ECS1501/201/1/2018

Tutorial Letter 201/1/2018

Economics IA
ECS1501

Semester 1

Department of Economics

IMPORTANT INFORMATION:
This tutorial letter contains the solutions to
Assignments 01 to 04.
Dear Student

The purpose of this tutorial letter is to provide you with the correct answers to Assignments 01 to 04.
However, before we get to the explanations allow me to say one or two things about multiple-choice
questions (MCQs).

The anatomy of a multiple-choice question

A multiple-choice question consists of a stem and alternatives, one of which is correct or the closest to
being correct (the answer). The incorrect alternatives are called distractors. The function of the distractors
is to mislead you.

How does one answer multiple-choice questions?

If you Google the topic you will find a whole range of suggestions on how to answer MCQs. While some
of the suggestions might be helpful, I would like to suggest the following approach:

Step 1: Be prepared. It goes without saying that you must work through all the relevant prescribed
material before you attempt the assignment.
Step 2: Read the stem of the question carefully (it usually contains the answer).
Step 3: Try to answer the question without looking at the alternatives (this is usually possible).
Step 4: Only now do you look at the alternatives. Select the one which matches/corresponds/is the
same as your answer in step 3.
Step 5: Proceed to the next question.

Please contact us at ECS1501-18-S1@unisa.ac.za if you experience problems with these explanations.

We will gladly assist you. We wish you every success in your studies.

Regards
Your lecturers

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1 ANSWERS TO ASSIGNMENT 01

1.1 The correct option is [1].

Economics cannot be defined as the study of money. It is concerned with the economic choices and
decisions made by businesses, government and individuals. Economics is the study of how scarce
resources are allocated to satisfy wants. Because businesses, individuals and government have unlimited
wants, whereas resources are limited, we have to make choices on how to use the scarce resources to
satisfy unlimited wants.

1.2 The correct option is [3].

Opportunity cost refers to the value of the best alternative given up when a choice is made. Opportunity
cost allows us to measure the cost of the alternative we have chosen in terms of the alternative that we
have to sacrifice. For example, if the Wild Coast Community Farm has to choose between farming
potatoes and fishing, the opportunity cost of farming potatoes would be fishing, which they give up.

1.3 The correct option is [1].

At point H, the allocation of resources is inefficient and it is possible to produce more potatoes at point C
without reducing the production of fish. It is also possible to produce additional fish at point D without
reducing the production of potatoes.

1.4 The correct option is [2].

Point H is a possible and inefficient level of production because resources are not fully employed. Point D
is a possible and efficient level of production because available resources are sufficient and fully
employed, whereas point G is an impossible level of production because it lies beyond the PPC and the
resources are not sufficient to attain such a production level.

1.5 The correct option is [4].

An improved technique for both catching fish and farming potatoes will make it possible for the Wild
Coast Community to produce more fish and potatoes than before, with the same available resources. This
can be illustrated by an outward shift of the PPC.

1.6 The correct option is [2].

The opportunity cost is two baskets of fish (sacrificed) for 45 kg of potatoes. This is because as we move
along the production possibilities curve from point E to point C, the production of potatoes increases by
45 kg while the production of fish decreases by two baskets.

1.7 The correct option is [3].

The fluctuations in the price of petrol in South Africa are an example of a microeconomic issue because it
is focused on the price of a single product, in this case, petrol. In microeconomics we focus on individual
parts of the economy. Microeconomics studies the decisions of individual consumers and firms.

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1.8 The correct option is [1].

This statement is positive because it can be proven by comparing it with facts. Options [2], [3] and [4] are
normative statements because they involve value judgments, not facts.

1.9 The correct option is [2].

In the command system, the economic activity is coordinated by a central authority. Central planners
decide what to produce, how to produce it and how the consumer goods are distributed.

1.10 The correct option is [3].

The three major flows in the economy are total spending, total production and total income.

1.11 The correct option is [4].

Loans, population and bottled water are examples of stock variables; they have no time dimension and
can only be measured at a particular point in time. Immigration, deposits, interest and depreciation are
however flow variables because they have a time dimension and can be measured over a period of time.

1.12 The correct option is [3].

In this case, Maria is an entrepreneur and she will earn a profit. Entrepreneurs are the inventors. They
make use of other factors of production to produce new products and sell them for a profit.

1.13 The correct option is [1].

Total expenditure on production consists of total consumption expenditure, total capital formation, total
government expenditure and net export.

1.14 The correct option is [2].

Box A represents households and arrow B shows the consumer spending on goods and services in the
goods market.

1.15 The correct option is [1].

Arrow C represents spending by firms on factors of production in the factor market.

