CAF - 02 - Economics - Study - Notes - and - MCQs-1 2 PDF

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CAF – 02
INTRODUCTION TO ECONOMICS
AND FINANCE
1st Edition
Study Notes and MCQs
By: Muhammad Asif, ACA

mhkorai.blogspot.com
ALL RIGHTS RESERVED.
1st Edition: April 2017
Introduction to Economics and Finance, 1/e
AUTHOR
Muhammad Asif, ACA
PREFACE
Why a Chartered Accountant:

Economics is a subject which is not seen as a critical subject for students of professional bodies,
and therefore, is not taught by chartered accountants in our profession. However, I personally
think that a chartered accountant is in a better position to teach any subject to the students of
ICAP, as he himself has gone through the education and examination system of ICAP and is fully
aware of specific requirements of examiner (which are quite different from requirements of
examiners of academic institutes and universities).
A chartered accountant also has overall picture of syllabus at CAF as well as CFAP Level,
therefore, he is also aware how concepts learnt at basic level are going to be applied at
advanced level and he can teach topics in such a way that these may help students in
preparation of their advance topics also. For example, many of the concepts learnt in finance
section of this subject will be applied by students in the CFAP – 4 (BUSINESS FINANCE
DECISIONS).
Why this Book:

While teaching Economics, I have seen a lot of students having problem in preparing the subject.
This problem arises for a number of reasons e.g. books available in the market on this subject
are not student-friendly, key concepts from examination point of view are not spotlighted,
students encounter many irrelevant paragraphs, and sometimes requirements are not arranged
in logical and practical sequence.
This book is an effort to make students’ life easy. I have tried to make this subject easy and
interesting. I hope you will find it so.
Is this book enough:

Students often ask me a question, “Is it enough if we read this book, or we also have to read
other study material e.g. official study text?”.
Answer is “YES, this book is enough”. Your study text is automatically covered if you cover this
book. However, there are certain paragraphs in ICAP’s Study Text which are not important from
exam point of view and therefore, are not covered in this book (refer transition pages # iii to vi
for list of such paragraphs). Once, you cover all concepts from this book, you are advised to
cover such paragraphs too from ICAP’s study text.
Additional study material:

Students are advised to visit weekly (or atleast monthly) the following web-page for subject
related queries, latest changes in syllabus, updates and other educational material on the
subject:
https://web.facebook.com/groups/CAF02
i
ANY SUGGESTIONS/COMMENTS?
This book is not the best book of economics. However, I am committed to make it the best book
for students. This aim cannot be achieved by a single person. Therefore, your help is needed.
If you find any errors in the book, any concept which needs to be improved (keeping in mind
students’ perspective), or any other suggestion, I will highly appreciate if you share it with me
so that in future this book may further be improved.
For any comments/ suggestions/additional support, you can contact me through:
Address: RISE School of Accountancy
06 Aurangzaib Block, New Garden Town, Lahore
Cell # : 0331-4585358 (sms only)
e-mail address: [email protected]
facebook page: https://web.facebook.com/groups/CAF02
Muhammad Asif
April 03, 2017
Lahore
ii
CROSS REFERENCE FOR TRANSITION FROM ICAP’S STUDY TEXT TO THIS BOOK
Ch.# 1: Fundamentals of economics Chapter 2: Microeconomics

ICAP’s Study Text ICAP’s Study Text
Coverage in This Book Coverage in This Book
Reference Reference
1.1, 1.2, 1.3 LO 1 of Ch.# 1 1.1 LO 3 of Chapter 1

2.1 LO 4 of Ch.# 1 1.2 LO 1 of Chapter 1
2.2, 2.3, 2.4 Not Covered 1.3 LO 8 of Chapter 1
3.1, 3.2 Not Covered 1.4 LO 1 of Chapter 2
LO 3 of Ch.# 1 1.5 LO 3 of Chapter 2
3.3 ("Importance and
1.6 LO 1 of Chapter 2
limitations" not covered)
1.7, 1.8 LO 3 of Chapter 1
3.4 LO 2 of Ch.# 1
2.1 Not Covered
3.5 LO 2 & LO 9 of Ch.# 1
3.6 LO 2 of Ch.# 8
LO 1 of Ch.# 1 ("Rational 2.3, 2.5 - 2.9 LO 1 of Chapter 2
3.7 behaviour" not covered) 2.4 LO 7 of Chapter 2
3.8 LO 9 of Ch.# 1 LO 2 of Chapter 2
LO 10 of Ch.# 1 2.10 - 2.12 ("explaining giffen
3.9 ("Applications" not goods" not covered)
covered)
4.1 LO 4 of Ch.# 1
4.2 LO 10 of Ch.# 1
3.3, 3.5 - 3.9 LO 3 of Chapter 2
4.3 LO 4 of Ch.# 1
4.4 LO 6 of Ch.# 1
4.5 LO 5 of Ch.# 1
4.6 LO 7 of Ch.# 1
4.1-4.2 LO 5 of Chapter 2
4.7 Not Covered
5.1 Not Covered
5.2 LO 11 of Ch.# 1
5.3 LO 11 of Ch.# 1
5.4 LO 5 of Ch.# 14
iii
Chapter 3: Demand and supply: elasticities Chapter 5: Costs, revenues and firms
Reference Reference
1.1 Not Covered 1.1 - 1.2 LO 4 of Chapter 5

1.2 LO 3 of Chapter 3 LO 1 of Chapter 5 ('very
1.3 long-run not covered)
LO 1, LO 2, LO 6 of
1.3 1.4 - 1.5 LO 4 of Chapter 5
Chapter 3
1.4 LO 6 of Chapter 3 1.6 LO 5 of Chapter 5
LO 4, LO 5 of Chapter 1.7 - 1.10 LO 6 of Chapter 5
1.5, 1.6 2.1 - 2.4 LO 7 & 8 of Chapter 5
3
2.1 Not Covered 2.5 Not Covered
LO 7, LO 8 of Chapter 3.1 LO 2 of Chapter 5
2.2
3 3.2-3.3 LO 3 of Chapter 5
3.1 Not Covered 4.2 LO 1 of Chapter 6
3.2 LO 10 of Chapter 3 4.3 Not Covered
Chapter 4: Utility analysis 4.6 LO 2 of Chapter 6
ICAP’s Study Text
Coverage in This Book
Reference Chapter 6: Macroeconomics: An introduction
ICAP’s Study Text
1.1 LO 3 of Chapter 4 Reference
1.2 Not Covered
LO 1 of Chapter 7 &
1.3 - 1.5 LO 2 of Chapter 4 1.1
LO 3 of Chapter 1
2.1 - 2.5 LO 3 of Chapter 4
1.2 Not Covered
3.1 Not Covered
LO 6, LO 7 of Chapter
3.2, 3.6, 2.1 LO 1 of Chapter 8
4
3.7 LO 4 of Chapter 4 2.2 - 2.4 LO 4 of Chapter 8
4.1 Not Covered 2.5 LO 7 of Chapter 8
4.2, 4.5 LO 9 of Chapter 4 3.2 LO 2 of Chapter 8
4.3, 4.6 LO 10 of Chapter 4 LO 3, LO 4 & LO 5 of
3.3 - 3.6
Chapter 8
4.1 Not Covered
4.2 LO 4 & LO 5 of Chapter 7
LO 2 & LO 3 of Chapter 7
4.3 (excluding Effective
demand)
iv
Chapter 7: Consumption, savings and investment Chapter 10: Public finance

Reference Reference
1.1 - 1.2 LO 1 of Chapter 9 1.1 LO 3 of Chapter 15

2.6 LO 5 of Chapter 12 Chapter 11: Money
ICAP’s Study Text
Chapter 8: Multiplier and accelerator Coverage in This Book
Reference
ICAP’s Study Text
Reference 1.1 - 1.6 Not Covered
2.1 LO 6 of Chapter 7 2.1 - 2.5 LO 1 of Chapter 12
2.2 LO 3 of Chapter 9 3.1 - 3.3 Not Covered
5.1 - 5.2 LO 3 of Chapter 10 4.1 Not Covered
4.3 - 4.4, 5.1 - 5.2 LO 4 of Chapter 12
Chapter 9: Growth and taxes LO 1 & LO 2 of Chapter
6.1 - 6.3
11
ICAP’s Study Text 6.4 LO 3 of Chapter 11
Reference
1.1 - 1.2 LO 1 of Chapter 8 6.6 Not Covered
2.1 - 2.3 LO 7 of Chapter 7 LO 10 & LO 11 of
6.10
2.4, 2.6 LO 4 & LO 9 of Chapter 15 Chapter 11
3.1 Not Covered
3.2, 3.4, 3.6 - 3.7 LO 5 of Chapter 15
3.3, 3.5 LO 6 of Chapter 15
v
Chapter 12: Monetary policy

ICAP’s Study Text
Reference
1.1 - 1.3 LO 5 of Chapter 12

2.1 - 2.2 LO 1 of Chapter 13
2.3 - 2.5, 2.7 LO 8 of Chapter 7
3.1 - 3.2 LO 2 of Chapter 13
Chapter 13: Credit

ICAP’s Study Text Note for Students
Reference
These transition pages are prepared
1.1 Not Covered to ensure that all concepts of ICAP’s
1.2 - 1.3 LO 3 of Chapter 13 study text have been covered in this
1.4 - 1.6 LO 4 of Chapter 13 book. This list will also be helpful for
students who want transition from
Chapter 14: Balance of payments and trade ICAP’s study text to this book.
ICAP’s Study Text However, there are certain paragraph

Reference which are not important from exam
point of view and therefore, are not
1.1 - 1.3, 1.5 - 1.8 LO 1 of Chapter 16 covered in this book. Once, you cover
1.4, 1.9 LO 2 of Chapter 16 all concepts from this book, you are
LO 3 & LO 4 of Chapter advised to cover such paragraphs too
2.1 - 2.5
16 from ICAP’s study text.
3.1 - 3.3 LO 6 of Chapter 16
4.1 - 4.2 LO 7 of Chapter 16
Chapter 15: Financial markets
ICAP’s Study Text

Reference
1.1 Not Covered

vi
TABLE OF CONTENTS
Chapter Page Number

Chapter Title
No. Notes MCQs
SECTION A: FUNDAMENTAL CONCEPTS

1 Fundamental Economic Concepts 1 154
SECTION B: MICRO ECONOMICS

2 Demand, Supply and Market Equilibrium 14 156
3 Elasticity of Demand and Supply 26 159
4 Consumer Equilibrium 36 162
5 Revenue, Costs and Firm Equilibrium 50 164
6 Types of Firms 62 167
SECTION C: MACRO ECONOMICS

7 Overview of Macroeconomics 75 169
8 Calculation of National Income 86 171
9 Analysis of Consumption and Investment Expenditures 95 174
10 Multiplier and Accelerator 104 175
11 Inflation, Unemployment and Business Cycle 110 177
12 Money 121 180
SECTION D: BANKING AND FINANCE

13 Banks and Their Functions 128 182
14 Financial Markets and Their Instruments 133 183
SECTION E: PUBLIC FINANCE

15 Public Finance, Fiscal Budget and Taxation 138 185
SECTION F: INTERNATIONAL ECONOMICS

16 Balance of Payment and Exchange Rates 146 187
viii
Economics – Study Notes Chapter 1 Fundamental Economic Concepts
CHAPTER ONE
FUNDAMENTAL ECONOMIC CONCEPTS
LO # LEARNING OBJCTIVE
PART A– DEFINITIONS OF ECONOMICS

LO 1 DEFINITIONS OF ECONOMICS
LO 2 AGENTS/PARTICIPANTS OF AN ECONOMY
LO 3 DIFFERENCE BETWEEN MICRO ECONOMICS AND MACRO ECONOMICS
PART B– BASIC ECONOMIC PROBLEM AND ECONOMIC SYSTEMS
LO 4 BASIC ECONOMIC PROBLEM
LO 5 MARKET ECONOMY / FREE ECONOMY / LAISSEZ-FAIRE ECONOMY
LO 6 PLANNED/COMMAND ECONOMY
LO 7 MIXED ECONOMY
PART C – OUTPUTS AND INPUTS OF AN ECONOMY
LO 8 TYPES OF GOODS (OUTPUTS)
LO 9 FACTORS OF PRODUCTION (INPUTS)

PART D – HOW ECONOMY CHOOSES AMONG ALTERNATIVES
LO 10 PRODUCTION POSSIBILITY FROENTIER/CURVE

PART E – ISLAMIC CONCEPTS OF ECONOMICS
LO 11 ISLAMIC ECONOMIC SYSTEM
1
PART A – DEFINITIONS OF ECONOMICS
LO 1: DEFINITIONS OF ECONOMICS:
By Adam Smith: (Classical Economist)
Definition:
“Economics is the science which studies the production, distribution, consumption and exchange of
wealth”.
Criticism:
Economics revolves around ‘wealth’ only and teaches selfishness. Its scope is narrow and ignores
the most important concepts of economics i.e. scarcity and choice.
By Alfred Marshal: (Neo-Classical Economist)

Definition:
“Economics is a study of mankind in the ordinary business of life. It examines that part of individual
and social action which is most closely connected with the attainment and use of material requisites
of well-being”.
Criticism:
Although this definition shifted focus of economics from “wealth” to “welfare”, however, it narrows
scope of economics by classifying only material goods in economics. Non-material goods should
also be studies in economics, provided they have values.
By Robbins: (Modern Economist)

Definition:
“Economics is the science, which studies human behavior as a relationship between ends and scarce
means, which have alternative uses".
Important aspects of the definition:

 Human wants are unlimited.
 Resources are Scarce. (Scarcity means resources available to humanity are insufficient to
satisfy all of man's wants).
 Therefore society has to make choice. (Choice means deciding to how to allocate limited
resources between alternative wants).
Study Tip: Needs, Wants and Goods

 Sometimes a distinction is made between Needs and Wants.
 Needs are the basic requirements for the citizens of society e.g. food, clothes, shelter.
 Wants are the desires of society. This is a broader concept which includes what citizens wish to have.
 Goods (including services) are materials that satisfy human wants.
LO 2: AGENTS/PARTICIPANTS OF AN ECONOMY:
There are four agents/participants of any economy:
1. Households: (also called buyer, consumer, individual):
The collective group of individuals consuming goods and services in an economy, and
providing labor for firms.
2
2. Firm: (also called seller, producer, business):

Firm is an organization which converts Inputs (i.e. factors of production) into Outputs (i.e.
production).
3. Government: (also called State):
Organisation that governs society through a combination of customs, exercises and laws.
4. Foreign Traders: (also called importers and exporters):
The collective group who exchange goods and services between different economies.
Importers purchase from other countries. Exporters sell to other countries.
Study Tip: Production and Consumption

 Firms produce goods. Production refers to the process that creates value i.e. converts of inputs
(factors of production) to outputs (goods or services).
 Individuals consume goods. Consumption is the purchases of goods and services by consumers.
LO 3: DIFFERENCE BETWEEN MICRO ECONOMICS AND MACRO ECONOMICS:

There are two branches of economics i.e. Microeconomics and Macroeconomics.
Microeconomics Macroeconomics
Micro means small. Microeconomics is the branch of Macro means large. Macroeconomics is the branch of
What it
economics concerned with the behavior of individual economics concerned with the overall performance of
is
entities such as markets, firms, and households. the economy.
Microeconomic is concerned with Market Macroeconomics is concerned with National Income,
What it equilibrium, Consumer Equilibrium, Firm National equilibrium, Economic Growth, Employment
covers Equilibrium, Factors influencing demand and supply Level and Price Level, Interest Rate, Balance of
and their effect on market equilibrium. Payment in a country.
CONCEPT REVIEW QUESTION

Highlight the main differences between microeconomics and macroeconomics. (06 marks)
(ICAP, CAF 02 Level – Autumn 2008)
PART B – BASIC ECONOMIC PROBLEM AND ECONOMIC SYSTEMS
LO 4: BASIC ECONOMIC PROBLEM:

Basic Economic Problem:
Due to scarcity of resources, every human society must select how to allocate its resources i.e.
1. What to produce in what quantity (e.g. whether capital goods or consumer goods)
2. How to produce (i.e. with what resources, and what production techniques to use), and
3. For whom are goods produced. (deciding about distribution of goods and services i.e. who
gets the goods and how much)
Economic System:
An economic system is a system which resolves the basic economic problem by making three
resource allocation decisions i.e. what to produce, how to produce, and for whom to produce.
There are three economic systems:

1. Free/Market/Laissez-Faire Economy (e.g. Capitalism)
3
2. Planned/Command Economy (e.g. Socialism or Communism)

3. Mixed Economy

Briefly explain the Laissez Faire. (02 marks)
(ICAP, CAF 02 Level – Spring 2010)
What do you mean by ‘economic system’?
LO 5: MARKET ECONOMY / FREE ECONOMY / LAISSEZ-FAIRE ECONOMY:

Definition:
This is an economic system in which decisions about resource allocation are made by individuals
and private firms through market-mechanism without intervention of government.
Market Mechanism or Price Mechanism:

Market/Price Mechanism refers to the system where price and quantity of goods are determined by
interaction of free forces of demand and supply.
Features of Market Economy OR Allocation of resources OR Resolving economic problem:

Below is the description how market economy (or price-mechanism/market mechanism) resolves
basic economic problem):
What to produce:
What to produce is determined by consumer demand. Firms produce the commodities that give the
highest prices.
How to produce:
Producers use those factors of production and production techniques which provide least cost e.g. if
labor is cheaper than machine, more of labor and less of machine will be used in production
technique (and vice-versa).
For whom to produce:

For whom to produce is determined by purchasing power. Production is made only for those who
have the ability and willingness to pay.
Merits/Benefits of Market Economy:

 Retains consumer sovereignty
 No costly planning of bureaucracy
 Dynamic and responsive to changes in demand and supply conditions
 Freedom of choice for consumers
 Freedom of entrepreneur
 Auto-adjusted price mechanism to remove surplus and shortage
Demerits/Drawbacks of Market Economy:

In a free market, there may inefficient allocation of resource which is called “Market Failure”.
Market failures may occur for many reasons e.g.
4
Creation of Monopolies:
Due to free working, big fish eats small fishes. Wealth may be concentrated in the hands of large
entrepreneur. Thereby, monopolies and oligopolies may be created causing disproportionate
balance of economic powers.
Social Costs of production and consumption are ignored:

Market works for Profit. In the process of earning profit, social costs and public welfare are ignored
e.g. ignoring air or water pollution, stress and crimes. Some undesirable products may be produced
e.g. drugs.
No Provision of Public Goods:

Public or merit goods (e.g. health, education, housing) are costly for poor. They may not afford high
prices for these necessities of life.
Risk of Unemployment and Inflation:

Unusual fluctuations in demand and supply may result in inflation and unemployment.
Waste of Resources:
Market economy may result in waste of resources e.g. advertising due to competition or allocation
resources to produce luxury goods for rich neglecting necessities of the poor.
Failure to plan long-run:

Market economy focuses on short-term objectives and does not plan about long-run.

What is “Market mechanism”? Explain how it resolves the basic economic problems. (07 marks)
How does the Market Economy function? (02 marks)
Enumerate the merits and demerits of Market Economy. (10 marks)
LO 6: PLANNED/COMMAND ECONOMY:
Definition of Planned Economy:
It is an economic system in which Government makes all important decisions about resource-
allocation.
Features of Planned Economy OR Allocation of resources OR Resolving economic problem:

 Government decides what a “common good” is, which should be produced.
 Resources are state-owned and state decided how to allocate them in production.
 State decides pricing of factors of production and production.
 Government produces for the entire economy through an administrative process.
Advantages of Planned Economy:

1. The social costs of production and consumption are fully considered in economic decisions.
2. Production is carried out for the needs of society and not for the benefit of the few.
3. Permits long term industrial and social planning fostering economic stability.
4. Full employment of the workforce is possible.
5. Less duplication and waste of resources.
5
Disadvantages of Planned Economy:

1. There is a limited variety of products as compared to market economy.
2. Central planning reflects preferences of central planners rather than preferences of society.
3. Consumers have less sovereignty (i.e. power to determine what goods and services should
be produced).
4. Bureaucratic and slow to respond to changing needs or technology.
5. Likelihood of corruption.
6. Lack of profit motive and competition makes the economy inefficient.

State any four disadvantages of a planned economy. (04 marks)
Enumerate the main characteristics of the Market Economy and the Planned Economy. (10 marks)
LO 7: MIXED ECONOMY:
Definition of Mixed Economy:
It is an economic system in which decisions about resource-allocation are made partly Government
and partly by market-forces of demand and supply.
Role of State in a mixed economy:

Laissez-faire is a thing of the past. Although the invisible hand can bring about solutions to
economic problems, there are times when the market fails. Government tries to remedy
shortcomings of the market in following ways:
Government takes actions to improve Efficiency:

 Govt. encourages competition to avoid monopoly (e.g. by deregulation)
 Govt. intervenes in market to remove negative externalities (e.g. by antipollution laws)
 Govt. encourages beneficial activities to provide public goods (e.g. education, health, roads)
Government takes actions to promote Equity:

Govt. redistributes income to reduce unacceptable inequality of income and wealth by taxing
policies (e.g. by progressive taxes) and by spending policies (e.g. by providing subsidies or transfer
payments to poor).
Government take actions to stabilize the economy:

Capitalist economies have gone through sever contractionary and expansionary times. Inflation and
unemployment have caused problems in the economy and led to instability.
The role for government in this case is to develop policy initiatives (e.g. through fiscal and
monetary policies) that will counteract these natural tendencies and will smooth trends in business
cycle.
Regulatory roles of government in market:

Regulations establish rules which limit the ability of firms to operate in their own best interest.
 Economic regulations set price-setting, wages-setting, buffer-stock schemes and safety
standards in many industries.
 Social regulations protect public health and safety and environment
6
Advantages:
 Retains dynamism of private sector.
 Public interest guarded by legislation and state provision.
Disadvantages:
 State may regulate economy for political ends.
 Responsibility for economic performance blurred.
 Government intervention creates costs and uncertainty.

Free market economy permits private ownership and control of factors of production. However, it is argued that it often
results in exploitation of weak economic agents because of which government has to intervene to control and regulate the
economy in several ways.
In the light of above, explain the role of government in a mixed economy. (06 marks)
In view of the scarcity of means and the multiplicity of ends, the economic problem lies in making the best possible use of
resources to get maximum satisfaction. Briefly discuss how resources are allocated under different economic systems to
optimize their use. (06 marks)
With reference to the experience of Pakistan, discuss the merits and demerits of Mixed Economy.
PART C– OUTPUTS AND INPUTS OF AN ECONOMY
LO 8: TYPES OF GOODS (OUTPUTS):

Our wants are satisfied by the consumption of goods. Goods can be classified:
 From consumers’ point of view.
 From producers’ point of view
 From government’s point of view.
Goods from Consumers’ Point of View
Normal, Inferior and Superior Goods:

Inferior goods:
Inferior Goods are those whose demand decreases as income increases. These goods have negative
income elasticity of demand. Examples include Public Transport.
Normal goods:
Normal Goods are those whose demand increases as income of consumer increases. These goods
have positive income elasticity of demand. Examples include Milk.
Superior goods:
Superior Goods are those whose demand increases by larger portion as income of consumer
increases. These goods have positive income elasticity of demand which is much greater than ONE.
Examples include Luxury Car.
7
Independent and Related Goods:

Independent Goods:
Independent Goods are those goods for which price of one good does not affect demand of other
good (i.e. they have cross price elasticity of zero) e.g. Shoes and fan, Chair and watch.
Related Goods:
Related goods are those goods for which price of one good affects demand of other good. There are
two types of Related Goods i.e.
1. Substitute goods/Competitive Goods:
These are goods which serve the same purpose, and are used in place of each other.
Increase in the price of one good leads to increase in demand for the other good. e.g. Coke
and Pepsi, Pens and Pencils, Tea and Coffee, Petrol and CNG, Mutton and Chicken.
2. Complimentary/Compliment Goods:
These are goods which serve different purposes, and are used together. Increase in the price
of one good leads to decrease in demand for the other good. e.g. Tooth Brush and Tooth
Paste, Car and Petrol, Pencils and eraser, Mobile and charger, DVD Player and DVD,
Cigarette and Lighter.
Goods from Producers’ Point of View
Substitute in production and compliments in production:

Compliments in Production (also called ‘goods in joint supply’, ‘joint products’ or ‘by-products’):
One of two goods that are produced together, using the same resources. Producing more of one will
lead to producing more of other e.g. production of beef and leather (from cow).
Substitutes in production:
One of two goods that can be produced as alternative, using the same factors of production.
Producing more of one will require producing less of other e.g. production of color printer and
black printer (by same firm).
Goods from Government’s Point of View
Merit Goods, and Demerit Goods:

Merit Goods are socially desirable goods because they are beneficial for the society. They create
positive externalities. Examples include Education, Health, Parks.
Demerit Goods are socially undesirable goods because they are harmful for the society. They
create negative externalities. Examples include Cigarette, Alcohol.
Public Goods, Private Goods and Club Goods:

Public goods are those goods which can be enjoyed by anyone and from which no one can be
excluded. Two key attributes of a public good are:
 Non-rivalry (i.e. cost of extending the service to an addition person is zero), and
 Non-excludability (i.e. it is impossible to exclude individuals from enjoying it).
Examples include National Defense System, High-ways, Public Parks.
Private goods are those goods which have characteristics of excludability (i.e. it is possible to
prevent consumers who have not paid for it from having access to it) and rivalry (A good whose
consumption by one consumer prevents simultaneous consumption by other consumers).
Examples include food, clothing, and most other goods that can be purchased in a store.
8
Club Goods are excludable but non-rivalrous. Examples include private golf courses, services by
club to their members.
Free Goods and Economic Goods:

Free goods are commodities that are available without limit.
Economic goods are commodities that we value that are limited in supply.

Differentiate between substitute goods, complimentary goods and independent goods. Give two examples of each.
(06 marks)
LO 9: FACTORS OF PRODUCTION (INPUTS):

Factors of Production/Inputs:
Factors of production (also called Inputs) are resources that are used by firms in their production
process i.e. Land, Labor, Capital and Entrepreneur.
Land:
Land means natural resources on the planet. These are gifts of nature and include:
 Surface of Earth (used for farming, housing, factories, roads)
 Non-renewable resources (e.g. natural gas, oil, coal, minerals, precious metals)
 Renewable resources (wood, agricultural products, wind power, hydro-electric power)
 Environmental resources (e.g. clean air, water)
Labour:
Labor is the human time spent in production e.g. workers in the factory, teachers in the college.
Division of Labor and Specialization

The division of labor refers to dividing the process of production into number of separate tasks.
Specialization occurs when workers use specialized skills and knowledge for completing specific tasks.
Benefits of Specialization: Specialization reduces time required for production, increases efficiency
and productivity, decreases average cost and firm experiences economies of scale.
Capital:
Capital means physical man-manufactured goods which firms use as an input to produce other
goods and services. Examples include Tools, semifinished goods, Machinery, Building.
However, Capital does not include Money (i.e. cash, bank balance, shares).
Capital Formation
Capital formation means addition or increase in stock of capital goods. Process of capital formation
involves three stages i.e. Creation of savings, Mobilization of savings, and Investment of savings.
Entrepreneur (or Enterprise):

An entrepreneur organises the three other factors of production, and takes the risk of the venture.
9
Reward/ Income of Factors of Production and Their Meaning:

Rent: (income of Land)
Rent is the payment for the use of factors of production that are fixed in supply.
Wages: (income of Labor)

Wages is a sum of money paid under contract by an employer to a worker for services rendered.
Interest: (income of Capital)

Interest is the price paid for the use of capital in any market.
Profit: (income of Enterpreneus)
Profit is the reward for the entrepreneur for taking risk.
Products (or Outputs)

Outputs are goods and services that result from the production process.

Name four factors of production and their respective rewards. (8 Marks)
(Institute of Chartered Accountants in Malawi – June 2014)
What do you understand by the term ‘Factors of production’? What types of factors of production are used by a school?
(03 marks)
PART D – HOW ECONOMY CHOOSES AMONG ALTERNATIVES
LO 10: PRODUCTION POSSIBILITY FROENTIER/CURVE:

Definition:
A Production Possibility Frontier/Curve (PPF or PPC) represents combinations of two alternative
goods that an economy can produce using all of its resources efficiently.
Schedule, Diagram and Explanation:
Possibilities Missile Wheat

A 0 15
B 1 14
C 2 12
D 3 9
E 4 5
F 5 0
10
Diagram Explanation
PPF is the menu of Choices of products i.e. i.e. an
economy can choose any point on PPC to produce e.g. B or
C or D.
PPF also shows concept of Opportunity cost e.g. if option

D is selected instead of option C, opportunity cost of
producing 1 more unit (3 – 2) of Missile will be lost
production of 3 units (12 – 9) of Wheat.
PPF shows concept of Scarcity i.e. an economy cannot

produce at a point beyond PPC because it is impossible
with given resources.
PPF shows concept of Economic Efficiency. It means an

economy should produce highest combination of goods
and services i.e. at a point on frontier (where all resources
are fully employed) and not at a point inside the PPF
(because there will be productive inefficiency if all
resources are not fully utilized).
Opportunity Cost and Marginal Rate of Product Transformation

Opportunity cost of a decision is the value of best alternative (good or service) sacrificed e.g.
opportunity cost of deciding not to work is the foregone wages that could have been earned.
Opportunity Cost:
 is not measured in terms of money paid, and
 only considers best alternative, and not all alternatives.
Marginal Rate of Product Transformation is the amount of one good which must be foregone to gain
one unit of the other good.
Characteristics of PPC:
PPF has two characteristics:
1. It has downward slope (because to increase production of one good, resources will be
shifted from other good which will decrease production of other good)
2. It is concave to the origin (because some of the resources in the economy are more efficient
at producing one type of good and some are more efficient at producing the other type of
good).
Shift in PPC: (i.e. Growth in economy)

PPC can shift outwards under following conditions:
 Increase in Natural resources (e.g. Oil, Gas, Coal, Other mineral resources)
 Increase in Quantity and Quality (i.e. education, skill, discipline) of Labor
 Increase in Supply of Capital (i.e. factories, machinery, intellectual property)
 Development in Entrepreneurship and Technology (Innovation, Technological
improvement, and increased efficiency)

(a) Explain the concept of Production Possibility Curve (PPC) with the help of a diagram. (07 marks)
(b) Briefly discuss how the concept of PPC is useful in explaining the economic concept of ‘scarcity’. (03 marks)
11
(a) What do you understand by the term “Production Possibility Curve” (PPC)? Why is PPC downward sloping and
concave to the origin? (04 marks)
(b) Under what conditions would PPC shift outwards? (03 marks)
Assume there are only two (2) kinds of goods; “consumer goods” and “capital goods”. With the aid of the production
possibilities curve, explain the concepts of :
(i) Scarcity (05marks)
(ii) Choice and (05marks)
(iii) Opportunity cost (05 marks)
(Institute of Chartered Accountants of Ghana - June 2014)
With the aid of a Production Possibility Curve illustrate the concept of Economic Growth. (06 marks)
(Institute of Chartered Accountants of Ghana - June 2010)
PART E – ISLAMIC CONCEPTS OF ECONOMICS
LO 11: ISLAMIC ECONOMIC SYSTEM:

Features of Islamic Economic System:
Allah is the sustainer:
It means Allah has created all the resources and is responsible for feeding and nourishing all
creature including human being.
God is the true owner of everything:

Human beings are only trustee of resources. Their authority to use resources is limited by certain
principles.
State ownership of resources:

Islam neither proposes not prohibits establishing state owned enterprise. Therefore, a free market
can exist where entrepreneur can earn profit.
Practising of moderation:
Islam teaching middle-way and fair distribution of resources. People are taught to share wealth.
Prohibition of charging interest (Riba):

It is forbidden for the lending party to earn interest on investment. Both parties must share risk and
rewards.
Earnings from Halaal activities only:

Earnings should be made only from goods or services which are allowed in Islam.
Hoarding of wealth is discouraged:

Islam does not discourage acquisition of wealth. However, Islam discourages hoarding of wealth
and encourages utilization of resources for welfare of society.
Zakat:
Zakat is a financial tax on wealth people to help poor. It ensures equal distribution of wealth.
12
Comparison of Islamic Economic System Capitalist Economic System:
Features Capitalist Economics System Islamic Economics System

Individuals have unlimited right to own
Islamic state also has authority to nationalize
Right to private property. This may lead to wealth-
private owned resources to prevent wealth
Ownership concentration.
concentration.
Public-interest business are maintained by
Private ownership of businesses results in government or maintained under joint-
Monopoly
Monopolies, Inflation and Unemployment. ownership of government and private sector to
balance the supply and demand.
Charing Interest is abolished in Islam. Islam
Financial The interest is a source of capital formation in
encourages Saving and Investment through
assistance a capitalist society.
Partnership and profit-sharing.
In Islamic system only "HALAL" goods/services
Capitalism’s motive is only profit. are allowed to be produced and consumed.
Economic
Entrepreneurs are free to do any business to "HARAM" goods and services (like alcohol drinks,
Freedom
earn profit. drugs) are not allowed to be produced and
consumed.
Islam discourages to hoard wealth and
Capitalism leads to unequal distribution of
Distribution encourages to share wealth for welfare of society.
wealth because of concentration of wealth in
of Wealth Due to "ZAKAT" and "SADQAT" wealth
few hands.
automatically transfer from rich to poor.
Capitalism is based on belief that resources Islam is based on belief that there are more than
Relative are scarce. Therefore, a minority group with enough resources to satisfy needs of all.
Scarcity wealth hoards most of the wealth and other Everyone should be both producing and
population cannot fulfil even its basic needs. consuming to ensure access to these resources.
Role of In capitalism, there is no or minimum role of In Islamic System, state ensures that public
Government government. interest and welfare is protected in markets.
Conclusion
We conclude that Capitalists are materialistic in nature and they only look to satisfy the
material wants of the people. But Islamic economic system provides a fine blend of materialism
and spiritualism.

Briefly describe any four core features of Islamic economic system. (04 marks)
Briefly discuss the important features of ‘Islamic economic system’. (08 marks)
13
Economics – Study Notes Chapter 2 Demand, Supply and Market Equilibrium
CHAPTER TWO
DEMAND, SUPPLY
AND MARKET EQUILIBRIUM
PART A – THEORY OF DEMAND

LO 1 DEMAND AND ITS DETERMINANTS
LO 2 LAW OF DEMAND (EFFECT OF PRICE ON DEMAND)
PART B – THEORY OF SUPPLY

LO 3 SUPPLY AND ITS DETERMINANTS
LO 4 LAW OF SUPPLY (EFFECT OF PRICE ON SUPPLY)

PART C–THEORY OF MARKET EQUILIBRIUM
LO 5 MARKET EQUILIBRIUM/LAW OF PRICE
LO 6 MARKET DISEQUILIBRIUM
PART D– CHANGE IN MARKET EQUILIBRIUM

DIFFERENCE BETWEEN “MOVEMENT ALONG DEMAND CRUVE” AND “SHIFT IN
LO 7
DEMAND CURVE”
LO 8 CHANGE IN MARKET EQUILIBRIUM (EFFECT OF DEMAND/SUPPLY ON PRICE)
PART E– SPECIAL MARKETS

LO 9 MARKET FOR PERISHABLE GOODS
14
PART A – THEORY OF DEMAND
LO 1: DEMAND AND ITS DETERMINANTS:

Demand:
Demand is the quantity of a good which buyers are willing and able to buy at different price levels.
Study Tip
Demand by a single individual is called “Individual Demand”. Sum of all the individuals’ demands for a
particular good or service is called “Market Demand”.
Determinants of Demand:
Price of the product:
Price is a primary determinant of demand. If price of a product decreases, its quantity demanded
increases.
Average Income of consumers:

If income of consumer increases, demand for normal goods increases e.g. demand for automobile
increases when economy is in boom but decreases when economy is in recession.
Study Tip – Difference between Income and Wealth

Income is the money that is earned by a factor of production at any given point of time e.g. rent, wages.
Wealth is the accumulated income that has been saved and stored. It is the difference between total
assets and total liabilities e.g. house, car.
Price of Related Goods:

If price of complimentary good decreases, demand for the product increases e.g. if price of cars
decreases then demand for petrol increases.
If price of substitute good increases, demand for the product increases e.g. if price of petrol
increases then demand for CNG increases.
Size of the Market (i.e. Population):

If number of buyers in a market increases, demand for the product will also increase e.g. demand of
cars in Karachi or Lahore is much higher as compared to Larkana or Gujrat.
Expectations about Price in Future:

If increase in price of product is expected, demand for the product will increase.
Expectations about Shortage in Future:

If a shortage of product is expected in future, current demand for the product will increase.
Tastes or Preferences:
Our tastes and preferences change due to change in culture, fashion, weather or special occasions.
This will cause change in demand for a product e.g. eating beef is common in Pakistan but a taboo in
India.
Advertisement:
A successful advertisement will increase the demand.
15
Availability of credit facilities:

Availability of credit facilities increases demand.
Study Tip
Reasons for decrease in demand will be opposite to those described above. But in exam, you may
discuss movement in only one direction e.g. how determinant causes increase in demand.

