A Level Economics Paper 2 by readandwrite.marketing

ECONOMICS Paper 2 Worked Solutions Article No. 152

Written by:

Muhammad Kamran Malik MBA, MA Economics Principal, Keynesian Institute of Management & Sciences (KIMS) O/A Level Examiner

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Economics A Level P-2 (Worked Solutions)

Author

Muhammad Kamran Malik Cell: +92 300 8488585 Email: kamran@kims.edu.pk

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PREFACE In addition to basic knowledge and comprehension, Cambridge International (CI) essay questions test a variety of higher order skills like application, analysis and evaluation. What motivated me to write this book was the fear of thousands of A Level Economics students to meet this challenging task. This book makes an effective learning tool for the application of existing knowledge to novel and unfamiliar situations, critical analysis involving logic and reasoning, evaluation of given policies and incorporation of oneâ&#x20AC;&#x2122;s own judgment into a comprehensive, well-structured essay. The broader aim, however, is to provide a sense of achievement to students and develop their self-confidence as they learn to tackle essay questions effectively. Memorizing the contents of this book and reproducing them as such will have no more than a marginal impact on their skill to produce a well-informed essay. We hope our readers bear in mind that investing time and effort in developing essay writing skills today will benefit them endlessly throughout their life. I strongly recommend students to attempt examination questions on their own before consulting the answers provided in this book. They must consult other textbooks, incorporate necessary changes and build what they think is a perfect answer before comparing it with the one this book provides. I particularly chose to write fully structured essays in place of brief, bulleted answers as the latter kill the entire spirit of a coherent essay. I hope my readers will be satisfied with the content this book has to offer them. At the same time, I look forward to their criticism and suggestions. Students may also find my other two books, Understanding Economics AS Level and Understanding Economics A2 Level, useful in meeting the study requirements of the CI Advanced Level Economics syllabus. Thank you.

Muhammad Kamran Malik Principal, KIMS & O/A Level Examiner

Keynesian Institute of Management & Sciences (Cambridge International Fellowship Centre) 3-C, Zahoor Elahi / Maratab Ali Road, Gulberg II, Lahore Phone: 35715467 Email: kamran@kims.edu.pk

Contents PREFACE

UNIT-1

ECONOMIC SYSTEMS, PRICE MECHANISM

UNIT-2

ECONOMIC PROBLEMS, PRODUCTION POSSIBILITY CURVE, OPPORTUNITY COST

UNIT-3

MARKET EQUILIBRIUM

UNIT-4

DEMAND ELASTICITIES

UNIT-5

PRICE ELASTICITY OF SUPPLY, PRIMARY GOODS, CONSUMER SURPLUS, TAXES, SUBSIDIES

UNIT-6

MAXIMUM & MINIMUM PRICES

UNIT-7

MERIT, DEMERIT, PUBLIC GOODS

104

UNIT-8

FACTORS OF PRODUCTION, DIVISION OF LABOUR, LABOUR PRODUCTIVITY

122

UNIT-9

MONEY & PRICE INDICES

130

UNIT-10

INFLATION

142

UNIT-11

COMPARATIVE ADVANTAGE

160

UNIT-12

FREE TRADE, ECONOMIC INTEGRATION

170

UNIT-13

TERMS OF TRADE, BALANCE OF PAYMENT, EXCHANGE RATE

176

UNIT-14

FISCAL, MONETARY & SUPPLY SIDE POLICIES

208

SUPPLEMENTARY MATERIAL

212

DATA RESPONSE

226

O/N 17/P23/Q1

226

O/N 17/P22/Q1

227

O/N 17/P21/Q1

230

M/J 17/P23/Q1

234

M/J 17/P22/Q1

236

M/J 17/P21/Q1

240

O/N 16/P23/Q1

244

O/N 16/P22/Q1

246

O/N 16/P21/Q1

250

M/J 16/P23/Q1

252

M/J 16/P22/Q1

255

M/J 16/P21/Q1

259

O/N 15/P23/Q1

262

O/N 15/P22/Q1

265

O/N 15/P21/Q1

268

M/J 15/P23/Q1

271

M/J 15/P22/Q1

274

M/J 15/P21/Q1

277

O/N 14/P23/Q1

280

O/N 14/P22/Q1

283

O/N 14/P21/Q1

285

M/J 14/P23/Q1

288

M/J 14/P22/Q1

291

M/J 14/P21/Q1

293

O/N 13/P23/Q1

296

O/N 13/P22/Q1

299

O/N 13/P21/Q1

301

M/J 13/P23/Q1

303

M/J 13/P22/Q1

306

M/J 13/P21/Q1

309

O/N 12/P23/Q1

311

O/N 12/P22/Q1

313

O/N 12/P21/Q1

315

M/J 12/P23/Q1

317

M/J 12/P22/Q1

318

M/J 12/P21/Q1

320

O/N 11/P23/Q1

322

O/N 11/P22/Q1

324

O/N 11/P21/Q1

325

M/J 11/P23/Q1

328

M/J 11/P22/Q1

330

M/J 11/P21/Q1

332

O/N 10/P22/Q1, O/N 10/P21/Q1

334

M/J 10/P22/Q1

336

M/J 10/P21/Q1

338

O/N 09/P22/Q1

340

O/N 09/P21/Q1

342

M/J 09/P21/Q1

344

O/N 08/P2/Q1

346

M/J 08/P2/Q1

348

O/N 07/P2/Q1

351

M/J 07/P2/Q1

353

O/N 06/P2/Q1

357

M/J 06/P2/Q1

359

O/N 05/P2/Q1

361

M/J 05/P2/Q1

363

O/N 04/P2/Q1

365

M/J 04/P2/Q1

367

O/N 03/P2/Q1

370

M/J 03/P2/Q1

372

O/N 02/P2/Q1

374

M/J 02/P2/Q1

376

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Unit-1

UNIT 1

Economic Systems, Price Mechanisms

Syllabus 2019 â&#x20AC;&#x201C;21 O/N 17/P22/Q3/b

Economic Systems, Price Mechanisms

M/J 15/P21/Q3/b O/N 12/P22/Q2/b M/J 12/P23/Q2/b M/J 11/P22/Q2/a O/N 10/P22/Q3/b O/N 09/P21/Q2/b M/J 09/P21/Q2/b M/J 08/P02/Q2/b M/J 08/P02/Q2/a O/N 07/P02/Q3/a M/J 07/P02/Q2/b O/N 06/P02/Q2/b M/J 05/P02/Q2/b

