INTRODUCTION TO ECONOMICS & FINANCE

Suggested Answers
Foundation Examinations - Spring 2010
A.1 (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) According to the Law of Increasing Returns when a variable factor of production is applied while
other factors remain constant, there is a more than proportional increase in the output.

The Law of Increasing Returns operates due to the economies of scale.

The economies of scale are attributable to the following factors:

Technical and Managerial Economies – Certain inputs, particularly those of mechanical inputs and
managerial skills used in the production process are available only in certain denominations and
cannot be subdivided into small sizes for small scale production.

High Degree of Specialization – The use of highly skilled workers and specialized equipment
increase the productivity per unit of input.

Functional Specialization – The dimensional relationship offers advantages of increasing returns

because of greater synergy accruing from optimal economies of combination of factors of
production.

Commercial Advantages – These advantages accrue from bulk purchases, rendering of better
marketing services, preferential treatment from financial institutions and spreading of risks.

(c) 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 Q 1 = 48,000; Q 2 = 60,000

P 1 = Rs. 12; P 2 = Rs. 11

⇒ ΔQ = Change in Demand = Q1 − Q 2 = 48,000 − 60,000 = −12,000

ΔP = 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.
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 INTRODUCTION TO ECONOMICS & FINANCE
Suggested Answers
Foundation Examinations - Spring 2010

A.2 (a) National Income is the name we give for the money measure of the overall annual flow of goods and
services in an economy, in a given period of time.

The components of National Income are:

(i) The wages/salaries and other forms of rewards uncluding compensations received by the
workers in one year.
(ii) The annual interest on various types of securities, bonds, loans e.t.c., issued in both the public
as well as private sector.
(iii) The annual rent of all types of land, building and properties duly received by the owners.
This also includes the rent of the houses in which the owners themselves are living.
(iv) Pre-tax profits earned by businesses, including self employed professionals and public
corporations.
(v) Social securities’ contribution by the entrepreneurs, which is paid out of their own profits.

(b) The important uses of calculation of National Income statistics are:

(i) to measure the performance of the economy and for comparison between various periods.
(ii) to enable government to formulate strategies for future planning.
(iii) to measure the level of standard of living in a country.
(iv) to compare the level of wealth of different countries.

A.3 (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:

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 INTRODUCTION TO ECONOMICS & FINANCE
Suggested Answers
Foundation Examinations - Spring 2010

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. LMC 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 LMC remains below the Marginal Revenue Curve i.e.
PL. The profit will be maximum when the LMC Curve cuts PL from below at which stage LMC
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 equipments.
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.

A.4 (a) Countries pursue policies of protectionism in international trade to achieve the following advantages:

(i) To encourage their infant industries which would otherwise not be able to survive in the face of
competition from the more developed countries.
(ii) To achieve greater self-sufficiency and reduce dependence on other countries for their essential
needs.
(iii) To increase production and employment levels and incomes of their citizens within the country.
(iv) To correct or improve balance of payments position and conserve foreign currency reserves.
(v) To augment the base of collection of revenues through taxes on locally manufactured goods.
(vi) To prevent dumping by other countries who seek to export their surplus products.

(b) Tariff results in increase in price and as a result discourages imports. However the process is slow
and is also ineffective if the demand is inelastic. Therefore, Quotas are more effective as the limits
are imposed immediately and are absolute.

A.5 (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
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 INTRODUCTION TO ECONOMICS & FINANCE
Suggested Answers
Foundation Examinations - Spring 2010
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.

A.6 (a) Exchange Rate is the ratio at which two currencies are traded for each other.

The major factors which influence the long-term movements in the exchange rates are:
 relative inflation rates
 relative interest rates
 balance of payments
 expectations of future economic and political environment
 speculative manipulations
 government policies

(b) The factors which are responsible for creating demand for foreign currency in any country are:
(i) Import of goods from foreign countries and payment for services rendered by foreign
nationals.
(ii) Expenditures incurred by the citizens of a country for tourism, foreign visits, foreign
education, etc.
(iii) Deposits by citizens in foreign banks.
(iv) Investments by local investors in foreign countries.
(v) Repayment of foreign debt/loans, remittances of dividend and payment of interest.
(vi) Purchase of foreign currency for speculative and security reasons.

(c) The Balance of Payments is a systematic and complete record of a county’s transactions with other
countries which took place over a period of time. The Balance of Payments is in deficit when a
country’s outflows are more than the inflows.

(d) The main headings under which the various accounts in the Balance of Payments are classified are:
(i) Current account
(ii) Capital/Financial account or External Assets and Liabilities
(iii) Miscellaneous Account or Balancing items

The Balance of Payments of Pakistan is recorded in Pak Rupees.

A.7 (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, upto 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.

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 INTRODUCTION TO ECONOMICS & FINANCE
Suggested Answers
Foundation Examinations - Spring 2010
(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 indiviudal 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 IC 1 and at a higher level of satisfaction when on IC 2 and so on.
(iv) IC 3 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.8 (a) According to the principles of Progressive Taxation, individuals with high incomes should pay taxes
at a relatively higher rate than those who have comparatively less incomes.

The merits of progressive taxation are:

(i) it is more equitable as the individual with higher incomes is taxed more heavily.
(ii) it yields greater revenue for the government.
(iii) it is more productive as cost of collection of progressive taxes increases at a lower rate than
the increase in the revenues of the government.
(iv) it helps to reduce the inequalities in the distribution of wealth.

(b) The objectives of World Trade Organization are to:

(i) raise the standard of living in member countries by expanding production and trade in goods
and services.
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 INTRODUCTION TO ECONOMICS & FINANCE
Suggested Answers
Foundation Examinations - Spring 2010
(ii) develop an integrated and viable multi-lateral trading system.
(iii) promote sustainable development in member countries by optimal use of resources.
(iv) help developing countries increase their share of international trade.
(v) reduce tariffs and other trade barriers among member countries.
(vi) eliminate discriminatory treatment in international trade relations.
(vii) achieve linkages between trade policies, environmental policies and sustainable development.

Q.9 (a) Financial intermediation is the process of channeling 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

A.10 (a) Oligopoly is an industry structure in which there are a small number of firms producing a particular
type of product. These firms are usually large and therefore entry of new firms is generally difficult.

(b) Laissez Faire is an economic set up in which individuals and firms pursue their own self-interests
without any central direction or regulation. In a laissez faire economy, it is envisaged that the market
economy would perform most efficiently if it is allowed to function without any intervention and be
able to contribute to the maximum benefit of the entire society.

(c) Transfer Payments are cash payments made by the government to individuals in the form of
pensions, outright grants and other welfare payments. The state makes these payments without
receiving service during the period in which the payment is made to the recipients.

(d) Structural Adjustment refers to a series of programs in developing countries to pursue policies of
privatization, reduce the size of the public sector, reduce budget deficits, control inflation and
encourage private savings.

(THE END)

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