Chapter 13: The economic environment of business and finance

Question 1

What is a market?

Answer 1

A market is where potential buyers and sellers come together for the purpose of exchange

Question 2

What is the market mechanism?

Answer 2

The market mechanism is the interaction of supply and demand for a particular item

Question 3

What is demand for product?

Answer 3

The demand for a particular good is the quantity that consumers are willing and able to buy at a given price

Question 4

What is a demand curve?

Answer 4

A demand schedule or curve shows demand at each price, assuming that all other variables are constant.

Question 5

Quantity demanded usually goes up as…

Answer 5

Quantity demanded usually goes up as price falls

• Lower prices make the goods more affordable to people on lower incomes
• Lower relative prices make the goods more attractive

Question 6

What are the determinants of demand?

Answer 6

• Price of the good itself
• Prices of other goods
• Substitutes (e.g., different brands of mobile phones)
  (e.g., an increase in Price B results in a decreased demand for B and an increased demand for A instead)
• National income - normal and inferior goods
  (Increasing income leads to greater demand for normal goods but an increased demand for inferior goods)
• Fashion
• Population size
• Credit terms

Question 7

What causes a shift in the demand curve?

Answer 7

• Changes in price cause movement along the demand curve
• Changes in other factors move the curve itself: an increase in demand will result in the demand curve shifting to the right - the quantity demanded will increase at each price level

Question 8

How does the demand curve account for less demand?

Answer 8

Less demand would be shown by the demand curve shifting to the left

Question 9

What would a shift of the demand curve to the right be caused by?

Answer 9

• An increase in household income
• An increase in the price of substitutes
• A decrease in the price of complements
• The good becoming more fashionable
• An expectation that the price of the good will be higher in the next period

Question 10

What is PED?

Answer 10

Price elasticity of demand (PED) looks at the degree to which demand is affected by changes in the selling price

Question 11

How do you calculate PED?

Answer 11

PED = % Demand / % Price

It is convention to ignore the sign of PED as it is almost always negative

Question 12

How do you demonstrate elastic and inelastic demand?

Answer 12

Inelastic: PED < 1
Elastic: PED > 1
Perfectly inelastic: PED = 0
Perfectly elastic: PED = (infinity symbol)
Unitary elastic: PED = 1

Question 13

What are the factors affecting the PED?

Answer 13

• Availability and closeness of substitutes i.e. if readily available or close substitutes exist then demand will tend to be much more elastic
• Time: generally, in the short run demand tends to be much less elastic, while in the long run it tends to be much more elastic
• Competitors pricing: if competitors copy a price cut then demand is unlikely to rise (inelastic). The same competitors may not copy a price rise resulting in a large fall in demand (elastic). This can give rise to ‘price stickiness’.
• Nature of the product: in the case of luxuries demand tends to be more elastic, with necessities less elastic. Habit-forming products are price inelastic
• Proportion of income accounted for by a good. If a good accounts for a large proportion of income, demand will tend to be elastic; if it accounts for only a small proportion, muss less elastic

Question 14

What is the significance of price elasticity?

Answer 14

• Allows managers to predict the effect of price changes on demand and revenue
• Inelastic products (PED < 1) - increasing the price will increase total revenue even though fewer units are sold
• Elastic products (PED > 1) - increasing the price will cut the total revenue and fewer units will be sold. For elastic demand the price must be cut to increase revenue

Question 15

What do Giffen and Veblen goods have in common?

Answer 15

Both Giffen and Veblen goods have upward-sloping demand curves and positive elasticity of demand

Question 16

What are Giffen goods?

Answer 16

Giffen looked at income effect of price changes eg.,

• The price of bread increases
• People still buy bread (staple)
• Can no longer afford other more expensive foods
• End up buying even more bread

Veblen goods are bought for ostentation (designed to impress), so a higher price makes them more exclusive and desirable

Question 17

What is income elasticity of demand and how is it calculated?

Answer 17

Income elasticity of demand (YED) looks at the degree to which demand is affected by changes in household income
YED = % Demand (increase or decrease) / % Household income (increase or decrease)

Question 18

How do you account for income elasticty?

Answer 18

YED > 0 for normal goods

YED < 0 for inferior goods

YED > 1 for luxury goods ( a type of normal good)

Question 19

What is cross elasticity of demand?

Answer 19

Cross elasticity of demand (XED) looks at the degree to which demand is affected by changes in the price of other products

XED = % Demand (increase or decrease) for product A / % Price for product B (increase or decrease)

Question 20

What is supply?

Answer 20

The supply of a particular good is the quantity that suppliers (and would-be suppliers) are willing and able to supply at a given price

Question 21

What is the supply curve? How does it extend?

Answer 21

The supply curve shows supply at each price, assuming that all other variables are constant.

The quantity supplied usually extends as price increases.

• Existing suppliers produce more
• New suppliers switch to making the product

Question 22

What is price elasticity of supply? How do you calculate it?

Answer 22

Price elasticity of supply (PES) looks at the degree to which supply is affected by changes in the price.

PES = Change in supply % / change in price %

Question 23

What is perfectly inelastic supply? What is perfectly elastic supply?

