FIRST YEAR FIRST SEMESTER EXAMINATION

THE DEGREE OF BACHELOR OF COMMERCE,

DFI103: PRINCIPLES OF MICRO-ECONOMICS

INSTRUCTIONS: Answer question one and any other two

questions
QUESTION ONE (30 MARKS)

a) Explain the following concepts in as used in economics

i. Production possibility curve (4 marks)

ii. Scarcity and choice (2 marks)

iii. Ordinal and cardinal utility approach (2 marks)

i. Production Possibility Curve (PPC) (4 marks)

• Definition: The Production Possibility Curve (PPC), or Production

Possibility Frontier (PPF), represents the maximum possible
combinations of two goods or services that an economy can produce
given fixed resources and technology.
• Purpose: The PPC illustrates the concepts of scarcity, efficiency, and
opportunity cost.
o Scarcity: Resources are limited, so producing more of one good
means producing less of another.
o Efficiency: Points on the curve represent efficient use of
resources; any point inside the curve indicates underutilization,
while points outside are unattainable given current resources.
o Opportunity Cost: Moving along the PPC shows trade-offs;
producing more of one good involves sacrificing some amount of
the other.
• Shape: The curve is typically concave to the origin, reflecting increasing
opportunity costs as resources are shifted from producing one good to
another.

ii. Scarcity and Choice (2 marks)

• Scarcity: In economics, scarcity refers to the basic problem that

resources (land, labor, capital) are limited, while human wants are
 virtually unlimited. This limitation requires individuals, firms, and
governments to make choices on how best to allocate resources.
• Choice: Due to scarcity, economic agents must make decisions on
which goods and services to produce, consume, or forgo. This choice-
making process is fundamental, as it involves opportunity costs—the
benefits of the next best alternative foregone when a choice is made.

iii. Ordinal and Cardinal Utility Approaches (2 marks)

• Ordinal Utility: Assumes consumers can rank their preferences in

order of satisfaction but cannot quantify the exact level of satisfaction
(utility). For example, a consumer may prefer good A over good B but
cannot specify how much more satisfaction A provides.
• Cardinal Utility: Assumes satisfaction (utility) can be measured
numerically, allowing consumers to assign specific values to different
levels of satisfaction. For example, a consumer may assign 10 utils to
good A and 5 utils to good B, indicating that good A provides twice the
satisfaction of good B.

b) Explain the factors that limit consumer sovereignty (5 marks)

➢ Monopoly and Market Power:

When a single producer or a small group of firms dominate a market, they can
influence prices, limit supply, or control the range of products available. This
reduces the options consumers have, limiting their ability to drive market
outcomes based solely on their preferences.

➢ Advertising and Manipulation:

Advertising can heavily influence consumer preferences and purchasing

behavior, often creating artificial desires or shaping perceptions about certain
products. Persuasive marketing tactics can lead consumers to make choices
based more on perceived benefits than on true needs or preferences, thereby
limiting genuine consumer sovereignty.

➢ Limited Information:

In many markets, consumers may not have complete or accurate information

about products, such as quality, price, or long-term effects. This information
asymmetry makes it difficult for consumers to make fully informed choices,
reducing their ability to influence the market effectively.

➢ Income Inequality:

Economic disparities restrict the purchasing power of low-income

consumers, limiting their access to a wide range of goods and services. In
such cases, consumer choices reflect their financial constraints more than
their actual preferences, reducing the influence of a large segment of
consumers in determining production decisions.

➢ Government Intervention and Regulations:

Governments sometimes intervene in markets by imposing taxes, subsidies,

or regulations that influence production and consumption patterns. While
these policies may aim to protect consumers or achieve social objectives,
they can also restrict consumer choice by limiting the availability or
affordability of certain products

c) Explain the features of free market system (5 marks)

• Private Property Rights:

Individuals and businesses have the right to own, control, and transfer
property, including resources, goods, and capital. Private ownership
incentivizes individuals to invest and improve resources, as they can directly
benefit from their investments.
 • Freedom of Choice and Enterprise:

Consumers, producers, and workers are free to make their own economic
decisions. Consumers can choose what to buy, producers decide what to
produce and how to produce it, and workers decide where to work. This
freedom encourages competition and efficiency.

• Competition:

The presence of multiple buyers and sellers fosters competition, which

typically leads to better products, innovation, and lower prices. Competition
forces businesses to be efficient and responsive to consumer needs, as
consumers can switch to alternatives if they’re dissatisfied.

