Economics Q&A PDF

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Introduction to
economics and finance
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© Emile Woolf International ii The Institute of Chartered Accountants of Pakistan

Certificate in Accounting and Finance
C
Introduction to economics and finance
Contents
Page
Question and Answers Index v
Questions
Section A Multiple choice questions 1
Section B Objective test and long-form questions 27
Answers
Section C Multiple choice answers 55
Section B Objective test and long-form answers 65
© Emile Woolf International iii The Institute of Chartered Accountants of Pakistan

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

I
Index to Objective test and

long-form questions and
answers
QUESTION ANSWER
PAGE PAGE
CHAPTER 1 – FUNDAMENTALS OF ECONOMICS
1.1 FACTORS OF DEMAND 27 66
1.2 PRODUCTION POSSIBILITY CURVE 27 67
1.3 ECONOMIC GROWTH 27 67
1.4 ISLAMIC ECONOMIC SYSTEM 28 68
CHAPTER 2 – MICROECONOMICS
2.1 TYPES OF GOODS 29 69
2.2 QUANTUM OF SUPPLY OF A PRODUCT 29 69
2.3 MOVEMENT 29 70
2.4 A MARKET ECONOMY 29 71
CHAPTER 3 – DEMAND AND SUPPLY: ELASTICITIES
3.1 ELASTICITY OF DEMAND 29 73
3.2 ELASTICITY OF DEMAND 2 29 74
3.3 ELASTICITY OF DEMAND 3 29 75
3.4 CALCULATE PEDS 29 76
3.5 CONCEPTS OF DEMAND 30 76
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QUESTION ANSWER
PAGE PAGE
3.6 COFFEE MARKET 30 78
COMPETITIVE GOODS AND

3.7 31 79
COMPLEMENTARY GOODS
3.8 PRICE ELASTICITY OF SUPPLY 31 81
3.9 CROSS ELASTICITY OF DEMAND 31 81
3.10 PRICE ELASTICITY OF DEMAND 31 82
3.11 TOTAL EXPENDITURE METHOD 31 82
PROPORTIONATE OR PERCENTAGE
3.12 31 82
METHOD
3.13 GEOMETRICAL METHOD 31 83
NUMERICAL EXERCISE: PRICE

3.14 31 85
ELASTICITY OF DEMAND
IMPORTANCE OF PRICE ELASTICITY OF

3.15 31 85
DEMAND
CHAPTER 4 – UTILITY ANALYSIS
4.1 CONSUMER’S EQUILIBRIUM 31 88
4.2 INDIFFERENCE CURVES 32 89
4.3 CONCEPTS 32 89
4.4 PRICE EFFECT 32 91
4.5 INCOME EFFECT 32 92
4.6 SUBSTITUTION EFFECT 32 93
4.7 LAW OF DIMINISHING UTILITY 33 93
4.8 INDIFFERENCE CURVES 1 33 94
4.9 INDIFFERENCE CURVES 2 33 95
4.10 MARGINAL RATE OF SUBSTITUTION 33 97
CHAPTER 5 – COSTS, REVENUES AND FIRMS
5.1 MONOPOLIST PROFIT 33 99
5.2 PERFECT COMPETITION 33 100
5.3 INCREASING RETURNS 33 101
© Emile Woolf International vi The Institute of Chartered Accountants of Pakistan

Index to questions and answers
QUESTION ANSWER
PAGE PAGE
5.4 LARGE FIRMS 33 101
5.5 THE SCALE OF PRODUCTION 34 103
5.6 MONOPOLY AND COMPETITION 35 104
5.7 PROFIT MAXIMISATION AND DEMAND

36 105
ANALYSIS
5.8 REVENUES AND COSTS 37 106
5.9 COSTS AND REVENUES 37 107
5.10 TYPES OF COSTS 38 108
5.11 MONOPOLY SETUP 38 109
5.12 CONSUMPTION GOODS 38 109
5.13 EQUILIBRIUM OF THE FIRM 38 110
5.14 MARKET FUNCTIONING 38 111
5.15 FREE FORCES 38 112
5.16 PRICE OUTPUT DETERMINATION 38 113
OLIGOPOLY AND DUOPOLY:

5.17 38 114
DIFFERENCE
5.18 PRICE CARTELS AND COLLUSION 38 114
5.19 PRICE LEADERSHIP 38 115
5.20 KINKED DEMAND CURVE 38 115
5.21 NON-PRICE COMPETITION 39 115
CHAPTER 6 – MACROECONOMICS: AN INTRODUCTION
6.1 NATIONAL INCOME 39 115
6.2 MEASURING NATIONAL INCOME 39 116
6.3 CIRCULAR FLOW OF INCOME 39 118
6.4 INJECTIONS AND WITHDRAWALS 39 119
6.5 AGGREGATE SUPPLY: SHORT RUN 39 120
6.6 AGGREGATE SUPPLY: LONG RUN 39 121
6.7 AGGREGATE DEMAND 40 121
© Emile Woolf International vii The Institute of Chartered Accountants of Pakistan

QUESTION ANSWER
PAGE PAGE
MACROECONOMIC EQUILIBRIUM:
6.8 40 122
RECESSION - KEYNESIAN
MACROECONOMIC EQUILIBRIUM:
6.9 40 124
INFLATIONARY GAP
6.10 DEFLATIONARY GAP 40 125
6.11 CALCULATION OF GDP 1 40 126
CHAPTER 7 – CONSUMPTION, SAVINGS AND INVESTMENT
7.1 CIRCULAR FLOW OF INCOME 42 130
7.2 INVESTMENT AND MEC 43 131
7.3 CONSUMPTION FUNCTION 43 132
7.4 PRIVATE INVESTMENT 43 133
CHAPTER 8 – MULTIPLIER AND ACCELERATOR
8.1 MULTIPLIER 43 134
8.2 MULTIPLIER 1 43 134
8.3 MULTIPLIER 2 44 135
8.4 ACCELERATOR QUESTION 44 136
CHAPTER 9 – GROWTH AND TAXES
9.1 INDIRECT TAXES 45 138
9.2 MACROECONOMIC POLICY 45 138
9.3 DIRECT AND INDIRECT TAXATION 45 139
9.4 TRADE CYCLE 46 141
9.5 MIXED ECONOMY 47 142
9.6 GROWTH RECESSION INDICATORS 47 144
9.7 ECONOMIC POLICY OBJECTIVES 47 145
AGGREGATE DEMAND AND AGGREGATE

9.8 47 146
SUPPLY
© Emile Woolf International viii The Institute of Chartered Accountants of Pakistan

Index to questions and answers
QUESTION ANSWER
PAGE PAGE
CHAPTER 10 – PUBLIC FINANCE
NATURE AND SCOPE OF PUBLIC

10.1 47 147
FINANCE
10.2 PUBLIC EXPENDITURE 47 147
10.3 CANONS OF TAXATION 47 148
CHAPTER 11 – MONEY
11.1 THE MONEY SUPPLY 47 148
MONEY SUPPLY AND QUANTITY

11.2 48 150
THEORY
11.3 IMPORTANT FUNCTIONS 48 151
11.4 UNEMPLOYMENT 48 152
11.5 PHILLIPS CURVE 49 153
11.6 LIQUID FORM 49 155
11.7 MONEY FUNCTIONS 49 155
CHAPTER 12 – MONETARY POLICY
12.1 FINANCIAL INTERMEDIATION 49 157
12.2 THE CENTRAL BANK 49 157
12.3 MONEY MARKETS 49 159
12.4 INTEREST RATE RISE 49 159
12.5 TYPES OF BANKS 49 159
12.6 CENTRAL BANKS 50 160
12.7 MONETARY POLICY 1 50 161
12.8 MONETARY POLICY 2 50 162
12.9 MONETARY AND FISCAL POLICY 50 163
CHAPTER 13 – CREDIT
13.1 CREDIT 50 164
13.2 BANKS 51 165
COMMERCIAL BANKS AND CREDIT

13.3 51 166
CREATION
© Emile Woolf International ix The Institute of Chartered Accountants of Pakistan

QUESTION ANSWER
PAGE PAGE
CHAPTER 14 – BALANCE OF PAYMENTS AND TRADE
14.1 A BALANCE OF PAYMENTS DEFICIT 51 168
BALANCE OF PAYMENT AND BALANCE

14.2 51 169
OF TRADE
14.3 BALANCE OF PAYMENTS 51 170
14.4 DISEQUILIBRIUM 51 170
14.5 BALANCE OF PAYMENTS: COMPONENTS 52 171
14.6 CURRENT ACCOUNT DEFICIT CAUSES 52 172
CURRENT ACCOUNT DEFICIT

14.7 52 172
NONMONETARY MEASURES
CURRENT ACCOUNT DEFICIT

14.8 52 173
MONETARY MEASURES
14.9 OPEN MARKET OPERATIONS 52 174
14.10 CHANGE IN EXCHANGE RATES 52 174
CHAPTER 15 – FINANCIAL MARKETS
15.1 USE OF MONEY AND CAPITAL MARKETS 53 175
15.2 DERIVATIVES 53 176
15.3 CAPITAL MARKET 53 176
15.4 CAPITAL MARKET INSTRUMENTS 53 177
© Emile Woolf International x The Institute of Chartered Accountants of Pakistan

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

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
CHAPTER 2 - MICROECONOMICS
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

95 Fiscal deficit can be controlled by reducing:
A Taxes
B Imports
C Unemployment
D Public expenditure
96 Which of the following is a direct tax?

A Sales tax
B Capital gains tax
C Federal excise duty
D Value added tax

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

A Income tax
B Sales tax
C Capital gains tax
D Property tax
98 The four main phases of a business cycle does NOT include:
A Depression
B Inflation
C Boom
D Recession
99 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
100 Economic growth in an industrial society results from:
A Technological change
B Innovation
C Capital production
D All of the above

101 Out of the following, which is the most important source of revenue to the state?
A Import tariff
B Service tax
C Wealth tax
D Sales tax
102 The difference between total expenditure and total amount of receipts is referred to
as
A Primary deficit
B Revenue deficit
C Budget deficit
D Fiscal deficit

103 Government budget is said to be balanced when:

A Government expenditure exceeds tax receipts
B Government tax receipts exceed expenditure
C Government spending decreases and revenues increase
D Government expenditure equals tax revenue
104 Which of the following should NOT be the aim of a government?

A Inequality of incomes
B Price stability
C Economic growth
D Full employment
105 Which of the following would cause income inequalities?

A Increased unemployment allowance
B Progressive taxation
C Regressive taxation
D Full employment
106 A benefit of tariff is:

A More competition
B Increased choice
C More trade
D Increased government revenue
107 The “ability to pay principle” can best be demonstrated by:

A Sales tax
B Excise tax
C Highway toll tax
D Personal income tax
108 Money does NOT function as a:
A medium of exchange
B hedge against inflation
C store of value
D measure of value
109 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

110 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
111 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
112 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
113 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
114 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
115 Which of the following is NOT a method of holding wealth?

A Bonds and equities
B Human wealth
C Consumer durables
D Commodities
116 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
117 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
118 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
119 Which of the following is a financial intermediary?

A Pension fund
B International Monetary Fund
C State Bank of Pakistan
D Stock exchange
120 Which of the following is NOT considered to be a credit instrument?

A IOU
B Draft
C Bond
D Stock

121 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
122 Which of these appears as a liability on a bank’s balance sheet?

A Reserves
B Checking accounts
C Loans
D Investments and securities
123 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
124 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
125 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
126 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
127 An increase in the Cash Reserve Ratio would:
A decrease prices
B reduce inflation
C control lending
D all the above

128 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
129 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
130 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.

131 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.
132 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

133 Which of the following measures would immediately increase the cost of imports?
A Tariff
B Quota
C Embargo
D Subsidies
134 Currency is usually devalued to:

A increase exports
B increase imports
C decrease inflation
D increase prices
135 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
136 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
137 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
138 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


139 Which of the following instruments are NOT traded in the capital market?
A Corporate bonds
B Treasury bills
C Mortgages
D Shares
140 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
141 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
142 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
143 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


B
Audit and Assurance
SECTION
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.
(b) Explain the role of State in a mixed economy.
1.2 PRODUCTION POSSIBILITY CURVE

Draw and briefly explain the “Production Possibility Curve”.
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
(ii) Economic growth will lead to a rise in the economic of
society.
(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.

(ii) The shift from curve 1 to curve 2 indicates that has
occurred.
(iii) Point X suggests an economy where there is either……..
(iv) Point Y is currently
(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
(c) State one factor which will encourage economic growth to occur:
(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
(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
(iii) High levels of economic growth may be unsustainable without a degree of
environmental pollution.
True or False
(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
1.4 ISLAMIC ECONOMIC SYSTEM

(a) Explain how the Islamic religion has impacted upon its economic system.
(b) What are its similarities and differences with the free market economic system?

Question bank: Objective test and long-form questions
2.1 TYPES OF GOODS
Differentiate between substitute goods, complimentary goods and independent goods.
Give two examples of each.
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.
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.
2.4 A MARKET ECONOMY

(a) Explain how the price system works to allocate resources in a market economy.
(b) Describe the main reasons why markets do not always allocate resources in an
efficient manner.

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.
(b) Briefly describe when Demand for a product is considered to be:
 Highly Elastic
 Unit Elastic
 Relatively Inelastic
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.
(b) Explain the usefulness to a business of information on price and income elasticity
of demand for its product.

(a) Define Arc elasticity of demand and provide the formula to measure it.
(b) Differentiate between point elasticity and Arc elasticity of demand.
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).
(b) The total sales revenue earned at the old and new price.

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

3.7 COMPETITIVE GOODS AND COMPLEMENTARY GOODS

(a) What is meant by “Competitive goods” and “Complementary goods”? Give two
examples of each.
(b) Explain briefly the factors which determine the Price Elasticity of Demand.
(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)
3.8 PRICE ELASTICITY OF SUPPLY
Describe briefly the factors influencing price elasticity of supply.
3.9 CROSS ELASTICITY OF DEMAND

Write a comprehensive note on Cross elasticity of Demand.
3.10 PRICE ELASTICITY OF DEMAND

Write a note on the relationship between Price elasticity of Demand and Revenue.
3.11 TOTAL EXPENDITURE METHOD

Describe briefly the Total Outlay or Total Expenditure Method.
3.12 PROPORTIONATE OR PERCENTAGE METHOD

Write a note on Proportionate or Percentage method giving numerical illustration.
3.13 GEOMETRICAL METHOD

Explain Geometrical measure of point elasticity of demand.
3.14 NUMERICAL EXERCISE: PRICE ELASTICITY OF DEMAND

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.
(ii) Calculate changes in total revenue if demand is met in full before and after the
change in price.
3.15 IMPORTANCE OF PRICE ELASTICITY OF DEMAND

Elaborate the usefulness of the concept of Price elasticity of demand.

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.

4.2 INDIFFERENCE CURVES

a) Explain why on an indifference map, the curve is convex? What concept does
this represent?
b) Explain why this indifference map doesn’t fit with economic theory.
4.3 CONCEPTS
Explain the following concepts with reference to consumer behaviour, using
appropriate diagrams:
 Price effect
 Substitution effect
 Income effect
4.4 PRICE EFFECT

Define price effect and display price effect using diagrams for.
 Substitute goods
 Independent goods
 Complementary goods.
4.5 INCOME EFFECT

Define Income effect using diagrams for.
 Normal goods
 When product X, is inferior
 When product Y, is inferior
4.6 SUBSTITUTION EFFECT

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

4.7 LAW OF DIMINISHING MARGINAL UTILITY

(a) Describe the Law of Diminishing Marginal Utility.
(b) When is a consumer in an Equilibrium position?
(c) Narrate the assumptions applicable to the indifference curve approach.
(d) With the help of Indifference Curves show how consumers maximize their levels
of satisfaction. Support your decision by drawing a suitable diagram.
4.8 INDIFFERENCE CURVES 1

(a) Narrate the basic assumptions applicable to the Indifference Curve Approach.
(b) Explain consumer’s equilibrium with the help of a diagram using indifference
curves.

(a) Define Indifference Curve.
(b) Prove that indifference curves are always convex to origin.
(c) Prove that indifference curves do not intersect each other.
4.10 MARGINAL RATE OF SUBSTITUTION

Write a detailed note on Marginal Rate of Substitution.

5.1 MONOPOLIST PROFIT
Explain the process of profit-maximization by a monopolist with the help of an
appropriate diagram.
5.2 PERFECT COMPETITION

(a) Briefly describe the important characteristics of a market under perfect
competition.
(b) Explain the equilibrium of a firm under perfect competition, with the help of an
appropriate diagram.
5.3 INCREASING RETURNS

Explain the law of increasing returns. How does the law apply in the case of a
manufacturing industry?
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
(b) using a diagram to illustrate your answer, what determines the optimum scale of
the firm in the long run?
(c) explain the different economies of scale that may occur, if a firm grows by merger
or take-over
(d) why might firms of very large size be justified?
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:
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:
(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
(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
(iii) output in a market is likely to be lower if the market is monopolistic rather
than perfectly competitive
True or False
(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
(c) Complete the diagram below to show the long run position for a firm in a perfectly
competitive market:
(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.
5.7 PROFIT MAXIMISATION AND DEMAND ANALYSIS

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

(c) Calculate the price elasticity of demand for the good for a price fall from £25 to
£23.
(d) Identify the factors which might explain the value of the elasticity of demand for
this good.
(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.
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.
(b) Calculate the firm's fixed costs and the marginal cost at each level of output.
(c) What level of output will the firm aim to produce and what amount of profit will it
make at this level?
(d) Describe and explain the effect on the firm's output and profits of the entry of
new producers into the industry.
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;
(ii) total profits.
(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;
(ii) new firms entered the industry.
(c) Explain the ways in which the firm might attempt to discourage the entry of new
firms into its industry.

5.10 TYPES OF COSTS
Explain the relationship between different types of costs using a table.
5.11 MONOPOLY SETUP

Briefly describe the disadvantages of having a monopoly setup.
5.12 CONSUMPTION GOODS

(a) Describe consumption goods and state the main determinants of demand for
these goods.
(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.
5.13 EQUILIBRIUM OF THE FIRM

(a) Explain the term Equilibrium of the Firm.
(b) State the conditions which are essential for the existence of Perfect
Competition in a market.
(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.
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.
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.
(b) Explain briefly why the short-run average cost curve is “U” shaped.
5.16 PRICE OUTPUT DETERMINATION

Explain with the help of an appropriate diagram, the price output determination
under monopolistic competition in the short-run.
5.17 OLIGOPOLY AND DUOPOLY: DIFFERENCE

Define and differentiate duopoly market and oligopoly market.
5.18 PRICE CARTEL AND COLLUSION

Define price cartel or price ring and collusion.
5.19 PRICE LEADERSHIP

When price leadership occurs?
5.20 KINKED DEMAND CURVE

What is kinked demand curve?

5.21 NON-PRICE COMPETITION

Write a note on Non-Price Competition.
CHAPTER 6 – MACROECONOMICS AN INTRODUCTION

6.1 NATIONAL INCOME
(a) Briefly describe three different approaches of measuring National Income.
(b) What difficulties are usually faced in measuring National Income?
6.2 MEASURING NATIONAL INCOME
(a) Explain the income, output and expenditure methods of measuring national
income.
(b) Describe some of the difficulties involved in their calculation.
6.3 CIRCULAR FLOW OF INCOME
(a) Draw a Diagram of Circular Flow of Income.
(b) Identify and explain briefly the three different types of Withdrawals and
Injections from the Circular Flow of Income.
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.
(b) How might the business sector be affected if there were a rise in the savings
rate in households?
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.
(b) Draw a shift in the supply curve as a result of a decrease in the cost of labour
throughout an economy.
(c) What are 6 reasons for a backward shift in a SRAS?
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.
(b) Is the LRAS more, or less likely to fluctuate than the SRAS? Explain your
answer.

6.7 AGGREGATE DEMAND

(a) What are the 5 components of aggregate demand (AD), and what is the
equation?
(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.
(c) Define what Keynes meant by “effective demand”.
6.8 MACROECONOMIC EQUILIBRIUM: RECESSION - KEYNESIAN

(a) Draw a graph using a Keynesian aggregate supply curve where the economy is
in a deep recession.
(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
(c) How would a neo-classical model of the economy interpret an increase of
government spending in a recession? Show with a diagram.
6.9 MACROECONOMIC EQUILIBRIUM: INFLATIONARY GAP

(a) Define an output gap. What are positive and negative output gaps known as?
(b) Draw a positive output gap on a graph.
(c) Explain how a positive gap is possible within an economy.
6.10 DEFLATIONARY GAP

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


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

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.
B Households E
F
C
Government Banking system Rest of the world

H
D I
A Firms G
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.

(b) For an open economy, state:

(i) the three injections into the circular flow;
(ii) the three withdrawals (leakages) out of the circular flow.
(c) Explain the effect on the business sector of an economy of an increase in the
household savings rate.
7.2 INVESTMENT AND MEC

(a) Explain (with a diagram) how a fall in interest rates will affect the level of
investment.
(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.
(c) Complete the following sentence: if the _____ generated from investment is
greater than the ______, then profit maximising firms will invest.
(d) What might cause a shift in the Marginal Efficiency of Capital curve?
7.3 CONSUMPTION FUNCTION

(a) Briefly explain the relationship between consumption, income and savings.
(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?
(c) How stable is the consumption function?
7.4 PRIVATE INVESTMENT

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

8.1 MULTIPLIER
(a) Explain what you understand by the term Multiplier.
(b) What are the limitations of the Multiplier?
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.

S = Savings, I = Investment, Q* = maximum GNP output, E = Equilibrium,

M = current level of output, B = zero savings level of output
(a) Explain how savings become investment in an economy. Which type of

organisation usually facilitates it?
(b) Are the levels of savings and investment planned, or actual levels? Comment on
the significance.
(c) Explain how if output was greater than M (i.e. in disequilibrium), the economy
would revert to equilibrium.
8.3 MULTIPLIER 2
(a) Fill in this description of the multiplier: “the consumption of one person becomes
the ___ ___ ___”
(b) Explain, with the help of separate diagrams, why Keynes believed it was
necessary to boost AD during a Depression, and not AS.
(c) Explain three limitations to the effectiveness of the multiplier.
8.4 ACCELERATOR QUESTION

(a) Define gross investment, and explain its importance in the accelerator principle.
(b) Complete the following example to calculate gross investment:
Example:
Year Y Stock of Net Depreciation Gross
(=Output) capital investment [3] investment
[1] [2] [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.
Example:
Year Y % change in Y Gross % change in
(=Output) investment 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.

9.1 INDIRECT TAXES
(a) What is meant by Indirect Taxes? Give three examples of Indirect Taxes.
(b) Briefly explain the disadvantages of Indirect Taxes.
9.2 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.
(b) Explain briefly the concepts of Demand-pull inflation and Cost-push inflation.
9.3 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.
(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.

9.4 TRADE CYCLE

The following data refer to the UK economy:
Change in business
Change in Gross investment Level of interest
Domestic rates
(excluding
Product from dwellings) (London Inter-Bank
previous year Rate)
from previous year
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.
(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.

9.5 MIXED ECONOMY

(a) Describe the main objectives of macroeconomic policy in a mixed economy.
(b) Explain how fiscal policy can be used to achieve these objectives.
9.6 GROWTH RECESSION INDICATORS

(a) Explain the features of an economy in a recession, and what might cause a
subsequent recovery.
(b) What are some of the leading, coincident and lagging indicators which might
confirm these phases?
9.7 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.
(b) Briefly discuss the policy tools usually adopted by the government to achieve
these objectives.
9.8 AGGREGATE DEMAND AND AGGREGATE SUPPLY

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

10.1 NATURE AND SCOPE
“The sole purpose of public finance is to raise sufficient revenues to meet public
expenditure” Do you agree with the statement?
10.2 PUBLIC EXPENDITURE

Describe the effects of public expenditure on production and distribution.
10.3 CANONS OF TAATION

Briefly describe Adam’s canons of taxation.
CHAPTER 11 - MONEY
11.1 THE MONEY SUPPLY
(a) Explain what is meant by the term 'the money supply'.
(b) Why do governments believe that it is important to control the growth of the
money supply?
(c) Describe the methods by which the government can attempt to control the money
supply.

11.2 MONEY SUPPLY AND QUANTITY THEORY

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.
(b) Explain the quantity theory of money.
(c) Describe the extent to which the data given are in line with the predictions of the
quantity theory of money.
(d) Explain how the effects of a change in the money supply might differ between the
short run and the long run.
11.3 IMPORTANT FUNCTIONS

(a) Identify the four important functions of money and highlight their significance.
(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.
11.4 UNEMPLOYMENT
(a) Explain the relationship between Inflation and Unemployment with the help of a
Phillips Curve.
(b) Full Employment is achieved when the rate of Unemployment reaches zero.
Discuss.
(c) Identify and briefly describe various types of Unemployment.

11.5 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?
(b) Draw this relationship, in the style of a Phillips Curve.
(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.
11.6 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.
11.7 MONEY FUNCTIONS

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

12.1 FINANCIAL INTERMEDIATION
(a) What is meant by Financial Intermediation?
(b) Give reasons why commercial banks strive hard to maintain adequate liquidity
at all times.
12.2 THE CENTRAL BANK

(a) Describe the role of a central bank when it acts as 'banker to the banks and
banker to the government'.
(b) Describe the main features of the 'supervision of the banking system'
undertaken by a central bank or by a regulatory authority.
12.3 MONEY MARKETS

Explain what is meant by the "money market" AND describe the role played by the
major institutions in that market.
12.4 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.
12.5 TYPES OF BANKS

a) What are the two main categories of banks? What are their features? Name
three ways in which they differ.
b) What are the drawbacks of a bank increasing its line of credit to customers?
What might affect its ability to do so?

12.6 CENTRAL BANKS

(a) What are the main objectives of a Central Bank?
(b) Is it possible for a Central Bank to meet all of these objectives? Explain your
answer.
12.7 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.
(b) Moral suasion.

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.
(b) Discount-rate policy.
12.9 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”.
(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.
13.1 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.
(b) give two examples of consumer credit and explain how this may be of benefit
to a firm.
(c) explain why a firm may choose to use long term credit rather than issue
shares.

(d) explain how credit can contribute to the money supply and the ways in which
the government may try to control its growth.
13.2 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'.
(b) explain how banks can create credit and the limitations of this ability.
(c) explain how and why banks can combine the aims of liquidity, profitability and
security when advancing money to customers.
13.3 COMMERCIAL BANKS AND CREDIT CREATION

(a) Describe the functions of commercial banks AND show how these meet the
needs of business customers.
(b) With reference to the process of credit creation, explain briefly
(i) how commercial banks can 'create credit'.
(ii) how the central bank can restrict the ability of commercial banks to
create credit.

14.1 A BALANCE OF PAYMENTS DEFICIT
(a) Explain what is meant by the term 'a balance of payments deficit'.
(b) Describe the main factors that might lead a country to experience a deficit on
the current account of its balance of payments.
(c) Explain the difference between 'financing' a balance of payments deficit and
'correcting' that deficit.
14.2 BALANCE OF PAYMENT AND BALANCE OF TRADE

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.
14.3 BALANCE OF PAYMENTS

Describe the measures a country may take to correct disequilibrium in the Balance
of Payments.
14.4 DISEQUILIBRIUM
(a) Briefly describe the main causes of disequilibrium in the balance of payments.
(b) State the measures for rectifying disequilibrium in the balance of payments.

14.5 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
(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.
(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.
14.6 CURRENT ACCOUNT DEFICIT CAUSES

(a) Explain a current account deficit with reference to the income and outflow of a
country.
(b) Name and explain three causes of a current account deficit in a country.
14.7 CURRENT ACCOUNT DEFICIT NONMONETARY MEASURES

(a) What is a tariff?
(b) Explain, with a diagram, how tariffs can help correct a current account deficit.
(c) What other non-monetary measures could a government take to reduce a
current account deficit?
14.8 CURRENT ACCOUNT DEFICIT MONETARY MEASURES

(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?
(b) If the exchange rate was Rs.6: US$1, and the rupee depreciates by 50%, what
will the new exchange rate be?
(c) Why might this strategy not be immediately effective at correcting a current
account deficit? Explain with reference to a J-curve.
14.9 OPEN MARKET OPERATIONS

What do we mean by ‘Open Market Operations’? Why does the Central Bank
undertake such operations?
14.10 CHANGE IN EXCHANGE RATES

Explain the effect on the business sector of an economy of


15.1 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.
(b) Using examples, show how a business might need to use both the money and
capital markets.
(c) Explain the circumstances under which the government might need to use the
capital market.
15.2 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.
(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.
15.3 CAPITAL MARKET

(a) What is the main distinction between capital markets and money markets?
(b) Who are the typical participants in the capital market?
(c) How might an individual investor have access to the capital market? Describe
in detail.
15.4 CAPITAL MARKET INSTRUMENTS

(a) Explain briefly the two categories of instruments traded on the capital
markets?
(b) Describe the difference between ‘common stock’ and ‘preference shares’.
(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?


C
SECTION
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
Percentage change in quantity demanded
Price elasticity of demand =
Percentage change in price
x
1.5 = (Price has dropped by 10% from £1 to
 10 %
£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 :
1 1 1 1
   2
MPT + MPM + MPS 1
4  1
10  3
20
10
20
1
2
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
1
The multiplier is calculated as:
rate of leakage
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.
1
Hence the multiplier is = 1 23
0.3  0.1  0.2

95 D
96 B
97 B
98 B
99 C
100 D

101 D
102 C
103 D
104 A
105 C
106 D
107 D

108 B
109 D
110 C
111 A
112 C
113 A
114 B
115 B
116 A
117 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.
118 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.

119 A
120 D
121 C
Customer's deposits are a liability of a commercial bank.
122 B
123 C
124 C
125 C
126 D
127 D

CHAPTER 13 - CREDIT
128 B
129 D
130 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.

131 B
132 C
133 A
134 A
135 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'.
136 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.
137 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.
138 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.


139 C
140 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.
141 B
This is rather an ambiguous question; the wording has to be read with care.
142 A
B and D relate to put options, and C means to sell a call option.
143 C
All the others are examples of activities within the parallel markets.

D
SECTION
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:
% change in quantity demanded
PED 
% change in price
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:
YED 
% change in income
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 P2 P1 A
of the average Arc elasticity
responsiveness to price B
changes exhibited by a
demand curve over some
finite stretch of the curve". Price P1P0
Price
D
The formula to measure Arc
Elasticity of demand is
Q 2  Q1 P2  P1
x
Q Q P2  P 1 O Q1Q QQ
E= 2 1 2 01
Where Q1 is the original Quantity Demand

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

3.4 CALCULATE PEDS

30
(288-258)/273 ( )
273
1. a) = -0.7
=-0.45, the price elasticity of demand = 0.45
(£2.50-£3.20)/£2.85 ( )
2.85
b) Old price: £3.20*258=£825.6

New price: £2.50*288=720
186
(447-261)/354 ( )
354
2. a) = -0.6
=-2.27, the price elasticity of demand = 2.27
(£2.30-£2.90)/£2.60 ( )
2.60
b) Old price: £2.90*261=£756.9

New price: £2.30*447=1028.1
50
(300-250)/275 ( )
275
3. a) = -0.5
=-1, the price elasticity of demand = 1
(£2.50-£3.00)/£2.75 ( )
2.75
b) Old price: £3.00*250=£750

New price: £2.50*300=750
3.5 CONCEPTS OF DEMAND

Unitary Elasticity of Demand:
Demand is unitary elastic when the percent change in the quantity demanded is the
same as the percent change in price. In case of unitary elastic demand, a decrease
in price from Po to P1 would result in increase in the quantity demanded from qo to
q1. However, the total expenditure would remain unchanged as the area marked A
is equal to the area marked B.

Relatively Elastic Demand:
Demand is relatively elastic when the percent change in the quantity demanded is
greater than percentage change in price. In case of relatively elastic demand, a
decrease in price from Po to P1 would result in increase in the quantity demanded
from qo to q1 The area marked A is less and area B is more showing that the
decrease in price will result in increase in the quantity demanded and also an
increase in the total expenditure.
Relatively Inelastic Demand:
Demand is relatively inelastic when the percent change in quantity demanded is

less than the percent change in price. In case of relatively inelastic demand, a
decrease in price from Po to P1 would result in increase in the quantity demanded
from qo to q1. However, the total expenditure would decline as area B is less than
area A.

Introductio
on to economicss and finance
3.6 COFFEE MARKET

M
(a) Marrket price is
s determine ed by the interaction of supply aand demand for a
prod vice. In thiss case the supply of coffee
duct or serv c had fallen for tw
wo main
reassons. The first
f was tha at over a period
p of tim
me coffee fa farmers hadd moved
awa ay from grow
wing their ttraditional crops
c to other alternativves becaus se of the
low prices paid for coffe ee due to the t collapsse of the Innternational Coffee
Agre eement. Thhe immedia ate impact on supply arose from m the seve ere frost
dammage to th he Brazilian n coffee plantations.
p The com mbination of
o these
circuumstances has led to a shift in the supply cu urve for cofffee from SS
S to S1S1
in th
he diagram below. If thhe demand for coffee remains
r thee same at th
he same
pricee then the demand ccurve remains unchang ged. Thereefore the chhange in
supply to S1S1 causes the coffee pric ce to rise fro
om P to P1.
Price
S1
D S
P1
P
S1
D
S
Q1 Q
Qua
antity
'Pricce elasticity' is the resp

ponsivenesss to change
es in price. ' Demand' is
s the
demmand for the e commodityy or goods. The price elasticity
e of demand is
therrefore a mea asure of thee responsiv emand to a change in price.
veness of de p It
is measured
m as
s:
∆Q
% cha
ange in quantitty demanded .100
Q
= ∆P
% change in price .100
P
Thee measure will

w be nega tive for a no
ormal dema and curve ass clearly a rise
r in
e would be expected to
price o reduce the quantity demanded
d aand vice versa. It
can be used to determine the extent of
o a rise res
sulting from a reductionn in
supply.
emand is ela
If de astic the peercentage rise in price will
w be relattively small to a fall
in de
emand. If demand is in nelastic the percentagee rise in pricce will be re
elatively
larger than the fall in dema
and.
e market pric
The ce prevailin
ng includes the
t effect of inflation. TThe 'real price' of
coffe
ee would bee the currennt market prrice after ad
djusting for inflation. As
s the
period from 19886 to 1993 wwas a periood of rapid inflation thee 'real price' would
havee fallen con
nsiderably m
more than thhe 15% drop in retail p rice.
© Emile W
Woolf International 78 The Institute of Chartereed Accountants of Pakistan
(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 quantity demanded of A
% change in price of B
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.
3.7 COMPETITIVE GOODS AND COMPLEMENTARY GOODS

(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
percentage change in the quantity demanded of commodity A

X.E.D. = 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.
...
Revenue gained ..................
P P
Revenue lost
P1 A P2 K
...................... .....................
......................................................................................................
..
B .... . .......................................................
. .. ............. .. . . .
P2 ................................................................................................. P1
J
.............................................................................. .
. . . . . . . . ...... D1
.............................................................................................
. ..... ..... .
............................................................................................... D2
. . . . .................
.......................................
.. .. . .. Q Q
Q1 Q2 Q2 Q1
(a) (b)
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.
3.12 PROPORTIONATE OR PERCENTAGE METHOD

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:
Percentage change in Demand
Elasticity of demand =
Percentage change in Price
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:

ΔQ P
PED = .
ΔP Q
Q = –16 P = 10
P =2 Qd = 96
–16 10
PED = 2 x 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:
Q1  Q 0 P1  P0
Elasticity = x
Q1  Q 0 P1  P0
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.
300 – 100 5 + 10
E = 300 + 100 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
Lower Point of the deamnd curve
E =
Upper Point of the demand curve
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.

B
D y
nit
n, u
er tha
at
gre
RA =
= B
E R
Price D R it y
n un
th a
l ess
ES =
D
S E= S
O qd A C
Fig. 2
RA
Elasticity at point 'R' is (-) RB and it is clear that lower portion is greater so elasticity
SC
is greater than unity and elasticity at 'S' is (-) SD 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=
P
Inelastic (E < 1)
O Q Quantity

3.14 NUMERICAL EXERCISE: PRICE ELASTICITY OF DEMAND

Percentage change in demand
Price elasticity of demand =
Percentage change in price
Product A:
Change in demand
Percentage change in demand =
Demand
25
Percentage change in demand = x 100  5%
500
Change in price
Percentage change in price = x 100
Price
-5
Percentage change in price = x 100 = - 12.5%
40
5
Percentage elasticity of demand = x 100 = - 0.4 (inelastic)
- 12.5
Product B:
100
Percentage change in demand = 100  33.3%
300
- 10  14.29
Percentage change in price = x 100 
70
33.3
Price elasticity of demand = = - 0.807 (inelastic)
14.29
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 equal to Rs. 1625.
Change in Total Revenue for Product ‘B’.
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. 3000.
3.15 IMPORTANCE OF PRICE ELASTICITY OF DEMAND

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 B 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.

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.
(1)
Substitute goods
A
Units of Commodity Y
E1
E2 PCC
IC1 IC2
x1 B x2 B1
Units of Commodity X

Y (2)
Y (1) (2) When Com X(3)and Com Y
Com
Com X andX Com
and Com Y are
Y are When Com X and Y are complimentary
unrelated goods
are complimentary
goods
goods
Unit of Commodity Y
Unit of Commodity Y
(independent goods) PCC
y1 E3
E1 E 2 E3 y2 E2 IC3
PCC y3 IC2
E1
IC2 IC 3 IC1
IC1
x1 x2 x3 x1 x2 x3 X
O X O
Unit of Commodity X Unit of Commodity X
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
C F (1)
Y I.C.C.
A
Commodity Y
E3
E2
IC 3
E1
IC2
IC1
x1 x2 x3 X
O B D G
Commodity X
Y (2) Y (iv)(3)
(iii)
Commodity Y is an Commodity X is an
Commodity Y iscommodity
a I.C.C.
inferior inferior
inferior commodity
inferior
commodity
Commodity Y
Commodity Y
commodity
E3
E 2 IC 3
E
E1 E 2 3
I.C.C. E1
IC2
IC 3
IC1 IC 2 IC 1
O B D GX O B D G X
Commodity X Commodity X
Note: Income effect is shown by a parallel shift of the budget line.

4.6 SUBSTITUTION EFFECT

When consumer’s equilibrium 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:
Product y
Y1 E1 PCC
E2
Y2 E3 IC2
IC1
X1 X3 X2 Product - X
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.

(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 equilibrium 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.
It is clear that the vertical distances

showing sacrifice of commodity ‘Y” is a
decreasing, which, shows that the marginal
Community Y
rate of substitution of commodity ‘X’ for c
commodity ‘Y’ is falling that is why this b
curve represents the indifference curve. e MRS is falling
d
f g
i
h
k
j
1C 1
O Community X X
(i) If an indifference curve is a straight line with a downward slope as shown in the
figure.
Y
Indifference curve which is a straight line
slopping downward, the vertical distance of
a MRS is constant
ab, cd and ef are equal which show that
marginal rate of substitution is constant which
is unnatural because for every next unit of c
Community Y
b
commodity ‘X’, marginal rate of substitution
must diminish. Therefore, it cannot be e
d
indifference curve.
d
f
1C
O Community X X
(ii) Suppose that indifference curve is concave
Y
It is clear from the figure that vertical MRS
distances are increasing with more units of a c is increasing
b e
commodity ‘X’. The distance ‘ji’ is greater d g
f
Community Y
than ‘hg’, also greater than ‘fe’ and so on. h i

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
j k
cannot be an indifference curve.
1C
X
O Community X

(c):
The main property of the indifference
curves is that Indifference curves do
not intersect each other. Suppose Y
that there are two indifference curves
IC1 and IC2 intersecting each other
Community Y
as shown in the figure. IC2 is higher
indifference curve, IC1, is lower
Indifference curve. Therefore, it can A
be concluded from the intersection of C
indifference curves . 1C1
The satisfaction at point A = B 1C 2

Satisfaction at point C. X
Community
The satisfaction at point A =
Satisfaction at point 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 ‘B’ 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).
Units of Units of
commodity commodity Marginal Rate of
Combinations
Substitution
(X) (Y)
A 1 16 –
B 2 8 8:1
C 3 5 3:1
D 4 4 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 Y

represents the Marginal A
Rate of Substitution y1 16
which is falling as more 12
units of commodity ‘X’
Community Y
A´ B
are consumed, less and y2 8
less units of commodity
‘Y’ are sacrificed by the B´ C
y3
consumer. y4 4 C´
D
O X
x1 x2 x3 x4
Community X
The Marginal Rate of Substitution at point B is:
Y2Y1 AA 
MRS =  or = 
X 2 X1 A B
The Marginal Rate of Substitution at point C is:
Y3Y2 BB /
MRS = X X =  /
3 2 B C
The marginal rate of substitution at D is:
Y4Y3 CC´
MRS = =X X =  C´D
4 3
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.

5.7 PROFIT MAXIMISATION AND DEMAND ANALYSIS

(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:
Price elasticity of demand 
% change in 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:
1 25%
PED  4
  3.125
2 / 25 8%
(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 ATC =
TFC TC=(TFC AFC=TFC/Q
of AFC +
+ TVC) AFC AVC=TVC/Q AVC
Output TVC MC
AVC
Q
1 30 30 60 30 30 60 30
2 30 40 70 15 20 35 10
3 30 45 75 10 15 25 5
4 30 50 80 7.5 12.5 20 5
5 30 60 90 6 12 18 10
6 30 72 102 5 12 17 12
7 30 89 119 4.3 12.7 17 17
8 30 110 140 3.75 13.75 17.5 21
9 30 135 165 3.3 15 18.3 25
10 30 170 200 3 17 20 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.
Q P Q P
Price elasticity =   
Q P Q P
Here Q1 = 48,000; Q2 = 60,000
P1 = Rs. 12; P2 = Rs. 11
 ∆Q  Change in Demand  Q1  Q 2  48,000  60,000  12,000
∆P  Change in Price  P1  P2  12  11  1
- 12,000 12 - 12,000 - 12
Price Elasticity =    12   3
48,000 1 48,000 4
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 OM at which price is OP’ =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
5.17 OLIGOPOLY AND DUOPOLY: DIFFERENCE

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: Oligopoly 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

Kinked Oligopoly Demand Curve or Sweezy’s Model 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.
By 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.
6.8 MACROECONOMIC EQUILIBRIUM: RECESSION - KEYNESIAN

(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.

6.9 MACROECONOMIC EQUILIBRIUM: INFLATIONARY GAP

(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.
change in consumption
MPC= , 0<MPC<1
change in income
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.
∆Y
Formula of Multiplier
=
∆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 Y1 to Y2 , 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 Stock of Net Depreciation Gross
(=Output) capital investment [3] investment
[1] [2] [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 % change in Y Gross % change in
(=Output) investment 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.


9.1 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.
9.2 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.
9.3 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 National 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.
9.4 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) = VY
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.
9.5 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.
9.6 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.
** One 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
9.7 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.

9.8 AGGREGATE DEMAND AND AGGREGATE SUPPLY

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.


10.1 NATURE AND SCOPE
Prior to Keynes the concept of public finance revolved around raising revenues
sufficient enough to meet the public expenditure but J.M Keynes revolutionised the
concept and changed the perception attached to it. The fundamental change he
brought about was the approach of using public finance. According to him public
finance should be used as an instrument meant for achieving certain economic and
social objectives. Examples covered in the following paragraphs would reflect the
same.
According to Keynes the taxation and expenditure policy of the State has a huge
impact on the income and employment of the country. He discussed how a
government during the phase of depression can reduce the impact by raising the
levels of public expenditure and employment.
On the contrary, if there is high demand and if the money supply is increased, it will
give rise to inflation. So here the role of fiscal policy is to reduce money supply in
order to reduce inflationary pressure, making people save more and consume less.
The objectives too vary depending upon the state of the economy. That means, in
case of under-developed countries, the objectives of public finance are to fill up the
gaps of capital formation, encourage industrialisation and productive investment in
order to trigger economic growth.
Whereas in case of developed countries the function is to accelerate economic
growth in order to remove unemployment and poverty prevailing in the country.
10.2 PUBLIC EXPENDITURE

We know that there has been a huge increase in the public expenditure of nations
around the world due to reasons such as; national defense, growth in the
population, higher rates of urbanisation, social welfare, economic growth, loan
interest, etc.
It goes without saying that public expenditure if carefully planned, and effectively
used can have a wholesome impact on the economy.
It can boost the productive capacity of the economy and can reduce the prevailing
inequalities in the income distribution.
In the developed countries, during the times of depression, idle productive capacity
could be found at one hand and unemployed workforce on the other, During such
times, increase in government expenditure would not only boost the production
process but would also cause an increase in the employment as well by way of
multiplier.
On the other hand, in case of developing countries, the investment if carefully
planned, can facilitate economic growth. This happens when the expenditure is
incurred on capital formation projects; e.g. roads, canals and other infrastructural
facilities. Such expenditure is likely to trigger long term economic growth.
With the help of public expenditure, government also redistributes income in favour
of the underserved people. Not all types of public expenditure would eliminate or
reduce the inequalities of income, in order to address the issue, it has to take the
form of social security measures, investment in subsidies, poverty alleviation
programs, encouraging labour intensive initiatives and the like.

Besides, if the reduction in inequalities is the goal then it must be supported by a

well designed pattern of public expenditure, the appropriate mode of financing and a
suitably adjusted system of taxation.
10.3 CANONS OF TAATION

 Canon of Equity
Canon of equity is meant for providing economic and social justice to the
citizens. The principle maintains that every individual should pay the tax as
per his ability to pay. The rich should pay higher taxes Adam Smith argued
that people should pay the taxes in proportion to the revenue which they earn
under the protection provided by the state.
 Canon of Certainty
It says, the individual should be certain about the amount he has to pay as
tax, the time at which the tax has to be paid, and the form the tax would take
when being paid to the government.
 Canon of Convenience
The mode and timing of tax payment should be convenient for the payers.it
can be considered as an extension of the canon of certainty. Convenient tax
system will encourage people to pay tax in due time and will increase tax
revenue. If this canon is not followed it might lead to tax evasion and
corruption.
 Canon of Economy
The tax administration should be economical. The incidental cost should be
lower than the amount of tax being collected. It may defeat the purpose
altogether, if the taxes imposed are widespread but are hard to manage.
11.1 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.
11.2 MONEY SUPPLY AND QUANTITY THEORY

(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.
11.3 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.
11.4 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.
11.5 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.
11.6 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.
11.7 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.


12.1 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
12.2 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.

12.3 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.
12.4 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.
12.5 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 20%) 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
12.6 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.

12.9 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:

13.1 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).

13.2 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.

13.3 COMMERCIAL BANKS AND CREDIT CREATION

(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.


14.1 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.
14.2 BALANCE OF PAYMENT AND BALANCE OF TRADE
Balance of payment
Balance 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
Balance 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.

14.3 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.
14.4 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 disequilibrium 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.
14.5 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

14.6 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 required 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
14.7 CURRENT ACCOUNT DEFICIT NONMONETARY MEASURES

(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.
14.8 CURRENT ACCOUNT DEFICIT MONETARY MEASURES

(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.
14.9 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.
14.10 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


15.1 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.

15.2 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 equalled 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
15.3 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.
15.4 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.)

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Question

© Emile Woolf International, October 2016

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

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

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

Index to Objective test and

CHAPTER 1 – FUNDAMENTALS OF ECONOMICS

1.1 FACTORS OF DEMAND 27 66

1.2 PRODUCTION POSSIBILITY CURVE 27 67

1.3 ECONOMIC GROWTH 27 67

1.4 ISLAMIC ECONOMIC SYSTEM 28 68

2.1 TYPES OF GOODS 29 69

2.2 QUANTUM OF SUPPLY OF A PRODUCT 29 69

2.4 A MARKET ECONOMY 29 71

CHAPTER 3 – DEMAND AND SUPPLY: ELASTICITIES

3.1 ELASTICITY OF DEMAND 29 73

3.2 ELASTICITY OF DEMAND 2 29 74

3.3 ELASTICITY OF DEMAND 3 29 75

3.4 CALCULATE PEDS 29 76

3.5 CONCEPTS OF DEMAND 30 76

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

3.6 COFFEE MARKET 30 78

COMPETITIVE GOODS AND

3.8 PRICE ELASTICITY OF SUPPLY 31 81

3.9 CROSS ELASTICITY OF DEMAND 31 81

3.10 PRICE ELASTICITY OF DEMAND 31 82

3.11 TOTAL EXPENDITURE METHOD 31 82

3.13 GEOMETRICAL METHOD 31 83

NUMERICAL EXERCISE: PRICE

IMPORTANCE OF PRICE ELASTICITY OF

CHAPTER 4 – UTILITY ANALYSIS

4.1 CONSUMER’S EQUILIBRIUM 31 88

4.2 INDIFFERENCE CURVES 32 89

4.4 PRICE EFFECT 32 91

4.5 INCOME EFFECT 32 92

4.6 SUBSTITUTION EFFECT 32 93

4.7 LAW OF DIMINISHING UTILITY 33 93

4.8 INDIFFERENCE CURVES 1 33 94

4.9 INDIFFERENCE CURVES 2 33 95

4.10 MARGINAL RATE OF SUBSTITUTION 33 97

CHAPTER 5 – COSTS, REVENUES AND FIRMS

5.1 MONOPOLIST PROFIT 33 99

5.2 PERFECT COMPETITION 33 100

5.3 INCREASING RETURNS 33 101

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

5.4 LARGE FIRMS 33 101

5.5 THE SCALE OF PRODUCTION 34 103

5.6 MONOPOLY AND COMPETITION 35 104

5.7 PROFIT MAXIMISATION AND DEMAND

5.8 REVENUES AND COSTS 37 106

5.9 COSTS AND REVENUES 37 107

5.10 TYPES OF COSTS 38 108

5.11 MONOPOLY SETUP 38 109

5.12 CONSUMPTION GOODS 38 109

5.13 EQUILIBRIUM OF THE FIRM 38 110

5.14 MARKET FUNCTIONING 38 111

5.15 FREE FORCES 38 112

5.16 PRICE OUTPUT DETERMINATION 38 113

OLIGOPOLY AND DUOPOLY:

5.18 PRICE CARTELS AND COLLUSION 38 114

5.19 PRICE LEADERSHIP 38 115

5.20 KINKED DEMAND CURVE 38 115

5.21 NON-PRICE COMPETITION 39 115