caf2 intorduction to economics and finance questionbank

2015

INTRODUCTION TOECONOMICS AND FINANCEQUESTION BANK

CAF-02

Question Bank IC

AP

P

Introduction to economics and finance

© Emile Woolf International ii The Institute of Chartered Accountants of Pakistan

Second edition published by Emile Woolf Limited Bracknell Enterprise & Innovation Hub Ocean House, 12th Floor, The Ring Bracknell, Berkshire, RG12 1AX United Kingdom Email: [email protected] www.emilewoolf.com © Emile Woolf International, January 2015 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, without the prior permission in writing of Emile Woolf Publishing Limited, or as expressly permitted by law, or under the terms agreed with the appropriate reprographics rights organisation. You must not circulate this book in any other binding or cover and you must impose the same condition on any acquirer. Notice Emile Woolf International has made every effort to ensure that at the time of writing the contents of this study text are accurate, but neither Emile Woolf International nor its directors or employees shall be under any liability whatsoever for any inaccurate or misleading information this work could contain.

© Emile Woolf International iii The Institute of Chartered Accountants of Pakistan

Certificate in Accounting and Finance Introduction to economics and finance

C

Contents

Page

Question and Answers Index v

Questions

Section A Multiple choice questions 1

Section B Objective test and long-form questions 25

Answers

Section C Multiple choice answers 55

Section B Objective test and long-form answers 65

© Emile Woolf International v The Institute of Chartered Accountants of Pakistan


I

Index to Objective test and long-form questions and

answers

QUESTION

PAGE ANSWER

PAGE

CHAPTER 1 – ECONOMIC CONCEPTS

1.1 FACTORS OF DEMAND 25 66

1.2 PRODUCTION POSSIBILITY CURVE 25 67

1.3 ECONOMIC GROWTH 25 67

1.4 ISLAMIC ECONOMIC SYSTEM 27 68

CHAPTER 2 - MICROECONOMICS

2.1 TYPES OF GOODS 27 69

2.2 QUANTUM OF SUPPLY OF A PRODUCT 27 69

2.3 MOVEMENT 27 70

2.4 A MARKET ECONOMY 27 71

CHAPTER 3 – DEMAND AND SUPPLY: ELASTICITIES

3.1 ELASTICITY OF DEMAND 27 73

3.2 ELASTICITY OF DEMAND 2 27 74

3.3 ELASTICITY OF DEMAND 3 28 75

3.4 CALCULATE PEDS 28 76

3.5 CONCEPTS OF DEMAND 28 76


© Emile Woolf International vi The Institute of Chartered Accountants of Pakistan

QUESTION

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3.6 COFFEE MARKET 28 78

3.7 COMPETITIVE GOODS AND COMPLEMENTARY GOODS

29 79

3.8 PRICE ELASTICITY OF SUPPLY 29 81

3.9 CROSS ELASTICITY OF DEMAND 29 81

3.10 PRICE ELASTICITY OF DEMAND 29 82

3.11 TOTAL EXPENDITURE METHOD 29 82

3.12 PROPORTIONATE OR PERCENTAGE METHOD

29 82

3.13 GEOMETRICAL METHOD 29 83

3.14 NUMERICAL EXERCISE: PRICE ELASTICITY OF DEMAND

29 85

3.15 IMPORTANCE OF PRICE ELASTICITY OF DEMAND

30 85

CHAPTER 4 – UTILITY ANALYSIS

4.1 CONSUMER’S EQUILIBRIUM 30 87

4.2 INDIFFERENCE CURVES 30 88

4.3 CONCEPTS 30 89

4.4 PRICE EFFECT 31 90

4.5 INCOME EFFECT 31 91

4.6 SUBSTITUTION EFFECT 31 92

4.7 LAW OF DIMINISHING UTILITY 31 92

4.8 INDIFFERENCE CURVES 1 31 93

4.9 INDIFFERENCE CURVES 2 31 94

4.10 MARGINAL RATE OF SUBSTITUTION 31 96

CHAPTER 5 – COSTS, REVENUES AND FIRMS

5.1 MONOPOLIST PROFIT 32 98

5.2 PERFECT COMPETITION 32 99

5.3 INCREASING RETURNS 32 100

Index to questions and answers

© Emile Woolf International vii The Institute of Chartered Accountants of Pakistan

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5.4 LARGE FIRMS 32 100

5.5 THE SCALE OF PRODUCTION 32 102

5.6 MONOPOLY AND COMPETITION 34 103

5.7 PROFIT MAXIMISATION AND DEMAND ANALYSIS

35 104

5.8 REVENUES AND COSTS 36 105

5.9 COSTS AND REVENUES 36 106

5.10 TYPES OF COSTS 36 107

5.11 MONOPOLY SETUP 36 108

5.12 CONSUMPTION GOODS 36 108

5.13 EQUILIBRIUM OF THE FIRM 37 109

5.14 MARKET FUNCTIONING 37 110

5.15 FREE FORCES 37 111

5.16 PRICE OUTPUT DETERMINATION 37 112

5.17 OLIGOPOLY AND DUOPOLY: DIFFERENCE

37 113

5.18 PRICE CARTELS AND COLLUSION 37 113

5.19 PRICE LEADERSHIP 37 114

5.20 KINKED DEMAND CURVE 37 114

5.21 NON-PRICE COMPETITION 37 114

CHAPTER 6 – MACROECONOMICS INTRODUCTION

6.1 NATIONAL INCOME 38 114

6.2 MEASURING NATIONAL INCOME 38 115

6.3 CIRCULAR FLOW OF INCOME 38 117

6.4 INJECTIONS AND WITHDRAWALS 38 118

6.5 AGGREGATE SUPPLY: SHORT RUN 38 119

6.6 AGGREGATE SUPPLY: LONG RUN 38 120

6.7 AGGREGATE DEMAND 39 120


© Emile Woolf International viii The Institute of Chartered Accountants of Pakistan

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6.8 MACROECONOMIC EQUILIBRIUM: RECESSION - KEYNESIAN

39 122

6.9 MACROECONOMIC EQUILIBRIUM: INFLATIONARY GAP

39 123

6.10 DEFLATIONARY GAP 39 124

6.11 CALCULATION OF GDP 1 39 126




CHAPTER 7 – CONSUMPTION, SAVINGS AND INVESTMENT

7.1 CIRCULAR FLOW OF INCOME 41 130

7.2 INVESTMENT AND MEC 42 131

7.3 CONSUMPTION FUNCTION 42 132

7.4 PRIVATE INVESTMENT 42 133

CHAPTER 8 – MULTIPLIER AND ACCELERATOR

8.1 MULTIPLIER 43 134

8.2 MULTIPLIER 1 43 134

8.3 MULTIPLIER 2 43 135

8.4 ACCELERATOR QUESTION 44 136

CHAPTER 9 – MONEY

9.1 THE MONEY SUPPLY 45 138

9.2 MONEY SUPPLY AND QUANTITY THEORY

45 139

9.3 IMPORTANT FUNCTIONS 46 141

9.4 UNEMPLOYMENT 46 142

9.5 PHILLIPS CURVE 46 143

9.6 LIQUID FORM 46 144

9.7 MONEY FUNCTIONS 46 145

Index to questions and answers

© Emile Woolf International ix The Institute of Chartered Accountants of Pakistan

QUESTION

PAGE ANSWER

PAGE

CHAPTER 10 – GROWTH AND TAXES

10.1 INDIRECT TAXES 46 146

10.2 MACROECONOMIC POLICY 46 146

10.3 DIRECT AND INDIRECT TAXATION 47 147

10.4 TRADE CYCLE 47 150

10.5 MIXED ECONOMY 48 151

10.6 GROWTH RECESSION INDICATORS 48 152

10.7 ECONOMIC POLICY OBJECTIVES 48 153

10.8 AGGREGATE DEMAND AND AGGREGATE SUPPLY

48 154

CHAPTER 11 – MONETARY POLICY

11.1 FINANCIAL INTERMEDIATION 48 155

11.2 THE CENTRAL BANK 48 155

11.3 MONEY MARKETS 48 157

11.4 INTEREST RATE RISE 49 157

11.5 TYPES OF BANKS 49 157

11.6 CENTRAL BANKS 49 158

11.7 MONETARY POLICY 1 49 159

11.8 MONETARY POLICY 2 49 160

11.9 MONETARY AND FISCAL POLICY 49 161

CHAPTER 12 – CREDIT

12.1 CREDIT 50 161

12.2 BANKS 50 162

12.3 COMMERCIAL BANKS AND CREDIT CREATION

50 163

CHAPTER 13 – BALANCE OF PAYMENTS AND TRADE

13.1 A BALANCE OF PAYMENTS DEFICIT 51 165

13.2 BALANCE OF PAYMENT AND BALANCE OF TRADE

51 166


© Emile Woolf International x The Institute of Chartered Accountants of Pakistan

QUESTION

PAGE ANSWER

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13.3 BALANCE OF PAYMENTS 51 167

13.4 DISEQUILIBRIUM 51 167

13.5 BALANCE OF PAYMENTS: COMPONENTS 51 168

13.6 CURRENT ACCOUNT DEFICIT CAUSES 51 169

13.7 CURRENT ACCOUNT DEFICIT NONMONETARY MEASURES

52 169

13.8 CURRENT ACCOUNT DEFICIT MONETARY MEASURES

52 170

13.9 OPEN MARKET OPERATIONS 52 171

13.10 CHANGE IN EXCHANGE RATES 52 171

CHAPTER 14 – FINANCIAL MARKETS

14.1 USE OF MONEY AND CAPITAL MARKETS 52 171

14.2 DERIVATIVES 52 172

14.3 CAPITAL MARKET 53 173

14.4 CAPITAL MARKET INSTRUMENTS 53 174

© Emile Woolf International 1 The Institute of Chartered Accountants of Pakistan


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Multiple choice questions


1 Which of the following is not a factor of production?

A Land

B Labour

C Money

D Entrepreneurship

2 Which of the following is not an economic resource?

A Air

B Water

C Sulphuric acid

C Books

3 Which of the following concepts is NOT illustrated by the Production Possibility

Curve?

A Efficiency

B Opportunity cost

C Equity

D Trade-off

4 Which of the following are regarded as withdrawals from the circular flow of income?

A Saving and taxation

B Export and import

C Investment and saving



5 The curvature of the Production Possibility Curve is due to:

A change in opportunity cost

B increase in resources

C decrease in demand

D decrease in supply

6 Which one of the following is a basic economic problem?

A Unlimited wants and scarce resources

B Lower incomes and higher indirect taxes

C Unemployment and inflation

D Recession


7 All of the following are determinants of supply except:

A price

B income level

C level of technology

D objectives of the firms

8 The demand curve slopes downward because of:

A consumer indifference

B elasticity of demand

C inelastic demand

D law of diminishing marginal utility

9 The supply curve of a factor for a firm that is in perfect competition in the input market

is:

A elastic

B inelastic

C perfectly elastic

D perfectly inelastic

10 Which ONE of the following will cause the demand curve for a good to move to the

right (outwards from the origin)?

A A decrease in the costs of producing the good

B A fall in the price of the good

C An increase in the price of a complementary good

D An increase in the price of a close substitute good

Question bank: Multiple choice questions


11 When only a small proportion of a consumer's income is spent on a good,

A the demand for the good will be highly price elastic

B the good is described as 'inferior'

C a rise in the price of the good will strongly encourage a search for substitutes

D the demand for the good will be price inelastic

12 When the price of a good is held above the equilibrium price, the result will be

A excess demand

B a shortage of the good

C a surplus of the good

D an increase in demand

13 The demand for and supply of a good are in equilibrium. An indirect tax is levied on

the good. Which one of the following will show the new equilibrium?

A A shift in the supply curve to the right

B A shift in the demand curve to the right

C A shift in the supply curve to the left

D A shift in the demand curve to the left

14 A shift to the right in the supply curve of a good, the demand remaining unchanged,

will reduce its price to a greater degree

A the more elastic the demand curve

B the less elastic the demand curve

C the nearer the elasticity of demand to unity

D the more elastic the supply curve


15 Which of the following products is likely to have the lowest price elasticity of demand?

A Salt

B Cars

C Houses

D Apples

16 Which statement is true of a curve with a constant slope?

A It is a straight line

B It is non linear

C It runs parallel to Y-axis

D It runs parallel to X-axis



17 Production and employment in which of the following industries would be least

affected by recession?

A Sugar

B Steel

C Garments

D Vehicles

18 If the market price of a product increases from Rs. 35 to Rs. 40 and in response, the

quantity demanded decreases from 1400 units to 1200 units, the value of its price elasticity of demand is:

A 0.9

B 1

C 1.1

D 1.2

19 Which of the following is NOT a method for the measurement of price elasticity of

demand?

A Total outlay

B Total savings

C Point method

D Arc method

20 If the price of a good fell by 10% and, as a result, total expenditure on the good FELL

by 10%, the demand for the good would be described as

A perfectly inelastic

B perfectly elastic

C unitary elastic

D elastic

21 Which one of the following statements about the elasticity of supply is not true?

A It tends to vary with time.

B It is a measure of the responsiveness of supply to changes in price.

C It is a measure of changes in supply due to greater efficiency.

D It tends to be higher for manufactured goods than for primary products.

22 If the demand for a good is price inelastic, which ONE of the following statements is

correct?

A If the price of the good rises, the total revenue earned by the producer increases.

B If the price of the good rises, the total revenue earned by the producer falls.

C If the price of the good falls, the total revenue earned by the producer increases.

D If the price of the good falls, the total revenue earned by the producer is unaffected.



23 An inferior good is one which has an income elasticity of demand that is

A positive but less than unity

B negative

C unitary

D zero

24 A business, currently selling 10,000 units of its product per month, plans to reduce

the retail price from £1 to £0.90. It knows from previous experience that the price elasticity of demand for this product is -1.5.

Assuming no other changes, the sales which the business can now expect will be

A 8,500 units

B 9,000 units

C 11,000 units

D 11,500 units

25 If the demand for a good is price elastic, a fall in price will lead to

(i) a rise in sales

(ii) a fall in sales

(iii) a rise in total expenditure on the good

(iv) a fall in total expenditure on the good

Which of the above are correct?

A (i) and (iii) only

B (i) and (iv) only

C (ii) and (iii) only

D (ii) and (iv) only

26 The price elasticity of supply means the

A change in supply divided by price

B responsiveness of the quantity supplied to a change in price

C responsiveness of the quantity supplied to a change in demand

D time taken for supply to adjust to a change in price

27 Price elasticity coefficient of 0.2 implies that the %age change in quantity for a 5%

change in price will be:

A 0.2

B 2.5

C 5

D 1



28 Assume that a fall in price of a commodity form Rs10 to Rs.9 per unit results in an

increase in weekly sales from 100 units to 110 units. Price elasticity of demand would be:

A 1.9

B Unity

C 2

D Zero

E 0.9

F 0.1

29 Very small or zero Co-efficient of price elasticity of demand means that the good is:

A a necessity

B a comfort

C a luxury

D any of the above

E none of the above.

30 The standard measure for measuring demand and supply elasticity is

A Zero

B Unity

C Infinity

D Two

31 The income elasticity of demand for an income inferior good has an arithmetic sign.

A Positive

B Zero

C Negative

D No sign

32 From the demand schedule below, the price elasticity of demand following a fall in

price from Rs 25 to Rs. 20 is:

Price (Rs.) Quantity (units)

30 15

25 20

20 25

15 30

A -1

B -1.25

C -1.50

D -1.75



33 If the price of a good fell by 20% but total expenditure on the good remained the

same, the demand curve could be described as

A Perfectly elastic

B Elastic

C Perfectly inelastic

D Unitary elasticity

34 Prices are most volatile when:

A supply is elastic, demand is elastic

B supply is inelastic, demand is inelastic

C supply is elastic, demand is inelastic

D supply is inelastic, demand is elastic


35 Which statement is true, in respect of every point on an indifference curve?

A The price of each good is the same.

B The level of satisfaction is the same.

C All of these statements are true.

D None of these statements is true.

36 Which of the following best defines marginal utility?

A The satisfaction of a want that results from consuming a good or service.

B The change in total utility as a result of consuming an additional unit of a product.

C The ability to buy more of a product or service when real income increases.

D The decrease in satisfaction that results from consuming an additional unit of a product.

37 With the principle of diminishing marginal utility in effect, increasing consumption will:

A lower total utility

B produce negative total utility

C lower marginal utility, and therefore total utility

D lower marginal utility, but may increase total utility

38 If a consumer’s marginal rate of substitution equals 2 apples for 1 carrot

A the consumer’s indifference curve will be positively sloped

B the consumer’s indifference curve will be convex to the origin

C the ratio of marginal utility of 1 apple must be ½ of 1 carrot

D all of the above



39 If all prices remain constant, an increase in income results in

A an increase in the slope of the budget line

B a decrease in the slope of the budget line

C an increase in the intercept of the budget line

D a decrease in the intercept of the budget line

E Both a and c

40 Indifference curve for the consumer is always:

A Concave

B Straight

C Convex to Origin

D Upward Sloping

41 Shift in consumer equilibrium due to change in price is called:

A Price effect

B Income effect

C Substitution effect

D None of the above

42 Marginal rate of substitution of X for Y along an ordinary indifference curve is:

A Diminishing

B Increasing

C Constant

D All of the above

E None of the above

43 The budget line of a consumer explains various combinations of two commodities

that:

A are actually purchased at market prices

B can be purchased at market prices

C equate consumers’ expenditure to his money income

D b and c above

E None of the above.


44 Under perfect market conditions, the supply curve of a firm is the same as:

A MC curve

B MR curve

C AR curve

D AC curve



45 In a perfectly competitive market ___________ is/are the price maker(s):

A the individual firm

B the industry

C a large number of consumers

D the trade association

46 Which of the following is NOT included in the explicit costs of a firm?

A Wages paid to labour

B Interest paid for borrowed capital

C Payments for purchases of materials

D Normal profit

47 Monopoly power may be based on:

A economies of large scale production

B patents

C control of key natural resources

D all of the above

48 Which of these is NOT a component of cost function of a product?

A Market price of the product

B Operating technology of the plant

C Operating capacity

D All of the above

49 The demand for a Factor of Production is called:

A quantity demand

B derived demand

C factor price

D cost of production

50 As its output increases, a firm’s short-run marginal cost will eventually increase

because of:

A diseconomies of scale

B a lower product price

C the firm’s need to break even

D diminishing returns



51 A firm that breaks even after all the economic costs are paid, is earning:

A economic profit

B no profit

C normal profit

D super normal profit

52 When diminishing returns begin to operate, the total variable cost curve will start to

A fall at an increasing rate

B rise at a decreasing rate

C fall at a decreasing rate

D rise at an increasing rate

53 Marginal cost is best defined as

A the difference between total fixed costs and total variable costs.

B costs which are too small to influence prices.

C the change in total costs when output rises by one unit.

D fixed costs per unit of output.

54 The 'law of diminishing returns' can apply to a business only when

A all factors of production can be varied.

B at least one factor of production is fixed.

C all factors of production are fixed.

D capital used in production is fixed.

55 Which of the following always rise when a manufacturing business increases its

output?

(i) fixed costs

(ii) marginal cost

(iii) average variable cost

(iv) total costs

A (i) and (ii) only

B (ii) and (iii) only

C (iii) and (iv) only

D (iv) only

56 The minimum price needed for a firm to remain in production in the short run is equal

to

A average fixed cost

B average variable cost

C average total cost

D marginal cost



57 A business employs 11 workers at a wage of £24 per day. To attract one more worker

it raises the wages to £25 per day.

The marginal cost of employing the extra worker is

A £1

B £12

C £25

D £36

58 The long-run average cost curve for a business will eventually rise because of

A the law of diminishing returns

B increasing competition in the industry

C limits to the size of the market for the good

D diseconomies of scale

59 Economies of scale

A can be gained only by monopoly firms

B are possible only if there is a sufficient demand for the product

C do not necessarily reduce unit costs of production

D depend on the efficiency of management

60 If the total cost curve is plotted, marginal cost curve can be illustrated by:

A U shapes curve cutting the total cost curve from its minimum point.

B a straight line cutting the curve at its lowest point.

C a straight line cutting the curve at its lowest point

D the slope of a tangent to the curve at any given output.

61 A firm, in the short run, would stop production if:

A marginal cost was equal to marginal revenue

B total costs were equal to total revenue

C total revenue were less than total variable cost

D total revenue were less than total fixed cost

E variable cost were to rise above fixed costs

62 The long term shape of the average cost curve is due to:

A economies of scale

B variable proportions

C change in technology

D imperfect competition

E diseconomies of the scale

F a and e

G b and d

H none of the above



63 In a diminishing cost industry, an increase in industry output causes the Average total

cost curve of a typical firm to shift:

A Upward

B Downward

C To the right

D To the left

64 In an increasing cost industry, an increase in output causes the Average total cost

curve of a typical firm to shift.

A To the left

B To the right

C Downward

D Upward

65 What does it mean to say that firms in an oligopoly are interdependent?

A The firms must charge identical prices for the products

B The firms economic profits must equal zero in the long run

C Barriers block the entry of new firms into the industry

D The output price decisions of one firm affect the output price decisions of other firms in the industry

66 Marginal cost curve intersects Average total cost curve at:

A the minimum point of ATC

B the minimum point of MC

C the minimum points of both the MC and ATC

D all of the above

E none of the above.

67 Duopoly is a special case of which of the following:

A Perfect competition

B Monopoly

C Monopolistic competition

D Oligopoly

E None of the above

68 Oligopoly is a type of market organization in which there exists:

A a single firm

B two firms

C a large number of firms

D few firms



69 Which of the following distinguishes oligopoly market from other forms of market

organization?

A Interdependence of producers

B Differentiated products

C Many firms in a small market

D Firms are price takers

E Price discrimination

70 Which of the following describes the dominant firm model?

(I) The dominant firm produces at the intersection of market demand by its MC curve.

(II) The small firms are price takers. (III) The dominant firm’s demand curve is derived by subtracting output supplied

by small firms from total market demand.

A II only

B III only

C I only

D II and II

E None of the above

71 All members of a cartel:

A produce at the same average cost

B produce where their MC equals price

C adopt independent price and output policy

D share the market equally

E None of the above

72 A cartel is a collusive agreement:

A among largest firms in an industry

B among smallest firms in an industry

C sanctioned by the government

D among firms to increase profit by reducing output

73 Duoplists producing homogeneous products will in the long run charge:

A uniform price

B different prices

C any of the above

D none of the above




74 Which of the following is a measure of income earned by a factor of production?

A Indirect taxes

B Depreciation

C Rent

D Corporate taxes

75 In the long-run, price is determined by:

(a) cost of production

(b) number of consumers

(c) influence of tastes and fashion

(d) competitive forces

76 The aggregate demand curve would shift to the right if:

A government taxes increase

B net exports increase

C government spending decreases

D the nominal money supply decreases

77 Which of the following topics are studied in Macro Economics?

A Theory of Demand

B Aggregate Demand and Aggregate Supply

C Equilibrium of Industry

D None of the above

78 Which of the following would decrease aggregate demand?

A Increased investment

B Increase in export revenue

C Increased taxation

D Increased consumption

79 A prolonged and deep recession is called:

A Hyperinflation

B Depression

C Stagflation

D Great depression

80 The aggregate supply curve:

A is the sum of the individual supply curves in the economy

B is a market supply curve

C embodies the same logic that lies behind an individual firm’s supply curve

D none of the above



81 Which of the following represent withdrawals from the circular flow of national

income?

(i) Distributed profits

(ii) Interest paid on bank loans

(iii) Income tax payments

(iv) Imports

A (i) and (ii) only

B (ii) and (iii) only

C (i) and (iii) only

D (iii) and (iv) only

82 An isolated island community produces only one good, fish. In a typical week the

island's fishermen manage to earn £800 selling their catch to the island's fish wholesaler. She, in turn, sells the catch to the island's two fish shops for a total of £1,200. To make a profit and pay wages to their employees the two shopkeepers sell the fish to the island's population for £1,500.

What will be the value of the island's output over the course of a year (52 weeks)?

A £140,400

B £182,000

C £78,000

D £36,400

83 An inflationary gap exists in an economy when

A the government has a budget deficit

B aggregate demand is greater than the full employment level of income

C withdrawals exceed injections at the full employment level of income

D the money supply rises faster than national income

84 Which ONE of the following would cause a fall in the level of aggregate demand in an

economy?

A A decrease in the level of imports

B A fall in the propensity to save

C A decrease in government expenditure

D A decrease in the level of income tax


85 When will savings increase in a country?

A When interest rate rises

B When inflation increases

C When more credit cards are issued by the banks

D When production of consumer goods decreases



86 An inflationary gap exists in an economy when

A the government has a budget deficit

B aggregate demand is greater than the full employment level of income

C withdrawals exceed injections at the full employment level of income

D the money supply rises faster than national income

87 Which of the following is likely to shift the marginal efficiency of capital (MEC)

schedule to the right?

(1) An increase in the supply of funds available

(2) Introduction of cost reducing technology

(3) A reduction of government subsidies on investment

A l only

B 2 only

C 3 only

D l and 2 only

88 Which of the following statements does not reflect the Keynesian view of the

economy?

A The economy will naturally settle at a level of output that ensures full employment

B Government can move the economy towards full employment by managing aggregate demand

C Measures to stimulate private consumption will raise the level of income

D The level of aggregate monetary demand will affect the level of income

89 Which of the following describes the effect of improved technology on the marginal

efficiency of capital curve?

A It will shift it to the left

B It will shift to the right

C The curve will be unaffected

D The curve will become more inelastic


90 Which of the following factor is not used in the multiplier formula for the open

economy?

A Marginal propensity to save

B Marginal propensity to import

C Marginal propensity to tax

D Marginal propensity to export



91 The concept of the Multiplier discusses:

A Savings and investments

B Income and investments

C Income and expenditure

D Income and savings

92 In an economy where, out of every extra £100 of national income, £25 is paid in tax,

£10 is spent on imports and £15 is saved, the value of the multiplier will be

A 2

B 2.5

C 5

D 10

93 Which of the following is the basic concept which underlies the accelerator theory of

investment?

A Investment depends on the level of savings

B Investment is inversely related to the rate of interest

C Investment is determined by the volume of commercial bank lending

D Investment rises when there is an increase in the rate of growth of demand in the economy

94 In a given economy, of each additional £1 of income, 30% is taken in taxes, 10% is

spent on imports and 40% is spent on domestically produced goods.

The multiplier is:

A 2.5

B 1.67

C 1.25

D 0.6

CHAPTER 9 – MONEY

95 Money does NOT function as a:

A medium of exchange

B hedge against inflation

C store of value

D measure of value

96 Which of the following is not a function of money?

A Store of value

B Unit of account

C Standard of deferred payment

D Payment of interest



97 The term “Precautionary motive” has been discussed in:

A Quantity theory of money

B Theory of consumer behaviour

C Liquidity preference theory

D Multiplier accelerator theory

98 Which of the following is not one a Keynesian motive for holding money?

A Investment motive

B Precautionary motive

C Speculative motive

D Transaction motive

99 On a short-run Phillips Curve, high rates of inflation coincide with:

A low interest rates

B high unemployment rates

C low unemployment rates

D low discount rates

100 Which of the following would reduce inflation?

A An increase in direct taxes

B An increase in indirect taxes

C Increase in government spending

D Increase in income

101 In the Keynesian theory of demand for money, the transactions demand for money is

determined by:

A the rate of interest

B the level of consumers’ income

C expected changes in consumer prices

D the amount of money in circulation

102 Which of the following is NOT a method of holding wealth?

A Bonds and equities

B Human wealth

C Consumer durables

D Commodities

103 According to the theory underlying the Phillips Curve:

(i) the rate of change in money 0wages is positively correlated with the level of unemployment.

(ii) there is a natural rate of unemployment in the economy.

(iii) money wage stability is only possible at full employment.

(iv) the rate of change in money wages is negatively correlated with the level of unemployment.



Which of the above statements is correct?

A (ii) and (iv)

B (i), (ii) and (iii)

C (i), (iii) and (iv)

D (iv) only

104 Which of the following is most likely to lead to a fall in the money supply?

A A fall in interest rates

B Purchases of government securities by the central bank

C Sales of government securities by the central bank

D A rise in the amount of cash held by commercial banks

105 According to Keynesian liquidity preference theory, an increase in the money supply

will

(i) raise the price of financial assets

(ii) reduce the price of financial assets

(iii) lower the rate of interest

(iv) increase the quantity of money people are willing to hold

Which of the above are correct?

A (i), (iii) and (iv) only

B (ii), (iii) and (iv) only

C (i) and (iii) only

D (ii) and (iii) only


106 Fiscal deficit can be controlled by reducing:

A Taxes

B Imports

C Unemployment

D Public expenditure

107 Which of the following is a direct tax?

A Sales tax

B Capital gains tax

C Federal excise duty

D Value added tax



108 Which of the following is an example of indirect tax?

A Income tax

B Sales tax

C Capital gains tax

D Property tax

109 The four main phases of a business cycle does NOT include:

A Depression

B Inflation

C Boom

D Recession

110 Which one of the following is NOT a feature of a good tax system?

A It should be equitable

B It should be economical

C The rate should be same for everybody

D It should be certain

111 Economic growth in an industrial society results from:

A Technological change

B Innovation

C Capital production

D All of the above


112 Which of the following is a financial intermediary?

A Pension fund

B International Monetary Fund

C State Bank of Pakistan

D Stock exchange

113 Which of the following is NOT considered to be a credit instrument?

A IOU

B Draft

C Bond

D Stock



114 Which one of the following is NOT an asset of a commercial bank?

A Balances at the central bank

B Money at call

C Customers' deposits

D Advances to customers

115 Which of these appears as a liability on a bank’s balance sheet?

A Reserves

B Checking accounts

C Loans

D Investments and securities

116 If the Reserve Ratio is 40%, and Rs.10,000 is deposited in a commercial bank, what

is the final outcome for the economy?

A Rs. 4,000

B Rs. 10,000

C Rs. 25,000

D Rs. 40,000

117 Which of the following is NOT the function of a central bank?

A Lender of the last resort

B Monetary policy

C Fiscal policy

D Credit creation

118 Which of the following is a central bank unable to do?

A Influence banks to tighten or loosen their credit policies

B Create a climate of monetary ease or restraint

C Directly set market interest rates

D Influence the interest rate on new treasury bonds

119 To counteract a recession, the Central Bank should:

A raise the reserve requirement and the discount rate

B sell securities on the open market and lower the discount rate

C buy securities on the open market and raise the discount rate

D buy securities on the open market and lower the discount rate

120 An increase in the Cash Reserve Ratio would:

A decrease prices

B reduce inflation

C control lending

D all the above




121 Which of the following is most likely to be affected by a change in interest rates?

A Consumer spending

B Investment spending

C Government spending

D Exports

122 A stimulative fiscal policy combined with a restrictive monetary policy will necessarily

cause:

A gross domestic product to increase

B gross domestic product to decrease

C interest rate to fall

D interest rates to rise

123 The government makes a new issue of bonds and sells them on the open market,

where they are bought by private investors using cheques drawn on their banks.

