INTRODUCTION TO ECONOMICS & FINANCE

Suggested Answers
Foundation Examinations Autumn 2012
A.1

A.2

Economic wealth:
Economic wealth can be viewed as the stock of net assets owned by households,
firms and the state. It can also be defined as the total stock of goods of a society at a
given time.

The goods must possess the following attributes in order for them to be considered
as wealth.
(a) They must possess utility. In other words they must be capable of yielding
satisfaction.
(b) They must have a monetary value.
(c) They must be limited in supply. Goods are scarce in the sense that the
resources available to society are insufficient to meet all wants to the level of
complete satiety.
(d) Ownership must be possible. The ownership of such goods must be capable of
being transferred from one person to another.

Classes of ownership of wealth:

Following are the main classes of ownership of wealth.
(a) Personal wealth: It comprises personal belongings such as clothes, cars, books
and consumer durables. It also includes houses, land, paintings, jewellery and
other property owned by individuals.
(b) Business wealth: It comprises such things as factory buildings, machinery, raw
materials and stocks of finished goods.
(c) Social wealth: It consists of wealth owned collectively and includes all
property owned by the national government and local authorities. For example,
roads, schools, public libraries and museums.

(a)

Iso-cost line:
It is a line which represents alternative combinations of two factors which can be
purchased with the given amount of total money.
Iso-quant curve
An iso-quant curve is a locus of points representing the various combinations of two
inputs, capital and labour, yielding the same output.
How producers maximize level of output

In the above diagram MN is the iso-cost line.

IQ 1, IQ 2 and IQ 3 represent various levels of production.
Page 1 of 8

INTRODUCTION TO ECONOMICS & FINANCE

Suggested Answers
Foundation Examinations Autumn 2012
The producer wants to produce at iso-quant IQ 3 , which shows highest level of
production at 300 units but his total cost does not allow him to reach at IQ 3 .
Although, producer can produce at iso-quant IQ 1 , which shows lowest level of
production at 100 units but he will not prefer to produce at IQ 1 because with the
given amount of total money he can produce only at IQ 2 , which shows higher level
of production at 200 units compared to IQ 1 .
Producers equilibrium occurs at point E where both the conditions of equilibrium
are satisfied. i.e.
(i) Slope of iso-cost line, MN is equal (tangent) to slope of iso-quant IQ 2 .
(ii) Iso-quant is convex to origin.
Factor combination E will cost the producer least for producing 200 units of output.
Therefore, at point E producer maximizes his level of output.
(b)

Decreasing returns to scale

When output increases less than proportionate to increase in inputs (capital and
labour) and the rate of rise in output goes on decreasing, it is called decreasing
return to scale.
Causes of decreasing returns to scale
Decreasing returns to scale arises mainly because of diseconomies of scale. Some of
the diseconomies which cause decreasing returns to scale are:

A.3

(a)

Managerial Inefficiency/Inefficient Control: Diseconomies begin to start first

at the management level. Managerial inefficiencies arise from expansion of scale
itself, which eventually decreases the level of outputs.

Exhaustibility of Natural Resources: It also leads to the decreasing returns to

scale. For example doubling the size of the coal mining plant does not double
the coal output because of limitedness of coal deposits or difficult accessibility to
coal deposits.

Price Output Determination Under Monopolistic Competition in Short-Run

(i) Super Normal Profit

(ii) Normal Profit

(iii)

Losses

AR > AC

AR < AC

In the above diagrams, AR is the average revenue curve, MR is marginal revenue

curve, SAC is the short-run average cost curve, and SMC is the short-run marginal
Page 2 of 8

INTRODUCTION TO ECONOMICS & FINANCE

Suggested Answers
Foundation Examinations Autumn 2012
cost curve. The marginal revenue curve (MR) and marginal cost curve (SMC)
intersect each other at the output OM at which price is OP =MP, because P is point
on AR (Average revenue), i.e. price.
In diagram (i), the firm is earning supernormal profit PT per unit of output which is
the difference between average revenue MP and average cost MT (T is on SAC) at
the equilibrium point. Total supernormal profit will be measured by the area of
rectangle PTTP, i.e. output multiplied by supernormal profit per unit of output.
In diagram (ii), the firm is earning normal profit where SAC curve is tangent to AR
curve i.e. AR=AC
In diagram (iii), the firm is incurring loss TP per unit of output which is the
difference between average cost MT (T is on SAC) and average revenue MP at the
equilibrium point. Total losses will be measured by the area of rectangle TPPT, i.e.
output multiplied by loss per unit of output.
In the short-run, therefore, the firm will be in equilibrium when it is maximising its
profits, i.e. when Marginal Revenue = Marginal Cost
(b)

Following are some factors on which the size of market depends:

Nature of supply:
For the extent of market for a product the fundamental thing that must be satisfied
is that it must be produced on a large scale. If it were to be produced on a small
scale, chances of it to expand its market are almost nil.
Durability:
Durable products have greater chances of extending their market e.g. electrical
goods, car, etc. stand a better chance of going for in the market area. This is because
durable products can last for a long period which maintain quality and usually keep
up with tastes and fashion of the consumers.
Transferability/Portability:
The movability, handiness, suitability, ease of increasing the supply, grading and
exact description of the products are some of the major attributes in determining the
size of market. The commodities which have such features are rubber, gold, silver,
etc.
Means of transport and communication:
Availability of transport and media for advertisement etc. are essential to expand
the market of a product. Without this factor, it will not be possible for the producer
to make his product available to a larger geographical segment of the economy.
Role of financial institutions:
Commercial banks and other financial institutions give loans to the producers so
that they may accumulate the capital to extend the market of their products. This
enables entrepreneurs to extend the market.
Peace and security / Political stability:
Naturally there must be peaceful environment so that transactions can take place
with ease and less obstacles. Countries at war find it difficult to extend the market of
their products.

Page 3 of 8

INTRODUCTION TO ECONOMICS & FINANCE

Suggested Answers
Foundation Examinations Autumn 2012
Policies of the state / Less government restrictions:
If the government were to impose high taxes on production or high tax on imported
products etc, the size of market will be retarded. Therefore, to give encouragement
for expansion of market, tax imposed should be at lower rates.
Degree of division of labour:
The greater the division of labour the cheaper would be the articles and
consequently the market would be wider.
A.4

A.5

(i)
(v)
(ix)
(xiii)
(a)

(a)
(c)
(b)
(b)

(ii)
(vi)
(x)
(xiv)

(c)
(a)
(a)
(c)

(iii)
(vii)
(xi)
(xv)

(b)
(d)
(d)
(b)

(iv) (d)
(viii) (c)
(xii) (d)

GDP :
GDP refers to Gross Domestic Product. It is the total value of goods and services
produced in a country in a year.
GNP :
GNP is the Gross National Product. GNP is the GDP plus net property income
from abroad and minus the net property income remitted abroad.
NNP :
NNP or national income is the Net National Product. NNP is the GNP minus a
fairly attributable amount of depreciation (capital consumption).
GDP at market price and GDP at factor cost:
GDP at market price is the actual amount paid for the goods by their buyers. GDP
at factor cost is the expenditure at market prices minus indirect taxes plus any
government subsidies.

(b)

Determinants of consumption function do not change in short run:

The various determinants of consumption and their behaviour in the short run, are
discussed below:
Objective factors:
Income distribution
Keynes believes that the income distribution in a country does not change in the
short run and hence does not influence the consumption function. If it is unequally
distributed it shall remain unequal and vice versa.
Consumers expectations
According to Keynes the peoples expectations remain stable i.e. they do not
forecast a fall in general price level or even speculate an increase in their income
level. As such expectations would result in the current consumption pattern to rise
and vice versa.
Stock of durable consumer goods
Stock of durable consumer goods of the people does not change in the short period.
Those who do not have the consumer goods in short run will not be able to obtain
them due to their constant level of income, whereas those who already possess these
goods do not lose those goods and thus the stock of durable consumer goods remain
constant in the short run and hence the consumption remains stable too.
Page 4 of 8

INTRODUCTION TO ECONOMICS & FINANCE

Suggested Answers
Foundation Examinations Autumn 2012
Liquidity preference
Keynes says that the liquidity preference of the people remains constant in short run
and as a result the consumption pattern would remain stable as well. The higher
liquidity preference results in the consumption pattern falling because with higher
liquidity preference the people have a higher tendency to save and vice versa.
Fiscal policy/Tax structure
Progressive taxes discourage saving and investment activities and raise the
consumption function whereas the regressive taxes pose the opposite problem.
Keynes assumes that the tax structure does not change in the short run and hence as
a result consumption function remains stable.
Rate of interest
Keynes believes that rate of interest remains constant in the short run and therefore
consumption function remains stable. With a change in rate of interest the
consumption function would shift e.g. if the rate of interest goes up, the income
level would fall and so would the investment level as a result consumption function
falls.
Consumer credit
Terms and conditions on which the credit is given to the consumer do not change in
the short run because with easy terms and conditions prevailing, credit facilities
would result in the encouragement of consumption and vice versa if hard terms
were imposed.
Deferred demand
Demand is not deferred and hence the consumption function remains stable. The
reason for this is that deferred demand shifts the consumption function either
upward or downward e.g. during the war, demand is deferred and the consumption
function shifts downwards and after the war consumption level shifts upwards due
to rise in demand for consumer goods.
Attitude towards thrift (saving habits)
The saving habits of people do not change in the short run and hence the
consumption function as a complementary to saving function does not shift
upwards or downwards.
Demographic factors
These are related to the size and composition of population. Such factors do not
change in the short run. A change in these factors would greatly influence the
consumption function e.g. if the size of a population increase or population of nonworking classes is large the consumption function would shift upwards or
downwards.
Subjective factors:
Psychology of human nature / social practices
Such factors are related with the psychology of people, mental trends and the social
and cultural behaviour of the society. Keynes says that psychological characteristics
of human nature and social practices of people and institutional behaviour toward
saving do not change in the short run and hence consumption function is not
affected.

Page 5 of 8

INTRODUCTION TO ECONOMICS & FINANCE

Suggested Answers
Foundation Examinations Autumn 2012
A.6

(a)

(b)

The Four major objectives of the governments economic policy are:

(i)

To achieve economic growth:

One of the major aims of the governments economic policy is to achieve
economic growth and increase the national income per head. This way the
GDP level will rise resulting in improvement in standards of living of the
people, higher production and more tax collection.

(ii)

To control inflation:
To have a stable price level is important so that the real income of the people
can increase with the passage of time and the standard of living can rise too.

(iii)

To achieve full employment:

This is also an important aim of the government as the government pays
unemployment benefits to the people. If there is full employment then the
government will save that money and also be able to collect more taxes. This
would help the government to increase provision of public and merit goods.
There will also be a high standard of living of the people.

(iv)

To achieve a balance between imports and exports:

Deficit in the BOT will be harmful for a countrys economy. Economic
growth would stop as more imports mean local industries are suffering from
severe competition from abroad.

Monetary policy: government increases interest rate and limits money supply to
curb inflation. However, an undue increase in interest rate and undue restriction on
money supply results in lowering growth and investment. Hence, the government
endeavours to achieve a balance by allowing a reasonable inflation to exist so that
growth and employment do not suffer.
Fiscal policy: Keynes believed that fiscal policy helps to control inflation too
(through subsidies and taxes). Through tax cuts, government can encourage
investment in industries and thereby increase production and growth. Government
spending can be increased to reduce unemployment and achieve growth. However,
tax cuts and spending may require government to borrow more which in turn would
increase inflation. Hence, here again, the government endeavours to achieve an
optimum level of taxation and spending to achieve growth and employment
without allowing inflation to rise beyond a reasonable limit.

(c)

Financial intermediary:
Financial intermediary is an institution which links lenders with borrowers by
obtaining deposits from lenders and then re-lending them to borrowers. They can
provide a link between savers and investors.
Financial intermediaries include:
(i) Banks;
(ii) Building societies, insurance companies, pension funds, unit trust companies
and investment trust companies.
Example: A person might deposit savings with a bank and the bank might use its
collective deposits of savings to provide a loan to a company.

Page 6 of 8

INTRODUCTION TO ECONOMICS & FINANCE

Suggested Answers
Foundation Examinations Autumn 2012
Role of financial intermediaries:
The role of financial intermediaries in an economy, such as banks and building
societies, is to provide means by which funds can be transferred from surplus units
in the economy to deficit units. The financial intermediaries develop the facilities
and financial instruments which make this lending and borrowing possible. They
obtain funds by issuing to the public their own liabilities e.g. saving deposits and
then use this money to lend or invest in entities that need the money. In this way
financial intermediaries mediate between original savers and final borrowers.

Surplus
Unit

A.7

(a)

Lends to

Financial
Intermediary

Lends to

Deficit
Unit

Following are some causes of disequilibrium in balance of payment:

Natural factors
Natural calamities like drought or flood may easily cause disequilibrium in balance
of payments. These natural calamities can adversely affect agricultural and
industrial production. Exports may decline and imports may go up, causing a
setback in the countrys balance of payment.
Trade cycles
Business fluctuations caused by the operation of trade cycles may also result in
disequilibrium in countrys balance of payments. For instance, if there occurs a
recession in foreign countries, it may induce a fall in the exports and exchange
earning of the country concerned, hence resulting in a disequilibrium in the balance
of payments.
Political instability
Political instability results in disrupting the productive potential within the country,
thereby causing a decline in exports and an increase in imports.
Relatively high rate of inflation
High rate of inflation as compared to other countries makes the goods produced by
that country relatively expensive. As a result, its exports decline and the balance of
payment runs into a deficit.
Trade restrictions by other countries
Sometimes other countries impose heavy custom duties or fix quotas or ban imports
from a country. It results in lower exports of that country.
Inelastic demand for machinery and industrial goods
The demand for these goods by less developed countries is inelastic because these
less developed countries have no choice since there is shortage of such goods in
these countries and to increase their growth rate they are going to need such goods.
Hence their imports remain high.

(b)

The following measures are usually taken to correct a disequilibrium in the Balance
of Payments:
(i)

Depreciation or devaluation of the home currency which makes the imports

costlier and uncompetitive, whereas exports become more competitive.
(ii) Protectionist measures resulting in either partial restriction or complete ban
on imports or increase in cost of imports.
(iii) Domestic deflation by reducing the supply of money and thereby aggregate
domestic demand so that the quantity of imported goods decreases.
Page 7 of 8

INTRODUCTION TO ECONOMICS & FINANCE

Suggested Answers
Foundation Examinations Autumn 2012
(iv) Increase in domestic interest rate to attract deposits from foreign countries.
(v) Import substitution to reduce the overall quantity of imports.
(vi) Exchange control regulations to restrict outflows of funds from the home
country.
(vii) Stimulating exports by providing subsidies and tax holidays to exportoriented industries.
(c)

Exchange Rate Policies of Government:

Following are the three types of policies which may be adopted by the government
for controlling exchange rate in the country:
(i)

Fixed Exchanged Rate: under Fixed Exchange Rate, either the rate is fixed at
a certain pre-determined level by the national monetary authority and can be
changed only by a government decision. or the monetary authority intervenes
by buying and selling foreign exchange to maintain the exchange rate at the
prescribed level.

(ii)

Freely Fluctuating Exchange: under Freely Fluctuating Exchange Rate, the

exchange rates are left entirely to the market forces and there is no official
intervention by the monetary authority.The price of a currency is allowed to
rise or fall according to the prevailing demand and supply conditions.

(iii) Managed Floating Exchange Rate System: In a Managed Floating Exchange

Rate system, the exchange rates are allowed to move broadly in line with the
market forces with a gradual adjustment in the exchange rate to reflect
underlying real economic factors.
The authorities intervene by buying and selling foreign exchange in the
market, but usually they are limited to managing the daily fluctuations caused
mainly by capital movements and hold the rate within certain limits. The
extent of intervention by the authorities is substantial only when speculative
forces threaten macroeconomic policies.
(THE END)

Page 8 of 8