Business Economics Exam

Question 1

Asset Definition

Answer 1

Something that can be used to create economic value. An asset can be tangible, such as a building or machinery or intangible, such as a patent or a brand name. Assets make up one side of a company’s balance-sheet; the other is liabilities.

Question 2

Asymmetric Information

Answer 2

This occurs when one party to a transaction knows more than the other. Asymmetry can lead to market abuse, as when those with inside information of a coming takeover buy shares in the target company. It can also lead to inefficiencies. Since buyers of used cars know less than sellers, they will be inclined to regard all cars as potential “lemons”, leading to lower prices.

Question 3

Austerity

Answer 3

A term used to describe efforts to reduce the share of public spending in GDP, particularly in the 2010s. When the economy is already weak, Keynesian economists view austerity programmes as a mistake, because they reduce demand. But free-market economists worry that, without austerity, the government’s role in the economy inexorably expands over time.

Question 4

Balance of Payments

Answer 4

A term used to describe a country’s transactions with the rest of the world. The import and export of goods and services are captured in the current account, which also includes investment income and transfers (such as expatriate workers sending money home). The capital account captures financial transactions such as foreign direct investment or purchases of bonds and equities. These will balance in the sense that a current-account deficit (or surplus) must be offset by a capital-account surplus (or deficit).

Question 5

Bank Rate

Answer 5

Term used in Britain to describe the official rate set by the Bank of England when it pays interest to commercial banks. By manipulating this rate, the Bank of England affects the level of rates that businesses and consumers pay to borrow money.

Question 6

Behavioural Economics

Answer 6

School of thought that believes that the economic decisions of individuals are often driven by psychological biases rather than the rational analysis of expected returns. One example is the endowment effect. Individuals value the goods they own more highly than they would pay for the same item in an open market. For more, see this article.

Question 7

Bounded Rationality

Answer 7

A theory which assumes that, while individuals try to act rationally, there is a limit to the amount of information they may have, or can absorb. This may make their decisions look irrational.

Question 8

Budget

Answer 8

The annual process through which a government sets out its spending plans and tax measures. A balanced budget is when revenues are expected to match expenditure. More usually, spending outstrips revenues and the government runs a budget deficit. Creating or expanding a deficit can be a deliberate act to boost an economy.

Question 9

Business Cycle

Answer 9

Another term to describe the way that economies tend to expand and contract over time. Various economists have tried to calculate the length of a typical cycle but these have varied widely over history. Booms tend to be much longer than busts, particularly in recent decades.

Question 10

Capital

Answer 10

A word that serves a lot of purposes in economics. It is used to refer to the investment that an entrepreneur puts into a new project or business (hence capitalism); to any lump sum that has been saved; and more broadly to the people and institutions who invest in the world’s financial markets. It can also refer to a bank’s equity capital.

Question 11

Capital Account

Answer 11

In international trade, the component of the balance of payments that comprises financial transactions, such as foreign direct investment. On a company’s balance-sheet, the capital account largely comprises the equity capital invested by the owners and retained profits.

Question 12

Capital Controls

Answer 12

Regulations designed to prevent money from moving across borders. They are often used in regimes with a fixed exchange rate; by preventing money from flowing abroad, they protect the domestic currency from depreciation. Capital controls were a key component of the Bretton Woods system.

Question 13

Capital Goods

Answer 13

Physical assets that companies use in the manufacturing process.

Question 14

Capitalism

Answer 14

A term coined to describe the use of private capital to finance economic activity. Investors and entrepreneurs use their money to create businesses, hiring workers, renting property and buying equipment as needed. Any surplus, or profit, belongs to the entrepreneur or investors. Communism is seen as the obverse of capitalism, as all economic activity is controlled by the state.

Question 15

Central Bank

Answer 15

The institution at the heart of a country’s financial system. It has many roles. Traditionally, it sets the level of short-term interest rates through its interactions with commercial banks. It uses rate changes to control inflation (often under an inflation targeting regime) and affect the level of economic output. More recently, central banks have attempted to affect long-term interest rates through quantitative easing. The central bank acts as a lender of last resort to protect the financial system from collapse; some central banks also act as regulators. Central banks also control foreign exchange reserves and can use these to intervene in the currency markets.

