The Association of Business Executives Diploma

1.11EPAB
EPAB1207

Economic Principles and their Application to Business

morning 3 December 2007

1 Time allowed: 3 hours. 2 Section A consists of a compulsory question comprising five TRUE/FALSE elements. 3 Answer THREE questions from a choice of seven in Section B. 4 All questions carry 25 marks. Marks for subdivisions of questions are shown in brackets. 5 No books, dictionaries, notes or any other written materials are allowed in this examination. 6 Calculators, including scientific calculators, are allowed providing they are not programmable and cannot store or recall information. Electronic dictionaries and personal organisers are NOT allowed. 7 Candidates who break ABE regulations, or commit any misconduct, will be disqualified from the examinations. 8 Question papers must not be removed from the Examination Hall.

EPAB1207

ABE 2007

L/500/3695

SECTION A: All candidates must answer Question 1 Q1 State clearly whether each of the following statements (a-e) is TRUE or FALSE. Explain clearly, using diagrams where appropriate, your choice of true or false.

(a)

If a cost function exhibits economies of scale, then the average cost curve is upwardsloping. (5 marks)

(b)

The demand curve for a Giffen good is upward-sloping.

(5 marks)

(c)

Monetary policy is most effective when business investment expenditure is not very sensitive to changes in interest rates. (5 marks)

(d)

In an open economy with a fixed exchange rate, the loss of foreign exchange reserves from the central bank would indicate a balance of trade deficit. (5 marks)

(e)

An improvement in the terms of trade means that export prices have fallen relative to import prices. (5 marks) (Total 25 marks)

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SECTION B: Candidates must answer any THREE questions (all questions carry equal marks) Q2 (a) Using an appropriate diagram: (i) explain how the market demand for a normal good changes with a change in its own price; (5 marks)

(ii)

explain how the market supply of a good changes with changes in the price of the good (assume that the industry is perfectly competitive); (5 marks)

(iii)

explain the term market equilibrium.

(5 marks)

(b)

Using Supply and Demand analysis: (i) explain how a market moves to equilibrium from an initial position of excess demand; (5 marks)

(ii)

explain what happens to equilibrium price and quantity traded in a market when the price of a substitute good rises. (5 marks) (Total 25 marks)

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Q3

The following table summarises the relationship between a firms output and its total cost:

Output 0 1 2 3 4 5 6 7 8

Total Cost () 100 110 140 180 240 310 420 560 840

(a)

Explain what is meant by fixed cost and identify the firms fixed cost.

(4 marks)

(b)

Explain what is meant by average variable cost and calculate the firms average variable cost schedule. (5 marks)

(c)

Explain what is meant by average total cost and calculate the firms average total cost schedule. (5 marks)

(d)

Using the data from above, make an accurate plot of the firms average total cost (ATC) and average variable cost (AVC) schedules on a graph, being careful to fully label the graph. (6 marks)

(e)

Comment on, and explain the difference between, the two schedules as output increases. (5 marks) (Total 25 marks)

Q4

(a)

Explain the characteristics of an oligopoly industry.

(5 marks)

(b)

Using an appropriate diagram, explain the kinked demand curve model of oligopoly. (10 marks)

(c)

Explain why collusive arrangements between firms in an oligopoly tend not to be sustainable. (10 marks) (Total 25 marks)

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Q5

(a)

Explain the key characteristics of a monopoly industry.

(5 marks)

(b)

Using an appropriate diagram, outline the model of monopoly.

(5 marks)

(c)

Compare the predictions (including equilibrium price, quantity, profit and dead-weight loss) of the monopoly model with those of the model of perfect competition. (15 marks) (Total 25 marks)

Q6

(a)

Define the output, income and expenditure approaches to the measurement of Gross Domestic Product (GDP). (6 marks)

(b)

Explain how indirect taxes and subsidies are accounted for when we calculate an economys GDP (at factor cost) from the components of total final expenditure. (8 marks)

(c)

Explain how net property income is accounted for when calculating Gross National Product from Gross Domestic Product. (7 marks)

(d)

Explain the distinction between real and nominal measures of national income. (4 marks) (Total 25 marks)

Q7

(a)

Explain what is meant by the term high powered money.

(5 marks)

(b)

Discuss how open market operations are used to expand and contract the money supply. (8 marks)

(c)

Explain how a central bank can use its control of the supply of money to reduce the rate of inflation in an economy. (12 marks) (Total 25 marks)

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Q8

You are given the following information about a closed economy: Y=C+I+G C = 50 + 0.8Yd I = 500 G = 1000 Where: Y refers to national income, and where C, I, and G refer, respectively, to consumption, investment and government expenditure. Yd refers to disposable income, and the tax rate in this economy is 0.2.

(a)

Calculate the equilibrium level of national income.

(5 marks)

(b)

Calculate the multiplier for this economy.

