1.

Megalith plc has authorised share capital of 25,000,000 preference shares

and 100,000,000 ordinary shares. Profit before tax was $27, 800,000. Tax
payable is $6,900,000 and preference dividend payable is $1,900,000. The
company has 95,000,000 ordinary shares in issue, with a market price of
$2.85 and 24,500,000 preference shares in issue, with a market price of
$1.15. What is Megalith plc's P/E number?
A 12.95 B 14.25 C 15.00 D 13.64
Ans P/E ratio = Market price of share/ EPS
EPS= $27.8m - $6.9m - $1.9m / 95m
=19/95 =0.2
PE = 2.85/0.2 = 14.25
If you thought the answer was 15.00, you have used the number of shares
authorised rather than the number issued. If you thought the answer was
12.95, you have included the preference dividend in your earnings figure. If
you thought the answer was 13.64, you have made both of these mistakes.
2. The present value of Megalith's forecast future cash flows is now $267
million. What will happen to this value if Megalith plc's cost of equity rises?
A It will rise B It will fall C It will remain the same D It is impossible to say
Ans B It will fall. The cost of equity is the discount rate for this calculation. An
increase in the discount rate used for a present value calculation will
inevitably produce a fall in the present value computed.
3. Which of the following cannot be true? In the short run, as output falls:
A AVC falls B ATC falls C AFC falls D MC falls
Ans C If output falls, fixed costs are divided over a smaller number of units,
therefore average fixed costs will rise. (It may help you to draw a diagram of
the cost curves, to illustrate this.)
4. Harold Ippoli employs 30 people in his factory which manufactures sweets
and puddings. He pays them $5 per hour and they all work maximum hours.
To employ one more person he would have to raise the wage rate to $5.50
per hour. If all other costs remain constant, the marginal cost of labour is
Ans- Cost of 31 people (at $5.50 per hour)
170.50
( less ) Cost of 30 people (at $5.00 per hour) 150.00
Marginal cost
20.50
5. Which of the following is NOT true?

A A firm will carry on producing in the short run provided that price at least
equals average variable cost
B A firm will carry on producing in the short run provided that price at least
equals average fixed cost
C A firm will carry on producing in the short run provided that total revenue
at least equals total variable cost
D A firm will stop producing in the long run if total revenue is less than total
cost
Ans- B A firm will carry on producing in the short run provided total revenue
at least equals total variable cost, and is therefore making a contribution
towards fixed costs (so C is true).
If total revenue must at least equal total variable cost, price (average
revenue) must at least equal average variable cost (so A is true).
In the long run, if total revenue is less than total cost, the firm is not making
a normal profit and so will stop producing.
6. A demand curve is drawn on all except which of the following assumptions?
A Incomes do not change. B Prices of substitutes are fixed. C Price of the
good is constant. D There are no changes in tastes and preferences
Ans- C
Short run supply curve - Its marginal cost curve where price is greater than
average variable costs
7. A price ceiling set above the equilibrium market price will result in: A Market
failure B Excess supply over demand C Market equilibrium D Excess
demand over supply
Ans- C If the price ceiling is above the equilibrium market price, it will not
interfere with the working of the price mechanism. The market will not be forced
from its current equilibrium. A price ceiling only affects the workings of the price
mechanism if the ceiling is set below the equilibrium price.
8.

Which one of the following would normally cause a rightward shift in the
demand curve for a product? A A fall in the price of a substitute product B A
reduction in direct taxation on incomes C A reduction in price of the product
D An increase in the price of a complementary product

Ans- B A reduction in income tax will increase 'real' household income, and so
demand for normal products will shift to the right, ie quantity demanded will be
greater at any given price.
A fall in the price of a substitute good would entice consumers away from the
original good. This would cause a leftward shift in the demand curve.