**** ***** ****

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2 ANSWERS TO ASSIGNMENT 02

2.1 The correct alternative is [4].

The demand for a product depends on two conditions:

i) intent – there must be a willingness to buy, and
ii) means to buy – you must have the income or purchasing power.
In general, we refer to demand as the quantities of a good or service a consumer is willing and able to
buy. Only statement [4] satisfies both these conditions.

2.2 The correct alternative is [2].

The law of supply refers to the relationship between the price of a product and the quantities producers
are planning to sell. This relationship is positive, that is, the higher the price the greater the quantities
producers will be willing to sell. Only statements [2] and [4] refer to the relationship between price and
quantity supplied (the other two statements can thus be ignored), whilst only statement [2] correctly
identifies the positive relationship – a decrease in price decreases the quantity supplied.

Questions 2.3 to 2.9 were based on the data given in a table. As part of the question you were asked to
draw a diagram of the market for ice cream. Some of you might have realised that one could have
answered the questions without drawing the diagram, but it is often easier to go the visual route (diagram)
when answering questions dealing with markets.

When one has to draw a diagram, the first step is to draw the axes. In this instance the axes were given so
we can skip this step. Next we need to label the axes, P on the vertical axis and Q on the horizontal axis.
The price numbers are then plotted on the P-axis (from 1 to 10) and the quantity numbers on the Q-axis
(up to 800). Note though that the scale on the axes need not be the same. However, it is important that
each increment (block) on the vertical axis consistently represents a R1 increase in price and on the
horizontal axis each block represents an increase of 100 ice creams.

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We can know plot the information. We start with the demand for ice cream: If the price of ice cream is
R10, the quantity demanded is 100.

If the price of ice cream is R9, the quantity demanded is 200, and so on:

We do this until we have plotted all the price and quantity demanded combinations:

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Linking the points we have plotted gives us the demand curve.

Now we turn to the supply side. If the price is R10, the quantity supplied is 900:

Similarly, we plot all the price and quantity combinations:

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If we link these points, the supply curve is shown and we have drawn a picture (diagram) of the market
for ice cream.

You can check whether the diagram meets the criteria of a market:
i) the demand curve shows the quantities consumers are willing and able to buy;
ii) the supply curve shows the quantities producers are planning to sell; and
iii) an equilibrium price (exchange ratio) has been established where the plans of consumers and
producers coincide, that is, where quantity demanded is equal to quantity supplied.

Having drawn the market for ice cream, we can return to the questions.

2.3 The correct alternative is [1].

This question is similar to question 2.2. However, we are now dealing with the law of demand which
refers to the relationship between the price of a product and the quantities consumers are willing and able
to buy. This relationship is negative, that is, the higher the price the smaller the quantities consumers are
willing and able to buy. Only statements [1] and [2] refer to the relationship between price and quantity
demanded (the other two statements can thus be ignored) but only statement [1] correctly identifies the
negative relationship – a decrease in price from R8 to R4 increases the quantity demanded from 300 to
700 (by 400).

2.4 The correct alternative is [3].

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If the price is higher than the equilibrium price, that is, if the price is higher than R6, say R8, the quantity
demanded is 300 and the quantity supplied is 700. The quantity supplied is more than the quantity
demanded and we have thus an excess supply. Producers are sitting with ice cream they cannot sell at the
current price and will therefore lower the price. A lower price increases the quantity demanded and
decreases the quantity supplied. This process will continue until quantity demanded is equal to quantity
supplied. This condition (equilibrium) is met at a price of R6.

Before we move to the next question, can you see how the suggested steps to answer multiple-choice
questions are applied?

Step 1: Read the stem of the question carefully (it usually contains the answer).
“If the price is higher than the equilibrium price”, …
Step 2: Try to answer the question without looking at the alternatives (this is usually possible).
What does it mean if the price is higher than the equilibrium price, for example at R8? At R8
“quantity demanded is 300 and quantity supplied is 700. The quantity supplied is more than
the quantity demanded and we have thus an excess supply. Producers are sitting with ice
cream they cannot sell at the current price and will therefore lower the price. A lower price
increases the quantity demanded and decreases the quantity supplied. This process will
continue until quantity demanded is equal to quantity supplied. This condition (equilibrium) is
met at a price of R6.”
Step 3: Only now do you look at the alternatives. Select the one which matches/corresponds/is the
same as your answer in step 2.
Only statement [3] ticks all the boxes. Statements [2] and [4] obviously do not as they refer to
excess demand, whilst statement [1] states that the process “continues until a lower market
equilibrium price than R6 is reached”.
Step 4: Proceed to the next question.

2.5 The correct alternative is [1].

A rightward shift of the demand curve indicates an increase in the demand for the product (ice cream). An
increase in demand could be the result of any of the following:

• an increase in the price of a substitute

• a decrease in the price of a complement
• an increase in income
• an increase in taste/preference
• an increase in the population
• an expected increase in the price

Now we are able to look at the alternatives and find the one that matches one of the above. Alternative [1]
correctly states: an increase in the price of a substitute for ice cream such as an ice drink. Note that
statement [4] refers to a decrease in the price of ice cream. A decrease in the price of a product increases
the quantity demanded and is shown by a movement along (on) the demand curve.

