ECONOMICS 1

F101ECO

Assignment No: 01

Submitted By: Naveed Iqbal 1002196

QUESTION 1

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a. Discuss the contention that economics is primarily concerned with resource choices. Economics is not just the study of how people gain their living whether by ordinary or extraordinary means, but how they use their time and resources, how they spend their lives, not just their money. Economics is concerned with identifying and clarifying choices, the range of possibilities which face us over time. On a personal level the choice might be between buying a book or a dress; saving for retirement or spending on a holiday, using our time for leisure of washing up. At level of the organization, such as a business firm, the choice could be between investing in new computer system or retaining and upgrading existing equipment. In health care charity the choice might manifest itself as the option of spending donation to reduce the suffering of chronically sick people now or investing those limited funds for research into prevention and cure in the future. In practice, these can be agonizingly difficult choices. At national level, in Britain, the choice could be between increasing government expenditure on motorways and ring roads and expanding the number of National Health Services beds. Indeed, there is the need to choose between alternative methods of financing such increased expenditure. No individual, not organization can avoid making choices about use of limited resources, including the time required to meet competing alternative ends. The management of societys resources is important because resources are scarce. There is scarcity. Economics is the study of how society manages its scarce resources. In most societies, resources are allocated not by a single central planner but through the combined actions of millions of households and firms. Economists therefore study how people make decisions: how much they work, what they buy, how much they save, and how they invest their savings. Economists also study how people interact with one another. For instance, they examine how the multitude of buyers and sellers of a good together determine the price at which the good is sold and the quantity that is sold. Finally, economists analyze forces and trends that affect the economy as a whole, including the growth in average income, the fraction of the population that cannot find work, and the rate at which prices are rising b. The following chart gives information about a small industriali zed country.

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i.

How would you account for the slightly different patterns in the two curves shown?

Answer:
Different patterns in the two curves shows:
y

GDP at current market prices curve is called Nominal GDP Curve. Nominal GDP is the sum value of all produced goods and services at current prices. Nominal GDP is more useful than real GDP when comparing sheer output, rather than the value of output, over time. GDP at 2004 prices curve is base year price which is Real GDP. Rea GDP is the sum value of all produced goods and services at constant prices. The prices used in the computation of real GDP are gleaned from a specified base year. By keeping the prices constant in the computation of real GDP, it is possible to compare the economic growth from one year to the next in terms of production of goods and services rather than the market value of these goods and services.

ii. Answer:

In which years shown was the level of GDP at current market prices at its highest and at its lowest? Briefly explain your answers.

Graph shows that GDP at current market prices (Nominal GDP) is highest at year 2007 which is 16% and lowest at year 2004 which is -3%.

iii. Answer:

If the index value for GDP in 2004 was 100, estimate the index value for real GDP in 2007.

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GDP at current year prices Index value for Real GDP 2007= GDP at base year prices = (16/10) x 100 = 160 iv. Answer: Estimate real GDP growth over the whole period 2001 to 2010. x 100

Graph shows that: Real GDP2001 = 7 Real GDP2010 = 6.50 Growth Rate Real GDP2001-

2010

 

=

It means the country economy is declining. Following table shows Real GDP growth over whole period 2001 to 2010.
Year 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Real GDP 7.0 7.50 7.75 -1.50 1.00 8.00 10.00 8.25 7.75 6.50 Growth Rate 0.0 7.14% 3.33% -80.65% 166.67% 700.00% 25.00% -17.50% -6.06% -16.13%

QUESTION 2 In your own words and with your own examples, explain what is meant by: y the substitution effect of a price change y the income effect of a price change Use a diagram to illustrate this distinction and make appropriate reference to elasticities.
y

the substitution effect of a price change:

When the price of goods falls, the good becomes cheaper relative to other goods. Conversely, a rise in price makes the goods more expensive relative to other goods. In either case, the consumer experiences the substitution effect. The change in the quantity of the good the consumer would purchase after price change to achieve same level of utility. For example if the price of food fall, the consumer can achieve same level of utility by substituting food for other goods, that is by buying more food and less of others goods. Similarly if the price of food rise, the consumer may substitute others goods for food to achieve same level of utility.

