Business Economics CIMA - Study - Notes PDF

Fundamentals of Business Economics
CIMA C04
Fundamentals of
Business Economics
1
INTRODUCTION
EXAM FORMAT
 2 HOURS
TYPES OF QUESTIONS
 Multiple choice
 Objective tests
NUMBER OF QUESTIONS
 75 - Combination of one or more parts
MARK ALLOCATION
 Single part questions generally worth about 1-2 marks
 Two and Three part questions may be worth 4 or 6 marks
WAY TO PASSING THE EXAM

 Knowledge
 Question practice
WHEN TO TAKE THE EXAM
2
THE BASIC ECONOMIC PROBLEM
The problem of allocating scarce resources to maximise

economic welfare
RESOURCES - REQUIRED TO PRODUCE GOODS
Factor of Production Reward
Land Rent
Labour Wages
Capital Interest
Enterprise Profit
BUT
When WANTS (of RESOURCES) are GREATER than RESOURCES

you get
SCARCITY
 CONSUMERS must choose what goods and services they will have.
 PRODUCERS must choose how to use their available resources, and

what to produce with them.
3
BASIC ECONOMIC ASSUMPTIONS
 PRODUCERS will seek to MAXIMISE their PROFITS
 CONSUMERS will seek to MAXIMISE the BENEFITS (UTILITY) from

their INCOME.
 GOVERNMENTS will seek to MAXIMISE the WELFARE of their

populations
KEY QUESTIONS TO BE ANSWERED
4
OPPORTUNITY COST
The benefit forgone from the next best alternative
 To produce more of Good X will involve sacrificing some production of

Good Y
 The real cost of making one good is the value of the other goods that
could have been made with the scarce resources
 Measured in terms of the forgone volume of output of the alternative good

or service NOT in terms of financial value
 For organisations, costs arises because their limited resources have

alternative uses
5
PRODUCTION POSSIBILITY CURVE

Illustrates the problems of SCARCITY and CHOICE
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LEARNING OUTCOME
B1a) - Distinguish between the goals of profit seeking organisations, not-for-
profit organisations (NPOs) and governmental organisations.
TYPES OF ORGANISATIONS
1. PRIVATE SECTOR ORGANISATIONS
Refers to all non-governmental organisations

a) Profit seeking organisations
b) Not-for profit organisations
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2. PUBLIC SECTOR ORGANISATIONS
Refers to all government/state organisations

a) Those that provide public services
b) State owned industries
8
LEARNING OUTCOME
B1d) - Distinguish between the potential objectives of management and those
of shareholders, and the effects of this principle-agent problem on
decisions concerning price, output and growth of the firm.
AIMS AND OBJECTIVES

PROFIT MAXIMISATION
INCREASE IN SHAREHOLDERS WEALTH/VALUE
9
AGENCY THEORY
 Where the management of a business is separated from the ownership of

the organisation, by the employment of professional managers.
 Shareholders contract another party – the agent
CONFLICT
 Managers use their power to promote the business for their own interests
SOLUTION

Reward incentives
ALTERNATIVE MANAGERIAL GOALS

 Baumol’s sales maximisation model
 Williamson’s management discretion model
10
Corporate Governance
CORPORATE GOVERNANCE
System by which organisations are directed and controlled
MANAGEMENT ACCOUNTABILITY
All managers have a duty of faithful service to the external purpose of the
organisation
FAILURES OF CORPORATE GOVERNANCE
 Emphasis on short-term profitability
 Misleading accounts and information
 Domination by a single or group of individuals
 Lack of control
 Lack of involvement by the board
 Lack of independent scrutiny
 Lack of contact with shareholders
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ADVANTAGES OF IMPROVING CORPORATE GOVERNANCE
 Reduces risk of financial failure or breaching regulations
 Improves performance and quality of decision making
 Enhances reputation
12
CORPORATE GOVERNANCE REFORM
1991 – Cadbury Committee
1995 – Greenbury Report
1998 – Hempel Commitee
1998 – Combined Code
Combined Code – sets out standards of good practice and includes broad
principles and specific provisions, including:
 Chairman and Chief Executive positions to be held by different people
 Board members to include both executive and non-executive directors
 Directors pay to be determined by a remuneration committee
 Companies should have an audit committee
13
LEARNING OUTCOME
B1c) - Identify stakeholders and their likely impact on the goals of organisations
and the decisions of management.
STAKEHOLDERS
DEFINITION
Anyone that has an interest in the strategy and behaviour of an

organisation
INTERNAL EXTERNAL
INTEREST
POWER AND INFLUENCE
CONFLICT
14
LEARNING OUTCOME
B1b) - Explain shareholder wealth, the variables affecting shareholder

wealth, and its application in management decision making
Objective of a business is to MAXIMISE SHAREHOLDER WEALTH
Shareholders are interested in the return on their capital in the form of:
 DIVIDENDS
 VALUE OF THEIR SHARES
SHORT-TERM MEASURES OF FINANCIAL PERFORMANCE

RETURN ON CAPITAL EMPLOYED (ROCE)
EARNINGS PER SHARE (EPS)
15
PRICE EARNINGS (P/E) RATIO
16
LONG-TERM MEASURES OF FINANCIAL PERFORMANCE
1 - Dividend valuation model
This uses the current and expected stream of dividends
Annual Dividend
Share price =
Cost of capital
17
2 – Free cash flow valuation
Where no dividends are paid then models based on earnings (free cash flow to
the firm or free cash flow to equity) may be used. This discounts future cash
flows to give a current market value of the company.
This uses the principles of discounting to give a net present value of future
earnings.
1
PV = CF x
(1+r) n
18
Example
ABC Ltd’s directors have forecast the company’s expected free cash flow to the
firm for the next 3 years as shown in the table below. The equity shareholders
require a rate of return on their investment of 20%.
What should the company’s current market value be?
What should the ordinary share price be if there are 300,000 ordinary shares in
issue?
Year Free cash flow to the firm Discount factor NPV

$ £
1 1,000,000
2 1,000,000
3 1,000,000
19
Free cash flow to the firm
FCFF = PBIT + Depreciation – Tax – Capital Expenditure
Change Impact on market value
Cash flows increase
Cash flows decrease
Cost of equity increases
Cost of equity decreases
20
LEARNING OUTCOME
C1a) - Identify the equilibrium price in a product or factor markets likely to result from
specified changes in conditions of demand or supply.
MARKET
Where buyers and sellers (suppliers) of a good or service come

together for the purpose of exchange
 A good or service has as a price if it is:

o
o
 Market prices are determined by the interaction of demand and supply
21
UTILITY
 TOTAL UTILITY - the pleasure or satisfaction or benefit derived by a
person from the consumption of a product
 MARGINAL UTILITY - measures the satisfaction gained from consuming

an additional unit of a product
Customers aim to maximize total utility with a limited income
 Consumers prefer more to less
 Willing to substitute if price is right
 Choices are transitive (if A is preferred to B, and B is preferred to C, then

A is preferred to C)
LAW OF DIMINISHING MARGINAL UTILITY

As buyers consume additional units of a product, the extra satisfaction (or
utility) they gain from each unit will fall.
22
DEMAND
Amount that consumers are willing and able to purchase at a
given price
 Basically it measures the quantity that households are actually able

and willing to buy at each and every price.
 Represents the ‘effective demand’ – what they want AND can afford!
SHAPE OF THE DEMAND CURVE

 Downward sloping, from left to right
– Progressively larger quantities are demanded as price falls
– Related to diminishing marginal utility
23
CHANGES IN DEMAND
2 TYPES:-
1. MOVEMENTS ALONG (CHANGE IN QUANITITY

DEMANDED)
 Caused by changes in PRICE
2. SHIFTS OF (CHANGES IN DEMAND)
 Caused by changes in other DETERMINANTS
24
1. A MOVEMENT ALONG THE DEMAND CURVE
Occurs when change in the PRICE of a product leads to change in the

quantity demanded
 An increase in the quantity demanded due to a price FALL – called an

EXTENSION of demand
 A decrease in the quantity demanded due to a price INCREASE – called a

CONTRACTION of demand
25
A SHIFT IN THE DEMAND CURVE
Occurs when at every price consumers are willing and able to buy more or
less than they did before
INCREASE IN DEMAND
TYPES OF GOODS
26
FACTORS THAT CREATE A SHIFT IN THE DEMAND CURVE

(DETERMINATES)
 Household income
 Tastes/fashion
 Price of substitutes
 Prices of complements
 Expectations of future price changes
27
28
TYPES OF GOODS
NORMAL GOODS
A consumer will buy more when their income rises.
INFERIOR GOODS
A consumer will buy less when their income rises
GIFFEN GOODS
As price rises the quantity demanded rises
29
SUPPLY
Amount that producers will be prepared to supply at any given
price
 Basically it measures the quantity that producers are actually able

and willing to produce at each and every price.
SHAPE OF THE SUPPLY CURVE

Upward sloping from left to right
- Progressively more is supplied as the PRICE increases
SUPPLY CURVE
30
CHANGES IN SUPPLY
2 TYPES
1. MOVEMENT ALONG THE SUPPLY CURVE (CHANGE IN

QUANTITY SUPPLIED)
 Caused by changes in PRICE
2. SHIFT OF THE SUPPLY CURVE (CHANGES IN SUPPLY)
 Caused by changes in other DETERMINANTS
31
1. MOVEMENT ALONG THE SUPPLY CURVE
A change in the price of a product will cause a change in the quantity

supplied
 An INCREASE in the PRICE will usually lead to an increase in the quantity

supplied – EXTENSION of supply
 A FALL in the QUANTITY SUPPLIED IS CALLED a CONTRACTION of

supply
32
2. SHIFTS IN SUPPLY
Means that the supply curve shifts to the right or to the left
 An INCREASE in supply is shown by a shift of the supply curve to the

RIGHT, more is supplied
 A DECREASE in supply shifts the supply curve to the left, less is supplied
at each and every price
33
REASONS
 CHANGE IN COSTS OF PRODUCTION
 CHANGE IN TECHNOLOGY
 CHANGE IN THE NUMBER OF PRODUCERS
 CHANGE IN INDIRECT TAXES
 CHANGE IN SUBSIDIES
34
PRICE MECHANISM
Market price is determined by interaction of Supply and Demand
EQUILIBRIUM where DEMAND = SUPPLY
The price mechanism acts as the following
 A SIGNAL AND INCENTIVE
 A RATIONING DEVICE
35
EFFECTS ON THE EQUILIBRIUM PRICE IF THERE ARE

CHANGES IN DEMAND
36
EFFECTS ON THE EQUILIBRIUM PRICE IF THERE ARE

CHANGES IN SUPPLY
37
LEARNING OUTCOME
C1b) - Calculate the price elasticity of demand and the price elasticity of
supply.
C1c) - Explain the determinates of the price elasticities of demand and
supply.
PRICE ELASTICITY OF DEMAND

Degree in which quantity responds to a change in the market price
PED = % Change in quantity demanded

%Change in Price
Normally negative
38
If PED = 0 Demand is Perfectly Inelastic

If PED is between 0 and 1 Demand is Relatively Inelastic
If PED = 1 Demand is Unitary Elastic
If PED is between 1 and  (infinity) Demand is Relatively Elastic
If PED =  (infinity) Demand is Perfectly Elastic
39
When calculating the price elasticity of demand there are two ways to do it;
1. Arc elasticity of demand
This is where the % change in price (quantity) is calculated based on the

average price (quantity) over the range being considered.
2. Point elasticity of demand
This is where the % change in price (quantity) is calculated based on a

specific price (quantity), which will be the starting position.
40
EXAMPLE
If the quantity demanded of a good rises from 200 to 300 units when the price
falls from £10 to £6.
What is;
1. The arc price elasticity of demand?

2. The point price elasticity of demand?
41
DETERMINANTS
 Degree of necessity
 Substitutes
 Habit, trend, fashion
 %of income spent on the product
 Time period
42
ELASTIC CURVE
INELASTIC CURVE
43
ELASTICITY OF SUPPLY
Price elasticity of supply is a measure of the responsiveness of
supply of a good to a change in its price
PES = %change in quantity supplied

% change in price
FACTORS AFFECTING ELASTICITY OF SUPPLY
 Number of firms in the industry
 Spare capacity
 Time period
44
EXAMPLE
Calculate the point elasticity of supply:
1. The price of a product is £10 and the quantity supplied is 200 units. The price
increases to £12 and the quantity supplied increases to 300 units.
2. The price of a product is £10 and the quantity supplied is 200 units. The price
increases to £12 and the quantity supplied increases to 220 units.
45
LEARNING OUTCOME
C1d - Identify the effects of price elasticity of demand on a firm’s revenues
following a change in prices
IMPACT OF A PRICE FALL ON REVENUE – DEPENDENT ON

THE PRICE ELASTICITY OF DEMAND
VALUE (ignoring the Impact on revenue of a

sign) Price fall
Price Elastic More than one Revenue increases
Unitary Elastic One Revenue stays the

same
Price Inelastic Less than one Revenue decreases
 Estimation of price elasticity of demand is very important for firms, when

determining a pricing strategy.
 Managers will often want to increase their revenue, to do this they should:
- Lower price, if Demand is Price Elastic
- Increase price, if Demand is Price Inelastic
46
EXAMPLE
The price of a product is decreased from £5 to £4.60. The quantity increases
from 1,700 units to 2,000 units
The price of a product is decreased from £8 to £7.50. The quantity demanded

increases from 9,500 to 10,000 units.
Answer the following for each situation
1. What is the point price elasticity of demand?
2. What is the original total revenue before the price change?
3. What is the new total revenue after the price change?
47
LEARNING OUTCOME
C2c - Explain the effects on prices, producer revenues and market equilibrium of
government policies to influence prices in markets.
C2d – Illustrate the impacts of price regulation in goods and factor markets.
EFFECTS ON THE EQUILIBRIUM PRICE OF INDIRECT TAXES
48
EFFECTS ON THE EQUILIBRIUM PRICE OF SUBSIDIES
49
EFFECTS ON THE EQUILIBRIUM PRICE OF MINIMUM AND

MAXIMUM PRICES
MINIMUM PRICES
50
MAXIMUM PRICES
51
COSTS OF PRODUCTION
LEARNING OUTCOMES
B2a) - Distinguish between the likely behaviour of a firm’s costs in the short and
long run
B2b) - Illustrate the potential effects of long run cost behaviour on prices, the size
of the organisation and the number of competitors in the industry.
KEY DEFINITIONS - COSTS

FIXED COST
 TFC
VARIABLE COST
 TVC
TOTAL COST
 TC
MARGINAL COST
 MC
52
AVERAGE COSTS
 AFC (Average Fixed Costs) =
 AVC (Average Variable Costs) =
 ATC (Average Total Costs) =
53
EXAMPLE
Calculate the following table:-
Units of Fixed Variable Average Average Total Average Marginal

output Costs Costs Fixed Variable Costs Costs Costs
FC VC Costs Costs TC AC MC
AFC AVC
$ $ $ $ $ $ $
1 20 50
2 20 80
3 20 100
4 20 140
5 20 220
6 20 310
54
SHORT RUN
 Period of time when at least one factor of production is fixed
 If a firm is to produce more units and is unable to purchase additional

machinery - it will employ increasing numbers of staff to operate the
machinery.
The relationship of AC to MC in the short run
55
LAW OF DIMINISHING RETURNS
As more units of a variable factor - eg. labour, is added to a fixed

factor, at first output will increase by a greater proportion, BUT
after a time the additional output will decrease.
‘U SHAPED AVERAGE COST CURVE’

SHORT-RUN
 As production increases the average cost curve FALLS. This is due to:
o Specialisation or the division of labour – increased efficiency as

staff become more proficient
o Utilisation of indivisibilities – labour becomes fully utilised and plant

approaches full capacity
o TFC are spread over more units of output
BUT
 Eventually extra units of variable factors produce reduced additions to
output as inefficiencies set in and average costs RISE – creating the ‘U’
shaped Average Cost Curve.
56
LONG RUN
Period of time when all factors of production are variable.
 All inputs are variable as management can increase resources and

change the scale of production.
 There are no fixed factors and therefore no fixed costs
According to the efficiency of the firm, there are three different possibilities
1. INCREASING returns to scale – ECONOMIES OF SCALE
 A given percentage increase in inputs will lead to a higher percentage

increase in output.
 Long run average costs of production fall as output increases
2. CONSTANT returns to scale
 A given percentage in inputs will create the same percentage increase

in output.
 Average costs and marginal costs per unit will remain constant
3. DECREASING returns to scale - DISECONOMIES OF SCALE
 A given percentage increase in inputs will cause a smaller percentage

increase in output.
 Long run average costs of production rise and output increases
57
LONG RUN AVERAGE COST CURVE
58
ECONOMIES OF SCALE
The economies obtained from large-scale production of two kinds
1. INTERNAL ECONOMIES – created by a firm through its own policies.
2. EXTERNAL ECONOMIES – open to a whole industry and outside the

control of any one firm.
INTERNAL ECONOMIES
 Technical
These relate to the scale of the production process.
For example large-scale operations may make greater use of more