A Level Economics Topical Paper 2

M/J 05/P02/Q2/a O/N 04/P02/Q4/b M/J 04/P02/Q2/b M/J 03/P02/Q2/a O/N 02/P02/Q2/b

Muhammad Kamran Malik Cell: 0300-8488585 kamran@kims.edu.pk

3-C, Zahoor Elahi Road GulbergII, Lahore 042-35714038 0336-5314141 readandwrite.publications@gmail.com readandwritepublications/Shop www.readnwrite.org

Unit-1

Economic Systems, Price Mechanisms

Economic Systems, Price Mechanism

O/N 17/P22/Q3/b Discuss the way in which resources are allocated in planned economies and free market economies. Consider which type of economic system is likely to have the more beneficial outcome. [12]

SUGGESTED ANSWER: For Analysis: That explains how resources are allocated in centrally â&#x20AC;&#x201C;planned economies including the strengths and weaknesses of this system. (Up to 4 marks) In a centrally planned economy, the government owns all non-human factors of production and is responsible for resource allocation without a role of the private sector (1 mark). Governments prefer public interest over profit maximization while allocating resources (1 mark). However, governments are slow to respond to changed customer requirements (1 mark) and lack innovation as profit motive is missing (1 mark). That explains how resources are allocated in free market economies including the strengths and weaknesses of this system. (Up to 4 marks) In a market / free economy, resources are owned by private individuals and firms, and allocated by price mechanism / demand and supply forces (1 mark). The firms aim to maximize profits whereas customers aim to maximize utility (1 mark). The motive to make profits and higher competition tempts firms to be more efficient (1 mark), but they often ignore externalities and fail to produce merit and demerit goods in the right quantities (1 mark). 8 marks maximum For Evaluation: That exercises some judgement in considering which type of economy would have more benefit. This must make use of the analysis that is offered. There must be a conclusion for full marks. The market economy is a better economic system as it is more responsive to customer requirements and higher competition prompts firms to innovate and keep developing new products to win over customers (1 mark). However, some government intervention will be required to ensure the provision of public goods and the provision of merit and demerit goods in the right quantities (1 mark). The government should regulate and monitor operations of private sector firms to minimize the chances of customer exploitation (1 mark). The best economic system is a mixed one, which has features of both centrally planned and free market economy (1 mark). 4 marks maximum M/J 15/P21/Q3/b Discuss whether entrepreneurs or governments are more likely to cause economic growth in a mixed economy. [12]

SUGGESTED ANSWER: For knowledge and understanding of mixed economy (up to 2 marks) In a mixed economy, resources are allocated both by demand and supply forces and the government

Unit-1

Economic Systems, Price Mechanisms

(1 mark). Private ownership of non-human resources is allowed in a mixed economy, but the government / public sector also owns economic resources (1 mark). For analysis of the role of entrepreneur and government in economic growth (up to 6 marks) For analysis of the role of entrepreneur in economic growth (up to 4 marks) Entrepreneur is the wheel / instrument of growth, as, through his vision and incentive to make profits, he innovates and brings in new products and ideas to fulfill the ever-changing requirements of customers (up to 2 marks). Entrepreneur selects and organizes other factors of production and assumes the risk of losses, thus providing a platform for setting up businesses and economic growth (up to 2 marks). For analysis of the role of government in economic growth (up to 4 marks) The government acts as a regulator and facilitator for the private sector by providing infrastructure, ensuring law and order and political and economic stability, by having cordial relations with neighbouring countries to reduce the fear of war, thus stimulating entrepreneurship and economic growth (up to 2 marks). The government provides public goods and merit goods such as education and health, and helps to provide a healthy and educated labour force to the private sector, thus encouraging investments and economic growth (up to 2 marks). For evaluation of which of the two is more likely to contribute to economic growth (up to 4 marks) The role of the entrepreneur is vital and primary in economic growth (1 mark), whereas that of the government is supportive and secondary, as it provides a conducive environment that facilitates risktaking behaviour and entrepreneurship (1 mark). The contribution of the government in economic growth may be higher in countries that have greater availability of funds in the public sector (1 mark), whereas in countries where entrepreneurs are skilful, the role of entrepreneurship is more significant in economic growth (1 mark). O/N 12/P22/Q2/b Discuss the ease with which a planned economy may be changed into a market economy.

[12]

SUGGESTED ANSWER: For analysis of the nature of the changes required to transform a planned economy into a market economy (up to 8 marks) Identification of features which need to be changed (up to 4 marks) Lesser government control, more reliance on free market forces, private ownership of non-human factors of production is allowed, greater consumer sovereignty (1 mark for each factor identified) Explanation of the implications of the changes (up to 4 marks) Lesser government control i.e. reducing the requirements for private firms to invest in strategically important areas such as telecommunication, power generation and development of infrastructure (up to 2 marks), privatizing state-owned businesses (1 mark), increasing the role of the private sector (1 mark), restricting the role of the government to upholding property rights (1 mark) and allowing firms to pursue the objective of profit maximization (1 mark) For evaluative comment on the ease of transformation (up to 4 marks) The workers of state-owned businesses may agitate (1 mark) as they fear losing jobs once these businesses are privatized (1 mark), which may cause unrest and delay the transformation (1 mark)

Unit-1

Economic Systems, Price Mechanisms

The private sector may not be fully prepared to take over (1 mark) and may result in under or over allocation of resources (1 mark) These firms may aim to lower the cost by laying off workers (1 mark) who resist delaying the transformation (1 mark) Prices may suddenly shoot up and long queues of customers are likely to be seen as the state control over prices is removed (up to 2 marks) M/J 12/P23/Q2/b Discuss whether planned economies should always be replaced by free market economies.