Which of the following describes the effect this has on the commercial banks?

A They can raise lending because their cash base will rise.

B There is no effect on bank lending.

C They must cut lending to maintain an appropriate ratio of cash to loans.

D They will only be able to increase long term loans.


124 If the American dollar is overvalued relative to the Pakistan rupee:

A Pakistani goods are cheaper than US goods.

B the Pakistan rupee is undervalued relative to the dollar.

C the rupee price of the dollar must rise.

D the cost of Pakistani goods in the United states must be increasing.

125 Index price of exports ÷ Index price of imports is equal to:

A Balance of trade

B Balance of payment

C Terms of trade

D Inflation



126 Which of the following measures would immediately increase the cost of imports?

A Tariff

B Quota

C Embargo

D Subsidies

127 Currency is usually devalued to:

A increase exports

B increase imports

C decrease inflation

D increase prices

128 Which ONE of the following would appear as a DEBIT item on the current account of

the balance of payments?

A Payment of interest on debts owed to overseas commercial banks

B Expenditure by tourists visiting the country

C Overseas capital investment by domestic companies

D Repayment of debts to overseas central banks

129 Which of the following is most likely to cause a country's balance of payments to

move towards a deficit?

A A devaluation of that country's currency

B An expansionary fiscal policy

C A contractionary fiscal policy

D A rise in the rate of domestic saving

130 The 'current account' of the balance of payments includes all the following items

EXCEPT which ONE?

A The inflow of capital investment by multinational companies

B Exports of manufactured goods

C Interest payments on overseas debts

D Expenditure in the country by overseas visitors

131 Which of the following might cause a country's exports to decrease?

A A fall in the exchange rate for that country's currency

B A reduction in other countries' tariff barriers

C A decrease in the marginal propensity to import in other countries

D A rise in that country's imports




132 Which of the following instruments are NOT traded in the capital market?

A Corporate bonds

B Treasury bills

C Mortgages

D Shares

133 Other things being equal, all of the following would lead to a rise in share prices

EXCEPT which ONE?

A A rise in interest rates

B A reduction in corporation tax

C A rise in company profits

D A decline in the number of new share issues

134 Which of the following does not engage in the buying and selling of shares in other

companies?

A Investment trusts

B Stock exchanges

C Insurance companies

D Pension funds

135 An investor who buys a call option is:

A buying the right to buy shares at a particular price

B buying the right to sell shares at a particular price

C selling the right to buy shares at a particular price

D selling the right to sell shares at a particular price

136 Which of the following occurs within a traditional money market?

A the issue of sterling certificates of deposit

B interbank lending in the sterling inter-bank market

C discount houses buying short term government debt in the discount market

D local authority borrowing in the euro-currency market


Certificate in Accounting and Finance Audit and Assurance

S E

C T

I O

N

B

Objective test and long-form questions


1.1 FACTORS OF DEMAND

(a) Explain any four factors on account of which the demand of a product may change even when its price remains the same. (06)

(b) Explain the role of State in a mixed economy. (05)

(11)

1.2 PRODUCTION POSSIBILITY CURVE

Draw and briefly explain the “Production Possibility Curve”. (07)

1.3 ECONOMIC GROWTH

The achievement of economic growth has been a major objective of most governments throughout the second half of the twentieth century. That period of time has seen a significant rise in living standards in the western world. One way to measure growth is by measuring the annual rate of growth of ‘real’ GDP per capita. This statistic is commonly used as an index of improvements in living standards. Although growth is highly desirable, and should lead to a rise in economic welfare, in recent years concern has grown about the extent to which economic growth can continue. Economists have begun to consider not just the opportunity cost of resource allocation decisions, but also the extent to which current rates of economic growth in the world are sustainable.

Required:

(a) Use your knowledge of economic principles to complete the following statements relating to economic growth:

(i) The phrase, ‘rate of growth of real GDP per capita’ means…..

Your answer must not exceed 30 words (02)

(ii) Economic growth will lead to a rise in the economic of society. (01)



(b) The diagram below can be used to illustrate the idea of economic growth. Complete the following statements about it:

(i) The curves in the diagram are referred to as curves. (02)

(ii) The shift from curve 1 to curve 2 indicates that has occurred. (01)

(iii) Point X suggests an economy where there is either…….. Your answer must not exceed 15 words (02)

(iv) Point Y is currently (01)

(v) Assuming that all resources are currently employed, the opportunity cost of increasing food production from 12 million units to 22 million units is……

Your answer should not exceed 5 words (01)

(c) State one factor which will encourage economic growth to occur: Your answer must not exceed 15 words (02)

(d) State whether each of the following statements about economic growth is true or false:

(i) A rise in output, occurring as an economy recovers from a deep recession with high unemployment, is usually regarded as an example of economic growth.

True or False (01)

(ii) A high level of growth is possibly unsustainable because there is a limit to the increases in output that can be achieved through technological advances.

True or False (01)

(iii) High levels of economic growth may be unsustainable without a degree of environmental pollution.

True or False (01)

(iv) Sustainable economic growth means increasing output in the present

without compromising the ability of future generations to meet their own needs.

True or False (01)

(16)

Question bank: Objective test and long-form questions


1.4 ISLAMIC ECONOMIC SYSTEM

(a) Explain how the Islamic religion has impacted upon its economic system. (10)

(b) What are its similarities and differences with the free market economic system? (06) (16)


2.1 TYPES OF GOODS

Differentiate between substitute goods, complimentary goods and independent goods. Give two examples of each. (06)

2.2 QUANTUM OF SUPPLY OF A PRODUCT

According to the law of demand, supply of a product increases when the price increases.

Briefly describe the other factors that affect the quantum of supply of a product. (09)

2.3 MOVEMENT

Explain what is Movement along the Demand Curve and Shift in the Demand Curve highlighting the difference between these two concepts. Also illustrate the difference by means of diagrams. (09)

2.4 A MARKET ECONOMY

(a) Explain how the price system works to allocate resources in a market economy. (10)

(b) Describe the main reasons why markets do not always allocate resources in an efficient manner. (10)

(20)


3.1 ELASTICITY OF DEMAND

(a) What is meant by Elasticity of Demand? List and explain briefly the factors which determine the Elasticity of Demand of a product. (07)

(b) Briefly describe when Demand for a product is considered to be:

Highly Elastic

Unit Elastic

Relatively Inelastic (03) (10)

3.2 ELASTICITY OF DEMAND 2

(a) Explain the concepts of price elasticity of demand and income elasticity of demand and the factors which determine their values for different goods. (12)

(b) Explain the usefulness to a business of information on price and income elasticity of demand for its product. (08)

(20)




(a) Define Arc elasticity of demand and provide the formula to measure it. (05)

(b) Differentiate between point elasticity and Arc elasticity of demand. (03)

(08)

3.4 CALCULATE PEDS

For each of the following diagrams calculate the following information;

(a) The price elasticity of demand (assume the change comes about from a fall in price). (09)

(b) The total sales revenue earned at the old and new price. (03)

(12)

3.5 CONCEPTS OF DEMAND

Explain briefly by means of diagrams, the concepts of Unitary Elastic Demand, Relatively Elastic Demand, and Relatively Inelastic Demand. Also, state the impact of a decrease in price on total expenditure in each of the different types of elasticities of demand. (12)

3.6 COFFEE MARKET

The following passage is based on newspaper articles and refers to the market for coffee.

Supermarkets recently ended ten years of cheap coffee when some raised the price of their own brands of instant coffee by up to 12%. Major producers of ground coffee said that their prices would also increase, but probably not for some weeks.

Reports of severe frost damage to Brazilian coffee plantations sent the open market price of coffee beans for September delivery up from $3,100 a ton to $4,000 a ton – the highest level since 1986. The price has risen five-fold since 1993. Even before the frost damage, the price had been rising because some coffee farmers, discouraged by the previous low price of coffee, had moved to other, more profitable crops. The depressed price of coffee before 1993 was partly due to the collapse of the International Coffee Agreement. This Agreement, effectively a cartel, had kept prices artificially high. When the Agreement broke down, supplies flooded into the market and the price of coffee fell.

The current price increases will end a golden age of cheap coffee for consumers. From 1986 to 1993, the retail price had fallen by more than 15%; given that these years were ones of rapid inflation, the real price of coffee fell even more steeply. This caused a boom in coffee drinking and the sales of coffee in the UK exceeded those of tea. Now it looks as if there may be a switch back to tea. This may be similar to the switch to tea which happened in the 1970s – the last time when coffee prices rose sharply. During that period, many coffee drinkers, especially young people, switched their consumption to tea.



Requirements:

Using BOTH your knowledge of economic theory AND information in the passage:

(a) (i) identify and explain TWO reasons why the price of coffee has risen recently, using an appropriate diagram (04)

(ii) explain the concept of 'price elasticity' and 'demand' AND show how it is important in determining the size of the rise in coffee prices (04)

(iii) explain the meaning of the statement 'the real price of coffee fell even more steeply'. (02)

(b) Explain the concept of 'cross elasticity of demand' AND use it to explain the relationship between the level of coffee prices and the demand for tea. (07) (17)


(a) What is meant by “Competitive goods” and “Complementary goods”? Give two examples of each. (04)

(b) Explain briefly the factors which determine the Price Elasticity of Demand. (06)

(c) Illustrate the relationship between the price and quantity demanded with the help of a diagram when the price elasticity of demand is Elastic, Unitary Elastic and Inelastic.

(Explanation is not required) (06) (16)

3.8 PRICE ELASTICITY OF SUPPLY

Describe briefly the factors influencing price elasticity of supply. (05)

3.9 CROSS ELASTICITY OF DEMAND

Write a comprehensive note on Cross elasticity of Demand. (05)

3.10 PRICE ELASTICITY OF DEMAND

Write a note on the relationship between Price elasticity of Demand and Revenue. (05)

3.11 TOTAL EXPENDITURE METHOD

Describe briefly the Total Outlay or Total Expenditure Method. (05)


Write a note on Proportionate or Percentage method giving numerical illustration. (05)

3.13 GEOMETRICAL METHOD

Explain Geometrical measure of point elasticity of demand. (08)


Product A, currently sells at Rs. 40/- per unit and its demand at this price was 500 units. If price fell to Rs. 35/- P.U, its demand extends to 525 units. Product B, currently sells at Rs. 70 per unit and its demand at this price was 300 units, it price fell to Rs. 60/- per unit, its demand extends to 400 units.



Required:

(i) Calculate price elasticity of demand for both the products. (05)

(ii) Calculate changes in total revenue if demand is met in full before and after the change in price. (05)

(10)


Elaborate the usefulness of the concept of Price elasticity of demand. (08)


4.1 CONSUMER’S EQUILIBRIUM

Demonstrate your familiarity with the indifference curve approach to the problem of consumer’s equilibrium. Support your description by drawing a suitable diagram. (12)

4.2 INDIFFERENCE CURVES

a) Explain why on an indifference map, the curve is convex? What concept does this represent? (08)

b) Explain why this indifference map doesn’t fit with economic theory.

(08) (16)

4.3 CONCEPTS

Explain the following concepts with reference to consumer behaviour, using appropriate diagrams:

Price effect

Substitution effect

Income effect (12)



4.4 PRICE EFFECT

Define price effect and display price effect using diagrams for.

Substitute goods

Independent goods

Complementary goods. (06)

4.5 INCOME EFFECT

Define Income effect using diagrams for.

Normal goods

When product X, is inferior

When product Y, is inferior (06)

4.6 SUBSTITUTION EFFECT

Sliding over the same IC is called Substitution effect. Explain with the help of a diagram. (05)

4.7 LAW OF DIMINISHING MARGINAL UTILITY

(a) Describe the Law of Diminishing Marginal Utility. (03)

(b) When is a consumer in an Equilibrium position? (02)

(c) Narrate the assumptions applicable to the indifference curve approach. (03)

(d) With the help of Indifference Curves show how consumers maximize their levels of satisfaction. Support your decision by drawing a suitable diagram. (07) (15)

4.8 INDIFFERENCE CURVES 1

(a) Narrate the basic assumptions applicable to the Indifference Curve Approach. (03)

(b) Explain consumer’s equilibrium with the help of a diagram using indifference curves. (09) (12)


(a) Define Indifference Curve. (03)

(b) Prove that indifference curves are always convex to origin. (06)

(c) Prove that indifference curves do not intersect each other. (04)

(13)

4.10 MARGINAL RATE OF SUBSTITUTION

Write a detailed note on Marginal Rate of Substitution. (05)




5.1 MONOPOLIST PROFIT

Explain the process of profit-maximization by a monopolist with the help of an appropriate diagram. (08)

5.2 PERFECT COMPETITION

(a) Briefly describe the important characteristics of a market under perfect competition. (05)

(b) Explain the equilibrium of a firm under perfect competition, with the help of an appropriate diagram. (05) (10)

5.3 INCREASING RETURNS

Explain the law of increasing returns. How does the law apply in the case of a manufacturing industry? (05)

5.4 LARGE FIRMS

Although the average factory size has not changed greatly over the past fifty years, the growth of firms has been significant. This can be explained to some extent by economies of scale and how the growth of the firm has been achieved. One of the main consequences of firms of very large size is that competition has declined and the consumer is the loser.

Using both your knowledge of economic theory and the passage above:

(a) explain how economies of scale may be achieved (05)

(b) using a diagram to illustrate your answer, what determines the optimum scale of the firm in the long run? (05)

(c) explain the different economies of scale that may occur, if a firm grows by merger or take-over (04)

(d) why might firms of very large size be justified? (02)

(16)

5.5 THE SCALE OF PRODUCTION

The twentieth century has seen a fairly significant rise in the size of the firm. In the UK, for example, in 1909, the 100 biggest manufacturing firms produced 16% of manufactured goods. By 1980, this figure had risen to more than 40%.

Many motives have been identified for this growth trend, including the desire to achieve economies of scale, market domination, and greater security for the firm.

Some of this growth has been internal or organic, but a significant amount has been achieved through merger activity.

Required:

Use your knowledge of economic concepts to answer the following questions relating to the above passage:

(a) The diagram below illustrates the cost structures for different sizes of firm in a particular industry. Study it and then complete the statements that follow:



(i) SRAC stands for….


(ii) LRAC stands for….


(iii) The significance of output level Q1 is that at this level the firm achieves the scale of production usually referred to as the…


(iv) Between Q1 and Q2 the firm is experiencing….


(v) The shape of the SRAC curves in the diagram is based on the law of diminishing returns (also known as the law of variable proportions).

The law states that……


(vi) The behaviour of LRAC beyond output level Q2 is due to what economists call….


(vii) State two specific examples of the phenomenon you identified in (vi) above:


(13)



5.6 MONOPOLY AND COMPETITION

The traditional view in economics is that the perfectly competitive market will provide benefits for society which are unlikely to occur under conditions of monopoly. Indeed, the introduction of the Monopolies Commission in 1948, and the ongoing development since then of controls on the activities of large dominant firms, suggest that monopoly presents considerable problems for society. However, there is an argument that monopoly is not necessarily always inferior to competition.

Required:

Using your knowledge of economic theory, answer the following questions relating to the above passage:

(a) (i) Complete the diagram below to illustrate the profit maximising:

position for a firm in a monopolistic situation

(ii) Assume that, at the profit maximising level of output, the profit earned is £20,000, average cost is £15 and average revenue is £25. Calculate the profit maximising level of output: (02)

(b) State whether each of the following statements about monopoly is true or false:

In a monopolistic market:

(i) normal profits are likely in the long run

True or False (01)

(ii) although the firm in perfect competition will, in the long run, produce at the lowest possible average cost, it will not necessarily produce more cheaply than a monopolistic firm

True or False (01)

(iii) output in a market is likely to be lower if the market is monopolistic rather than perfectly competitive

True or False (01)

(iv) economies of scale may allow a monopolist to produce a larger output at lower cost than would be possible if the market is perfectly competitive

True or False (01)



(c) Complete the diagram below to show the long run position for a firm in a perfectly competitive market:

(04) (d) Complete the following statement:

A firm in a perfectly competitive market is said to be technically efficient because it will produce the level of output at which…..

Your answer must not exceed 10 words. (02)

(16)


The following data refer to the costs of a firm and the demand for its product.

Quantity sold Price Total cost £ £ 1 34 12 2 30 20 3 27 34 4 25 53 5 23 75 6 21 102 7 19 131

Requirements:

Using BOTH your knowledge of economic theory AND the data above,

(a) Calculate for each level of output

(i) the marginal cost (02)

(ii) the marginal revenue. (02)

(b) Calculate the level of profit at EACH level of output AND identify the profit-maximising level of output. (02)

(c) Calculate the price elasticity of demand for the good for a price fall from £25 to £23. (04)

(d) Identify the factors which might explain the value of the elasticity of demand for this good. (05)

(e) Explain how you would expect the demand curve for this firm to vary if the number of firms in the industry were to rise. (05)

(20)



5.8 REVENUES AND COSTS

The following data refer to the revenue and costs of a firm.

Output Total revenue Total costs 0 - 110 1 50 140 2 100 162 3 150 175 4 200 180 5 250 185 6 300 194 7 350 219 8 400 269 9 450 325 10 500 425

(a) Calculate the marginal revenue for the firm and state which sort of market it is operating in. (04)

(b) Calculate the firm's fixed costs and the marginal cost at each level of output. (04)

(c) What level of output will the firm aim to produce and what amount of profit will it make at this level? (04)

(d) Describe and explain the effect on the firm's output and profits of the entry of new producers into the industry. (08)

(20)

5.9 COSTS AND REVENUES

Consider a monopolistically competitive firm.

(a) State the effect of a rise in the firm's costs at all levels of output on:

(i) the equilibrium price and output; (01)

(ii) total profits. (1)

(b) State what would happen to the firm's average and marginal revenue curves and its equilibrium price and output if:

(i) consumer incomes rose; (2)

(ii) new firms entered the industry. (2)

(c) Explain the ways in which the firm might attempt to discourage the entry of new firms into its industry. (8)

(14)

5.10 TYPES OF COSTS

Explain the relationship between different types of costs using a table. (10)

5.11 MONOPOLY SETUP

Briefly describe the disadvantages of having a monopoly setup. (08)

5.12 CONSUMPTION GOODS

(a) Describe consumption goods and state the main determinants of demand for these goods. (02)



(b) Define Price Elasticity of Demand. Compute the price elasticity of a product if a decline in the price of the product from Rs. 12 per unit to Rs. 11 per unit increases its demand from 48,000 units to 60,000 units. (04) (06)

5.13 EQUILIBRIUM OF THE FIRM

(a) Explain the term Equilibrium of the Firm. (02)

(b) State the conditions which are essential for the existence of Perfect Competition in a market. (05)

(c) Explain by means of a diagram how price and output are determined in the long-run for a firm operating under conditions of Perfect Competition. (08) (15)

5.14 MARKET FUNCTIONING

Explain six different features which distinguish a market functioning in an environment of perfect competition from a market which operates as a monopoly. (09)

5.15 FREE FORCES

(a) How do free forces of demand and supply determine equilibrium price and equilibrium quantity? Support your answer with the help of a diagram. (07)

(b) Explain briefly why the short-run average cost curve is “U” shaped. (06) (13)

5.16 PRICE OUTPUT DETERMINATION

Explain with the help of an appropriate diagram, the price output determination under monopolistic competition in the short-run. (10)


Define and differentiate duopoly market and oligopoly market. (04)

5.18 PRICE CARTEL AND COLLUSION

Define price cartel or price ring and collusion. (04)

5.19 PRICE LEADERSHIP

When price leadership occurs? (03)

5.20 KINKED DEMAND CURVE

What is kinked demand curve? (04)

5.21 NON-PRICE COMPETITION

Write a note on Non-Price Competition. (06)




6.1 NATIONAL INCOME

(a) Briefly describe three different approaches of measuring National Income. (06)

(b) What difficulties are usually faced in measuring National Income? (06) (12)

6.2 MEASURING NATIONAL INCOME

(a) Explain the income, output and expenditure methods of measuring national income. (6)

(b) Describe some of the difficulties involved in their calculation. (14)

(20)

6.3 CIRCULAR FLOW OF INCOME

(a) Draw a Diagram of Circular Flow of Income. (04)

(b) Identify and explain briefly the three different types of Withdrawals and Injections from the Circular Flow of Income. (06)

(10)

6.4 INJECTIONS AND WITHDRAWALS

(a) Explain what is meant by 'injections' and 'withdrawals' in the circular flow of income model AND show their role in determining the level of national income. (12)

(b) How might the business sector be affected if there were a rise in the savings rate in households? (8)

(20)

6.5 AGGREGATE SUPPLY: SHORT RUN

(a) The neo-classical branch of economists believe that there is a short run aggregate supply curve (SRAS) and a long run aggregate supply curve (LRAS).

Draw a SRAS curve. (02)

(b) Draw a shift in the supply curve as a result of a decrease in the cost of labour throughout an economy. (04)

(c) What are 6 reasons for a backward shift in a SRAS? (06) (15)

6.6 AGGREGATE SUPPLY: LONG RUN

(a) Delete/ insert where appropriate:

Going from the short run to the long run, the aggregate supply curve gets <steeper/ flatter>. This is because in the <short run/ long run> resources are used at their most efficient point. The long run aggregate supply curve (LRAS) is a <horizontal/vertical> line as it is completely <dependent/ independent> of the price level. (04)

(b) Is the LRAS more, or less likely to fluctuate than the SRAS? Explain your answer. (04) (08)



6.7 AGGREGATE DEMAND

(a) What are the 5 components of aggregate demand (AD), and what is the equation? (04)

(b) Draw a shift in the AD curve as a result of consumers having less disposable income. Give two other examples that could cause this shift. (06)

(c) Define what Keynes meant by “effective demand”. (02) (12)


(a) Draw a graph using a Keynesian aggregate supply curve where the economy is in a deep recession. (04)

(b) The government increases spending in the economy. Show how this will change the equilibrium in the economy. Make particular reference to:

(i) the general price level

(ii) the level of output in the economy (04)

(c) How would a neo-classical model of the economy interpret an increase of government spending in a recession? Show with a diagram. (06) (14)


(a) Define an output gap. What are positive and negative output gaps known as? (03)

(b) Draw a positive output gap on a graph. (04)

(c) Explain how a positive gap is possible within an economy. (09) (16)

6.10 DEFLATIONARY GAP

Explain, using a diagram, the concept of deflationary gap in the economy. (06)

6.11 CALCULATION OF GDP 1

Given the following data of a firm in an economy during a certain period of time. Calculate GDP according to

(a) Income approach

(b) Expenditure approach

(c) Value added approach. Rupees

(i) Raw material imports 400,000

(ii) Wages and salaries paid 900,000

(iii) Output sold 2,000,000

(iv) Profits 700,000

(v) Pays its post-tax profits to Shareholders as dividend 400,000

(vi) Taxes on labor are 200,000 and on the company 300,000

(vii) Domestic consumer's expenditure 1,100,000

(1,100,000 = 700,000 wages + 400,000 (profits) dividends)

(viii) Government expenditures

(500,000 = 200,000 tax on labor + 300,000 tax on company) 500,000

(ix) Exports 400.000

(12)




The following data relates to the economy of a country over one year period.

Rs. in million

Consumers expenditures 20,000

Federal government expenditures 4,500

Capital formation 5,100

Physical decrease in stocks (100)

Exports receipts 7,000

Imports payments 6,500

Taxes on expenditures 6,000

Subsidy 500

Net property income from abroad 500

Depreciation (Capital consumption Expenditures) 2,000

Required

(i) GDP at market prices

(ii) GDP at factor cost

(iii) GNP at market prices

(iv) GNP at factor cost

(v) National income at factor cost

(vi) NNP at Market price

(12)


The Economic Survey of the government of Pakistan discloses the following

Rupees in millions

Government expenditure 7,500

Sales value of output of firms 30,000

Imports 6,000

Profit before tax of firms 10,500

Consumers’ expenditure 16,500

Wages etc. received by employees 12,000

Tax deducted out of wages 1,500

Exports 6,000

Cost of goods and services purchased from outside country firms 6,000

You are required to compute Gross Domestic Product (GDP) by using:

(i) expenditure approach

(ii) income approach

(iii) value added approach




Following data relates to the economy of a country over a year period.

Capital consumption 2,625

Subsidies 450

Exports 9,675

Imports (9,360)

Consumers’ expenditure 27,600

Taxes on expenditure (4,140)


Value of physical decrease in stocks (30)

Gross domestic fixed capital formation 7,380

General government final consumption 6,810

Required:

You are required to compute the following, showing necessary workings

a. Gross Domestic Product (GDP) at market prices and at factor cost

b. Gross National Product (GNP) at market prices and at factor cost

c. National Income at factor cost and at Market price



The following diagram shows the circular flow of income for an economy.

Requirements:

(a) State which of the lettered flows in the diagram refer to:

(i) a government purchase of computer equipment from a UK producer;

(ii) households' transfer incomes;

(iii) corporation tax;

(iv) reinvestment of business profits to finance capital investment;

(v) a UK firm's sales of goods to a firm in Japan. (5)

Firms

Banking system Rest of the world

Households

Government

A

J

G

I D

H

C F

E B



(b) For an open economy, state:

(i) the three injections into the circular flow;

(ii) the three withdrawals (leakages) out of the circular flow. (3)

(c) Explain the effect on the business sector of an economy of an increase in the household savings rate. (4)

(12)

7.2 INVESTMENT AND MEC

(a) Explain (with a diagram) how a fall in interest rates will affect the level of investment. (4)

(b) How might the motives for an investment by a government and a private sector firm differ? And give examples of the projects that they might undertake. (6)

(c) Complete the following sentence: if the _____ generated from investment is greater than the ______, then profit maximising firms will invest. (2)

(d) What might cause a shift in the Marginal Efficiency of Capital curve? (4) (16)

7.3 CONSUMPTION FUNCTION

(a) Briefly explain the relationship between consumption, income and savings. (02)

(b) How does an increase of income affect the level of consumption in an economy? How does Keynes explain the difference based on household income, and what are the implications of this? (10)

(c) How stable is the consumption function? (04) (16)

7.4 PRIVATE INVESTMENT

State briefly how a government can influence the level of private investment in the country. (10)




8.1 MULTIPLIER

(a) Explain what you understand by the term Multiplier. (03)

(b) What are the limitations of the Multiplier? (06) (09)

8.2 MULTIPLIER 1

Output determination occurs when the savings of all of the households in an economy are equal to the desired investment opportunities.

The diagram shows an economy in equilibrium.

(a) Explain how savings become investment in an economy. Which type of organisation usually facilitates it? (04)

(b) Are the levels of savings and investment planned, or actual levels? Comment on the significance. (02)

(c) Explain how if output was greater than M (i.e. in disequilibrium), the economy would revert to equilibrium. (04)

(10)

8.3 MULTIPLIER 2

(a) Fill in this description of the multiplier: “the consumption of one person becomes the ___ ___ ___” (02)

(b) Explain, with the help of separate diagrams, why Keynes believed it was necessary to boost AD during a Depression, and not AS. (06)

(c) Explain three limitations to the effectiveness of the multiplier. (06)

(18)

S = Savings, I = Investment, Q* = maximum GNP output, E = Equilibrium, M = current level of output, B = zero savings level of output



8.4 ACCELERATOR QUESTION

(a) Define gross investment, and explain its importance in the accelerator principle. (04)

(b) Complete the following example to calculate gross investment: (04)

Example:

Year Y

(=Output)

Stock of

capital

[1]

Net

investment

[2]

Depreciation

[3]

Gross

investment

[4]

(0) (200) (600)

1 200

2 220

3 240

4 250

5 250

[1]: Capital : output ratio = 3:1

[2]: Net investment = 3*change in output compared to previous year

[3]: Depreciation = 0.1*Stock of previous year’s capital

[4]: Gross investment = Net investment + depreciation

(c) Using your answer from part (b), determine the rate of change of Gross investment. (04)

Example:

Year Y

(=Output)

% change in Y Gross

investment

% change in

gross

investment

(0) (200)

1 200 from (b)

2 220 from (b)

3 240 from (b)

4 250 from (b)

5 250 from (b)

The shows the disparity in the rates of change of output and gross investment.

(d) Comment on the relationship between %change in output and % change in gross investment. (03) (15)



CHAPTER 9 - MONEY

9.1 THE MONEY SUPPLY

(a) Explain what is meant by the term 'the money supply'. (04)

(b) Why do governments believe that it is important to control the growth of the money supply? (08)

(c) Describe the methods by which the government can attempt to control the money supply. (08)

(20)


The following data for the UK refer to the rate of inflation, as measured by the retail price index (RPI), and the growth of the money supply (M0).

Growth of Rate of money supply inflation (% rise in M0) (% rise in RPI)

1976 11.2 12.9

1977 13.1 17.6

1978 13.7 7.8

1979 11.9 15.6

1980 5.8 16.9

1981 2.4 10.9

1982 3.2 8.7

1983 6.0 4.2

1984 5.4 4.5

1985 3.8 6.9

1986 5.3 2.4

1987 4.3 4.4

1988 7.7 4.8

1989 5.7 8.2

1990 2.7 9.8

1991 3.1 5.5

1992 2.8 3.7

1993 6.0 1.4

1994 6.9 2.3

1995 6.1 3.5

(Source: Economic Trends, HMSO)

Requirements:

Using BOTH your knowledge of economic theory AND material contained in the table,

(a) Describe the apparent relationship between the money supply (M0) and the rate of inflation. (04)

(b) Explain the quantity theory of money. (06)

(c) Describe the extent to which the data given are in line with the predictions of the quantity theory of money. (06)

(d) Explain how the effects of a change in the money supply might differ between the short run and the long run. (04)

(20)



9.3 IMPORTANT FUNCTIONS

(a) Identify the four important functions of money and highlight their significance. (08)

(b) Keynes has identified three different motives on account of which a person refers to keep his money in liquid form. Identify these motives and describe their influence on the liquidity preference of an individual. (06)

(14)

9.4 UNEMPLOYMENT

(a) Explain the relationship between Inflation and Unemployment with the help of a Phillips Curve. (06)

(b) Full Employment is achieved when the rate of Unemployment reaches zero. Discuss. (04)

(c) Identify and briefly describe various types of Unemployment. (08) (18)

9.5 PHILLIPS CURVE

(a) Explain the trade-off between inflation and unemployment in an economy. Why, at low unemployment is inflation likely to be higher, and vice versa? (3)

(b) Draw this relationship, in the style of a Phillips Curve. (3)

(c) Economist Milton Friedman agreed that such a relationship existed, however argued that in the long run, no trade-off between inflation and unemployment existed. Explain this with the aid of a diagram. (10) (16)

9.6 LIQUID FORM

According to Keynes, individuals have various motives for retaining their money in liquid form.

Identify these motives and explain their influence on the liquidity preference of an individual. (06)

9.7 MONEY FUNCTIONS

Explain what is meant by the term "money" AND explain the functions it performs.

(14)


10.1 INDIRECT TAXES

(a) What is meant by Indirect Taxes? Give three examples of Indirect Taxes. (02)

(b) Briefly explain the disadvantages of Indirect Taxes. (09) (11)

10.2 MACROECONOMIC POLICY

(a) In your opinion what are the three most important primary goals of a well-conceived Macroeconomic policy?

Briefly discuss the significance of each of these macroeconomic goals. (06)

(b) Explain briefly the concepts of Demand-pull inflation and Cost-push inflation. (04) (10)



10.3 DIRECT AND INDIRECT TAXATION

Following decades of relatively high levels of direct taxation, the 1980s and 1990s have seen a consistent movement towards lower direct taxation, accompanied by higher rates of indirect taxation and a widening of the scope of indirect taxes. Clearly, this change has a significant influence on business costs and prices, and may represent a considerable burden for consumers and producers alike.

Requirements:

Using your knowledge of economic ideas, answer the following questions relating to the above passage:

(a) Distinguish between direct and indirect taxation and explain the principles underlying a good taxation system. (06)

(b) Assess the effects on businesses of a major shift from direct to indirect taxation, and explain how the elasticities of demand and supply affect the burden of indirect taxes. (10)

(16)

10.4 TRADE CYCLE

The following data refer to the UK economy:

Change in Gross Domestic

Product from previous year

Change in business investment (excluding dwellings)

from previous year

Level of interest rates

(London Inter-Bank Rate)

1978 + 3.5% +10.1% 9% 1979 + 2.8% + 3.4% 13% 1980 - 2.0% - 3.9% 17% 1981 - 1.1% - 4.8% 13% 1982 + 1.7% + 8.4% 12% 1983 + 3.7% - 2.0% 10% 1984 + 2.0% + 4.9% 10% 1985 + 4.0% + 4.1% 12% 1986 + 4.0% + 0.5% 10% 1987 + 4.6% + 17.3% 9% 1988 + 4.9% + 17.8% 9% 1989 + 2.2% + 6.1 % 14% 1990 + 0.6% - 3.1 % 15% 1991 - 2.3% - 9.5% 11% 1992 - 0.5% - 5.1 % 10% 1993 + 2.0% - 0.7% 6% 1994 + 3.0% + 4.6% 5%

(source: HMSO "Economic Trends") Requirements:

Using BOTH your knowledge of economic theory AND the data above,

(a) explain what is meant by the "trade cycle" AND show the recovery and recession phases of the trade cycle between 1978 and 1994. (04)

(b) explain briefly what is meant by the accelerator principle AND assess the extent to which the data show the presence of an accelerator effect. (08) (12)



10.5 MIXED ECONOMY

(a) Describe the main objectives of macroeconomic policy in a mixed economy. (12)

(b) Explain how fiscal policy can be used to achieve these objectives. (08)

(20)

10.6 GROWTH RECESSION INDICATORS

(a) Explain the features of an economy in a recession, and what might cause a subsequent recovery. (06)

(b) What are some of the leading, coincident and lagging indicators which might confirm these phases? (10) (16)

10.7 ECONOMIC POLICY OBJECTIVES

To achieve economic policy objectives, the government has a vital economic role in building the necessary infrastructure, ensuring the availability of adequate financing facilities, moulding the social structure and adapting the legal framework to the tasks of development.

(a) List down the main objectives of the economic policies of a government. (06)

(b) Briefly discuss the policy tools usually adopted by the government to achieve these objectives. (06) (12)


Explain with the help of a diagram using the concepts of Aggregate Demand and Aggregate Supply, how equilibrium level of national income is achieved. (12)


11.1 FINANCIAL INTERMEDIATION

(a) What is meant by Financial Intermediation? (02)

(b) Give reasons why commercial banks strive hard to maintain adequate liquidity at all times. (02) (04)

11.2 THE CENTRAL BANK

(a) Describe the role of a central bank when it acts as 'banker to the banks and banker to the government'. (10)

(b) Describe the main features of the 'supervision of the banking system' undertaken by a central bank or by a regulatory authority. (10)

(20)

11.3 MONEY MARKETS

Explain what is meant by the "money market" AND describe the role played by the major institutions in that market. (06)



11.4 INTEREST RATE RISE

Explain three ways how a manufacturer of computer games might be affected by a 0.5% rise in interest rates by the central bank. (06)

11.5 TYPES OF BANKS

a) What are the two main categories of banks? What are their features? Name three ways in which they differ. (08)

b) What are the drawbacks of a bank increasing its line of credit to customers? What might affect its ability to do so? (08) (16)

11.6 CENTRAL BANKS

(a) What are the main objectives of a Central Bank? (06)

(b) Is it possible for a Central Bank to meet all of these objectives? Explain your answer. (10) (16)

11.7 MONETARY POLICY 1

Suppose a central bank is looking to reign in the level of aggregate demand in an economy through tightening the money supply. There are a number of options available to them. Talk through how the following policies would look to achieve this:

(a) Reducing the level of reserves of commercial banks. (10)

(b) Moral suasion. (04) (14)


Suppose a central bank is looking to increase the level of aggregate demand in an economy through expanding the money supply. Talk through how the following policies would look to achieve this:

(a) Open-Market Operations. (10)

(b) Discount-rate policy. (08) (18)

11.9 MONETARY AND FISCAL POLICY

(a) Complete the following sentence: In general, monetary policy is undertaken by “government/ the central bank/ commercial banks/ industrial bodies” and fiscal policy is undertaken by “government/ the central bank/ commercial banks/ industrial bodies”. (02)

(b) Show, with the aid of a neo-classical aggregate supply diagram, how monetary and fiscal policy can work together to increase the level of output in an economy during a recession without increasing the price level. (10) (12)




12.1 CREDIT

All businesses rely to some extent on credit, in at least a few of its forms. Short term, as well as medium and long term credit, provide sources of finance to enable a business to expand or survive the problems of economic recession. The length of the credit term chosen depends on the life of the asset or project for which the funding is to be used. Credit also has an effect on the economy as it contributes to money supply, which can be inflationary, and so the government has a responsibility to keep it under control.


(a) give two examples of short term credit, medium term credit and long term credit, available to business. (03)

(b) give two examples of consumer credit and explain how this may be of benefit to a firm. (03)

(c) explain why a firm may choose to use long term credit rather than issue shares. (04)

(d) explain how credit can contribute to the money supply and the ways in which the government may try to control its growth. (06)

(16)

12.2 BANKS

Commercial banks are an essential part of the business infrastructure. They act as financial intermediaries, providers of all forms of finance and enable the payment of debts but at the same time are in business to make profits for their shareholders. Their position is so strong that they are unlikely to fail to make a profit.


(a) explain the term 'financial intermediary'. (04)

(b) explain how banks can create credit and the limitations of this ability. (06)

(c) explain how and why banks can combine the aims of liquidity, profitability and security when advancing money to customers. (06)

(16)


(a) Describe the functions of commercial banks AND show how these meet the needs of business customers. (06)

(b) With reference to the process of credit creation, explain briefly

(i) how commercial banks can 'create credit'. (04)

(ii) how the central bank can restrict the ability of commercial banks to create credit. (04)

(14)




13.1 A BALANCE OF PAYMENTS DEFICIT

(a) Explain what is meant by the term 'a balance of payments deficit'. (05)

(b) Describe the main factors that might lead a country to experience a deficit on the current account of its balance of payments. (10)

(c) Explain the difference between 'financing' a balance of payments deficit and 'correcting' that deficit. (05)

(20)


What do you understand by balance of payment and balance of trade? Describe the steps that may be taken if there is an adverse balance of payment. (09)

13.3 BALANCE OF PAYMENTS

Describe the measures a country may take to correct disequilibrium in the Balance of Payments. (07)

13.4 DISEQUILIBRIUM

(a) Briefly describe the main causes of disequilibrium in the balance of payments. (07)

(b) State the measures for rectifying disequilibrium in the balance of payments. (07) (14)

13.5 BALANCE OF PAYMENTS: COMPONENTS

(a) What are the four components of the current account? Place the following in each of the categories:

(i) Finished goods

(ii) Tourism

(iii) Dividends from shares in foreign firms

(iv) Overseas aid (08)

(b) The capital and financial accounts record the flow of capital and finances between domestic country and the rest of the world. Describe three of these flows. (03)

(c) Net errors and omissions compensate for discrepancies in current and capital accounts. If a government had a balance of payments deficit, how could they balance. (02) (13)

13.6 CURRENT ACCOUNT DEFICIT CAUSES

(a) Explain a current account deficit with reference to the income and outflow of a country. (03)

(b) Name and explain three causes of a current account deficit in a country. (06) (09)




(a) What is a tariff? (02)

(b) Explain, with a diagram, how tariffs can help correct a current account deficit. (10)

(c) What other non-monetary measures could a government take to reduce a current account deficit? (06) (18)


(a) If a country experiences exchange rate depreciation in relation to a trading partner, will its exports become more, or less attractive to the other country? (01)

(b) If the exchange rate was Rs.6: US$1, and the rupee depreciates by 50%, what will the new exchange rate be? (02)

(c) Why might this strategy not be immediately effective at correcting a current account deficit? Explain with reference to a J-curve. (09) (12)

13.9 OPEN MARKET OPERATIONS

What do we mean by ‘Open Market Operations’? Why does the Central Bank undertake such operations? (05)

13.10 CHANGE IN EXCHANGE RATES

Explain the effect on the business sector of an economy of (5)


14.1 USE OF MONEY AND CAPITAL MARKETS

(a) Distinguish between the 'money market' and the 'capital market', and identify the main institutions which operate in each market. (08)

(b) Using examples, show how a business might need to use both the money and capital markets. (10)

(c) Explain the circumstances under which the government might need to use the capital market. (06) (24)

14.2 DERIVATIVES

(a) Briefly explain what differentiates a derivative instrument from other financial instruments. For example a share, and a call option based upon a share price. (08)

(b) What are the two ways that an investor can buy a derivative product? Explain how they differ, and what the benefits and drawbacks of each are. (08) (16)



14.3 CAPITAL MARKET

(a) What is the main distinction between capital markets and money markets? (02)

(b) Who are the typical participants in the capital market? (04)

(c) How might an individual investor have access to the capital market? Describe in detail. (06) (12)

14.4 CAPITAL MARKET INSTRUMENTS

(a) Explain briefly the two categories of instruments traded on the capital markets? (04)

(b) Describe the difference between ‘common stock’ and ‘preference shares’. (06)

(c) Suppose a government wishes to raise money through capital markets for a long term investment. Explain the choices that they have, and what factors are likely to affect their choice? (06) (16)



S E

C T

I O

N

C

Multiple choice answers




1 C

2 A

3 C

4 A

5 A

6 A


7 B

8 D

9 C

10 D

A is not relevant as this affects the supply curve for the good. A fall in the price of the good will result in a movement along the curve not a shift of the whole curve, hence B is not correct. An increase in the price of a complementary good is likely to shift the whole demand curve to the left i.e., inwards towards the origin, hence C is not correct.

11 D

A consumer will not change the amount normally demanded of a good even if its price changes provided that it does not affect significantly his or her overall spending pattern.

12 C

When the price of a good is held above the equilibrium price supply will exceed demand which will cause a surplus of the good, therefore C.

13 C

Indirect taxes such as VAT shift a producer's supply curve to the left. At each price the producers supply less because part of sales income goes in tax to the government.

14 B


15 A

16 A

17 A

18 B

19 B

20 A

Elasticity of demand measures how responsive consumers are to changes in price. Demand is elastic when a fall in price brings about an increase in total expenditure. If expenditure fell by the same amount as the price fall then demand must be perfectly inelastic to A.

Answer bank: Multiple choice answers


21 C

A, B and D are all true statements about the elasticity of supply. C is to do with productivity.

22 A

If a good is price inelastic then the ratio of the percentage change in quantity demanded to the percentage change in price is less than one. In other words the proportionate change in quantity demanded is less than the proportionate change in price so an increase in price will increase total revenue and a fall in price will reduce total revenue. Hence only A is correct.

23 B

B is the correct answer since the definition of an inferior good is one where less is purchased as income increases.

A is incorrect as this would imply that as incomes rose so would the consumption of the good, although to a lower extent than the increase in income.

C is incorrect as this implies that more is purchased in line with the rise in income.

D is incorrect as in this case any change in income would have no effect on the amount purchased.

24 D

Price elasticity of demand = price in change Percentage

demandedquantity in change Percentage

1.5 = %10

x

(Price has dropped by 10% from £1 to

£0.90)

x = 15%

As x is positive it means the quantity demanded has risen by 15%. Hence 10,000 units plus 15% = 11,500.

25 A

If a good is price elastic then its sensitivity to price changes is high, hence a certain change in price will give rise to a greater percentage change in quantity demanded. The correct response is therefore A.

26 B

27 D

28 B

29 B

30 B

31 C

32 B

33 D

34 D




35 B

36 B

37 D

38 C

39 C

40 C

41 A

42 A

43 A


44 A

45 B

46 D

47 D

48 D

49 B

50 D

51 C

52 D

When diminishing returns set in, employing more units of a variable resource with a fixed amount of other resources will lead to increasingly small increments in output as total variable costs rise.

53 C

54 B

55 D

Fixed costs may remain the same, marginal costs and average variable cost may even fall if gains from large scale production become available.

56 B

Note we are talking about the short run situation, obviously in the long-run all costs must be covered.

57 D

The full wage of the extra worker = 25

The extra £1 per worker for all workers already employed (Note: It is not just the new worker who gets £25 but all workers)

11 £1 = 11

£36



58 A

The traditional theory of the firm is based on the premise that the objective of a firm is to maximise profits and will thus strive to achieve this situation by producing at the equilibrium position where marginal cost equals marginal revenue.

59 B

A is not true, any firm can benefit from economies of scale providing they are of sufficient size to obtain such economies. C is not true by definition. D is not true, management can generally be inefficient and still make some good decisions.

60 D

61 C

62 F

63 B

64 D

65 D

66 A

67 D

68 D

69 A

70 D

71 A

72 A

73 A


74 C

75 A

76 B

77 B

78 C

79 B

80 D

81 D

Withdrawals from the circular flow of income are those amounts not passed on from firms to households or vice versa. There are three categories of withdrawals - savings, taxation and imports. The correct response is D because it includes tax payments and imports - distributed profits and interest paid on bank loans are both types of income which are passed on from firms to households and are thus not withdrawals.

82 C

The answer is found by adding the value added at each stage of production and multiplying by 52.

£(800 + 400 + 300) 52 = £78,000



Answer B is wrong because output has been double counted. Answer A ignores the contribution of the fishermen and double counts the remainder. Answer D ignores the contribution of the fishermen.

83 B

The inflationary gap is a Keynesian concept which describes a situation where demand exceeds the level required to bring about full employment.

84 C

A decrease in the level of imports, a fall in the propensity to save and a decrease in the level of income tax are all injections into the circular flow of funds and will thus tend to increase the level of aggregate demand in an economy.


85 A

86 D

The inflationary gap is a Keynesian concept which describes a situation where demand exceeds the level required to bring about full employment.

87 B

Regarding 1, the MEC schedule is essentially the demand curve for investment, showing the relationship between capital invested and the return on that capital. An increase in the supply of funds available will reduce the price of capital i.e., the rate of interest and cause a movement to the right along the same curve. Hence (1) is incorrect.

Regarding 2, the introduction of cost reducing technology will increase the demand for investment, i.e., the MEC schedule will shift to the right, hence (2) is correct.

Regarding 3, a reduction of government subsidies will reduce rather than increase the demand for investment, i.e., (3) is incorrect.

88 A

Keynes argued that it is highly unlikely that the economy will automatically produce that level of output which employs all resources. The other three answers all reflect the Keynesian notion that demand management can influence income, output and employment.

89 B

Improved technology will raise the rate of return at all levels of capital stock. Therefore the downward sloping (left to right) MEC curve shifts to the right.


90 D

91 B

92 A

An injection into an economy (in this case an increase in income) can be expected to increase activity not merely by the amount injected but by some multiplying factor - essentially as a result of money passing from hand to hand. The recipients of the increase in income cannot each spend more than the increase but they can spend less.



A proportion is bound to be saved. Thus the multiplier is defined as 1 over MPS, the marginal propensity to save. But other leakages can occur which will make the multiplier smaller. In the example given these are taxation defined as the marginal propensity to taxation (MPT) and imports defined as the marginal propensity to import (MPM). Thus we have :

2111

MPS + MPM + MPT

1

21

2010

203

101

41

93 D

The accelerator theory emphasises the importance of changes in consumer demand or National Income in investment decisions. A, B and C are thus incorrect as the theory has nothing directly to say about the level of savings, rates of interest or volumes of commercial bank lending.

94 B

The multiplier is calculated as: leakageofrate

1

The rate of leakage is made up of:

Taxes 30%

Imports 10%

Saving 20% as this represents the balance after deducting taxes, import spending and domestic consumption.

Hence the multiplier is 2.01.03.0

1

= 1 3

2

CHAPTER 9 – MONEY

95 B

96 D

97 C

98 A

99 C

100 A

101 B

102 B

103 A

104 C

Only C takes money out of the economy since balances have to be drawn down to pay for the securities. A reduced quantity of money, other things remaining equal, will lead to a reduction in the money supply. It should be noted that a sale of government securities will only have this effect if they are sold to the non-bank public and the question should perhaps have made this clear, although it would have also made the answer more obvious.



105 B

According to Keynesian liquidity preference theory if the government wishes to increase the money supply it must purchase bonds and hence their price rises (not falls as in (ii)) and because of the inverse relationship with the rate of interest, the rate of interest falls. In such circumstances, the theory suggests, people are less willing to hold bonds and prefer to hold cash.


106 D

107 B

108 B

109 B

110 C

111 D


112 A

113 D

114 C

Customer's deposits are a liability of a commercial bank.

115 B

116 C

117 C

118 C

119 D

120 D

CHAPTER 12 - CREDIT

121 B

122 D

123 C

As private investors pay for the bonds, using funds in their bank accounts, the cash position of the commercial banks will be squeezed. As a result they may be forced to cut their lending portfolio to maintain an adequate relationship between cash and loans.


124 B

125 C

126 A

127 A



128 A

Expenditure by tourists is a credit item on the current account and both C and D are non-current account items, appearing instead under the heading 'transactions in UK assets and liabilities'.

129 B

A balance of payments deficit occurs when there is a net outflow of funds. With an expansionary fiscal policy consumers will have more money to spend on imports thus increasing the outflow of funds without a corresponding inflow since industry is unlikely to export more due to inflationary pressures and high domestic demand.

130 A

The current account of the balance of payments is the visible balance plus the invisible balance. The inflow of capital investment by multi-national companies would go in the capital account, so A.

131 A

A fall in the exchange rate for a country's currency will encourage exports as they will become relatively cheaper to the foreign importer, hence A is incorrect. B is also wrong since reducing tariff barriers will open up export markets giving exporting countries more opportunities. A rise in a country's imports could indicate that that country has a buoyant and growing economy and in order to meet increased aggregate demand firms may switch sales to the home market at the expense of exports, however the more likely explanation is C i.e., a decrease in the marginal propensity to import in other countries.


132 C

133 A

According to the liquidity preference theory, a rise in interest rates is inversely related to the price of bonds which will therefore fall, hence the exception is A.

134 B

This is rather an ambiguous question; the wording has to be read with care.

135 A

B and D relate to put options, and C means to sell a call option.

136 C

All the others are examples of activities within the parallel markets.



S E

C T

I O

N

D

Objective test and long-form answers




1.1 FACTORS OF DEMAND

(a) PRICE AND DEMAND

These factors can be summarized below:

(i) Change in taste or fashion: If the consumer’s tastes have changed or if the commodity has gone out of fashion, the price falls.

(ii) Change in income: If the consumer’s income rises, demand may increase even with no change in price.

(iii) Discovery of substitute: Discovery of an alternate substitute may cause demand to fall even with no change or decrease in price.

(iv) Change in prices of substitutes: A decrease in prices of other goods may cause a decrease in demand even with decrease or no change in price.

(v) Change in the price/supply of complementary goods: If the price of one of the complementary goods changes, the demand of the other is also changed.

(vi) Change in weather: Demand of a good may change due to an expected change in the weather without a change in price.

(vii) Change in population: Demand of a product may increase due to increase in population without a corresponding change in price.

(viii) Future expectations: The demand of a product may increase due to future expectation of an increase in price, even though there is no change in current price.

(b) In the mixed economic system, the state has an important role to play which is as follows:

Distribution of income:

Corrects the unequal distribution of income and wealth that exists under free market system. For that purpose, taxation, duties, subsidies etc. are used.

Price control

Restrains the monopolies that may exploit consumers by charging exorbitant prices. Price monitoring, price fixation, etc. are used.

Production of needed goods/demerit goods:

Provide commodities that private sector is unable to supply due to the absence of appropriate profitability e.g. state may establish food processing units, price floors etc.

Control on economy

Manages and controls the levels of inflation, unemployment, trade balance and economic growth to ensure economic stability. By way of monitory and fiscal policies the state intervenes in the economic activities of the country.

Answer bank: Objective test and long-form answers


1.2 PRODUCTION POSSIBILITY CURVE

The resources at the disposal of an economy are limited whereas the requirements are unlimited. A country therefore has to try to choose the best possible combination of goods and services that can be produced from the available resources, depending upon its economic needs.

The production possibility curve depicts all possible combinations. The diagram is shown below:

For the purpose of simplicity the curve is based on two products only i.e. X and Y and we assume that all the resources are allocated for producing the two goods only. The curve indicates that the economy can produce a number of combinations such as 60 units of X and 100 units of Y or 90 units of X and 60 units of Y and so on.

The cost of an item measured in terms of the alternatives forgone is called its opportunity cost. Thus, if an economy produces 60 units of X and 100 units of Y (point H) instead of producing 90 units of X and 60 units of Y (point J), then the opportunity cost of producing (100-60) more units of Y would be the lost production of (90-60) units of X.

If the economy produces lesser quantities, it would not be utilizing the full resources whereas quantities in excess of those represented by the curve cannot be produced on account of limited resources.

1.3 ECONOMIC GROWTH

(a) (i) the rate at which the gross domestic product per head of population is growing in real terms, i.e. after allowing for the distorting effects of inflation.

(ii) welfare

(b) (i) production possibility

(ii) economic growth

(iii) some degree of inefficiency in the use of resources, or a degree of unemployment

(iv) unattainable

(v) 13 million units of capital



(c) Any one of the following main factors:

capital investment leading to the growth of the capital stock

technological progress enabling a greater level of output from a given level of inputs

research and development activity enabling technological progress to occur

education and training systems that encourage greater levels of productivity in the labour force

adequate investment in the infrastructure of the economy

(d) (i) false

(ii) false

(iii) true

(iv) true

1.4 ISLAMIC ECONOMIC SYSTEM

(a) Its main influence is how resources are distributed throughout the economy, rather than the “science” of improving manufacturing etc.

This has led to a number of features within the system:

State ownership: There is no ban on the state owning an enterprise, however a free market still exists where entrepreneurs can profit so long as they abide by the other rules of the Islamic economic system.

Practising of moderation: Islam aims for an equitable distribution of resources, and so the population is taught to share wealth where they can.

Prohibition of charging interest: It is forbidden for a lending party to earn interest from a transaction without taking on as much risk. Instead there is a system whereby both parties must gain or lose from the transaction.

Earnings: must only be made from goods which are allowed in Islamic teachings.

Ban on hoarding of wealth: As resources should be utilised for a good cause, rather than remaining in private possession.

Zakat: This is a financial tax on the wealthy in order to aid the poorer in society.

(b) Below is an idea for some which could be used

Similarities:

Entrepreneurs can earn profit

Efficiencies are still sought after

Acceptable for some members of society to be richer than others

Differences:

Interest not being charged on transactions

Explicit attitude towards hoarding wealth

General influence of religion in the operations of an economic system



CHAPTER 2 – MICROECONOMICS

2.1 TYPES OF GOODS

Substitute goods

Goods are substitutes if an increase in the price of one, increases the demand for the other.

Example: Petrol and Diesel, Beef and Mutton

Complimentary goods

Goods are compliments if an increase in the price of one decreases the demand for the other.

Example: Automobile and fuel, Electricity and electrical appliances

Independent goods

Goods are independent if the price change for one has no effect on the demand for the other.

Example: Beef and text books; shoes and computers.

2.2 QUANTUM OF SUPPLY OF A PRODUCT

Determinants of supply:

Time – Short run / Long run

In the short run supply cannot be increased beyond a certain limit. In the long run supply can be increased by increasing production facilities.

Seasonal Effects

The supply of certain products increases in one season and decreases in the other due to weather etc.

Input prices

A reduction in input price results in decrease in price and increase in demand, which increases the supply.

Technological progress

It reduces cost of production and increases efficiency which leads to increase in supply.

Price/Cost of other product line

A refrigerator company can also produce air conditioners. Fall in the price of one of the products (Refrigerator) may lead to the rise in the supply of other product (Air conditioners).

Government policy

When government imposes restriction on production, e. g. import quota on inputs, taxation, etc., production tends to fall.

Non-economic factors

The factors like war, drought, flood, etc. adversely affect the supply of products.

Agreement among producers

Supply can be decreased / increased by agreement among the producers to maximize general profitability level.



Price Expectation

Suppliers’ expectation of future prices affects current supply. An optimistic future expectation encourages the supplier to reduce the supply and vice versa.

Supply of Related Goods

Increase in supply of one product may increase the supply of its related product, e.g. increase in supply of meat from goats or cows may result in the increase of supply of leather.

Nature of Goods

Durable goods have greater supply whereas perishable goods have less supply.

2.3 MOVEMENT

Movement along the demand curve shows the relationship between quantity demanded and the price of a product. The movement indicates the number of units that the consumers are willing and able to buy at different price levels during a specific period of time. It is also indicative of the fact that less quantities of a product would be demanded at relatively high prices and more quantities would be demanded at relatively low prices during a specified period.

Shift in the Demand Curve takes place when the demand for a product increases or decreases due to changes in:

(i) size of the population

(ii) income levels of the consumers

(iii) tastes and preferences of the consumers, or

(iv) prices of substitute products.

If the consumers want to purchase more of a product at a given price than they wanted previously, then there is a shift in the demand curve. An increase in demand is portrayed by an outward or right movement i.e. shift of the demand curve. If the consumers purchase less quantities of a product at any given price, then the demand curve would shift inwards or towards the left.

Movement along the Demand Curve and Shift in the Demand Curve are illustrated in the following diagrams.

Movement along the Demand Curve Shift in Demand



2.4 A MARKET ECONOMY

(a) All economies have to have a system for answering the key economic questions of what to produce and how much, how to produce and to whom to distribute output given that all resources are finite and thus scarce to a greater or lesser degree. In a free market economy the answers to these questions are the outcome of the millions of decisions taken by households and firms.

Households decide how they will allocate their income between saving and spending and the pattern of spending on the different goods and services that compete for their favour. They also have to decide upon where and in what line of activity they will seek to earn that income - where and in what line of activity they will hire out their labour and whatever property they have available for hire.

Businesses, on the other hand, have to decide what and how much of each type of output they will produce, and what resources and how much of each they will employ in order to produce that output.

In the free market economy it is the price mechanism that co-ordinates all these decisions and allocates resources. Price conveys information between consumers, producers and resource suppliers and reconciles their decisions. This is best illustrated by an example. Diagram 1 below represents the market for televisions.

Diagram 1

The demand curve is drawn on the assumption that, other things being equal, more televisions will be demanded at a lower price than at a higher price; and the supply curve on the assumption that more will be supplied by television producers at a higher price than at a lower price. Now if demand exceeds supply as at price P1 then producers seeing the shortage respond by raising price and producing more. Price adjusts to its equilibrium P2, supply increases from Q1, demand contracts from Q3 and the quantity bought and sold rises to Q2. In the opposite situation of excess supply, stocks of televisions would build up, and producers would let price fall in order to sell more. This fall in price would bring about a rise in demand, a contraction of supply and a reconciliation of production and consumption plans at Q2 with price P2.



Diagram 2

Diagram 2 shows a disturbance from this equilibrium brought about by a shift to the right in the demand curve for televisions. This increase in quantity demanded at each price now sets up the excess demand situation discussed above, and the market reacts accordingly to induce producers to supply more with price and quantity traded rising to P4 and Q4 respectively.

Changes in product demand as above (and also shifts in the supply curve) transmit themselves to resource markets. Thus in the case of Diagram 2 where there is a stimulus to television production, manufacturers would need to employ more resources. In the resource markets in question this would bid up the price of resources, increasing their earnings and bringing forth an increase in supply to this particular use. Diagram 2 can again be used to illustrate this. In this way the price mechanism allocates and reallocates resources to different lines of production and determines the distribution of income.

(b) While the free market system works to answer the key questions referred to earlier it is not always problem free or efficient in its operation nor in the results that it produces. The free market system assumes certain conditions in the market place. Firstly perfect communications are necessary so that information regarding changing conditions is quickly transmitted without distortion throughout the market in order for resources to be relocated where the system indicates. If either the communication is imperfect or resources are not mobile the system will be less than efficient. In reality reallocating resources is likely to be quite slow in that resources are often industrially, occupationally and/or geographically not very mobile.

Secondly, market power on the part of producers can reduce the extent to which price signals respond to demand changes. Furthermore it is also assumed that producers are free to enter and leave the market as a natural response to changing market conditions i.e., there are no barriers of entry or exit. This is clearly not the case.

Thirdly, producers base their supply plans on price and the costs that they incur in production, while consumers base their consumption plans on price and the benefit they themselves derive from their purchases. This is a problem as it means that producers do not take account of costs that they avoid but that their production activities impose on society e.g., pollution; and consumers do not take account of wider benefits to society that are associated



with, for example, merit goods like health facilities. Hence the existence of externalities can lead to a sub-optimal allocation of resources.

A fourth issue is that the distribution of income produced is likely to be highly unequal. Those who own sought after property and whose labour commands a high price do well. But at the other extreme those with no property and who remain out of employment get nothing from the market system.

A final matter is that the market allocative mechanism guarantees neither full employment, low inflation nor a sound balance of payments. All are the concern of government intervention, indeed as are all the other problems of the market cited above.


3.1 ELASTICITY OF DEMAND

(a) Elasticity of Demand is the degree of responsiveness in the quantity demanded of a product due to a change in its price or consumers’ income or price of another product.

The factors which determine the elasticity of demand of a product are:

(i) Nature of the Product – necessities such as basic foodstuff have highly inelastic demand as they are not very responsive to above changes.

(ii) Availability of Close Substitutes – goods which have close substitutes have greater price and income elasticity of demand and vice versa.

(iii) Proportion of Income of Consumers spent on the particular item – if the proportion of the consumers’ income spent on a product is very insignificant, then the demand for that product would be inelastic.

(iv) Time Factor – Demand for many products is more elastic in the long run than in the short run.

(b) (i) Demand is highly elastic when the percentage change in quantity demanded of a product is much greater than the percentage change in its price/ in consumers’ income.

