Competitive Markets chapter test

20 marks - 1 hour

Answer both questions: DEDU: Define, explain theory, Diagram, Understanding

1. Explain how the circular flow of income model shows interdependence between the
various economic agents in a complex and open economy.

A circular flow of income model is a diagram which demonstrates the flow of income in
different sectors on an economy. Within this model, there are two main agents, the
households and the firms. The households and the firms work hand in hand in order to
create our economy. A complex and open economy is one that is divided into sectors:
the financial market, government sector and the foreign sector. In that economy, there
are leakages and injections which are the exchanges of income in and out of the
model. Leakages express how income flows out or is lost whereas injections express
how income flows into the economy. Functions are ways to which these leakages and
injections occur in our society. Examples of functions in leakages are taxes, imports,
and savings and injections in the firms are government expenditures, exports and
investments. Within each sector there is a pair in the household branch and the firm
branch: savings are the equivalent of investments in the financial market, taxes are the
equivalent of government expenditures in the government sector and imports are the
equivalent of exports in the foreign sector. These agents are dependent on one
another for the households provide the firms with workers/they consume goods and
services, and the firms provide those good and services to the households. Without
firms, there would be no money/income flowing into the economy causing income to
be reserved solely for personal purposes, which might create solely leakages. The
best example of the agent’s interdependence is during imports and exports. There
needs to be imports from the foreign sector in order to an economy to establish foreign
relations but there also needs to be exports to bring in money into the economy, in
order to grow it.

As you can see from

the ‘circular’ flow of
income, everything is
connected and
dependent on one
another, making one
whole system.

[10 marks]
2. Explain how the price mechanism will move the market for an inferior good to a new
equilibrium after an increase in average consumer income.

Market equilibrium is the intersection of supply and demand, the balance of supply and
demand in a market. When the market isn’t balanced, we say there is disequilibrium
and in order to reestablish equilibrium, the price mechanism is used. The price
mechanism is the system which expresses how pricing affects and changes the supply
and demand of a good or service. Within an inferior good, which is the declination of a
product after income rises, the price mechanism will signal, incentive, relocate or
ration the product. When the average income of consumers increases, the
accessibility of products of higher increases as well, causing cheaper goods to turn
inferior. When referring to the price mechanism, the scarcity of a product is usually
referred. When a shift in income occurs, the price mechanism signals to consumers
and producers the decrease in demand for a certain product creating a new
equilibrium in pricing and production of a certain good. In this case the incentive
decreases as there are lack of profit off the inferior good and more towards other
goods. This then causes the product to be relocated to areas with below average
income, in order to still sustain profit off the product, consequently rationalizing it. Take
for example off brand cereal, once the average income increases, the appeal of off
brand cereal will decrease causing it to become an inferior good. Once that occurs,
the pricing mechanism signals this change in preference to producers causing the
product to decrease in supply, increasing scarcity. The cereal is then relocated to
below average income making homes in order to incentivize some profit off the
product and ration it out.

Due to a decrease in the

demand/supply for the
off-brand cereal, there is
bound to be a decrease
in price as well.

[10 marks]

[Total: 20 marks]