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the income effect of a price change:

When the price of good falls, the consumers purchasing power increases, since the consumer can now buy the same basket of goods as before the price decrease and still have money left over to buy more goods. Conversely, a rise in price decrease the consumers purchasing power such as the consumer can no longer afford to buy the same basket of goods. This change in purchasing power is termed the income effect. Because it effect the consumer in much the same way as a change in income would; Consumer realizes a higher or lower level of utility because of increase or decrease in purchasing power. Therefore purchases a higher or lower amount of good whose price has changed. The income effect accounts for the part of total different in the quantity of the good purchased that is not accounted for by the substitution effect. Example: For instance, a fast food chain sells pizza and Pepsi. If the price of pizza goes up, but the price of Pepsi stays the same, we might be more inclined to buy Pepsi. This tendency to change our purchase based on changes in relative price is called the substitution effect. When the price of pizza goes up, it makes pizza relatively expensive and Pepsi relatively cheap, which influence us to buy fewer pizza and more Pepsi than we usually would. Likewise, a decrease in pizza price would cause us to eat more pizza and fewer Pepsi, according to the substitution effect. This conclusion is summarized in following table: Goods Income effect Pepsi Substitution effect Total effect

Pizza

Consumer is rich, so Pepsi is relatively cheaper, so Income and substitution he buys more Pepsi. consumer buys more Pepsi. effects act in same direction, so consumer buys more Pepsi. Pizza Consumer is Pizza is relatively more Income and substitution richer, so he buys expensive, so consumer buys effects act in opposite directions, so the total more pizza. less pizza. effect on pizza consumption is ambiguous.

We can use indifference curve analysis to illustrate the two effects.

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Figure:
Figure shows how to decompose the change in the consumers decision into the income effect and the substitution effect. Substitution effect is movement along and indifference curve to a point with different marginal rate of substitution is shown as the change from point A to point B along indifference curve l1. Income effect is the shift to higher indifference curve is shown here as the change from point B on indifference curve l1 to point C on indifference curve l2 When the price of Pepsi falls, the consumer moves from initial optimum point A, to new optimum point C. We can view this change as occurring in two steps. First, the consumer moves along the initial indifference curve l1 from point A to point B. Second, the consumer shifts to the higher indifference curve l2 by moving from point B to point C. they have the same marginal rate of substitution. That is, the slope of the indifference curve l1 at point B equals the slope of the indifference curve l2 at point C. Although the consumer never actually chooses point B, this hypothetical point is useful to clarify the two effects that determine the consumers decision.

QUESTION 3 Most firms lie between the two extremes of perfect competition and monopoly. Examine any one economic model of such imperfect competition, and assess how well it explains the behavior of real firms, and the results such behavior might have upon the efficiency of resource allocation.
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Monopolistic Competition: Definition: A markets that have some features of perfect competition and some features of monopoly. This market structure is called imperfect competition or monopolistic competition. Economic Model of Imperfect Competition: An example of a monopolistically competitive model we may think of King Burger, McDonald in restaurants industry. There is free entry and it is at least possible that people know enough about their food specialty options so that the "sufficient knowledge" condition is fulfilled. But the products of different restaurants are not perfect substitutes. Their services are differentiated by location. A restaurant in Center City Philadelphia is not a perfect substitute for a restaurant in the suburbs, although they may be good substitutes from the point of view of a customer who lives in the suburbs but works in Center City. Restaurants' services may be differentiated in other ways as well. Their food serving may be different; the interior decoration of the restaurant may be different, and that may make a difference for some customers; and even the quality of the conversation may make a difference. The behavior of monopolistically competitive firm in the short run: First we consider the short-run situation, either firm enter or exit. Each firm in a monopolistically competitive market is, in many ways, like a monopoly. To maximize profit, it set its quantity where marginal revenue equals to marginal cost. Because monopolistically firm faces downward-sloping demand curve, its profit maximizing price and quantity balance the increase revenue from a higher price with lost customers brought on by the higher price. The marginal-revenue equals marginal-cost condition achieves this balance. The profitmaximizing quantity is showed by dashed vertical line in the graph (a) and (b) of figure.

Figure shows a profit-making situation in part (a) and loss-making situation in part (b) for monopolistically competitive firm. The firm will always adjust its price and output level so that MR equal to MC. In part (a), the firms demand curve is such that it produces Q1 quantity at P1 price. The resulting profit is showing by shaded area. In part (b), the demand for the firms product is weak; the entire demand curve lies below its ATC curve and the firm is unable to make a positive profit. The best firm can do is to produce Q2 and charge price P2. In this way it minimizes its losses, which is represented by shaded area. The behavior of monopolistically competitive firm in the long run -equilibrium: When firms are making profits, new firms have an incentive to enter the market. This entry increases the number of products from which customers can choose and, therefore, reduces the demand faced by each firm already in the market.
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Conversely, when firms are making losses, firms in the market have an incentive to exit. As firms exit, customers have fewer products from which to choose. This decrease in the number of firms expands the demand faced by those firms that stay in the market. As the demand for the remaining firm products rises, these firms experience rising profit. This process of entry and exit continues until the firms in the market are making exactly zero economic profit. Figure part (c) depicts the long-run equilibrium.

