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EPAB

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EPAB1207 ABE 2007 L/500/3695

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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 thisexamination.

6 Calculators, including scientific calculators, are allowed providing they are not

programmable and cannot store or recall information. Electronic dictionaries andpersonal organisers are NOT allowed.

7 Candidates who break ABE regulations, or commit any misconduct, will bedisqualified from the examinations.

8 Question papers must not be removed from the Examination Hall.

The Association of Business Executives

Diploma

Economic Principles and theirApplication to Business

morning 3 December 2007

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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 upward-

sloping. (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 excessdemand; (5 marks)

(ii) explain what happens to equilibrium price and quantity traded in a market whenthe 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 itstotal cost:

Output Total Cost ()

0 100

1 1102 1403 180

4 2405 310

6 4207 560

8 840

(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 averagevariable cost schedule. (5 marks)

(c) Explain what is meant by average total cost and calculate the firms average total costschedule. (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 besustainable. (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 ofGross Domestic Product (GDP). (6 marks)

(b) Explain how indirect taxes and subsidies are accounted for when we calculate aneconomys 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 expandand contractthe 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 expenditurewere to increase to 2000.

(10 marks)(Total 25 marks)

End of Question Paper

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Diploma

Economic Principles and theirApplication 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 unitsof 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 isthat 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 incomeeffect (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 thanthe substitution effect.


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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 theconsumption 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 moreand 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 intersectsthe 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 isequal 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 supplymore. 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 pointtotal cost comprises only fixed cost. According to the table, total cost at zero

output = fixed cost = 100.

(b) Average variable cost = total variable cost / number of units produced. The averagevariable cost schedule for this firm is:

Output Average Variable Cost ()

0 1 10

2 203 26.7

4 355 42

6 53.37 65.7

8 92.5

(c) Average total cost = total cost / number of units produced. The average total costschedule for this firm is:

Output Average Cost ()

0 1 110

2 70

3 604 605 62

6 707 80

8 105

(d) The following graph illustrates.

(e) The ATC and AVC get closer together for higher levels of output. The reason for this isthat as output increases, the size of fixed costs per unit (which is the differencebetween 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.

(b) The kinked demand curve theory of oligopoly was developed in an attempt to explainprice rigidities observed in many oligopolistic markets. The essence of the theory is

encapsulated in the following diagram.

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 relativelyelastic demand curve D

uand associated marginal revenue curve MR

u. The demand

curve is elastic because the firm does not expect rival firms in the industry to follow theprice 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

andassociated marginal revenue curve MR

d. The demand curve here is relatively inelastic

because the firm expects rival firms to match any cut in price thereby limiting the extentto which price reductions lead to an increase in its own demand. The firm therefore

faces the kinked demand curve (the dark boldline) passing through point A. Thisdemand curve implies the kinked marginal revenue curve (the light boldline) passing

through points B and C. Since the firm maximises profit where marginal revenue isequal 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 ator 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 atpoint 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 themodel is that it fails to explain why we should be at the initial equilibrium.

Dd

MR d

MC

A

B

C

QUANTITY

MR u

Du

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Q5 (a) + (b) Monopoly describes an industry in which there is a single firm, who, in theabsence of rival producers, faces the market (downward-sloping) demand curve

(D) and is free to set price above marginal cost (MC). Given the monopolistsdemand 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 alsobe 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 competitivepressures 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 ischaracterised 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 (Q

c) is greater than under monopoly (Q

m). In long run

equilibrium profit under perfect competition is zero, whilst under monopoly it is given byarea P

madP

c. 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 owncontribution to total output. The expenditure approach measures the GDP in terms of

the categories of expenditure required to purchase the total production. The incomeapproach measures GDP in terms of the factor-income claims generated in the course

of producing the total output.

(b) 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 valueof 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 toexpenditure to obtain GDP at factor cost.

(c) 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 receiptsby 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 onassets located in the domestic country but owned abroad.

(d) 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.

Q7 (a) 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 monetarybase 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 theeconomy by buying securities, and it pays for these purchases by issuing high powered

money.

(b) By open market operations the central bank buys or sells government bonds with theintention 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 moneymarket. 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 centralbank 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 reserveratios 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 highpowered money supply and the money supply as a whole.

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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 afixed 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, forexample, 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 foreigncurrency, 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, thecentral 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 itsstock 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= 1550Y= 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

(c) Recalculating part (a) with G = 2000, yields, 7083.3. The key point here is that theincrease in G will bring about a multiplied increase in national income which will mean

buoyant sales and prices. In these circumstances, the businessman should beencouraged to invest.

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