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Assignment # 1

Economic Environment of the Business

Course # 5571

Khurram Mirza
COL/MBA AD513306
Teacher: Prof. Rabia Malik.

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Question # 1=

(a) How is microeconomics different from macroeconomics? Discuss also the

subject matter of microeconomics in detail.

(b) How different is a market economy from a centrally planned economy?

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Microeconomics can be variously defined as:

Study of group behavior in individual markets (Frank, Robert H., Microeconomics and Behavior, 2nd ed., 1994).

Study of the role of markets in which property rights are exchanged, and contracts and coalitions
are formed to enable greater production and resolution of conflicts of interest (Alchian, Armen and
William Allen, W, Exchange and Production, 3rd ed., 1983).

Price theory

Many textbooks equate microeconomics with “price theory,” which at its core is a theoretical
answer to the question: what determines the price of a good? The answer is usually given as:
“supply and demand,” so that microeconomics is the study of what determines supply and
demand. But of course, supply and demand does not exist in a vacuum; in fact they intersect in
something called “a market,” which is of course a place where people who sell meet people who

When we consider that those who sell are “firms” and those who buy are “households,” we can
say that microeconomics is the study of how households and firms make decisions and how they
interact in markets.

The textbook definitions suggest the thematic areas of microeconomics, and some of its sub-

Supply and demand (markets as its intersection)

Incentives (what drives behavior – utility or profit maximization for consumers or producers)

Market failures (which arise when there are no property rights and when there are transaction
and information costs), Game theory is a sub-discipline in microeconomics which is often used to
analyze market failures (most famous example: the so-called prisoners’ dilemma)

Public choice is another sub-discipline which studies the economics of democracy.

Institutional economics is yet another sub-discipline which focuses on how economic

institutions work.


Macroeconomics is, like microeconomics, susceptible of many (equivalent) definitions.

One way to define macroeconomics is to say that it is the economics of the national economy. At
one point, I told you that the economy is the “social institutions” for production and consumption,
based on Stigler’s definition of economics. Here, the word “national economy” does not refer to
such social institutions. Instead it refers to the economy in terms of aggregates, as measured by
national or global product or income, employment, and monetary and credit aggregates. Hence,
macroeconomics is the study of aggregate figures, based on a concept of the national economy
in terms of three markets (goods and services, labor, and money or credit).

In one textbook (Mankiw), macroeconomics is defined as “a study of economy-wide

phenomena.” Thus, it deals with such topics as unemployment and inflation, the effect of
government activity (taxes, expenditures, subsidies) on the economy, and the exchange rate.

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Parkin defines macroeconomics as the study of the national and global economy, focusing on
inflation, employment, aggregate (national or global) income and production.

Sicat does not seem to have given an explicit definition of macroeconomics, though it may be
inferred that he thinks of macroeconomics as a branch of economics that seeks to explain
national income and monetary aggregates, inflation, unemployment, and the business cycle.


Some textbooks give an analogy for distinguishing macroeconomics from microeconomics: the
former deals with aggregate behavior (the “forest”), while the latter deals with individual behavior
(the “trees”).

Microeconomics attempts to answer the so-called “big” economic questions relating to the goods
that are produced and, of course, consumed: what to produce, how to produce them, who will
consume, and what are the prices of these goods. Macroeconomics attempts to explain why
there is unemployment, why the national economy goes through a boom-and-bust cycle, and
what causes the value of money to fall because of price and wage inflation.

I submit that the real distinction between microeconomics and macroeconomics is with respect to
an important assumption – one relating to whether prices and wages are flexible or fixed. In
microeconomics, the focus is on market equilibrium, and normally, prices and wages are thought
(or assumed) to be flexible and determined by the market. In macroeconomics, it is assumed that
prices and wages are “fixed” outside the market (they are said to be “rigid”), and the
macroeconomist looks at the interaction of labor as consuming households, on the one hand, and
firms as employers and producers, on the other hand.


The following are the fundamental concepts of microeconomics:

1-Scarcity and opportunity cost, which are twin concepts. Scarcity means a choice has to be
made. The “opportunity cost” of a choice is what you give up by not making that choice. Recall
that opportunity cost is the next best alternative.

Scarce good: A good that is scarce necessarily has an opportunity cost. What is the opportunity
cost of P100 of cell phone load? It is what you can buy with P100 (say, a meal at the cafeteria for
2 people; or 200 pages of copying at the copy center).
What is a free good? It is a good which you can consume without giving up anything else as a
result. “Free-ness” depends on the point of view. It may be free to individuals, but it is not free for
society. An example is information. It is free to individuals who receive it because as you
“consume” information, you don’t destroy it; you can pass it on, and it doesn’t result in a loss in
your ability to derive happiness from the information. But the originator of the information – the
researcher or news reporter – needs to be paid for producing the information; society as a whole
will have to pay for that, otherwise it will not be produced (see property rights below).

A good may be free because it is so abundant, that there is not enough demand to use it all up.
Example: sunlight, moonlight, starlight, and salt water on the high seas. If you couldn’t see,
would you consider sunlight a good?

There is a statement, often attributed to economists: “There is no free lunch.” Why is that true
some things appear to be free because it is offered to you as such. But usually, there is a price to
pay, at some later time. In other words, there is an opportunity cost to the lunch, because, well
good food and wine, and pretty tablecloths are not exactly free goods.
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What about the statement that “The best things in life are free”? Is it really? What is the
opportunity cost of “love”?

2. Rational choice means thinking at the margin. Averages don’t matter. The last unit does,
whether it is the last one chosen or the last one given up. Recall that being rational is not the
same as being “reasonable.”