Explain any four factors on account of which the demand of a product may change even when its price remains the same.
(06 marks)
LO 2: LAW OF DEMAND (EFFECT OF PRICE ON DEMAND):

Any law in economics can be presented in 3 ways i.e. Descriptive Form, Tabulation Form and
Graphical Form (i.e. picture of the law – the best way to present a law).
Description of the Law of Demand:

If price of a product increases, its quantity demanded decreases; and if price of a product decreases,
its quantity demanded increases (ceteris paribus).
Study Tips
1. “Ceteris Paribus” means assumption that other factors/determinants remaining same/equal/
constant/unchanged.
2. Increase or decrease in demand is sometimes called ‘expansion-contraction of demand’ and ‘rise-
fall of demand’
Assumptions of Law of Demand:

1. Units are homogenous.
2. Units must be consumed simultaneously.
3. Income of consumers does not change.
4. Price of Complimentary Goods does not change.
5. Price of Substitute Goods does not change.
6. Population/Number of buyers does not change.
7. Expectations about Price or Availability in Future do not change.
8. Tastes or preferences of society do not change.
9. Advertisement does not change.
10. Availability of credit facilities does not change.
Tabulation of the Law (i.e. Demand Schedule):

The demand schedule shows how much of a good consumers are willing and able to purchase at
different prices.
Price Quantity Demanded
1 5
2 4
3 3
4 2
5 1
16
Graphical presentation of the Law i.e. Demand Curve:
Diagram Explanation
1. At Y-axis, we show Price and at X-axis we show

Quantity Demanded.
2. The line D is called Demand Curve. Demand curve
is a graph that shows how much quantity of a
good is demanded by consumers at different
prices.
3. Demand Curve is downward slope showing
inverse relationship between price and quantity
demanded because of Law of Diminishing
marginal utility, Substitution Effect and Income
Effect.
Study Tips
No number/figures are required to be specified alongwith axes of any diagram in economics.
Why Slope of Demand Curve is Negative:

Due to Law of Diminishing Marginal utility:
This law states that extra consumption of goods brings in less satisfaction, and consumers do not
buy more unless price is reduced to match their satisfaction.
Due to Income Effect and Substitution Effect:

1. Real Income Effect:
As price decreases, existing consumers buy more because their purchasing power/real
income increases.
2. Substitution Effect:
As price decreases, consumers will shift to lower priced goods to satisfy their needs leaving
higher priced goods.
Practical Importance of the Law of Demand:

1. Law of demand contributes to the determination of price of a certain commodity.
2. Producer can see the effect on demand due to increase or decrease in price and can take
decisions accordingly
3. Demand schedule helps the entities plan for future by analyzing the impact of change in
prices on the quantity demanded
4. It also helps state in raising taxes e.g. if increase in tax decreases demand, it is not wise to
increase tax as overall amount will decrease.
Limitations of the Law of Demand:

There are certain cases wherein the law of demand does not apply i.e., the demand does not rise
when the prices fall and vice versa. These exceptions or limitations are as under:
1. Change in trends
2. Change in income
3. Shortage of goods
4. Expectation in price change
5. Basic necessities of life
17
Exception of the Law of Demand:

Giffin goods:
A Giffen Good is a type of inferior goods whose demand increases if its price increases e.g. Potato,
Pulse.
Study Tips
Often we observe if price of houses rise, demand for houses still goes up. It does not mean that houses
are giffen goods, rather, reasons are:
1. Houses are not homogenous produces. Their prices differ because they differ in design,
construction material and location etc.
2. Non-price determinants also affect demand e.g. population, availability of borrowing.

According to the law of demand, when price of a commodity increases, its demand falls. The law holds good under certain
assumptions. Briefly describe these assumptions and the limitations of the law. (06 marks)
What is the usual shape of Demand Curve, and Why?
What is the relation of law of demand to the principle of diminishing utility?
PART B – THEORY OF SUPPLY
LO 3: SUPPLY AND ITS DETERMINANTS:

Supply:
Supply is the quantity of a good which sellers are willing and able to sell at different price levels.
Study Tip – Difference between Stock and Supply

Stock is the quantity of goods available to firm. Firm may not supply all of its stock to market.
Supply is the quantity which firms are willing and able to supply at the prevailing market price.
Determinants of Supply:
Price of the product:
Price has positive effect on supply i.e.
 if price of a product increases, its quantity supplied increases.
 if price of a product decreases, its quantity supplied decreases.
Study Tip – Reserve Price

Reserve Price (or Reservation Price) is the minimum price a firm is willing to receive for its good. It
indicates the price level below which it is not profitable for a firm to supply to the market.
Following factors affect level of reservation price:

1. Cost of production
2. Disposable income of the buyers:
3. Availability of substitute goods
4. Nature of objectives of firms or marketing strategies of firms
18
Cost of Inputs (or Factors of Production)

If cost of inputs for a production (e.g. land, labor, capital) increases, supply of the product will
decrease e.g. when oil prices or interest rates increase, supply decreases.
Availability, Quality and Mobility of Factors of Production

Availability of factors of production (e.g. discovery of natural resources) increases supply.
Good quality of factors of production also increases supply. Further, mobility of factors of
production (e.g. from one sector to another) increases supply.
Technology
Advancements in technology increases efficiency and productivity in production and increases
supply.
Indirect taxes and Subsidies on Product

 Indirect tax on product by government decreases supply.
 Subsidy on product by government increases supply.
Environmental conditions
Unfavorable conditions adversely affect supply, particularly for agricultural products. These
conditions may be:
 Bad weather.
 Diseases in livestock and corps
 Natural disasters and wars
Price of substitutes in production

A rise in the price of a substitute in production will cause a decrease in supply for the good under
examination.
Price of complements in production

A rise in the price of a complement in production will lead to an increase in supply of the good
under examination.
Number of sellers in the market

If number of sellers in a market increases, supply for a product will also increase.
Expectations about Price in Future

If increase in price is expected, supply of the product will decrease.
Expectations about Demand in Future

If increase demand is expected, supply of the product will decrease.
Study Tip – Relationship between Time and Supply

Time is a significant consideration in determining supply. If factors affecting demand and supply cause
short-run increase in equilibrium quantity (e.g. demand for umbrella in unexpected rainy season), then
suppliers increase their production using existing resources. However, if increase is permanent (e.g.
change in climate throughout the year), suppliers will increase their capacity by opening new factories.
19

Briefly explain any five factors that are responsible for ‘Change in Supply’. (05 marks)
What do you understand by ‘Reservation price’? Briefly describe three factors which may affect the reservation price.
(05 marks)
LO 4: LAW OF SUPPLY (EFFECT OF PRICE ON SUPPLY):

Description of the Law of Supply:
If price of a product increases, its quantity supplied increases; and if price of a product decreases,
its quantity supplied decreases, ceteris paribus.
Tabulation of the Law (i.e. Supply Schedule):
Price Quantity Supplied

1 1
2 2
3 3
4 4
5 5
The supply schedule shows how much of a good sellers are willing and able to sell at different
prices.
Graphical presentation of the law (i.e. Supply Curve):
Diagram Explanation
1. At Y-axis, we show Price and at X-axis we

show Quantity Supplied.
2. The line S is called Supply Curve. Supply
curve is a graph that shows how much
quantity of a good is supplied by producers at
different prices.
3. Supply Curve has upward slope showing
positive relationship between price and
quantity supplied because of law of
diminishing returns. This law states that
extra production of goods brings in (after
certain point) less efficient, higher-cost
factors of production, and producers do not
supply more unless price is increased to
match their high cost.
Assumptions of Law of Supply:

1. Cost of factors of production remains same.
2. Availability of factors of production remains same.
3. Technology remains same.
4. Indirect taxes and Subsidies on Product remain same.
5. Environmental conditions remains same.
6. Price of substitutes in production and complements in production remains same.
20
7. Number of sellers in the market remains same.

8. Expectations about Price or Demand in Future remains same.
9. There is no discovery and depletion of natural resources.
Practical Importance of Law of Supply:

1. Determines equilibrium price of product.
2. Entities need to keep an eye on the demand and supply relationship in order to find out as
to which products to focus on.

Enumerate the law of supply with a numerical example and graphical presentation. (14 marks)
(ICMA PAKISTAN, FUNDAMENTAL LEVEL F2 – Spring 2012)
PART C – THEORY OF MARKET EQUILIBRIUM
LO 5: MARKET EQUILIBRIUM/LAW OF PRICE:

Law of Price/Market Equilibrium
In a free market, only that price prevails at which demand and supply are equal.
Tabulation of the Law:
Price Quantity Demanded Quantity Supplied

1 5 1
2 4 2
3 3 3
4 2 4
5 1 5
Graphical presentation of the law:
Diagram Explanation
1. At Y-axis, we show Price and at X-axis we

show Quantity Demanded.
2. The line D is called Demand Curve which is
downward. The line S is called Supply Curve
which is upward.
3. Point at which demand equals supply is called
Equilibrium Point.
4. Price at which demand equals supply is called
Equilibrium Price/Market Clearing Price.
5. Quantity at which demand equals supply is
called Equilibrium Quantity.
21
Study Tip – Equilibrium Price and Regulated Price

Equilibrium/Market Price:
Market Price is the price determined by market forces of demand i.e. price where demand is equal to supply.
Regulated Price:
Regulated Price is the price fixed by government. Government can set a minimum price (called floor) or a
maximum price (called ceiling/cap) for a product.

How do free forces of demand and supply determine equilibrium price and equilibrium quantity? Support your answer
with the help of a diagram. (07 marks)
LO 6: MARKET DISEQUILIBRIUM:
What is a market disequilibrium:
Market is in disequilibrium if price in market is above or below the equilibrium price. If a market is
in disequilibrium, there will be either shortage or surplus.
1. Shortage is the excess of demand over supply which arises when price in market is below
equilibrium price.
2. Surplus is the excess of supply over demand which arises when price in market is above
equilibrium price.
Graphical presentation of market disequilibrium:
How market reaches to equilibrium:

If price in market is below equilibrium price, there will be shortage of inventory (i.e. quantity
demanded exceeds the quantity supplied). Due to shortage of inventories, price rises. The higher
price encourages producers to increase quantity supplied (by increasing their production) and
forces consumers to decrease quantity demand (by substituting other goods for this product).
Study Tip
If prices are above equilibrium (i.e. Surplus), opposite happens in reaching equilibrium.
22

When the price is not at the equilibrium point there is a state of disequilibrium in the market. Explain with the help of a
diagram, disequilibrium which may exist when the quantity demanded is not equal to the quantity supplied. State how
forces of demand and supply may push prices from disequilibrium to equilibrium. (06 marks)
PART D – CHANGE IN MARKET EQUILIBRIUM
LO 7: DIFFERENCE BETWEEN “MOVEMENT ALONG DEMAND CRUVE” AND “SHIFT IN DEMAND

CURVE”:
Movement along demand curve (also called change in ‘quantity demanded’):
1. Movement along demand curve is caused by change in own price of the product.
2. It means movement from one point to another point on the same demand curve.
Shift in demand curve (also called ‘change in demand’):

1. Shift in demand curve is caused by change in non-price determinants of demand (also called
conditions of demand).
2. It means shift of entire demand curve i.e. a new demand curve is created.
Study Tips
Same concept applies to Supply i.e. difference between “change in quantity supplied” and “change in
supply”.

What do you understand by ‘Change in Quantity Supplied’ and ‘Change in Supply’? (02 marks)
23
LO 8: CHANGE IN MARKET EQUILIBRIUM (EFFECT OF DEMAND/SUPPLY ON PRICE)

Reason of change in market equilibrium:
Equilibrium point changes when there is a change in non-price determinants of demand or supply
(i.e. there is shift in demand curve or supply curve).
Effect of change in market equilibrium:
Change in market equilibrium affects equilibrium Price and equilibrium Quantity.
Effect on
Situation Graphical Presentation
Equilibrium
Rightward shift in
Demand Curve:
Quantity  Up
(due to change in any of
Price  Up
non-price
determinants)
Leftward shift in
Demand Curve:
Quantity  Down
Price  Down
non-price
determinants)
Rightward shift in
Supply Curve:
Quantity  Up
Price  Down
non-price
determinants)
Leftward shift in
Supply Curve:
Quantity  Down
Price  Up
non-price
determinants)
24
Study Tip
In exam question, whenever you face a demand and supply problem, always draw a diagram on paper (if it
is a theory based question) or in your mind (if it is MCQ type question).

Illustrate with the help of a diagram, how new equilibrium market price of a good is achieved when price of substitute
good increases. (06 marks)
Show how the equilibrium price of a commodity changes (i) when its demand increased (ii) when its demand falls (iii)
when its supply increases (iv) when its supply falls. (04 marks)
(ICMA PAKISTAN, FUNDAMENTAL LEVEL F2 – Fall 2011)
Below is the list of factors which may affect market equilibrium. Fill the table showing appropriate effect of the factor on
market.
Affects demand Shifts left or Price increase or Quantity increase or
Factor
or supply? right? decrease? decrease?
Decrease in no. of consumers
Cost of production decreases
Tariffs are imposed
Average income of consumers increases
Technology improves
Product becomes popular
PART E – SPECIAL MARKETS
LO 9: MARKET FOR PERISHABLE GOODS:

Perishable goods:
Perishable goods are those goods whose value will decrease significantly by the passage of time e.g.
foodstuffs.
Effect of Perishability of good on its supply:

The supply of perishable goods is considered relatively inelastic because suppliers cannot control
its supply by storing it or producing it in short-run. Therefore, supply curve will eventually become
perfectly inelastic. At this stage the whole price mechanism is dependent on movements in the
demand curve.
25
Economics – Study Notes Chapter 3 Elasticity of Demand and Supply
CHAPTER THREE
ELASTICITY OF DEMAND AND SUPPLY
PART A – ELASTICITY OF DEMAND

LO 1 DEFINITION AND CLACULATION OF ELASTICITY OF DEMAND
LO 2 TYPES OF ELASTICITY OF DEMAND
LO 3 DETERMINANTS/FACTORS AFFECTING ELASTICITY OF DEMAND
LO 4 OTHER VARIANTS OF ELASTICITY OF DEMAND
LO 5 INTERPRETATION OF ELASTICITY – SIGN AND NUMBER
LO 6 PRACTICAL SIGNIFICANCE OF ELASTICITY OF DEMAND
PART B – ELASTICITY OF SUPPLY

LO 7 DEFINITION AND CALCULATION OF ELASTICITY OF SUPPLY
LO 8 TYPES OF ELASTICITY OF SUPPLY
LO 9 DETERMINANTS/FACTORS AFFECTING ELASTICITY OF SUPPLY
PART C – PRICE INSTABILITY IN CERTAIN MARKETS

LO 1 0 REASONS FOR PRICE INSTABILITY AND GOVERNMENT’S POLICIES
LO 1 1 COBWEB THEORY TO CYCLIC FLUCTUATION IN PRICES
26
PART A – ELASTICITY OF DEMAND
LO 1: DEFINITION AND CLACULATION OF ELASTICITY OF DEMAND:

Definition of Price Elasticity of Demand: (or Price Elasticity)
Price Elasticity of Demand is the percentage change in quantity demanded divided by the
percentage change in price.
Ed = Percentage change in Demand / Percentage change in Price
Calculating Elasticity using Percentage Method:

There are two approaches to calculate elasticity of demand using percentage method i.e.
1. Point Elasticity (preferred method), and
2. Arc Elasticity.
Both use same formula to calculate elasticity. The only difference is that:
1. In Point elasticity, single point value is used as base to calculate percentage change.
2. In Arc elasticity, average of both points is used as base to calculate percentage change.
Calculation of Elasticity – An Example

Compute the price elasticity of a product if a decline in the price of the product from Rs. 12 per unit to
Rs. 11 per unit increases its demand from 48,000 units to 60,000 units. (04 marks)
Price Demand
12 48,000
11 60,000
Change –1 +12,000
(i) Elasticity of Demand using Point Method:

Percentage change in demand = +12,000/48,000 * 100 = 25%
Percentage change in price = –1/12*100 = –8.33%
Ed =25% / –8.33% = –3.00
(ii) Elasticity of Demand using Arc Method:

Percentage change in demand = +12,000/54,000 * 100 (where 54,000 = 48,000+60,000/2) = 22.22%
Percentage change in price = –1/11.5 * 100 (where 11.5 = 12+11/2) = –8.70%
Ed =22.22% / –8.70% = –2.55
(Exam Tip: If no method is specified in question, you can use Point Method)
Study Tip
Note that the numerator and the denominator both contain percentage changes in quantities and prices
rather than absolute changes in quantities and prices.

The price of a component is Rs.1.50 per unit and its annual demand is 900,000 units. An increase in price of 20 Paisa per
unit will result in a fall of annual demand for the component by 15,000 units. Calculate the elasticity of demand at the
current price of Rs.1.50 units. (04 marks)
(ICMA Pakistan, Fundamental Level F2 – Fall 2012)
Check Figure: Ed = –0.125
27
LO 2: TYPES OF ELASTICITY OF DEMAND:

Definitions of Types of Elasticity of Demand:
Perfectly Inelastic:
If demand remains fixed and does not change with change in price, it is called Perfectly inelastic
demand i.e. Ed = 0
Inelastic or Relatively Inelastic or Highly Inelastic:

If percentage change in demand is less than percentage change in price, it is called Inelastic demand
i.e. Ed < 1.
Unit Elastic:
If percentage change in demand is equal to percentage change in price, it is called Unit elastic
demand i.e. Ed = 1.
Elastic or Relatively Elastic or Highly Elastic:

If percentage change in demand is greater than percentage change in price, it is called elastic
demand i.e. Ed > 1.
Perfectly Elastic:
If extremely small change in price causes extremely large change in demand, it is called Perfectly
elastic demand i.e. Ed = ∞
Study Tip
Beware of difference between Inelastic demand and Perfectly Inelastic demand (and similarly between
Elastic demand and Perfectly Elastic demand).
Diagrams of Types of Elasticity of Demand:
28
Study Tip – Calculating Elasticity using Geometric Method

The elasticity of demand is not constant as you move down a linear demand curve. Demand is elastic at
upper-half, unit elastic at mid-point, and inelastic at lower-half i.e.
Ed = lower segment of demand curve / upper segment of demand curve

Briefly describe when Demand for a product is considered to be:
 Highly Elastic
 Unit Elastic
 Relatively Inelastic (03 marks)
Explain briefly by means of diagrams, the concepts of Unitary Elastic Demand, Relatively Elastic Demand, and Relatively
Inelastic Demand. Also, state the impact of a decrease in price on total expenditure in each of the different types of
elasticities of demand. (12 marks)
LO 3: DETERMINANTS/FACTORS AFFECTING ELASTICITY OF DEMAND:

Availability of substitutes:
Demand will be elastic if more substitutes are available.
(because if price increases, people will switch to other lower-priced substitutes.)
Degree of Necessity:
 Demand will be elastic for Luxury goods e.g. Cars or Jewellery
 Demand will be inelastic for Necessity goods e.g. Food or medicines)
(because if price increases, people can live without luxuries but cannot live without necessities)
Scope of definition of a good/market:

 Demand will be elastic if good is narrowly defined (e.g. Rice or Wheat).
 Demand will be inelastic if good is broadly defined (e.g. Food).
(Because for broad category, there will be lesser substitutes)
Brand loyalty:
Demand will be inelastic if there is strong brand loyalty.
(Because people stick to brands.)
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Time Period:
 Demand will be elastic in long run.
 Demand will be inelastic in short run.
(because as time passes, people find substitutes or may change habits)
Portion of budget used on item:

 Demand will be elastic if higher percentage is spent on good e.g. vehicle.
 Demand will be inelastic if lower percentage is spent on good e.g. salt.
(because people will respond less if budget is affected less)
Degree of addiction:
Demand will be inelastic if there is addiction of the good e.g. cigarette/tea.
(Because people will not quit their established habit as long as they can afford.)

(a) Define Price Elasticity of Demand. Identify and briefly explain the factors which determine the Price Elasticity of
Demand. (06 marks)
(b) Compute the price elasticity of a product if an increase in the price of the product from Rs. 10 per unit to Rs. 11 per
unit causes a decrease in its demand from 2.5 million units to 1.9 million units. (03 marks)
LO 4: OTHER VARIANTS OF ELASTICITY OF DEMAND:

Elasticity of demand calculated and discussed above is called Elasticity of Demand (or Ed)Price
Elasticity of Demand (PED). There are two other variances of demand based on non-price
determinants i.e. based on Income and based on Price of related goods.
Income Elasticity of Demand (YED):

Income Elasticity of Demand is a measure of how much demand of a product changes as a result of
change in income of consumer i.e.
YED = Percentage change in Demand / Percentage change in Income of consumer
Cross Elasticity of Demand (XED):

Cross Elasticity of Demand is a measure of how much demand of a product changes as a result of
change in price of the related good i.e.
XED = Percentage change in Demand / Percentage change in Price of related good

Briefly explain the following:
(i) Income elasticity of demand
(ii) Cross price elasticity of demand (10 marks)
(i) The quantity demanded for Alpha decreases from 300 units to 250 units, when the price of Beta increases from Rs. 50
to Rs. 55.
(ii) The quantity demanded for Gamma increases from 400 units to 450 units, when the price of Delta increases from Rs.
100 to Rs. 125.
For each of the above cases, you are required to:
 determine the Cross Price Elasticity of Demand (XED) and
 on the basis of XED determined above, comment on whether the goods are substitutes or complements. (08 marks)
Check Figure: XED (Alpha & Beta) = –1.67, XED (Gamma & Delta) = +0.5
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LO 5: INTERPRETATION OF ELASTICITY – SIGN AND NUMBER:

Interpretation of Number:
1. If number is 0, demand is “perfectly inelastic”.
2. If number is less than 1, demand is “inelastic or relatively inelastic”
3. If number is 1, demand is “unitary elastic”
4. If number is more than 1, demand is “elastic or relatively elastic”
5. If number is ∞, demand is “perfectly elastic”.
Interpretation of Sign:
In Price Elasticity of Demand:
 If sign is “–”, it is a normal good.
 If sign is “+”, it is an giffen good.
In Income Elasticity of Demand:

 If sign is “–”, it is inferior good.
 If sign is “+”, it is a normal good. (If number is between 0 to 1, it means good is necessity. If
number is greater than 1, it means good is luxury.)
In Cross Elasticity of Demand:

 If sign is “–”,it is complimentary good.
 If sign is “+”, it is substitute good. (if number is 0, it means goods are unrelated/
independent)
Study Tip
In Interpretation of elasticity, sign and number both are to be interpreted separately.

Product Zeta currently sells for Rs.10 per unit and the demand at this price is 22,000,000 units. If the price fell to Rs.8 per
unit, demand would increase to 27,000,000 units. Compute price elasticity of demand and interpret your result.
(05 marks)
LO 6: PRACTICAL SIGNIFICANCE OF ELASTICITY OF DEMAND:

For Firm:
In pricing decision (i.e. through study of relationship between Price and Total Revenue):
Elasticity affects total revenue in following ways:
1. If demand is inelastic, an increase in price will increase total revenue (and decrease in price
will decrease total revenue).
2. If demand is elastic, an increase in price will decrease total revenue (and decrease in price
will increase total revenue).
3. If demand is unit-elastic, increase or decrease in price will not affect total revenue.
Study Tip – Calculating Elasticity using Total Expenditure Method

Inverse rule can be applied to identify elasticity of demand from total expenditure/revenue/outlay i.e.
1. If total revenue increase with increase in price, demand is inelastic.
2. If total revenue decreases with increase in price, demand is elastic.
3. If total revenue does not change with increase/decrease in price, demand is unit-elastic.
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In Price Discrimination by Monopolist:

If different consumers have different elasticity, higher price can be charged to consumers with
inelastic demand.
In Shifting of Tax Burden:

If demand is inelastic the larger part of the indirect tax can be shifted upon buyers by increasing
price. If the demand is elastic than the burden of tax will be more on the producer.
For Government:
In Tax Decisions:
If demand of a product is inelastic, an increase in indirect-tax rate will increase total revenue of
government without losing business e.g. on cigarette.
In International Trade:
If demand of an export-product is inelastic, an increase in price will improve “Balance of Payment”
of country.

Explain how knowledge of price elasticity of demand would be relevant to:
(i) a firm seeking to practise price discrimination; (07 marks)
(ii) a government seeking to introduce taxes on goods and services. (06 marks)
(ACCA UK- June 1999)
PART B – ELASTICITY OF SUPPLY
LO 7: DEFINITION AND CALCULATION OF ELASTICITY OF SUPPLY:

Elasticity of Supply is a measure of how much supply of a product changes as a result of change in
price of the product i.e.
Es = Percentage change in Supply / Percentage change in Price
LO 8: TYPES OF ELASTICITY OF SUPPLY:

Types of Elasticity of Supply:
There are five types of elasticity of supply:
Perfectly Inelastic:
If supply remains fixed and does not change with change in price, it is called Perfectly inelastic
supply i.e. Es = 0
Inelastic or Relatively Inelastic:

If percentage change in supply is less than percentage change in price, it is called Inelastic supply
i.e. Es < 1.
Unit Elastic:
If percentage change in supply is equal to percentage change in price, it is called Unit elastic supply
i.e. Es = 1.
Elastic or Relatively Elastic:

If percentage change in supply is greater than percentage change in price, it is called elastic supply
i.e. Es > 1.
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Perfectly Elastic:
If extremely small change in price causes extremely large change in supply, it is called Perfectly
elastic supply i.e. Es = ∞
Diagrams of Types of Elasticity of Supply:

State the meaning of ‘price elasticity of supply’. Briefly discuss different types of elasticity of supply. (05 marks)
LO 9: DETERMINANTS/FACTORS AFFECTING ELASTICITY OF SUPPLY:

Time period to respond:
 Supply is inelastic in short run.
 Supply is elastic in long run.
(because firm can increase its production and capacity in the long run by installing new machinery
or new factory)
Possibility to store stock:

 Supply is inelastic for perishable goods.
 Supply is elastic for durable goods.
( because of perishable goods is fixed and they cannot be stored)
Availability/Mobility of factors of production:

Supply will be elastic if there is availability and mobility of factors of production.
(because supply can be increased or decreased when desired).
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Spare Capacity:
 Supply will be elastic if there is Spare Capacity.
 Supply will be inelastic if there is no spare capacity.
(because firm can increase supply if it has spare capacity.)
Production Time:
 Supply will be inelastic if good can be produced in long time (e.g. agricultural products)
 Supply will be elastic if good can be produced in short time e.g. industrial products.
Barriers to Entry:
Supply will be inelastic if there are high barriers to entry in market.
(because new firm cannot enter market to increase supply)

Define the concept of ‘Price elasticity of supply’ and how it may be calculated. Identify the factors which would increase
the price elasticity of supply. (05 marks)
PART C – PRICE INSTABILITY IN CERTAIN MARKETS
LO 10: REASONS FOR PRICE INSTABILITY AND GOVERNMENT’S POLICIES:

In certain market prices remain stable, whereas in others, prices change drastically.
Reasons for Instability in price:

 Weather conditions (good or bad) can dramatically affect the size of market.
 Inelastic demand and supply of products. The more elasticity that exists in both supply and
demand, the more price stability exists in the market.
 Periodic fluctuations in market where the amount produced must be chosen before prices
are observed (specially in agricultural markets since there is a lag between planting
and harvesting)
Government’s Policies to increase Stability:

Govt.’s Policies:
 Direct payments or providing subsidies to producers for producing particular crops
 Buffer stock scheme (purchasing and storage of surplus stock by government and selling at
time of shortage to stabilize prices in the market)
Disadvantages of government’s policies to intervene market:

1. It is extremely difficult to decide the price at which the market should be stabilised
2. Government needs public fund to purchase stock.
3. Purchase of surplus stock by government at higher price may encourage overproduction,
which may have to be dumped in world market.
4. There are lot of administrative efforts, storage cost with maintaining buffer stock.
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LO 11: COBWEB THEORY TO CYCLIC FLUCTUATION IN PRICES:

Theory:
The cobweb model or cobweb theory explains periodic fluctuations in certain markets where the
amount produced must be chosen before prices are observed. This cyclic fluctuation can be
observes specially in agricultural markets since there is a lag between planting and harvesting.
Diagram and Explanation:

Diagram Explanation
First time period:
In the first period, assume market is operating at a price
higher than equilibrium price i.e. at P1 producing Q1.
Second time period:

Higher price leads producers to increase their supply to Q2
in 2nd time period. When this increased supply reaches
market, producers will be disappointed to see that price
has fallen to P2 (due to rightward shift of supply curve).
Third time period:

Lower price leads producers to decrease their supply to Q3
in 3rd time period. When this decreased supply reaches
market, producers will be delighted to see that price has
risen to P3 (due to leftward shift of supply curve).
It is easy to see what will happen in subsequent time

periods: price and quantity will continue to oscillate until
market reaches clearing price.
Critique of Cobweb Theory:

After a few rounds, producers would learn that it is not a best strategy to base production decision
on last period’s prices.
35
Economics – Study Notes Chapter 4 Consumer Equilibrium
CHAPTER FOUR
CONSUMER EQUILIBRIUM
LO 1 INTRODUCTION TO THEORY OF CONSUMER EQUILIBRIUM

PART A – CONSUMER EQUILIBRIUM THROUGH UTILITY APPROACH
LO 2 UTILITY AND ITS PROPERTIES
LO 3 LAW OF DIMINISHING MARGINAL UTILITY
LO 4 LAW OF EQUI-MARGINAL UTILITY (CONSUMER EQUILIBRIUM)

PART B – CONSUMER EQUILIBRIUM THROUGH INDIFFERENCE CURVE
APPROACH
LO 5 INDIFFERENCE CURVE AND ITS PROPERTIES
LO 6 BUDGET LINE / PRICE LINE / BUDGET CONSTRAINTS
LO 7 CONSUMER EQUILIBRIUM UNDER INDIFFERENCE CURVE APPROACH
LO 8 CHANGE IN CONSUMER EQUILIBRIUM – INCOME EFFECT
LO 9 CHANGE IN CONSUMER EQUILIBRIUM – PRICE EFFECT
LO 1 0 CHANGE IN CONSUMER EQUILIBRIUM – EXTENDED ANALYSIS OF PRICE EFFECT
36
LO 1: INTRODUCTION TO THEORY OF CONSUMER EQUILIBRIUM:

Consumer equilibrium means the point at which consumer gets maximum possible
utility/satisfaction by allocating all of his limited income to multiple goods.
There are two approaches to find out consumer equilibrium:

1. Marshallian Utility Approach
2. Hicksian Indifference Curve Approach

When is a consumer in an Equilibrium position? (02 marks)
PART A – CONSUMER EQUILIBRIUM THROUGH UTILITY APPROACH
LO 2: UTILITY AND ITS PROPERTIES:

Utility:
Utility means the amount of satisfaction/pleasure/benefit which a person gets from consumption of
a good or service.
Properties of Utilities:
1. Utility can be measured Cardinally.
Utility can be measured quantitatively (like any other physical commodity) by assigning a numeric
value to it e.g. 10, 20.
Ordinal Measurement of Utility (Opposite viewpoint to Cardinal Measurement)

Ordinal measurement of utility means utility cannot be measured using numeric values. Consumer can
only give ranking/preference to different commodities on the basis of satisfaction received from each
commodity e.g. 1st, 2nd, 3rd.
2. Marginal Utility of every additional unit decreases.

This property is called Law of Diminishing Marginal Utility which states that Marginal Utility of a
good decreases with every successive unit consumed

Distinguish between cardinal and ordinal approaches in utility analysis. (05 marks)
(ICMA Pakistan, Fundamental Level F2 – Fall New Questions 2011)
LO 3: LAW OF DIMINISHING MARGINAL UTILITY:

Law of Diminishing Marginal Utility:
Marginal Utility (i.e. additional utility from consumption of an additional unit) of a good decreases
with every successive unit consumed, other things remaining the same.
Assumptions of the Law of Diminishing Marginal Utility:

1. Cardinal measurement of utility is possible.
2. Income of consumer is fixed.
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3. Consumer has single want.

4. Consumer is rational and wants maximum satisfaction.
5. Consumer has perfect knowledge of utilities derived from goods.
6. All units should be homogenous.
7. Size of all units should be standardized.
8. Consumption must be continuous without time-breaks.
9. Taste/Fashion should remain same during consumption.
Table/Schedule:
Units Total Utility Marginal Utility

1 4 4
2 7 3
3 9 2
4 10 1
5 10 0
6 9 -1
Consumer Surplus
Consumer surplus is the difference between what people would are willing to pay for a given product, and
what they actually pay in the market
Total Utility (T.U.):

Total utility (TU) is the aggregate utility derived by a consumer after consuming all the available
units of a commodity.
Marginal Utility (M.U.):

Marginal Utility is the additional utility (i.e. satisfaction) from consumption of an additional unit of a
commodity i.e.
Marginal Utility = Change in Total Utility / Change in Number of Units
Diagram:
Diagram Explanation
1. In this diagram, Units of good are shown on X-
axis, and Marginal Utility and Total Utility are
shown on Y-axis.
2. M.U. curve moves downward because marginal
utility decreases with every successive unit. At
unit 5, marginal utility becomes zero and
thereafter it becomes negative.
3. T.U. curve moves upward at start. At unit 5,
total utility is at maximum level. Thereafter it
moves downward.
4. Relationship between M.U. and T.U. can also be
explained from the diagram i.e.
a. when M.U. is positive, T.U. increases.
b. when M.U. is zero, T.U. is maximum.
c. when M.U. is negative, T.U. decreases.
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Exceptions of the Law of Diminishing Marginal Utility:

1. Wealth
2. Knowledge
3. Hobbies (e.g. collecting antiques/rare items etc.)
Practical Importance of the Law of Diminishing Marginal Utility:

1. Law of diminishing marginal utility forms the basis of many other laws like law of
substitution, law of demand, concept of consumer surplus etc.
2. This law helps the state in formulating the fiscal policy by way of imposing higher taxes on
rich people and lower on poor, which in turn helps in reducing unequal distribution of
wealth.
3. The law also helps in the price determination as basically the price of a commodity depends
upon the utility derived from it.
4. By consuming one additional item of a product the utility decreases. Due to this behavior
the buyer cuts the expenditure on that specific commodity accordingly.

Describe the Law of ‘Diminishing marginal utility’. Support your answer with the help of a schedule and a diagram.
(07 marks)
Describe the limitations of the Law of Diminishing Marginal Utility. (05 marks)
Define the term utility. What is the difference between total utility and marginal utility? Explain the law of diminishing
marginal utility giving a numeric example. (10 marks)
(ICMA Pakistan, Fundamental Level F2 – Summer 2011)
Marginal utility means the additional utility a consumer gets from consumption of an additional unit of a commodity. How
does the concept apply to;
(i) Normal goods
(ii) Money (04 marks)
LO 4: LAW OF EQUI-MARGINAL UTILITY (CONSUMER EQUILIBRIUM):

Law of Equi-Marginal Utility:
A consumer gets maximum utility when he spends all of his income on multiple commodities in
such a way that the marginal utility of last rupee spent on each commodity is equal i.e.
MUA/PA = MUB/PB = ………….
Assumptions:
1. Cardinal measurement of utility is possible.
2. Income of consumer is fixed.
3. Consumer has many wants.
4. Wants and Goods can be substituted and are divisible.
5. Consumer is rational and wants maximum satisfaction.
6. Consumer has perfect knowledge of utilities derived from goods.
7. Law of diminishing marginal utility also operates.
39
Table:
Suppose consumer has five Rupees that he wants to spend on apples and bananas.
Money MU of MU of
(Units) Apples Bananas
1 4 3
2 3 2
3 2 1
4 1 0
5 0 -1
Graph:
Limitations of Law of Equi-marginal utility:

Indivisibility of Goods:
Sometimes goods cannot be sub-divided e.g. cars cannot be divided into small parts like juices.
Therefore, optimum point of utility cannot be achieved.
Consumer Ignorance:
Customer may not have perfect knowledge of availability of all goods and their utilities.
Consumers do not make conscious calculation:

Consumers often don’t think about utility in terms of numeric values.
Custom and Fashion:

Sometimes consumers buy on the basis of habits, customs and fashions, and NOT on the basis of
utility.
Other assumptions of the law:

Other assumptions of the law may also not be true in practice e.g.
 Utility cannot be cardinally measured.
 Marginal utility of durable goods are difficult to compare with marginal utility of
perishable goods.
40
Practical Importance of the Law of Equi-Marginal Utility:

This law provides solution to basic Economic Problem i.e. how to manage scarce (limited)
resource against unlimited wants e.g.:
Application in Consumption:
It guides consumers that to get maximum satisfaction, they must buy goods of greater marginal
utility and must quit goods of lower marginal utility.
Application in Production:
It guides producers to use those factors of production which have high marginal productivity and
should quit factors of production with lower marginal productivity.
Application in Exchange:
It helps buyers and sellers to decide ratio of exchange i.e. the ratio at which marginal utility of
both goods is same.