[12]

SUGGESTED ANSWER: For knowledge and understanding of planned and market economies (2 marks) In a free market economy, non-human factors of production are owned privately and resources are allocated by market forces (1 mark). A planned economy is based on state ownership and control, and the government allocates all the resources (1 mark). For an analysis of the advantages and disadvantages of replacing planned economies with free market economies (up to 8 marks) (Maximum 6 marks for one side) Market economies have performed more successfully in terms of raising living standards. Because of the profit motive, the private sector is expected to be more efficient and more responsive to customer requirements. The competition results in improved quality and lower prices, and the customers dictate what is produced in the market. There is greater variety of goods and the market economy is based on consumer sovereignty. (Up to 6 marks) On the other hand, market economies exhibit greater instability, as prices may suddenly go up when demand rises or supply falls. The gap between the rich and poor keeps increasing, as the poor are unable to afford necessities such as education and health for their children. Thus, their children cannot command high wages when they grow up. There could be cases of market failure such as negative externalities, overproduction of demerit goods, underproduction of merit goods and high prices, as monopolies may be formed. The market economy will also fail in providing public goods. (Up to 6 marks) (Maximum 8 marks for both sides) For evaluative comment on whether planned economies should always be replaced by free market economies (2 marks) In the real world, none of the economies could be completely free or planned. Every economy is a mixed economy and the role of the government is mandatory for smooth running of the economy, whereas reliance on demand and supply forces is essential for efficiency. There may be greater reliance on demand and supply forces; however, the government must regulate and supervise the private sector activities to ensure that consumers are not exploited and the environment is not damaged. M/J 11/P22/Q2/a Explain the role that a government should fulfill in a mixed economy.

[8]

Unit-1

Economic Systems, Price Mechanisms

SUGGESTED ANSWER: All real world economies are mixed economies. A mixed economy is one where economic decisions are partly made by the government and partly through the market. Governments imbued with centralized control and the power to shape legislation may direct certain industries such as telecommunication or transportation whereas private businesses control the remaining industries and generally thrive or fail according to the dictates of the market. The role of planning and government intervention becomes crucial for welfare oriented projects which are slow yielding but beneficial for the economy on the whole. Individuals driven by selfinterest and the price mechanism may ignore or underestimate the benefits of such projects. Even if individuals realize all the social benefits, they may not have any incentive to establish and provide for national goals. Governments help provide public goods which cannot be provided under a market system as it is not possible to charge a price for them. Goods and services such as street lighting and national defence, for instance, cannot be charged for individually and necessitate intervention by the government. Likewise, governments provide and encourage consumption of merit goods and services. If provided by a market system, some people who need these services either do not afford them or do not believe that they need them. There is a danger, therefore, that such goods and services would be under-consumed. Common examples of merit goods are health and education. Planning also helps overcome negative externalities or the spillover effects on non-members of an economic transaction. In contrast to profit maximizing behavior under the free market system, governments invest large sums of capital in the provision of basic necessities to the masses at reasonable prices. However, arbitrary prices set by the state may not reflect the true scarcity of resources, hence causing inefficient allocations. Moreover, the assumption of everyone working for the common good may not always manifest itself in reality. O/N 10/P22/Q3/b Discuss the importance of price in the effective operation of a mixed economy.

[12]

Unit-1

Economic Systems, Price Mechanisms

where demand and price are on the rise. Consumers would have unlimited demand for a product if given away free of any cost. Prices tend to ration demand and bring demand and supply to an appropriate balance. Consider a product experiencing a rise in demand as shown in the figure below. Since supply falls short of demand, price rises to ration the commodity to those who have higher money votes and thus reduces demand. It also rises to attract more producers to supply the commodity and hence causes a movement along the supply curve too. This mechanism continues till demand and supplies are brought into balance once again and the new equilibrium is established at e1. Y 10 8 6 4 2 O

C X

Prices, therefore, act as an allocative mechanism, appointing resources to their best possible use. When the incentive function triggers, re allocation from low to high profit markets continues till no further shift in resources is required. Where firms and consumers understand price signals correctly, their responses bring stability and certainty to the economy. However, there are many cases where prices fail to perform their functions and the role of planning and government intervention becomes crucial. For example, welfare oriented projects which are slow yielding but beneficial for the economy on the whole require government support. Individuals driven by self-interest and the price mechanism may ignore or underestimate the benefits of such projects. Even if individuals realize all the social benefits, they may not have any incentive to establish and provide for national goals. Governments help provide public goods which cannot be provided under a market system as it is not possible to charge a price for them. Goods and services such as street lighting and national defence, for instance, cannot be charged for individually and necessitate intervention by the government. Likewise, governments provide and encourage consumption of merit goods and services. If provided by a market system, some people who need these services either do not afford them or do not believe that they need them. There is a danger, therefore, that such goods and services would be under-consumed. Common examples of merit goods are health and education. Planning also helps overcome negative externalities or the spill over effects on non-members of an economic transaction. O/N 09/P21/Q2/b Discuss whether government intervention always improves the operation of the market.

