businessmen have borrowed money from the local banks. In case the country’s interest rate will increase, the local businesses will also be negatively affected. Aside from the environmental degradation, the excessive use of these machineries will make the local people suffer from the after effects of over production of goods and the increasing number of unemployment rate. Excessive supply of goods will make the prices of commodities go down. Q.5 ‘Production for the world’s primary commodity markets represents a trap rather than an opportunity for development.’ Consider the validity of this assertion. The demand for primary commodities will always be high. Basically, primary commodities are used as raw materials for manufacturing another product. For this reason, I find the statement to be incorrect. Since we use the primary commodities in the manufacturing of another product, the production of world’s primary commodities will always open new opportunities for development. Q.6 Briefly outline the ideas known as the ‘Washington Consensus’ and explain their effect on the financial policies pursued by the International Monetary Fund and the International Bank for Reconstruction and Development towards developing countries. ‘Washington Consensus’ is basically composed of a set of ten economic policy prescription (a ‘standard’ reform) that is used in solving economic / financial crisis of a country. In general, Washington consensus does not believe that financial markets make the borrowings of money possible. Instead, Washington consensus main belief is that debt crisis is a result of the implementation of a wrong policy in the debtors’ country. Upon promoting the Washington consensus, the International Monetary Fund, the International Bank for Reconstruction and Development towards the developing countries began to concentrate on polishing its policy in order to solve financial economic problems. For example: The International Monetary Fund could be focusing on its monetary policy like maintain a fixed exchange rate with the U.S. dollar, etc. Q.7 Out of all the trade reforms under discussion at the Doha Round of trade talks, which do you consider to be the most helpful to the economic progress of developing countries? Even though the implementation of WTO’s Doha Round of Multilateral Trade Negotiations could result to a huge potential gain in agriculture, the presence of a large gap between the WTO-bound and the applied rates of protection (tariff rates) within the developing countries could negatively affects the use of the this reform. In line with the agricultural activities in developing countries, I believe that the most helpful Doha Round Trade Reforms for agriculture is the implementation of tariffs’ cut as well as providing sufficient financial assistance to the farmers. Q.8 Why do the aid programmes of the developed economies over the last fifty years appear to have achieved so little? The main purpose of Aid programmes is to provide an overseas assistance in order to promote a countries economic growth. In the case of a developed economy, the economy itself has already reached a high level of economic growth. Therefore, only a little result is expected to become evident over a long period of time. Read More