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(a) Explain and illustrate using suitable diagrams, the impact of external costs and external benefits on resource allocation: 
(b) Why does a good or service become a public good or service

(c) Explain why each of the following examples are either public goods or services, or private goods or services eh mark each correct classification and 1/2 marks for each reason).

(i) A privately owned engineering and material research laboratory undertaking contractual research on weapons development:

(ii) The qua:amen sem

(iii) A toll road originally financed through government debt:

(iv) Courses °flared by a fee dining privately owned teaching institution that receives some govemnu•nt funding: (v) Contact lenses. 


Question 2: (a) Suppose the income closeicily of demand (or pre-recorded music compact disks is -6.0 and the income elasticity of demand for a cabinet maker's work is .0.6. Compare the impact on pre-recorded music compact disks and the cabinet maker's work of a recession that reduces consumer incomes by 10 per cent.
(b) How might you determine whether the pre-recorded music compact discs and MP3 music players are in competition with each other
(c) Interpret the following Income Elasticities of Demand (YED) values for the following and state if the good is normal or inferior.
YED = • 0.8 YED • 1.8 (d) Interpret the following Cross-Price Elasticities of Demand (XED) and explain the relationship between these goods.
XED 0.79 
XED = -3.5 

External Costs and External Benefits

The presence of external cost or external benefit in the production or consumption process prevents the efficient allocation of resources. External cost are the cost associated with production process but not accounted by those directly engaged in such activity. This type of cost is termed as negative externality (Baumol and Blinder 2015). Under this, the private marginal cost is lesser than social marginal cost and therefore, the good is overproduced indicating resources are over allocated. The figure below describes external cost and the resulted inefficiency in resource allocation.

Figure 1: Inefficient allocation with external cost

            External benefit on the other hand indicates additional benefit that society or third party enjoys an additional benefit from production or consumption of a particular good or service. Here, social benefit is greater than private benefit. Private market thus produces lower than socially efficient quantity.

Figure 2: Inefficient allocation with external benefit

Answer b

            Goods or services with some specific characteristics cannot be supplied efficiency by private market. Two prominent characteristics are non rivalry and non excludability. The feature of non-rivalry indicates that consumption by one individual does not lower the benefit to another individual. The characteristic of non-excludability indicates that consumption once the good is supplied no one could be deceived from enjoying benefit of the good. With this feature efficient functioning of free market fails (Cowen and Tabarrok 2015). The government then need to intervene in the marketand provides such goods and services for public benefit.

Answer c

  1. Private good

Excludable:  Weapons are provided only to the contractor.

Rivalry: Weapons are used exclusively and cannot be used by others.

  1. Public good

Non-excludable: Every people in the society enjoy benefits from the service

Non-rivalry: The service provided on one does not affect utility enjoyed by others.

iii.  Private good

Excludable: use of the road is limited to only those who pay toll

Rivalry: Presence of too many cars in the road lead to the congestion problem and hence reduce utility of the road

  1. Private good

Excludable: Course is offered only to those who pay fees for the course.

Rivalry: As number of students increases available seat for the course to others reduces.

  1. Private good

Excludable: enjoyed only by private parties who purchase the lenses.

Rivalry: once the lenses purchased by one individual, the same cannot be enjoyed by others.

Answer 2

Answer a

            Income elasticity of compact disc is +6.0. If income reduces by 10 percent due to a recession would cause the demand for compact disc to increase by (6 *10) = 60 percent.In case of cabinet makers, income elasticity is given as +0.6. Therefore, a downfall in income by 10 percent cause a (0.6*10) = 6% downfall in demand. The same percentage reduction in income thus affects the compact disc market more severely as compared to cabinet maker because of higher responsiveness for a change in income.

Impact of External Costs and External Benefits on Resource Allocation

Answer b

            Competitiveness between pre-recorded music compact discs and MP3 players depend on relation between the two goods. One way to determine this competitiveness is to estimate cross price elasticity of demand between them. Positive estimate for cross price elasticity implies two goods are substitute and hence, they are in price competition with each other to undercut market share of the competitor (Mankiw 2015). The negative cross price elasticity projects complementary relation and therefore no competition exists.

Answer c

            YED = +0.8. The positive income elasticity estimate infers that a surge in income leads to a corresponding upsurge in demand. This indicates the good is a normal.

YED = - 3.8. The negative income elasticity estimate infers that a growth in income leads to a corresponding shrinkage in demand. This indicates the good is an inferior.

Answer d

            XED = +0.79. The given measure reflects a positive relation between demand and price of the related goods. The two goods therefore are substitutes.

            XED = -3.5. The given measure reflects a negative relation between demand and price of the related goods. The two goods therefore are complementary.

