Fundamentals of Economics 1

Question 0

Explain private property rights and its significance

Answer 0

1. Private property rights are the rights to do what you want with what you own as long as you do not infringe on the private property rights of others.
2. Private property rights confer ownership. Without ownership, nations do not progress.
3. If you own something you take care of it. If no one owns something or if everyone has common ownership rights to something, no one takes care of that something.

Question 1

Define Economics

Answer 1

1. Economics is the study of how societies use scarce resources to produce valuable commodities and distribute them among different people.
2. Economics studies how individuals, firms, government, and other organisations within our society make choices and how these choices
   determine society’s use of its resources.

Economics studies the economic activities of mankind.

Question 2

Explain economic freedom, its importance and its relation to HDI

Answer 2

1. Economic freedom means you can engage in voluntary transactions without interference or restrictions from government or others.
2. With private property rights and economic freedom, nations prog- ress, standards of living improve, and human development increases.
3. The Index of Economic Freedom is a measure of how much freedom from interference in transactions you voluntarily enter into you have.
4. The higher the index of economic freedom, the higher a nation’s standard of living.
5. The Index of Human Development is a measure of the quality of life in a nation.
6. The more economic freedom, the higher is the index of human development.

Question 3

Define scarcity and trade-offs

Answer 3

1. Scarcity:
   - In reasonable societies, not everyone can get what they want. There is not enough of anything to satisfy everyone. This is called scarcity.
   - Scarcity exists when people want more of an item than exists at a zero price.
   - Why are diamonds so expensive while water and air—necessities of life— are nearly free? The reason is that diamonds are relatively scarcer; that is, rela- tive to the available quantities, more diamonds are wanted than water or air.
2. Trade-offs:
   - What must be given up to acquire something else is called trade off
   - Societies, like individuals, face scarcities and must make choices, that is, have trade-offs. Because resources are scarce, a nation cannot produce as much of everything as it wants.

Question 4

Explain resources

Answer 4

1. Inputs used to create goods and services are called resources.
   Goods are produced with resources (also called factors of produc- tion and inputs). Economists have classified resources into three categories: land, labor, and capital.
   -land:
   the general category of resources encompassing all natural resources, land, and water
   -labor:
   the general category of resources encompassing all human activity related to the productive process
   -capital:
   the equipment, machines, and build- ings used to produce goods and services
   -financial capital:
   the funds used to purchase capital
2. Income comes from the ownership of resources.

Question 5

What is the rule of specialisation and gain from the trade also explain comparative advantage

Answer 5

The rule of specialization:

• is that the individual (firm, region, or nation) will specialize in the activity in which it has the lowest opportunity cost.
• Specialization and trade enable individuals, firms, and nations to get more than they could without specialization and trade.
• By specializing in an activity that one does relatively better than other activities, one can trade with others and gain more than if one carried out all activities oneself. This additional amount is referred to as gains from trade.

Comparative advantage:
- the situation where one individual’s opportunity cost is relatively lower than another’s.

Question 6

Explain Opportunity Cost

Answer 6

1. Economics is the study of how people choose to allocate scarce resources to satisfy their unlimited wants.
2. Scarcity is universal; it applies to anything people would like more of than is available at a zero price. Because of scarcity, choices must be made.
3. Opportunity costs are the forgone opportunities of the next best alternative. Choice means both gaining something and giving up something.
4. When you choose one option, you forgo all others. The benefits of the next best alternative are the opportunity costs of your choice.

Question 7

Define Macro and Micro Economics

Answer 7

Macroeconomics:
looks at the economy as an organic whole, concentrating on economy-wide factors such as interest rates, inflation and unem- ployment.
Macroeconomics also encompasses the study of economic growth and how governments use monetary and fiscal policy to try to moderate the harm caused by recessions.

Microeconomics:
focuses on individual people and individual businesses. Microeconomics explains how individuals behave when faced with decisions about where to spend their money or how to invest their savings, and how profit-maximising firms behave both individually and when they’re competing against each other in markets.

Question 8

How are goods and services allocated?

Answer 8

1. The allocation of scarce goods, services, and resources can be carried out in any number of ways. The market mechanism is one possible allocation mechanism.
2. The market mechanism is the most efficient allocation mechanism in most instances.
3. There are cases in which the market mechanism is not used because people do not like the result of the market allocation.
4. There are cases in which the market mechanism is not used because the market mechanism is not the most efficient.

Question 9

What is demand?

Answer 9

1. Demand is the quantities that buyers are willing and able to buy at alternative prices.
2. The quantity demanded is the amount buyers are willing and able to buy at a specific price.
3. The law of demand states that as the price of a well-defined commodity rises (falls), the quantity demanded during a given period of time will fall (rise), everything else held constant.
4. Demand will change when one of the determinants of demand changes; that is, when income, tastes, prices of related goods and services, expectations, or number of buyers change.
   A demand change is illustrated as a shift of the demand curve.

Question 10

What is supply?

Answer 10

1. Supply is the quantities that sellers will offer for sale at alternative prices.
2. The quantity supplied is the amount sellers offer for sale at one price.
3. The law of supply states that as the price of a well-defined commodity rises
   (falls), the quantity supplied during a given period of time will rise (fall),
   everything else held constant.
4. Supply changes when one of the determinants of supply changes; that is, when prices of resources, technology and productivity, expectations of producers, number of producers, or prices of related goods or services (in production) change.
   A supply change is illustrated as a shift of the supply curve.

Question 11

What is equilibrium and disequilibrium price and how is price determined by demand and supply?

Answer 11

1. Equilibrium is the price at which the quantity buyers are willing and able to buy equals the quantity sellers are willing and able to sell.
   - Equilibrium occurs when the quantity demanded and the quantity supplied are equal: it is the price–quantity combination where the demand and supply curves intersect.
   - the price and quantity at which quantity demanded equals quantity supplied
2. Disequilibrium price is a price level at which quantities demanded and supplied are not the same
3. A price that is higher than equilibrium means that buyers are willing and able to buy less than sellers are willing and able to supply. This will force sellers to reduce the price.
4. A price that is lower than equilibrium means that buyers are willing and able to buy more than sellers are willing and able to supply. This will force sellers to raise the price.
5. Together, demand and supply determine the equilibrium price and quantity.

Question 12

Explain shortage and surplus

Answer 12

1. A price that is above the equilibrium price creates a surplus. Produ- cers are willing and able to offer more for sale than buyers are willing and able to purchase.
2. A price that is below the equilibrium price leads to a shortage. Buyers are willing and able to purchase more than producers are willing and able to offer for sale.

Question 13

Explain the implications of changes in demand and supply

Answer 13

1. When demand changes, price and quantity change in the same direction. Both rise as demand increases, and both fall as demand decreases.
2. When supply changes, price and quantity change but not in the same direction. When supply increases, price falls and quantity rises. When supply decreases, price rises and quantity falls.

Question 14

What happens when government intervenes in the markets by setting a price floor or price ceiling, when it sets quota or ban certain goods and services?

Answer 14

1. A price ceiling is a limit on how high the price can be. If it is set below the equilibrium price, it creates a shortage.
2. A price floor is a limit on how low the price can be. If it is set above the equilibrium price, it creates a surplus.
3. A quota raises the price of the goods or service on which the quota has been placed.
4. A ban is a prohibition against the purchase or sale of a good or service. If effective, the market for that good or service is eliminated.
5. Goods or services that used the banned item as an ingredient will have to be altered to use substitutes. The ban raises the cost of the good or service.

Question 15

Define total revenue, average revenue and marginal revenue

Answer 15

1. Total revenue is the quantity sold multiplied by the price at which each unit is sold.
2. Average revenue (per-unit revenue) is the total revenue divided by the number of units sold.
3. Marginal revenue is the incremental revenue, the additional revenue obtained by selling one more unit of output.
4. Average revenue is the same as price.

Question 16

Define price elasticity of demand

Answer 16

price elasticity of demand:
the percentage change in quantity demanded divided by the percentage change in price

Question 17

Define the terms elastic, unit elastic, inelastic, perfectly elastic and perfectly inelastic in context of price and demand

Answer 17

1. elastic:
   percent change in quantity demanded greater than percent change in price
2. unit elastic:
   price elasticity= -1
3. inelastic:
   percent change in quantity demanded less than percent change in price
4. perfectly elastic:
   infinite price elasticity
5. perfectly inelastic:
   zero price elasticity

• The price elasticity of demand is a measure of how sensitive consu- mers are to price changes.

An elastic demand is one for which a 1 percent change in price leads to a greater than 1 percent change in the quantity demanded.

An inelastic demand is one for which a 1 percent change in price leads to a less than 1 percent change in quantity demanded.

• When demand is elastic, a 1 percent price decrease will lead to a greater than 1 percent increase in the quantity demanded. This means that total revenue rises when the price is decreased in the elastic region of demand.
• When demand is inelastic, a 1 percent decrease in price leads to a smaller than 1 percent increase in quantity demanded. As a result, total revenue declines whenever price is decreased in the inelastic region of a demand curve.

Question 18

What happens to sales when price of goods and services changes?

Answer 18

1. The price elasticity of demand is a measure of the responsiveness of consumers to changes in price. It is defined as the percentage change in the quantity demanded of a good divided by the percentage change in the price of the good.
2. Demand is price-elastic when the percentage change in price is less than the percentage change in quantity demanded; it is price-inelastic when the percentage change in price is greater than the percentage change in quantity demanded; it is unit elastic when the price elasticity is -1.
3. The price elasticity of demand is always a negative number because of the law of demand; when price goes up, quantity demanded goes down, and vice versa. If demand is price-elastic, total revenue and price changes move in opposite directions. An increase in price causes a decrease in total revenue, and vice versa. If demand is inelastic, then price changes and total revenue move in the same direction.
4. Firms use price elasticity to set prices. In some cases, a firm will charge different prices to different sets of customers for an identical product. This is called price discrimination.
5. The greater the number of close substitutes, the greater the price elasticity of demand.
6. The greater the proportion of a household’s budget a good constitutes, the greater the household’s price elasticity of demand for that good.
7. The demand for most products over a longer time period has a greater price elasticity than the same product demand over a short time period.

Question 19

What is Law of Diminishing Marginal Returns

Answer 19

law of diminishing marginal returns:

• It is the relationship between quantities of a variable resource and quantities of output is called the law of diminishing marginal returns.
• as the quantity of a variable resource is increased while fixed resources do not change, output initially rises rapidly, then more slowly, and eventually may decline.
• The law of diminishing marginal returns applies only to the short run as variable resources are combined with a fixed resource.
• According to the law of diminishing marginal returns, as successive units of a variable resource are added to the fixed resources, the additional output will initially rise but will eventually decline.
• Diminishing marginal returns occur because the efficiency of variable resources depends on the quantity of the fixed resources.
• The law of diminishing marginal returns results in the U-shaped curves of average total and marginal costs.

e. g. Bicycle assembly unit:
- As the first units of the variable resource (employees) are hired, each additional employee can prepare and sell many bicycles.
- But after a time, there are too many employees in the store (“too many chefs stirring the broth”), and each additional employee adds only a little to total bicycles offered for sale.
- If the employees must stand around waiting for tools or room to work on the bikes, then an additional employee will allow few, if any, additional bicycles to be repaired or assembled and sold.
- Eventually, adding another employee may actually detract from the productivity of the existing employees as they bump into each other and mix their tools up.
- The limited capacity of the fixed resources—the number of repair sta- tions, repair stands, cash registers, and building space—causes the efficiency of the variable resource—the employees—to decline.

Question 20

Define Average Total Cost (ATC) and Marginal Cost (MC)

Answer 20

1. Average total costs (ATC) are total costs divided by the total quantity of the good offered for sale (Q). Average total costs are per-unit costs.

ATC= total costs /quantity of output

2. Marginal costs (MC) are the incremental costs that come from producing one more or one less unit of output:

MC= change in total costs / change in quantity of output

Question 21

Define economic profit, zero economic profit, positive economic profit, negative economic profit and normal profit

Answer 21

1. economic profit= total revenue - opportunity costs
   revenue less all costs, including the opportunity cost of the owner’s capital
2. zero economic profit:
   revenue just pays all opportunity costs
3. positive economic profit:
   revenue exceeds all opportunity costs
4. negative economic profit:
   revenue does not pay for all opportunity costs
5. normal profit:
   zero economic profit

Question 22

What is profit maximising rule? And why is profit maximised when MR=MC?

Answer 22

1. The profit-maximizing rule is to produce the quantity at which marginal revenue equals marginal cost, MR=MC, and to sell that quantity at the price given by demand.
2. Profit is maximized at the output level at which total revenue exceeds total costs by the greatest amount, at the point at which MR = MC.
3. The supply rule for all firms is to supply the quantity at which the firm’s marginal revenue and marginal costs are equal and to charge a price given by the demand curve at that quantity.

Question 23

What is the relationship between costs and output in the short run?

Answer 23

1. The short run is a period of time just short enough so that the quantity of at least one of the resources cannot be altered.
2. Average total costs are the costs per unit of output—total costs divided by the quantity of output sold.
3. As quantity rises, total costs rise. Initially, as quantity rises, total costs rise slowly. Eventually, as quantity rises, total costs rise more and more rapidly. This means that average total costs fall initially as output is increased but eventually rise.
4. According to the law of diminishing marginal returns, when successive equal amounts of a variable resource are combined with a fixed amount of another resource, the additional output will initially rise but will eventually decline.
5. The U shape of short-run, average-total-cost curves is due to the law of diminishing marginal returns.
6. The objective of firms is to make a profit. The difference between sales, or the value of output, and the input costs (including the opportunity costs) is called economic profit.

Question 24

What are the benefits of competition?

Answer 24

1. Competition drives price to the lowest possible level, where opportunity costs are paid and economic profit is zero.
2. Competition ensures resources are used where their value is highest.
3. Competition drives inefficient and obsolete activities out of existence.

Question 25

What is creative destruction?

Answer 25

1. Competition means that firms have to offer what consumers want at prices they are willing and able to pay. Firms that are wasteful or inefficient and firms that offer obsolete products will be driven out of business. In other words, businesses and industries are destroyed by competition as new ones are created.
2. Creative destruction is part of the process of creating benefits for society. It also means that some members of society will be harmed by competition.
3. Resources used in the activities that are obsolete or inefficient will be displaced.
   e. g. The transistor radio barely remains in existence; try finding one in Best Buy or Target or anywhere else. It has been replaced by MP3 devices such as the iPod. People want to listen to the music they desire rather than listening to the talk or music offered by a radio station. Resources that were used in manufacturing vac- uum tubes were left without tasks once consumers switched to the transistors. Resources used in transistor radios are being left without tasks as people switch to the MP3s. This means that some land previously used for buildings, equipment, and retail stores that sold transistor radios will be left without use. Some employees will be left without jobs. Over time, some of these resources and employees will find uses in other activities, where they have more value than they would in the transistor business. This process of the destruction of old, inefficient activities is called creative destruction. Competition is the engine of creative destruction.

Question 26

What does free entry and competition mean?

Answer 26

1. With free entry and competition, firms will earn zero economic profit.
2. Positive economic profit attracts rivals who bid the price down until firms are able to pay for opportunity costs but nothing more. This type of market is referred to as a commodity market and called perfect competition.
3. When a firm offers something unique or different, the demand curve for its good or service slopes downward. If the firm earns a positive economic profit and rivals can open businesses that offer the same thing, then the demand curve for the first firm shifts in and flattens out, or becomes more elastic. If competition results in the firms offering identical goods and services, then the demand curve for any one firm is horizontal, perfectly elastic.

Question 27

What are barriers to entry?

Answer 27

1. If a firm is able to create a special attribute, some way to differentiate its product that consumers value, then entry and competition will not necessarily drive economic profit to zero.
2. If consumers place a value on the attribute that other firms cannot compete with, then the firm is able to earn positive economic profit as long as consumers continue to value that special attribute.
3. If a firm is the only firm selling a product without close substitutes, it is called a monopoly.
4. A market in which firms offer similar but not identical products and can begin a business easily is called monopolistic competition.
5. If entry is easy, it is not possible for a firm to earn positive economic profit in the long run. If a firm earns a positive profit, others see that the firm is earning more than the owners’ opportunity costs and want to get in on the good thing as well. More firms enter the business, compete with the first, and drive profit to zero.
6. If entry is difficult, a firm can earn a positive economic profit for as long as entry does not occur.

Question 28

Is there a difference in behavior when there are just a few competitors as compared to when there are lots of competitors?

Answer 28

1. An oligopoly is a market dominated by just a few firms. Firms are interdependent, meaning that what one does significantly affects rivals. Because of this interdependence, it is often not possible to illustrate a firm’s demand using a simple demand curve.
   Instead, game theory and other approaches are used to illustrate the interaction of consumers and firms in an oligopoly.
2. Oligopolies can arise from government interference in business and/or from economies of scale.
3. Collusion and cartels, both illegal in the United States, are forms of interaction that can arise from oligopolies.
4. Economies of scale occur when the costs per unit of output decline as all resources (the size of the firm) increase—that is, as output rises.
5. In an industry or business that has economies of scale, the larger firms can produce more cheaply than the smaller firms. As a result, the larger firms can sell at a price that is lower than what the smaller firms can.

Question 29

Explain commodity

Answer 29

Commodity: goods perceived to be identical no matter who supplies them

• When entry is free and rivals can duplicate identically what each other does, the price will be bid down until there is no more incentive for new businesses to enter. At this point, that product, has been turned into what is called a commodity.

Question 30

What is perfect competition

Answer 30

perfect competition:
a market structure characterized by such a large number of firms that no one firm has an effect on the market

• If the coffee is a commodity, then one cup of coffee from one shop is no different than a cup from another shop, and there are lots of sellers of coffee. Economists refer to a situation where there are lots of sellers of a com- modity product as perfect competition. With perfect competition, every prod- uct is identical and all sell for the same price—the opportunity cost.

Question 31

What is monopoly and monopolistic competition

Answer 31

monopoly:
a market structure in which there is just one firm, and entry by other firms is not possible

monopolistic competition:
a market structure characterized by a large number of firms, easy entry, and differentiated products

e.g. Suppose the university has decided to allow only one coffee shop to locate on the campus. This coffee shop is the only seller of coffee in the vicinity of the campus. It has a monopoly. It can set a price of $1.50 and not fear that competitors will enter and begin taking away sales because the university does not allow entry to occur. The coffee shop earns a profit of $.70 per cup. It has to pay the university in return for giving the firm a monopoly, but as long as its profit is greater than zero, it is better off than if it did not have the monopoly. Moreover, since rivals cannot enter and compete with the monopoly, the firm can earn positive economic profit for as long as it is the sole supplier.

Question 32

What are economies and diseconomies of scale

Answer 32

1.economies of scale:
the decreases in per-unit costs when all resources are increased.
The term economies of scale means that as the size of a firm increases (all of its resources are increased), its per-unit costs decline. If economies of scale exist, a larger firm can produce a product at a lower per-unit cost than a smaller firm can. This means that a new entrant would have to enter as a big firm in order to compete with existing firms.

2.diseconomies of scale:
the increases in per-unit costs when all resources are increased.
larger size does not automatically improve efficiency. The special- ization that comes with large size often requires the addition of specialized man- agers. A 10 percent increase in the number of employees may require an increase greater than 10 percent in the number of managers. A manager to supervise the other managers is needed. Paperwork increases. Meetings are held more often. The amount of time and labor that are not devoted to producing output increases. It may become increasingly difficult for the CEO to coordinate the activities of each division head and for the division heads to communicate with one another. Larger machines are not always more efficient than smaller ones. A larger building may not allow more efficient production than a smaller building. When increasing size leads to higher per-unit costs, we say that there are diseconomies of scale.

Question 33

What is oligopoly? Explain with example.

Answer 33

Oligopoly is a market structure characterized by,

(1) few firms,
(2) either standardized or differentiated products, and
(3) difficult entry.

• Oligopoly may take many forms. It may consist of one dominant firm coexisting with many smaller firms or a group of giant firms that dominate the industry.
• Whatever the number of firms, the characteristic that describes oligopoly is interdependence—that is, an individual firm in an oligopoly does not decide what to do without considering what the other firms in the industry will do.
• In perfectly competitive markets, what one firm does affects each of the other firms so slightly that each firm essentially ignores the others. Each firm in an oligopoly, however, must watch the actions of the other firms closely because the actions of one can dramatically affect the others. This interdependence among firms leads to actions not found in the other market structures.
  e. g.Microsoft, Google, and Apple dominate operating software; Airbus and Boeing dominate aircraft building; there are just a few major airlines and a few auto producers. In Mexico, only two or three companies provide goods and services in areas such as finance, telecommunications, broadcasting, and retailing. And in Poland, a candidate for finance minister argued that the country’s current economic problems are due to the dominance of just one or a few firms in the fuel sectors and the financial markets.

Question 34

What is “game theory” and explain the dilemma in it

Answer 34

game theory:

Game theory is a study of strategic decision making. Specifically, it is “the study of mathematical models of conflict and cooperation between intelligent rational decision-makers”.

An alternative term suggested “as a more descriptive name for the discipline” is interactive decision theory.

Game theory is mainly used in economics, political science, and psychology, as well as logic and biology.

The subject first addressed zero-sum games, such that one person’s gains exactly equal net losses of the other participant(s).

The Dilemma: Game Theory:

Consider the situation in which two firms that dominate a market must decide whether to devote additional resources to advertising. When a firm in any given industry advertises its product, its demand increases for two reasons.

First, people who had not used that type of product before learn about it, and some will buy it.

Second, other people who already consume a different brand of the same product may switch brands.

The first effect boosts sales for the industry as a whole, whereas the second redistributes existing sales within the industry.

If firm A can earn higher profits by advertising than by not advertising, whether or not firm B advertises, then firm A will surely advertise. This is referred to as a dominant strategy—a strategy that produces the best results no matter what strategy the opposing player follows.

On the other hand both firms would be better off if neither advertised but the firms cannot afford to not advertise because they would lose more if the other firm advertised and they didn’t. And this is the dilemma.

This situation is also known as the prisoners’ dilemma

Question 35

Explain Prisoners Dilemma

Answer 35

Two people have been arrested for a crime, but the evidence against them is weak.

The sheriff keeps the prisoners separated and offers each of them a special deal: If the prisoner confesses, that prisoner can go free as long as only he confesses, and the other prisoner will get 10 or more years in prison.

However, if both prisoners confess, each will receive a reduced sentence of two years in jail.

The prisoners know that if neither confesses, they will be cleared of all but a minor charge and will serve only two days in jail.

The problem is that they do not know what deal the other is being offered, nor whether the other will take the deal.

The dominant strategy for both prisoners is to confess and receive two years of jail time. If the prisoners had been loyal to each other, each would have received a much smaller penalty. Because both chose to confess, each is worse off than he or she would have been if he or she had known what the other was doing.

Yet in the context of the interdependence of the decisions, each is bound to make confession as it is the only dominant strategy available in the present context.

Question 36

Explain Nash Equilibrium

Answer 36

In game theory, the Nash equilibrium is a solution concept of a non-cooperative game involving two or more players, in which each player is assumed to know the equilibrium strategies of the other players, and no player has anything to gain by changing only their own strategy.

If each player has chosen a strategy and no player can benefit by changing strategies while the other players keep theirs unchanged, then the current set of strategy choices and the corresponding payoffs constitute a Nash equilibrium.

Stated simply, Amy and Will are in Nash equilibrium if Amy is making the best decision she can, taking into account Will’s decision, and Will is making the best decision he can, taking into account Amy’s decision.

Likewise, a group of players are in Nash equilibrium if each one is making the best decision that he or she can, taking into account the decisions of the others in the game.

Question 37

What is Cartel

Answer 37

cartel:
an organization of independent firms whose purpose is to control and limit production and maintain or increase prices and profits; an organization of independent producers that dictates the quantities produced by each member of the organization.

The cartel most people are familiar with is the Organization of Petroleum Exporting Countries (OPEC), a group of nations rather than a group of independent firms.

During the 1970s, OPEC was able to coordinate oil production in such a way that it drove the market price of crude oil from $1.10 a barrel to $32 a barrel.

For nearly eight years, each member of OPEC agreed to produce a certain, limited amount of crude oil as desig- nated by the OPEC production committee.

Then in the early 1980s, the cartel began to fall apart as individual members began to cheat on the agreement. Members began to produce more than their allocation in an attempt to increase profit.

As each member of the cartel did this, the price of oil fell from about $30 per barrel to $12 per barrel in 1988. (Today the price is nearly $100 per barrel because of the cartel and the increased demand for oil.)

Production quotas for different firms or different nations are not easy to maintain. Most cartels do not last very long because their members cheat on the agreements.

If each producer thinks that it can increase its own production, and thus its profits, without affecting what the other producers do, all producers end up producing more than their assigned amounts; the price of the product declines, and the cartel falls apart.

If they compete, price is driven down to where it just covers opportunity costs.

If they agree to keep price high and split the profits, they are both better off. An agreement not to reduce prices is called collusion.

Question 38

What are the benefits of the free market?

Answer 38

The market allocates resources to their highest-valued use. In the market, those willing and able to pay for a good or service get the good or service; those not willing or not able are left without.

Question 39

What is antitrust policy?

Answer 39

1. A monopoly charges a higher price and sells a lower quantity than a market with competition and free entry. This allows the monopolist to earn a positive economic profit.
2. Antitrust policy is the attempt by government to restrict firms from monopolizing a market.
3. Antitrust law is the government’s attempt to minimize the negative impacts of cartels, collusion, and other unfair business practices on society. Cartels and collusion are illegal. Other practices are scrutinized by the Justice Department and Federal Trade Commission and are the subject of lawsuits.

Question 40

What is the purpose of regulation?

Answer 40

The purpose of regulation is to limit the power of natural monopolies.

Question 41

What is “too big to fail”?

Answer 41

1. By “too big to fail,” people mean that should a firm collapse, it will affect the entire economy or global economy.
2. Government policy to protect those considered too big to fail leads to moral hazard and other problems.

Question 42

What are market failures? and how can it be corrected?

Answer 42

1. A market failure occurs when the market does not allocate resources to their highest-valued use.
2. An externality occurs when some costs or benefits created by a private transaction are not accounted for in the private transaction.
3. A public good is a good or service that is not excludable and is not rivalrous. Common ownership means anyone can have access to the item commonly owned. As a result, no one has an incentive to pay for it or to take care of it.
4. Asymmetric information means that buyers and sellers have different amounts of information about a private transaction. This can lead to adverse selection, where bad quality drives good quality out of the market. It can also lead to moral hazard, where people change their behavior and behave in a certain way after an agreement has been made.

How to correct market failure:
5. One solution to market failure is to clearly define private property rights.
6. One solution to market failure is for the government to intervene with a tax or a subsidy.
7. One solution to market failure is for government to dictate what behavior is allowed.
8. One solution to market failure is for government to define private property rights, specify quantities, and turn allocation over to a market.

Question 43

What are Government failures?

Answer 43

1. Logrolling: Legislators may participate in logrolling in order to get benefits for constituents and get elected. Logrolling is the practice of trading votes— I vote for your bill if you vote for mine.
2. Special interest groups: Government decisions may be determined by special interest groups rather than what is best for the economy or society as a whole.

Question 44

What is consumer surplus and deadweight loss?

Answer 44

1. consumer surplus:
   the difference between what the con- sumer is willing to pay for a unit of a good and the price that the consumer actually has to pay; the difference between what consumers would be willing to pay and what they have to pay to purchase some item
2. deadweight loss:
   the reduction of consumer surplus without a corresponding increase in monopoly profit when a perfectly competitive firm is monopolized
   - Consumer surplus is a measure of the benefits consumers get from competition and free entry. It is the difference between the market price and the price consumers would be willing and able to pay for a good or service.
   - Without competition, consumer surplus is reduced because the seller is able to charge a higher price and offer a smaller quantity of a good or service for sale.
   - Deadweight loss is a measure of the benefits that would result from competition and free entry when entry is limited or restricted.

Question 45

Explain externalities with example and discuss ways to minimise negative externalities.

Answer 45

Externalities:

• A cost or benefit created by a transaction that is not paid for or enjoyed by those carrying out the transaction or Externality occurs when a specific economic activity—production, consumption, or trade—affects a bystander who is not party to the specific economic activity.
• Externalities can be positive or negative. If they are negative, they impose costs on others; if they are positive, they grant benefits to others.
• On the other hand most of the activities have positive as well as negative externalities.
  e. g. Inventions:

Every innovation and invention creates jobs and new industries. These are positive externalities. At the same time, the innovation and invention replace now obsolete jobs and industries, thereby driving them out of business. These are negative externalities.
- some activities said have both positive as well as negative externalities

e.g.1. SUV owners vs others (negative externality)

The decision to purchase an SUV affects others,

• The emissions for an SUV are larger than those for a small car or a hybrid battery–gasoline car.
• In addition, if a collision between an SUV and a small car occurs, the inhabitants of the SUV are much less likely to be injured.

Yet the effects on pollution or the environment created by those emissions that affect everyone are not the responsibility of the SUV owners.

The SUV owners don’t have to compensate the small car owners for putting their lives at risk nor pay for the additional pollution.

The problem is that people who are not voluntarily part of the transaction to purchase the SUV have to bear these costs—you or me or anyone who does not own an SUV.

Because the people who are not part of the decision to purchase and drive the SUV must bear the costs of that transaction, these costs are called externalities.

e. g.2. Vaccinated people vs others (positive externality)
- positive externality is created by vaccination programs, such as those for the flu. It takes time to get a shot. It often costs and often hurts, so many people choose not to get the vaccine. As long as many other people get the vaccine, then someone who doesn’t is less likely to come down with the flu.

Those who do not get the vaccine benefit from those who do get the vaccination.

e.g. 3. Smokers vs Non-Smokers (+ve as well as -ve)

Secondhand cigarette smoke is an irritant and bothers some people a great deal—a negative externality.

The American Lung Association says that the average smoker dies seven years earlier than the average nonsmoker.

This might be viewed as a positive externality in that these people won’t live long enough to enjoy social security or receive society-provided health care.

Nonsmokers get to share the funds left by smokers.

• Are all of these externalities distortions of the market—that is, inefficient uses of resources? How can governments mitigate externalities?
• Case for private property:

If you love gardening and thus create a beautifully landscaped front lawn that provides benefits to people just passing by, will you stop doing the gardening because the people passing by don’t pay you for the benefits they receive? Although a positive externality is created, it is not sufficient to alter the amount of gardening that occurs.

Nobel Laureate Ronald Coase did not necessarily see externalities as market failures. He saw the problem as one of private property rights (ownership).

If private property rights are well defined, then the externality often can be resolved through private negotiation. Consider how Coase might describe the following situation.

One neighbor, Bob, liked to play his music late into the night. Another neighbor, Rosa, was an early-to-bed, early-to-rise person. The music was an externality to Rosa. If Bob owned the right to play the music, Rosa would have to work something out, perhaps by improving soundproofing in her house or paying Bob not to play the music. If Rosa owned the right to quiet, then Bob would have to play the music less loudly or pay Rosa to allow him to play it loudly. In either case, once someone has the property right, the externality is solved; it is said to have been internalized.

Question 46

Explain, How can government mitigate externalities?

Answer 46

• One way govt can mitigate negative externalities is by encouraging activities that have positive externalities.
• Recently, central govt gave 20% subsidy on the production of the electric car ‘Reva’,
• advantages of electric car,(+ve externalities)
  Environmental
  Economical
  Geo-political
• govt would want the benefits to be amplified and hence subsidising it would encourage more people to buy the car over other cars increasing +ve externalities.
• Similar case can be deduced in favour of subsidies for providing free primary education, vaccination, prenatal medical and nutritional support. etc.

Question 47

Define (pure) public good, club good, non-excludability and non-rivalry in consumption

Answer 47

(pure) public good:
A good or a service characterised by non-excludability and non-rivalry in consumption.

Club good:
A good or a service that is characterised by excludability and non-rivalry in consumption.

Non-excludability:
A market characteristic where a producer cannot prevent an individual–physically or by demanding an appropriate price–from consuming a good or a service.

Non-rivalry in consumption:
A market characteristic where the consumption of a good or service by an individual does not affect consumption by another individual.

Question 48

What is Natural Monopoly? and explain why public utilities such as water supply, electricity and landline telephone services are referred to as natural monopolies.

Answer 48

Natural monopolies:

A situation where the per-unit cost of producing a good or a service for a given market is lower for a single firm than it would be if there would be two or more firms.

In case of services like water supply, landline telephone, post etc the cost of duplication of the infrastructure (capital investment) is impractical with different private firms competing to offer this service.

Even if few private firms are willing to undertake it, they would incur high costs and the costumer base would get divided among the competing firms.As a result, the per-unit cost of delivering water would be extremely high.

The per unit cost of delivering water would come down only if a single firm were to offer this service. That way there would be no duplication of capital costs, and the capital costs for a single operator would get distributed over the large volume of water delivered.

This implies that there is room for a single firm–that is a monopoly. (However, if only single private firm were allowed to offer this service, it would turn into a monopolist, trying to maximise their profits charging more for less) the goods and services that fall into this category are called ‘natural monopolies’.

Governments avoid the dilemma of such natural monopolies by undertaking these activities themselves and charging a low average price which would be close to competitive price.

These natural monopolies in common parlance are referred to as public utilities or just utilities.

Question 49

What is free market?

Answer 49

free market:
1. A free competitive market is one in which entry is easy and prices and other information are well known.
2. A free market is not interfered with by government.

Question 50

What does the phrase Laissez-faire mean?

Answer 50

Laissez-faire is an economic environment in which transactions between private parties are free from government restrictions, tariffs, and subsidies, with only enough regulations to protect property rights.

Question 51

What is the main reason many economists do not believe in or trust the free market?

Answer 51

1. The free market adjusts to demand and supply changes, but the time it takes to adjust is what concerns many economists.
2. John Maynard Keynes captured the debate with his statement that “in the long run we are all dead.”

Question 52

Can a free market provide health care or is a government-run health care system necessary?

Answer 52

1. A free market can handle health care just as it handles any other good or service, but the current health care market is far from a free market.
2. The free market means some people get the good or service and some don’t. Care is not distributed equally. But with health care being scarce, no allocation system will ensure everyone gets equal health care.
3. The government interventions such as Medicare and Medicaid have led to rapidly rising health care costs.
4. Health care costs have also risen because of the way health insurance is provided. An employer-based system creates inefficiencies—for example, those without jobs do not have insurance, and those with preconditions have difficulty finding insurance.
5. The third-party payer system—where neither buyer nor seller pays for health care—creates inefficiencies. Buyers do not care how much health care costs, and sellers provide services on the basis of reimbursement rates, not on consumer costs.

Question 53

Is the free market able to handle environmental accidents?

Answer 53

1. Environmental issues occur in the markets for resources.
2. Renewable resources are resources that can replenish themselves.
3. Nonrenewable resources are resources whose total amount in existence is limited and production (natural cycle) is very slow.
4. The market for resources determines prices at which the rate of use of renewable resources allows the resources to replenish and limits the rate at which the nonrenewable resources are consumed.
5. A free resource market would not necessarily guarantee that accidents and environmental disasters would never occur. However, without government interventions and restrictions in the market, it is likely fewer accidents would occur.
6. Most environmental problems are the result of private property rights not being well defined. When no one owns something, no one takes care of it.
7. When an externality occurs, either too much or too little is consumed or produced relative to the quantities that would occur if all costs and benefits were included.
8. If the costs of the externalities can be internalized, the socially desired level of emissions will result. The market will minimize externalities if private property rights are well defined so that the creators of externalities are forced to internalize the externalities.
9. Global environmental problems are more difficult to resolve than domestic ones because of the lack of property rights. When no one government owns the resource being damaged by an externality, then the externality cannot be resolved by any one government.

Question 54

Will a free market for drugs be better than the war on drugs?

Answer 54

1. Banning or prohibiting items for which consumers have a price-elastic demand is relatively easy. People just switch to a close substitute. Banning items for which demand is price inelastic is another matter. Consumers don’t have substitutes, so they continue attempting to purchase the banned item.
2. The war on drugs has raised the cost of supplying and selling drugs. Yet because demand is price inelastic, consumption has not decreased much. Costs are passed along to consumers, who pay higher prices but consume nearly as much.
3. The war on drugs results in suppliers offering ever more potent forms of the drugs. In addition, the incentive to maintain quality of the drugs is reduced as suppliers seek additional profits.
4. Crime rises as suppliers compete for turf and sales and consumers look for resources with which to purchase the drugs.
5. Legalization of drugs would reduce crime and lower the prices of drugs, possibly leading to increased consumption.

Question 55

Does discrimination makes economic sense?

Answer 55

1. Discrimination occurs when some factor not related to an individual’s value to the firm affects the wage rate that person receives.
2. Discrimination is costly to those who discriminate and should not last in a market economy, at least when entry is easy.
3. Statistical discrimination is the result of imperfect information and can occur as long as information is imperfect.

Question 56

Discuss the factors influencing the economic rationale of Non-renewable vs renewable energy.

Answer 56

renewable resources:
resources that can renew themselves

nonrenewable resources:
resources that cannot replenish themselves

Renewable resources are the trees, plants, and animals that can reproduce. Nonrenewable resources are resources that can be used only once and cannot be replaced, such as coal, natural gas, and oil.

1.Non-renewable sources of energy:

Only a fixed amount of oil or coal exists, so the more that is used in any given year, the less remains for future use. As some of the resource is used today, less is available next year. Although there is a fixed amount in total, at any given time there is a varying amount depending on the price of the resource.

• As the price rises, more is extracted now, leaving less available in the future. This causes the supply curve of the resource in the future to shift up. The shift occurs because the cost of acquiring or extracting the resource rises as the amount of the resource in existence falls.
• the price in the future is likely to be higher than the price today if some of the resource is extracted and sold today. The resource owner must decide whether to extract and sell the resource today or leave it in the ground for future use.The answer depends on how much profit the resource owner expects to earn on the oil one year from now, which depends on the price of oil and the cost of extraction one year from now.
• The high price would also induce people to search for alternatives—to invent new technologies that do not use petroleum, for example.
• Thats why economists argue that it is unlikely the world will ever run out of nonrenewable resources. As the total amount of oil or any other nonrenewable resource in existence is reduced, its price in the future will rise. It will continue rising as the supply dwindles until it is so high that no one would extract the oil, thus saving it for the future.
  2. Renewable energy:
• Renewable natural resources are different from nonrenewable resources in the sense that renewable (nonexhaustible) natural resources can be used repeat- edly without depleting the amount available for future use.
• The problem is not that there is a fixed quantity of a renewable nat- ural resource but that it will be consumed too rapidly for it to reproduce.
• The role of the market for renewable resources is to determine a price at which the quantity of the resource used is just sufficient to enable the resource to renew itself at a rate that best satisfies society’s wants.
• For instance, the rate at which trees are harvested depends on comparing the rate at which the value of the for- ests increases over time and the rate that could be earned by razing the forests, selling the trees, and placing the money into another activity today. A large har- vest one year means fewer trees available in the future and a longer time for renewal to occur. This would suggest a lower price for the trees today and a higher price in the future, which would induce some tree owners to hold off harvesting their trees.
• The markets for nonrenewable and renewable resources operate to ensure that current and future wants are satisfied in the least costly manner and that resources are used in their highest-valued alternative now and in the future.
• The markets for natural resources can allocate resources to their highest- valued uses as long as private property rights are well defined and enforced. Problems arise when private property rights are not well defined and enforced.

Question 57

Explain Inflation and deflation/disinflation

Answer 57

1. WHAT IS INFLATION:

Definition:
- Sustained Increases in general level of prices of goods and services in overall economy over time is called ‘Inflation’.
- If price of just one good has gone up then it is not inflation IT IS INFLATION only if prices of MOST OF THE GOODS HAS GONE UP for a sustained period of time.
- Inflation measures changes in ‘absolute’ prices.
e.g. Let’s look at an example using the prices of fish and beef:
Year 1 Year 2
1 pound of fish ₹100 ₹200
1 pound of beef ₹200 ₹400

In year 1, beef is twice as expensive as fish. This is the price of beef relative to fish.
In year 2, beef is still twice as expensive as fish.
The relative prices have not changed between years 1 and 2.
What has changed? The prices of both beef and fish have doubled. The absolute levels of all prices have gone up, but because they have increased by the same percentage, the relative prices are unchanged.

2. HOW ITS MEASURED:
   - The rate of inflation is measured on the basis of price indices, which are of two kinds, WPI (Wholesale Price Index) and CPI ( Consumer Price Index). A price index is a measure of (weighted) average level of prices of goods and services in the economy.
   - In the index the total weight is taken as 100 at a particular year of the past (i.e. ‘Base year’), this when compared to the current year shows a rise or fall in the prices of current year, there is a rise or fall in the ‘100’ in comparison to the base year–and this inflation is measured in digits.
3. TYPES OF INFLATION:
   i. demand-pull inflation:
   inflation caused by increasing demand for output
   ii. cost-push inflation:
   inflation caused by rising costs of production
4. WHY INFLATION IS A PROBLEM:

• Inflation becomes a problem when income in the economy rises at a slower rate than prices.
• Unexpectedly high inflation hurts those who receive fixed-dollar payments (e.g., creditors) and benefits those who make fixed-dollar payments (e.g., debtors).
• Inflation results in income redistribution which is unfavourable to fixed-income earners.

DEFLATION/DISINFLATION:

• If there’s a sustained fall in the level of prices of goods and services over a period of time then it is called Deflation or Disinflation.
• But in contemporary economic parlance the fall in prices is termed as ‘fall in Inflation’ and rise in prices is termed as ‘rise in inflation’.

Question 58

Explain ‘Hyperinflation’

Answer 58

• Hyperinflation is an extremely high rate of inflation.
• In most cases hyperinflation eventually makes a country’s currency worthless and leads to the introduction of a new currency.
• Argentina, 1980s :

Experienced hyperinflation in the 1980s. People had to carry large stacks of currency for small purchases.

Cash registers and calculators ran out of digits as prices reached ridiculously high levels.

After years of high inflation, Argentina replaced the old peso with the peso Argentino in June 1983.

• Zimbabwe, 2007-08 :

The most dramatic hyperinflation in recent years, and one of the most dramatic ever, occurred in Zimbabwe in 2007–2008.

Although the government has not been forthcoming about inflation data, research indicates that the price index rose from a value of 1.00 in January 2007 to 853,000,000,000,000,000,000,000 by mid-November 2008, when the price level was doubling every 24 hours.

As prices rose, the government issued larger and larger units of paper money as people had to carry huge stacks of old currency to buy anything.

A 100 trillion Zimbabwe dollar bill was issued in January 2009.

Then in the same month, the government sanctioned the use of U.S. dollars as a substitute currency in Zimbabwe as the local currency had become essentially worthless.

Question 59

What is Headline Inflation

Answer 59

• Headline Inflation is the inflation which is calculated on the basis of the Wholesale Price Index (WPI).
• It excludes prices of services but includes prices of raw materials, semifinished products, and even imported commodities that are traded at the wholesale level.

Question 60

Explain CPI and WPI

Answer 60

CPI : Consumer Price Indices:

Question 61

What is Core Inflation

Answer 61

• Oil and Agricultural prices are subject to wide fluctuations due to number of unpredictable variables.
• Fluctuations may not give a correct picture of inflation in the long run. Over a long period of time such fluctuations may get ironed out.
• To mitigate their effect, use is made of core inflation. Which EXCLUDES THE PRICES OF FOOD AND FUEL FROM THE CALCULATION OF THE PRICE INDEX AND THE INFLATION RATE.
• IN INDIA CORE INFLATION IS CALCULATED BY EXCLUDING FOOD AND FUEL PRICES FROM WPI. ( In many countries core inflation is calculated by excluding food and fuel prices from CPI )
• With the wider scope and coverage of goods and services in the new CPIs launched in Jan 2011, the Government of India May use CPI as the reference index to calculate the reference index for calculating a representative inflation rate for the country, and for basing core inflation on CPI without food and fuel prices.

Question 62

How to tackle Inflation?

Answer 62

Inflation can occur due to,
1. Cost-push/Supply shock or
2. Demand-pull factors,
Therefore policies need to be in place for countering both kinds of inflationary pressures.

1. Managing Cost-Push:
   - govt can ease the supply constraint by removing import restrictions.
   - in the long run, investments in agricultural infrastructure and innovative technologies such as GM crops may help ease supply constraint and hence the pressure on prices.
   - calibrations in existing govt programmes (e.g. MGNREGS) can also reduce agricultural costs and, in tern, inflation.
   - presenting competition to APMCs (e.g. Multi-brand retailers, FDI)
2. Restricting the Demand-Pull:
   - fundamental reason for demand pull inflation is the overwhelming demand for goods and services outstripping the capacity constraints or normal use of the economic resources leading to inflationary situation due to excess demand.
   - some factors that can cause such optimistic demand outlook are: strong export demand, innovative practices, good governance etc
   - dealing with such irrational-exuberance boils down to REDUCING DEMAND FOR GOODS AND SERVICES so that prices are pushed lower.
   - at such a stage govts and central banks intervene by means of holding back any expenditure or initiation of new projects that might add to the demand, rolling back existing spending commitments or increasing taxes but for govt of the day these are very sensitive political issues and hence the often policy focus is placed in RBIs court.
   - RBI then takes necessary steps to curb the money supply or make it very difficult for the market and consumer to go with the flow, reducing demand ergo inflation.
   RBI may alter CRR (Cash Reserve Ratio) and SLR (Statutory Liquidity Ratio) but not frequently.
   RBI can also alter the OMOs (Open Market Operations) and Repo Rate (re-purchase rate)

Question 63

What is Stagflation?

Answer 63

• Inflation accompanied by lower output and employment in known as ‘Stagflation’.
• Shortage of crude oil and the resultant high prices of goods which use crude oil in the market result in overall smaller quantities of goods
  being purchased in the market. This leads to general reduction of production and employment in the economy. Such an inflation which leads to lowering of output and employment is known as ‘Stagflation’.

Question 64

Define: Microeconomics

Answer 64

Study of economic behaviour of agents such as households and firms and determination of prices and outputs in product and input markets.

Question 65

Define: Macroeconomics

Answer 65

Study of behaviour of aggregate variables in any economy such as national income, unemployment, interest rates, and inflation.

Question 66

What is the difference between “cost” and “price”?

Answer 66

What is the difference between “cost” and “price”?
> Most people tend to use these words interchangeably when they want to mean the amount of money required to buy something. For example, we can say, “What is the price of the car’’ or “How much does the car cost”?
> In business however, the two words have a different meaning.
> When you talk about the “cost’’ of something, what you are referring to is the amount of money that you spent to make that particular thing. For example, when businessmen talk about the cost of a car, they are referring to the amount they spent manufacturing it.
> “Price”, on the other hand, refers to the amount of money that the car is sold for. It is the amount that the customer pays. A toy may cost Rs. 200 to manufacture, but it may be priced at Rs. 500.

> The word “cost”, unlike the word “price”, is normally used with services. For example, one talks about the cost of getting one’s car repaired, and the cost of going on holiday. “Cost” is also used with abstractions; one talks about the “cost of living”, the “cost of war”, etc. When you wish to use an adjective, then it is “price” that is used. For example, you talk about “exorbitant” prices, “great prices”, and “bargain prices”.
As everyone knows every politician has his/her price. Yes, the word price is normally used when you wish to bribe someone. You can tell the individual to name his/her price.