3. Incentives matter in the sense that there are costs and benefits that drive rational behavior.
Incentives generally can help to explain why airline food is not as good as food on earth, or why
you can seldom find large-denomination money (or big bills) on the sidewalk.

4. Property rights are part of the incentive structure of an economy based on voluntary exchange
(markets). A market cannot exist without property rights.

5. Transactions and information costs make a difference in how buyers and sellers might bargain
with each other.

6. Efficiency and the production possibility curve (PPC): a process or rule is efficient, or a
situation is in a state of efficiency, if, we cannot make any person better off without making
another worse off. Efficiency also means that resources are put to their best use, i.e., we use
resources to produce the goods we value the most. It also means that if we fix the amount of
production of a given good, we will arrange resources and use them to produce the most that we
can of another good. The concept of the production possibility curve illustrates how we can
determine efficient from inefficient outcomes. Production on the PPC is efficient, whereas
production at points “below” the PPC is inefficient. Production “above” the PPC is impossibility


The following are some interesting (possibly controversial) results or conclusions from

1. Inefficiency is usually due to market failure or to situations when a normal market process is
impeded by some circumstances, such as the fact that the good in question is a public good, the
presence of monopoly, or when there are unusual transactions costs that hinder bargaining.

2. Another cause of inefficiency is the use of the “wrong” social institution (dictatorship or
regulation), when a market would have worked well enough.

3. The legal rule on abortions determines the crime rate (Levitt’s hypothesis). If you allow
abortion, you lower crime. This leads to the surprising conclusion that an “immoral” society has
less crime than a “moral” or righteous society.

4. If you strictly enforce the anti-drug laws, you increase the crime rate. This is true if the demand
for drugs is inelastic (which appears to be the case).

5. Traffic problems arise from over-use of the roads, which is a finding that results from an
economic model called The Tragedy of the Commons. One solution in medium-sized cities in
Philippine provinces is to reduce the number of slow-moving traffic, such as motorized Pedi cabs,
and this may actually be easy to implement if the collective income of all Pedi cab drivers will
increase as their number declines, leaving enough extra to “buy out” those who hesitate to find
other means of livelihood. A more general solution is to charge road users a fee during peak or
congested hours of road use.

6. Even if we assume that firms attempt to maximize profits, competitive forces in a market
economy will eventually drive profits down to zero (or to “normal” business profit). The process
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by which firms seek to maximize profits is the engine of “efficiency” of an economy. In other
words, “greed” is good!

Ref: Revised May 31, 2009

(b) How different is a market economy from a centrally planned economy?

Planned Economy
A planned economy or directed economy is an economic system in which the state or workers'
councils manage the economy. It is an economic system in which the central government makes
all decisions on the production and consumption of goods and services. Its most extensive form is
referred to as a command economy, centrally planned economy, or command and control
economy. In such economies, central economic planning by the state or government is so
extensive that it controls all major sectors of the economy and formulates all decisions about their
use and about the distribution of income.

The planners decide what should be produced and direct enterprises to produce those goods.
Less extensive forms of planned economies include those that use indicative planning, in which
the state employs "influence, subsidies, grants, and taxes, but does not compel." This latter is
sometimes referred to as a "planned market economy". A planned economy may consist of
state-owned enterprises, private enterprises directed by the state, or a combination of both.

Though "planned economy" and "command economy" are often used as synonyms, some make
the distinction that

Command economy, the means of production is publicly owned.

Planned economy is an economic system in which the government controls and regulates
production, distribution, prices, etc.

Important planned economies that existed in the past include the economy of the Soviet Union,
which, according to CIA Fact book estimates, was for a time the world's second-largest economy,
China during 1949 to 1978, and India, prior to its economic reforms in 1991.

Planned economies are in contrast to unplanned economies, such as a market economy, where
production, distribution, pricing, and investment decisions are made by the private owners of the
factors of production based upon their own interests rather than upon furthering some
overarching macroeconomic plan

Beginning in the 1980s and 1990s, many governments presiding over planned economies began
deregulating (or as in the Soviet Union, the system collapsed) and moving toward market-based
economies by allowing the private sector to make the pricing, production, and distribution
decisions. Although most economies today are market economies or mixed economies (which
are partially planned), planned economies exist in some countries such as Cuba, Libya, Saudi
Arabia, Iran, North Korea, and Burma.

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Scope of the Planned Economies

Planned economies may be intended to serve collective rather than individual needs: under such
a system, rewards, whether wages or perquisites are to be distributed according to the value that
the state ascribes to the service performed. A planned economy eliminates the individual profit
motives as the driving force of production and places it in the hands of the state planners to
determine what the appropriate production of different sets of goods is.

The government can harness land, labor, and capital to serve the economic objectives of the
state. Consumer demand can be restrained in favor of greater capital investment for economic
development in a desired pattern. It could be seen as the government deciding: Who produces
what, where it is produced, how much it costs, and where it goes.

The state can begin building a heavy industry at once in an underdeveloped economy without
waiting years for capital to accumulate through the expansion of light industry, and without
reliance on external financing. This is what happened in the Soviet Union during the 1930s when
the government forced the share of GNP dedicated to private consumption from 80 percent to 50
percent. As a result, the Soviet Union experienced massive growth in heavy industry, at the
expense of stifled growth of living standards.

Advantages of Economic Planning

Supporters of planned economies cast them as a practical measure to ensure the production of
necessary goods one which does not rely on the vagaries of free market(s).

