Economics question answer

What is Utility?
Law of
Diminishing
Marginal Utility
Utility is the quality in goods to satisfy human
wants. Thus, it is said that “Wants satisfying
capacity of goods or services is called Utility.
In modern time utility has been called as ‘expected
satisfaction.’ Expected satisfaction may be less or
equal to or more than the real satisfaction.
In economics, production refers to the creation
of utilities in several ways. Thus, there are
different types of utility: Form Utility; Place Utility,
Time Utility and Service Utility.

Total Utility: Total Utility is the aggregate sum of satisfaction or benefit
that an individual gains from consuming a given amount of goods or
services in an economy.

Marginal Utility: It is the utility derived from the last or marginal unit of
consumption. It refers to the additional utility derived from an extra unit of
the given commodity purchased, acquired or consumed by the consumer.
MU= Change in TU/ Change in quantity
consumed

The
law of
Diminishing
MU
Law of diminishing marginal utility
describes a familiar and fundamental
tendency of human behavior.
The law of diminishing MU states that as
a consumer consumes more and more
units of a specific commodity, utility
from the successive units goes on
diminishing .

The law of Diminishing MU
Statement of the law of diminishing MU
Burger 01: Eating the first burger gives the consumer a lot of satisfaction.
(Utility)
Burger 02: Eating a second burger will not give as much extra satisfaction as
the first did. ( Marginal Utility)
Burger 03: Eating a third will give even less extra satisfaction then eating the
second one. (Diminishing MU)

This means that when a consumer consumes any commodity the very first unit
consumed in the beginning gives him the maximum satisfaction, with every
successive unit of consumption the additional satisfaction derived will keep on
decreasing.
Unit Total Utility Marginal Utility
1st glass of water 20 20
2nd glass of water 32 12
3rd glass of water 40 8
4th glass of water 42 2
5th glass of water 42 0
6th glass of water 39 -3

In this above figure, OX measure units of commodity consumed and OY shown the
MU. The MU of the first glass of water is called initial utility. It is equal to 20 units.
The MU of 5th glass of water is zero. It is called satiety point. The MU of 6th glass of
water is negative (-3).

Economic System
An economic system is the set of mechanisms and institutional that resolve
the what, how and for whom question.
Problems all economic face
Unlimited Wants Scarcity Limited resources
1. What to produce?
2. How to Produce?
3. Whom to produce?

Market Economic System
Also Known as capitalism, free market or free enterprise.
Defined: Ownership of resources by individuals, basically free of government
control in deciding goods and services produced.
Ownership of Resources: Productive resources privately owned and
operate.
Allocation of Resources: Resources are obtained through the lure of profit
in market.
Role of Government: Government only tries to make sure there in some
competition and produces some public goods.

Market Economic System
Goals: Profit for individuals, people are motivated by economic rewards.
Methods: Competition, supply and demand
Characteristics: Private property, specialization and minimum government
regulation.
Political System: Democracy/Parties
Current world example: Canada, chile, south Africa etc.

Market Economic System Solving
Problems
What to produce: Determined by consumer preferences.
How to produce: Produces seeking profit.
Whom to produce: Purchasing power.

Command Economic
Defined: An economy in which all of the major economic questions are answered
by a central authority.
Ownership of Resources: All productive resources are owned and operated by
government.
Allocation of Resources: Central planning group directs all resources.
Role of Government: Government make all decision.
Goals: Equal distribution of income.
Methods: Revolution to gain control no opposition forces allowed.

Command Economic
Characteristics: No private property, one political party.
Political System: Totalitarian
Current world example: Cuba, North korea, china etc.

Command Economic Problem solving
What to produce: Government preference.
How to produce: Determine government and their employees.
For whom to produce: Government preference.

Mixed Economy System
Defined: A market based economic system in which government is involved
to some extent, it combining both public and private enterprise.
Ownership of Resource: Public and private.
Allocation of Resource: Properly allocated.
Role of Government: Rules and regulation to protect the producers and
consumers in the market.
Goal: Equal distribution of income.
Methods: High tax

Mixed Economy System
Characteristic: Limited competition, lots of government planning, service
paid for by government like health, education, welfare etc
Political system: Political party voted in.
Current world example: Bangladesh, Sweden, France etc.

Mixed Economy System Problem
Solution
What to produce: Consumer preference and partly by government.
How to produce: Producers seeking profit and partly by government.
Whom to produce: Purchasing power and partly by government preference.

Elasticity of Demand
Demand elasticity refers to how sensitive the demand for a good is to changes
in other economic variables, such as the prices and consumer income.
Demand elasticity is calculated by taking the percent change in quantity of a
good demanded and dividing it by a percent change in another economic
variable.
A higher demand elasticity for a particular economic variable means that
consumers are more responsive to changes in this variable, such as price or
income.

Types of Elasticity of Demand
• Price elasticity of demand
• Cross elasticity of demand
• Income elasticity of demand

Price Elasticity of Demand
Price elasticity of demand is the degree of responsiveness of quantity demanded
of a good to a change in its price. Precisely, it is defined as:
"The ratio of proportionate change in the quantity demanded of a good caused by a
given
proportionate change in price".
Price Elasticity of Demand = Percentage change in Quantity Demand
Percentage Change in Price
Simplified formula:
Ed = ΔQ X P
ΔP Q

Price Elasticity of Demand Example
The price initially is $20.50 and the
quantity demanded is 9 pizzas an
hour.
The price falls to $19.50 and the
quantity demanded increases to 11
pizzas an hour.

