NCEA Scholarship Economics free practice questions with answers

Question 1 (8 marks) [Natural monopoly and regulation]

(a) Use information from Resource A and your knowledge of micro-economic theory. Explain, with a labelled diagram, why the water network is a natural monopoly and why, if unregulated, it will produce less than the allocatively efficient output. Price ($ thousand) Quantity (thousand kilolitres) Q(m) P(m) Q(e) D MR MC ATC DWL Red triangle: deadweight loss from the monopoly output Q(m) instead of the efficient output Q(e), where P = MC.

(a) Answer: Falling average cost over the whole market; MR below price so the monopolist restricts output

• Entry step: worth marks in the 1-4 range of the 8-point question score.

• Fixed costs are large and marginal cost is constant, so average total cost = 400 ÷ Q + 10 falls as output rises and keeps falling over the whole range of demand. One firm can supply the market at lower cost than two, so competition is wasteful and a single seller emerges (a natural monopoly). [1 mark]

• A monopolist faces the downward-sloping market demand curve, so to sell more it must lower the price on every unit: marginal revenue lies below demand. It maximises profit where MR = MC, at Q = 40, and charges 50 from the demand curve. The allocatively efficient output is where price = MC (Q = 80); between the two outputs each unit is worth more to consumers than it costs to supply, so there is a deadweight loss. [1 mark]

(b) Calculate the unregulated output, price, profit and deadweight loss (all in $ thousand where they are money).

(b) Answer: Q = 40 thousand kL at P = 50; profit $1200 thousand; DWL $800 thousand

• Scholarship band (5-6): the part needs your own method and accurate reasoning.

• MR = 90 − 2Q; setting MR = MC = 10 gives Q = 40 and P = 90 − 40 = 50. ATC at that output = 400 ÷ 40 + 10 = 20, so profit = (50 − 20) × 40 = $1200 thousand. [1 mark]

• The efficient output has P = MC: 90 − Q = 10, so Q = 80. Deadweight loss = ½ × (P − MC) × (Q(e) − Q(m)) = ½ × (50 − 10) × (80 − 40) = $800 thousand. [1 mark]

(c) Calculate the output, price and the profit or loss under (i) marginal-cost pricing and (ii) average-total-cost pricing, and the deadweight loss under each. Give outputs and prices to 2 decimal places and the deadweight loss to the nearest $0.1 thousand.

(c) Answer: (i) Q = 80 at P = 10, loss $400 thousand, DWL 0; (ii) Q = 74.64 at P = 15.36, normal profit, DWL $14.4 thousand

• Scholarship band (5-6): the part needs your own method and accurate reasoning.

• (i) P = MC = 10 gives Q = 80. ATC = 400 ÷ 80 + 10 = 15 > P, so the loss is (15 − 10) × 80 = $400 thousand (exactly the fixed cost). Allocative efficiency is achieved: DWL = 0. [1 mark]

• (ii) P = ATC: 90 − Q = 400 ÷ Q + 10, so Q² − 80 Q + 400 = 0, giving Q = [80 + √(6400 − 1600)] ÷ 2 = 74.64 (the larger root, which gives the greater output with price still equal to ATC). P = 90 − 74.64 = 15.36, so profit is zero. DWL = ½ × (15.36 − 10) × (80 − 74.64) = $14.4 thousand. [1 mark]

(d) Evaluate the three options available to the council (leave it unregulated, marginal-cost pricing funded from rates, average-cost pricing). Recommend one, and say whether any other pricing scheme could do better.