An important advantage of a planned economy, it does not suffer from business cycles; it does
not experience crises of overproduction such as the one that was believed to have contributed to
the Great Depression. From the modern perspective, it does not result in asset bubbles
irrational massive misallocations of resources such as the dot-com bubble of the late 1990's or
the housing bubble of mid-2000.

The other aspect is that a centrally planned economy can easily provide public goods which
would not have been available at all, or would require explicit government intervention, in a free-
market economy. For example, a nationwide highway system is a public good - it benefits
everyone, but no market participants would voluntarily spend money to build one. In a free-market
economy, the government would have to achieve this goal through taxation. In a planned
economy, state planners would simply allocate resources to building highways.


Long-term infrastructure investment can be made without fear of a market downturn (or loss of
confidence) leading to abandonment of the project. This is especially important where returns are
risky (e.g. fusion reactor technology) or where the return is diffuse (e.g. immunization programs or
public education).

Disadvantages of Economic Planning

Inefficient resource distribution surplus and shortage

Critics of planned economies argue that planners cannot detect consumer preferences,
shortages, and surpluses with sufficient accuracy and therefore cannot efficiently co-ordinate
production (in a market economy, a free price system is intended to serve this purpose). From the
modern viewpoint, such a shortage indicates a mismatch between supply and demand -
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suggesting that planners have misjudged the demand for the product, the equilibrium price, or
both. An imbalance, which would've been corrected naturally in a matter of years in a free-market
economy, persisted for decades, while central planners turned a blind eye on it.

Critics of central planning say that a market economy prevents long-term surpluses because the
operation of supply and demand causes the price to sink when supply begins exceeding demand,
indicating to producers to stop production or face losses. This frees resources to be applied to
satisfy short-term shortages of other commodities, as determined by their rising prices as demand
begins exceeding supply. It is argued that this "invisible hand" prevents long-term shortages and
surpluses and allows maximum efficiency in satisfying the wants of consumers.

Free Markets or Market System in Action

Laisssez-faire is from French: “allow to do” This is an economy in which individuals households
and firms pursue their own self –interests without any central direction d or regulation.

Today called free markets economy there is no directions ad regulations from the center to
coordinate the decisions of the individuals households and firms. Some markets are simple and
some are complex and they in any case engage the buyers and the sellers for exchanges of
goods and services. The behavior of the buyer and seller in Lasissez-faire market economy
determines that what gets produced, how it is produced and who gets to by the goods.

Prices in a market act as a signaling device. An increase in the price indicates that these products
become scarcer. The price increase gives signals to the consumer to purchase less or divert
towards cheaper substitutes.

The free markets consists of many interconnected markets the firms could assume to be highly
competitive and to operate free of government interference. In reality many markets are
imperfectly competitive and monopolistic influences and government interventions in the market
system is a feature of even the most enthusiastically capitalistic societies. Indeed in some cir
some intervention shown to be a necessary condition for achieving economic efficacy.

Economic Planning Vs. The Command Economy

A centrally-planned economy is one in which most of the economy is planned by a central

government authority. This is further contrasted with a command economy, in which the state
allocates its resources as needed, without having to adhere to market principles. An example of
this is the expropriation that took place in the Communist states compared to the nationalization
that took place in the Western European countries. Another key difference is that command
economies are more authoritarian in nature whereas indicative economic planning controls the
economy through incentive-based methods. Economic planning can be practiced in a
decentralized manner through different government authorities. For example, in some
predominately market-oriented and mixed economies, the state utilizes economic planning in
strategic industries such as the aerospace industry. Mixed economies usually employ
macroeconomic planning, while micro-economic affairs are left to the market and price system.
The People's Republic of China currently has a socialist market economy in place. Within this
system, macroeconomic plans are used as general guidelines and as government goals for the
national economy, but the majority of state-owned enterprises are subject to market forces. This
is heavily contrasted to the command economy model of the former Soviet Union.

Economic environment of Business (AIOU-MBA)

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Question # 2

Production process may be labor intensive or capital intensive. To achieve

productive efficiency, what criteria must a firm apply in choosing the production
process to produce a certain quantity of output?

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Production Process / Production Theory

The act of transforming inputs into outputs is called Production Process. The production
function shows a physical relationship between inputs and outputs.

According to; Rojer.R.Miller “Production function is a schedule or mathematical equation that

gives a maximum quantity of out put that can be produced form specified sets of inputs while
techniques of the production are given”.

The first production theory was presented by Von Thunen in 1826, in this contest Prof. Hicks
presented the neo-classical production function in 1839. After Hicks the economists like Carison,
Dano, Samison and Leontif have presented a lot of production functions.

Classical Production Function

The concept of classical production is concerned with the short sun period. Short Sun represents
such particular period where some or at least one factor of production is kept constant. It is stated
Q = f (L) K
Here K is the capital which is constant.

Neo-Classical Production Function

It is concept concerned with the long sun period. Long Sun period that particular period where all
the factors of the production are variables. It is stated as;

Q = f (L, K)

Or in general terms it can represents as;

Q = f (L,K,N,Tech).

Types of the production Process

It is important to distinguish between capital-intensive and labour-intensive methods of



• Capital' refers to the equipment, machinery, vehicles and so on that a business uses to
make its product or service.
• Capital-intensive processes are those that require a relatively high level of capital
investment compared to the labour cost.
• These processes are more likely to be highly automated and to be used to produce on a
large scale.
• Capital-intensive production is more likely to be associated with flow production (see
below) but any kind of production might require expensive equipment.
• Capital is a long-term investment for most businesses, and the cost of financing,
maintaining and depreciating this equipment represents a substantial overhead.
• In order to maximize efficiency, firms want their capital investment to be fully utilized (see
notes on capacity utilization).
• In a capital-intensive process, it can be costly and time-consuming to increase or
decrease the scale of production.

