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Question 1: Fundamentals of economics

(a) ‘New Zealand’s health budget is underfunded. Patients are waiting months for urgent eye operations and some patients are going blind while waiting.’ Why doesn’t the government fully fund all health boards for all eye operations?

(b) Compare and contrast the economic system in New Zealand with that of China, our largest trading partner. Use the timber industry, and logging in particular, as your example to compare economic systems.

(c) Manuka Products Limited (MPL) produces hand care products. MPL can produce the combinations as shown in the table below. Assume all resources are fully utilised. Production combination possibilities Manuka hand cream (tube) Manuka exfoliate lotion.

(i) Based on MPL’s production possibility schedule, draw a production possibility curve plotting all combination possibilities. Note: label your vertical axis ‘manuka hand-cream’ and the horizontal axis manuka exfoliate lotion.

(ii) Identify and explain one assumption in this model, other than ‘all resources are fully employed’.

(iii) Calculate the opportunity cost of moving from combination B to combination C.

(iv) Discuss one reason why MPL may wish to produce at combination C.

(v) Assume MPL wishes to make 30 manuka hand cream and 30 manuka exfoliate lotion products. Explain why this is attainable or unattainable.

(d) Assume the following graph represents current demand and supply for Jazz apples in New Zealand where P is the current equilibrium price and Q is the quantity. Use the information in this supply and demand graph as a starting point, and for each of the following scenarios explain the impact on the market equilibrium for New Zealand Jazz apples in 2019.

Treat each scenario independently of the others and draw a labelled graph for each. Clearly identify any movement along or shifts in the curve.

(i) Storms destroy 30% of the Jazz apple crop.

(ii) Research confirms that eating an apple a day results in less tooth decay and better overall health.

(iii) The government decides to grant a subsidy of \$10 for every Jazz apple tree planted.

(e) Wiremu has decided to buy shares in a company. After researching the market and taking advice from professionals and family he is now deciding between the following two options.

¾ Company A which sells razors.

¾ Company B which sells hand care products.

The income elasticity for razors is -0.3 and the income elasticity for hand care products is 0.2. Economists predict that consumer income will increase over the next five years.

Analyse this data and determine which company Wiremu should invest in and explain why.

Explain any assumptions you have made.

(f) Two key economic ideas used in economics to examine how people make selections and interact with markets are:

¾ people are rational

¾ people make optimal decisions at the margin

Explain these economic ideas and, for each, provide a personal example that reflects the economic idea.

## Question 1

• In New Zealand there exists a scarcity of funds. This leads to difficult choices that need to be made by the government regarding where to invest and what to fund. This is why not all health boards for eye operations are fully funded. The funding decisions are made on the basis of the certainty of the treatment.
• New Zealand has a mixed economic system while China has a “Socialist Market Economy”. However, China is also the second largest trade partner of New Zealand and as the Chinese economy has been growing in terms of infrastructure it is experiencing high demands for timber and logs and is therefore importing it from New Zealand.

(ii) The assumption in the theory of production possibility frontier that the economy produces only two goods is met in this model as the company produces hand-cream and exfoliating lotion and has to make choices regarding the production of the two.

(iii) The opportunity cost for shifting from combination B to C is, producing 8 units less of the hand-cream in order to produce 8 more units of the exfoliating lotion. At combination B the company is producing 48 units of hand-cream and 8 units of exfoliating lotion while in combination C they are producing 40 units of hand-cream and 16 units of exfoliating lotion.

(iv) One of the main reasons to move to combination C from B is the same for both as 8 units of hand-cream has to be sacrificed to produce additional 8 units of the exfoliating lotion therefore, the firm will be indifferent between the two goods.

(v) Producing 30 units of hand-cream and 30 units of exfoliating lotion is unattainable because if the firm wants to produce 30 units of hand-cream, it can produce 24 units of exfoliating lotion due to the opportunity cost and limited resources that the firm has to spend.

• (i) The storm will lead to a fall in supply reflected by the leftward shift of the supply curve in figure 2. This will happen as there is a destruction of 30% of the crops. This will lead to a new equilibrium where the price is higher at P1 and quantity is lower at

(ii) The results from the recent research will lead to increased demand reflected bya outward shift of the demand curve as shown in figure 3. This is because people will increase their consumption of apples and this will lead to a new equilibrium with a higher price and quantity combination at point P1 and Q1

(iii) The supply will increase with a subsidy of \$10 for every apple tree because producers, in order to benefit from the subsidy will increase their supply and this has been reflected as a shift in the supply curve to the right in figure 4. The new equilibrium point from this change will lead to the price to fall to P1 and the quantity to rise to Q2.

