Q. What is a Firm and explain its different types?

Answer:

Firm: Firm is a basic producing unit. A firm is a commercial enterprise, a company that buys and sells
products and/or services to consumers with the aim of making a profit.

 A sole proprietorship or sole trader is owned by one person, who is liable for all costs and
obligations, and owns all assets. Although not common under the firm umbrella, there exists
some sole proprietorship businesses that operate as firms.
 A partnership is a business owned by two or more people; there is no limit to the number of
partners that can have a stake in ownership. A partnership's owners each are liable for all
business obligations, and together they own everything that belongs to the business.
 In a corporation, the businesses' financials are separate from the owners' financials. Owners
of a corporation are not liable for any costs, lawsuits, or other obligations of the business. A
corporation may be owned by individuals or by a government. Though business entities,
corporations can function similarly to individuals. For example, they may take out loans, enter
into contract agreements, and pay taxes. A firm that is owned by multiple people is often called
a company.
 A financial cooperative is similar to a corporation in that its owners have limited liability, with
the difference that its investors have a say in the company's operations.

Q. Define economies of scale and factors which are responsible for economies of scale?

Answer:

Economies of scale are the advantages, in the form of reduced cost per unit of goods or services
produced, that result from large scale production. When more and more units are produced during a
given length of time, the percentage increase in total cost is less than the percentage increase in total
units. But only up to a certain limit i.e. there is an upper limit on production beyond which the
advantages of large-scale production begin to decline (known as diseconomies of scale).

Economies of scale are sometimes classified into internal and external economies of scale. Internal
economies arise from factors within the firm whereas external economies are caused by factors
in the environment in which the firm operates.
Factors
Major factors causing economies of scale are:

Specialization:
Firms producing at a large scale employ a large number of workers. This allows the firms to practice
specialization by splitting jobs into smaller tasks. These individual tasks are assigned to separate
workers. In this way workers spend all their work time on the part they know best and it also allows
them to perfect their skills. Overall result of this is that an average unit is produced at lower cost.
Specialization also works at management level.

Efficient Capital:
The most efficient machines and equipment are based on cutting edge technology and have high
production capacity. Firms with large scale production can afford such equipment and benefit from their
full capacity. At full utilization such machinery or equipment achieves lower production cost per unit.
Firms having small scale production either cannot afford such equipment or cannot utilize such
machinery to its full capacity.

Negotiation Power:
Larger firms are in powerful position to negotiate better outcomes with parties such as suppliers, labor
unions, financial institutions and government. When purchasing raw material, larger firms can obtain
better trade discounts by bulk purchasing. They can negotiate lower wages because people are eager to
work at large companies even at low wages (not below minimum wage of course). Financial institutions
such as banks are more willing to offer loans at lower interest rate to well-established firms having large
scale production.
Purchasing:
Firms might be able to lower average costs by buying the inputs required for the production process in
bulk or from special wholesalers.

Managerial:
Firms might be able to lower average costs by improving the management structure within the firm. The
firm might hire better skilled or more experienced managers.

Technological:
A technological advancement might drastically change the production process. For instance, fracking
completely changed the oil industry a few years ago. However, only large oil firms that could afford to
invest in expensive fracking equipment could take advantage of the new technology.

Q. What is a business cycle? Explain its phases and discuss how these phases can affect the
business activity?

Answer:

Business Cycle: It consists of alternative periods of rise and fall in the level of economic activity.

Stages of the Business Cycle

All business cycles are characterized by several different stages, as seen below.

1. Expansion
This is the first stage. When the expansion occurs, there is an increase in employment, incomes,
production, and sales. People generally pay their debts on time. The economy has a steady flow in the
money supply and investment is booming.

2. Peak
The second stage is a peak when the economy hits a snag, having reached the maximum level of growth.
Prices hit their highest level, and economic indicators stop growing. Many people start to restructure as
the economy's growth starts to reverse.

3. Recession
These are periods of contraction. During a recession, unemployment rises, production slows down, sales
start to drop because of a decline in demand, and incomes become stagnant or decline.

4. Depression
Economic growth continues to drop while unemployment rises and production plummets. Consumers
and businesses find it hard to secure credit, trade is reduced, and bankruptcies start to increase.
Consumer confidence and investment levels also drop.

5. Trough
This period marks the end of the depression, leading an economy into the next step: recovery.
6. Recovery
In this stage, the economy starts to turn around. Low prices spur an increase in demand, employment
and production start to rise, and lenders start to open up their credit coffers. This stage marks the end of
one business cycle.

Impact on Business Operations

How the business cycle affects business operations may be best explained by looking at how one
business responds to these cycles. Normal Maintenance is a small business that provides a variety of
construction services to homeowners. They specialize in roofing, deck installations, siding, and general
home maintenance. They employ three full-time workers, who typically work forty hours per week
for an average of twelve dollars per hour. The company has been in business in the same town for than
twenty years and has a solid reputation for quality work and reliability.

Expansion

Normal Maintenance is busy and has recently had to turn down jobs because it lacks the capacity to do
all the work offered. Homeowners now want to make home repairs and improvements which they had
had to put off during the sour economy. With the economy improving, others are fixing up their homes
to sell. Faced with so much demand, the owner of Normal Maintenance must decide whether to pay his
existing workers overtime (which will increase the costs for each job and reduce profits) or hire
additional workers. The competition for qualified construction labor is steep, and he is concerned that
he will have to pay more than his usual rate of twelve dollars per hour or possibly get workers who are
not as qualified as his current crew. He is, however, able to charge higher prices for his work because
homeowners are experiencing long waits and delays getting bids and jobs completed.  The owner
purchases a new truck and invests in additional tools in order to keep up with the demand for services.
Customers are willing to pay more than usual so they can get the work done. Business is expanding to
such an extent that Normal Maintenance and its suppliers are starting to have trouble obtaining
materials such as shingles and siding because the manufacturers have not kept pace with the economic
expansion. In general, business is great for Normal Maintenance, but the expansion brings challenges.

Peak  

At the peak of the business cycle, the economy can be said to be “overheated.” Despite hiring additional
workers, the owner and crews of Normal Maintenance are working seven days a week and are still
unable to keep up with demand. They can’t work any harder or faster. As a result, the crews are
exhausted and the quality of their work is beginning to decline. Customers leave messages requesting
work and services, but the owner is so busy he doesn’t return phone calls. Jobs are getting started and
completed late as the crews struggle to cover multiple job sites. As a result, customer complaints are on
the rise, and the owner is worried about the long-term reputation of the business. Neither the business
nor the economy can sustain this level of activity, and despite the fact that Normal Maintenance is
making great money, everyone is ready for things to let up a little.

Contraction

As the economy begins to contract, business begins to slow down for Normal Maintenance. They find
that they are caught up on work and they aren’t getting so many phone calls. The owner is able to
reduce his labor costs by cutting back on overtime and eliminate working on the weekends. When the
phone does ring, homeowners are asking for bids on work—not just placing work orders. Normal
Maintenance loses out on several jobs because their bids are too high. The company begins to look for
new suppliers who can provide them with materials at a cheaper price so they can be more competitive.
The building material companies start offering “deals” and specials to contractors in order to generate
sales. In general, competition for work has increased and some of the businesses that popped up during
the expansion are no longer in the market. In the short term the owner is confident that he has enough
work to keep his crew busy, but he’s concerned that if things don’t pick up, he might have to lay off
some of the less experienced workers.

Trough

On Monday morning, the crew of Normal Maintenance show up to work and the owner has to send
them home: there’s no work for them. During the week before, they worked only three days, and the
owner is down to his original crew of three employees. Several months ago he laid off the workers hired
during the expansion. Although that was a difficult decision, the owner knows from hard experience
that sometimes businesses fail not because their owners make bad decisions, but because they run out
of money during recessions when there isn’t enough customer demand to sustain them. Without
enough working capital to keep the doors open, some are forced to close down.

Representatives from supply companies are stopping by the office hoping to get an order for even the
smallest quantity of materials. The new truck and tools that the owner purchased during the boom now
sit idle and represent additional debt and costs. The company’s remaining work comes from people who
have decided to fix up their existing homes because the economy isn’t good enough for them to buy
new ones. The owner increases his advertising budget, hoping to capture any business that might be
had. He is optimistic that Normal Maintenance will weather this economic storm—they’ve done it
before—but he’s worried about his employees paying their bills over the winter.
Q. Explain in detail different recessionary strategies, which can be used by business in
order to minimize the losses?

Answer:

The primary policies will be

 Loosening of monetary policy – cutting interest rates to reduce cost of

borrowing and encourage investment
 Expansionary fiscal policy – increased government spending financed
by borrowing will enable an injection of investment into circular flow
 Ensure financial stability – in a credit crunch, government intervention to
guarantee bank deposits and major financial institutions can maintain
credibility in the banking system.

Policies:

1. Expansionary monetary policy – cutting interest rates.  Cutting interest

rates should help to boost aggregate demand. Amongst other things, lower
interest rates reduce mortgage interest payments, giving consumers more
disposable income. Lower interest rates also encourage firms and consumers to
spend rather than save. (effect of lower interest rates)
As well as cutting base rates, the monetary authorities could try and reduce other
interest rates in the economy. e.g. the Central Bank could buy government bonds
or mortgage securities. Buying these bonds causes lower interest rates and
helps to boost spending in the economy.
2. Expansionary fiscal policy
Expansionary fiscal policy involves increasing government spending and/or
cutting taxes. This injection into the circular flow is financed by government
borrowing. If the government cut income tax or VAT, it increases disposable
income and therefore increases spending.

If effective expansionary fiscal and monetary policy will increase AD and lead to
increase in real GDP.

 There is no guarantee tax cuts will boost spending if confidence is very

low. Some economists are concerned higher government borrowing will
cause crowding out – where private sector lend to the government and
then spend less themselves. However, Keynes argued in recession, there
are surplus savings, so there will be no crowding out and fiscal policy will
be effective in boost demand and preventing a recession. Can tax cuts
avoid a recession?
 Expansionary fiscal policy is less practical for countries in the Euro, who
have less flexibility over borrowing levels in the Eurozone.

Other policies:

Higher Inflation Target.

A government bailout of major firms.

Ensure financial stability.

Devaluation.

Q. What is circular flow of income? Explain how it affects the business activities of business
person.

Answer:

The circular flow of income and spending shows connections between different

sectors of an economy
  It shows flows of goods and services and factors of production between firms and
households
 The circular flow shows how national income or Gross Domestic Product is
calculated

Leakages (withdrawals) from the circular flow

Not all income will flow from households to businesses directly. The circular flow shows
that some part of household income will be:

 1.Put aside for future spending, i.e. savings (S) in banks accounts and other
types of deposit
 2.Paid to the government in taxation (T) e.g. income tax and national insurance
 3.Spent on foreign-made goods and services, i.e. imports (M) which flow into the
economy

Withdrawals are increases in savings, taxes or imports so reducing the circular flow of

income and leading to a multiplied contraction of production (output)

Injections into the circular flow are additions to investment, government spending or

exports so boosting the circular flow of income leading to a multiplied expansion of
output.
 1. Capital spending by firms, i.e. investment expenditure (I) e.g. on new technology
2. The government, i.e. government expenditure (G) e.g. on the NHS or defence
3. Overseas consumers buying UK goods and service, i.e. UK export expenditure
(X)

An economy is in equilibrium when the rate of injections = the rate of

withdrawals from the circular flow.

Q. How does Inflation affects a business?

Answer:

Inflation: A state of rising prices/price level. Inflation is a sustained increase in the average price
level of an economy.
The rate of inflation is measured by the annual percentage change in the level of prices. In the
UK this is most commonly measured by the consumer price index.

Effect of Inflation on Consumers

 As prices rise (inflation) money loses its value and people lose confidence in money as
the value of savings is reduced
 Inflation can get out of control - price increases lead to higher wage demands as people
try to maintain their living standards
 Consumers on fixed incomes (e.g. pensioners) lose out because the their real incomes
fall

Effects of Inflation on Businesses

Positive effects:

 Industry-wide price rises enable revenues to grow

 Growing revenues + constant gross margin = higher gross profit
 Makes using debt as a source of finance cheaper in real terms

Negative effects:
  If costs are rising due to inflation, a business may not be able to pass them onto
customers (PED)
 Inflation can disrupt business planning and lead to lower investment
 Rising inflation is associated with higher interest rates - this reduces economic growth
and can lead to a recession

Loss:

 Fixed Income Group

 Creditors
 Savers

Gainer:

 Producer
 Stock lists
 Property Holders
 Debtor

Remains Unaffected:

 Self-Employed People
 Indexed Salary Recipients

Q. Monopolist is a business person, who can fix any high price. In order to maximize profit,
what price change will monopolist implement if elasticity of demand is E=0, E<1, E>1 ?

Answer: