Chapter 13 The economic environment of business of finance

Question 1

1.1 The microeconomic environment: market mechanism

Answer 1

The market mechanism is the interaction of supply and demand for a particular item. In particular how prices are determined by the interaction of supply and demand.

Question 2

2.1 Demand

Answer 2

The demand for a good is the number of consumers willing and able to buy at a given price. A demand schedule or curve shows demand at each price assuming other variables are constant. Quantity demanded goes up as price falls, lower prices makes the goods more attractive. Price of the good, price of other goods, substitutes (different brands), complements, national income, fashion, population size and credit terms all determine demand.

Question 3

2.3 Shifts of the demand curve

Answer 3

Change in price cause movements along the demand curve. Changes in other factors move the curve itself, the curve will shift right (increase in demand) if there is an increase in household income, increase in price of substitutes, decrease in price of complements, the good being more fashionable and an expectation that the price of good will be higher in the next period.

Question 4

2.4 Price elasticity of demand

Answer 4

Looks at the degree to which demand is affected by changes in selling price. PED = % change in demand / % change in Price
Inelastic means PED is less than 1, elastic means PED is greater than one, perfectly inelastic means PED = 0, perfectly elastic means PED is infinity and unitary elasticity means PED is 1.
Factors affecting PED include:
- Availability of substitutes
- Time – short run demand tends t be less elastic but in long term more elastic
- Competitors pricing
- Nature of the product
- Proportion of income accounted for by a good

Question 5

2.5 Significance of price elasticity

Answer 5

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

Question 6

2.6 Giffen and Veblen goods

Answer 6

Giffen said: the price of bread increases but people still buy bread (staple), but they can no longer afford other more expensive foods, so they end up buying more bread. Veblen goods are bought for ostentation, so a higher prices makes them more exclusive and desirable.

Question 7

2.7 other elasticities of demand

Answer 7

Income elasticity of demand (YED) looks at the degree to which demand is affected by changes in household income. YED = % change in demand / % change in household income.
- YED is more than 0 for normal goods
- YED is less than 0 for inferior goods
- YED is more than 1 for luxury goods
Cross elasticity of demand (XED) looks at the degree to which demand is affecting by changes in the price of other products. XED is the % change in demand for product A / % change in demand for price in product B.
- XED is more than 0 for substitutes
- XED is less than 0 for complementary goods
- XED is equal to 0 for unrelated goods

Question 8

3.1 Supply

Answer 8

The supply of a good is the quantity that suppliers are willing to and able to supply at a given price. The supply curve shows supply at each price, assuming other variables are constant. The quantity usually extends as price increases. Existing suppliers produce more, and new suppliers switch to making the product.

Question 9

3.2 Price elasticity of supply

Answer 9

Price elasticity of supply looks at the degree to which supply is affected by changes in the price. PES is the % change in supply / the % change in price.
- Perfectly inelastic supply means supply remains constant at all prices
- Perfectly elastic supply means supply is infinite at a particular price. Below this price supply drops instantly to zero

Question 10

3.3 Determinants of supply

Answer 10

These include price of the good itself, price of other goods, price of joint products, costs, change in technology and other things like weather and harvests.

Question 11

3.4 Shifts of the supply curve

Answer 11

Changes in price cause movements along the supply curve, as well as changes in other factors. The factors influencing elasticity of supply include:
- 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
- Long run: can expand capacity, new firms can enter industry, more elastic

Question 12

4.1 The equilibrium price

Answer 12

This is the price at which supply, and demand are equal. If the price is too high supply will exceed demand causing a surplus and the supplier will respond by lowering prices to attract more demand. If the price is too low demand will exceed supply causing a shortage, the supplier will respond by increasing prices to reduce the shortage. Eventually equilibrium is achieved with supply equal to demand.

Question 13

4.2 Price regulation

Answer 13

Governments may intervene to try and affect prices in the market, they may have a maximum price this is to ensure essential goods are affordable and to limit inflation as part of a prices and income policy. The result is excess demand, queues, rationing and black markets.
They also may have minimum prices to protect suppliers (EU CAP, minimum wage agreements), the result is excess supply, can lead to farmers paid not to grow crops and unemployment.

Question 14

5.1 Macroeconomic environment: national economy

Answer 14

Changes in the macroeconomic environment impact business. The national output of goods and services is measured against GDP. Fours factors are considered which generate a return: land (returns rent), labour (returns wages), capital (returns interest) and entrepreneurship (returns profit). GDP is the amount of expenditure spent on output. The level of national output is a measure of economic activity in a country.