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2.6 The correct alternative is [2].

An increase in the demand for ice cream is shown by a rightward shift of the demand curve.

At the current price (R6), an excess demand is created. Quantity demanded is greater than quantity
supplied. This forces the price upwards. As the price increases, the quantity demanded decreases and the
quantity supplied increases. This process continues until the quantity demanded is equal to the quantity
supplied (at R8). Note that the increase in price caused a movement along the demand and supply curves
respectively.

2.7 The correct alternative is [3].

Read the statement (stem) carefully. “What will happen to the equilibrium position if there is a decrease
in the price of milk that is used in the production of ice cream?” The first question one can ask is whether
the initial or immediate effect of a decrease in the price of milk has an effect on the demand for ice cream
or the supply of ice cream? We know the demand of a product is affected by factors such as taste, fashion,
the weather (if the weather is hot the demand might increase), and so on. None of these factors was
referred to in the statement. And supply? The supply of a product is mainly affected by the cost of
production and milk is certainly one of the main ingredients (inputs) of ice cream. A decrease in the price
of milk therefore reduces the cost of producing ice cream. A reduction in the cost of producing ice cream
is shown by a downward (rightward) shift of the supply curve. Note that we have redrawn our market for
ice cream, we moved away from the specific information given in the table to a picture (diagram)
showing the market for ice cream in general.

Thus, the equilibrium price will decrease and the equilibrium quantity will increase.

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2.8 The correct alternative is [3].

If you have understood question 2.7 you would have realised that the answer to this question is given in
the explanation above. An increase in supply leads to a decrease in the equilibrium price for ice cream
and an increase in the equilibrium quantity.

Alternatively, you could have picked any price/quantity combination showing a lower price and higher
quantity, for example point A on the diagram below.

Now try to reach point A by shifting the demand curve. A rightward shift (an increase in demand) leads to
a higher price and higher quantity (point B) and a shift to the left (a decrease in demand) leads to a lower
price and lower quantity (point C).

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On the other hand, a decrease in supply (a leftward shift of the supply curve) leads to a higher price and a
lower quantity (point F), whilst an increase in supply (shown by a rightward shift of the supply curve)
leads to a lower price and a higher quantity (point A).

2.9 The correct alternative is [2].

A decrease in the demand for ice cream is illustrated by a leftward shift of the demand curve leading to a
decrease in the equilibrium price and equilibrium quantity.

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The entry of a new supplier increases the supply of ice cream and this is shown by a rightward shift of the
supply curve. The equilibrium price decreases while the equilibrium quantity increases.

In both cases we see a decrease in the equilibrium price for ice cream so we can be sure that the
equilibrium price will definitively decrease, but what is the net effect of a decrease in demand and an
increase in supply on the equilibrium quantity?
If we show the two shifts on the same diagram we see that the equilibrium quantity decreases.

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But is this always true? What would have happened if the increase in supply is greater than the decrease
in demand?

The net result is an increase in the equilibrium quantity.

The decrease in demand could also be equal to the increase in supply.

In this instance, the equilibrium quantity stayed the same.

In all three scenarios, we saw the effect on equilibrium quantity depends on the relative sizes of the shifts
of the supply and demand curves. Thus, the equilibrium quantity could increase, decrease or stay the
same. That is, the effect on the equilibrium quantity is uncertain (indeterminate).
2.10 The correct alternative is [3].

We know that at equilibrium quantity demand equals quantity supplied or Qd = Qs.

We were given the equations for Qd (= 100 – 5P) and Qs (= –20 + 3P) respectively, thus at equilibrium

𝑄𝑄𝑄𝑄 = 𝑄𝑄𝑄𝑄
100 − 5𝑃𝑃 = −20 + 3𝑃𝑃
100 + 20 = 3𝑃𝑃 + 5𝑃𝑃
120 = 8𝑃𝑃
or
8𝑃𝑃 = 120
𝑃𝑃 = 15

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2.11 The correct alternative is [2].

To obtain the equilibrium quantity we first need to calculate the equilibrium price and then substitute the
P-value into either the Qd or Qs equations.

At equilibrium

𝑄𝑄𝑄𝑄 = 𝑄𝑄𝑄𝑄
50 − 8𝑃𝑃 = −17,5 + 10𝑃𝑃
50 + 17,5 = 10𝑃𝑃 + 8𝑃𝑃
67,5 = 18𝑃𝑃
or
18𝑃𝑃 = 67,5
𝑃𝑃 = 3,75

Now substitute this value into either the Qd or Qs equations

𝑄𝑄𝑄𝑄 = 50 − 8𝑃𝑃
= 50 − 8(3,75)
= 50 − 30
= 20

or

𝑄𝑄𝑄𝑄 = −17,5 + 10𝑃𝑃

= −17,5 + 10(3,75)
= −17,5 + 37,5
= 20

2.12 The correct alternative is [2].

Consumer surplus is defined as the difference between what consumers pay and the value that they
receive, indicated by the maximum amount they are willing to pay. The maximum they are willing to pay
is shown by the demand curve.