A change in the price of the good itself does not cause a shift in the curve but a
movement along it.
Complementary products tend to be bought and used together, so an increase in
the price of one will lead to a reduction in demand for the other, reflected in a
leftward shift in the demand curve
6th qus of 4th chapter
9. If the absolute value of the price elasticity of demand for dry white wine is
greater than one, a decrease in the price of all wine would result in: A A more
than proportional decrease in the quantity of dry white wine purchased B A
less than proportional decrease in the quantity of dry white wine purchased
C A less than proportional increase in the quantity of dry white wine
purchased D A more than proportional increase in the quantity of dry white
wine purchased
Ans- D Assuming a normal good, a decrease in price results in a greater quantity
being demanded. Given that demand is price elastic, the increase in quantity will be
proportionally greater than the price fall.
10.Which combination of demand and supply curves would be appropriate for a
firm attempting to increase its profits by increasing its market share? A
Inelastic demand, inelastic supply B Elastic demand, elastic supply C
Inelastic demand, elastic supply D Elastic demand, inelastic supply
Ans- B To increase market share requires greater quantities of the firm's products to
be both demanded and supplied. To sell more, a firm needs to lower price. For this
to be profitable, demand must be elastic. To produce more, supply must also be
elastic.
11.When demand is price elastic, a fall in price will increase total spending on
the good
Qus 7th of 5th chap
12.Which of the following statements is always true if an indirect tax is imposed
on a good or service
A The price will rise by an amount equal to the tax B The producer will bear
more of the tax than the consumer C The price rise will be smaller the
greater the price elasticity of demand is D The price rise will be greater the
greater the price elasticity of demand is
Ans- C The price rise will be lower for products with a higher price elasticity
of demand. In the extreme case, if demand is perfectly elastic, there will be
no increase in the price at all.

Option A would be true if the good or service had a perfectly inelastic

demand, but that is the only condition under which it would be true. Equally,
Option B would be true if demand was relatively more elastic than supply, but
it will not always be true.
Economies of scale may be possible under any market form, though they are,
perhaps, less likely under perfect competition
13.How can a firm in perfect competition make supernormal profits?
Ans- In the short run, the number of firms in the market is fixed. If the
prevailing market price is above the lowest point on a firm's average total
cost curve, it will make supernormal profits
14.The necessary conditions for a firm to be able to discriminate on price are: (i)
The firm is a price setter (ii) The markets are kept separate (iii) Price
elasticity of demand is different in each market.
Aggregate concentration ratio this measures the sh of total production or
employment contributed by the largest firms in the whole eco
A lack of barriers to entry in an industry is likely to result in firms being X-inefficient
true in the long run such firms will become X-inefficinet

Integration occurs when firms join together , by either merger or takeover , a

merger Is an amalgamation of at least 2 firms into 1 org , it is usual for sh holders in
the old firm to exchange their old shs for shs in the new firms in agreed
proportions
General objectives of mergers & takeovers is to increase profits , usually in the short
run , and EPS.
Horizontal integration economies of scale , to reduce rivalry , increased market
sh , to fight off imports , to pool tech
Vertical integration the eliminiation of transaction costs eg removal of middlemen ,
increased entry barriers , securing supplies , improved distribution network ,
economies of scale , use of better tech
Conglomerates r financial holding
Perfect co no seller & buyer can influence price , firms r profit maximisers ,perfect
info about the market & homogenous product , no govt interference , perfect
mobility for both products & factors of production , normal profits in d long run ,
suppliers can sell all their output at the the price in the market so no incentive to
cut prices , firms r price takers

All producers sell at the same price because the product is homogenous eg farming
Monopoly- how does a mnonpoly decide price of the product ? ans either they fix
the price & let demand determine the amt supplied or fix the supply and let dd
determine the price , the price is likely to be higher and qty supplied lower , no
allocative and tech efficiency , economies of scale , the price may be lower than the
perfect competition
Price discrimination may be by time ( weekends or weekdays ) , customer , income
, place .
At least 2 diff markets , a market imperfection & diff elasticities

Specific industry regulators can set price caps & reduce barriers to entry
Monopsony a market with single supplier
A monopoly has very high avg fixed costs
In perfect co all producers charge the same price because products r homogenous
Price discrimination in monopoly can be used to increase output and reduce
allocative inefficiency
Firms only produce at full capacity under perfect co
Oligopoly markets do not show price co because producers decisions r
interdependent
A monoplosits AR curve falls downward because market dd increases as price falls
Currency bloc EU , groups of countries fix their exchange rate against a major
currency
In a mixed economy there are pvt and public sector
ROCE =Profit before interest and tax (PBIT) * 100 / avg cap employed
Profit before interest and tax, or profit from operations, is profit available for all
holders of capital (shares and loans). Capital employed is defined as total assets
less current liabilities.
Return on net assets =Operating profit (before interest and tax)*100/ Total assets
minus current liabilities

Earnings per share (EPS) is usually regarded as a measure of how well the company
has performed for its equity shareholders specifically , ROCE is a more general
measure of the overall productivity of capital.) ie for both lenders and sh holders
EPS =Profit after tax and preference dividends(Profit available for ordinary
shareholders ) / Number of equity shares issued ( remember these have to shs
issued fig not the fig of authorized shs )

Price earnings (P/E) ratio ( multiple ratio ) = Market price per share/ EPS
he P/E ratio is interesting in that it reflects shareholder opinion about company
prospects because it shows, in effect, the number of years' worth of earnings from a
share that would be needed to make up the price of buying a share. A high P/E
number indicates that investors are content with a relatively low current return from
the share. This is usually because they anticipate that their return will improve
substantially in the future, possibly as a result of emerging opportunities or new and
impressive products. A high P/E ratio shows that the market is confident about the
future prospects of the company.
the measure for EPS we looked at earlier only looks at earnings per share, it doesn't
take into account the price an investor would have to pay to acquire the share. The
earnings yield addresses this shortcoming by comparing the earnings per share with
the market price of the share
Earnings yield = EPS*100/ market price of the sh
ROCE and EPS are both based on historical accounting information. As a result, their
usefulness is greatest as measures of how a company has performed in the recent
past , p/e looks into recent future
Measure of long term -Cost of capital is the minimum acceptable return on an
investment ( disc factor )
There are two ways to measure this - expected future dividends , free cash flow to
equity
We assume that a constant dividend will be paid each year into the indefinite future.
This dividend valuation model shows the from pg 29 to 34
The present value of Megalith's forecast future cash flows is now $267 million. What
will happen to this value if Megalith plc's cost of equity rises? It will fall. The cost of
equity is the discount rate for this calculation. An increase in the discount rate used
for a present value calculation will inevitably produce a fall in the present value
computed.

, normal profit is the opportunity cost of preventing the entrepreneur investing

elsewhere.
(a) MC = increase in total cost of production (b) MC = increase in variable cost of
production , both a and b are correct
(a) Total cost. Total costs of production carry on rising as more and more units are
produced.
(b) Average cost. AC changes as output increases. It starts by falling, reaches a
lowest level, and then starts rising again.
(c) Marginal cost. The MC of each extra unit of output also changes with each unit
produced. It too starts by falling, fairly quickly reaches a lowest level, and then
starts rising.
(d) AC and MC compared. At lowest levels of output, MC is less than AC. At highest
levels of output, though, MC is higher than AC. There is a 'cross-over' point, where
MC is exactly equal to AC.
Economic costs are different from accounting costs, and represent the opportunity
costs of the factors of production that are used.
Accounting profits consist of sales revenue minus the explicit costs of the business
relevant costs for decision-making purposes are future costs incurred as a
consequence of the decision, Relevant future costs are the opportunity costs of the
input resources to be used..
When the average cost curve is rising, the marginal cost will always be higher than
the average cost.
When the average cost curve is falling, marginal cost lies below it
When the average cost curve is horizontal, marginal cost is equal to it
The relationship between marginal costs and average costs means that the
marginal cost curve always cuts through the average cost curve at the lowest point
of the average cost curve
Qus - (a) It is possible for the average total cost curve to be falling while the
average variable cost curve is rising. True or false? (b) Marginal fixed costs per unit
will fall as output increases. True or false?
Ans - (a) True. Average total cost (AC) comprises average fixed cost (AFC) and
average variable cost (AVC). AFC falls as output rises, and the fall may be sufficient
to outweigh a possible increase in AVC. In such a case, AC will fall while AVC rises.
(b) False. It is average fixed costs per unit that fall as output increases. Marginal