State and explain the law of Equi-Marginal Utility with the help of a diagram, assuming there are only two commodities i.e.
A and B and the consumer has limited income at his disposal. (08 marks)
Discuss practical importance of law of equi-marginal utility. (07 marks)

41
PART B – CONSUMER EQUILIBRIUM THROUGH INDIFFERENCE CURVE

APPROACH
LO 5: INDIFFERENCE CURVE AND ITS PROPERTIES:

Indifference Curve:
Definition:
Indifference Curve represents various combinations of two goods, where each combination
provides same level of utility/satisfaction i.e. consumer is indifferent among each combination.
Example:
Suppose that a consumer has following combinations of two goods (Apple and Banana) and each
combination gives consumer same satisfaction:
Combination Units of Food Units of Cloth Level of Satisfaction MRS

A 2 10 Same -
B 5 5 Same 5:3 or 1.67: 1
C 10 2 Same 3:5 or 0.60: 1
Marginal Rate of Substitution (MRS):

Marginal rate of substitution (also called slope of the indifference curve) is the rate at which a
consumer is willing to trade or substitute one good for other to maintain the same level of
satisfaction. i.e.
MRS (also the Slope of IC) = change in Units of B/change in Units of A
Indifference Map
Indifference maps are sets of indifference curves, each representing a different level of utility
42
Properties of Indifference Curve:

1. Indifference Curve never touches X-axis or Y-axis:
Because Indifference Curve represents combination of two goods and if it touches any axis, quantity
of one good will become zero.
2. Higher Indifference Curve represents higher satisfaction:

Higher indifference curve (further from the origin) gives higher satisfaction because they may contain more of
both goods, which means more satisfaction.
3. Two Indifference Curves can never intersect each other:

Because at point of intersection, both curves will represent same satisfaction but at any other point
one curve will represent higher and other will represent lower satisfaction, which is illogical
because satisfaction remains same throughout the indifference curve.
4. Indifference curves usually slope downwards:

Keeping satisfaction level same, there is a trade-off between two goods on indifference If a
consumer consumes more of one good, he must consume less of the other good to keep satisfaction
same.
5. Indifference curves are usually convex to the origin:

Because Marginal Rate of Substitution (or slope of indifference curve) diminishes as we move
rightward of the curve due to Law of Diminishing Marginal Utility.

What is an indifference curve? List the properties of an indifference curve. (03 marks)
Explain why indifference curves for economic goods are negatively sloped? (04 marks)
‘Two indifference curves on a single indifference map never intersect each other’.
Comment with the help of a diagram. (06 marks)
Why are the Indifference curves convex to the origin? (02 marks)
43
LO 6: BUDGET LINE / PRICE LINE / BUDGET CONSTRAINTS:

Budget Line:
Definition:
A budget line represents various combinations of two goods that a consumer can buy with his fixed
income, at given market prices.
Example:
Suppose, Sameer has 40 rupees to spend on units of Food and Cloth. He can spend his total income
as follows:
Option Food (units) Cloth (units)
A 20 0
B 10 20
C 0 40
Graph and Explanation:
Graph Explanation
 Bundles on the curve represent exhaustion of the

total budget.
 Bundles below the curve represent expenditure of
less than the total budget.
 Bundles above the curve are too expensive for the
consumer.
Change in Budget Line:

Budget Line changes when there is change in:
1. Income of Consumer or
2. Price of Goods
Study Tips – Effect of Change in Income and Price on Budget Line

Effect of Change in Income of Consumer:
 If income of a consumer increases, budget line will shift parallel rightward (from both corners).
 If income of a consumer decreases, budget curve will shift parallel leftward (from both corners).
Effect of Change in Price of Goods:
 If price of a good increases, budget line will come closer to the origin (from relevant one corner only).
 If price of a good decreases, budget line will go away from origin (from relevant one corner only).

What is meant by Budget Line? (03 marks)
44
LO 7: CONSUMER EQUILIBRIUM UNDER INDIFFERENCE CURVE APPROACH:

Consumer Equilibrium:
A consumer is in equilibrium if he selects the highest possible indifference curve within range of his
budget Line. It is that point where following two conditions are met:
1. Budget Line should be tangent to Indifference curve.
2. Marginal Rate of Substitution (i.e. slope of indifference curve) is equal to relative prices of
goods (i.e. slope of budget line). Symbolically, MRS = Py/Px
Diagram:
Diagram Explanation
1. Units of Good X and Good Y are shown on X-axis
and Y-axis respectively.
2. Line BL represents Budget Line of the consumer.
3. IC1, IC2 and IC3 are three indifference curves
representing different levels of satisfaction.
4. IC2 represents highest level of satisfaction but it
is beyond budget line, hence it is impossible to
attain.
5. IC3 is within budget but is represents lowest
level of satisfaction, hence it is inefficient.
6. IC1 represents highest possible indifference
curve on which budget line is tangent hence
tangent point “E” on this curve is the Equilibrium
Point.
Assumptions of Indifference Curve:

1. Satisfaction is measured using Ordinal measurement.
2. Whole income of consumer is to be spent on two goods only.
3. Income of the consumer is fixed.
4. Consumer is rational and wants to maximize its satisfaction.
5. Goods are substitutable and divisible.
6. Preferences are not self-contradictory.
Study Tip
An indifference curve cannot intersect any other indifference curve, but an indifference curve can intersect
any other budget line.

(a) Narrate the basic assumptions applicable to the Indifference Curve Approach. (03 marks)
(b) Explain consumer’s equilibrium with the help of a diagram using indifference curves. (09 marks)
Explain the term marginal rate of substitution with the help of an example. (04 marks)
45
LO 8: CHANGE IN CONSUMER EQUILIBRIUM – INCOME EFFECT:

Income Effect (I.E.):
Income Effect is the change in consumer equilibrium (i.e. change in quantity purchased of goods)
due to change in income of consumer.
Income Effect through Diagram:

There are two possible scenarios with Income Effect i.e.
1. When goods are normal.
2. When one good is inferior.
Hints for showing Income Effect through diagram

Effect on equilibrium Effect on equilibrium
Situation
quantity if good is normal quantity if good is inferior
Increase in Income Increase Decrease
Decrease in Income Decrease Increase
Income Effect when goods are normal Income Effect when one good is inferior
Study Tip
1. You have seen the effect of increase in income in both cases. Now, practice yourself the effect of
decrease in income on consumer equilibrium in both cases.
2. Income Consumption Curve (ICC) shows how consumption of two goods is affected by change in
income of consumer.

Write short note on the Income Effect. (2.5 marks)
In context of Consumer’s Equilibrium, explain the effect of a change in income when the goods being used are ‘inferior’.
(03 marks)
46
LO 9: CHANGE IN CONSUMER EQUILIBRIUM – PRICE EFFECT:

Price Effect (P.E.):
Price Effect is the change in consumer equilibrium (i.e. change in quantity purchased of goods) due
to change in price of a good.
Price Effect through Diagrams:

There are three possible scenarios with Price Effect:
1. When goods are complement
2. When goods are Substitute.
3. When goods are independent.
Hints for showing Price Effect through diagram

Effect on equilibrium Effect on equilibrium Effect on equilibrium
Situation quantity if goods are quantity if goods are quantity if goods are
Complement Substitute Independent
X increases X increases X increases
Decrease in Price of X
Y increases Y decreases Y Same
X decreases X decreases X decreases
Increase in Price of X
Y decreases Y increases Y Same
Price effect when goods are Price effect when goods Price effect when goods are
Complement are Substitute Independent
Explanation:
1. Units of Good X and Good Y are shown on X-axis and Y-axis respectively.
2. Line BL0 represents Original Budget Line of the consumer, which is tangent on Indifference curve IC0 making E0
as original Equilibrium Point.
3. Now, suppose price of X decreases, which results in new Budget Line BL1 and new Equilibrium point E1.
4. Now the difference between quantity of X at E0 and E0 is “Price Effect”.
Study Tip
1. You have seen the effect of decrease in price of a good in all three cases. Now, practice yourself the
effect of increase in price on consumer equilibrium in these cases.
2. Price Consumption Curve (PCC) shows how consumption of two goods is affected by change in price
of a good.
47
LO 10: CHANGE IN CONSUMER EQUILIBRIUM – EXTENDED ANALYSIS OF PRICE EFFECT:

Extended Analysis of Price Effect:
Effect of price on quantity demanded can be bifurcated into Real Income Effect and Substitution
Effect i.e.
Price Effect = Substitution Effect (S.E.) + Real Income Effect (I.E.)
Substitution Effect (S.E.):

Substitute Effect of a price change is change in consumption of a good as consumers substitute
cheaper goods in place of expensive goods.
Income Effect (I.E.)

Income Effect of a price change is change in consumption of a good as real income / purchasing
power of consumer changes.
There are three possible scenarios with extended analysis of Price Effect:
1. When good is Normal.
2. When good is Inferior.
3. When good is Giffen.
Diagram:
Diagram Explanation
1. Units of Good X and Good Y are shown on X-axis
and Y-axis respectively.
2. Line BL0 represents Original Budget Line of the
consumer, which is tangent on Indifference
curve IC0 making E0 as original Equilibrium
Point.
3. Now, suppose price of X decreases, which
results in new Budget Line BL1 and new
Equilibrium point E1.
4. Now draw a hypothetical budget line which is
“parallel to new budget line but tangent on old
indifference curve at point E/”. This will
compensate increase in real income of
consumer.
5. Now the Price Effect has been divided into two
classes i.e.
a. Substitution Effect = difference between
E0 and E/.
b. Income Effect = difference between E/ and
E1.
Study Tips
1. Substitution effect is always positive.
2. If Income Effect is positive, it is normal good.
3. If Income Effect is negative and does not dominate Substitute Effect, it is inferior good.
4. If Income Effect is negative and dominates Substitute Effect, it is Giffen good.
48

With the help of a diagram, prove that :
Price effect = Income effect + Substitution effect (08 marks)
Diagrammatically show the income and substitution effect of a price increase for a Normal good. (03 marks)
Explain the following concepts with reference to consumer behaviour, using appropriate diagrams:
 Price effect
 Substitution effect
 Income effect (12 marks)
49
Economics – Study Notes Chapter 5 Revenue, Costs and Equilibrium of Firm
CHAPTER FIVE
REVENUE, COSTS AND EQUILIBRIUM OF
FIRM
LO 1 WHAT IS MEANT BY FIRM & ITS EQUILIBRIUM

PART A – THEORY OF REVENUE
LO 2 TYPES OF REVENUE
LO 3 REVENUE CURVES AND THEIR RELATIONSHIP
PART B –THEORY OF COST

LO 4 TYPES OF COST
LO 5 COST CURVES AND THEIR RELATIONSHIP
PART C – PRODUCTION FUNCTION

LO 6 PRODUCTION FUNCTION IN SHORT RUN – LAW OF VARIABLE PROPORTION
LO 7 PRODUCTION FUNCTION IN LONG RUN – RETURNS TO SCALE

DIFFERENCE/RELATIONSHIP BETWEEN LONG-RUN AVERAGE COST AND SHORT-
LO 8
RUN AVERAGE COST
APPENDIX – DIAGRAMS OF FIRM’S EQULIBRIUM
HOW TO DRAW DIAGRAM FOR EQUILIBRIUM OF A FIRM UNDER DIFFERENT
APX 1
SITUATIONS
50
LO 1: WHAT IS MEANT BY FIRM & ITS EQUILIBRIUM:

Meaning of Firm:
Firm is a market participant who combines different factors of production (i.e. inputs) and converts
them into production (i.e. output).
There are two broad types of Firms i.e.

1. Firms under Perfect Competition and
2. Firms under Imperfect Competition.
Study Tip
1. Perfect Competition: a situation in industry where large numbers of sellers are selling homogenous
products.
2. Imperfect Competition: a situation in industry where individual sellers can change the price of their
output. Major kinds of imperfect competition are Monopolistic Competition, Oligopoly and Monopoly.
Meaning of “Equilibrium” of Firm:

Firm’s Equilibrium means level of output at which firm earns maximum profit. It is the point where
MC = MR and MC cuts MR from below.
There are two types of equilibrium of any firm i.e.:

1. Equilibrium in Long-run, and
2. Equilibrium in Short-run.
Study Tip
1. Profit = Total Revenue – Total Cost
2. Long run is a period of time in which firm can adjust production by changing all factors of
production. In long-run, all of the cost will be variable.
3. Short run is a period of time in which firm can adjust production by changing only variable factors
of production. There are some fixed factors of production which cannot be changed. In short-run,
some of the cost will be fixed and some variable.
CONCEPT REVIEW QUESTIONS

Explain the term equilibrium of the firm. (02 marks)
(CA CAF - Spring 2015)
Differentiate between Short-Run and Long-Run in relation to Cost. (05 marks)

PART A – THEORY OF REVENUE
LO 2: TYPES OF REVENUE:
Total Revenue:
Total Revenue means revenue from the sale of all output i.e.
Total Revenue = Average Revenue * Total Output
51
Marginal Revenue:
Marginal Revenue is the increase in total revenue because of increase in sale of an additional unit.
Marginal Revenue = Change in Total Revenue / Change in Output
Average Revenue: (also called Price)

Average Revenue = Total Revenue / Units of Output
Study Tip
In Economics, decisions are made on the basis of Marginal Revenue, and Average Revenue.

What exactly is meant by Marginal Revenue? (03 marks)
LO 3: REVENUE CURVES AND THEIR RELATIONSHIP:

Revenue Curves under Perfect Competition:
Price remains same at all level of output, hence Price, Average Revenue, Marginal Revenue remain
same.
Schedule and Graph:

Total Average Marginal
Quantity Price Revenue Revenue Revenue
(Q) (P) TR = Q * P AR = TR / Q
1 5 5 5 5
2 5 10 5 5
3 5 15 5 5
4 5 20 5 5
5 5 25 5 5
Revenue Curves under Imperfect Competition:

In imperfect competition, firms have to reduce price to sell more. Therefore, Average Revenue and
Marginal Revenue both have downward slope.
Schedule and Graph:

Total Average Marginal
Quantity Price Revenue Revenue Revenue
(Q) (P) TR = Q * P AR = TR / Q
1 5 5 5 5
2 4 8 4 3
3 3 9 3 1
4 2 8 2 -1
5 1 5 1 -3
52
Study Tip
1. Revenue curves under perfect competition are different from imperfect competition.
2. “Average Revenue = Price” and “AR Curve = Demand Curve”.

Explain, with reasons, the relationship among marginal revenue, average revenue and price under perfect competition.
(06 marks)
Explain the relationship between AR, MR and elasticity under monopoly. (05 marks)
(ICMA Pakistan, Fundamental Level F2 – Fall New Questions 2011)
PART B – THEORY OF COST
LO 4: TYPES OF COST:
Fixed Cost:
Fixed costs are those costs which do not vary with the level of output. It will still have to be paid
even if output is zero.
Examples of Fixed Cost:

 Rent of factory.
 Insurance Expense.
 Property Taxes.
 Interest on capital.
Variable Cost:
Variable costs are those costs which vary with the level of output. These will change with every unit
of production.
Examples:
 Purchase of material.
 Wages paid to labor.
 Energy Cost (e.g. Electricity and Fuel etc. at factory).
Diagram of Fixed and Variable Cost:
53
Study Tips
To calculate profit, accountants consider only Explicit Cost (i.e. the cost of production that requires a
monetary payment e.g. Rent paid for factory, Wages paid to labor, Interest paid on loan). However,
economists consider Explicit Cost as well as Implicit Cost (i.e. the cost of production that does not
require a monetary payment e.g. normal profit, opportunity cost of resources).
Point to understand is that when economists say “zero economic profit”, it still includes normal profit.
Total Cost:
Total Cost means cost of the production of all units i.e.
Total Cost = Fixed Cost + Variable Cost.
OR
Total Cost = Average Cost * Output
Marginal Cost:
Marginal Cost is the extra cost of producing one more unit of product.
Marginal Cost = ∆TC / ∆Q (i.e. Change in Total Cost / Change in Output)
Average Fixed Cost:

Average Fixed Cost (AFC) = Fixed Cost / Units of Output
Average Variable Cost:

Average Variable Cost (AVC) = Variable Cost / Units of Output
Average Total Cost: (also called Average Cost)

Average Cost is the unit cost of producing product at a given level of output.
Average Total Cost (ATC or AC) = Total Cost / Units of Output
Study Tip
In Economics, decisions are made on the basis of Marginal Cost, and Average Cost.

Distinguish between fixed cost and variable cost with the help of a diagram. (04 marks)
(ICMA Pakistan, Fundamental Level F2 – Spring 2012)
Differentiate the Explicit Cost & Implicit Cost. (05 marks)

The following data refers to the total revenue and total costs of a firm at various output levels:
Output (units in million) 0 1 2 3 4 5 6 7 8 9
Marginal revenue (Rs. In million) - 12 12 12 11 11 10 10 10 9
Total costs (Rs. in million) 22 28 32 35 36 37 40 44 54 65
(a) Calculate the firm’s fixed cost and the marginal cost at each level of output. (03 marks)
(b) Determine the level of output at which the firm would optimise its profits. Also determine the amount of profit that
the firm will make at the desired level of output. (05 marks)
54
LO 5: COST CURVES AND THEIR RELATIONSHIP:

Schedule:
Fixed Variable Total

Marginal Average Fixed Variable Total Marginal Average
Input Input Product
Product Product Cost Cost Cost Cost Cost
(i.e. Land) (i.e. Labor) (Output)
= ΔTP =3/2 (5) (6) 7=5+6 = ΔTC = 7/3
(1) (2) (3)
1 0 0 0 0 10 0 10 - -
1 1 1 1 1.0 10 10 20 10.00 20.00
1 2 3 2 1.5 10 20 30 5.00 10.00
1 3 6 3 2.0 10 30 40 3.33 6.67
1 4 10 4 2.5 10 40 50 2.50 5.00
1 5 13 3 2.6 10 50 60 3.33 4.62
1 6 15 2 2.5 10 60 70 5.00 4.67
1 7 16 1 2.29 10 70 80 10.00 5.00
Study Tip
1. Relationship between “Total Output and Marginal Cost” is called “Laws of Cost”.
2. Relationship between “Variable Input and Marginal Output” is called “Laws of Return”
Graph and Explanation:
Graph Explanation
Cost curves (AC and MC) are U-shaped because:
1. In the early stage of production, marginal returns
increase and marginal cost decreases.
2. Eventually marginal returns start to decrease and
marginal cost increases, as output increases.
Marginal Cost curve intersects the Average Cost curve at its

minimum point from below which means:
1. If MC < AC, AC decreases.
2. If MC = AC, AC is at its minimum.
3. If MC > AC, AC increases.
Study Tip
MC Curve (& AC Curve) is U-shaped because of Law of Increasing Marginal Product and Law of Diminishing
Marginal Product (which will be discussed later in this chapter).

What do you mean by marginal cost and average cost? Prepare a graph to show the relationship between average cost and
marginal cost. (08 marks)
55
Complete the following table: (07 marks)
(ICMA Pakistan, Fundamental Level F2 – Spring 2015)
PART C – PRODUCTION FUNCTION

A production function describes a relationship between inputs (i.e. factors of production) used in
the production process and output (i.e. production) .i.e. how much quantity of output you will get
from a given quantity of inputs.
Production funcation can be studied in short-run as well as in long-run.
LO 6: PRODUCTION FUNCTION IN SHORT RUN – LAW OF VARIABLE PROPORTION:

Law of Variable Proportion (or Laws of Returns/Productivity):
If units of variable factor of production (e.g. labor) are added to fixed factors of production (e.g.
Land or Capital), initially the marginal product of variable inputs will increase. However, after a
certain level, the marginal product will diminish.
Assumptions:
Short-run Period:
Law is valid in short-run so that some factors of production are held constant.
Constant Technology:
Technology and technique of production should remain same. A more efficient technology or
method of production may give different result.
Factors of Production are Homogenous:

Every unit of variable factor of production should be identical in quantity and quality.
Schedule/Table:
Fixed Factor of Variable Factor of Total Product Marginal Average

Production (i.e. Land) Production (i.e. Labor) (Output) Product Product
1 0 0 0 0
1 1 1 1 2
1 2 3 2 3
1 3 6 3 4
1 4 10 4 4
1 5 13 3 3.6
1 6 15 2 3
1 7 16 1 2.3
56
Diagram:
Diagram Explanation
Following are stages of law of variable proportion:
Stage 1: Stage (or Law) of increasing

returns/Productivity:
If units of variable factor of production are added to
fixed factors of production, initially the marginal
product of variable inputs will increase. Due to
increasing return, marginal cost of the product also
decreases during this stage.
This stage is shown in the table from unit 1 till unit 4.
Stage 2: Stage (or Law) of decreasing

returns/Productivity:
If units of variable factor of production are added to
fixed factors of production, after a certain point, the
marginal product of variable inputs will decrease.
The point at which marginal product decreases is the
point at which diminishing marginal returns have set
in. Due to decreasing return, marginal cost of the
product also increases during this stage.
This stage is shown in the table from unit 5.
Study Tip
1. Marginal Product (or Marginal Physical Product) is the amount of extra output that is produced when one
extra worker is added, while other inputs are held constant.
2. Terms “product”, “output” and “Return” are synonymously used in economics.

Describe the Law of ‘Diminishing marginal utility’. Support your answer with the help of a schedule and a diagram.
(07 marks)
Explain briefly why the short-run average cost curve is “U” shaped. (06 marks)
State and explain "The law of diminishing marginal returns" with the help of a schedule and a diagram. (12 marks)
Explain the law of variable proportions. Discuss the various stages of law of variable proportions with the help of a
diagram (schedule not required). Also explain at which stage a rational producer would stop production. (10 marks)
LO 7: PRODUCTION FUNCTION IN LONG RUN – RETURNS TO SCALE:

Return to Scale:
Returns to scale is a long-run concept that shows how total output increases due to increase in all
inputs. There may be three phases of Return to Scale i.e.
57
1. Increasing returns to scale: If increase in all inputs leads to a more-than-proportional

increase in output, this is called Increasing return to scale. It occurs due to Economies of
Scale.
2. Constant returns to scale: If increase in all inputs leads to a proportional increase in
output, this is called Constant return to scale.
3. Decreasing returns to scale: It increase in all inputs leads to a less-than-proportional
increase in output, this is called Decreasing return to scale. It occurs due to Diseconomies of
Scale.
Economies of Scale:
Definition:
These are the advantages of large scale production in long-run which cause increase in return to
scale and decrease in long-run average total cost.
Factors/Reasons of Economies of Scale:

Internal Economies of Scale:
Internal economies of scale arise from within the firm, by making efficient use of resources e.g.
1. Mechanical/Technical Economies (a single large machine is cheaper as compared to many small
machines)
2. Managerial Economies (large business take advantage of employing specialized labour)
3. Trading/Commercial Economies (Inputs becomes cheaper when purchased in bulk quantities
due to discounts)
4. Financial Economies (large firms can negotiate loan or issue shares at favourable terms)
5. Risk-bearing Economies (large firms manage/reduce their risk by diversification in products or
markets).
External Economies of Scale:

These are outside the control of a particular firm and are attained by the member firms due to
growth of the industry as a whole.
For example, firms may cluster together to perform:

 joint research & development activities,
 development of specialized labor force.
 sharing extra-risk with each other (e.g. in Insurance companies)
Diseconomies of Scale:
Definition:
These are the disadvantages of large scale production in long-run (firms grows so large, that it
becomes difficult to handle them) which cause decrease in return to scale and increase in long-run
average total cost.
Factors/Reasons of Diseconomies of Scale:

Organizations face following problems when they grow:
1. Managerial Inefficiencies e.g. when gap between workers and management increases, it
becomes difficult to control them and to motivate them.
2. Inefficiencies in Production e.g. not utilizing fixed assets at full capacity, greater wastages.
3. Communication and Coordination problems between workers and departments.
4. Delay in decision making.
58

Define the term ‘Economies of scale’? Describe any four ways by which a firm may achieve internal economies of scale.
(06 marks)
What is the difference between ‘Returns to scale’ and ‘Law of variable proportions’. (02 marks)
Briefly discuss the term ‘Returns to scale’ and distinguish between the different phases of returns to scale. (04 marks)
What is meant by “Decreasing returns to scale”? Describe its main causes. (06 marks)
LO 8: DIFFERENCE/RELATIONSHIP BETWEEN LONG-RUN AVERAGE COST AND SHORT-RUN

AVERAGE COST:
Because fixed costs are variable in the long run, the average cost curve in the short run differs from
the average cost curve in the long run.
1. The long-run average cost curve is a much flatter U-shape than the short-run average cost
curve.
2. In addition, all the short-run curves lie on or above the long-run curve.
3. At planned level of output, short run average total cost and long run average total cost are
equal but at any other level of output short-run average cost is higher than long run average
cost. This is called “envelope relationship” between long-run cost and short-run cost.
Study Tip
In short-run, law of increasing return and law of diminishing return are the reasons of U-shape of Cost
Curves. In long-run increasing return to scale and decreasing return to scale are the reasons of U-shape
of Cost Curves.

Long run costs describe the behaviour of unit cost as the firm makes significant changes to its volume of production.
Describe a firms long-run average cost curve by clearly showing economies of scale, constants return to scale and
diseconomies of scale? (08 marks)
59
APPENDIX – DIAGRAMS OF FIRM’S EQULIBRIUM
APX 1: HOW TO DRAW DIAGRAM FOR EQUILIBRIUM OF A FIRM UNDER DIFFERENT

SITUATIONS:
Rules to draw Diagrams of firms’ equilibrium:
1. You will need 4 curves to draw equilibrium point of firms under different competitions i.e.
a. Marginal Revenue and Average Revenue Curves.
b. Marginal Cost and Average Cost Curve.
2. First draw both Revenue Curves i.e. MR Curve & AR Curve (depending on whether firm is in
perfect competition or imperfect competition).
3. Then draw Marginal Cost Curve and identify Equilibrium Quantity. Equilibrium Quantity is the
quantity at which “Marginal Cost = Marginal Revenue”.
4. Now draw Average Cost Curve (depending on whether firm is in profit, breakeven or loss) i.e.
a. To draw graph for Super-normal Profit (called profit in accounting), AC Curve should pass
below AR Curve at equilibrium quantity.
b. To draw graph for Normal Profit (called break-even in accounting), AC Curve should pass at AR
Curve at equilibrium quantity.
c. To draw graph for Sub-normal Profit (called loss in accounting), AC Curve should pass above
AR Curve at equilibrium quantity.
5. In the given diagram,
a. Total Revenue = Equilibrium Quantity * Average Revenue (at equilibrium quantity)
b. Total Cost = Equilibrium Quantity * Average Cost (at equilibrium quantity)
c. Profit = Total Revenue – Total Cost
Examples of Diagrams under Perfect Competition:
(a) Super-normal Profit (b) Normal Profit (c) Sub-normal Profit
60
Examples of Diagrams under Imperfect Competition:

What is meant by Normal Profit? (05 marks)
61
Economics – Study Notes Chapter 6 Types of Firms
CHAPTER SIX
TYPES OF FIRMS
LO 1 PERFECT COMPETITION
LO 2 MONOPOLISTIC COMPETITION
LO 3 MONOPOLY
LO 4 OLIGOPOLY
62
LO 1: PERFECT COMPETITION:
Definition of Perfect Competition:
“A situation in industry where large numbers of sellers are selling homogenous products.”
Examples:
 Wheat market
Conditions/Features/Characteristics of Perfect Competition:

Following are the conditions which are necessary for the existence of perfect competition:
Large number of sellers:

There are large number of small firms, each so small that change in output of any firm cannot affect market
price. Therefore, firms in perfect competition are price-takers and their demand curve is perfectly
elastic.
Homogenous Product:
Firms produce homogeneous products (i.e. which are identical to the products produced by other firms and are
perfect substitutes).
Perfectly Elastic Demand:

Individual firms perceive their demand as perfectly elastic.
Free entry and exit:

There are no barriers to entry (legal, strategic or structural). Firms can easily enter and exit the
market if profit is increased or decreased.
Perfect knowledge of price:

Buyers and sellers are fully aware of prices. Therefore, no producer can charge price different than
market price.
Transportation costs are zero or minor:

Because of zero transportation cost, price-discrimination at different location is not possible.
Perfect mobility of factors of production:

Therefore, factors of production can easily move ‘in’ or ‘out’ of the market to adjust supply in
accordance with demand.
63
Outcomes/ Economic Effects of Features of Perfect Competition:

Economic effect of Perfect Competition is that:
 Firms are Price Takers (i.e. firm has no control over price; and price is determined by
market demand and supply), and
 Firms earn normal profit in long-run.
Study Tip
1. Marginal Cost curve (upward sloping) of a firm is also its Supply curve; and Average Revenue Curve of a
firm is also its Demand Curve.
2. For a firm under perfect competition, Average Revenue = Demand = Price = Marginal Revenue
3. For a firm under imperfect competition, Average Revenue = Demand = Price > Marginal Revenue
Long-run Equilibrium under Perfect Competition:

In long run, a firm under perfect competition will be earning Normal Profit only.
Diagram Explanation
1. In perfect competition, no buyer and seller is in a

position to influence the price therefore same
price prevails in the market i.e. MR = AR = P
(Price).
2. The firm will produce as long as MR>MC.
3. The profit of the firm will maximize when MC =
MR and MC cuts MR from below, which is also the
firm’s equilibrium point.
4. Here firm is earning normal profit at equilibrium
quantity.
5. At equilibrium quantity, AC curve is tangent to AR
curve i.e. AR = AC
Short-run Equilibrium under Perfect Competition:

In short run, a firm under perfect competition can earn Super-normal Profit, Normal Profit or Sub-
normal profit.
Graphs:
64
Explanation:
Explanatory points for all diagrams:
1. In perfect competition, no buyer and seller is in a position to influence the price therefore same price prevails in
the market i.e. MR = AR = P (Price).
3. The profit of the firm will maximize when MC = MR and MC cuts MR from below, which is also the firm’s
equilibrium point.
Further Explanation of Diagram “a”:

1. Here firm is earning supernormal profit at equilibrium quantity.
2. Supernormal profit is the difference between Total Revenue (i.e. Average Revenue * Equilibrium Quantity) and
Total Cost (i.e. Average Cost * Equilibrium Quantity).
3. Super-normal profit is measured by rectangle area CDEF and is shown by shaded area.
Further Explanation of Diagram “b”:

1. Here firm is earning normal profit at equilibrium quantity.
2. At equilibrium quantity, AC curve is tangent to AR curve i.e. AR = AC
Further Explanation of Diagram “c”:

1. Here firm is earning subnormal profit at equilibrium quantity.
2. Subnormal profit is the difference between Total Cost (i.e. Average Cost * Equilibrium Quantity) and Total
Revenue (i.e. Average Revenue * Equilibrium Quantity).
3. Sub-normal profit is measured by rectangle area CDEF and is shown by shaded area.
Restoration of short-run equilibrium to long-run equilibrium:

Although a firm under perfect competition can earn super-normal profit, normal profit or sub-
normal profit in short-run but they can earn only normal profit in the long-run.
Explanation:
If firms are initially earning super-normal profit because of high prices, new firms to enter the market causing rightward
shift in supply curve and decrease in price to a level equal to average total cost.
In case of sub-normal profit, some existing firms will exit the market causing leftward shift in supply curve and increase in
price to a level equal to average total cost.
Therefore, in the long-run, price always moves back to the position where all firms are earning normal profits.
Shut-down Point under Perfect Competition:

“Shut-down point is the point in short-run, where price is equal to average variable cost (AVC).
Firm will stop its production if price falls before AVC.”
Diagram Explanation
In short-run firm has two types of costs i.e. fixed

cost and variable cost. Fixed cost cannot be
changed in the short-run. Shutdown point is the
point at which price is equal to AVC. If price falls
below this point, firms can minimize their losses in
the short run by producing no output and paying
only their fixed costs. If price is below AVC and a
firm continues to produce, losses will include not
only fixed costs but also a portion of variable costs.
65
Study Tip
Economic profits: Price is greater than average total costs.
Zero-profit point: The zero-profit point occurs where price is equal to ATC. At this point, economic profits are zero.
Shutdown point: Price is equal to average variable costs.

What do you understand by Perfect Competition? Briefly explain the important conditions which are necessary for the
existence of Perfect Competition in a market. (07 marks)
What do you understand by the term Perfect Competition? With the help of an appropriate diagram, explain the
Equilibrium of a Firm under perfect competition in the long run. (08 marks)
Describe a firm's equilibrium under perfect competition in the short run with the help of diagrams. (15 marks)
Explain with the help of a diagram, the shut down point of a firm under perfect competition. (06 marks)
With the aid of diagrams show that in a perfectly competitive industry, the typical firm earns only normal profits in the
long run. (16 marks)
(Institute of Chartered Accountants – Ghana)
LO 2: MONOPOLISTIC COMPETITION:
Definition and Examples of Monopolistic Competition:
Definition:
Monopolistic Competition is a situation in which large numbers of sellers compete fiercely by
differentiating their products.
Examples:
 Haircuts  College text-books
 Shoes  Shampoos
 Soaps  Toothpastes
Features of Monopolistic Competition:

 Many producers and many consumers .
 Knowledge is widespread, but not perfect.
 Differentiated products (i.e. those products whose important characteristics vary e.g.
personal computers.)
 Producers have some control over price (i.e. they are price makers).
 Barriers to entry and exit do exist, but are low.
 Brand loyalty exists, making demand less elastic.
 Firms also engage in some form of marketing.
66
Long-run Equilibrium under Monopolistic Competition:

In long run, a firm under monopolistic competition can earn Normal Profit only.
Diagram Explanation
1. In monopolistic competition, firm is able to

control price. Its AR curve and MR curve are
downward sloping and are not identical because
firm has to reduce its price to sell more output.
3. The profit of the firm will maximize when MC =
MR and MC cuts MR from below, which is also the
firm’s equilibrium point.
4. Here firm is earning normal profit at equilibrium
quantity.
5. At equilibrium quantity, AC curve is tangent to AR
curve i.e. AR = AC
Short-run Equilibrium under Monopolistic Competition:

In short run, a firm under monopolistic competition can earn Super-normal Profit, Normal Profit or
Sub-normal profit.
Graphs:
Explanation:
Explanatory points for all diagrams:
1. In monopolistic competition, firm is able to control price. Its AR curve and MR curve are downward sloping and
are not identical because firm has to reduce its price to sell more output.
3. The profit of the firm will maximize when MC = MR and MC cuts MR from below, which is also the firm’s
equilibrium point.
Explanation of Diagram “a”:

1. Here firm is earning supernormal profit at equilibrium quantity.
2. Supernormal profit is the difference between Total Revenue (i.e. Average Revenue * Equilibrium Quantity) and
Total Cost (i.e. Average Cost * Equilibrium Quantity).
3. Super-normal profit is measured by rectangle area CDEF and is shown by shaded area.
67
Explanation of Diagram “b”:

1. Here firm is earning normal profit at equilibrium quantity.
2. At equilibrium quantity, AC curve is tangent to AR curve i.e. AR = AC
Explanation of Diagram “c”:

1. Here firm is earning subnormal profit at equilibrium quantity.
2. Subnormal profit is the difference between Total Cost (i.e. Average Cost * Equilibrium Quantity) and Total
Revenue (i.e. Average Revenue * Equilibrium Quantity).
3. Sub-normal profit is measured by rectangle area CDEF and is shown by shaded area.
Advantages and Disadvantages of Monopolistic Competition:

Advantages of Monopolistic Competition:
 No significant barriers to entry
 Differentiation
 Increased consumer choices
 Efficient than Monopoly
Disadvantages of Monopolistic Competition:

 Differentiation can be unnecessary
 Prices are higher than Marginal Cost

What is meant by Monopolistic-Competition? Enumerate its main characteristics. (05 marks)
Explain the short and long run equilibrium of a firm under monopolistic competition with the help of diagrams.
(10 marks)
LO 3: MONOPOLY:
Definition and Examples of Monopoly:
Definition:
“Monopoly is a market situation in which there is only a single supplier with complete control over
output and price, selling unique product (with no close substitute).”
Examples:
 Local utility companies providing water, electricity (e.g. WASA, LESCO).
 A pharmaceutical company discovers a new drug and gets it patented.
 Microsoft Windows
Features of Monopoly:
Features of Monopoly:
1. Single firm supplying to whole market.
2. Product is unique and there is no close substitute.
3. Very high barriers prevent the entry of new firms into the industry.
Outcomes/ Economic Effects of Features of Monopoly:

Economic effects of Monopoly are that:
 Firms are Price Makers (i.e. firm has control over price), and
 Firms earn super-normal profit in long-run.
 Firm can practice Price Discrimination.
 Prices are high and output is low as compared to other market structures.
68
Advantages and Disadvantages of Monopoly:

Advantages of Monopoly:
1. A single large firm may be able to achieve economies of scale which will lower unit cost.
2. A monopoly earns super-normal profit in the long-run, which means they can allocate huge
resources to research and development activities to improve quality of product.
3. Firm can operate internationally at competitive rates.
4. Investments and Decisions are made considering long-term approach.
Disadvantages of Monopoly:
1. There is insufficient utilization of resources as firm is already earning huge profits.
2. Less motivated towards innovation.
3. Price discrimination may decrease consumers’ welfare/surplus.
4. There is less choice for consumers.
5. There is less sovereignty for consumers.
6. Different types of inefficiencies may arise e.g. Technical inefficiencies, Productive
inefficiencies, and X-inefficiencies.
Barriers to entry in Monopoly:

Barriers to entry are factors which make it difficult for new firms to enter a market. These could be:
1. Legal (i.e. Barriers enforced by law to protect a monopolist)
 Patents or Copyrights
 Entry-restrictions through Licensing (e.g. in utilities market)
 Foreign trade tariffs and quotas.
2. Strategic (i.e. Barriers enforced by monopolist to make entry harder)

 Predatory pricing (selling goods at much lower price to drive other firms out of the
market, and then increasing the price again once they leave)
 Product differentiation (a new entrant will have to spend much on Research &
development, and Advertising to design and promote a better brand)
3. Structural (i.e. enforced by differences in production process)

 Economies of scale (large firms can produce more cheaply and then under-sell small
firms, which cannot survive)
 Heavy amount of fixed cost to start operations (e.g. it requires billions of dollars to start
an aircraft company)
 Exclusive control over input resources
 Expertise/ reputation of monopolist (e.g. there is wide acceptability of programs like MS
Word or MS Excel and people will not be attracted easily towards new programs).
Inefficiencies in Monopoly:
Technical Inefficiency:
A firm is technically inefficient when it is not producing the maximum output from the minimum
quantity of inputs e.g. using too many employees to produce output.
Productive Inefficiency:
Productive inefficiency occurs when a firm is not producing at its lowest unit cost.
X-Inefficiency:
X-inefficiency is when a firm fails to be technically efficient because of absence of competitive
pressures. e.g. lack of motivation to follow best practices.
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Long-run Equilibrium under Monopoly:
Diagram Explanation
(explanation is the same as in the case of

monopolistic competition)
Short-run Equilibrium under Monopoly:

Same as in the case of Monopolistic Competition.
Price Discrimination:
Definition:
Price discrimination means charging different consumers different prices for the same product.
Firms want to charge higher prices to consumers whose demand is more inelastic.
Examples of Price Discrimination:

1. Identical text books are sold at lower prices in Asia than in United States.
2. Airlines charge different prices for same travel from business travelers or pleasure
travelers.
3. Utility companies (e.g. electricity) charging different for domestic and commercial users.
4. Telephone calls with different tariff for peak and off-peak timings.
5. Hotels charging rooms with different rent for working day and holidays.
6. Railway charges different rates for different commodities.
Conditions required for Price discrimination:

Monopoly Power:
Seller must keep competitors out of the market to have control over supply and prices.
Separation of Markets:
There must be atleast two different group of buyers. Seller must be able to prevent resale of
product by buyers paying lower price to buyer paying higher price.
Elasticity of Demand:
Each group of buyer must have a different elasticity of demand to extract consumer surplus.
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How a firm uses Price Discrimination to maximize Revenue:
A monopolist can increase its supernormal profit by charging higher price in market where elasticity of demand is low
(market A) and charging lower price in market where elasticity of demand is high (market B).
Monopolist will transfer some units of the output from market A to market B. This will cause increase in price in market A
and decrease in price in market B. However, due to different elasticities, gain in total revenue in market B is more than
sacrifice in total revenue in market A.
This shift will continue until marginal revenue in both markets are equal.

(a) One of the characteristics of a monopolist is the ability to engage in price discrimination. Describe the term ‘Price
Discrimination’. Briefly explain the conditions which must exist to enable the monopolist to exercise the power of price
discrimination effectively. (04 marks)
(b) Monopolist will be in equilibrium at that price-output level at which his profits are maximized. Explain the price-
output equilibrium of a monopolist with the help of a diagram. (08 marks)
State the main features of monopoly and name any one organisation which operates under monopoly. (03 marks)
Briefly describe the disadvantages of having a monopoly setup. (08 marks)

Explain the process of profit-maximization by a monopolist with the help of an appropriate diagram. (08 marks)
(a) What is ‘Price discrimination’? Give two practical examples of price discrimination. (03 marks)
(b) Explain with the help of diagrams how a monopolist finds it profitable to charge discriminating prices when the
elasticities of demand in the two markets are different. (09 marks)
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LO 4: OLIGOPOLY:
Definition and Examples of Oligopoly:
Definition:
Oligopoly is a situation in which an industry is dominated by a few large sellers, which are
interdependent on each other.
Examples:
 Airline market
 Car makers
 Oil and Gold Producers
Features of Oligopoly:
Few Large Firms:
In oligopoly, there are few large firms with a high concentration ratio. Each large firm has
substantial control over market.
Nature of Product:
In oligopoly, firms may produce homogenous products (e.g. petrol, steel, cement) as well as
differentiated products (e.g. cars, cigarettes, electronic equipments).
Interdependence of Firms:
As goods are substitute and have high cross elasticity of demand, therefore, each individual firm can
affect market price. Therefore, if a firm reduces its price to increase his market share, rivals will
also decrease prices and a Price-War may start.
Study Tips
1. If firms in oligopoly co-operate with each other to agree on a common pricing and output decision, or
divide market among themselves, this is called Collusive Oligopoly or Collusion.
2. If firms make their own decisions about pricing and output, this is called Non-collusive Oligopoly.
Indeterminate Demand Curve:

The pattern of demand curve is not definite. Demand curve may show different behavior with
different changes in price.
Barriers to Entry:
In oligopoly, large firms create high barriers to entry. Therefore, entry in the market is difficult but
not impossible.
Role of Advertisement:
As goods are good substitutes of each other, some oligopolies engage in advertisement and other
sales promotional activities.
Outcomes/ Economic Effects of Features of Oligopoly:

 Firms may create Price-Cartels.
 Output is lower and prices are higher as compared to competitive markets.
 Firms do not operate at minimum cost.
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Advantages and Disadvantages of Oligopoly:

Advantages of Oligopoly:
 Members of oligopoly may set prices through an agreement.
 As there are few firms, they can make large profits.
 Barriers to entry allow oligopolist to earn super-normal profit in the long run.
 Price comparison is easy for customers.
 Prices are stable.
Disadvantages of Oligopoly:
 Price setting among oligopoly firms may be at disadvantage to consumers.
 No incentive for product improvement.
 There may be price war between oligopolists.
 Small players cannot enter market.
Cartel: (or Price Cartel)

Definition:
When oligopolies collude among themselves and make a formal or informal agreement to fix price
for the market and individual share of each firm, it is called Cartel. An example of international oil
cartel is OPEC.
Success (or failure) of Price Cartels depend on following factors:

1. Control over Supply:
Cartel should consist of most of the producer in the market, so that they are able to control
the supply and consequently price in market. Otherwise, buyers will shift to supplier selling
goods at low price.
2. No Availability of Substitute:
There should be no close substitute. If substitutes are available, buyers will shift to them if
prices are increased.
3. Price Elasticity of Demand:
Cartels are effective if demand is inelastic. If demand is elastic, increase in price will result
in decrease in total revenue.
4. Ease with which supply can be controlled:
Cartel is successful if supply can be easily controlled. However, if supply is dependent on
weather or political conditions (e.g. agricultural products), cartel may not be successful.
5. Agreement on individual share:
Cartel is successful if firms agree on their individual shares in the market. However, if they
secretly increase their supply in the market, price will decrease and cartel will collapse.
6. Non-intervention by government.
Cartel is successful if government does not interfere in market. If government announces
cartels to be illegal, cartels will not be successful.
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Kinked Demand Curve:

The kinked demand curve explains how non-collusive oligoplists accept a price in the market
without price cartel. Kinked demand curve is an oligopolist’s demand curve which is downward
sloping and has different segments with different elasticities which join at a corner or kink.
Diagram Explanation
Assumptions/Explanation of the kinked demand

curve:
1. Firms in oligopoly want to maximize profit, but
attitude of each seller depends on attitude of his
rivals.
2. If a firm increases price, other firms will not
increase their prices so this firm will lose its
much share of the market. Therefore demand is
elastic for price increase.
3. If a firm decreases price, other firms will also
decrease their prices so this firm will not gain
much share of the market. Therefore demand is
inelastic for price decrease.

What is meant by ‘Oligopoly’? List any four advantages and disadvantages of Oligopolies. (05 marks)
(a) Oligopoly is the situation where industry is dominated by a few large suppliers. Briefly discuss any six features of
oligopoly. (06 marks)
(b) When oligopolists fix prices by collusion among themselves, they are known as cartel. Discuss the factors that are
responsible for the success / failure of price cartel. (04 marks)
How does oligopoly differs from monopolistic competition? (04 marks)

74
Economics – Study Notes Chapter 7 Overview of Macroeconomics
CHAPTER SEVEN
OVERVIEW OF MACROECONOMICS
LO 1 OBJECTIVES OF MACROECONOMICS
PART A – MACRO-ECONOMIC EQUILIBRIUM

LO 2 AGGREGATE DEMAND
LO 3 COMPONENTS OF AGGREGATE DEMAND
LO 4 AGGREGATE SUPPLY
LO 5 DETERMINANTS OF AGGREGATE SUPPLY

AD-AS MODEL TO DETERMINE MACROECONOMIC EQUILIBRIUM AND OUTPUT
LO 6
GAP
PART B – GOVERNMENT POLICIES TO INFLUENCE AGGREGATE DEMAND
LO 7 FISCAL POLICY
LO 8 MONETARY POLICY
LO 9 LIQUIDITY TRAP
75
LO 1: OBJECTIVES OF MACROECONOMICS:
Objectives of Macroeconomics:
Economic Growth:
Economic growth means an increase in the real potential output of a nation over time. Government
makes policies to stimulate and achieve consistency in economic growth.
Full Employment Level:

Government has social objective to achieve full employment level:
 to ensure maximum utilization of human resources and increase national output, and
 to reduce crimes, or social security payments as a result of unemployment.
Stability in Price Levels and Exchange Rates:

Government ensures there is no or low inflation ensuring stability in prices and exchange rates.
Equilibrium in Balance of Payment:

Through its policies, government ensures that there is a balance between its imports and its exports
by restricting imports and promoting exports.
Equilibrium in Fiscal Budget:

Through fiscal policies, government ensures that there is a balance between its public expenditures
and its tax revenues.
Equal Distribution of Wealth:

Through fiscal policies, government ensures that there is equal distribution of wealth.
Credit Control:
Though monetary policies, government can exercise controls over supply of money and credit.
Study Tip
Objectives of Fiscal Policy are same (except credit control) and objectives of Monetary Policy are also same
(except equilibrium in fiscal budget and equal distribution of wealth).
Conflict between Objectives:

Objectives of a government may be in conflict with each other. Therefore, government should
prioritize and balance its objectives to achieve a good combination. For example, following conflicts
may exist between various objectives of Macroeconomics.
Price stability versus full employment:

There is an inverse relationship between inflation and unemployment. Therefore, if government
reduces tax rates (or central bank reduces interest rates) to increase aggregate demand and to
reduce unemployment, it may also result in inflation.
Economic growth versus exchange rate stability:

To boost economic growth, government may decide to depreciate local currency to increase its
exports and to achieve economic growth. However, such act would cause instability in exchange
rates.
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Economic growth versus credit control:

Economy may grow through the expansion of credit, as it would stimulate investment and
spending. However, there would be a risk of bad debts.
PART A – AGGREGATE DEMAND & AGGREGATE SUPPLY MODEL TO

MACRO-ECONOMIC EQUILIBRIUM
In macroeconomics, an equilibrium level of output is one where the different forces of spending and
output (i.e. Aggregate Demand & Aggregate Supply, Aggregate Expenditure & Aggregate Output, and
Withdrawals and Injections) are in balance.
LO 2: AGGREGATE DEMAND:
Aggregate Demand (AD):
The aggregate demand is the sum of demand of all goods and services in an economy. AD has four
components i.e.
Aggregate Demand (AD) = Consumption (C ) + Investment (I) + Govt. Spending (G) + Net Exports (X – M)
Aggregate Demand Curve (AD Curve):

Aggregate Demand Curve shows how much GDP will be demanded at each general price level.
Diagram Explanation of Diagram
AD curve is downward sloping as quantities demanded will

increase when the price falls.
Study Tips - Shift in Aggregate Demand Curve

Government can influence Aggregate Demand (i.e. can shift it rightward or leftward) through:
 Fiscal Policy and Multiplier Model (emphasized by Keynes), and
 Monetary Policy (emphasized by Milton Friedman)

(a) Define the term aggregate demand. (2 Marks)
(b) Write and explain an equation that represents the components of an aggregate demand. (5 Marks)
(Institute of Chartered Accountants in Malawi – December 2012)
77
LO 3: COMPONENTS OF AGGREGATE DEMAND:

Aggregate Demand (or Total Expenditure) in an economy affects the equilibrium level of national
income or output. Each component of aggregate demand is outlined below.
Private Consumption:
This includes purchase of consumer goods and services by households (except new houses).
Private Consumption is further classified into following categories:

 Durable goods (tangible items consumed in a long period of time e.g. automobiles, furniture)
 Nondurable goods (tangible items consumed in a short period of time e.g. food, clothing)
 Services (intangible items of value e.g. education services, medical services)
Study Tips
1. “Private” means purchase by households only is included (Govt. purchases is not included here).
2. These expenditures are inclusive of “Indirect Taxes” and Import Purchases.
Gross Private Investment:

Investment means purchase of goods by firms which will be used in future to produce more goods
and services.
Gross Private Investment is further classified into following categories:

 Capital Investment (i.e. purchases of capital goods e.g. Machinery, Equipment, office building)
 Residential Investment (i.e. purchase/expenditures on new houses by households)
 Inventory Investment (i.e. increase/decrease in unsold inventory at year-end)
Study Tips
1. “Private” means purchase by firms only is included (i.e. Govt. purchases is not included here).
2. Investment does not includes Money or Financial Investment i.e. Purchase/Sale of Shares (i.e. stocks
and bonds) and Debentures (i.e. bonds).
Government Spending/Purchases/Expenditure:
Government spending includes expenditure of government on:
 Capital goods (e.g. construction of schools, hospitals and roads)
 Consumer goods/services(e.g. office supplies, salaries to govt. employees, military purchases)
 Transfer payments (e.g. pensions)
Net Export:
Net Export means “Export – Imports”.
Study Tips - Shift in Aggregate Demand Curve

Factors/Determinants affecting these components will be discussed in detail in later chapters.

For each of the components of aggregate demand name and explain one factor that may cause it to change. (09 Marks)
78
LO 4: AGGREGATE SUPPLY:
Aggregate Supply (AS):
The aggregate supply is the total quantity of all final goods and services in an economy which
suppliers are willing and able to produce at different general price levels.
Aggregate Supply Curve (AS Curve):

Aggregate Supply Curve shows how much goods and services will be supplied at each general price
level.
Diagram and its Explanation:
Keynesian Range or Excessive Spare Capacity Range (or Immediate short-run):

At this stage, prices of outputs as well as inputs are fixed. There is large amount of spare capacity and workforce (i.e.
economy is in recession or depression). This phase is shown by horizontal AS Curve.
If AD increases, prices remain same, national output increases and unemployment decreases.
Intermediate Range (or Short-run):

At this stage, prices of output can vary but prices of input are fixed. There is limited spare capacity (i.e. economy is in
recovery). This phase is shown by upward AS curve. AS curve is upward in short-run because input prices are fixed (e.g.
wage contracts, rental agreements) and more factors of production are available. Therefore, suppliers have incentive to
supply more at higher price.
If AD increases, prices increase, national output increases and unemployment decreases.
This stage also shows “demand-pull inflation” and “inverse relationship between inflation and unemployment”.
Classical Range or Full employment Range (or Long-run):

At this stage, prices of output as well as prices of input can vary. There is no spare capacity (i.e. economy is at boom). This
phase is shown by vertical AS Curve. As curve is vertical in long-run input prices also vary and there will be same ratio of
price to cost, even after increase in price. Therefore, suppliers have no incentive to supply more at higher price and level
of output supplied is independent of price level.
If AD increases, prices increase, but there is no change in real output or unemployment level.
This stage also shows “demand-pull inflation” and “independence of inflation and unemployment”.
Study Tips
Full employment is the point at which all factors of production of an economy are fully utilized.
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LO 5: DETERMINANTS OF AGGREGATE SUPPLY:

Aggregate Supply depends on Production Costs and Potential Output.
Production Cost:
Following are the reasons for rightward shift of AS Curve:
 Lower Wages.
 Decrease in cost of other input e.g. raw material, overheads.
 Lower Import prices, or appreciation in exchange rates
Potential Output:
Potential output is the maximum sustainable level of output that an economy can produce, and that
is also compatible with stable prices. It comes at full employment level i.e. point when labor and
other inputs of an economy are fully utilized.
Potential Output is influence by the same factors which influence economic growth.
 Natural resources (e.g. Oil, Gas, Coal, Other mineral resources)
 Quantity and Quality (e.g. education, skill, discipline) of Labor
 Supply of Capital (e.g. factories, machinery, intellectual property)
 Entrepreneurship and Technology (e.g. Innovation, Technological improvement, and
increased efficiency).

(a) With the aid of a diagram, define and explain the terms “aggregate demand” and “aggregate supply”. (06 Marks)
(b) Name two factors which influence aggregate demand and two factors which influence aggregate supply. (02 Marks)
LO 6: AD-AS MODEL TO DETERMINE MACROECONOMIC EQUILIBRIUM AND OUTPUT GAP:

A national economy will reach equilibrium where the aggregate demand curve and
aggregate supply curve intersect.
Diagram Explanation
Actual level of national income (or output) is the
point of intersection of AS and AD i.e. at i.e. at Ye, and
Yf is the national income (or output) at full
employment.
If actual national income is less than national income

at full employment, it is called Deflationary/
Recessionary/ Negative Output Gap. At this point:
 If AD changes at this level, price level
remains constant and national output
changes.
 Price level is below of what it would be with
full employment in the economy.
If actual national income is more than national

income at full employment, it is called Inflationary/
Positive Output Gap. At this point, if AD increases,
price level increases rapidly but output remains
constant.
80
Study Tips
Terms “GDP” and “Outputs” are synonymously used in economics.

Explain with the help of a diagram, the equilibrium of aggregate supply (AS) and aggregate demand (AD) under neo-
classical approach. (07 marks)
Illustrate with the help of a diagram, the concept of deflationary gap in the economy. (04 marks)
Explain the concept of Inflationary Gap in an economy. Illustrate your answer with the help of a diagram. (06 marks)
PART B– GOVERNMENT POLICIES TO INFLUENCE AGGREGATE DEMAND

Tools/Instruments available to Govt.’s policy makers are:
1. Fiscal Policy, and
2. Monetary Policy
LO 7: FISCAL POLICY:
Definition of Fiscal Policy:
Use of government expenditure and taxes to achieve macroeconomic objectives (by influencing
aggregate demand).
Study Tip
When govt. uses fiscal policies to increase Aggregate Demand (and to reduce deflationary output gap), these
are called Expansionary Policies. When govt. uses fiscal policies to decrease Aggregate Demand (and to
reduce inflationary output gap), these are called Contractionary Policies.
Tools of Fiscal Policy: (use explained as expansionary policy)

Government Expenditures:
An increase in Government expenditures (i.e. govt. purchases and transfer payments) will lead to
injection into circular flow of income, and consequently increase in aggregate demand. This impact
is magnified due to multiplier effect.
Taxation:
A decrease in taxation will lead to more disposable income which will cause increase in
consumption and saving, and consequently increase in aggregate demand. This impact is magnified
due to multiplier effect.
Study Tip
Under Contractionary Policies, same tools will be used in opposite direction to decrease aggregate demand.
81
Limitations of Fiscal Policies:

Crowding-out Effect:
Crowding-Out effect means increase in Government Expenditure may lead to decrease in Private
Expenditure because:
 Some government expenditure may replace private expenditures e.g. expenditure on
colleges, hospitals etc.
 If Government obtains loan from banks, there are less loans available for consumers and
producers.
Trade-off Effect due to conflict in objectives:

All macro-economic objectives cannot be achieved simultaneously e.g.
 If inflation is reduced, unemployment will increase and vice-versa.
 If exchange rate is depreciated to increase exports, this will harm stability in exchange rates
and price levels.
 Expansion of credit is necessary for economic growth.
Forecasting of Multiplier Effect:

It is difficult to accurately predict multiplier effect on GDP.
Marginal Propensity to Save:

It is difficult to predict the effect of change in taxation on GDP because of Marginal Propensity to
Save.
Time-lag:
There may be considerable time-lag between planning a fiscal policy and implementing a fiscal
policy.

State what is meant by the term Fiscal Policy. Explain how fiscal policy measures may help to stimulate aggregate demand
and reduce unemployment in an economy. (10 marks)
Fiscal policy means the process of shaping government taxation and government spending so as to achieve certain
objectives. Discuss any six objectives of fiscal policy. (06 marks)
Explain any two limitations of fiscal policy. (04 marks)

LO 8: MONETARY POLICY:
Definition of Monetary Policy:
The central bank’s regulation of the nation’s money, credit, and banking system to achieve macro-
economic objectives.
Study Tip
When govt. uses monetary policies to increase Aggregate Demand (and to reduce deflationary output gap),
these are called Expansionary Policies. When govt. uses monetary policies to decrease Aggregate Demand
(and to reduce inflationary output gap), these are called Contractionary Policies.
82
Tools of Monetary Policy: (use explained as expansionary policy)

Open Market Operations:
Open market operations mean the sale and purchase of govt. securities by central bank in open
market. Buying govt. securities will lead to injection of money in market, and will cause increase in
supply of money.
Reserve requirements:
Reserve ratio is the amount of reserves that a bank has to deposit with the central bank. If this
reserve is decreased, commercial banks will have more money to increase the level of loans that they
give out to public. Decrease in reserve ratio will also increase “credit multiplier”, hence, this impact
is magnified. Ultimately, this will increase supply of money and aggregate demand.
Discount Rate (or Base Rate) Policy:

Discount rate is the rate which is charged by central bank on loans given to commercial banks. If
central bank lowers discount rate on loans to commercial banks, commercial banks increase their
level of borrowings, which leads to increase in supply of money and aggregate demand.
Moral Persuasion:
Central bank morally persuades commercial banks to take specific steps that are consistent with
the central bank’s macroeconomic objectives.
Study Tip
Under Contractionary Policies, same tools will be used in opposite direction to decrease aggregate demand.
Diagram showing effect of Expansionary Policy on AD, Diagram showing effect of Contractionary Policy on AD,
Output, Employment and Inflation Output, Employment and Inflation
Limitations of Monetary Policies:

Existence of non-monetary sector:
Usually, people in developing countries and in rural areas do not use banking channel or money for
their transactions. Monetary policies cannot cover such non-monetary sector (e.g. barter
transactions) existing in the economy.
83
Existence of non-banking financial institutions:

These are some organizations which provide finance to consumers and investors, but do not come
under supervision of central bank. Monetary policies cannot cover such non-banking financial
institutions.
Agents using own liquid money:

When a central bank reduces supply of money, economic agents can create their own liquid money
against policies of central bank.
Time-lag:
There may be considerable time-lag between planning a monetary policy and implementing it. A
change in monetary policy may take months to affect an economy.
Lack of co-ordination between monetary and fiscal policies:

Strictly speaking, monetary policy is implemented by central bank and fiscal policy is implemented
by government. If both organizations do not work in co-ordination with each other, both policies
will fail.
Trade-off Effect due to conflict in objectives:

(same as in Fiscal Policy)

Illustrate the process through which the central bank may reduce the level of aggregate demand in the economy using
open market operations. (05 marks)
Explain how the central banks are able to reduce the level of aggregate demand in an economy by changing the reserve
requirements of commercial banks? (08 marks)
(a) There are various objectives of monetary policy but it is not possible to satisfy all of them simultaneously. Briefly
describe the conflicts that may exist between various objectives of monetary policy. (06 marks)
(b) Monetary policy may bring about many advantages but in the real economy, there are certain limitations to its
effectiveness. Discuss any four such limitations. (04 marks)
List any four tools that a central bank may use to implement its monetary policy. (02 marks)
A country named Greenland wishes to increase economic growth. Which type of monetary policy will be formulated by its
Central Bank to achieve this objective? How this policy will affect the aggregate demand and output level? Illustrate your
explanation with suitable diagram. (10 marks)
(PIPFA –Winter 2015)
(a) Describe the four major objectives of a government’s economic policy. (06 marks)
(b) Explain how monetary and fiscal policies can be used to achieve the above objectives. (06 marks)
84
LO 9: LIQUIDITY TRAP:
Liquidity Trap:
Liquidity trap is a situation when nominal interest rate decreases near to zero (in recession). In
such situation, banks do not lend loans at such low rates and prefer to hold reserve. Thus, monetary
policy by central bank fails to stimulate economic growth.
Overcoming the Liquidity Trap:

 Fiscal Policy:
Government should spend/investment more by running a budget deficit.
 Developing expectations for higher prices in future:
Higher inflation will cause savings to be worth less, as its real value will decrease. Therefore
consumption will increase.
 Developing expectations for low interest rates
 Helicopter Drop Approach (i.e. central bank giving money directly to consumers to stop
commercial banks to hoarding money)

What is Keynesian liquidity trap? Identify any three policies which can help to break out of the liquidity trap. (04 marks)
85
Economics – Study Notes Chapter 8 Calculation of National Income
CHAPTER EIGHT
CALCULATION OF NATIONAL INCOME
LO 1 ECONOMIC GROWTH
LO 2 CIRCULAR FLOW OF INCOME
PART A – GDP AND ITS CALCULATION

LO 3 APPROACHES/METHODS OF CALCULATION OF GDP
LO 4 FORMAT FOR CALCULATION OF NATIONAL INCOME
LO 5 ITEMS NOT INCLUDED IN THE CALCULATION OF GDP/NATIONAL INCOME
LO 6 DIFFICULTIES IN CALCULATION AND COMPARISON OF GDP
PART B – OTHER CONCEPTS

LO 7 RELATIONSHIP BETWEEN PERSONAL INCOME, CONSUMPTION AND SAVINGS
86
LO 1: ECONOMIC GROWTH:
Economic Growth:
Definition:
Economic growth is usually measured as the annual rate of increase in a nation’s real potential GDP.
Percentage Growth Rate = (Real GDP of Y1 – Real GDP of Y0)/ Real GDP of Y0 * 100
Advantages:
 Increased per-capita income and higher living standards.
 High employments
 Fiscal Benefits (i.e. increased taxes)
 Enterprise confidence
 Higher investment
Disadvantages:
 Environmental problems
 Inequality of income and wealth among citizens
 Risk of inflation
 Social problems (e.g. upsets in social lives)
Gross Domestic Product:

Gross Domestic Product (GDP):
“GDP is the aggregate market value of all final goods and services produced within boundaries of a
country in a given period.”
GDP Per-capita:
GDP per-capita means average GDP of a country per person i.e.
GDP per capita = GDP / Population
Nominal GDP and Real GDP:

Nominal GDP means measurements of GDP at current market prices (i.e. without adjustment for
inflation).
Nominal GDP = Quantity of Production * Prices
Real GDP means measurement of GDP at constant market prices (i.e. after adjustment for inflation).
Real GDP= Nominal GDP / GDP Deflator
Exam Tip
1. Theoretically GDP and National Income are same; however in calculation, both are different.
2. Economists love to make comparison in real terms, and NOT in nominal terms.

What is meant by ‘Economic growth’? Briefly describe the benefits of economic growth. (08 marks)
Distinguish between the following concepts:

(i) Gross domestic product (GDP) and net domestic product (NDP). (04 marks)
(ii) Nominal GDP and Real GDP. (04 marks)
(The Institute of Chartered Accountants of Ghana – December 2014)
87
LO 2: CIRCULAR FLOW OF INCOME:

Definition of Circular Flow of (national) Income:
Circular flow of income explains how Goods and Money flow within an economy among economic
agents.
Diagram of Circular flow of income:
Diagram Explanation
1. Firms engage households to provide factors of
production and in return give them rent, wages etc.
(which is income for households).
2. Households use this money to buy goods/services
from Firms. (which is expenditure for households).
3. There are two types of flows in the diagram which
move in opposite direction i.e.
a. “Real Flow” which is the inner flow of factors of
production and production.
b. “Money flow” which is outer flow of income and
expenditure.
4. Circular flow proves that “National Product =
National Income = National Expenditure”.
Withdrawals and Injections in Circular Flow of Income:

Leakages/ Withdrawals: (i.e. funds going out of the circular flow)
1. Savings (S) i.e. Percentage of income which is not consumed by households.
2. Taxation (T) i.e. Percentage of income paid by households to government.
3. Imports (M) i.e. Payments to foreigners on purchase from abroad.
Injections: (i.e. funds coming into the circular flow)

1. Investments (I) i.e. Expenditures by firms on purchase/manufacturing of capital goods.
2. Government Spending (G) i.e. Expenditures by government on consumption or investment
goods.
3. Exports (X) i.e. Receipts from foreigners on sale to abroad.
Exam Tip
Lord Keynes has explained that if Withdrawals >Injections, National income will decrease (leading to
recession in economy). If Injections > Withdrawals, National income will increase (leading to boom).

(a) Draw a diagram of Circular Flow of Income. (04 marks)
(b) List three types of ‘Withdrawals’ and ‘Injections’ from/into the Circular Flow of Income. (03 marks)
What happens to the size of the circular flow when leakages exceed injections? (02 Marks)
(Institute of Chartered Accountants in Malawi – June 2014)
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PART A – GDP AND ITS CALCULATION
LO 3: APPROACHES/METHODS OF CALCULATION OF GDP:

Expenditure/Product Method:
Under Expenditure method, an economy is divided into different sectors and spending by all
sectors during the year is added i.e.
GDP = C + I + G + (X – M)
Sector of Economy Spending Called Spending Denoted by

Consumers Private Consumption "C"
Business Gross Private Investment "I"
Government Government Purchases "G"
Foreign Net Exports "X – M"
Income/Earnings Method:
Under this method, an economy is divided into different factors of production; and then income of
all factors is added i.e.
National Income = Rent + Wages + Interest + Profit
Factor of Production Income Called

Land Rent
Labor Wages
Capital Interest
Entrepreneur Profit
Value added / Output/ Production approach:

Under this method, an economy is divided into different sectors of production; and then net value of
all final goods and services produced during the year are added i.e.
National Income = Value of Final goods/services – Value of Intermediate goods/services (all
sectors)

Define the term National Income and list the components of National Income under the Income Method. (03 marks)
Briefly describe three different approaches to measure National Income. (06 marks)
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LO 4: FORMAT FOR CALCULATION OF NATIONAL INCOME:

Expenditure Method
Category of Expenditure Amount

Private Consumption (C):
Gross Private Investment (I):
Government Spending (G):
Net Exports (X – M):
C + I + G + X-M = Gross Domestic Product (at Market Price) * -
Add: Net Property Income from abroad/Foreign Factor Income

(i.e. Income of Citizens from abroad – Income of Foreigners in country)
= Gross National Product (at Market Price) * -
Less: Capital Consumption/ Depreciation
= Net National Product = National Income (at Market Price)* -
Less: Net indirect Taxes
(i.e. Indirect Taxes - Subsidies)
= National Income (at Factor Cost) -
*National Income at market price means National Income before deduction of “net indirect taxes”.
National Income at factor cost means National Income after deduction of “net indirect taxes”.
Study Tips
1. Gross National Product is the aggregate market value of all final goods and services produced by
citizens of a country in a given period.
2. “Gross” means before depreciation and “Net” means after deductions of depreciation e.g.
Net Domestic Product = Gross Domestic Product – Depreciation
Net National Product = Gross National Product – Depreciation
Income Method
Category of Income Amount

Rent: -
Pre-tax Wages: -
Interest: -
Pre-tax Profits of firms: -

This includes profit of Proprietors and Corporations.
National Income (at Factor Cost) -
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Value Added Method
Market Value of Intermediate Goods* Market Value of Final Goods

Stage of Production Value Added
(i.e. Input) (i.e. Output)
Raw Material 0 15 15
Manufacturing 15 50 35
Retail 50 90 40
National Income (i.e. Sum of Value Added) 90
* To avoid double counting, we include only final goods produced in GDP and exclude the intermediate goods that are
used up in making the final goods.
Final goods:
These are the goods produced as output at the end of the production process, to be used for
consumption or investment.
Intermediate goods:
Intermediate goods are goods which are used as inputs to produce other goods e.g.
Steel/tyres/leather used in a Car.
Value added:
The difference between a firm’s sales and its purchases of materials and services from other firms.
Study Tip
If you are required to calculate GDP/National Income but no method is prescribed, use Expenditure
Method.

What do you understand by the terms GDP, GNP and NNP? Briefly describe GDP at market price and GDP at factor cost.
(08 marks)
Following data relates to the economy of a country over a year period.

Rs. In Millions
Capital consumption 2,625
Subsidies 450
Exports 9,675
Imports (9,360)
Consumers’ expenditure 27,600
Taxes on expenditure (4,140)
Net property income from abroad 315
Value of physical decrease in stocks (30)
Gross domestic fixed capital formation 7,380
General government final consumption 6,810
Required:
You are required to compute the following, showing necessary workings:
a. Gross Domestic Product (GDP) at market prices and at factor cost (06 marks)
b. Gross National Product (GNP) at market prices and at factor cost (06 marks)
c. National Income at factor cost (03 marks)
Check Figures: National Income (at Factor Cost) = 36,075 & GDP at factor cost = 38,385 & GNP at factor cost = 38,700
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The Economic Survey of the government of Aladina discloses the following:

Rupees in millions
Government expenditure 7,500
Sales value of output of firms 30,000
Imports 6,000
Profit before tax of firms 10,500
Consumers’ expenditure 16,500
Wages etc. received by employees 12,000
Tax deducted out of wages 1,500
Exports 6,000
Cost of goods and services purchased from outside firms 6,000
You are required to compute the Gross Domestic Product (GDP) by:
i) Expenditure approach (05 marks)
ii) Income approach (05 marks)
iii) Value added approach (05 marks)
Check Figures: GDP = Rs. 24,000
Assume a small economy consisting of one firm. During a given period, the firm:
(i) Imported raw materials amounting to Rs. 90 million;
(ii) Paid salaries to employees amounting to Rs. 180 million (before deduction of tax);
(iii) earned sales revenue of Rs. 400 million, comprising of domestic sales of Rs. 240 million, sales to government
organisations of Rs. 90 million and exports of Rs. 70 million;
(iv) Distributed dividends of Rs. 100 million to the shareholders.
(v) Taxes deposited on salaries paid to employees and on the firm’s profits were Rs. 40 million and Rs. 50 million
respectively.
Calculate the Gross Domestic Product under Expenditure, Income and Value-added approaches. (06 marks)
Check Figures: GDP = Rs. 310 million
LO 5: ITEMS NOT INCLUDED IN THE CALCULATION OF GDP/NATIONAL INCOME:

Transfer Payments:
Transfer payment is a one-way payment of money in which there is no exchange of goods or
services in current period. These could be either:
1. Govt. Transfer Payment i.e. govt. to individual (e.g. Pensions, social security benefits) or
2. Private Transfer Payment i.e. individual to individual (e.g. Gifts, Charity)
Transfer payments are NOT included in GDP or National Income. However, transfer payments are
included in Personal Income and Fiscal Budget.
Non-Productive Transactions:
These are the transactions which do not increase in current year’s production e.g. 2nd
hand sale of goods, financial Transactions (e.g. securities bought/sold), appreciation in value of
inventory or property.
Underground (or Black or Shadow) Economy:

This means income not reported to government e.g. unreported income to avoid tax, or income
earned from illegal sources (e.g. drugs, gambling, bribe, immoral activities).
Non-monetary transactions:
These are Goods/Services produced during the period but are not exchanged for money e.g. Do-it-
yourself activities, Work of house-wives, Eatables grown and used at home, Barter transactions.
92

‘Income method measures the national income after it has been distributed and appears as income earned or received by
individuals of the country’.
List the items which are excluded from the computation of national income under the income method. (03 marks)
What do you understand by the term Gross Domestic Product? State the reason for excluding intermediate goods from the
calculations of GDP. (04 marks)
Briefly explain “Transfer Payments” (02 marks)

LO 6: DIFFICULTIES IN CALCULATION AND COMPARISON OF GDP:

Difficulties in calculation of GDP:
1. Some income cannot be captured e.g.
a. Non-market transactions
b. Non-monetized transactions.
c. Underground (or Black/Shadow) Economy Transactions.
2. Risk of double counting.
3. Complications in treatment of income of multinational firms.
4. Illiteracy, Non-availability of reliable data, and Lack of appropriately skilled staff
5. Calculation of depreciation, valuation of inventories is a difficult and subjective procedure.
6. Further problems arise in underdeveloped countries and villages where:
a. Lot of transactions are done on barter-system.
b. No systematic accounts are maintained.
c. People simultaneously engage in many occupations.
Difficulties in making comparisons:

Difficulties in making single country comparisons:
Increase in national income may be due to Inflation, and not due to economic growth. This difficulty
is overcome by use of GDP deflator.
Difficulties in making international comparisons:

1. Exchange rate distorts comparability of figures
2. Choice of method may affect result of process.
3. There may be difference in countries regarding classification of activities.