Question 16

Classical Economics

Answer 16

The dominant school of thought in the late 18th and 19th centuries, as developed by Adam Smith and David Ricardo. It largely focused on the self-correcting nature of economies if left alone by governments and thus argued for a laissez faire approach and, thanks in part to the theory of comparative advantage, developed by Ricardo, a belief in free trade.

Question 17

Coase’s Theory of the Firm

Answer 17

Ronald Coase, a British economist, tried to explain why companies exist in “The nature of the firm”, a paper published in 1937. His answer was that markets can be expensive and fiddly to use, especially for non-standard goods. Rather than arrange contracts for each and every transaction, entrepreneurs set up firms and employ workers to do a range of tasks. This allows them to shift employees from one area to another as they see fit. The paper, along with his work on externalities and property rights, helped to win Coase the Nobel prize for economics in 1991. For more detail, read our Schools Brief.

Question 18

Commercial Banks

Answer 18

Banks that focus on taking in money in the form of deposits and lending it out to individuals and businesses. Such banks have a weakness in that most deposits can be withdrawn instantly whereas it can take time to recall loans. This can lead to a bank run.

Question 19

Commodity

Answer 19

A raw material, such as oil or copper, that is usually traded in bulk. Changes in commodity prices can have significant economic effects by, for example, feeding through into consumer prices. A sharp rise in energy prices can adversely affect consumer demand; because consumers have to spend more on energy, they have less to spend elsewhere.

Question 20

Comparative Advantage

Answer 20

This idea has been called one of the most profound insights in economics. If country A can make cars more cheaply than country B, and B can produce shirts more cheaply than A, it clearly makes sense to trade. Each has an absolute advantage in one area. But what if A is more efficient at producing everything than B? It still makes sense for them to trade, with B producing the goods where it is more competitive; if for example it is 90% as efficient as A in making shirts, and only 60% in car manufacturing, then it should specialise in making shirts and trade them for cars. Both countries will gain.

Question 21

Competition

Answer 21

A concept at the heart of economics. Firms compete to sell the best goods and services to consumers, and to attract the best workers. The aim is to allocate resources in the most efficient manner.

Question 22

Consumer Confidence

Answer 22

A measure, taken from a survey, of the public’s attitude towards the economic outlook. If people are worried about their jobs, or political unrest, or a pandemic, they will be less likely to spend money.

Question 23

Consumption

Answer 23

The spending of money on goods and services by households. Consumers can either spend their income, or save it. When consumers are cautious, they spend less and save more. This can have adverse economic effects as consumption is usually the largest component of aggregate demand, ahead of public spending and investment.

Question 24

Cost-benefit analysis

Answer 24

A process of assessing the feasibility and profitability of a public-sector project or business decision. As the name suggests, all the potential costs are compared with the potential revenues and other benefits. Although the idea is sound, the estimates are subject to a lot of uncertainty. Building projects are notorious for running over time and over budget. Quantifying non-monetary factors (eg, the value of life or the environment) is difficult—and controversial.

Question 25

Curent Account

Answer 25

This measures all the non-financial transactions between a country and the rest of the world—chiefly its imports and exports of goods and services—and transfers such as remittances and financial aid. Since the balance of payments must balance, a current account deficit necessitates a capital account surplus (an inflow of money) to balance it.

Question 26

Default

Answer 26

When a borrower fails to repay a debt. Widespread defaults are problematic since they can lead to a collapse in the banking system.

Question 27

Deflation

Answer 27

Falling prices across an entire economy. Deflationary years were quite common under the gold standard when prices were stable over the long run, with some up and some down years. But deflation tends to be a problem in the modern era since it tends to be associated with falling nominal incomes. Since debt repayments are fixed in nominal terms, deflation often leads to a crisis as debtors struggle to repay their loans. Not to be confused with disinflation

Question 28

Aggregate Demand

Answer 28

The flow of spending, across the economy, on goods and services. Demand can fall, even if people’s income and wealth are unchanged, if they decide to save, rather than spend.

Question 29

Depression

Answer 29

A prolonged and sharp fall in economic output, associated with a high level of unemployment. The Great Depression of the 1930s is the most notable example.