fixed costs = 0, because fixed costs do not change when one extra unit of output is
produced
Total variable costs therefore vary with output in the short run as well as in the long
run.
(a) the sgort run variable cost per unit is more or less constant (eg wages costs
and materials costs per unit of output are unchanged). If the average fixed
cost per unit is falling as output rises, and the average variable cost per unit
is constant, it follows that the average total cost per unit will also be falling as
output increases
(b) However, there are other reasons for the initial fall in average total cost. The
first is the effects of the division of labour and specialisation.
(c) The second reason is the utilisation of indivisibilities.
It is important that you appreciate that diminishing returns set in once the rate at
which the increase in productivity from adding an extra unit of a factor of production
starts to fall. This does not necessarily mean, however, that total output has started
to fall.
If output increases more than in proportion to inputs (for example doubling all
inputs trebles output) there are beneficial economies of scale. Economies of scale
mean that the long run average costs of production will continue to fall as the
volume of output rises.
If output increases in the same proportion as inputs (for example doubling all inputs
doubles output) there are said to be constant returns to scale.
Tech eco - Dimensional economies of scale arise from the relationship between the
volume of output and the size of equipment (eg storage tanks) needed to hold or
process the output. Technical economies arise in the production process. They are
also called plant economies of scaleA large firm also benefits from economies of
scale by overcoming indivisibilities
internal economies of scale are potentially more significant than external economies
to a supplier of a product or service for which there is a large consumer market.
External economies of scale are potentially significant to smaller firms who
specialise in the ancillary services to a larger industry
it is generally accepted that in any industry there is a minimum efficient scale of
production which is necessary for a firm to achieve the full potential economies of
scale
in the short run a firm will carry on producing provided its total revenue exceeds
total variable costs because this means it is making a contribution towards fixed
costs.

In the long run, by definition, there are no fixed costs, so all costs are variable.
Therefore, in the long run a firm will only carry on producing if total revenue is
greater than or equal to total cost, or if average revenue (price) is greater than or
equal to average cost. This means that, in the long run, a firm will only carry on
producing if it is making at least a normal profit
Conglomerate diversification. A company might take over or merge with another
company in a completely different business altogether. This form of merger is
diversification
Horizontal expansion or integration
Advantages Economies of scale from larger production quantities, ie lower costs.
Technical economies (use of larger machines or more specialised machines)
Managerial economies (greater specialisation of middle managers) Commercial
economies (bulk buying and selling) Financial economies (ability to borrow money
more cheaply) Risk-bearing economies (some greater spread of products made
within the same general market should help the firm to spread its risks)
Knowledge economies (consolidating research and development facilities to
advance technical knowledge) To increase market share with the possibility of
achieving monopoly or oligopoly status, and so having greater influence in the
market and chance to earn supranormal profits and raise prices.
Disadvantages Top management might be unable to handle the running of a large
firm efficiently, ie there might be management diseconomies of scale. The
creation of a monopoly will be unacceptable to government
Vertical integration
Advantages Gives the firm greater control over its sources of supply (backward
vertical integration) or over its end markets (forward vertical integration). This
should improve cost efficiency between the various stages of production, because
there are no longer third parties trying to make a profit It should also increase the
reliability of supplies (which is an important requirement for flexible manufacturing
techniques) By increasing control over the sources of supplies and/or the sales
and distribution network, a firm can increase barriers to entry stopping new
entrants joining the industry. Achieves financial economies of scale and possibly
some commercial economies. Otherwise few economies of scale unless production
now becomes better co-ordinated through its various stages.
Disadvantages Possible management diseconomies of scale, owing to lack of
familiarity with businesses acquired.
Diversification
Advantages Risks are spread by operating in several industries. If one industry
declines, others may thrive. Economies of scale in finance and administration.