(ii) Demand is unit elastic when percentage change in quantity demanded of a product is equal to the percentage change in its price/ in consumers’ income.

(iii) Demand is inelastic when percent change in quantity demanded of a product is less than the percentage change in its price/in consumers’ income.




(a) The price elasticity of demand (PED) for a product (or factor of production) is a measure of the responsiveness of demand for the product (measured by the quantity demanded in a given time period) to a change in price of the product. It may be calculated using the formula:

priceinchange%

demandedquantityinchange%PED

Since the effect of an increase in price is usually a fall in demand quantity, the numerical value of PED will be negative; however the negativity is customarily ignored in quoting the value of PED.

When the quantity effect exceeds the price effect the demand for the good is said to be price elastic. If however, the quantity effect is less significant than the price change which has brought it about, the demand is inelastic.

Income elasticity of demand is a measure of the responsiveness of demand to changes in income. It may be calculated using the formula:

incomeinchange%

demandedquantityinchange%YED

When the change in income is greater than the effect on demand, the good is said to be income inelastic. If the rise in demand is greater than the change in income, the good is said to be income elastic. For some goods, known as inferior goods, as income rises demand falls. For normal goods, as consumers' income rises, they are likely to buy more of the goods, income and quantity demanded move in the same direction and YED will be positive. However, if we considered say, poor cuts of meat, as consumers' income rise they are likely to choose better cuts of meat and less of the cheaper cuts. These are said to be inferior goods for which the YED is negative.

The value of the PED is influenced by several factors. Firstly the availability of substitutes. If consumers are able to easily switch from one product to an alternative, the effect of a price increase in the one will cause a large fall in quantity demanded i.e., demand will be elastic.

The proportion of household income spent on a good will affect its elasticity. The smaller the proportion of income spent on a commodity the less any price change will affect demand.

Goods which are addictive, e.g. cigarettes will tend to show inelastic demand.

Lastly, in the long term consumers may be able to adapt their consumption to other products which were not acceptable substitutes immediately following a price increase. Thus demand will be inelastic in the short run becoming more elastic in the long run.

As was stated earlier, whether the YED of a good is positive or negative depends on whether the good is normal or inferior, however the current standard of living of the consumer also is a determining factor. In counties where a high standard of living is enjoyed, when income expands, sales of consumer durables such as televisions, washing machines etc, will rise. Basic commodities, such as potatoes, rice toothpaste etc, are probably high, while that of basic commodities is likely to be low. By contrast third world economies are likely to have the reverse pattern, as much of the population is unable to afford even basic commodities. Thus the YED for the same product will vary according to the general income level of the economy in which it is being sold.



(b) Since the total revenue received by a company is the price of the product multiplied by the quantity sold, the elasticity of demand will determine the effect of an increase in price on the total revenue. It follows that the principal importance of PED is in assessing the effect of changes in price on the total revenue of a company and hence on the size of that company. This information will be of significance to the managers within a business who will use the information in deciding whether, or to what extent, price should be raised or lowered. It should be noted, however, that the effect on costs is also significant, since the firm should be maximising profits rather than revenue.

Manager in associated markets (e.g. suppliers of raw materials or components) and suppliers of factors of production will also be interested in the PED of the product as known or predicted price changes in the principal market will determine the demand from that market for parts, labour etc.

Once again, as with PED, business people can use the YED for a product to help sales and production planning as they can use the information to forecast the impact of changes in income upon demand for individual products. As an economy grows and incomes rise firms need to be producing goods which have a high YED in order to ensure the business grows and sales increase. This may entail a switching of resources from the production of goods which have a low YED to those with a high YED. Alternatively, existing products may be graded to give them a higher YED. Knowledge of YED is therefore very important for a business when deciding on its future product range.


(a) The elasticity at two different points on the demand curve is Arc Elasticity of demand, or arc elasticity is a measure of the average responsiveness to price changes exhibited by a demand curve over some finite stretch of the curve".

The formula to measure Arc Elasticity of demand is

E = 1P

2P

1P

2P

x

1Q

2Q

1Q

2Q

Where Q1 is the original quantity and Q2 is the new quantity. P1 is the original price and P2 is the new price.

O

A

D

Arc elasticity

P1

Q0Q1

Quantity Demand

P0

B

Price

(b) The elasticity of demand on a single point on a demand curve is called point elasticity

of demand whereas the elasticity at two different points on the demand curve is Arc Elasticity of demand. Point elasticity of demand is used to measure very small changes in price and quantity demanded whereas arc elasticity measure is used for determining higher changes in demand and price.

P2

Price P1

Q2 Q1



3.4 CALCULATE PEDS

1. a) -

-

-

- . , the price elasticity of demand = 0.45

b) ld price . .

ew price .

2. a) -

-

-

- . , the price elasticity of demand = 2.27

b) ld price . .

ew price . .

3. a) -

-

-

- , the price elasticity of demand = 1

b) ld price .

ew price .

3.5 CONCEPTS OF DEMAND

Unitary Elasticity of Demand:

Demand is unitary elastic when the percent

Relatively Elastic Demand:



Demand is relatively elastic when the percent

Relatively Inelastic Demand:

Demand is relatively inelastic when the

3.6 COFFEE MARKET

(a) Market price is determined by the



'Price elasticity' is the responsiveness to

The measure will be negative for a normal demand curve as clearly a rise in price would be expected to reduce the quantity demanded and vice versa. It can be used to determine the extent of a rise resulting from a reduction in supply.

If demand is elastic the percentage rise in price will be relatively small to a fall in demand. If demand is inelastic the percentage rise in price will be relatively larger than the fall in demand.

The market price prevailing includes the effect of inflation. The 'real price' of coffee would be the current market price after adjusting for inflation. As the period from 1986 to 1993 was a period of rapid inflation the 'real price' would have fallen considerably more than the 15% drop in retail price.

(b) Cross-elasticity of demand measures the responsiveness of the demand for goods to changes in the price of another.

It is measured as:

change in uantity demanded of A

change in price of

Goods, which are complementary to each other will have a negative measure whereas goods which can substitute will have a positive measure. In this case coffee and tea are regarded as substitutes for each other. If the price of coffee goes up then people will drink tea instead. This was experienced in the 1970s when coffee prices rose sharply and people switched to drinking tea. The cross-elasticity will be higher if there is some ambivalence as to whether one good is preferred or the other.


S1

S

S1

S

D

D

P1

P

Q1 Q

Price

Quantity



(a) (i) Competitive Goods: Competitive goods are goods that may be substituted for each other.

An increase in the price of one good increases the demand for the other.

Example: Beef and Mutton, Coca-cola and Pepsi, tea and coffee, petrol and diesel.

(ii) Complementary Goods: These are the goods that tend to be bought and used together.

An increase in the price of one good decreases the demand for the other.

Example: Computer hardware and software, DVD players and DVDs, automobiles and fuel.

(b) Determinants of Price Elasticity of Demand:

A number of factors determine the price elasticity of demand:

(i) Substitutes: More the substitutes, the higher the elasticity, as people can easily switch from one good to another if a minor price change is made.

(ii) Percentage/ratio of income: The higher ratio of the product’s price to the consumers’ income, the higher is the elasticity, as people are careful while purchasing the good.

(iii) Necessity: The more necessary a product is, the lower the elasticity, as people will buy it no matter what the price is, such as medicine, wheat etc.

(iv) Time: The elasticity is higher in the long run, as more and more people stop demanding the good if high price persists.

(c) Unitary Elastic Demand



Elastic Demand

Inelastic Demand



3.8 PRICE ELASTICITY OF SUPPLY

Factor The supply for a good is relatively price-elastic because

Time in the long run, firms can adjust all factor inputs to change supply easily

Production time if a good is manufactured quickly, supplies can be changed easily

Stocks if a firm has a large amount of stocks, supplies can be changed easily

Capacity if labor and capital are underused, supplies can be changed easily

Factor mobility if resources can move in and out of the industry, supplies can be changed easily

3.9 CROSS ELASTICITY OF DEMAND

Cross elasticity of demand (X.E.D.) measures the responsiveness of demand for good A to a given change in the price of good B

X.E.D. = percentage change in the quantity demanded of commodity A

percentage change in the price of commodity of B

Since X.E.D. can be negative, it is important to include minus signs.

If X.E.D. is positive, the two goods are in competitive demand i.e. substitutes.

If X.E.D. is negative, the two goods are in joint demand i.e., complements.

If X.E.D. is zero, the two products are unrelated i.e. independent goods.

Type of Cross Elasticity of Demand

a) Positive Cross Elasticity (Substitute)

A rise in the price of one good causes an increase in the demand for its substitute.

E.g. butter and margarine

b) Negative Cross Elasticity (Complimentary goods)

A rise in the price of one good cause a decrease in the demand for its complement.

E.g. tea and sugar

c) Zero Cross Elasticity (Unrelated or independent goods)

If two goods are independent of each other, a rise or falls in the price of one good will not affect the demand for the other good.

e.g. pen and coffee.



3.10 PRICE ELASTICITY OF DEMAND

The effect of a price change on revenue depends on the elasticity of demand. Figure shows how a change in price can increase revenue.

If P.E.D. is elastic, a fall in price increases revenue.

If P.E.D. is inelastic, a rise in price increases revenue.

If P.E.D. is unitary, a price change leaves revenue unchanged.

A

B

QQ

D1

P1P2

P2P1

PP

D2

K

J

Q1 Q1Q2 Q2

(a) (b)

.. .............. ... ..

.. .................................... ...

..........

...........

...........

...........

..........

.............

... ... ......................... ... ..

....................................

..........

............

..........

........

......

.... .... .... .... .........................

... ... ................

....................................

...........

........................

..........

..........

......................

...........

...........

...........

...........

.................. ...

.. ... ......... .... ...

...........

...........

...........

...........

...........

......................

...........

..........

.........................

... .................

...........

...........

...........

...........

................... ... ....

...........

..........

.........

........

.......

........... ....

Revenue gained

Revenue lost

Figure (a) Elastic demand and revenue. Since the price decrease results in a proportionately larger increase in quantity demanded, revenue rises. (b) elastic demand and revenue. Since the price increase results in a proportionately smaller decrease in quantity demanded, revenue rises.

3.11 TOTAL EXPENDITURE METHOD

In this method we compare the changes in total expenditure before and after the changes in price.

(i) If with a change in price total expenditure remains the same, the elasticity of demand is unit elastic.

(ii) If with an increase in price total expenditure decreases and with a decrease in price total expenditure increases, the elasticity of demand is elastic.

(iii) If with an increase in price, total expenditure increases and with a decrease in price, total expenditure decreases, the elasticity of demand is inelastic.


In this method we compare percentage change in quantity demanded to a percentage change in price. If the percentage change in quantity demanded is equal to percentage change in price, elasticity of demand is unit elastic. If the percentage change in quantity demanded is greater than the percentage change in price, elasticity of demand is elastic and if the percentage change in demand is less than the percentage change in price, elasticity of demand is inelastic.

The formula to measure elasticity of demand is:

Elasticity of demand = PriceinchangePercentage

DemandinchangePercentage

Note: Mathematically we can measure elasticity of demand. If price of a commodity increases from Rs. 10 to Rs. 12 and demand contracts from 96 to 80 units. The elasticity of demand with the help of formula, elasticity method can be measured as follows:



PED = Q

P.

ΔP

ΔQ

Q = –16 P = 10

P = 2 Qd = 96

PED = –16

2 x

10

96 = – 0.83 or inelastic

Note: The elasticity of demand is always negative, although by convention it is taken as positive. It is negative because price and quantity demanded are negatively related. Elasticity is always less than zero, unless the demand curve is abnormal i.e., it slopes upward from right to left.

The formula to measure arc elasticity of demand is as follows:

Elasticity =

0P1P

0P1Px

0Q1Q

0Q1Q

Where Q0 is the original quantity demanded and Q1 is the new quantity demanded. P0 is the original price and P1 is the new price.

If following is the schedule of demand, elasticity of demand can be measured with the help of above formula.

Price Per Kg. Quantity Demanded (Kg.)

10 – P 0 100 – Q0

5 – P1 300 - Q1

By putting the values in the above formula we get.

E = 300 – 100

300 + 100

5 + 10

5 – 10 = - 1.5 or elastic

Note: Point elasticity of demand is measured on a single point on a demand curve while arc elasticity of demand is measured between two points on a demand curve.

3.13 GEOMETRICAL METHOD

When we measure elasticity of demand on a single point on the demand curve it is referred to as geometrical method. Elasticity on a demand curve is different at different points it may be greater than unity, less than unity and equal to unity.

The formula to measure elasticity of demand is

E = curve demand the ofPoint Upper

curve deamnd the ofPoint Lower

Elasticity on a point on the demand curve is measured by drawing tangent on that point. It can be explained with the help of a diagram.



Y

O

D

D

D RPrice

B

A

E =RA

RB= grea

terthan,unity

E=ES

SD=

less than

unity

S

qd

Fig. 2

C

Elasticity at point 'R' is (-) RARB

and it is clear that lower portion is greater so elasticity

is greater than unity and elasticity at 'S' is (-) SCSD

and it is clear that lower portion is

smaller than the upper portion so elasticity is less than unity.

The formula for determining elasticity utilizes the percentage change, not the absolute change, in quantity demanded relative to price. In the upper half of the price range (the lower half of the range of quantity), any decrease in price is bound to be relatively small in percentage terms because the base price is relatively high. By the same token, the corresponding increase in quantity must be relatively high in percentage terms because the base quantities from which the percentage is calculated are relatively low. This is illustrated in Figure, which shows that the upper half of the demand line is elastic, whereas the lower half is inelastic. At the half point, the demand is unitary elastic. In fact, as long as the demand is a straight line, as in Figure, we can state that it will have an elastic half and an inelastic half with unitary elasticity occurring right in the middle. If the demand curve is not linear, then the relationship between range of prices and elasticity does not hold.

Figure

Price

Elastic (E > 1)

E= 1

Inelastic (E < 1)

P

O Q Quantity




Price elasticity of demand = priceinchangePercentage

demandinchangePercentage

Product A:

Percentage change in demand = Demand

demandinChange

Percentage change in demand = 5%100x500

25

Percentage change in price = 100xPrice

priceinChange

Percentage change in price = 100x40

5-=

- 12.5%

Percentage elasticity of demand = 100x12.5-

5=

- 0.4 (inelastic)

Product B:

Percentage change in demand = 33.3%100300

100

Percentage change in price = 2914.100x

70

-10

Price elasticity of demand = 14.29

.333=

- 0.807 (inelastic)

Change in Total Revenue for Product ‘A’.

Before change in price Total Revenue = 40 x 500 = Rs. 20,000 (PxQx)

After the change in price Total Revenue = 35 x 525 = Rs. 18,375

Firm’s total revenue will fall as a result of fall in price which is e ual to Rs. .

Change in Total Revenue for Product ‘ ’.

Before change in price Total Revenue is Rs. 70 x 300 = Rs. 21,000

After the change in price Total Revenue is Rs. 60 x 400 = Rs. 24,000

Firm’s total revenue will increase as a result of fall in price which is Rs. .


The importance of elasticity of demand can be viewed from the following

1. For finance minister

Basic job of a finance Minister is to prepare Budget. The concept of elasticity of demand guides him and he levies more taxes on goods which are having elastic demand i.e., luxuries and less taxes on goods where elasticity of demand is inelastic.

2. For producers

The producers can increase the prices of those goods for which elasticity of demand is inelastic and avoids increase in prices for those goods for which elasticity of demand is elastic.



3. Price discrimination

A monopolist charges higher price from those persons whose income is high and elasticity of demand is elastic while charges low price from poor.

4. Determination of fare

The concept of elasticity of demand is kept in view while determining transportation fares e.g. Pakistan Railways charges fares at different rates from different persons depending upon demand elasticity of the passengers.

5. Joint demand

in case of goods which are sold, purchased or used jointly, higher price is charged for goods having inelastic demand and lower price is charged for goods having elastic demand.

6. For exporters

Exporters are charging high prices for goods having inelastic demand and lower price for goods having elastic demand.

7. Increasing returns industry

When industry is subject to increasing returns, expansion in production lowers the average cost of the product. If at the same time the demand of such product is elastic, the producer can raise his profit by slightly reducing the price and producing larger quantity.

8. Wages

If the demand for a particular type of labor is inelastic, the labor union can easily get higher wages from the entrepreneurs for the workers.

9. Paradox of poverty in plenty

If the demand for a product is inelastic, its increased production may result in less profit. Take an example of potatoes. Suppose their demand is inelastic at a certain period of time. Now if farmers grow more potatoes, their total income will decrease rather than increase. So, for them, plenty of potatoes mean poverty.

10. The government

1. Knowledge of price elasticity of demand would be useful to the government and the policy making authorities in general. It might be useful to the government in assessing cost or the likely effectiveness of price support schemes such as those common in agriculture.

2. Similarly, knowledge of price elasticity of demand would be useful if it was decided to influence consumption through the use of taxes or subsidies. For example taxes might be used to discourage the use of demerit goods, while subsidies might be used to encourage the consumption of merit goods. Again, knowledge of price elasticity of demand would provide an indication of how successful the policy is likely to be and, in the case of subsidies it would be useful in providing an estimate of likely cost of the subsidy.

3. For any government considering devaluation/revaluation of its currency, knowledge of price elasticity of demand is essential in order to predict the changes in import expenditure and export revenue following devaluation/revaluation.



11. The business sector

Those involved in the business would find that knowledge of price elasticity of demand is useful if they were considering a price change for their product. If demand is inelastic, a price rise will lead to a rise in profits because revenue will rise. In other situations such as price fall, the effect of profitability depends on the proportionate change in cost and revenue following a price change. Note, however that the aim of price fall is to increase sales revenue, it is important that demand is elastic. Firms might wish to increase sales as to increase their market share or to enable them to reap important economies of scale.


4.1 CONSUMER’S EQUILIBRIUM

The consumer is said to be in equilibrium when he obtains the maximum possible satisfaction from his purchases, given the prices in the market and the amount of money he has for making purchases.

The assumptions applicable to the indifference curve approach are as follows:

the customer has an indifference map showing his scale of preferences for various combinations of the two commodities. (suppose Product A and B)

each of the goods is homogenous and divisible; and

the consumer acts rationally, that is, he tries to maximize his satisfaction.

Conditions of Equilibrium

Thus two conditions must be satisfied for a consumer to attain equilibrium.

(i) The price line should be tangent to an indifference curve or MRS of one commodity for another should be equal to their relative prices.

(ii) At the point of equilibrium an indifference curve must be convex to the origin.

It can further be explained with the help of an indifference map as shown below:



(i) The price line facing the consumer is AM, given a certain amount of money he has to spend on products A and B and their prices in the market.

(ii) Since his income and the relative prices of the two goods to be purchased are shown by the price-income line AM, his equilibrium must be on some point on this line. That is why this line is called the price- opportunity line.

(It is the line that contains all the possible opportunities of combining the two goods that are open to our hypothetical consumer.)

(iii) The customer’s level of satisfaction increases as he moves from a lower indifference curve to a higher indifference curve i.e. he is at a lower level of satisfaction at the combinations represented by IC1 and at a higher level of satisfaction when on IC2

and so on.

(iv) IC3 is the highest indifference curve to which he can go, given the money he has and the prices of the goods in the market. The price line (is tangent to) touches it at point P which is the point of maximum satisfaction.

(v) Thus the consumer will be in equilibrium at the point P, i.e., he will be buying OH of product A and OJ of product B.

4.2 INDIFFERENCE CURVES

(a) The convex shape of an indifference curve is due to the concept of diminishing marginal utility. This states that you get less value from consuming the "next one" of a good or service than you got from consuming the previous one.

If you got the same marginal utility from consuming the next unit of some good or service, the indifference curve would be straight (though still downward sloping).

The kernel here is that an indifference curve indicates all of the combinations of goods that give one the same level of satisfaction. Due to diminishing marginal utility; more and more of another good is needed to equate the same level of utility if the quantity of the other good is decreased from an already low level.

When this concept is illustrated, the indifference curve must be convex to the origin.

(b) The point to note is that the indifference curves have crossed.

To explain why this doesn’t fit with economic theory, talk through an explanation of the transivity rule.

This is a rule that implies agent’s decisions are consistent. If a consumer prefers Good A to Good B, and Good B to Good C, then it can be inferred that consumer also prefers Good A to Good C.

Suppose that an individual has indifference curves that cross, as in the case of U1 and U2 above. This implies that the individual is indifferent between combinations A and B and between combinations A and C. As a result, he must be also indifferent between points B and C. But point B has to be preferred to point C because it is above the indifference curve on which point C is located.

The individual is consuming more of both goods at point B than at point C. The crossing of two indifference curves presents a logical contradiction in the sense that the individual is behaving in an irrational manner.



4.3 CONCEPTS

Price Effect:

The effect on a consumer’s indifference curve resulting from a change in the relative price of good A if the price of good and the consumer’s income remains the same, is known as Price Effect.

If the price of good A falls then the indifference curve will shift upwards, meaning that the consumer can buy more of both product A and B with the same income.

Price Effect

Substitution Effect:

Substitution effect means the effect on the indifference curve due to change in quantity of goods purchased due to change in relative prices with no change in income.

If the price of good A increases and the price of good B falls, the consumer will decrease the consumption of good A and increase the consumption of good B.

Substitution Effect

Here, Z1 is the equilibrium after the increase in price of A.



x1 x2

Income Effect:

Income Effect means the effect on the indifference curve due to a change in the income of the consumer with no change in prices of both the goods.

When the income of the consumer increases, the quantity purchased of both goods A and B shall increase.

Income Effect

4.4 PRICE EFFECT

A change in consumer's equilibrium because of change in relative prices of goods is

known as price effect.

(i) Figure 1 shows the price effect for substitute goods.

(ii) Figure 2 presents the case of independent goods which says if the price consumption curve is horizontal it means commodity X and commodity Y are unrelated goods (independent goods).

(iii) Figure 3 displays the case of complimentary goods that shows if the price consumption curve slopes upward, commodity X and commodity Y are complementary goods.

A

Un

its

of

Com

modit

yY

Units of Commodity X

E1E 2

IC2IC1

B1B

PCC

(1) Substitute goods



Y

XO

E1

E2

E3

IC3

IC2

IC1

Unit of Commodity X

Un

it o

f C

om

mo

dit

y Y

Y

XO

E3E2E1

IC 3IC2IC1

PCC

Com X and Com Y are

Un

it o

f C

om

mo

dit

y Y

Unit of Commodity X

PCC

(1)(2)

When Com X and Com Yare complimentary goods

x1 x2 x3 x1 x2 x3

y1y2

y3

4.5 INCOME EFFECT

A change or shift in consumer's equilibrium because of change in income of the consumer while prices of the goods remain unchanged is known as income effect.

(i) Figure 1 shows the case of income effect for Normal goods.

(ii) Figure 2 represents the income effect where product Y is inferior and shows when an Income Consumption Curve (ICC) is moving towards X-axis it reflects that commodity Y, is an inferior commodity.

(ii) Figure 3 displays the income effect where product X is inferior and shows when an Income Consumption Curve (ICC) is moving towards Y-axis it signifies that commodity X, is an inferior commodity.

Y

X

E3E2

E1

IC3

IC2

IC1

I.C.C.

Com

mod

ity

Y

Commodity X

O B D G

FC

Y

A

x1 x2x3

Y

XO

E3E2E1

IC3IC2IC1

I.C.C.

(iii)

Commodity Y is a

inferior

commodity

B D G

Commodity X

Com

mo

dit

yY

Y

XO

E 3

E2

E1

IC 3

IC2

IC1

I.C.C.

(iv)

inferior

commodity

B D G

Com

mo

dit

yY

Commodity X

Note: Income effect is shown by a parallel shift of the budget line.

(2) Com X and Com Y are

unrelated goods (independent goods)

(3) When Com X and Y are complimentary

goods

(1)

(2) Commodity Y is an inferior commodity

(3) Commodity X is an inferior commodity



4.6 SUBSTITUTION EFFECT

When consumer’s e uilibrium changes because of change in relative prices of goods it is called price effect and if price changes but the consumer's income also changes in such a way as to leave their total utility unchanged the quantities of goods consumed will still change; because consumer will buy more of goods whose relative price, has fallen and less the goods whose relative price, has risen. When a consumer purchases more of the good whose price has fallen and has become even cheaper to relative good although increase in real income because of fall in price of good 'X' has been withdrawn is known as substitution effect or sliding over the same I.C.

The substitution effect can be shown with the help of a diagram:

In the figure x1, x2, is price effect and x1 x3 is the substitution effect.

4.7 LAW OF DIMINISHING MARGINAL UTILITY

(a) According to the Law of Diminishing Marginal Utility, the additional satisfaction derived from consuming additional units of a commodity will diminish with each successive unit consumed. The total utility will continue to increase as each successive unit is consumed, up to the point when the marginal utility is positive. The Law of Diminishing Utility is subject to all other conditions remaining the same e.g. incomes, fashion and tastes.

(b) The consumer is said to be in equilibrium when the maximum possible satisfaction is obtained from the individual’s purchases, at the prices prevailing in the market and the amount of money the individual possess for making purchases.

(c) The assumptions applicable to the indifference curve approach are:

(i) the consumer has an indifference map showing his scale of preferences for various combinations of the two commodities, say product A and product B,

(ii) each of the goods is homogenous and divisible,

(iii) price of both the goods are given,

(iv) consumer’s income remain unchanged,

(v) the consumer acts in a rational manner to maximize his satisfaction.

Product y

Y1 E1 PCC

E2

Y2 E3 IC2

IC1

X1 X3 X2 Product - X



(d) The point at which a consumer can maximize his level of satisfaction can be demonstrated by means of Indifference Curve diagram as shown below:

(i) The price line facing the consumer is AM, given the amount of money the individual has to spend on products A and B at the prices prevailing in the market.

(ii) This line is called the price-opportunity line as it contains all the possible options of combining the two goods that are open to the consumer. Since income and the relative prices of the two goods are shown by the price-income line AM, the equilibrium must be on some point on this line.

(iii) The level of satisfaction increases as the individual moves from lower indifference curve to higher indifference curve i.e. the individual is at a lower level of satisfaction at the combinations represented by IC1 and at a higher level of satisfaction when on IC2

and so on.

(iv) IC3 is the highest indifference curve to which the individual can go, given the money and the prices of the goods in the market. The price line is tangent to the indifference curve at point P which is the point of maximum satisfaction.

(v) Thus the consumer will be in equilibrium at the point P, i.e., when the individual purchases OH quantities of product A and OJ quantities of product B.


(a) The assumptions applicable to the indifference curve approach are:

(i) the consumer has an indifference map showing his scale of preferences for various combinations of the two commodities, say product A and product B,

(ii) each of the goods is homogenous and divisible,

(iii) price of both the goods are given and constant,

(iv) consumer’s income remains unchanged,



(b) The consumer is said to be in equilibrium when the maximum possible satisfaction is obtained from the individual’s purchases, at the prices prevailing in the market and the amount of money the individual possesses for making purchases.

The consumer’s e uilibrium can be demonstrated by means of Indifference Curve using the following diagram:

(i) AM is the consumer’s price line. Each point on the line represents a

combination of quantities of products A and B which the consumer can buy at the prevailing prices, given the amount of money the individual has to spend on the two products. Hence the equilibrium must be on some point on this line.

(iii) The level of satisfaction increases as the individual moves from a lower indifference curve to a higher indifference curve i.e. the individual is at a lower level of satisfaction at the combinations represented by IC1 and at a higher level of satisfaction when on IC2

and so on.

(iv) IC3 is the highest indifference curve to which the individual can go, given the money and the prices of the goods in the market. The price line is tangent to the indifference curve at point P which is the point of maximum satisfaction because all other points on the curve are beyond the budget line.

(v) Thus the consumer will be in equilibrium when the individual purchases OH quantities of product A and OJ quantities of product B.


(a) Indifference curve is the curve on which the consumer is indifferent. An indifference curve is a locus of points where each point represents a combination of two goods and each combination gives equal satisfaction to the consumer.

Or

An indifference curve represents satisfaction of a consumer from two goods. It is drawn on the assumption that for all possible points on an indifference curve, the total satisfaction remains the same.

An indifference curve may be called as an ISO (same) utility curve. The s lope of indifference curve shows the marginal rate of substitution.



(b) Convex to Origin:

The indifference curve is convex to the origin when we have more units of commodity X. Every next unit of Commodity ‘X’ is giving less and less satisfaction, therefore less and less units of commodity ‘Y’ will be sacrificed that is marginal rate of substitution (MRS) of Commodity X, for Commodity Y, goes on falling.

1C 1

Y

XO

Com

mun

ity

Y

Community X

a

b

e

g

i

k

c

d

f

h

j

MRS is falling

(i) If an indifference curve is a straight line with a downward slope as shown in the figure.

1C

Y

XO

Com

mun

ity

Y

Community X

a

c

e

d

b

d

f

MRS is constant

(ii) Suppose that indifference curve is concave

a d

c b e

f g

h

1C

X Community X

Co

mm

un

ity

Y

Y

O

MRS

is increasing

It is clear that the vertical distances showing sacrifice of commodity ‘Y” is decreasing, which, shows that the marginal rate of substitution of commodity ‘X’ for commodity ‘Y’ is falling that is why this curve represents the indifference curve.

Indifference curve which is a straight line slopping downward, the vertical distance of ab, cd and ef are equal which show that marginal rate of substitution is constant which is unnatural because for every next unit of commodity ‘X’, marginal rate of substitution must diminish. Therefore, it cannot be indifference curve.

It is clear from the figure that vertical distances are increasing with more units of commodity ‘X’. The distance ‘ji’ is greater than ‘hg’, also greater than ‘fe’ and so on. That is marginal rate of substitution is increasing while it should diminish as for an indifference curve marginal rate of substitution must diminish therefore, it cannot be an indifference curve.

i

k j



(c):

The main property of the indifference curves is that Indifference curves do not intersect each other. Suppose that there are two indifference curves IC1 and IC2 intersecting each other

as shown in the figure. IC2 is higher indifference curve, IC1, is lower Indifference curve. Therefore, it can be concluded from the intersection of indifference curves .

The satisfaction at point A = Satisfaction at point C.

The satisfaction at point A = Satisfaction at point B.

X

Y

Community

X

Com

munit

y Y

A C

1C 1

1C 2 B

As per transitive rule. If A = B and A = C then B must be equal to C. Whereas B C

because ‘C’ point is on higher IC2 and point ‘ ’ is on lower IC1. Because of

intersection we have to prove that higher and lower indifference curves have equal

satisfaction which is impossible.

4.10 MARGINAL RATE OF SUBSTITUTION

The concept of Marginal Rate of Substitution is an important tool of indifference curve technique. The Marginal Rate of Substitution shows how much of one commodity is substituted for how much of another. Or it is the rate at which a consumer is willing to substitute one commodity for the other in his consumption pattern. The concept of marginal rate of substitution (MRS) can be explained with the help of the following schedule (It is assumed that all the combinations are giving equal total satisfaction to consumer).

Combinations

Units of commodity

(X)

Units of commodity

(Y)

Marginal Rate of Substitution

A

B

C

D

1

2

3

4

16

8

5

4

–

8 : 1

3 : 1

1 : 1

Above table shows that MRS is diminishing from 8:1 to 1:1. It can also be explained with the help of a figure.



The slope of the curve represents the Marginal Rate of Substitution which is falling as more units of commodity ‘X’ are consumed, less and less units of commodity ‘Y’ are sacrificed by the consumer.

X

Y

Community X

Co

mm

un

ity

Y

16

12

8

4

A

B

C D

x 1 x 2 x 3 x 4

y 1

y 2

y 3 y 4

A´

B´

C´

O

The Marginal Rate of Substitution at point B is:

MRS = 12

12

XX

YY or =

BA

AA

The Marginal Rate of Substitution at point C is:

MRS = Y3Y2X3X2

= CB

BB/

/

The marginal rate of substitution at D is:

MRS = = Y4Y3X4X3

= CC´C´D

Note: Negative sign is by convention shows that downward slopping indifference curve.




5.1 MONOPOLIST PROFIT

Profit Maximisation

A monopolist keeps on producing as long as Marginal Revenue is greater than Marginal Cost i.e. MR>MC.

As soon as marginal cost exceeds marginal revenue, his profit will start declining.

Hence, the profit will maximize when MR = MC.

MC = Marginal cost

MR = Marginal revenue

AC = Average cost

The reason for the MC and AC curves to be ‘dish shaped’ is explained by the law of returns which describes three phases of the curve:

1. Increasing returns (MC goes down)

As output begins to increase, the large manufacturing processes/equipment still not fully utilised means that TC only increases slightly. The additional labour can be productive as they can always use the equipment to its full potential, for example. As such the MC is relatively low.

2. Constant returns (MC goes sideward)

At this point, labour is producing its optimal output per unit. The marginal cost is therefore at its lowest.

3. Diminishing returns (MC goes up)

The more labour is employed, the less marginal output they are able to produce. This could be a result of too many people to efficiently operate/ rotate use of machinery. The cost increases more and more to generate an extra unit of output, because of labour exhibiting diminishing returns in the short run.



5.2 PERFECT COMPETITION

(a) Characteristics of a market under perfect competition:

(i) Large number of buyers and sellers

There are large number of buyers and sellers, operating in the market. No single buyer or seller is able to influence the price, because the output of a single firm or the quantity demanded by a single buyer is a very small proportion of the total market.

(ii) Homogenous product:

The products produced by all firms are standard or identical. Any difference will allow the producer to charge different price.

(iii) Free entry or exit:

There should be no restriction, legal or otherwise on the firm’s entry or exit from the market.

(iv) Perfect knowledge of prices:

The buyers and sellers are fully aware of the price prevailing in the market.

(v) Transport costs should be zero or very minor:

If the same price is to exist throughout a market then it is necessary that transport cost should be zero or insignificant.

(b)

Explanation:

Under perfect competition the firm can sell as much as it wants without affecting the price, therefore MR=AR of the product.

Therefore, under perfect competition, the firm keeps on producing as long as MR is greater than MC.

When the MC exceeds MR the profit will start declining.

Therefore, the profit will maximize when MR = MC.

Therefore, the firm is in equilibrium at point L.



5.3 INCREASING RETURNS

The law of increasing return states that as additional units of a variable factor are employed while other factors remain the same, the production increases at a higher rate.

The higher rate of increase continues so long as there in no deficiency of an essential factor in the process of production. As soon as there occurs a wrong or defective combination in productive process, the marginal productivity begins to decline.

Application of the law of increasing return in the manufacturing industry:

The increasing return mainly arises due to the fact that large scale production is able to secure certain economies of scale, both internal and external.

These advantages may be on account of division of labour, specialized machinery, commercial advantages of buying and selling wholesale, utilization of by-products, use of extensive publicity and advertisement, availability of cheap credit etc.

The law of increasing return operates as long as the plant is producing below capacity. The increase in the marginal return continues till the plant begins to produce its full capacity.

This can be illustrated as follows:

The productivity of the variable factor will vary. This will cause the shape of the cost

curves to change from being linear to being curvi-linear.

5.4 LARGE FIRMS

(a) Economies of scale can be achieved internally by the firm as it grows in size. As a result of economies of scale, long run average cost falls as output increases. Economies of scale can be achieved in the following ways:

Technical economies – as the firm expands it can make better use of larger machinery producing larger quantities more efficiently. In industries such as oil refining or vehicle manufacture where the minimum scale of capital is large and expensive, large firms with large outputs have significant cost advantages over smaller ones. Moreover, when operations are carried out on a large scale, it becomes possible to combine different types of machinery operating at different rates or speeds more cost effectively.



Managerial economies – larger firms can employ specialist managers to optimise the use of all resources. The cost per unit of clerical and administrative procedures will also be lower as output grows. The word processing cost of an order for 10,000 units is not ten times the cost of processing an order for 1,000 units.

Trading economies – larger size enables the firm to buy in bulk and sell in bulk, reducing both the costs of buying and selling. Advertising costs can also be reduced as I advertisement can sell one item or a million items – the larger the quantity the lower the cost per item.

Financial economies – larger firms can offer more assets as security and are less dependent on one product or market, making them a better risk for lenders and reducing the interest rate on loans and other forms of finance.

External economies of scale are available by locating close to other firms in the same industry or by being able to benefit from innovations made by other firms or industries. Such ‘localisation’ of industry enables firms to benefit from a pool of skilled workers or nearness to supplies or markets.

(b) Diagram to show the optimum size of a firm

As the firm expands its size, in the long run, it is able to take advantage of economies of scale and average cost falls. After a certain level of output is reached all economies of scale have been achieved and this point on the average cost curve is called minimum efficient scale. Further output beyond this point can result in the same average cost per unit, but eventually average cost will start to rise, as diseconomies of scale are produced. Diseconomies of scale are essentially the result of communication problems as the firm grows too large. In addition, the larger the organisation becomes, the more difficult it becomes to co-ordinate the activities of all of the people involved. This will result in the duplication and omission of work due to confusion over areas of responsibility. Finally, the larger the organisation, the greater the difficulty for management to ensure that subordinates are carrying out the tasks allocated to them.

The level of output at which minimum efficient scale is reached will vary with different industries. Where very large output quantity is needed to achieve minimum efficient scale, the number of firms in the industry would be few, for example, coal mining. In industries where minimum efficient scale can be achieved with relatively small output quantity, the number of firms can be much greater, for example, hairdressing.



(c) Merger tends to imply that firms have joined amicably whereas take-over implies that one firm has absorbed another against its wishes. However, the result is the same in that two firms have become one.

Merged firms may produce different products or the same product at a different stage of the production process (vertical integration). In either case, technical and trading economies may not be available. However, in horizontal mergers, where both firms are involved in producing the same good at the same stage of production such economies may well be available.

In all cases, firms may obtain economies by reducing staff in centralised functions, such as accounting, personnel or human resource functions and computer or systems functions. All firms may also benefit from financial economies as the larger firm has more assets to use as security, reducing interest rates and increasing the sources from which funds may be obtained.

(d) Large size firms may have monopoly power within a domestic Economy which may appear to be against the public interest. But such size may be needed to enable the firm to compete on a global basis. In such cases, the domestic economy can benefit from employment and the taxation of profits, which can be used for the benefit of the whole economy. In addition, there are circumstances where a large firm can produce more cheaply, and offer a lower price, than a number of smaller competing firms. This is the case when there are heavy capital costs involved in setting up in business; hence, it would be less cost effective to have two competing rail networks in the UK. This is known as a natural monopoly.

5.5 THE SCALE OF PRODUCTION

(a) (i) short run average cost

(ii) long run average cost

(iii) minimum efficient scale

(iv) constant returns to scale

(v) as more units of a variable factor of production are used in combination with a fixed amount of other factors of production, a point will eventually be reached where the returns obtained from the employment of the variable factor will begin to diminish.

(vi) diseconomies of scale

(vii) Any two of the following:

As the scale of the enterprise increases

it becomes increasingly difficult to control the activities of all of the people involved and to ensure work is being carried out properly.

co-ordination of work is more difficult, increasing the danger that there is duplication of effort or that important tasks are left uncompleted.

effective communication becomes more difficult both vertically and horizontally, increasing the risk of distortion and thus costly inefficient behaviour.

(b) (i) false

(ii) false

(iii) true



5.6 MONOPOLY AND COMPETITION

(a) (i)

TR = OPAQ, TC = OCBQ, Abnormal Profit = CPAB

(ii) AR = £25, AC = £15, therefore profit per unit = £10

profit = no. of units x profit per unit

£20,000 = 2,000 units x £10

profit maximising output is 2,000 units

(b) (i) false

(ii) true

(iii) true

(iv) true

(c) Revenue / cost

(d) the average cost of production is at a minimum.




(a)

Quantity Total Marginal Total Marginal

sold Price cost cost revenue revenue

£ £ £ £ £

1 34 12 12 34 34

2 30 20 8 60 26

3 27 34 14 81 21

4 25 53 19 100 19

5 23 75 22 115 15

6 21 102 27 126 11

7 19 131 29 133 7

(i) The marginal cost is the extent to which total costs change when output is changed by one unit.

(ii) Marginal revenue is the change in revenue obtained when sales are changed by one unit.

(b)

Quantity Total Total

sold revenue cost Profit

£ £ £

1 34 12 22

2 60 20 40

3 81 34 47

4 100 53 47

5 115 75 40

6 126 102 24

7 133 131 2

From the table in (a) above it can be seen that the profit-maximising level of output is 4 as this is where marginal cost at £19 equals marginal revenue which is a condition of profit-maximisation.

(c) Price elasticity of demand for a good is the relationship between the proportionate change in price and the proportionate change in quantity demanded of that good. It is calculated precisely using the formula:

priceinchange%

demandedquantityinchange%demand of elasticity Price

Thus if the price falls from £25 to £23 and demand rises from 4 to 5 units as indicated in the table in (a) above, the price elasticity of demand will be:

125.38%

25%

25 / 2PED 4

1

(d) A PED value of 3.125 indicates that demand for the good is elastic, the proportionate change in quantity demanded being greater than the proportionate fall in price. The major influence on elasticity of demand is the availability of close substitutes. Thus it is possible in this case that substitutes exist and consumers have switched following a rise in price. The good could also be one which accounts for a large proportion of consumers' incomes.



In which case, a relatively small change in price will have a big impact on disposable incomes available to purchase the good. Lastly the time period over which these changes occur is relevant since demand elasticity rises over time as consumers have time to consider and then alter their purchasing habits following a price rise.

(e) If the number of firms in the industry rose there would be a twofold effect on the demand curve for this firm. Firstly more firms would mean more alternatives for consumers to consider, and the more substitute goods available the more elastic the demand curve would become for this individual firm within the industry.

Secondly, it is likely that the extra firms would result in a smaller market share for each firm. A fall in demand means that less is now demanded at each and every price, hence this firm's demand curve will move inwards from right to left.

5.8 REVENUES AND COSTS

The completed table looks like this:

Output Total revenue Marginal revenue Total cost Marginal cost

0 - - 110 - 1 50 50 140 30 2 100 50 162 22 3 150 50 175 13 4 200 50 180 5 5 250 50 185 5 6 300 50 194 9 7 350 50 219 25 8 400 50 269 50 9 450 50 325 56 10 500 50 425 100

(a) Marginal revenue is defined as the addition to total revenue from producing one more unit. The marginal revenue is the same at all levels of output i.e. total revenue increases by £50 each time an extra unit is produced. Marginal revenue is therefore constant throughout and must be the same as average revenue, or price. Graphically, average revenue in thus a horizontal straight line i.e., the demand curve is perfectly elastic. This can happen only under conditions of perfect competition and this firm is operating in a perfect market.

(b) The fixed costs of a firm are those which, in the short run at least, do not vary with output. Fixed costs have to be paid even when output is zero and they are the only ones paid when no production is taking place, since variable costs are incurred only when output is being produced. The firm's fixed costs are therefore the total cost of zero output re £110.

The marginal costs are the additions to total cost of producing extra units, and are shown in the table.

(c) The firm aims to maximise profits and it will do this where the marginal revenue gained from selling the last unit is just equal to the marginal cost of producing that unit. The only output level where marginal revenue equals marginal cost is 8 units, where both MR and MC are £50. The firm will thus produce 8 units.

Profit equals total revenue minus total cost. At 8 units this is £400 £269 = £131.



(d) There are no barriers to entry in a perfect market and so new producers can come in. They will do so, however, only if there is enough profit to attract them in i.e., only if the existing firm (or firms) is making a supernormal profit. The industry will be in equilibrium, i.e. new firms will stop entering, when all firms are making a normal profit. Normal profit is that amount of profit which will just keep a firm in business and it is earned when the firm covers all its costs, including the opportunity cost of giving up the next best alternative employment.

The entry of new producers will reduce the supernormal profit being earned by the existing firm and will also cause its output to fall. This can be illustrated graphically.

When new firms enter the market, the industry supply curve increases i.e. shifts to the right. The new supply curve S2 interacts with the original demand curve and causes market price to fall from P1 to P2. Each firm therefore receives a lower price and average and marginal revenue curves fall from AR1 to AR2 and from MR1 to MR2. The firm's output is reduced from Q1 to Q2. Output and price will continue to fall as new firms continue to enter until all firms are earning just normal profit - there is now no further incentive for any more firms to join the industry.

In conclusion, the firm's output and profits will both fall as new producers enter the market.

5.9 COSTS AND REVENUES

(a) (i) An increase in the firm's costs will cause equilibrium price to rise and output to fall.

(ii) Total profits will fall.

(b) (i) If consumer incomes rose, average revenue and marginal revenue would shift to the right, causing equilibrium price and output to rise.

(ii) New firms entering the industry would shift average revenue and marginal revenue to the left, causing equilibrium price and output to fall.



(c) The entry of new firms may be discouraged by:

increased advertising and brand awareness to encourage consumer loyalty

reducing price (limit pricing) to particularly affect new firms with high start-up costs

reducing price to very low levels (price wars) and sustaining losses for short periods of time as longer established firms may survive where new firms cannot

product differentiation to enable competition in all sectors of the market

vertical integration to control sources of supply or market outlets to give existing firms an advantage

5.10 TYPES OF COSTS

TABLE

The concept of total costs, average total costs, average fixed costs, average variable costs and marginal costs can be explained with the help of a schedule. Fixed cost of the firm is 30.

Units of

Output

Q

TFC

TVC

TC=(TFC + TVC)

AFC=TFC/Q

AFC

AVC=TVC/Q

AVC

ATC = AFC + AVC

MC

1

2

3

4

5

6

7

8

9

10

30

30

30

30

30

30

30

30

30

30

30

40

45

50

60

72

89

110

135

170

60

70

75

80

90

102

119

140

165

200

30

15

10

7.5

6

5

4.3

3.75

3.3

3

30

20

15

12.5

12

12

12.7

13.75

15

17

60

35

25

20

18

17

17

17.5

18.3

20

30

10

5

5

10

12

17

21

25

35

It is clear from the above schedule that the fixed cost is unchanged throughout that is 30 but Average Fixed Cost is diminishing because when output increases, the fixed costs spread over the total output and hence, Average Fixed Cost is diminishing due to law of increasing returns.

Relationship between Marginal Costs and Average Total Cost

1. It is clear from the table that from 1st unit to 6th unit average total cost is diminishing and marginal cost is less than average total cost.

2. Marginal cost at 7th unit is equal to Average Total Cost and Average Total Cost is minimum.

3. Average total cost is increasing from 8th unit to 10th unit and marginal cost is also increasing but average total cost is increasing at a slower rate than the marginal cost.



Relationship between Marginal Costs and Average Variable Cost

1. Average variable cost is diminishing from 1st unit to 5th unit and marginal cost is less than average variable costs.

2. Average variable cost is minimum at 6th unit of output and marginal cost is equal to average variable costs.

3. Average variable cost is increasing from 7th to 10th unit and marginal cost is also increasing but marginal cost is increasing at a faster rate than the Average Variable Cost.

5.11 MONOPOLY SETUP

Disadvantages of having a monopoly setup.

(i) To retain the market power a monopolist might restrict competition by placing barriers to entry of new firms and by taking over small competitive firms.

(ii) Quite often a monopolist enjoys control over vital resources and might take decisions which may not be in the public interest. For example, in case of strategically important industries such as, steel mills, electricity generation and nuclear plants etc.

(iii) Mostly the monopolists are less receptive towards innovation as they are already earning super normal profits.

(iv) Monopolists are likely to indulge in price discrimination i.e. charge different prices from different people in accordance with their ability to pay to maximize their already high profits for the same product.

(v) They do not use resources in the most efficient possible way. That is combining factors of production so as to minimize average unit cost. Therefore there are no economies of scale. Eventually a monopoly will produce less and sell at higher prices than combination of firms in a competitive market.

5.12 CONSUMPTION GOODS

(a) Consumption goods are products and services that are directly consumed by the customer himself, and are not bought with the purpose of either reselling or using in production of products/services to sell.

The demand for consumption goods is determined by:

(i) income levels of consumers

(ii) wealth of consumers

(iii) preferences of consumers

(iv) prices of related/ complementary goods

(v) prices of substitutes

(vi) future expectations of price changes



(b) Price elasticity is the measure of the responsiveness of the quantity demanded of a product to any changes in its price.

Price elasticity =

P

P

P

P

Q

Q

Q

Q

Here Q1 = 48,000; Q2 = 60,000

P1 = Rs. 12; P2 = Rs. 11

12,00060,00048,000QQDemandin ChangeΔQ 21

11112PPPriceinChangeΔP 21

Price Elasticity =

1

12

48,000

12,000- 12

48,000

12,000-

4

12- 3

Ignoring the –ve sign* Price Elasticity = 3

*The negative sign shows the normal (decreasing) demand curve.

5.13 EQUILIBRIUM OF THE FIRM

(a) Equilibrium of the Firm is the point at which the firm has no incentive either to expand or contract its output. A firm would not change its level of output as it is earning maximum profits at this point.

(b) The essential conditions for the existence of conditions for perfect competition are:

(i) Large number of buyers and sellers

There are large number of buyers and sellers operating in the market. No single buyer or seller is able to influence the price because the output of a single firm or the quantity demanded by a single buyer is a very small proportion of the total market.

(ii) Homogenous product

The products produced by all firms are standard or identical. Any difference will allow the producer to charge different price.

(iii) Free entry or exit

There are no restrictions, legal or otherwise on the firms to enter or exit from the market.

(iv) Perfect knowledge of prices

The buyers and sellers are fully aware of the price prevailing in the market and hence the same price prevails throughout the market.

(v) Transport costs are zero or very insignificant

If the same price is to exist throughout a market, it is necessary that the transport cost should be zero or insignificant.



(c) The equilibrium of a firm under perfect competition and in the long run is depicted by the following diagram:

Under conditions of perfect competition, the same price prevails in the market and hence sale of each additional unit produces the same revenue and therefore MR=AR=P(Price) . PL is the line which represents MR as well as AR. LRMC is the marginal cost curve which depicts the increase in cost on account of production of each additional unit. With the sale of each additional unit the total profit of the firm would increase till such time that the LRMC remains below the Marginal Revenue Curve i.e. PL. The profit will be maximum when the LRMC Curve cuts PL from below at which stage LRMC would be equal to Marginal Revenue. At this stage the firm would be producing OM units.

In the long run, the firms are able to increase/decrease their output by varying their equipment. Therefore, in the long run no firm is in a position to earn super normal profits. If price increases and the firms start earning super profits, other firms enter the market or present firms increase their output. If price decreases and there are below normal profits, firms exit the market. Therefore, in the long run, the price always reverts back to the position where all firms are earning normal profits.

5.14 MARKET FUNCTIONING

The features which distinguish a market functioning in an environment of perfect competition from a market which operates as a monopoly are:

(a) Number of Sellers - In conditions of perfect competition there are a large number of sellers in the market. The individual sellers compete to sell their products in the market, but in a monopoly there is only a single firm which sells the product.

(b) Entry and Exit of Firms- In perfect competition, new firms can freely enter the industry and inefficient firms can exit if they suffer losses. Under conditions of monopoly, there are several barriers which are difficult to overcome for prospective new entrants.



(c) Options available to Buyers - In a market characterised by perfect competition, the buyers have the option to purchase from any firm in the market. Under conditions of monopoly, the buyers must purchase from the only seller who dominates the market.

(d) Earning of Normal and Super-normal Profits - In perfect competition, a firm may earn super-normal profits in the short-run. In the long-run, the firm can earn only normal profits as new firms would enter the market and force the prices to fall. Under conditions of monopoly, a firm can earn super-normal profits in the short-run as well as in long-run due to the existence of barriers which prevent entry of new firms.

(e) Price Discrimination - A firm under perfect competition cannot sell at discriminatory prices as the prices are given and an individual seller cannot influence the price. A monopolist can increase the total revenues by discriminating among the buyers and charging higher prices from buyers whose demand is inelastic and lower prices from customers whose demand is elastic.

(f) Price of Products and Level of Output - Under conditions of perfect competition, the prices are lower and the output is larger. A monopolist often charges higher prices from the customers and can manipulate the level of output to obtain maximum revenues.

(g) Consumer Welfare - Consumer welfare is considered to be maximum under conditions of perfect competition as every individual firm strives to produce at its optimum level. On the other hand, a monopolist is in a position to manipulate his output even at sub-optimum levels, and therefore consumers have to pay higher prices than under conditions of perfect competition.

5.15 FREE FORCES

(a) Determination of equilibrium price and equilibrium quantity through the forces of demand and supply:

In the above diagram, there is only one price P at which the quantity demanded and the quantity supplied is equal and this is the point where the market is deemed to be in equilibrium. Thus Q is the equilibrium quantity and P is the equilibrium price.



At prices and quantities other than the equilibrium, either demand exceeds supply or supply exceeds demand.

For instance at price P1 supply exceeds demand resulting in unsold stocks. The reaction of suppliers would be to accept lower prices than P1 to encourage sales. This reduction in price will lead to a contraction in supply and an expansion in demand until equilibrium is reached at price P.

Conversely, at price P2 demand exceeds supply resulting in a shortage. This excess demand will lead to an increase in market price. As a result the demand will contract and supply will expand until equilibrium is reached at price P.

(b) Short-run average cost curve is U shaped:

The average cost is made up of an average fixed cost per unit plus an average variable cost per unit.

Average fixed cost will fall as the level of output rises. Spreading fixed costs over a larger amount of output is a major reason why (short-run) average costs per unit fall as output increases.

The standard assumption about the variable costs is that up to a certain level of output, the variable cost per unit is more or less constant (e.g. wages costs and materials costs per unit of output are unchanged).

Nevertheless, there is evidence that average variable costs rise when output increases beyond a normal capacity level.

Average variable costs will therefore begin to rise at some point, even assuming that there are no overtime payments or use of more skilled labour.

As variable costs per unit rise, the average total cost per unit will rise too.

Hence the curve falls on account of spread of fixed costs and rises when the variable costs start rising after a certain level, thus giving the curve a U shape.

5.16 PRICE OUTPUT DETERMINATION

(a) Price – Output Determination Under Monopolistic Competition in Short-Run

Monopolistic competition is a market structure where many sellers produce similar, but not identical, goods. Each producer can set price and quantity without affecting the marketplace as a whole

Monopolistic competition is similar to perfect competition in some ways (number of buyers and sellers etc); however there are also a number of features that differ.

A comprehensive list of features is as follows:

Many producers and many consumers

Knowledge is widespread, but not perfect

Non-homogenous products

Producers have some control over price (“price makers”)

Barriers to entry and exit do exist, but are low

Brand loyalty exists, making demand less sensitive to price

Firms also engage in some form of marketing

Ability to make some supernormal profit



(i) Super Normal Profit (ii) Normal Profit (iii) Losses

In the above diagrams, AR is the average revenue curve, MR is marginal revenue curve, SAC is the short-run average cost curve, and SMC is the short-run marginal cost curve. The marginal revenue curve (MR) and marginal cost curve (SMC) intersect each other at the output M at which price is P’ MP, because P is point on AR (Average revenue), i.e. price.

In diagram (i), the firm is earning supernormal profit PT per unit of output which is the difference between average revenue MP and average cost MT (T is on SAC) at the equilibrium point. Total supernormal profit will be measured by the area of rectangle PTT’P’, i.e. output multiplied by supernormal profit per unit of output.

In diagram (ii), the firm is earning normal profit where SAC curve is tangent to AR curve i.e. AR=AC

In diagram (iii), the firm is incurring loss TP per unit of output which is the difference between average cost MT (T is on SAC) and average revenue MP at the equilibrium point. Total losses will be measured by the area of rectangle TPP’T’, i.e. output multiplied by loss per unit of output.

In the short-run, therefore, the firm will be in equilibrium when it is maximising its profits, i.e. when Marginal Revenue = Marginal Cost


Duopoly: Duopoly is a special case of market when there are only two sellers and both the sellers are independent in price and output determination yet a change in price and output of one affects the other, and may set up a chain of reaction.

Oligopoly: ligopoly is a “Market Model with a few sellers producing either homogenous or differentiated products and where the decisions of any single firm are based on the expected reaction of other firms and where entry is difficult or blocked”.

5.18 PRICE CARTEL AND COLLUSION

Price Cartels:

A price cartel or price ring is created when a group of oligopoly firms combine to agree on a price at which they will sell their product in the market. Cartel agreement attempts to charge higher price by restricting supply.

Collusion:

Each oligopoly firm could increase its profits if all the big firms in the market charge the same price and split the market share among them. This is known as collusion.



5.19 PRICE LEADERSHIP

Price Leadership occurs when all the firms realize that price initiated by one firm is beneficial to them, so follow the leader and charge the same price. Price leadership firm may not be of big size but its price and output policy is followed by other oligopoly firms.

5.20 KINKED DEMAND CURVE

K k Ol o ol D C v o Sw z ’s Mo l of Oligopoly:

Sweezy believed that the rival firm will follow a price decrease policy but may not follow a price increase policy. This gives a kink in the demand curve. The kinked demand curve shows that the demand curve will be more elastic before a certain point and inelastic after that point. Before price cartel it behaves like monophonic completion and after price cartel is formed it behaves like monopoly. Therefore, the curve is initially elastic and then inelastic.

5.21 NON-PRICE COMPETITION

Oligopolies tend to avoid price competition because competitors will match any price cuts. Firms wishing to increase sales are more likely to use non-price competition such as:

(i) Advertising, where firms promote information about the company or a product. Advertising aims to:

(1) Increase demand for a product;

(2) Improve brand image and encourage consumer loyalty, thereby making demand more price-inelastic;

(3) Create separate markets for the same product so that price discrimination can take place e.g. soap, powders, shampoo etc.

(ii) Organizing promotion campaigns (e.g. free offers).

(iii) Providing improved “after– sales service”.


6.1 NATIONAL INCOME

(a) (i) Production / output / value added method:

In this method the National Income is found out by adding up net values of all production that has taken place in all sectors during a given period.

The net values of production of all the industries and sectors of the economy plus the net income from abroad give us the Gross National Product (GNP).

By subtracting the total amount of deprecation of the assets used in production, from the figure of GNP, we get the National Income.

(ii) Income Method:

This method measures the National Income after it has been distributed and appears as income earned or received by individuals of the country.

In this method National Income is calculated by adding up the rent of land, wages of employees, interest and profit on capital and income of self employed people.



(iii) Expenditure Method:

This method arrives at National Income by adding up all the expenditure made on goods and services during the year.

The National Income is found by summing up all the conventional and the investment expenditure by individuals, corporations and the government of a country during the given period.

(b) Difficulties in Measurement of National Income:

Non-marketed production

Many kind of productive works such as services of housewives, agricultural products used by farmer for own consumption are ignored.

Barter transactions

Since no money is involved, these transactions are either totally ignored or included on the basis of approximation.

Foreign Firms

Income of foreign firms creates a complication i.e. whether to include it in national income of the country of operation or country of origin.

Lack of trained staff

Collection, compilation and analysis of statistical data is a highly technical exercise and availability of sufficient trained staff is often difficult.

Illiteracy/unreliable record keeping

Due to illiteracy many producers keep unreliable data of their production.

Black Economy

A significant part of economic activity relates to black economy and is often ignored in such calculations.

6.2 MEASURING NATIONAL INCOME

(a) The calculation of the national income is based on the concept of the circular flow of output, expenditure and income and the assumed equality of each of these stages of the flow. Given this concept, it should be possible to sum total income and total output and the results should be the same. On this basis, the official figures show the calculation of national income by each of the three methods:

(i) The expenditure method totals payments made for final goods and services. It shows the following main items: consumer spending, public authorities' current spending on goods and services, capital investment (termed gross domestic fixed capital formation) and the value of the change in stocks of goods and goods being made. These items give total domestic expenditure. When adjusted for imports, exports and property income from abroad the total becomes the gross national product (national expenditure).

(ii) The income method aggregates payments to all factors of production. It thus shows income from employment, income from self-employment, trading profits of companies and public corporations and other trading enterprises and rent. These items totalled give the gross domestic product (domestic income) and this is also adjusted for property income from abroad to give gross national product (income).



(iii) The output method is found by summing all the totals of value added by each business and industry sector and the various sectors of public health, education, administration etc.

All three methods should produce the same total figure however in practice this is not usually the case mainly due to the enormity of the number of transactions being aggregated.

(b) There are many difficulties involved in producing accurate national income figures. The major problem comprises that of double counting. For instance using the output method, outputs of some firms become inputs of others. For example, the output from a factory making electrical components will be used as inputs in the motor industry. If the total value of both industries' output were included in the aggregate then the value of the components used in the motor industry would be included twice. To avoid this problem only the value added at each stage of production is added. Double counting also becomes a problem when using the income method. The sum of all factor incomes is not the same as the sum of all personal incomes as these also include transfer incomes, which are subsistence payments for no actual productive process. In the UK these mainly include social security payments. In essence these payments are purely transfers from tax payers who provide the money to other persons such as the unemployed or disabled and thus should not be included twice as two forms of income.

Another major problem is that of self-provided services. Some goods and services are not actually traded through the market sector and are not therefore included as part of the aggregate output figure although they do form part of the country's output. Examples include repair and improvement work done on a DIY basis or housework carried out at home. There is no market measurement of the value of the output and thus it is not included. In some cases an imputed value is used for instance the value of owner occupied housing where the market rents of similar properties are used as guidelines.

A problem using the income method is the non-distribution of some factor incomes to factors of production. Companies as well as the government may retain profits and surpluses and thus an allowance has to be made in the national income figures to account for these undistributed amounts. A similar problem arises when using the expenditure method due to the distortion in the figures which indirect taxes and subsidies make and for which an adjustment must be made. Indirect taxes increase the total expenditure on goods and services compared to the amount received by the factors of production and vice versa for subsidies. The expenditure total is therefore adjusted to factor cost by deducting indirect taxes and adding back subsidies. Finally still more adjustments are necessary for changes in stock levels, for exports net of imports and an allowance for depreciation to allow for the capital used up in the production process.

In addition to all the specific problem already mentioned there is the added problem of accuracy of the figures which affects all three measurements.




(a) Diagram of the Circular Flow of Income

(b) WITHDRAWALS

A withdrawal is where money exits the circular flow of income, and is no longer passed between agents.

Savings – Households do not spend all their income and save a certain portion. These savings are withdrawals from the Circular Flow of Income

Taxation – The amount of taxes paid to the government is not available for spending by the households and is therefore considered as withdrawals from the Circular Flow of Income

Imports – The expenditures incurred on the purchase of imported goods and services accrue to firms in foreign countries and therefore constitute withdrawals from a country’s Circular Flow of Income.

INJECTIONS

An injection is where money enters the circular flow of income from an external source, meaning that it can then be passed between agents. Investments - Investments in capital goods are a form of spending on future output which is addition to the expenditure and are therefore considered as injection of funds into the Circular Flow of Income

Government Spending - The funds spent by the government are injections in the Circular Flow of Income. The funds may be raised by way of taxes or borrowings by the government.

Exports – The goods and services produced by the firms in the country and exported, result in income from abroad and are therefore injections in the Circular Flow of Income.



6.4 INJECTIONS AND WITHDRAWALS

(a)

Figure 1

Figure 1 shows that in simplistic terms, the behaviour of the national economy is determined by the circular flow of income between two principal agencies, households and firms. Households will spend their income on things purchased from firms, this is consumption. Firms, however, will spend all their income on hiring factors of production i.e., land, labour, capital and entrepreneurship from households. Hence, what households spend on consumption is in fact what firms have paid out to them in terms of factor rewards. Thus total sales revenue of firms should equal total consumption of households, assuming all income is spent. Clearly this is not the case. Households do not spend all their income on consumptions, some is disposed of by way of savings, taxation and payments for imported goods. These are the withdrawals from the circular flow. Conversely, there are inflows into the circular flow in the form of capital investment undertaken by firms, government expenditure and payments made by foreigners in order to purchase UK goods i.e. exports. These are known as injections.

If withdrawals and injections are equal, the circular flow will remain in equilibrium and there will be no change in the level of national income. However, if for instance, injections rise and thus spending exceeds available output, national incomes will rise. Producers will react by increasing output in the following period to meet the increased demand. As the national income grows, so too will withdrawals as households choose to save some of their increase in income or spend on imports. When the increase in withdrawals finally matches the original increase in injections, national income will be restored to an equilibrium level albeit a higher one.

(b) Savings represent a withdrawal from the circular flow of income. If households choose to increase their rate of saving it would mean less expenditure on goods and services provided by firms and thus a reduction in their revenue. As a consequence of this in the following period firms will reduce their output since stock levels will be higher as not all production will have been sold and to take account of the reduced consumer spending level.

The initial fall in output experienced by the business sector will in fact be magnified due to the multiplier process. The fall in output will eventually lead to a fall in employment and income and hence to a further fall in consumer spending. The equilibrium level of national income will only be restored if and



when planned withdrawals including savings once again match planned injections. Because of the reductions in output etc. this will be at a reduced level and the economy can be said to be operating in a downturn phase of the business cycle.

An increase in the rate of savings may affect the business sector in another way by making available a greater supply of funds to financial intermediaries, who according to the loanable funds theory should then be offering these funds for investment purposes at a lower rate of interest. The business sector may therefore be encouraged to invest taking advantage of the cheaper funds. However it may be put off due to lower expectations of profitability given the reduction in the national income.

6.5 AGGREGATE SUPPLY: SHORT RUN

(a) A curve similar to:

Higher prices in the economy lead to an expansion of aggregate supply in the

short run.

(b) The curve needs to shift outwards

The shift from SRAS1 to SRAS2 shows an increase in aggregate supply at each

price level



(c) The following are reasons for a backward shift in SRAS. Other answers that refer to a change in SRAS are acceptable, as long as it doesn’t refer to a movement along the curve

i. Decrease in factor productivity of both labour and capital

ii. Decrease in size and quality of capital stock, through investment

iii. Decrease in size and quality of the labour force

iv. Increase in producer taxes

v. Decrease in producer subsidies

vi. Increase in inflationary expectations (e.g. causing a rise in inflation, and a rise in wages, causing supply to shift inwards)

6.6 AGGREGATE SUPPLY: LONG RUN

(a) “Going from the short run to the long run, the aggregate supply curve gets “steeper”. This is because in the “long run” resources are used at their most efficient point. The long run aggregate supply curve (LRAS) is a “vertical” line as it is completely “independent” of the price level.

(b) Less likely.

y its nature, it is assumed that the LRAS curve doesn’t fluctuate too greatly.

Instead, if there are significant, permanent changes to the productive potential of the economy, then this will lead to a shift.

An increase in the quantity and productivity of the factors of production, or an advance in technological capabilities in the economy would cause an increase in the productive potential, and therefore the LRAS.

A lot of changes in the SRAS come about from resources becoming more or less efficient. However because the LRAS assumes full efficiency, it isn’t affected by these changes.

6.7 AGGREGATE DEMAND

(a) C: consumer expenditure on goods and services

I: Investment spending

G: Government spending

X: Level of exports

M: Level of imports

The equation is: AD = C + I + G + (X – M)



(b) The curve shifts inwards

AD1 to AD3 is a decrease in aggregate demand

Other examples could be:

Firms have a wave of pessimism and cut back on investment in projects

Government decides to spend less on infrastructure projects

Exports become less attractive to foreign firms

Imports become more desirable for domestic firms

(c)

Definition: Effective demand

Actual expenditure in an economy is based on existing/ actual income, rather

than if the economy was at its productive potential (when all resources are fully

utilised).

This asserts that agents in an economy will only make expenditures with a percentage of their income, rather than an assumption that if the economy is in the long run, all income could possibly be used to fuel aggregate demand.




(a)

(b)

The key point to note is that the level of output increases proportionately more than the price level. In a deep recession/ depression the price level won’t increase at all.

(c) Important here is to show that there is an SRAS and an LRAS, rather than one supply curve.

Equilibrium in both cases should be to the left of the LRAS

An increase in AD leads to an increase in output, but also to an increase in the price level.




(a) The difference between the actual output of an economy, and the production potential of an economy is known as the output gap.

Definition: Output gap

The difference between potential GDP and actual output in an economy.

A positive output gap is known as an: inflationary gap

A negative output gap is known as a: deflationary gap

(b) The key point is that the equilibrium of AD and SRAS is beyond the LRAS

(c) The key point is that after a while, the SRAS shifts upwards and equilibrium is restored on the LRAS, however at a higher price level.



Have a diagram similar to below:

There is an increase in AD, and then a shift back in SRAS

With equilibrium beyond the LRAS, caused by a shift in AD from an increase in government spending, the equilibrium in the economy moves from A to B. This increases the price level from P1 to P2 because if demand increases, consumers on the aggregate are willing to pay a higher price for goods.

When the equilibrium is at B, this is unsustainable. To produce that much output would mean that there is a shortage of labour. In the long run, this will mean wages will increase, causing a rise in the level of SRAS.

This takes the economy from B to C. In doing so, the price level increases from P2 to P3.

This is important to note: a price rise does not equate to inflation.

However, persistent price rises (i.e. two or more) is the definition of the start of inflation.

6.10 DEFLATIONARY GAP

Deflationary gap:



Or the following are acceptable

In the above diagram, Aggregate supply is shown by the line AS and Aggregate demand by the line AD.

The actual level of national income is at the intersection of the AD and AS curves i.e. at Ye.

Yf is the national income at full employment.

The gap between actual level of national income and national income at full employment is called a deflationary gap. Prices are fairly constant and real output changes as aggregate demand varies.

The unfavourable consequences of unemployment are:

(i) Loss of Output – Unemployment results in the under-performance of the economy and low levels of output of goods and services. Consequently, there is a decline in the level of national income.

(ii) Loss of Human Capital – Unemployment leads to gradual erosion of the work skills of the unemployed workers and deterioration in their capacity to perform satisfactorily in future.

(iii) Increase in Inequality in Distribution of Wealth – Unemployment results in loss of incomes and decline in savings of unemployed persons. This leads to more inequitable distribution of wealth among the citizens.

(iv) Social Costs – Unemployment brings social problems of mental depressions, increase in crime rates and causes personal suffering to the unemployed workers and their families.



6.11 CALCULATION OF GDP

(a) The expenditure approach.

(i) Consumer expenditures Rs. 1,100,000

(ii) Government expenditures Rs. 500,000

Total expenditure Rs. 1600,000

(iii) Exports Rs. 400,000

Total 2,000,000

(iv) Imports (–) 400,000

GDP Expenditure approach 1,600,000

(b) Income Approach

Income received by the labor force (Pretax) = Rs. 900,000

Gross profits of the firms (Pretax) = Rs. 700,000

GDP Income approach Rs. 1,600,000

(c) Value added approach/output approach.

Total output produced & sold = Rs. 2,000,000

Imports of raw material Rs. (–) 400,000

GDP Value added approach Rs. 1,600,000

IMPORTANT NOTES

Note NO. 1

GDP at market prices = Consumption expenditures + Federal Govt. expenditures + Capital formation – physical decrees in stocks + Exports–Imports

Note NO. 2

GNP at market prices = GDP at market prices (+) Net property income earned from abroad.

Note NO. 3

GDP at factor cost = GDP at market prices – Taxes on expenditures + subsidies

Note NO. 4

GNP at factor cost = GDP at factor cost + Net property income earned from abroad.

Note NO. 5

National income at factor cost = GNP at factor cost – Depreciation i.e., capital




(i)

Rs. million

Consumption expenditure 20,000

Federal Govt. Consumption expenditures 4,500

Capital formation 5,100

Total Expenditure 29,600

Value of physical decrease on stocks (100)

Total domestic expenditures 29,500

Exports 7,000

Total 36,500

Imports (6500)

Total domestic expenditures 30,000

(iii) GDP at market prices 30,000


GNP at market prices 30,500

(ii) GDP at market prices 30,000

Taxes on expenditure (6000)

Total 24,000

Subsidy 500

GDP at factor cost 24,500

(iv) GDP at factor cost 24,500


25,000

(v) GNP at factors cost 25,000

Depreciation (Capital Consumption) (2000)

National Income (NNP) at factor cost 23,000

(vi) GNP at market price 30,500

( - ) Capital consumption (2,000)

NNP at market prices 28,500




(i) Computation of G.D.P. by expenditure approach

Rupees

in million

(a) Consumer’s expenditures 16,500

(b) Government expenditure 7,500

(c) Total exports 6,000

Total expenditures 30,000

(d) Total imports (6,000)

Total expenditures 24,000

(ii) Computation of G.D.P. by income approach

(a) Profit before tax of firms 10,500

(b) Wages etc. received by employees 12,000

Total income 22,500

(c) Tax deducted out of wages 1,500

Total income 24,000

(iii) Computation of G.D.P. by value added approach

(a) Sale value of output of firms 30,000

(b) Cost of goods and services purchased from outside firms ( 6,000)

Total value 24,000


(a) GDP at market prices = Consumption expenditure +Federal Government

expenditure + capital formation physical decrease

in stocks + exports imports.

(i) Consumers expenditure Rs. 27,600 million

(ii) Gross domestic fixed capital formation Rs. 7,380 million

(iii) General Govt. final consumption Rs. 6,810 million

Total 41,790

(iv) Physical decrease Rs. (30) million

Total 41,760

(v) Exports Rs. 9,675 million

Total 51,435

(vi) Imports Rs. (9,360) million

GDP at market prices Rs. 42075



(b) GDP at factor costs = GDP at market price Taxes on expenditure + subsidies.

(i) GDP at market prices Rs. 42,075million

(ii) Subsidies Rs. 450 million

42,525

(iii) Taxes on expenditure Rs. (4,140) million

GDP at factor cost Rs. 38,385

(c) GNP at market prices = GDP at market prices + Net property income earned

from abroad.

(i) GDP at market prices Rs. 42,075 million

(ii) Net property income from abroad Rs. 315 million

GNP at market prices Rs. 42,390

(d) GNP at factors cost= GDP at factor cost + net property income from

abroad.

(i) GDP at factor prices Rs. 38,385 million

(ii) Net property income from abroad Rs. 315 million

GNP at factor cost Rs. 38,700

(e) National income at factor cost= GNP at factor cost () Capital Consumption

(i) GNP at factor cost Rs. 38,700 million

(ii) Capital consumption Rs. 2,625 million

National Income at factor cost Rs. 36,075

(f) NNP at Market prices

(i) GNP at market prices Rs. 42,390

(ii) Capital consumption Rs.(2,625)

NNP at Market prices Rs. 39,765





(a) (i) D

(ii) C

(iii) H

(iv) J

(v) G

(b) (i) Injections to the circular flow are:

exports

government spending

investment

(ii) Leakages from the circular flow are:

imports

taxation

savings

(c) (i) An increase in household savings increases the pool of funds available for investment. This may lead to a fall in interest rates but also reduces the spending of households (due to interdependence of consumption and saving) and therefore demand for the goods and services produced by firms.

A decrease in interest rates reduces the cost of borrowing for firms which should promote investment but the reduction in demand may have a serious effect on sales. The extent of the effect will depend on the type of product, as those for which demand may be postponed will be the worst affected.

The fall in interest rates could have a positive effect on consumption. Lower interest rates might result in some consumers having more disposable income as they pay less for mortgages and loans etc. Also, the lower interest rates make saving less attractive and this might slow or reverse the trend to save more.



7.2 INVESTMENT AND MEC

(a) A fall in interest rates should decrease the cost of investment relative to the potential yield that the investment might bring, thereby increasing the likelihood that investment will occur.

Firms will invest if the discounted yield (i.e. the benefit) exceeds the cost of the project

The MEC schedule shows the total level of investment which will take place in the economy at each level of the interest rate.

(b) Governments are more likely to undertake autonomous investment: investment that is motivated by the wellbeing to society that it delivers

This is independent of the profit it may bring, as it is not carried out for that purpose.

This type of investment is ordinarily undertaken by public bodies, or private organisations not pursuing profit

Examples of autonomous investment include: construction of highways, street lighting and other infrastructure projects

Private firms are more likely to undertake induced investment: investment that is motivated by the margin of profit that it delivers

The greater the margin, the more will be invested until the economic gains no longer outweigh the costs.

This type of investment is associated with private enterprise in pursuit of maximising profit.

Examples of this include: improvements to machinery, human capital (i.e. staff training that will generate an economic return) and new assets

(c) “Discounted yield” & “cost of the project”

(d) The MEC curve can shift outwards if the expected rate of return increases. This could be due to:

an increase in business confidence (future demand for goods will increase)

an expectation that interest rates will decrease



7.3 CONSUMPTION FUNCTION

(a) Each household has an income, with which they can choose to either spend on goods and services immediately (i.e. consume), or choose to not spend it in the current period (i.e. save).

Income = Consumption + Savings

(b) It is important to bring in the concept of the marginal propensity to consume.

MPC change in consumption

change in income, MPC

This leads to a discussion of Keynes’ Psychological Law people increase their consumption as their income increases, but not by as much as their income increases

There are 3 propositions that can be inferred from this law:

1. Aggregate consumption can increase due to increased aggregate income, but the increase in aggregate consumption will be less than the increase in income. This is because as basic necessities are fulfilled, people begin to save additional income, hence savings increase.

2. What isn’t spent on consumption is saved.

3. The increase in income will lead to increased consumption or savings. It is not possible for an increase in income to lead to a decrease in consumption and savings.

A low-income family is likely to consume a greater amount of their income than a high-income family.

Investment is crucial: because consumption makes up less and less of revenue as it increases, it is important to boost investment to make up this shortfall. Failure to do so would result in unemployment.

Redistribution of wealth: The transfer of money from high-income households to low-income households will lead to an increase in the overall level of consumption in the economy.

(c) When looking at the stability of the consumption function, it is necessary to view it in both the short and long run.

In the short run, it is assumed the APC will remain the same: if a household receives an additional $100, they will save and spend in the same proportions as they have previously.

However, in the long run, it may be that not all households will consume and save at the same rate.

As income rises, a household will (as a percentage of total income) spend less, and save more, meaning that over time, the APC will decrease (and thereby not remain constant).



7.4 PRIVATE INVESTMENT

(a) The government can influence the level of private investment in several ways:

(i) Control interest rates: By keeping interest rates low, for example, the government might encourage a higher volume of investments, whereas by allowing interest rates to rise, the government would probably cause the volume of investment to fall. Government can influence interest rates.

(ii) Provide direct encouragement to investing firms: By offering investment grants, perhaps directed at particular regions, by lowering the cost of investment i.e. cost of doing business, by improving the rule of law, by providing tax incentives etc.

(iii) Seek to stimulate business confidence: By developing and announcing an economic policy for continued growth which should be consistent with the stated goals. Frequent and sudden changes in economic policy results in loss of business confidence.

(iv) Encourage technological developments: By financing research schemes of its own as well as those of private firms. In the long run, investment in education might be significant for the strength of innovative research and development by the country’s industries.

(v) Influencing the volume of consumption: Sometimes the government indirectly influence the level of investment, for instance a policy to control the growth in the money supply, would help in credit control and would in turn affect consumer spending, especially in consumer durable goods. Changes in consumption affects investment levels, with the influence of the accelerator.

(vi) Government spending: Higher government spending in infrastructure cerates demand which stimulates investment by the private sector.




8.1 MULTIPLIER

(a) Multiplier is the ratio of the increase in Total National Income to the Initial increase in National Income that brought about the change.

Formula of Multiplier =

∆Y

∆I

It is a measure of the effect on Total National Income due to a unit change in a certain component of aggregate demand, particularly investment spending, consumption spending, government spending or exports.

(b) The limitations of the Multiplier are:

(i) Efficiency of Production: If the production system of the country cannot cope with increased demand for consumption goods and make them readily available, the incomes generated will not be spent as envisaged.

(ii) Regular Investment: the value of the multiplier will also depend on regular repeated investments. A steadily increasing level of investment is essential to maintain the momentum of economic activity.

(iii) Leakages: Leakages from the circular flow of income would make the value of multiplier very low and extra spending in the economy would have nominal effect, particularly where there is a high marginal propensity for imports.

(iv) Multiplier Period: A long period of adjustment would be required before the benefits of multiplier are realized. If a government strives for prompt measures to improve the economy, relying on demand management and the multiplier would not yield effective results.

(v) Full Employment Ceiling: As soon as full employment of the idle resources is achieved, further beneficial effect of the multiplier will practically cease.

8.2 MULTIPLIER 1

(a) There is a simple process for savings becoming investment in an economy:

Rich households don’t wish to consume all of their capital

Entrepreneurs require capital to invest in projects

An agreement is made between household and entrepreneur

Therefore savings become used for investment

This process is usually facilitated by banks

(b) Planned. There is a time lag between when investment decisions are made, and the eventual change in output.

It will not necessarily follow that agents in the economy will follow this level, however it is the intent that is important.



(c) If output is beyond M, then

Households will save a higher portion of their income.

This means that they will be holding back from consumption

Which means firms will not invest (because there will not be the demand to meet it)

Firms not investing will reduce the eventual output in the economy

The economy comes to rest again at M

8.3 MULTIPLIER 2

(a) “income of another”

(b) If aggregate demand is boosted

When the economy was in a deep depression, Keynes argued that the AS curve would be flat. There would be so much spare capacity for firms that an increase in production wouldn’t lead to an increase in price.

For example, if there is high unemployment, if a firm needs to hire more workers to increase supply, then the cost to the firm will be comparatively low, compared to if the economy was at full employment, and wages would be high.

The increase in AD has caused output to increase from Y to Y , but the price

level remains unchanged.

This shows how a boost in AD has the effect of increasing output, thereby helping the economy move out of depression.

If aggregate supply is boosted

The types of policies that Keynes argued were not necessary were ones that looked to increase the competitiveness or capacity of supply. Examples of these are measures to reduce wages, or the cost of raw material.

From the point of being in a depression, Keynes argued that there would be no change in the output of the economy, because AD would remain stubbornly fixed. This is illustrated below.



The increase in AS has had no effect on the equilibrium output because the AS

curve remains horizontal at that stage.

(c) Choose from:

Marginal Propensity to Consume: how much of income generated through the investment will be spent on other goods and services in the economy. If MPC is high, then the multiplier effect is stronger

Tax rate: how much of this income will be returned to the government in the form of tax. The lower the tax rate, the higher the multiplier effect

Marginal Propensity to Import: how likely individuals are spend their income outside of the domestic economy, which reduces the impact of the multiplier

Supply-side capacity of the economy: if there is no spare capacity in the economy, an increase in government investment may lead to inflation, which would lessen the ‘real’ effects of the investment

Time lag: planned investment takes time to implement. There could be many years before the effects of the multiplier are felt.

8.4 ACCELERATOR QUESTION

(a) Gross investment = net investment + depreciation

The amount of investment required for all new investment, plus to service the fall in value of existing capital

The accelerator principle asserts that investment levels in an economy are positively related to a change in the rate of GDP

If the rate of GDP increases, then firms will increase investment.

In order to meet a fixed capital: output ratio, a firm needs to not only invest in new capital, but also cover the depreciation of capital from the previous year.

Gross investment is the actual level of investment that firms undertake in response to a change in GDP.



(b)

Example:

Year Y

(=Output)

Stock of

capital

[1]

Net

investment

[2]

Depreciation

[3]

Gross

investment

[4]

(0) (200) (600)

1 200 600 0 60 60

2 220 660 180 60 240

3 240 720 180 66 246

4 250 750 90 72 162

5 250 750 0 75 75

[1]: Capital : output ratio = 3:1

[2]: Net investment = 3*change in output compared to previous year

[3]: Depreciation = 0.1*Stock of previous year’s capital

[4]: Gross investment = Net investment + depreciation

(c)

Example:

Year Y

(=Output)

% change in Y Gross

investment

% change in

gross

investment

(0) (200)

1 200 0 60

2 220 10 240 300

3 240 9.1 246 2.5

4 250 4.17 162 -34.1

5 250 0 75 -53.7

(d) There is a disparity in the rates of change of output and gross investment.

When % change in Y increases, the %change in gross investment increases quickly

When % change in Y begins to slow, the % change in gross investment falls dramatically.



CHAPTER 9 – MONEY

9.1 THE MONEY SUPPLY

(a) An important distinction when considering money, is that to be made between 'real' or 'true' money and 'quasi-money' or 'near money' and this distinction is connected with the idea of liquidity. Liquidity is the extent to which an asset can be realised quickly for full value i.e., without capital loss. The general acceptability which is a vital attribute of money makes it the most liquid of all assets. Money is completely liquid and immediately and always exchangeable for full value for goods and services. At the other end of the range of liquidity is an asset such as land, the seller of which will have to pay marketing costs and may have to wait for some time before a buyer appears. Closer to the liquid end of the range are certain financial assets which are defined as 'near-money' or 'quasi-money' because they can be held with little loss of liquidity. National Savings Bank Ordinary Accounts, for example, cannot be regarded as money because they are not generally acceptable in paying debts i.e., they do not perform the medium of exchange function. However, they are a good store of value since they have a rate of interest paid on them and usually they can be easily and quickly turned into 'real' or 'true' money - specified as notes, coin and current accounts - without loss and so are highly liquid assets.

Official statistics of the money supply have traditionally been based on money defined as notes, coin and bank deposits, by far the most significant of these three components being bank deposits. The banks can create money in the form of bank deposits through their lending activities - a process known as credit creation. However, the close substitutability of funds between bank and non-bank financial institutions such as building societies and the latter's introduction of such services as current accounts and personal lending, has led the monetary authorities to formulate and monitor wider monetary aggregates than those based on the old definition of notes, coin and bank deposits. This has been done by developing aggregates in accordance with a distinction that has been made between what is referred to as 'narrow' money and 'broad' money.

'Narrow money' - M0 refers generally to money held predominantly for spending immediately or in the near future i.e. for transactions purposes. M0 therefore consists of notes and coins in public circulation, plus the banks' working balances with the Bank of England.

There are a number of alternative definitions of 'broad money' depending on what is included within the definition. M4 is a broad definition which adds to M0 all sterling deposits at UK banks and building societies. This definition aims to provide an indication of the overall level of liquidity of the economy.

(b) Governments consider it important to control the money supply as they often given credence to the monetarist theories of inflation which in essence maintain that there is a direct link between changes in the price level and changes in the money supply. This stems from the Quantity Theory of Money which is based on the equation MV=PT

where M is the total money stock

V is the velocity of circulation of money

P is the average price level

T is the total number of transactions



The theory assumes that V is constant and that the economy is at full employment hence the volume of transactions is fixed at a constant level which reflects the full employment level of output. Applying these assumptions to the equation, the average price level P will therefore be determined solely by M, the quantity of money in circulation. An increase in the money supply will lead directly to a proportionate rise in the price level.

The rationale for this result is that it is assumed that people hold money only as a means of purchasing goods and services i.e., a transactions motive, and they do not have a speculative motive. Beginning with a position of equilibrium as regards desired money holdings, if the money supply is increased people will find that they are holding more money than they need to cover their transaction requirements, they will therefore spend the excess on goods and services. As the economy is assumed to be at full employment output cannot increase in the short term so prices will rise.

(c) There are various means by which the government can attempt to control the money supply. Firstly, open market operations. This involves the buying and selling of bills by the Bank of England on behalf of the government on the open market. Such action will inevitably affect the credit-creating abilities of the commercial banks. For example, if the Bank of England sells bills, the public will obviously need to pay for them by drawing on their accounts with the commercial banks. As these banks have to maintain a stable ratio between cash and loans, they will have to cut back on their lending and hence the growth of the money supply will be curtailed.

The government, through the Bank of England, has an unpublished band of interest rates which it wishes to prevail within the economy. It can influence the direction of movement of rates through the Treasury Bill issue which results in all major financial institutions altering their rates accordingly. If the government raises interest rates this reduces the demand for money since less people will want to take out bank loans, thus less money is created.

Thirdly the government could make use of special deposits. These have not been used since 1981 but are still available should circumstances prove necessary. They involve the deposit of a certain proportion of the commercial banks' assets at the Bank of England. This effectively reduces their ability to create credit and thus would support a contractionary monetary policy.

A further alternative is Treasury directives. These are guidelines on lending policy issued by the Bank of England to which the commercial banks are expected to adhere.

Lastly, the government could reduce the growth in the money supply by controlling the Public Sector Borrowing Requirement (PSBR). If it restricts the PSBR it will in turn mean less finance is required and will reduce the need for certain methods of government borrowing which lead to increases in the money supply.


(a) The figures in the table show no clear relationship between the money supply (M0) and the rate of inflation. For example over the three year period from 1976 to 1978 inclusive, when the growth of the money supply rose steadily, inflation jumped around from 12.9% to 17.6% then right back down to 7.8%. In 1979 M0 fell from 13.7% the previous year to 11.9%, however in the same period inflation rose from 7.8% to 15.6%. There were periods (1983, 1988,1993 to 1995) when M0 grew more than 6% but inflation was moving at less than 5%, and other periods when inflation was well above 6% but M0 was



well below 4% (1981, 1982, 1985 and 1990). In the final three years M0 remained steady at around 6% but inflation increased from 1.4% to 2.3% and finally to 3.5%.

(b) Classical theory suggests that there is a relationship between changes in the money supply and the rate of inflation. Such beliefs are based on the quantity theory of money which can be expressed using Fisher's equation of exchange:

MV=PT

where M is the total money stock or money supply

V is the velocity of circulation

P is the average value of transactions in a period ie, the average price level

T is the number of transactions that takes place in a period.

MV is the value of total expenditure in a period which must be equal to the value of goods and services sold in the same period which is PT. Hence the equation is really merely a statement of fact.

However the equation is useful as an explanation of inflation when certain assumptions are made and which, if accepted, means that the average price level (P) is solely determined by changes in the money supply (M).

The assumptions are firstly that V, which is the frequency with which the money stock is spent, is determined by the transactions demand for money and empirically has been shown to be relatively stable and predictable.

Secondly, T, the number of transactions which take place in the economy, essentially depends on the number of goods available for purchase. This is fixed by the productive capacity of the economy which can only change slowly over time.

Hence it follows that if V and T are constant any change in the money stock will result in a proportionate change in the price level.

(c) The predictions of the quantity theory of changes in the money supply resulting in changes in the price level do not seem to be born out directly by this data. A fairly tenuous relationship can be shown where changes in the money supply are coupled with changes in the rate of inflation after a two-year time lag. This occurs for instance, in 1977, 1978, 1983, 1988 and 1993 where an acceleration in M0 is followed by an increase in the rate of inflation in 1979, 1980, 1985, 1990 and 1995. This relationship does not seem to hold in reverse however. When the slowdown in the growth in M0 occurs in 1985, 1987 and 1992 it is not complemented by a de-acceleration in the price level in 1987, 1989 and 1994.

(d) The effects of a change in the money supply in the short and long run will vary depending on whether a Keynesian or a Monetarist view is being used.

Keynesian theory suggests, taking an increase in the money supply as an example, that an increase in expenditure on financial assets will result and hence a fall in interest rates (an increase in the demand for bonds automatically results in a fall in the rate of interest.) This fall in interest rates will stimulate the demand for consumption and investment goods although in a relatively small way as, according to Keynes, expenditure is interest rate inelastic. The lower rates will however mean consumers will have more money to spend on goods and services as the cost of mortgages and other domestic loans decrease. In the short run the increase in demand will be met by spare



capacity in the economy, so prices will remain steady. In the long run however, if all the spare capacity is used up and if productivity has not improved the increase in demand could cause prices to rise.

Monetarists believe that increases in the money supply will lead to a rise in demand for all goods and services. In the short run this extra spending can lead to a rise in prices, but producers will expand output as a response to the higher demand. In the long run producers will realise that in real terms they are no better off and output will return to the level it was before the rise in the money supply. This is known as the natural unemployment level of national income. If there are further money supply increases prices alone will rise without any increase in output.

9.3 IMPORTANT FUNCTIONS

(a) (i) Medium of exchange

It removes the inconvenience of a barter system.

(ii) Standard measure of value

It is possible to compare value of goods and services which are dissimilar and entirely different from each other.

(iii) PAYMENT Standard of deferred payment

The value of money usually remains stable over a period of time. Hence it serves as a standard for the purpose of lending and borrowing.

(iv) Store of value

Money serves as a store of value and it helps a person keep his assets liquid.

(b) Transaction motive

The transaction demand for money is the demand for money to carry on day to day dealings/ transactions. There exists a direct relationship between the transactions demand for money and the level of income. The higher the level of income the higher will be the transactions motive.

Precautionary motive

Precautionary demand for money arises out of people’s desire to save money for unforeseen circumstances. The amount of money held under this motive will depend on the nature of the individual and on the conditions in which he lives.

Speculation motive

The speculative motive refers to the desire of a person to hold one’s resources in liquid form to take advantage of market movements regarding future changes in the rate of interest or bond prices. The amount of money held under speculation motive is influenced by the level of income and rate of interest.



9.4 UNEMPLOYMENT

(a) Phillips curve depicts a relationship whereby unemployment falls when the inflation rises and vice versa. The curve is shown in the following diagram:

(i) The curve crosses the horizontal axis at a positive value for the unemployment rate. This means that zero inflation will be associated with some unemployment; it is not possible to achieve zero inflation and zero unemployment at the same time.

(ii) The shape of the curve shows that at a lower level of unemployment, a slight decrease in unemployment will be accompanied by a high rate of increase in inflation.

(b) The term full employment refers to a situation where the rate of unemployment is at the minimum level which an economy can expect to achieve. The rate of unemployment can never be equal to zero as there would always be a certain minimum rate of unemployment on account of various natural reasons.

(c) The various types of unemployment are as under:

Frictional unemployment:

Even when there are enough jobs some unemployment is inevitable as workers move from one job to another. Such unemployment occurs when there is a shortage of a particular type of workers at one place and similar type of workers are in surplus at some other place. Such unemployment is usually temporary.

Seasonal unemployment:

Such unemployment takes place in Industries/businesses where demand is seasonal, like in agricultural sector or in tourism industry, etc.



Cyclical unemployment

Such unemployment increases in recession when aggregate demand and prices are falling and decreases in boom period when aggregate demand and prices are on the rise.

Structural unemployment:

When an economy undergoes structural changes for example when the economy moves from one sector to another or from primary goods to value added goods etc. re-adjustments are needed. In such situations those workers who are unable to acquire the new skills or are otherwise reluctant to change their jobs become unemployed.

Technological unemployment:

Due to technological development machines replace labour resulting in unemployment of this sort. However when the productivity increases it generates demand for other types of goods and the unemployment starts reducing as the workers acquire newer skills.

9.5 PHILLIPS CURVE

(a) The trade off between unemployment and inflation can be explained like so:

As unemployment falls, labour shortages may begin to occur where skilled labour is in short supply. This puts upward pressure on wages

At high levels of unemployment, individuals do not have the bargaining power to increase their own wage, therefore inflation is likely to stay low

(b) The relationship can best be displayed on a graph:

At point A, the trade off between inflation and unemployment is great, because

resources are near full capacity.

At point B though, there is more spare capacity in the economy, meaning that the

level of wage inflation is low.



(c) The argument that Friedman put forward was that each SRPC was based upon a fixed expectation of inflation. If there was an increase in the expectation of inflation, then this would cause the SRPC to shift higher.

In his opinion, boosting AD would only have a short run effect on unemployment. In the long run, people would adjust their expectations to account for higher inflation, and a new SRPC curve would form.

This can be shown in the diagram below:

The economy begins in equilibrium at A.

There is an increase in government spending to boost AD, decreasing

unemployment and taking the economy to point B where inflation is 6%

A point B, firms’ costs and individuals’ wage demands increase, meaning output

falls, unemployment rises, and hence SRPC1 shifts to SRPC2.

This means that in the short run, a trade off may occur, however in the long run, it is not possible to expand beyond the LRPC.

9.6 LIQUID FORM

The motives for retaining money in liquid form are:

Transactions motive – Individuals need money to meet their day-to-day requirements of purchases of goods and services. The need to hold money for transactions arises because the payments and receipts of individuals are not exactly synchronised. The liquidity preference or transactions demand for money will increase either by an increase in the real national income or an increase in the general price level or any combination of the two.



Precautionary motive – Individuals keep money in hand or with banks as a precautionary measure to meet any unforeseen fluctuations in receipts and payments. The precautionary demand for money arises due to uncertainty regarding the timing and size of payments and receipts. The higher the level of national income, the larger amounts of money balances that would be needed for precautionary purposes, reflecting higher liquidity preference.

Speculative motive – The holding of money has an opportunity cost in the form of income foregone by not using the money to purchase an income bearing asset e.g. a bond. When interest rates are high, individuals will hold lesser amounts for speculative purposes and therefore have low liquidity preference. When the interest rates tend to be low, individuals will retain large amounts in anticipation of increase in interest rates and would have high liquidity preference.

9.7 Money functions

Anything may serve as money providing it is readily acceptable as a method of payment and is generally available. In order to qualify as such the commodity chosen must be divisible, portable and durable. The normal forms of money used today in most economies are coins, notes, bank and building society deposits, none of which are desirable for themselves but for what they can do. Thus, money has some important functions which can be summarised as follows:

(i) A medium of exchange

Anything which will act as a medium of exchange is money. Bank notes, coins, cigarettes, luncheon vouchers, cheques, all have this quality or have had it within certain communities at certain periods of time. The more widely acceptable the item is for the settlement of debts, the more satisfactory it is as money. Luncheon vouchers, for example, are completely acceptable in payment for lunches at appropriate shops, but they are not usable for anything else. Items such as this are sometimes known as 'partial money'.

(ii) Measure of value

It must be capable of being used as a measure of value, or unit of account. This means that a good or service which is being exchanged between a buyer and a seller can be precisely valued. Also, accounts may be kept and transactions recorded, using money as the recording medium. In times of inflation, this function is threatened and confidence in the measurement of value is diminished.

(iii) Means for deferred payment

Many transactions are based on credit, particularly in the advanced economies of the world. This means that payments are made and received some time after the underlying transaction has taken place. The debts are expressed in monetary terms, and would be valueless if money were not an acceptable standard. This function is vital in the modern world, not just in day-to-day transactions, but also in the world of high finance, for example in the foreign exchange markets where global deals are done every minute and in the world of imports and exports.

If there is any uncertainty concerning the purchasing power of the money used as the standard for deferred payments, there is always the danger that credit will be restricted and that trade will decline. Thus, the more stable the purchasing power of the money unit used, the more acceptable deferred payments will be.



(iv) Store of wealth

Money can be used to preserve purchasing power so that people may build up a store which is then available for future needs or for passing on to their children. In an inflationary situation, however, bank notes and bank deposits become less acceptable than rights to the ownership of physical assets, such as Stock Exchange securities, or the physical property itself e.g., land, buildings, works of art or postage stamps.


10.1 INDIRECT TAXES

(a) An Indirect Tax is a tax which is collected from an intermediary/supplier who subsequently shifts the burden of the tax to the consumers as it is included in the prices of the goods/services sold. Indirect taxes are levied in the form of excise duties, customs duties and value- added taxes.

(b) The disadvantages of Indirect Taxes are:

(i) Indirect taxes are of a regressive nature because the impact of these taxes are more severe on the poorer segments of the society than on the rich persons as a uniform rate of tax is applicable on a product/service to all sections of society.

(ii) Indirect taxes lead to inflationary pressures as the incidence of the taxes are passed on the consumers in the form of higher prices.

(iii) Indirect taxes are uncertain as it is not always possible to anticipate the repercussions of the tax imposed on a particular commodity/product.

(iv) Indirect taxes do not promote civic consciousness among the taxpayers because the individuals do not feel the burden of the taxes as the taxes are in-built in the prices of the products purchased.

(v) Indirect taxes are uneconomical to collect as several intermediaries are involved in the collection of taxes and the process involves a very large number of transactions and close monitoring of the activities.

(vi) Indirect taxes can be evaded on a large scale by even a few collecting agents or intermediaries, resulting in substantial losses to the government.

10.2 MACROECONOMIC POLICY

(a) The most important primary goals of a well-conceived macroeconomic policy are to achieve the following objectives:

High Rate of Employment

High rate of employment is essential to overcome the problems of immense human suffering, undesirable social effects and loss of output caused by failure to create job opportunities. Inability to achieve high rates of employment can adversely affect the overall goals of achieving equitable economic growth and result in political turmoil with far -reaching adverse consequences



Satisfactory Rate of Economic Growth

Economic growth is a major factor responsible for long-term increase in the standard of living of citizens of a country. The rate of economic growth which is higher than the rate of increase in population, along with equitable distribution of wealth are essential for the long term prosperity and stability of a country.

Stable Price Level

Stable price levels are essential as wide fluctuations in the prices of different factor inputs, consumer and capital goods and services can have far-reaching consequences for the levels of production, living standards of people and distribution of wealth. Inflationary pressures have serious adverse consequences on the citizens, particularly for the poor segments of the population.

(b) Demand-pull Inflation - In demand-pull inflation, the aggregate demand for goods persistently exceeds their supply. As the demand for goods is more than the total supply of goods at current prices, there will be a tendency for increase in prices. The concept of demand-pull inflation is generally observed in situations of full employment.

Cost-push Inflation - In cost-push inflation, the prices of goods rise due to persistent increase in the cost of production of goods, while their demand and supply remain steady.

10.3 DIRECT AND INDIRECT TAXATION

(a) Direct taxes can be defined as those taxes that are levied directly on the intended taxpayer. They are principally taxes on income and capital and in the UK take the main forms of income tax, corporation tax, capital gains tax and inheritance tax. Indirect taxes then become those taxes that are levied on the intended taxpayer via some third party. These are taxes on expenditure and in the UK are Value Added Tax (VAT) and specific sales taxes, mainly customs and excise duties (e.g. on petrol, tobacco and alcohol).

Underlying a good taxation system is a set of principles described by Adam Smith in his Wealth of Nations as the four ‘canons’ of taxation. They were, firstly, equity. Taxes should be levied according to the ability to pay of the taxpayer. A progressive tax is considered an equitable tax since it takes a higher proportion of income in tax as income rises, it therefore can be used to redistribute wealth away from the rich to the poor.

The second canon is that of certainty. The taxpayer should know when the tax should be paid, how much should be paid and which transactions give rise to a tax liability. Thus a tax should not be too complicated nor riddled with special arrangements or exemptions and most importantly it should not be avoidable.

Convenience is the third canon. The tax should be convenient to pay, not involving the taxpayer in time-consuming activities, hence ideally collected when people receive and spend their income.

The fourth canon is that of economy; the tax should be cheap to collect, not burdened by administrative cost. This is something of a problem in the collection of income tax in the UK, as the tax is complex and difficult to



administer. Self assessment could be seen as a way of passing part of that burden from the tax collecting authorities to the individual.

Principles of taxation which may be added to those of Adam Smith are those of ease of adjustability, upwards or downwards according to the government’s economic policy and lastly it should not act as too much of a discouragement to hard work and enterprise. Both direct and indirect taxes meet the principles of a good tax in different ways and to different degrees.

(b) A major shift from direct taxation to indirect taxation will affect a business in terms of its cost structure and the demand for its products. Lower direct taxation will reduce a company’s corporation tax charge, thus raising its profits after tax. If the company then retains these profits and invest them is say new technology, the company will inevitably become more efficient and thus reduce its costs of production. Unit costs are also likely to fall due to lower employment costs; employer’s ational Insurance contribution are a form of direct taxation, if these are reduced, companies may hire more labour or just incorporate the lower labour cost into their price, making their products more competitive.

Direct taxation is often argued to be a form of tax which discourages hard work and enterprise. Lower direct taxation could act therefore, as a spur of firms to become more innovative, developing new techniques and new products.

Having looked at the way a reduction in direct taxation is likely to affect a business, we can now consider the impact of an increase in indirect taxation on the same business.

A production, or indirect, tax is a tax on goods and services. The effects of indirect tax in the market place will depend upon the relative elasticities of demand and supply and the extent of the tax charge.

As far as supply and demand analysis is concerned the imposition of a production tax is treated as an increase in business costs. This is because the firms in the market now incur an additional ‘expenditure’ each time they sell extra units, this ‘expenditure; being the amount of tax which has to be passed to government. At first consideration it might appear that a simple solution of passing the entire amount of the tax on to the consumer would be appropriate. However, the extent to which firms are able to do this depends upon the relative elasticities of demand and supply. The following diagram indicates the effects of this.

Diagram 1 – the imposition of an indirect tax



As the diagram shows, the effect of the tax increase is indicated by a leftward shift of the supply curve. This signifies that the firms in the market have incurred an increase in costs, in this instance arising from the government demand that tax should be raised on the sales of the goods in question. As can be seen, the equilibrium price increases from P1 to P2 which results in a contraction in demand from Q1 to Q2. The proportion of the tax paid by the consumers is the increase in price attributable to the tax change. Obviously this is the difference between P1 and P2. However, the consumers do not bear the entire burden of the tax. As shown on the diagram the total tax increase is indicated by the vertical distance between the two supply curves marked as ab. Thus, if the consumers are contributing P2 – P1 (or ac) the producers are contributing the rest, shown as cb.

The extent to which firms can pass on the tax increase depends upon the elasticity of demand in relation to the elasticity of supply. For example, if demand is perfectly inelastic it is possible to pass on the entire tax burden because consumers will be prepared to purchase the good at any price. However, if this is not the case then the burden must be shared. In diagram 1 demand is more inelastic than supply, and it can be seen that the consumer bears a large proportion of the tax burden. However, in the diagram below demand is relatively elastic, and supply less so, resulting in the opposite outcome.

Diagram 2 – the imposition of an indirect tax – elastic demand

As the diagram shows the consumers bear a small proportion of the tax increase (ac), while the producers bear a much larger proportion (cb).

Thus, although the elasticity of demand is an important determinant of the incidence or burden of an indirect tax, we cannot ignore the elasticity of supply.

If demand is more inelastic, the consumer shoulders the major part of the burden. If supply is more inelastic, the producer bears the lion's share of the burden.

Note also that the larger the elasticities of demand and supply for a good, the greater will be the reduction in output following a rise in indirect taxation on that good. For, if the combined elasticities are high, not only will the firm have to absorb most of the tax increase itself but output will also fall resulting in a fall in total revenue. This represents an additional burden on the producer.



10.4 TRADE CYCLE

(a) The trade cycle is a term used to describe the changes in economic activity over a period of time. The economy moves in a roller-coaster type of figure from periods of boom at the high points to periods of recession at the low points recovering again up to another high and so on in a regular pattern. During the boom period the rate of growth of output is high with low unemployment, low interest rates but probably rising prices. As the economy dips down into recession all these characteristics gradually reverse.

The data given in the question illustrates the trade cycle scenario. The downswing starts in 1979 with only a 2.8% change in GDP compared with 3.5% the previous year. The decline continues until 1982 when the rate of growth of GDP starts to rise again; the recovery period peaks in 1998 (apart from a blip year in 1984) when the downswing starts again bottoming out in 1992 with recovery showing in 1993.

(b) The accelerator principle suggests that changes in the level of demand are a more important determinant of investment than the rate of interest. The principle stresses the relationship between the level of net investment (i.e., investment over and above that necessary to maintain the present productive capacity) and changes in National Income which determines aggregate demand. This can be summarised using the formula:

Net Investment (I) = VY

where V = the accelerator coefficient, a fixed capital output ratio ie, it is the amount of investment necessary to produce an extra unit of output.

Y = change in demand

As an example let us assume an accelerator coefficient of 2.

Year Y Y I (excluding replacement)

1 100 0 0

2 110 10 20

3 150 40 80

4 175 25 50

5 185 10 20

6 185 0 0

The example illustrates that net investment depends on the rate of growth of demand not the absolute level, and that changes in the rate of growth of demand produce magnified changes in investment, and when the rate of increase of demand falls the absolute level of net investment falls. The data for the UK appears to support the accelerator principle. The falls in investment in 1980/81 and 1990/93 were significantly greater than the falls in GDP for the same years, whilst the high positive changes in investment in 1978, 1982, 1984, 1987, 1988 and 1994 were much higher than the growth in GDP in the same years.



10.5 MIXED ECONOMY

(a) The generally accepted goals of macroeconomic policy are: full employment; low inflation; rapid and stable economic growth; and a sound balance of payments position. Each of these requires some comment in explanation.

Full employment as a policy objective is subject to interpretation. Clearly it does not mean zero unemployment. In a dynamic economy unemployment will always exist; individuals change jobs both within an industry and move between industries as structural adjustment occurs. Full employment can be defined therefore as the full utilisation of factors of production available and desiring to work. Less than full employment means output is lower than it could be, and a lower standard of living will ensue.

Lower inflation is another goal of policy which needs interpretation. Some have taken this to mean stable prices while others take a less rigid view and relate it more to achieving a somewhat better performance than our major international competitors. Inflation refers to the rate of rise in the general price level and in the UK this is most commonly measured by the percentage change in the retail price index over the past twelve months. This, however, is difficult to compare with inflation indices used by other countries. Hence the current emphasis on 'the underlying rate of inflation' which excludes mortgage interest payments from the index.

Economic growth as a policy objective is usually taken to refer to the annual rate of growth of real GDP (i.e., after allowing for inflation) and this is commonly used as an index of the improvement in living standards. However, a part of this growth can come from taking up slack in the economy as occurs when the economy recovers from recession. For the economist, economic growth is more properly the growth of productive potential. That is the rate of growth of real GDP sustainable with a common margin of unused resources.

Finally, the objective of a sound balance of payments relates to the country's trade situation and its overall international payments situation. The objective breaks down into avoiding continued current account deficit and avoiding persistent overall payments deficits. The first of these means that the country is continually living beyond its means, the second that its exchange rate will become unsustainable. This is a problem in so far as exchange rate fluctuations damage trade and growth and a falling exchange rate fuels inflation.

(b) Fiscal policy is concerned with government expenditure, income and borrowing. The use of fiscal measures to achieve government economic objectives was formalised by Keynes in the 1930s when he demonstrated that demand management (ie, fiscal policy) could be used to reduce cyclical unemployment. As a result of this, fiscal measures became the central means by which government controlled the economy during the post-war period up to the mid-1970's.

In general terms, fiscal policy can be used to meet the objectives of stimulating growth and hence increasing employment by increasing aggregate demand through a reduction in taxation and an increase in government expenditure. The government would be running a budget deficit where expenditure exceeds tax revenues. However if the economy is unable to gear up to increased production in order to accommodate the increase in aggregate demand, either prices of home produced goods will rise or imports will increase depending on the country's marginal propensity to import; either way there will be a detrimental effect on the balance of payments, since inflation



will mean a lack of international competitiveness and hence a likely fall in exports.

If there is inflationary pressure within the economy, fiscal policy can be used to meet the objective of alleviating the situation and keeping it under control by the government running a budget surplus where tax revenues exceed government expenditure. This will result in a reduction in aggregate demand and ultimately output and incomes will fall. There should also be a consequent reduction in demand for imports which should help achieve the objective of a balance of payments equilibrium. However, the deflationary effects of a budget surplus will inevitably take its toll on the level of unemployment.

Unfortunately all policies appear to have some negative side effects, through policy conflicts and trade-offs. Using fiscal policy alone has proved in the past to be ineffective in simultaneously achieving all the main government macroeconomic objectives.

10.6 GROWTH RECESSION INDICATORS

(a) Recession/ depression

With unemployment levels high, incomes low, consumer demand low and investment low, the economy slips into a state where output remains very low.

There is an under-utilisation of resources as machinery lies dormant. Business confidence is extremely low, as profits and prices go lower and lower.

Economic activity is at its lowest, meaning the business cycle is at its trough.

Recovery

From the low point, there is an increase in levels of economic activity as demand begins to increase slightly. With an increase in demand, production increases, causing an increase in investment.

This causes a steady rise in output, incomes and business confidence. This leads to an increase in investment, somewhat helped by banks increasing credit.

Assets in the economy begin to be utilised again, and levels of GNP increase once more.

b) Discussion will indicate how in a recession, these figures will have a negative outlook on the economy, whereas when the economy moves into a recovery stage, the outlook of the indicators will improve.

Leading economic indicators

The nature of these indicators is that they are used to forecast at what stage the economy will be in, at some time in the future. These in particular give an indication for whether a peak or trough will be reached in the following 3-12 months.

Index of business confidence

Manufacturers’ new orders

New building permits for private housing

The money supply



Coincident economic indicators

These indicators are events and measures that occur at the same time as a peak or trough occurs. They are used by governments to assess at what stage in the cycle the economy is in.

Number of people in employment

Industrial production

Personal incomes

Manufacturing and trade sales

Lagging economic indicators

These indicators are used to assess whether an economy has reached a peak or trough 3-12 months after it would have occurred.

Consumer Price Index (i.e. level of inflation) *

Average duration of unemployment

Interest rates **

Average income

* There is no exact relationship between inflation and when an economy is in recession. This is because there are both demand-pull, and cost-push factors. The demand-pull factors will cease in a recession, and begin to return in a recovery, however the presence of cost-push factors may have an influence on the final level of inflation which is independent.

ne wouldn’t expect to see interest rates be raised too early in a recovery, in case it “killed off” any growth. Valid discussion should be rewarded.

It is never an exact science to classify at what stage in the business cycle an economy is in which is why the variety of indicators presented above are used; to give the best estimate of how the economy has/ will perform

10.7 ECONOMIC POLICY OBJECTIVES

(a) The following are the main objectives of a government’s economic policies

(i) To achieve full employment or high and stable levels of employment.

(ii) To achieve price stability in order to maintain the cost of living of the population.

(iii) To maintain satisfactory balance of payment position.

(iv) To achieve an acceptable rate of economic growth in order to raise the standard of living.

(v) To achieve equitable distribution of income and wealth

(b) To try to achieve its intermediate and overall objectives, a government will use a number of different policy tools or policy instruments. These include the following:

(i) Monetary Policy: Control over the growth of the money supply (regulate credit) is necessary to reduce inflation and eventual economic uncertainty which deters growth.

(ii) Fiscal Policy: In this regard taxation is used as an instrument for checking consumption, increasing savings and for preventing investment in undesirable channels and turning them in to desired directions so that economic growth is accelerated. It is also aimed at equitable distribution of wealth.



(iii) Prices and Incomes Policy: Inflation is tackled through government controls over prices and incomes.

(iv) Exchange Rate Policy: Economic objectives such as improving balance of trade and balance of payment can be achieved through management of the exchange rate by the government.

(v) External Trade Policy: A government might have a policy for promoting exports and controlling import. Measures are taken to provide some form of protection for domestic manufacturing industries by making the cost of imports higher and thus lower the volume of imports. Protection encourages domestic output to rise, thus stimulating the domestic economy.


The equilibrium of National Income is shown by the following diagram:

In the diagram, Aggregate Supply is shown by the line AS. Aggregate supply means the total supply of goods and services in the economy.

The aggregate supply curve will be upward sloping, an increasing price level implies that many firms will be receiving higher prices for their products and will increase their output.

In the economy as a whole, supply will at some point reach a labour constraint, when the entire labour force is employed. When there is full employment, and firms cannot find extra labour to hire, they cannot produce more even when price rise, unless there is some technical progress in production methods. The aggregate supply curve will therefore rise vertically when the full employment level of output is reached (AS in the diagram).

Aggregate demand (AD) is total desired demand in the economy, for consumer goods and services, and also for capital goods, no matter whether the buyers are households, firms or government.

The AD curve will be downward sloping as quantities demanded will increase when the price falls.

A national economy will reach equilibrium where the aggregate demand curve and aggregate supply curve intersect i.e. at Y (as shown in the diagram). Price levels will be at P. Y therefore represents the level of satisfied demand in the economy.




11.1 FINANCIAL INTERMEDIATION

(a) Financial intermediation is the process of channelling funds between those who intend to lend or invest and those who want to borrow them. For example accepting deposits or loans by an institution and lending them to those who require funds for investment purposes.

(b) The important reasons why commercial banks strive hard to maintain sufficient liquidity are:

(i) to comply with the statutory requirements of the central bank

(ii) to meet withdrawals of funds by depositors

11.2 THE CENTRAL BANK

(a) Within a mixed economy it is necessary for a central bank to operate effectively in order to perform certain functions. The Bank of England is the central bank in the UK. However its major activities are consistent with any other central bank operating in the same type of economic system.

The premier role of the bank is as a banker to the government. Obviously, the government receives money in the form of taxes and duties. Such monies are dealt with by the bank and are used for government department's expenditure. If government expenditure exceeds receipts, the difference is funded by the bank by, in the short-term, issuing securities such as Treasury Bills and in the long-term issuing bonds known as gilts. The bank also has the role of administering the national debt which involves making sure interest is paid on the securities and capital sums are repaid as the securities mature.

Prior to the new Labour Government of 1997 an aspect of the Bank's relationship with the government was as its implementer of monetary policy. Monetary policy in the form of manipulation of interest rates has been the government's main weapon against inflation since the end of the 1970s. The new government has now made the Bank of England autonomous in terms of using interest rates to control inflation. The Bank and the government together decide on a target rate of inflation and the Bank alone decides when to raise or reduce interest rates in order to achieve the target. The process by which the bank can control or influence short-term interest rates is known as open market operations. Put simply, this is where the bank buys from or sells to the discount market eligible bills. When bills are bought and sold, they are traded at a discount to their face value, and there is an implied interest rate in the rate of discount obtained. Interest rates on bills traded in open market operations have an immediate influence on other money market interest rates, swiftly filtering right through to the rates banks will lend out on loans and overdrafts. Not only are interest rates manipulated in this way but open market operations will also affect the actual level of liquidity in the economy. If the Bank wishes to reduce the quantity of money in circulation it makes additional sales of government securities without spending the proceeds. If it wishes to increase the money supply it will buy back government securities thus injecting funds back into the money market.

The bank also has responsibility for administering the gold and foreign exchange reserves of the nation. This is done through the Exchange Equalisation Account where the bank buys and sells currency in order to



influence the exchange rate. If the government considers the exchange rate is too high, the bank will sell sterling and vice versa if it is too low.

A further role of the bank is as banker to the commercial banks, who keep their operational deposits with the bank and, from these, they settle daily inter-bank indebtedness arising from cheque transactions. The bank's relationship with the commercial banks also helps it in its role of administering government policy. It can request them to control their lending or, if desired, it could re-introduce reserve requirements or order the placing of special-deposits with the bank.

The bank acts as a lender of last resort to the banking system as a whole via the discount houses. If the banks become short of liquid funds, for example, at times of the year when large tax payments are made, the bank will relieve the shortage by either buying bills from the banks in the normal way or the banks would call in money at call with the discount houses. In turn the discount houses may choose to call upon the bank to act as lender of last resort to them. The bank always stands ready to come to the assistance of the banking system in times when it is threatened by cash shortage in order to avoid any confidence crisis.

(b) A major function of a central bank is the supervision and regulation of the banking system. Supervision of the banking system has been much discussed in recent years following the collapse of BCC1 and the Barings Bank and measures have been adopted to try and ensure such problems do not reoccur. Firstly, banks have to adhere to capital adequacy rules to ensure they are covered against any possible bad debts. The adequacy of a bank's capital is determined by reference to its risk assets, which are weighted by category. The weighting is decided by the status of the borrower and the collateral given on the loans. The Bank of England will set a minimum for a bank's capital base having calculated its weighted risk assets. Shareholders' capital and accumulated profits must account for at least half of the capital requirement, the remainder typically being loan stocks and general provisions against losses. Secondly, banks must have adequate liquidity to meet day-to-day transactions. The Bank of England discusses with each bank on an individual basis its liquidity requirements and advises on changes where it considers necessary.

Thirdly, the banks' bad and doubtful debt provisions are monitored by The Bank of England. Banks have to report large exposures to a single borrower or to a particular sector such as property. Also, a bank is disallowed from lending more than 10% of its capital base to a single borrower. It has produced guidelines for banks to rank their debtors' ability to repay against a list of financial and other economic factors.

Lastly, the Bank of England plays a supervisory role in terms of the banks' senior positions. Directors, managers and large shareholders must satisfy the Bank that they are 'fit and proper' people to hold such positions. It also requires banks to make periodic reports on controls and procedures and the reporting accountants must supply assurances that the Bank's guidelines have been observed. They also provide the Bank with statistical data which forms part of its monitoring system.



11.3 MONEY MARKETS

The 'money market' is really several inter-connected wholesale money markets all dealing in the lending and borrowing of short-term funds. Because they so closely intermesh they are often regarded as one entity.

The money market can be sub-divided into the traditional or discount market and the parallel markets. The traditional market participants include the Government, via the Bank of England and the discount houses who buy and sell short-term debt to the commercial banks, building societies and companies.

The parallel markets developed in the 70's and 80's and comprise the euro-currency market, the dollar certificate of deposit (CD) market and several sterling markets. The four main sterling markets are the CD market, the commercial paper market, the inter-bank market and the local authority market. The parallel money markets developed partly as a need to get round the restrictions of the monetary authorities and partly to meet legitimate financial needs, for example where companies wish to lend excess funds in the short term. Transactions are usually arranged through brokers rather than the principals directly.

11.4 INTEREST RATE RISE

The manufacturer might be affected directly in three ways.

(1) If it has borrowed money at a variable rate of interest, for example a medium-term bank loan, its borrowing costs (interest charges) will rise and its profits will be affected.

(2) If the company has been planning new investments, it might re-consider the decision to invest if it is intended to finance the investments by borrowing.

(3) The increase in interest rates might result in a stronger currency, with the country’s currency rising in value against other currencies. This would make any exports more expensive to foreign buyers. The manufacturer might therefore suffer a fall in export orders.

The manufacturer might also be affected eventually by the effect of a higher interest rate on the economy generally, through the transmission mechanism. Higher interest rates might eventually result in a fall in consumer spending. If this happens, demand in the domestic market for computer games is likely to fall.

11.5 TYPES OF BANKS

(a) Retail banks and Investment banks.

Retail: These banks receive money from the public through deposits, and other means, and in return finance the business sector and individuals.

Banks often issue this money, and are not able to recall it immediately, such are the terms of use. This can lead them into potential bankruptcy problems.

These banks can be run by both the public and private sector.

Investment: an investment bank works by assisting a range of institutions with raising capital by underwriting their securities and other assets. They also advise on many issues a business might face.

The investment bank can also aid companies with acquiring funds, and facilitate a number of transactions through utilising the financial markets (#4).

An investment bank will not accept deposits, this most often dealt with by a bank’s commercial division.



b) The main drawback is that by issuing too much credit, a bank may not be able to fulfil all of the demands placed on it by its depositors.

It can also lead to inflation in the economy, if too much money is circulating.

For this reason, a number of safeguards are put in place to ward off this risk

Total amount of cash: firstly, the amount of credit is dependent on the initial size of the money supply. The larger this is, the more credit can be created

Size of reserve ratio: the lower the ratio requirements are, the more credit can be created. In many countries, there is a minimum level (usually ) that banks must adhere to, so that there isn’t too much credit within the economy

Liquidity Preferences: how much cash people want to hold. If, say, there is high inflation, then people may not wish to hold their money in banks where the real value is set to diminish

Central Bank policies: the central bank may utilise a number of instruments to control how much credit is created by banks

Availability of quality securities: banks will not issue credit to everyone – they will only issue if they can receive a high value asset in return from the borrower. If this does not exist, then credit will not be created as readily

11.6 CENTRAL BANKS

(a) There are numerous objectives that monetary policy looks to achieve and, as we shall see, it is not possible to satisfy all of them.

Price stability: keeping inflation low and steady for a more stable economic performance

Economic growth: with appropriate economic policy, the government wishes to develop the overall per capita income within the country

Exchange rate stability: achieve stable exchange rates between countries in part through adjusting for the balance of payments

Full employment: here, it is necessary to increase production and demand for goods, allowing resources to be fully utilised and the economy to reach full employment

Credit control: making banks exercise control over their issuance of credit, but also ensuring that the most vulnerable in society are receiving their fair share

(b) Though these objectives are all desirable, it is not possible to achieve all of these at once – some conflict between them exists

Price stability vs. full employment

By undertaking monetary policy to increase full employment, a central bank could undertake policies to increase aggregate demand. Doing so could drive up inflation, putting more pressure on the price stability target



Economic growth vs. exchange rate stability

In order to boost economic growth, a central bank may decide to manipulate exchange rates to increase the likelihood of exports. Doing so would jeopardise stability in exchange rates

Economic growth vs. credit control

A way to grow the economy might be through the expansion of credit, as it would spur investment and spending. However, this comes with heightened economic risk of credit defaulting.

Any other discussion of conflict of interests should be credited.


(a) Suppose the central bank is looking to reduce the level of aggregate demand in an economy, they can do so through manipulating the reserves that commercial banks must hold. In order that the reserves are kept safe, commercial banks will have them deposited at the central bank.

1. Reduce reserves available to banks: the central bank controls the level of reserves that commercial banks must hold with them. By decreasing the level of reserves that they must hold, and keeping the reserve ratio constant, the commercial banks must reduce the level of loans that they give out

2. A Rs.1 reduction in the level of reserves that commercial banks must hold translates, through the multiplier effect, to be a much bigger contraction in the overall money that they loan out. This causes the money supply to decline

3. As the money supply contracts, money becomes “tight” (i.e. less available and more expensive). This reduced level of money in the economy raises the interest rate, and reduces the amount of credit available in the economy. Consequently interest rates rise for mortgage borrowers and firms looking for investment are discouraged from borrowing, and spending more money

4. High interest rates reduce the wealth of firms and individuals, causing a drop in consumption and investment. This causes a shift to the left of aggregate demand (AD = C+I+G+(X-M)). In short, tight money has a contractionary effect on aggregate demand.

5. The effect of tight money reduces the level of aggregate demand, causing a drop in output, employment and inflation.

This is a very important aspect of what a central bank does. By affecting the level of reserves that commercial banks must hold, they are able to affect the level of output and spending in the real economy. This is a powerful tool for the central bank.

(b) Moral suasion

The central bank can also discourage behaviour from banks by simply conducting personal discussions with them, and persuading them not to go through with actions that may jeopardise the wider objectives that the central bank has.

This is not a particularly easy instrument to measure, but is nevertheless an important part of the central bank’s arsenal.




(a) The central bank can buy or sell government securities on the open market, to change the level of reserves that are held by commercial banks.

Let’s suppose that the central bank wishes to increase the level of aggregate demand in the economy; the process will follow like so:

1. Central bank decides it wants to increase the level of aggregate demand

and so agrees to buy Rs.1 billion government bonds from their portfolio

of reserves.

2. The bonds are bought from dealers in government bonds, who in turn

have bought them from commercial banks, and other financial

institutions.

3. Selling these government bonds to the central bank increases the

balance of reserves that the commercial banks have

4. As we have seen, if the cash reserves of a commercial bank rise, then

the level of demand deposits that they can take increases by a

magnitude of the money multiplier

5. Consequently, the level of money supply expands, and aggregate

demand rises.

(b) Discount-rate policy

The central bank makes loans to commercial banks. When banks are borrowing, this helps to increase their total level of reserves, and when the level of borrowing declines, the total reserves declines.

It is difficult for a central bank to set the exact level of borrowing that occurs between commercial banks and itself. It may believe that commercial banks need to borrow more, but it is not possible for them to set precise levels.

The central bank can however encourage more borrowing by lowering the discount rate that it offers to commercial banks, as a means to induce them into borrowing more.

1. A lower discount rate increases the level of cash reserves a commercial

bank can obtain

2. This induces them to distribute more loans to its customers

3. These loans are used for capital investment and consumption in the

economy

4. Consequently the level of aggregate demand is boosted

The discount rate is used as a proxy against which banks offer interest rates to individuals in the economy. In the press, the discount-rate can also be referred to as the “base rate”.

The logic goes that commercial banks will charge a premium on the base rate that will remain constant throughout. If the base rate falls, the interest rate faced by consumers will fall also, hence affecting the activity in the real economy.



11.9 MONETARY AND FISCAL POLICY

(a) In general, monetary policy is undertaken by “the central bank” and fiscal policy is undertaken by “government”

(b) The key issue here is that the SRAS and AD both need to shift outwards.

The central bank can increase the level of AD through an expansionary monetary policy, such as Open-Market Operations or reducing the discount rate to commercial banks

The government can increase SRAS through providing a subsidy to firms on their output.

Another alternative could be:

The central bank selling domestic reserves to devalue the exchange rate and to encourage exports (increasing AD) and;

The government increasing SRAS by increasing subsidies to firms.

Graphically, it should be represented as follows:


12.1 CREDIT

(a) Issue of ordinary shares involves giving away part of the ownership of the firm as each ordinary share carries 1 vote. This means that the ownership proportion of each existing shareholder is diluted, unless it is maintained by the purchase of a corresponding number of shares from the new issue. The issue of debentures by a public limited company gives the holder liquidity, as such loan stock can be sold on the Stock Exchange, but does not give a share of ownership. Such stock may be preferred by lenders as it can be secured on the assets of the company, giving a degree of protection in the case of non payment of interest or capital.



Loan stock normally carries a fixed rate of interest, which means that the cost of the borrowing is predictable. If interest rates rise in the future, it can be low cost borrowing. If the firm is successful in the future, shareholders may demand an increase in dividends paid, but loan stock holders are restricted to the fixed rate of interest.

(b) Money supply can be measured in a number of ways and broader definitions include consumer credit as it increase the purchasing power of the population. Much of this credit is created by banks. As banks lend money to their customers, they create new deposits, increasing the supply of money in the economy. An increase in money supply and therefore demand in the economy can lead to inflationary pressure.

Governments may try to control money supply by increasing rates of interest to make borrowing more expensive or by direct credit controls such as minimum deposit percentages. The rate of interest is the most likely option for present governments but its effect depends on the interest elasticity of demand. In the housing market interest is not the major consideration of buyers and it is therefore interest inelastic. Other markets may react more quickly to interest rate increases, for example consumer electrical goods, often considered to be luxuries. The monetary authorities can also attempt to influence interest rates and the money supply through open market operations. The Bank of England can sell securities on behalf of the government, directly to the 'non-bank' private sector; i.e. the public. Most people will withdraw funds from their bank accounts to pay for the securities, reducing banks' liquidity, and thus their overall ability to make loans and create credit money. So, as long as the funds are retained by the government, the growth of the money supply will be slowed.

Excessive government spending leading to heavy borrowing by the government from the banking system, has been blamed for inflation in the past. If the government is forced to borrow from the banking system to fund the PSBR, this has the effect of increasing the liquidity and the lending capacity of the banks, allowing them to bring about an increase in credit creation and the money supply. Monetarist economists, who have championed this view in the last 20 years or so, argue for cuts in government spending and a reduction in the PSBR to avoid the inflationary effects of an overly rapid growth of the money supply. (Note: the PSBR is now known as the Public Sector Net Cash Requirement – PSNCR).

12.2 BANKS

(a) Financial intermediaries are institutions, such as banks or building societies, which provide funds for lending long term, by borrowing from other groups of people, on a short term basis. Short-term borrowing provides a pool of funds from which those borrowers can maintain liquidity, should they need it, and a pool from which long-term lending can be given. The building society instant access account provides a secure home for small amounts of savings, with interest, from a large number of savers. This money can be lent long-term to house buyers, at a slightly higher rate of interest, for periods of 20 or 30 years. The large number of savers provides protection for those wishing to withdraw money and the long-term loans.

(b) Commercial banks operate on a fractional reserve system which means that only a small proportion of cash needs to be available at any time to maintain the confidence of depositors. The remainder of their assets can be made up of advances or loans to customers, which is a profitable investment.



Credit creation can be illustrated by an example which assumes that there is only one bank in the system and that all money is re-deposited in the bank.

A deposit of £100 will create a liability for the bank, as the money is repayable to the depositor, and an asset of cash.

If the bank works on a 10% fractional reserve system, it will need to keep 10% of its assets as cash, leaving it free to create advances of up to 90% of its total assets. The borrower can spend the advance as the bank will honour the cheque, and as the cheque is deposited in the bank, liabilities will again equal assets. The Balance Sheet would appear as follows:

Assets £ Liabilities £

Cash 100 Depositor A 100

Advance to B (90% of £1,000) 900 Depositor B 900

______

______

1,000 1,000

______

______

The limitation on credit creation consists fundamentally of the need to exercise prudence. Whereas the more lending a bank can do, the more money it is likely to make, it must take care not to overextend its lending activities and face the potentially disastrous consequences of running short of cash. Fractional reserve banking depends on the continuing confidence of the bank's customers, who must believe that cash will be available at any time at which they require it.

From time to time in the past, government has imposed limitations on the ability of banks to create credit, but this has not been an influencing factor in recent years.

Finally, banks have been able to be more aggressive in their lending over recent years, as the population increasingly uses payment methods, from cheques to credit cards, which do not rely on the everyday use of cash.


(a) The commercial banks provide several important functions for their business customers. Firstly, they have a duty to safeguard any deposits made with them. Deposit accounts earn interest for the saver depending on their size and their accessibility. For businesses that are looking to store their daily takings overnight before moving them on, the overnight rate is very low. Long-term deposits earn a higher rate to compensate for the loss of liquidity. Current accounts either earn no or very little interest but give the depositor a safe place to store its funds together with the facility to write cheques and withdraw the funds on demand.

A second function of the commercial banks is to lend money. The interest rates charged on loans, which differ depending on estimated risk and length of loan, are higher than those given to savers. The difference is obviously bank profit.

A third function is to effect an efficient method of transferring money between different accounts within the same branch, between different branches and between different banks. Hence they provide a means of transmitting money for payments and receipts between different customers.



Lastly, commercial banks provide a wide range of general financial services to their business customers that are designed specifically to facilitate domestic and international business. For instance, they arrange insurance, provide foreign exchange facilities, accept commercial bills, all of which are aimed at making trade easier.

(b) (i) The credit creating ability of the commercial banks can be explained, initially, within a single bank system. If the bank receives deposits of £100 it will learn through experience that a high percentage (up to 90%) of the funds will be left with the bank. As a result of this it will be able to lend up to £90 against security thereby creating credit. This £90 will eventually be deposited at the bank further raising the base upon which credit can be created. In this manner credit can continue to build, governed principally by the prudence of the bank and the cash or liquidity ratio which it decides to keep.

The rate of growth of credit is determined by the liquidity ratio – translated into the credit creation multiplier. Credit will be created in a multi-bank system in exactly the same manner with scope for credit creation still being determined by the initial amount of cash in the system and the liquidity ratios held by the individual banks. This process is known as multiple credit creation.

(ii) To control banks' credit creation ability the central bank must be able to control either directly or indirectly, the banks' liquidity position, upon which their ability to create credit is based. There are several methods available.

The first relates to interest rates. While the government, through the central bank, does not fix the rate of interest it will signal the direction and magnitude of change to the markets through its dealings with the discount houses. High interest rates will reduce demand for credit from bank customers while at the same time making all bonds, including those issued by government, more attractive. This is due to the inverse relationship between the rate of interest and the price of bonds. In such circumstances the public will be encouraged to purchase bonds thereby drawing funds from their bank accounts. As a result of this the banks' ability to create credit will be reduced, while demand will also fall in response to the high interest rate policy.

Secondly, there are open market operations. This is where the central bank sells government securities on the open market. The buyer will pay for these securities with cheques drawn on their commercial bank accounts. The central bank will settle these claims against the commercial banks by deducting the appropriate amount from their operational deposits which they have to keep at the Bank. This therefore reduces the commercial banks' cash reserves, and thus with less liquidity the banks must restrain their credit creation.

A further control upon credit creation relates to the size of the cash base established by the central bank, i.e., direct quantitative controls. To ensure that a minimum amount of liquidity is retained by commercial banks they can be required to deposit, without interest, a percentage of their balances with the central bank, and these deposits, known as 'Special Deposits', cannot be counted for credit creation purposes.

Finally, the central bank can issue non-obligatory directives to the commercial banks to encourage them in the direction they would like their credit creation to follow.




13.1 A BALANCE OF PAYMENTS DEFICIT

(a) The balance of payments account records all the transactions between residents of the UK and residents of the rest of the world over a period of time. There have been a number of changes in the presentation of the accounts in recent years and transactions are now divided into two main groups; current account and transactions in UK external assets and liabilities which are recorded in the financial account (formerly known as the capital account).

The current account records all exports and imports of goods and services whereas the financial account records inflows and outflows of capital.

The account is drawn up using the double-entry method of bookkeeping and thus it must always balance. However, at any moment in time any individual part of the account can be in deficit or surplus. If the current account is in deficit it means that the country has spent more on imports than it has received from exports. If the financial account is in deficit it means there has been a greater outflow of capital than inflow. Generally speaking, a balance of payments deficit usually refers to a current account deficit which thus has to be balanced out by movements in capital in the financial account.

(b) A deficit on the current account of the balance of payments can be due to one or more factors. Firstly, on the domestic front, the economy could be suffering from lower productivity and high rates of inflation than its trading partners which ultimately makes its goods and services uncompetitive in the international market place and thus exports are likely to fall. Domestic consumers will, at the same time be increasing their spending on imports which will be relatively cheaper than home produced goods.

Secondly, a deficit on the current account can be due to an overvalued exchange rate. If a country has higher rates of interest than others, this will encourage the inflow of capital funds. The demand for the domestic currency will therefore rise and so, as exchange rates are determined by the supply and demand for a currency, the exchange rate will also rise. As a result exports will become more expensive to foreign buyers and are therefore likely to fall, and vice versa for imports. The current account will move into deficit if the demand for exports and imports is elastic.

Lastly, excess aggregate demand (AMD) in an economy can lead to a balance of payments deficit. The demand for imports is, amongst other things, a function of national income, while demand for exports is dependent on other countries income. If domestic AMD rises faster than in the economies of our trading partners, the likely result is an increase in the import bill compared to exports. This will especially be the case if there is a high propensity to import. This could be made worse if domestically produced goods for the export market are diverted to the home market to meet the increase in demand.

(c) The size and complexity of international trade makes it unlikely that the current account will be in balance at any period of time, it may be in deficit or it may be in surplus. Either way the overall balance of payments account must balance so funds must be used accordingly. Financing a deficit involves the use of funds from the financial account to offset deficits in the current account. These funds include gold and foreign currency reserves; borrowing from overseas banks or the International Monetary Fund. A country's borrowing power obviously is not infinite, and if the deficit persists measures must be taken to correct the situation rather than try to fund it continuously.



Measures to correct a balance of payments deficit include deflationary policies designed to reduce AMD and hence expenditure, such as raising taxes or monetary tools such as raising interest rates. The idea is that by reducing AMD in the economy, the demand for imports will fall and one components of the deficit will be corrected. Furthermore, if the deflationary measures work on the domestic price level, goods and services will become more competitive on the international market leading to an increase in exports which again should help to correct the deficit.

Devaluation of a country's currency is another correcting measure. This will have the effect of making goods and services cheaper in export markets while imports will become more expensive. Providing that the elasticities of demand for both are price elastic it should result in an increase in exports and a reduction in imports.

In conclusion, financing measures must be seen merely as short term methods of dealing with balance of payments deficits. Corrective measures must be used if the deficit becomes long-term.


Balance of payment

alance of payment is a record of a country’s international trade transactions and capital transactions with other countries during a given period of time.

Balance of trade

alance of trade is a record of a country’s international trade transactions (import and export of goods) with other countries during a given period of time.

Remedies for an adverse balance of payments

(i) Depreciation or devaluation of the home currency results in imports being costlier in terms of the home currency.

(ii) Increase in import tariffs results in increase in cost of imports.

(iii) Domestic deflation to reduce aggregate demand domestically so that the quantity of imported goods decreases.

(iv) Increase domestic interest rate to attract deposits from foreign countries.

(v) Introduction of import quotas to reduce the overall quantity of imports.

(vi) Exchange control regulations to restrict outflow of funds from the home country.

(vii) Introduce measures to boost exports so that there is an increase in flow of funds.



13.3 BALANCE OF PAYMENTS

The following measures are usually taken to correct a disequilibrium in the Balance of Payments:

(a) Depreciation or devaluation of the home currency which makes the imports costlier and uncompetitive, whereas exports become more competitive.

(b) Increase in import tariffs resulting in increase in cost of imports.

(c) Domestic deflation by reducing the supply of money and thereby aggregate domestic demand so that the quantity of imported goods decreases.

(d) Increase in domestic interest rate to attract deposits from foreign countries.

(e) Introduction of import quotas to reduce the overall quantity of imports.

(f) Exchange control regulations to restrict outflows of funds from the home country.

(g) Stimulating exports by providing subsidies and tax holidays to export-oriented industries.

13.4 DISEQUILIBRIUM

(a) Following are some causes of disequilibrium in balance of payment:

Natural factors

Natural calamities like drought or flood may easily cause disequilibrium in balance of payments. These natural calamities can adversely affect agricultural and industrial production. Exports may decline and imports may go up, causing a setback in the country’s balance of payment.

Trade cycles

Business fluctuations caused by the operation of trade cycles may also result in dise uilibrium in country’s balance of payments. For instance, if there occurs a recession in foreign countries, it may induce a fall in the exports and exchange earning of the country concerned, hence resulting in a disequilibrium in the balance of payments.

Political instability

Political instability results in disrupting the productive potential within the country, thereby causing a decline in exports and an increase in imports.

Relatively high rate of inflation

High rate of inflation as compared to other countries makes the goods produced by that country relatively expensive. As a result, its exports decline and the balance of payment runs into a deficit.

Trade restrictions by other countries

Sometimes other countries impose heavy custom duties or fix quotas or ban imports from a country. It results in lower exports of that country.

Inelastic demand for machinery and industrial goods

The demand for these goods by less developed countries is inelastic because these less developed countries have no choice since there is shortage of such goods in these countries and to increase their growth rate they are going to need such goods. Hence their imports remain high.



(b) The following measures are usually taken to correct a disequilibrium in the Balance of Payments:

(i) Depreciation or devaluation of the home currency which makes the imports costlier and uncompetitive, whereas exports become more competitive.

(ii) Protectionist measures resulting in either partial restriction or complete ban on imports or increase in cost of imports.

(iii) Domestic deflation by reducing the supply of money and thereby aggregate domestic demand so that the quantity of imported goods decreases.

(iv) Increase in domestic interest rate to attract deposits from foreign countries.

(v) Import substitution to reduce the overall quantity of imports.

(vi) Exchange control regulations to restrict outflows of funds from the home country.

(vii) Stimulating exports by providing subsidies and tax holidays to export-oriented industries.

13.5 BALANCE OF PAYMENTS: COMPONENTS

(a) Trade in goods

Items that include the import and export of finished goods, semi-finished goods, and component parts for assembly

Trade in services

These services include tourism, financial services and consultancy

Investment income

Overseas activity that leads to a flow of money back to the country. For example, interest received from domestic investment, the activities of subsidiaries, and dividends earned from owning shares in foreign firms

Transfers

Items moved between countries such as overseas aid.

(b)

i. Real foreign direct investment: a domestic firm setting up a factory in

another country, and earning money from that

ii. Portfolio investment: a domestic investor buying shares in a business

that is already established. They have no control over these companies

iii. Financial derivatives: financial instruments where the underlying value

is based on another asset

iv. Reserve assets: a Central Bank will use foreign financial assets to

cover deficits and imbalances

(c) If there is a deficit, it is balanced by:

Selling gold, or other financial reserves

Borrowing from other Central Banks



13.6 CURRENT ACCOUNT DEFICIT CAUSES

(a) Running a deficit means that there is a net outflow of demand versus the income that comes into a country. This can be thought of as a country “not paying their way”

The current account isn’t re uired to balance, because the capital account can run a surplus. As we have seen though, running a surplus is sometimes dependent on selling reserve assets, and other unsustainable means

(b) There can be many factors across the economy that mean a current account deficit is likely to occur. For example:

High income elasticity of demand for imports: with strong consumer spending, the volume of imports will increase swiftly

Long term decline in manufacturing potential: with a fall in the productive potential of an economy, it is less likely that goods can be produced and exported

Changes in commodity prices: if a country imports a high portion of raw material, if these prices swing drastically, then this will increase the current account deficit.

Or any answer that eludes to more money being spent on imports, than being received on exports


(a) Tariffs are duties placed upon imports. This directly increases the price of imports, making them less attractive to the domestic market.

(b)

The domestic price (where domestic supply equals domestic demand) is higher

than the world price (Wp).

The level of imports is determined by the supply and demand for goods at

different price levels.

At Wp, Qd – Qs must be imported.

With the addition of a tariff, the world price increases, and as such a smaller

amount is needed to be imported (Qd1 – Qs1)

This therefore improves the current account deficit



(c)

Quotas: a government may fix a permanent amount of a good that may

be imported into a country. Restricting the quantity decreases the level

of imports, thereby improving the current account deficit

Export promotion: a government can help exporters sell their goods

and services on the international market through organising exhibitions

and trade fairs, as well as striking diplomatic deals

Import substitution: a country can reduce the level of imports that buy,

by becoming more self-reliant and producing these goods and services

domestically. This can be done through providing specialist training,

subsidies and tax assistance.


(a) More attractive

(b) Rs.9: US$1.

50% of 6 = 3. (6+3=9).

Depreciates means more rupees per dollar

(c) The J-curve is an interesting continuation of one of the main combative strategies to a current account deficit: exchange rate depreciation.

To recap, the logic behind depreciating the exchange rate is that exports will become relatively cheaper, whereas imports will become relatively more expensive. Hence, it will redress the imbalance in the balance of payments

However, the J-curve shows how in the short run, the deficit may get worse before improving.

This shows how, starting from Point A, the deficit increases before swinging up

and going into a surplus as time goes on



Why is this the case?

Assuming that economy starts at Point A, the government decides to devalue the currency.

The reason the deficit first gets bigger is to do with a time lag. Producers and consumers will take time to adjust to the change in currencies. Producers, for example will have orders with firms in other countries at agreed prices, and not be able to respond to the price change.

Export revenues may therefore not rise immediately. However import revenues may increase sharply due to high inelastic demand for foreign goods. This would make the deficit greater.

After time, firms will be able to adjust to the favourable currency conditions, and export revenues should be seen to rise.

It should be said though, that a devalued currency will lead to higher import prices, and therefore have a contributory effect to inflation. As this is usually a government’s macroeconomic priority, many will be wary of undertaking a policy that could so directly increase inflation.

13.9 OPEN MARKET OPERATIONS

Open market operations means the sale and purchase of government securities by the central bank in the open market (Inter-bank market).

The purpose of open market operation is to maintain monetary stability. In an inflationary situation the central bank sells the government securities and reduces the excessive money in circulation to reduce inflationary pressure. In case of deflation, the central bank purchases government securities and increases the money supply to reduce deflation.

13.10 CHANGE IN EXCHANGE RATES

A rise in the exchange rate has the effect of making exports more expensive and imports cheaper.

Those firms dependent on price for sales in export markets will become less competitive and could lose market share.

Firms competing against imported goods will have to reduce prices to maintain competitiveness.

Firms importing raw materials or components may benefit from lower import prices, which serve to reduce their costs


14.1 USE OF MONEY AND CAPITAL MARKETS

(a) The capital market and money markets are not places where financial instruments are traded but rather a process or set of institutions that organise and facilitate the buying and selling of capital instruments.

The money markets are a number of inter connected wholesale markets for short-term funds. The major participants are the Bank of England, discount houses, the banks, local authorities, building societies and large companies. These markets can be further sub-divided into the traditional or discount market and parallel markets. The traditional market is where the Government,



through the Bank of England and the discount houses, buy and sell short term debt to the commercial banks and companies. The parallel markets are used for firms and local authorities.

The capital market services the long term financial requirements of companies and the institutions which provide long term finance are The Stock Exchange, The Alternative Investment Market, The Over the Counter Market and the Venture Capital Market. The Stock Exchange is essentially the market for the issued securities of public companies, government bonds, local authority and other publicly owned institution loam. Without the ability to sell long-term securities easily, few people would be prepared to risk making their money available to businesses or public authorities.

(b) The money market is used by firms who need to borrow funds in the short-term since payment and receipts very rarely coincide. A company which is expanding may find bank overdraft, debtors and stock rising and the money market provides a service for firms who have inadequate working capital. Creditors will also rise during this period so it may be necessary to extend trade credit in order to satisfy customer requirements. Examples of money market instruments include loans and overdrafts, trade credit, hire purchase, leasing, bills of exchange and commercial paper.

The capital market is used by firms who need to borrow funds over the long term for investment purposes. Where retained profit is inadequate long-term borrowing may be found although such a policy would have an adverse effect on the gearing ratio. If the market thinks highly of a company, it will be easy to raise new capital through a rights issue via the Stock Exchange. The Alternative Investment Market(AIM) is geared towards attracting young and fast growing businesses with the aim of promoting enterprise, innovation and employment. The major provider of funds to this market are the pension funds and insurance companies.

(c) Governments have been using the capital markets since 1694 when the Bank of England was set up. Up until the end of the second world war it was primarily used to finance various wars. However, since the Bank was nationalised in 1946, fiscal policy has played a much greater role in the regulation of economic activity and successive governments have deliberately run a budget deficit or surplus. Depending on where we were on the trade cycle, the level of economic activity falls, unemployment rises leading to an increase in welfare payments and incomes and profit fall leading to a fall in government tax revenue. Such a phase is likely to lead to an increase in the public sector borrowing requirement whereby the government through the Bank of England are forced to sell long term government securities known as bonds or gilts.

14.2 DERIVATIVES

(a) An instrument whose price is dependent on one or more underlying asset(s). It is merely a contract between two parties. Changes in the underlying asset(s) can cause great fluctuations in the price of the derivative.

Share: not a derivative. An investor will see profits rise and fall in direct correlation with the share price

Option: is a derivative. Though there will be some correlation with the share price, the value of the derivative will still retain value even in if the share price falls.



(b) Over the counter and through an Exchange: OTC vs. ETD.

OTC derivatives

The conditions for establishing and trading an OTC derivative are much less strict than exchange traded derivatives (ETDs).

The issue and trade of each instrument is on an individual basis, meaning a financial intermediary (usually investment bank) will ‘make a market’ between buyers and sellers.

Benefits: greater flexibility with regard to the terms of the deal.

Drawbacks: the level of risk is much higher as counter parties can be affected if the trade loses a lot of money

ETDs

A derivative must meet certain strict criteria to be traded on an exchange.

There are variables (maturity length, credit rating etc) that can be controlled for to allow a derivative to be traded on an exchange.

Benefits: ETDs reduce the risk involved with a transaction by ensuring that whenever a party goes “long” (i.e. will see reward if the underlying price increases) there is another party that is “short”.

The fact that these two positions are e ualled off (“net zero”) means the overall risk is reduced if the underlying price moves drastically. Performing the trade through an official exchange also reduces the level of counterparty risk, as trades are done through a clearing house.

Drawbacks: reduces the quantity of derivative products that can be traded if they don’t meet the criteria

14.3 CAPITAL MARKETS

(a) The main distinction between money and capital markets is the good that is traded. Whereas in money markets it is short-term credit, in capital markets it is for longer term investments. The capital market has instruments that have a maturity length of over a year, whereas money markets are less than this.

(b) The main types of organisation that operate in the markets are as follows:

Corporations

Commercial banks

Stock exchanges

Investors

Nonbank institutions (insurance companies/ mortgage banks)

Corporations mainly use capital markets to fund long term projects that they wish to undertake. They use a commercial bank to deal with the mechanics of taking their offering to the market, which usually happens on a stock exchange. It is then investors who, using commercial banks again, will purchase the instruments that are being sold.

(c) The sums of money necessary to trade on the capital markets means it is rarely possible for an individual investor can gain access.

However, it is possible to do so through a mutual fund investment vehicle.



This is where many investors pool their resources together to be invested in a variety of financial instruments that we have laid out above. They are operated by professional money managers who have specialist knowledge of the money, and capital markets.

The investment objectives of each mutual fund are explained in the investment prospectus, and investors choose ones that best fits their profile.

The main advantage of a mutual fund is that it gives individual investors access to the market. A mutual fund portfolio can be constructed to be diversified, and across a range of securities. For an investor with a small amount of capital, this would be near impossible to replicate.

However, by becoming a shareholder in a mutual fund, the investor can participate in the gains or losses of the fund. Each share in a mutual fund can often be sold or purchased at the Net Asset Value (NAV) of the fund.

14.4 CAPITAL MARKET INSTRUMENTS

(a) On the capital markets, there are a number of different instruments that can be bought or sold. These broadly fit into two categories: debt and equity. Debt is a corporation issuing an agreement to repay a certain sum at a later date, and equity is selling rights of ownership in the company.

(b) There are two different types of shares that are traded on stock exchanges, and they differ in their characteristics. The two are:

Common stock: An instrument issued by companies that can be obtained via the primary or secondary market. Investment in the business means part-ownership of the company, and also rights and privileges – such as voting power, and the ability to hold a position.

An investor in debt is entitled to interest payments, the equity holder may or may not be paid dividend, depending on the company’s policy.

There is a high risk factor involved, as the price of the stock can fluctuate greatly. Holders of the instrument rank at the bottom of the scale if the company were to go into liquidation

Preference shares: An instrument issued by companies that rank

higher than common stock in terms of scale of preference. They possess

the same characteristics as equity in that its value is based upon the

share price fluctuating.

However it also acts similar to debt instrument, in that dividends are fixed, and the holder does not hold any voting rights.

The rates of return are formed on a much more individual basis, and there is more emphasis on the forces of supply and demand, rather than pegging to an official rate of interest.

(c) The way in which a government would utilise the capital markets is on the debt side, as they do not have equity themselves that they can sell off.

The two main instruments that are available to them are:

Debentures: A debt instrument where there is no physical asset used as collateral. Instead, a government or firm’s creditworthiness is used by investors to adjudicate the risk involved.



Bonds: An investor will buy debt from a government or corporation in exchange for a fixed return at various points of time, and then the principal (amount paid for it). There are two features that determine the price of a bond: credit quality and duration.

A longer held bond will have a higher interest rate returned, due to the time value of money. A bond issued by a riskier institution will also yield a higher interest rate, as there is less of a chance that the amount can be paid back.

Sovereign bonds are also an acceptable answer

The considerations for the government are:

Rate of interest that needs to be paid to investors

Length of time to pay back

The risk factor of them not returning money to investors

Alternative methods of raising capital (increasing taxes etc.)

2015

INTRODUCTION TOECONOMICS AND FINANCEQUESTION BANK

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