[12]

SUGGESTED ANSWER: Government intervention for the provision of goods and services may be necessitated in instances

Unit-1

Economic Systems, Price Mechanisms

where free markets fail to allocate resources efficiently. The role of planning and government intervention becomes crucial for welfare oriented projects which are slow yielding but beneficial for the economy on the whole. Individuals driven by self-interest and the price mechanism may ignore or underestimate the benefits of such projects. Even if individuals realize all the social benefits, they may not have any incentive to establish and provide for national goals. Governments help provide public goods which a free market system fails to provide altogether. Public goods are non-excludable i.e. once provided, they are available to everyone and non-rival i.e. consumption by one does not diminish the amount available to others. Such characteristics make it impossible to charge a price for public goods and hence, lead to the free rider problem. Governments however, can step forward in such situations to provide goods like street lighting and national defence for all. Governments provide and encourage consumption of merit goods and services. These can be provided by a market system but if they were, there is a possibility that some people who need these services would either not afford them or would not believe that they need them. There is a danger therefore, that such goods and services would be under-consumed. Common examples of merit goods are health and education. Greed for profits may tempt private firms into misallocating resources and under producing merit goods by ignoring their external benefits. In contrast to profit maximizing behavior under the free market system, governments invest large sums of capital in the provision of basic necessities to the masses at reasonable prices. However, arbitrary prices set by the state may not reflect the true scarcity of resources, hence causing inefficient allocations. Moreover, the assumption of everyone working for the common good may not always manifest itself in reality, making direct provision of goods and services by the government undesirable and resorting to free market systems more suitable. Governments are often criticized for lack of efficiency whereas free markets promote competition and provide firms with an everlasting incentive to employ resources efficiently. Public sector firms are also often corrupt and indulge in rent seeking behavior. WAPDA in Pakistan, is criticized for being unable to generate enough electricity to meet average consumer demands while still billing citizens heavily for electricity consumption. Government provision has little or no regard for changing consumersâ&#x20AC;&#x2122; needs and results in shortages and surpluses most of the times. Free markets on the other hand, may be desirable for functioning automatically through the price mechanism. Economic decisions need not be coordinated, yet the economy responds quickly to changing demand and supply conditions. Thus, direct government intervention in economic affairs may not be desirable except for instances where markets fail to allocate resources efficiently, such as merit goods etc. However, governments can help overcome market failures by encouraging private initiative and providing an economic environment conducive to private entrepreneurship. M/J 09/P21/Q2/b Discuss whether a market economy can solve the problem of scarcity more effectively than a command economy. [12]

Unit-1

Economic Systems, Price Mechanisms

decentralized decisions of many firms and households as they interact in markets for the exchange of goods and services. The price mechanism is the allocative mechanism in a free market economy, where prices perform important functions like signaling, incentivizing, rationing and allocating resources. Prices tend to ration demand by bringing demand and supply to an appropriate balance whenever there is a shift in either. For example, shortages are eliminated through a rise in price which rations commodities to those with higher money votes and simultaneously attracts more producers to bring about an increase in supply. When the incentive function triggers, re allocation from low to high profit markets continues till no further shift in resources is required. Therefore, no resources are wasted in coordinating economic decisions as reallocation is automatic and quick. Self-interested behavior under the price mechanism withdraws resources from inefficient uses and employs them where consumers’ utility and producers’ profits are maximized, reducing the problem of scarcity. However, there are instances where the free market fails to allocate resources efficiently, resulting in too much or too little production and/or consumption of commodities. This typically happens in the case of positive and negative externalities where non-members bear the benefit or cost of an economic transaction respectively. Merit goods yield positive externalities and are ‘social desirables’ the government believes people consume too little of if provided by the free market system. Common examples of merit goods are health and education. Demerit goods or the other hand, are ‘social undesirables’ bearing negative externalities which are consumed and produced excessively. Such failure of free market systems may be rectified by withdrawing unnecessary resources employed in demerit goods and re directing them to more productive outcomes or merit goods to reduce the problem of scarcity. Whereas free markets are thought to promote competition and efficiency, the price mechanism may often result in inefficient outcomes under imperfect competition such as monopolies and oligopolies. Where monopoly control commissions are weak in functioning, monopolists may divert excessive precious resources to mass advertising etc. in an attempt to maintain high entry barriers. Greed for profits encourages monopolists to exploit consumers by restricting quantity and charging excessively high prices for it. Oligopolistic market structures promote collusive behavior among market players who indulge in price or quantity fixing agreements. A lot of resources are wasted in monitoring conforming or non-conforming behavior of players or judging rivals’ reactions while making decisions as the market is dominated by strategic interdependence. Such wastage of resources worsens the basic economic problem. Government intervention may become desirable in instances where the price mechanism results in inefficient resource allocation. However, direct provision of goods and services by the government more often results in corruption, rent seeking behaviour and inefficiency. WAPDA in Pakistan is criticized for being unable to generate enough electricity to meet average consumer demands while still billing citizens heavily for electricity consumption. Government provision has little or no regard for changing consumers’ needs and results in shortages and surpluses most of the times. Thus, it may not be any better at reducing the basic economic problem than free markets. It is desirable that free market systems be allowed to allocate resources in an economy, provided they functions smoothly without any friction. M/J 08/P02/Q2/b Discuss whether the price mechanism is an effective way to solve the basic economic problem. [12]