Expertise can be shared across areas which would previously have been
unconnected.
Disadvantages No technical or commercial economies of scale. Possible
management diseconomies of scale, owing to lack of familiarity with businesses
acquired.
5 Which of the following cannot be true? In the short run, as output falls: A Average
variable costs falls B Average total cost falls C Average fixed cost falls D Marginal
costs falls
6 The tendency for unit costs to fall as output increases in the short run is due to
the operation of: A Economies of scale B The experience of diminishing marginal
returns C Falling marginal revenue D Increasing marginal returns
Ans - 5 C If output falls, fixed costs are divided over a smaller number of units,
therefore average fixed costs will rise. (It may help you to draw a diagram of the
cost curves, to illustrate this.) 6 D The benefits of specialisation and the division of
labour could allow increasing marginal returns Economies of scale only operate in
the long run. B results in rising unit costs in the short run. C is nothing to do with
costs.
changes in demand caused by changes in price are represented by movements
along the demand curve, from one point to another. These changes in quantity
demanded in response to a change in price are called expansions or contractions in
demand. The price has changed, and the quantity demanded changes (prompting a
movement along the curve), but the demand curve itself remains the same.
Factors determining demand for a good The price of the good The size of
households' income (income effect) The price of other substitute goods
(substitution effect) Tastes and fashion Expectations of future price changes
The distribution of income among households.
A demand curve shows how the quantity demanded will change in response to a
change in price provided that all other conditions affecting demand are unchanged
that is, provided that there is no change in the prices of other goods, tastes,
expectations or the distribution of household income.
Shifts of the demand curve , when there is a change in the conditions of demand,
the quantity demanded will change even if price remains constant.
Short run supply curve
If we assume there is a single, constant selling price for all firms, then a firm's
average revenue (AR) and marginal revenue (MR) will be identical. We can show this
as Price = Average Revenue = Marginal Revenue. We know that the firm will supply

where MC = MR in order to maximise profit. Consequently, the firm's chosen levels

of output (forming its supply curve) are as shown in Figure 5 below
Fig 5 from pg 77 to 78
The prices of other goods. When a supplier can switch readily from supplying one
good to another, the goods concerned are called substitutes in supply. An increase
in the price of one such good would make the supply of another good whose price
does not rise less attractive to suppliers. When a production process has two or
more distinct and separate outputs, the goods produced are known as goods in joint
supply or complements in production. Goods in joint supply include, for example,
meat and hides. If the price of beef rises, more will be supplied and there will be an
accompanying increase in the supply of cow hide.
Changes in technology. Technological developments which reduce costs of
production (and increase productivity) will raise the quantity of supply of a good at a
given price
a change in price will cause a change in supply along the supply curve. A change in
other supply conditions will cause a shift in the supply curve itself.
A rightward (or downward) shift of the curve shows an expansion of supply and may
be caused by the factors below. (a) A fall in the cost of factors of production, for
example a reduction in the cost of raw material inputs (b) A fall in the price of other
goods. The production of other goods becomes relatively less attractive as their
price falls. Firms are therefore likely to shift resources away from the goods whose
price is falling and into the production of higher priced goods that offer increased
profits. We therefore expect that (ceteris paribus) the supply of one good will rise as
the prices of other goods fall (and vice versa) (c) Technological progress, which
reduces unit costs and also increases production capabilities (d) Improvements in
productivity or more efficient use of existing factors of production, which again will
reduce unit cost
A demand curve is drawn on all except which of the following assumptions?
A Incomes do not change. B Prices of substitutes are fixed. C Price of the good is
constant. D There are no changes in tastes and preferences ans C
Full chap 5
Externalities: the differences between private and social costs.
Public goods: goods which cannot be provided privately because if they are,
everyone will benefit from them; regardless of whether they have paid for them or
not. As a result, individuals would have no incentive to pay for these goods. Merit
goods: goods which need to be provided in the long-term public interest.