First we observe that price is greater than marginal-cost for monopolistically competitive firm. Production is too low because the marginal-cost. Each firm has some market power, it restrict output slightly and get a higher price. The sum of producer plus consumer surplus is reduced by relative to that is competitive market. In the other words, there is loss of efficiency. Second in Figure(c) the quantity produced is not at the minimize point on the average total cost curve. The quantity that monopolistic competitor produces is at a higher-cost point than the quantity that the perfectly competitor produce. Thus monopolistically firms operate in situation of excess costs. If each firm expand production and lowered its price, average total cost would decline. Each firm operates with some excess capacity. In the sense that it could increase output and reduce average total cost. Economic evaluation of monopolistic competition firm: We now examine monopolistically competitive market for its economic evaluation. Monopolistic competition and resource allocation: We could say that monopolistic competition is wasteful because too many firms are operating at excess capacity. Excess capacity means that a firm is producing less output than is required to attain ATC. In long-run equilibrium, the monopolistically competitive firm produces output Q3 and charges a price P3 see fig(c). To the right of this equilibrium point, there is a section of demand curve that still lies above the marginal cost curve. There are thus consumers willing to pay a price for the product that exceeds the marginal cost of producing it, but unable to obtain the product at such price. Economic efficiency and product differentiation: Monopolistically competitive markets offer consumers a choice of product on the basis of quality, service, product image and other aspects of non-price competition. The consumer, how-ever pays for the advantage of product variety. QUESTION 4 With reference to the special characteristics of land as a factor of production, explain:

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a. why land prices can tend to fluctuate significantly in a free market; Answer: The real estate market made up of many scattered, unrelated transaction that occur between property buyers and sellers, landlords and tenants. The free marketplace operates in complex manner responding to a number of different factors. One of the most important to real estate is the principle of supply and demand. Simply stated, when the supply of any product is limited and there is demand for that product, prices rises because competing consumers are willing to pay more. On the other hand, when there is greater supply of product, and not many consumers interested in buying, price go down in an effort to entice the consumer to buy or rent. As supply and demand fluctuates, other events occur in the marketplace that may cause ripple throughout the general economy. Changes and trends fall into four different categories that may appear in the overall economy and in real estate markets singly, doubly or all at the same time. These changes are classified as cyclic, seasonal, random or long-term. The real estate sector has a ripple effect on many other economic sectors, including construction, finance, professional services, and retail, wholesale and manufacturing sectors. Just like throwing a stone in a pond, the real estate investment ripples to other economic sectors in the form of jobs, increased spending and higher demand for goods and services. The real estate sector is a vital component of the economies of emerging market countries. Because the real estate sector is extremely decentralized, with many links to other industry sectors, it is of significant economic importance to the rest of a countrys economy. b. Why taxes on land are often regarded as preferable to taxes on other factors; Answer: Classical economists identified land, labor, and capital as the three factors of production. Under capital they understood all means of production that have been created through human effort, while they used land and labor to describe natural resources that were not created through human effort. Economic theory of land value taxation: Economic theory shows that under the assumption of perfect markets, a tax on any good with perfectly inelastic supply and non-zero elasticity of demand will be born entirely by the supplier of the good; it cannot be shifted to its user because any increase in the price would lead to an excess supply of the good. In a competitive market the demand for units that are offered at a price above the market price will drop to zero. Therefore a tax on land has to be paid in full by the owner of the land. Given that the supply of land is fixed, the tax does not have any substitution effect and therefore no deadweight loss, which makes it an ideal tax from an efficiency point of view. Preference of land value tax to other taxes: y As the fact that a land value tax carries virtually no deadweight loss, its revenue earning potential is huge. Various studies have estimated that introducing Land value tax into Britain raise at least 200 billion a year in 2002 prices. That is more than the combined revenue of 174 billion from income tax, corporation tax, capital gains tax,
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inheritance tax, stamp duties, insurance premium tax and all council taxes and national non-domestic rates, in that year, corresponding to around half of all government revenue. Land value tax stimulate investment and economic activity, which would raise the demand for land, and therefore land values, the amount of revenue that could be collected through land value tax would tend to increase considerably over time. Land value tax is inherently a fair tax, because the value of a site upon which the tax would be based is determined not by the owner or occupier, but by its location, and the social and economic activities of society as a whole, and by what nature has provided, which should be shared by all. Land value tax is fairer because it is practically impossible to avoid. People do not end up having to pay more tax to compensate for those who evade it. In the case of income tax and taxes on business, there is a flourishing shadow economy. Land value tax has a built-in counter cyclical mechanism. When there is an economic downturn for whatever reason, land values tend to fall so that for a given rate of tax the amount of land value tax due would also fall. This would mean that people would have more to spend, thus helping to boost economic demand, and therefore investment and employment, and businesses would have more to invest, all of which would help to offset any economic downturn.

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