Unit-1

Economic Systems, Price Mechanisms

SUGGESTED ANSWER: Price mechanism is the allocative mechanism in a free market system, where prices are determined by the interaction of demand and supply and any surpluses or shortages in the market are eliminated automatically. Such quick, automatic re allocation of resources is impossible to achieve without the signaling, incentivizing, rationing and allocative functions prices perform in a free market economy. Prices convey information about relative scarcity and abundance of goods and services to both households and firms. They signal consumers and producers how to behave in a market. Such signals help producers learn what is most profitable for them to produce and adjust their supply schedules accordingly. Prices incentivize producers into directing production towards commodities in high demand. They act as an allocative mechanism, appointing resources to their best possible use. When the incentive function triggers, re allocation from low to high profit markets continues till no further shift in resources is required. Therefore, self-interested behavior under the price mechanism withdraws resources from inefficient uses and employs them where consumers’ utility and producers’ profits are maximized, reducing the problem of scarcity. Prices tend to ration demand and bring demand and supply to an appropriate balance whenever there is a shift in either. For example, shortages are eliminated through a rise in price which rations commodities to those with higher money votes and simultaneously attracts more producers to bring about an increase in supply. However, there are instances where the price mechanism fails to allocate resources efficiently, resulting in too much or too little production and/or consumption of commodities. This typically happens in the case of positive and negative externalities where nonmembers bear the benefit or cost of an economic transaction respectively. Merit goods yield positive externalities and are ‘social desirables’ the government believes people consume too little of if provided by the free market system. Common examples of merit goods are health and education. Demerit goods or the other hand, are ‘social undesirables’ bearing negative externalities which are consumed and produced excessively. Such failure of the price mechanism may be rectified by withdrawing unnecessary resources employed in demerit goods and re directing them to more productive outcomes or merit goods to reduce the problem of scarcity. Whereas free markets are thought to promote competition and efficiency, the price mechanism may often result in inefficient outcomes under imperfect competition such as monopolies and oligopolies. Where monopoly control commissions are weak in functioning, monopolists may divert excessive precious resources to mass advertising etc. in an attempt to maintain high entry barriers. Greed for profits encourages monopolists to exploit consumers by restricting quantity and charging excessively high prices for it. Oligopolistic market structures promote collusive behavior among market players who indulge in price or quantity fixing agreements. A lot of resources are wasted in monitoring conforming or non-conforming behavior of players or judging rivals’ reactions while making decisions as the market is dominated by strategic interdependence. Such wastage of resources worsens the basic economic problem. Government intervention may become desirable in instances where the price mechanism results in inefficient resource allocation. Governments for instance, provide public goods which cannot be charged a price for and are hence not provided altogether under free market systems. However, direct provision of goods and services by the government more often results in corruption and inefficiency. Price mechanism, if allowed to function smoothly without friction, makes a better allocative system.

Unit-1

Economic Systems, Price Mechanisms

M/J 08/P02/Q2/a Explain the three economic questions that all economies face because of the basic economic problem. [8]

SUGGESTED ANSWER: The basic economic problem of scarcity is characterized by limited means and unlimited wants and constrains all individuals, firms, countries and regions. Scarcity, the limiting factor, brings thousands of trade-offs our way and necessitates economizing on the use of our resources. Among all the competing uses, an individual, household, firm or an economy has to choose the most important objective it wishes to put it resources to work at. Microeconomics focuses on the economic behavior of decision makers-consumers and producers, and is concerned with explaining the mechanism which leads to the allocation of limited resources among competing uses. While allocating resources, there are three main questions any economy has to answer: 

How to produce (production techniques/methods)



What to produce (choice/selection)



For whom to produce (target market/distribution)

The first question is difficult to answer as scarcity calls for employing resources such that maximum wants are satisfied. It addresses the production function of the economy- how to organize factors of production etc. An economy can either opt for self-sufficiency where its people try to fulfill their needs and wants in a more direct manner or use division of labor, which calls for a high degree of specialization. The second approach yields productive advantages as there is better utilization of the given amount of resources. The result is enhanced output, reducing the problem of scarcity. ‘What to produce’ calls for deciding upon the allocation of resources between different goods and services e.g. should an economy concentrate on the provision of education or sacrifice that in the way of increased defence expenditures? It mainly addresses the issue of settling countless tradeoffs in favor of certain goods after taking into account the respective opportunity costs. Opportunity cost is the real cost measured in terms of goods and services which must be given up in order to obtain something else. The last question addresses the distribution function of the economy- who gets what and how much? For instance, goods and services may be allocated to those who afford to pay for them or those who desire to have them. A university may make an offer of admission to a poor but talented student than one who affords the fee but is not competent enough. Similarly, governments may choose to construct small roads linking farmers and markets rather than investing in building motorways connecting big cities. O/N 07/P2/Q3/a Explain how resources are allocated in a market economy.

[8]

SUGGESTED ANSWER: A free market economy allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services. There is private ownership of nonhuman resources and private individuals or groups that own resources may rent them out to firms for the production of goods and services. Ownership can be delegated in this way. The role of the government is restricted to upholding property rights of individuals, so that contractual agreements

Unit-1

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between consumers and producers are made possible. The government only facilitates the provision of a smooth environment for the operation of demand and supply forces. Price mechanism is the allocative mechanism in a free market economy. It is the channel through which consumers signal to producers about goods and their respective quantities which they want them to produce. Consumers signal to producers through demand forces whereas the latter respond through supply. A free market economy calls for high levels of competition, where nearly every market is perfectly competitive- with numerous buyers and sellers and no barriers to entry or exit. Prices convey information about relative scarcity and abundance of goods and services to both households and firms. They signal consumers and producers how to behave in a market. Such signals help producers learn what is most profitable for them to produce and adjust their supply schedules accordingly. Prices incentivize producers into directing production towards commodities in high demand. They act as an allocative mechanism, appointing resources to their best possible use. When the incentive function triggers, re allocation from low to high profit markets continues till no further shift in resources is required. Therefore, self-interested behaviour under the price mechanism withdraws resources from inefficient uses and employs them where consumers’ utility and producers’ profits are maximized, reducing the problem of scarcity. Self-interest is the driving force for consumers and producers in a market economy. Consumers strive to maximize their satisfaction or welfare whereas producers concentrate on maximizing their profits or rate of return. Consumers enjoy independent decision making- they consume what they want, given their limited money income and dictate producers about the goods and their respective quantities that they want them to produce. Producers likewise, are free to utilize resources in producing whatever they desire to produce and sell it in markets of their own choice. There is free mobility of resources-land, labour and financial capital are free to be sold in any market. M/J 07/P2/Q2/b Discuss the desirability of the worldwide movement towards the market economy and away from the planned economy. [12]

