ECO701 Economics and the Business Environment

Question. 1

A Monopolistic Market describes a market where a few or only one company may provide
products and services to the consumers. It is entirely different from a perfectly competitive
market. A perfectly competitive market has an infinite number of firms who provide almost
the same product, and they are price takers (Sloman et al., 2019). On the contrary, a
monopoly firm can restrict production, set suitable price, and ensure a maximum profit in the
long-run.

Figure: Monopoly Market

Source: (Sloman et al., 2019)

The Provided diagram represents a firm that operates in a Monopolistic market structure.
Here, the business is of selling rugs for homeware.

Therefore, we can understand that in a monopolistic market, the firm has full control over
manufacture, distribution and pricing. Here, X-Axis and Y-Axis represent Quantity and Price
receptively, and O is the initial point. MR=Marginal Revenue, MC=Marginal Cost,
ATC=Average Total Cost and D curve represents the demand. In the figure, the MR and MC
curve intersected in a point. This point supports the condition of MR=MC, which is necessary
for profit maximisation. The X-Axis coordinate of this point indicates to the quantity to be
produced for profit maximisation. The vertical dotted line on this point intersects ATC curve
at B point, and its Y-Axis coordinate indicates the maximum cost of the specific quantity.
Also, the Y-Axis coordinate of point A indicates the selling price.
A. On the light of the above interpretation, the most optimal quantity for profit
maximisation is 400 units. The firm should charge 100 currencies for each unit.

B. The total revenue of the firm= (100x 400) currencies= 40,000 currencies
The total cost of the firm= (40x 400) currencies= 16,000 currencies

C. We know, in monopolistic competition will get supernormal profit if,

Cmax (Maximum Cost)< Rmax (Maximum Revenue)
Then we get Pmax= Rmax- Cmax
Here in the diagram, (0, 100, A, 400) rectangular area represents Rmax area and (0, 40, B
400) rectangular area represents Cmax. Therefore, the (40, 100, A, B) rectangular area
represents Pmax. In the figure, Cmax< Rmax is clear. Therefore, the company will have a
supernormal profit.
Here, Rmax=40,000 currencies, Cmax= 16,000 currencies.
Therefore, , supernormal profit, Pmax= Rmax- Cmax= (40,000- 16,000) currencies= 24,000
currencies.

D. The diagram shows the short-run equilibrium in a proper way. As it is a monopolistic

market, revenue is there (Sloman et al., 2019). However, more competitors enter the
market; it will result in a dramatic fall of product demand which will eventually lead to no
profit or even loss.
Question. 2

Externality is generally considered as the cost as well as benefits made by the producer that is
not incurred financially and the produces does not receive it. The economic value cannot
measure an externality. It is an impact which is abstract. The effect can be visible in society.
Generally, the externality can be divided into two ways which are

 Positive Externality
 Negative Externality

Positive externality means having a positive impact on society. The economic plan may not
generate economic profit, but the aftermath leaves a good outcome. On the other hand, a
negative externality is an inverse to the positive externality. Negative externality creates a
terrible impact on the society, which can eventually lead to chaos or even the ultimate fall of
a society (Parkin, 2017).

Figure: Positive Externality

Source: (Parkin, 2017)

Policy 1: This policy says that alcohol consumption in public places is banned. Public places
like restaurants, bars will no longer sell, and none are allowed to consume it in public places.

Alcohol consumption in public places causes negative externality. Every year more than
3,500 people get injured caused from alcohol centred accidents in the UK. There are around
85,000 accident cases only in England & Wales driven by dinking-related accidents. The
alcoholic impact resulted in 250 dead only in 2017. It was larger than in any year since 2009,
and 20 more than in 2016. Therefore, if the consumption of alcohol is restricted, then there is
a chance of less drunken driving cases. Accidents and injuries and related violence may
decrease. It will reduce the negative impact on society.

Policy 2: In this policy, education is declared to be free up to an undergraduate degree. For a

further study like masters or PhD, one has to pay.

