Economics

1- What are the factors affecting demand?

Demand is the quantity of a commodity that an individual is willing and
able to buy during a given time period. Below are some of the factors that affect
the demand.
The first factor is the price of the good. A change in price causes a
movement along the demand curve. The Law of Demand states that “the quantity
demanded of a commodity is inversely related to its price, over a given time
period and other things being equal”. For example: The lower the price of
Hamburgers, the more people will buy, if burger prices go up, people buy less.
Secondly, the price of related goods such as complimentary or substitute
goods can also affect the demand of a product. A substitute is a good or service
that can be used in place of another good or service. So for example; when the
price of a coffee fall, consumers would switch to coffee causing demand for the
tea to fall and vice versa. This is because coffee is a substitute of tea.
Complimentary goods mean that the goods are often used together, because
consumption of one good tends to enhance consumption of the other. So for
example; if the price of golf clubs rises, demand for a complement good like golf
balls decreases, too and vice versa.
The third factor is income of the people. The greater the incomes of the
people, the greater will be their demand for goods. This is because more income
means more purchasing power. Therefore, when incomes of the people increase,
they can afford to buy more. It is because of this reason that increase in income
has a positive effect on the demand for a good. When the incomes of the people
fall, they would demand less of a good and as a result the demand curve will shift
downward. For example; a drought would decrease agricultural farmer’s income,
so they would demand less of cotton cloth or other manufactured products.
Fourthly, expected future prices also influence the demand. If due to some
reason, consumers expect that in the near future prices of the goods would rise,
then in the present they would demand greater quantities of the goods so that in
the future they should not have to pay higher prices. Similarly, when the
consumers expect that in the future the prices of goods will fall, then in the present
they will postpone a part of the consumption of goods resulting a fall in their
present demand.
Population also affects the demand of a good. As the population grows,
there will be an increase in demand for goods and services. The more people are
there, the more needs and wants are required to be satisfied. For example; if
median age of the population rises, there will be more elderly people and thus
increased demand for goods such as retirement homes and specialist holidays for
elderly people.
Lastly, changing taste and preference of consumers also affect the demand
of a good. People’s tastes and preferences for various goods often change and as
a result there is change in demand for them. If a commodity is in fashion or is
preferred by the consumers, then demand for such a commodity rises and vice
versa. For example; One type of dresses high in demand now may not be in
demand anymore after a year.
2- What are the factors affecting supply?
Supply is defined by the willingness of the supplier to supply a certain
commodity or a service at a given price over a given period of time. Supply
curve is controlled by the sellers of the market. However, if it is a controlled
item, suppliers do not have their freedom to set the quantity supplied or the
prices. Below are some of the factors that affect the supply of goods.
Firstly, it’s the price of the good itself. Unlike demand, there is a direct
relationship between the price of a product and its supply. The Law of Supply
states that as the price of a commodity rises, the quantity supplied increases
and vice versa. For example, a business will make more video game systems
if the price of those systems increases.
Secondly, the objective of the firm in the industry also affects the supply
of their goods. Firms can have different goals. Usually, profit-maximization
and sales maximization are the most fundamental objective of a firm. Changes
in these objectives of the firms will lead to a change in quantity supplied. For
example; a firm wishing to maximize sales will increase supply in order to sell
more.
Thirdly, price of related goods such as substitutes and complimentary
goods also influences the supply of a good. A substitute is a good or service
that can be used in place of another good or service. Suppose the price of corn
increases. Profit-minded farmers would increase the quantity supplied of corn.
However, in that this requires additional resources, fewer are available to
produce a substitute good, such as soya beans. Complimentary goods mean
that the goods are often used together, because consumption of one good tends
to enhance consumption of the other. Example is price of hot dog increases,
means supplier would increase supply of both hot dogs and hot dog buns and
vice versa.
Then it is the price of factors of production. !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
Furthermore, the state of technology also influences the supply.
Improvement in technology enables more efficient production of goods and
services. Thus reducing the production costs and increasing the profits. As a
result, supply is increased and supply curve is shifted rightwards. Since
technology in general rarely deteriorates, therefore it is needless to say that
deterioration of technology reduces supply. For example, the production of
fertilizers and good quality seeds increases the production of crops. This
further increase the supply of food grains in the market.
Lastly, expectation of an increase or fall of price in the future also
affects the supply of a good. when producers expect higher prices in the future,
they may increase their production to earn higher profits in the future and as a
result the supply increases. They could also cut down production in order to
wait higher prices in the future, in this case the supply decreases. For example,
when farmers suspect the future price of a crop to increase, they will withhold
their agricultural produce to benefit from higher price thus reducing the
supply. In case of manufacturers, when they expect the future price to increase,
they will employ more resources to increase their output and this may increase
current supply as well.
3- Briefly explain the three types of economic system.
Economic systems are the means by which countries and governments
distribute resources and trade goods and services. They are used to control the
five factors of production, including: labour, capital, entrepreneurs, physical
resources and information resources. There are many economies around the
world. Each comes with a distinguishing characteristic and can be categorized
into three types; free market system, command market system and mixed
market system.
The free market system is also known as capitalist system. In this
system; (USA, UK)
 The three basic questions (what to produce, how to produce and for
whom to produce) is answered by the private sector, not by the
government.
 The role of government is very limited, therefore there is also a very
large variety of demerit goods. The government also has no quota
imposed on the sellers of the market.
 The sellers are free to compete and they either prefer capital intensive
or labour intensive method of production. Using capital intensive
method helps producers to maximize output with the aid of latest
technologies. The number of goods to be produced is based on the
availability of capital.
 Sellers usually target high income earners meaning there is a large
variety of luxury goods in the economy too. There is no consumer
sovereignty by firms who has monopoly powers as the buyers of a
monopoly would not be price sensitive at all.
 Some firms, however do sell tailored made products according to the
needs and desires of the consumers. This is because there is high
competition among sellers resulting in high quality goods available at
lower prices.
 The resources are allocated by the price mechanism. This means it is
based on the forces of demand and supply.
 There is both price completion and non-price competition present in the
economy. The price competition (price wars) are only carried out for
goods that are non-homogeneous. As for non-price competition, sellers
compete each other in all aspects except price. This competition is
encouraged because it leads to more research and development being
done.
 The profit margins of sellers are low because they need to maintain
quality even a low price.
 The sellers also use price discrimination strategy. The rich and poor
would usually be kept apart using two different pricing strategies.
Sellers with similar good would sell good at different price to different
target markets. This means there would be a gap between rich and poor
and the government won’t be able to interfere to correct this as their
role is limited.
 There will also be a limited variety of public goods available. This is
because the public goods can only be sold at very cheap price and this
is not desired by private individuals.
 In free market economy, there would also be a huge wastage of
resources. This is because there is usually an oversupply of goods in the
market to keep the prices low. However, if the mass produced goods are
unsold and expire, the natural resources used in the production would
be wasted.
The command market system is also called the planned market system or the
socialist market system.

 In this economic system, the resources are allocated by the command

system. This means the government makes all the decisions. They assign
the producers of target level output and fixes the price too. The
government fixes either a maximum price or minimum price. There is
absolutely no interference from the private individuals.
 The government assign target level of output to producers by imposing
quotas. Producers are given instructions about what to produce and
frequently the quality to be produced. They are given a target level of
expected output (quota) by the state but are frequently left to decide how
to produce to meet their target. This is done to make sure that there is no
wastage of resources and to make sure that demand is equal to supply.
 Government also favours labour intensive method of production. This is
to make sure that the unemployment rates remain low and there is
availability of more job opportunities for the public.
 There is also no keen competition present in the economy. This results in
low motivation for sellers to work and less research and development
being done. Low R&D means few or no product improvements. R&D is
also not done by sellers because it increases cost and they cannot do
anything to pass on this cost to consumers as they cannot set own price
and there is a quota.
 The lack of competition however, reduces any inefficiencies such as
wastage of resources in the economy.
 There is also increase use of monopoly power in the interest of the
community.
 Due to increased interference from government, there is an availability of
large variety of merit goods and high quality public goods in the economy.
Usually, merit goods will have a lower maximum price and demerit goods
will have a higher minimum price.
 Despite this, there is no consumer sovereignty, because the government
only provide that goods they think is good for the consumers. Goods and
services produced will be distributed to consumers through the means of
physical rationing or through price mechanism. However, the purchasing
decisions of individual consumers have little or no influence on the type
or range of goods / services produced.
 The government also ensures that resources are adequately provided to the
community and they will take corrective measures such as imposing
progressive taxes on people to correct any gaps between the rich and the
poor.
 In these economies, there is also production of non-sale goods such as
guns and bombs. These are produced not for the purpose of buying and
selling, but for defence/military purposes.

Mixed market economy is a joint decision making between the government and
the private sectors. This system has characteristics of both the free market and
central planned economics. E.g. most Asian Countries

 The government provides merit goods and quality public goods whereas
the private sector produces luxury goods as well as demerit goods. For the
capital goods, government does not enforce a quota, but they intervene by
providing subsidised and imposing taxes.
 Subsidies are financial grants or funds given to private sector to produce
merit goods or high quality goods.
 Goods that government discourage consumption, such as demerit goods
like cigarettes, government impose very high taxes so that price of
Cigarette will increase. Price increase means that demand for cigarettes
will also fall.
 There is also a healthy competition level present in the economy, but not
as much as in the free market economy. Due to this there is an average
consumer sovereignty.
 Lastly, while the price would be fixed by the forces of demand and supply,
the government sometimes do control the prices in these economies.