SUGGESTED ANSWER: Encountered by all societies and communities, the basic economic problem of scarcity and choice led to the evolution of various economic systems. Economic systems are institutional frameworks that address issues regarding organization, distribution and exchange of goods and services. Planned economies lie at one end of the spectrum and are essentially characterized by a single, centralized authority i.e. the state. Free markets occupy the other extreme and allocate resources through the decentralized decisions of many firms and households as they interact in markets for the exchange of goods and services. There were many more planned economies on the map of this earth than are seen today. The core existence of planned economies was marked by the class conflict and the Marxian ideology against the exploitative powers of the bourgeoisie. The idea of introducing a centralized authority was to ensure that class inequalities were eliminated and common good prevailed. Essentially, the state would enjoy collective ownership of resources and the poor would be granted access to the same goods and services, same essentials and luxuries as the rich. Prices would be reasonable so as to do away with any consumer exploitation at the hands of monopolistic producers while employment and wages would be high to give labourers a fair day’s wage for a fair day’s work. Despite drawing motivation from such strong sources, planned economies gradually failed in meeting their economic objectives because of their simplistic approaches. It takes considerable

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imagination to understand the complexity of tasks that an ideal planned economy would have to take care of. Collecting information, analyzing data, organizing resources and distributing goods and services throughout a sizeable economy is almost an impossible task. Apart from administration issues, arbitrary prices set by the state failed to reflect the true economic scarcity of resources and resulted in inefficient resource allocations. Failure to judge consumer demands along with artificially low prices often led to huge shortages and surpluses of commodities. The idea that everyone would work for the common good never manifested itself in reality and corruption and bribery were widespread. Industries were clearly overstaffed and inefficient in production as there was little or no competition to promote efficiency. Such economic circumstances necessitated a revolutionary shift to free market systems by several economies, including China and the USSR. Free markets encouraged private ownership of resources and functioned through the â&#x20AC;&#x2DC;invisible handâ&#x20AC;&#x2122; or price mechanism. The economy functioned automatically, without having to coordinate buying and selling decisions. Self-interest was the driving force for consumers and producers- consumers strove to maximize their satisfaction or welfare whereas producers concentrated on maximizing their profits or rate of return. Individuals dictated producers about the goods and their respective quantities that they wanted them to produce. Producers likewise, were free to utilize resources in producing whatever they desired to produce and sell it in markets of their own choice. However, time revealed instances where free markets led to inefficient resource allocations and failed to provide certain goods altogether. The former addresses the issue of positive and negative externalities in production and the latter refers to the failure of provision of public goods under free market economies. The role of government became desirable in rectifying such market failures by encouraging the production of social desirables or merit goods, controlling the consumption and production of demerit goods bearing negative externalities and undertaking responsibility for the provision of public goods. It was also required to control inefficiencies and consumer exploitation at the hands of monopolistic or oligopolistic producers. Thus, although free markets were and still are desirable to a great extent, there is little doubt to the fact that proper functioning required at least some government intervention. As a result, most real world economies today exist as mixed economic systems, borrowing traits from both free market and planned economic systems. O/N 06/P2/Q2/b Discuss whether a mixed economy is the best way for a country to deal with the basic economic problem. [12]

SUGGESTED ANSWER: For understanding the mixed economy and economic problem (up to 5 marks) The basic economic problem concerns limited resources, unlimited wants and scarcity (1 mark). A mixed economy combines features of market and planned systems / In a mixed economy, economic decisions are partly made by the government and partly through the market. Governments imbued with centralized control and the power to shape legislation may direct certain industries such as telecommunication or transportation whereas private businesses control the remaining industries and generally thrive or fail according to the dictates of the market. Private ownership, profit motive and markets operate as well as government ownership, service provision and market intervention. (up to 4 marks)

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For discussion of the mixed economy's benefits (up to 5 marks) A mixed system should benefit from the advantages of the two systems. The market system should provide incentive and efficiency while equity and market failure should be dealt with by the government. The role of planning and government intervention becomes crucial for welfare oriented projects which are slow yielding but beneficial for the economy on the whole. Governments help provide public goods, which cannot be provided under a market system as it is not possible to charge a price for them. Goods and services such as street lighting and national defence cannot be charged for individually and necessitate intervention by the government. Likewise, governments provide and encourage consumption of merit goods and services. If provided by a market system, some people who need these services would either not afford them or would not believe that they need them. There is a danger therefore, that such goods and services would be under-consumed. Common examples of merit goods are health and education. Planning also helps overcome negative externalities or the spill over effects on non-members of an economic transaction. Market forces, on the other hand, encourage high levels of competition and eliminate shortages and surpluses automatically. Individuals help minimize scarcity by acting in their own interest and employing resources efficiently. For discussion of the mixed economy's drawbacks (up to 5 marks) However a mixed economy may suffer from the disadvantages of both planned and market economic systems, producing inequality, inefficiency and low levels of welfare. In contrast to profit maximizing behaviour under the free market system, governments invest large sums of capital in the provision of basic necessities to the masses at reasonable prices. However, arbitrary prices set by the state may not reflect the true scarcity of resources, hence causing inefficient allocations. Moreover, the assumption of everyone working for the common good may not always manifest itself in reality. Individuals driven by self-interest and the price mechanism may ignore or underestimate the benefits of projects yielding welfare. Even if individuals realize all the social benefits, they may not have any incentive to establish and provide for public and merit goods. Ethical objections dampen the usefulness of free market forces. These forces reward self-interested behaviour and may encourage selfishness, greed and materialism. They may also widen income inequalities as market systems tend to throw up individuals who become very rich whilst there are others that struggle to survive. Those who have more, gain at the expense of those who have less. Such wide income inequalities may lead to a range of social and economic problems and tensions. Max. 12 marks M/J 05/P2/Q2/b Discuss the desirability of the direct provision of goods and services by the government.