• Wiremu should invest in razors as it has a higher income elasticity signifying that changes in income will lead to more changes in consumption. It has been predicted that the income is expected to rise in the next five years and this means that the market for razor has a potential for generating growth and profit.
• The assumption or idea of rationality is that when individuals are provided with a set of choices they will make a choice that will maximize their utility and minimize their losses. For example, a rational consumer who is planning to purchase a car will not make the purchase while the car prices are rising.

The assumption that optimal decisions are made at a margin implies that a decision maker considers the marginal benefit or cost of a decision before making it. If the marginal benefit is greater than the additional cost then the decision is take. For example, when deciding whether to engage in recreational activities or to study an extra hour is made after weighing the costs and the benefits of each.

• When the local movie theatre charges different prices for different kinds of customers, this method of charging price is known as price discrimination in economics. This is a kind of pricing strategy which charges different price for same services to different customers. In this case it can be seen from the question that children, students and the Gold Card holders are charged less compared to the adults. The reason behind this is that the adults are mostly employed and as they have a fixed amount of income they can afford to pay more compared to the students, children. The Gold Card customers are charged less for holding the card..
• In case of Microsoft office monopoly market exits. Huge investment in development and research made it a monopoly. In technology sectors and in research and development sectors monopoly is highly effective. There are also patent provided for the new sectors which encourages firms to pay for the initial research. Some of the examples of monopoly market includes provider of natural gas and electricity.
• (i) The two large retail petrol companies operating in New Zealand are Chevron and ExxonMobil.

(ii) The petroleum industry of New Zealand has been deregulated with the enactment of petroleum sector reform act 1988.  The deregulation was made in order to increase competition with the different industry. In case of fuel in a country like New Zealand the margin of interest is also known as gross margin which states the difference of payment made by the consumers at the petrol pump and the price of refined products which may include handling cost, storage cost at the retail station. The retail gross margins in Wellington                                                                                                                                                                                                                have increased at a faster rate.

(iii) One way of differentiation in petrol companies is loyalty program which would provide discounts. Another way is to introduce powerful additive packages which will help to keep up with the engine health by protecting and cleaning it.

## a) New Zealand's Health Budget

(iv) In the absence of Gull the petrol prices would rise in Wellington as its pricing strategy lowers the overall price level of the petroleum market. In the absence of Gull the prices would go up in Wellington. Currently the petrol companies are facing an elastic demand curve where changes in price will have an immediate impact on the consumption choices of the consumers.

• Golden Harvest Orchard should produce 3100000 kilos of Golden Queen peaches because beyond that the marginal revenue would exceed the marginal cost. Since the market is  a perfect competition, marginal revenue should be equal to the marginal cost.
 Quantity (000) Price \$ Total Cost Total Revenue Marginal Cost Marginal Revenue SRAC 0 1600 100 1000 1 10 1700 1000 1700 200 900 2 9.5 1900 1900 950 300 800 3 9 2200 2700 733.3333 400 700 4 8.5 2600 3400 650 600 600 5 8 3200 4000 640 700 500 6 7.5 3900 4500 650

(ii) From the given data it can be seen that the market structure of KiwiEats is an oligopoly market for takeaway food. Since every area has several takeaway shops it means that it is not a monopoly as there are other competitors in the market. In addition the data shows that the marginal revenue is greater than the marginal cost till 5 units of output and the average cost is also increasing continuously. This is different from the features of a perfect competition or monopolistically competitive market. Therefore is can be said that the market for takeaway is an oligopoly market with a many sellers in every area.

(iii) KiwiEats should produce 5 units of output as till this point the marginal revenue is greater than marginal cost. After this the marginal cost exceeds the marginal revenue and so it will no longer be profitable for the company to increase its output.

(iv) The net profit that KiwiEats earns is 400 which shows that the company earns a supernormal profit. This is a typical feature which fits the market structure of an oligopoly.

• Golden Harvest Orchard was a perfect competition which is a very different market structure in comparison the market structure for KiwiEats which is an oligopoly. When it comes to barriers to entry KiwiEats has high barriers while Golden Harvest Orchard has absolutely no barriers as it is a perfect competition. In the case of elasticity, the market for Golden Harvest Orchard has high elasticity while KiwiEats faces lower elasticity in its comparison.

The equilibrium point is given at the intersection off the market demand and supply curves at price \$2 ad quantity Q is demanded in the market. When a minimum price of \$2 is placed the equilibrium would change. At this higher price level of alcoholic drinks, its demand falls by a little amount from the previous level as a result of the price rise whereas the quantity of supply increases. This has been shown in the graph with the quantity demand falling to QD and the quantity supplied rising to QS from Q.

(ii) Price floors are set to fix the lowest level the price can go and in this case the price floor of a standard alcoholic drink is set at \$2 which is higher than the prevailing price of alcoholic drinks. In this case the price floor is set to discourage the vast consumption of standard alcoholic drinks above equilibrium. If the price is allowed to fall then it will encourage consumption of alcohol. Government would always try to device policies to reduce the consumption of substances that are harm the wellbeing of individuals and therefore the government would introduce the price floor for standard alcoholic drinks.

(iii) Equity is a way of distribution of resources in a manner which brings economic fairness in terms of welfare or taxes. It is a concept of welfare economics and is concerned with proper distribution. Introduction of a price floor will not be equitable to consumers as the equilibrium price of alcohol was much lower than the government regulated price but its is equitable from the stakeholder and liquor outlets’ perspective as very low prices through market interaction would eat out of their profits. The consumers of alcohol do not need it for survival hence it is not a necessity so from an overall view the decision to enforce a price floor is equitable for the country’s welfare.

## b) Comparison of Economic Systems in NZ and China

(iv) The negative impact of a price floor is that it leads to a fall in the quantity demanded due to a rise in the price of the commodity, in this case alcohol. Regular consumers of alcohol will be worse off. Moreover, the fall in demand will also affect the suppliers due to reduction in their sales and due to the floor, they are unable to reduce the prices to promote sales.

(b) (i) The economic term for this situation is called a negative externality.

(ii) Air pollution in Timaru is an example of a market failure as the pollution is caused due to the industrial activities and the air pollution is a negative externality.

(iii) In this case of rising deaths the government needs to take measures to reduce the pollution. Taxation is a method that can be used where the polluter will be taxed for the pollution so that the society does not have to bear the cost of pollution. This will lead to an increase in the costs of the producer but the society will benefit in terms of welfare. The output of the good that was causing pollution would however fall. Provisioning is another method that can be used where the government set limits to how much a particular activity is allowed to release harmful gases beyond which they would be penalized. Here the pollution is controlled which leads to the welfare of the society but the producer will have to pay the price. The producer can in some cases raise their prices and shift their losses in which case the final consumers are having to pay the cost. Implementation of the ideas of a green city may incur costs but will lead to long term benefits. All the three solutions to reduce pollution will be successful if implemented in a fair and just manner without market imperfections.

(c) (i) It is a merit good as it is non-rivalrous but excludable as the injections will have a subsidy for a set age bracket.

(ii) This is a common good as its consumption is not excludable as it is supplied by the state but is rivalrous as the water will be used by everyone residing in the town.

(iii) This is a private good as it is both excludable and rivalrous. It is the decision of the florist whether to sell the flowers and due to scarcity of the flowers, there is rivalry in consumption.

(d) The New Zealand government is trying to ensure that the oil industry has adequate competition as it is an oligopoly market less competition would mean a rise in the prices as the suppliers of oil will form cartels and charge the cartel fixed price but with competition these cartels will not exist and the consumers will not be inconvenienced.

The report aims to identify the appropriate price of ticket for New Plymouth City Council that will maximize revenue and profit. Information are provided related to number of patrons corresponding to different prices. Main analysis of the report is based on price elasticity of demand analysis.

## c) Production Possibility Schedule

Decision regarding ticket price is taken by comparing revenues corresponding for different combination of price and number of patron attending per day. Profit on the business however depends both on revenue and cost (Baumol & Blinder, 2015). No information relating to cost are provided which is one limitation of the analysis.

The analysis of elasticity is based on elasticity computed using mid-point method. In this method, changes in demand is observed taking average prices as initial price. Unlike point elasticity method, the mid-point method undermines measured elasticity by taking the average price and average quantity as initial level of price or demand (Sloman & Jones, 2017).

Table 1: Revenue and elasticity

 Price Number attending per day Total Revenue per day Total Revenue per year Percentage change in Quantity Percentage change in price Elasticity Type of elasticity \$2.00 1485 \$2,970.00 \$1,069,200.00 -3.77 22.22 -0.17 Inelastic \$2.50 1430 \$3,575.00 \$1,287,000.00 -3.92 18.18 -0.22 Inelastic \$3.00 1375 \$4,125.00 \$1,485,000.00 -4.08 15.38 -0.27 Inelastic \$3.50 1320 \$4,620.00 \$1,663,200.00 -18.18 13.33 -1.36 Elastic \$4.00 1100 \$4,400.00 \$1,584,000.00

Price elasticity demand signifies changes occur in the quantity demanded of a good response to the changes occur in the offered market price. Revenue of a business is defined as quantity sold times the per unit price. Revenue thus affected from changes in both changes in demand. From the law of demand an inverse relation is between own price and demand of the product. As demand moves in opposite direction of price the magnitude of change in price and demand is important to find out the movement in revenue (Jain & Ohri, 2015). Demand is termed as inelastic if demand changes by a lesser magnitude compared to price. In this case, declining the price is not a beneficial strategy as demand does not change much. Instead, business should consider an upward revision of price to increase revenue. Demand of a good is known as relatively elastic is demand changes by a greater magnitude than price. Here, an increase in price reduces demand largely and hence, revenue decreases. In this situation, firms should lower price to increase revenue as fall in price is more than offset by the relatively large change in demand. In determination of direction of change in revenue and profit, the analysis of price elasticity of demand thus plays an important role (Hill & Schiller, 2015).

From the table computed elasticity for a change in price from \$2.50 to \$2.00 is -0.17. From the measured elasticity, it can be inferred that the decline in price is associated with a relatively small increase demand. More specifically, as price declines from \$2.50 to \$2.00 increase the number attending per day from 1430 to 1485. Lowering price thus reduces revenue from \$3575 to \$2970. Therefore, NPCC should never lower the price at this point. Instead they should go with increasing the ticket price. Price should be increased up to till \$3.50. Until this point, revenue increases along with the increase in price because of relatively inelastic nature of demand. The revenue is maximum at \$3.50. The estimated demand elasticity is -0.27. Further increase in ticket price causes revenue to fall because of a relatively elastic demand (Cowell, 2018). The computed elasticity between the price of \$3.50 and \$4.00 is 1.36. The increase in price thus reduces revenue by pulling down demand.

People having a relatively lower income are more sensitive to a change in price. As ticket price of the swimming pool increase beyond \$3.50, it becomes unaffordable for many of the lower income household (Cowen, T., & Tabarrok, 2015). They might choose not to go the swimming pool because of higher price. This makes the demand relatively elastic beyond this level.

Several other factors might affect elasticity of demand for New Plymouth City Council. One such factor is presence of any other swimming pool in the nearby region. If there is any other swimming pool in the nearby region then this will make demand more sensitive to price change (Moulin, 2014). If NPCC charges a relatively high ticket price, then people will tend to go to the other pool. This largely reduces demand when ticket price increase making demand more elastic.

As discussed in the previous section, the council can maximize its revenue by charging a ticket price of \$3.50.  However, the scenario might change following change in other relevant factors. One such factor is the cost structure (Mankiw, 2015). Changes in cost structure for providing some added facility or others might undermine the proposed fee structure.

The report briefly analyzes how number attending per day the NPCC swimming pool changes for a change in ticket price. Based on the relative elasticity of demand, decision can be taken regarding optimum ticket price (Hill & Schiller, 2015). The price elasticity of demand between \$2.00 and \$2.50 is -0.17. This indicates, 10 percent increase in ticket price here reduces demand by 1.7 percent. Between \$2.50 and \$3.00 price elasticity of demand is -0.22 and for prices ranging between \$3.00 and \$3.50 the price elasticity of demand is -0.27. At this price, number attending per day is 1320. The maximum revenue earned at this price is \$4620 per day. By charging this ticket price, NPCC will be able to earn a revenue of \$16633200 per year. The estimated price elasticity at the ticket price of \$4.00 is -1.36. As demand is relatively elastic an increase in price reduces demand more than the price increase .NPCC should therefore charge a ticket price of \$3.50 to maximize revenue. If the ticket price is currently \$4.00, then it should reduce the ticket price earn maximum revenue

Income of people is one significant factor that affect demand elasticity. For low income household, demand is relatively more elastic. This is one reason why demand is relatively elastic at a higher price. As ticket price increases beyond a certain level, low income household might not afford it anymore (Sloman & Jones, 2017). However, before taking pricing decision NPCC should consider its cost structure and other related factors.

References list

Baumol, W. J., & Blinder, A. S. (2015). Microeconomics: Principles and policy. Nelson Education.

Cowell, F. (2018). Microeconomics: principles and analysis. Oxford University Press.

Cowen, T., & Tabarrok, A. (2015). Modern principles of microeconomics. Macmillan International Higher Education.

Hill, C., & Schiller, B. (2015). The Micro Economy Today. McGraw-Hill Higher Education.

Jain, T. R., & Ohri, V. K. (2015). Principal of Microeconomics. FK Publications.

Mankiw, N. G. (2015). Principles of Microeconomics, Cengage Learning. Stamford, CT, 213.

Moulin, H. (2014). Cooperative microeconomics: a game-theoretic introduction (Vol. 313). Princeton University Press.

Sloman, J., & Jones, E. (2017). Essential Economics for Business. Pearson.

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