Answer 23

Perfectly inelastic supply: Supply remains constant at all prices, e.g., antiques

Perfectly elastic supply: Supply is infinite at a particular price. Below this price supply drops instantly to zero. e.g., pizza, bread, books, pencils

This is signified by a vertical straight line - the supply is fixed whatever price is offered

Question 24

What are some determinants of supply?

Answer 24

• Price of the good itself
• Price of other goods - suppliers may switch to producing other more profitable goods, e.g., farmers growing coffee rather than food
• Price of joint products: a price rise for one will make production of both more attractive
• Costs
• Changes in technology
• Other, e.g., weather, harvests

Question 25

How does the supply curve shift?

Answer 25

• Changes in price cause movements along the supply curve

- Changes in other factors move the curve itself

Question 26

What are the factors influencing elasticity of supply?

Answer 26

• Market period - inelastic as changes in supply limited to availability of inventory
• Short run - can change production plans but still limited by capacity due to fixed plant and machinery, for example
• Long run - can expand capacity, new firms can enter industry - more elastic

Question 27

What is the equilibrium price?

Answer 27

The equilibrium price is the price at which supply and demand is equal

Question 28

How will the supply be affected if the equilibrium price is too high?

Answer 28

• Supply will exceed demand causing a surplus
• This will be reflected in the short-term by retailers having unwanted goods, returns made to manufacturers, reduced orders and some products being thrown away
• the supplier will respond by lowering prices to attract more demand

Question 29

What happens to supply if the equilibrium price is too low?

Answer 29

• Then demand will exceed supply causing a shortage
• This will be reflected in the short-term by retailers having empty shelves, queues, increased orders and high second-hand values
• the supplier will respond by increasing prices to reduce the shortage

Question 30

Why and when would the government intervene with price regulation?

Answer 30

Implement maximum prices:
- to ensure that essential goods are affordable
- to limit inflation as part of a ‘prices and incomes’ policy
Result: Excess demand - queues, rationing, black markets

Minimum prices:
- to protect suppliers, eg., EU CAP, minimum wage agreements
Result: Excess supply - butter mountains, farmers paid not to grow crops, unemployment?

Question 31

What is the macroeconomic environment? What is GDP?

Answer 31

The national economy:
- The national output of goods and services is measured as gross domestic product (GDP)
GDP = amount of expenditure spent on output
Level of national output is important as it is a measure of economic activity in a country

Question 32

What are the four factors considered within GDP?

Answer 32

Land = Rent
Labour = Wages
Capital = Interest
Entrepreneurship = Profit

Question 33

Potatoes are a Giffen good. An increase in the price of potatoes will cause?

Answer 33

An increase in demand for potatoes

Question 34

What is a ‘normal good’?

Answer 34

With normal goods, a rise in incomes will be accompanied by a rise in demand for them as opposed to a fall in demand for inferior goods.

With normal goods, if incomes rise demand for the product will rise and this will be the case regardless of the existence of either substitutes or complements.

Question 35

How do you categorise a ‘natural monopoly’?

Answer 35

With a natural monopoly, fixed costs will be high, marginal costs will be low (B) and economies of scale(rather than scope) provide an effective barrier to entry

Question 36

What defines a market specifically as monopolistic?

Answer 36

the large number of sellers in the market defines this market specifically as monopolistic competition.

Question 37

What are three features of perfect competition?

Answer 37

Suppliers earn ‘normal’ profits
Consumers lack influence over market price
A single selling price

Question 38

What is the basic economic problem facing all national economies?

Answer 38

Allocating scarce resources - economics is the study of how those scarce resources are or should be used

Question 39

What are the four factors of production?

Answer 39

Enterprise is one of the four factors of production, along with labour (including management), land and capital.

• Enterprise
• Labour (including management)
• Land
• Capital

Question 40

What does the marginal propensity to consume measure?

Answer 40

The relationship between changes in income and changes in consumption.

Question 41

What is the correct sequence in a business cycle?

Answer 41

Boom, Recession, Depression, Recovery

When an economy booms, it reaches a turning point and goes into recession.
The recession deepens into a depression.
Eventually, there is another turning point in the economy, and the business cycle goes into recovery and then back into boom, and so on.

Question 42

How might the government seek to reduce the rate of demand-pull inflation?

Answer 42

Lower interest rates is likely to result in higher consumer borrowing and even stronger demand-pull inflation.

Question 43

What is fiscal policy concerned with?

Answer 43

Fiscal policy is concerned with the government’s tax income, expenditure and borrowing (to make up the difference between income and expenditure).

Question 44

‘Supply side’ economic concerns:

Answer 44

The behaviour of the aggregate supply curve in connection with the levels of prices, incomes and employment. It is aggregate supply in the economy which is at issue.

Question 45

How can the supply curve alter?

Answer 45

If supply conditions (such as the cost of making a product) alter, a different supply curve is created.When there is a fall in costs, suppliers will be willing to increase supply for a given selling price and the supply curve will shift to the right.

Question 46

What is demand pull inflation?

Answer 46

Demand pull inflation causes price rises in the economy and is the result of persistent excess of demand over supply in the economy as a whole.