[12]

SUGGESTED ANSWER: Government intervention for the provision of goods and services may be necessitated in instances where free markets fail to allocate resources efficiently. The role of planning and government intervention becomes crucial for welfare oriented projects which are slow yielding but beneficial for the economy on the whole. Individuals driven by self-interest and the price mechanism may ignore or

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underestimate the benefits of such projects. Even if individuals realize all the social benefits, they may not have any incentive to establish and provide for national goals. Governments help provide public goods which a free market system fails to provide altogether. Public goods are non-excludable i.e. once provided, they are available to everyone and non-rival i.e. consumption by one does not diminish the amount available to others. Such characteristics make it impossible to charge a price for public goods and hence, lead to the free rider problem. Governments however, can step forward in such situations to provide goods like street lighting and national defence for all. Governments provide and encourage consumption of merit goods and services. These can be provided by a market system but if they were, there is a possibility that some people who need these services would either not afford them or would not believe that they need them. There is a danger therefore, that such goods and services would be under-consumed. Common examples of merit goods are health and education. Greed for profits may tempt private firms into misallocating resources and under producing merit goods by ignoring their external benefits. In contrast to profit maximizing behavior under the free market system, governments invest large sums of capital in the provision of basic necessities to the masses at reasonable prices. However, arbitrary prices set by the state may not reflect the true scarcity of resources, hence causing inefficient allocations. Moreover, the assumption of everyone working for the common good may not always manifest itself in reality, making direct provision of goods and services by the government undesirable and resorting to free market systems more suitable. Governments are often criticized for lack of efficiency whereas free markets promote competition and provide firms with an everlasting incentive to employ resources efficiently. Public sector firms are also often corrupt and indulge in rent seeking behavior. WAPDA in Pakistan, is criticized for being unable to generate enough electricity to meet average consumer demands while still billing citizens heavily for electricity consumption. Government provision has little or no regard for changing consumersâ&#x20AC;&#x2122; needs and results in shortages and surpluses most of the times. Free markets on the other hand, may be desirable for functioning automatically through the price mechanism. Economic decisions need not be coordinated, yet the economy responds quickly to changing demand and supply conditions. Thus, direct provision of goods and services by the government may not be desirable except for instances where markets fail to allocate resources efficiently, such as merit goods etc. However, governments can help overcome market failures by encouraging private initiative and providing an economic environment conducive to private entrepreneurship. M/J 05/P2/Q2/a Explain the differences in the features of a market economy and a planned economy.

[8]

SUGGESTED ANSWER: Features of Market Economy [up to 4 marks] Individual actions and consumer sovereignty dominate in the market economy. [1] Profit motive and self-interest lead to motivation. [1] Private ownership of non-human resources is possible. [1] The market forces of demand and supply determine allocation of resources. [1] It often provides a high level of competition [1] and provides consumers and producers the freedom to choose. [1]

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It provides a variety of goods to consumers and a variety of options to producers. [1] The role of the public sector is limited to upholding property rights. [1] Features of Planned Economy [up to 4 marks] In a planned economy there are government ownership, planning bodies and the state direction of resources. [1] Motivation is not to make profits, but to look after public interest. [1] Centralized decisions by the government dominate economic activity. [1] Consumers and producers do not have the freedom to choose. [1] O/N 04/P2/Q4/b Discuss whether economic actions by individuals always result in a net benefit to society.

[12]

SUGGESTED ANSWER: An economic system encouraging individuals and private enterprise to make economic decisions is characterized as a free market system. It allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services. Questions regarding the organization, distribution and exchange of goods and services i.e. how, what and for whom to produce are addressed purely by the market. The high level of competition forces factors of production to be organized efficiently. Firms specialize and tend to be productively and allocatively efficient in the long run. Consumers dictate what is to be produced through money votes and whoever has access to more of them can enjoy greater amounts of goods and services. Free market system may be desirable as it functions automatically through the price mechanism. Economic decisions need not be coordinated, yet the economy responds quickly to changing demand and supply conditions. Also, high levels of competition ensure that prices remain reasonable and that no single firm has great market power. Competition also provides firms with an everlasting incentive to be efficient. One of the defining features of free market systems is self-interested behaviour, where consumers strive to maximize their satisfaction or welfare and producers concentrate on maximizing their profits or rate of return. The pursuit of self-interest through buying and selling in competitive markets helps minimize the central problem of scarcity. Firms employ resources efficiently, producing goods in line with consumersâ&#x20AC;&#x2122; wishes. Greater efficiency leads to greater profits. On the other hand, consumers maximize their satisfaction from consumption- meaning they decide more carefully about what to buy and increase the value for money that they receive. In practice however, markets fail to function properly due to a variety of reasons and necessitate government intervention. The role of planning and government intervention becomes crucial for welfare oriented projects which are slow yielding but beneficial for the economy on the whole. Individuals driven by self-interest and the price mechanism may ignore or underestimate the benefits of such projects. Even if individuals realize all the social benefits, they may not have any incentive to establish and provide for national goals. Governments help provide public goods, which cannot be provided under a market system as it is not possible to charge a price for them. Goods and services such as street lighting and national defence cannot be charged for individually and necessitate intervention by the government. Governments provide and encourage consumption of merit goods and services. These can be provided by a market system but if they were, there is a possibility that some people who need these

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services would either not afford them or would not believe that they need them. There is a danger therefore, that such goods and services would be under-consumed. Common examples of merit goods are health and education. Planning also helps overcome negative externalities by imposing taxes on polluters and bringing pollution and production to acceptable levels. Ethical objections dampen the usefulness of free market systems. Free market economies reward self-interested behavior and may encourage selfishness, greed and materialism. They may also widen income inequalities as market systems tend to throw up individuals who become very rich whilst there are others that struggle to survive. Those who have more, gain at the expense of those who have less. Such wide income inequalities may lead to a range of social and economic problems and tensions. In contrast to profit maximizing behavior under the free market system, governments invest large sums of capital in the provision of basic necessities to the masses at reasonable prices. However, arbitrary prices set by the state may not reflect the true scarcity of resources, hence causing inefficient allocations. Moreover, the assumption of everyone working for the common good may not always manifest itself in reality. Realizing the problems posed by both the free market and planning, many economies today operate as mixed economic systems. A mixed economy is one where economic decisions are partly made by the government and partly through the market. Governments imbued with centralized control and the power to shape legislation may direct certain industries such as telecommunication or transportation whereas private businesses control the remaining industries and generally thrive or fail according to the dictates of the market. History has witnessed the transition of many economies from the state controlled end of the spectrum towards free-er markets. There has also been increasing emphasis on privatization i.e. selling of nationalized industries to the private sector in recent years. However, the role of the government can never be reduced beyond a certain point as it is necessary to overcome the deficiencies and inefficiencies of the free market system. M/J 04/P2/Q2/b Discuss whether the operation of a market economy always produces a desirable outcome.

[12]

SUGGESTED ANSWER: Benefits of a Market Economy [up to 6 marks] A properly functioning market economy should provide greater choice [1], better quality [1] and competition [1]. It makes better utilization of economic resources and avoids waste. [1] It is a more efficient system of resource allocation. [1] Limitations of a Market Economy [up to 6 marks, but a maximum of 8 marks for both benefits and drawbacks of market economy] Market economies fail as they overproduce in case of negative externalities [1] and underproduce when there are positive externalities [1] as they ignore external cost as well as external benefits. [1] Market economies also overproduce demerit goods [1] and underproduce merit goods.[1] They fail to produce public goods because of the free rider problem. [1] There are greater income inequalities in market economies. [1]

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Economic Systems, Price Mechanisms

Market economies are often criticized for ignoring ethics and public interest [1] as an overemphasis on profits and self-interest may encourage selfishness, greed and materialism. [1] Evaluation/Conclusion/Judgement [up to 4 marks] Market Economy is a better system as it promotes competition and efficiency. [1] However, government intervention is desirable [1] in situations where the market fails to allocate resources efficiently. [1] Government intervention could be in the form of regulation and control. [1] M/J 03/P2/Q2/a Explain the functions of price in a market economy.

[10]

SUGGESTED ANSWER: A free market economy allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services. The free market system functions through price mechanism, where prices are determined by the interaction of demand and supply and any surpluses or shortages in the market are eliminated automatically. Such quick, automatic re allocation of resources is impossible to achieve without the several important functions prices perform in a free market economy. Prices convey information about relative scarcity and abundance of goods and services to both households and firms. They signal consumers and producers how to behave in a market. Consumers use prices for comparison between different commodities and on choosing the best buy, indicate producers what and how much to produce through demand forces. Producers face tradeoffs between different combinations of goods. However, receiving signals from the consumers, they learn what is most profitable for them to produce and adjust their supply schedules accordingly. Prices also provide an incentive mechanism for producers. Learning about changes in the preferences of consumers, producers are incentivized to direct production towards commodities in high demand. The possibility of higher market prices provides producers with an incentive to expand output. Firms thus quit markets where prices and profits are declining and enter new, growing ones where demand and price are on the rise. Consumers would have unlimited demand for a product if given away free of any cost. Prices tend to ration demand and bring demand and supply to an appropriate balance. Consider a product experiencing a rise in demand as shown in the figure. Since supply falls short of demand, price rises to ration the commodity to those who have higher money votes and thus reduces demand. It also rises to attract more producers to supply the commodity and hence causes a movement along the supply curve too. This mechanism continues till demand and supplies are brought into balance once again and the new equilibrium is established at e1.

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Economic Systems, Price Mechanisms

P S

e1 P1 e0 P0 D1 D0 O

Prices thus act as an allocative mechanism, appointing resources to their best possible use. When the incentive function triggers, re allocation from low to high profit markets continues till no further shift in resources is required. Where firms and consumers understand price signals correctly, their responses bring stability and certainty to the economy. O/N 02/P2/Q2/b Discuss whether planning has any role to play in the allocation of resources in a modern, mixed economic system. [12]

SUGGESTED ANSWER: All real world economies are mixed economies. A mixed economy is one where economic decisions are partly made by the government and partly through the market. Governments imbued with centralized control and the power to shape legislation may direct certain industries such as telecommunication or transportation whereas private businesses control the remaining industries and generally thrive or fail according to the dictates of the market. The role of planning and government intervention becomes crucial for welfare oriented projects which are slow yielding but beneficial for the economy on the whole. Individuals driven by selfinterest and the price mechanism may ignore or underestimate the benefits of such projects. Even if individuals realize all the social benefits, they may not have any incentive to establish and provide for national goals. Governments help provide public goods, which cannot be provided under a market system as it is not possible to charge a price for them. Goods and services such as street lighting and national defence cannot be charged for individually and necessitate intervention by the government. Likewise, governments provide and encourage consumption of merit goods and services. If provided by a market system, some people who need these services would either not afford them or would not believe that they need them. There is a danger therefore, that such goods and services would be under-consumed. Common examples of merit goods are health and education. Planning also helps overcome negative externalities or the spill-over effects on non-members of an economic transaction. Ethical objections dampen the usefulness of free market systems. Free market economies reward self-interested behavior and may encourage selfishness, greed and materialism. They may also widen income inequalities as market systems tend to throw up individuals who become very rich whilst there are others that struggle to survive. Those who have more, gain at the expense of those who have less. Such wide income inequalities may lead to a range of social and economic problems and

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tensions. In contrast to profit maximizing behavior under the free market system, governments invest large sums of capital in the provision of basic necessities to the masses at reasonable prices. However, arbitrary prices set by the state may not reflect the true scarcity of resources, hence causing inefficient allocations. Moreover, the assumption of everyone working for the common good may not always manifest itself in reality. Mixed economic systems are popular as they rely on market forces for economic decisions whereas public service projects are owned and controlled by the government. History has witnessed the transition of many economies from the state controlled end of the spectrum towards free-er markets. There has also been increasing emphasis on privatization i.e. selling of nationalized industries to the private sector. However, the role of the government can never be reduced beyond a certain point as it is necessary to overcome the deficiencies and inefficiencies of the free market system.

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Economic Systems, Price Mechanisms