if pricing policy is to maximise net social benefit then it also needs to include
externalities when calculating costs.
Figure 1 shows two possibilities. (a) If a free market exists, the amount of the good
produced will be determined by the interaction of demand (curve D) and supply
curve S. Here, output would be Y, at price Py (b) If social costs are taken into
account, and the market operated successfully, the supply curve should shift
leftwards, and the amount of the good produced should be X, at price Px. As we will
see in detail in a later chapter, the profit maximising level of production for a firm
(and therefore the level of production a firm will aim for) is that where marginal cost
equals marginal revenue. If a firm's private costs are adjusted to take account of
social costs, its optimum level of production will still occur when MC = MR, but now
marginal cost also includes the cost to society of producing an extra unit of output.
This is the concept of social marginal costs.
Pg 124 fig
Some goods, by their very nature, involve so much 'spill-over' of externalities that
they are difficult to provide except as public goods whose production is organised by
the government. , non exclusive
Merit goods are considered to be worth providing to everyone irrespective of
whether everyone can afford to pay for them, because their consumption is in the
long-term public interest. Education is one of the chief examples of a merit good.
Merit goods are different from public goods in that they are divisible
Indirect taxes are levied on expenditure on goods or services as opposed to direct
taxation which is applied to incomes. A selective indirect tax is imposed on some
goods but not on others (or is imposed at a higher rate on some goods than on
others).
Indirect taxation may be used to improve the allocation of resources when there are
damaging externalities. If an indirect tax is imposed on a good, the tax will shift the
supply curve upwards (leftwards) by the amount the tax adds to the price of each
item. This is because although the price to consumers includes the tax, the revenue
the suppliers receive is only the net-of-tax price
Pg 128 to 131
6 Which of the following are weaknesses of a completely free-enterprise economic
system? 1 It only reflects private costs and private benefits; 2 It may lead to serious
inequalities in the distribution of income and wealth; 3 It may lead to production
inefficiencies and a wastage of resources.
A 1 and 2 only B 2 and 3 only C 1 and 3 only D 1, 2 and 3

7 Muddy Waters Co is an industrial company which has altered its production

methods so that it has reduced the amount of waste discharged from its factory into
the local river. Which of the following is most likely to be reduced? A Total private
costs B Social costs C External benefit D Variable costs
8 Much Wapping is a small town where a municipal swimming pool and sports
centre have just been built by a private firm, Builder Co. Which of the following is an
external benefit of the project? A The increased trade of local shops B The increased
traffic in the neighbourhood C The increased profits for the sports firm D The
increased building on previous open land
9 The government has just increased the tax on tobacco. Assuming that the
demand for cigarettes is completely inelastic, who pays the tax? A It is shared
between supplier and consumer in proportions equal to the relative prices before
and after the increase. B The supplier C The consumer D It is shared between
supplier and consumer in proportions equal to the relative quantities sold before
and after the increase.
10 Which of the following statements is always true if an indirect tax is imposed on
a good or service: A The price will rise by an amount equal to the tax B The
producer will bear more of the tax than the consumer C The price rise will be
smaller the greater the price elasticity of demand is D The price rise will be greater
the greater the price elasticity of demand is
6 D The need to limit or avoid these weaknesses is the chief argument in favour of
some government involvement in the allocation of economic resources ie in favour
of a mixed economy or even a command economy. 7 B Social cost is the sum of the
private cost to a firm plus the external cost to society as a whole. Here, social cost is
the sum of production costs (private costs) plus the cost of pollution (external cost).
The firm's private costs might have been increased by the measures to reduce
pollution, but the external costs will have fallen, so that total social costs should
have fallen too. 8 A This is correct because the benefits to local shops are additional
to the private benefits of the sports firm and as such are external benefits. B is an
external cost of the project, since increased volumes of traffic are harmful to the
environment. C is a private benefit for the firm. D would only be an external benefit
if a building is better for society than the use of open land, which is unlikely. 9 C As
the consumer's consumption is not altered by the price rise, the supplier can pass
the price rise on in full. 10 C The price rise will be lower for products with a higher
price elasticity of demand. In the extreme case, if demand is perfectly elastic, there
will be no increase in the price at all. Option A would be true if the good or service
had a perfectly inelastic demand, but that is the only condition under which it would
be true. Equally, Option B would be true if demand was relatively more elastic than
supply, but it will not always be true.

When a firm can sell all its extra output at the same price, the AR 'curve' will be a
straight horizontal line on a graph. The marginal revenue per unit from selling extra
units at a fixed price must be the same as the average revenue (see Figure 1). If the
price per unit must be cut in order to sell more units, then the marginal revenue per
unit obtained from selling extra units will be less than the previous price per unit
(see Figure 2). In other words, when the AR is falling as more units are sold, the MR
must be less than the AR.
Fig 1 and 2 on pg 136
Note that in Figure 2, at any given level of sales, all units are sold at the same price.
The firm has to reduce its selling price to sell more, but the price must be reduced
for all units sold, not just for the extra units. This is because we are assuming that
all output is produced for a single market, where a single price will prevail.
Pg 138 to 141
'price takers', unable to influence the market price individually, perfect info ,
producers act to maximize their profits, There is no point charging a lower price
than the market price because the firm can sell all its output at the given price.
Thus the demand curve for the firm is perfectly elastic at price P1
Pg 143-147
Fig 12 on pg 148
Study the diagram in Figure 12 above. At what price and output level would the firm
maximise its sales revenue? Answer At the point where MR = 0. Price PZ and
output Z. Further sales will lead to negative MR, and hence a reduction in total
revenue.
It is important that you should understand what the MR and AR (demand) curves are
showing us in Figure 12. (a) At output quantity X, the marginal revenue earned from
the last unit produced and sold is MRX, but the price at which all the X units would
be sold is PX. This is found by looking at the price level on the AR curve associated
with output X. (b) Similarly, at output quantity Y, the marginal revenue from the last
unit produced and sold is MRY, but the price at which all Y units would be sold on
the market is, from the AR curve for Y output, PY. (c) At output Z, the marginal
revenue from the last unit produced is zero, and the price at which all Z units would
be sold is Pz. Total revenue will be maximised at Z. If any more units are sold, MR
will be negative, thereby reducing total revenue
The condition for profit maximisation is, as we have seen, that marginal revenue
should equal marginal cost (MC = MR). This is true for any firm. As long as marginal
revenue exceeds marginal cost, an increase in output will add more to revenues
than to costs, and therefore increase profits. A monopolist will have the usual Ushaped cost curves.

Pg 149 till wherever required

forward price is the spot price ruling on the day a forward exchange contract is
made plus or minus the interest differential for the period of the contract. This
differential reflects expectations of the movements in the various currencies
between the current time and the date the forward rate becomes due. The expected
exchange rate movements are likely to reflect interest rate differentials between the
two countries , The forward rate is not a forecast of what the spot rate will be on a
given date in the future; it will be a coincidence if the forward rate turns out to be
the same as the spot rate on that future date.
Forward rates are not always quoted in full, but may be quoted at a discount or
premium to the spot rates
Forward rate cheaper Quoted at discount
Forward rate more expensive Quoted at premium
A discount is therefore added to the spot rate, and a premium is therefore
subtracted from the spot rate, The longer the duration of a forward contract, the
larger the quoted premium or discount will be.
The $/ spot rate is currently quoted at 1.5900 1.6100 and the 1 month forward
rate at 0.0006 0.0010 discount. Required Calculate the actual forward rate.
Sol - Because the forward rate is quoted at a discount, that means that more dollars
can be obtained for each pound. The rate is therefore 1.5906 1.6110
Qus - The /$ spot rate is currently quoted at 0.9000 0.9200 and the 3 month
forward rate at 0.0012 0.0008 premium. Required Calculate the actual forward
rate
Ans - Because the forward rate is quoted at a premium, that means that fewer euros
can be obtained for each dollar. The rate is therefore 0.8988 0.9192
Govt uses its official reserves to create en axact match b/w ss and dd
Using the official reserves will therefore cancel out a surplus or deficit on the current
account and non-official capital transactions in their balance of payments. A balance
of payments surplus would call for an addition to the official reserves, and a balance
of payments deficit calls for drawings on official reserves.
Advantages of fixed exchange ratesfiscal policy becomes more effective , A fixed
rate system also imposes economic disciplines on countries in deficit (or surplus)
Dis loss of flexibility , A government might be forced to reduce demand in the
domestic economy (for example by raising taxes and so cutting the demand for
imports) in order to maintain a currency's exchange rate and avoid a devaluation.

