Economics Questions and Answers on Resources and Profit

Assignment Questions:
Question 1:
The removal of imperfections in the market leads to an increase in efficiency in the allocation of resources. Discuss whether you agree with this view (25 marks)
Question 2:
Explain what is meant by normal and abnormal profit and when such profits might occur (12 marks)
Discuss the three reasons as to why people demand money, according to the liquidity preference theory (13 marks)
Table of Contents (Jump to)
Question 1:
A. Allocative Efficiency and Perfectly Competitive Market
B. Allocative Efficiency and Monopoly
Question 2 (a):
A. Perfect Competition
B. Monopoly
C. Monopolistic Competition
Question 2 (b)
A. Transaction Motive
B. Precautionary Motive
C. Speculative Motive
Referencing
List of Figures (Jump to)
Figure 1: Pure Competition – MSC & MSB Curves
Figure 2: Consumer Surplus & Producer Surplus
Figure 3: The short run and long run in perfect competition
Figure 4: The short run and long run monopoly market
Figure 5: The short run and long run monopolistic competition
Figure 6: Money Demand Curves (liquidity preference theory)
Question 1:
The removal of imperfections in the market leads to an increase in efficiency in the allocation of resources. Discuss whether you agree with this view (25 marks)
A. Allocative Efficiency and Perfectly Competitive Market
Allocative Efficiency occurs when it is not possible to reallocate resources in order to make someone better off without making at least another person worse off. It arises where:
Marginal Social Cost (MSC) = Marginal Social Benefit (MSB).
The MSC refers any extra cost to society of producing one more unit of output. The law of diminishing returns implies that MSC will be upward sloping. On the other hand, the MSB is any extra benefit to society of producing one more unit of output. The law of diminishing marginal utility implies that MSB will be downward sloping.
For example: If the 20th unit of output is produced, then it costs the society $10, but yields a benefit of $20. Thus, the society’s welfare increases by $10 (i.e. MSB – MSC). Since MSB is greater than MSC, people is better off. On the contrary, it is not in the society’s interest to produce the 40th unit.

In perfect competition, both consumer surplus and producer surplus is maximised (as illustrated by figure 1), where the price is equal to the marginal cost. The consumer surplus is the total net benefit enjoyed by all consumers buying the product. For instance, a consumer paying $20 for a product whose market price is $15; thus enjoying the benefit of $5 ($20 – $15 = $5).
Producer surplus is the difference between the market price the producer receives and the marginal cost of producing this unit.
Demand curves measure the maximum price that consumers are willing to pay for a given quantity of a good. Hence, the demand curve is a measure of marginal benefit (or marginal utility) to the consumer. Therefore, in absence of externalities, MSB = D = P. In perfectly competitive market, the supply curve is a measure of the marginal cost in the industry. In the absence of externalities, MSC = S = MC.
Therefore, an efficient allocation of resources under perfect competition happens when price equals to marginal cost, i.e. P = MC, in the short and long run.
B. Allocative Efficiency and Monopoly
Monopoly market structure is one of the major sources of market imperfections. A monopoly is having one firm producing and selling a product with the existence of barriers to entry. A monopolist is a price taker. The monopolist can set the price or the output, but not both. They can even earn abnormal profits at the expense of efficiency and welfare of consumer and society.

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Since price is higher than marginal cost, this will lead to a loss of allocative efficiency and a failure of the market. In fact, the monopolist is extracting a price from consumer that is higher than the cost of resources required. Thus, at price Pm, the monopolist is charging a higher price and restricting output to Qm, whereby capturing a portion of the consumer surplus.
Under monopoly, there is a portion (triangle ABC) where both the consumer surplus and producer surplus are recovered. This is known as “deadweight loss”.

Figure 2: Consumer Surplus & Producer Surplus
Imperfections in the market leads to misallocation and underutilisation of resources and reduction in consumer surplus since price is greater than marginal cost, i.e. P > MC.
But imperfections in market do have some benefits such as:

Monopolist are supplying products on a very large scale, thus they may be in a better place to exploit increasing returns to scale leading to a fall in average total costs of production. This reduction in costs will lead to an increase in monopoly profits, but some gains in productive efficiency may pass onto consumer in the form of lower prices.
Earning abnormal profits in the long run may lead to faster rate of technological development thereby reducing costs and producing of better quality.
Supernormal profits may be used to invest in research and development programmes that have the potential to bring dynamic efficiency gains to consumers in the markets.