Question 30

Deregulation

Answer 30

It is a staple of conservative thought that there are too many regulations which hold back economic growth. So every few years, governments announce a policy of deregulation to cut back the red tape. It turns out, however, that public opinion often demands that governments act to ban things that are bad, or that are disliked. And so more regulations are introduced.

Question 31

Derivatives

Answer 31

Financial assets whose value “derives” from something else, such as a stockmarket index or a commodity price. Examples include futures, options and swaps. Derivatives are often used to insure against a sudden change in the value of a key variable, such as a sharp rise in the oil price. But they can also be used to speculate on price movements which is why Warren Buffett, a veteran investor, described them as “financial weapons of mass destruction”.

Question 32

Devaluation

Answer 32

A formal reduction in the value of a currency. This occurs when a country has a fixed exchange rate and decides to alter the rate; for example, sterling was devalued in 1949 and 1967. Depreciation, in contrast, is a day-to-day currency decline.

Question 33

Developed Countries

Answer 33

A term used for nations where incomes per person are high, relative to the global average. These countries tended to industrialise early and are mainly based in Europe, and in former European settler colonies in North America and Australasia. Many Asian nations such as Japan and South Korea are also classified as developed.

Question 34

Developing Countries

Answer 34

A term used to describe countries where income per person is lower than in “developed nations”. These countries will usually have industrialised later than those in Europe or America. There is no official designation of developing countries and the World Bank uses the terms “lower-middle” and “low-income”.

Question 35

Diminishing Returns

Answer 35

Production involves certain inputs; labour, machinery, raw materials. At first, adding more inputs will improve productivity substantially; using fertilisers on crops for example or adding waiters in a restaurant to serve more diners. But eventually the marginal gains from adding more inputs will reduce; the waiters will have fewer people to serve. This is the law of diminishing returns.

Question 36

Disinflation

Answer 36

A situation where prices across the economy are rising, but more slowly than before—eg, a fall in the annual inflation rate from 10% to 5%. Not to be confused with deflation.

Question 37

Disintermediation

Answer 37

Cutting out the middleman, or connecting customers directly with producers. In theory, this should reduce costs. In practice, middlemen emerge in a new form; high-street travel agents may have declined in importance but many people use online versions such as Expedia or Booking.com

Question 38

Dividend

Answer 38

A regular payment made by a company to its shareholders. The payment comes from a company’s profits. Normally companies try to increase dividends over time; when they cut the dividend, this is a sign of trouble.

Question 39

Division of Labour

Answer 39

One of the fundamental principles of economics, described by Adam Smith in “The Wealth of Nations”. Work can be undertaken more efficiently if broken up into discrete tasks. It is also more efficient for individuals to focus on their own jobs and use their wages to purchase goods and services, rather than attempt to grow their own food or make their own electrical devices.

Question 40

Duopoly

Answer 40

A situation where two producers control a market.

Question 41

Economies of scale

Answer 41

The owner of a firm needs to buy machinery, rent property, and so on. Some of these costs are fixed. As the firm produces more, these costs are spread over more units; the average cost of production falls. These economies of scale mean that mass production tends to result in cheaper goods.

Question 42

Efficient market hypothesis

Answer 42

The theory that market prices reflect all public information. Trading, or investing, on the basis of that information will thus not offer any advantage. The hypothesis explains why so many fund managers fail to beat the market, after costs, and has led to the popularity of low-cost index funds, which simply buy all the securities in the index.

Question 43

Elasticity

Answer 43

A measure of the responsiveness of one variable to changes in another. For example, if a good rises in price by 10%, then demand could fall by less than 10% (price inelasticity) or more than 10% (price elasticity). Essential goods like food and fuel tend to be price inelastic.

Question 44

Emerging Markets

Answer 44

A term, largely used in investment circles, for developing countries. Investors might put their capital into emerging markets because they believe the growth prospects for such countries (and thus the returns on equities) will be higher. But emerging markets tend to be risky, and can suffer from capital flight when investors become risk-averse.

Question 45

Equilibrium

Answer 45

One of the commonest concepts in economics. At its simplest, equilibrium means a balance between the supply of and demand for a good at a market-clearing price. But economists also study equilibria across the entire economy (“general equilibrium”) or in which markets do not clear (see involuntary unemployment). Unhelpfully, equilibria need not be stable (see the commodity cycle) or socially optimal. See also Nash equilibrium. Some economists think too much attention has been given to equilibrium.