For every quantity between zero and 300 they are willing to pay more than R4. For example, to get 120
units of the product some consumers are willing to pay R7, but they only have to pay R4. Therefore, the
consumers pay less than they are prepared to pay.

2.13 The correct alternative is [4].

From the law of supply we know that a decrease in price leads to a decrease in quantity supplied and it is
shown by a movement along the supply curve. If the price decreases from R4 to R3, the quantity supplied
decreases from 300 to 240.

Producer surplus is defined as the (positive) difference between the lowest price at which producers are
willing to supply different quantities of a product and the price they actually receive. Thus, the producer
surplus will also decrease as the price the producers receive is lower (it decreased from R4 to R3).

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2.14 The correct alternative is [1] or [4].

Complements are products that are used together – fish and chips, “pap and vleis”, motorcars and tyres
and so on. If you consume more of the one product, more of the other will be consumed.

An increase in the cost of the production of motorcars will lead to an increase in the price of motorcars
and fewer motorcars will be bought. This means that fewer tyres will be demanded.

But what if the increase in the price of motorcars was the result of an increase in the demand for
motorcars (brought about by an increase in the income of consumers). In this instance, more motorcars
will be sold and as a result more tyres will be required. The demand for the complement (tyres) will thus
increase.

Depending on the line of argument, either statement [1] or statement [4] is correct. All students were
credited with the marks for this question.
2.15 The correct alternative is [2].

From the diagram depicting the coffee market, we see that consumers are drinking more coffee. They will
therefore drink less tea. The demand for tea will decrease. The demand curve for tea will shift leftward
leading to a decrease in the equilibrium price and equilibrium quantity of tea.

**** ***** ****

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3 ANSWERS TO ASSIGNMENT 03

3.1 The correct alternative is [3].

The first thing to remember when one talks about price controls is that it carries legal authority: “It’s the
law”.

Secondly, the name of the specific price control states what is legal or not in terms of the price control.
A maximum price sets the maximum price that can be asked for a product. Sellers can ask or the market
can establish a price lower than the maximum price, but not higher. A maximum price is also called a
price ceiling: If you want to hang a picture of your girlfriend/boyfriend/husband/wife on the living-room
wall, you can hang it at any height you like, but you cannot go higher than the ceiling ‒ the ceiling sets
the maximum height you can hang the picture.

Similarly, the floor of your living room sets the lowest place on the wall you can hang a picture of your
ex-girlfriend/boyfriend/wife/husband. You can hang it at any height, but not lower than the floor. The
minimum height (price) you can hang it is determined by the floor.

Statements [1] and [2] refer to the highest or lowest prices established by the markets for chicken and
maize (you can hang the picture at any height you like). However, statements [3] and [4] correctly refer to
legally established prices, but only statement [3] correctly identifies the minimum price for sugar as a
price floor.

3.2 The correct alternative is [1].

The saying “every picture tells a story” also applies to diagrams. The diagram (picture) of the market for
the economics course is also telling us a story:

Looking at the diagram, we can confirm it is indeed a picture of a market – (i) the demand curve shows
the students (consumers) willing and able to buy the course, (ii) the supply curve represents the plans of
the university (producer) and (iii) an agreed fee of R3 500 (the equilibrium price) is shown. At this fee,
15 000 students want to take the course and the university is willing to offer it to 15 000 students –
quantity demanded is equal to quantity supplied.

But that is not the whole story. Government comes along and sets a maximum fee the university can ask
for its courses. The new price or fee the university can ask is R2 500. How do the students and the
university react to the new price? Eighteen thousand (18 000) students want to enrol for the course, but at
the lower fee the university probably cannot afford as many economic lecturers and with fewer lecturers
available only 12 000 students can be accommodated. Quantity demanded (18 000) is more than quantity
supplied (12 000) and there is thus an excess demand of 6000.

3.3 The correct alternative is [2].

There are two ways society can address the excess supply resulting from the price floor. We could firstly
say that there is an excess supply (surplus) because producers are producing too many of the products at
the given price, and to get rid of the surplus, producers must be forced to produce less. Or secondly, we
could argue that consumers are not demanding enough of the product and the quantity demanded must
therefore be increased. As the consumers do not want the product at the given price, government needs to
buy the excess. Statement [2] is the only statement dealing with either of these two options.

Note, the other three statements indicate how a situation of excess demand could possibly be addressed.

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3.4 The correct alternative is [2].

This question assessed your definition of the price elasticity of demand: “The price elasticity of demand is
the percentage change in quantity demanded if the price of the product changes by one percent”. In other
words, price elasticity gives an indication how sensitive or responsive quantity demanded is to a change
in price.

If we mirror the statements against the definition we see only statement [2] passes the test.

Note, statement [3] could serve as an application of the law of demand as it deals with the inverse
relationship between price and quantity demanded (an increase in the price of petrol will reduce the
quantity of petrol demanded).

3.5 The correct alternative is [3].

We need to calculate the price elasticity coefficient for restaurant meals for the price range R100 to
R110. Thus, we have to use the formula for arc (or midpoint) elasticity:

(𝑄𝑄2 − 𝑄𝑄1 )/(𝑄𝑄1 + 𝑄𝑄2 )

𝑒𝑒𝑝𝑝 =
(𝑃𝑃2 − 𝑃𝑃1 )/(𝑃𝑃1 + 𝑃𝑃2 )
(750 − 1 000)/(1 000 + 750)
=
(110 − 100)/(100 + 110)
250
= 750
1
10
210
250 210
= 𝑥𝑥
1750 10
1 21
= 𝑥𝑥
7 1
21
=
3
=3

Before we can answer questions 3.6 to 3.8, we need to calculate the price elasticity of business travellers
and of holiday travellers if the price increases from R1 700 to R3 000.

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The price elasticity of demand of business travellers:

(𝑄𝑄2 − 𝑄𝑄1 )/(𝑄𝑄1 + 𝑄𝑄2 )

𝑒𝑒𝑝𝑝 =
(𝑃𝑃2 − 𝑃𝑃1 )/(𝑃𝑃1 + 𝑃𝑃2 )
(1 400 − 1 600)/(1 600 + 1 400)
=
(3 000 − 1 700)/(1 700 + 3 000)
200
= 000
3
1 300
4 700
200 4 700
= 𝑥𝑥
3 000 1 300
1 47
= 𝑥𝑥
15 13
47
=
195
= 0,24

The price elasticity of demand of holiday travellers:

(𝑄𝑄2 − 𝑄𝑄1 )/(𝑄𝑄1 + 𝑄𝑄2 )

𝑒𝑒𝑝𝑝 =
(𝑃𝑃2 − 𝑃𝑃1 )/(𝑃𝑃1 + 𝑃𝑃2 )
(600 − 1 200)/(1 200 + 600)
=
(3 000 − 1 700)/(1 700 + 3 000)
600
= 800
1
1 300
4 700
600 4 700
= 𝑥𝑥
1 800 1 300
1 47
= 𝑥𝑥
3 13
47
=
39
= 1,2

3.6 The correct alternative is [2].

The price elasticity of demand of business travellers (0,24) is smaller than 1 and is therefore inelastic. The
price elasticity of demand of holiday travellers (1,2) is elastic as the elasticity value is larger than 1.

3.7 The correct alternative is [1].

The price elasticity for business travellers is more inelastic compared to the price elasticity for holiday
travellers.

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3.8 The correct alternative is [2].

In this question we need to find a possible explanation for the difference between the price elasticity for
business travellers and the price elasticity for holiday travellers. We know any one or even a combination
of the following factors determines the price elasticity of a product:
• the substitution possibilities
• the decree of complementarity of the product
• the time period under consideration
• the proportion of income spent on the product
• the definition of the product
• advertising
• the number of uses of the product
• addiction
Now we are able to look at the alternatives and find the one that matches one of the above. Business
travellers usually travel on short notice and if they need to travel long distances they want to get from
point A to B as quickly as possible. As alternative [2] indicates, airline tickets are sometimes seen as a
necessity for business travellers.

3.9 The correct alternative is [3].

There are two ways to answer this question:

i) Calculate the total revenue.

Total revenue before the price increase:

𝑇𝑇𝑇𝑇 = 𝑃𝑃 𝑥𝑥 𝑄𝑄
= 100 𝑥𝑥 1 000
= 100 000
Total revenue after the price increase:
𝑇𝑇𝑇𝑇 = 𝑃𝑃 𝑥𝑥 𝑄𝑄
= 110 𝑥𝑥 750
= 82 500

Thus, the total revenue of the firm is lower after the increase in the price of a restaurant meal.

ii) Use the price elasticity value.

We know from question 3.5 that the price elasticity of demand is 3, that is, it is elastic. Thus, an increase
in price will have caused a proportionally larger decrease in quantity demanded and the total revenue will
decrease.

3.10 The correct alternative is [1].

This question assessed your understanding of the relationship between price elasticity and total revenue.
There are numerous ways to explain and remember the relationship but, as is often the case, going the
graphical route is probably the easiest.

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From our discussions of price elasticity of demand we know when

i) demand is elastic, total revenue will change in the opposite direction to the price change, and when
ii) demand is inelastic, total revenue will change in the same direction as the price change.
And from our graphical analysis of elasticity, we know that

i) price elasticity is equal to 1 (i.e. unitary elastic) at the midpoint on a demand curve,
ii) at any point (price) above the midpoint, the elasticity value will be greater than 1 (elastic) and
iii) at any point (price) below the midpoint, it will be smaller than 1 (inelastic).

If we apply these observations to our diagram we can conclude:

Any movement away from the midpoint will decrease total revenue and any movement towards the
midpoint will increase total revenue.

From this, if demand is inelastic, a decrease in price represents a movement away from the midpoint (say
from A to B) and total revenue will decrease. Similarly, an increase in price (from B to A) shows a
movement towards the midpoint and total revenue will increase.

A quick scan of the alternatives shows that only statement [2], “If demand is inelastic an increase in price
will increase total revenue while a decrease in price will decrease total revenue”, correctly reflects the
relationship between price elasticity of demand and total revenue.

3.11 The correct alternative is [4].

If the cross-elasticity of demand between two products is positive, we are dealing with substitutes.

If you are not sure, take two products which you know are substitutes, say Coke and Pepsi. If the price of
Coke increases (positive change or a plus +), people will buy less Coke and the demand for Pepsi will
increase (positive change or a plus +). Apply this to the formula for cross elasticity:

%∆𝑄𝑄 𝑜𝑜𝑜𝑜 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

𝑒𝑒𝑐𝑐 =
%∆𝑃𝑃 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
+
=
+
= +

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(From your school maths you might still remember a positive divided by a positive is a positive.)

What is the effect of a fall in the cost of producing good B? Does it affect the demand or the supply of
product B? The cost of production affects the supply of product B (if you are not sure why, revisit the
determinants of demand and supply). A reduction in cost is shown by a downward (rightward) shift of the
supply curve.

The equilibrium price will decrease and the equilibrium quantity will increase.

Consumers are buying more of product B and the demand for product A will consequently decrease. A
decrease in the demand for product A is illustrated by a leftward shift of the demand curve leading to a
decrease in the equilibrium price and equilibrium quantity.

3.12 The correct alternative is [1].

If you have read the section on utility with understanding, you would have realised the important role
played by the marginal concept in economic analysis. As you carry on with this module, you will see that
the marginal concept re-appears again and again: from marginal utility, to marginal output, marginal cost
and marginal profit. But the marginal concept is not only a feature of microeconomics, when you start
your macroeconomic studies you will soon be introduced to concepts like marginal tax rate, marginal
propensity to consume or the marginal propensity to save. So please make sure you are comfortable with
this section of the work.

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The marginal utility of a good or service is the change in total utility if one more unit of that good or
service is consumed. As long as the extra satisfaction (the marginal utility) is positive, total utility will
increase. As one consumes more of a product, the additional satisfaction might decrease – consuming a
second bunny chow might not be as satisfying as the first one was, but it still adds to your total
satisfaction. Only when the marginal utility is negative will total utility decrease. Note the difference
between a decreasing marginal utility and a negative marginal utility.

3.13 The correct alternative is [4].

Would you agree with the statement that the average, normal man/woman in the street just wants the best
or maximum value for their money? And he or she will shop around until they are satisfied that they have
found that product at the “right” price. If you are a rational consumer, you will agree with the statement,
and if you do, the jump to “a utility-maximising consumer will choose to purchase another unit of a good
if the good has the highest weighted marginal utility” is not that big. The highest weighted marginal
utility, that is the marginal utility divided by the price, is indeed where the consumer gets the maximum
value for his or her money.

3.14 The correct alternative is [1].

The weighted marginal utility of a product is the marginal utility of the product divided by the price of the
product, that is
𝑀𝑀𝑀𝑀
=
𝑃𝑃

We have to find the product with the highest weighted marginal utility:
72
• The weighted marginal utility of a chocolate is 3
= 24.
100
• The weighted marginal utility of an ice cream is 5 = 20.
120
• The weighted marginal utility of a cold drink is 10 = 12.
60
• The weighted marginal utility of bread is 12,5 = 4,8.

Thus, chocolate has the highest weighted marginal utility (alternative [1]).

3.15 The correct alternative is [3].

Eric will be in equilibrium when the weighted marginal utilities of tea and coffee are the same ‒ and he
spends all his income. How does one find the equilibrium basket of tea and coffee?

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Eric walks into the restaurant, he has a determined look on his face (he is very thirsty) and he has R30 in
his pocket. Sitting down at the counter he orders a cup of tea. Why tea and not coffee? Well the first cup
of tea gives him a weighted marginal utility of 12, whereas the first cup of coffee gives a weighted
marginal utility of 5.

Will Eric have a second cup to drink? Yes, we know he is very thirsty and he still has R30 – R4 = R26
left in his pocket. He orders another cup of tea. Tea? This cannot be right; surely he would rather order a
cup of coffee? Let’s see. The weighted marginal utility of the second cup of tea is 10, compared to the
weighted marginal utility of 5 of the first cup of coffee. So tea it is.

Eric still has R22 left. He orders another cup of tea. Yes, the weighted marginal utility of the third cup of
tea is 8, and the weighted marginal utility of the first cup of coffee is (still) only 5.

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With R18 in his pocket Eric orders a cup of coffee. Coffee? Why, was the waiter just lucky to correctly
predict Eric will get tired of tea or what made him go for his first cup of coffee? Eric is a rational
consumer; his first cup of coffee gives him a weighted marginal utility of 5 whereas another (fourth) cup
of tea would have only given him a weighted marginal utility of 4.

And so we can carry on. Eric has R12 left to spend. He orders another cup of coffee; the weighted
marginal utility is 4 which is the same as the next cup of tea so he could have chosen either of the two.

He still has R6. He orders his fourth cup of tea (yes, the weighted marginal utility of the third cup of
coffee [3] is less).

Eric has only R2 left. He has to stop as it is not enough for either a cup of coffee or tea. He throws the R2
in the basket for tips for the waiters and …

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4 ANSWERS TO ASSIGNMENT 04

4.1 The correct alternative is [3].

This question assessed whether you can distinguish between the short and the long run. The short run is
defined as the period during which at least one of the inputs is fixed. In the long run all the inputs are
variable. In the long run, that is, a time period long enough for firms to adjust the quantity of any input,
there are no fixed inputs.

4.2 The correct alternative is [2].

The correct option is [2]. Economic profit equals total revenue minus total costs (explicit and implicit),
including normal profit.
Note the return to the marginal concept in alternative [3] – do you still remember the relationship between
total values and marginal values?

Questions 4.3 to 4.5

The first thing to remember when confronted by a table like this is that you do not have to complete all
the blank columns or cells of the table. It is an unnecessary waste of time. The values for only three cells
are required so concentrate on what is being asked.

The marginal cost of the fourth unit:

The marginal value refers to the amount that the total value increases when the quantity increases by one
or when the marginal cost shows by how much TC increased when production increased by 1 unit (from 3
to 4). Thus, to calculate the marginal cost:

∆𝑇𝑇𝑇𝑇
𝑀𝑀𝑀𝑀 =
∆𝑄𝑄
166 − 220
=
1
= 54

The average fixed cost of the fifth unit is the following:

We do not have the value of TFC, but we do know that 𝑇𝑇𝑇𝑇 = 𝑇𝑇𝑇𝑇𝑇𝑇 + 𝑇𝑇𝑇𝑇𝑇𝑇 𝑜𝑜𝑜𝑜 𝑇𝑇𝑇𝑇𝑇𝑇 = 𝑇𝑇𝑇𝑇 − 𝑇𝑇𝑇𝑇𝑇𝑇. We also
know that TFC remains the same regardless of the number of units produced. The total cost when no
production takes place is 100 (see the first row of the table). However, if no production takes place, TVC
must be zero, thus
𝑇𝑇𝑇𝑇𝑇𝑇 = 𝑇𝑇𝑇𝑇 − 𝑇𝑇𝑇𝑇𝑇𝑇
= 100 − 0
= 100
and the AFC when 5 units are produced is
𝑇𝑇𝑇𝑇𝑇𝑇
𝐴𝐴𝐴𝐴𝐴𝐴 =
𝑄𝑄
100
=
5
= 20

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The average variable cost of the third unit is the following:

We first have to calculate the TVC when 3 units are produced. We know that

𝑇𝑇𝑇𝑇 = 𝑇𝑇𝑇𝑇𝑇𝑇 + 𝑻𝑻𝑻𝑻𝑻𝑻

and if we rearrange it we get
𝑇𝑇𝑇𝑇𝑇𝑇 = 𝑇𝑇𝑇𝑇 − 𝑇𝑇𝑇𝑇𝑇𝑇 .

TC for 3 units is 166 (see the table) and TFC for 3 units is 100 (see the calculation above ‒ remember
fixed cost remains the constant regardless of the number of units produced). If we substitute the values
into our formula:

𝑇𝑇𝑇𝑇𝑇𝑇 = 𝑇𝑇𝑇𝑇 − 𝑇𝑇𝑇𝑇𝑇𝑇

= 166 − 100
= 66
and

𝑇𝑇𝑇𝑇𝑇𝑇
𝐴𝐴𝐴𝐴𝐴𝐴 =
𝑄𝑄
66
=
3
= 22

If you have completed all the cells in the table, your table should look like this (but as we have said, it is
really a waste of time – which you don’t have in the exam).