Price Elasticity of Demand Example
The percentage change in quantity
demanded,
%DQ or DQ/Qave = 2/10
= 1/5.
The percentage change in price,
%DP or DP/Pave =$1/$20
= 1/20.
The price elasticity of demand =
%DQ/ %DP
= (1/5)/(1/20)
= 20/5
= 4.

Price Elasticity of Demand
The concept of price elasticity of demand can be used to divide the goods in to three
groups.
(i) Elastic. When the percent change in quantity of a good is greater than the percent
change in its price, the demand is said to be elastic. Q>P
(ii) Unitary Elasticity. When the percentage change in the quantity of a good demanded
equals percentage in its price, the price elasticity of demand is said to have unitary
elasticity. Q=P
(iii) Inelastic. When the percent change in quantity of a good demanded is less than the
percentage change in its price, the demand is called inelastic. Q<P

Cross Elasticity of Demand
Cross elasticity of demand is a measure of the responsiveness of demand for
a good to a change in the price of substitute or a complement goods other
things remain same. It is also defined as the percentage change in the
demand of one good as a result of percentage change in the price of another
goods.
The cross elasticity of demand for
 a substitute is positive.
 a complement is negative.
The formula for calculating the cross elasticity is:
Percentage change in quantity demanded
Percentage change in price of substitute or complement

Calculates the cross elasticity of
demand.
If a 12% rise in the price of orange juice,
• decrease the quantity of orange juice demanded by 22%
• increase the quantity of apple juice demanded by 14%,
Calculate cross elasticity of demand between orange juice and apple juice.

Calculates the cross elasticity of demand
cross elasticity of demand between orange juice and apple juice :
Percentage change in price of substitute or complement
14%
=
12%
=1.67

Income Elasticity of Demand
The degree of change or responsiveness of quantity demanded of a good to
a change in the income of a consumer is called income elasticity of demand.
The formula for calculating the income elasticity of demand is
Percentage change in income

Income Elasticity of Demand
• If the income elasticity of demand is greater than 1, demand is income
elastic and the good is a normal good.
• If the income elasticity of demand is greater than zero but less than 1,
demand is income inelastic and the good is a normal good.
• If the income elasticity of demand is less than zero (negative) the good is
an inferior good.

Basic Concepts Of Economics
Wants: Want may be defined as an insatiable desire or need by human beings to
own goods or services that give satisfaction.
Needs: These are basic requirements for survival like food and water and shelter.
In recent years we have seen a perceived shift of certain items from wants to needs.
Scarcity: Scarcity is defined as the limited supply of resources which are used for
the satisfaction of unlimited wants.

Choice: It can be defined as a system of selecting or choosing one out of a
number of alternatives.
Opportunity cost: It is defined as an expression of cost in terms of forgone
alternatives.
Capital is that part of wealth which is used for further production of wealth.
Goods: Tangible commodity. These are bought, sold, traded and produced.

Value means the power that goods and services have to exchange other
goods and services, i.e. value-in-exchange.
Price is value expressed in terms of money.
Wealth means money, property, gold, etc. In economics it is used to describe
all things that have value. For a commodity to be called wealth, it must
possess utility, scarcity and transferability. If it lacks even one quality, it
cannot be termed as wealth.
Services: Work that is performed for someone. Service cannot be touched or
felt.

Demand Forecasting
All organizations operate in an atmosphere of uncertainty but decisions must be made
today that affect the future of the organization. A forecast is a prediction or estimation
of a future situation, under given conditions.
Demand forecast will help the manager to take the following decisions effectively.
The steps to be followed:
• Identification of objectives
• Nature of product and market
• Determinants of demand
• Analysis of factors
• Choice of technology
• Testing the accuracy

Demand Forecasting Methods
1. Survey of buyers’ intension
2. Delphi method
3. Expert opinion
4. Collective opinion
5. Naive model
6. Smoothing techniques
7. Time series / trend projection
8. Controlled experiments
9. Judgmental approach

Surplus and Shortage
• A surplus is the amount by which the quantity supplied exceeds the
quantity demanded at the current price.
• A shortage is the amount by which the quantity demanded exceeds the
quantity supplied at the current price.

Production Function
Production function expresses the relationship between inputs and
outputs.
Production function is an equation, a table, a graph, which express the
relationship between inputs and outputs.
Production function explains that the maximum output of goods or services
that can be produced by a firm in a specific time with a given amount of
inputs or factors of production.
Production Function: Q = f (L, M, N, C, T̅ )

Production Function
Here
Q Represents quantity of goods
L Represents Labor employed,
M Represents Management (of organization),
N Represents (or natural resources)
C Represents Capital employed
T̅ Represents Technology

Short-Term Production Function
Short-Term production function is a function, which we are producing goods
in the short-term by employing two inputs that are :
Capital (C) : It is fixed input which is constant in the short-term.
Labor (L) : It is variable input in the short-term.
In the short-term we are producing only one product by employing two
inputs. The two inputs are capital (C) and labor (L).
In the short term we will increase L input and we will keep C as constant.

The Long-Run Production Function
In the long run, a firm has time enough to change the amount of all of its inputs.
Thus, there is really no difference between fixed and variable inputs.
This behavior of output with the increase in scale of operation is termed as
increasing returns to scale, constant returns to scale and diminishing returns
to scale. These three laws of returns to scale are now explained, in brief, under
separate heads.
(1) Increasing Returns to Scale:
If the output of a firm increases more than in proportion to an equal
percentage increase in all inputs, the production is said to exhibit increasing
returns to scale.
For example, if the amount of inputs are doubled and the output increases
by more than double, it is said to be an increasing returns to scale. When there is
an increase in the scale of production, it leads to lower average cost per unit
produced as the firm enjoys economies of scale.

The Long-Run Production Function
(2) Constant Returns to Scale:
When all inputs are increased by a certain percentage, the output increases by the same
percentage, the production function is said to exhibit constant returns to scale.
For example, if a firm doubles inputs, it doubles output. In case, it triples output. The
constant scale of production has no effect on average cost per unit produced.
(3) Diminishing Returns to Scale:
The term 'diminishing' returns to scale refers to scale where output increases in a smaller
proportion than the increase in all inputs.
For example, if a firm increases inputs by 100% but the output decreases by less than
100%, the firm is said to exhibit decreasing returns to scale. In case of decreasing
returns to scale, the firm faces diseconomies of scale. The firm's scale of production
leads to higher average cost per unit produced.

Economies of Scale
Economies of Scale:
As a result of increasing production the production cost is low, and it is known as
economies of scale.
As long as the output is increased in the long run, the cost of production will be
at minimum level, this is known as economies of scale, Economies of scale is
divided into two parts.
1. Internal Economies
2. External Economies
• Internal Economies:
Internal economies are those benefits or advantages enjoyed by an individual
firm if it increases its size and the output.

Forms of Internal Economies
• Labors Economies : A large firm can attract specialist or efficient labors and due to
increasing specializations the efficiency and productivity will be increased, leading to
decrease in the labors cost per unit of output.
• Technical Economies: A large firm can adopt and implement the new and latest
technologies, which helps in reducing the cost of manufacturing process, whereas the
small firm may not have the capacity to implement latest technologies. A large firm can
make optimum utilization of machinery, and it can manage the production activities in
continuous series without any loss of time thereby saving the time and transportation
cost.
• Managerial Economies: The managerial cost per unit will decrease due to mass scale
production. Like, the salary of general manager, which remains the same whether, the
output is high or low. Moreover, a large firm can recruit the skilled professionals by
paying them a good salary, but a small firm does not have the much of capacity to pay high
salaries. Thus, mass scale of production will decrease the managerial cost per unit.

Forms of Internal Economies
Marketing Economies: A large firm can purchase their requirements on a
bulk scale therefore, they get a discount. Similarly the advertisement cost
will be reduced because a large firm produces a variety of different types of
products. Moreover, a large firm can employ sales professional for
marketing their products effectively.
Financial Economies: A large firm can raise their financial requirements
easily from different sources than a small one. A large firm can raise their
capital easily from the capital market because the investor has more
confidence on the large firm than in small firm.
Risk Bearing Economies: The large firm can minimize the business risk
because it produces a variety of products. The loss in one product line can
be balanced by the profit in other product line.

External Economies
External Economies are those benefits, which are enjoyed by all the firms in an industry
irrespective of their increased size and output. All the firms in the industry share
external economies.
Economies of Localization: When all the firms are situated at one place, all the firms
will be enjoying the benefits of skilled labors, infrastructure facilities and cheap
transport thereby reducing the manufacturing cost.
Economies of Information: All the firms in an industry can have a common research
and development center through which the research work can be undertaken jointly.
They can also have the information related to market and technology.
Growth of subsidiary Industry: The production process can be divided into different
components. Specialized subsidiary firms at a low cost can manufacture each
component.
Economies of By-Products: The waste materials released by a particular firm can be
used as an input by the other firm to manufacture a by-product.

Concepts of Cost of Production
Production Cost: It includes material costs, rent cost, wage cost, interest
cost and normal profit of the entrepreneur.
Selling Cost: It includes transportation, marketing and selling costs.
Sundry Cost: It includes other costs such as insurance charges, payment of
taxes and rate, etc., etc.
Unit Cost: A unit cost is the total expenditure incurred by a company to
produce, store and sell one unit of a particular product or service.

Explicit Cost:
Explicit cost is also called money cost or accounting cost. Explicit cost
represents all such expenditure which are incurred by an entrepreneur to pay for
the hired services of factors of production and in buying goods and services
directly.
Implicit Cost:
The implicit costs are the imputed value of the entrepreneur's own resources
and services. Expenses that an entrepreneur does not have to pay out of his own
pocket but are costs to the firm because they represent an opportunity cost.
Real Cost:
Real costs are the pains and inconveniences experienced by labor to produce a
commodity. These costs are not taken in the costing of a commodity by the firm.
Real cost has been defined differently by different economists.

Sunk cost:
Sunk costs are those that cannot be recovered if a firm goes out of business. Examples:
spending on advertising and marketing, specialist machines that have no scrap value,
and stocks which cannot be sold off.
Direct Cost:
Direct costs can be defined as costs which can be accurately traced to a cost object with
little effort. Cost object may be a product, a department, a project, etc. Examples: Cost of
gravel, sand, cement and wages incurred on production of concrete.
Indirect Cost:
Costs which cannot be accurately attributed to specific cost objects are called indirect
costs. Examples: Cost of depreciation, insurance, power, salaries of supervisors incurred
in a concrete plant.

Opportunity Cost:
The concept of opportunity cost has a very important place in economic analysis.
The value of a resource in its next best use. It is the amount of income or
yield that could have been earned by investing in the next best alternative.
Historical cost:
A historical cost is a measure of value used in accounting in which the price
of an asset on the balance sheet is based on its nominal or original cost when
acquired by the company.
Replacement Cost:
The amount needed to replace an asset such as inventory, equipment, buildings,
etc.

Social cost:
Social cost is the total cost to society. It includes both private costs plus
any external costs.
• Example: Smoking
• If anyone smokes, the private cost is Tk.100 for a packet of 20 cigarettes.
But, there are also external costs to society - Air pollution and risks of
passive smoking, Litter from discarded cigarette butts, health costs, etc.
Private Cost:
A producer's or supplier's cost of providing goods or services. It includes
internal costs incurred for inputs, labor, rent, and depreciation but
excludes external costs incurred as environmental damage.

Fixed Cost
Refer to the costs that remain fixed in the short period. These costs do
not change with the change in the level of output. For example, rents,
interest, and salaries. TFC remains constant with respect to change in the level
of output. Therefore, the slope of TFC curve is a horizontal straight line.

Variable Cost
Refer to costs that change with the change in the level of production.
For example, costs incurred on purchasing raw material, hiring labor, and
using electricity.

Average Fixed Cost
Refers to the per unit fixed costs of production. In other words, AFC
implies fixed cost of production divided by the quantity of output produced.
It is calculated as AFC = TFC/Q. TFC is constant as production increases,
thus AFC falls.

Average Variable Costs
Refer to the per unit variable cost of production. It implies organization’s
variable costs divided by the quantity of output produced. It is calculated
as: AVC = TVC/ Q, Initially, AVC decreases as output increases. After a certain
point of time, AVC increases with respect to increase in output.

Average Cost
Refer to the total costs of production per unit of output. AC is calculated as:
AC = TC/ Q. AC is also equal to the sum total of AFC and AVC. AC curve is also
U-shaped curve as average cost initially decreases when output increases
and then increases when output increases.

Marginal Cost
Refer to the addition to the total cost for producing an additional unit of the
product. Marginal cost is calculated as: MC = TCn - TCn-1
n= Number of units produced
It is also calculated as: MC = ∆TC/∆Q
MC curve is also a U-shaped curve as marginal cost initially decreases as
output increases and afterwards, rises as output increases. This is because TC
increases at decreasing rate and then increases at increasing rate.

The significance of Marginal Cost
The marginal cost curve is significant in the theory of the firm for two
reasons:
i) It is the leading cost curve, because changes in total and average
costs are derived from changes in marginal cost.
ii) The lowest price a firm is prepared to supply at is the price that just
covers marginal cost.
It is important to note that marginal cost is derived solely from variable
cost, and not fixed cost. The marginal cost curve falls briefly at first, then
rises. Marginal costs are derived from variable costs and are subject to
the principle of variable proportions.

Relationship between AC and MC
Average cost and marginal cost are connected because they are derived from the
same basic numerical cost data. The general rules governing the relationship are:
i) Marginal cost will always cut average cost from below.
ii) When marginal cost is below average cost, average cost will be
falling, and when marginal cost is above average cost, average cost will be
rising.
iii) A firm is most productively efficient at the lowest average cost, which is
also where average cost (AC)=marginal cost (MC).

Relationship between AC and MC

Economies of Scale
Economies of scale is the cost advantage that arises with increased output of a
product.
Economies of scale arise because of the inverse relationship between the quantity
produced and per-unit fixed costs; i.e. the greater the quantity of a good produced,
the lower the per-unit fixed cost because these costs are spread out over a larger
number of goods.
Economies of scale may also reduce variable costs per unit because of
operational efficiencies and synergies.
Economies of scale can be classified into two main types: Internal – arising from within
the company; and External – arising from extraneous factors such as industry size.

Diseconomies of Scale
Diseconomies of scale is an economic concept referring to a situation in
which economies of scale no longer functions for a firm.
With this principle, rather than experiencing continued decreasing costs
and increasing output, a firm sees an increase in marginal costs when
output is increased.
 Diseconomies of scale can occur for various of reasons, but the root cause
usually comes from the difficulty of managing an increasingly large
workforce

Externalities
In managerial economics, externalities refer to beneficial or harmful effects realized by
individuals or third parties who aren’t directly involved in the market exchange.
An externality is a cost (in the case of a negative externality) or benefit (in the case of a
positive externality) that is not reflected in the good’s price.
An externality is defined as a benefit or cost that is imposed on a third party, such as society,
other than the producer or consumer of a good or service, or, more simply, an economic side
effect.
The more of a product that is consumed or produced, the more of an externality that
results.
When discussing externalities in general terms, positive externalities refer to the benefits and
negative externalities refer to the costs associated with the production or consumption of a good
or service.

Examples of Negative Externality
Pollution from a factory can cause health problems and erode the quality of life
and property values in a community.
A power plant that burns coal to generate electricity emits pollution. The more
electricity that is demanded by customers, the more coal that is burned in order
to produce it. Increasing the amount of coal burned to generate electricity thus
increases the level of pollutants emitted into the atmosphere that can lead to
such things as global warning, acid rain and smog.
Second-hand cigarette smoke causes health problems in people other than
smoker.
A loud party next door can cause those not involved in the festivities to lose
sleep.

Negative externalities: The Pollution
Example

Examples of Positive Externalities
Immunizations, such as a flu shot, etc., provide a positive externality to
third parties in that it helps prevent the spread of illness in the general
public.
A company provides funds for its employees to obtain specialized training
or degrees. By doing so, the company can be benefited by increased
production which also benefits the customer. At the same time, this can
benefit society as a whole by increasing the level of education, quality of
life, etc.
Significant home improvements will not only raise a person's property
value, but it will also increase the values of the home nearby.
Improving driving habits will decrease the risk of accident for everyone on
the road as well as eventually reduce insurance premiums of the driver.

Positive Externalities: Example

Cost-Benefit Analysis (CBA)
Process of quantifying costs and benefits of a decision, program, or project (over
a certain period), and those of its alternatives (within the same period), in order
to have a single scale of comparison for unbiased evaluation.
Unlike the present value (PV) method of investment appraisal, CBA estimates the
net present value (NPV) of the decision by discounting the investment and
returns.
Though employed mainly in financial analysis, a CBA is not limited to monetary
considerations only.
It often includes those environmental and social costs and benefits that can be
reasonably quantified. See also feasibility study.

Procedure of Cost Benefit Analysis
The following is a list of steps that comprise a generic cost–benefit analysis.
List alternative projects/programs.
List stakeholders.
Select measurement(s) and measure all cost/benefit elements.
Predict outcome of cost and benefits over relevant time period.
Convert all costs and benefits into a common currency.
Apply discount rate.
Calculate net present value of project options.
Perform sensitivity analysis.
Adopt recommended choice.

National Income (NI)
National income is an uncertain term which is used interchangeably with
national dividend, national output and national expenditure. On this basis,
national income has been defined in a number of ways. In common
parlance, national income means the total value of goods and services
produced annually in a country.
In other words, the total amount of income accruing to a country from
economic activities in a year’s time is known as national income. It
includes payments made to all resources in the form of wages,
interest, rent and profits.

Concepts of National Income
There are various concepts of National Income. The main concepts of NI
are:
i) GDP,
ii) GNP,
iii) NNP,
iv) NI,
v) PI,
vi) DI, and
vii) PCI.
These different concepts explain about the phenomenon of economic
activities of the various sectors of the various sectors of the economy.

Gross Domestic Product (GDP)
The most important concept of national income is Gross Domestic Product. Gross domestic
product is the money value of all final goods and services produced within the domestic
territory of a country during a year.
Algebraic expression under product method is,
GDP=(P*Q)
where,
GDP=Gross Domestic Product
P=Price of goods and service
Q=Quantity of goods and service
denotes the summation of all values.

Nominal GDP & Real GDP
Nominal GDP is gross domestic product (GDP) evaluated at current
market prices, GDP being the monetary value of all the finished goods
and services produced within a country's borders in a specific time period.
Real gross domestic product (GDP) is an inflation-adjusted measure
that reflects the value of all goods and services produced by an economy in
a given year, expressed in base-year prices, and is often referred to as
"constant-price," "inflation-corrected" GDP .

Gross National Product (GNP)
Gross National Product is the total market value of all final goods and
services produced annually in a country plus net factor income from abroad.
Thus, GNP is the total measure of the flow of goods and services at market
value resulting from current production during a year in a country including
net factor income from abroad. The GNP can be expressed as the following
equation:
GNP=GDP+NFIA (Net Factor Income from Abroad)

Net National Product (NNP)
Net National Product is the market value of all final goods and services
after allowing for depreciation. It is also called National Income at
market price. When charges for depreciation are deducted from the gross
national product, we get it.
Thus,
NNP=GNP-Depreciation
or, NNP=C+I+G+(X-M)+NFIA-Depreciation

National Income (NI)
National Income is also known as National Income at factor cost. National
income at factor cost means the sum of all incomes earned by resources
suppliers for their contribution of land, labor, capital and organizational
ability which go into the years net production. Hence, the sum of the
income received by factors of production in the form of rent, wages, interest
and profit is called National Income.
Symbolically,
NI=NNP+Subsidies-Indirect Taxes

Personal Income (PI)
• Personal Income is the total money income received by individuals and
households of a country from all possible sources before direct taxes.
• Therefore, personal income can be expressed as
follows:
PI=NI-Corporate Income Taxes-Undistributed Corporate Profits-
Social Security Contribution + Transfer Payments

Disposable Income (DI)
The income left after the payment of direct taxes from personal income is called
Disposable Income. Disposable income means actual income which can be spent
on consumption by individuals and families.
Thus, it can be expressed as:
DI=PI-Direct Taxes
From consumption approach,
DI=Consumption Expenditure + Savings

Per Capita Income (PCI)
Per Capita Income of a country is derived by dividing the national
income of the country by the total population of a country.
Thus,
PCI=Total National Income/Total National Population

Measuring GDP
There are three different ways to measure GDP:
i) Product Method,
ii) Income Method and
iii) Expenditure Method.
These three methods of calculating GDP yield the same result
because,
National Product = National Income= National Expenditure.

The Product Method
In this method, the value of all goods and services produced in
different industries during the year is added up. This is also known
as the value added method to GDP or GDP at factor cost by
industry of origin.
The following items are included : agriculture and allied services;
mining; manufacturing, construction, electricity, gas and water
supply; transport, communication and trade; banking and
insurance, real estates and ownership of dwellings and business
services; and public administration and defense and other services
(or government services). In other words, it is the sum of gross
value added.

The Income Method
The people of a country who produce GDP during a year receive incomes
from their work.
Thus GDP by income method is the sum of all factor incomes:
 Wages and Salaries (compensation of employees) + Rent + Interest +
Profit.

Expenditure Method
This method focuses on goods and services produced within the country during
one year.
GDP by expenditure method includes:
(1) Consumer expenditure (C) on goods (durable and non-durable ) and services,
(2) Investment (I) in fixed capital such as residential and non-residential building,
machinery, and inventories,
(3) Government expenditure (G)on final goods and services,
(4) Export of goods and services (X) produced by the people of country,
(5) Less imports (M). That part of consumption, investment and government
expenditure which is spent on imports is subtracted from GDP. Similarly, any
imported component, such as raw materials, which is used in the manufacture of
export goods, is also excluded.
Thus GDP by expenditure method at market prices = C+ I + G + (X – M),
where (X-M) is net export which can be positive or negative.

Aggregate Demand (AD)
Aggregate demand is an economic measurement of the sum of all final goods and services produced in
an economy, expressed as the total amount of money exchanged for those goods and services. Since
aggregate demand is measured by market values, it only represents total output at a given price
level and does not necessarily represent quality or standard of living.
Aggregate demand consists of the amount households plan to spend on goods (C), plus planned spending
on capital investment, (I) plus government spending, (G) plus exports (X) minus imports (M) from abroad.
The standard equation is:
AD = C + I + G + (X – M)
Total level of demand for desired goods and services (at any time by all groups within a national economy)
that makes up the gross domestic product (GDP). Aggregate demand is the sum of consumption
expenditure, investment expenditure, government expenditure, and net exports.

The components of Aggregate Demand
C: Consumers' expenditure on goods and services: Also known as consumption,
this includes demand for durables e.g. audio-visual equipment and vehicles &
non-durable goods such as food and drinks which are “consumed” and must be re-
purchased.
I: Capital Investment – This is spending on capital goods such as plant and
equipment and new buildings to produce more consumer goods in the future.
Investment includes spending on working capital such as stocks of finished and
semi-finished goods.
G: Government Spending – This is spending on state-provided goods and services
including public goods and merit goods. Decisions on how much the government
will spend each year are affected by developments in the economy and the
political priorities of the government.
X: Exports of goods and services - Exports sold overseas are an inflow of demand
(an injection) into our circular flow of income and spending adding to aggregate
demand.
M: Imports of goods and services. Imports are a withdrawal of demand (a
leakage) from the circular flow of income and spending.

Shocks to Aggregate Demand
Some of the causes of AD shocks are as follows:
A large rise or fall in the exchange rate – affecting export demand and second-round
effects on output, employment, incomes and profits of businesses linked to export
industries.
A recession in main trading partners affecting demand for exports of goods and
services.
A slump in the housing market or a big change in share prices
An event such as the credit crunch (global financial crisis) – involving a fall in the
amount of credit available for borrowing by households and businesses.
An unexpected cut or an unexpected rise in interest rates or change in government
taxation and spending – for example deep cuts in government spending as part of
fiscal austerity

Aggregate Supply (AS)
Aggregate supply, also known as total output, is the total supply of
goods and services produced within an economy at a given overall price
level in a given period.
It is represented by the aggregate supply curve, which describes the
relationship between price levels and the quantity of output that firms
are willing to provide.
Normally, there is a positive relationship between aggregate supply
and the price level.

Components of Aggregate Supply
Consumer Goods
Private consumer goods and services, such as motor vehicles, computers,
clothes and entertainment, are supplied by the private sector, and
consumed by households. For a developed economy, this is the single
largest component of aggregate supply.
Capital Goods
Capital goods, such as machinery, equipment, and plant, are supplied to
other firms. These investment goods are significant in that their use adds
to capacity, and increases the economy’s ability to supply private consumer
goods in the future.

Components of Aggregate Supply
Public and merit goods
Goods and services produced by private firms for use by central or local
government, such as education and healthcare, are also a significant
component of aggregate supply. Many private firms such as those in
construction, IT and pharmaceuticals, rely on contracts to supply to the
public sector.
Traded goods
Goods and services for export, such as chemicals, entertainment, and
financial services are also a key component of aggregate supply.

Short‐Run AS Curve (SRAS)
• In the short run, aggregate supply responds to higher demand (and prices)
by increasing the use of current inputs in the production process.
• In the short run, the level of capital is fixed, and a company cannot, for
example, erect a new factory or introduce a new technology to increase
production efficiency.
• Instead, the company ramps up supply by getting more out of its existing
factors of production, such as assigning workers more hours or increasing
the use of existing technology

Long-Run Aggregate Supply Curve(LRAS)
.
In the long run, however, aggregate supply is not affected by the price level
and is driven only by improvements in productivity and efficiency.
• Such improvements include increases in the level of skills and education
among workers, technological advancements and increases in capital.
• Certain economic viewpoints, such as the Keynesian theory, assert that
long-run aggregate supply is still price elastic up to a certain point.
• Once this point is reached, supply becomes insensitive to changes in the
price level

Causes of Shifts in AS
The main cause of a shift in the aggregate supply curve is a change in business costs –
for example:
Changes in Unit Labor Costs - i.e. labor costs per unit of output.
Changes in Other Production Costs: For example rental costs for retailers, the price
of building materials for the construction industry, a change in the price of hops used in
beer making or the cost of fertilizers used in farming.
Commodity Prices Changes to raw material costs and other components e.g. the
prices of oil, natural gas, electricity copper, rubber, iron ore, aluminum and other inputs
will affect a firm’s costs
Exchange Rates: Costs might be affected by a change in the exchange rate which
causes fluctuations in the prices of imported products. A fall (depreciation) in the
exchange rate increases the costs of importing raw materials and component supplies
from overseas

Causes of Shifts in AS
Government Taxation and Subsidies:
An increase in taxes to meet environmental objectives (known as green taxes) will
cause higher costs and an inward shift in the SRAS curve – for example a higher price
for carbon emissions
Lower duty on petrol and diesel would lower costs and cause an outward shift in SRAS
The Price of Imports:
Cheaper imports from a lower-cost country has the effect of shifting out SRAS
A reduction in an import tariff on imports or an increase in the size of an import
quota will also boost the supply available at each price level causing an outward
shift of SRAS

Business Cycle
The business cycle is the fluctuation in economic activity that an economy
experiences over a period of time. A business cycle is basically defined in
terms of periods of expansion or recession.
During expansions, the economy is growing in real terms (adjusting
inflation), as evidenced by increases in indicators like employment,
industrial production, sales and personal incomes.
During recessions, the economy is contracting, as measured by decreases in
the above indicators. Expansion is measured from the trough (or bottom) of
the previous business cycle to the peak of the current cycle, while recession
is measured from the peak to the trough.
From a conceptual perspective, the business cycle is the upward and
downward movements of levels of GDP (gross domestic product) and refers
to the period of expansions and contractions in the level of economic
activities (business fluctuations) around a long-term growth trend.

Phases of Business Cycle
Each business cycle has four phases.
i) Expansion,
ii) Peak,
iii) Contraction and,
iv) Trough.
They don’t occur at regular intervals. But they do have recognizable
indicators.
The phases of a business cycle follow a wave-like pattern over time with
regard to GDP, with expansion leading to a peak and then followed by
contraction leading to a trough.

Phases of the Business Cycle
Business cycles are identified as having four distinct phases: Expansion, Peak,
Contraction, and Trough.
An expansion is characterized by increasing employment, economic growth, and
upward pressure on prices.
A peak is realized when the economy is producing at its maximum allowable output,
employment is at or above full employment, and inflationary pressures on prices are
evident.
 Following a peak an economy, typically enters into a correction which is characterized
by a contraction, growth slows, employment declines (unemployment increases),
and pricing pressures subside.
The slowing ceases at the trough and at this point the economy has hit a bottom
from which the next phase of expansion and contraction will emerge.

Risk & Uncertainty
Risk refers to the set of unique outcomes for a given event which can be
assigned probabilities. Risk exists when the decision maker is in a position
to assign probabilities to various outcomes i.e. a probability distribution is
known to him. This happens when he has some historical data on the
basis of which he assigns probability to other projects of the same nature.
Uncertainty refers to the outcomes of given event which are too unsure to
be assigned probabilities. Uncertainty exists when the decision maker has
no historical data from which to develop a probability distribution and
must make intelligent guesses in order to develop a subjective probability
distribution

Difference between Risk and Uncertainty
Distinction in Nature:
• Uncertainty is an unknown risk, while Risk is a measurable uncertainty.
Probability of Quantitative Measurement:
• Risk Can be quantitatively measured by any form.
• Uncertainty Cannot be measured in any form.
Insurance and Insurability:
• There are certain risks that can be fully covered by taking insurance
policies such as fire, flood, draught, theft, robbery etc. While in uncertainty
the insurance is not possible.
Transferability:
• Risk can be transferred into another risk. But uncertainty cannot be
transferred.

Difference between Risk and Uncertainty
Elements of Cost:
• Cost of production includes the cost of risk bearing also. Entrepreneur does
not get any profit for risk bearing. Uncertainty on the other-hand is not included
in the cost of production The reality is that the profit is the reward of the
entrepreneur for bearing uncertainty.
Subjective and Objective:
• Risk is objective while uncertainty is subjective as Risk can be measured while
Uncertainty can only be realized.
Knowledge of Alternatives:
• All the possible alternatives of a problem are known to the economists in
advance. But in uncertainty such previous knowledge is not possible.
Nature of Decisions:
• Decisions taken under the conditions of uncertainty are more important than the
Risk decisions taken under the conditions of Risk because measurement of
alternatives is not possible in case of uncertainty.

Types of Risks
Systematic risk refers to the risk intrinsic to the complete market or the
complete market segment. Systematic risk is also sometimes referred as “market
risk” or “un-diversifiable risk”. Systematic risk results from political factors,
economic crashes, and recessions, changes in taxation, natural disasters, and
foreign-investment policy. These risks are widespread as they can affect any
investment or any organization. While this risk type affects a wide range of
securities, unsystematic risk affects quite a particular group of securities or even
an individual security. Moreover, systematic risk can be reduced by just being
hedged.
Non-systematic risk is the industry or company specific risk which is inherent
in every investment. Putting it simple, unlike systematic risk affecting the entire
market, it applies only to certain investments. Moreover, it is the element of
price risk which can be eliminated largely through adequate diversification
within a specific asset class. It is, therefore, the individual business risk related
to underlying stock, if the company goes bankrupt, it can be stated as a non-
systematic risk event and usually has little to do with the general recede and
flow of the entire market.

Types of Risks
Economic risk: Choice of loss due the fact that all possible outcomes and their probability of
occurrence are unknown.
Business risk: Chance of loss associated with a given managerial decision.
Market risk: Chance that a portfolio of investments can lose money due to volatility in the
financial market.
Inflation risk: A general increase in the price level will undermine the real economic value of
any legal agreement that involves a fixed promise to pay over an extended period.
Interest rate risk: The changing interest rates affect the value of any agreement that involves
a fixed promise to pay over a specified period.
Credit risk: May arise when the other party fails to abide by the contractual obligations.

Types of Risks
Liquidity risk: Difficulty of selling corporate assets and investments.
Derivative risk: Chance that volatile financial derivatives could create losses on investments by
increasing price volatility.
Cultural risk: Risk may arise due to loss of markets differences due to distinctive social
customs.
Currency risk: Is the probable loss due to changes in the domestic currency value in terms of
expected foreign currency.
Government policy risk: Chance of loss because of domestic and foreign government policies.
The above listed various types of risks are involved in business. Therefore it is
essential for the manager to understand the type of risk and strategies to overcome
the same. The manager must know the possible outcomes of a particular event, action
or decision. The manager must be aware of the probability of risks in business.

Some Common Measures of Risk
Risk Management is a crucial process used to make investment decisions.
The process involves identifying the amount of risk involved and either
accepting or mitigating the risk associated with an investment.
Some common measures of risk are :
i) Standard deviation,
ii) Beta,
iii) Value at risk (VaR) and
iv) Conditional value at risk.

Managing the Risk and Uncertainty
There are four ways to manage the risk and uncertainty:
Insurance (Business risks are transferred through Insurance Policies)
Hedging is a mechanism whereby the expected loss is to be offset by an
expected profit from another contract.
Diversification is a method of managing the risk where the risk is spread to
various investments and thus the risk is minimized to each investment.
Adjusting risk is the mechanism whereby the provision is made to offset the
expected loss.

Theory of Inflation
Inflation is the rate at which the general level of prices for goods and services is
rising and, consequently, the purchasing power of currency is falling.
Inflation means a sustained increase in the aggregate or general price level in an
economy. Inflation means there is an increase in the cost of living.
Deflation
Deflation is a fall in the price level of the economy. It means there will be a
negative inflation rate.
Stagflation
A condition of slow economic growth and relatively high unemployment –
economic stagnation – accompanied by rising prices, or inflation, or inflation and
a decline in Gross Domestic Product (GDP). Stagflation is an economic problem
defined in equal parts by its rarity and by the lack of consensus among academics
on how exactly it comes to pass.

How Does A Government Cure Inflation
Reducing aggregate demand
Tightening fiscal policy. This is the classic Keynesian response. Basically,
this involves reducing government spending and/or increasing
taxation. Reducing government spending directly shifts the AD curve to
the left, and increases in taxation do the same, but indirectly, through the
reduction of consumers' disposable income, which leads to, reduced
consumer spending.
Tightening monetary policy: This means increasing interest rates,
which makes it more expensive for firms to invest and consumers to
borrow and spend. Higher interest rates tend to push the value of the
‘TK’ up anyway, which helps keeps the price of imports down.

How Does A Government Cure Inflation
Increasing Aggregate Supply
Incomes policies: Basically it involves controlling wage rises and so stopping
the AS curve from shifting further to the left. This will make cost-push inflation
less likely. It is not very popular! This is obviously not something that
monetarist economists (who like free markets) believe in, as it disrupts the free
working of labor markets.
Improving the supply side: In the topic called 'Aggregate demand and
aggregate supply' we looked, in some depth, at ways in which the long run
aggregate supply curve might shift to the right, increasing the productive
potential of the economy and reducing the price level for a given aggregate
demand curve (assuming the LRAS curve is vertical). Policies included
improved education and training, privatization and deregulation, control of the
trade unions, increasing the flexibility of the labour market and incentives for
firms to invest.

Investment
Investment is spending on capital goods such as new factories & other
buildings machinery & vehicles. Much investment include and takes
advantages of advances in technology.
Investment is a component of AD, and is a factor affecting
competitiveness in a globalizing world. In market-based economies, most
investment is done by private sector businesses but a substantial amount
comes from the government (in the state sector).
A broader definition of investment includes spending on improving the
human capital of the workforce through training and education to
improve the skills and competences of workers.
Gross investment – capital depreciation = net investment

Key Factors Affecting Capital Investment
Spending
Interest Rates – which affect the cost of capital
If the rate of interest increases, the cost of funding investment increases, lowering the
expected rate of return on a capital project
Higher interest rates also raise the opportunity cost of using profits to finance
investment – i.e. a business might decide that they can earn a better return by simply
investing the cash.
Risk: When risk and uncertainty is high for example during times of volatility then
business investment spending may fall.
The Rate of Growth of Market Demand: Investment tends to be stronger when
consumer spending is rising. Higher expected sales also increase potential profits – in
other words, the price mechanism should allocate extra funds and factor inputs towards
capital goods into those markets where consumer demand is rising.
Corporate Taxes
Corporation tax is paid depending on the level of business profits. If the government
reduces the rate of corporation tax there is a greater incentive to invest.

Key Factors Affecting Capital Investment
Spending
Technological Change and Degree of Market Competition: In markets where
technological change is rapid, companies may have to invest simply to remain
competitive. A good example is the intense competition in the markets for smart-
phones.
Business Confidence: During a downturn many businesses may postpone
investment because they feel that demand will not be high enough to give them the
rate of profit they need. The Keynesian term for business confidence is animal
spirits.
Social Costs and Benefits: In the public (government) sector, a different set of
criteria may be used. Typically local and central government will use Cost-Benefit
Analysis when assessing the likely economic and social effects of investment; this
is often used for infrastructure projects.

Economics question answer

Recommended

Recommended

More Related Content

What's hot

What's hot (20)

Similar to Economics question answer

Similar to Economics question answer (20)

More from Muwas Mia

More from Muwas Mia (20)

Recently uploaded

Recently uploaded (20)

Economics question answer