Part A – Microeconomics: Question 1: (a) Suppose that oil prices rise sharply for years as a result of a war in the Middle East. Illustrate with a diagram what happens to the: (1 mark each) (i) Demand...

Part A – Microeconomics:
Question 1:
(a) Suppose that oil prices rise sharply for years as a result of a war in the Middle East. Illustrate with a diagram what happens to the: (1 mark each)
(i) Demand for automobiles?
Answer:
Oil and automobiles are complemetary to each other. So if price of oil rises, demand of automobile will fall, shifting demand curve leftward.
Figure1:
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(ii) Demand for home insulation?
Answer:
Oil is directly or indirectly demanded for insulating a house. So if price of oil goese up, the demand of home insulation is likely to go down because cost of insulating has gone up. This would be shown by upward movement along the demand curve of home insulation.
Figure2:
(iii) Demand for coal?
Answer:
Coal is used as a substitute for oil. So if price of oil rises, people will demand more of coal, leading rightward shift in demand curve for coal.
Figure3:
(iv) Demand for tyres?
Answer: [Assuming tyre is an input in the automobile]
Increase in the oil price, would cause fall in the demand for automobile because both are complementary to each other. This fall in the demand for automobile would mean fall in the demand for tyre because demand for tyre is a derived demand. As a result, demand curve for tyre would shift leftward.
Figure4:
(v) Demand for bicycles?
Answer:
Since the cost of driving the automobolie has gone up, and therefore demand for bicycle would increase, shifting the demand curve for bicycles rightward.
Figure5:
(b) Explain the impact of external costs and external benefits on resource allocation; (2.5 marks)
Answer:
The existence of both external cost and internal cost will lead to inefficient allocation of resources. In case of external cost, social marginal cost (SMC) exceeds private marginal cost (PMC). Since at equili
ium, a producer equates private marginal cost with marginal benefit, so he ends of producing more than socially efficient level and thereby causes overutilization of resources. [Refer the figure6, where a producer is producing (Q*) which is more than socially efficient level (Q**), where socially efficient level is determined by the intersection of social marginal cost with marginal benefit]
Figure6:
In case of external benefit however, social marginal cost would be equal to private marginal cost but social marginal benefit (SMB) exceeds private marginal benefits (PMB) (denoted by demand curve). Since at equili
ium, a producer equates private marginal banefit with marginal cost, so he ends of producing less than socially efficient level and thereby causes underutilization of resources. [Refer the figure7, where a producer is producing (Q*) which is less than socially efficient level (Q**), where socially efficient level is determined by the intersection of marginal cost with social marginal benefit]
Figure7:
(c) Why are public goods not produced in sufficient quantities by private markets? (2.5 marks)
Answer:
Public goods are those goods which are non-rival and non-excludable in consumption i.e. these are those goods 1) whose consumption by one person does not reduces their availability for another person and, 2) nobody can be denied or exclude from the consumption of public goods. For example; national defence, radio
oadcasting etc. The non-excludable feature of public goods is the root reason why public goods are not provided in sufficient quantities by private markets. If a private player makes an a
angement for a public good, it would not get adequate compensation because it would not be able to exclude anybody from consuming it and it would have less incentive to go for the provision of public goods. Moreover, knowing that they cannot be excluded from the consumption of public goods, people would just like to free ride (on the effort made by some other peoples for the provision of public goods) and would not make much effort to have public goods. Thus public goods would not be provided in sufficient quantities by private markets.
Question 2:
(a) Explain why scarcity forces individuals and society to incur opportunity costs. Give specific examples. (2.5 marks for explanation and diagram plus 2.5 marks for specific examples)
Answer:
Scarcity arises when demand of resources exceeds their supply i.e. it is the case where resources are less but they have many usages. However, opportunity cost of a thing is defined as the value of all those things which needs to be forgone to get that thing. In other words, it is defined as the value of next best alternative of a thing. When resources are scarce, we cannot use them in all the production activities, and therefore we need to make a choice over where and how to use those resources; if all resources are employed in the production of good A, then because of scarcity, we would need to forgone production good B, similarly if all resources are employed in the production of good B, then because of scarcity, we would need to forgone production good A. Thus in either case we note that the because of scarcity, there is something which we need to forgone to perform a task. The value of these forgone things is called opportunity cost of performing the initial task and thereby we say that scarcity forces individuals and society to incur opportunity costs. Because of scarcity we would have downward sloping production possibility frontier, implying that production of both the goods cannot be increased together.
Figure8:
(b) Suppose a chocolate bar manufacturer promotes its products by advertising and opportunity to win a ‘free car’. Is this car free because the winner pays zero for it? (2.5 marks)
Answer:
No, this car is not free for the winner because there is still some cost in terms of opportunity...