Question 46

Exchange Rate

Answer 46

The rate at which one currency is exchanged for another. Generally, this is either a fixed exchange rate or a floating exchange rate although halfway houses (such as a crawling peg) have been attempted.

Question 47

Externality

Answer 47

An externality is a cost or benefit to a third party as a result of someone else’s actions. Externalities lie outside the market system. Polluted air, caused by a chemical plant’s emissions, is a negative externality. A common textbook example of positive externalities involves beehives next door to an orchard: the nectar feeds the bees, which in turn pollinate the trees.

Question 48

Factors of Production

Answer 48

The ingredients necessary for economic activity: land, labour, capital and entrepreneurship, which is needed to bring the other three elements together.

Question 49

Financial Markets

Answer 49

The places where money is invested, in the form of short-term loans, bonds, equities and derivatives. Often anthropomorphised in the media (eg, “The markets were unhappy with the government’s budget plans”).

Question 50

Fiscal Drag

Answer 50

A way in which inflation can boost tax revenues. In most tax systems, workers must earn a certain amount before they pay income tax, or pay it a higher rate. If those allowances are not uprated every year in line with inflation, workers end up paying more in tax in real terms when their wages rise.

Question 51

Fiscal Policy

Answer 51

Decisions relating to the amount a government raises in taxes and spends on public services. Fiscal tightening means the government is raising taxes, or cutting spending (or both) and thus taking demand out of the economy. Fiscal easing means the government is lowering taxes, or raising spending (or both) and thus adding demand. A fiscally neutral budget would neither add nor subtract demand by, say, raising taxes and spending by the same amount.

Question 52

Fixed Costs

Answer 52

Costs of production that do not change when output changes, for example the rent paid on a factory.

Question 53

Foreign Direct Investment

Answer 53

When a foreign investor sets up a new operation in a country, or buys an existing business. FDI is distinct from portfolio investment, the purchase of a small stake in a business by a pension fund or sovereign wealth fund. FDI can boost productivity, by bringing new technology and upgrading the skills of domestic workers. It expanded rapidly at the end of the 20th century. But governments can be suspicious if a foreign company takes over an industry in an area (like technology or defence) which is perceived to be strategically important.

Question 54

Framing

Answer 54

In behavioural economics, the idea that how a proposition is framed can affect the reaction of individuals. So expressing the cost of an annual subscription at $72 a year will attract fewer customers than describing it as $6 a month.

Question 55

Free-market economists

Answer 55

Those who believe that the market is better at allocating resources than governments and that excessive regulation and high public spending tend to diminish growth in the long run. See also Austrian school, Chicago school, laissez-faire and neoliberalism.

Question 56

Game Theory

Answer 56

A technique for analysing how people, firms and governments behave in situations they must take into account what others are likely to do and might respond to what they do. For instance, competition among firms can be analysed as a game in which they strive for long-term advantage; game theory has also been applied to nuclear deterrence (see this article).

Question 57

Gig Economy

Answer 57

A term given to workers whose jobs are part-time or temporary, and who thus lack job security. Many work for the new wave of platform companies that have emerged in the 21st century such as Uber, a ride-sharing company, or Deliveroo, a food-delivery group. As contractors, gig-economy workers have few rights such as holiday pay or pensions, although courts have ruled that some must be treated as conventional employees.

Question 58

Globalisation

Answer 58

The tendency for national economies to become integrated with each other, through the movement of goods and services, capital and people. The first modern wave of globalisation in the late 19th century was brought to an end by the first world war. A second stage emerged during the late 20th century as China, and the ex-communist countries of eastern Europe, joined the global trading system

Question 59

Great Depression

Answer 59

The era in the 1930s when economic output and volumes of international trade collapsed. The depression was a challenge to classical economics which held that market forces would eventually bring the economy back to growth and eventually led to the adoption of Keynesian economics after the second world war.

Question 60

Great Compression

Answer 60

A period from in the mid-20th century when income differentials narrowed in the face of the growth of the welfare state and high rates of marginal taxation.

Question 61

Great Moderation

Answer 61

A period from the mid-1980s to 2007 when recessions in the developed world were rare, inflation was mostly low, interest rates steadily fell and asset markets soared. Came to a halt with the financial crisis of 2007, in what could be described as a Minsky moment.

Question 62

GDP

Answer 62

The main measure of an economy’s size. GDP is calculated from the market value of all the finished goods and services within a country’s borders over a set period of time. It has its critics; if a vandal breaks a window, the cost of its repair is an addition to GDP even though human welfare has hardly improved. It is also hard to calculate and initial GDP figures are often revised later.

Question 63

Gross National Product

Answer 63

GNP is the value of all goods and services produced by citizens of a country, both domestically and internationally. Income earned by foreign residents is deducted. The difference can sometimes be dramatic. Thanks to Ireland’s low corporate-tax rate, so many multinationals are based in the country that its GDP is much higher than its GNP.

Question 64

Hot Money

Answer 64

Short-term capital that flows into a country in search of quick returns. Hot money tends to flow through the banks, leading to a lending spree that causes speculation in the property market. It also drives up the country’s currency, making life more difficult for its exports. When sentiment turns, hot money flows out, causing the currency to slump, bursting any speculative bubbles and leading to a banking crisis. Nations prefer to rely on foreign direct investment, which is more permanent.

Question 65

Human Capital

Answer 65

The skills and brainpower of workers. Improving human capital through training and education is often seen as a way of improving productivity, although the effectiveness of such programmes can be hard to measure.

Question 66

Hedging

Answer 66

This occurs when individuals, companies and institutions try to protect themselves against adverse market movements, such as changes in commodity prices, currencies or interest rates.

Question 67

Hyperinflation

Answer 67

When inflation gets out of control—as happened, for example, in Germany in 1923. A loaf of bread cost 200bn marks in November 1923 and workers were paid twice a day because their wages fell in value during the day. Such high rates of inflation are fuelled by rapid expansion of the money supply.

Question 68

Illiquid assets

Answer 68

Assets that cannot readily be tuned into cash or can only be sold quickly at a substantial discount. Illiquid assets are often the cause of financial crises when entities like banks have a mismatch between their liabilities (customers’ deposits, which can be instantly withdrawn) and their assets (long-term loans, which are illiquid). Illiquid assets will often offer a higher return because of their greater risk.

Question 69

Indirect Taxation

Answer 69

Tax collected by an entity other than the government. Examples include sales tax (collected by retailers), levies on alcohol and tobacco, and taxes on tourism (collected by hotels and airlines). Governments can favour these as a way of increasing revenues without changing the headline rate of direct taxes like income tax.

Question 70

Inequality

Answer 70

A subject of perennial debate among economists is how much inequality is “normal” and which changes in economic policy are likely to decrease or increase it? Inequality is often measured by the Gini coefficient but other gauges include the share of income and wealth taken by the top 1% or 10% of the population. One hypothesis, the Kuznets curve, suggested that industrialisation initially increases inequality, then decreases it. This seemed plausible during the Great Compression from 1940 to 1980 but inequality in the developed world has increased since then. This Briefing explores a debate among economists about whether inequality is increasing and this Explainer examines the relationship between inequality and economic growth.

Question 71

Inflation

Answer 71

A general rise in the price level. This is normally calculated by comparing the price of a basket of goods (measured by a consumer price index) at different times, and can be used as a measure of the cost of living. But consumers can substitute cheaper products for more expensive ones (eg, chicken for beef) and a hedonic adjustment needs to be made to reflect the improved quality of goods. Central banks often have a mandate to control inflation and may look at a wide range of gauges to understand the underlying trend; for example, measures of “core” inflation that exclude volatile items such as food and energy.

Question 72

Informal Economy

Answer 72

Activities that have economic value but are not registered with the country’s authorities; this may include teenagers who babysit for neighbours, hawkers who sell tourist souvenirs in big cities and ticket touts. The International Labour Organisation has estimated that 2bn people may have occasional involvement in the informal economy.

Question 73

Insider Trading

Answer 73

The use of non-public information to gain an advantage in financial markets. It is illegal in many countries because it discriminates against other investors and can cause confidence in the probity of financial markets to fall.