• Price Mechanism:

Prices in a free market are determined by supply and demand. The price
mechanism serves as a signal to both producers and consumers, guiding
resource allocation. High demand and limited supply drive prices up,
encouraging production, while excess supply leads to lower prices,
discouraging overproduction.

• Limited Government Intervention:

In a free market, the government’s role is generally limited to protecting

property rights, enforcing contracts, and ensuring fair competition. The
absence of extensive government regulation allows markets to adjust quickly
to changes in supply and demand, promoting economic freedom and
efficiency.

d) You are given the following information regarding a certain firm with
labor as the
only variable input in the production of output

Labour (L) Total

product (TP)
0 -

1 100

2 220

3 360

4 460

5 530

6 570

7 595

8 600

9 594

10 560

Find:
i. Marginal product (MP) (2 marks)

ii. Average product (AP) (2 marks)

e) Explain in details the properties of indifference curves (8 marks)
QUESTION TWO (20 MARKS)

a) You are further given the following market mode

Qd =19_p2

Qs= _8+1p2
Determine equilibrium price and quantity (6 marks)

• Demand equation: Qd=19−p2Q_d = 19 - p_2Qd =19−p2

• Supply equation: Qs=−8+1p2Q_s = -8 + 1p_2Qs =−8+1p2

Steps to Find Equilibrium

1. Set QdQ_dQd equal to QsQ_sQs to find the equilibrium price p2p_2p2:

19−p2=−8+1p219 - p_2 = -8 + 1p_219−p2 =−8+1p2

2. Solve for p2p_2p2:

a. Add p2p_2p2 to both sides: 19=−8+2p219 = -8 +
2p_219=−8+2p2
b. Add 8 to both sides: 27=2p227 = 2p_227=2p2
c. Divide by 2: p2=272=13.5p_2 = \frac{27}{2} = 13.5p2 =227
=13.5

So, the equilibrium price p2p_2p2 is 13.5.

3. Substitute p2=13.5p_2 = 13.5p2 =13.5 back into either the demand

or supply equation to find the equilibrium quantity QQQ.

Using the demand equation:

Qd=19−13.5=5.5Q_d = 19 - 13.5 = 5.5Qd =19−13.5=5.5

Therefore, the equilibrium quantity QQQ is 5.5.

Answer

• Equilibrium Price (p2)(p_2)(p2): 13.5

• Equilibrium Quantity (Q)(Q)(Q): 5.5
b) Consider the following total cost function

C=2Q3_5Q2+4Q+150
Determine;

i. The fixed cost function (FC) (1 mark)

ii. The variable cost function (VC) (1 mark)

iii. The average fixed cost function (AFC) (1 mark)

iv. The average variable cost function (AVC) (1 mark

i. Fixed Cost Function (FC)

• Fixed costs (FC) are the costs that do not depend on the level of output
QQQ. They are represented by the constant term in the cost function.
• In this case, the fixed cost is the constant term 150.

Answer: FC=150FC = 150FC=150

ii. Variable Cost Function (VC)

• Variable costs (VC) depend on the level of output QQQ. In this function,
they are represented by terms involving QQQ.
• Here, the variable cost function includes 2Q3−5Q2+4Q2Q^3 - 5Q^2 +
4Q2Q3−5Q2+4Q.

Answer: VC=2Q3−5Q2+4QVC = 2Q^3 - 5Q^2 + 4QVC=2Q3−5Q2+4Q

iii. Average Fixed Cost Function (AFC)

• Average Fixed Cost (AFC) is the fixed cost per unit of output,
calculated as: AFC=FCQAFC = \frac{FC}{Q}AFC=QFC
• Substituting FC=150FC = 150FC=150: AFC=150QAFC =
\frac{150}{Q}AFC=Q150

Answer: AFC=150QAFC = \frac{150}{Q}AFC=Q150

iv. Average Variable Cost Function (AVC)

• Average Variable Cost (AVC) is the variable cost per unit of output,
calculated as: AVC=VCQAVC = \frac{VC}{Q}AVC=QVC
• Substituting VC=2Q3−5Q2+4QVC = 2Q^3 - 5Q^2 +
4QVC=2Q3−5Q2+4Q: AVC=2Q3−5Q2+4QQAVC = \frac{2Q^3 - 5Q^2 +
4Q}{Q}AVC=Q2Q3−5Q2+4Q
• Simplify by dividing each term by QQQ: AVC=2Q2−5Q+4AVC = 2Q^2 -
5Q + 4AVC=2Q2−5Q+4

Answer: AVC=2Q2−5Q+4AVC = 2Q^2 - 5Q + 4AVC=2Q2−5Q+4

c) Describe how firms achieve equilibrium in the short-run under perfect

competition
10 marks)

1. Market Characteristics:

• Many Buyers and Sellers: A large number of firms and consumers

exist, ensuring no single entity can influence market prices.
 • Homogeneous Products: All firms produce identical products, leading
to perfect substitutes for consumers.
• Free Entry and Exit: Firms can enter or exit the market without
significant barriers.

2. Profit Maximization:

• Marginal Cost (MC) and Marginal Revenue (MR): Firms aim to

maximize profits by producing at a level where MR equals MC. In perfect
competition, the price (P) equals MR because firms are price takers.
Thus, firms will continue to produce as long as P ≥ MC.
• Profit Calculation: If the price is above average total cost (ATC), firms
earn economic profits. Conversely, if the price is below ATC, firms incur
losses. The equilibrium output occurs where P = MC.

3. Short-Run Equilibrium Conditions:

• Profit or Loss Situations:

o Economic Profit: If firms can sell at a price above ATC, they will
earn economic profits. This attracts new firms to the market in the
long run, shifting supply to the right and reducing prices until
profits are zero.
o Loss: If firms face a price below ATC, they will incur losses. Firms
may continue operating in the short run if the price covers average
variable costs (AVC), allowing them to minimize losses. If losses
persist, firms will exit the market in the long run.

4. Adjustment Process:

• Supply and Demand Dynamics: In the short run, firms adjust their
production levels based on current market prices. If demand increases,
prices rise, leading firms to increase output until new equilibrium is
reached.
 • Shifts in Supply Curve: If many firms enter the market due to economic
profits, the supply curve shifts right, lowering prices and profits.
Conversely, if firms exit due to losses, the supply curve shifts left,
increasing prices.

5. Graphical Representation:

• Graphs typically illustrate this process, showing the demand curve (D)
and the marginal cost curve (MC). The intersection of MC and D
indicates the profit-maximizing output level. Areas above the ATC curve
represent profits, while areas below represent losses.

QUESTION THREE (20 MARKS)

a) Explain the distinguishing features of firm in a monopoly market
structure (6 marks)

a) Distinguishing Features of a Firm in a Monopoly Market Structure (6

marks)

1. Single Seller: In a monopoly, a single firm dominates the market and is

the sole producer of a product or service. This gives the firm significant
market power.
2. Price Maker: The monopolist can set the price for its product, as it is
the only provider. Unlike firms in competitive markets, monopolies face
downward-sloping demand curves, allowing them to influence prices.
3. Unique Product: The product offered by a monopolist has no close
substitutes, making consumers dependent on that specific product.
This uniqueness contributes to the monopolist's pricing power.
4. High Barriers to Entry: There are significant obstacles for other firms to
enter the market, such as legal restrictions (patents, licenses), high
startup costs, or control of essential resources. These barriers protect
the monopolist's market position.
 5. Limited Consumer Choice: Since there is only one seller, consumers
have no alternative options, resulting in a lack of competition and
potentially leading to less favorable pricing and product quality.
6. Profit Maximization: Monopolists maximize profits by producing where
marginal cost (MC) equals marginal revenue (MR). They often earn
positive economic profits in both the short run and long run due to
barriers to entry.

b) Explain the exceptions to the law of demand (4 marks)

Exceptions to the Law of Demand (4 marks)

1. Giffen Goods: These are inferior goods for which demand increases as
the price rises, violating the law of demand. This occurs because the
income effect outweighs the substitution effect, leading consumers to
buy more of the Giffen good when it becomes more expensive.
2. Veblen Goods: Veblen goods are luxury items for which demand
increases as prices rise due to their status symbol effect. Higher prices
may enhance their desirability, leading consumers to purchase more to
signify wealth.
3. Necessities: Certain essential goods (e.g., medications) may see
demand remain constant or even increase despite price hikes, as
consumers cannot forego these products for their health or well-being.
4. Consumer Expectations: If consumers expect prices to rise in the
future, they may purchase more of a good at the current higher price,
anticipating that they won't afford it later. This shift can lead to
increased demand despite higher prices.

c) By the use of a diagram, explain how a consumer achieves equilibrium

(10 marks)
Consumers Equilibrium

In order to display the combination of two goods X and Y, that the

consumer buys to be in equilibrium, let’s bring his indifference
curves and budget line together.

We know that,

• Indifference Map – shows the consumer’s preference scale

between various combinations of two goods
• Budget Line – depicts various combinations that he can
afford to buy with his money income and prices of both the
goods.

In the following figure, we depict an indifference map with 5

indifferences curves – IC1, IC2, IC3, IC4, and IC5 along with the
budget line PL for good X and good Y.
From the figure, we can see that the combinations R, S, Q, T, and
H cost the same to the consumer. In order to maximize his level of
satisfaction, the consumer will try to reach the highest
indifference curve. Since we have assumed a budget constraint,
he will be forced to remain on the budget line.

So, which combination will he choose?

Let’s say that he chooses the combination R. From Fig. 1, we can

see that R lies on a lower indifference curve – IC1. He can easily
afford the combinations S, Q, or T which lie on the higher ICs.
Even if he chooses the combination H, the argument is similar
since H lies on the curve IC1 too.

Next, let’s look at the combination S lying on the curve IC 2. Here

again, he can reach a higher level of satisfaction within his budget
by choosing the combination Q lying on IC3 – higher indifference
curve level. The argument is similar for the combination T since T
lies on the curve IC2 too.

Therefore, we are left with the combination Q.

QUESTION FOUR (20 MARKS)

a) With the aid of diagram explain the law of diminishing marginal returns
to a factor (12 marks)

• The Law of Diminishing returns to a factor refers to a situation in

which each additional unit of a variable factor adds a lesser and lesser
amount of output, i.e., when the marginal product of a factor falls as
 more of it is dram used. In this situation, output tends to increase at a
diminishing rate as more of the variable factor is combined with the fixed
factor.
• In this stage total product goes on increasing, but at a diminishing rate.
It reaches the maximum as shown by point T in the upper panel, and
the second stage ends here. In this stage, both the marginal product
and the average product of the variable factor are diminishing, but are
positive. The second stage starts from the point where AP is maximum,
i.e., point A. It ends where the marginal product of the variable factor is
zero. This is shown by the MP curve reaching L, on the X-axis (which
corresponds to the highest point T of the TP curve) in the lower panel.
This stage is the most important as the producers would like to operate
in this stage.
#SPJ2
b) Distinguish between price offer and income offer curve (8 marks)

Price Offer Curve

1. Definition: The price offer curve (also known as the price-demand curve) illustrates
the relationship between the price of a good and the quantity demanded by
consumers, holding all other factors constant, including income.
2. Concept: This curve captures how changes in the price of a good affect the quantity
demanded. Typically, as the price of a good decreases, the quantity demanded
increases, and vice versa. This reflects the law of demand.
3. Shape: The price offer curve is usually downward sloping from left to right,
indicating an inverse relationship between price and quantity demanded.
4. Example: If the price of apples drops, consumers are likely to buy more apples,
shifting the quantity demanded along the curve.
5. Use: It is useful in analyzing consumer behavior related to price changes and can
help businesses set optimal pricing strategies.
Income Offer Curve

1. Definition: The income offer curve represents the relationship between consumer
income and the quantity of a good demanded, holding prices constant.
2. Concept: This curve shows how changes in income affect the quantity demanded of
a good. Generally, as income increases, the quantity demanded of normal goods
rises, while the quantity demanded of inferior goods may fall.
3. Shape: The income offer curve typically slopes upwards for normal goods, reflecting
a direct relationship between income and quantity demanded.
4. Example: If a consumer’s income increases, they may buy more of a normal good
(like organic food) but may buy less of an inferior good (like instant noodles).
5. Use: It helps in understanding how variations in income levels impact consumer
purchasing behavior and can inform policy decisions regarding taxation and
subsidies.

Summary of Key Differences

Feature Price Offer Curve Income Offer Curve
Focus Relationship between price and Relationship between income and
quantity demanded quantity demanded
Shape Downward sloping (inverse Upward sloping (direct relationship
relationship) for normal goods)
Constant Income constant Prices constant
Factors
Implications Useful for analyzing price changes Useful for analyzing income effects
Example Effect of price changes on demand Effect of income changes on demand
for apples for organic food

QUESTION FIVE (20 MARKS)

a) Distinguish between shift in demand curve and movement along the
demand curve
(4 marks)

Shift in the Demand Curve:

 • A shift in the demand curve occurs when there is a change in the
quantity demanded at every price level due to factors other than price.
This results in the entire demand curve moving either to the right
(increase in demand) or to the left (decrease in demand).
• Example: If consumer income increases, the demand for normal goods
(like luxury cars) may shift to the right. Conversely, if consumers expect
a recession, the demand for such goods may shift to the left.

Movement Along the Demand Curve:

• Movement along the demand curve refers to changes in the quantity

demanded due to a change in the price of the good itself. This is
represented by a movement up or down along the existing demand
curve.
• Example: If the price of a good decreases, the quantity demanded
typically increases (movement down the curve). Conversely, if the price
increases, the quantity demanded typically decreases (movement up
the curve).

b) Explain the factors that influence price elasticity of demand (8 marks)

Substitutability:

• The more substitutes available for a good, the more elastic the demand.
If the price of a product rises, consumers can easily switch to
substitutes.
• Example: Demand for butter is more elastic because there are many
substitutes like margarine.

Necessity vs. Luxury:

• Necessities tend to have inelastic demand, as consumers will buy them

regardless of price changes. Luxuries tend to have elastic demand, as
consumers can forgo them when prices rise.
 • Example: Insulin has inelastic demand, while a luxury vacation has
elastic demand.

Proportion of Income:

• Goods that take up a large proportion of a consumer's income tend to

have more elastic demand, as price changes significantly impact
consumers’ budgets.
• Example: Rent (inelastic) vs. a cup of coffee (elastic).

Time Period:

• Demand elasticity can vary over time. In the short run, demand may be
inelastic as consumers need time to adjust their behavior; in the long
run, they may find substitutes, making demand more elastic.
• Example: Gasoline demand may be inelastic in the short term but more
elastic in the long term as consumers switch to more fuel-efficient cars.

Brand Loyalty:

• Products with strong brand loyalty typically exhibit inelastic demand

because consumers are less likely to switch to substitutes even if
prices rise.
• Example: Demand for Apple products may be inelastic due to strong
brand loyalty.

Consumer Preferences:

• Changes in consumer preferences can influence elasticity. If a good

becomes trendy, demand may become more elastic as people rush to
purchase it, and vice versa.
• Example: Demand for organic food products may become more elastic
as more consumers seek alternatives.

Durability:
 • Durable goods (goods meant to last) tend to have more elastic demand
since consumers can postpone purchases when prices rise.
• Example: Demand for cars is more elastic than for food items, as
consumers can delay buying a new car.

Addictiveness:

• Addictive goods tend to have inelastic demand because consumers will

continue purchasing them regardless of price changes.
• Example: Demand for cigarettes is typically inelastic.

c) With aid of examples distinguish between price elasticity of demand

and cross price
elasticity of demand (8 marks)

Price Elasticity of Demand (PED):

• Price elasticity of demand measures the responsiveness of the quantity

demanded of a good to a change in its price. It is calculated as the
percentage change in quantity demanded divided by the percentage
change in price.
• Example: If the price of a soft drink increases by 10% and the quantity
demanded decreases by 20%, the price elasticity of demand would be:
PED=Percentage change in quantity demandedPercentage change in
price=−20%10%=−2PED = \frac{\text{Percentage change in quantity
demanded}}{\text{Percentage change in price}} = \frac{-20\%}{10\%}
= -2PED=Percentage change in price Percentage change in quantity
demanded =10%−20% =−2 This indicates elastic demand.

Cross-Price Elasticity of Demand (XED):

• Cross-price elasticity of demand measures the responsiveness of the
quantity demanded of one good to a change in the price of another
good. It is calculated as the percentage change in the quantity
demanded of Good A divided by the percentage change in the price of
Good B.
• Example: If the price of tea increases by 15% and the quantity
demanded of coffee increases by 5%, the cross-price elasticity of
demand would be: XED=Percentage change in quantity demanded of
coffeePercentage change in price of tea=5%15%≈0.33XED =
\frac{\text{Percentage change in quantity demanded of
coffee}}{\text{Percentage change in price of tea}} = \frac{5\%}{15\%}
\approx 0.33XED=Percentage change in price of tea Percentage change
in quantity demanded of coffee =15%5% ≈0.33 This indicates that tea
and coffee are substitutes, as the increase in the price of tea leads to an
increase in the quantity demanded of coffee.