Identify any six types of difficulties that are commonly faced in measuring National Income. (03 marks)
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PART B – OTHER CONCEPTS
LO 7: RELATIONSHIP BETWEEN PERSONAL INCOME, CONSUMPTION AND SAVINGS:

Personal Income:
The amount of income that individuals actually receive.
Disposable Personal Income:

The portion of personal income that can be used for consumption or saving.
National Income at Factor Cost -

Less: Corporation Taxes & Undistributed Corporate Profit -
Add: Transfer Payments -
= Personal Income -
Less: Personal Taxes (e.g. income taxes, property taxes, inheritance taxes) -
= Disposable Personal Income -
Less: Consumption -
= Saving -

Differentiate the following with the help of an equation for each:
Personal Income (P.I) and Personal Disposable Income (P.D.I) (02 marks)
(ICMA Pakistan, Fundamental Level F2 – Winter 2008)
94
Economics – Study Notes Chapter 9 Analysis of Consumption and Investment Expenditures
CHAPTER NINE
ANALYSIS OF CONSUMPTION AND
INVESTMENT EXPENDITURES
PART A – ANALYSIS OF CONSUMPTION EXPENDITURE

LO 1 RELATIONSHIP BETWEEN DISPOSABLE INCOME, CONSUMPTION AND SAVING
LO 2 CONSUMPTION AND ITS DETERMINANTS
LO 3 CONSUMPTION FUNCTION
PART B – ANALYSIS OF INVESTMENT
LO 4 TYPES OF INVESTMENET
LO 5 DETERMINANTS OF INVESTMENET
PART C– ALTERNATIVE MODELS TO MACRO-ECONOMIC EQUILIBRIUM
LO 6 AGGREGATE EXPENDITURE MODEL TO OUTPUT DETERMINATION
LO 7 SAVING-INVESTMENT MODEL TO OUTPUT DETERMINATION
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PART A – ANALYSIS OF CONSUMPTION EXPENDITURE
LO 1: RELATIONSHIP BETWEEN DISPOSABLE INCOME, CONSUMPTION AND SAVING:

There is a precise accounting relationship between disposable income, consumption, and saving.
Disposable income = Consumption + Saving
This relationship has been further analyzed by Keynes in his Psychological Law of Consumption.
Keynes’ Psychological Law of Consumption:

“Fundamental psychological law is that, on average, men increase their consumption as their
income increases; but not by as much as the increase in their income”.
Propositions of Keynes’ Psychological Law of Consumption:

 When income increases, consumption also increases.
 Increase in consumption is less than increase in income.
 What is not spent on consumption, is saved.
LO 2: CONSUMPTION AND ITS DETERMINANTS:

Consumption:
Consumption is that part of disposable income which is spend by households on purchase of
consumer goods and services.
Determinants of Consumption:
Disposable income:
Primary determinant of the consumption is disposable income of consumer. If income increases,
consumption also increases.
Wealth:
When the wealth of households increases, consumption function will move upwards. Changes in
prices of assets (held by households), and rate of inflation also affect wealth.
Distribution of Income and Wealth:

A more equal distribution of income (e.g. through tax and benefits system) will shift the
consumption function upward.
Expectations about price changes:

If prices are expected to increase, households will increase their consumption in current period.
Changes in Interest rates and credit availability:

Consumers finance expensive goods (e.g. house, cars) by borrowings. If interest rates decrease and
credit is offered, consumptions will increase.
Changes in tax rates:

If tax rates decrease, this will cause increase in disposable income of consumer leading to increased
consumption.
96
Study Tip
As saving is inversely related to consumption, everything which influences consumption will influence
saving but in opposite direction.

Briefly describe the determinants of consumption in an economy. (06 marks)
LO 3: CONSUMPTION FUNCTION:
Consumption Function:
Consumption function is a schedule which shows the relationship between level of consumption
and disposable income.
Consumption function is expressed as “C = a + bY” where:

 “C “ represents total consumption by consumer. It has two parts i.e.
o Autonomous Consumption (part of consumption which does not change with the
change in income. It is incurred even if income is Zero i.e. Rs. 10 in our example).
o Induced Consumption (consumption which changes with the change in income).
 “b” represents Marginal Propensity to Consume which is the ratio of a change in
consumption due to change in disposable income.
MPC = Change in consumption / Change in Income
 Income (Y) represents total disposable income of consumer.
Study Tip
Saving is the amount of disposable income not spent to consumption. Saving function is a schedule
which shows the relationship between level of savings and disposable income.
Table:
Income Consumption Saving MPC MPS APC

(Y) (C) (b)
0 10 -10 - - -
10 18 -8 0.80 0.20 1.80
20 26 -6 0.80 0.20 1.30
30 34 -4 0.80 0.20 1.13
40 42 -2 0.80 0.20 1.05
50 50 0 0.80 0.20 1.00
60 58 2 0.80 0.20 0.97
In this table:
1. Average propensity to consume is the ratio of total consumption to total disposable income.
2. It is also important to note that as income increases, MPC does not change but APC decreases.
3. Marginal Propensity to Save (MPS) = 1 – MPC
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Graphs of Consumption Function AND Saving Function:
Diagram of Consumption Function Explanation
 C is the consumption curve which rises with

increase in disposable income.
 S is the saving function which is derived by
subtracting consumption from income.
 Note that the break-even point is at the income
level of Rs. 40.
Study Tip
If a determinant other than income changes (e.g. wealth, interest rate), the consumption function (and
the corresponding saving function) will shift up or down.

Write short note on “Consumption Function”. (05Marks)
Explain the concepts of Average Propensity to Consume (APC) and Marginal Propensity to Consume (MPC). (06 marks)
Discuss the Keynes’ Psychological Law of Consumption and the related propositions. (04 marks)
PART B – ANALYSIS OF INVESTMENT
LO 4: TYPES OF INVESTMENET:
Definition of Investment:
Investment means purchase of goods by which will be used in future to produce more goods and
services.
Types of Investment:
Autonomous Investment:
Investment which does not depend on National Income/GDP is called as Autonomous or
Government Investment. These investments are made for the well-being of society and not for
making profits.
 Construction of highways and transportation facilities
 Construction of dams, hospitals, schools etc.
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Induced Investment:
Investment which changes with the changes in National Income (because business reinvest their
incomes), is called Induced or Private Investment. These investments are made for making profits.
Examples of induced investment:

 Constructing of a new warehouse by a company.
 Purchase of a new machinery by company to expand its production

Differentiate between “Autonomous” and “Induced” investments. Give any two examples of each. (04 marks)
LO 5: DETERMINANTS OF INVESTMENET:
Rate of interest:
There is an inverse relationship between rate of interest and investment. If market rate of interest
decreases, MEC increases resulting in increase planned investment (and vice-versa).
Investment demand curve (or MEC Schedule) shows the total level of investment which will take
place in the economy at each level of the interest rate.
Study Tip
Marginal Efficiency of Capital (MEC) is the rate of discount which equates net present value of profits
from an investment to its supply price (i.e. cost).
Other Determinants of Investment:

If a determinant other than interest rate change, Investment demand curve (or MEC Curve) will
shift rightward or leftward. These other determinants are discussed below:
Changes in the level of national income:

If national income rises rapidly there will be pressure on firms to invest in new plant and
equipment to meet the increase in demand. This positive relationship between the rate of change of
output and the rate of investment is known as the accelerator principle.
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Technological change:
In any dynamic economy there is likely to be a quick pace of technological change. In order to keep
up with advances in technology and to remain competitive firms will need to invest.
Demand for the product:

If demand for a product is expected to grow, it would induce the firms to make investment.
Expectations/business confidence:
If businesses are optimist about the future of the economy, they will invest more.
Population growth:
If the rate of population growth is increasing dramatically, then this will boost future demand for
goods, and thus encourage investment.
Government Policies:
Government can influence the level of private investment in many ways e.g. by
 government spending.
 influencing interest rates.
 influencing tax rates.
 stimulating business confidence.
 influencing money supply.
 encouraging technological development.

Briefly explain any four measures by which government may influence the level of private investment in an economy.
(04 marks)
Explain the concept of ‘Marginal Efficiency of Capital’. (05 marks)

(a) The rate of interest and marginal efficiency of capital (MEC) determine the level of investment in an economy. Explain
the relationship between rate of interest and MEC with the help of a diagram. (07 marks)
(b) The MEC curve shifts outwards when expected rate of return increases. Briefly discuss any three other factors that
might cause an outward shift in MEC curve. (03 marks)
Suppose Govt. of Pakistan aims to increase the private investment in the country. Write down at least four suggestions for
Government to stimulate investment. (07 marks)
(PIPFA – Winter 2015)
100
PART C – ALTERNATIVE MODELS TO MACRO-ECONOMIC EQUILIBRIUM
LO 6: AGGREGATE EXPENDITURE MODEL TO OUTPUT DETERMINATION:

Aggregate Expenditure Equilibrium:
Under Aggregate Expenditure model, economy will be in equilibrium at that level of output at which
total expenditure of the nation will be equal to “45° break-even line”.
Diagram:
Explanation:
In the above diagram, The 45° line shows points where aggregate expenditure is exactly equal to
GDP/national income. AE is the curve total expenditure (i.e. C + I + G + X-M) at different levels of
GDP/national income. The economy is in equilibrium at the point where the TE curve crosses the
45° line—at point E.
If AE > Output:
Consumers are trying to buy more goods than are being produced. There will be unplanned
decrease in inventories which causes producers to increase the amount of production in the
economy. They would keep increasing their output until output reaches its equilibrium level.
Concluding, if total expenditure in the economy exceeds the level of output, the economy will
expand.
If AE < Output:
Consumers are not buying all the output that is being produced. There will be unplanned increase
in inventories which causes producers to reduce their production. They would keep reducing their
output until the equilibrium level of output was reached.
Concluding, if total expenditure in the economy is less than the level of output, the economy will
contract.
101
LO 7: SAVING-INVESTMENT MODEL TO OUTPUT DETERMINATION:

Saving-Investment Equilibrium:
Macroeconomic equilibrium is reached not only by the equality of AD and AS, but also when
planned injections into circular flow of income are equal to planned withdrawals of circular flow of
income i.e. where
S+T+M=I+ G+X
Under Saving-Investment model, a simple-closed economy will be in equilibrium at that level of
output at which desired saving will be equal to desired investment.
Assumptions:
1. Simple economy is assumed i.e. economy consists of only consumers and firms. Therefore,
Effect of G, T, X and M are excluded from analysis.
2. Investment spending is autonomous i.e. independent of GDP. Therefore, investment curve is
a horizontal line.
Diagram:
Explanation:
The curve “I” represents planned investment curve which is a horizontal line assuming it
independent of GDP (i.e. autonomous investment). The curve S represents saving curve which
increases as income increases. These two curves intersect at point E and hence, the equilibrium
level of income is determined.
If saving is less than investment:

Consumer will purchase more output than firms anticipated (saving is less means consumption is
more). There will be unplanned decrease in inventories. Firms will increase their production and
employment and economy shall move towards higher level of GDP/Output.
If saving is more than investment:

Consumer will purchase less output than firms anticipated (saving is more, means consumption is
less). There will be unplanned increase in inventories by 10 million. Firms will cut-back their
production and employment and economy shall move towards lower level of GDP/Output.
102

Output is determined where savings of all of the households in an economy are equal to the desired investment
opportunities. Explain the equilibrium between savings and investments with the help of diagram. (10 marks)
103
Economics – Study Notes Chapter 10 Multiplier and Accelerator
CHAPTER TEN
MULTIPLIER AND ACCELERATOR
LO 1 MULTIPLIER PRINCIPLE
LO 2 ACCELERATOR PRINCIPLE
LO 3 HOW ACCELERATOR AND MULTIPLIER MOVE TOGETHER IN ECONOMY
104
LO 1: MULTIPLIER PRINCIPLE:
Multiplier Effect/Principle:
Multiplier effect is the phenomenon that initial change in aggregate demand will cause more that
proportionate change in total output.
Multiplier:
Definition:
The multiplier is the ratio of the change in total output to the change in a component of aggregate
demand (e.g. investment).
Formula to calculate Multiplier:

Multiplier = 1/(MPS + MPT + MPM).
Exam Tip
If MPT or MPM is not given in the question, these may be assumed as zero.
Determinants of Multiplier:
Multiplier is affected by any leakage/withdrawal from circular flow of income i.e. by Savings, Tax,
and Imports. Therefore, following are three factors that determinant size of of multiplier:
1. Marginal Propensity to Save (MPS is the percentage of income that is saved).
2. Marginal Propensity to Tax (MPT is the percentage of income that is paid to government as
tax).
3. Marginal Propensity to Import (MPM is the percentage of income that is used to buy goods
and services from foreign economy).
Exam Tip
These determinants affect multiplier inversely i.e. the higher the MPS, MPT or MPM, the lower the
multiplier.
How Multiplier works:

Assume that MPC is 0.6, which means MPS is 0.4 and multiplier is 2.5 (= 1/0.4). Further, assume
that Rs. 1,000 is introduced in the economy.
Round Change in National Income Change in Saving Change in Consumption

(A) (B = A * MPS) (C = A * MPC)
(MPS = 0.4) (MPC = 0.6)
1st (initial) 1,000.00 400.00 600.00
2nd 600.00 240.00 360.00
3rd 360.00 144.00 216.00
4th 216.00 86.00 130.00
All later rounds 324.00 129.60 194.40
Total 2,500.00 1,000.00 1,500.00
Total change in output (Rs. 2,500) is equal to initial investment (Rs. 1,000) * Multiplier (2.5).
105
Multiplier effect with the help of diagram of Aggregate Expenditure:

Diagram Explanation
In the above diagram, The 45° line shows points
where aggregate expenditure is exactly equal to
GDP/national income. AE is the curve total
expenditure (i.e. C + I + G + X-M) at different levels
of GDP/national income. The economy is in
equilibrium at the point where the TE curve
crosses the 45° line—at point E.
If now there is an increase in investment by Rs.

1,000, then AE0 curve will shift to new position of
AE1 and now two curves will intersect at point E1
which would be the new equilibrium level of
income.
Hence, the diagram shows that an increase in

investment by Rs. 1,000 million would increase the
national income by Rs. 250 million (1 ÷ MPS ×
change in investment). Thus the value of multiplier
is equal to 2.5.
Multiplier effect with the help of diagram of Saving-Investment:

Diagram Explanation
The curve I represents planned investment curve
which is a horizontal line assuming it independent
of GDP (i.e. autonomous investment). The curve S
represents saving curve which increases as income
increases. These two curves intersect at point E and
hence, the equilibrium level of income is
determined. When the economy is at equilibrium
the desired spending and savings of households is
equal to the desired production and investment of
firms.
If now there is an increase in investment by Rs.

1,000 million, then II curve will shift to the position
of I1 and the two curves I1 and S will intersect at
point E1 which would be the new equilibrium level
of income.
Hence, the diagram shows that an increase in

investment by Rs. 1,000 million would increase the
national income by Rs. 250 million (1 ÷ MPS ×
change in investment). Thus the value of multiplier
is equal to 2.5.
Limitations of Multiplier:
Full employment ceiling:
The basic multiplier model does not work very well when the economy is close to full employment
because it is difficult for the economy to produce more real output. As soon as full employment
level is achieved, further effect of multiplier will be increase in prices and NOT increase in output.
Time lag:
A long period of time is required between initial expenditure and when full effects of multiplier are
obtained. If a government wants prompt measures to improve economy, multiplier will not be
effective.
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Leakages:
Leakages from circular flow of income would make the value of multiplier very low. In such case,
extra spending will have nominal effect only.
Regular repeated investments:

Multiplier is effective only if investments are regularly made, one after another.
Stability of consumption function

Marginal propensity to consume or save may not be same during all rounds of expenditure.
Exam Tip
Limitations can also be used as assumptions in exam, by carefully changing wording.

In an open economy, the marginal propensity to consume is 0.7 and the proportion of additional income that is spent on
imported goods is 20%. National income is Rs. 100,000,000 and the current account is in balance. What would be the new
equilibrium of national income if the government increases its expenditure by Rs. 50,000,000? (02 marks)
What do you understand by the term ‘Multiplier’? With the help of a diagram show the multiplier effect of an increase in
investment by Rs. 100 million on the equilibrium level of income where marginal propensity to save is 1/3. (06 marks)
(a) What is ‘Multiplier’? Explain the working of the Multiplier with the help of a numerical example. (for the purpose of
working, assume that marginal propensity to consume is equal to 0.6) (05 marks)
(b) Briefly state the limitations of Multiplier. (04 marks)
(c) The difference between increase in income and the increase in consumption represent a leakage from the flow of
income stream. These leakages obstruct the growth of national income.
(i) Discuss the principal leakages in the income stream and their effect on multiplier. (09 marks)
(ii) What would be the effect on multiplier, marginal propensity to consume, investment and employment if there were no
leakages from the flow of income stream? (02 marks)
Define the concept of Investment Multiplier. What determines its size? (05 marks)
In response to a small increase in the investment level, there is a greater increase in national income. Explain the reasons
thereof with the help of a table. (07 marks)
LO 2: ACCELERATOR PRINCIPLE:
Accelerator Effect/Principle:
As demand rises, firms want to increase output. To do so, they need a larger capital stock (i.e.
investment). Otherwise stated, Investments are positively related to Output. This is known as the
accelerator principle.
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How Accelerator works:

Assume that Capital-Output Ratio is 1:10, and life of capital equipment is 10 years (i.e. depreciation
rate is 10%).
Investment needed to meet output

Capital Replacement
New % change in
Year Output Equipment /Depreciatio Gross
Investment investment
needed n
0 1,000 100 - 10 10 -
1 (10% increase in demand) 1,100 110 10 10 20 100%
2 (demand is constant) 1,100 110 - 11 11 -45%
3 (10% decrease in demand) 990 99 (11) 11 0 -100%
This table shows when output is increasing, there is sharp increase in the level of investment and
vice-versa. This is why it is called the accelerator effect i.e. a change in output accelerates the
change in investment.
Limitations of Accelerator Effect:

Existence of Spare Capacity:
If there is spare capacity, investments will not be increased because producers will use existing
capacity to increase output instead of making new investment.
Time Lag/Adjustment cost:

Time and cost required to increase the investment is not considered in this model.
Capital-Output ratio is not constant:

In reality, capital-output ratio cannot be generalized for whole economy. It varies from one industry
to another. Therefore, concept of accelerator is limited to industry and is not applicable to whole
economy.
Temporary changes in demand:

Accelerator principle does not apply to temporary changes in demand. If change is demand is
temporary, firms do not increase their investments. Rather, they only work above full capacity (e.g.
overtime) to meet temporary demand.
Non-availability of financial resources:

If firms are facing financial constraints, they cannot increase investment even if demand increases.
Business Expectations:
If entrepreneur do not expect profit, they would not invest even if there is increase in demand.
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(a) Discuss gross investment and explain its relevance to the accelerator principle. (03 marks)
(b) Consider the following information and determine the rate of change of gross investment for each of the following five
years (year 1 to 5) using the accelerator principle based on the following data:
 Capital output ratio is 4:1
 Depreciation is 10% of previous year’s capital
 Output details for the five years are as follows:
Year 0 1 2 3 4 5
Output (in billion) 200 200 240 280 320 320
(07 marks)
Explain briefly the Accelerator Principle. Identify and explain any five limitations of Accelerator Principle. (08 marks)
LO 3: HOW ACCELERATOR AND MULTIPLIER MOVE TOGETHER IN ECONOMY:

Economists combine the multiplier model with the accelerator principle to explain business cycle.
In this approach, every expansion breeds recession, and every recession breeds expansion in a
repeating chain.
1. According to the accelerator principle, rapid output stimulates investment, which is
amplified by the multiplier.
2. High investment, in turn, stimulates more output, and the process continues until the
capacity of the economy is reached, at which point the economic growth rate slows.
3. The slower growth, in turn, reduces investment spending, and this, working through the
multiplier, tends to send the economy into a recession.
4. The process then works in reverse until the trough is reached, and the economy then
stabilizes and turns up again.
5. Accelerator model working with Multiplier model explains fluctuations that we call
business cycles.

Briefly explain the multiplier-accelerator theory. Also give suitable examples.
109
Economics – Study Notes Chapter 11 Inflation, Unemployment and Business Cycle
CHAPTER ELEVEN
INFLATION, UNEMPLOYMENT AND
BUSINESS CYCLE
PART A – INFLATION
LO 1 INFLATION AND FORMS OF INFLATION
LO 2 MEASUREMENT OF INFLATION
LO 3 IMPACT/COSTS OF INFLATION
LO 4 TYPES AND CAUSES OF INFLATION
LO 5 MEASURES TO CONTROL INFLATION
PART B – UNEMPLOYMENT
LO 6 DEFINITION AND CONSEQUENCES OF UNEMPLOYMENT
LO 7 TYPES OF UNEMPLOYMENT
LO 8 MEASURES TO REDUCE UNEMPLOYMENT
LO 9 FULL EMPLOYMENT
PART C – RELATIONSHIP BETWEEN INFLATION AND UNEMPLOYMENT
LO 1 0 THE PHILLIPS CURVE – KEYNESIAN VIEW
LO 1 1 THE PHILLIPS CURVE – MONETARIST VIEW
PART D – BUSINESS CYCLE
LO 1 2 BUSINESS CYCLE
LO 1 3 INDICATORS OF PHASES OF BUSINESS CYCLE
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PART A– INFLATION
LO 1: INFLATION AND FORMS OF INFLATION:

Economists look for price stability by calculating inflation.
Inflation:
Inflation is a continuous or persistent increase in the general price level.
Inflation Rate = (Average Price Level in current year – Average Price Level in previous year) /
Average Price Level in previous year * 100
Exam Tip
Depending on purpose, different Price Indexes are used to measure average price level.
Following are different forms of inflation:

1. Low/Mild inflation (typically means inflation rate upto 5% annually)
2. Moderate inflation is characterized by less than double-digit rates, and relatively stable
relative prices.
3. High inflation (typically means inflation rate more than 5% and upto 100% annually)
4. Hyperinflation (typically means inflation rate more than thousands time annually. In
hyperinflation, money becomes worthless and is no more store of value. It cannot be used
for transactions and people move to barter system)
5. Deflation/Disinflation (Deflation is a persistent decrease in the general price level i.e.
negative inflation rate).
LO 2: MEASUREMENT OF INFLATION:
Price Index:
Price Index is a weighted average of the prices of a group of goods and services.
Examples of Price Index:
 GDP Deflator (or GDP Price Index),  Producer Price Index
 Consumer Price Index  Core Index.
Difference between GDP Deflator and Consumer Price Index:

GDP Deflator Consumer Price Index (CPI)
GDP Deflator is a Price index used to convert nominal GDP to CPI measures the changes in prices of a fixed basket of
real GDP. It measures change in price of all goods and goods and services bought by the typical urban consumer.
services included in GDP.
GDP Deflator = Nominal GDP / Real GDP
It takes into account capital as well as consumer goods It takes into account only consumer goods e.g. Food,
produced domestically. Clothes, Housing, Education, Medical Care, and
Transportation etc.
It takes into account only local goods. It takes into account local as well as imported goods.
It is used to convert nominal GDP into real GDP. It is used to calculate rate of inflation.
Limitations of Consumer Price Index as a measure of inflation:

 Not representative of full economy.
 Index-number problem (i.e. what to take as ‘base year’).
 Effect of change in quality of goods and services may distort CPI.
111

What is meant by Price Index? Explain any three commonly used price indices. (08 marks)
Discuss the concept of Consumer Price Index (CPI). State any three limitations of CPI as a measure of inflation.(06 marks)
LO 3: IMPACT/COSTS OF INFLATION:
Undesirable redistribution of income and wealth between Receivables and Payables:
If inflation rate increases, Receivable party will receive less value and Payable party will pay less
value of money.
Negative real interest rates:

If inflation rate exceeds saving rate, pensioners or other persons relying on savings will become
poorer.
Wage bargaining
Wage demands (particularly from trades' unions) will be increased in times of high inflation. If they
are successful then a wage/price spiral will take hold, which will reinforce the problem.
Balance of payments effects:

If prices of goods are increased in domestic market as compared to foreign market, exports of a
country will decrease and imports will increase. As a result, the balance of trade will suffer.
Other Problems:
 Fall in real incomes
 High cost of borrowings
 Business uncertainty

What is inflation? Briefly state any four harmful effects of inflation on the economy. (05 marks)
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LO 4: TYPES AND CAUSES OF INFLATION:

Demand Pull Inflation:
Definition:
Demand-pull inflation occurs when AD rises more rapidly than the economy’s productive potential.
Demand-pull inflation is generally observed in a situation of full employment.
Diagram of Demand Pull Inflation:
Causes of Demand Pull Inflation:

 Fiscal stimulus increasing aggregating demand in the country (e.g. decrease in taxes,
increase in government spending, increase in transfer payments)
 Monetary stimulus increasing aggregating demand in the country (e.g. decrease in interest
rates, buying government securities)
Cost Push Inflation: (also known as supply-shock inflation)

Definition:
Cost-push inflation occurs when there is persistent increase in the cost of production of goods,
while their demand remains consistent. GDP and employment tends to fall in cost push inflation.
Diagram of Cost-push inflation:
Causes of Cost-push inflation:

 An increase in the price of raw material, labor and other inputs.
 An increase in the indirect taxes.
 Wage-price spiral i.e. Expectations of inflation by workers will cause workers to demand
higher wages. Increase in wages will increase prices, which will lead to another expectation
of inflation by workers and so on.
 Currency Exchange rate depreciation increases cost of imports.
113

(a) What do you understand by Demand-pull inflation and Cost-push inflation? (04 marks)
(b) Briefly discuss the probable causes of Demand-pull inflation and Cost-push inflation. (06 marks)
LO 5: MEASURES TO CONTROL INFLATION:

Remedies to Demand Pull Inflation:
Decrease Aggregate Demand by Contractionary Policies i.e.
 Fiscal Policies: Increase taxes, decrease government spending, decrease transfer payments.
 Monetary Policies: reduce money supply by increasing discount rates, increasing reserve
ratio, selling government securities.
Remedies to Cost Push Inflation:

Increase Aggregate Supply by decreasing cost of inputs i.e.
 Keep wages low.
 Limit cost of utilities (e.g. energy cost)
 Reducing cost of imports by appreciating currency exchange rate.

Briefly discuss any two measures that may be adopted for controlling inflation if an economy is facing:
 cost-push inflation
 demand-pull inflation (04 marks)
What steps are usually adopted by the authorities to control inflationary pressures? (06 marks)
114
PART B– UNEMPLOYMENT
LO 6: DEFINITION AND CONSEQUENCES OF UNEMPLOYMENT:

Definitions:
Labor Force:
Total population of an economy is classified into:
 Labor Force (Persons who are employed, unemployed but are searching for jobs), and
 Not Labor Force (Persons who are neither working nor searching for work e.g. students,
household wives, retirees).
Unemployment:
Unemployment is that part of the labor force who are searching for job but cannot find work.
Unemployment Rate (%age) = Unemployed People / Labor Force * 100
Consequences of unemployment:
1. Loss of Output and National Income because of under-performance of economy
2. Loss of Human Capital because of gradual decrease in skill and quality of performance of
unemployed people.
3. Unequal distribution of wealth among citizens
4. Social Costs e.g. depression, crime rates, personal suffering, suicide
5. Burden on Govt. for Social Security Benefits

Briefly discuss any four unfavorable consequences of unemployment. (04 marks)
LO 7: TYPES OF UNEMPLOYMENT:
Economists have identified three major types of unemployment i.e. Frictional unemployment,
Structural unemployment, and Cyclical unemployment.
Frictional unemployment:
Unemployment due to the movement of people between jobs or geographical locations. This is
short-term unemployment, lasting for transitional period of leaving old job and joining new job.
Structural Unemployment:
Unemployment due to mismatch between the skills required by employers and skills possessed by
workers. It arises through inefficiencies in the labour market when an economy goes through
structural long-term changes.
Cyclic/ Demand Deficient Unemployment:

Such unemployment occurs in recession due to decrease in aggregate demand e.g. in recession,
when prices decrease, firms cut-back production and reduce labor.
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Real Wage/Classical Unemployment:

Such unemployment occurs when minimum wage for labor is kept higher than equilibrium rate (by
govt. or by labor unions). Firms cannot afford to employ all available work force at such higher rate
and reduce labor.
Exam Tip
Unemployment can be Voluntary (people choose not to work at the prevailing wage rate) or
involuntary (people want to work at prevailing wage rate but cannot find work).

Describe the type of unemployment that is generally observed during a period of recession in an economy. (02 marks)
(i) Full Employment is achieved when the rate of Unemployment reaches zero. Discuss.
(ii) Identify and briefly describe various types of Unemployment. (12 marks)
LO 8: MEASURES TO REDUCE UNEMPLOYMENT:
Type of
Suggested Measures/Policies to reduce unemployment
Unemployment
Frictional  Maintain database of unemployed people.
Unemployment  Provide information on available vacancies.
Structural  Provide education and training to acquire new skills.
Unemployment  Assistance in mobility/export of labor to different occupations or locations.
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Demand Side Policies to increase Aggregate Demand

 Increase in subsidies, grants and even tax exemptions.
 Decrease interest rates.
Cyclic
Supply side Policies to increase Aggregate Supply
Unemployment
 Policies to increase competition and avoid monopolistic actions on Prices and
Output.
 Policies to increase quantity and productivity of factors of production.
LO 9: FULL EMPLOYMENT:
Full Employment:
Full employment is the situation where all available Labor force and other factors of production are
fully utilized in an economy. It does not mean zero unemployment because there will always be a
“natural rate of unemployment”.
Natural Rate of Unemployment

Natural Rate of Unemployment (NRU) is the average level of unemployment that is expected to
prevail in economy in long run. It occurs when cyclical unemployment is zero i.e.
NRU = Frictional Unemployment + Structural Unemployment

Explain the concept of ‘Natural rate of unemployment’ with the help of a diagram. (05 marks)
PART C– RELATIONSHIP BETWEEN INFLATION AND UNEMPLOYMENT
LO 10: THE PHILLIPS CURVE – KEYNESIAN VIEW:

Phillips Curve:
Phillips Curve is a graphical presentation which shows Inflation Rate and Unemployment Rate have
inverse relationship i.e.
 If Inflation Rate increases, Unemployment Rate decreases, and
 If Inflation Rate decreases, Unemployment Rate increases.
Diagram of Short-run Phillips Curve Explanation

Why is there trade-off between Unemployment and
Inflation in Short-run:
If government increases Aggregate Demand, more
workers are needed to increase output. When demand
for workers increases, wage-rate also increases (and
vice-versa).
Significance of Phillips Curve:

Phillips curve is considered a “menu of choice” for
Government i.e. Government has to choose between “a
lower unemployment with higher inflation”, and “a
higher unemployment with lower inflation. Price
stability and full employment cannot both be achieved
together.
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Exam Tip
Stagflation means high inflation in periods of high unemployment.

Define Phillips Curve. Explain the trade-off between unemployment and wage inflation with the help of a Phillips Curve.
(08 marks)
LO 11: THE PHILLIPS CURVE – MONETARIST VIEW:

Long-Run Phillips Curve:
Monetarist Economists (Milton Friedman) suggested that “there is a trade-off between inflation and
unemployment in the short run, but not in the long run”.
Therefore, there are two Phillips Curves i.e.

1. A short-run Phillips curve (which shows inverse-relationship between Inflation and
Unemployment) and
2. A long-run Phillips curve (which shows that unemployment is unaffected by inflation and
stays at Natural Rate of Unemployment).
Diagram of Long-run Phillips Curve Explanation

Why is there no trade-off between Unemployment
and Inflation in Long-run:
If government increases Aggregate Demand, more
workers are needed to increase output. This increases
bargaining power of workers and wage-rate also
increases. However, as time passes, producers
increases their prices to cover wage increase. Workers
will ultimately realize that their real wages (adjusted
by expected inflation) are lower than they thought.
Therefore, some workers will quit job. This will
decrease employment but not the inflation (as existing
workers have revised their inflation expectations
upward).This will shift Phillips curve rightward i.e. to
a point where unemployment is again at previous level
but inflation is now at higher level.
Significance of Long-run Phillips Curve:

Any action of government to decrease unemployment
below NRU will ultimately result in inflation only. The
only way to decrease unemployment in long-run is to
increase the level of Aggregate Supply.

Monetarist economists state that inverse relationship between inflation and unemployment exists in short run only, but
not in long-run. Explain this statement with the help of a diagram. (06 marks)
118
PART D – BUSINESS CYCLE
LO 12: BUSINESS CYCLE:

Business Cycles:
Business cycles are economy-wide periodic fluctuations in national output, income, and
employment.
Diagram Explanation
The trend line shows a stable and steady growth path for the
macroeconomy. However, in reality, the growth path follows
the different fluctuations in business cycle called Peak,
Recession, Trough and Recovery. To provide stability in
economic growth, government takes actions to move the
economy closer to trend line.
Boom / Peak / Prosperity:

Peak is the highest point in the business cycle, just before it
begins to turn down.
Recession/ Downturn/Contraction:
Recession refers to the decline in Real GDP that occurs after
the economy has peaked.
Trough/Depression:
A severe and prolonged recession is called Depression. The
trough is the lowest point in the business cycle, just before it
begins to turn up.
Recovery/ Upturn/ Expansion:
Contraction refers to the increase in Real GDP that occurs
after the economy has depressed.
Characteristics of Four Phases of Business Cycle:
Boom / Recession/ Recovery/

Trough/
Peak / Downturn/ Upturn/
Depression
Prosperity Contraction Expansion
Level of GDP/Output High Decreasing Low Increasing

Level of Employment and Income High Decreasing Low Increasing
General Price Level High Decreasing Low Increasing
Level of Demand and Consumption High Decreasing Low Increasing
Level of Bank Credits High Decreasing Low Increasing
Level of Interest Rates High Decreasing Low Increasing
Level of MEC and Investments High Decreasing Low Increasing
Level of Confidence of Businessmen Optimist Decreasing Pessimist Increasing

Identify and briefly explain the different phases of business cycle. (06 marks)
Briefly describe any two features of each of an economy in a period of downturn. (02 marks)
119
LO 13: INDICATORS OF PHASES OF BUSINESS CYCLE:

Leading Economic Indicators:
1. Index of business confidence
2. Manufacturers’ new orders
3. New building permits for private housing
4. Money supply
Coincident Economic Indicators:

1. Number of people in employment
2. Industrial production
3. Personal incomes
4. Manufacturing and trade sales
Lagging Economic Indicators:

1. Consumer Price Index (i.e. level of inflation)
2. Average duration of unemployment
3. Interest rates
4. Average income

List any eight indicators which would confirm the stages of business cycle the economy is in. (04 marks)
120
Economics – Study Notes Chapter 12 Money
CHAPTER TWELVE
MONEY
PART A – INTRODUCTION OF MONEY

LO 1 BARTER AND MONEY SYSTEMS
LO 2 TYPES OF MONEY AND LIQUIDITY PREFERENCE THEORY
PART B – DEMAND AND SUPPLY OF MONEY
LO 3 DEMAND OF MONEY
LO 4 SUPPLY OF MONEY
PART C – INTEREST RATE
LO 5 INTEREST RATE
121
PART A – INTRODUCTION OF MONEY
LO 1: BARTER AND MONEY SYSTEMS:

Barter:
Definition of Barter System:
Barter consists of exchange of goods for other goods.
Problems associated with Barter System:

Although barter system is better than no trade at all, however, it has certain problems e.g.
 Lack of double coincidence of wants.
 Lack of standard measure to decide ratio of exchange
 Lack of divisibility of goods
 Lack of savings
Money:
Definition of Money:
Money is anything that serves as a commonly accepted medium of exchange.
Evolution/Kinds of Money:
 Commodity Money: Particular physical goods (e.g. cattle, oil, copper, gold, silver,
diamonds), with some intrinsic value, that also serves as a medium of exchange.
 Metallic Money: By 18th century, commodity money was almost exclusively limited to
metals like silver and gold, which is called metallic money.
Advantage: It has intrinsic value so there was no need for the govt. to guarantee its value.
Shortcoming: Scarce resources are required to dig it out of the ground.
 Paper Money: Paper money is a piece of printed paper with engraving on it by government.
Many years ago, paper money was backed by gold or silver. However, today paper money is
fiat money. Fiat money is the money which has no intrinsic value; however, it is recognized
as the legally accepted medium of exchange.
 Bank Money: Bank money means use of cheques, debit cards and electronic transfers as
replacement of paper money.
Functions of Money:
1. Medium of Exchange:
It removes the inconvenience of a barter system. The man with the cow, who wants to
purchase a horse, need not search for a horse-seller, who wants a cow. He can sell his cow in
the market for money and then purchase a horse with the money thus obtained.
2. Unit of Account:
Money can be used as the unit by which we measure the value of things. This common unit
simplifies economic decisions.
3. Store of Value or Wealth:
Money can easily and safely be stored in large quantities. Any other commodity will usually
require large space and will be subject to deterioration. It is also less risky as compared to
many other assets (e.g. stocks or real estate).
Rapid inflation adversely affects all the functions of money. It will lose its value, relative prices will not
be comparable and people will stop holding it or exchanging goods against it.
122
Characteristics of Good Money:

1. Durability
2. Divisibility
3. Transportability
4. Non-counterfeitability

Discuss how introduction of money has resulted in overcoming the shortcomings of barter system. (04 marks)
Identify and describe the functions of money. (04 marks)

LO 2: TYPES OF MONEY AND LIQUIDITY PREFERENCE THEORY:

Types of Money:
There are different types/components/definitions of money. As you move to “higher” definition, the
additional components of money become less and less liquid.
 M0 = Notes and Coins in circulation. This is the money outside the banking system and is
used by people for transactions purposes.
 M1 = M0 + Checking deposit. Checking deposit is the money that is in people’s accounts
which they can access immediately.
 M2 = M1 + Saving deposit. Saving deposit is the money that belongs to people but which
they cannot access immediately.
 M3 = M2 + Large time deposits and Institutional money market funds.
Study Tips
Now a days, concept of money is limited to M1 (i.e. only currency and checking deposits are included in money).
Liquidity Preference Theory:

Liquidity means the ease with which an asset can be converted into cash.
Liquidity Preference Theory:

“People prefer to hold liquid assets (i.e. cash) rather than illiquid assets to meet their motives.
However, people can hold illiquid assets if they are paid interest in return i.e. there is inverse
relationship between money demanded and rate of interest”.
Motives of Holding Money:

 Transactional motives i.e. people hold money to purchase goods and services.
 Precautionary motives i.e. people hold money for emergency purposes.
 Speculative motives i.e. people hold money to take advantage in future from change in
prices.