Figure: Negative Externality

Source: (Parkin, 2017)

It can also be described as a positive externality. The dropout rate is very low in the UK
which is around 6% of total students. However, only one in ten school droppers were without
a job or college place, which is according to the state data of 2009. Among the European
Union nations, a few countries have higher rate including Italy and Spain. Free education can
lessen the dropout rate. Furthermore, more students will get the opportunity for higher
studies. Literacy, as well as skilful human resources, will grow. Therefore, it can be
determined as a positive externality.
Question. 3

a. Here, given that,

Autonomous Consumption, C0 = 10000,

Marginal Propensity to Consume, C = 0.4,

Investment, I = 15000,

Government Spending, G = 20000,

Net Exports, n = 5000,

Income Tax rate, Tr = 25%.

Equilibrium income, Ye = αZ

α= 1/(1-C)= 1/(1-0.4) = 1.67

T= nTr= 0.25*5000 = 1250

Z= C0+ I+ G- CT = 10000+ 15000+ 20000- (0.4*1250)

= 44500

Ye = 1.67*44500

= 74315 (Ans.)

b. Here, given that,

multiplier, α= 1.67

Increase of Government spending= 20000

Increase of national income= 20000x 1.67= 33400

Yes, the increase in government spending has increased national demand. However, it has

now exceeded the desired increase limit.

c. Here, given that,

Desired increase= 30000

Multiplier, α= 1.67

Therefore, the Increase of Government spending= 30000/1.67= 17964.07~ 17964

(approx.)

To achieve the desired goal, the government increase should be 17964 (approx.)
Question. 4

There are three states of the economy:

 Real GDP is less than Natural Real GDP

 Real GDP is higher than Natural Real GDP
 Real GDP is equal to Natural Real GDP

 If the economy faces less production than the natural real GDP, it is known as a
recessionary Gap (Bishop et al., 2017). Here, the real unemployment rate is
undoubtedly higher than the natural unemployment rate. The labour market face
surpluses and the income of labours get dropped.
 When the economy is producing more than Natural Real GDP, it is called an
Inflationary Gap. In this situation, the Unemployment rate is lower than the natural
unemployment rate. Thus, in the labour market, there is a shortage.
 When the real GDP that is produced in the economy is equal to the Natural Real GDP,
the economy is in long-run equilibrium.

When the economy is unstable, it means it has either an inflationary gap or a recessionary
gap. The Government of the UK takes different policies to bring stability in the economy.
These policies are called Monetary and Fiscal Policy. The objectives of these policies are:

 To keep low inflation in the economy, CPI= 2%

 To ensure stable economic growth but avoid inflationary growth
 To reduce unemployment in the economy and achieve full employment in the long
run
 To avoid massive deficits in the Balance of Payments. When the Government
spending is more massive than the Government Revenue, it is called a deficit budget

Monetary Policy: The Bank of England, which is the central bank of the UK controls the
Monetary Policy of the United Kingdom. Their target is to control inflation CPI (2% +/- 1)
and also, consider the growth of the economy (Samuelson and Nordhaus, 2010). The Bank of
Canada uses interest rate and money supply as the tools to implement the policies. Monetary
policy can be of two types:
 1. Expansionary Monetary Policy
2. Contractionary Monetary Policy

The Bank of England conducts a committee named the monetary policy committee which
provides the monetary policies of the UK. The honourable Chancellor could set the interest
rate until 1997 but now the Bank of England has a complete independence to set it.

Expansionary Monetary Policy

Figure: Monetary Policy & a Recessionary Gap

Source: (Samuelson and Nordhaus, 2010)

During the recession, the Bank of England takes expansionary monetary policies. It expands
the money supply or reduces the interest rate.