(10 marks)

(c)

You are asked to give advice to a businessman who is thinking of investing in this economy. Explain why you would recommend investment if government expenditure were to increase to 2000. (10 marks) (Total 25 marks)

End of Question Paper

EPAB1207

Diploma Economic Principles and their Application to Business Examiners Suggested Answers SECTION A Q1 (a) FALSE. Average cost (AC) is defined as total cost divided by the number of units of output. Economies of scale are said to occur when the production of extra units of output causes average cost to fall. This can be illustrated as follows:

(b)

TRUE. As the price of a Giffen good increases the consumer increases consumption of the good: the demand curve slopes upwards, as illustrated below. The reason for this is that the increase in price of the good has a substitution effect (the consumer is attracted to buy cheaper substitutes, hence less of the Giffen good) and an income effect (the consumers real income falls and hence the demand for the Giffen good an inferior good rises). In the case of the Giffen good, the income effect is larger than the substitution effect.

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(c)

FALSE. Monetary policy works by affecting the level of interest rates in an economy. Monetary policy is most effective when investment expenditures (and other interest sensitive expenditures eg hire purchase agreements) are highly sensitive to changes in interest rates. In this case, a given change in interest rates will generate a proportionately bigger change in aggregate demand. When investment expenditures are comparatively inelastic to changes in interest rates, proportionately bigger changes in interest rates are required to achieve a given change in aggregate demand. TRUE. A deficit on the balance of trade means that domestic citizens owe more to the rest of the world than the rest of the world owes them. In order to finance this debt, domestic citizens need to exchange their domestic currency for foreign currency. In other words, the supply of domestic currency to be exchanged for foreign currency rises. To meet this increased demand for foreign currency the central bank runs down its foreign exchange reserves. FALSE. The terms of trade are defined as: (average price of exports/average price of imports), usually expressed as an index. If the terms of trade rise, or improve, then export prices have risen faster than import prices and so less exports need to be sold to purchase a given quantity of imports.

(d)

(e)

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SECTION B Q2 (a) (i) As the price of a normal good decreases, individual consumers each demand more of the good and new consumers are attracted to the consumption of the good. Price and market demand are inversely related as indicated in the diagram below.

(ii)

As the price of a good increases, individual firms are each willing to supply more and new firms are attracted to the industry. Price and supply are positively related as indicated in the diagram below.

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(iii)

Market equilibrium occurs at the point where the market demand curve intersects the market supply curve, as illustrated by point A in the diagram below. At this point, the price, P* is such that the market clears: the number of units supplied is equal to the number of units demanded (Q*).

(b)

(i)

In the diagram below, the market is initially in disequilibrium at price P. At this price, market demand Qd is greater than market supply Qs: there is excess demand. However, in a situation of excess demand, the consumers bid up the price of the scarce units on offer. As the price rises, the firms are willing to supply more. This process continues until the market reaches equilibrium at (price, output) combination (P*, Q*).

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(ii)

In the diagram below, the market is initially in equilibrium at (price, output) combination (P*, Q*). The rise in the price of a substitute good will cause the demand curve to shift outwards leading to a new equilibrium with the higher (price, output) combination (P, Q).

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Q3

(a)

Fixed cost is the cost which the firm will face in the short run even if no output is produced. If output is zero, the firm faces no variable costs, hence at this point total cost comprises only fixed cost. According to the table, total cost at zero output = fixed cost = 100. Average variable cost = total variable cost / number of units produced. The average variable cost schedule for this firm is:

(b)

Output 0 1 2 3 4 5 6 7 8

Average Variable Cost () 10 20 26.7 35 42 53.3 65.7 92.5

(c)

Average total cost = total cost / number of units produced. The average total cost schedule for this firm is: Output 0 1 2 3 4 5 6 7 8 Average Cost () 110 70 60 60 62 70 80 105

(d)

The following graph illustrates.

(e)

The ATC and AVC get closer together for higher levels of output. The reason for this is that as output increases, the size of fixed costs per unit (which is the difference between the two schedules) decreases.
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Q4

(a)

Oligopoly characteristics include: There are a number of firms producing goods that are substitutable: the goods may be perfect substitutes but there is usually some degree of product differentiation. Each firm has a degree of market power: each faces a downward sloping demand and marginal revenue curve. The firms are mutually interdependent: the industry is characterised by strategic interaction. There may or may not be barriers to entry. Abnormal profits may be earned in the short-run and the long-run. The kinked demand curve theory of oligopoly was developed in an attempt to explain price rigidities observed in many oligopolistic markets. The essence of the theory is encapsulated in the following diagram.

(b)

MC A Du B MR u C Dd MR d QUANTITY

A firm in the industry faced with marginal cost MC, begins with the price and output combination at point A. If the firm increases its price then it would face the relatively elastic demand curve Du and associated marginal revenue curve MRu. The demand curve is elastic because the firm does not expect rival firms in the industry to follow the price rise and so the firm would quickly become uncompetitive and lose demand. If the firm decreases its price then it faces the relatively inelastic demand curve Dd and associated marginal revenue curve MRd. The demand curve here is relatively inelastic because the firm expects rival firms to match any cut in price thereby limiting the extent to which price reductions lead to an increase in its own demand. The firm therefore faces the kinked demand curve (the dark bold line) passing through point A. This demand curve implies the kinked marginal revenue curve (the light bold line) passing through points B and C. Since the firm maximises profit where marginal revenue is equal to marginal cost, the firm will optimally choose the price and output combination at point A so long as the marginal cost curve cuts the kinked marginal revenue curve at or between the points B and C. If this vertical segment of the marginal revenue curve is quite large then this leads to the conclusion that the firm would choose to remain at point A even in the face of relatively large changes in marginal cost. Thus the model predicts a degree of price rigidity. Of course, one of the critical short-comings of the model is that it fails to explain why we should be at the initial equilibrium.

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Q5

(a) + (b)

Monopoly describes an industry in which there is a single firm, who, in the absence of rival producers, faces the market (downward-sloping) demand curve (D) and is free to set price above marginal cost (MC). Given the monopolists demand curve is downward-sloping its marginal revenue (MR) is also downward sloping. In fact, if the demand curve is linear then the marginal revenue will also be linear but twice as steep. The monopolist maximises profit at the point where marginal revenue is equal to marginal cost, which results in a (price, output) combination (Pm, Qm), as illustrated in the diagram below.

Given the existence of entry barriers, the monopolist is able to sustain economic profit in the short and the long-run. However, the absence of competitive pressures may lead the monopolist to pursue goals other than profit-maximisation e.g., allowing costs to inflate. This is an example of X-inefficiency. (c) Compared with a situation of monopoly, a perfectly competitive industry is characterised by price = marginal cost. In the diagram below we assume marginal cost is equal to average cost (AC) for simplicity.

Consequently, equilibrium price under perfect competition (Pc) is lower than under monopoly (Pm), but output (Qc) is greater than under monopoly (Qm). In long run equilibrium profit under perfect competition is zero, whilst under monopoly it is given by area PmadPc. Dead-weight loss under monopoly is given by the area ade whilst under perfect competition, dead-weight loss is zero.

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Q6

(a)

The output approach measures GDP in terms of the value added of each firms own contribution to total output. The expenditure approach measures the GDP in terms of the categories of expenditure required to purchase the total production. The income approach measures GDP in terms of the factor-income claims generated in the course of producing the total output. Indirect taxes that are part of the sale price of commodities do not create income since they are paid to the government. These taxes drive a wedge between the market value of commodities produced and the factor incomes generated by their production. Indirect taxes must therefore be deducted from expenditure to obtain GDP at factor cost. The opposite applies in the case of subsidies which must be added to expenditure to obtain GDP at factor cost. Net property income measures income earned in a given country in return for contributions to current production. To obtain GNP from GDP we have to add receipts by domestic citizens of dividends, interest and profits from assets which they own but which are located from overseas, and subtract dividends, interest and profits earned on assets located in the domestic country but owned abroad. Changes in real and nominal income are determined by changes in physical quantities and prices. Nominal national income refers to the current money value of this income. Real GDP (or GDP at constant prices), refers only to the changes in the physical quantities of output produced. High powered money consists of currency (bank notes and coins) held by the public and the banks and of deposits held by the banks with the central bank. This monetary base is referred to as high powered because it is the basis upon which a much bigger stock of monetary assets is built. The central bank gets high powered money into the economy by buying securities, and it pays for these purchases by issuing high powered money. By open market operations the central bank buys or sells government bonds with the intention of altering the stock of high powered money. If the central bank wanted to reduce the stock of high powered money they would sell securities in the money market. These could be bought either by private citizens or by banks. The payment for the securities would involve a transfer from the clearing banks deposits with the central bank to the governments account. This lowers the stock of high powered money because it lowers the banks deposits with the central bank. To maintain their reserve ratios the banks would have to reduce their loans eg by calling in overdrafts, and the money supply would fall. The opposite applies in the case of an expansion of the high powered money supply and the money supply as a whole.

(b)

(c)

(d)

Q7

(a)

(b)

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(c)

Foreign exchange reserves and central bank credits are the two components of a central banks high powered money stock which arise from external transactions. In a fixed exchange rate regime the central bank is required to defend the exchange rate and it does so by using up its reserves of foreign exchange. In the case of a deficit, for example, there is a net demand for foreign currency. In the absence of central bank intervention, this would lead to a depreciation. To meet the net demand for foreign currency, the central bank runs down its reserves of foreign exchange (which contracts the stock of high powered money). In the case of a floating exchange rate regime, the central bank does not have to intervene to protect the exchange rate. In the case of a deficit, the central bank allows the exchange rate to depreciate with no effect on its stock of foreign exchange reserves or the stock of high powered money.

Q8

(a)

The level of national income is: Y = 50 + 0.8(Y 0.2Y ) + 500 + 1000 Y 0.64Y = 1550 Y = 4305.5

(b)

The multiplier, K, is defined as: K = 1/1c(1t), where c is the marginal propensity to consume, and t is the tax rate. Inserting values yields: 2.777 Recalculating part (a) with G = 2000, yields, 7083.3. The key point here is that the increase in G will bring about a multiplied increase in national income which will mean buoyant sales and prices. In these circumstances, the businessman should be encouraged to invest.

(c)

1258-111-1

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