The Association of Business Executives

Diploma

1.11 EPAB
EPAB1210

Economic Principles and

their Application to Business
Morning 29 November 2010

1 Time allowed: 3 hours.

2 SECTION A consists of a compulsory question comprising five TRUE/FALSE elements.

3 Answer any THREE questions from a choice of seven in SECTION B.

4 All questions carry 25 marks. Marks for subdivisions of questions are shown in brackets.

5 No books, dictionaries, notes or any other written materials are allowed in this
examination.

6 Calculators, including scientific calculators, are allowed providing they are not
programmable and cannot store or recall information. Electronic dictionaries and
personal organisers are NOT allowed. All workings should be shown.

7 Candidates who break ABE regulations, or commit any misconduct, will be disqualified
from the examinations.

8 Question papers must not be removed from the Examination Hall.

EPAB1210 © ABE 2010 L/500/3695

 SECTION A

Candidates must answer Question 1 (Compulsory)

Q1 State whether each of the following statements (a-e) is TRUE or FALSE.

Explain your answer clearly, using diagrams where appropriate.

(a) A demand curve for a commodity is usually drawn on the assumption that factors
influencing demand other than price are held constant. (5 marks)

(b) Look at the diagram below which illustrates the marginal cost (MC) and the marginal
revenue (MR) conditions for a profit maximising firm operating in a perfectly competitive
market.

PRICE
(per
unit) MC
(£s)

MR

0 Q1 Q2 Q3 OUTPUT

Under these conditions, the firm will maximise profits at the output level Q2. (5 marks)

(c) The following is an example of a positive economic statement:

“An increase in income tax will cause a rise in unemployment.” (5 marks)

(d) A depreciation of an open economy’s foreign exchange rate is likely to reduce the
pressure of cost-push inflation in that economy. (5 marks)

(e) Look at the table below which shows two countries, the UK and France, which, before
trade, each produce two products, bread and wine. Assume that before trade they each
devote half of all their productive resources to the production of bread and half to the
production of wine.

Bread Wine
(units of productive resource) (units of productive resource)
UK 20 10
France 16 4

Based on the above information, we can conclude that France should specialise in
wine production because the Opportunity Cost of producing bread in France is higher
than the Opportunity Cost of producing bread in the UK. (5 marks)
(Total 25 marks)

EPAB1210 2
 SECTION B

Answer any THREE questions from this section

Q2 (a) Explain the term ‘price elasticity of demand’. (4 marks)

(b) Identify three factors that might influence the price elasticity of demand of a product.
(6 marks)

(c) The table below shows the level of demand for a firm’s product at different prices:

Price per unit (£) 0 1 2 3 4 5 6 7 8 9 10 11 12

Demand (000s) 12 11 10 9 8 7 6 5 4 3 2 1 0

(i) Using the graph paper provided in the answer book, draw an accurate graph of
the demand schedule based on the data from the table above. Fully label your
graph. (6 marks)

(ii) Calculate the price elasticity of demand when the price is £10. (3 marks)

(iii) What is the price when the price elasticity of demand is zero? Explain your
answer. (3 marks)

(iv) The firm’s current price is £4 per unit. Outline what will happen to its total revenue
if it increases its price to £6 per unit. (3 marks)
(Total 25 marks)

EPAB1210 3 [Turn over

Q3 (a) Explain why a firm’s supply curve (an example of which is shown below), will normally
slope upwards from left to right.

PRICE
(per unit)
(£s) S (SUPPLY)

0 QUANTITY (5 marks)

(b) Starting from an initial position of market equilibrium for a good, use demand and
supply diagrams to explain what happens to the market equilibrium price and quantity
in each of the following situations:

(i) The government decides to subsidise the production of this good. (6 marks)

(ii) There is a significant increase in the cost of the factors of production necessary
to produce this good. (6 marks)

(c) The diagram below shows the effect of a specific tax on the supply of a product. SO
represents supply before tax and ST represents supply after tax. D represents demand.

PRICE ST
(£s)

16
SO

10
8

D
0
100 120 QUANTITY

(i) Calculate the value of the specific tax. (2 marks)

(ii) Calculate the percentage of the tax paid by the producer. (3 marks)

(iii) Calculate the total tax revenue received by the government. (3 marks)
(Total 25 marks)

EPAB1210 4
Q4 (a) Draw an accurately labelled diagram to illustrate how a profit maximising monopoly
might operate in a long-run equilibrium situation. Identify the profit maximising price,
the profit maximising level of output and the total profit gained. (10 marks)

(b) Explain why a monopoly might operate at a level of output which will produce:

(i) Abnormal profits (5 marks)

(ii) X-inefficiency (5 marks)

(iii) A ‘Deadweight Welfare Loss’ (5 marks)

(Total 25 marks)

Q5 (a) Outline the key characteristics of a firm operating in monopolistic competition.

(10 marks)

(b) The diagram below shows a firm operating in monopolistic competition:

PRICE
(£s)

AC
MC
60
50
40
12
10 MR AR
50 60 90 100 OUTPUT (Q)

(i) Identify and explain the profit maximising level of output and price. (5 marks)

(ii) Calculate the total profits earned at the profit maximising level of output. Explain
your answer. (5 marks)

(iii) Identify the level of output which will produce a normal profit. Explain your
answer. (5 marks)
(Total 25 marks)

EPAB1210 5 [Turn over

Q6 (a) Describe the key factors which might affect an individual’s savings and an individual’s
consumption expenditure. (10 marks)

(b) Distinguish between the Average Propensity to Save (APS) and the Marginal
Propensity to Save (MPS). (5 marks)

(c) In a simple two sector economy C = 50 + 0.9 Y and I = 100

Where C = Consumption Expenditure, Y = National Income and I = Investment

Expenditure.

(i) Calculate the MPS. (2 marks)

(ii) Calculate the investment multiplier. (2 marks)

(iii) Calculate the equilibrium level of national income. (3 marks)

(iv) Explain why a decision to engage in international trade might affect the value of
the investment multiplier. (3 marks)
(Total 25 marks)

Q7 (a) Draw a fully labelled diagram to show the Keynesian explanation of the determination
of interest rates. (5 marks)

(b) If a Central Bank decides to reduce the level of interest rates, discuss the possible
effects on:

(i) The consumer (5 marks)

(ii) A business (5 marks)

(iii) The government (5 marks)

(iv) The money supply (5 marks)

(Total 25 marks)

EPAB1210 6
Q8 (a) Explain the Purchasing Power Parity (PPP) theory. (5 marks)

(b) Using the PPP theory, calculate the exchange rate between the UK pound and the US
dollar if:

(i) A basket of goods can be bought for £100 in the UK and the same basket of
goods can be bought for $180 in the US. (4 marks)

(ii) Due to inflation, prices rise by 10% in the UK and by 5% in the US over the next
year. (6 marks)

(c) Discuss the advantages and disadvantages of a floating exchange rate system.
(10 marks)
(Total 25 marks)

End of Question Paper

EPAB1210 7
 Examiner’s Suggested Answers

Q1

(a)
Students will receive marks for:
• recognising that the statement is true
• stating that a price change will cause a movement along a demand curve whilst all
other factors will cause the curve to shift
• stating that this assumption will then allow an examination of the relationship
between changes in price and subsequent change in demand

(b)
Students will receive marks for:
• recognising that the statement is false
• recognising that the firm can still add to profit by increasing output to Q3 because MR
is greater than MC between Q2 and Q3
• explaining that Q3 is the profit maximising output because MC=MR when MC is
upward sloping.
• stating that the profit maximisation point is where MC=MR
• stating profit maximisation output will be Q3

(c)
Students will receive marks for:
• recognising that the statement is true
• stating that it is possible to measure changes in income tax and changes in
unemployment
• recognising that the statement can be tested by observing factual evidence
• explaining that the statement is value free and can be tested by an appeal to the
facts

(d)
Students will receive marks for:
• recognising that the statement is false
• explaining that a depreciation will result in a fall in value of that economy’s currency.
• recognising that a fall in the value of the currency will make imports more expensive.
• linking a depreciation to the increase in the price of certain imports, for example raw
materials, which will increase costs and this is likely to result in rising prices and
increase the pressure of cost push inflation in that economy.

(e)
Students will receive marks for:
• recognising that the statement is false
• stating that the UK should specialise in wine and France should specialise in bread
• explaining that the opportunity cost of producing wine in the UK is 2 bread whereas
the opportunity cost of producing wine in France is 4 bread. Therefore UK has a
 lower opportunity cost of producing wine and therefore should specialise in wine
production whilst France should produce bread.

Q2

(a)
• Students will receive marks for definition of price elasticity of demand:
• Price elasticity of demand measures the responsiveness of demand to a change in
price. It can be calculated by dividing the percentage change in the quantity
demanded by the percentage change in price.
• Students will receive marks for price elasticity of demand formula.

(b)
• Students will receive marks for each factor identified.
• Factors would include the availability of substitutes; the proportion of ones income
accounted for by the price of the good; the time period between the change in price
and the need to purchase the good; the number of alternative uses to which the good
could be put.
• No marks were given for answers which only discuss factors which affect demand.

(c)
(i)
downward sloping demand curve, drawn accurately
correct label horizontal axis i.e. quantity demanded per time period
correct label vertical axis i.e. price per unit

(ii)
Students will receive marks for:
• Correct formula – percentage change in quantity demanded divided by percentage
change in price
• Correct working but wrong answer
• Correct answer (Ped = 5)

(iii)
• Students will receive marks for calculation showing price elasticity of demand equals
zero
Ped = P x change in Q
Q x change in P
When Ped = 0 therefore price = 0

• Marks for identifying correct price from the table (Price = 0)

• Mark for an appropriate explanation

(iv)
Students will receive marks:
• for calculating total revenue (price x quantity sold) when price equals £4 per unit x 8
=(£32)
• for calculating total revenue when price equals £6 x 6 per unit = (£36)
• for correct calculation of the change in revenue after the price change (Change in
TR = £4)
• if they state that TR will be £36
• if they state that TR will rise
Q3

(a)
• for explaining that as output rises costs are also likely to rise therefore firms are only
willing to increase output if prices also rise
• for explaining that as prices rise, total revenue is likely to rise therefore more will be
supplied at higher prices
• if they state that it will lead to an increase in profits

(b)
(i)
• Marks for correct explanation:
A subsidy will lead to an increase in supply, this will lead to a downward shift to
the right of the supply curve and this will reduce the equilibrium price and lead to
an increase in the amount sold.
• Marks for accurate, correctly labelled diagram
(ii)
Up to 4 marks for a correct explanation
An increase in the cost of factors of production will lead to a decrease in supply, this will
produce an upward shift to the left of the supply curve and this will increase the equilibrium
price and lead to a decrease in the amount sold.
Up to 4 marks for accurate, correctly labelled diagram

(c)
(i)
Marks for correct value (£8)
(ii)
Marks for correct percentage or correct proportion £2 (25%)
£8
(iii)
Marks for correct calculation (£800) £8 x 100

Q4

(a)
Students will receive marks for:
• an accurately labelled diagram
• identifying profit maximising price; profit maximising price would equal AR at profit
maximising output
• identifying profit maximising output; profit maximising output would be where MC =
MR
• showing total profit gained; Total profit gained would be attained by subtracting Total
Costs from Total Revenue at the profit maximising output
(b)
(i)
• Marks for definition of abnormal profits:
Abnormal profits are those profits above those necessary to cover a firm’s
opportunity costs
• Marks for use of diagram to explain why a monopoly might produce abnormal profits

(ii)
• Marks for definition of X-inefficiency:
X-inefficiency is a measure of the excess cost of production of output of a
good or service by an organisation over the cost of producing the same
output in the most efficient available organisation.
• Marks for a relevant diagram
• Marks for an explanation linking to monopoly:
Monopolies due to their market power and lack of market competion often
lack the drive to keep their operating costs to a minimum and frequently incur
higher costs associated with excess bureaucracy.

(iii)
• Marks for explanation of a ‘Deadweight Welfare Loss’:
Deadweight welfare loss is the loss of consumers’ plus producers’ surplus in
imperfect markets, compared with perfect competition.
• Marks for use of diagram to identify and explain concept of deadweight welfare loss

Q5

(a)
• Marks for each characteristic:
• Characteristics might include : freedom of entry and exit; differentiated product; small
firms; perfect knowledge; price makers; profit maximisers; normal profit only in the
long run.
• No marks for describing characteristics associated with Monopoly.

(b)
(i)
• Marks for correct output and price (output = 60 price = £60)
• Marks for correct explanation
• Profit maximisation would be attained where MR = MC

(ii)
• Marks for correct calculation of profits (profit = £600)
• Marks for correct explanation:
 Profits would be calculated by subtracting total costs = £3000 from total
revenue of £3600, at the profit maximising output of 60.

(iii)
• Marks for correct output (output = 100)
• Marks for correct explanation:
Normal profit would be attained where Total Cost is equal to Total Revenue or
where Average Cost equals Average Revenue, this would be achieved when
output = 100 because AC = AR at this level of output.

Q6

(a)
• Marks for each determinant of savings
Determinants would include: level of income; interest rates; attitudes to thrift;
distribution of income; government policy; expectations.
• Marks for each determinant of consumption expenditure
Determinants would include: level of income; availability and cost of credit;
government policy; level of wealth; expectations of inflation.

(b)
• Marks for formula and explanation of Average Propensity to Save
• Average propensity to save is the total savings as a proportion of the individual’s total
income
APS = S
Y
• Marks for formula and explanation of Marginal Propensity to Save
• Marginal propensity to save is the change in an individual’s income as a proportion of
the change in the individual’s income.

MPS = Change in S
Change in Y

(c)
(i)
Marks for correct calculation (mps = 0.1)
Marks for correct formula

(ii)
Marks for correct calculation (multiplier = 10)
Marks for correct formula

(iii)
Marks for correct formula
Marks for correct calculation (equilibrium Y = 1500)
(iv)
Marks for correct explanation
Marks for reference to an increase in imports
Marks for reference to an increase in withdrawals
Marks for a reference to a decrease in the value of the multiplier

Q7

(a)
Mark for each correctly labelled axis
Mark for correct supply of money curve
Mark for correct demand for money curve
Mark for correctly identifying equilibrium rate of interest

(b)
(i)
Marks for each possible effect identified and discussed
Effects might include: savings; credit expansion; expenditure; expectations.

(ii)
Marks for each possible effect identified and discussed
Effects might include: savings; borrowing; investment; profits; expectations.

(iii)
Marks for each possible effect identified and discussed
Effects might include: cost of servicing the national debt; cost of financing the public sector
borrowing requirement; expectations and inflation; economic growth; exchange rate.

(iv)
Marks for each possible effect identified and discussed
Effects might include: increase in bank lending leading to an increase in bank deposits thus
leading to an increase in the money supply; increase government borrowing therefore
leading to an increase in the money supply; decrease in exchange rates therefore leading to
outflow of short term capital, thus possibly decreasing the money supply.

Q8

(a)
• Marks for correct formula
PPP = Value of basket of goods in country A
Value of same basket of goods in country B
• Marks for correct explanation
PPP suggest that exchange rates will be in long run equilibrium when the rate when
the rate enables people in different countries to buy the same basket of goods with
 an equal amount of money. It equates the long run exchange rate with the relative
inflation rates in each country.

(b)
(i)
• Marks for correct formula (see above)
• Marks for correct calculation (£1 =$1.80 or $1 = £0.55)
• Accept exchange rate calculation either way around i.e. £s in $ and vice versa
• Currency sign not needed to gain full marks but must calculate correct answer

(ii)
• Marks for calculating inflation effect in UK
• Marks for calculating inflation effect in US
• Marks for correct calculation (£1= $1.718 or $1 = £0.58)

(c)
• Marks for each advantage identified and explained
• Benefits might include: balance of payments would be self correcting; interest rates
can be kept free to be part of domestic monetary policy; it is not necessary to keep
large amounts of foreign exchange reserves.

• Marks for each disadvantage identified and explained

• Disadvantages might include: might create uncertainty on international markets;
levels of investment by businesses might be negatively affected; increase
transactions costs; possible negative effects of speculation; may worsen existing
levels of inflation.