When, the Bank of England, buy bonds, it gives the commercial banks more cash. This cash
flow in the economy helps the investors to invest more, which increases the Real GDP.
Again, when the interest rate decreases, people take more loans from the banks and expand
investment. Thus, money flow increases in the consumption and investment in the economy,
which shifts the AD curve rightward and increases the Real GDP.
Contractionary Monetary Policy: The Bank of England introduces contractionary monetary
policy for controlling the inflation of the economy to a large extent. It helps to reduce
inflation. When the inflation target crosses and the price level increases high, the value of

money decreases.

Figure: Monetary Policy and an Inflationary Gap

Source: (Dornbusch et al., 2018)

Thus, the Bank of England sells more bonds to the commercial banks which take out the
money from the economy, and thus people get less cash in hand, price level decreases. It also
raises the interest rates for which peoples' willingness to take loans decreases (Dornbusch et
al., 2018). This lower consumption and investment leads to shift the AD curve leftward and
control inflation.

Fiscal Policy: In UK, Fiscal Policy is not frequently used. The Government of UK takes
fiscal Policies. However, due to political difficulties, fiscal policies are often avoided. Fiscal
Policy tools are tax rates and Government spending (Dornbusch et al., 2018). These policies
are mainly taken in very deep recessions. There are two types of fiscal policies

 Expansionary Fiscal Policy

 Contractionary Fiscal Policy
 Figure: Expansionary Fiscal Policy

Source: (Dornbusch et al., 2018)

Expansionary Fiscal Policy: In 2009, the UK Government cut the rate of VAT to stimulate
consumption. Cut in the tax rate, and increased Government spending increases consumption
and investment and increases Aggregate Demand curve. Thus recession can be fought by the
Government.

Contractionary Fiscal Policy: To fight inflation, the Government increases tax rates to
reduce consumption and investment, which gradually shifts AD curve leftward.

Figure: Contractionary Fiscal Policy

 Source: (Garrett et al., 2014)

Fiscal policies may take longer time than Monetary Policies and also has more uncertainties.
Recessionary gap is skipped or eliminated by the expansionary fiscal policy in Keynesian
theory (Garrett et al., 2014). It increases government purchases, decreases taxes, or both,
which leads to a rightward shift in the aggregate demand curve from AD 1 to AD2. This
change in AD restores the economy to the natural level of Real GDP, QN.

An inflationary gap can be eliminated using the contractionary fiscal policy. It decreased
government purchases, increases taxes, or both, which leads to a leftward shift in the
aggregate demand curve from AD1 to AD2. This change in AD restores the economy to the

natural of Real GDP, QN

Figure: Destabilized Economy for Fiscal Policy

Source: (Garrett et al., 2014)

Fiscal policy may destabilise: In the economy, Fiscal policy may destabilise. From the
figure, the SRAS1 curve shifts rightward to heal the economy from this recessionary gap. The
policy makers do not know this information (Garrett et al., 2014). Therefore, the AD and
SRAS2 get intersected at point 2 instead of intersecting SRAS 1 at point 1. The policymakers
thus move the economy into an inflationary gap, thus destabilising the economy.
Question. 5

An exchange rate indicates the value of the currency of another nation or economic zone
comparing to a specific currency. Exchange rates can be of two types. It can be either fixed or
floating.

 Fixed exchange rate: Generally, the exchange rate of any country is decided by its
central bank.
 Floating exchange rate: The central bank decides the rate of exchange based on the
demand and the supply of the currency.

Most of the exchange rates are free-floating and will increase or decrease based on supply
and demand in the market. Therefore, me currencies in the market are not free-floating and
have restrictions. Nowadays, various types of exchange rates are observed including currency
Peg, Free Floating, Onshore vs Offshore, etc. In currency, two situations are noticed;
Currency Appreciation and currency depreciation.

Currency Depreciation: It is the loss of value of a country's currency concerning one or more
external reference currencies. That means one country has to pay more than before to
exchange with the other currency.

Currency Appreciation: It is in the same context, an increase in the value of the currency. It
means that one country's currency has to pay less to exchange with others. Usually,
depreciation and appreciation are measured in the scale of the US Dollar.
 Figure: Demand & Supply of Currencies

Source: (Krugman, 2016)

Currency appreciation and depreciation profoundly influence the export-import market. If

there is currency depreciation, then it means the importer has to pay more. Therefore, the
import is dearer. However, other countries have to pay less to the export is cheaper. On the
other hand, if there is currency appreciation, then it means the exporter has to pay more
(Krugman, 2016). Therefore, the export is dearer. However, the native country has to pay less
to the import is cheaper. It also influences foreign investments. If the value of currency
depreciates, then there is more currency in exchange for a unit dollar. Therefore, it
encourages foreign investors to invest in the country.

On the contrary, if the value of currency appreciates, then there is less money in exchange for
a unit dollar. Therefore, foreign investors get discouraged from investing. If there is no
foreign investment in the country, then there is no economic growth. Furthermore, if there is
currency depreciation, then trading becomes imbalanced, which leads to an economic
recession. Therefore, a balance is needed.

Quantitative Easing (QE): In this type of monetary policy, the central bank purchased
securities for long-term from the market. As a result, the supply of money and encourage
lending and investment get increased. As a result, new money is added to the country.
Besides, it can also serve in lower interest rates. The central bank's financial statement or the
balance sheet also gets boost through it. The interest rate in the short-run market becomes
zero which is also a target of the central bank. On the contrary, the central bank buys asset
instead of it. (Krugman, 2016). Generally, Quantitative Easing (QE) generates money in the
society by purchasing asset to a great extent where new banks also collaborate. The countries
of the EU are likely to go for a Q.E. in the economy to boost growth.

Case-1: In the given situation, we can see that the first situation is that there is less
confidence in investing in the UK. We know that foreign investments lessen when there is
currency appreciation. Therefore, we can decide that the UK is facing currency appreciation.
 Exchange Rate

QS Of £

£1 = €1£1 =
€0.8

QD Of £

Quantity of Pound

Figure: Pound Appreciation

Source: (Idrac et al., 2019)

Case-2: In the second situation, the European bank is trying to conduct quantitative easing. It
means that the bank is going to purchase some more assets to increase safety and increase
QD’ Of £
currency in the market. That means the currency supply will increase. There will be more
Euro in the market. Therefore, the demand for the Euro will be lessened. Thus the
depreciation may occur.Exchange Rate

QS Of

£1 = €1.2£1 =
€1
E

QD' of
££

Q£ Q£* Quantity of Pound

Figure: Pound Appreciation

Source: (Idrac et al., 2019)

Case-3: The last situation is about Canada. It is a prediction where it is predicted that there is
a possibility of an increase in foreign investment in Canada. From the statement, we can
interpret that, Canada is going through currency depreciation. It is attracting foreign investors
to invest in Canada more and more.

Exchange Rate

QS Of £

£1 = €1£1 =
€0.8

QD’ Of £

QD Of £

Q£ Q£* Quantity of Pound

Figure: Pound Appreciation

Source: (Idrac et al., 2019)

Finally, it is wise to buy currencies in Canada as it will eventually lead to higher profit. The
currency depreciation will allow an investor to get maximum profit. However, he has to pay
less.
References

Bishop, M. et al. (2017) Privatization and economic performance. Oxford: Oxford University

Press.
Dornbusch, R. et al. (2018) Macroeconomics. New York, N.Y.: McGraw-Hill Education.
Garrett, E. et al. (2014) Fiscal challenges. Cambridge: Cambridge University Press.
Idrac, A. et al. (2019) The state of the union 2018.
Krugman, P. (2016) Exchange rate targets and currency bands. Cambridge: Cambridge
Univ. Press.
Parkin, M. (2017) Microeconomics. Harlow: Pearson.
Samuelson, P. & Nordhaus, W. (2010) Microeconomics. Boston: McGraw-Hill Irwin.
Sloman, J. et al. (2019) Economics. Harlow, United Kingdom: Pearson Education Limited.