Question 15

5.2 Influences on the national economy

Answer 15

• The government: producing goods and services (education and health etc), purchasing goods and services, investing in capital projects (such as schools), and transferring payments from one section of economy to another (taxes to fund unemployment payments).
• Consumers: spending their disposable income on goods rather than saving. The amount spent depends on changes in disposable income and marginal propensity to consume (spend rather than save), changes in distribution of wealth, government policy (via tax and spending), development of new products, interest rates and price expectations
• Savers: investing what they choose not to spend, the amount saved depends on income, interest rates and the need for long term savings.
• Businesses: the amount they invest in capital goods which drives growth of the economy

Question 16

5.3 The business/trade cycle

Answer 16

The continual sequence of rapid growth in GDP, followed by a slow-down in growth and then a fall. Growth comes again, and when this has reached a peak, the cycle turns once more. Four main phrases of the business cycle can be distinguished: recession, depression, recovery, and boom.
Recession: consumer demand falls, businesses sell fewer goods, failure occurs, employment and production fall, deflation can occur, and business and consumer confidence diminish. Recession begins quickly due to speed with which declining demand is felt by businesses suffering a loss in sales revenue.
Depression (stagflation): if demand is not stimulated, a period of full depression may set in, and the economy reaches a depression.
Recovery: the economy recovers, it can be slow due to lack of consumer confidence. Governments limit the decline by boosting demand in the economy, which quickens the recovery.
Boom: output levels climb and the economy booms. Demand may outstrip supply causing inflation, businesses tend to be profitable, and expectations of the future are optimistic.

Question 17

5.4 Inflation

Answer 17

Inflation is increase in price levels and a decline in purchasing power of money. Deflation is falling prices, normally associated with low rates of growth and recession. A high rate of inflation is undesirable because fewer people can afford goods, wage inflation occurs and productivity falls whilst new rates are agreed, exports falling as imports appear cheaper and consumers may stockpile fearing price increases leading to shortages and prices increased further.
The types of inflation are cost-push inflation (price rises resulting from an increase in the costs of production) and demand-pull inflation (price rises resulting from a persistent excess of demand over supply). The two main causes of demand pull inflation are fiscal (increase in government spending or a reduction in taxes will raise demand in the economy) and credit (if levels of credit extended to customers increase, expenditure rises, inflation accompanied by customers increasing their debt burdens).

Question 18

6.1 Government macroeconomic policies: monetary policy and aggregate demand

Answer 18

Monetary policy is the government policy on interest rates, exchange rates and the money supply. The effects of increasing rates are the price of borrowing in the economy rises, leading to reducing borrowing and investment in non-current assets for companies. Households increase savings and reduce spending. The outcome is a reduction in the aggregate demand in the economy. This results in higher exchange rates for sterling, keeps cost of exports higher, foreign investors attracted to sterling, reductions in spending and investment and the outcome is reduces the aggregate demand in economy.

Question 19

6.2 Fiscal policy and aggregate demand

Answer 19

Fiscal policy is government’s policy on spending, taxation and borrowing. The government can increase spending to stimulate aggregation demand and influence the distribution of wealth. The government can increase tax to raise funds, influence wealth distribution and suppress economic growth. The government can borrow to fund spending in excess of income, the approach can be neutral (spending equals tax), expansionary (spending more than tax, increased borrowing) and contractionary (spending less than tax, reduced borrowing).

Question 20

6.3 Supply-side macroeconomic policies

Answer 20

Are policies designed to encourage suppliers to produce more goods at lower prices. The main supply side polices are:
- More involvement in private sector in provision of services
- Reduction in taxes to increase incentives to supply
- Increasing flexibility in labour market by reducing power of trade unions
- Improving education and training, enhancing labour
- Increased competition through deregulation and privatisation of utilities
- Abolition of exchange controls and allowing free movement of capital

Question 21

7.1 Market structures

Answer 21

Is a description of the number of buyers and sellers in a market for a particular good and their bargaining power. The main types of market structure is perfect competition, monopolistic competition, oligopoly, and monopoly.
- Perfect competition: large number of buyers and sellers who alone do not influence the price. Free entry and exit from the marketplace. Free access to information on market conditions, resulting in identical cost structures. Therefore, there is a single selling price and suppliers make normal profits in the long run and are price takers (only sell at market price).
- Monopoly: one supplier, many buyers. Barriers prevent new entrants such as economies of scale, patents, public sector protection and access to unique resources. The supplier can fix price of quantity and make super-normal profits. A pure monopoly is one supplier, actual monopoly is one dominant supplier, government franchise monopoly based one government policy and a natural monopoly is not due to legal factors
- Monopolistic competition: many buyers and sellers, some variation of products, some customer loyalty, and few barrier to entry. Firms have freedom to set prices and normal profits in the long run
- Oligopolies: few large suppliers, differentiation of products and a high degree of mutual dependency. Actions of competitors difficult to predict, may prefer non-price competition and a collusion to form cartels

Question 22

8.1 Market failure

Answer 22

When a free market fails to product the optimum allocation of resources can be due to market imperfections, externalities, public goods, and economies of scale.
- Market imperfections: markets do not satisfy assumptions of perfect competition, monopolists charge higher prices, powerful customers drive prices low and imperfect information results in poor decisions.
- Public goods: without government intervention public goods would not be provided by a market economy (for example police force and street lighting). Public goods have the property of non-excludability (benefit from the good without paying), all of society benefits and consumption of the good by one person does not reduce the amount for consumption by others. As a result, a market for this type of goods does not exist
- Externalities: costs or benefits which the market mechanism fails to take into account as the market only incorporates private costs and benefits. Private cost measures the cost to the supplier, private benefit measures the benefit obtained directly by the supplier. Social cost measures the cost to society by producing the good, social benefit measures the benefit obtained by society as a whole
- Perfect competition involves smaller firms, in practice large firms benefit from economies of scale, this results in lower prices for consumers than under perfect competition. The economy of scale results in large firms making more profit and them pushing small firms out of business, reducing choice.