Identify three reasons why people prefer to hold money in liquid form. (03 marks)
123
PART B – DEMAND AND SUPPLY OF MONEY
LO 3: DEMAND OF MONEY:
Demand for Money:
The demand for money is the desired holding of financial assets in the form of money (i.e. in cash
and checking deposits).
Factors affecting demand for money:

Interest Rate:
If interest rate increases, quantity demanded of money decreases and people hold less money.
However, if interest rate decreases, quantity demanded increases and people hold more money.
Money Demanded (MD) curve is also called “Liquidity Preference Curve”.
Pace of financial innovation:

If financial innovation is increased, demand for money is decreased.
Level of Prices:
If level of prices is increased, demand for money is increased.
Level of GDP:
If GDP is increased, demand for money is increased.

Identify three reasons why people prefer to hold money in liquid form. (03 marks)
An increase in ‘GDP’ and ‘financial innovation’ are the two important factors that influence the total demand for money in
an economy.
Briefly explain with the help of suitable diagrams, how each of the above factors affects the quantity of money demanded
in an economy. (06 marks)
124
LO 4: SUPPLY OF MONEY:
Supply of Money:
In economics, the money supply or money stock, is the total amount of monetary assets available in
an economy at a specific time.
Importance of Supply of Money:

Supply of money affects:
 Interest rate (via interaction of demand of money and supply of money), and
 Price Level (via Quantity Theory of Money)
Quantity Theory of Money:

Quantity theory of money:
“Money supply does not have any effect on real economy i.e. on production or employment. If
money supply is doubled, so will be the price level”.
Symbolically:
M*V=P*Y
Where,
M means Nominal Money Supply.
V means Velocity of circulation of money.
P means the Average Price Level.
Y is the real GDP/national output.
Assumptions of the Theory:

1. Velocity of money is constant.
2. Real value of National Output is not influenced by monetary variables.
Implication of the Theory:

If government wants to control price level, it should control money supply.
Controlling the Supply of Money:

The ultimate control of the money supply lies with a country’s central bank which can control
money supply by following methods:
1. Open Market Operations: (already explained in topic of monetary policy)
2. Reserve requirements: (already explained in topic of monetary policy)
3. Interest Rate/Base Rate: (already explained in topic of monetary policy)
4. Government Borrowing: (i.e. increase in govt. borrowing reduces the money supply and
vice-versa)

What are the tools available to the central bank of a country for controlling the supply of money in the economy?
(06 marks)
Briefly explain the ‘Quantity Theory of Money’. (03 marks)

Compute the velocity of circulation of money in an economy using the Quantity Theory of Money, where the average price
level is 1.8, real GDP is Rs. 28,726 billion and the nominal money supply is Rs. 12,926 billion. (02 marks)
125
PART C – INTEREST RATE
LO 5: INTEREST RATE:
Definition:
Interest rates are the price of borrowing money. It is the amount charged by a lender to a borrower
on the amount borrowed.
Interest rates are expressed as a percentage of principal.
Types:
Nominal Interest Rate:
Nominal interest rate is the interest rate which is stated on a bond or borrowing. Nominal interest
rate is the rate before adjustment of inflation.
Real Interest Rate:

The real interest rate is the rate of interest that is after adjustment of inflation. For example if the
nominal interest rate on a loan is 10%, and the inflation rate is 6% then the real interest rate is 4%.
Determinants of Interest Rate:

Demand of Money and Supply of Credit Money:
Interest rate is the price for credit money. Like any other product, interest rate is determined by
interaction of demand of money and supply of credit money. If demand of credit money increases,
interest rate increases (and vice-versa). If supply of credit money is increased, interest rate
decreases (and vice-versa).
Inflation Rate:
To produce positive returns, interest rates are always kept above inflation rate. Therefore, if
inflation rate increases, interest rate shall also increase.
Monetary Policies:
Central bank influences interest rates by implementing monetary policy.
Balance of Payment:
If a country has continuous deficit in balance of payment and is in need of more funds, it may
increase rate of interest to attract foreign investors.
Other factors:
Interest rate is also affected by other multiple factors e.g. type of loan, credit rating, credit risk, type
of security, and duration of loan.
Effects of change in interest rate:

Decrease in interest rate affects economy in following ways:
1. Savings will be decreased and borrowings will be increased.
2. Consumption and investment in the economy will be increased.
3. Disposable income of households (with loans and mortgages) will increase.
4. There will be outflow of funds to other countries (with higher interest rates). This will further
depreciate exchange rate.
5. Fiscal deficit of government will decrease as it will have to pay less interest.
126
Study Tips
1. Increase in interest rate will affect opposite.
2. Market Interest rate has inverse relationship with price/value of a Bond i.e. if market interest rate
increases, price of a Bond decreases and vice versa.

Illustrate the concepts of ‘Nominal interest rate’ and ‘Real interest rate’. (05 marks)
Elaborate the main factors that affect the general rate of interest in an economy. (05 marks)
127
Economics – Study Notes Chapter 13 Banks and Their Functions
CHAPTER THIRTEEN
BANKS AND THEIR FUNCTIONS
LO 1 CENTRAL BANK AND ITS FUNCTIONS

LO 2 COMMERCIAL BANK, ITS TYPES AND ITS FUNCTIONS
LO 3 CREDIT (OR CREDIT MONEY)
LO 4 CREDIT CREATION (OR CREDIT MONEY CREATION)
128
LO 1: CENTRAL BANK AND ITS FUNCTIONS:

Central Bank:
Central bank is the entity responsible for overseeing the overall monetary policy in a country. It is
also concerned with meeting a number of other objectives e.g. currency stability (i.e. exchange rate
stability), price stability (i.e. low inflation), economic growth, full employment and credit control.
Functions of Central Bank:

Sole supplier of currency:
The central bank has the responsibility of supplying the notes and coins throughout a country in
order to bring uniformity. It also to exercise greater control over it.
Banker to the Govt.

It offers advice on public debts of country and also provides funding for governments looking to
fund projects, in the same way a commercial bank would to its customers.
Banker to the banks

By holding cash reserves from each bank for safe keeping, the central bank brings a level of
protection to the banks.
Further, a central bank can offer a counselling service to commercial banks if ever they find
themselves in financial difficulty, and in need of advice.
Lender of the last resort

If a commercial bank is unable to use other sources to meet its financial requirements then they use
the central bank. This brings greater liquidity to the system, and helps protect savers’ deposits.
Exchange Rate Controls

The central bank has control over a country’s foreign currency. These are used in times to
manipulate the exchange rates with other countries, and also other policy objectives, such as the
balance of payments.
Clearing agent for banks

As all commercial banks have accounts with the central bank, when undertaking transactions with
each other, they can do so within the central bank, reducing the necessity of transferring cash.
Establishes specialized banks

In some cases, a central bank will allow the creation of banks to serve a particular purpose, usually
not for commercial means. For example, a bank that organises the funds for agricultural workers, or
another sector of the economy.
Study Tip - Monetary union (or Currency Union)

The decision of the countries to adopt a common currency and to operate under same central bank. An
example is European Union (EU) which comprises 28 member states sharing Euro as common currency.

List any four functions of a central bank. (02 marks)
Identify eight functions which are generally performed by the central bank in a country. (04 marks)
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Write notes on:

The role of State Bank of Pakistan as banker to the Government. (05 marks)
(a) How does State Bank act as a lender of the last resort? (04 marks)
(b) Briefly state the role of State Bank as ‘Controller of Credit’. (05 marks)
LO 2: COMMERCIAL BANK, ITS TYPES AND ITS FUNCTIONS:

Financial Intermediaries:
A financial intermediary is a financial institution through which savers can indirectly provide funds
to the borrowers e.g. banks, mutual funds and pension funds.
Bank:
Bank is a financial institution licensed to perform financial services within an economy.
Types of Banks:
There are following types of banks:
 Commercial banks (Commercial bank is a financial institution licensed to accept deposits
from general public and then lends money to public in return of interest. It also performs
many other services.)
 Retail banks (normally a branch of commercial bank to deal with large businesses and
corporations)
 Investment banks (investment banks assists institutions in raising capital and also
provides underwriting services)
 Specialized Banks (a bank which targets a specific section of the economy e.g. Agricultural
Development Bank of Pakistan)
 Cooperative banks/building society/credit union.

Briefly describe any two features of Investment banks. (02 marks)
What do you understand by the term “Financial intermediary”? Give example.
(ICAP, CAF 02 Level – Autumn 2012, amended)
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LO 3: CREDIT (OR CREDIT MONEY):

Credit:
A contractual agreement whereby a borrower receives something of value in the present, in
exchange for payment in the future, generally with interest.
Types of credit:
Bank credit: (between a bank and an individual whereby bank gives money to an individual
against a security and receives its money back in accordance with terms of credit)
Trade credit: (between a customer and a seller whereby a purchaser receives the goods now and
pay for them after some credit period e.g. 30 days or 60 days)
Consumer Credit: (usually between a retailer and consumer in which amount of credit is used by
consumer on purchase of goods/services.
Advantages of Credit:
1. Allows individuals immediate consumption of expensive goods, based on future earnings.
2. Cause of Industrial revolution ie allows firms to invest, expand and generate future
revenues.
3. Government may need credit to meet its expenditures.
4. Level of credit determines interest rate (as stated by Liquidity Preference Theory)
5. Credit increases spending and consumptions.
6. Credit can be used as a tool in implementing economic policies e.g. growth.
7. Used in Inter-bank transactions.
Disadvantages of Credit:
1. There is always a risk of bad debt.
2. It may not be possible to establish trust between parties.
3. There is problem of Inflation.
4. Monopolies of large scale industries and enterprises
5. Unproductive loans
6. Credit costs more than paying in cash.
7. Credit ties up future income.

What is meant by credit money? (02 marks)
LO 4: CREDIT CREATION (OR CREDIT MONEY CREATION):

Credit Creation/Credit Money Creation:
The most important function of a commercial bank is the creation of credit. Commercial banks
accept deposits and create credit by advancing loans. However, commercial banks cannot use the
entire amount of deposits for lending purposes. They are required to keep a certain percentage of
deposits as reserve for immediate delivery to depositors (called Reserve Ratio).
Money Multiplier/Credit Multiplier:

It is possible for banks to lend out more money than they have in deposits. The money/credit
multiplier is the multiple (or ratio) of credit that can be created by an initial deposit.
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Formula to calculate Money/Credit Multiplier:

Money Multiplier = 1 / Reserve Ratio
How Process of Credit Creation works – An Example:

Assume reserve ratio in an economy is 40% which means multiplier is 2.5 (= 1/0.4). Further,
assume that Rs. 1,000 is deposited in the bank A.
1. Bank A will keep Rs. 400 with itself and will lend Rs. 600 to another person.
2. Another person receiving the loan amounting Rs. 600 will ultimately deposit it again in a
bank. Now that other bank can keep reserves of Rs. 240 (i.e. 600 * 40%) and can lend the
remaining money of Rs. 360 to another person.
3. This process continues until total of Credit equals 2,500 (1,000 * 2.5) and Reserves equals
initial money i.e. Rs. 1,000.
Round Amount Deposited in Bank Reserve Requirement Credit Creation

(A) (B = A * 0.4) (C = A – B)
1st (initial) 1,000 400 600
2nd 600 240 360
3rd 360 144 216
4th 216 86 130
All later rounds 324 130 194
Total 2,500 1,000 1,500
Limitations of Credit Creation:
Limitation Explanation
In case the ratio falls, the credit creation would be more and vice
Reserve Ratio
versa.
Cash Leakage/ Liquidity If people hold cash outside the banking system, this will decrease
preference by people the credit to be created.
If banks hold cash more than reserve ratio (e.g. for strategic
Excess Reserves
purposes), this will decrease the credit to be created.
Availability of Borrowers There will be no credit creation if there are no borrowers.
Effects of Trade Cycles Conditions of boom and depression set a limit on the creation.
While lending, the banks insist upon the securities from the
Availability of Good
customers. All type of assets are not acceptable to banks as
Securities
securities.
Central bank may utilise a number of instruments to control how
Central Bank Policies
much credit is created by banks.

(a) Commercial banks play a vital role in creation of credit money in an economy. Describe the process of credit creation
by commercial banks by means of advancing loans, with the help of an example. (06 marks)
(b) Briefly discuss any four factors which might limit the commercial banks’ ability to create credit money in an economy.
(04 marks)
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Economics – Study Notes Chapter 14 Financial Markets and Their Instruments
CHAPTER FOURTEEN
FINANCIAL MARKETS AND THEIR
INSTRUMENTS
LO 1 FINANCIAL MARKET AND ITS TYPES

LO 2 CAPITAL MARKET INSTRUMENTS –EXAMPLES
LO 3 MONEY MARKET INSTRUMENTS –EXAMPLES
LO 4 DERIVATIVE INSTRUMENTS – DEFINITION AND EXAMPLES
LO 5 SHRIA LAW AND ISLAMIC FINANCING
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LO 1: FINANCIAL MARKET AND ITS TYPES:

Definition and Types of Financial Markets:
Financial Markets are places for sale and purchase of financial instruments e.g. stocks, bonds.
Examples of financial markets include Money Markets, Capital Markets and Derivative Markets.
Different between Capital Market and Money Market:
Capital Market Money Market

Capital market is a financial market used to Money market is a financial market used to raise
Definition raise long-term finance i.e. for a period short-term finance for a period not exceeding
exceeding three months. three months.
Type of Finance Equity as well as Debt. Debt.
Maturity period Long term, usually more than a year Short-term e.g. three months
 Shares  Treasury Bills
Examples of  Corporation Bonds  Commercial Papers
Instruments  Sovereign Bonds  Certificate of Deposits
 Gilt-edged Securities
 Government  Governments
 Corporation  Mutual Funds
Institutions that
 Commercial Banks  Commercial banks
operate
 Non-banking financial institutions (e.g.  Discount houses
insurance companies, mortgage banks)  Corporation
Mutual funds:
 This is an investment scheme in which various investors pool their money which is then
invested in a variety of financial instruments.
 The main advantage of a mutual fund is that it gives individual investors access to the
market.
 Mutual funds’ own share can be purchased/sold at Net Asset Value price.
Financial Institutions/ Financial Intermediaries:

Institutions which provide financial services are called financial intermediaries. Examples include
Banks, and Non- Banking Financial Institutions (e.g. Insurance Companies, Pension Funds, Mutual
Funds).

Define ‘Money market’. Briefly describe any two marketable instruments traded on money markets. (04 marks)
(a) Define capital market and list any four types of organizations that operate in the capital market. (04 marks)
(b) If a government wishes to raise money through the capital market, explain the choice of instruments that are available
to it. Also state what matters it would consider while raising the money through capital market. (06 marks)
Describe the main advantages of investing through mutual funds. (02 marks)
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LO 2: CAPITAL MARKET INSTRUMENTS –EXAMPLES:

Shares:
Definition:
Total capital of a company is subdivided into different smaller parts, which are called shares.
Types of Shares:
There are two types of shares i.e. Equity/Ordinary/Common shares and Preference shares.
Equity/Ordinary shares Preference shares
Voting rights Can vote at general meetings. Cannot vote at general meetings.
Dividend and repayment are made after Preference shares carry priority rights of
Rights of dividend
payments to preference shareholders. receiving dividend and repayment of capital in
and repayment
winding up.
Percentage of
Uncertain. Normally fixed.
dividend
Redeemable Not redeemable. Redeemable.
Corporation bonds:
Bonds/Debentures are financial instruments issued by corporations with following characteristics:
1. These may be secured or unsecured.
2. These do not carry voting rights in corporations.
3. In case of winding up of company, these are paid before shares.
4. Fixed payment in respect of interest is paid.
5. Interest is deductible expense for corporation in income tax.
Sovereign Bonds:
Sovereign Bonds are issued by government to fund a large, long-term infrastructure project
through capital markets.
Gilt-edged Securities:
High-grade bonds issued by a government or corporation which has a strong record of consistent
earnings, and therefore will carry a lower yield (i.e. lower interest).

Identify any two capital market instruments that are available to the government for financing its expenditure. What
factors the government should consider before raising finances through these instruments? (04 marks)
Give a brief description of any six instrument of capital market. (06 marks)
Explain four differences between a ‘share’ and a ‘debenture’. (03 marks)

135
LO 3: MONEY MARKET INSTRUMENTS –EXAMPLES:

Treasury Bills(T-bills):
Treasury bills (T-bills) are instruments issued by government to raise money from the public. T-
bills have short maturities and are usually less risky as they are backed by government.
Commercial Papers:
Commercial papers are instruments issued by a corporation to raise money from the public. This is
issued with the promise to repay the holder a certain amount at a certain date.
Certificate of Deposit:
This is a time deposit with a commercial bank, whereby after a fixed time, money will be returned
to the holder. This has a slightly higher yield because the default risk is higher with a bank, than
with the government.

(a) Distinguish between ‘Money Market’ and ‘Capital Market’. Identify any three institutions which operate in each
market. (06 marks)
(b) Various sources of short-term and long-term credit are available to the firms. Briefly discuss any two sources in each
case. (06 marks)
LO 4: DERIVATIVE INSTRUMENTS – DEFINITION AND EXAMPLES:

Definition and Examples:
A derivative is a financial instrument whose value depends on the values of other more basic
underlying variables. It is a contract between two parties whose price changes with change in
underlying asset.
Examples of Derivatives:
− Futures Contracts (A Future contract is an agreement to buy or sell an asset at a certain
time in future for a certain price.)
− Forward Contracts (Forward contracts are similar to futures except that they trade in the
over-the-counter market.)
− Options (An option is the right to buy or sell an asset (stocks, bonds, foreign exchange, land,
etc.) for a specified price on or before a specific date. A call option is the right to buy the
stock, while a put option is the right to sell the stock.)
− Swaps (Swap is a transaction in which two parties agree to pay each other a series of cash
flows)
Derivative Markets:
Derivatives can be traded on a Stock Exchange or Over the Counter.
Exchange Traded Derivatives (ETD) Over The Counter (OTC) Derivatives
Decentralized and less regulated market for
Organized and regulated market for financial
financial instruments. The conditions for
Description instruments. A derivative must meet certain
establishing and trading an OTC derivative are
strict criteria to be traded on an exchange.
much less strict.
 High Liquidity
Greater flexibility with regard to the terms of the
Benefits  Backed by Clearing House.
deal.
 Low Risk and Low Cost.
 Low or No Liquidity
Less flexibility and therefore less quantity of
Drawbacks  Not backed by clearing house.
derivatives to be traded.
 High Risk and High Cost.
Examples Futures Forwards and Options.
136

What do you understand by the term ‘Derivative’? List different ways in which derivatives are traded. (03 marks)
Explain the following financial instruments:

(i) Call and Put Options (04 marks)
(ii) Swaps (03 marks)
Briefly describe the role of capital markets in any country. (03 marks)
Briefly describe any two features of each of the following:

(i) Derivative instruments (ii) Mutual funds (04 marks)
LO 5: SHRIA LAW AND ISLAMIC FINANCING:

Principles of Trade in Shria Law:
 Making money from money - e.g. charging interest is usury and therefore not permitted
 Wealth should only be generated through legitimate investment in assets and legitimate
trade
 lnvestment in companies involved with gambling, tobacco, pornography and alcohol is
prohibited
 Short selling and non-asset backed derivatives are not permitted
Modes of Islamic Financing:

1. Mudaraba - This is where a financial expert offers specialist investment in which the
customer and bank share profits.
2. Musharaka - This is an investment partnership with profit sharing terms agreed in advance
and losses limited to the initial capital invested.
3. Murabaha - This is a form of credit that enables customers following lslamic principles to
make a purchase without the need to take out an interest bearing loan. The substance of the
transaction is that the bank buys an item then sells it to the customer on a deferred basis.
4. Ijara - This is a leasing agreement whereby the bank buys an item for a customer then
leases it back to them over an agreed time period. The bank makes a fair profit by charging
rent on the property.
5. ljara-wa-lqtina - Similar to ljara but the customer is able to buy the item at the end of the
contract.
137
Economics – Study Notes Chapter 15 Public Finance, Fiscal Budget and Taxation
CHAPTER FIFTEEN
PUBLIC FINANCE, FISCAL BUDGET AND
TAXATION
PART A – PUBLIC FINANCE

LO 1 PUBLIC FINANCE AND ITS FUNCTIONS
LO 2 IMPORTANCE OF PUBLIC FINANCE
LO 3 DIFFERENCE BETWEEN PRIVATE FINANCE AND PUBLIC FINANCE
PART B – FISCAL BUDGET
LO 4 FISCAL BUDGET
LO 5 TYPES AND CLASSES OF TAXES
LO 6 CANONS OF TAXATION
LO 7 CAUSES OF CONTINUOUS INCREASE IN PUBLIC EXPENDITURE

LO 8 ROLE/IMPORTANCE OF PUBLIC EXPENDITURE
LO 9 NATIONAL/PUBLIC DEBT
138
PART A – PUBLIC FINANCE
LO 1: PUBLIC FINANCE AND ITS FUNCTIONS:

Definition of Public Finance:
Public finance is the study of the role of the government in the economy. It is the branch
of economics which deals with the government-revenue and government-expenditure of the public
authorities and the adjustment of one or the other to achieve macroeconomic goals. It addresses the
question as to how does the government raises the finances for its ever increasing expenditure.
Functions of Public Finance:

There are three functions of public finance i.e. (1) Efficient allocation of resources, (2) Distribution
of income, and (3) Macroeconomic stabilization.
Allocation Function:
Allocation function refers how the country’s resources will be allocated to different sectors of the
economy. Government divides its resources among various public goods to be provided to
members of society either free or at prices well below their real value e.g. infrastructure or national
defense.
Distribution Function:
Distribution function refers how to redistribution resources between individuals of society to
reduce economic inequalities created by free markets. Government uses taxation and other tools to
ensure optimal income distribution.
Stabilization Function:
Stabilization refers to the overall role of ensuring economic stability in general price levels,
unemployment levels, economic growth and in balance of payment etc. This is achieved particularly
by monetary and fiscal policies.

Briefly describe the main functions of ‘Public finance’ as stated by Musgrave. (06 marks)
LO 2: IMPORTANCE OF PUBLIC FINANCE:

Equity:
Public finance plays a great role in eliminating or reducing the inequalities of income and wealth in
a capitalist economy. This is achievable by transferring the purchasing power from the rich to the
poor. Public finance provides government programs that moderate the incomes of the wealthy and
the poor.
Taxation:
Taxation is a tool used in public finance to control economic activity e.g. it can be levied in such a
way:
 to encourage certain useful industries by giving exemptions, and
 to discourage certain harmful industries (e.g. tobacco, alcohol) by imposing higher taxes
139
Provision Public Goods:

Governments provide public good, the government-financed items and services such as roads,
military forces, lighthouses, and streetlights. Private citizens even the wealthy ones would not
voluntarily pay for these services, and therefore businesses have no incentive to produce them.
Economic planning:
Government usually have rolling plans for more than a year, a times the implementation of say five
year plan tends to require a huge fund. Thus, government need to combine resources, taxation and
public borrowing effectively which is done by public finance.
LO 3: DIFFERENCE BETWEEN PRIVATE FINANCE AND PUBLIC FINANCE:
Private Finance Public Finance

Adjustment of income Individuals adjust their expenditure Government adjusts its revenue according to its
and expenditure according to their revenue. expenditure.
 Individuals make budget monthly or  Public authorities make budget on yearly basis.
even more frequently.  Public authorities do not necessarily run
Budgeting
 Individuals try their best to make balanced budget, rather they may run deficit
budget with surplus or balanced. budget to stimulate economic activities.
Individuals can obtain loan only from Government has multiples options of borrowings i.e.
Borrowing
external sources (within the country). from home and foreign countries/organizations.
Individuals cannot create money to meet Government can print currency notes to create
Deficit Financing
their expenditures. money to finance its debt.
Different objectives Focuses on individual welfare. Focuses on welfare of overall society.
Provision for the Individuals plan for short-run focusing Government plans for the long-run, for future
future on quick returns. generations.
Earning and spending matters are Government makes public its sources of finance and
Secrecy
confidential affair of individuals. expenditure to ensure transparency.
Subject A subject of micro economics. A subject of macro economics.
PART B – FISCAL BUDGET
LO 4: FISCAL BUDGET:
Fiscal Budget or Govt. Budget is a statement of estimated revenue and expenditures of governments
during a period.
Fiscal budget may be:

 Deficit (i.e. estimated revenue < estimated expenditure)
 Balanced (i.e. estimated revenue = estimated expenditure)
 Surplus (i.e. estimated revenue > estimated expenditure)
If a government has a deficit in fiscal budget, it will have to:

 finance deficit (i.e. use of borrowings to pay for deficit) or
 correct deficit (i.e. use of government policies to reduce deficit)
Study Tip
Difference between public revenue and public expenditure can be filled by public borrowing or repayment.
140
LO 5: TYPES AND CLASSES OF TAXES:

Functions of Taxation:
 Raising revenue for government.
 Optimum allocation of available resources in economy.
 Reduction of inequality in income and wealth.
 Management of economic growth
 Used as a tool to manage savings and investment.
Types of Taxes:
A tax can be either Direct Tax or Indirect Tax.
Direct Tax:
A direct tax is a tax levied directly upon individuals or firms. It is paid by tax payer directly to
revenue authorities, and cannot be shifted to others. Examples include:
 Income tax  Inheritance tax
 Wealth tax  Capital gains tax.
Indirect Tax:
An indirect tax is a tax levied on goods and services, and hence only indirectly on individuals or
firms who consume those goods and services. It is paid by an intermediary (a supplier) to revenue
authorities, and it can be shifted by taxpayers to consumers by including it in the price of the good.
Examples include:
 Sales Tax / Value-added Tax  Excise Duty
 Fuel Tax  Custom Duty
Advantages and Disadvantages of Direct and Indirect Taxes:
Advantages Disadvantages
 Equitable (as rich pays more and poor pays  Discourages saving/investment
less)  Possible to evade
 Revenue generation for government is  Inconvenient and unpopular for payer.
Direct
certain (as people don’t stop earning if
Taxes
government imposes tax)
 Low cost of collection
 Discourage consumption of ‘harmful’  Increases inequality (as rich and poor pay the same)
products  Causes cost-push inflation (as cost of goods is
 Only mean of reach every person in the increased)
economy.  Can motivate “black market” with collusion of some
 Convenient for people to pay (as they have buyers and some sellers (e.g. by getting goods without
Indirect
liberty on choosing when to pay/consume) bill or buying from illegal market).
Taxes
 Difficult to evade  Revenue generation for government is uncertain (as
people may stop buying items heavily taxes specially
items with elastic demand)
 High cost of collection
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Classes of Tax:
A tax can also be Progressive, Flat or Regressive.
Progressive Tax:
A progressive tax means percentage/ rate of tax goes up as income goes up e.g. income tax on
individuals.
Flat/Proportional Tax:
A flat/proportional tax means percentage/ rate of tax remains same as income goes up e.g. income
tax on companies.
Regressive Tax:
A regressive tax means percentage/ rate of tax goes down as income goes up e.g. sales tax.

(a) What is meant by ‘direct taxation’ and ‘indirect taxation’? Give two examples of each type of taxation. (04 marks)
(b) State any three advantages and three disadvantages of direct and indirect taxation. (06 marks)
What is meant by Direct and Indirect taxes? Briefly discuss the features of a good tax system. (08 marks)
Explain briefly different classes of taxes with the help of a diagram. (06 marks)
LO 6: CANONS OF TAXATION:
By canons of taxation we simply mean the characteristics or qualities which a good tax system
should possess.
Four canons of taxation by Adam Smith:

Canon of equality:
It means that the tax should be based on ability-to-pay approach. Govt. should tax people in
proportion to their income or wealth i.e. the higher the income or wealth, the higher the taxes. It
will ensure equal distribution of wealth in an economy.
142
Canon of certainty:
The tax payers should be well-aware of the purpose, amount and manner of the tax payment.
Canon of convenience:
The time and manner of payment must be convenient for the tax payer so that he is able to pay his
taxes in due time.
Conon of economy:
Tax is economical when the cost of collecting it is small. A tax is also economical when it does not
hamper the economic progress of the country.
Other Canons of Taxation:

Canon of Productivity:
It is better to have fewer taxes with large revenues, rather than more taxes with lesser amounts of
revenue.
Canon of Simplicity:
The system of taxation should be made as simple as possible. The entire process should be simple,
non-technical and straightforward.
Canon of Flexibility/Elasticity:
Canon of flexibility means that the entire tax system should be flexible enough that the taxes can
easily be increased or lowered, in accordance with the government needs.
Canon of Diversity:
The cannon requires that there should be a number of taxes of different varieties so that every class
of citizen may be called upon to pay.
Canon of Benefit:
Govt. should impose tax on people in proportion to the benefit they receive from government
programs.
LO 7: CAUSES OF CONTINUOUS INCREASE IN PUBLIC EXPENDITURE:

Definition of Public Expenditure:
Public expenditure refers to Government expenditure i.e. Government spending. It is incurred by
Central, State and Local governments of a country. Public expenditure can be defined as, "The
expenditure incurred by public authorities like central, state and local governments to satisfy the
collective social wants of the people is known as public expenditure."
Public expenditure can be financed through taxes, public debt, and international aid.
Causes of continuous increase in public expenditure:

Size of Population of Country:
Due to increase in population growth, expansion in administrative activities of the government (like
defence, police, and judiciary) has resulted in a growth of public expenditures in these areas.
143
War and national defense:

Countries which are at war or have threat of war, have to invest heavily in defense equipment to
maintain a minimum deterrence level. Condition worsens when countries have rivals in
neighborhood like Pakistan and India.
Welfare state ideology:

Modern states different programmes to promote people’s welfare like health, education. It builds
up not only social infrastructure but also economic infrastructure in the form of transport,
electricity, etc.
Economic Development:
Economic development is largely conditioned by the availability of economic infrastructure. Only by
building up economic infrastructure, road, transport, electricity, etc., the structure of an economy
can be made to improve. Obviously, for financing these activities, government spends money.
Government Subsidies:
The Government has been providing subsidies on a number of items such as food, fertilizers,
interest to priority sector, exports, education, etc. Because of the massive amounts of subsidies, the
public expenditure has increased.
Ability to Tax:
The increase in national income also resulted in more income to the government by way of tax
revenue and other income. As a result of which the government Expenditure also increased because
under the circumstances, the Government is not only expected to expand its traditional activities
but it also undertakes new activities.
Debt Servicing:
The government has been borrowing heavily both from the domestic market and from foreign
sources, to meet its expenditure. As a result of which, the government has to make huge amounts of
money towards interest payments.
Expansion in social services:

Increase in social services (e.g. education, public health services), and public utility services (e.g.
electricity, water, transport) have increased public expenditure.
Rise in price level.

Since the beginning of the Second World War, the price level has been showing an upward trend in
almost all the countries of the world. Like individuals, the Government has also to buy goods and
services at higher prices.
LO 8: ROLE/IMPORTANCE OF PUBLIC EXPENDITURE:

Economic development is an affair of any state and it depends almost entirely on public
expenditure. Public expenditure promotes economic development in the following ways:
Social and Economic Development:

Economic overheads like the roads and railways, irrigation and power projects are essential for
speeding-up economic development. Social overheads like hospitals, schools, and colleges and
technical institutions too are essential. Money for these things cannot come out of private sources.
144
Balanced Regional Growth:

Special attention has to be paid to the development of backward areas and underdeveloped regions.
This requires huge amounts for which reliance has to be placed on public expenditure.
Development of Agriculture and Industry:

Development of agriculture and industry is vital to the overall economic progress of a country. To
promote economic development, Government has to incur lot of expenditure in the agricultural
sector, e.g., on irrigation and power, seed farms, fertilizer factories, warehouses, etc., and in the
industrial sector by setting up public enterprises like the steel plants, heavy electrical, heavy engin-
eering, machine-making factories, etc.
Exploration and Extraction of Mineral Resources:

Minerals provide a base for further economic development. The government has to undertake
schemes of exploration and development of essential minerals, e.g., coal and oil. Public expenditure
has to play its role here too.
Subsidies and Grants:

Subsidies have to be given to encourage the production of certain goods especially for export to
earn much-needed foreign exchange.
LO 9: NATIONAL/PUBLIC DEBT:
National Debt/Public Debt:
National/Public debt refers to the debt/borrowings of the government:
 from internal sources or
 from external sources (e.g. foreign governments or from foreign lending institutions like
IMF, World Bank).
Relationship between Fiscal Deficit and National Debt:

The national debt is simply the accumulation of the government's budget deficits. Increase in fiscal
deficit will lead to increase in national debt.
Economic Problems of high national debt:

 Government has to pay high interest which reduces growth rate.
 Government may print money to pay its debts which increases inflation.
 Payment of interest to foreigners will adversely affect balance of payment.
 To repay debt, government may raise taxes which will adversely affect consumption and
investment.
How government can reduce size of Public Debt:

 by restricting its expenditures to most essential goods.
 by raising its revenue by imposing additional taxes.

What is meant by Public Debt and how can the government reduce the size of the Public Debt? (03 marks)
Briefly explain the economic problems which a country may face on account of high national debt in relation to its Gross
Domestic Product. (04 marks)
What is meant by public debt and how can the government reduce its size? (04 marks)
145
Economics – Study Notes Chapter 16 Balance of Payment and Exchange Rates
CHAPTER SIXTEEN
BALANCE OF PAYMENT AND
EXCHANGE RATES
PART A : BALANCE OF PAYMENT

LO 1 WHAT IS A BALANCE OF PAYMNET ACCOUNT
LO 2 DEALING WITH CURRENT ACCOUNT DEFICIT

PART B : EXCHANGE RATES
LO 3 EXCHANGE RATES AND ITS DETERMINATION
LO 4 CHANGE IN EQUILIBRIUM EXCHANGE RATE
LO 5 TYPES OF EXCHANGE RATE SYSTEM
LO 6 MANAGING THE EXCHANGE RATE
PART C : DEVALUATION AND CURRENT ACCOUNT DEFICIT

EFFECT OF DEVALUATION /REVALUATION OF CURRENCY ON CURRENT
LO 7
ACCOUNT
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PART A – BALANCE OF PAYMENT

Open economy means an economy that engages in of international trade.
LO 1: WHAT IS A BALANCE OF PAYMNET ACCOUNT:

What is a Balance of Payment Account:
Balance of Payment Account is a statement of all economic transactions of a country with rest
of the world over a period of time.
Format/Components of Balance of Payment Account:

Pakistan's Balance of Payment
For the year ended June 30, 2014
Net Balance/
Credits/+ Debit/–
+ or –
Current Account:
Trade-in-Goods 25,078 (41,668) (16,590)
Trade-in-Services 5,345 (7,995) (2,650)
Investment Income /Primary Income 508 (4,463) (3,955)
Unilateral Transfers/Secondary Income 20,222 (157) 20,065
Total of Current Account
Surplus/(Deficit) (3,130)
Financial and Capital Account:

Foreign Direct Investment 1,572
Portfolio investment 3,981
Financial Account Balance 5,553
Govt.'s Borrowings 1,857

Official Reserves Assets (3,858)
Capital Account Balance (2,001)
Errors & Omissions (422)
Total of Financial and Capital Account 3,130
Exam Tips – Rules of Debits and Credits in Balance of Payment Account

1. If a transaction inflows foreign currency (e.g. exports, or sale of securities, or borrowings or sale of reserve
assets by government), it is recorded as a plus/credit item.
2. If a transaction outflows foreign currency (e.g. imports, or purchase of securities, or repayments by
government), it is recorded as a negative/ debit item.
3. Value of Net exports in GDP (i.e. X – M) is equal to surplus or deficit in current account.
Explanation of Current Account:

Current account records imports and exports of goods and services, investment income and
unilateral transfers between domestic country and rest of the world.
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Trade-in-Goods:
This includes imports and exports of visible goods e.g. raw material, work in process and
finished goods.
Exam Tips – Balance of Trade and Terms of Trade

Balance of Trade: Net Balance of Trade-In-Goods (i.e. net balance of import and export of only visible
goods) is called “Balance of Trade”.
 If exports > imports, it is called “favorable balance of trade” or “trade surplus”.
 If exports< imports, it is called “unfavorable balance of trade” or “trade deficit”.
Terms of Trade: A country’s terms of trade is “a ratio of export prices to import prices” i.e.
Terms of Trade = Index of Export Prices / Index of Import Prices x 100
Terms of trade greater than 100 is considered as “improving”, and terms of trade less than 100 is
considered as “worsening”. However, improving terms of trade do not necessarily result in surplus in
current account (and vice-versa) because terms of trade consider only prices, whereas, balance of
payment considers prices as well as quantities.
Trade-in-Services:
This includes imports and exports of services e.g. International Transport, Tourism, financial
services and consultancy.
Investment Income /Primary Income:

This includes Interest and Dividends on Foreign Investments)
Unilateral Transfers/Secondary Income:

This includes Remittance from those Pakistanis working abroad.
Explanation of Financial and Capital Account:

It records inflows and outflows of assets and debts between domestic country and rest of the
world.
Financial Account:
It represents purchase of shares/bonds in domestic companies by foreigners or in foreign
companies by residents. It could be
 Foreign Direct Investment (long-term investment and involvement in management
e.g. setting a factory in foreign country)
 Portfolio Investments (short-term investment and no active involvement in
management e.g. purchase of less than 10% shares or bonds in a foreign company).
Capital Account:
It includes:
 Govt. Borrowings or their Repayments (e.g. Debts from other
countries/international organizations, issuance of govt.'s securities)
 Purchase or Sale of Official Reserve Assets (e.g. Foreign Currency, Gold)
Exam Tips
1. Sum of both section of balance of payment should always be zero. Current Account may be in Deficit,
in Balance, or in Surplus, however, financial and capital account should be exactly equal to current
account.
2. The term “deficit in balance of payment” is technically wrong because sum of balance of payment
should always be zero. By deficit here, examiner means deficit in current account.
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Balance of payments is a combination of current account and capital/financial account. Briefly discuss the
components of:
– current account
– capital/financial account (08 marks)
What do you understand by ‘Terms of Trade’? Briefly explain whether improved terms of trade always mean a fall in
the balance of payments deficit. (04 marks)
LO 2: DEALING WITH CURRENT ACCOUNT DEFICIT:

Reasons or Causes of Current Account Deficit:
 Foreign goods are cheaper (i.e. low in price) than local goods.
 Foreign goods are better (i.e. in performance, after-sale-service) than local goods.
 Appreciation in exchange rate (i.e. strong domestic currency makes imports cheaper
and exports expensive)
 Decrease in output of country due to natural disasters or political instability.
Dealing with Current Account Deficit:

If a government has a deficit in current account, it will have to:
 finance deficit, or
 correct deficit
Financing a Current Account Deficit:

Financing a current account deficit means use of finance to pay for deficit. A government can
finance the current account deficit by:
 Selling its assets to foreigners.
 Obtaining external debt from foreign governments, foreign banks or investors, or from
international organizations e.g. IMF or World Bank.
 Utilizing its foreign currency reserves held in central bank.
Correcting a Current Account Deficit:

A current account deficit cannot be financed for a long term. Therefore, government must use
policies to reduce (or remove or rectify) deficit.
Measures to correct Current Account Deficit (or Balance of Payment Deficit):

 Deflation in prices of domestic goods.
 Providing Import substitution to consumers
 Devaluation of domestic currency (i.e. weak domestic currency makes imports
expensive and exports cheaper)
 Controls over foreign exchange reserves.
 Protectionist measures to restrict imports e.g.
o Tariffs (It is a tax on imported goods.)
o Import Quotas (It is a limit on quantity of foreign goods that can be sold in
domestic markets.)
o Embargo (total ban) on imports from a certain country.
 Providing subsidies to exporters (e.g. tax exemptions or finance at reduced rates).
 Organization of exhibitions and trade fairs to create awareness among overseas
importers.
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(a) Briefly discuss five main causes of disequilibrium in the balance of payments. (05 marks)
(b) State and briefly describe the impact of any five measures that a government may take to rectify the
disequilibrium in the balance of payments. (05 marks)
(a) Explain what is meant by the term ‘balance of payments deficit’. (03 marks)
(b) Discuss the difference between ‘financing’ a balance of payments deficit and ‘correcting’ that deficit. (07 marks)
PART B– EXCHANGE RATES

Foreign trade involves the use of different foreign currencies.
Foreign Exchange is the market where different currencies are traded.
 When we import goods from foreign countries, we demand dollars to pay in foreign currency.
 When we export goods to foreign countries, we supply dollars to receive in domestic currency.
LO 3: EXCHANGE RATES AND ITS DETERMINATION:

What is an Exchange Rate:
An exchange rate is the price of a unit of foreign currency expressed in terms of domestic
currency.
How exchange rate is determined:

In a free market, Exchange Rate is determined by the equilibrium of demand of foreign
currency and supply of foreign currency.
Diagram Explanation
On X-axis, we measure quantity of foreign
currency (i.e. dollars). On Y-axis, we measure
price of foreign currency (i.e. exchange rate) in
terms of Pak Rupees.
D represents demand curve of dollar whose

slope is negative which shows if exchange rate
of dollar appreciates, demand for dollar
decreases because imports become expensive
(and vice-versa).
S represents supply curve of dollar whose slope

is positive which shows if exchange rate of
dollar appreciates, supply for dollar increases
because exports become cheaper (and vice-
versa).
The intersection of the demand-for-dollar curve

D and the supply-of- dollar curve S determines
the equilibrium price of dollar i.e. Rs. 100 = 1$.
That means that the exchange rate is Rs. 100/$.
Study Tips
1. Like any supply-and-demand diagram, Quantity of foreign currency is measured on the horizontal
axis, and Price of foreign currency is measured on the vertical axis.
2. Regardless of which currency market you are studying, the currency which is measured on the
horizontal axis will always be in the denominator of the price on the vertical axis.
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LO 4: CHANGE IN EQUILIBRIUM EXCHANGE RATE:

Depreciation and Appreciation in Exchange Rate:
A market-determined fall in the price of one currency in terms of others is called depreciation
in exchange rate; and a market-determined rise in the price of one currency in terms of others
is called appreciation in exchange rate.
In a free market, exchange rate may depreciate or appreciate when:

 Demand or supply of foreign currency increases or decreases, or
 When there is change in relative prices of different countries.
Study Tip
When a foreign currency appreciates, local currency automatically depreciates (and vice-versa).
LO 5: TYPES OF EXCHANGE RATE SYSTEM:

A Government can follow any of three types of exchange rate policies i.e.
1. Flexible or Floating Exchange Rate System
2. Fixed Exchange Rate System
3. Managed Floating Exchange Rate System
Flexible or Floating Exchange Rate System:

Definition:
This is a system in which exchange rate for a currency is determined by market forces of
demand and supply of foreign currency; government does not interfere in exchange market.
Advantages of Floating Exchange Rate System:

 Governments do not have to spend or even hold foreign currency reserves
 Balance of payments deficit or surplus are automatically corrected. A deficit will result
in the exchange rate falling; this will improve competitiveness, raise exports and
restore equilibrium.
 The need for government intervention in the foreign exchange markets is eliminated.
Government can concentrate on internal issues such as unemployment and inflation.
Disadvantages of Floating Exchange Rate System:

 If exchange rates appreciate too much, then exports of the country will decrease and
imports will increase. As a result, GDP and employment may fall across the economy.
 If exchange rates falls too much, then cost of imported goods will increase. As a result,
Cost-push inflation may occur.
 Uncertainty surrounding fluctuations in exchange rate could deter trade.
 Currency risk will be maximised under a system of floating exchange rates.
Fixed Exchange Rate System:

Definition:
This is a system in which government sets exchange rate for its currency.
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Advantages of Fixed Exchange Rate System:

 Avoids speculation against the currency.
 Promotes trade as importers and exporters are protected from exchange rate risks.
 Government has to pursue responsible economic policies domestically because excess
variation in currency would make it difficult to support the currency in the long term.
Managed Floating Exchange Rate System:

Definition
This is a system in which exchange rates are basically determined by market forces of demand
and supply of foreign currency, but central bank intervenes to influence exchange rates (e.g.
through monetary policy).

What do you understand by the terms ‘floating exchange rate’ and ‘fixed exchange rate’? List three advantages of
each of the above types of exchange rates. (07 marks)
LO 6: MANAGING THE EXCHANGE RATE:

Reasons/Objectives for Managing the Exchange Rate:
The government may wish to influence exchange rates for a number of reasons:
 To discourage imports and encourage exports (to rectify deficit in balance of payment).
 To remove disequilibrium in exchange market
 To discourage speculation in foreign currency
 To lower inflation.
 To stabilize currency
Government policy to influence exchange rates:

If government wants to depreciate foreign currency (and appreciate Pak Rupees), it can either
decrease demand for foreign currency or may increase supply of foreign currency by following
instruments:
 Central bank sells foreign currency in market. This will increase supply of foreign
currency.
 Central bank increases domestic interest rate. This will decrease demand of foreign
currency.
 Govt. discourages the behaviors of people for investment in foreign currency for
speculative purposes. This will decrease demand of foreign currency.
 Government will try to remove deficit in current account by encouraging exports. This
will increase supply of foreign currency.
Study Tip
These instruments can be used in opposite way to appreciate foreign currency (and depreciate Pak
Rupees).

Governments often seek to achieve certain objectives by influencing the exchange rates. Identify any three such
objectives. (03 marks)
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PART C– DEVALUATION AND CURRENT ACCOUNT DEFICIT
LO 7: EFFECT OF DEVALUATION /REVALUATION OF CURRENCY ON CURRENT ACCOUNT:

Devaluation:
Under fixed exchange rate system, when a country lowers the official price of its currency in
the market, this is called a devaluation.
Effect of Devaluation on Current Account Balance:
J – Curve Explanation/Effect of Devaluation

Devaluation removes current account deficit by making
exports cheaper and imports expensive.
If a country devalues its currency, its current account

balance experiences J-Curve i.e. at first current account
balance declines (i.e. deteriorates) further and then
gradually rises (i.e. improves) to a higher level than it
was before decline.
This is because of inelastic demand of imports and

exports, and existing import/export contracts which
require time-lag to adjust.
Study Tip
1. Similarly, Current Account balance experiences inverse J-curve if a country revalues its currency to
remove surplus.
2. Under fixed exchange rate system, when a country raises the official price of its currency in the
market, this is called a revaluation.
Effectiveness of Policy:
The effectiveness of policy of devaluation depends on:
1. Price elasticity of demand for imports:
If the demand for imported goods and services is inelastic then a rise in the price of
imports will not significantly reduce the volume demanded. It would however, increase
total expenditure on imports thus deepening the deficit.
2. Price elasticity of demand for exports

If demand for exported goods and services is price inelastic then a fall in their price will
not significantly increase the volume demanded. It would however, reduce total
income from exports and deepen the deficit.

What do you understand by ‘J curve’? Explain with the help of a ‘J curve’, how in the short-run the current account
deficit may get worse before improving. (10 marks)
Governments often follow a policy of deliberately weakening the domestic currency by reducing its parity value
within a fixed rate system. Identify the purpose of following such policy and also discuss the factors upon which
effectiveness of such policy depends. (07 marks)
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Economics – Study Notes Multiple Choice Questions
Chapter 1: Fundamental Economic Concepts
Select the most appropriate answer from the options available for each of the following Multiple Choice Questions. Each
MCQ carries ONE mark. Questions marked with single asterisk (*) are selected from past examination papers of ICAP
(CA), and questions marked with double asterisks (**) are selected from past examination papers of FPSC (CSS).
1. * Which of the following is a measure of income earned by a factor of production?

(a) indirect taxes (c) rent
(b) depreciation (d) corporate taxes
2. * Following concept is NOT illustrated by the Production Possibility Curve:

(a) efficiency (c) equity
(b) opportunity cost (d) trade-off
3. * Which one of the following is a basic economic problem?

(a) Unlimited wants and scarce resources (c) Unemployment and inflation
(b) Lower incomes and higher indirect taxes (d) Recession
4. * Economic growth in an industrial society results from:

(a) Technological change (c) Capital production
(b) Innovation (d) All of the above
5. * Which of the following is NOT associated with macroeconomics?

(a) Study of collective decisions by households or producers.
(b) The role of the State Bank in regulating the money supply.
(c) The economic behaviour of buyers and sellers in particular markets.
(d) Study of issues such as unemployment, inflation, economic growth, etc.
6. * If the production possibility curve moves outward to the right, it means that:
(a) the economy is capable of producing more goods and services than it could produce previously.
(b) the economy is not able to produce goods and services that it could produce previously.
(c) it is not possible to produce the optimum combination of goods and services.
(d) there is significant decline in population or exhaustion of natural resources.
7. * Which of the following is not an issue in macroeconomics?

(a) issues relating to balance of payment
(b) determination of prices in the agricultural sector
(c) relationship between inflation and unemployment
(d) possible effect of a budget deficit on the level of investment
8. * The production possibility curve would move inwards when:

(a) there is a change in consumer taste
(b) there is an increase in employment of skilled labour
(c) there is a depletion of natural resources
(d) all of the above
9. * Which of the following topics are studied in Macro Economics?

(a) Theory of Demand (c) Equilibrium of Industry
(b) Aggregate Demand and Aggregate Supply (d) None of the above
10. * Which of the following is not a factor of production?

(a) Land (c) Money
(b) Labour (d) Entrepreneurship
11. * Which of the following is not an economic resource?

(a) Air (c) Sulphuric acid
(b) Water (d) Books
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12. * The curvature of Production Possibility Curve is due to:

(a) Increase in resources (c) Change in opportunity cost
(b) Decrease in demand (d) Decrease in supply
13. * Microeconomics may be defined as the study of:

(a) the ‘focused picture’ of the national economy
(b) acquisition of new technological skills by the factors of production
(c) a study of the level of aggregate production and reasons for its fluctuations
(d) none of the above
14. * Which of the following is NOT a measure of income earned by a factor of production?
(a) Rent (c) Profits
(b) Interest (d) Taxes
15. * Which of the following is a basic economic problem?

(a) Lower incomes and higher taxes (c) Unlimited wants and scarce resources
(b) Unemployment and inflation (d) Balance of payment deficits and recession
16. * Which of the following is more likely to be found in a free market economy than in a planned economy?
(a) An even distribution of wealth
(b) An incentive to innovate
(c) Production of goods for benefit of society as a whole
(d) Full employment of labour
17. * The production possibility frontier is concave to the origin because:

(a) in order to produce one good, resources must be diverted from the other
(b) some resources are better at producing one good and some resources are good at producing other good
(c) there is always some level of unemployment
(d) all resources contribute towards production equally
18. * In which of the following options consumer sovereignty is in the order of highest to lowest?
(a) Market economy, mixed economy, planned economy
(b) Mixed economy, market economy, planned economy
(c) Market economy, planned eco
(d) None of the above
19. ** Keep in mind Production Possibility Frontier (PPF):

(a) All the points on the PPF could be efficient points
(b) Production may be chosen inside PPF which will be efficient
(c) Production out side the PPF is efficient
(d) None of these
20. ** If a firm can fund an investment from its own sources, the opportunity cost of its investment is
(a) less than Zero (c) more than zero
(b) Zero (d) neither
SUGGESTED SOLUTIONS
MCQ # Correct Option MCQ # Correct Option MCQ # Correct Option
1. c 8. c 15. c
2. c 9. b 16. b
3. a 10. c 17. b
4. d 11. a 18. a
5. c 12. c 19. a
6. a 13. d 20. c
7. b 14. d
155
Chapter 2: Demand, Supply and Market Equilibrium
1. * Which statement is true of a curve with a constant slope?

(a) it is a straight line (c) it runs parallel to Y-axis
(b) it is non linear (d) it runs parallel to X-axis
2. * The demand for a Factor of Production is called:

(a) quantity demand (c) factor price
(b) derived demand (d) cost of production
3. * All of the following are determinants of supply except:

(a) price (c) level of technology
(b) income level (d) objectives of the firms
4. * Demand curve slopes downward because of:

(a) Consumer indifference (c) Law of diminishing marginal utility
(b) Elasticity of demand (d) Inelastic demand
5. * If peas and beans are substitutes of each other, an increase in the price of peas will:
(a) increase the quantity of beans demanded
(b) increase the price of beans and the quantity sold
(c) decrease the quantity of peas sold

(a) consumer indifference (c) elasticity of demand
(b) law of diminishing marginal utility (d) inelastic demand
7. * During the year, a flood destroyed significant portion of agricultural land used to produce rice. What would be the short-
run effect on supply diagram for rice?
(a) A movement down the existing supply curve (c) A shift to the left of the supply curve
(b) A shift to the right of the supply curve (d) A movement up the existing supply curve

(a) consumer indifference (c) inelastic demand
(b) elasticity of demand (d) law of diminishing marginal utility
9. * Which of the following has a relatively flat supply curve?

(a) Raw material (c) Labour
(b) Land (d) Capital
10. * A movement along a supply curve is caused by a:

(a) change in the unit price of the particular product
(b) change in the number of producers
(c) change in the level of technology
(d) change in supply of the particular product
11. * If the government sets the maximum price of a product below the market equilibrium price, it would lead to:
(a) excess supply (c) excess demand
(b) market equilibrium (d) economies of scale
12. * Which one of the following will NOT shift the demand curve for a normal good to the left?
(a) A fall in consumers incomes (c) A rise in the price of a complementary good
(b) A rise in the price of the normal good (d) A fall in the price of the substitute good
156
13. ** Demand curve in case of Giffen good is:

(a) Negatively sloped (c) Positively sloped
(b) Vertical (d) None of these
14. ** Normal goods experience an increase in consumption when:

(a) real income increase (c) price rises
(b) real income falls (d) tastes change
15. ** Ceteris paribus is a Latin term meaning:

(a) “one by one” (c) “other things being equal.”
(b) “equal under the law.” (d) “in accordance with the law.”
16. ** If the quantity of X increases whenever the price of X decreases, one can conclude that:
(a) the relationship between the price and the quantity of X is direct
(b) the relationship between the price and the quantity of X is inverse
(c) the relationship between the price and the quantity of X is linear
(d) the relationship between the price and the quantity of X is nonlinear
17. ** A simultaneous decrease in demand and supply will always result in:
(a) a decrease in the equilibrium price (c) a decrease in the equilibrium quantity
(b) an increase in the equilibrium price (d) an increase in the equilibrium quantity
18. ** Given the usual downward – sloping shape of a market demand curve, what should be the effect of a tax that affects only
the fixed cost of every firm remaining in a competitive market on the price received and the quantity supplied by each
competitive firm?
(a) Price up and quantity up (d) Price down and quantity down
(b) Price up and quantity down (e) Price and quantity remain unchanged
(c) Price down and quantity up
19. ** A demand curve shows the relationship between the quantity demanded for a commodity over a given time and:
(a) The tastes of consumer. (c) The price of related commodities
(b) The money income of consumer (d) The price of the commodity
20. ** A supply schedule shows the relationship between the quantity supplied of a commodity over a given time and:
(a) Factor prices (c) Both (a) and (b)
(b) Technology (d) The price of the commodity
21. ** The intersection of market demand and supply curves for a given commodity determines
(a) The equilibrium price of the commodity
(b) The equilibrium quantity of the commodity
(c) The point of neither surplus nor shortage for the commodity
(d) All of these
22. ** Increase in the number of buyers in the market would lead to a shift of the demand curve to:
(a) the right (c) upwards along the curse
(b) the left (d) None of the above
23. ** In supply of and Demand for a product, an increase in production costs will shift:
(a) Demand Curve to the left (c) Demand Curve to the right
(b) Supply Curve to the right (d) Supply Curve to the left
24. ** When a demand schedule is drawn up. Which of the following is not held constant?
(a) Price of substitutes (c) Price of Complementary goods
(b) The price of the goods (d) None of the above
25. ** Which cause the demand curve for a good to move to the right,
(a) Decrease in the cost of production,
(b) A fall in the price of the good.
(c) An increase in the price of a complimentary good
(d) An increase in the price of a close substitute good.
157
SUGGESTED SOLUTIONS
1. a 10. a 19. d
2. b 11. c 20. d
3. b 12. b 21. d
4. c 13. c 22. a
5. d 14. a 23. d
6. b 15. c 24. b
7. c 16. b 25. d
8. d 17. c
9. b 18. b
158
Chapter 3: Elasticity of Demand and Supply
1. * Which of the following products is likely to have the lowest price elasticity of demand?
(a) salt (c) houses
(b) cars (d) apples
2. * If the market price of a product increases from Rs. 35 to Rs. 40 and in response, the quantity demanded decreases from
1400 units to 1200 units, the value of its price elasticity of demand is:
(a) 0.9 (c) 1.1
(b) 1 (d) 1.2
3. * Which of the following has the most inelastic demand?

(a) Fuel (c) Meat
(b) Wheat (d) Sugar
4. * Price elasticity of demand depends upon:

(a) proportion of income spent on the particular (c) substitution elasticity of demand.
good. (d) all of the above.
(b) income elasticity of demand.
5. * Over a long period of time:

(a) demand becomes more elastic and supply becomes less elastic.
(b) demand becomes less elastic and supply becomes more elastic.
(c) both demand and supply becomes more elastic.
(d) both demand and supply becomes less elastic.
6. * Demand for imports may be price inelastic due to:

(a) high dependence on imports
(b) firmly entrenched preferences for imported goods
(c) lack of flexibility of domestic firms to replace imports
7. * Production and employment in which of the following industries would be least affected by recession?
(a) Sugar (c) Garments
(b) Steel (d) Vehicles
8. * Which of the following is NOT a method for the measurement of price elasticity of demand?
(a) Total outlay (c) Point method
(b) Total savings (d) Arc method
9. * Marginal Revenue is greater than zero if:

(a) the elasticity of demand is greater than one (c) the elasticity of demand is one
(b) the elasticity of demand is less than one (d) none of the above
10. * A firm with existing sales of 1,000,000 units per annum is planning to increase the price of a product from Rs. 100 to Rs.
120 per unit. If price elasticity of demand for that product is 1.25, assuming no other changes, the sale of the firm after
price increase would be:
(a) 1,250,000 units (c) 1,200,000 units
(b) 750,000 units (d) 800,000 units
11. ** Income elasticity of demand for an inferior good is:

(a) Positive (c) Negative
(b) Zero (d) None of these
159
12. ** When demand is elastic:

(a) a fall in price is more than offset by an increase in quantity demanded, so that total revenue rises.
(b) the good is probably a necessity, so price has little effect on quantity demanded
(c) a rise in price will increase total revenue, even though less is sold.
(d) buyers are not much influenced by prices of competing proceduts
13. ** If the price elasticity of demand for product is 0.5, this means that:
(a) a 1 percent change in price will change quantity demanded by 50%
(b) a 1 percent increase in quantity demanded is associated with a 0.5 percent fall in price
(c) a 1 percent increase in price is associated with 0.5% fall in quantity demanded
(d) a 1 percent increase in price will cause a 0.5% increase in quantity demanded.
14. ** Price elasticity of demand for a commodity tends to be greater:

(a) the more of a necessity it is (c) over shorter time periods
(b) the more substitutes there are for it (d) the lower the price.
15. ** The law of demand is valid when price elasticity of demand is:
(a) inelastic (d) both (a) and (c)
(b) perfectly elastic (e) none of these
(c) unitary elastic
16. ** The % change in quantity demanded due to % change in income is:

(a) Price elasticity (c) Income elasticity
(b) Prices cross elasticity (d) All of these
17. ** If the % change in quantity demanded is more than % change in price coefficient of price elasticity is:
(a) > 1 (c) =1
(b) < 1 (d) =Zero
18. ** If the coefficient of income elasticity is negative:

(a) It is inferior good (c) It is luxury good
(b) It is normal good (d) All of these
19. ** Two commodities are considered to be substitutes for each other if cross elasticity is
(a) positive (c) zero
(b) negative (d) none of these
20. ** A commodity is considered to be a “luxury” if its income elasticity is:

(a) equal to one (d) zero
(b) greater than one (e) None of these
(c) less than one
21. ** Which of the following products will have an elastic demand:

(a) Flour (c) Honda City
(b) Cloth (d) None of these.
22. ** If the price elasticity for a product is -2, a 10 % fall in its price will;
(a) Decrease total revenue by 20% (c) increase sales volume by 20%.
(b) Increase sales volume by 10% (d) increase total revenue by 20%
23. ** If demand is inelastic, which of the following statement is correct.

(a) If price of the good rises, the total revenue earned will increase.
(b) If price of the good rises, the total revenue earned will fall.
(c) If price of the good falls, the total revenue earned will increase.
(d) If price of the good falls, the total revenue earned is unaffected.
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SUGGESTED SOLUTIONS
1. a 9. a 17. a
2. b 10. b 18. a
3. b 11. c 19. a
4. d 12. a 20. b
5. c 13. c 21. c
6. d 14. b 22. c
7. a 15. d 23. a
8. b 16. c
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Chapter 4: Consumer Equilibrium
1. * Which statement is true, in respect of every point on an indifference curve?

(a) the price of each good is the same (c) all of these statements are true
(b) the level of satisfaction is the same (d) none of these statements is true
2. ** The locus of equilibrium of consumers due to changes in price of a commodity is known as:
(a) Price consumption curve (c) Production possibility curve
(b) Income consumption curve (d) none of these
3. ** The more a person consumes of a thing:

(a) The smaller is his total gain
(b) The lower is the rate of increase in his total pleasure
(c) The higher is the price
(d) None of these
4. * A movement along an indifference curve from left to right means that the consumer’s:
(a) Marginal utility has risen (c) Marginal utility has fallen
(b) Total utility is unchanged (d) Money income is unchanged
5. * Which of the following best defines marginal utility?

(a) The satisfaction of a want that results from consuming one additional unit of product
(b) The ability to buy more of a product due to increase in real income
(c) The change in total utility as a result of consuming an additional unit of a product
(d) The decrease in satisfaction that results from consuming an additional unit of a product
6. * Which of the following is not a characteristic of Indifference Curve (IC)?

(a) IC is negatively sloped (c) ICs cannot intersect each other
(b) Higher IC curve signifies higher level of utility (d) IC is concave to the origin
7. * Farhan has fixed income which he spends on only two goods i.e. X and Y. Farhan’s total utility will be maximized when he
distributes his total income in a manner that:
(a) average utility of last unit of X purchased is equal to the average utility of last unit of Y purchased
(b) marginal cost of last unit of X is equal to marginal cost of last unit of Y
(c) total utility of good X is equal to the total utility of good Y
(d) marginal utility of last unit of X purchased is equal to the marginal utility of last unit of Y purchased
8. ** Price consumption curve in case of complementary goods is:

(a) Downward sloping (c) Upward sloping
(b) Vertical (d) None of these
9. ** In case of two goods, following utility approach, a consumer is in equilibrium when:

(a) MUx/Px = MUy/Py (c) MUx/Mx > MUy/Py
(b) MUx/Px < MUy/Py (d) Both (b) and (c)
10. ** Modern microeconomic theory generally regards utility as:

(a) cardinal (c) independent
(b) ordinal (d) Republican
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11. ** A basic assumption of the theory of consumption choice is that:

(a) the consumer tries to get on the highest indifference curve
(b) the consumer tries to get the most of good Y
(c) the budget line is concave
(d) none of these
12. ** The substitution effect must always be:

(a) positive (c) zero
(b) negative (d) bigger than the income effect
13. ** The income effect:

(a) must always be negative (c) can be negative or positive
(b) must always be positive (d) must be smaller than substitution effect
14. ** The marginal utility of a good refers to the:

(a) total utility of the good prior to consumption of the last unit
(b) extra utility associated with consuming another unit of the good
(c) utility associated with consuming an alternative good
(d) consumer surplus associated with the consumption of an alternative good
15. ** If the marginal utility of a commodity is zero, then:

(a) Total utility for this commodity has reached a maximum.
(b) The commodity in question has no utility, i.e. it is not one that consumers want to use.
(c) The paradox of value must be involved.
(d) The consumer has reached his or her equilibrium position with respect to purchase of this commodity.
(e) Total utility for this commodity must be zero also.
16. ** Indifference curves shows various combinations of:

(a) One commodity (c) Three
(b) Two (d) All of these.
SUGGESTED SOLUTIONS
1. b 7. d 13. c
2. a 8. c 14. b
3. b 9. a 15. a
4. b 10. b 16. b
5. c 11. a
6. d 12. b
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Chapter 5: Revenue, Costs and Firm Equilibrium
1. * Under perfect market conditions, the supply curve of a firm is the same as:
(a) MC curve (c) AR curve
(b) MR curve (d) AC curve
2. * In a perfectly competitive market ___________ is/are the price maker(s):

(a) the individual firm (c) a large number of consumers
(b) the industry (d) the trade association
3. * Which of the following is NOT included in the explicit costs of a firm?

(a) wages paid to labour (c) payments for purchases of materials
(b) interest paid for borrowed capital (d) normal profit
4. * As its output increases, a firm’s short-run marginal cost will eventually increase because of:
(a) diseconomies of scale (c) the firm’s need to break even
(b) a lower product price (d) diminishing returns
5. * The supply curve of a factor for a firm that is in perfect competition in the input market is:
(a) Elastic (c) Perfectly elastic
(b) Inelastic (d) Perfectly inelastic
6. * ABC Limited employs 100 skilled workers at a wage rate of Rs. 2,800 per week. To attract 10 more workers it raises the
wage rate to Rs. 3,000 per week. The marginal cost of employing the extra workers is:
(a) Rs. 20,000 (c) Rs. 50,000
(b) Rs. 30,000 (d) Rs. 200
7. * Under perfect market conditions, the supply curve of a firm is the same as:
(a) MC curve (c) AR curve
(b) MR curve (d) AC curve
8. * Which of the following statement is correct with respect to relationship between the average cost curve and marginal
cost?
(a) Average cost curve will slope downwards when marginal cost is less than average cost
(b) Average cost curve will slope upwards when marginal cost is less than average cost
(c) Average cost curve will slope downwards when marginal cost is more than average cost
(d) There is no direct relationship between average cost curve and marginal cost
9. * Which of the following will always increase when a manufacturing business increases its output?
(a) Fixed costs (c) Total costs
(b) Marginal cost (d) Average variable cost
10. * In the short run, a firm would stop production if:

(a) marginal cost was equal to marginal revenue
(b) total revenues were less than total variable costs
(c) total costs were equal to total revenues
(d) total revenues were less than total fixed costs
11. * Diseconomies of scale occur when:

(a) long run average costs begin to rise (c) long run average costs begin to fall
(b) short run average costs begin to rise (d) short run average costs begin to fall
164
12. * A firm that breaks even after all the economic costs are paid, is earning:
(a) Economic profit (c) Normal profit
(b) No profit (d) Supper normal profit
13. * The short-run average cost curve is:

(a) Upward sloping (c) U shaped
(b) Downward sloping (d) A straight line
14. * Increasing long-run average costs are associated with:

(a) Law of diminishing return (c) Increasing returns to scale
(b) Constant returns to scale (d) Decreasing returns to scale
15. * A profit maximising firm will produce output where:

(a) Total sales are maximised (c) Marginal cost equals marginal revenue
(b) Average total costs are minimised (d) Average revenue is maximized
16. * The productivity of an input is NOT affected by:

(a) Technological change (c) Advances in knowledge
(b) Economies of scale (d) Diminishing returns
17. * Which of these costs will increase or decrease with increase or decrease in production levels?
(a) Marginal cost (c) Financial cost
(b) Fixed cost (d) All of the above
18. * If marginal revenue is Rs. 50 and marginal cost is Rs. 40, the firm seeking profit maximization would:
(a) increase price (c) reduce price
(b) reduce output (d) increase output
19. * The demand curve for the product of a firm operating under conditions of perfect competition would be:
(a) identical to the marginal revenue
(b) intersecting the marginal revenue curve at the point where marginal cost is equal to marginal revenue
(c) intersecting the average variable cost curve at its lowest point
(d) perfectly inelastic
20. * Shahid has employed 25 workers to whom he pays wages at the rate of Rs. 150 per day. He is now intending to increase
the wage rate of all workers by Rs. 20 per day in order to attract one additional worker. Given that all other costs remain
constant, the marginal cost of labour per day would be:
(a) Rs. 20 (c) Rs. 670
(b) Rs. 170 (d) Rs. 4,420
21. * An industry is a group of firms:

(a) located in the same geographical area
(b) producing similar products
(c) which supply the various inputs needed to produce a final product
(d) owned by a corporation
22. * With 50 units of labour, a firm can produce 1,800 units of output. With 60 units of labour the firm can produce 2,100 units
of output. The marginal product of labour is:
(a) 0.33 (c) 30
(b) 3 (d) 300
23. ** The long run average cost curve is:

(a) U-shaped (d) Both (a) and (b)
(b) J-shaped (e) None of these
(c) Hyperbola shape
24. ** The firm’s profit will be maximum when its:

(a) Marginal cost is greater than marginal revenue (c) Marginal cost is equal to marginal revenue
(b) Marginal revenue is greater than marginal cost (d) Both (a) and (b)
165
25. ** The firm’s cost functions are determined by:

(a) the price of its product (c) its production function
(b) its assets (d) the age of the firm
26. ** When a firm is experiencing economies of scale:

(a) the MP curve slopes upward
(b) the LRAC curve slopes downward
(c) diminishing returns to labor have been suspended
(d) the MC curve slopes downward
27. ** In the theory of the firm, profit maximization is always synonymous with:
(a) profitability (d) both (a) and (c)
(b) economic profit making (e) none of these
(c) maximization of the sales revenue
28. ** In perfect competition if a firm maximizes profit, then equilibrium:

(a) MR=MC. (c) MR = AR = PRICE = MC
(b) AR = AC (d) ALL of these
29. ** A market is in equilibrium, when:

(a) AC = P (d) TC = TR
(b) MC = MR (e) None of these
(c) AC = AR
30. ** In the long run:

(a) fixed costs will be greater than variable costs (c) all costs are variable costs
(b) variable costs will be greater than fixed costs (d) none of the above
31. ** A competitive firm will maximize profits at the output where:

(a) the difference between price and marginal cost is highest
(b) price is higher than the average total cost by the largest amount
(c) total revenues and total costs are exactly equal
32. ** When AC is less than MC:

(a) An increase in output would cause AC to rise
(b) Fixed costs must be rising
(c) AC to fall
(d) Should not producer beyond minimum AC
SUGGESTED SOLUTIONS
1. a 12. c 23. a
2. b 13. c 24. c
3. d 14. d 25. c
4. d 15. c 26. b
5. c 16. d 27. e
6. c 17. a 28. d
7. a 18. d 29. e
8. a 19. a 30. c
9. c 20. c 31. c
10. b 21. b 32. a
11. a 22. c
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Chapter 6: Types of Firms
1. * Monopoly power may be based on:

(a) economies of large scale production (c) control of key natural resources
(b) patents (d) all of the above
2. * Which of the following is NOT a characteristic of monopolistic competition?

(a) Existence of many firms
(b) Barrier to entry or exit from the market
(c) Product differentiation
(d) Goods produced are close substitutes of one another
3. * Which of the following is the example of price discrimination?

(a) Peak and off-peak call charges
(b) A doctor charging higher consultancy fees in posh area
(c) Business and economy class flights
(d) Both (a) and (b)
4. * Which of the following is NOT a characteristic of oligopolies?

(a) Mutual dependence (c) Large number of firms
(b) Growth through merger (d) Non-price competition
5. * Identify the key element of a market structure:

(a) Barriers to entry (c) Product differentiation
(b) Barriers to exit (d) None of the above
6. * In conditions of oligopoly:
(a) the steps taken by the market leader are observed very closely by the other firms
(b) the market leader is always in a position to assess accurately the market reactions of the other firms
(c) the market leader’s higher costs and higher prices discourage the rival competitors from undercutting the
market leaders price
(d) the other firms would not dare to make secret price cuts and antagonize the market leader
7. * Which one of the following is NOT a barrier to entry into a monopoly market?
(a) Significant economies of scale (c) Large capital requirements
(b) Heavy potential advertising costs (d) Constant returns to scale
8. ** During perfect competition, the firm would earn a normal profit when:
(a) AC>AR (c) P=MP
(b) AR<AC (d) None of these
9. ** Demand curve in monopolistic competition is:

(a) Relatively flatter than monopoly (c) Negatively sloped and same as monopoly
(b) Relatively steeper than monopoly (d) None of these
10. ** A market with few entry barriers and with many firms that sell differentiated products is:
(a) Purely competitive (c) Monopolistically competitive
(b) Monopoly (d) Oligopolistic Competition
11. ** In case of perfect competition, the sellers are:

(a) Two (c) Very large
(b) A few (d) None of these
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12. ** The following industry often is a natural monopoly:

(a) cigarette industry (c) drug industry
(b) publishing industry (d) electric power industry
13. ** Under perfect competition, rivalry is:

(a) impersonal (c) nonexistent since the firms cooperate
(b) very personal and direct, advertising being (d) all of these
important
14. ** Monopolies arise as a consequence of:

(a) patents (c) franchise
(b) control over the supply of a basic input (d) all of these
15. ** A monopolistic firm will expand its output when:

(a) marginal revenue exceeds marginal cost (c) marginal cost equals marginal revenue
(b) marginal cost exceeds marginal revenue (d) marginal revenue is negative
16. ** In oligopoly market seller are :

(a) a Few (c) Some
(b) Four (d) A large number
17. ** Monopoly market is characterized by:

(a) A large number of sellers (c) Thousands of seller
(b) Only one seller (d) All of these
18. ** If in a market the seller is charging different prices for the same commodity from different consumers, it is known as:
(a) Price discrimination (c) Profit maxi-mizer in Monopoly
(b) Efficient selling (d) All of these
19. ** A monopolist gains more if:

(a) elasticity of demand for his product is low comparatively
(b) elasticity of demand for his product is high comparatively
(c) demand elasticity does not change.
20. ** Which of the following is often considered to be inconsistent with the notion of perfect competition?
(a) large number of firms (c) complete mobility
(b) free entry (d) none of the above
21. ** Which of the following is not a condition of perfect competition?

(a) Inelastic Demand curve (c) Uniform product
(b) single price (d) many buyers
SUGGESTED SOLUTIONS
1. d 8. d 15. a
2. b 9. a 16. a
3. d 10. c 17. b
4. c 11. c 18. a
5. d 12. d 19. a
6. a 13. c 20. d
7. d 14. d 21. a
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Chapter 7: Overview of Macroeconomics
1. * The aggregate demand curve would shift to the right if:

(a) government taxes increase (c) government spending decreases
(b) net exports increase (d) the nominal money supply decreases
2. * A stimulative fiscal policy combined with a restrictive monetary policy will necessarily cause:
(a) gross domestic product to increase (c) interest rate to fall
(b) gross domestic product to decrease (d) interest rates to rise
3. * Which of the following are regarded as withdrawals from the circular flow of income?
(a) saving and taxation (c) investment and saving
(b) export and import (d) Government spending and borrowing
4. * Which of the following would decrease aggregate demand?

(a) increased investment (c) increased taxation
(b) increase in export revenue (d) increased consumption
5. * To counteract a recession, the Central Bank should:

(a) raise the reserve requirement and the discount rate
(b) sell securities on the open market and lower the discount rate
(c) buy securities on the open market and raise the discount rate
(d) buy securities on the open market and lower the discount rate
6. * The aggregate supply curve:

(a) is the sum of the individual supply curves in the economy
(b) is a market supply curve
(c) embodies the same logic that lies behind an individual firm’s supply curve
7. * Inflation will increase when:

(a) aggregate demand increases faster than aggregate supply.
(b) aggregate supply increases faster than aggregate demand.
(c) aggregate demand falls.
(d) both b and c.
8. * A deflationary gap exists in an economy when:

(a) aggregate demand is less than the full employment level of income
(b) injections exceed withdrawals at the full employment level of income
(c) the government has a budget surplus
9. * The inflationary gap may only be bridged by:

(a) raising the government spending (c) raising the output level
(b) raising the price level (d) raising the employment level
10. * If a government were to pursue an expansionary monetary policy it would:

(a) raise interest rates and sell securities (c) raise interest rates and buy securities
(b) lower interest rates and sell securities (d) lower interest rates and buy securities
11. * Increase in Cash Reserve Ratio would:

(a) Decrease prices (c) Control lending
(b) Reduce inflation (d) All the above
169
12. * Which of the following is a tool of expansionary policy?

(a) Increase taxes (c) Allow tax rebates
(b) Reduce subsidies (d) Freeze wages
13. * While pursuing contractionary monetary policy, the central bank would:
(a) raise interest rates and sell securities (c) raise interest rates and buy securities
(b) lower interest rates and sell securities (d) lower interest rates and buy securities
14. * Long Run Aggregate Supply (LRAS) curve is a vertical line because it is:
(a) dependent on price level and signifies the upper limit of the capacity in the economy
(b) dependent on price level and signifies the lower limit of the capacity in the economy
(c) independent of price level and signifies the upper limit of the capacity in the economy
(d) independent of price level and signifies the lower limit of the capacity in the economy
15. * Which of the following is an example of contractionary monetary policy?

(a) A decrease in spending on infrastructure
(b) An increase in direct taxes
(c) An increase in interest rates
(d) A decrease in reserve to be maintained with central bank
16. * Which of the following is an objective of fiscal policy?

(a) Zero inflation (c) Low exchange rates
(b) Reduced money supply (d) Stable economic growth
17. ** Actual GDP may exceed potential GDP for a short period of time when:
(a) the unemployment rate is high
(b) plants run extra shifts that ordinarily are not scheduled.
(c) plants are shut down to remove old equipment and install new equipment
(d) any or all of the above occur.
18. ** When economists speak of investment, they are speaking of:

(a) The part of GNP used by households for current use.
(b) The part of GNP, past and present, that has been set aside to add to productive capacity.
(c) The part of GNP captured in the computation of rupee value of goods butn ot services.
(d) The part of GNP that the government devotes to the construction of roads, airports, and the like.
(e) The part of GNP used by business to add to productive capacity, and by households to add to their stock of new
houses.
19. ** Monetary policy that results in lowering interest rate is:

(a) Contractionary (c) Moderate
(b) Expansionary (d) deflationary
20. ** Which one of the following would cause a fall in the level of aggregate demand in the economy.
(a) a decrease in the level of imports (c) a decrease in government expenditure
(b) a fall in the propensity In save (d) a decrease in the level of income lax
21. ** Which of the following is not part of aggregate demand?

(a) Investment (c) net exports
(b) Govt. Spending (d) Taxes
SUGGESTED SOLUTIONS
1. b 8. a 15. c
2. d 9. b 16. d
3. a 10. d 17. b
4. c 11. d 18. e
5. d 12. c 19. b
6. d 13. a 20. c
7. a 14. c 21. d
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Chapter 8: Calculation of National Income
1. * The GDP deflator is the:

(a) Ratio of nominal GDP to real GDP multiplied by 100
(b) Ratio of real GDP to nominal GDP multiplied by 100
(c) Difference between real GDP and nominal GDP multiplied by 100
(d) Difference between nominal GDP and real GDP multiplied by 100
2. * The quantities of domestic goods given up to obtain a unit of imported goods is called:
(a) Balance of trade
(b) Terms of trade
(c) Substitution effect
(d) Balance of payment
3. * Which of the following is NOT a determinant factor in the rate of growth of a country’s standard of living?
(a) Lowering of retirement age
(b) Capital investment
(c) Technological improvements
(d) Upgrading of educational standards at the university level
4. * GDP is equal to:

(a) the market value of all final goods and services produced during the course of the year.
(b) the sum of the incomes earned by suppliers of resources in the economy.
(c) the sum of value-added at all stages of production.
(d) all of the above.
5. * Which of the following statement is correct?

(a) Disposable Income is equal to consumption plus saving.
(b) Disposable Income is equal to personal income less personal taxes.
(c) Disposable Income is either spent on consumer goods and services or saved.
(d) All of the above.
6. * A Pakistani resident makes an investment in a company resident in United States. This transaction will be recorded in
Pakistan as:
(a) credit in current account (c) credit in capital account
(b) debit in current account (d) debit in capital account
7. * Consider the following with reference to circular flow of national income:

(a) subsidy on agricultural produce
(b) import of capital goods
(c) export of consumer goods
(d) levy of withholding tax
Which of the above represent injections into the circular flow of national income:
(a) (A) and (B) only (c) (A) and (C) only
(b) (B) and (D) only (d) (C) and (D) only
8. * Which of the following constitute(s) injection into the circular flow of income?
(a) Investments by businesses
(b) Government expenditures on goods and services
(c) The value of exports
(d) All of the above
171
9. * The difference between GDP and GNP consists of:

(a) Consumption of fixed capital (c) Public and private transfer payments
(b) Indirect business taxes (d) Net foreign factor income
10. * If planned injections are less than planned withdrawals:

(a) Unemployment will tend to reduce (c) Balance of trade will tend to improve
(b) Inflation will tend to rise (d) National income will tend to rise
11. * To transform GDP from market prices to basic prices it is necessary to:
(a) Exclude imports (c) Subtract taxes and add subsidies
(b) Subtract taxes and subsidies (d) Add income from abroad
12. * Net National Product (NNP) can be arrived at from Gross National Product (GNP) by:
(a) deducting depreciation
(b) adding indirect taxes
(c) deducting indirect taxes and adding depreciation
(d) adding depreciation
13. * Which of the following represents a withdrawal from the circular flow of national income?
(a) A rise in consumption (c) A surplus on the balance of trade
(b) A deficit on the balance of trade (d) A rise in public investment
14. ** Net exports are always:

(a) Positive (c) Balance
(b) Negative (d) None of these
15. ** Per Capita Income is calculated as:

(a) N.I+Population (c) N.I/Population
(b) N.I.*Population (d) Both (a) and (c)
16. ** Gross Domestic Product equals:

(a) GNP – NFI (c) GNP – indirect taxes
(b) GNP + NFI (d) Both (a) and (c)
17. ** Disposable income is:

(a) the same as personal income
(b) income that is used only for consumption
(c) Personal income remaining after income taxes
(d) exclusive of social security payments or welfare.
18. ** The difference between GNP and GDP is:

(a) net factor payments to foreigners
(b) indirect business taxes paid to all levels of government
(c) net exports of goods and services.
(d) capital consumption allowances.
19. ** A country that makes large net income payments to investors in another country is likely to:
(a) have a large GDP than GNP
(b) have smaller GDP than GNP
(c) grow slower economically than the other country
(d) grow faster economically than the other country.
20. ** Which of the following would be the best measure of changes in the standard of living in an economy, expressed in a time
series?
(a) real GDP (c) real GDP per capita
(b) output per labor hour of output (d) nominal GDP per capita
21. ** Disposable income is:

(a) Income less taxes (c) Income less indirect taxes
(b) Income less Direct taxes (d) All of these
172
22. ** Most important economic indicator of the health of an economy is:

(a) Income per capita (c) Literacy rate
(b) National output (d) None of the above
23. ** Which one of the following is a transfer payment in National income accounting
(a) Educational scholarships (c) Payments for text books
(b) Salaries of employees (d) Payment for examination fee
24. ** In calculating National income, double counting can be avoided by.

(a) deducting taxes and adding subsidies
(b) deducting imports and adding exports
(c) excluding the value of the output from intermediate goods
(d) excluding the value of transactions in second hand goods
25. ** If capital consumption is greater than gross investment

(a) Gross investment must be negative (c) Net investment is negative
(b) Gross investment must be declining (d) replacement investment is rising
26. ** An increase in disposable income:

(a) increases economic good (c) reduces spending
(b) reduces economic good (d) has no effect on economy
27. ** Real GDP refers to:

(a) GDP, at constant prices (c) GDP, at nominal prices over time
(b) GDP, at current prices over time (d) None of the above
SUGGESTED SOLUTIONS
1. a 10. c 19. b
2. b 11. c 20. c
3. a 12. a 21. b
4. d 13. b 22. a
5. d 14. d 23. a
6. d 15. c 24. d
7. c 16. a 25. c
8. d 17. c 26. a
9. d 18. a 27. a
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Chapter 9: Analysis of Consumption and Investment Expenditures
1. * The ratio of change in consumption to change in income is called:

(a) Marginal propensity to consume (c) Aggregate consumption
(b) Average propensity to consume (d) Consumption function
2. * The inverse relationship between rate of interest and level of investment is shown by:
(a) supply curve (c) demand curve
(b) the marginal efficiency of capital curve (d) indifference curve
3. ** Sum of MPC and MPS equals:

(a) 2 (c) More than 1
(b) Less than 1 (d) 1
4. ** When Slope of the Aggregate Expenditure Curve increases; (Keynesian Cross model)
(a) National Income will increase (d) There will be inflationary gap
(b) National Income will decrease (e) None of these
(c) There will be recessionary gap
5. ** The investment demand curve is always:

(a) Negatively sloped (c) Vertical
(b) Positively sloped (d) Horizontal
6. ** An MPC of less than 1 means that an increase in current disposable income would cause desired consumption
expenditures to:
(a) fall slightly because the increase in income will increase saving.
(b) rise by the full increase in disposable income.
(c) stay the same because the MPS is also less than 1.
(d) rise by less than full increase in disposable income.
7. ** Counterpart of the intercept of consumption function is the intercept of:

(a) import function (d) X-M
(b) exports (e) None of these
(c) saving function
SUGGESTED SOLUTIONS
1. a 4. a 7. c
2. b 5. a
3. d 6. d
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Chapter 10: Multiplier and Accelerator
1. * Which of the following factor is not used in the multiplier formula for the open economy?
(a) marginal propensity to save (c) marginal propensity to tax
(b) marginal propensity to import (d) marginal propensity to export
2. * The basic concept which underlies the accelerator theory of investment is:
(a) investment depends on the level of savings
(b) investment is inversely related to the rate of interest
(c) investment is determined by the volume of commercial bank lending
(d) investment in an economy is a function of output
3. * Which of the following situations would cause the value of the multiplier to fall?
(a) A fall in the level of government expenditure (c) A rise in the marginal propensity to save
(b) A rise in the marginal propensity to consume (d) A fall in business investment
4. * The concept of Multiplier discusses:

(a) Savings and investments (c) Income and expenditure
(b) Income and investments (d) Income and savings
5. * The multiplier measures the relationship between an increase in income caused by an increase in :
(a) expenditures (c) taxes
(b) investment (d) savings
6. * In a given economy, out of every additional Rs. 1,000 of national income, Rs. 200 is taken in taxes, Rs. 100 is spent on
imports and Rs. 500 is spent on domestically produced goods. The multiplier is:
(a) 1.25 (c) 2.5
(b) 2 (d) 1.67
7. * If there is an increase in investment in an economy by Rs. 250 million and marginal propensity to consume is 3/4, then
overall effect on the total output of the economy would be:
(a) Rs. 1,000 million (c) Rs. 187.50 million
(b) Rs. 333.33 million (d) Rs. 750 million
8. * Which of the following is correct?

(a) People with low incomes have higher average propensity to spend
(b) National income is said to be in an equilibrium when planned withdrawals from circular flow of national income
are equal to planned injections into circular flow of national income
(c) People with high incomes have higher average propensity to spend
9. ** A pure number by which change in investment is multiplied to calculate change in income is called:
(a) Multiplier (c) Stabilizer
(b) Accelerator (d) All of these
10. ** There is positive relationship between multiplier and:

(a) Marginal propensity to consume (c) Marginal efficiency of capital
(b) Marginal propensity to save (d) All of these.
11. ** If MPC=2/3, the investment multiplier is:

(a) 2/3 (c) 3/2
(b) 1/3 (d) None of these
175
12. ** Which is the basic concept which underlines accelerator theory of investment
(a) investment depends on the level of savings
(b) investment is inversely related to the rate of interest
(c) investment is determined by the volume of Commercial Bank Lending
(d) investment rises when there is an increase in the rate of growth of demand in the economy
SUGGESTED SOLUTIONS
1. d 5. b 9. a
2. d 6. b 10. a
3. c 7. a 11. d
4. b 8. d 12. d
176
Chapter 11: Inflation, Unemployment and Business Cycle
1. * On a short-run Phillips Curve, high rates of inflation coincide with:

(a) low interest rates (c) low unemployment rates
(b) high unemployment rates (d) low discount rates
2. * Which of the following would reduce inflation?

(a) an increase in direct taxes (c) increase in government spending
(b) an increase in indirect taxes (d) increase in income
3. * A prolonged and deep recession is called:

(a) Hyperinflation (c) Stagflation
(b) Depression (d) Great depression
4. * Unemployment arising from a long term decline in a particular industry causes an increase in:
(a) structural unemployment. (c) frictional unemployment.
(b) seasonal unemployment. (d) cyclical unemployment.
5. * Which of the following statement is correct?

(a) A government can help to counter demand-pull inflation by reducing interest rate.
(b) A government can help to counter cost-push inflation by linking wage increase to productivity improvement.
(c) A government can help to counter cost-push inflation by increasing income tax rate.
6. * Period of a business cycle in which real GDP is increasing is called:

(a) recovery (c) recession
(b) downturn (d) trough
7. * The four main phases of business cycle are:

(a) boom, inflation, recession and recovery (c) recession, downturn, recovery and growth
(b) inflation, recession, recovery and boom (d) boom, downturn, recession and recovery
8. * Which of the following would NOT lead to inflation?

(a) Increase in money supply (c) Increase in tax exemptions
(b) Increase in interest rate (d) Exchange rate depreciation
9. * Farhan lost his job when Orient Bank closed its operations in Karachi. He received various offers but remained
unemployed because he wanted a job in a bank only. Farhan’s unemployment would be termed as:
(a) frictional unemployment (c) demand-deficient unemployment
(b) structural unemployment (d) seasonal unemployment
10. * Which of the following would reduce inflation?

(a) Increase in government spending (c) Increase in indirect taxes
(b) Increase in direct taxes (d) All of the above
11. * Which of the following does not normally happen in the recession phase of the business cycle?
(a) A fall in the level of national output (c) A rise in the level of unemployment
(b) A rise in the rate of inflation (d) All of the above
12. * The four main phases of a business cycle does NOT include:
(a) Depression (c) Boom
(b) Inflation (d) Recession
177
13. * A contraction in an economy’s aggregate output combined with inflation is called:

(a) Disinflation (c) Stagflation
(b) Deflation (d) Recession
14. * Rapid increases in price level during recession or high unemployment is referred to as:
(a) Stagnation (c) Stagflation
(b) Inflation (d) Slump
15. * The sum of frictional and structural unemployment is considered as the:

(a) Demand deficient unemployment (c) Seasonal rate of unemployment
(b) Natural rate of unemployment (d) Cyclical rate of unemployment
16. * A period of stagflation is characterized by:

(a) increasing prices and increasing employment
(b) increasing prices and declining employment
(c) declining prices and increasing employment
(d) declining prices and declining employment
17. * The level of structural unemployment would most likely be reduced by:
(a) increase in the level of consumer expenditure
(b) increase in research and development grants for technology
(c) increase in labour mobility
(d) both (a) and (b)
18. * Slow economic growth and high unemployment refers to:

(a) Stagflation (c) Wage spiral inflation
(b) Hyper inflation (d) Deflation
19. * The Phillips curve indicates that there is a trade-off between the objectives of:
(a) inflation and economic growth (c) inflation and balance of payments
(b) inflation and unemployment (d) inflation and exchange rate
20. ** If inflation is expected to be 5 percent in the coming year and the nominal interest rate is 8 percent, then the real interest
rate is:
(a) –3 percent (c) 8 percent
(b) 3 percent (d) 13 percent
21. ** Unemployment Rate is a percentage relation with reference to:

(a) Total Population (d) Unemployed Persons
(b) Labour Force (e) None of these
(c) Employed Persons
22. ** Most commonly referred indicator of Inflation is:

(a) Wholesale Price Index (d) Consumer Price Index
(b) Retail Price Index (e) None of these
(c) Sensitivity Price Index
23. ** Cost - push inflation is the result of:

(a) increase in the production cost (c) escalation of international prices
(b) increase in the price of industrial production (d) None of the above
24. ** Structural unemployment can be eliminated by

(a) training the technologically unemployed (c) an increase in the general credit level
(b) increased federal expenditures (d) none of the above
25. ** Increase in minimum wage:

(a) Helps in controlling unemployment (c) Reduces wage bill
(b) Increases unemployment (d) None of these
178
26. ** Demand pull inflation is:

(a) When aggregate demand is rising (c) when costs are rising
(b) When aggregate demand is low (d) When costs are low
SUGGESTED SOLUTIONS
1. c 10. b 19. b
2. a 11. b 20. b
3. b 12. b 21. b
4. a 13. c 22. d
5. b 14. c 23. a
6. a 15. b 24. a
7. d 16. b 25. b
8. b 17. c 26. a
9. a 18. a
179
Chapter 12: Money
1. * Money does NOT function as a:

(a) medium of exchange (c) store of value
(b) hedge against inflation (d) measure of value
2. * If the nominal interest rate is 5% and the inflation rate is 2%, then the real interest rate is:
(a) 2% (c) 5%
(b) 3% (d) 7%
3. * When will savings increase in a country?

(a) When interest rate rises
(b) When inflation increases
(c) When more credit cards are issued by the banks
(d) When production of consumer goods decreases
4. * Which of the following is NOT a method of holding wealth?

(a) Bonds and equities (c) Consumer durables
(b) Human wealth (d) Commodities
5. * Other things being equal, an increase in the rate of interest leads to:
(a) an increase in consumer spending. (c) an increase in business activity.
(b) an increase in saving. (d) an increase in government spending.
6. * Under the Quantity Theory of Money, changes in price level are:

(a) inversely related to change in money supply.
(b) determined primarily by the Government.
(c) directly proportional to changes in money supply.
(d) independent of changes in money supply.
7. * According to the Quantity Theory of Money, if the money supply is Rs. 125 million, the average price level is Rs. 5 and
national output is Rs. 300 million, the velocity of circulation of money is:
(a) 4 (c) 12
(b) 8 (d) 16
8. * Which of the following is most likely to be affected by change in interest rates?

(a) Consumer spending (c) Government spending
(b) Investment spending (d) Exports
9. * Which of the following is not a function of money?

(a) Store of value (c) Standard of deferred payment
(b) Unit of account (d) Payment of interest
10. * The term “Precautionary motive” has been discussed in:

(a) Quantity theory of money (c) Liquidity preference theory
(b) Theory of consumer behaviour (d) Multiplier accelerator theory
11. * In the Keynesian theory of demand for money, the transactions demand for money is determined by:
(a) The rate of interest (c) Expected changes in consumer prices
(b) The level of consumers’ income (d) The amount of money in circulation
12. * Which of the following is NOT a motive for holding money?

(a) Inflationary motive (c) Transactions motive
(b) Precautionary motive (d) Asset motive
180
13. * Which of the following functions money performs best when used to purchase or sell different goods and services?
(a) Store of value (c) Standard of value
(b) Medium of exchange (d) Statement of financial resourcefulness
14. * According to Keynes, individuals retain cash for:

(a) motives of transactions (c) motives of speculation
(b) motives of precaution (d) all of the above
15. ** The following is the narrowest measure of supply of money:

(a) M2 (c) M1
(b) M3 (d) None of these
16. ** Money is:

(a) Currency and Coins (d) Promissory notes
(b) Credit cards and drafts (e) None of these
(c) Bonds
17. ** Real interest rate is:

(a) Interest rate divided by prices (c) Interest rate minus inflation
(b) Interest rate divided by inflation (d) Interest rate plus inflation
18. ** Money can be a standard of deferred payments only if the value of money itself:
(a) Remains stable (c) Decreases
(b) Increases (d) None of these
19. ** According to Keynes, the relationship between money demanded and rate of interest is:
(a) Negative (c) Indirect
(b) Positive (d) None of these
20. ** In a period of deflation (i.e. of generally falling prices), the “real” rate of interest obtained by a lender on money lent:
(a) Will exceed the nominal rate
(b) Will become a negative figure
(c) Will fall below the stated rate, although not to the extent of becoming a negative figure.
(d) Will become a meaningless or incalculable figure
(e) Will be less than the nominal rate.
21. ** Value of bonds fall when:

(a) Interest rate falls (d) Interest rate fluctuates
(b) Interest rate rises (e) None of these
(c) Interest rate remains constant for long time
SUGGESTED SOLUTIONS
1. b 8. b 15. c
2. b 9. d 16. a
3. a 10. c 17. c
4. b 11. b 18. a
5. b 12. a 19. a
6. c 13. b 20. a
7. c 14. d 21. b
181
Chapter 13: Banks and Their Functions
1. * Which of the following deposits can NOT be withdrawn by cheque?

(a) a PLS deposit account (c) a certificate of deposit
(b) a demand deposit (d) none of the above
2. * Central banks can act as lenders of last resort because:

(a) they have the ability to create money
(b) they are the only financial institution that is legally allowed to make loans during financial crises
(c) it provides consulting services to commercial banks whenever they find themselves in financial difficulty
3. * Which of the following is NOT the function of a central bank?

(a) Lender of the last resort (c) Fiscal policy
(b) Monetary policy (d) Credit creation
4. * Which of the following is a financial intermediary?

(a) Pension fund (c) State Bank of Pakistan
(b) International Monetary Fund (d) Stock exchange
5. * Which of the following is a central bank unable to do?

(a) Influence banks to tighten or loosen their credit policies
(b) Create a climate of monetary ease or restraint
(c) Directly set market interest rates
(d) Influence the interest rate on new treasury bonds
6. * The main difference between an investment bank and a commercial bank is that investment bank:
(a) does not accept deposits (c) does not assist companies in acquiring funds
(b) does not underwrite shares (d) none of the above
7. ** The Central Bank of a country plays a significant role in her macroeconomics performance by regulating the:
(a) money supply (d) money market
(b) supply credit (e) all of these
(c) interest rate
SUGGESTED SOLUTIONS
1. c 4. a 7. e
2. a 5. c
3. c 6. a
182
Chapter 14: Financial Markets and Their Instruments
1. * Which of the following instruments are NOT traded in the capital market?
(a) Corporate bonds (c) Mortgages
(b) Treasury bills (d) Shares
2. * The financial market which is used to raise short term finance is called:
(a) capital market (c) derivative market
(b) money market (d) bond market
3. * The main advantage of a mutual fund is that:

(a) it provides short term finance for investment in capital and money market
(b) it provides long term finance for investment in capital and money market
(c) it gives opportunity to investors to invest in a diversified portfolio
4. * An investor who acquires a put option:

(a) buys the right to buy shares at a particular price
(b) buys the right to sell shares at a particular price
(c) sells the right to buy shares at a particular price
(d) sells the right to sell shares at a particular price
5. * An option that protects profit after the underlying asset has experienced a significant gain is called:
(a) forward (c) swap
(b) collar (d) call option
6. * An instrument whose price is dependent on one or more underlying asset(s) is called:

(a) share (c) derivative
(b) certificate of deposit (d) treasury bill
7. * Islamic mode of financing includes an arrangement in which a person participates with his money and another with his
efforts/expertise. This mode of financing is known as:
(a) Ijara (c) Musharaka
(b) Mudaraba (d) Murabaha
8. * Preference shares enjoy certain privileges over ordinary shares. Which of the following is NOT a privilege of preference
shares?
(a) First right to dividend
(b) Greater voting rights
(c) First right to assets in the event of liquidation of a company
(d) Both (b) and (c)
9. * Which of the following instruments would be expected to give the lowest yield?
(a) Sovereign bonds (c) Certificates of deposit
(b) Corporate bonds (d) Shares
10. * Which of the following is the main distinguishing factor between capital and money markets?
(a) Transaction costs (c) Time to maturity
(b) The amounts involved (d) Risk involved
11. * Which of the following is NOT considered to be a credit instrument?

(a) IOU (c) Bond
(b) Draft (d) Stock
183
12. * The gilt edged market is regarded as the market for:

(a) stocks and shares (c) high rated debt securities
(b) derivatives (d) all of the above
13. * The instrument that may be issued by government in capital market to raise money for a long-term investment is:
(a) certificate of deposits (c) preference shares
(b) commercial paper (d) bonds
SUGGESTED SOLUTIONS
1. c 6. c 11. d
2. b 7. b 12. c
3. c 8. b 13. d
4. b 9. a
5. b 10. c
184
Chapter 15: Public Finance, Fiscal Budget and Taxation
1. * Which one of the following is NOT a feature of a good tax system?

(a) It should be equitable (c) The rate should be same for everybody
(b) It should be economical (d) It should be certain
2. * Fiscal deficit can be controlled by:

(a) increasing taxes (c) reducing public expenditure
(b) reducing subsidies (d) all of the above
3. * Fiscal deficit can be controlled by reducing:

(a) Taxes (c) Unemployment
(b) Imports (d) Public expenditure
4. * Which of the following is a direct tax?

(a) Sales tax (c) Federal excise duty
(b) Capital gains tax (d) Value added tax
5. * Which of the following is an example of indirect tax?

(a) Income tax (c) Capital gains tax
(b) Sales tax (d) Property tax
6. * Which of the following is a direct tax?

(a) Federal excise duty (c) Sales tax
(b) Value added tax (d) Capital gains tax
7. * Sales tax on food items is an example of:

(a) direct tax (c) progressive tax
(b) fixed tax (d) regressive tax
8. * Mohsin pays income tax of Rs. 2,500 on his earnings of Rs. 20,000. Danish pays Rs. 4,000 income tax on his earnings of Rs.
32,000.Kinza pays Rs. 5,000 income tax on her earnings of Rs. 40,000. The income tax system is:
(a) regressive (c) progressive
(b) proportional (d) equitable
9. * Murad pays a tax of Rs. 100 on his income of Rs. 1000 while Sohail pays a tax of Rs. 200 on his income of Rs. 800. Identify
the tax system prevailing in the country.
(a) Progressive (c) Proportional
(b) Regressive (d) Equitable
10. ** An increasingly higher marginal income tax is:

(a) progressive (d) both (b) and (c)
(b) regressive (e) none of these
(c) proportional
11. ** Indirect Taxes are:

(a) Direct Taxes - Subsidies (c) Sales Taxes
(b) Subsidies (d) Income Taxes
(e) None of these
12. ** Incidence of a tax refers to:

(a) Who eventually bears the burden of tax (c) Whether the tax is direct or indirect
(b) A principle of taxation (d) A tax is periodically levied
185
SUGGESTED SOLUTIONS
1. c 5. b 9. b
2. d 6. d 10. a
3. d 7. d 11. c
4. b 8. b 12. a
186
Chapter 16: Balance of Payment and Exchange Rates
1. * If the American dollar is overvalued relative to the Pakistan rupee:

(a) Pakistani goods are cheaper than US goods
(b) the Pakistan rupee is undervalued relative to the dollar
(c) the rupee price of the dollar must rise
(d) the cost of Pakistani goods in the United states must be increasing
2. * Which of the following is regarded as an argument in favour of trade protection?

(a) to protect domestic labour against cheap foreign labour
(b) to reduce domestic unemployment
(c) to protect infant industries
3. * Which of the following is NOT considered to be a protectionist measure?

(a) Tariff (c) Export subsidies
(b) Exchange control regulations (d) Free imports
4. * The rate of exchange of the currency of a country will tend to increase, if:
(a) the demand for the country’s goods and services increases in the foreign markets.
(b) the value of the dominant reserve/transaction currency appreciates significantly.
(c) the supply of currency of that country in foreign exchange markets increases.
(d) citizens of that country increase import of foreign goods and services.
5. * A devaluation of the currency will normally result in:

(a) a reduction in the current account deficit (c) a reduction in the domestic cost of living
(b) an increased level of economic activity (d) both (a) and (b)
6. * Which of the following is the advantage of floating exchange rates?

(a) Avoids damaging speculation against the currency
(b) Avoids the need for government intervention in the foreign exchange markets
(c) There is no need to hold reserves
7. * Index price of exports ÷ Index price of imports is equal to:

(a) Balance of trade (c) Terms of trade
(b) Balance of payment (d) Inflation
8. * Which of the following measures would immediately increase the cost of imports?
(a) Tariff (c) Embargo
(b) Quota (d) Subsidies
9. * Currency is usually devalued to:

(a) Increase exports (c) Decrease inflation
(b) Increase imports (d) Increase prices
10. * Which of the following measures would immediately increase the cost of imports?
(a) Tariff (c) Embargo
(b) Dumping duty (d) Subsidies
187
11. * If the UK Pound is overvalued relative to the Pak rupee:

(a) Pakistani exporters will be in an advantageous position
(b) Pakistani importers will be in an advantageous position
(c) UK exporters will be in an advantageous position
(d) Both (b) and (c)
12. * Which of the following is a monetary measure for correcting the current account deficit?
(a) Quotas (c) Import substitution
(b) Export promotion (d) Exchange rate depreciation
13. * Balance of payments surplus is balanced by:

(a) buying gold or other foreign reserves (c) selling gold or other foreign reserves
(b) paying off debts (d) both (a) and (b)
14. * Which of the following cannot be used as a tool to correct balance of payments disequilibrium?
(a) Floating exchange rate
(b) Fixed exchange rate
(c) Domestic interest rate
(d) Buying / selling of domestic currency by central bank
15. * In an economy where demand for imports is price inelastic and demand for exports is price elastic, an appreciation in the
value of domestic currency would result in:
(a) increase in imports spending and decrease in exports revenue
(b) increase in exports revenue and decrease in imports spending
(c) increase in imports spending as well as exports revenue
(d) decrease in imports spending as well as exports revenue
16. * The Current Account of the Balance of Payments consists of:

(a) Trade in goods and services (c) Transfers
(b) Investment income (d) All of the above
17. * The protective measure of a government where only a fixed amount may be imported into a country refers to:
(a) Import tariff (c) Quota
(b) Export tariff (d) Import substitution
18. ** A devaluation of a currency takes place under

(a) Flexible exchange rate (c) Both of these
(b) Fixed exchange rate (d) None of these
19. ** The account in balance of payment that consists of all transactions in financial assets is known as:
(a) Capital account (c) Official Reserve account
(b) Current account (d) None of these
20. ** The difference between exports and imports of visible items of a country is called:
(a) Budget surplus (c) Balance of trade
(b) Balanced budget (d) Both (a) and (c)
21. ** The terms of trade are measured by:

(a) the quantity of imported goods that can be obtained for each unit of an exported good.
(b) the ratio of the price of imports to the price of exports.
(c) the value of imported goods that can be obtained for each dollar of exported goods.
(d) all of the above.
22. ** A substantial fall in the price of Pakistani currency relative to foreign currencies could be expected to affect physical
quantities of exports from Pakistan and imports into Pakistan as follows:
(a) Increase both exports and imports
(b) Increase exports, decrease imports
(c) Decrease both exports and imports
(d) Decrease exports, increase imports
(e) Have no perceptible affect on either imports or exports.
188
23. ** A difference between a tariff on an imported good and a quota on such a good is:
(a) That a quota can never be made to yield revenue for the government, whereas a tariff can.
(b) That a tariff can never be made to yield revenue for the government, whereas a quota can.
(c) That a quota can be used to shut off all, or virtually all, the inflow of the imported good whereas a tariff cannot.
(d) That a tariff can be used to shut off all, or virtually all, the inflow of the imported good whereas a quota cannot.
24. ** Devaluation of rupee would result into:

(a) Expensive exports (d) Overvalued Rupee
(b) Expensive Imports (e) None of these
(c) Expensive Labour
25. ** Balance of Trade Deficit refers to:

(a) Excess of payments for import of goods and services over receipts from exports of goods and services
(b) Excess of receipts from commodity exports minus payments for imports of goods
(c) Payments for commodity imports minus receipts from commodity exports
26. ** Balance of payments deficit implies:

(a) Deficit to the current account (c) All of these
(b) Deficit in the Capital account (d) None of these.
SUGGESTED SOLUTIONS
1. b 10. a 19. a
2. d 11. a 20. c
3. d 12. d 21. b
4. a 13. d 22. b
5. d 14. b 23. a
6. b 15. d 24. b
7. c 16. d 25. c
8. a 17. c 26. a
9. a 18. b
189

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mhkorai.blogspot.

Study Notes and MCQs

By: Muhammad Asif, ACA

ALL RIGHTS RESERVED.

1st Edition: April 2017

Introduction to Economics and Finance, 1/e

Why a Chartered Accountant:

Why this Book:

Is this book enough:

Additional study material:

For any comments/ suggestions/additional support, you can contact me through:

Address: RISE School of Accountancy

06 Aurangzaib Block, New Garden Town, Lahore

Cell # : 0331-4585358 (sms only)

e-mail address: [email protected]

facebook page: https://web.facebook.com/groups/CAF02

Ch.# 1: Fundamentals of economics Chapter 2: Microeconomics

1.1, 1.2, 1.3 LO 1 of Ch.# 1 1.1 LO 3 of Chapter 1

1.1 Not Covered 1.1 - 1.2 LO 4 of Chapter 5

Chapter 7: Consumption, savings and investment Chapter 10: Public finance

1.1 - 1.2 LO 1 of Chapter 9 1.1 LO 3 of Chapter 15

Chapter 12: Monetary policy

1.1 - 1.3 LO 5 of Chapter 12

Chapter 13: Credit

ICAP’s Study Text However, there are certain paragraph

Chapter 15: Financial markets

ICAP’s Study Text

1.1 Not Covered

Chapter Page Number

SECTION A: FUNDAMENTAL CONCEPTS

SECTION B: MICRO ECONOMICS

SECTION C: MACRO ECONOMICS

SECTION D: BANKING AND FINANCE

SECTION E: PUBLIC FINANCE

SECTION F: INTERNATIONAL ECONOMICS

PART A– DEFINITIONS OF ECONOMICS

LO 8 TYPES OF GOODS (OUTPUTS)

LO 9 FACTORS OF PRODUCTION (INPUTS)

LO 10 PRODUCTION POSSIBILITY FROENTIER/CURVE

LO 11 ISLAMIC ECONOMIC SYSTEM

PART A – DEFINITIONS OF ECONOMICS

By Alfred Marshal: (Neo-Classical Economist)

By Robbins: (Modern Economist)

Important aspects of the definition:

Study Tip: Needs, Wants and Goods

2. Firm: (also called seller, producer, business):

Study Tip: Production and Consumption

LO 3: DIFFERENCE BETWEEN MICRO ECONOMICS AND MACRO ECONOMICS:

CONCEPT REVIEW QUESTION

PART B – BASIC ECONOMIC PROBLEM AND ECONOMIC SYSTEMS

LO 4: BASIC ECONOMIC PROBLEM:

There are three economic systems:

2. Planned/Command Economy (e.g. Socialism or Communism)

CONCEPT REVIEW QUESTION

LO 5: MARKET ECONOMY / FREE ECONOMY / LAISSEZ-FAIRE ECONOMY:

Market Mechanism or Price Mechanism:

Features of Market Economy OR Allocation of resources OR Resolving economic problem:

For whom to produce:

Merits/Benefits of Market Economy: