CIMA Certificate Course Book

CIMA BA1
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2
Introduction to the course
Contents
Welcome to BA1 Fundamentals of Business Economics 4

Exam Technique Overview 10
Syllabus Content
1 Organisations and stakeholders 13
2 Measuring returns to shareholders 29
3 Demand, supply and price 45
4 Price elasticity 65
5 Cost behaviour 83
6 Market failure 101
7 National income 119
8 The trade cycle 139
9 Index numbers 157
10 Government economic policy 175
11 International economics 191
12 International trade 207
13 Functions of the financial system 219
14 Commercial and Central banks 233
15 Financial mathematical techniques 245
16 Impact of interest & exchange rate changes on business performance 269
17 Data and information 281
18 Forecasting 301
Test your learning answers 331
Appendix A: Present Value Tables 341
Bibliography 345
Index 347
3
Welcome to BA1 Fundamentals of Business Economics
Description of the paper
This subject primarily covers the economic and operating context of business and
how the factors of competition, the behaviour of financial markets and government
economic policy can influence an organisation. It also deals with the information
available to assist management in evaluating and forecasting the behaviour of
consumers, markets and the economy in general.
The focus of this syllabus is on providing candidates with an understanding of the
areas of economic activity relevant to an organisation's decisions and, within this
context, the numerical techniques to support such decisions.
Syllabus Areas and their weighting
Weight Syllabus topic
25% A. Macroeconomic and Institutional

Context of Business
30% B. Microeconomic and Organisational
Context of Business
20% C. Informational Context of Business
25% D. Financial Context of Business
The Objective Test exam

Format Computer Based Assessment
Duration 2 hours
Number of Questions 60
Marking No partial marking – each question marked correct or
incorrect
All questions carry the same weighting (ie same marks)
Weighting As per Syllabus Areas
All component learning outcomes will be covered
Question Types Multiple Choice
Multiple Response
Number Entry
Drag and Drop
Hot spot
Item Sets
Booking availability On demand
Results Immediate
4
Verb Hierarchy
LEVEL LEARNING OBJECTIVE VERBS USED DEFINITION

3
APPLICATION Apply Put to practical use
How you are expected Calculate Ascertain or reckon mathematically
to apply your knowledge
Demonstrate Exhibit by practical means
Prepare Make or get ready for use
Reconcile Make or prove consistent/compatible
Solve Find an answer to/prove with certainty
Tabulate Arrange in a table

2
COMPREHENSION Describe Communicate the key features of
What you are expected Distinguish Highlight the differences between
to understand
Explain Make clear or intelligible/state the meaning or purpose of
Identify Recognise, establish or select after consideration
Illustrate Use an example to describe or explain something

1
KNOWLEDGE List Make a list of
What you are expected State Express, fully or clearly, the details/facts of
to know
Define Give the exact meaning of
5
Learning Outcomes
A. Macroeconomic and institutional context of business (25%)
On completion of their studies, students should be able to:
Lead Component Level
1. Explain the principal (a) Explain determination of macroeconomic 2

factors that affect the phenomena, including equilibrium
level of a country's national income, growth in national
national income and income, price inflation, unemployment,
the impact of changing and trade deficits and surpluses
economic growth rates
(b) Explain the stages of the trade cycle 2
and prices on business.
and the consequences of each stage for
the policy choices of government
(c) Explain the main principles of public 2

finance (i.e. deficit financing, forms of
taxation) and macroeconomic policy
(d) Describe the impacts on business of 2

potential policy responses of government,
to each stage of the trade cycle
(e) Calculate indices for price inflation and 3

national income growth using either
base or current weights and use indices
to deflate a series
2. Explain the factors (a) Explain the concept of the balance of 2

affecting the trade of a payments and its implications for
country with the rest of government policy
the World and its
(b) Identify the main elements of national 2
impact on business.
policy with respect to trade
(c) Explain the impacts of exchange rate 2

policies on business
3. Explain the influences (a) Explain the concept of globalisation and 2

on economic the consequences for businesses and
development of national economies
countries and the
(b) Explain the role of major institutions 2
effects of globalisation
promoting global trade and development
on business.
(c) Identify the impacts of economic and 2
institutional factors using the PESTEL
framework
6
B. Microeconomic and Organisational Context of Business (30%)

1. Distinguish between the (a) Distinguish between the goals of profit 2

economic goals of seeking organisations, not-for-profit
various stakeholders organisations and governmental
and organisations. organisations
(b) Explain shareholder wealth, the 2

variables affecting shareholder wealth,
and its application in management
decision making
(c) Distinguish between the potential 2

objectives of management,
shareholders, and other stakeholders
and the effects of these on the
behaviour of the firm
2. Demonstrate the (a) Identify the equilibrium price in 2

determination of prices product or factor markets
by market forces and
(b) Calculate the price elasticity of 3
the impact of price
demand and the price elasticity of
changes on revenue
supply
from sales.
(c) Explain the determinants of the price 2
elasticities of demand and supply
(d) Calculate the effects of price elasticity 3

of demand on a firm's total revenue
curve
3. Explain the influence of (a) Identify the influence of costs on the 2

economic and social size and structure of the organisation
considerations on the
(b) Explain the sources of market failures 2
structure of the
and the policies available to deal with
organisation and the
them
regulation of markets.
7
C. Informational Context of Business (20%)
1. Apply techniques to (a) Explain the difference between data 2

communicate business and information and the
data as information to characteristics of good information
business stakeholders.
(b) Identify relevant data from graphs, 2
charts and diagrams
2. Demonstrate the uses of (a) Describe the principal business 3

big data and analytics applications of big data and analytics
for understanding the
(b) Demonstrate the relationship between 3
business context.
data variables
(c) Demonstrate trends and patterns using 3

an appropriate technique
(d) Prepare a trend equation using either 3

graphical means or regression
analysis
(e) Identify the limitations of forecasting 2

models
D. The financial context of business (25%)

1. Explain the functions of (a) Explain the role of various financial 2

the main financial assets, markets and institutions in
markets and institutions assisting organisations to manage
in facilitating commerce their liquidity position and to provide
and development. an economic return to providers of
liquidity
(b) Explain the role of commercial banks 2

in the process of credit creation and in
determining the structure of interest
rates and the roles of the 'central
bank' in ensuring liquidity
(c) Explain the role of the foreign 2

exchange market in facilitating trade
and in setting exchange rates
8
2. Apply financial (a) Calculate future values of an 3

mathematical techniques investment using both simple and
in a business decision- compound interest
making context.
(b) Calculate the present value of a future 3
cash sum, an annuity and a perpetuity
3. Demonstrate the impact (a) Describe the impact of interest rate 2

of changes in interest changes on market demand and the
and exchange rates on costs of finance
controlling and
(b) Calculate the impact of exchange rate 3
measuring business
changes on export and import prices
performance.
and the value of the assets and
liabilities of the business
(c) Explain the role of hedging and 2

derivative contracts in managing the
impact of changes in interest and
exchange rates
9
Exam Technique Overview
1 The Best Approach to the CBA
You're not likely to have a great deal of 'spare time' during the CBA itself so
you must make sure you don't waste a single minute.
You should:
1. Work through the whole exam, answering any questions you think you
can answer correctly in a reasonably short time. If you find on occasion
that you are not very confident with your answer, click the 'Flag for
Review' button before moving on.
2. Click 'Next' for any that have long scenarios or are very complex and
return to these later.
th
3. When you reach the 60 question, use the Review Screen to return to any
questions you skipped past or any you flagged for review
Here's how the tools in the exam will help you to do this in a
controlled and efficient way:
The 'Next' button
What does it do? This will move you on to the next question whether or not
you have completed the one you are on.
When should I use it? Use this to move through the exam on your first pass
through if you encounter a question that you suspect is going to take you a
long time to answer. The Review Screen (see below) will help you to return to
these questions later in the exam.
The 'Flag for Review' button
What does it do? This button will turn the icon yellow and when you reach the
end of the exam questions you will be told that you have flagged specific
questions for review. If the exam time runs out before you have reviewed any
flagged questions then they will be submitted as they are.
When should I use it? Use this when you've answered a question but you're
not completely comfortable with your answer. If there is time left at the end
then you can quickly come back via the Review Screen (see below) but if time
runs out at least it will submit your current answer. Do not use the Flag for
Review button too often or you will end up with too long a list to review at the
end. Important Note – scientific studies have shown that you are usually best to
stick with your first instincts(!)
The Review Screen
What does it do? This screen appears after you click 'Next' on the 60 question.
th
It shows you any Incomplete Questions and any you have Flagged for Review. It
allows you to jump back to specific questions OR work through all your
Incomplete Questions OR work through all your Flagged for Review Questions.
When should I use it? As soon as you've completed your first run through the
th
exam and reached the 60 question. The very first thing to do is to work through
10
all your Incomplete Questions as they will all be marked as incorrect if you don't
submit an answer for these in the remaining time. Importantly, this will also help
to pick up any questions you thought you'd completed but didn't answer
properly (eg you only picked two answer options in a multi-response question
that required three answers to be selected). After you've submitted answers for
all your Incomplete Questions you should use the Review Screen to work through
all the questions you Flagged for Review.
2 The different Objective Test Question Types
Passing your CBA is all about demonstrating your understanding of the
technical syllabus content. You will find this easier to do if you are comfortable
with the different types of Objective Test Questions that you will encounter in
the CBA, especially if you have a practised approach to each one.
You will find yourself continuously practising these styles of questions
throughout your Objective Test programme. This way you will check and
reinforce your technical knowledge at the same time as becoming more and
more comfortable with your approach to each style of question.
Multiple choice
Standard multiple choice items provide four options. 1 option is correct and
the other 3 are incorrect. Incorrect options will be plausible, so you should
expect to have to use detailed, syllabus-specific knowledge to identify the
correct answer rather than relying on common sense.
Multiple response
A multiple response item is the same as a multiple choice question, except
more than one response is required. You will be told how many options you
need to select.
Number entry
Number entry (or 'fill in the blank') questions require you to type a short
numerical response. You should carefully follow the instructions in the question
in terms of how to type your answer – eg the correct number of decimal places
Drag and drop
Drag and drop questions require you to drag a 'token' onto a pre-defined
area. These tokens can be images or text. This type of question is effective at
testing the order of events, labelling a diagram or linking events to outcomes.
Hot spot
These questions require you to identify an area or location on an image by
clicking on it. This is commonly used to identify a specific point on a graph or
diagram.
Item set
2-4 questions all relating to the same short scenario. Each question will be
'standalone', such that your ability to answer subsequent questions in the set
does not rely on getting the first one correct.
11
Key to icons
A key definition which is important to be

Key term
aware of for the assessment
A formula you will need to learn as it will not

Formula to learn
be provided in the assessment
A formula which is provided within the

Formula provided assessment and generally available as a pop-
up on screen
An example which allows you to apply your

knowledge to the technique covered in the
Activity
Course Book. The solution is provided at the
end of the chapter
A worked example which can be used to

Illustration review and see how an assessment question
could be answered
Assessment focus point A high priority point for the assessment
12
Organisations and
stakeholders
Learning outcomes
Having studied this chapter you will be able to:

 distinguish between the goals of profit-seeking organisations, not-for-profit organisations and
governmental organisations
 distinguish between the potential objectives of management, shareholders and other
stakeholders and the effects of these on the behaviour of the firm
Chapter context
The main theme of this chapter is that the behaviour of any organisation will depend on its
objectives, which in turn depend on the type of organisation that it is.
An organisation will also have to recognise and manage any conflicts between the needs of different
stakeholder groups.
Syllabus context
This chapter is part of syllabus Section B which looks at the 'microeconomic and organisational
context of business'.
This syllabus area has a weighting of 30% and is covered by Chapters 1-6.
13
Chapter overview
Forms of Principal/agent
organisations problem
Manager does not own

company may not have
same goals as owner
Public Private
eg
Separation of
 Satisficing
ownership
 Maximise sales
Not-for- Profit and control
 Favour their own
profit seeking
interests
Not for profit organisations
Solutions
Financial  Corporate
Types
constraints governance
 Link pay with
 Public and  Not paid for performance
private by users
Goals of organisations Corporate

How
and their stakeholders governance
companies
are run
Problems Solutions
Stakeholders
 One person  Separate

dominates chairman and
 Directors not chief executive
Types Approaches Not for profit involved in  Independent
management directors
 Internal Prioritise with Wide range of
 Lack of control  Independent
 Connected Mendelow's matrix stakeholders
setting of pay
 External Can Influence  Non-executive
 Appease  Objectives and directors
dominant group goals
 Satisfy as many  Strategies
as possible
14
1: Organisations and stakeholders
1 Organisations
An organisation has a purpose that goes beyond the personal goals of individuals.
It will involve established hierarchies and methods of working that are designed to
make sure that goals are achieved.
Organisation
An organisation is a social arrangement for the controlled performance of collective
goals. (NAO Value for money, 2016)
1.1 Public and private sector organisations
Organisations
Public sector Private sector
The public sector consists of the parts of the economy that provide central or local
government services and are under the control of government organisations.
The private sector consists of the parts of the economy that are not controlled by
the government.
Sometimes the public and private sector collaborate, this is sometimes referred to as
a public-private partnership (PPP) or as a private-finance initiative (PFI).
Activity 1: Idea generation

Required
Why do we need organisations?
Solution
15
1.2 Not-for-profit organisations
Organisations
Not-for-profit Not-for-profit Profit seeking

organisations organisations organisations
1.2.1 Public sector and value for money

Public sector organisations include public service providers (eg schools, hospitals),
state-owned industries, government departments and quangos.
Quangos are quas-autonomous non-governmental organisations funded by, but not
directly controlled by, the government eg government regulatory bodies.
Public sector organisations are likely to have primarily 'not-for-profit' objectives.
'Value for money' is a commonly used framework for not-for-profit objectives:
Value for money

 Economy: purchase of inputs of appropriate quality at minimum
cost
 Efficiency: maximising output from given inputs, or minimising
inputs for a given output
 Effectiveness – achieving an organisation's objective(s)
The primary objective(s) is likely to be effectiveness; this will often be non-

financial eg crime clear-up rates for a police force.
Economy and efficiency are secondary objectives and will often be financial (eg
operating within budget is a possible efficiency measure) although they may also be
non-financial (eg arrests per police officer is a possible non-financial efficiency
measure for a police force).
16

Required
Suggest possible value-for-money objectives for a not-for-profit school.
Solution
Economy
Efficiency
Effectiveness
1.2.2 Private sector not-for-profit organisations

Not-for-profit organisations exist in the private sector too, for example:
(a) Charities
(b) Professional bodies (eg CIMA)
(c) Mutual organisations (eg trade unions) provide services for members using
member subscriptions
(d) Co-operatives are similar to mutual organisations but generally deal in
tangible goods and services. Profits are an aim of some co-operatives but they
are not normally its primary aim eg a co-operative retailer is owned by its
members and primarily aims to deliver good value to its customers.
1.2.3 Financial constraints in not-for-profit organisations

The primary objective of not-for-profit organisations is not to generate income. In
fact services will often be free for users, meaning demand for services will be high.
Not-for-profit organisations will therefore often operate within challenging financial
constraints. Although they will be judged on the services that they provide, they must
also stay within their budgets.
17
1.3 Profit-seeking organisations
Organisations
Not-for-profit Profit-seeking
organisations organisations
The main objective of many private sector organisations is to maximise the wealth
of their owners (this is discussed in the next chapter).
There are different types of profit-seeking organisations eg
(a) Unincorporated – the law does not recognise a difference between the
business and its owners.
(i) Sole trader – one person in business
(ii) Partnership – a collection of people working together, sharing the
profits and liabilities of a business venture.
(b) Incorporated – Business is legally separate to its owners.
(i) Private limited company – shares may not be offered to the public
(ii) Public limited company – shares may be offered to the public.
All of these organisations typically seek to survive, to grow and to make a return for
their owners.
In this course we are mainly concerned with profit-seeking organisations.
2 Stakeholders
Profit-seeking organisations typically exist to maximise their owners' wealth.
However, there will be other parties with an interest in an organisation. These are
called stakeholders.
Stakeholders
Stakeholders are people or groups with an interest in an organisation's strategy and
activities.
Each type of stakeholder will have their own objectives.

There are three broad types of stakeholders: internal, connected, external (ICE):
18
Connected
eg
Shareholders Customers Suppliers Financiers
Organisation
Internal
eg management
employees
Community Government Pressure groups
External
Figure 1.1: Stakeholders
Different stakeholders will influence the organisation in different ways.
(a) Some will support management
(eg local authority granting planning permission)
(b) Some will oppose management
(eg workers demanding pay rises)
(c) Some will participate with management
(eg shareholders voting on proposals)
19
2.1 Mendelow's matrix
Mendelow classified stakeholders on a matrix whose axes are the level of power
(or influence) the stakeholder can exert and the degree of interest the stakeholder
has in the organisation's activities.
These factors will help define the type of relationship the organisation should seek
with its stakeholders.
Level of interest
Low High
Low
A B
Power/influence
C D
High
Figure 1.2: Mendelow's matrix

(a) Minimal effort is expended on Segment A. An example might be a
contractor's labour force.
(b) Stakeholders in Segment B do not have great ability to influence strategy, but their
views can be important in influencing more powerful stakeholders,
perhaps by lobbying. They should therefore be kept informed. Community
representatives might fall into Segment B.
(c) Stakeholders in Segment C must be treated with care. While often passive,
they are capable of moving to Segment D. They should, therefore, be kept
satisfied. Large institutional shareholders might fall into Segment C.
(d) Key players are found in Segment D: any strategy the organisation wants to
adopt must be acceptable to them, at least. An example would be a major
customer. Key stakeholders may participate in decision making.
2.2 Stakeholders and not–for–profit organisations

In profit-seeking organisations, the owners will be important stakeholders. In not-for-
profit organisations, other stakeholders will be more important.
20

Required
Identify three key stakeholder groups for a charity, and what problems might occur
if each stakeholder group is dissatisfied.
Solution
3 Agency issues
In most organisational types that we have outlined there is a separation between the
provider of finance (known as the principal) and the management of the
organisation (provided by the agents).
3.1 The principal/agent problem
Principal-agent problem
This occurs where managers (the agents) are managing an organisation to meet
their own needs, not the needs of the owner/provider of finance (the principal).
3.2 Management goals other than profit maximisation

Although profit-seeking organisations typically exist to maximise the wealth they
generate for their shareholders (by maximising profit) alternative management goals
can include:
(a) Satisficing – managers will work just hard enough to achieve the minimum
level of profit that shareholders will be satisfied with.
(b) Sales maximisation – Managers believe that running a large company
brings better benefits and more prestige (an example of empire-building). This
is not always consistent with profit maximisation.
3.3 Principal/agent problem in the public sector

The principal/agent problem also exists in the public sector:
(a) Public workers may use government money to pay for high salaries or lavish
offices.
21
(b) The administrators of a charity may focus activities on a part of the charity's
work that they are personally interested in.
This type of organisational slack is sometimes referred to as x-inefficiency. Large
organisations, especially if public sector, often exhibit x-inefficiency because
managers are not maximising the entity's performance but instead are concentrating
on achieving their own agenda eg empire building, minimising their workload etc.
Activity 4: Exam standard

In which two of the following organisations is the principal/agent
problem most likely to be a significant problem?
A A sole trader
B A partnership
C A quango
D A public limited company
3.4 Resolving the principal/agent problem
The principal/agent problem can be addressed by monitoring the actions of

management (corporate governance) or by the use of incentive schemes.
Corporate governance
The systems by which companies are directed and controlled.
(CIMA Official Terminology)
Here are some of the main requirements for effective corporate governance:
Composition of board of directors Key committees

 Separate the roles of CEO & Chairman – to Remuneration committee
reduce the power of the CEO  Pay & incentives of executive directors set by
 Minimum 50% independent non-executive NEDs
directors (NEDs) - to monitor the actions of the Audit committee
executive directors
 To ensure sound risk management and internal
control, staffed by NEDs only
Nomination committee
 Choice of new directors made by NEDs
Commonly used incentive schemes include:

(a) Performance related pay – either against profit or a strategic
performance measure.
22
If incentive schemes are based on profit they can encourage short-term thinking
which can in fact damage long-term shareholder wealth.
(b) Share options – options to buy shares in the future (eg three years' time) at
today's share price.
This should encourage management to take actions to increase the share price
(this is discussed in the next chapter). This will benefit the owners of the
business.
However, if the share prices are low (eg due to economic recession) then this
may not be a strong incentive.

The following statements have been made about corporate governance.
(1) Sound systems of corporate governance involve the establishment of risk
management and internal control procedures for the organisation.
(2) Good corporate governance requires the organisation to always act in an
ethically acceptable manner even if that is contrary to the law.
(3) Non-executive directors should not be paid for their services to an organisation
in order to keep them independent.
Which of these statements is/are correct?
A (1) and (3) only
B (1), (2) and (3)
C (1) only
D (3) only
23
Chapter summary
 The economy consists of the private sector and public sector.

 Public sector organisations do not seek profits. Private sector organisations may be
profit-seeking or not-for-profit.
 Not-for-profit organisations aim to achieve 'value for money': economy, efficiency
and effectiveness. Because their services are often free they often face severe
financial constraints.
 Stakeholders can be divided into internal, connected and external groups. The
organisation's response to different stakeholder groups can be analysed according
to their power (or influence) and their interest.
 Stakeholders can influence an organisation through their power to support, oppose
or be consulted on its objectives. Organisations must have strategies to deal with
these stakeholders.
 A separation of ownership from control occurs where the employment of
professional managers means the firm is controlled by the managers rather
than the owners. This means the firm may be run in the interests of the
management instead of in the interests of the owners.
 The main ways to resolve the principal/agent problem are improved scrutiny of
agents, checks and balances on their power (corporate governance), and
appropriate incentives.
24
Keywords
• Organisation: An organisation is a social arrangement for the controlled
performance of collective goals.
• Value for money
– Economy: purchase of inputs of appropriate quality at minimum cost
– Efficiency: maximising output from given inputs, or minimising inputs for a
given output
– Effectiveness: achieving an organisation's objective(s)
• Stakeholders: Stakeholders are people or groups with an interest in an
organisation's strategy and activities.
• Principal-agent problem: This occurs where managers (the agents) are
managing an organisation to meet their own needs, not the needs of the
owner/provider of finance (the principal).
• Corporate governance: The systems by which companies are directed and
controlled.
25
Activity answers

The existence of organisations should enable more to be achieved than if
individuals were working on their own, for many reasons, for example:
 Allowing skills and knowledge to be shared
 Allowing people to specialise
 Pooling and co-ordinating resources
 Creating a system of controls to allow performance to be objectively
assessed and managed.

Example of VFM objectives for a school
• Economy – cost per member of staff, premises cost/square metre
• Efficiency – teaching days per teacher, teacher/pupil ratios, operating
within budget
• Effectiveness – pass rates, absenteeism.
Charity
Funding Services
Employees/
Donors Volunteers End users
– Contribute cash – Accept low/no – Charity exists to

wages as believe in serve them
value of work
– Will cease to pay if – Will leave if – If dissatisfied will

dissatisfied with dissatisfied complain
charity  bad publicity
 loss of funding
26

Answer – C and D
A sole trader and a partner are likely to have direct control of the management of
the key areas of the business.
A quango (quasi-autonomous non-governmental organisation) is financed by the
government but is not managed by the government so agency issues could be a
significant problem (eg empire-building).
A public limited company is financed by shareholders but is not normally managed
by shareholders so, again, agency issues could be a significant problem.