Answer 3

Answer a

Firm A

Quantity

0

 

1

 

2

 

3

 

4

 

5

 

6

Total Revenue ($)

0

10

20

30

40

50

60

Marginal Revenue ($)

10

10

10

10

10

10

Total Cost ($)

30

42

50

60

76

100

140

Marginal Cost ($)

12

8

10

16

24

40

Average Cost  ($)

42

25

20

19

20

23.33333

Firm B

Quantity

0

 

1

 

2

 

3

 

4

 

5

 

6

Total Cost ($)

100

134

154

177

216

266

366

Average Cost  ($)

134

77

59

54

53.2

61

Marginal Cost ($)

34

20

23

39

50

100

Price ($)

140

130

120

110

100

90

80

Marginal Revenue ($)

130

110

90

70

50

30

Total Revenue ($)

0

130

240

330

400

450

480

Firm A: Operating in short run

Firm B: Operating in short run

Answer c

Firm A: Operates in perfect competition

Firm B: Operates in imperfect competition

Answer d

Firm A: Produces 3 units of output in the short run

Firm B: Produces 5 units of output in the short run

Answer e

Firm A: Corresponding to the equilibrium level output, Firm A suffers a loss of $30

Firm B: Corresponding to short run equilibrium, Firm B enjoys a profit of $184.

Answer 5

Answer a

            The monopolistically competitive market lack both allocative and productive efficiency. The monopolistically competitive firms face a downward sloping demand curve. The firms here charge a price above the marginal cost (Sloman and Jones 2017). This indicate non-occurrence of allocative efficiency. In the long run the firms stop production to the eft of minimum average cost indicating productive n inefficiency.

Figure 3: Efficiency in monopolistically competitive market

In case of perfect competition, price is always at per marginal cost ensuring allocative efficiency. The zero profit condition in the long run under perfect competition indicates that firms’ operation take place at the minimum point of average cost which ensures productive efficiency.

Figure 4: Efficiency in perfectly competitive market

Answer b

Public Goods and Services

            Firms under perfect competition in the long run successfully achievedallocative efficiency as followed by the condition P = LAC (min) = LMC. The point if operation for monopolist on the other hand is given by the point E (Figure 5). At this point neither productive nor allocative efficiency is achieved following the fact that price is set above the marginal cost and the monopolist might stop production before reaching the efficient point (minimum of LAC) (Friedman 2017).

Figure 5: Efficiency comparison between competitive and monopolist firm

Answer c

Figure 6: Short run profit under perfect competition

            In the short run, firms engaged in perfect competition have a scope to enjoy economic profit or economic loss by operating above or below the average cost. As the firms might not operate in at minimum of average cost productive efficiency does not occur. Firms equilibrium and resource allocation in the short run followed by two condition MR = MC and MC intersect MR from below. Industry equilibrium on the other hand is obtained where demand and supply matches with each other ensuring an efficient allocation of resources.

Answer d

            The above figure explains long run equilibrium under perfect competition. The corresponding equilibrium point is shown as A. The long run equilibrium condition is P = LAC (min) = LMC (Arrow 2015). At the point corresponding to long run equilibrium firms have zero economic profit.

Answer 9

Answer a

i)In response to a sharp rise in oil price demand for automobile would fall. This leads to outward shift in automobile demand curve as shown in the figure above causing a corresponding decline in price and quantity of automobile.

ii)

            In order to enhance efficiency of energy use in response to a higher price of oil demand for home insulation increases.This moves the demand curve of home insulation outward (shown in the above figure). The increased demand increase price and quantity sold in equilibrium.

iii) The increase in price of oil increase coal demand as coal is a substitute oil. Here again, demand curve shifts outward causing equilibrium to occur at a higher price and quantity.

iv)

Tyre is a sub part of automobile. With a decline in demand for automobile tyres demand decreases as well as displayed by an inward shift in tyre demand curve. Price and quantity declines under new equilibrium.

v) With increase in oil price, people will tend to reduce the use of car and prefer bicycle to save the fuel cost. This increase demand for bicycles. This is presented with a rightward shifts of the bicycle demand curve indicating an increase in price and number of bicycles sold in the market.

Answer b

            Non-rivalry and non-excludability are the two distinctive features of public goods. Because of non-excludability, people have a tendency to enjoy the good leading to a free rider problem. For these kind of goods people never reveal their real preferences. The demand curve which under free market condition represents marginal social benefits fails to capture the true preference or willingness of the goods (Maurice and Thomas 2015). Because of incomplete information about preference and actual benefit, it is not possible for private market to supply such goods in sufficient quantity.

Reference list

Arrow, K., 2015. Microeconomics and operations research: their interactions and differences. Information Systems Frontiers, 17(1), pp.3-9.

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

Cowen, T. and Tabarrok, A., 2015. Modern principles of microeconomics. Macmillan International Higher Education.

Friedman, L.S., 2017. The microeconomics of public policy analysis. Princeton University Press.

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

Maurice, S.C. and Thomas, C., 2015. Managerial Economics. McGraw-Hill Higher Education.

Sloman, J. and Jones, E., 2017. Essential Economics for Business. Pearson.

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