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• Labour' refers to the people required to carry out a process in a business.

• Labour-intensive processes are those that require a relatively high level of labour
compared to capital investment.
• These processes are more likely to be used to produce individual or personalized
products, or to produce on a small scale
• The costs of labour are: wages and other benefits, recruitment, training and so on.
• Some flexibility in capacity may be available by use of overtime and temporary staff, or by
laying-off workers.
• Long-term growth depends on being able to recruit sufficient suitable staff.
• Labour intensive processes are more likely to be seen in Job production and in smaller-
scale enterprises.

How to achieve the efficacy in Productivity

Physical productivity is the quantity of output produced by one unit of production input in a unit
of time. For example, certain equipment can produce 10 tons of output per hour.

Economic productivity is the value of output obtained with one unit of input. For example, if a
worker produces in an hour an output of 2 units, whose price is 10$ each, then his productivity is
20$. It is clear that both technological and market elements (as output quantities and prices,
respectively) interacts to determine economic productivity.


Average economic productivity is computed by dividing output value and (time/physical) units of
input. If the production process uses only one factor (e.g. labour) this procedure gives the
productivity of that factor, in this case labour productivity.

When more than one input is used, for each factor it is possible to compute by the same
procedure its productivity, called in this case "partial".

"Total factor productivity" is the attempt to construct a productivity measure for an aggregation
of factors. The meaningfulness of such an aggregation requires additional hypotheses, thus it is
not assured in a general framework.

Determinants Factors

Technology determines the maximal physical quantity of output that can be reached as well as
the number and the quality of inputs required. Adopted technology is in turn an economic choice,
taken upon both economic and technological reasons.

The spectrum of concurrent technologies that can be chosen is influenced by available

innovations and adopter's compatibilities. Reversibility of this choice is often low because of high
switch costs. Technological change is fast only in some industries, whereas in many others it is
much more gradual. The typical examples are the “computer” and “software” industries where the
change in the technologies and technological supports are very fast where as in heavy machinery
like MTF (machine tool factory Pakistan) is using gradual shift in the technology and technological

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In any case, the diffusion of worse technology than that presently in use is a marginal and
irrelevant phenomenon. Technology always improves. Physical productivity, too.
Economic productivity will depend also on pricing and demand. If consumers require fewer
products than potentially producible, plants will not work at full productive capacity. Thus
economic productivity can well fall, as with decreasing demand and prices.

On a macroeconomic level, labour productivity, i.e. GDP per worker, depends on the
corresponding dynamics of the two aggregates (GDP and employment). Productivity will rise if
GDP increases faster than employment.

A prolonged structural increase in productivity is the result of many factors, among which the

• Capital accumulation through investments;

• The long-lasting process of diffusion of new technologies (often imported from abroad), which
in turn can be accelerated by a pro-diffusion tax;

• Domestic innovative efforts;

• Imitations of organizational and technological modes of production from world-class practices;

• Enhanced division of work;

• The development of physical and social infrastructure;

• Higher levels of education;

• A higher involvement and motivation of workers in the production processes.

At firm level, firms' incentives increase workers productivity through a stimulating environment
and the removal of obstacles to their effective work.

In a broader perspective, an increase of productivity is due to a squeeze in waste of resources, to

narrower limits of irrational processes of production and governance, to an effective link between
market and social needs.

Impact on other variables

Higher productivity impacts on

Then, with lags and without automatic mechanisms, on wages.

If production costs do not overshoot that productivity increase, unit cost of production will be
lower, opening the possibility of price fall or stability. In this vein, higher productivity is conducive
to lower inflation.
International competitiveness will increase by the same chain of reasons. If the increase of GDP
is slower than the increase in productivity, a fall in employment will take place (as a matter of

If a firm dismisses workers after having invested in new machines, technological unemployment
will take place. If on the contrary the improved production can be sold at higher prices or
produced with less wasted materials and energy, output value added can rise and one can obtain

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even an increase in employment. Employment in machine-producer industries will rise in both


Productivity as a Business Cycle Behavior

Economic productivity usually shows a pro-cyclical behavior, while at the same time it is
necessary to distinguish smaller sub-phases and wider multiplicity of paths than in the case of
other variables.

Just after high peaks, GDP slowing dynamics is not immediately matched by employment.
Productivity per worker falls. As far as recession takes momentum, firms begin to dismiss workers
in attempt of reducing losses. This move should increase productivity again, but dismissed
workers reduce their consumption and GDP contract further. The net effect on productivity
depends on the speed and strength of the two factors.

When recovery begins, once more employment is lagging, thus there is a drastic improvement in
productivity and productive capacity utilization. These developments positively impact on profits
and on the willingness of firms to invest.

Opt for the right approach to maximize the productivity

Depending on institutional incentives, firms can opt for an unbalanced mix of the following

1. Better exploit existent employment and massively use overhead, so that per-worker
productivity rises dramatically.

2. Enlarge employment proportionally to output, keeping productivity stable.

3. To invest in labour-saving machinery, with a lagged increase of productivity and,

potentially, a negative impact on employment.

Depending on the aggregated effect of these decentralized choices, productivity will be more or
less increase with GDP rise.

4. Course book: Economic Environment of the Business (AIOU-COL/MBA)

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Question # 3

(a) Does the existence of a shadow or ‘black’ economy imply that the price
system is not working? Is its existence consistent with the laws of demand and

(b) The government gains revenue by imposing a sales tax. Who stands to lose
the most, the consumer or the producer, or both?

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Shadow Economy

The underground economy or black market is a market where all commerce is conducted
without regard to taxation, law or regulations of trade. The term is also often known as the
underdog, shadow economy, black economy, parallel economy or phantom trades.

In modern societies the underground economy covers a vast array of activities. It is generally
smallest in countries where economic freedom is greatest, and becomes progressively larger in
those areas where corruption, regulation, or legal monopolies restrict legitimate economic activity.

Characteristics of the Shadow Economy

• Low initial capital and qualification requirements.

• Small scale of operation.
• Qualifications are often acquired outside of the formal education.
• Methodologies demand big expenditure of labour and adaptation of new technologies.
• People within shadow economy do not have their own representation in the democratic

The shadow economy has been growing stably in the developing countries during last 30 years.
In order to survive large surplus of labour force has to create their own source of income not
minding formalities.

Causes of the Shadow Economy

Legal economy has limited possibilities of absorption of labour force.

Costs of launching new legal enterprises are growing: because of over-regulation, corruption cost
of licenses, property rights, etc.

Weakly developed institutions that should provide training, education, infrastructure and other

Structural adaptation programs of the 1980s and ‘90s accelerated shadow economy in the
developing countries: disappearance of public sector and shutting down non-competitive state
businesses. Incomes form taxes are smaller because of growing shadow economy. It results in
poorer public services which in large extent begin to be carried out by the shadow economy.

Global integration (globalization) discriminates labour force in favor of capital, especially labour
force which is unqualified and immobile. Big capital much more easily crosses the borders.

Informal economy is strongly supported by continuously growing migration from rural areas to
cities what is combined with demand for low quality products and services.

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Many governments remain unaware of economic influences of informal economy and do not
consider intervention as necessary. They believe that the informality is going to die out
spontaneously; shadow economy left to it has very few obstacles in its development.

The number of women entering the non-farming labour market is growing. Although many of them
run micro-businesses only small number enters the formal economy.

In Pakistan

The condition of black economy is as acute in Pakistan as India. It has been assumed by the
State Bank of Pakistan. In fact, the size of the black economy in Pakistan is equivalent of half of a
formal economy. The entire situation is pretty critical as the black economy there could have a
negative impact on the public welfare plans in Pakistan. The black economy in Pakistan has
grown throughout the years as a result of the immense amount of unethical and unlawful
practices that have exploited the lack of documentation in Pakistani economy.

Pricing System and Shadow Economy

Goods acquired illegally take one of two price levels:

• They may be cheaper than legal market prices. The supplier does not have to pay for production
costs or taxes. This is usually the case in the underground market for stolen goods. Criminals
steal goods and sell them below the legal market price, but there is no receipt, guarantee, and so

• They may be more expensive than legal market prices. The product is difficult to acquire or
produce, dangerous to handle or not easily available legally, if at all. If goods are illegal, such as
some drugs, their prices can be vastly inflated over the costs of production.

Black markets can form part of border trade near the borders of neighboring jurisdictions with little
or no border control if there are substantially different tax rates, or where goods are legal on one
side of the border but not on the other. Products that are commonly smuggled like this include
alcohol and tobacco. However, not all border trade is illegal.

Consumer issues

Even when the underground market offers lower prices, most consumers still buy on the legal
market when possible, because:

• They may prefer legal suppliers, as they are easier to contact and can be held accountable for

• In some customers may be charged with a criminal offence if they knowingly participate in the
black economy, even as a consumer.

• They may feel in danger of being hurt while making the deal

• They may have a moral dislike of black marketing

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• In some jurisdictions (such as England and Wales), consumers in possession of stolen goods
will have them taken away if they are traced, even if they did not know they were stolen. Though
they themselves commit no offence, they are still left with no goods and no money back. This risk
makes some averse to buying goods that they think may be from the underground market, even if
in fact they are legitimate (for example, items sold at a car boot sale).

But some actively prefer the underground market, particularly when government regulations
hinder what would otherwise be a legitimate service. For example: the changing prices of petrol
and increasing amount of levies on the petrol in Quetta a city of Pakistan where due to this
regulations and price constrain the local people are using the smuggled petrol from Iran, As Iran
extends the boarders with Quetta that is the reason the summgulled goods are easily spill out
from the boarder areas.

Transition from shadow economy to formal economy:

Transition to formal economy occurs spontaneously in the moment when barriers disappear
(regulations, corruption, high cost of capital, high labour costs).

Attempts of civilizing the shadow economy in the region: (a) “Patent” Lithuania (low price ticket
legalizing micro-business), (b) Russia: simplifying tax systems for micro-business (taxation does
not consider profit or turnover but for example square meters of business activity space, amount
of used water or other indicators)

World Bank recommendations

a) Reduction of number of licenses

b) Easy administrative process (streamlining)

c) Adopting simple tax system (flat tax?)

d) Access to capital


The shadow economy cannot be treated as temporary phenomenon any longer. Moreover the
shadow economy has growing potential of creating jobs and creating income and enables the
poor to access low priced goods and services.

Economic Environment of the Business AIOU.

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Assignment # 1



“It is a compulsory contribution or payment paid by a person to the public

authority to cover the cost of services rendered by the state for the general
benefit of its people and the person who pays tax cannot claim a definite
service in return.”


“A sales tax is a consumption tax charged at the point of purchase for

certain goods and services.”

The tax is usually set as a percentage by the government charging the tax. When you buy the
products subject to sales taxes, you pay the price tag plus the tax. In Pakistan sales taxes cover
a large number of goods and services. There is usually a list of exemptions. The tax can be
included in the price (tax-inclusive) or added at the point of sale (tax-exclusive).


Most sales taxes are collected by the producer, who pays the tax over to the government which
charges the tax. The economic burden of the tax usually falls on the purchaser, but in some
circumstances may fall on the seller. Sales taxes are commonly charged on sales of goods, but
many sales taxes are also charged on sales of services. Ideally, a sales tax is fair, has a high
compliance rate, is difficult to avoid, is charged exactly once on any one item, and is simple to
calculate and simple to collect. This can be best explained by the

Following example:

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As in the above figure, when the sales tax is introduced, it leaves the demand curve intact while it
raises the supply curve by the amount of tax, $0.05. To see the logic remember that the supply
curve represents the quantities that a firm is to offer at alternative process.

The supply curve in figure reflects prices excluding taxes charged by the seller. When the tax is
levied, the price charged by the seller must reflect the tax. Therefore the supply curve jumps up
(a decrease in supply) by the amount of tax (5 cents on vertical axis). Note that this shift is a
parallel shift since the amount of tax is fixed per liter of gasoline and does not change with the
volume of consumption. The tax inclusive supply curve reflects the fact that sellers are willing to
supply the same quantities only if they get paid 5 cents more than before per liter.

The 5 cents added to the price is the seller’s new obligation to the government. At new
equilibrium, point B, the price has risen and volume of transactions has fallen. However the
equilibrium price of $0.53 is the price paid by consumers. Note that the price does not rise by the
full amount of 5 cents to consumers even though the government has levied a 5 cent tax. In order
to see this point more clearly, remember that the vertical distance b/w the two supply curves is 5
cents. As long as the demand curve is not perfectly vertical, consumer will pay only a portion of
tax. The remaining portion is paid by the sellers (producer) that are receiving $0.48 per liter as
opposed to $0.50 (point C). Therefore the burden of tax is shared by both consumers and
producers, 3 cents by the consumer and 2 cents by the seller.

The government collects its 5 cents regardless how the burden is shared. In this example,
consumer’s share in sales tax (3 cents) is greater than the producer’s share (2 cents). In general,
who is going to loose more is the function of slopes of demand and supply curve. The steeper the
gasoline demand curve, greater will be the portion paid by the consumers, the flatter the demand
curve, smaller will be the consumer’s share. Also, the flatter the supply curve, greater the portion
paid by the consumer and vice versa.

Economic Environment of Business (AIOU)

Khurram Mirza 19
COL MBA – AD513306
Assignment # 1

Question # 4

(a) Define the concepts: (i) price elasticity of demand; (ii) cross-elasticity of
demand; and (iii) income elasticity of demand. How are these elasticity
estimated? Explain why it might be important for a firm to know their values.

(b) What does the demand curve facing the firm in imperfect competition look
like? How is the marginal curve drawn in relation to the demand curve in
imperfect competition?

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An important aspect of a products demand curve is how much the quantity demanded changes
when the price changes. The economic measure of this response is called price elasticity of
demand. PED measures the responsiveness of a change in demand, after a change in price. The
formula for the Price Elasticity of Demand (PED) is:

PEoD = % change in Quantity Demanded.

% change in price

To calculate the price elasticity, we need to know what the percentage change in quantity
demand is and what the percentage change in price is. It's best to calculate these one at a time.

Calculating the Percentage Change in Quantity Demanded

The formula used to calculate the percentage change in quantity demanded is:

[QDemand (NEW) - QDemand (OLD)] / QDemand (OLD)

Calculating the Percentage Change in Price

Similar to before, the formula used to calculate the percentage change in price is:

[Price(NEW) - Price(OLD)] / Price(OLD)

Final Step of Calculating the Price Elasticity of Demand

PEoD = (% Change in Quantity Demanded)/(% Change in Price)


Price elasticity of demand it is used to see how sensitive the demand for a good is to a price
change. The higher the price elasticity, the more sensitive consumers are to price changes. Very
high price elasticity suggests that when the price of a good goes up, consumers will buy a great
deal less of it and when the price of that good goes down, consumers will buy a great deal more.
Very low price elasticity implies just the opposite, that changes in price have little influence on


It is also known as cross price elasticity of demand. The Cross-Price Elasticity of Demand
measures the rate of response of quantity demanded of one good, due to a price change of
another good. The common formula for the Cross-Price Elasticity of Demand (CPEoD) is given

CPEoD = (% Change in Quantity Demand for Good X)/(% Change in Price for Good Y)

Substitute goods are alternative. There CPEoD will be positive,

• The weak substitutes like tea and coffee will have a low CPEoD.

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• Dawn bread and Gourmet bread are close substitutes so CPEoD is higher.

Complements goods, these are goods which are used together, therefore CPEoD is negative.

• If the price of DVD players falls, then there will be a increase in demand for DVD disks,


The cross-price elasticity of demand is used to see how sensitive the demand for a good is to a
price change of another good. High positive cross-price elasticity tells us that if the price of one
good goes up, the demand for the other good goes up as well. A negative tells us just the
opposite, that an increase in the price of one good causes a drop in the demand for the other
good. A small value (either negative or positive) tells us that there is little relation between the two

• If CPEoD > 0 then the two goods are substitutes

• If CPEoD =0 then the two goods are independent (no relationship between the two goods

• If CPEoD < 0 then the two goods are complements


The Income Elasticity of Demand measures the rate of response of quantity demand due to a
raise (or lowering) in a consumer’s income. The formula for the Income Elasticity of Demand
(IEoD) is given by:

IEoD = (% Change in Quantity Demanded)/(% Change in Income)


Income elasticity of demand is used to see how sensitive the demand for a good is to an income
change. The higher the income elasticity, the more sensitive demand for a good is to income
changes. Very high income elasticity suggests that when a consumer's income goes up,
consumers will buy a great deal more of that good. Very low price elasticity implies just the
opposite, that a change in a consumer’s income has little influence on demand.

• If IEoD > 1 then the good is a Luxury Good and Income Elastic

• If IEoD < 1 and IEOD > 0 then the good is a Normal Good and Income Inelastic

• If IEoD < 0 then the good is an Inferior Good and Negative Income Inelastic

Economic Environment of Business (AIOU)

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Market Structures
Traditional price theory delineates four basic market structures.

• Pure Competition
• Monopolistic Competition
• Oligopoly
• Monopoly

Features of the Four market Structures

Perfect Competition

It is market where uniform price is charged for all units of goods. These markets has homogeneity
in products those are identical to each other that is the reason the price charged for the units an
goods will remain the same throughout the market.

Imperfect Competition

Imperfect competition means either having differentiated products and/or significant barriers to
entry. The extent of the differentiation and the level of significance of the barriers will determine
what kind of general market structure the market will take. Barriers to entry will determine both
number of firms in the market and whether it will be easy for new firms to enter. Generally higher
barriers to entry entail fewer firms and difficult entry to the market. Though other factors like
market size and symmetric information does play a part in determining market structure, lets

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assume all else constant(ceterus paribus). Therefore, excluding the perfect competition rest of
the market structures are in Imperfect Competitive environment.

• Monopolistic Competition
• Oligopoly
• Monopoly

Imperfect Competition and Market Dynamics

All firms seek to obtain and expand market power, and many firms have some degree of such
power. A minority of firms has significant market power and account for a large portion of the
market, if not the entire market. To understand the market system, you need to know how the
system functions when individuals firms possess significant market power. Lets proceed by
looking at Monopoly, next in the logical sequence is Monopolistic Competition and at conclusion
the findings on Oligopoly.

Demand Curve Faced by a Firm

The firm under an imperfect market faces the market demand curve or part of it. In either case,
the firm faces a downward sloping demand curve this implies that if the firm wants to sell more, it
should lower the price; if it wishes a higher price, he should restrict output.
In contrast, a perfectly competitive firm, since it has no control over price, faces a horizontal
demand curve.


In contrast with the perfectly competitive market if there is only one seller of a particular product
and service called Monopoly. When a firm has monopoly it has a significant power to determine
the price for its outputs. For example, there may be only one store in the shopping mall of
particular area (Clifton Karachi) that sells the gourmet coffee.

when ever a firm has monopoly in particular markets or market , the economy theory state that it
still must adhere to the MR=MC (marginal revenue = marginal cost) rules to maximize its short
term profit because it is price maker rather a price taker firm. Therefore, Monopoly can define as
“A market structure in which only one producer or seller exists for a product that has no
close substitutes.”

Characteristics of Monopoly

• The degree of control over price that is held by the monopolist

• The individual supply of the monopolist coincides with the market supply
• Market demand equals the demand for the monopolist’s product or service
• The monopolist is a “price maker”

Sources of Monopoly

Economies of scale
In capital intensive industries, the economies of large-scale production may lead to a small
number of firms producing the product

Natural monopolies: Public utilities

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In cases where one or two firms can adequately supply all the service needed, it may be
desirable to limit the number of firms within a given territory. Government regulation of these
monopoly franchises.

Control of raw materials

An effective barrier to entry is ownership or control of essential raw materials

The exclusive right to use, keeps, or sells an invention for a period of 20 years
Threat of infringement suits against the new entrants will restrict the entry in the monopoly.

Competitive tactics
Aggressive production and merchandising techniques, Illegal predatory pricing policies,
Aggressive innovation techniques. All those tactics support monopoly.

Determining the monopoly price

The monopolist’s demand curve slopes downward to the right because it is the market demand
curve of all consumers. The first question the monopolist asks is, “How many units of my good
can I expect to sell at various prices?” With one firm in a monopoly market, there is no distinction
between the firm and the industry. In a monopoly, the firm is the industry. The market demand
curve is the demand curve facing the firm, and total quantity supplied in the market is what the
firm decides to produce.

The demand curve facing a perfectly competitive firm is perfectly elastic; in a monopoly, the
market demand curve is the demand curve facing the firm.

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Case Study;
We can show how the monopoly (a hairdresser, for example) would precede to the price her
product by combining its cost structure with the type of demand and marginal revenue.

Quantity Sold Price (P) Total Revenue Average Revenue Marginal Revenue
(Q) (P) - $ TR AR MR
Hairstyle per day (PXQ) (TR/Q) dTR/dQ
1 10 10 - -
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
6 5 30 5 0
7 4 28 4 -2
8 3 24 3 -4
9 2 18 2 -6
10 1 10 1 -8

The table shows that the total revenue, column 3, reaches a peak b/w unit 5 and 6. Marginal
Revenue, column 5. Is initially positive up to the 6th unit and subsequently becomes negative.

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Price $
Ep > 1

Ep = 1
MR Ep < 1

5 6 y

30 $


5 6

A monopolist’s marginal revenue is always less than its price. The reason is that in order for the
monopolist to sell an extra unit of output, the firm must cut its price, and the price cut applies to all
units sold. The additional unit as well as all previous units. However, the addition to revenue from
selling an extra unit is less than the price change. In order to consider and understand the point

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4 5 Quantity

As it is clear from the fig that when the price is 7 and 6 $ respectively, total revenue is 28$ and
30$ respectively, marginal revenue however is 2$. Here we can appreciate that a monopolist has
to decrease his price from 7 to 6 but in return the revenue generated is not in compliance with the
price change.