Answer: C
Sound corporate governance does not include breaking the law and non-executive
directors can expect to be paid for their services but not in such a way that impairs
their independence (eg in shares or share options).
27
Test your learning
1 What does the term 'stakeholders' mean?
2 Which one of the following is not a stakeholder for a mutual organisation?
A Customers
B Staff
C Shareholders
D Directors
3 Which of the following denotes a stakeholder that should be Kept Informed in
Mendelow's matrix?
A High power/low interest
B High interest/low power
C Low interest/low power
D High power/high interest
4 Which of the following is not a mechanism to improve corporate governance?
A Issue directors with long-term employment contracts to improve their loyalty
B Separate the roles of Chairman and Chief Executive to avoid the board being
dominated by an individual
C Provide incentives to directors that are based on the value they create for
shareholders
D Employ non-executive directors to provide an independent viewpoint at board
meetings
5 A director of a business division who does not own shares in the business can be
termed:
A A principal
B An agent
C A non-executive director
D None of the above
6 What does the term 'unincorporated' mean?
7 Which one of the following describes an organisation that is jointly owned by a
state-owned organisation and a profit-seeking organisation?
A Quango
B Mutual
C Public/private partnership (PPP)
D Co-operative
28
Measuring returns to
shareholders
Learning outcomes

 explain shareholder wealth, the variables affecting shareholder wealth and its application in
management decision making.
Chapter context
The main theme of this chapter is how to evaluate the performance of a profit-seeking organisation,
and assess its ability to create wealth for its owners (ie shareholders).
Syllabus context
29
Chapter overview
ROCE EPS
Profit before finance Short term Profit after tax and
costs and tax preference dividend
Total assets less Issued equity shares

current liabilities (number)
Measuring returns to
shareholders
Discount free
Value of Value of
Long term cash flows to
business shares equity
 Discount free cash

flows to firm
Required rate
Risk free rate Systematic risk Unsystematic risk
Affected by  Risk associated  Risk associated

 Time value of with market with company
money sector
 Inflation
30
2: Measuring returns to shareholders
1 Short-term measures of return

A profit-seeking company can use ratio analysis to give a snapshot of its short-
term financial performance.
1.1 Return on capital employed (ROCE)

Simply measuring profit does not give a good measure of how well a firm is
performing because it doesn't consider the amount of long-term finance (capital) that
has been invested in the firm.
Illustration 1
If a company earns a profit of $10,000 this would be a good performance if
$50,000 had been invested in the company (10,000 / 50,000  100 = 20%
return) but not if $1 million had been invested (10,000 / 1 million  100 = 1%
return).
1.1.1 Measuring capital employed

Capital is the total amount of long-term finance committed by investors eg
 Long-term debt finance: eg a long-term loan
 Preference shares: these are shares that pay a fixed dividend
 Ordinary shares (equity finance): ordinary shareholders are the owners
of the company; these shares do not pay a fixed dividend. The dividend they
pay can vary from year to year.
Return on capital employed (ROCE) measures a company's current success by
relating the amount of profit to the value of the resources employed in
generating it. This reflects the efficiency with which the resources have been used.
Formula to learn
ROCE = Profit before interest and tax %

Long-term debt plus equity
Profit before interest and tax is sometimes called 'operating profit'
Alternatively, capital can be measured in terms of how the long-term finance has
been invested ie the assets that have been purchased (net of any short-term
liabilities). Assets can include non-current assets (ie long-term) such as land and
buildings, or current assets (ie short-term) such as inventory or trade receivables.
Formula to learn
ROCE = Profit before interest and tax %

Total assets – current liabilites
The figure for capital employed is normally averaged out between the
beginning and the end of the year. However, the ROCE calculation can also be
31
based solely on the value of capital employed at the end of the year, so you will
have to read the question to see how to perform the calculation.

Strontium Lining Co has the following results.
20Y6 20Y5
$'000 $'000
Operating profit 15,000 12,000
Interest paid (finance costs) (2,000) (2,000)
13,000 10,000
Taxation (4,000) (3,000)
Profits after tax 9,000 7,000
220Y6 20Y5
$'000 $'000
Non-current assets 60,000 50,000
Current assets 50,000 48,000
110,000 98,000
Equity 50,000 50,000

Non-current liabilities 30,000 25,000
Current liabilities 30,000 23,000
110,000 98,000
Required
Calculate ROCE
(i) for both years based on closing capital employed in each year
(ii) for 20Y6 based on average capital employed
Solution
32
1.2 Earnings per share (EPS)

EPS shows the maximum dividend that could be paid to the owners of the business
(ie the ordinary or equity shareholders) out of that year's profit after all payments
have been made to other providers of finance (eg banks and preference
shareholders).
Formula to learn
Profit after interest, tax and preference dividend
EPS =
Number of issued equity shares
EPS shows the return earned by the ordinary shareholders only, unlike ROCE which
considers the return generated to all the investors including those who have just lent
money to the company (eg banks).

Zani Co has the following results.
$'000
Operating profit 100,000
Interest paid (finance charges) (10,000)
90,000
Taxation (26,000)
Profits after tax 64,000
Dividends payable* (30,000)
Retained earnings 34,000
Issued share capital (shares of $1) 100 million
* Includes preference dividend of $10 million

Required
Calculate earnings per share (EPS).
Solution
1.3 Analysing short-term returns to shareholders

Profit-based measures such as ROCE or EPS show short-term financial performance,
but they do not show whether the level of returns being achieved is acceptable to
the owners of the business (ie ordinary shareholders).
33
1.3.1 Measuring the return expected by shareholders
Investors can invest their money in ways that eliminate risk eg in short-term
government debt (assuming the government has a good credit rating!), or in a bank
account (which may be guaranteed by the government up to a certain limit). The
rate of return that is available on risk-free investments will be low, and is often
referred to as the risk-free rate.
Ordinary shareholders will expect a rate of return above the risk-free rate because
of the high risks associated with owning shares. Risks can be classified as:
(a) Systematic risk – the risk associated with a particular market sector eg car
industry – if there is a recession then all car manufacturers will be heavily
affected because buying a new car is not a necessity.
(b) Unsystematic risk – the risk associated with a specific company
because of factors unique to it eg a product recall by a specific car
manufacturer. Shareholders can reduce their exposure to this type of risk by
investing in a number of different companies (ie by building an investment
portfolio).
The rate of return that shareholders expect will increase as the level of risk
(especially systematic risk) increases.
10%
Return
8%
6%
x y Risk
The risk and return of companies A (risk = x, return = 8%) and B are illustrated in
the risk-return diagram shown above.
Required
What factors may explain this data?
Solution
34
1.3.2 Assessing if return is acceptable

The return expected by shareholders is sometimes referred to as the cost of
equity. This can be used to assess whether the level of return (ie profit) that has
been achieved is acceptable to shareholders.
Illustration 2
Zani Co has the following results
$'000
Operating profit 100,000
Finance charges (10,000)
90,000
Taxation (26,000)
Profits after tax 64,000
Dividends payable (including $10m preference dividend) (30,000)
Retained earnings 34,000
Zani has $100 million of equity capital and $100 million of retained
earnings (including the $34 million from the current year as shown above).
Zani's shareholders expect a return of 10%.
Required
Assess whether Zani Co is producing an adequate short-term return to shareholders.
Solution
Profit after tax = $64 million. This belongs to ordinary shareholders.
Zani's shareholders expect a return of 10% on their equity investment of $200
million (share capital + retained earnings) ie 200 x 0.1 = $20 million.
Profits after tax are greater than $20 million so Zani is producing an adequate
short-term return to its shareholders.
2 Long-run measures of return

The usual assumption is that companies are trying to maximise the wealth of their
shareholders by making a profit. However, for a company whose shares are traded
on a stock market the critical issue for shareholders is the movement in the share
price.
The value of shares depends on a company's future cash flow potential, not
just its current profitability.
35
2.1 Discounting future cash flows
When valuing a share on the basis of future cash flows we need to recognise that
money expected to be received in the future is worth less than money received
today. This is because investors prefer to receive money sooner rather than later.
So the value of a company's future cash flows will need to be adjusted to reflect this
time value of money; this process is called discounting.
This is introduced below but is dealt with in more detail in Chapter 15.
2.1.1 Discounting free cash flows to equity
Free cash flows to equity

The cash flows generated by a business in a particular year after interest and
tax and investment spending.
Free cash flows to equity are available either to pay as a dividend or to keep within
a business – either way this cash is a benefit to ordinary (equity) shareholders.
Illustration 3
Normington Co is predicted to generate the following free cash flows to
equity.
Year 1 $50 million Year 2 $55 million Year 3 $94 million
There are 50 million shares and shareholder's required rate of return is 10%; this is
to reflect the time value of money and indicates the rate at which future cash flows
are to be discounted.
The discounted, or present, value of the cash flows in year 1 can be calculated as
$50m / 1.1 = $45.5m.
This means that shareholders are indifferent between receiving $45.5m now or
$50m in 1 year.
On the same basis the cash flows for year 2 and 3 can be valued as:
$55m /1.12 $45.5m
$94m /1.13 $70.6m
Total value = $45.5m + $45.5m + $70.6m = $161.6m

Price per share = $161.6m / 50m = $3.23
36
2.1.2 Discounting free cash flows to the firm
Free cash flows to the firm

The cash flows generated by a business in a particular year after tax and
investment spending (but before interest).
Free cash flows to the firm are available to pay to all investors, whether
shareholders or providers of debt finance.
Illustration 4
Normington Co (above) has a $20m three-year loan costing 10%. Repayments on
this loan are $2m in year 1, $2m in year 2 and $22m (capital plus interest) in year
3. Normington is predicted to make the following free cash flows to the firm.
Year 1 $52 million Year 2 $57 million Year 3 $116 million
There are 50 million shares and the overall cost of capital is 10%.
The discounted value of the cash flows in year 1 can be calculated as
$52m / 1.1 = $47.3m. On the same basis the cash flows for year 2 and 3 can be
valued as:
$57m /1.12 $47.1m
$116m /1.13 $87.2m
Total value = $47.3m + $47.1m + $87.2m = $181.6m

This is the value of the cash flows to all investors (debt or equity); the value of
debt therefore needs to be subtracted to obtain the value of equity.
Value of equity = $181.6m - $20m = $161.6m
Price per share = $161.6m / 50m = $3.23 (as before)
2.1.3 Discounting free cash flows to perpetuity

If you are asked to calculate the present value of a constant cash flow that is
expected for the foreseeable future, this is called a perpetuity.
Formula to learn
Cash flow
Present value to perpetuity =
Cost of capital
37
Gerrard Co is predicted to generate free cash flows of $50m per year for the
foreseeable future. These cash flows are before finance costs.
Gerrard Co's cost of equity is 8%; this is the same as its overall cost of capital.
There are 100m ordinary shares in issue. Gerrard has $50m of debt finance
costing 8% pa.
Required
Calculate Gerrard Co's share price using:
(i) the free cash flows to equity
(ii) the free cash flows to the firm
Solution
2.1.4 Increasing shareholder wealth

The value of the company's shares directly influences shareholder wealth.
Although future cash flows will partly depend on the state of the
economy, management also have the ability over the long run to
affect these cash flows and therefore to increase the share price.
Over the long run it is the ability of the management team to increase the share
price that will be of most importance to shareholders.
38

Required
What types of actions can management take to increase the share price?
Solution
39
Chapter summary
 Investors invest in companies by buying their shares. The companies are expected to
maximise the wealth of their shareholders by generating profit from trading
operations. Investors will only provide funds if they believe that the prospective
returns from investing in a company are adequate.
 Shareholders need objective measures of company performance if they are to make
sensible investment decisions. Short-term measures include ROCE and EPS.
 Before deciding whether to buy, hold or sell shares in a firm the investor will
consider whether the returns from the firm are adequate to compensate them for
the risks of investing in the firm. The minimum rate of return that is
acceptable to shareholders is called the required rate.
 An increase in forecast dividends or free cash flows will lead to an increase in
current market price, as will a reduction in the cost of equity.
40
Keywords
 Free cash flows to equity: The cash flows generated by a business in a
particular year after interest and tax and investment spending.
 Free cash flows to the firm: The cash flows generated by a business in a
particular year after tax and investment spending (but before interest).
41
Activity answers

(i)
20Y6 20Y5
Profit before finance costs and tax 15,000 12,000
Long - term debt plus equity 30,000  50,000 25,000  50,000
15,000 12,000
80,000 75,000
18.75% 16%
Alternatively, capital employed can also be calculated as total assets – current
liabilities
20Y6 20Y5
Profit before finance costs and tax 15,000 12,000
Total assets – current liabilitie s 110,000 – 30,000 98,000 – 23,000
15,000 12,000
80,000 75,000
18.75% 16%
(ii)
Average capital employed in 20Y6 = (closing year 20Y5 value + closing year
20Y6)/ 2
SO average capital employed in 20Y6 = (75,000 + 80,000) / 2 = 77,500
20Y6
Profit before finance costs and tax 15,000
Long - term debt plus equity 77,500
19.35%

64,000 – 10,000
100,000
54c per share
42

The risk-free rate of 6% seems quite high; this may be explained by:
 the rate of inflation in the economy
 the credit rating of the country's government
Investing in X carries some risk, so shareholders will want a higher return of 8% ie
2% above the risk-free rate.
Y is riskier so shareholders expect a higher return of 10%. This may be due to Y
operating in a riskier sector of the economy that will be more volatile in the event of
an economic slowdown eg car manufacturing compared to low-cost airlines.

(i) Free cash flows to equity (after finance costs) are $50m – $4m = $46m.
The discounted value (or present value) of the cash flows is $46m / 0.08
= $575m. $575m / 100m shares = $5.75 per share.
(ii) Free cash flows to firm (before finance costs) are $50m. The discounted
value (or present value) of the cash flows is $50m / 0.08 = $625m. This
is the value of the company to all its investors – so then subtracting the
debt of $50m leaves a value of equity of $575m or $5.75 per share.

The share price will be strongly influenced by expectations of the discounted value
(present value) of the company's future cash flows. The present value of future cash
flows may be expected to rise if management is investing in attractive projects (more
on this in Chapter 15).
The share price will also rise if the cost of capital falls – this may happen if
managers can take action to reduce the risk associated with the company, eg
reducing the level of debt.
Other factors may also impact on the share price that are outside management
control, eg confidence in wider economy, actions of competitors.
43
Test your learning
1 How do shares give wealth to shareholders?
A By paying annual dividends only
B By rising in price only
C By a combination of annual dividends and share price rises
D By entitling the shareholder to votes
2 Which of the following, in theory, determines the price of a share?
A It will be the same as its EPS
B It will be the same as the price it was sold at when the share was issued
C The discounted present value of the expected future earnings of the firm
divided by the number of shares in issue
D The value of this year's dividend
3 What is the name given to the risks of investing in the shares of firms from a
particular industrial sector?
4 What is the formula for return on capital employed?
5 What is the formula for earnings per share?
6 Which of the following best describes the risk-free rate?
A The rate of interest on a loan
B The rate of dividend on a preference share
C The minimum return that a shareholder will accept on a company's shares
D The minimum return a shareholder will accept to compensate for tying their
money up and suffering loss of value due to inflation.
7 The present value of Megalith's forecast future cash flows is now $267 million.
What will happen to this value if Megalith plc's cost of equity rises?
A It will rise
B It will fall
C It will remain the same
D It is impossible to say
8 What is the name of the process through which future income streams are given a
present value?
44
Demand, supply
and price
Learning outcomes

 identify the equilibrium price in a product or factor market
Chapter context
This chapter is a key topic because demand and supply analysis can be applied to many areas of
economics. A good understanding of this chapter is required before progressing through the
remainder of the course.
Syllabus context
45
Chapter overview
Price determination
Functions Market
 Allocate
 Signal
 Reward
Demand Supply
Law of Conditions of Law of Conditions of

demand demand supply supply
 Income  Costs of production

 Substitutes  Availability of
 Complements resources
Price ↑  Tastes Price ↑  Taxes/subsidies
Demand ↓  Expectations Supply ↑  Substitutes
 Complements
 Climate
Interaction of demand and supply

 Supply >  Demand >
demand supply
= surplus Price too high Price too low = shortage
 Price falls  Price rises
 Supply falls  Supply
 Demand increases
Equilibrium
increases  Demand falls
46
3: Demand, supply and price
1 Introduction – nature of a market

A market consists of all of the buyers and sellers of a good or service, or a factor
of production (a resource required for production to take place eg labour, land).
The price and output decisions of a firm will be affected by market forces ie the
behaviour of consumers (see Section 2) and suppliers (see Section 3).
2 Demand
Demand is the amount (quantity) which consumers are willing and able to
purchase of a certain good at a given market price over a certain time period.
The law of demand

As the price of a good falls, all other things being equal, the quantity demanded of
that good increases.
The Law of demand can be illustrated as a demand curve.
Illustration 1
Demand curve
Price
contraction
$20,000
$15,000
extension
$10,000
$5,000
Demand curve
10 20 30 40 Quantity
units/time
As an example, the diagram shows the demand for Mini cars.

• If the price is $20,000/unit : demand is 10,000 pa
The demand curve slopes downwards from left to right, reflecting an inverse
relationship between price and quantity.
(a) Extension (or expansion) of demand:
increase in quantity demanded because price has fallen. Shown by a
rightward movement along the existing curve.
(b) Contraction of demand:
decrease in quantity demanded because price has risen. Shown by a leftward
movement along the curve.
47
2.1 Explanation
Consumers seek to maximise total satisfaction (utility) derived from scarce resources
(disposable income). A fall in price increases the value for money of the product
because it increases the satisfaction per $ spent upon it compared to that available
from other goods (assuming the prices of those goods are unchanged). The demand
for the good whose price has fallen will increase, with demand for other goods
falling. This is called the substitution effect.
2.2 Conditions of demand

A demand curve is drawn on the assumption of 'all other things being equal' ie on
the assumption that, apart from price, no other potential influences on demand
change in the current time period.
However, there are other factors which can influence demand, and these are
sometimes called the conditions of demand. Here are some examples:
(a) Level of disposable income (income after tax)
(i) A normal good is one where buyers buy more as their income
increases.
(ii) An inferior good is one where buyers buy less as their income
increases.
(b) Price of substitutes (two or more goods that satisfy the same need)
(c) Price of complements (two or more goods that are consumed together)
(d) The pattern of tastes and preferences for the product
(e) Market expectations of future changes in the price of the good (or
shortages of it)
If there is a change in the conditions of demand then the demand curve will
shift to the left or right.
Illustration (Mini cars continued)

Price
$20,000
Shift (rise) in demand
$15,000
$10,000
$5,000 D1
D0
10 20 30 40 Quantity units/time
(000s)
The demand curve has shifted outwards (from D0 to D1).

This could be caused by, for example, an increase in consumers' disposable income
48

Required
Explain how each of the following conditions of demand might lead the demand
curve for Mini cars to shift to the left (inwards)?
Solution
(a) Price of substitutes
(b) Price of complements
(c) Pattern of tastes and preferences
(d) Market expectations
Remember: a change in price will lead to a movement along the demand curve.
A change in any of the conditions of demand will lead to a shift in the
demand curve.
3 Supply
Supply is the amount (quantity) which firms are willing and able to supply to the
market at a given market price over a certain time period.
The law of supply

'as the price of a good rises, all other things being equal, the quantity supplied of
that good increases'.
The relationship between price and quantity supplied can be illustrated as a

supply curve; this shows the minimum prices necessary to encourage firms to
supply a given quantity of a product or service.
49
Illustration 2
Supply curve
Price
Supply curve
$20,000
$15,000
$10,000
$5,000
20 Quantity units/time
10 30 40
(000s)
The diagram shows the supply of Mini cars.

Price/unit ($) Quantity supplied (No. of Minis pa)
5,000 10,000
10,000 20,000
15,000 30,000
20,000 40,000
A supply curve can represent a single firm (as here) or the whole market.
The supply curve slopes upwards from left to right, reflecting a direct relationship
between price and quantity (ie as price rises, quantity supplied rises).
(a) Extension of supply: increase in quantity supplied because price has risen.
Shown by a rightward movement along the existing curve.
(b) Contraction of supply: decrease in quantity supplied because price has
fallen. Shown by a leftward movement along the existing curve.
Price Supply curve
$20,000 contraction
$15,000
$10,000 extension
$5,000
units/time
50
3.1 Explanation
Profit is the difference between total revenue and total cost. A rise in market price,
all other things being equal, increases the profit available from the product and so
firms will want to produce more of it ie they will supply more of the product whose
price has increased, by transferring more resources into making that product instead
of making alternative products whose prices have stayed constant.
3.2 Conditions of supply

A supply curve is drawn on the assumption of 'all other things being equal', ie that,
apart from price, no other influences on supply are changing.
However, there could be other influences on supply and these are sometimes called
the conditions of supply. Here are some examples:
(a) The costs of production (eg cost of labour)
(b) The availability of productive resources (affects amount available)
(c) Level of indirect taxes (eg a tax on the supply of petrol) or subsidies
(d) Prices of substitutes in production (alternative products which the
firm could produce)
(e) Prices of complements in production: where goods are by-products
of each other (eg sheep milk and wool)
If there is a change in the conditions of supply then the supply curve will
shift to the left or right.
Price
S0
S1
$20,000
Increase in
$15,000
supply
$10,000
$5,000
units/time (000s)
The supply curve has shifted outwards, from S0 to S1. This could be caused by, for
example, a fall in production costs.
51
Required
Forecast the effect of the following factors on the supply curve of wheat in Europe.
(a) A poor growing season
(b) A rise in the cost of farm labour
(c) A rise in the price available for oats (an alternative crop)
(d) Government scheme to pay $1 per tonne subsidy to wheat farmers
Solution
Remember – a change in price will lead to a movement along the supply curve.
A change in any of the conditions of supply will lead to a shift in the supply
curve.
4 Equilibrium price
Equilibrium price
The price at which quantity demanded and quantity supplied will be equal, and
which will be restored by market forces following any changes in the conditions of
either supply or demand.
52
Illustration 3
Mini cars continued from illustration 1 and 2
Price $
Supply curve
12,500
Demand curve
Quantity
25 units/time (000s)
4.1 Movement to equilibrium

The market mechanism operates to remove situations of disequilibrium:
(a) Shortage: where quantity demanded exceeds quantity supplied at the
prevailing market price (ie there is excess demand).
(b) Surplus: where quantity supplied exceeds quantity demanded at the
prevailing market price (ie there is excess supply).
Activity 3: Preparation question

Required
The dotted lines on the diagrams below show the point where supply and demand
for Minis are in equilibrium. Illustrate the following on the diagrams.
(a) A situation of surplus at $20,000 where too many Minis are being produced
relative to the demand for them.
(b) A situation of shortage at $5,000 where demand exceeds supply.
Also discuss how the surplus and shortage are removed.
53
Solution
(a)
Quantity pa (000s)
(b)
Quantity pa (000s)
4.1.1 Removal of a shortage

Where demand is above supply, consumers will find it hard to find supplies of the
product. Firms will see a rise in sales. As a result firms will increase prices and
extend supply by transferring resources to this product to get higher profits.
As price rises, demand contracts as consumers find substitutes giving better value for
money.
This will continue until the shortage is eliminated.
4.1.2 Removal of a surplus

Where supply is above demand, firms will see a rise in unsold products (inventory).
As a result firms will cut prices and supply.
As price falls, demand extends as consumers are attracted by the fall in price.
54
4.2 Functions of the price mechanism

The role of the price of the product in removing shortages and surpluses is
sometimes referred to as the price mechanism.
The price mechanism has three functions:
(a) Signalling to producers where supply is too low (shortages) or too high
(surpluses).
(b) Rationing and allocating the resources of a firm to produce those goods
that are in high demand.
(c) Rewarding firms for meeting consumer needs.

Required
Predict the effect of the following on the price and quantity bought and sold of
chocolate biscuits using sketched diagrams to help you.
Solution
(a) Rise in the price of custard cream biscuits (take custard creams as a substitute
in consumption, not production)
(b) Rise in price of instant coffee, a complement in consumption
55
(c) Increase in the price of cocoa beans, a key ingredient in chocolate biscuits.
56
Chapter summary
 As price falls, quantity demanded of a good or a factor of production (eg labour)

increases and quantity supplied decreases.
 A change in price results in a contraction or extension along the demand
and supply curve.
 A change in other factors will result in a shift of the demand and supply curve.
 The equilibrium price is the price at which the quantity demanded and supplied
will be equal.
• The competitive market process results in an equilibrium price, which is the price at
which market supply and market demand quantities are in balance. In any market,
the equilibrium price will change if market demand or supply conditions change.
• The three functions of the price mechanism are to signal where there are shortages
or surpluses, to ration scarce supply amongst potential buyers, and to reward firms
and households for alleviating shortages or surpluses.
• The effects of demand and supply conditions on markets can be analysed by
studying the behaviour of both demand and supply curves.
57
Keywords
 The law of demand: As the price of a good falls, all other things being equal,
the quantity demanded of that good increases.
 The law of supply: 'As the price of a good rises, all other things being equal,
the quantity supplied of that good increases'.
 Equilibrium price: The price at which quantity demanded and quantity supplied
will be equal, and which will be restored by market forces following any changes in
the conditions of either supply or demand.
58
Activity answers

A shift to the left represents a fall in demand.
(a) Price of substitutes: fall in price of another compact saloon (eg Beetle) making
the alternative relatively more attractive than a Mini
(b) Price of complements: rise in insurance premiums on Minis
(c) Tastes and preferences: Minis cease to be fashionable
(d) Expectations: Mini prices expected to fall due to more competition between
dealers. (Therefore, rather than buying a Mini now, a consumer will wait and
buy one at a later date once the price is lower).

(a) Fall in supply (less available) – supply curve shifts to the left
(b) Fall in supply (as labour costs rise, the amount of profit farmers can make from
selling at any given price will fall) – supply curve shifts to the left
(c) Fall in supply (produce oats instead of wheat) – supply curve shifts to the left
(d) Rise in supply (more produced to get more subsidy) – supply curve shifts to the
right

(a)
Price per Surplus S
unit
$'000
20
15
12.5
10
5
D
10 20 25 30 40 50
Quantity ('000s)
per annum
At $20,000 S = 40,000 }
D = 10,000 } so surplus = 30,000 Minis
59
Suppliers find that inventories cannot be cleared.
– The only way to clear the surplus is for firms to lower price (the
price mechanism has signalled to them that the $20,000 price is
too high).
– As price is lowered, demand extends owing to the law of demand,
and supply contracts owing to the law of supply. (ie firm reduces
production of Minis, so fewer resources are allocated to
production of Minis)
– This process of price reduction continues until all that is produced is
sold – the equilibrium price of $12,500 is arrived at.
– The new price of $12,500 per unit is the reward given to the
resources: some pays the labour, some goes towards rent, some
goes on profit to the entrepreneur and so on.
(b)
Price per S
unit
$'000
20
15
12.5
10
5
Shortage D
10 20 25 30 40 50
Quantity ('000s)
per annum
At $5,000 S = 10,000 }
D = 40,000 } so shortage = 30,000 minis
– Consumers willing to pay more to purchase desired good, so price
rises.
– Suppliers increase supply (the price mechanism has signalled to
them that more profits are available).
– As price rises, demand contracts due to the law of demand, and
supply increases due to the law of supply (more resources are
allocated to the production of Minis).
– This process of price increase continues until all that is produced is
sold.
– Equilibrium price of $12,500 is arrived at.
60

(a) P
S
F
P1
P0
E
D1
D
Q
Q 0 Q1
Custard creams are a substitute for chocolate biscuits and therefore there will
be a rise in demand for chocolate biscuits. The diagram above describes the
chocolate biscuit market where equilibrium is initially at point E with price at P0
and quantity supplied and demanded at Q0. The rise in the price of custard
creams makes chocolate biscuits relatively better value for money and so the
demand curve shifts from D to D1. A new equilibrium will be restored at F with
price at P1 and quantity supplied and demanded at Q1.
(b) Instant coffee is a complement to chocolate biscuits. A rise in the price of
instant coffee will cause demand for coffee to contract and, to some extent, the
demand for chocolate biscuits to fall.
P
S
P0 E
P1
F
D1
Q
Q1 Q0
The chocolate biscuit market is initially in equilibrium at E. The rise in
coffee prices causes demand for chocolate biscuits to fall from D to D1. A
new equilibrium will be found at price P1 and quantity Q1 – point F on the
diagram.
61
(c) An increase in cocoa bean prices is a rise in the costs of production and will
cause the supply curve for chocolate biscuits to shift to the left.
S1
P
S
F
P1
P0 E
D
Q
Q1 Q0
The initial equilibrium is Q0 P0 at point E. As the increase in the price of cocoa
shifts the supply curve to the left, the new equilibrium will now be at F (Q1 P1).
62
Test your learning

1 What factors influence demand for a good?
2 What are (a) substitutes and (b) complements?
3 What factors affect the quantity of a good supplied?
4 What is meant by equilibrium price?
5 A demand curve is drawn on all except which of the following assumptions?
A Incomes do not change.
B Prices of substitutes are fixed.
C Price of the good is constant.
D There are no changes in tastes and preferences.
63
64
Price elasticity
Learning outcomes

 calculate the price elasticity of demand and the price elasticity of supply
 explain the determinants of price elasticity of demand and supply
 calculate the effects of price elasticity of demand on a firm's total revenue following a change in
prices
Chapter context
When managers make decisions about price and output they must consider how responsive demand
will be to changes in price.
With some products, customers will be extremely sensitive to price changes so a small price increase
may lead to a significant fall in sales volume.
With other products, customers will not be particularly bothered about price changes so a relatively
large price increase may only lead to a relatively small drop in sales volume.
We call the degree of sensitivity to changes in price 'elasticity' and this chapter shows how we can
measure it and understand what affects it.
Syllabus context
65
Chapter overview
Elasticity
Price elasticity Price elasticity

of demand of supply
Calculation Consider Calculation Consider
% change in quantity  Substitutes % change in quantity  Time

demanded  Brand loyalty supplied  Substitutes in
% change in price  Status % change in price production
 Proportion of  Cost of increasing/
spending reducing workforce
 Time  Excess capacity
 Barriers to entry
Interpretation Interpretation
66
4: Price elasticity
1 Price elasticity of demand (PED)

To help an organisation make its pricing decisions, it can be useful to measure
the likely responsiveness of demand to a change in price; this is referred to as price
elasticity of demand.
Formula to learn
% change in quantity demanded
Price Elasticity of Demand =
% change in price
An understanding of price elasticity of demand can also help with production

decisions: to help a firm predict the change in demand for a product if its price
changes.
1.1 Calculation of price elasticity of demand

Price elasticity of demand can be calculated in two slightly different ways, but both
are based on the formula above:
 Simple point method
 Average (midpoint) method
1.1.1 Simple point method
This measures the responsiveness of demand compared to the starting or initial
demand and price.
Formula to learn – simple point method

New demand – Initial demand
 100
Initial demand
New price – Initial price
 100
Initial price
Illustration 1
Company X has decreased the price of daily ski passes from $105 to $100. As a
result, demand has risen from 12,000 to 15,000. Elasticity of demand is therefore:
15,000 –12,000
100
12,000
100 –105
100
105
25
= = 5.2
–4.8
67
Note. Although, mathematically, price elasticity of demand is usually a negative
number, the minus sign tends to be ignored. So, in this case, although
mathematically PED = –5.2, it would be more common just to say that PED = 5.2.

Required
The figures below show how demand for Goods A and B has changed following
changes to their prices.
Calculate price elasticity of demand (PED) for Good A and Good B, to one decimal
place.
Good A Good B
Price Quantity Price Quantity
Before 60c 150 $2.99 500
After 50c 170 $3.20 440
Solution
Simple method PEDA= PEDB=
1.1.2 Drawback of simple point method

A problem with the simple (point) method is that the value of price elasticity of
demand depends on the starting point.
Illustration 2
Let's look at Company X from the previous illustration again, and imagine that it has
increased the price of daily ski passes from $100 to $105. In response to this
change, demand falls from 15,000 to 12,000.
The simple point method of calculating price elasticity of demand, which we had
previously calculated as 5.2 using the same data now becomes:
12,000 –15,000
100
15,000 –20 = 4.0
=
105 –100 5
100
100
68
4: Price elasticity
So the management of Company X would have a different assessment of price

elasticity of demand (4.0 vs 5.2) depending on the starting point for this analysis.
This does not seem sensible.
The alternative method of calculating price elasticity of demand, the average or
midpoint method, removes this problem.
1.1.3 Average (midpoint) method

The average (midpoint) method: measures the responsiveness of demand
compared to the average demand and price.
Formula to learn – average method

New demand – Initial demand
100
Average demand
New price – Initial price
100
Average price
Illustration 3
Company X has increased the price of daily ski passes from $100 to $105.
Demand falls from 15,000 to 12,000.
Average price is (100+105)/2 = $102.5.
Average demand is (12,000+15,000)/2 = 13,500.
Elasticity of demand is therefore:
12,000 –15,000
×100
13,500 –22.2
= = 4.5 (ignoring the negative sign)
105–100 4.9
×100
102.5
Note that with this method the answer is the same whether starting from a price of
$100 and increasing it to $105, or starting from $105 and decreasing it to $100.

Required
Calculate the price elasticity of demand for Goods A and B, using the midpoint
(average) method. Give your answer to one decimal place.
Good A Good B
Price Quantity Price Quantity
Before 60c 150 $2.99 500
After 50c 170 $3.20 440
69
Solution
Midpoint method PEDA= PEDB=
1.1.4 In the exam

The midpoint (average) method is the preferred method for the exam.
However, the simple method may be required if questions ask you to predict a
change in price or quantity demanded.
Illustration 4
If we look at Company X again and imagine that you have been told that the price
elasticity of demand is –4.0. You may be asked to assess the impact on demand if
the price rises from $100 to $105 and demand is currently 15,000.
It would be too complex to apply the mid-point method here so the simple method
can be used.
If price has risen by 5% then, if the price elasticity of demand is –4.0, demand must
fall by 4  5% = 20%.
So 15,000  (1 – 0.2) = 12,000
2 Interpreting price elasticity of demand

2.1 Value greater than 1: elastic demand
Elastic demand
If price elasticity of demand (ignoring the minus sign) is greater than 1 this
means that the % change in demand is greater than the % change in
price. Demand is said to be price elastic; ie responsive to price changes.
When demand is elastic, companies will experience:

 A rise in revenue if prices are cut, and
 A fall in revenue if prices are increased.
70
4: Price elasticity
Illustration 5
When Company X decreased the price of daily ski passes from $105 to $100,
demand rose from 12,000 to 15,000. Elasticity of demand was above 1 (by either
method). Demand for ski passes is price elastic.
Because demand has risen at a faster rate than price has fallen, Company X will
experience a rise in revenue if it cuts price (or a fall in revenue if it increases price).
At a price of $105: revenue = $105  12,000 = $1.26 million
At a price of $100: revenue = $100  15,000 = $1.50 million
Note: We are only looking at the impact on revenue here. This does not necessarily
mean that Company X's profits would rise, because higher output would mean
higher costs.
The value of elasticity is affected by the slope of the demand curve for a product.
Higher values of price elasticity of demand will result from a flatter demand curve.
Price
Quantity
demanded

The data below shows the price elasticity of demand for Good C (using the simple
method) and the data used to calculate these values.
Good C
Price elasticity of demand = 2
Price Quantity
Before $200 500
Required
How much will the revenue of Good C change by (in $s) if a price cut of 10% is
implemented?
71
Solution
2.2 Value less than 1: inelastic demand
Inelastic demand
If price elasticity of demand (ignoring the minus sign) is less than 1 this means
that the % change in demand is less than the % change in price.
Demand is said to be price inelastic; ie unresponsive to price changes.
When demand is price inelastic, companies will experience:

 a fall in revenue if prices are cut, and
 a rise in revenue if prices are increased.
The value of elasticity is affected by the slope of the demand curve for a product.
Lower values of price elasticity of demand will result from a steeper demand curve.
72
4: Price elasticity
Illustration 6
A large drop in price will only cause a small rise in demand (meaning that total
revenue will fall as a result).
Price
Quantity
demanded
If a product has a low price elasticity of demand (for example) this would seem to
imply that firms producing these products should always be increasing their prices
(revenue would rise and costs would be lower because less is produced).
The reason that this is not the case is that a straight line demand function suggests
that whenever price rises by a set amount, for example by $5 (using the ski pass
example) the fall in demand is also a set amount (eg 3,000 units in the ski pass
example).
So a $5 price rise will be a lower percentage change as prices rise.
So price elasticity demand will change as price changes.
73
Illustration 7
If Company X increases the price of daily ski passes by $5, demand falls by 3,000
units. Its price elasticity of demand will rise as prices rise, as demonstrated in the
table below.
Initial price & demand Price $50 Price $100

Demand 45,000 Demand 15,000
% change in demand 3,000 / 45,000  100 = 3,000 / 15,000  100 =

6.7% 20.0%
% change in price 5 / 50  100 = 5 / 100  100 =

10.0% 5.0%
PED (simple method) 6.7 / 10 = 20 / 5 =

0.67 4.0
So if a product has a low price elasticity of demand (for example) this does not
imply that firms producing these products should always increase their prices.
In fact we can see that demand will become more elastic (more responsive to price
rises) at higher price levels (as you might expect).
This relationship between price and price elasticity of demand can also be shown
as a diagram:
Price
PED rises as price rises
D
Quantity
demanded
Footnote:
the mid-point of the demand function can be shown to have a PED of 1, but only if
the demand curve is straight which is rare in reality.
74
4: Price elasticity

The data below shows the price elasticity of demand for Good D (using the simple
method) and the data used to calculate these values.
Good D
Price elasticity of demand = 0.8
Price Quantity
Current $60 150,000
Required
What percentage change in revenue will result from a price cut of 10% for
Good D?
Solution
2.3 Determinants of price elasticity of demand.

There are a number of factors that will influence elasticity. For example, price
elasticity of demand will be higher if:
 Many substitute products are available at a competitive price
 Brand loyalty is weak so consumer demand is very price sensitive
 The product is a luxury (not a necessity) – for example soft drinks have an
estimated PED of 2.4 compared to 0.8 for fruit and vegetables (Eyles, 2012)
 A high proportion of income is spent on the product – because price
rises have a bigger impact on the consumer where this is the case
 The time period since the price changed is longer – consumers tend
not to notice or react strongly to price changes in the short term. However,
over time, they react to price rises (for example) by searching for and finding
cheaper alternatives. The internet has increased the ability of consumers to
research price differences and has therefore helped to increase the price
elasticity of demand.
75
In the illustration earlier in the chapter we identified that Company X has calculated
that the PED for ski passes is 4.0.
Required
Which of the following statements best explains this?
A Elasticity is low because there are few substitute providers
B Elasticity is high because prices are low
C Elasticity is high because the time period of the analysis was short term
D Elasticity is high because the ski pass is expensive compared to income
2.4 Special values of price elasticity of demand

(a) Perfectly inelastic ie 0
P
D
Demand totally
unresponsive to change
in price. Raise price to
increase revenue
PED : 0
Q1 Q
(b) Unitary ie 1
Revenue is the same at any price level
(c) Perfectly elastic ie infinite (∞)
P
Demand totally responsive
to change in price.
Any price change leads to
total loss of demand.
D
P1 Raise price lose all revenue
PED ∞
76
4: Price elasticity
3 Price elasticity of supply

3.1 Definition
A measure of the responsiveness of quantity supplied to a change in price.
Formula to learn: elasticity of supply

% change in quantity supplied
% change in price
Price elasticity of supply reflects the ability of firms to increase output when
demand rises.
3.2 Influences on price elasticity of supply

If the market price of a product rises, producers will want to increase supply. Their
ability or willingness to do this (ie the price elasticity of supply) will be greater if:
 The time period since the price changed is longer (allowing a firm more time
to organise extra production)
• The cost of attracting more factors of production (eg labour, capital) is lower
• Excess inventories are available which can be used to supply the market
• There is spare capacity (meaning that it is easy for a firm to increase
production levels)
• Technology permits an increase in supply at little or no extra cost eg provision
of e-services such as online music downloads incur little if any extra cost.

Required
The figures below show how the supply of Good F has changed following changes
to their prices.
Calculate price elasticity of supply for Good F, to one decimal place.
Good F
Price Quantity
supplied
Before $2.20 140
After $4.40 168
Solution
77
Chapter summary
• Price elasticity of demand indicates the responsiveness in the quantity demanded of

a good to a change in the price of that good.
• For the assessment, you need to be able to understand the factors influencing
elasticity, to measure price elasticity from given price and demand data, to draw
appropriate conclusions from such information, and to draw the correct implications
for the producer's total revenue of changes in the price of the product.
• The main factors affecting PED are the percentage of income spent on the good,
the availability of substitutes, whether the good is a necessity or a luxury, the time
horizon, and the degree of brand loyalty for the product.
• Elasticity of supply measures the responsiveness of the quantity of a good supplied
following a change in the price of that good.
78
4: Price elasticity
Keywords
 Elastic demand: If price elasticity of demand (ignoring the minus sign) is greater
than 1 this means that the % change in demand is greater than the % change in
price. Demand is said to be price elastic; ie responsive to price changes.
 Inelastic demand: If price elasticity of demand (ignoring the minus sign) is less
than 1 this means that the % change in demand is less than the % change in price.
Demand is said to be price inelastic; ie unresponsive to price changes.
79
Activity answers
PED A = (170 150)/150 PED B = (440  500)/500

(50  60)/60 (3.20  2.99)/2.99
= 0.8 = 1.7

Good A Good B
Average 160 470
quantity
Average price 55c $3.095
PED A = (170 150)/160 PED B = (440  500)/470
(50  60)/55 (3.20  2.99)/3.095
= 0.7 = 1.9

Revenue = price x quantity = $200  500 = $100,000
A price cut of 10% means that the new price will be $200  0.9 = $180
If elasticity = 2 the change in demand is twice the change in price
ie demand will rise 2  10% = 20% so new demand is by 1.2  500 = 600
So new revenue = $180  600 = $108,000
This is a rise of $8,000
When demand is elastic then a price cut should cause an increase in revenue.

Revenue = price x quantity = 60  150,000 = $9,000,000
If elasticity = 0.8 the change in demand is 80% of the change in price
ie demand will rise by 10%  0.8 = 8%
So new revenue = ($60  0.9)  (150,000  1.08) = $54  162,000 =
$8,748,000
252,000
This is a fall of $252,000, in % terms this is ×100 = –2.8%
9,000,000
80
4: Price elasticity

Correct answer – D
The ski prices are expensive (they are daily ski passes)
A – elasticity is not low (ie not <1)
B – elasticity is low when prices are low
C – elasticity is low in the short term

(168 140)/140
(4.4  2.2)/2.2
= 0.2
81
Test your learning
1 What is meant by the price elasticity of demand (PED) for a commodity?
2 What is the significance of PED to a manufacturer?
3 If the absolute value of the price elasticity of demand for dry white wine is
greater than one, a decrease in the price of all wine would result in:
A A more than proportional decrease in the quantity of dry white wine
purchased
B A less than proportional decrease in the quantity of dry white wine
purchased
C A less than proportional increase in the quantity of dry white wine
purchased
D A more than proportional increase in the quantity of dry white wine
purchased
4 What is the likely impact of a price rise for a low price but high quality fish
and chip shop with few substitutes?
A Demand will rise by less than the price rise
B Demand stays the same
C Demand falls by a greater percent than the price rise
D Demand falls by a lower % than the price increase as a %
5 Using the simple method, what is the price elasticity of demand of product X
as price falls from its current price of $20 to $15?
Old New
Price 20 15
Quantity 10 15
A 0.5
B 1
C 1.5
D 2
82
Cost behaviour
Learning outcomes

 identify the influence of costs on the size and structure of the organisation
Chapter context
Here we look at the influence of economic considerations on the size and structure of an
organisation. Costs will behave differently for different industries and this will have an impact on the
number of firms operating in the industry and the size of these firms.
Syllabus context
83
Chapter overview
Fixed – don't vary with Definitions Average – Total divided by

output output
Variable – do vary with
output
Total – Fixed & variable Cost behaviour
 Equipment and
Long run scale can be varied
 No fixed cost
Economies Constant returns Diseconomies

of scale to scale of scale
Internal External Internal External

 Technical eg loss of eg high raw
 Trading control material costs
 Financial eg demotivation
 Managerial
Impact  MES – in some
industries the MES
is high due to
economies of scale
Alternative Cost
 A high MES leads
strategies reduction
to high
concentration
 Shared service
ratios
centre
 Flexible staffing
84
5: Cost behaviour
1 Understanding cost behaviour

1.1 Short run
In the short run, a firm's output is constrained by its scale of operation (for example,
the size of its factory, or the number of staff it employs). This can lead to
inefficiencies when volume is increased. The reason for this is a loss of efficiency
from factors of production including higher costs of labour, such as paying premium
rates for overtime working and using contract staff.
1.2 Long run

In the long run a firm can adjust permanently to higher output levels by investing in
new resources, such as plant and machinery, IT systems, staff, and premises in order
to gain greater efficiency. Higher efficiency will mean lower average costs (where
average cost = total cost / total output, ie the cost per unit).
The diagram below shows how average costs may change as a firm increases the
scale of its operations (ie its size) in the long run.
Figure 5.1: Long run changes

As production scale increases towards the output level labelled QMES the average
cost falls. This is the effect of economies of scale.
Economies of scale
A reduction in cost per unit due to an increase in the size of the firm or of the
industry.
If a firm can achieve economies of scale it will have a potential source of

competitive advantage against existing rivals. Economies of scale will also make it
harder for new firms to enter the market ie low costs per unit act as a barrier to
entry.
85
If the firm increases production above QMES towards QMAX it will enjoy no further
reduction in average costs, because the potential for further economies of scale has
been exhausted. This is the range of constant returns to scale.
If the firm increases output beyond QMAX it begins to suffer inefficiencies and rising
average costs. These are diseconomies of scale.
In this chapter we will identify how economies and diseconomies of scale influence
the ideal size of a firm and, therefore, the number of firms that can exist profitably
in an industry.
2 Economies of scale
Economies of scale
Internal External
 Arising within the  Arising because of

firm from the the growth of the
organisation industry as a whole
2.1 Internal economies of scale

Internal economies of scale arise from the firm, either through its own growth or
potentially from growth by acquisition. This is the type of economy of scale that is
under the control of management.
Internal economies of scale
Trading Financial
Technical Managerial
2.1.1 Trading economies of scale (internal)

(a) Buying economies may be available, reducing the cost of material
purchases through bulk purchase discounts
(b) Bulk selling will enable a large firm to make relative savings in
distribution costs and advertising costs
86
5: Cost behaviour
(c) Economies of scope refer to the cost savings available by offering a wider
range of products, eg a sales team can sell a wider range of products without
incurring extra cost.
2.1.2 Financial economies of scale (internal)
It may be cheaper and easier for large firms to raise finance. Investors accept lower
returns if risk is lower. Larger firms are perceived to be less risky because they often
have:
 Valuable assets to pledge as security
 High levels of market power
 Less reliance on a single product or market
Quoted firms can also raise finance by selling shares to the public via a stock
exchange.
2.1.3 Technical economies of scale (internal)

These arise in the production process. In many industries a high proportion
of costs are fixed costs eg aircraft manufacture, car manufacture, logistics
companies. In these industries, larger firms may have a significant cost advantage
because the fixed costs can be spread over a larger number of units.
It may be possible for a small company to simply invest in a lower amount of fixed
infrastructure costs, but sometimes this will not be possible because the investment
cannot be subdivided eg robotic machinery used in car assembly plants. Such
assets are said to be indivisible.
Illustration 1
Large Co and Small Co are parcel delivery companies. They have both established
a national network of depots at an annual cost of $20 million. The average variable
cost of delivering a parcel, for both companies, is $1.5 per parcel. If Large Co
delivers 10 million parcels per year and Small Co delivers 2 million parcels per
year, average costs per unit will be:
Large Co Small Co
Number of parcels 10m 2m
Total variable costs 10m  1.5 = $15m 2m  1.5 = $3m
Fixed costs $20m $20m
Total costs $35m $23m
Average cost / unit $35m / 10m = $3.5 per $23m / 2 = $11.5 per
unit unit
Large Co will therefore have a significant cost advantage over Small Co.
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Axe Co produces 3 million supermarket trolleys per year at a total cost of $450m,
20% of its costs are (indivisible) fixed costs.
New Co is thinking of entering this market, but initially will only produce 0.5m
trolleys.
Required
Calculate how much higher, in % terms, New Co's average cost per
unit will be compared to Axe Co's (assuming that New Co has the same
average variable cost per trolley as Axe Co).
Solution
2.1.4 Technical economies of scale (continued)
Division of labour
As a firm increases in size it can break down jobs into individual tasks that can be
assigned to separate individuals; this is called the division of labour.
The division of labour can increase productivity by creating a labour force who are
specialists in their specific tasks. This can help to reduce unit costs because:
(a) Staff need less time to learn the job because they are being trained for only
one task and not all the tasks
(b) Tasks can be allocated to staff with the greatest aptitude for the task
(c) Learning effects will be enjoyed as staff members learn and find ways to
perform their task more quickly
(d) Time is not wasted with staff switching between tasks, such as in moving from
machine to machine or in putting one set of tools away before selecting a
different tools to use on a new task
Dimensional economies of scale arise from the relationship between the
volume of output and the size of equipment (eg storage tanks) needed to hold or
process the output.
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5: Cost behaviour
For example, the cost of a container for 10,000 gallons of product will be much less
than ten times the cost of a container for just 1,000 gallons. This is sometimes called
the cube law, and can apply to buildings as well. For example, building a
warehouse of double the cubic capacity requires only a small increase in the size of
two walls.
2.1.5 Managerial economies of scale (internal)

The average cost of co-ordinating and controlling the business can fall as scale
rises:
(a) Centralisation of functions such as administration, R&D and marketing may
reduce the burden of overheads (ie the indirect costs of production) on
individual operating locations
(b) More efficient use of management because the number of management and
supervisory staff does not increase at the same rate as output, for example a
hotel with 100 bedrooms and a hotel with 1,000 bedrooms would each have
a single General Manger, Head Chef and so on.
(c) Specialist staff save money because large firms can justify employing specialist
staff in IT, HR, accountancy etc and their skills can be fully utilised in their
specialist areas.
2.2 External economies of scale

It is also possible for costs per unit to fall because of a growth in the size of the
industry (not the firm). Here are some examples.
(a) To support a growing industry, the government may provide educational
services that are geared towards training new entrants. This saves firms in
the industry from having to incur the costs of training.
(b) Specialised ancillary (support) industries will develop to provide
components, distribution and other services, eg law firms may be set up to
specialise in the affairs of the industry, saving firms the costs of in-house legal
teams.
(c) Government assistance may be granted to industries that promise large
amounts of jobs or export earnings. In recent years, information technology,
green energy and biotechnology industries have benefited from this.
89
Stride Co makes specialist robotic equipment for use in the assembly lines of
manufacturers of electric cars. The robotics manufacturing and electric car industries
have been growing rapidly in recent years.
Required
Which of the following is an example of an external economy of
scale that may benefit Stride Co?
A The growth in size of suppliers to the robotic equipment market leading to a
fall in production costs
B A fall in Stride Co's fixed costs per unit due to the growth in sales.
C More competition among the manufacturers of robotic equipment
D Technological breakthroughs driving down the costs of making robotic
equipment
Solution
3 Diseconomies of scale
Economic theory predicts that there will be diseconomies of scale (ie rising cost
per unit) once the firm gets beyond its optimum size. The main reasons for possible
internal diseconomies of scale are:
(a) Chains of command may become excessively long, and management will
become too remote and lose control over operations.
(b) Morale and motivation amongst staff may deteriorate in large firms and there
may be conflicts between different departments.
(c) Senior management may have difficulty in assimilating all the information they
need in sufficient detail to make good quality decisions.
(d) There may be increased levels of bureaucracy.
The implication of diseconomies of scale is that while firms need to achieve a
certain size to benefit from economies of scale, they should not become too big,
because if they do cost controls might slacken and organisational inefficiency may
be likely to result.
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5: Cost behaviour
3.1 External diseconomies of scale

There may also be external diseconomies of scale which affect all firms in an
industry as the industry grows. For example, if a shortage of materials or labour
occurs (due to high levels of demand across the industry) then this might lead to
higher raw material and labour costs.
4 Impact of long run costs on industry structure

4.1 Minimum efficient scale (MES)
Minimum efficient scale is the lowest level of output at which a firm can achieve its
minimum average cost. If a firm is producing at quantities below the MES, its unit
costs of production may be higher than those of its bigger rivals. This means it will
be at a competitive disadvantage.
Figure 5.2: Minimum efficient scale

If Firm A is producing at QA it will have unit costs of CA. It has not reached minimum
efficient scale. Firm B is producing at QB and has unit costs of CB, the minimum
feasible cost in the industry.
Firm B might seek to set market price at P0 to inflict losses of CA – P0 per unit on Firm
A whilst making profits per unit of P0 – CB itself. This could have the effect of driving
Firm A from the industry.
4.2 MES in different sectors

The level of the MES will vary in different industries. In industries where fixed costs
are low, then the MES will be low (eg software, apps) but where fixed costs are
higher as a percentage of total costs the MES will be high (eg aircraft manufacture,
mining).
Sometimes the MES may be so high that it leads to a situation of natural
monopoly in which the forces of competition drives all but one firm from the
industry, eg piped gas, mains electricity and water, and fixed-line telephones. So
the level of the MES influences the number of firms that can compete efficiently in an
industry.
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Stride Co makes specialist robotic equipment for use in the assembly lines of
manufacturers of electric cars. The MES in this industry is estimated at 15,000 units
per year. Industry sales are 120,000 units per year.
Required
Which of the following statements is correct?
A At least 8 firms will be able to compete efficiently in this industry.
B Only 8 firms will be able to compete efficiently in this industry.
C A maximum of 8 firms will be able to compete effectively in this industry.
D Diseconomies of scale will set in above output of 15,000 units
Solution
4.3 Concentration ratios

The extent to which large firms dominate an industry is often measured as a
concentration ratio.
Normally this involves calculating the percentage of total output in an industry that
comes from the largest firms (often the largest three, four or five firms).
A measure of the total output of the top five firms would be called a five-firm
concentration ratio, eg the five-firm concentration ratio for UK supermarkets in 2015
is approximately 78% (ie the five largest firms account for 78% of total sales).
4.4 Methods of growth

Companies can increase the scale of their operations by:
 internal (organic) growth – investing to build the company's own
capacity to enable higher production levels so that internal economies of scale
can be generated.
 acquiring other companies – a strategy of buying another company may be
referred to either as an acquisition, merger or as an integration strategy.
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5: Cost behaviour
4.4.1 Types of integration

There are different types of integration that you need to be aware of, as shown
below.
Suppliers
Backward vertical
Rival New
business Existing business business
Horizontal
Conglomerate
Forward vertical diversification
Similar Different
customers Customers customers
Figure 5.3: Types of integration
 Horizontal integration
– involves the acquisition of a rival firm in the same line of business eg
FIAT acquired Chrysler in 2014.
Horizontal integration is likely to create internal economies of scale and
to reduce competition.
 Vertical integration
– the acquisition of a firm that operate at different stages of
production.
Backward vertical integration is where a firm merges with a
supplier.
Forward vertical integration is where a firm merges with a customer eg
Booker, a food supplier, acquired Budgens and Londis (food retailers) in
2015.
 Conglomerate integration
– also called diversification, this involves the acquisition of a firm in a
different line of business.
Sometimes there may be a link between the two businesses eg Lenovo
(computers) acquisition of Motorola (mobile phones) in 2015.
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Horizontal integration builds a firm's scale of production in a specific market and
will be likely to generate internal economies of scale. Vertical and conglomerate
integration do not increase a firm's size within a specific market.
Required
What, if any, types of internal economy of scale are likely with these types of
integration?
Solution
5 Alternative strategies for firms

Although economies of scale encourage firms to get bigger, small firms can still
survive and be competitive. Strategies such as outsourcing of high-cost activities,
or off shoring, often enable smaller firms to survive.
5.1 Strategies involving other companies

5.1.1 Outsourcing
Outsourcing refers to transferring an activity previously conducted by the firm itself
to an outside contractor.
When supplying a market, a firm undertakes a chain of activities, eg an internet
shopping firm must develop websites, purchase inventory, provide warehousing,
employ and pay its staff, operate a home delivery service etc.
Each activity will have its own MES. Where a firm is being made uncompetitive due
to the high costs of one of its activities it can reduce its costs by outsourcing that
activity to a contractor. The contractor can perform the activity at lower cost
because it pools the work of the firm with the work of other clients and so achieves
economies of scale from working at the minimum efficient scale, eg a small internet-
based retail company can use an external logistics company to deliver goods to its
customers, rather than running its own delivery service (employing its own delivery
staff, purchasing delivery vehicles etc).
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5: Cost behaviour
5.1.2 Off shoring

The costs of operation vary widely from country to country, due to factors such as:
(a) Lower general pay rates
(b) Better skills available
(c) Better support services such as transportation, information systems or education
and training
(d) More favourable regulatory environment such as lower taxation, less costs of
complying with government regulations.
A firm may decide to locate some its in-house operations offshore or may
outsource some of its activities to off-shore locations in order to gain cost
efficiencies needed to compete in its market.
5.1.3 Network organisations

Outsourcing means a firm will rely on several other firms to supply a product. So,
the supply of a good involves several firms in partnership. If a firm has outsourced
most of its activities, it is called a network organisation.
5.2 Other strategies

5.2.1 Shared service centre
This is the provision of a service by one part of a firm where that service had
previously been found in more than one part of that firm, eg using a central finance
team, rather than the different divisions in a company each having their own
finance team. This is often motivated by an attempt to create economies of scale.
5.2.2 Flexible staffing

This involves the use of a variety of flexible working arrangements; for example the
use of temporary staff, or full time staff on zero-hours contracts.
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Chapter summary
 In the long run, costs per unit fall because of economies of scale, reach their lowest
point at minimum efficient scale (MES), remain constant for a while before
increasing because of diseconomies of scale.
 Economies and diseconomies of scale can be caused by internal (financial, trading,
technical, managerial) or external factors.
 MES determines whether the industry will be dominated by large firms. If the MES is
high relative to industry size then the concentration ratio in that industry will be
high.
 Acquisitions can be horizontal, vertical or conglomerate.
• Smaller firms will often attempt to remain competitive by using strategies such as
outsourcing and off shoring.
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5: Cost behaviour
Keywords
 Economies of scale: A reduction in cost per unit due to an increase in the size of
the firm or of the industry.
 Division of labour: As a firm increases in size it can break down jobs into
individual tasks that can be assigned to separate individuals; this is called the
division of labour.
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Activity answers

Axe Co's costs can be broken down as:
$90m fixed
$360m variable (0.8  $450m).
Variable costs per unit are therefore $360m / 3m = $120 / trolley
Total costs per unit are $450m / 3m = $150 / trolley
New Co's costs will therefore be:
$90m fixed (the same as Axe Co because the fixed costs are indivisible)
$60m variable (120  0.5m).
Total costs are therefore $150m and cost per unit = $150m / 0.5m = $300 /
trolley
New Co's cost per unit will therefore be 100% higher (300 / 150 – 1) than Axe
Co's.
This will make it difficult for New Co to compete against Axe Co and demonstrates
how economies of scale can act as a barrier to entry against potential entrants
to a market.

Correct answer: A
The economies of scale enjoyed by suppliers will be passed on to Stride – and are a
result of the growth in Stride Co's industry.
B is a technical economy of scale, and so is internal (not external).
C (increased competition) is likely to result in lower prices and/or lower profits so
won't benefit Stride.
D will result in lower costs but do not relate to 'scale'.
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5: Cost behaviour

Correct answer: C
120,000 / 15,000 = 8.
A maximum of 8 firms could operate efficiently (output 15,000) in this industry.
A – this implies that a higher number could compete efficiently, eg 10 firms. But
this would not be possible because the average output would be 120,000 /
10 = 12,000 which is below the MES (so average costs would be higher than
the minimum average cost, which is achieved at the MES of 15,000).
B – not necessarily; there is likely to be a period of output over which returns are
constant so it may be possible for fewer than 8 firms to compete efficiently.
D – not necessarily; there is likely to be a range of outputs over which returns are
constant.

Vertical integration may create:
 Financial economies of scale – providers of finance may accept lower
returns if risk is lower because a firm has less reliance on external suppliers or
customers.
Conglomerate integration (especially if in a related market) may create:
 Economies of scope – cost savings available by offering a wider range of
products, eg a sales team can sell a wider range of products without incurring
extra cost.
 Financial economies of scale (internal) – providers of finance may
accept lower returns if risk is lower because a firm is less reliant on a single
product or market
 Managerial economies of scale – centralisation of functions such as
administration and finance (it is possible that vertical integration may
sometimes also create managerial economies of scale).
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Test your learning
1 Which of the following best defines a fixed cost?
A A cost that does not change from year to year
B A cost that does change when output rises
C A cost that does not change when output changes
D A cost that has been laid down in a contract
2 Why might there be internal diseconomies of scale?
3 Which of the following is NOT an advantage of the division of labour?
A Less training costs and time for workers to learn the job
B Opportunity to use specialist tools and equipment
C Repetition of same task leads to boredom and errors
D Workers can do tasks suited to their natural abilities
4 Which of the following terms describes a situation where a firm can reduce unit
costs by offering a wider selection of products?
A External economy of scale
B Economy of increased dimensions
C Financial economy of scale
D Economy of scope
5 Which of the following is an example of an external economy of scale?
A Increased wage costs due to falling unemployment in the region.
B The employment of specialist managers by a firm to cope with higher output
levels.
C The extension of low-cost telecommunication links to an area of the country not
previously served by such links.
D Cheaper finance in recognition of the firm's increased share of the market and
therefore its stability.
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Market failure
Learning outcomes

 explain the sources of market failure and the policies available to deal with them
Chapter context
Our previous analysis has suggested that the forces of demand and supply should result in a market
quickly settling down at equilibrium. In practice, various factors may delay the market reaching
equilibrium or may prevent it happening altogether. In these circumstances, the government may
have to intervene to resolve the problems. Organisations need to be aware of the potential for this
type of government intervention in the economy.
Syllabus context
This chapter is part of syllabus Section B which looks at the 'microeconomic and
organisational context of business'.
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Chapter overview
Market failures
Examples Government Price

response regulation
 Failure to consider  Direct provision Minimum pricing

externalities  Indirect taxes and  high price
 Dominant firm subsidies  supply high
exploiting market  Polluter pays  demand low
power policies  surplus
 Failure to consider  need admin controls
social goals Maximum pricing
 Failure to provide  low price
public goods  supply low
 demand high
 shortage
 governments will ration
Effects
Minimum wage
Ensure standard May create

of living over-supply ie
unemployment
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6: Market failure
1 Market failure
We have already seen that the market forces of demand, supply and the price
mechanism should lead to equilibrium, ie a situation where there are no
shortages or surpluses.
Market failure
A situation where market forces lead to a sub-optimal allocation of resources
Market failures can occur for a variety of reasons, which are discussed in the
next two sections.
Market failures are likely to give rise to some form of government intervention,
and we consider a variety of forms that this could take later in this chapter.
2 Market failure 1 – externalities
Externalities
A positive or negative impact of a transaction on people who are external to that

transaction (ie not a buyer or seller).
2.1 Positive and negative externalities

By definition, externalities are not directly considered by buyers and sellers, ie they
are not considered by the market forces of demand and supply.
(a) Positive externalities

– benefits from production or consumption of a good or service that extend
beyond the trading parties (ie the buyer and seller)
(b) Negative externalities
– costs from production or consumption of a good or service that extend
beyond those paid for by the trading parties
2.2 Merit and demerit goods

Sometimes a product generates such a high impact in terms of externalities that it is
generally agreed that this product is either good or bad for society as a whole.
(a) Merit good
– generates positive externalities to society as a whole (social benefits). For
example, vaccinations, education
103
(b) Demerit good
– generates negative externalities to society as a whole (social costs). For
example, smoking.

Required
Are the following statements true or false?
Solution
(a) The cost of high health insurance premiums due to an individual being a
smoker is an example of a negative externality
TRUE / FALSE
(b) The cost of dental care due to an individual consuming sugary drinks is an
example of a negative externality.
TRUE / FALSE
(c) A fine incurred by a company for polluting the environment is a negative
externality.
TRUE / FALSE
(d) Home improvements which increase the value of a property and neighbouring
properties suggests that DIY products are a merit good.
TRUE / FALSE
2.3 Dealing with externalities

A free market will result in the under-consumption of merit goods and the over-
consumption of demerit goods. Government intervention will be needed to remedy
this.
Possible forms of government intervention are summarised below and dealt with in
more detail in the subsequent sections.
Merit goods Demerit goods

(a) Subsidies to reduce the price. (a) Indirect taxation to raise price.
(b) Public information campaign to (b) Public information campaign to raise
stress benefits. awareness of risks.
(c) Public provision of the product. (c) Legislation/ban on product, eg
smoking in public buildings.
(d) Price regulation (maximum price). (d) Tax levy eg polluter pays policy.
(e) Price regulation (minimum price).
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6: Market failure
3 Market failure 2 – other issues

3.1 Other market failures
A completely unregulated economy can also result in a number of other market
failures. Government intervention (see following sections) will be required to address
these failures.
3.1.1 Failure to provide public goods
Public goods
Public goods have two defining characteristics:
(a) Non-diminishability: the good or service can serve a small or large

number of people at exactly the same cost, ie the good or service does not
diminish in supply as more people enjoy it.
(b) Non-exclusivity: providers of the good or service cannot exclude non-

payers, which makes it unlikely that it will be provided by profit-seeking
providers.
Note that not all goods provided by the public sector are public goods, eg
healthcare is a merit good, not a public good, because it is diminishable (ie there is
less healthcare available for others as more people use healthcare resources).

Required
List some examples of public goods.
Solution
Because the enjoyment of a public good is not restricted to those who have paid for
it, this allows non-payers to 'free ride' at the expense of those who pay. The
consequence may be that no-one will be prepared to pay for the public good
because they hope to enjoy it as a free rider.
If no-one will voluntarily pay for the good/service, no private enterprise is likely to
supply the good. This is the free rider problem.
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The most obvious remedy to the free-rider problem is for governments to provide
the good (or to finance its provision by the private sector) and to fund it through
taxation.
3.1.2 Exploiting market power

There are many possible examples of this, but typically we might think of large,
powerful firms exploiting their power by charging unfairly high prices or paying
unfairly low wages.
Governments may try to address this by preventing takeovers that create large firms
which dominate a market, or by price and wage regulation (see Section 5).
3.1.3 Failure to provide information for buyers to make rational

decisions
There are many possible examples of firms making misleading claims about
products that lead to consumers making unwise buying decisions eg mis-selling
financial products such as PPI (payment protection insurance).
Governments may try to address this by introducing regulations on the information
that is provided to consumers.
3.1.4 Failure to consider social goals

There is concern over rising levels of inequality – this will not be addressed by the
free market and will also require some form of government intervention.
4 Government intervention 1 – indirect taxes &

subsidies
4.1 Indirect tax
An indirect tax is a tax levied on spending. The producer is responsible for
collecting and paying the tax to the government, but much of the tax is passed on to
the consumer (due to a higher price being charged).
A key purpose of an indirect tax is to reflect social costs by adding them as a cost to
be paid by the producer. This will result in less of the product being consumed,
which is especially desirable in the case of demerit goods such as alcohol.
Illustration 1
The price of a bottle of whiskey is $10. At this price, the amount consumed is Q0. If
the government imposes an indirect tax of $5 per bottle, this is paid to the
government by the producer. The producer will now only be prepared to sell the
same quantity when the price is $15 per bottle (rather than $10). Therefore, the
supply curve moves up by $5 from S0 to S1.
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6: Market failure
However, at this new price of $15, demand for whiskey will be lower. There is now
a surplus of whiskey (Q1 – Q0), so whiskey producers will cut their price until the
surplus is removed at B, where price is $13.
P S1
15 S0
13 B
Consumers' portion (13 –10) = 3
10 A
Firm's portion (5 – 3) = 2
8
Total tax per unit =5
D
Q
Q1 QE Q0
As a result of the tax, price rises by $3 (from 10 to 13) – so $3 of the tax is passed
on to the consumer. The rest of the burden of the tax ($2) is borne by the supplier.
4.1.1 Price elasticity and the impact of indirect taxes

The impact of an indirect tax will be that the price of the good rises, and that the
quantity produced and sold falls. The extent to which a price rise causes a
fall in quantity depends on the price elasticity of demand and supply.
 If the price elasticity of demand is very low (inelastic) then the quantity
demanded will not fall significantly as a result of a price rise.
 If the price elasticity of supply is very low (inelastic) then the quantity
supplied will not fall significantly, and in some cases supply may be fixed
in the short term regardless of price, eg output of gas from a fracking
site.
So the imposition of an indirect tax may not achieve a significant reduction in the
consumption of a demerit good. However, it can still raise useful income to finance
government spending and to force producers to bear some of the costs of managing
the negative externalities resulting from production.

Required
If the price elasticity of demand and the price elasticity of supply of the goods being
taxed are low (ie inelastic), what will be the impact of a tax rise on:
(a) Raising income to finance government expenditure.
(b) Discouraging consumption of demerit goods.
(c) Forcing producers to bear the costs of managing the negative externalities.
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Solution
4.1.2 'Polluters pay' policies

Demerit goods often cause negative externalities, such as pollution. We have seen
that indirect taxes may not be effective in reducing the production and consumption
of demerit goods if demand and supply for them are inelastic, so other approaches
are employed in attempt to 'make the polluter pay' but in a way that is more likely
to also make them take actions to reduce pollution. Other 'polluters pay' policies
include:
(a) Tradable permits.
A firm is allowed to produce a certain level of pollution. If it produces
more it will have to pay for additional permits. If it produces less, it can
sell its unused permits for a profit to other companies.
(b) Charges for dumping waste products eg landfill tax.
(c) Fines for breaching regulations.
4.2 Subsidy
A subsidy is a financial contribution from government to reduce the costs of
production. It can have a number of aims:
(a) To reduce cost of living by making essential goods affordable.
(b) To encourage production or consumption of merit goods.
(c) To stabilise incomes of producers (eg farm subsidies).
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6: Market failure
4.2.1 Impact of a subsidy

A per-unit subsidy shifts the supply schedule downwards (rightwards) by the
amount of the subsidy per unit.
Illustration 2
S0
A S1
10
Consumers' portion (10 – 8) = 2
8
B Firm's portion (5 – 2) = 3
5
D
Q0 QE QS
The equilibrium is initially at A, where the price is $10 and the quantity is Q0.
The government grants a subsidy of $5 per item. This encourages producers to
make more of the product, so the supply curve shifts to S1 and the amount supplied
increases to Qs.
There is now excess supply of Qs – Q0. So suppliers reduce their price until a new
equilibrium is reached at B. At B the price is $8, so consumers benefit from $2 of
the subsidy ($10 – $8) and suppliers take the rest of the benefit ($3).
4.2.2 Price elasticity and the impact of subsidies

The impact of a subsidy will be that the price of the good falls, and that the quantity
produced and sold rises (ie from Q0 to QE in Illustration 2 above). The extent to
which a price fall causes a rise in quantity depends on the price elasticity of
demand and supply.
 If the price elasticity of demand is very low then the quantity demanded will
not rise significantly as a result of the lower price.
 If the price elasticity of supply is very low then the quantity supplied will not
rise significantly, because supply may be fixed in the short term regardless of
price eg subsidies for nuclear fuel.
5 Government intervention 2 – direct provision and

regulation
5.1 Direct provision
Where the free market is producing too few merit goods, or where the market
power of private firms is seen to be too high, the government may decide to act as
109
a provider of goods and services, eg provision of healthcare in the UK through the
National Health Service (NHS).
There are potential problems with this approach, for example:
 Government organisations do not need to make a profit so there is less
incentive for them to control costs.
 State ownership leads to large organisations which are difficult to control.
 Some international trade treaties forbid state ownership.
Government intervention is especially important in the case of public goods (see
earlier).
5.2 Price regulation

The government can manipulate the market by setting a maximum or minimum price
for goods or services. This can be a useful intervention to address market power or
to achieve social goals (two market failures identified earlier).
5.3 Minimum pricing policies

A minimum price is a price level below which the market price will not be permitted
to fall ie a price floor.
An example of this the imposition of a statutory minimum wage.
Price $ Excess supply S
Pmin
P0
Qd Q0 Qs Quantity

Required
Complete the following descriptions (with reference to the above diagram).
(a) Setting a minimum price has the effect of supply from the
equilibrium level of to .
(b) Raising the from P0 to .
(c) Overall there is now excess supply in the market represented by the distance
between and .
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6: Market failure
5.3.1 Effects of a minimum price

(a) Increases welfare of producers.
A higher price to suppliers of goods will result if the minimum price is
established at a level that is above the current market price.
(b) Create a surplus (excess supply)
In the diagram above, there is an overall excess supply represented by Qd to
QS. This may lead to informal arrangements whereby suppliers agree to supply
the good for less than the minimum price.
5.3.2 Effects of a minimum wage

(a) Increases pay of workers.
A higher price to suppliers of labour will result if the minimum wage is
established at a level that is above the current market price.
(b) Create a surplus (unemployment)
In the diagram above, there is an overall excess supply of labour represented
by Qd to QS. However, the unemployment caused by the minimum wage itself
is only the distance Qd to Q0 (because the equilibrium point prior to the
minimum wage was Q0). This may lead to informal arrangements whereby
workers agree to work for less than the minimum wage.

Required
A national minimum wage is less likely to create unemployment in which TWO of
the following scenarios:
A There is already a high level of unemployment
B Price elasticity of demand for labour is low
C It is easy to substitute labour with machinery
D Low wage workers account for a small proportion of the employer's costs
Solution
111
5.4 Maximum pricing
A maximum price is a price level above which price will not be permitted to rise ie
a price ceiling.
An example of this is the imposition of a maximum price for household rents.
Price $ S
P0
Pmax
Excess demand
D
Qd Q0 Qs Quantity

Required
Complete the following descriptions, with reference to the above diagram.
(a) Setting a maximum price has the effect of supply from the
equilibrium level of to .
(b) Reducing the from P0 to .
(c) Overall there is now excess demand in the market represented by the distance
between and .
5.4.1 Effects of maximum price (price ceiling)

(a) Consumers are protected from the effects of high prices, eg rent controls are
used in many cities (eg New York, Berlin) for this reason.
(b) A shortage is created, and the market will not be able to ration the good
between customers. So the government will have to perform the rationing
function by:
(i) Formal rationing – eg by issuing coupons or deciding allocation (in New
York priority for apartments is given to long-term New York residents).
(ii) Implementing waiting lists.
(c) Shortages may lead to illegal trading on the parallel (or black) market.
112
6: Market failure
Chapter summary
 Market failure results in a suboptimal use of economic resources.

 Market failure can result from market forces ignoring externalities, social goals,
market power, information problems and the free-rider problem (public goods).
 The existence of market failures is an argument for government intervention.
• Government may intervene by:
– Indirect taxes (or other 'polluter pays' policies)
– Subsidies
– Direct provision and regulation
• Government may also impose maximum or minimum prices. Examples include:
– Minimum wages
– Maximum rents
113
Keywords
 Market failure: A situation where market forces lead to a sub-optimal allocation
of resources
 Externalities: A positive or negative impact of a transaction on people who are
external to that transaction (ie not a buyer or seller).
 Public goods
Public goods have two defining characteristics:
(a) Non-diminishability: the good or service can serve a small or large number
of people at exactly the same cost, ie the good or service does not diminish in
supply as more people enjoy it.
(b) Non-exclusivity: providers of the good or service cannot exclude non-payers,
which makes it unlikely that it will be provided by profit-seeking providers.
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6: Market failure
Activity answers
Activity 1 : Exam standard

All are FALSE.
(a) The cost of high health insurance premiums due to an individual being a
smoker is an example of a negative externality this is a cost affecting the
buyer. Although the impact of an individual smoking could have negative
externalities, the specific impact on an individual's insurance premiums is not
an externality (because it only affects the parties directly involved in the
transaction – ie the consumer and the provider of the insurance).
(b) The cost of dental care due to consumption of sugary drinks is an example of a
negative externality this is a cost affecting the buyer.
(c) A fine incurred for polluting the environment is a negative externality this is a
cost affecting the seller. As with statement (a), although the pollution itself is a
negative externality, the fine imposed on the company is not.
(d) A merit good has to affect society as a whole eg home improvements may
add to property values in the street, but DIY products are not merit goods.

 Lighthouses
 Street lighting
 Defence
 Public radio service
All of these have the characteristics of non-diminishability and non-exclusivity.

(a) Raising income to finance government expenditure.
Government revenue depends on tax per unit  units produced. So if elasticity
of demand or supply is low, then output is relatively unchanged as a result of a
price rise and government revenue will be higher.
(b) Discouraging consumption of demerit goods.
If elasticity of demand or supply is low then output is relatively unchanged as a
result of a price rise and therefore the consumption of demerit goods will not
reduce significantly.
(c) Forcing producers to bear the costs of managing the negative externalities.
If demand is inelastic then although the producer is responsible for paying the
tax to the government, they can actually pass on much of the cost of the tax to
the consumer. This means that, in a sense, the consumer pays. In the diagram
below the effect of completely inelastic demand is illustrated.
115
Consumer pays 100% of the indirect tax
D S1
15
S0
Consumers' portion (15-10) = 5
Firm's portion =0
10

(a) – Increasing
– Q0
– Qs
(b) – Price
– Pmin
(c) – Qd
– Qs

Correct answers B and D
A – In such a situation demand for labour is already low so increasing the price of
labour is likely to create further unemployment.
B – In this situation an increase in the price of labour will not lead to a significant
reduction in demand.
C – This will mean that workers will be replaced by machinery.
D – This will mean that price elasticity of demand for labour is low (see B) because
employers are not too concerned with changes in the price of labour. (Where
this is not the case (eg childrens' nurseries) then unemployment will be
created).

(a) – Contracting
– Q0
– Qs
(b) – Price
– Pmax
(c) – Qs
– Qd
116
6: Market failure
Test your learning

1 What is an externality?
2 List the various forms of government intervention in markets.
3 Which of the following are weaknesses of a completely free market?
1 It only reflects private costs and private benefits
2 It may lead to serious inequalities in the distribution of income and wealth
3 It may lead to production inefficiencies and a wastage of resources.
A 1 and 2 only
B 2 and 3 only
C 1 and 3 only
D 1, 2 and 3
4 Much Wapping is a small town where a municipal swimming pool and sports
centre have just been built by a private firm, Builder Co. Which of the following is
an external benefit of the project?
A The increased trade of local shops
B The increased traffic in the neighbourhood
C The increased profits for the sports firm
D The increased building on previous open land
5 The government has just increased the tax on tobacco. Assuming that the demand
for cigarettes is completely inelastic, who pays the tax?
A It is shared between supplier and consumer in proportions equal to the relative
prices before and after the increase.
B The supplier
C The consumer
D It is shared between supplier and consumer in proportions equal to the relative
quantities sold before and after the increase.
6 Which of the following statements is always true if an indirect tax is imposed on a
good or service:
A The price will rise by an amount equal to the tax
B The producer will bear more of the tax than the consumer
C The price rise will be smaller, the greater the price elasticity of demand is
D The price rise will be greater, the greater the price elasticity of demand is
117
118
National income
Learning outcomes

 explain the determination of macroeconomic phenomena, including equilibrium national
income, growth in national income, inflation, unemployment, and trade deficits and surpluses
(inflation, unemployment, trade deficits/surpluses are covered in more detail in the next chapter)
Chapter context
Businesses will be affected by general economic conditions, so it is important to have an
understanding of the principal factors that cause changes in the overall level of economic activity.
Syllabus context
This chapter is part of syllabus Section A which looks at the 'macroeconomic and institutional
119
Chapter overview
National
income
An indicator of
economic success
Influenced by Influenced by
aggregate demand aggregate
supply
Expenditure (E) = Income (Y) Circular flow

of income
Injections (J) = Withdrawals (W)
Components of
demand
Consumption Government Exports Investment

(C) expenditure (X) (I)
(G)
 Exchange rates
Multiplier theory: higher injections
 Competiveness
stimulate consumer spending. Marginal
MPC = Marginal propensity to consume  Foreign income efficiency of
Multiplier = 1/1-MPC investment
Increase in Y = 1/1–MPC × injection
 Low interest rates
=> high investment
 High interest rates
=> low investment
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7: National income
1 National income
The key measure of overall economic activity in a country is national income.
Broadly speaking, national income is a measure of the value of goods and services
produced in a year.
The value of the spending on these goods and services creates income for suppliers,
which is why this is referred to as national income.
1.1 Different measures of economic activity

Other measures of overall economic activity also exist, including gross domestic
product (GDP) and gross national product (GNP). In the exam these terms are
normally used to mean the same thing as national income ie as a measure of overall
economic activity. However, technically there is a slight difference between these
measures.
GDP = the market value of final goods and services produced within an
economy.
GNP = GDP + net property income (NPI) from abroad
(NPI = profits, dividends, interest earned from foreign investments less those paid
out to foreign investors)
National income = GNP – depreciation
(depreciation is an estimate of the decline in the value of the assets within the
economy during the period; it is often referred to as capital consumption)
In the remainder of this material, as is normal in the exam, the terms GDP, GNP and
national income are used interchangeably.
1.2 Different measures of economic activity

The percentage change in national income during a year is often used as an
indicator of the economic success of an economy, ie as an indicator of changes in
living standards.
However, there are some problems with this assumption:
 Not all economically valuable goods and services are bought at their market
value.
 No distinction is made between consumer goods and capital goods (eg a
factory).
 Economic growth may be occurring simply because population is increasing.
 Economic growth may create environmental problems that are not measured.
 Economic growth may not result in an increase in living standards for the
average person.
 Rising national income may be due to increases in price levels, ie inflation.
121
Required
Analyse why the problems described in Section 1.2 above may mean that faster
economic growth (over time or versus other countries) may not mean higher average
living standards.
Solution
2 Factors affecting national income

We have already seen how the equilibrium level of output for individual firms is
determined by demand and supply. The equilibrium level of output (national income)
in an economy is determined in a similar way, but in this case instead of looking at
demand from individual consumers and supply from individual firms we are looking
at aggregate demand and aggregate supply.
Aggregate demand total demand for goods and services in a country.
Aggregate supply total supply of goods and services in a country.
Prices
Aggregate supply
Aggregate demand
0 Y YF National income
ie output
As with a normal demand curve, aggregate demand (AD) is downward sloping,

because when prices are high people cannot afford to buy many products.
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7: National income
As with a normal supply curve, aggregate supply is upward sloping as higher prices
will encourage suppliers to produce more. However, aggregate supply becomes
vertical at YF because at this output level we will be using all the resources in our
country and cannot make anything else; this is full-employment output.
2.1 Influences on national income

Demand and supply curves can be used to illustrate some basic influences on
national income. National income may increase due to:
 An increase in aggregate demand ie the demand curve moves to the
right.
The components of aggregate demand are covered in detail in Section 3, but
one example could be an increase in government spending. Governments may
act to stimulate demand using 'demand management' policies – these are
considered in the next chapter.
 An increase in aggregate supply ie the supply curve moves to the right
This could be due to increased investment in technology and capital
equipment, or improvements in training, or increased incentives for firms to
employ workers and expand output in the economy. Governments may act to
stimulate these increases in supply using 'supply-side policies' – these are
also considered in the next chapter.

Required
Using the AD and AS curves below, contrast the effect of 'demand management'
and 'supply side' policies that are designed to stimulate economic growth.
Price AS
AD
National income
Y
123
Price AS
AD
National income
Y
3 The circular flow of income

Another way of illustrating why national income may change is to use the circular
flow of income model. A simplified version of this model is shown below. This
divides the economy up into households and firms.
Income
(Y)
Factor services
(employment)
Households Firms
Goods & services
(welfare)
Expenditure
(E)
Figure 7.2: Circular flow of income

Households purchase goods and services using income that is received from
providing 'factors of production' to firms, eg income from employment, rent of land,
profits from running companies etc.
Firms provide goods in exchange for expenditure from households.
3.1 Consumer spending

The amount households plan to spend on goods and services produced in their own
country during a year is called consumer spending (or consumption).
Consumer spending is normally analysed into two elements:
1 Income induced consumption rises as income rises. The proportion of
any additional income which will be devoted to consumption is referred to as
the marginal propensity to consume, or MPC.
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7: National income
Marginal propensity to consume (MPC)

A measure of the proportion of extra income that is spent on consumer goods.
2 Autonomous consumption is not dependent upon the current level of

income. It depends upon past savings, welfare benefits, and attitude to – and
availability and cost of – borrowing.
3.1.1 Formula for consumer spending
Consumer spending can be expressed as a formula
C = a + bY
Where a = autonomous consumption, b = the marginal propensity to consume, and
Y = national income.
3.2 The full circular flow

So far, in our circular flow model, we have suggested that an economy only
includes two components (households and firms) and that households only consume
domestically produced goods and services.
However, this is not the case. So we need to extend our model.
Income
(Y)
Factor services
(employment)
Households Firms
Goods & services
(welfare)
Expenditure
(E)
Withdrawals Injections
Figure 7.3: Full income flow
3.2.1 Injections and withdrawals

In reality, some spending takes place that is not directly financed by household
incomes – these types of spending are called injections and include investment
spending, government expenditure and export demand).
In addition, some household income is not spent on the purchase of domestically
produced goods or services – collectively instances when this occurs are called
withdrawals and include savings, taxation and purchases of imports.
125
Income (Y)
Households Firms
Consumption (C)
Total expenditure (E)
Saving (S) Financial

Investment spending (I)
sector
Taxation (T) Government Government spending (G)

sector
Import demand (M) Foreign

Export demand (X)
sector
Figure 7.4: Injections and withdrawals
3.2.2 Equilibrium condition

The economy will be stable where national income (Y) shows no tendency to
change through time. This is a state of macroeconomic equilibrium (macroeconomic
means 'the economy as a whole'). This will occur when planned expenditure (ie
demand) equals national income (ie supply).
E=Y
This equilibrium will also occur where injections = withdrawals.

Autonomous consumer spending is $100m and the marginal propensity to consume
= 0.3. Injections are $250m.
Required
Using the formula C = a + bY for consumer spending and E = Y for equilibrium,
calculate the equilibrium level of national income.
Solution
126
7: National income
4 Causes of changes in national income

4.1 Reasons for a fall in national income
National income may fall due to a reduction in planned expenditure. This will
encourage firms to cut output and employment in response to the lower demand.
Decreases in demand can be stimulated by increases in 'withdrawals' ie savings,
imports, tax.
4.2 Reasons for a rise in national income

National income may increase due to an increase in planned expenditure
(consumer spending + injections). This will encourage firms to increase output and
employment to meet higher demand.
Increases in demand can be stimulated by increases in 'injections' ie investment,
government spending and exports.
4.2.1 Investment (I)
Investment spending
Investment is spending on creating new assets for the economy. Examples include
investment in inventory, machinery and industrial and new residential buildings.
Note that in this context investment does NOT mean the purchase of financial assets
such as shares (this is referred to as 'savings' by economists).
Investment spending can be encouraged by lower interest rates, which make it
cheaper for firms to borrow to finance this spending.
Also, it is only 'efficient' to use capital to finance an investment project if the
returns from the investment project are greater than the cost of finance. So, if the
cost of finance (the interest rate) is lower, investment spending will rise (ie more
investment projects become efficient). This is illustrated below:
Interest
rate
Marginal efficiency of investment (MEI)
Figure 7.5: Marginal efficiency of investment
127
Other factors may also affect investment, for example:
(a) Increase in the relative cost of using labour compared to capital (eg pay rises)
In such circumstances, firms will try to substitute capital for labour (and
therefore capital investment will increase)
(b) Improved productivity of capital equipment (eg due to innovation)
(c) Fall in the price of capital goods
(d) Expectations of higher demand for products in the future (eg economic growth)
4.2.2 Government spending (G)

Government expenditure is determined by the government's policy on spending and
taxation. This is called 'fiscal policy' and is covered in more detail in the next
chapter.
4.2.3 Exports (X)

Demand from foreign consumers will be determined by a number of factors
including:
 Competitiveness of domestic industries: exports will increase if
domestic goods are perceived to be high quality with low production costs.
 Income in foreign countries: if incomes are high abroad, demand will be
high from consumers in those countries.
 The exchange rate (covered later in the course)
4.2.4 Multiplier effect

The circular flow model can be used to demonstrate the potential for a relatively
small increase in injections to cause a large impact on national income. This is
often referred to as the multiplier effect.
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7: National income
Illustration 1
The government spends $200m on a new hospital, funded by borrowing.
This money flows back to households as extra income (eg to construction workers).
Assuming that 60% of this income is withdrawn (ie savings, tax, imports) then 40%
of this extra income is spent on consumer goods, ie the marginal propensity to
consume, or MPC, is 0.4.
So consumer spending rises by $200m  0.4 = $80m.

This extra spending again flows back to households as extra income. Assuming that
40% of this extra income is spent on consumer goods, then consumer spending
rises.
Consumer spending rises by $80m  0.4 = $32m.

And so it continues; this extra spending flows back to households as extra income.
Assuming that 40% of this extra income is spent, then consumer spending rises
by $32m  0.4 = $13m (to the nearest million).
Once again, this extra spending flows back to households as extra income, so
consumer spending rises by $13m  0.4 = $5m.
And this extra spending flows back to households as extra income, so consumer
spending rises by $5m  0.4 = $2m.
This extra spending again flows back to households as extra income, so consumer
spending rises by $2m  0.4 = $1m.
And then the effect becomes negligible.
In summary, we can see that the overall effect of increasing an injection (here
government spending) by $200m has been to increase national income by:
$200m + $80m + $32m + $13m + $5m + $2m + $1m = $333m.
4.2.5 The multiplier

In the illustration above, the initial increase in income of $200m will result in a final
increase in national income of $333m. The effect of a $200m injection is to
increase national income by a multiplicative effect of $333m / 200m = 1.67.
This 1.67 is called a multiplier. A short cut to calculating the multiplier is to use
this formula:
Formula to learn – the multiplier

1 1
In the above example this gives = 1.67
1 MPC 1– 0.4
129
Footnote: Income can either be spent or withdrawn. 1 – MPC (here 1 – 0.4 = 0.6)
is the same as the marginal propensity to withdraw (MPW); ie if 40% of income is
spent (MPC) then 60% is withdrawn. An exam question may give you the MPW
(here 0.6) and if so the formula for the multiplier becomes 1 / MPW.
The fact that (in the previous example) an initial injection of $200 million leads to
an increase of $333m in national income is called the multiplier effect.
A short cut to calculating the multiplier effect is to use this formula:
Formula to learn – the multiplier effect

1
The change in national income =  rise in injections
1 MPC
In the previous example this gives $200m  1.67 = $333m

Required
Identify factors that would make the MPC greater (therefore making the multiplier
greater).
Solution

Required
Calculate and insert the missing figures in the following table using the multiplier.
Solution
Change in MPC MPW Value of Change in Change in

injections multiplier national consumption
income
50m 0.4
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7: National income
4.2.6 Implications of the multiplier effect

The potential to create a multiplier effect in order to increase aggregate expenditure
(national income) by more than the initial injection creates a logic for government
intervention to stimulate demand if the economy is depressed.
This is considered in more detail in the following chapter, where we look at
government macroeconomic policy.
However, we can note here that the size of the multiplier will be an important
influence on the effectiveness of this approach.
131
Chapter summary
 National income is the output produced in the economy. It is determined by

aggregate demand and aggregate supply.
• The economy will be in equilibrium where E=Y and injections = withdrawals.
• Small increases in expenditure will lead to larger increases in output (multiplier
effect).
• Consumption is determined by autonomous consumption and income-induced
consumption (MPC).
• Investment spending can be stimulated by lower interest rates.
• Governments may spend money to stimulate the economy through a multiplier effect.
132
7: National income
Keywords
 GDP = the market value of final goods and services produced within an
economy.
 GNP = GDP + net property income (NPI) from abroad
(NPI = profits, dividends, interest earned from foreign investments less those paid
out to foreign investors)
 National income = GNP – depreciation
(depreciation is an estimate of the decline in the value of the assets within the
economy during the period; it is often referred to as capital consumption)
 Marginal propensity to consume (MPC): A measure of the proportion of
extra income that is spent on consumer goods.
 Investment spending: Investment is spending on creating new assets for the
economy. Examples include investment in inventory, machinery and industrial and
new residential buildings.
133
Activity answers

 Not all economically valuable goods and services are bought at
their market value.
Some goods are unpaid, for example some leisure activities such as
gardening, walking. So if the working week is getting longer and people are
enjoying less leisure time then, although national income may be rising, living
standards may be falling.
Some services are unpaid; for example if more people are moving out of the
home and into paid work then the value of free services (eg unpaid home
workers providing child care or care of the elderly) is being lost, so living
standards may be falling.
Some goods and services are not purchased at their true market price (eg
publicly provided healthcare, defence). So if one economy has lower national
income but provides more of these types of services, then living standards in
that economy may be understated.
 No distinction is made between consumer goods and capital
goods (eg a factory).
Economies with heavy spending on capital goods but with lower spending on
consumer goods will not be providing an increase in living standards in the
short term but will have greater potential to increase living standards in the
longer term.
Consumer goods give an immediate boost to standards of living (eg a new
car) but capital goods will increase standards of living over a longer period of
time.
 Economic growth may be occurring simply because population is
increasing.
The greater the number of people, the more can be produced. National
income needs to be divided by the number of people to give a better
indication of living standards. This is sometimes called national income per
capita (ie per head).
 Economic growth may create environmental problems that are
not measured.
For example – pollution, congestion.
 Economic growth may not result in an increase in living
standards for the average person.
For example – if inequality is high and rising.
134
7: National income
 Rising national income may be due to increases in price levels, ie

inflation
So national income needs to be adjusted for the impact of inflation, this
adjusted national income is called 'real' national income and is covered in a
later chapter.

Demand management is likely to increase prices (from P to P1) as well as output
(from Y to Y1). This will create inflation.
Price AS
P1
P
AD1
AD
Y Y1 National income
Supply-side policies, if effective, are likely to increase output (from Y to Y1), without
creating inflation.
Price AS AS1
P
P1
AD
Y Y1 National income

E = Y at equilibrium
So consumer spending + injections = Y
So 100 + 0.3Y + 250 = Y
So 350 = Y – 0.3Y = 0.7Y
So 350 / 0.7 = Y = $500m
135
 Reduction in interest rates (less incentive to save)
 Reduction in taxation (more disposable income to spend)
 Fall in exchange rate (making imports more expensive, meaning domestically
produced goods become more attractive, so spending on these will increase in
place of spending on imports.)
Note: These factors also reduce MPW, which also makes the multiplier greater.
(Since saving, taxation and imports are the three components of 'withdrawals' from
the economy.)

Change in MPC MPW Value of Change in Change in
injections multiplier national income consumption
50m 0.6 0.4 2.5 125m 75m
(1/0.4) (50  2.5) (125m – 50m)
136
7: National income
Test your learning

1 What is the marginal propensity to consume?
2 How might a government try to influence the volume of investment by firms?
3 Injections into the economy are:
A Consumption and Investment
B Investment and Government Expenditure
C Investment, Government Expenditure and Export Demand
D Consumption, Investment, Government Expenditure and Export Demand
4 If a consumption function has the formula C = 750 + 0.4Y where Y is the change in
national income, and injections are 500, then equilibrium national income will be
at:
A 833
B 1,250
C 2,083
D 3,125
5 What is the multiplier effect?
6 In an economy, the marginal propensity to consume is 0.85. What is the multiplier
in that economy? (Give your answer to two decimal places.)
137
138
The trade cycle
Learning outcomes

 explain the stages of the trade cycle and the consequences of each stage for the policy choices
of government
 describe the impacts on business of potential policy responses of government to each stage of
the trade cycle
Chapter context
Businesses will be affected by general economic conditions beyond their control. While they cannot
influence these conditions, managers must understand the causes and effects of different stages in the
trade cycle so they can take appropriate steps to maximise their firms' profits in time of economic
prosperity and protect their investors' interests in times of economic downturn.
Syllabus context
This syllabus area has a weighting of 25% and is covered by Chapters 7-12
139
Chapter overview
The trade cycle
Objectives of
government policy
Monetary policy Tools of government Supply-side policy

economic policy
Fiscal policy
Recession
Stages of the Depression
trade cycle
Recovery
Boom
Implications of
the trade cycle
Economic Balance of Unemployment Inflation and

growth and trade and the and the trade the trade
the trade cycle trade cycle cycle cycle
140
8: The trade cycle
1 Objectives of government economic policy

Governments have a number of economic objectives. At any given point in time,
some objectives may be more important than others.
Economic
growth
Balance of trade
stability Objectives Control of
inflation
Low
unemployment
1.1 Economic growth

Economic growth has been discussed in the previous chapter. Economic growth
implies an increase in national income in real terms (ie after adjusting for inflation –
an area that is covered further in Chapter 9). Increases caused by price inflation are
not real increases at all.
1.2 Low unemployment

The unemployment rate is normally defined as the percentage of the population (of
working age) and who are actively seeking work (ie not full-time students, unpaid
home makers, pensioners etc) who are unemployed.
1.3 Low inflation
Inflation
An increase in the general level of prices of goods and services in the economy.
Keeping inflation to a low level has become a central economic objective for many
governments, because experience has shown that high and unstable inflation has a
number of undesirable consequences.
141
 Industrial relations conflict
Different expectations over inflation levels increase the probability of conflict
between employers and employees during wage negotiations; this makes
strikes more likely.
 Interference with the price mechanism
The price mechanism will signal that goods are in high demand by increasing
the market price. This should attract an increase in supply.
Inflation makes it harder for this mechanism to operate effectively, because it
may be unclear to producers whether higher inflation or higher demand is
causing price increases.
 Redistribution of income and wealth
Inflation often causes those living off their savings to experience a loss in
purchasing power, ie the amount of goods and services they can buy with that
income.
On the other hand, those who have borrowed money may gain as the real
value of their repayments falls.
Income may also be distributed from suppliers to customers. For example, if
you owed $1,000, and prices then doubled, you would still owe $1,000, but
the real value of your debt would have been halved.
 Balance of payments effects
If a country has a higher rate of inflation than its major trading partners, its
exports will become relatively more expensive and imports into it will be
relatively cheaper. As a result, the balance of trade (export revenue less the
cost of imports) may worsen. International trade is covered in more detail in
Chapter 11.
 Creates expectations of inflation
Once the rate of inflation has begun to increase, there is the danger that,
whether the factors that have caused inflation still exist or not, there will be an
expectation of further inflation in the future which leads to continued increases
in wages and prices.
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8: The trade cycle

Required
Do changes in the distribution of income caused by inflation matter from an
economic perspective?
Solution
1.4 Balance of trade stability (to achieve a balance

between exports and imports).
If imports (a cost to the economy) are higher than exports (generating revenue for
the economy) for a sustained period of time this may cause financing problems.
Issues related to a country's balance of trade are covered in Chapter 11.
2 Tools of government economic policy

In order to achieve its objectives, a government has several types of
macroeconomic policy instruments at its disposal.
2.1 Fiscal policy

Fiscal policy relates to government policy on taxation, public borrowing and
public spending.
2.2 Monetary policy

Monetary policy is mainly concerned with government policy on the money
supply, interest rates and exchange rates.
Fiscal and monetary policy attempt to attain the macroeconomic policy objectives
by influencing aggregate demand in an economy.
2.3 Supply-side policy

Supply-side policies, on the other hand, attempt to increase the level of
aggregate supply by increasing efficiency, motivation or productive capacity.
Examples include deregulation, re-training, privatisation and cutting corporation tax.
143
2.4 Merits of these policies
The relative merits of these policies are discussed in Chapter 10, but here we
examine the potential use of such policies (except exchange rate policy which is
covered in later chapters) by a government to achieve its economic goals.
3 Economic growth and the trade cycle

Trade cycle
A trade cycle is a repeated pattern of changes in economic growth.
Trade cycles are a continual sequence of growth in national income, followed by

a slow-down in growth and then a fall in national income (recession).
After this recession comes growth again, and when this has reached a peak, the
cycle turns into recession once more.
3.1 Phases of the trade (or business) cycle

Actual
output
Output
D
Trend in
output
A
Time
Figure 8.1: The trade cycle
3.2 Recession
At point A in Figure 8.1, the economy is entering a recession (normally defined as
two consecutive quarters of negative growth).
In the recession phase, output is falling. Business failures will occur as firms find
themselves unable to sell their goods. Production, investment and employment will
fall. This creates a wave of unemployment and falling incomes spreading across the
economy as a downward multiplier effect.
3.3 Depression
Eventually, in the absence of any stimulus to aggregate demand, a period of full
depression sets in and the economy will reach point B.
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8: The trade cycle
This stage may last for a long period of time unless the government can act to
stimulate an economic recovery.
3.4 Recovery
At point C the economy has reached the recovery phase; this will feature modest
rates of economic growth and improved consumer confidence.
Rising production, sales and profits will mean that to new investment will be more
readily undertaken. This creates a wave of employment and rising incomes
spreading across the economy as a multiplier effect kicks in.
3.5 Boom
This is shown as point D in Figure 8.1.
As recovery proceeds, the output level climbs above its trend path, in the boom
phase of the cycle. During the boom, capacity and labour will become fully utilised.
4 Economic growth and the trade cycle

4.1 Impact on business
Business decisions will be affected by the stage of the trade cycle. Key business
decisions include:
 Investment
 Pricing
 Recruitment
 Production levels

Required
Higher / Lower / No change
Insert the appropriate term above into the following table, to identify whether the
level of each of the following will be higher or lower during the recession stage of
the trade cycle, compared to recovery.
Investment Pricing Recruitment Production
Business decisions will also be affected by government action (see below) to deal
with the various stages of the trade cycle.
145
4.2 Government action
We have identified three main economic policy tools: fiscal and monetary policy
(mainly tools of managing demand) and supply-side policy. Each has a potential
role to play in smoothing out the effects of the trade cycle on the rate of economic
growth.
Here, the key roles of government are often seen as:
1 Taking action to boost demand if the economy is in recession or
depression.
Government action is often required because, during a downswing in
economic activity, private sector investment is normally low. Consumer
spending also falls because of concerns about rising unemployment – this
means that consumers try to cut back on spending funded by credit cards and
try to increase savings. (In fact, lower consumer spending may cause a fall in
national income so total savings may even fall – this idea that saving can
actually cause economic harm is sometimes called the paradox of thrift).
2 Policy decisions to increase the efficiency, motivation and capacity of the
economy so that it is capable of growing at a faster rate for a longer
period of time, eg tax cuts to encourage private sector investment. These
are supply-side policies and are covered in more detail in Chapter 10.

Required
Insert examples of how fiscal, monetary and supply-side policies may be used to
stimulate economic growth during the trade cycle.
Fiscal policy Monetary policy Supply-side policy
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8: The trade cycle
4.3 Automatic stabilisers

In fact, the need for direct, planned, government initiatives is lessened by the
automatic effect of the trade cycle on government spending (an injection) and
taxation (a withdrawal). Total spending on welfare benefits will
automatically rise because unemployment rises if the economy moves towards a
recession. Withdrawals will also fall because taxation of incomes will
automatically fall as incomes fall in a recession. These 'automatic stabilisers' help to
support aggregate demand during a recession.
5 Unemployment and the trade cycle

Cyclical unemployment
The type of unemployment that is caused by a decline in the general level of
economic activity is called cyclical unemployment.
If the level of aggregate demand is below the level need to sustain

full employment, there is said to be a deflationary gap (Figure 8.2).
Figure 8.2: Deflationary gap
5.1 Deflationary gap and cyclical unemployment

In Figure 8.2, the economy is currently in equilibrium at Ye (with aggregate demand
AD) but it would need to be at Yf (with aggregate demand AD2) to achieve full
employment.
A deflationary gap can be described as the extent to which the aggregate
demand function will have to shift upward to produce the full employment level of
national income.
147
5.2 Other types of unemployment
However, not all types of unemployment relate to fluctuations in aggregate demand.
Economists identify two other key categories of unemployment which are not due to
a downturn in the trade cycle: structural unemployment and frictional unemployment.
Structural unemployment
The long-term unemployment that exists even when the economy is growing at
a normal rate. It may be due to a general lack of skills, or a lack of appropriate
skills (eg due to a collapse in a sector of the economy), or due to wages being set at
artificially high levels (perhaps due to a minimum wage).
Frictional unemployment
This is short-term unemployment due to the time it takes workers to find jobs,
or due to seasonal factors.
Taken together, the amount of unemployment that is due to frictional and structural
factors is sometimes called the 'natural rate of unemployment'.

We have identified three main economic policy tools: fiscal and monetary policy
(mainly tools of managing demand) and supply-side policy. Each has a potential
role to play in managing the level of unemployment. The appropriate policy will
depend on the type of unemployment that a government is trying to tackle.

Required
It is winter, and Country Z is experiencing high levels of unemployment due to the
relocation of some major employers from the east of Country Z to Country Y. During
winter there is little work available in the agricultural sector, so unemployment is
always higher at this time.
Match two of the following government policy options to the categories of
unemployment that are being experienced in Country Z.
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8: The trade cycle
Government policy options

Increase government spending Subsidise retraining of workers
Remove minimum wages Anti-union legislation
Type of unemployment Appropriate government policy
Cyclical
Frictional
Structural
6 Inflation and the trade cycle

Demand-pull inflation
The type of inflation that is caused by an increase in the general level of economic
activity is called demand-pull inflation.
In a situation where the trade cycle is at its boom phase, aggregate demand may
rise above aggregate supply. If labour is at full employment, and factories are at full
capacity, then firms will be unable to increase output to meet higher demand and so
will simply increase prices, causing inflation.
6.1 Inflationary gap

If the level of aggregate demand is above the level needed to sustain full
employment, there is said to be an inflationary gap (Figure 8.3).
Prices
AS
P
Inflationary gap
PF
AD1
AD2
YF Real national income
Figure 8.3: Inflationary gap
149
An inflationary gap can be described as the extent to which the aggregate demand
function would have to shift downward to produce the full employment level of
output without price rises.
In Figure 8.3, an inflationary gap can be removed by shifting the aggregate
demand curve to the left, from AD1 to AD2.
6.2 Cost-push inflation
Cost-push inflation
If firms are forced to increase prices because of a general increase in their costs,
this is called cost-push inflation.
As with unemployment, not all types of inflation relate to fluctuations in aggregate

demand. Cost-push inflation can result from:
 Upward pressure on wages exerted by powerful unions
 Upward pressure on commodity prices (eg oil): sudden shocks in the price of
key commodities can cause a combination of high inflation and lower
output/higher unemployment. This is sometimes called stagflation (a
combination of a stagnant economy and high inflation levels).
 A fall in the value of the domestic exchange rate meaning that the cost of
imported goods and services increase (this is covered in Chapter 11).

Fiscal and monetary policy and supply-side policy all have a potential role to play
in managing the level of inflation. The appropriate policy will depend on the type of
inflation that a government is trying to tackle.

Required
Country Y is experiencing an economic boom and inflation levels are high.
Choose the correct government policy option for this situation.
A Increase interest rates
B Decrease welfare payments
C Cut income tax
D Anti-union legislation
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8: The trade cycle
7 Balance of trade and the trade cycle

We have mentioned that an economy will need to achieve a balance between
exports and imports.
If an economy is in the boom phase of the trade cycle then this balance may be
harder to achieve due to the high levels of demand in the economy. For example, if
the economy in the UK is booming, and levels of aggregate demand in the UK are
high:
 Imports will also be high due to high levels of consumer spending
 But exports are not necessarily high because the level of exports depends on
demand outside the UK (eg in Europe and the US)
This area is covered in Chapter 11.
151
Chapter summary
 The main macroeconomic policy goals of governments are to sustain economic

growth, limit price inflation, achieve low unemployment and to achieve balance of
payments equilibrium.
• To achieve these aims, governments can use fiscal, monetary or supply-side
policies.
• Fiscal policy provides a method of managing aggregate demand in the economy
through taxation and government spending.
• Monetary policy focuses on the relationship between interest rates and the supply of
money in an economy, and how the two of them together can influence aggregate
demand.
 Trade cycles (sometimes called business cycles) describe the tendency for
economies to swing between years of growth and high employment, and
years of stagnation and high unemployment on a regular basis.
 The impacts of the trade cycle on business include the direct effects of the
changes in aggregate demand and employment, and the secondary effects of
the resulting intervention by governments to correct it.
• Unemployment is where not all workers willing to take a job at the present level
of wages can find work. Unemployment can be related to the trade cycle (cyclical)
or to other factors (frictional, structural). The appropriate government action
depends on the type of unemployment.
• High rates of inflation are harmful to an economy. Inflation redistributes income
and wealth. Uncertainty about the value of money makes business planning more
difficult.
1 Demand-pull inflation arises from an excess of aggregate demand over the
productive capacity of the economy.
2 Cost-push inflation arises from increases in the costs of production.
3 The appropriate government action depends on the type of inflation.
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8: The trade cycle
Keywords
 Inflation: An increase in the general level of prices of goods and services in the
economy.
 Trade cycle: A trade cycle is a repeated pattern of changes in economic growth.
 Cyclical unemployment: The type of unemployment that is caused by a decline
in the general level of economic activity is called cyclical unemployment.
 Structural unemployment: The long-term unemployment that exists even when
the economy is growing at a normal rate. It may be due to a general lack of skills,
or a lack of appropriate skills (eg due to a collapse in a sector of the economy), or
due to wages being set at artificially high levels (perhaps due to a minimum wage).
 Frictional unemployment: This is short-term unemployment due to the time it
takes workers to find jobs, or due to seasonal factors.
 Demand-pull inflation: The type of inflation that is caused by an increase in the
general level of economic activity is called demand-pull inflation.
 Cost-push inflation: If firms are forced to increase prices because of a general
increase in their costs, this is called cost-push inflation.
153
Activity answers

The impact on distribution of income refers to the impact on borrowers and savers.
High and erratic inflation discourages saving – serious economic problems could
flow from this. It could lead to a shortage of funds available for lending to firms to
finance investments, and possibly to a shortage of savings to finance pensions.
High and erratic inflation may encourages reckless borrowing; this can also lead to
serious economic consequences because high borrowing can lead to economic
instability as consumer and commercial debt levels increase.
Activity 2: Exam standards

The recession and depression stages of the trade cycle feature low or falling
national income. Business confidence will be low and demand levels will be low.
Investment Pricing Recruitment Production

Lower Lower Lower Lower

Fiscal policy Monetary policy Supply-side policy
Higher government Lower interest rates may Any policies designed to
spending (financed by be used to try to stimulate increase efficiency,
borrowing) can be used to higher levels of productive capacity or
generate a multiplier effect investment. motivation are unlikely to
during a downswing in have a short-term impact
economic activity. If but over the longer term
government spending is may allow for a more
higher than taxation prolonged upswing in
revenue this is called a economic activity (as it
budget (or fiscal) deficit. takes longer for the
economy to reach
maximum capacity).
154
8: The trade cycle

Winter unemployment is seasonal – this is an aspect of frictional short-term
unemployment.
The high levels of unemployment due to the relocation of some major employers
from the east of Country Z means that workers in this region have the wrong skills –
this is an example of structural unemployment.
There is no indication that cyclical unemployment is a problem here – or that
powerful trade unions are a problem either.
Type of unemployment Appropriate government policy
Cyclical
Frictional Subsidise retraining of workers
Structural Subsidise retraining of workers

Correct answer: A
Increasing interest rates should help to reduce aggregate demand which is essential
where inflation is 'demand-pull' as is the case here.
Decreasing welfare payments will also reduce demand but is unlikely to be effective
during a boom where unemployment will be low.
Cutting income tax will boost demand and worsen inflation.
Anti-union legislation may be appropriate if inflation is cost-push but this is not the
case here.
155
Test your learning
1 What is the difference between fiscal policy and monetary policy?
2 What are the stages of the trade cycle (in the correct order)?
3 Outline how the government may use fiscal policy to influence aggregate demand.
4 What type of inflation is due to changes in the trade cycle?
5 What type of unemployment is due to changes in the trade cycle?
6 Give an example of a monetary policy action that will address demand-pull
inflation.
156
Index numbers
Learning outcomes

 calculate indices for price inflation and national income growth using either base or current
weights and use indices to deflate a series.
Chapter context
An understanding of index numbers is important in order to be able to interpret economic data.
Syllabus context
157
Chapter overview
Index numbers
Fixed base
Deflating a time
series
Chain base
Price and
quantity indices
Base Current
weights weights
(Laspeyre) (Paasche)
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9: Index numbers
1 Introduction to index numbers

Index numbers are used to provide a standardised way of comparing values over
time. Economists often use index numbers when making comparisons over time. An
index starts in a given year, the base year, at an index number of 100.
Single item index numbers can be calculated by comparing the price (or quantity
levels) over two periods and multiplying by 100.
Illustration 1
If the price of a cup of coffee was 40c in 20X0 and 50c in 20X1, then using 20X0
as a base year (value = 100) the price index number for 20X1 would be 50/40 ×
100 = 125. This means that the price has risen by 25%.
1.1 Fixed base and chain base methods

There are two ways in which index numbers can be compared: using a fixed base
or a chain base.
Fixed base
In the fixed base method, a base year is selected (index 100), and all subsequent
changes are measured against this base.
Chain base
In the chain base method, changes are calculated with respect to the value of the
item in the period immediately before.
159
Illustration 2
The price of Product A was $2.70 in 20X0, $3.11 in 20X1, $3.42 in 20X2 and
$3.83 in 20X3.
A chain index would be as follows:
20X0 100
20X1 115 (3.11/2.70 × 100)
20X2 110 (3.42/3.11 × 100)
20X3 112 (3.83/3.42 × 100)
A fixed index would be as follows:

20X0 100
20X1 115 (3.11/2.70 × 100)
20X2 127 (3.42/2.70 × 100)
20X3 142 (3.83/2.70 × 100)
 The chain base numbers show the rate of change in prices from year to year
(eg 112 in 20X3 means that prices rose by 12% in 20X3)
 The fixed base numbers show changes relative to prices in the base year (eg
142 in 20X3 means that price has risen by 42% since 20X0).
1.2 Price indices and quantity indices

Index numbers can be used to measure the change in the monetary value
of a group of items over time. These are called price indices.
For example the Consumer Prices Index (CPI) is used in the UK, and internationally,
to measure changes in the rate of inflation.
Index numbers can also be used to measure the change in the
non-monetary values of a group of items over time. These are quantity indices
(or volume indices).
An example is an index number for production volume showing the production
achieved by a factory over time.
2 Using price indices to calculate inflation

The consumer prices index (CPI) measures the change in the average
basket of goods and services. It is published every month, and its principal
use is as a measure of monthly and annual inflation.
The CPI measures the percentage changes, month by month, in the average level
of prices of 'a representative basket of goods'.
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9: Index numbers
The composition of the basket of goods is reviewed every year to ensure that CPI
calculations reflect up-to-date shopping patterns.
The data is presented as a fixed index with reference to a base year.
Illustration 3
In the UK in 2015 e-cigarettes and subscriptions for music streaming were added to
the basket, and yoghurt drinks and satnavs were removed.
In the UK the base year is 2005, so an index of 127.1 (the actual value for the UK
in January 2015) means that prices have risen by 27.1% since January 2005.

Required
Using the CPI data below calculate the annual rate of inflation in 20X8 (to one
decimal place).
Year 20X5 20X6 20X7 20X8
CPI 100 106 112 110
Solution
2.1 Base weighted price indices

One way of working out the change in price of a basket of goods is to weight the
price rises by the quantities purchased at the start of the period (ie in the base year).
This type of index is called a base weighted price index (or Laspeyres index).
161
Illustration 4
Imagine that only three products are being purchased, bread, tea and caviar, in the
quantities and at the prices shown below.
Item Quantity in 20X1 Price in 20X1
(millions)
Q0 P0
Bread 6 $20
Tea 2 $25
Caviar 0.067 $450
During 20X2 the price of bread has risen to $40, the price of tea has risen to $30,
and the price of caviar has fallen to $405. What is the overall price index for this
'basket' of goods, using a base weighted approach?
The 20X2 price index value could be calculated by weighting the price changes
using the quantities purchased as the weights.
Item Quantity Price in Base-year Price relative Base year
(millions) 20X1 value value x
price
relative
Q0 P0 P0 x Q0 P1 / P0
Bread 6 20 120 40/20 = 2 240
Tea 2 25 50 30/25 = 1.2 60
Caviar 0.067 450 30 405/450 = 0.90 27
200 327
327
Index in 20X2 =  100 = 163.5
200
In other words, the weighted average price rise is 63.5%
2.1.1 Formula
The base weighted price index uses quantities consumed in the base
period as weights. The approach we have used in the previous illustration can be
expressed mathematically as:
  w   P1 / Po  
w
where P1 represents the prices in the current year, P0 represents prices in the base
year and w represents weights using base-year values.
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9: Index numbers
2.2 Current weighted indices

Another way of working out the change in price of a basket of goods is to weight
the price rises by the quantities currently being purchased. This type of index is
sometimes called a current weighted price index (or the Paasche index).
With this approach, the weights are changed every time period. This is time
consuming, but it does mean that the price rises reflect the change in the current cost
of living; CPI is calculated using current weights for this reason.
The calculations for the current weighted index are similar to those demonstrated for
the base weighted index but use the up-to-date purchasing behaviour of
consumers.
Illustration 4
Imagine that only three products are being purchased, bread, tea and caviar, in the
quantities and at the prices shown below.
Item Quantity Price in Quantity Price in
(millions) 20X1 (millions) 20X2
Q0 P0 Qn Pn
Bread 6 20 5 40
Tea 2 25 1.5 30
Caviar 0.067 450 0.12 405
What is the overall price index for this 'basket' of goods, using a current weightings
approach?
The 20X2 price index value can be calculated by weighting the price changes,
using the quantities currently purchased as the weights.
Item Quantity Price in Value Price Value x
(millions) 20X1 relative price
relative
Qn P0 P0 x Qn P1 / Po
Bread 5 20 100 2 200
Tea 1.5 25 37.5 1.2 45
Caviar 0.12 450 54 0.9 48.6
191.5 293.6
293.6
Index in 20X2 = 191.5  100 = 153.3
In other words, the average price rise is 53.3%
163
2.2.1 Formula
The current weighted price index uses quantities consumed in the current
period as weights. The approach we have used can be expressed mathematically
as:
  w   P1 / Po  
w
where ܲଵ represents the prices in the current year, ܲ଴ represents prices in the base
year and w represents weights using current-year values.

The price index in Ruritania is made up from the prices of five items. The price of
each item and the average quantities purchased by manufacturing and other
companies each week were as follows, in 20X0 and 20X2.
Item Quantity Price per unit Quantity Price per unit
20X0 20X0 20X2 20X2
'000 units Roubles '000 units Roubles
P 60 3 80 4
Q 30 6 40 5
R 40 5 20 8
S 100 2 150 2
T 20 7 10 10
Required
Calculate the price index in 20X2, if 20X0 is taken as the base year, using the
following:
(a) Base weightings (Laspeyre)
(b) Current weights (Paasche)
Solution
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9: Index numbers
3 Using price indices to deflate a time series

3.1 Adjusting time series data for inflation
A time series is a series of data over time – it may be historic or forecast data.
Analysis of time series data will be complicated by the existence of inflation.
One of the uses of a price index is to deflate data that includes inflation, often
called 'nominal' data, by stripping out the effect of inflation so that the data
becomes 'real' (ie not distorted by inflation).
Illustration 5
In Country E, average wages have increased between 20X2 and 20X6 from
$10,000 per head to $16,000 in nominal terms.
CPI data for Country E is given below as a fixed index.
Year 20X2 20X3 20X4 20X5 20X6
CPI 100 106 110 117 125
How much better off are workers in real terms?

This can be addressed by expressing wages in terms of base year (ie 20X2) prices.
20X2 wages are already in terms of 20X2 prices. 20X6 wages of $16,000 can be
adjusted by dividing by 125/100 ie $16,000 / 1.25 = $12,800.
12,800
So 'real' wages have risen by ( –1) x 100 = 12.80%
10,000

M Co has seen an increase in annual revenue from $212 million to $225 million
between 20X3 and 20X6, in nominal terms.
CPI data is given below as a fixed index.
Year 20X2 20X3 20X4 20X5 20X6
CPI 100 106 110 117 125
Required
Calculate how much annual revenues have changed in real terms between 20X3
and 20X6.
Solution
165
4 Calculating quantity indices
We have seen that price indices are usually weighted by quantities. We will now
look at quantity indices, which measure changes in quantities and use prices as
weights. One application of this is to measure changes in national income.
Illustration 6
Country F produces four types of goods and services.
In 20X0 the quantities of good produced and their average price were as follows.
Quantity Price per
(billions) unit
Units $
Good A 20 2
Good B 5 10
Good C 40 3
Good D 15 6
The total value of output (national income) is (20bn  $2) + (5bn  $10) + (40bn 
$3) + (15bn  $6) = $300 billion.
In 20X2 the quantities of good produced were as follows.
Quantity
Units
Good A 15
Good B 6
Good C 36
Good D 25
Using 20X0 as a base year, calculate the quantity index value in 20X2 for national
income of Country F.
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9: Index numbers
Solution
Quantity
produced Quantity PoQo x
Price in 20X0 relative relative
Po Qo PoQo ($) Q1/Qo
Good A $2 20 40 15/20 = 0.750 30
Good B $10 5 50 6/5 = 1.200 60
Good C $3 40 120 36/40 = 0.900 108
Good D $6 15 90 25/15 = 1.667 150
300 348
348
Quantity index =  100 = 116
300
This would suggest that the level of national income has grown by 16% since 20X2.
4.1 Formula
This is an example of a quantity index using base year price weightings; it can
be expressed as:
  w   Q1 / Qo  
w
where ܳଵ represents the quantity in the current year, ܳ଴ represents quantity in the
base year and w represents weights using current or base year values.

The following data relates to production in Country D in 20X3 and 20X4.
Quantity Price per unit Quantity Price per unit
produced produced
20X3 20X3 20X4 20X4
'000 $ '000 $
Good A 3 1.20 4 1.50
Good B 6 0.95 5 0.98
Good C 1 1.40 2 1.30
Good D 4 1.10 3 1.14
167
Required
Calculate the following quantity indices for 20X4 (with 20X3 as the base year).
(a) A quantity index using base year weightings
(b) A quantity index using current year weightings
Solution
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9: Index numbers
Chapter summary
• An index is a measure, over time, of the average changes in the value (price or
quantity) of a group of items.
• Index numbers can be calculated using the fixed base method or the chain base
method.
• Time series deflation is a technique used to obtain a set of index numbers that
measure the changes in the real value of some commodity with respect to some
given indicator.
• Weighting is used to reflect the importance of each item in the index.
• Weighted average of relative indices are found by calculating indices and then
applying weights either based on current year or base year weights.
• The consumer prices index (CPI) is used to measure price inflation and can be used
to deflate data and for index linking.
169
Keywords
 Fixed base: In the fixed base method, a base year is selected (index 100), and
all subsequent changes are measured against this base.
 Chain base: In the chain base method, changes are calculated with respect to the
value of the item in the period immediately before.
170
9: Index numbers
Activity answers

110 / 112 x 100 = 98.2
ie inflation is 98.2 – 100 = –1.8%
This indicates that on average prices are falling.

Item Base weightings Current weightings
PoQo x PoQn x price
Qo Po Qn P1/Po PoQo price relative PoQn relative
P 60 3 80 1.333 180 240 240 320
Q 30 6 40 0.833 180 150 240 200
R 40 5 20 1.60 200 320 100 160
S 100 2 150 1.0 200 200 300 300
T 20 7 10 1.429 140 200 70 100
900 1,110 950 1,080
20X2 index numbers are as follows.

1,110
(a) base weighted index = 100  = 123.3
900
1,080
(b) current weighted index = 100  = 113.7
950
The current weighted index for 20X2 reflects the decline in consumption of the
relatively expensive items R and T since 20X0. The base weighted index for 20X2
fails to reflect this change.

This can be addressed by expressing sales in terms of base year (ie 20X2) prices.
20X3 sales can be adjusted by dividing by 106/100 ie $212m / 1.06 = $200m.
20X6 sales of $225m can be adjusted by dividing by 125/100 ie $225m / 1.25
= $180m.
180
So 'real' sales have fallen by ( –1) x 100 = –10%
200
171
Workings
Base year Current year
Quantity
relative PoQo x PnQo x
Qo Po (Q1 / Qo) Pn PoQo relative PnQo relative
Good A 3 1.20 1.333 1.50 3.60 4.80 4.50 6.00
Good B 6 0.95 0.833 0.98 5.70 4.75 5.88 4.90
Good C 1 1.40 2 1.30 1.40 2.80 1.30 2.60
Good D 4 1.10 0.750 1.14 4.40 3.30 4.56 3.42
15.10 15.65 16.24 16.92
Quantity index numbers for 20X4 are as follows.
15.65
(a) 100  = 103.64
15.10
16.92
(b) 100  = 104.19
16.24
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9: Index numbers
Test your learning

1 Complete the following equations using the symbols in the box below.
(a) Price index =  100 P1 P1
(b) Quantity index =  100 Q1 Q0
2 Match the description to the appropriate method.
Fixed base method Changes are measured against base period

Chain base method Changes are measured against the previous period
3 In 20Z6 the retail price index was 198 with 20X7 = 100. Convert a weekly wage
of $421 in 20Z6 back to 20X7 prices (to two decimal places).
4 The chain base index for an item last year was 130. The price of the item has risen
by 10% between last year and this year.
What is the chain base index for this year?
5 In 20Y8, a price index based on 20X4 = 100 stood at 139. In that year it was
rebased at 20Y8 = 100. By 20Z0, the new index stood at 120. For a continuous
estimate of price changes since 20X4, the new index may be expressed in terms of
the old as (to one decimal place)
173
174
Government economic
policy
Learning outcomes

 explain the main principles of public finance (ie deficit financing, forms of taxation) and
macroeconomic policy
Chapter context
The approach taken by a government to managing its finances will need to be assessed by a
business to understand the potential impacts that the government's actions could have on the
business; these can be direct (eg tax rises) and indirect (eg impact on economic stability).
Also, the approaches that a government adopts to managing the economy may create a number of
opportunities and problems for a business.
Syllabus context
175
Chapter overview
Government economic
policy
Supply-side
Fiscal policy Monetary policy
policies
 Attempt to improve
quality and quantity
Influence demand by  Influence demand by
of supply
taxation and government restricting availability
expenditure of credit  Increase competition
 Too much money  Encourage
 inflation investment
 Improve labour
effectiveness
Fiscal Taxation Interest Money Exchange

stance rates stock rates
 Budget deficit  Principles Central Bank

 Cyclical  Functions
deficit  Types
 Incentives
 Structural
deficit
176
10: Government economic policy
1 Government spending
The amount of money that a government plans to spend will depend on the attitude
to government involvement in the economy and other factors such as the stage of the
trade cycle (as discussed in Chapter 8).
The table below shows the significance of government spending.
Country Government expenditure (% of GDP)
Finland 57.5
France 57.0
Sweden 52.4
Italy 51.1
United Kingdom 44.9
Germany 44.5
Spain 44.1
United States 38.8
(OECD, 2013)
This demonstrates the powerful impact of government spending, which is more than
half of total aggregate demand in some developed countries.
1.1 Types of government spending

The three main categories of government expenditure are:
(a) Government final consumption expenditure:
this is the provision of goods and services to be used by the population,
eg health care (such as the NHS in UK).
(b) Government investment (gross fixed capital formation):
the building of roads and other infrastructure
(c) Transfer payments:
Welfare payments including pensions, welfare benefits and social care.
177
For example, in the UK in 2014/2015, about 33% of government spending
was on welfare payments, split as follows:
UK welfare payments % welfare % government

2014/15 budget spending
Pensions 42% 14%
Family benefits 17% 6%
Incapacity benefits 16% 5%
Personal social services 13% 4%
Housing benefits 10% 3%
Unemployment benefit 1% <0.5%
(ONS, 2016)
2 Financing central government spending – taxation

Taxation is the main method of financing government spending.
Although raising revenue is the main objective of taxation, remember that tax is also
used to cause certain products to be priced to take into account their
social costs (negative externalities).
2.1 Types of taxation

There are two basic types of tax, direct tax and indirect tax.
Direct taxes
A direct tax is paid directly by the person or business on whom the tax is imposed,
ie it is a tax on income.
Examples include income tax, capital gains tax, corporation tax, inheritance tax.
Indirect taxes
An indirect tax is collected by an intermediary from the person who ultimately bears
the economic burden of the tax, ie it is a tax on spending.
Examples include VAT, tax on cigarettes, alcohol etc. A retailer would be
responsible for collecting and paying these taxes to the government (ie the retailer is
the intermediary), but the consumer bears the burden through higher prices.
2.1.1 Direct taxation

One of the attractions to government of direct taxes is that they are linked to the
ability of the taxpayer to pay.
Depending on the way that the direct tax is structured it will either be
proportional or progressive.
178
– Proportional tax: average rate of tax is the same at all income levels, eg
20% income tax for all levels of income.
– Progressive tax: the rate of tax increases as income increases so that a
higher proportion of total income is paid as tax by the better-off.
However, direct taxes can act as a disincentive to work, for example:
(a) Higher taxes on extra corporate profits might deter
entrepreneurs from developing new companies because the potential
increase in after-tax profits would not be worth the risks involved in
undertaking new investments.
(b) Individuals and firms might try to avoid or evade paying tax by
transferring their wealth to other countries, or by setting up companies in tax
havens where corporate tax rates are low.
(c) When direct taxes are high they could act as a deterrent to initiative.
Skilled workers might leave the country and look for employment in countries
where they can earn more money (after tax).
2.1.2 Indirect taxation

The use of indirect taxes avoids the potential disincentives to work and enterprise
that are associated with direct taxes.
However, an indirect tax is likely to be a regressive tax, ie a tax that takes a
higher proportion of a poor person's salary than of a rich person's.
For example, in the UK the television licence fee (the annual licence fee people have
to pay in the UK to watch television) is an example of regressive tax since the fee is
the same for all people.
Sales taxes (such as VAT in the UK) are also regressive because they take a greater
proportion of the income of low income workers.
2.1.3 Balance of different types of tax

In reality, a balance of direct and indirect taxes is used, to make sure that the tax
system offers a reasonable balance of incentives to work, without being too
regressive.
179
Required
Below are details of three taxation systems, one of which is regressive, one
proportional and one progressive. Which is which?
Income Income after
before tax tax
$ $
System 1 10,000 8,000
40,000 30,000
System 2 10,000 7,000
40,000 28,000
System 3 10,000 9,000
40,000 38,000
3 Financing the central government budget –

borrowing
3.1 Budget deficits
A budget deficit arises when the government spends more than it receives from
taxes; this will need to be financed by government borrowing.
3.2 Cyclical deficits

A cyclical budget deficit arises as a consequence of the trade cycle. During a
recession, governments will receive less tax but will spend more – we referred to this
in Chapter 9 as an automatic stabiliser.
3.3 Structural deficits

Structural deficits are long-term deficits not associated with the trade cycle; they can
be caused by:
(a) Increased role of government eg increased spending on government-
provided services such as health and education.
(b) Past government spending – if the deficit is caused by interest on past
borrowing.
Since the banking crisis of 2007–2010, international financial institutions have
become unwilling to lend to governments with high structural deficits.
This is because investors believe that the deficit each year, when added to the
existing debts of the country (national debt), will lead to a total debt that the
180
country will not be able to pay the interest on and therefore will eventually
default on its national debt.
This has led to escalating borrowing costs for governments with high structural
deficits as investors demand a risk premium to invest in them.
3.3.1 Policies to deal with structural deficits
Policies to deal with the financial crisis of countries with structural deficits include:
(a) Emergency loans from other national governments and international
institutions at low interest rates to finance the present deficit.
(b) Austerity measures adopted, often as a condition of receiving the
emergency loans, to cut public spending and increase taxation. This includes
seeking efficiency savings in government spending and even reductions to
pension benefits.
(c) Sale of state assets: governments may be required to sell nationalised
industries, mines, land rights and public buildings to private investors to raise
the funds needed to repay some of their past borrowings.
The danger of such measures are that they can cause a huge reduction in
aggregate demand which can lead to a deep and prolonged recession
that may also worsen the budget deficit by reducing tax revenues.
4 Fiscal policy
We have already seen (in Chapter 8) that a government has several types of
macroeconomic policy instruments at its disposal. These are fiscal policy,
monetary policy, and supply-side policies.
After briefly revisiting these policy instruments we will move on to consider the
relative merits of these policies.
Fiscal policy relates to government policy on taxation, public borrowing and
public spending, ie the government budget. As discussed in Chapter 8, a number of
different policies can be followed, depending on the stage of the trade cycle:
(a) Fiscal (or budget) deficit:
Government spending exceeds tax revenue; the government borrows the
shortfall. This boosts aggregate demand. An expansionary fiscal policy (or
expenditure increasing policy) is mainly used in the recession and depression
phases of the trade cycle.
(b) Fiscal surplus:
Government spending is less than tax revenue; the surplus is used to repay
past borrowings. A contractionary (or deflationary) fiscal policy is more likely
in the recovery and boom phases of the trade cycle.
(c) Balanced budget:
This is where government spending equals tax revenue.
181
Required
Compare the effect on business of a government operating a budget deficit in the
following phases of the trade cycle:
(a) Depression
(b) Boom
Solution
(a)
(b)
5 Monetary policy
Monetary policy refers to government policy on the money supply, interest rates,
and exchange rates. (Exchange rates are covered in the next chapter).
Like fiscal policy, monetary policy is often used to manage the level of aggregate
demand in an economy.
5.1 The money supply

Control of the money supply is normally in the hands of the Central Bank (eg the
Bank of England in the UK). By expanding growth in the money supply (see
quantitative easing in Chapter 14) there will be more money in the financial system,
which may lead to:
 Lower interest rates (an increase in the supply of money will lead to a fall in
the 'price' of money, ie the interest rate)
 Higher consumer spending
 Higher lending to businesses to finance investment spending
 Higher share prices, making it easier for companies to issue shares to finance
investment spending
However, there is the danger that allowing the money supply to increase can cause
inflation (this is the view of monetarist economists).
182
5.2 Interest rates

Interest rates are also normally in the hands of the Central Bank. This is seen by
many as an advantage, since the Central Bank will be more motivated to change
interest rates for sound economic reasons instead of political reasons.
In the UK, the Bank of England has had control over interest rates since 1997. To
increase interest rates, the Bank of England will change the 'Bank Rate'; this is the
rate of interest that the Bank of England pays on reserve balances held at the Bank
of England by commercial banks.
Between December 2007 and March 2009 the Bank of England's Monetary Policy
Committee reduced interest rates from 5.75% to 0.5% in an attempt to stimulate
spending at the height of an economic recession.

Required
What are the likely impacts of a decrease in interest rates?
Solution
To deal with high inflation, interest rates can be increased; this should have the
effect of reducing aggregate demand (and may also cause the exchange rate to
rise, reducing the cost of imported goods – see next chapter).
6 Relative merits of fiscal policy and monetary

policy
Fiscal and monetary policy are normally used as part of 'demand management'.
There are advantages and disadvantages of each policy, which are likely to have
an indirect impact on business.
6.1 Advantages of fiscal policy vs monetary policy

 Fiscal policy has a powerful immediate impact on spending. For
example an increase in government spending during a recession is likely to
create an immediate and powerful multiplier effect.
In contrast, interest rate reductions (monetary policy) may eventually lead to
higher borrowing and spending, but the timing of this is uncertain and the fall
in spending from people relying on interest earned on their savings will offset
some of this.
183
 Fiscal policy is more directly under the control of government.
Monetary policy is normally controlled by independent Central Banks.
6.1.1 Money supply growth (monetarism)

This is a special form of demand-pull inflation put forward by economists who are
termed monetarists. They argue that an increase in the supply of money
causes an increase in demand for goods and services, which leads to inflation.
Quantity theory of money
Quantity theory of money: theory which argues that changes in the level of prices
are caused predominantly by changes in the supply of money.
Control of the money supply is covered in Chapter 14.
6.2 Advantages of monetary policy vs fiscal policy

 Monetary policy can create extra demand without creating high levels
of government debt.
 An expansionary fiscal policy may result in the government borrowing funds
that would otherwise have been borrowed by private business. If the increased
government expenditure diverts money and resources away from the private
sector, this is called a 'crowding-out' effect.
 Changes to monetary policy can be implemented more quickly, eg interest
rates can be changed every month, while tax and spending decisions (fiscal
policy) are normally only changed annually.
7 Supply-side policies
Supply-side policies
Supply-side policies attempt to increase the level of aggregate supply by increasing
efficiency, motivation or productive capacity.
Examples include deregulation, re-training, privatisation, cutting corporation tax.
Supply-side economics is characterised by the following propositions.

(a) The predominant long-term influences upon output, prices and employment are
the conditions of aggregate supply.
(b) Inflexibility in the labour market (eg trade unions) forces wages to high
levels, creating unemployment and restricts aggregate supply.
(c) The rates of direct taxation have a major influence upon aggregate supply
through their effects upon the incentive to work. Changes to direct tax can
therefore be seen as a part of fiscal policy (if used to change aggregate
demand) or supply-side policy (if being used to change aggregate supply).
184
(d) There is only a limited economic role for government. State-owned

industries are likely to be inefficient and therefore restrict aggregate supply.
Illustration 1
AS0
AS1
P0
P1
AD0
Y0 Y1
If the economy is at full employment at Y0 (the point where only natural

unemployment remains), it is impossible in the long run to increase output beyond Y0
by raising aggregate demand. However, improved competitiveness and efficiency
will shift the aggregate supply curve to the right (from AS0 to AS1) and promote
growth to income level Y1 at price level P1.
7.1 Policy measures

 Increasing competition through deregulation and privatisation of state-
owned industries.
 Reduction in direct taxes in order to increase incentives to invest and to
work.
 Improve labour effectiveness by reducing the monopoly power of unions
and professional associations. Encourage hiring through relaxation of
minimum wages and employment protection legislation.
 Improvement in skills through provision of training.
 Reduction in disincentives to work through reform of benefit system.
7.2 Supply-side policies compared to demand management

policies
7.2.1 Advantages of supply-side policies
(a) Don't suffer inflationary tendencies of demand-side policies.
(b) Unlikely to lead to balance of trade deficits because they increase
competitiveness.
185
7.2.2 Disadvantages of supply-side policies
(a) Only operate in longer term, so less useful to deal with the short-term problems
of the recession phase of the trade cycle.
(b) Reduction in tax rates may, in short run at least, necessitate cuts in welfare
expenditure.
186
Chapter summary
 Government spending is a significant component of total aggregate demand.

• Direct taxes have the quality of being progressive or proportional. Income tax is
usually progressive, with higher rates of tax charged on higher bands of taxable
income. Indirect taxes can be regressive, if the taxes are placed on essential
commodities or commodities consumed by poorer people in greater quantities.
• A government must decide how it intends to raise tax revenues, from direct or
indirect taxes, and in what proportions tax revenues will be raised from each
source.
• Budget deficits arise when governments borrow more than they spend. Deficits may
be cyclical or structural.
• Fiscal policy is about government taxation and expenditure.
• Monetary policy is about interest rates, the money supply and exchange rates.
• Fiscal policy is capable of giving a more powerful stimulus to demand than
monetary policy but will often lead to a high national debt.
• Supply-side policies are about improving the efficiency, motivation and productive
capacity of the economy. Supply-side policies are important for long-term economic
growth but are less useful for stimulating an economy that is in recession.
187
Keywords
 Direct taxes: A direct tax is paid directly by the person or business on whom the
tax is imposed, ie it is a tax on income.
Examples include income tax, capital gains tax, corporation tax, inheritance tax.
 Indirect taxes: An indirect tax is collected by an intermediary from the person
who ultimately bears the economic burden of the tax, ie it is a tax on spending.
Examples include VAT, tax on cigarettes, alcohol etc. A retailer would be
responsible for collecting and paying these taxes to the government (ie the retailer is
the intermediary), but the consumer bears the burden through higher prices.
 Quantity theory of money: Theory which argues that changes in the level of
prices are caused predominantly by changes in the supply of money.
 Supply-side policies: Supply-side policies attempt to increase the level of
aggregate supply by increasing efficiency, motivation or productive capacity.
Examples include deregulation, re-training, privatisation, cutting corporation tax.
188
Activity answers

Tax paid on Tax paid on
low income high income Nature of tax
% %
System 1 20 25 Progressive
System 2 30 30 Proportional
System 3 10 5 Regressive

(a) Here a budget deficit may be essential to eliminate a deflationary gap and to
stimulate the economy.
Government spending can create a powerful immediate multiplier effect that
can act to kick-start the economy.
(b) Here a budget deficit will fuel excessive demand.
This is likely to cause higher (demand-pull) inflation. Chapter 8 has looked at
the problems of inflation – for example a higher risk of industrial relations
problems.

A reduction in interest rates makes saving less attractive and borrowing more
attractive, which should stimulate spending.
Lower interest rates can also affect consumers' and firms' cash-flow – a fall in
interest rates reduces the income investors receive from their savings, but it also
reduces the interest payments that borrowers have to make on their loans.
Borrowers tend to spend more of any extra money they have than investors, so the
net effect of lower interest rates through this cash-flow channel is normally to
encourage higher spending in aggregate.
189
Test your learning
1 What is:
(a) A regressive tax?
(b) A proportional tax?
(c) A progressive tax?
2 Distinguish between direct taxation and indirect taxation.
3 The government of a certain country decides to introduce a new tax, which will
involve a flat-rate levy of $200 on every adult member of the population. This new
tax could be described as:
A Regressive
B Proportional
C Progressive
D Ad valorem
4 High rates of personal income tax are thought to have a disincentive effect. This
refers to the likelihood that the high rates of tax will:
A Encourage illegal tax evasion by individuals
B Lead to a reduction in the supply of labour
C Lead to a reduction in savings by individuals
D Discourage consumer spending and company investments
5 Which of the following will not be the immediate purpose of a tax measure by the
government?
A To discourage an activity regarded as socially undesirable.
B To influence interest rates.
C To influence the level of aggregate demand
D To raise revenue to spend on public or merit goods
6 What is the crowding-out effect?
7 How do supply-side policies affect inflation and unemployment?
Answer in terms of the effect on the aggregate supply curve.
190
International
economics
Learning outcomes

 explain the concept of the balance of payments and its implications for government policy
 explain the impacts of exchange rate policies on business
 explain the role of the foreign exchange market in facilitating trade and in setting exchange
rates
Chapter context
The implications of an economy's balance of payments position can have important practical impacts
in terms of the government action that it can stimulate, and in terms of the resulting impact on the
exchange rate. The exchange rate has an important impact on the competitiveness of exported
goods and services, and on the cost of imported goods and services.
Syllabus context
191
Chapter overview
International economics
Balance of Exchange rates Government

payments policies
 Current account  Determination using  Fixed rate system

(visibles & invisibles) demand and supply
 Floating rate system
 Financial account  Relationship to
 Managed float
balance of
 Capital account
payments, interest
 Fundamental rates and inflation.
imbalance -
consequences
192
11: International economics
1 The balance of payments

Balance of payments
The balance of payments accounts record international trade and investment
transactions. The balance of payments accounts have three parts: the current
account, the capital account and the financial account.
Note. in this chapter we discuss the balance of payments using the UK as an

example.
1.1 Current account

The current account mainly records trade in goods and services and income
earned or paid out on international investments.
Trade in goods relates to exports and imports of tangible (visible) goods, such as
oil, machinery, transport equipment, electrical goods, clothing etc.
Trade in services relates to exports and imports of services (sometimes referred to
as invisibles), and includes such things as international travel, financial and other
services.
Income relates to income from employment of overseas residents by overseas firms
and income from capital investment overseas (eg dividends and interest).
1.1.1 Recording current account transactions
Debits Credits
Imports are a cost to an economy and Exports create income for an economy
are recorded as a debit. and are recorded as a credit.
Foreign currency (eg $s) needed to pay for Foreign currency (eg $s) earned from
imports will be required, this will lead to a exports will be converted into local
fall in foreign currency reserves in local currency (eg £s) and will lead to a build-
banks. up of foreign currency reserves in local
banks.
The overall balance of exports and imports is referred to as the current

account balance (the surplus or deficit on trade in goods only is also known as
the balance of trade).
In the United Kingdom in 2015, the current account deficit is estimated to be £96bn
or 5.2% of GDP, the largest since records began in 1948.
1.2 Capital account

The capital account balance is made up of public sector flows of capital
into and out of the country, such as government loans to other countries. This is a
minor part of the balance of payments accounts.
193
1.3 Financial account
The financial account is made up of flows of capital to and from the non-
government sector, such as direct investment in overseas facilities; portfolio
investment (eg shares, bonds); and speculative flows of currency. Movements on
government foreign currency reserves are also included under this heading.
1.3.1 Recording financial account transactions
 Credit entries in the financial account are made for an increase in
foreign currency liabilities (eg a factory is built in the UK by a foreign
company) or a fall in foreign currency assets
 Debit entries are made for an increase in foreign currency assets (eg
a factory is built overseas by a UK company) or a fall in liabilities.
1.4 Overall balance

The sum of the balance of payments accounts will be zero (ignoring statistical errors
in collecting the figures) because every transaction will generate both a debit and a
credit entry.
Illustration 1
If a country has an overall current account deficit of $100 billion (a debit entry), the
currency required to pay for imported goods will be balanced by an equivalent
credit entry (in the financial account).
This will reflect either (or a combination of):
 A fall of $100 billion in currency reserves to pay for the imported goods (this
is a credit entry because the foreign assets held by the economy have fallen),
or
 $100 billion of foreign currency being raised from capital inflows from foreign
investors (this is a credit entry because foreign investment creates a liability for
the local economy)
1.4.1 Imbalance
Although technically the balance of payments accounts sum to zero, when
economists speak of the balance of payments they are generally referring to the
deficit or surplus on the current account and it is the causes and effects of
this imbalance on the current account that is important for this exam.
A fundamental imbalance refers to a long-term deficit or surplus on the
current account.
194
For example, the UK's historic current account balance is shown in the following
diagram.
Figure 11.1: UK's Balance of payments history

Required
Discuss how a current account imbalance relates to the circular flow of income (ie
aggregate demand) and any possible problems that may arise from a persistent
current account surplus.
Solution
195
2 Causes and effects of an imbalance
2.1 Reasons for deficits
There are many factors that can cause a country to suffer a current account deficit.
Cause Explanation
Uncompetitive This may be due to out dated machinery or labour costs being too
production high due to minimum wage regulations or powerful trade unions.
costs
Fragmented Domestic firms may be too small to compete with larger

industry international rivals.
structure
High exchange This makes exports more expensive and imports cheaper, meaning
rate that demand for a country's exports falls, whereas demand for
imported goods into the country rises (see Section 3).
High levels of At the peak of a trade cycle, if aggregate demand is high then
aggregate imports will rise (more foreign goods are purchased as well as
demand local goods) but exports will not rise (and may even fall if local
firms divert production from overseas markets to the local market)
so the current account deficit will rise.
2.2 Consequences of balance of payments deficits

An important consequence of a fundamental (long-term) imbalance is a fall in
foreign exchange reserves and a rise in external debt as the central bank
may need to borrow currency (eg from the International Monetary Fund (IMF), as
discussed in the next chapter) to provide to banks to make up the shortfall between
earnings from selling exports and the greater expenditure on imports. Eventually the
government will run out of places to borrow from.
A current account deficit will also mean the demand to buy the country's currency in
the foreign exchange markets will be weaker than the supply of the country's
currency for sale. As a consequence, there will be pressure on the exchange rate to
depreciate in value.
2.3 Impact of likely government policy responses

Because a long-term deficit is hard to sustain, governments will have to take action
to try to deal with the deficit. However, in turn, the government actions could also
have an effect on businesses, for example:
 Deflating demand
Any government action to reduce demand (eg reducing government spending,
raising interest rates or taxes) should lead to a fall in the quantity of imported
goods. Domestic companies, which will be faced with lower domestic demand
for their goods, may also switch more effort into selling to export markets.
196
However, any expenditure-reduction policy may lead to a reduction in

industrial output and a loss of jobs in the country's economy.
 Protectionist measures to reduce imports
These are discussed in more detail in the next chapter, but could involve
imposing taxes (tariffs) on imported goods. This will encourage consumers to
switch to locally produced goods and is an example of an expenditure-
switching policy.
 Decreasing the local exchange rate
As a result of a fall in the value of the currency, exports would become
relatively cheaper to foreign buyers, and imports will become relatively more
expensive. Again, this is likely to encourage consumers to switch to locally
produced goods and is an example of an expenditure-switching policy.
Exchange rates are discussed in the next section and in Chapter 16.
3 Exchange rates
An exchange rate is the price of one currency in terms of another, and is
determined by the demand for and supply of the currency on the foreign
exchange market.
Exchange S€
rate
$
R1
RE
RZ
D€
0 QD1 QS2 QE QD2 QS1 Quantity at

currency traded
Figure 11.2: Determination of the exchange rate

Figure 11.2 shows the price of the euro in terms of how many dollars ($) are
needed to buy one euro. The diagram shows a downward sloping demand curve
for the currency, the euro, and an upward sloping supply curve. These forces of
demand and supply are examined in Sections 3.1 and 3.2.
3.1 Demand
Demand for the local currency (here the euro) is created when:
 Exports are sold; demand for the local currency will be created as foreign
currency revenue from export sales are converted into the local currency (eg
from dollars to euros)
 Overseas investors invest in the local economy (here Europe).
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Demand for the local currency will rise as its exchange rate (its price)
falls.
Illustration 2
Imagine a European car maker is trying to sell cars in the USA. The required
revenue per car is 30,000 euros.
If the exchange rate is $1.4 per euro (as it was in 2014) then a price of 30,000 
1.4 = $42,000 is charged.
However, if the value of the euro falls to $1.15 per euro (its value in mid-2016)
then a price of a car falls to $34,500 (30,000  1.15).
The price in dollars has fallen significantly, so demand from US customers will
increase, and more cars will be exported to the USA as a result of a fall in the
exchange rate.
Conversely, a high exchange rate, as illustrated at R1 in Figure 11.2 above, means
that any given price in euros results in a higher price in dollars. So demand for
exports from Europe will be lower.
3.2 Supply
Supply for the local currency (here the euro) arises when:
 Imports (here goods bought from the USA) are purchased. The euros used to
pay for these will be supplied to the foreign exchange market and will be
converted from euros to dollars
 Local investors invest in overseas businesses.
The supply of the local currency will fall as its exchange rate (price)
falls.
Illustration 3
Imagine an American car maker is trying to sell cars in Europe. The required
revenue per car is $37,030.
If the exchange rate is $1.4 per euro then a price of 37,030 / 1.4 = 26,450 euros
is charged.
However, if the value of the euro falls to $1.15 then the price of a car rises to
32,200 euros (37,030 / 1.15).
The price in euros has risen significantly and fewer US cars will be demanded by
European consumers. Therefore, the level of imports into Europe from USA will fall
as a result.
A low exchange rate, say R2 in Figure 11.2 above, means that any given price in
dollars costs more in Euros. Therefore demand for imports will be lower.
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3.3 Exchange rates and the balance of payments

Having shown that a lower exchange rate will stimulate exports and reduce imports,
we can say that a potential solution to a balance of payments deficit on
the current account is to take action to reduce the exchange rate.