Question 74

Insurance

Answer 74

The act of protecting yourself against the financial impact of risk. Traditionally, insurance was developed to cover fire, the sinking or seizure of a ship, or the death of the family breadwinner. Insurance companies attempted to calculate the likelihood of such risks occurring and protected themselves by diversification. In the modern era, insurance is also widely used to protect, or hedge, against risks such as changes in market prices or interest rates. Sometimes the other side of the risk is assumed by speculators hoping to make a profit.

Question 75

Intangible Asset

Answer 75

Something without physical form that can create value. Examples include patents and brand names.

Question 76

Interest Rates

Answer 76

The return for lending money, and the cost of borrowing it. The level of interest rates depends on the time value of money, the credit risk of the borrower, the level of inflation and other factors. Short-term rates are generally set by, or are closely linked to, the decisions of the country’s central bank. Long-term interest rates, including long-term bond yields, are affected by the balance between the supply of savings and the demand for credit.

Question 77

Investment

Answer 77

This term is used in two linked ways, both referring to putting money to work, usually for the long term. Business investment occurs when companies buy new machines, or build new factories, or conduct research and development, with the aim of increasing profits. Portfolio investment occurs when individuals or institutions put money into long-term assets such as bonds, equities and property.

Question 77

Invisible Hand

Answer 77

A metaphor used by Adam Smith to describe how an individual may be “led by an invisible hand to promote an end which was no part of his intention”. This has been interpreted in the modern era to suggest that individuals who act in their own self-interest may end up promoting the good of society as a whole.

Question 78

Involuntary unemployment

Answer 78

The unemployment that results when not everyone who is willing to work at the prevailing wage can find a job. Causes can include a shortfall in aggregate demand or some rigidity in the labour market. A central idea in Keynesian economics.

Question 79

J-Curve

Answer 79

This describes the normal pattern of a country’s balance of payments after the devaluation or sharp depreciation of its currency. Initially imports are more expensive and exports are cheaper, so the balance deteriorates (the deficit widens). Eventually, foreigners buy more of the country’s exports while domestic consumers buy fewer imports and the balance improves.

Question 80

Joint Supply

Answer 80

When the process of producing one product leads to the production of another. For example, the distillation of crude oil yields gasoline, kerosene, asphalt and more.

Question 81

Keynesian Economics

Answer 81

John Maynard Keynes, a British academic and government official, changed the field of economics. Under classical economics, governments did little to manage the economic cycle, which they believed would right itself. But Keynes argued, in the face of the Great Depression, that a recession could dent the “animal spirits” of businesspeople and discourage consumers from spending. Governments, rather than balance their budgets, could borrow to spend money and this spending would revive demand. After 1945, many governments adopted a Keynesian approach and used fiscal policy to manage the economic cycle.

Question 82

Labour

Answer 82

John Maynard Keynes, a British academic and government official, changed the field of economics. Under classical economics, governments did little to manage the economic cycle, which they believed would right itself. But Keynes argued, in the face of the Great Depression, that a recession could dent the “animal spirits” of businesspeople and discourage consumers from spending. Governments, rather than balance their budgets, could borrow to spend money and this spending would revive demand. After 1945, many governments adopted a Keynesian approach and used fiscal policy to manage the economic cycle.

Question 83

Labour Theory of Value

Answer 83

The idea, mentioned by Adam Smith and championed by Karl Marx, that the value of a good depends on the labour put into it. The problem is that the value of a good is also dependent on demand; someone might put an enormous amount of effort into assembling a model of the Eiffel Tower from old pencils, but it will have little market value if no one wants to buy it.

Question 84

Laissez-faire

Answer 84

This French term refers to the idea that governments should leave the economy alone as much as possible, and should allow free trade. Associated with the classical school of economics.

Question 85

Loss Aversion

Answer 85

A psychological trait, discussed in behavioural economics, that dislikes the acceptance of losses. Investors may hold on to losing positions, rather than sell them, because they are unwilling to recognise their mistake. Depending on how a proposition is framed, people may act differently; a discount for paying taxes early will be less effective as an inducement for early payment than a penalty for paying late. See also framing and sunk cost syndrome.