4- What is a firm and what are the decisions they have to take?
The Firm – “a decision making production units, which transforms resources
into goods and services which are ultimately bought by consumers, the
government and other firms.”
These are some of the decisions they have to take.
 What goods shall it produce?
 How shall it raise the necessary capital?
 What techniques shall be adopted and what shall be the scale of operations?
 Where shall production be located?
 How shall its product be distributed?
 How shall be the size of output?
 How shall it deal with its employees?
5- What are the two types of taxation?

Taxation is a compulsory payment made by an individual to a certain body;

usually the government on workers' income and business profits, or added to the
cost of some goods, services, and transactions. It is a means by which
governments finance their expenditure by imposing charges on citizens and
corporate entities. Governments use taxation to encourage or discourage certain
economic decisions and it is the principal source of revenue for them. Taxation
has four main purposes or effects: Revenue, Redistribution, Reprising, and
Representation. There are two type of taxes; direct taxes and indirect taxes.

A direct tax cannot be transferred to a second or a third party. A taxpayer,

for example, pays direct taxes to the government for different purposes, including
real property tax, personal property tax, income tax or taxes on assets. Sometimes,
direct taxes, can become a disincentive to work hard and earn more money,
because the more money a person earns, the more taxes he pays. Income tax is an
example of direct taxes. This is divided further into two parts; progressive income
tax (the higher the income, the more the tax to pay), and regressive tax (the more
you earn, the less you pay). Direct taxes are usually designed to be progressive,
and so can be effective in redistributing income

Indirect taxes are collected by one entity in the supply chain (usually a
producer or retailer) and paid to the government, but it is passed on to the
consumer as part of the purchase price of a good or service. The consumer is
ultimately paying the tax by paying more for the product. The customers bear the
final tax burden. As a result, these taxes are an important part of the total cost.
Generally, depending on the elasticity of the product, consumer may end up
paying some or all of the indirect tax as indirect tax burden can be passed on.
Indirect taxes tend to be regressive, such as VAT, so this would result in increased
inequality and create inflation.
6- What are the effect of tax on goods?
Taxation is a compulsory payment made by an individual to a certain
body; usually the government on workers' income and business profits, or
added to the cost of some goods, services, and transactions. It is a means by
which governments finance their expenditure by imposing charges on citizens
and corporate entities. Taxation has four main purposes or effects: Revenue,
Redistribution, Reprising, and Representation. There are two type of taxes;
direct taxes and indirect taxes.
Taxes would usually increase the cost of production if the supplies of
goods and services are taxed. Increase in the cost of production will usually
be compensated by businesses by reducing the quantity supplied of the
products available at each price.
Direct taxes such as corporate income tax burdens cannot be passed on
to the consumers as high priced goods because direct taxes aren’t allowed to
be passed onto second or third parties.
On the other hand, indirect taxes affect the good as the burden can be
passed on to consumers. The effect of these taxes on a good depend on the
elasticity of a good.
(EXPLAIN WHAT HAPPENS IN THE DIAGRAM)
The Government would rather place indirect taxes on commodities
where demand is inelastic because the tax causes only a small fall in the
quantity consumed and as a result the total revenue from taxes will be greater.
It is also used to discourage consumption of demerit harmful goods. An
example of this is the high level of duty on cigarettes.
However, that has a little impact on the demand of demerit goods such
as cigarettes, so it has little impact and only result in government cost
increasing due to the cost of collection.
Lastly, Higher indirect taxes may cause inflation affecting consumers
who did not pollute and international competitiveness if taxes are higher in
one country than another. Inflation would generally increase the price of all
the goods in a country, making the cost of living higher for everyone.
7- What is the effect of tax on an organization?
Taxation is a compulsory payment made by an individual to a certain
body; usually the government. It is a means by which governments finance
their expenditure by imposing charges on citizens and corporate entities.
Taxation has four main purposes or effects: Revenue, Redistribution,
Reprising, and Representation. There are two type of taxes; direct taxes and
indirect taxes. These taxes have several effects on business organizations.
Firstly, taxes reduce the economic activities of a business. If a country
has a high income tax rate, then people’s purchasing power would be lowered.
This means they would be able to carry out less transactions in the economy.
This results in lower demand for a business’s goods and services which would
decrease their trade activities and production activities too if they decide to
lower production due to slow demand.
Secondly, taxes are deducted from the profits made by a business, (e.g.
corporate taxes) which would reduce the amount of profit available for
reinvestment purposes. When a state government increases its sales tax,
businesses may choose to leave prices where they are and simply earn less
profit per sale. They might choose to do this depending on the elasticity of
good they are selling. If they increase the price, they might lose a huge number
of customers and face much more severe losses.
Thirdly, taxes also increase the cost of production if the supplies of
goods and services are taxed. Increase in the cost of production will usually
be compensated by businesses by reducing the quantity supplied of the
products available at each price. This reflects the fact that businesses can now
produce less for the same amount of money. This occurs because businesses
now must pay more for the products they buy, including machinery, office
furnishings and computer equipment.
Moreover, taxes also affect the price of the goods sold by the
businesses. As tax increase the cost of production as mentioned above,
businesses will increase the price of the goods in order to gain higher revenue
despite high cost of production. Usually this depends on the type of tax. In
case of an indirect tax, usually the burden will be passed onto consumer as
higher prices. E.g. GST, VAT. The degree of the burden falling on business
and consumer depends on the elasticity of the goods sold by the business.
However, if it is a direct tax such as corporate income tax, business cannot
transfer this burden onto the consumers as higher prices.
Lastly, the supply of labour of an organization would also be affected.
This happens if high taxes are imposed on people’s income, they would be
demotivated to work. When workers’ earnings rise but their after-tax income
rises less—because of increases in their income and payroll taxes, their
incentive to work typically declines. For this reason, some people’s
productivity levels fall and some even may actually find it better to stay home
and enjoy unemployment benefits rather than working. This leads to an overall
drop in the number of output produced by a business as well as reduce the
supply of skilled labour available for the business.
8- Discuss each stage of the economic cycle with identification of four
characteristics for each.
The term economic cycle (or boom-bust cycle) refers to economy-wide
fluctuations in production, trade, and general economic activity. From a
conceptual perspective, the economic cycle is the upward and downward
movements of levels of GDP (gross domestic product) and refers to periods of
expansion and contraction in the level of economic activities (business
fluctuations) around a long-term growth trend.
(DRAW THE ECONOMIC CYCLE)
The first stage is the boom stage. A boom occurs when real national output
is rising at a rate faster than the trend rate of growth. Some of the characteristics
of a boom include:
 A fast growth of consumption helped by rising real incomes, strong
confidence and a surge in house prices and share prices.
 Then there will be an increase in demand for capital goods as businesses
invest in extra capacity to meet strong demand and to make higher profits.
 Also, more jobs will be created and there would be falling unemployment
and higher real wages. This causes quality of living to improve among the
people.
 Moreover, there will be a high demand for imports which may cause the
economy to run a larger trade deficit because it cannot supply all of the
goods and services that consumers are buying.
 Also, government tax revenues will be rising as people earn and spend
more and companies are making larger profits – this gives the government
money to increase spending in areas such as education, the environment,
health and transport.
The second stage is the inflation. This occurs when an increase inflationary
pressures would be created if the economy overheats and has a positive output
gap. This means that the rate of growth decelerates – but national output is still
rising. This stage begins when the economy reaches a peak of activity and ends
when the economy reaches depression. Some characteristics of this stage include;

 If companies want to survive the recession they must reduce costs and
generally they cut employees to do this, so unemployment starts to
increase. This further increases as foreign firms leave the country, meaning
that the income of people would fall drastically. This also result in fall in
their living standards and they won’t be able to afford goods which are very
expensive in this stage.
 There will also be an increase in money supply in the economy. This is
because in this stage people need more money to buy the same product they
could previously buy with less money. Increase in money supply will cause
the country’s currency value to fall making the economy undesirable in the
international market.
 Firms will stop investing and producing more due to rising costs. They may
also have to shut down due to fall in profits during this stage. This would
further fuel the rising unemployment level which again causes the
consumption rates to drop.

The next stage is the depression stage. Depression is the lowest of the phases of
business cycles. It is a severe form of recession. Some characteristics of this stage
are:

 There would be no sign of economics growth or a negative growth rate in

the economy.
 This is because of falling output and employment levels.
 Unemployment level is the highest because of firms shutting down and
outflow of FDI. Purchasing power is extremely low due to extremely low
wage rates and there is so much low consumption/ demand that there is
excess supply in the economy. People won’t be able to afford goods and
there would be a massive drop in their living standards.
 There would be so much excess money supply in the economy and high
speculation that the currency value starts falling. This results in economy
facing weak exchange rates.
 There would also be a huge deficit in the balance of payment. Government
would need to borrow it to finance the deficit which means their national
debt would be increasing. Another reason why it would be increasing is
because government would have to increase their spending a lot on
investments, unemployment benefits and cut down on taxes to boost
spending which would reduce government tax revenues.

The last stage of economic cycle is recovery. An economic recovery is a

stream of improved business activity indicating the end of a recession.

 In a recovery there will be lower interest rates. Central bank would

lower interest rates to encourage inflow of FDI and businesses invest in
projects. Low interest rates mean lower interest expenses for both
households and businesses, which could mean more spending.
 Anticipation of consumer spending would normally attract businesses
to resume investment and production. So they would slowly start hiring
more people, creating job opportunities in the economy and thus
reducing the high levels of unemployment present in the economy
gradually. Factories restarting production would also increase demand
for raw materials and components and also increase the total output of
the economy.
 Increasing employment would mean disposable income of people
would slowly start to increase. This means the purchasing power of
people will increase and they would be able to afford quality products
that would enhance the quality of their living standards.
 Government would also start to carry out more number of transactions
to help the slowly growing economy.
9- Why does diseconomies of scale happen?
If output increases less than in proportion to inputs, there are
diseconomies of scale and the long run average costs of production will rise
as output volume rises. Diseconomies of scale occur when the firms outgrow
in the size which results in the increase in employee cost, compliance cost,
administration cost etc. These are some of the reasons why some firms face
diseconomies of scale.
The first reason is due to communication problems. Increase in the
number of employees resulting in an increasing number of communication
channels. Complex communication channels result in high cost, wastage of
time and efforts. The distortion or leakages at each stage reduces the
effectiveness of communication. Communication failure results in low
process coordination and poor employee engagement. Failing to communicate
effectively result in business making wrong and costly mistakes/decisions.
Secondly, the long chain of command also leads to diseconomies of
scale. This usually happens in a tall organization structure. There are more
layers in the hierarchy that can distort a message and wider spans of control
for managers. This means managers are unable to make timely decisions or
they would make delayed decisions that could be costly to the entire business.
The next reason is poor morale of workers. Workers can often feel more
isolated and less appreciated in a larger business and so their loyalty and
motivation may diminish. The main result of poor employee motivation is
falling productivity levels and an increase in average labour costs per unit.
Falling productivity levels also means that firm won’t be able to meet target
output so may have to hire more workers, increasing the labour cost further.
Another reason is the wage differentials present in same industry. If
another firm in the industry has the higher wage rate for the same level/skill
of an employee, other firms in the industry would be forced to increase the
wage rate. If not, the employees would leave the job and go to the firm which
offers them the highest level of pay.
Lastly, if difficulties for senior managers in assimilating information
they need to make quality decisions can also result in diseconomies of scale.
Sometimes the organization grows too large that the managers have too many
or too less information about a particular issue that they are unable to decide
which information is relevant or which information to use for making good
decisions.
10- What are the reasons for a long run average cost curve?
Long run average cost curve (LRAC) is U-shaped. This is because as
output increases, long run cost will fall because of the internal economies of
scale. As output increases, long run average cost will remain constant, because
of constant economies of scale which will bring about constant return of scale.
The LRAC, curve of a firm shows the minimum or lowest average total cost
at which a firm can produce any given level of output in the long run (when
all inputs are variable). There are several reasons why the LRAC curve is
created.
(DRAW THE DIAGRAM)
Firstly, it is because the firm might want to cease at the lowest cost.
Secondly, it might be because firms might be facing financial crisis and
cannot afford a diseconomies of scale.
Lastly, it could also be due to hyperinflation.
11- What causes large firms to achieve economies of scale?
If output increases more than in proportion to inputs, there are
economies of scale and in the long run average costs of production will
continue to fall as output volume rises. There are two types of economies of
scale; external and internal economies of scale. External economies of scale is
when firm grow in size. Internal Economies of Scale arise from the more
effective use of available resources and from increase specialization when
production capacity is enlarged. There are several reasons why large firms
achieve these economies of scale.
Firstly, they might achieve economies of scale by buying in bulk. Firms
experience reduced costs for buying inputs, such as raw materials and parts,
because of a larger discount given to a larger purchase than smaller businesses
can make. Purchasing goods in bulk creates an economy of scale by allowing
a lower cost per unit and contributing to lower production costs. If you're a
large manufacturer, for example, you have more bargaining power than your
smaller competitors have to negotiate lower prices with your suppliers.
Secondly, by specialization. Specialization can lead to economies of
scale because it allows for increased output. Economic theory indicates that
specialization is useful to growth. Specialization, means focusing on one task
rather than multiple tasks toward productive output. This supports growth as
specialization of labour, for example, allows workers to perfect one task rather
than focus on many. As workers become more adept at a specialized task, they
become more efficient and production increases.
Thirdly, by use of effective marketing. When larger firms are able to
lower the unit cost of advertising and promotion perhaps through access to
more effective marketing media helps them to achieve marketing economies
of scale. It can also be done through use of extensive network or through a
large network of agents. Large number of agents working for a firm means
more people will be made aware of that firm’s products hence increase in sales
for that firm.
Moreover, firms achieve economies of scale by use of efficient
administration. This means dividing the business process/task into specialized
departments. It is the size of large firms that enable them to use more advanced
and specialized management techniques. Different departments may enjoy
specialist management personnel. In other words, this is really applying
division of labour in the field of management. This will ultimately lower down
management costs per unit of output.
Furthermore, research and development also assist firms in achieving
economies of scale. It is only the large firms that can conduct its own research
and development (R & D) programme so that newer and improved techniques
of production are developed. R&D also means those firms can now use
advanced technology in production by themselves. Need to buy technology
from outside is eliminated which reduces the cost. Improvement in technology
allows firms to use specialized and highly efficient machinery along with
specialized labour. Mechanized production means mass production with
minimal costs and wastages.
12- What are the factors affecting PES?

Price Elasticity of Supply (PES) is defined as a measure of the extent to

which the quantity supplied of a good respond to changes in one of the influencing
factors. The 3 responsiveness of PES are; Perfectly inelastic, Perfectly elastic and
Unit elastic. There are several factors affecting the PES of a good.

Firstly, the perishability of the good affects the PES of a the good.
Perishable goods have a limited shelf life and the buyers know it. The buyers can
wait for some time and producers will have to lower the prices or take the losses
that arise from wastage. The supply of perishable goods is therefore highly elastic
since whatever has been produced has to be disposed of at the earliest. However,
when it comes to non-perishable goods it has been observed that the supply is
usually inelastic since producers can hold on for as long as they have to. They are
under no immediate compulsion to sell and hence the supply is inelastic.

Secondly, the cost affects the PES. If supply is to be increased it is

necessary to attract resources from other industries. This usually involves raising
the prices of these resources. As their prices rise, cost of production also
increases. So supply becomes relatively inelastic because producers are hesitant
to increase production levels. If these resources can be obtained cheaply then
supply is likely to be relatively elastic. Also, if marginal cost increases slowly,
then also the supply will tend to be more elastic.

Thirdly, the time is also a factor influencing the PES of a good. Supply is
more elastic in the long run than in the short run. Business firms may find it
difficult to increase their usage of labour and output immediately after price rise.
So supply is likely to be less elastic. However, with the passage of time, business
firms can hire more labour, capital and set up new factories so as to expand
production capacity. Thus supply will increase considerably. So supply will be
more elastic in the long run than in the short run because producers take some
time to adjust their capacity to changes in demand.

Moreover, the feasibility of storage also affects the PES of the goods.
When the producers have more ability to store the products such as big
warehouses, they can respond more quickly to price increases. In this case, supply
is more elastic. However, if the producer only has a small warehouse and
therefore a limited storing capability, he won’t be very flexible with the change
in prices. Therefore, supply of his goods will be fairly inelastic. For example;
price of beef is low for a few months, but if a farmer has no extra capacity to
house cattle until the beef price increases, the supply would be fairly less elastic.

Lastly, the nature of the good also affects it PES. Supply of goods such as
agricultural products would be severely affected by the change in seasons. In a
season of heavy rain and flooding, the PES of agricultural products would be
fairly elastic because of volatile climate changes. Also, products that take a longer
period to grow such as plums would also have a fairly elastic PES.
13- What are the factors affecting PED?

Price Elasticity of Demand (PED) is defined as the degree of

responsiveness of quantity demanded to changes in price, ceteris paribus. The 5
responsiveness of PED are Perfectly inelastic, Perfectly elastic, Unit elasticity,
Fairly elastic and Fairly inelastic. There are several factors affecting the PED of
a good.

Firstly, the proportion of income spent on a good affects PED of a good. If

a high proportion of income is spent on a particular commodity, its demand will
be elastic. In comparison, for items requiring a small proportion of income such
as soap, tea, milk, oil, etc., the demand is inelastic. Even if the prices of these
items were to be increased, consumers will still buy the same quantity, since the
effect on overall budget would be small.

Secondly, the availability of substitutes also affects the PED of the good.
If there is a greater availability of substitutes, then the good is likely to be more
elastic. For example, if the price of one soda brand goes up, people can turn to
other brands. So, a small change in price is likely to cause a greater fall in quantity
demanded. On the other hand, a lack of substitutes will make a commodity's
demand inelastic.

Thirdly, the durability of a good also affects PED. If a commodity is not

durable, e.g., toilet paper, it will have to be replaced fairly often, even though the
price has risen in the meantime. Thus, a rise in price does not have a great effect
on quantity demanded — demand is inelastic. Commodities which last a long
time, i.e., durable commodities (e.g., radios, T.V. sets, etc.) generally have an
elastic demand. The reason is that when the prices of such commodities increase
people can postpone pur-chases. Hence, the quantity demanded is not much
affected by price changes.
Moreover, the number of alternative uses for a good influences its PED. If
the commodity under consideration has several uses, then its demand will be
elastic. When price of such a commodity increases, then it is generally put to only
more urgent uses and, as a result, its demand falls. When the prices fall, then it is
used for satisfying even less urgent needs and demand rises. For example,
electricity is a multiple-use commodity. Fall in its price will result in substantial
increase in its demand, particularly in those uses (like AC, Heat convector, etc.),
where it was not employed formerly due to its high price. On the other hand, a
commodity with no or few alternative uses has less elastic demand.

Furthermore, whether the good is Addictive or habit-forming good also

affect the PED of it. Commodities, which have become habitual necessities for
the consumers, have less elastic demand. It happens because such a commodity
becomes a necessity for the consumer and he continues to purchase it even if its
price rises. Alcohol, tobacco, cigarettes, etc. are some examples of habit forming
commodities.

Lastly, the time period under consideration also affects the PED of a good.
Price elasticity of demand is always related to a period of time. Elasticity of
demand varies directly with the time period. Demand is generally inelastic in the
short period. It happens because consumers find it difficult to change their habits,
in the short period, in order to respond to a change in the price of the given
commodity. However, demand is more elastic in long rim as it is comparatively
easier to shift to other substitutes, if the price of the given commodity rises.
14- Identify 3 approach of National Income (NI) and discuss 6 problems in
calculating NI and 6 uses of NI!
15- Discuss 6 merits and 6 demerits of monopolies!

Monopoly is a market structure that has only one seller and many buyers.
If there is a monopoly in a single market with no other substitutes, it becomes a
“pure monopoly.” Monopolies can be considered an extreme result of free-
market capitalism in that absent any restriction or restraints, a single company or
group becomes large enough to own all or nearly all of the market for a particular
type of product or service.

DISAVANTAGES

Firstly, there is a high barrier to entry and exit. Some of the key barriers to
entry are: government license or franchise, resource ownership, patents and
copyrights, high start-up cost, and decreasing average total cost. Barriers to entry
prevent or discourage competitors from entering the market. They also do this by
doing heavy R&D on product development so that any new firm will need huge
capital to start business. So there is also a risk that if forced to exit, the huge
capital invested will be lost.

Secondly, there is also a cut-throat competition by the monopolies. If a new

firm enters the market, monopoly firm will lower the price so much that the new
firm will be forced to exit the market. Monopoly firms are usually the dominant
player and will have the capital and capability to reduce price and have low profits
for shorter period of time. This again removes any competition and monopoly is
again free to exploit the consumers and no incentive to do any product
developments.

Thirdly, monopolies also do price discrimination. This means that

monopoly charging different rates from different customers for the same good or
service. The degree of price discrimination vanes in different markets by
monopolies. In first degree price discrimination, a monopolist charges the
maximum price that each buyer is willing to pay. In second degree price
discrimination, seller gives a larger discount if a larger volume is bought and
gives a smaller discount if the buyer buys a smaller quantity. In third degree price
discrimination, the monopolist divides the entire market into submarkets and
different prices are charged in each submarket. Such price discriminations create
a large gap between the rich and the poor of an economy.

Moreover, in monopolies, the buyers are exploited. The buyers of a

monopoly aren’t price sensitive as there is only one unique product present in the
market. They do not have a wide range of choices of goods because there is
absolutely no substitute for the monopoly firm’s product. Due to this, the
monopoly will charge extremely high price as they are the price setters, in order
to earn a subnormal profit. They are price setters and they often set prices so much
higher that the marginal cost in order to obtain a supernormal profit in both short
run and long run. As monopolies don’t allow competitors, they may also not
bother to make innovative quality products, so consumers are forced to buy the
low quality product even at high prices.

Furthermore, monopoly firms create market failures.

The monopoly restricts its output that can be produced using available
capital so it may not necessarily be producing at the cost minimising level of
production. They do this so that supply would be low and they could charge a
higher price. They create inefficiency in land factor, by not utilizing land to its
full benefit. For e.g. if they do not produce in mass despite having a large
warehouse and paying huge storage fees, they aren’t utilizing the land efficiently.
They also underutilize the labour by asking the labour to perform lower than their
capabilities. For e.g. asking them to produce 100 units when they have the ability
to produce 200. The same thing might happen in case for creating inefficiencies
with entrepreneurs.

Lastly, monopolies use predatory pricing to create dumping of goods.

Predatory pricing is the illegal act of setting prices low in an attempt to eliminate
the competition. They use this for dumping purposes. Dumping is a special case
of price discrimination. Instead of selling the whole output either in home market
or in the world market, the monopolist will sell a part of it in the home market at
higher price and a part in the world market at the lower price, since it gives him
maximum returns.

ADVANTAGES

The first advantage of monopoly is that they do price discrimination. This

was highlighted as a disadvantage, but it has some benefits too. Those include
creating an opportunity for people with different income to consume the same
product at different prices. For example, firms often offer a 10% reduction to
students. Students typically have lower income so their demand is more elastic.
This means they benefit from lower prices.

Secondly, Monopolies can make supernormal profit, which can be used to

fund high-cost capital investment spending. Successful research can be used for
improved products and lower costs in the long term. R&D also creates
opportunity for new product innovations and inventions that could provide
several benefits to consumers. Many innovations are developed by firms who
then look to apply for patents on 'leading-edge' technologies and they become
monopolies. Therefore, in this market structure there is a high level of dynamic
efficiency.

Thirdly, monopoly firms enjoy economies of scale. A monopolist might be

better placed to exploit increasing returns to scale leasing to an equilibrium that
gives a higher output and a lower price than under competitive conditions. This
is illustrated in the next diagram, where we assume that the monopolist is able to
drive marginal costs lower in the long run, finding an equilibrium output of Q2
and pricing below the competitive price.

This way consumers are able to get quality products at cheaper cost
whereas the monopoly firm also benefit from the cost advantages of economies
of scale.

Furthermore, monopolies create a lot of job opportunities in an economy.

Monopolies are large firms that conduct mass production of goods. For the mass
production, there will be many tasks and stages involved. Therefore, they would
need more labour thus increasing their demand for labour in the economy.
16- Briefly explain Perfect competition, monopolistic competition and
oligopoly.
PERFECT COMPETITION
Perfect competition describes a market structure, where a large number
of small firms compete against each other.
In perfect competition there is no barrier to entry and exit implying that
any firm can enter the market and start selling the product, hence old firms
cannot afford to be unworried because chances of losing market share to new
firms always loom over them. Sometimes there might be firms who take
benefit of low entry costs and enter the market only for the short run. These
firms practice ‘hit and run’ where they charge extremely low prices, get all the
consumers, make supernormal profit and leave the market. However, this also
means that if they have to liquidate, they can exit with little costs.
The products in perfect competition markets are homogenous. This
means that there is an abundance of substitutes in the market making the goods
elastic in demand. The buyer would get equal satisfaction from any good and
therefore he would be very price sensitive.
There are many buyers and sellers in this market who has perfect
knowledge about all aspects of the market. This means buyers know that
products are homogeneous and cannot be differentiated whereas sellers know
that buyers are price sensitive.
Perfect competition sellers only make a normal profit in both long run
and short run. This is because they are not price setters, instead they are price
takers therefore they have to adopt the prices existing in the market. The price
is fixed by the forces of demand and supply because in theory it is believed
that in this market structure demand is always equal to supply. The products
are also homogeneous which is another reason why they cannot charge higher
prices. So in both long run and short run, sellers will have Marginal Cost
equivalent to Marginal Revenue (normal profit).
However, in some situations the perfect competition sellers can achieve
a supernormal profit. This is only when the firm is able to control a number of
firms in the market. This means the longest surviving firms in the market can
form a collusion and all agree to charge a higher price to the consumers. If one
seller disagrees this cannot happen and it is only possible in the short run too.
Homogeneous goods create an incentive for the seller to continuously
find ways to differentiate and compete in non-price factors such as branding,
quality and packaging. This way buyer would be lured to buy that particular
brand good. However, this means there is need for conducting Research and
Development, which many firms aren’t willing to conduct. This is because
they only earn a normal profit and R&D is very costly. So many sellers would
be highly demotivated to conduct any R&D to innovate or add more features
to the product because seller cannot charge higher than normal price. So he
would keep selling standardized product at price fixed by market forces of
demand and supply. So there is very little scope for dynamic efficiency in this
market.
Perfect competition has very little or no advertisement expense because
products are homogeneous and if firm keeps the price as decided by market
forces then sales will automatically happen without company incurring huge
publicity and advertisement expense.
In perfect competition it is also believed that there is an efficient
allocation of resources. Perfect competition markets achieve productive
efficiency and allocative efficiency. This is because in both the short and long
run price is equal to marginal cost (P=MC) and in the long run the equilibrium
output is supplied at minimum average cost.
OLIGOPOLY

In an oligopoly there are few sellers and many buyers. Oligopolies may be
identified using concentration ratios, which measure the proportion of total
market share controlled by a given number of firms. There are two types of
oligopolies. Perfect oligopoly and imperfect oligopoly.

In perfect oligopoly, there are homogeneous products provided by all the

firms in the market (e.g. Aluminium industry). This means that there is an
abundance of substitutes in the market making the goods elastic in demand. The
buyer would get equal satisfaction from any good and therefore he would be very
price sensitive. Homogeneous goods create an incentive for the seller to
continuously find ways to differentiate and compete in non-price factors such as
branding, quality, promotions and packaging. (for example; celebrity
endorsements, free gifts…). There is also very minimal cost of advertising
because products are homogeneous and if firm keeps the price as decided by
market forces then sales will automatically happen without company incurring
huge publicity and advertisement expense.

Imperfect oligopoly occurs when product differentiation exists (e.g.

Talcum powder industry). This means that there are no perfect substitutes in the
market making the goods inelastic in demand. The buyer would get different level
of satisfaction from each good and therefore he would be less price sensitive.
There is also very aggressive advertising specially in non-price factors because
products are differentiated in quality and features so firm need to do publicity and
advertisement activities.

Oligopolies are price setters. The small number of firms let oligopolies to
set prices and output levels, to some extent. However, because there are rival
firms, oligopolies must be aware of how they react to its change in price, output,
product or advertising. Oligopolies dominate the industry by controlling the
production and supply of the good produced which makes it easier for them to
affect the price strategy of that industry.

Oligopolies also make supernormal profits in both long run and short run.
This is because their Prices are set above marginal cost. However, in a perfect
oligopoly there is price rigidity.

If a business raises price and others leave their prices constant, then that
firm will see quite a large fall in their quantity demanded making demand
relatively price elastic. The business would then lose market share and expect to
see a fall in its total revenue. If a business reduces its price but other firms follow
the same price, the quantity demanded would increase only by a small amount
meaning demand would be inelastic. Cutting prices when demand is inelastic
leads to a fall in revenue with little or no effect on market share.

Firms in oligopoly may still be very competitive on price, especially if they

are seeking to increase market share. In some circumstances, we can see
oligopolies where firms are seeking to cut prices and increase competitiveness. A
feature of many oligopolies is selective price wars. For example, supermarkets
often compete on the price of some goods (bread/special offers) but set high
prices for other goods, such as luxury cake.

Another possibility for firms in oligopoly is for them to collude on price

and set profit maximising levels of output. This maximises profit for the industry.

In the above example, the industry was initially competitive (Qc and Pc).
However, if firms collude, they can agree to restrict industry supply to Q2, and
increase the price to P2. This enables the industry to become more profitable. At
Qc, firms made normal profit. But, if they can stick to their quotas and keep the
price at P2, they make supernormal profit. Collusion is illegal, but tacit collusion
may be hard to spot. For collusion to be effective, there need to be barriers to
entry and all parties involved must agree. A cartel is a formal collusive
agreement. For example, OPEC is a cartel seeking to control the price of oil.
MONOPOLISTIC COMPETITION

Monopolistic competition is a market structure which combines elements

of monopoly and competitive markets.

Essentially a monopolistic competitive market is one with freedom of entry

and exit, but firms can differentiate their products. Therefore, they have an
inelastic demand curve and so they can set prices. Also, because each firm makes
a unique product, it can charge a higher or lower price than its rivals.

As they are price makers, they do earn a supernormal profit. This is because
they have the freedom to set price above their marginal cost. However, because
there is freedom of entry, supernormal profits will encourage more firms to enter
the market leading to normal profits in the long term.

In the short run, the diagram for monopolistic competition is the same as
for a monopoly. The firm maximises profit where MR=MC. This is at output Q1
and price P1, leading to supernormal profit. However, sometimes in the long-run,
supernormal profit encourages new firms to enter. This reduces demand for
existing firms and leads to normal profit.

To deal with this, firms operating under monopolistic competition usually

have to engage in advertising. Firms are often in fierce competition with other
(local) firms offering a similar product or service, or new firms. So they may need
to advertise on a local basis, to let customers know their differences. Common
methods of advertising for these firms are through local press and radio, local
cinema, posters, leaflets and special promotions.

The buyers and sellers in this market structure have no perfect knowledge.
Sellers don’t know everything about buyers and buyers don’t know about sellers.
And as they are price makers, there is no price rigidity because the sellers can
increase or decrease the price anytime they want without affecting other firms.

Lastly, the market is more efficient than monopoly but less efficient than
perfect competition - less allocative and less productive efficient. However, they
may be dynamically efficient, innovative in terms of new production processes
or new products. For example, retailers often constantly have to develop new
ways to attract and retain local customers.

Sometimes, monopolistic competition is considered a market failure too as

it practices excess capacity. Some differentiation does not create utility but
generates unnecessary waste, such as excess packaging. Advertising may also be
considered wasteful, though most is informative rather than persuasive.

Furthermore, monopolistic competition firms create market failures.

The monopolistic competition firms restrict its output that can be produced
using available capital so it may not necessarily be producing at the cost
minimising level of production. They do this so that supply would be low and
they could charge a higher price. They create inefficiency in land factor, by not
utilizing land to its full benefit. For e.g. if they do not produce in mass despite
having a large warehouse and paying huge storage fees, they aren’t utilizing the
land efficiently. They also underutilize the labour by asking the labour to perform
beyond their capabilities. For e.g. asking them to produce 100 units when they
have the ability to produce 200. The same thing might happen in case for creating
inefficiencies with entrepreneurs.
17- What are the causes of inflation?
Inflation means too much money chasing after too few goods. Inflation
is a sustained rise in the general price level. Inflation can come from both the
demand and the supply-side of an economy. There are several causes of
inflation.
Firstly, inflation arises due to demand-pull. Demand Pull Inflation is
changes in price levels are accounted for by changes in aggregate demand.
The AD is greater than AS. A rise in demand for goods and services will cause
a rise in demand for factors of production and thus their prices will be bid
upward. When there is excess demand, producers can raise their prices and
achieve bigger profit margins. Demand-pull inflation becomes a threat when
an economy has experienced a boom with GDP rising faster than the long-run
trend growth of potential GDP. Demand-pull inflation is likely when there is
full employment of resources and SRAS is inelastic.
The second cause of inflation is import- cost push inflation. happens
when a country imports more than its export. Money will be “flowing out” of
a country. As the price of imports increase, prices of domestic goods using
imports as raw materials also increase, causing an increase in the general
prices of all goods and services. This type of inflation may be caused by
foreign price increases or depreciation of a country's exchange rate.
Thirdly, expectations also create inflation in an economy. This occurs
when price is expected to rise in the market for goods and services.
Sometimes, sellers in a country will increase the price because the
neighbouring countries face inflation. Also, if a country for instance faces a
threat of a terrorist attack, the export levels will fall drastically as foreign firms
will pull out from the economy. This means AS is falling drastically and the
prices start to increase. If the price is expected to rise, people will hoard
durable goods, demand high wages and firms will start rising prices to ensure
profits.
Moreover, excess money supply is one reason as to why inflation is
created. This means too much money in the market. This might be due to either
low money value where the public no longer wishes to hold hard money or
during the time of boom where most people have a higher disposable income.
In a boom situation, people will always carry out more number of transactions
which increase the money supply in the economy. Increasing the money
supply faster than the growth in real output will cause inflation. The reason is
that there is more money chasing the same number of goods. Therefore, the
increase in monetary demand causes firms to put up prices.
Lastly, structural rigidity also causes inflation. Here, it is assumed that
resources do not move quickly from one use to another and that it is easy to
increase wages and prices but hard to decrease them. Given these conditions,
when patterns of demand and cost change, real adjustments occur only very
slowly. (Shortages appear in expanding sectors and thus price increases fast).
18- What are the effects of hyperinflation and creeping inflation?
Inflation means too much money chasing after too few goods. Inflation
is a sustained rise in the general price level. Inflation can come from both the
demand and the supply-side of an economy.
Hyperinflation is used to describe situations where the prices of goods
and services rise uncontrollably over a defined time period. In other words,
hyperinflation is extremely rapid inflation. Hyperinflation is caused by
dramatically increasing the amount of money in an economy. It cannot be
overcome once hit badly and causes major damages to an economy of a
country. Some of these damages include;
Firstly, hyperinflation forces governments into huge national debts.
Secondly, it drives away FDI- it creates massive unemployment- low
wages, low living standards- relative poverty rates increase
Thirdly, hoarding of durable goods – if prolonged hyperinflation,
hoarding of perishable goods too. The practice causes a vicious cycle – as
prices rise, people hoard more goods, in turn, creating a higher demand for
goods and further increasing prices. If hyperinflation continues, it causes a
major economic collapse.
Lastly, currency depreciate- sell local currency- devalues the currency
further as money supply again increase- loses value in international market-
Creeping inflation is defined as the circumstance where the inflation of
a nation increases gradually, but continually, over time. This type of inflation
can be overcome and it causes minor damages such as;
Firstly, it
These are really minor damages and so sometimes government tends to
overlook them. Also, if government takes action to correct the creeping
inflation beforehand, it might even come and go without turning into
hyperinflation.
19- What are the negative effects of inflation?
Inflation means too much money chasing after too few goods. Inflation
is a sustained rise in the general price level. Inflation can come from both the
demand and the supply-side of an economy
 Investment fall – FDI away- unemployment increase- living
standard fall
 Cost of living increase- living standard fall
 Inequality of income distribution- Those with well-paying jobs
or incomes that exceed inflation receive more income than those
who only keep pace with inflation- a reduction in their standard
of living if they do not receive an increase in income that at least
matches inflation.
 BOP deficit- currency devalue- expensive imports-
 National debt increase due to financing BOP deficit- paying
unemployment benefits
 Low unemployment and output lead to low AD- low GNI and
low GDP- hinders economic growth
20- How to correct a BOP deficit?
Balance of Payment (BOP) is defined as statistical “accounting” record
of a country’s international trade transactions (purchase / selling of a good or
services) and capital transactions (acquisition / disposal of assets / liabilities).
The balance of payments is a record of all financial transactions between one
country and those in the rest of the world.
The first way to correct a deficit is through devaluation of a country’s
currency values. This is done by a controlled exchange rate system.
Devaluation refers to deliberate attempt made by monetary authorities to bring
down the value of home currency against foreign currency. When devaluation
is done, the value of home currency goes down against foreign currency,
making exports cheaper in foreign market. This happens because after
devaluation, more domestic currency will be received for one foreign
currency. At the same time, imports become costlier as locals will have to pay
more domestic currencies to obtain one foreign currency. Thus demand for
imports is reduced.
Secondly, government can take direct measures to reduce aggregate
demand (C+I+G+X) such as restrict imports by imposing tariffs and quotas.
Tariffs are duties (taxes) imposed on imports. For example; U.S. put a tariff
on France’s Roquefort Cheese. When tariffs are imposed, the prices of imports
would usually increase to the extent of tariff. The increased prices will have
reduced the demand for imported goods and at the same time induce domestic
producers to produce more of import substitutes. Under the quota system, the
government may fix and permit the maximum quantity or value of a
commodity to be imported during a given period. For example; EU has a quota
for fish. By restricting imports through the quota system, the deficit is reduced
and the balance of payments position is improved.
Thirdly, government can also increase the administrative burden in
order to correct the BOP deficit. Administrative burdens are bureaucratic
procedures/ administrative tasks (red tape barriers), product standards, health
regulations that a trading firm has to get though when shipping the product
into a country. Increasing or tightening of administrative burdens would
increase the cost of importing the product to the import firms. This way they
would be discouraged from importing a lot into the country, thus reducing the
country’s import levels and so improving the balance of payment position.

21- Discuss 6 impacts of BOP Surplus.

The balance of payments is a record of all financial transactions
between one country and those in the rest of the world. It is the statistical
“accounting” record of a country’s international trade transactions. A balance
of payments surplus means the country exports more than it imports. Its
government and residents are savers. They provide enough capital to pay for
all domestic production. They might even lend outside the country. There are
several impacts of a BOP surplus.
The first impact of a BOP surplus is large inflow of FDI into a country.
When there is a surplus in BOP the people have more money, government has
more money to invest in better infrastructure and overall economy is growing.
This means it would attract foreign direct investors to the economy and so
there is a net inflow of money into the circular flow and aggregate demand
will rise. Rise in AD would increase the country’s GDP and boost economic
growth.
The second impact is improved infrastructure arising from increased
government revenue. During a surplus, the government revenue is high from
the increased export revenue, and low cost of imports. The rising AD also
indicate that national income is increasing, so government has to spend less
on welfare benefits and earn more from income taxes. All this increase
government revenue which can be used to build better roads, better buildings,
better necessary services like railways which would create incentive for
investment by both local and foreign investors.
The third impact is government enjoying a low national debt. During a
surplus, the government revenue is high from the increased export revenue,
and low cost of imports. The rising AD also indicate that national income is
increasing, so government has to spend less on welfare benefits and earn more
from income taxes. All this means government is now able to pay back its
debts and sometimes a nation might also become completely debt-free which
would bring a lot of advantages to the domestic economy. This might include
tax incentives and government subsidies to fund R&D.
Moreover, a BOP surplus means a strong exchange rate of the domestic
currency. BOP surplus means the exports is higher than imports. This means
that revenue coming into the country is more than the expenditures. This is a
sign of economic growth. Higher demand for exports means more foreign
currency is entering in to the country which can be changed to domestic
currency. This creates an appreciation of a currency.
Also, during a BOP surplus there would be more jobs created in the
economy. This is because the government’s debt is low and they are
generating a higher revenue which makes them capable to grant subsidies to
small firms to boost up their economic activity. For example; Japanese
government subsidizes rice farmers. Therefore, rice firms will now be able to
hire more labour to grow in size and achieve economies of scale. Also, as
exports demand is high and highly rewarding during a BOP surplus, firms may
want to hire more people to further increase their output to increase AS and
increase their returns.
Furthermore, BOP surplus also increase the wage rate of the people
working in that country. During a surplus people have more money and so do
businesses and government, this means there is an increase in the net income
flow into the circular flow of money. This will boost up the AD and thus
industries will increase productivity and enjoy economies of scale. This also
increases the AS of an economy and make the firms capable to afford to pay
the workers a higher minimum wage and charge low price which in return
improves the living standards of the people in the domestic economy.
Lastly, BOP surplus would indicate that the exports revenue is high and
this would encourage the local producers to improve the quality of the local
goods further. High quality goods mean there would be a lot of R&D
conducted which leads to more number of innovations being created in the
economy. Advancements in technology and new innovations means increase
of the attractiveness of the country in global market and higher productivity
levels by the country. This improves both GDP and GNI of a country.

22- Discuss effects of BOP Deficit.

The balance of payments is a record of all financial transactions
between one country and those in the rest of the world. It is the statistical
“accounting” record of a country’s international trade transactions. BOP
deficit is a situation in which imports of goods, services, investment income
and transfers exceed the exports of goods, services, investment income and
transfers. There are several impacts of a BOP deficits.
The first effect of BOP deficit is government imposing a high level of
tariff on imports. Tariffs are taxes placed on imports. For example; U.S. put a
tariff on France’s Roquefort Cheese. They may have the objective of either
raising revenue or protecting industries. Tariffs are the most common type of
anti-dumping measure. If a country has been able to prove that dumping has
taken place, then it can place a tariff on the imported goods to raise their prices
and eliminate the cost advantage of the dumped imports. Therefore, due to the
high cost of importing, import levels will start to fall and BOP position would
start to become better.
The second impact of a BOP deficit would be imposition of quotas by
government in order to control the rising import levels. A quota is a physical
quantitative limit on the number or value of goods that can be imported into a
country. For example, the EU imposes import quotas on Chinese garlic and
mushrooms. Once quota is imposed, there is an excess demand causing price
to rise. Even if the price rises, importers are not allowed to supply more,
because they have filled their quota, so domestic producers begin to enter the
market, attracted by the higher price of the product. This safeguards and
benefits the domestic producers while also reducing the import levels.
Lastly, a deficit would also lead to a creation of embargos in a country.
An embargo is a complete or partial block of trade and business activities
between two nations, usually imposed by one nation against the other as a
diplomatic tool. Embargos are imposed due to mainly two reasons. The first
is if there is a perfect substitute with similar quality and level of satisfaction
available in the local market. The second reason is if the good that is going to
be imported is a demerit good. So such embargos restrict imports of such
goods thus the import levels decrease.
23- Elaborate the two type of exchange rates.
The exchange rate is the rate at which one currency exchanges for
another; in other words, it is the price of one currency in terms of another. For
example: UK (exporter) and US (importer) trade, US must buy sterling pounds
using US dollars. There are two type of exchange rates; floating and fixed
exchange rate.
Fixed exchange rate is also known as pegged exchange rate. A fixed
exchange rate is an exchange rate regime where the value of a currency is
fixed, or pegged, to the value of another currency, or to the average value of a
selection of currencies, or to the value of some other commodity, such as gold.
Deciding upon, and then maintaining the fixed value of the currency is usually
carried out by the government or the central bank. If the value of the currency,
in a fixed exchange rate regime, is raised, then it is a revaluation of the
currency. If the value is lowered, then it is a devaluation of the currency. (For
example, Malaysian Ringgit is pegged against the US dollars; US Dollar 1 =
MR3.80)
A fixed exchange rate should reduce uncertainty for all economic agents
in the country. Business will be able to plan ahead in the knowledge that their
predicted costs and prices for international trading agreements will not change.
There is also a reduction of speculation in the short term. (Maybe 2 years). So
businesses can continue investments without any fear of change rate
fluctuations during this period of time.
Fixed exchange rate is also a way to discipline domestic policies. It can
be used as a tool to deal with Balance of Payment (BOP) deficits. Fixing an
exchange rate means that the import levels can now be controlled. This means
that value of import will remain same, not allowing the deficit to grow larger
and larger every year.
Setting a fixed exchange rate is very difficult and costly. A country with
a fixed exchange rate has to maintain high levels of foreign reserves in order
to make it clear that it is able to defend its currency by the buying and selling
of foreign currencies. They also cannot touch these reserved unless
government decides to unpeg the currency. The high cost of pegging a
currency makes it undesirable and damages the economy. Currency loses its
value and identity in foreign markets.
The main way government maintain fixed exchange rate is through the
manipulation of interest rates. However, if the exchange rate is in danger of
falling, then the government will have to raise the interest rate in order to
increase demand for the currency, but this will have a deflationary effect on
the economy, lowering demand and increasing unemployment. This means
that a domestic macroeconomic goal (low unemployment) may have to be
sacrificed
Lastly, pegged exchange rate can also create intense speculation in the
long period. This is because businesses will always be wondering and worried
about if the government is going to unpeg the currency or not. This reduces
business confidence which would reduce investment levels thus fall in
productivity. Also, there are often attempts to destabilize fixed exchange rate
systems in order to make speculative gains.

Floating exchange rate is an exchange rate regime where the value of a

currency is allowed to be determined solely by the demand for and supply of,
the currency on the foreign exchange market. There is no government
intervention to influence the value of the currency. The exchange rates are
changing daily based on the forces of demand and supply.
Floating rates are also cheaper as there is no need of a foreign reserve
to back up the exchange rate. As reserves are not used to control the value of
the currency, it is not necessary to keep high levels of reserves of foreign
currencies and gold.
Floating exchange rate also helps a country to be recognized in both
international and domestic markets. It would be of value and use in other
markets unlike fixed exchange rate currencies.
Also, because the exchange rate does not have to be kept at a certain
level, interest rates are free to be employed as domestic monetary tools and
can be used for demand management policies, such as controlling inflation.
Floating exchange rate creates speculation in both short and long run.
They tend to create uncertainty on international markets. Businesses trying to
plan for the future find it difficult to make accurate predictions about what
their likely costs and revenues will be. Investment is more difficult to assess
and there is no doubt that volatile exchange rates will reduce the levels of
international investment, because it is difficult to assess the exact level of
return and risk.
Floating exchange rates do not help in disciplining the BOP deficits.
Instead as there is no control over the exchange rates, the import values can
go out of hand and BOP deficit would continue to widen every year.
A floating exchange rate regime may worsen existing levels of inflation.
If a country has high inflation relative to other countries, then this will make
its exports less competitive and its imports more expensive. The exchange rate
will then fall, in order to rectify the situation. However, this could lead to even
higher import prices of finished goods, raw materials and thus cost-push
inflation, which may further fuel inflation.
24- What are the effects of appreciation of a country’s currency?
Currency appreciation is an increase in the value of one currency in
relation to another currency. E.g., a change in the value of the US$ from a first
exchange rate of US$1=€0.80 to a second exchange rate of US$1=€0.85. In
When currency appreciates, there is a downward pressure on the
inflation rates in an economy. If the value of the exchange rate is high, then
the price of finished imported goods will be relatively low. In addition, the
price of imported raw materials and components will reduce the costs of
production for firms, which could lead to lower prices for consumers. The
lower price of imported goods also puts pressure on domestic producers to be
competitive by keeping prices low. All these factors also contribute to higher
economic growth.
During an appreciation of a country’s currency the output of the country
increases. The high exchange rate will threaten their international
competitiveness so they will be forced to lower costs and become more
efficient in order to maintain competitiveness. While this might result in the
laying off of workers, there are other means of increasing efficiency that will
result in greater economic productivity for the country. Increased productivity
will increase both GDP and GNI of a country.
There also will be availability of cheap imports during a currency
appreciation. If the value of the exchange rate is high, then each unit of the
currency will buy more foreign currencies, and so more foreign goods and
services. This means import value would decrease and it would help to bring
the BOP to a surplus. Also, both visible imports, such as technology, and
invisible imports, such as foreign travel will be available at a cheap price
which will improve quality of local’s living standards.
Moreover, firms would start to restart any investment projects that they
had previously postponed. During a depreciation of the currency government
would most likely stop spending on investment projects in order to reduce the
money supply in the economy. This means several investment projects would
be postponed or cancelled. However, an appreciation of the currency is a sign
of economic growth, meaning there would be increased demand in the
economy. This means firms would find it profitable to restart any postponed
or cancelled projects now.
However, it also leads to short time working and labour redundancies.
Due to availability of advanced cheap technologies, firms may switch to
capital intensive method of production resulting in unemployment or less
wages due to shorter working time. Also with greater levels of imports being
purchased, because imports are now relatively less expensive, domestic
producers may find that the increased competition causes a fall in the demand
for their goods and services. This may lead to a further increase in the level of
unemployment as firms cut back. This also could create labour wastage if
government restricts laying off workers to avoid massive unemployment.
25- What are the effects of a currency depreciation?
Currency depreciation is a fall in the value of a currency in a floating
exchange rate system. For example; If the EUR/GBP exchange rate falls from
0.75 to 0.72 the British pound (GBP) has depreciated by £0.03. One euro now
costs £0.72 pounds (or 72 pence) instead of £0.75.
When currency depreciates, exports become cheaper. A devaluation of
the exchange rate will make exports more competitive and appear cheaper to
foreigners. This will increase demand for exports. Also, after a devaluation,
UK assets become more attractive; for example, a devaluation in the Pound
can make UK property appear cheaper to foreigners.
It also makes imports expensive. A devaluation means imports, such as
petrol, food and raw materials will become more expensive. This will reduce
demand for imports. It may also encourage British tourists to take a holiday in
UK, rather than US – which now appears more expensive. Cheap export and
expensive import help to correct the BOP deficit and country can enjoy current
account surpluses.
A devaluation could cause higher economic growth. Part of AD is (X-
M) therefore higher exports and lower imports should increase AD (assuming
demand is relatively elastic). In normal circumstances, higher AD is likely to
cause higher real GDP and inflation. However, if the global economy is in
recession, then a devaluation may be insufficient to boost export demand. If
growth is strong, then there will be a greater increase in demand. However, in
a boom, a devaluation is likely to worsen inflation.
Inflation is likely to occur following a currency depreciation because:
Imports are more expensive – causing cost push inflation, AD is increasing
causing demand pull inflation and exports becoming cheaper manufacturers
may have less incentive to cut costs and become more efficient. Therefore,
over time, costs may increase.
26- What are government interventions in Exchange Rate Policies?

The exchange rate is the rate at which one currency exchanges for another;
in other words, it is the price of one currency in terms of another. For example:
UK (exporter) and US (importer) trade, US must buy sterling pounds using US
dollars. There are two type of exchange rates; floating and fixed exchange rate.
These are some ways governments intervene in the exchange rate policies.

The first way is through devaluation. This means selling own currency for
foreign currency using reserves. Government simply buys foreign currencies on
the foreign exchange market, increasing its foreign currency reserves. To buy the
foreign currencies, the government uses its own currency and this increases the
supply of the currency on the foreign exchange market and so lowers its exchange
rate.

Then they also buy back their own currency by using reserves. If the
government wished to increase the value of the currency, then it can use its
reserves of foreign currencies to buy its own currency on the foreign exchange
market. This will increase the demand for its currency and so force up the
exchange rate.

The next way government intervene is by changing interest rates in banks.

If the government wants to decrease the value of their currency, they would ask
the central banks to increase the interest rates. This would cause the foreign direct
investors to pull out their investments from the economy in hope of investing it
in a country where there are low interest rates. This would depreciate domestic
currency. However, if government wants to increase the value of domestic
currency they would ask central bank to lower the interest rates which would
attract FDI, and thus appreciating domestic currency as they start demanding
more of the domestic currency.
27- What are the factors influencing the exchange rate?

The exchange rate is the rate at which one currency exchanges for another;
in other words, it is the price of one currency in terms of another. For example:
UK (exporter) and US (importer) trade, US must buy sterling pounds using US
dollars. There are two type of exchange rates; floating and fixed exchange rate.
These are some factors influencing the exchange rate of a country.

The first factor is the rate of inflation. An increase in the price of goods
and services caused by domestic inflation will tend to decrease the demand for
exports. Therefore, the exchange rate will tend to fall in value as a result of
inflation. This happens when the economy is in the second stage of the economic
cycle. However, countries with a stable economic growth with lower inflation
rates tend to see an appreciation in the value of their currency. For example, the
long-term appreciation in the German D-Mark in the post-war period was related
to the relatively lower inflation rate.

The next way government intervene is by changing interest rates in banks.

If the government wants to decrease the value of their currency, they would ask
the central banks to increase the interest rates. This would cause the foreign direct
investors to pull out their investments from the economy and sell domestic
currency, in hope of investing it in a country where there are low interest rates.
This would depreciate domestic currency. However, if government wants to
increase the value of domestic currency they would ask central bank to lower the
interest rates which would attract FDI, and thus appreciating domestic currency
as they start demanding more of the domestic currency.

The balance of payment position also affects the exchange rate of a

country. A deficit on the current account means that the value of imports (of
goods and services) is greater than the value of exports. If this is financed by a
surplus on the financial/capital account, then this is OK. But a country which
struggles to attract enough capital inflows to finance a current account deficit will
see a depreciation in the currency. A surplus on a country’s BOP means the
country exports more than it imports, there is a high demand for its goods, and
thus, for its currency causing an appreciation of that currency.

Speculation is another factor that affects the exchange rate of a country. If

speculators believe the currency’s value will rise in the future, they will demand
more now to be able to make a profit. This increase in demand will cause the
exchange rate value to rise. For example, if UK market see news which makes an
interest rate increase more likely, the value of the pound will probably rise in
anticipation. A negative speculation such as for a currency that is pegged at a
certain level, if investors believed the currency was overvalued, they would start
selling their reserves – putting downward pressure on the price. This causes a fall
in the value of that country’s currency.

Lastly, the government policies also affect the exchange rates of a

country’s currency. This includes pricing policies such as setting up a minimum
price or maximum price. If government imposes a minimum price on the imports,
imports would become expensive and thus import value will fall. Fall in import
value would mean less demand for foreign currencies in exchange for domestic
currency, causing domestic currency to appreciate.
28- What are some of the obstacles to trade?
Globalisation refers to the increased economic integration between
countries. Globalization lead to the emergence of international trade.
International Trade takes place where two or more countries trade with each
other. This allows all countries to trade globally, however, due to certain
reasons there are some obstacles/barriers for international trade.
The first obstacle is tariffs. Tariffs are taxes placed on imports. They
may have the objective of either raising revenue or protecting industries.
Tariffs are the most common type of anti-dumping measure. If a country has
been able to prove that dumping has taken place, then it can place a tariff on
the imported goods to raise their prices and eliminate the cost advantage of the
dumped imports.
The next obstacle is quotas. A quota is a physical quantitative limit on
the number or value of goods that can be imported into a country. For example,
the EU imposes import quotas on Chinese garlic and mushrooms. Once quota
is imposed, there is an excess demand causing price to rise. Even if the price
rises, importers are not allowed to supply more, because they have filled their
quota, so domestic producers begin to enter the market, attracted by the higher
price of the product. This safeguards and benefits the domestic producers.
Another obstacle is political frontiers. This means hindering trade by
language or by legal differences. This means imposing legal regulations to
imports to restrict their entry. These include things like safety standard,
pollution standards, product standards that the import product should meet in
order to enter that particular country. Ex: Car manufacturers often have to pass
certain safety ratings to sell the car in the importing country. Language barrier
means regulations which require the product to display certain information on
the packaging of the product that is going to be imported.
Moreover, the government could also use the currency regulations to
restrict trade. This means government is doing exchange control. This refers
to restrictions placed upon the ability of citizens to exchange foreign currency
freely. (Example; Malaysian government restricts Malaysians to convert only
RM5,000 into foreign currency for holidays abroad.)
Also, disguised barriers act as trade barriers. Governments may be able
to discriminate in favour of home producers by such things as health and safety
regulations. (Japanese and automobile industry) Importers may find it difficult
and prohibitively expensive to carry out the necessary certification to prove
that they meet the international standards. The costs involved in certification
may make it difficult for such countries to successfully exploit their
comparative advantage.
Lastly, by joining large trading blocs such as ASEAN or NAFTA acts
as a trading barrier for some countries. The bloc members give each other
special benefits they don't offer other countries, such as reducing tariffs and
other barriers to trade. NAFTA, the North American Free Trade Agreement,
is an example of a trade bloc agreement involving Canada, Mexico and the
United States. Therefore, countries not belonging to this trade bloc would find
it extremely costly and difficult or sometimes not even be allowed to trade
with members in this trade bloc.
29- What are some of the reason for trade barriers/protection?
Globalisation refers to the increased economic integration between
countries. Globalization lead to the emergence of international trade.
International Trade takes place where two or more countries trade with each
other. This allows all countries to trade globally, however, due to certain
reasons there are some obstacles/barriers for international trade. These reasons
are explained below.
The first reason in favour of trade barriers is because it helps to reduce
unemployment in a country. Too much imports mean local producers will face
low demand for their products. So industries might start to decline because
they cannot compete with foreign competition. If the industries are relatively
large, this will to high levels of structural unemployment, and governments
often attempt to protect the industries in order to avoid the unemployment by
imposing high tariffs.
Secondly, governments impose trade barriers in order to prevent
dumping. This takes place when surplus foreign goods are sold abroad at a
lower price than in the home market. This creates unfair competition. For
example, the EU may have a surplus of butter and sell this at a very low cost
to a small developing country. Where countries can prove that their industries
have been severely damaged by dumping, their governments are allowed
under international trade rules to impose anti-dumping measures to reduce the
damage.
A country might also wish to be self- sufficient. It is sometimes argued
that certain industries need to be protected in case they are needed at times of
war, for example, agriculture, steel, and power generation. Steel, for example,
is needed for many defence items such as planes and tanks, and a steel industry
would argue that it must be protected in order to stay competitive.
Trade barriers also exist to protect sunrise or infant industries. Many
governments argue that an industry that is just developing may not have the
economies of scale advantages that larger industries in other countries may
enjoy. The domestic industry will not be competitive against foreign imports
until it can gain the cost advantages of economies of scale. Because of this, it
is argued that the sunrise industry needs to be protected against imports, until
it achieves develops and grow in size where it is able to compete on an equal
footing.
Lastly, trade protection methods also governments sometimes impose
protectionist measures to attempt to reduce import expenditure and thus
improve a current account deficit whereby the country is spending more on its
imports of goods and services than it is earning for its exports of goods and
services.
30- Why do some countries trade?
Globalisation refers to the increased economic integration between
countries. Globalization lead to the emergence of international trade.
International Trade takes place where two or more countries trade with each
other. This allows all countries to trade globally, and there are many reasons
why a country might be involved in international trade.
The main reason why countries trade is due to lack of resources.
(EXPLAIN ALL FOUR RESOURCES). Advantageous trade can occur
between countries if the countries differ in their endowments of resources.
Resource endowments refers to the skills and abilities of a country's
workforce, the natural resources available within its borders (minerals,
farmland etc.), and the sophistication of its capital stock (machinery,
infrastructure, communications systems).
Secondly, countries trade because their production cost is too expensive
in their local countries. This might mean that there could be expensive labour
force in the country resulting from high skill/education or low population.
There also could be scarce natural resource available in the country making
the available ones of really high price. Also, it might be difficult to obtain
better quality technology and innovations cheaply in the home country.
Therefore, some countries start to trade and open production plants in
countries where cost of production would be lower such as in many Asian
Countries.
Thirdly, countries trade so that consumer choice is increased.
Consumers can now access products that they were not able to before.
International trade brings in different varieties of a particular product from
different destinations. This gives consumers a wider variety of choices which
will not only improve their quality of life but as a whole it will help the country
grow.
Moreover, countries trade to enable local goods to achieve an
international recognition. Doing business in other countries can boost your
company's reputation. Successes in one country can influence success in other
adjacent countries, which can raise your company's profile in your market
niche. It can also help increase your company's credibility, both abroad and at
home.
Furthermore, trade allows exchange of knowledge and technology.
Some countries might not have the ability/skill or finances to fund the
development of new knowledge, innovations and advance technology.
International trade allows countries to import these technologies and
knowledge from countries which has abundance of it. This means local
producers will now have more knowledge and technology skill to improve the
quality of their production.
Trade also allows good political relationship to be created between
countries – aid when in need – allow free trade
Lastly, international trade has opened doors for increased FDI into
many countries-
31- Effect of iflation on firms and individuals
Firms
High cost of production
Workers want goods instead of money, becuz goods has more value than
money
Devaluation of capital as inflation depreciates currency itself

Individuals
Low purchasing power- becuz cost of living mark up daily
Money has become useless- worthless, ppl have to carry bundle of money to
buy basic goods
Standard of living decrease- price of everything spiral out of control

32- Why do governments impose taxes?

 To combat/control inflation – fiscal policy tools
 To increase government revenue- to improve quality of public goods
 Discourage consumption of demerit and harmful goods
 Minimize inequality between rich and poor (progressive and
regressive taxation)
 Protect domestic goods against imported goods
 To prevent fast depletion of natural resources
33- What happens if Aggregate Supply is greater than the Aggregate
Demand?
Consequences:
• High Unemployment- there will be an involuntary build up in stocks
(inventories)- less sales – less profit
• High Inflation– firms shut down as COP is extremely high- high storage
costs- charge high price- people unable to buy goods- hoard durable goods
• Imbalance of National Income -disequilibrium- national income increase
as output in the country increase- but no demand, so eventually firms will
start to decrease production causing output levels to fall
• Deficit in Balance of Payment –increase supply – low price of export-
export value fall- deficit increase