Marginal Average Average Average

Output Total cost
cost fixed cost variable cost total cost
(units) (R)
(R) (R) (R) (R)
0 100
1 110 10 100 10 110
2 130 30 50 15 65
3 166 36 33,3 22 55,3
4 220 54 25 30 55
5 300 80 20 40 60

To summarise:

4.3 The correct alternative is [4].

4.4 The correct alternative is [2].

4.5 The correct alternative is [2].

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4.6 The correct alternative is [4].

In this question we revisit the distinction between fixed and variable inputs and the relationship between
total and marginal values. Note how the law of diminishing marginal returns depends on a clear
understanding of these concepts.

The law of diminishing returns states that as more of a variable input is combined with one or more fixed
inputs in the production process, points will eventually be reached where first the MP, then the AP and
finally the TP will start to decline.

4.7 Alternatives [2] and [4] are correct.

This question refers to marginal revenue (instead of utility or cost or output), but the basic definition or a
marginal value remains the same:

The marginal value (revenue) refers to the amount that the total value (revenue) increases when the
quantity increases by 1 or
∆𝑇𝑇𝑇𝑇
𝑀𝑀𝑀𝑀 =
∆𝑄𝑄

A number of students chose alternative [4] – “A firm’s marginal revenue (MR) is equal to the price of the
product”. Strictly speaking the statement is only true under perfect competition, which is the default
market structure in this module. In addition, we do not qualify or explain why MR is not equal to P when
firms are faced with a downward sloping demand curve (that is, under conditions of imperfect
competition).

All students were credited with the marks for this question.

4.8 Alternatives [1], [3] and [4] are correct.

Question 4.8 should have read:

“Which one of the following statements is incorrect?

Under perfect competition

[1] average revenue is always equal to the price of the product.

[2] marginal revenue is always equal to marginal cost.
[3] marginal revenue is always equal to the price of the product.
[4] average revenue is always equal to marginal revenue.”

Alternative [2] is the only incorrect statement. Marginal revenue is only equal to marginal cost (MR =
MC) when profit is maximised. All the other alternatives correctly describe the relationship between
average revenue, marginal revenue and the price of a product under perfect competition.

All students were credited with the marks for this question.

4.9 The correct alternative is [2].

All perfectly competitive firms are price takers and maximise profits where MR = MC. They also operate
in markets where there is perfect information. In the short run, however, they do not all produce at
minimum average costs.

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4.10 The correct alternative is [3].

The firm maximises profit by producing where MR (or P) = MC. From the diagram we see that P = 20
and to find the output level we have to pinpoint the spot where the price line (the AR or MR curve)
intercepts the MC curve, and then read off the corresponding value on the output (horizontal) axis, as
output = 100.

4.11 The correct alternative is [4].

The total daily revenue of the profit-maximising firm is

𝑇𝑇𝑇𝑇 = 𝑃𝑃 𝑥𝑥 𝑄𝑄
= 𝑅𝑅20 𝑥𝑥 100
= 𝑅𝑅2 000

4.12 The correct alternative is [4].

The only incorrect statement is the fourth one. In the short run, the perfectly competitive firm may earn a
loss, a normal profit or an economic profit, but in the long run only normal profit is earned. In the long
run, firms making a loss will leave the market (driving the market price up) or if economic profits are
made, new firms will enter the market (putting downward pressure on the market price). Thus, market
forces will ensure that only normal profit is earned in the long run.

4.13 The correct alternative is [2].

This question assessed your understanding of a number of sections dealing with the labour market.

If you mirror the alternatives with the lists of

i) differences between the labour and goods markets and
ii) the characteristics of the labour market
you will notice that alternatives [1], [3] and [4] are incorrect.

Alternative [2] correctly defines the equilibrium position for an individual firm in a perfectly competitive
labour market – when MRP = wage rate (w).

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4.14 The correct alternative is [2].

The correct alternative is [2]. The derived demand curve for labour is given by the downward sloping
marginal revenue product. The market demand will change if a non-wage determinant like the price of
the product changes. Participants in a perfectly competitive labour market are price (or in this instance,
wage) takers.

4.15 The correct alternative is [3].

Minimum wages are the price floors of the labour market. Thus, we are just applying our knowledge of
the effects of a minimum price on the goods market to the labour market.

A minimum wage which is imposed below the equilibrium wage, will serve no purpose as it will have no
effect on the wage rate or the level of employment. A minimum wage will lead to an excess supply of
labour and consequently to unemployment (alternative [3]). Minimum wages are instituted as a means of
avoiding the exploitation of low-wage workers and to ensure a certain minimum standard of living for
them.

**** ***** ****

Please do not hesitate to contact one of the lecturers if you experience any difficulties with the
explanations.

Good luck with your studies.

Your ECS1501 lecturers

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