Question 2 (a):
Explain what is meant by normal and abnormal profit and when such profits might occur? (12 marks)
Normal profit is the minimum level of profit that a company needs to remain competitive in the market. If firms in an industry are making normal profit, then there is no reasons for them to leave or for other firms to join the industry. Normal profit occurs when revenue equals cost.
Abnormal profit (or super normal profit) is profit in excess of normal profit. If firms in an industry are making abnormal profit, then there is a reason for other firms to join the industry if they can. Abnormal profit occurs when the revenue is greater than the costs.
A. Perfect Competition
In the short run, firms can make abnormal profits or losses, whereas they can only make normal profits in the long run, as illustrated below:

Figure 3: The short run and long run in perfect competition
B. Monopoly
Monopolies can earn abnormal profits in the short run and in the long run due to the existence of strong barriers to entry.

Figure 4: The short run and long run monopoly market
C. Monopolistic Competition
Monopolistic competition involves many sellers with differentiated products, e.g. shoe producers or restaurants. In the short run, firms can make abnormal profit whereas in the long run, other firms will be attracted by the abnormal profits causing firms’ demand to fall until only normal profits are made.

Figure 5: The short run and long run monopolistic competition
As a conclusion, if firms are making abnormal profits, other firms will be attracted by such profit, and will try to enter that particular market to reap some of that profits. As a result, firms in perfectly competitive market and monopolistic competitive market will enjoy normal profit with the entrance of new firms in the long run. On the other hand, firms in monopoly market will enjoy abnormal profits both in the short run and in the long run due to the existence of strong barriers to entry.
Question 2 (b)
Discuss the three reasons as to why people demand money, according to the liquidity preference theory (13 marks)
According to Keynes’ Liquidity Preference theory, people demand moneyand hold their wealth in monetary form because of the following three main reasons:
A. Transaction Motive
Day-to-day transactions are performed by both individuals and firms. An individual person holds cash in order to meet his/her daily expenditures. Business holds cash to meet its current needs such as payments of raw materials, etc…
Therefore, we can say that money needed by consumers, businessmen and others, is known as the demand for money for transactions motive. This demand depends upon the following:

Size of the income: If income is high, more will be available for daily transactions and vice versa.
Time gap between receipts of income: If a person gets his pay daily, he/she will demand less cash and vice versa.
Spending habit: If a person is spent a lot, he/she will do more transactions and thus will demand more money.

B. Precautionary Motive
Precautionary motive for holding money refers to the desire to hold cash for unforeseen contingencies such as illness, accidents, unemployment, etc… Business keeps cash reserve to safeguard their future. This type of demand for liquidity is called demand for precautionary motive. This demand depends upon many factors:

Size of the income: If a person earns a high income, he/she will demand more money for safeguarding his future.
Nature of the person: Some persons are optimistic, i.e. they anticipate less of future risk and danger, and hence they will demand less money for precautionary motive. On the other hand, pessimistic persons foresee dangers, calamities, and emergencies in the future, and hence, they want to have more cash with them.
Farsightedness: They are persons who can proper guess of the future, and thus they will keep more money (in cash) with then in case of more emergencies expectation and vice versa.

C. Speculative Motive
The speculative motive relates to the desire to hold cash and take advantage of future changes in the rate of interest or bond prices. For instance, if the price of bond is expected to rise, meaning the rate of interest is expected to fall, then people will buy bonds and sell later when the price rises, and vice versa.
According to Keynes, “the higher the rate of interest, the lower the speculative demand for money and vice versa”.

Figure 6: Money Demand Curves (liquidity preference theory)
Keynes hold that the transaction and precautionary motives are completely interest inelastic, whereas the speculative demand for money is a smooth curve which slopes downward from left to right, as illustrated in above figure.
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