Marginal Revenue Curve Facing a Monopolist

For a monopolist, an increase in output involves not just producing more and selling it, but also
reducing the price of its output to sell it. At every level of output except one unit, a monopolist’s
marginal revenue is below price.

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Short run Profit Maximization






QM Quantity

The figure represents the demand cure D faced by the monopolists market. And corresponding
marginal revenue MR curve. Superimposed on this the cost curves of the monopolist-the short
run average cost ATC and marginal cost MC curves.

The profit maximization is up to the point when marginal cost per unit rises to produce up to meet
the falling marginal revenue. This point occur at output level Qm. Notice that every unit to the
right of the Qm has marginal cost grater than its marginal revenue; it therefore, not be produced.
Likewise, every unit to the right to the Qm cost less than it earns (marginally or incrementally).
The firm’s profit can be seen as PmABC.

For a management point of view if a firm in a monopoly should not sell the products at high price
where as sell the product at right price which equates the firm’s profits. The right price is one that
is the marginal cost with marginal revenue, in doing so the firm’s could earn maximum profits.

Monopolistic Competition

Monopolistic competition is a common form of industry (market) structure, characterized by a

large number of firms, none of which can influence market price by virtue of size alone. Some
degree of market power is achieved by firms producing differentiated products. New firms can
enter and established firms can exit such an industry with ease.

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Product Differentiation Reduces the Elasticity of Demand Facing a Firm

Based on the availability of substitutes, the demand curve faced by a monopolistic competitor is
likely to be less elastic than the demand curve faced by a perfectly competitive firm, and likely to
be more elastic than the demand curve faced by a monopoly.


A market structure in which relatively few firms produce identical or similar products
Two basic characteristics:

1. Each firm has some ability to influence price

2. The interdependence among firms in setting their pricing policies

Entry barriers exist.

Competition in Oligopoly
Firms in oligopolies tend to concentrate on non-price competitive policies like advertising
Frequently use administered prices
A predetermined price set by the seller rather than a price determined solely by demand
and supply in the marketplace
Use of non-price competition e.g. rebates promotional deals, etc.

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Economic Environment of Business (AIOU)

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Question 5

What are the assumptions of the theory of monopolistic competition? In what way
do these assumptions differ from those of the perfectly competitive and monopoly

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Assumptions of the Monopolistic Competition

The assumptions in monopolistic competition

1. There are large no buyers and sellers in the market place, non of whom are large
enough to influence the price.

2. The sellers are described as price takers.

3. There is freedom of entry and exit into the market i.e. barriers to entry are low and
firms must be able to quickly established themselves in the market place.

4. Buyer and seller have perfect knowledge; economic agents are fully informed of
prices and out put in the industry.

5. Firms produce non homogeneous differentiated products

Monopolistic Competition

Monopolistic competition is a common form of industry (market) structure, characterized by a

large number of firms, none of which can influence market price by virtue of size alone. Some
degree of market power is achieved by firms producing differentiated products. New firms can
enter and established firms can exit such an industry with ease.

Product Differentiation Reduces the Elasticity of Demand Facing a Firm

Based on the availability of substitutes, the demand curve faced by a monopolistic competitor is
likely to be less elastic than the demand curve faced by a perfectly competitive firm, and likely to
be more elastic than the demand curve faced by a monopoly.

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Monopolistic competition in short run

In the short-run, a monopolistically competitive firm will produce up to the point where MR = MC.

This firm is earning positive profits in the short-run.

Profits are not guaranteed. Here, a firm with a similar cost structure is shown facing a weaker
demand and suffering short-run losses.

Monopolistic Competition in long run

The firm’s demand curve must end up tangent to its average total cost curve for profits to equal
zero. This is the condition for long-run equilibrium in a monopolistically competitive industry.

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Perfect & Imperfect Markets Compared

• High degree of competition benefits consumers

• Under perfect competition, firm tend to have lower prices, produces more outputs and obtain
normal profits in the long run.

• Each firm produces at the minimum ATC curve and P (AR) = MC (and ATC).

Perfectly Competitive versus Monopolistic Pricing:

Possible Long-Run Price under Monopolistic Competition

Possible Equilibriums under Perfect Competition, Monopoly, and Oligopoly

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Prefect competition Monopoly Monopolistic Competition

There are large no buyers and There is only one firm in the There are large no buyers and
sellers in the market place, industry, the monopolist sellers in the market place,
none of whom unite and none of whom are large
influence the price. enough to influence the price.
The sellers are described as The sellers are described as The sellers are described as
price takers. price makers price takers.
There is freedom of entry and Barrier to enter into the market There is freedom of entry and
exit into the market i.e. Entry and exit for the firm is exit into the market i.e. barriers
barriers to entry are low and difficult. to entry are low and firms must
firms must be able to quickly be able to quickly established
established themselves in the themselves in the market
market place. place.
Buyer and seller have perfect Buyer and seller have perfect Buyer and seller have perfect
knowledge; economic agents knowledge; the goal of the firm knowledge; economic agents
are fully informed of prices and is short term profit are fully informed of prices and
out put in the industry. The maximization. out put in the industry.
goal of the firm is profit
Firms produce homogeneous Firms produce Unique Firms produce non
non-differentiated products products homogeneous differentiated

It can be seen that the assumptions in monopolistic competition are as perfect competition
despite the monopolistic firms only produce non homogeneous differentiated products. as for as
monopoly is concerned it is single dominant market situation.


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