Countries regard devaluation as an indicator of failure of economic policy and often

resist devaluation until long after it should have taken place
. A government cannot correct a balance of payments current account deficit
through its own budget.
Receipts in the balance of payments (external balance) come from exports of goods
and services and inflows of capital
The balance of payments accounts have three parts: (a) Current account
The current account can be subdivided as follows:
Visibles
Trade in goods
dividends) Transfers

Invisibles
Trade in services Income (interest, profit,

Income is divided into two parts. (a) Income from employment of UK residents by
overseas firms (b) Income from capital investment overseas (such as dividends and
interest earned)
Transfers are also divided into two parts: (a) Public sector payments to, and receipts
from, overseas bodies , (b) Non-government sector payments to and receipts from
bodies such as the EU
Capital account The capital account balance is made up of public sector
flows of capital into and out of the country, such as government loans to
other countries.
Financial account The balance on the financial account is made up of
flows of capital to and from the non-government sector, such as direct
investment in overseas facilities; portfolio investment (in shares, bonds
and so on); and speculative flows of currency ('hot money'). Movements on
government foreign currency reserves are also included under this
heading. Similarly, if speculators buy up sterling in response to interest
rate or exchange rate movements, these 'hot money' movements will still
be shown as inflows in the financial account even though they are shortterm capital movements.
(b) Capital account (c) Financial account

Net errors and ommisions - A positive balancing item indicates unrecorded

net exports: a negative one, net imports. The sum of the balance of
payments accounts must always be zero, So if the current account is in
deficit it must be matched by a surplus on the capital or financial

accounts. If a country has a current account deficit this represents a net

withdrawal from the circular flow of income, and so a deficit on a country's
current account will be deflationary.
Qus - 'If the balance of payments always balances why do we hear about
deficits and surpluses?'
Ans - If a UK exporter sells goods to a foreign buyer: (a) The value of the
export is a plus in the current account of the balance of payments (b) The
payment for the export results in a reduction in the deposits held by
foreigners in UK banks (a minus in the assets and liabilities section) When
we use the phrases 'deficit' or 'surplus on the balance of payments' what
we actually mean is a deficit or surplus on the current account. If there is
a surplus (+) on the current account we would expect this to be matched
by a similar negative amount on the assets and liabilities section. This will
take the form of: (a) Additional claims on non-residents (for example,
overseas loans) (b) Decreased liabilities to non-residents (paying off our
loans abroad) This will involve not only banks and other firms but it may
also involve the government too, since it is responsible for the 'reserves'.
If there is a deficit (-) on the current account the result will be a similar
positive amount on the assets and liabilities section. This will consist of
inward investment and/or increased overseas indebtedness, representing
how the
deficit has been 'financed'. This means that banks and other firms will owe
more money abroad and the government may also be borrowing from
abroad.
Bal of trade deficit or surplus in goods only
A balance of payments is in equilibrium if, over a period of years, the
exchange rate remains stable and autonomous credits and debits are
equal in value (the annual trade in goods and services is in overall
balance). However, equilibrium will not exist if these things require the
government to introduce measures which create unemployment or higher
prices, sacrifice economic growth or impose trade barriers (eg import
tariffs and import quotas).
High income elasticity of demand for imports increases demand for
imports as national income grows.
Low income elasticity of demand in foreign markets, so demand for exports only
grows slowly despite foreign national incomes growing. Equally a country might
have low exports because its own domestic market is growing, hence its producers
will concentrate on domestic sales rather than looking to export

Current a/c deficits resrves will drain out , depreciation in value , mport quotas will
be put up
[Note: A devaluation occurs when the value of a currency is lowered in a fixed
exchange rate system. A depreciation occurs when an exchange rate is reduced
under a floating exchange rate system.]
(Appreciation of a currency will have converse effects to those of a depreciation.)
The cost of imports would rise as a result of currency depreciation because more
domestic currency would be needed to obtain the foreign currency to pay for
imported goods. The volume of imports would fall, although whether or not the total
value of imports fell too would depend on the elasticity of demand for imports. (a) If
demand for imports is inelastic, the volume of demand would fall by less than their
cost goes up, so that the total value of imports would rise. (b) If demand for imports
is elastic, the total value of imports would fall since the fall in volume would
outweigh the increase in unit costs.
If a country imports raw materials and exports manufactured goods which are made
with those materials, the cost of imported raw materials will rise, and so producers
will have to put up their prices to cover their higher costs. There will be a net fall in
export prices, as explained above, but perhaps not by much.