Worked Solutions
Topic 2: Consumers and Business — Worked Solutions (Preliminary Economics)
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Worked examples for Topic 2 of Preliminary Economics. Each shows where the marks are awarded, the key idea, and the full solution explained by your choice of tutor — Stella, Ella or Cassie.
How to use these
Try each question first, then check your working. Use the tutor tabs to read the full solution in the style that suits you: Stella is direct and challenging, Ella is warm and explains the why, and Cassie is concise and analytical.
Example 1 — Average propensity to consume and save
Question
A household earns a disposable income of \$60 000 per year and spends \$48 000 of it on goods and services.
(a) Calculate the household's average propensity to consume (APC). (1 mark)
(b) Calculate the average propensity to save (APS) and explain what it tells us about this household. (2 marks)
Solution
(a) APC is the share of disposable income that's spent: $APC = \dfrac{C}{Y_d} = \dfrac{48\,000}{60\,000} = 0.8$.
(b) Whatever isn't consumed is saved, so $APS = 1 - APC = 1 - 0.8 = 0.2$. Check it directly: savings are $60\,000 - 48\,000 = 12\,000$, and $\dfrac{12\,000}{60\,000} = 0.2$.
An APS of 0.2 means the household saves 20 cents of every dollar of disposable income. Remember the identity $APC + APS = 1$ — disposable income is either spent or saved, nothing else, so the two always sum to one.
(a) The average propensity to consume tells us what proportion of a household's disposable income goes on consumption. We divide spending by income: $APC = \dfrac{C}{Y_d} = \dfrac{48\,000}{60\,000} = 0.8$. So 80% of income is spent.
(b) Anything not spent must be saved, so the average propensity to save is $APS = 1 - APC = 1 - 0.8 = 0.2$. You can confirm it from scratch: savings $= 60\,000 - 48\,000 = 12\,000$, and $\dfrac{12\,000}{60\,000} = 0.2$.
What does 0.2 mean? For every dollar of disposable income, this household sets aside 20 cents. The reason APC and APS always add to 1 is that disposable income has only two possible destinations — it's either consumed or saved — so the fractions going to each must cover the whole.
(a) $APC = \dfrac{C}{Y_d} = \dfrac{48\,000}{60\,000} = \mathbf{0.8}$.
(b) $APS = 1 - APC = \mathbf{0.2}$.
- Check: $S = 60\,000 - 48\,000 = 12\,000$; $\dfrac{12\,000}{60\,000} = 0.2$. ✓
- Meaning: 20c of every \$1 of disposable income is saved.
- Identity: $APC + APS = 1$ (income is either consumed or saved).
Where the marks go
- 1 mark: Correctly calculates APC = 0.8
- 1 mark: Correctly calculates APS = 0.2
- 1 mark: Explains that APS shows the proportion of disposable income saved (20 cents per dollar)
Key idea
Disposable income is either consumed or saved, so APC + APS = 1; APC is the spent share and APS the saved share.
Example 2 — Sources of income and business decisions
Question
(a) Distinguish between income earned from labour and income earned from the ownership of capital, giving an example of each. (2 marks)
(b) Explain how the goal of maximising profit influences a firm's decisions about price and output. (3 marks)
Solution
(a) Labour income is the return for supplying your labour — wages and salaries. Example: a nurse's annual salary. Income from capital is the return for owning a productive asset. Example: rent from an investment property, or dividends from shares. The line is clear: labour income is payment for effort, capital income is payment for ownership.
(b) A profit-maximising firm wants the biggest gap between total revenue and total cost. That shapes two decisions:
- Output — the firm expands production while each extra unit adds more to revenue than to cost, and stops once the next unit would add more cost than revenue.
- Price — the firm sets the price the market will bear for that level of output; it won't price so high that sales collapse, nor so low that it leaves profit on the table.
Profit is the disciplining goal: every pricing and output choice is judged by whether it widens revenue over cost.
(a) The difference comes down to what is being rewarded. Labour income is what people earn for the work they do — their wages and salaries. A teacher's salary is a good example. Income from capital is the reward for owning an asset that helps produce goods and services — like the rent a landlord receives, or dividends paid to a shareholder. So labour income rewards effort and time; capital income rewards ownership of a productive resource.
(b) Firms in the private sector typically aim to maximise profit, which is total revenue minus total cost. This goal guides them in two linked ways:
- Output decisions — the firm keeps producing as long as selling one more unit brings in more than it costs to make. Once an extra unit would cost more than it earns, expanding would shrink profit, so the firm stops there.
- Pricing decisions — the firm chooses a price that, given how much customers will buy at each price, returns the largest possible profit. Set it too high and customers walk away; too low and the firm sacrifices revenue it could have captured.
In short, the profit goal acts like a compass: each decision about how much to make and what to charge is steered toward the widest possible gap between revenue and cost.
(a)
- Labour income — reward for supplying labour (wages/salaries). Example: a nurse's salary.
- Capital income — reward for owning a productive asset. Example: rent from property; dividends from shares.
- Distinction: effort vs ownership.
(b) Profit = TR − TC; firm maximises the gap.
- Output: expand while extra revenue > extra cost; stop when extra cost > extra revenue.
- Price: set the price that yields greatest profit given demand — not so high sales collapse, not so low revenue is lost.
- Profit goal disciplines both choices.
Where the marks go
- 1 mark: Defines labour income with a valid example (wages/salary)
- 1 mark: Defines capital income with a valid example (rent/dividends/interest)
- 1 mark: States profit = total revenue − total cost as the firm's goal
- 1 mark: Explains the output decision in terms of comparing extra revenue and extra cost
- 1 mark: Explains the pricing decision in terms of maximising profit given demand
Key idea
Labour income rewards effort while capital income rewards ownership; a profit-maximising firm sets output and price to widen the gap between revenue and cost.