specialised plant and machinery, or manual operations may become more
automated.
More resources can be devoted to research and development – this may lead
to further technical improvements and cost reductions.
 Buying economies
A larger business should have a better idea of what the market has to offer
and may negotiate lower prices or bulk discounts
 Marketing economies
These result from large companies making use of mass advertising media,
e.g. television, national press
 Financial economies
This is the ability of larger firms to raise finance on more advantageous terms,
because of having better security for borrowings and access to financial
markets.
 Managerial economies
The managerial team does not need to grow as fast as capacity. In addition a
larger organisation has access to higher quality management, since it offers
better prospects
 Welfare economies
A large company can derive benefits from the provision of ‘staff welfare’
facilities. A small firm finds this very difficult.
59
EXTERNAL ECONOMIES
As an industry grows in size:
 a large pool of skilled labour may become available. This may lower the
training costs of a firm.
 specialist ancillary industries may develop. Suppliers of raw materials,

components and other services may set up to specialise in the industry as
they can gain from the large market.
Several firms engaged in the same kind of production are often found in the
same area because of the economies which derive from this geographical
proximity.
DISADVANTAGES OF LARGE SCALE OPERATIONS
Some economists argue that very large-scale operations may also give rise to
diseconomies – where the percentage increase in oputput is less than the
percentage increase in the factors of production
INTERNAL
 Bureaucracy
 Poor communication
 Demotivation
 Management decision making impaired
 Large administrative overheads
EXTERNAL
 Resource shortages
60
THE FIRM’S OUTPUT DECISION

LEARNING OUTCOME
B3a) - Demonstrate the point of profit maximisation graphically using total cost
and total revenue curves.
B3b) - Calculate the point of profit maximisation for a single product firm in the
short run using data.
KEY DEFINITIONS – REVENUE & PROFITS

TOTAL REVENUE (TR)
AVERAGE REVENUE (AR)
MARGINAL REVENUE (MR)
PROFIT
61
Using the example we had before, complete the following table, assuming the
average revenue (price) per unit is as stated.
Units of Average Total Total cost Profit Marginal Marginal

output revenue revenue TC revenue Costs
AR(price) TR MR MC
$ $ $ $ $ $
1 160 70
2 140 100
3 120 120
4 100 160
5 80 240
6 60 330
Profit maximisation occurs when:
 TR exceeds TC by the greatest amount

 MC = MR and MC is rising
62
63
LEARNING OUTCOME
C3b – identify the impacts of the differing forms of competition on prices,

output and profitability
THE SPECTRUM OF MARKET STRUCTURES
64
PERFECT COMPETITION
CHARACTERISTICS
 Many buyers and sellers
 No barriers to entry
 Perfect mobility
 Perfect information
 Products are homogeneous
 Market price determined by supply and demand
 Price taker
 Normal profits – in long run
INDUSTRY
65
COST & DEMAND CURVES OF FIRM – PERFECT COMPETITION
EQUILIBRIUM IN SHORT RUN
EQUILIBRIUM IN THE LONG RUN
66
MONOPOLY
CHARACTERISTICS
 One supplier, many buyers
 Can fix price, let demand determine the amount supplied – PRICE
MAKER
 Can fix supply, let demand determine the market price – QUANTITY –
SETTER
 Strong barriers to entry
 Achieves economies of scale
INDUSTRY
67
EQUILIBRIUM IN THE SHORT AND THE LONG RUN
68
DIFFERING BARRIERS TO ENTRY
 LEGAL
 GEOGRAPHICAL
 ECONOMIES OF SCALE
 TECHNICAL
 CONTROL
69
OLIGOPOLY/CARTELS
CHARACTERISTICS
 A few large firms
 Products may be homogeneous or may be differentiated
 Non-price competition
 Customers lack detailed market information, susceptible to the market strategies
of the suppliers
 Not easy to enter the market
 Greater interdependence between firms than in other market structures
EQUILIBRIUM
70
LEARNING OUTCOME
C3a - Describe market concentration and the factors giving rise to differing levels of
concentration between markets, including acquisitions and combinations.
MARKET CONCENTRATION
Market concentration is the extent to which supply to a market is provided by a

small number of firms.
Concentration ratio
This measures the proportion of output (or employment) accounted for by the
largest producers.
Examples of UK industries with the highest five-firm concentration ratios include
Industry Output (%)
Sugar 99%
Tobacco 99%
Gas Distribution 82%
Examples of UK industries with the lowest five-firm concentration ratios include
Industry Output (%)
Metal Forging 4%
Plastic Products 4%
Furniture Making 5%
71
FIRMS AND THEIR GROWTH

MERGERS
TYPES OF MERGER
1 HORIZONTAL INTEGRATION
2 VERTICAL INTERGRATION
3 DIVERSIFICATION
72
LEARNING OUTCOME
C3c - Explain the main policies to prevent the abuses of monopoly power by firms.
REGULATION OF ORGANISATIONS
WHY REGULATE?
COMPETETION COMMISSION
 Independent public body established by the Competition Act 1998
 Conducts in-depth inquiries into mergers, markets and the regulation of

the major regulated industries.
 Every inquiry is undertaken in response to a reference made to it by

another authority:
o Office of Fair Trading (OFT)
o the Secretary of State,
o sector-specific regulator
73
SECTOR–SPECIFIC REGULATORS
CONSEQUENCES OF REGULATION
 Enforcement costs
 Firms attempt to limit effectiveness by substituting away from the

regulated activity
74
LEARNING OUTCOME
C3d - Explain market failures and their effect on prices, efficiency of market operation
and economic welfare.
C3e – Explain the likely responses of government to market failures.
MARKET FAILURE
Occurs when a free market mechanism fails to produce the most efficient
allocation of resources
75
EXTERNALITIES
If the price of the good or service does not reflect the true cost (or benefit) of that
good or service the government may intervene.
 Negative externalities
 Positive externalities
GOVERNMENT RESPONSE
76
PUBLIC GOODS
Public goods are those goods where one person’s consumption does not
diminish someone else’s consumption (non-rivalry or non-diminishable) and that
person cannot stop someone else from benefiting from it (non-exclusivity).
As an individual can benefit from a public good without bearing the cost, all
individuals hope someone else will provide them. As a result public goods will not
be provided in the free market.
GOVERNMENT RESPONSE
77
MERIT GOODS
Merit goods are those goods that are generally deemed to have positive
externalities and should be consumed by all.
If left to market forces, merit goods will tend to be under consumed.
GOVERNMENT RESPONSE
78
PRIVATISATION
Moving economic resources from the public sector to the private sector
ARGUMENTS FOR
More efficient use of economic resources

 Incentive of profit / competition
Lower prices for consumers

 Competition / efficiency – cheaper products
Improved quality
 Customers have a wider choice
Encourages investment
 From abroad as well as home
ARGUMENTS AGAINST
Private monopolies created

 Competition has not been enhanced
Reduced quality services

 Private companies try to cut costs t0 improve profits
Fewer services
 Private companies only provide the most profitable services
Poor, sick, unemployed

 Can’t afford the services
Government regulation restricted

 Can’t always intervene
79
LEARNING OUTCOMES
D1a - Identify the factors leading to liquidity surpluses and deficits in the short, medium
and long run in households, firms and governments.
FUNCTIONS OF MONEY
 A medium of exchange
Buyers and sellers can meet and trade, without the problems of bartering
Some goods are indivisible – rate of exchange can be disputed
 A store of value
When people receive money, may not spend it all on consumption – may
save it till required – so needs to be able to be stored without losing its
value.
 A unit of account
Money allows goods to be compared in a common denomination, which

people understand.
Money allows people to establish relative values.
 A standard of deferred payment
Ability to determine the value of future payments in contracts, specifying

prices and payments measured in money terms.
80
QUALITIES OF MONEY
 Acceptability
All participants in a transaction must be willing to accept money in
exchange for real goods and services in order to fulfill the function of
acting as a medium of exchange.
 Durability
Does not physically deteriorate.
 Stable value
The purchasing power of money must be stable otherwise money cannot
act as a store of value or a standard of deferred payment
 Portable and divisible
Money needs to be convenient for small transactions and easily

transported
81
LIQUIDITY PREFERENCE THEORY
a) Transaction motive
b) The precautionary motive
c) The speculative motive
82
FLOW OF FUNDS
Movement of money, between people, or institutions in the economic

system
3 main sectors
 Households and individuals - personal sector
 Firms - business sector
 Government organisations - government sector
Within each of these there is a continual movement of funds on a short-term /

medium-term / long-term basis.
HOUSEHOLDS
Receipts
Household income is received in a variety of forms:
 Wages and salaries

 Income from investments
 Social security and pension payments
Payments
 Short Term
o Day to day expenditure
 Medium Term – as above plus:

o Infrequent expenditure
 Long Term – as above plus:

o Major assets
Credit to deal with the mismatch of receipts and payments comes from:
 Credit agreements
 Bank loans
 Mortgages
83
FIRMS
Receipts
Income for firms can come in a variety forms:
 Sale of goods
 Income from investments
 Sale of assets
Payments
 Short Term
o Day to day expenditure
 Medium Term – as above plus:

o Infrequent expenditure
 Long Term – as above plus:

o Major assets
Firms can also experience a mismatch between receipts and payments.
84
Finance
 Short term
o Credit agreements e.g. trade credit, hire purchase, credit card
o Bank overdraft
o Medium-term loans
o Bills of exchange
o Commercial paper
o Retained cash
 Long term
o Equity - Issue share capital
o Retained profits
o Debt (borrowing) e.g. debentures and bonds
o Venture capital
85
GOVERNMENTS
RECEIPTS
 Taxes on income and capital gains
 Indirect taxes on expenditure
 Social security contributions
 Other revenues
PAYMENTS
SHORT – TERM
 Wages and salaries to government employees
 Social security and state pensions – unemployed and retired
 Payments to providers of goods and services to enable the day to day

running of government activities
MEDIUM – TERM
 Schools and hospital buildings
 Construction projects for the economic infrastructure – e.g. motorways and

railways
 Loans to private sectors – help finance activities like

technology/aerospace
LONG – TERM
 Very long term investment projects – nuclear power and

telecommunications
 Repayments of long term loans
86
Finance
 Short term
o Credit provided by the central bank
 Medium term
o Budget deficits – borrow from private sector
o Issue bonds
 Long term
o Long term borrowing via government bonds (National Debt)
87
LEARNING OUTCOMES
C2 - Explain the role of various financial assets, markets and institutions in assisting
organisations to manage their liquidity position and to provide an economic return
to holders of liquidity.
ORGANISATIONS OF THE FINANCIAL SYSTEM
FINANCIAL INTERMEDIARIES
 A financial intermediary is an institution which channels funds from savers

to borrowers - by obtaining deposits from lenders and then re-lending
them to borrowers
88
DIAGRAM OF RELATIONSHIP BETWEEN FINANCIAL INTERMEDIARIES,

SAVERS AND BORROWERS
89
BENEFITS
 SAVING - Offers ways of saving money
 BORROWING - Offers ways of borrowing funds
 AGGREGATION - Package up the amounts lent by savers and lend to

borrowers
 MATURITY TRANSFORMATION - bridge gap between the wish of

lenders for liquidity and the desire of borrowers for loans over longer
periods
 RISK TRANSFORMATION - spreads the risk and reduces the risk to any
one saver to almost zero.
90
TYPES OF FINANCIAL MARKETS
 Money markets
These are financial markets for lending and borrowing short-term capital
 Capital markets
These are financial markets for raising and investing long-term capital
 International capital markets
These are markets that are mainly concerned with the purchase and sale
of foreign exchange
91
D2b Explain the role of commercial banks in the process of credit creation and in
determining in structure of interest rates
THE CREDIT CREATION PROCESS
Example
 Day 1 Customer A deposits £1,000
 Day 2 Bank lends customer B £500
 Day 3 In the normal course of business B pays C £500, who then
banks the £500
Day Bank’s Asset Bank’s Liabilities
Cash ratio
Percentage of cash expected to be withdrawn
Deposit multiplier
Deposits = Cash
Cash ratio
92
YIELD ON FINANCIAL INSTRUMENTS
Yield is a general term to describe the return from investment
Return
Yield = x 100
Market price
BONDS
Normally pay a fixed rate of interest. For example, a bond with a nominal price of
£100 may have a £10 coupon rate (i.e. the fixed rate is 10%). However the
market value of bonds may rise or fall:
Question
If the market price is £90 the yield is:
As stock approaches maturity the market price tends to approach the nominal
price due to the lower risk of losses from default and inflation.
93
D2e Explain the role of foreign exchange market and the factors influencing it, in
setting exchange rates
D2f Explain the role of national and international governmental organisations in

regulating and influencing the financial system
THE ROLE OF THE FOREIGN EXCHANGE MARKET

The foreign exchange market enables organisations to buy and sell foreign
currency. Demand comes from:
 Trading
 Investment
 Loans
 Speculative dealing
Types of trading
 Spot
 Forward
EXCHANGE RATES
The exchange rate between currencies represents the price of one currency
expressed in another currency.
For example:
£1 = $1.62 or $1 = £0.62
94
EXCHANGE RATE SYSTEMS
Exchange rate markets enable companies, fund managers and bank to buy and
sell other currencies. This enables entities to buy and sell assets and
investments in overseas’ countries.
There are several types of exchange rate systems that can be in place:
 Floating
 Fixed
 Dirty Floating
95
FLOATING EXCHANGE RATES
Within this system exchange rates are determined by the interaction of supply
and demand.
This assumes that currency is only supplied and demanded for trading purposes.
Interaction of supply and demand
 Demand for pounds reflects demand for British exports

 Supply of pounds represents the demand for British imports (because
pounds are required to buy the foreign currencies needed to pay for the
imports)
 If demand for British exports falls then demand curve will shift downwards
This causes a fall in the exchange rate (depreciation) assuming the
demand for British imports remains unchanged
A new equilibrium position is now in force
96
Example calculation
The pound depreciates from £1 = $1.62, to £1 = $1.50.
If we export a British product priced at £5 how much would it cost in America

before and after the depreciation?
 Therefore a fall in the exchange rate makes British goods more

competitive and should encourage more exports
 This should increase demand for pounds and cause the exchange rate to
rise (appreciate)
97
Advantages of floating exchange rates
1. Adjusts a balance of payments disequilibrium automatically
If imports > exports - economy contracting (balance of payments deficit)
With the floating rate system if there is more money going out of the
economy than coming in i.e. a deficit, then the exchange rate will fall to
make exports cheaper and therefore increase demand for exports.
If exports > imports - economy growing (balance of payments surplus)
The reverse is also true, so in the long term a floating rate system will
enable the balance of payments to come back to a neutral position.
2. Resources will be efficiently allocated around the world
Floating exchange rates respond to changes in economic conditions
Disadvantages of floating exchange rates
1. Uncertainty over future exchange rates
2. If exchange rates fall too much then the cost of imports, and therefore
inflation, will rise
Factors influencing floating exchange rates other than trade
 Deposits transferred from one currency to another at short notice

o Relative interest rates
o Expectations of exchange rates
o Inflation
 Speculative motives
98
FIXED EXCHANGE RATES
 Rate is fixed.
 Advantages – no uncertainty
 Disadvantages
o Doesn’t correct balance of payments disequilibrium
o Does not allocate resources efficiently
 Reduction in exchange rate is called a devaluation
99
DIRTY FLOATING
This system is where the exchange rates are open to market forces and are free
to fluctuate. However, there will be significant government intervention to achieve
or maintain an exchange target rate.
The central bank will be instructed to:
 Buy or sell currency to raise or lower the exchange rate

 Alter interest rates to encourage the buying or selling of the currency
100
D2c Explain the role of the ‘central bank’ in ensuring liquidity and in prudential
regulation
THE ROLE OF THE CENTRAL BANK
 Acts as banker for the government
 Acts as banker to the bank
 Issues notes
 Supervision of the banking system
 Lender of last resort
 Monetary stability
101
A1a Explain the determination macroeconomic phenomena, including growth,

inflation, unemployment, demand management and supply-side policies, using
circular flow of income and aggregate supply and demand analysis.
NATIONAL INCOME
KEY MEASURES OF NATIONAL INCOME
GDP – GROSS DOMESTIC PRODUCT
- A measure of the productivity of the economy
 Measures the value of all output produced within UK exclude any income
generated by assets held by UK resident’s abroad
GNP – GROSS NATIONAL PRODUCT
- A measure of the standard of living
 GDP + income earned by UK companies and individual residents on

assets held abroad less income earned by overseas companies and
individuals on assets held in UK and sent back to their own country.
102
CIRCULAR FLOW OF INCOME

DEFINITIONS
Y = National Income
C = Consumption
S = Savings
I = Investment
T = Taxation
G = Government Expenditure
X = Exports
M = Imports
SIMPLE MODEL
CHARACTERISTICS
 No government
 No overseas sector
 All income is spent on consumption
 All production is sold to the households
HOUSEHOLDS FIRMS
103
CIRCULAR FLOW OF INCOME (Full Model)
Households Firms
104
AGGREGATE DEMAND AND NATIONAL INCOME

Another way to explain equilibrium in the economy is to focus on the
AGGREGATE DEMAND (AD) equation.
AD = C + I + G + (X – M)
AD = total national expenditure (GNP)

C = Domestic Consumption (demand for goods and services by households)
I = Investment (demand for goods and services by firms)
G = government spending on goods and services
X = Total exports (including income from property abroad)
M = Total imports (including money paid as income to residents in other countries
for property they hold in the country)
In equilibrium
Expenditure
National income
ANALYSIS OF AGGREGATE DEMAND: CONSUMPTION,

SAVINGS AND INVESTMENT
105
CONSUMPTION
 Expenditure on consumer goods and services to satisfy current needs
(biggest component in the circular flow of income)
DETERMINANTS
 Single most important determinant of the level of consumption is the level
of income - for both individuals and the economy as a whole
 Wealth
 The cost and availability of credit
 Price expectations
 Government policy
CONSUMPTION FUNCTION
C = a + bY
C = the level of consumption spending
a = the level of spending even if incomes were zero
b = the marginal propensity to consume – this is the proportion
of each extra £1 earned that is spent on consumption
Y = the disposable income
106
MARGINAL PROPENSITY TO CONSUME (MPC)
Proportion of an increase in income, which a consumer will spend
MPC = Change in consumption

Change in Income
107
DETERMINANTS
 The level of income
 Wealth
 The cost of availability of credit
 Price expectations
 Government policy
SAVINGS
Amount of income not spent
DETERMINANTS
 INCOME
 INTEREST RATES
 INFLATION
 CREDIT
108
INVESTMENT
 Fixed capital formation (e.g. plant and machinery)

 The value of physical increase in stock of raw materials, WIP and finished
goods
DETERMINANTS
 RATE OF INTEREST
 MARGINAL EFFICIENCY OF CAPITAL
109
MULTIPLIER EFFECT
Where an increase in the planned injections into the economy increase

national income by more than the initial increase
EXAMPLE
 An increase in government spending by £1million may increase National
Income by £5 million, therefore the multiplier would be 5
TYPES OF CHANGES
 Government pays suppliers
 Suppliers purchase raw materials
 Workers receive wages which they can then spend on other goods and
services
FORMULA TO CALCULATE MULTIPLIER
1
1 - MPC
If the MPC is 0.8:-
110
AN INCREASE IN AGGREGATE DEMAND WHEN THE MPC IS HIGH:
AN INCREASE IN AGGREGATE DEMAND WHEN THE MPC IS LOW:
111
GOVERNMENT ECONOMIC POLICY

MAIN OBJECTIVES ARE:-
1. Full Employment
2. Price Stability
3. Economic Growth
4. Equilibrium on the Balance of Payments
5. An acceptable Distribution of Income
INFLATION
A persistent or continuing tendency for the price level to rise usually
expressed as an annual percentage increase in price
MEASUREMENT
Need to know
 The rise in prices of all goods and services
 The relative importance of each good or service in the consumption
patterns of the population
MEASURE FOR
 Consumers → the retail price index

 The whole economy → the GDP deflator
CAUSES
 DEMAND PULL
Where inflation results from an increase in aggregate demand in the

economy → where prices are said to be ‘pulled-up’
Too much money chasing too few goods
112
 COST- PUSH
Where inflation results from an increase in basic costs eg: raw materials /
labour costs etc.
OTHERS
 Import cost factors
 Expectations
 Excessive growth in the money supply
113
Inflation – Aggregate Supply and Aggregate Demand
Prices
Output
114
QUANTITY THEORY OF MONEY

Where changes in prices are caused predominantly by changes in the
supply of money in the economy
MV = PT
M = money supply
V = velocity of circulation
P = the average price of each transaction
T = the number of transactions in a year
115
INFLATION ISSUES
 Uncertainty
 Resource costs
 Economic growth and Investment
116
UNEMPLOYMENT
The non-utilisation of labour resources as a result of which the actual
output of the economy is below its potential output
TYPES
a) STRUCTURAL
b) SEASONAL
c) VOLUNTARY
d) FRICTIONAL
e) TECHNOLOGICAL
f) CYCLICAL
117
CAUSES OF UNEMPLOYMENT
1. DEMAND DEFICIENCY
 A fall in aggregate demand below the level required for full employment
may result in a fall in:-
a) Consumer expenditure
b) Business investment
c) Exports
d) Government expenditure
2. STRUCTURAL CHANGE
 Occurs all the time but sometimes this change is particularly rapid and
thus structural unemployment is likely to arise, maybe because of:-
a) Rapid technological change
b) Shifts in world economy
118
SUPPLY-SIDE PROBLEMS
 If there is a shift in the aggregate supply curve to the left, national income
will be in equilibrium at a lower level – implying a higher rate of
unemployment
 The most important supply-side factors as those operating in the labour
market, factors such as:-
a) Trade Unions
b) Labour market regulation
c) Social security systems
EFFECTS OF UNEMPLOYMENT
 Economic
 Social
 Financial
 Political costs of unemployment
FULL EMPLOYMENT NATIONAL INCOME
119
Prices
Output
INFLATIONARY GAP
Prices
Output
DEFLATIONARY GAP
120
Prices
Output
STAGFLATION
Prices
Output
121
THE RELATIONSHIP BETWEEN INFLATION AND

UNEMPLOYMENT
THE PHILLIPS CURVE
122
LEARNING OUTCOME
A1b - Explain the stages of the trade cycle, its causes and consequences for the policy
choices of government
A1c – Explain the consequences of the trade cycle for organisations
TRADE CYCLE
STAGES OF THE CYCLE

 TROUGH
 RECOVERY
 PEAK
 DOWNTURN
123
LEARNING OUTCOME
A1d - Explain the main principles of public finance (i.e. deficit financing, forms of
taxation) and macroeconomic policy.
A1e – Describe the impacts on organisations of potential policy responses of
government, to each stage if the trade cycle.
ECONOMIC GROWTH
 The growth of productive potential for the economy
 Increase in real GNP
FACTORS INFLUENCING ECONOMIC GROWTH

 The amount of economic resources
 The productivity of these factors of production
 Investment of capital
 Quantity and quality of labour
124
POLICIES TO IMPLEMENT GOVERNMENT OBJECTIVES
1. Monetary policy
2. Fiscal policy
3. Supply-side policy
MONETARY POLICY – Money Supply and Interest Rates
 Concerned with managing the monetary environment

 Done by affecting:-
a) Availability of credit
b) Price of credit – interest rates
125
Effects Of Interest Rate Changes
Increase in rates
Overall DEFLATE the economy
INTERNAL EFFECTS
 Spending falls
 Investment falls
 Asset values fall
EXTERNAL EFFECTS
 Foreign funds attracted into the country
 The exchange rate rises
Decrease in rates
 Spending increases
 Investment increases
 Exchange rate falls
126
POLICIES
 LOOSE
 TIGHT
LIMITATIONS OF MONETARY POLICY

 Restricted information
 Dislike of close supervision
 Restrictive control
 Conflicting objectives
127
FISCAL POLICY – taxation and government spending
TAXATION
GOVERNMENT SPENDING
128
PUBLIC SECTOR NET CASH REQUIREMENT (PSNCR)

 The difference between central government income and expenditure is termed
the budget deficit
 Balance was regarded as public sector borrowing (PSBR) now PSNCR
DEFICIT
SURPLUS
PROBLEMS OF GOVERNMENT BORROWING
129
SUPPLY SIDE POLICY

Managing aggregate supply in the economy
Changes in the conditions of aggregate supply can cause an increase in output

and employment
Prices
National income
Supply side policies
 Reduction in taxes
 Reduction in unemployment benefits
 Reduce power of trade unions
 Emphasis on vocational training and education
 Deregulation and privatisation
130
LEARNING OUTCOME
A2a - Explain the concept of the balance of payments and its implications government
policy.
A2b - Identify the main elements of national policy with respect to trade
A3a - Explain the concept and consequences of globalization for businesses and
national economies.
A3b - Identify the major institutions promoting global trade and development.
THE INTERNATIONAL ECONOMY
GLOBALISATION AND TRADE

BENEFITS
 Specialisation
 Economies of Scale
 Competition
 Increased choice
131
TRADE PROTECTION
REASONS FOR PROTECTION

 To protect employment
 To help a new industry
 To prevent unfair competition
 To protect the balance of payments
 To maintain security
132
ARGUMENTS AGAINST PROTECTION

 Insufficient is encouraged
 Resources are misallocated
 The cost of living is raised
 Welfare gains will be lost
 Retaliation may occur
METHODS OF PROTECTION
 Tariffs
 Quotas
 Hidden restrictions
 Subsidies
133
BALANCE OF PAYMENTS
Balance of payments records all transactions between one country and the
rest of the world
CURRENT ACCOUNT
 Trade in goods
 Trade in services
 Income (interest, profit and dividends)
o Income from employment of UK residents by overseas firms
o Income from capital investment overseas
 Transfers
o Public sector payment to and receipts from overseas bodies e.g.
EU
o Non government sector payments to and receipts from overseas
bodies e.g. EU
CAPITAL ACCOUNT
 Public sector flow of capital into and out of the country
FINANCIAL ACCOUNT
 Non government sector flows of capital into and out of the country
o Direct investment in overseas businesses
o Portfolio investment
 Movements on government foreign currency reserves
134
 SURPLUS
 DEFICIT
135
THE INTERNATIONAL MONETARY FUND (IMF)
 Promotes international monetary co-operation
 Facilitates the expansion and balances growth of international trade
 Promote exchange rate stability
 Supports members who are experiencing balance of payments difficulties
THE WORLD BANK
 Provides loans and grants on favourable terms
 Provides analytical and advisory services
136

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Fundamentals of Business Economics

WAY TO PASSING THE EXAM

WHEN TO TAKE THE EXAM

THE BASIC ECONOMIC PROBLEM

The problem of allocating scarce resources to maximise

RESOURCES - REQUIRED TO PRODUCE GOODS

Factor of Production Reward

When WANTS (of RESOURCES) are GREATER than RESOURCES

 PRODUCERS must choose how to use their available resources, and

BASIC ECONOMIC ASSUMPTIONS

 PRODUCERS will seek to MAXIMISE their PROFITS

 CONSUMERS will seek to MAXIMISE the BENEFITS (UTILITY) from

 GOVERNMENTS will seek to MAXIMISE the WELFARE of their

KEY QUESTIONS TO BE ANSWERED

 To produce more of Good X will involve sacrificing some production of

 Measured in terms of the forgone volume of output of the alternative good

 For organisations, costs arises because their limited resources have

PRODUCTION POSSIBILITY CURVE

1. PRIVATE SECTOR ORGANISATIONS

Refers to all non-governmental organisations

b) Not-for profit organisations

2. PUBLIC SECTOR ORGANISATIONS

Refers to all government/state organisations

b) State owned industries

AIMS AND OBJECTIVES

INCREASE IN SHAREHOLDERS WEALTH/VALUE

 Where the management of a business is separated from the ownership of

ALTERNATIVE MANAGERIAL GOALS

 Williamson’s management discretion model

System by which organisations are directed and controlled

FAILURES OF CORPORATE GOVERNANCE

 Emphasis on short-term profitability

 Misleading accounts and information

 Domination by a single or group of individuals

 Lack of involvement by the board

 Lack of independent scrutiny

 Lack of contact with shareholders

ADVANTAGES OF IMPROVING CORPORATE GOVERNANCE

 Reduces risk of financial failure or breaching regulations

 Improves performance and quality of decision making

CORPORATE GOVERNANCE REFORM

1991 – Cadbury Committee

1995 – Greenbury Report

1998 – Hempel Commitee

1998 – Combined Code

principles and specific provisions, including:

 Chairman and Chief Executive positions to be held by different people

 Board members to include both executive and non-executive directors

 Directors pay to be determined by a remuneration committee

 Companies should have an audit committee

Anyone that has an interest in the strategy and behaviour of an

POWER AND INFLUENCE

B1b) - Explain shareholder wealth, the variables affecting shareholder

Objective of a business is to MAXIMISE SHAREHOLDER WEALTH

 VALUE OF THEIR SHARES

SHORT-TERM MEASURES OF FINANCIAL PERFORMANCE

EARNINGS PER SHARE (EPS)

PRICE EARNINGS (P/E) RATIO

LONG-TERM MEASURES OF FINANCIAL PERFORMANCE

1 - Dividend valuation model

This uses the current and expected stream of dividends

2 – Free cash flow valuation