Required
Which TWO of the statements below best describe the impact of a reduction in the
value of the euro compared to the US dollar on a European business selling goods
in the USA, but also buying goods from US suppliers.
A Costs per unit will rise, and profits will fall
B It will benefit from an increase in economic activity resulting from the exchange
rate change
C Revenues will rise, but its profits may not
D Its costs will fall leading to rising profits
3.4 Exchange rates and interest rates

Any movement in demand or supply curves for a currency will cause a movement in
the exchange rate.
A common reason for exchange rates to move is that interest rates in a country have
changed.
Interest rates will affect the demand for a currency, eg lower interest rates will cause
a fall in demand from overseas investors (eg US) looking to put money on deposit in
the local economy (eg Europe).
If interest rates fall the demand for the currency will also fall, leading to a fall
in the exchange rate. This is shown in Figure 11.3.
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Exchange
rate S
R0
R1
D
D1
0 QD Q1 Q0 Quantity of
currency
Figure 11.3: Impact of a fall in interest rates

In Figure 11.3 the exchange rate is initially at R0 and the quantity demanded and
supplied of the currency is Q0.
The reduction in interest rates means that the demand curve for the currency shifts
from D to D1.
The resulting fall in demand from Q0 to QD creates a surplus of currency, and
consequently the exchange rate falls to R1 at which point equilibrium between
supply and demand for the currency is restored.
It follows that if interest rates rise, the demand for a currency will rise, and the
exchange rate will rise.
3.5 Exchange rates and inflation rates

Changes in the rate of inflation are another common reason for the exchange rate
to move.
If a country experiences a rise in inflation rate so that its rate is higher
than that of its trading partners this means that the country's products are
becoming more expensive relative to the goods produced by its trading
partners.
This will lead the demand for its exports to fall, and therefore the demand for its
currency to fall (leading to the same effect as a fall in interest rates that is illustrated
in Figure 11.3).
200

Required
Which TWO statements below are most likely to describe the impact of a reduction
in the interest rate in Europe on a European business selling goods in the USA, but
also buying goods from US suppliers.
A Revenue is likely to rise in euros but not in dollars.
B It will benefit from an increase in economic activity from the resulting exchange
rate change.
C The company's investment spending will fall.
D Costs per unit are likely to rise.
4 Government policies on exchange rates

4.1 Free floating exchange rates
Free floating exchange rate

Free floating or flexible exchange rates occur when exchange rates are left to the
interaction of market forces and there is no official financing at all.
In other words, the exchange rate will reflect the interaction of supply and demand
for a currency.
A problem with allowing exchange rates to be determined by market forces is that if

exchange rates change too much, the uncertainty surrounding fluctuations in
exchange rates could deter trade and investment.
So, in practice, governments may prefer to intervene in the market to buy or sell
currency in order to achieve a degree of exchange rate stability. This is sometimes
called a managed (or dirty) floating exchange rate policy.
4.2 Fixed exchange rates
Fixed exchange rate

A government policy of buying and selling currency to fixed exchange rates by
using its official currency reserves to create an exact match between supply and
demand for its currency in the foreign exchange markets, in order to keep the
exchange rate unchanged.
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A fixed exchange rate system removes exchange rate uncertainty and so
encourages international trade.
There is inevitably some loss of flexibility in economic policy making once a
country fixes its exchange rates.
For example, if there is excess supply of a currency, and a government runs out of
currency reserves then it might be forced to reduce demand in the domestic
economy (for example, by raising taxes and so cutting the demand for imports) in
order to maintain a currency's exchange rate and avoid a devaluation.
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Chapter summary
 The balance of payments accounts consist of a current account (visibles and

invisibles) section and the financial and capital accounts. The sum of the balances
on these accounts must be zero, although, in practice, there is a balancing figure
for measurement errors.
• When newspapers and the press talk about a surplus or deficit on the balance of
payments, they usually mean a surplus or deficit on the current account.
• A key consequence of perpetual balance of payments deficits is the rise in external
debt as a country's central bank borrows currency to provide to banks, to make up
the shortfall between earnings from selling exports and the greater expenditure on
imports. Eventually the government will run out of places to borrow from.
 The main policies for dealing with a current account deficit are to
depreciate/devalue the currency, or to introduce protectionist measures, or to
reduce demand for imports and encourage exports by deflating the economy.
• An exchange rate is the price of one currency in terms of another. Exchange rates
are determined by the relative demand and supply for the currency on the foreign
exchange market.
• In the short run, the foreign exchange rate adjusts to equilibrium by the actions of
foreign exchange traders. Longer-term shifts in exchange rates are caused by
changes in the balance of trade, the impact of changes in relative interest rates, the
rate of inflation and expectations of future movement in exchange rates.
• Government policies on exchange rates might be to set fixed exchange rates or to
allow floating exchange rates. Alternatively, governments may look for a policy
somewhere between the two.
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Keywords
 Balance of payments: The balance of payments accounts record international
trade and investment transactions. The balance of payments accounts have three
parts: the current account, the capital account and the financial account.
 Free floating exchange rate: Free floating or flexible exchange rates occur
when exchange rates are left to the interaction of market forces and there is no
official financing at all.
In other words, the exchange rate will reflect the interaction of supply and demand
for a currency.
 Fixed exchange rate: A government policy of buying and selling currency to
fixed exchange rates by using its official currency reserves to create an exact match
between supply and demand for its currency in the foreign exchange markets, in
order to keep the exchange rate unchanged.
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Activity answers

Exports are an injection to the circular flow, so higher exports will lead to higher
aggregate demand.
Imports are a withdrawal from the circular flow, so higher imports will lead to a
fall in aggregate demand.
If exports are higher than imports there is a current account surplus. If aggregate
demand is already high then a further injection of demand may lead to demand-pull
inflation and therefore to all the problems that we associate with inflation.
Normally, however, a current account surplus is good news for an economy
because it means that there is a net injection of finance which creates a positive
multiplier effect and this can help to boost output and to create jobs.

B and C
A reduction in the value of the euro will increase the costs of this business but will
also increase its revenues for overseas sales. So costs per unit will rise but profits
may rise or fall depending on the change in costs and revenues (this means the
definitive statement that 'profits will fall' in Option A is incorrect).
A reduction in the value of the euro will stimulate exports from Europe and this
should lead to a multiplier effect creating higher demand within Europe, which this
company should be able to benefit from.

B and D
The fall in the interest rate should have a number of impacts:
Demand in Europe will be stimulated
A resulting fall in the value of the euro should increase revenue in dollars
A resulting fall in the value of the euro should increase costs in dollars
Investment means creating new assets, eg new factories – this is likely to rise as
demand rises (also a fall in interest rates would be expected to lead to a rise in
investment because it will reduce the cost of capital).
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Test your learning
1 How do deflationary measures help to eliminate a balance of payments deficit?
2 What is the balance of trade?
A The balance of payments on current account
B Net visible trade
C Net visible and invisible trade
D The balance of trade investment, exports and imports
3 The balance of payments current account will include which of the following items?
(i) Expenditure in a country by overseas visitors
(ii) The inflow of capital investment by multinational companies
(iii) Exports of manufactured goods
A (iii) only
B (i) and (iii)
C (ii) and (iii)
D (i), (ii) and (iii)
4 What is the main advantage of a system of free floating exchange rates?
A Currency risk will be minimised
B Imposes policy discipline on governments
C Balance of payments deficits or surpluses are automatically corrected
D Consumers can compare prices across borders more easily
5 If a country has a freely floating exchange rate, which one of the following would
lead to a rise (appreciation) in the rate of exchange for its currency?
A A decrease in the level of exports
B A decrease in the country's interest rates
C A decrease in the country's inflation rate
D A decrease in the level of capital inflows into the country
6 Which of the following would normally result from a fall (depreciation) in a
country's exchange rate?
A A fall in the country's rate of inflation
B A rise in the volume of exports
C A worsening in its balance of payments
D A rise in the volume of imports
7 Which of the following would normally lead to an increase in a country's exchange
rate?
A A rise in the country's rate of inflation
B An increase in the country's balance of payments deficit
C A rise in the country's interest rate
D A decline in the forecast profits of the country's firms
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International trade
Learning outcomes

 identify the main elements of national policy with respect to trade
 explain the concept of globalisation and the consequences for businesses and national
economies
 explain the role of major institutions promoting global trade and development
 identify the impacts of economic and institutional factors using the PESTEL framework
Chapter context
This chapter aims to:
 Explain the factors affecting the trade of a country with the rest of the world and its impact
on business.
 Explain the influences on economic development of countries and the effects of
globalisation on business.
Syllabus context
207
Chapter overview
International trade
Free trade Types of trade Institutions

agreement
Advantages of international Free trade area  WTO

trade Customs union  IMF
Problems Common/single market  World Bank
Protectionism Economic union
Globalisation PESTEL
 Political
 Economic
 Social
 Technological
 Environmental
 Legal
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12: International trade
1 Free trade
1.1 Advantages of international trade
There are a number of powerful advantages of international trade:
 We have already seen how specialisation can boost productivity.
International trade extends the principle of specialisation to countries.
 Trade allows countries to obtain goods that are not possible to produce in their
own country, eg oil.
 International trade increases competition among suppliers in the world's
markets; this will increase the pressures on them to be efficient.
 It creates larger markets for a firm's output, and so some firms can benefit from
economies of scale by engaging in export activities.
1.2 Free trade – problems

In reality, many countries try to protect local companies and to improve their
balance of payments by reducing imports. Sometimes there is an argument that
foreign competition is not appropriate because:
(a) Imported products are being sold below production cost to destroy domestic
firms (this is called dumping)
(b) Domestic firms are new and are too small to be able to compete against larger
foreign rivals yet, and so need protecting from them (sometimes called the
infant industry argument)
(c) Some industries must not be allowed to be driven out of existence by foreign
rivals because they have a long-term strategic importance to the country, eg
shipbuilding
(d) Some countries have an unfair advantage because they don't pay the social
costs of production (eg decent wages and working conditions)
1.3 Protectionism
In response to the potential problems with free trade, some countries try to protect
their economies by using a variety of protectionist measures, ranging from:
 An outright ban on imports (or on imports of certain products)
 Import taxes (tariffs) making imported goods relatively more expensive
compared to domestically produced goods
 Quotas (a restriction on the number of items that are allowed to be imported,
eg the EU has quotas for agricultural output such as beef)
 Subtle measures such as offering subsidies to domestic producers or
placing administrative burdens on importers (eg increasing the safety
standards that imported goods must comply with).
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Free trade refers to an environment in which protectionist measures have been
removed. A number of institutions and agreements exist to promote free trade,
which are covered in the next section.
2 Types of trade agreement
Free trade Customs Common Single Economic

area union market market union
2.1 Free trade area

A free trade area exists when there is no restriction on the movement of goods
and services between countries, although individual member countries can
impose their own restrictions on non-member countries.
For example, the North American Free Trade Agreement (NAFTA) is a free trade
area that includes Canada, the USA and Mexico.
2.2 Customs union

A free trade area may be extended into a customs union when there is a free
trade area between all member countries of the union and, in addition, there are
common external tariffs applying to imports from non-member countries into
any part of the union.
Where there are common policies on product regulation this is sometimes called a
'single market'.
For example, Mercosur is a customs union comprising Argentina, Brazil, Paraguay,
Uruguay and Venezuela.
2.3 Common and single markets

A common market encompasses the idea of a customs union but has a number
of additional features. In addition to free trade among member countries there are
also free markets in each of the factors of production and a move to
standardise market regulations (eg safety and packaging rules).
Eventually a common market becomes a single market with no restriction of
movement or regulatory differences.
For example a citizen in the European Union (EU) has the freedom to work in any
other country of the EU.
2.4 Economic union

A common/single market may eventually evolve into economic and monetary
union.
210
In addition to the features in a common market, an economic union will involve a

common Central Bank and a common interest rate and a single
currency.
For example, within the EU, most member countries are part of the eurozone; they
share a single currency and co-ordinate economic policies.

A group of countries have created an agreement that operates to remove trade
barriers between these countries and to impose common tariffs for imports from
outside this group.
Each country operates its own regulations and has its own currency. There isn't any
freedom of movement for workers at present, but there is a general consensus that
the countries will work to increase economic harmonisation over time.
Required
Choose which of the following best describes the arrangement between these
countries:
A A customs union
B A free trade zone
C A common market
D A single market
3 World Trade Organisation (WTO)

The WTO has been established to support the development of international trade.
The organisation (which has over 150 member countries) provides a mechanism for
identifying and reducing trade barriers and resolving trade disputes.
The WTO will impose fines, if members are in breach of their rules.
Members of the WTO cannot offer selective free trade deals with another country
without offering it to all other members of the WTO. (This is known as 'the most
favoured nation' principle).
4 International Monetary Fund (IMF)

The IMF's main purpose is to support the stability of the international monetary
system by providing support to countries with balance of payments problems, for
example problems in making debt repayments to international creditors. Most
countries are members of the IMF.
211
Where a member is having balance of payments problems the IMF will:
(a) Offer advice on economic policy
(b) Lend money (normally over a 3-5 year period)
4.1 Terms attached to IMF loans

The IMF normally insists that a country should take action to reduce the demand for
goods and services (eg by increasing taxes and cutting government spending).
This will reduce imports and help to curb any price rises. The country's industries
should then also be able to divert more resources into export markets, and so
exports should increase in the longer term.
With 'deflationary' measures along these lines, standards of living will fall (at least
in the short term) and unemployment may rise. The IMF regards these short-term
hardships to be necessary if a country is to succeed in sorting out its balance of
payments and international debt problems.
It has been suggested that the strict terms attached to IMF loans can lead to
economic stagnation as countries struggle to repay these loans. Deflationary policies
imposed by the IMF may damage the profitability of multinationals' subsidiaries by
reducing their sales in the local markets.
5 The World Bank

The World Bank lends to credit worthy governments of developing nations to
finance projects and policies that will stimulate economic development and alleviate
poverty.
The existence of the World Bank affects multinational companies by bringing
a measure of financial stability by helping to finance infrastructure projects in
developing economies. This allows multinational companies (MNCs) to participate
directly in infrastructure projects. It also creates a platform for multinational companies
to invest in such countries.
6 Globalisation
Since the Second World War international trade volumes have grown rapidly. The
emergence of high levels of international trade, investment and migration is
sometimes called 'globalisation'. It has been argued that globalisation has brought
higher standards of living and growth to economies, but increasingly concerns have
also been expressed about its potential for allowing the exploitation of developing
countries.
One reason for increasing globalisation is improved communications – the
speed of access to the internet has increased the access of consumers to goods from
anywhere in the world. This has also improved the ability of companies to
co-ordinate production facilities that may be spread across the globe.
Political realignments such as the opening up of markets in Russia and China
have also contributed to globalisation.
212
However, probably the most important factors are:

 The breakdown of some trade barriers by free trade organisations and
treaties (discussed earlier)
 The emergence of multinational corporations (discussed below)
6.1 The size and significance of multinational enterprises

A multinational company (MNC) is one that has production or service facilities
in more than one country. Over the past few decades, MNCs have grown rapidly
and now exercise a dominant force in many market sectors.
Illustration 1
Here is an indication of the dominance of large MNCs across a range of industries.
These statistics measure the market share of the largest four firms in selected
industries:
Search engines 98.5%
Satellite TV 94.5%
Carbonated drinks 93.7%
Tyre production 91.3%
Source: IBISWorld 2012
6.1.1 Globalisation of production

MNCs may locate production facilities in particular countries (see off shoring in
Chapter 5) for a variety of reasons:
 To give access to markets protected by tariffs
 To reduce transport costs
 To take advantage of low labour costs and, thereby, reduce production costs
6.2 PESTEL
PESTEL is useful tool for analysing opportunities and threats in the external
environment of a business.
PESTEL covers six areas that would often be analysed before key decisions are
made, eg whether to locate in a new market.
Political issues relating to the government, eg government spending

priorities can have a significant impact on a business
Economic economic growth, tax rates, inflation, interest rates, exchange

rates
Social changes in culture (eg interest in environmental issues) and

demographic changes (eg aging population)
213
Technological changes in the IT and transport infrastructure
Environmental / Ecological
factors that could impact on the ecological balance of the
environment and could include such issues as climate change
and pollution energy consumption, waste disposal
Legal including legislation on trading, pricing, dividends, tax,

employment, as well as health and safety.

Required
Select which of the following is an effect of globalisation?
A Less foreign competition in domestic markets
B Changes in IT making communication easier
C Reduced interdependency between economies
D Reduced price differentials between economies
214
Chapter summary
• Trade agreements include free trade areas, common / single markets and economic
unions.
 Global financial institutions, like the World Bank, the WTO and the IMF, act to help
countries that are suffering financial problems and to promote international trade.
• Globalisation refers to a widespread extension of trade between countries and a

high degree of interdependence of production between countries.
• Globalisation has been assisted by the globalisation of production by multinational

companies (MNCs) and the globalisation of capital markets.
• PESTEL is a useful structure to analyse complex business environments. As such, it

could be especially useful for MNCs.
215
Activity answers

A
Definition. A customs union is like a free trade area but also has common external
tariffs. A common market is like a customs union but also has freedom of movement
of factors of production between the countries involved. A single market is a
common market where many regulations are the same.

D
Foreign competition is likely because of the entry of MNCs into markets around the
world.
Changes in IT are more of a cause than an effect of globalisation.
Globalisation increases trade which increases the strength of the economic ties
(interdependencies) between countries. Over time, low-wage/low-price economies
attract investment. This drives up wages and prices, so reducing price differentials.
This has happened in China in recent years.
216
Test your learning

1 What is a tariff?
2 What is the difference between a free trade area and a customs union?
3 What is the difference between the WTO and the IMF?
4 What is a multinational company?
5 What does PESTEL stand for?
217
218
Functions of the
financial system
Learning outcomes

 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 providers of liquidity
Chapter context
Have you ever wondered why we have a banking sector? Governments, households and businesses
will sometimes have surplus cash, while at other times they will face cash shortages. The financial
system enables them to manage these short-term and long-term liquidity issues.
Businesses needing to borrow funds can either use financial institutions, such as banks, or they can
obtain finance directly from investors through the financial markets.
Syllabus context
This chapter is part of syllabus Section D which looks at the 'financial context of business'.
This syllabus area has a weighting of 25% and is covered by Chapters 13-16 although there is
also a degree of overlap with Section A of the syllabus which covers some of these areas (especially
Chapters 11-12).
219
Chapter overview
Financing for
firms
Matching concept
Functions of the financial

system
Financial markets Financial

intermediaries
Maturity transformation
Disintermediation Aggregation of funds
Pooling losses
Money Capital
markets markets
 Bills of  Shares
exchange  Bonds
 Bank bills
 Commercial
paper
220
13: Functions of the financial system
1 Finance for firms

1.1 Short-term financing needs:
Production costs Sales receipts

Short-term
– Inventory is built – Cash receipts from sales may be
finance
up prior to sales delayed if sales are on credit
Because a firm has to finance production (costs of labour, raw material etc) before
any sales receipts accrue, it may need funds to bridge the gap between paying for
production and obtaining receipts from sales. This type of finance is sometimes
called working capital finance. Working capital refers to short-term assets such
as inventory and receivables. The finance required will be short term.
Illustration 1
The market for childrens' toys is highly seasonal, with sales peaking at Christmas.
For toy manufacturers this means that they will have to incur production costs, and
pay suppliers, well before Christmas but often receive payment from sales to
retailers after Christmas. This creates a significant mismatch between cash outflows
and inflows for a few months and this requires short-term finance.
1.2 Long-term financing needs

A firm may also need funds to buy property, machinery, etc. The benefits from these
investments are typically long term and are often financed by long-term finance.
1.3 The matching concept
Matching concept
It is normal for a company to try to match the time period of the finance to
the life of the assets they finance. This is referred to as the matching concept.

Required
What problems may be caused by a firm failing to match the time period of the
finance to the life of the assets, eg using long-term finance for short-term
working capital needs, or short-term finance for long-term investments?
221
Both short and long-term finance can be obtained from either:
 Financial intermediaries, or
 Financial markets
2 Financial intermediaries
Financial intermediaries
Financial intermediaries are institutions, such as banks or building societies, which
channel funds from savers (looking for an economic return) to borrowers. In doing
so, the intermediaries provide a link between savers and borrowers.
Financial
Savers Borrowers
intermediaries
Other examples of financial intermediaries
Investment (or merchant) banks Provide large corporate loans
Pension funds Invest to meet future pension liabilities
Insurance companies Invest to meet future liabilities
Venture capital companies Invest in risky ventures eg start-ups
2.1 Functions of financial intermediaries

Functions Description
Maturity Banks bridge the gap between savers' desire for liquidity (the
ability to convert their investment into cash) and the desire of
transformation
borrowers for long-term loan finance.
A bank can lend for the long-term (eg a 10-year loan) while still
allowing its depositors to take money out whenever they want ie
maintaining their liquidity.
Short-term deposits are transformed into long-term loans.
Aggregation of A bank can aggregate lots of small amounts of money into a large
loan. Without this, a borrower would have to find a number of
funds
different savers prepared to lend to them.
Pooling losses Losses sustained from a single bad debt will not impact directly on
savers, because the bank has earned enough interest from its
other loans to cover the loss. (This is sometimes referred to as risk
transformation).
222
Financial intermediaries also encourage saving because they provide a convenient

and secure mechanism for a saver to save money and to earn an economic
return on their savings.
2.2 Financial intermediaries and short-term finance

Sources of short-term finance available from financial intermediaries include:
Functions Description
Overdraft A short-term facility which allows businesses to borrow money up

to an agreed limit. The bank will charge interest only when the
overdraft facility is being used – so this can be a valuable means
of overcoming a short-term cash flow problem.
An overdraft facility is not normally guaranteed, and can be
amended or withdrawn by the bank at any time. However, it is
possible (for a fee) to set up a revolving credit facility, which
involves a bank agreeing an overdraft facility for a period of time
eg in 2014 Marks & Spencer had a committed revolving credit
facility of £1.325 billion set to mature at the end of 2017.
Short-term loan Unlike an overdraft, a bank loan cannot be withdrawn by the

bank after the loan has been granted (assuming the loan terms
have been met) so this is a more secure source of finance.
Short-term Some assets (eg vehicles, printers) can be financed by short-term

lease rental agreements (operating leases) which remove the risk of
owning the asset (eg technological change, equipment failure) but
are expensive.

Required
Which of the following is not a benefit of a financial intermediary?
A Maturity transformation
B Risk transformation
C Aggregation
D Matching
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2.3 Financial intermediaries and long-term finance
Sources of long-term finance available from financial intermediaries include:
(a) Long-term loans. Companies may have to provide security for a long-term
loan or may have to make promises (loan covenants) about their future
behaviour eg maintaining certain levels of particular financial
ratios eg the gearing (debt/equity) ratio.
(b) Long-term (finance) leases. A long-term rental that transfers substantially
all the risks and rewards of ownership of an asset (to the lessee). This may be
easier to organise than a bank loan, because the provider of the lease (the
lessor) retains legal ownership of the asset.
3 Financial markets
A financial market brings a firm into direct contact with its investors.
The trend to raising finance directly from investors, bypassing financial
intermediaries such as banks, is called disintermediation.
Savers Borrowers
3.1 Functions of financial markets
Financial markets are useful to both savers and borrowers:
 Borrowers – can raise new finance; this is called the primary market
 Savers – can sell assets (eg shares) to other investors; this is called the
secondary market
3.2 Financial markets and short-term finance

The markets for short-term finance are called the money markets. Available
financing products include:
(a) Bills of exchange:
When a business has made a large sale (eg more than £75,000) a legal
document can be drawn up and signed by the customer
confirming their obligation to pay in the near future (up to 180
days ahead) – this is called a bill of exchange.
This document can then be sold by a business to a bank or a discount house if
the business needs to raise short-term finance.
224
Illustration 2
A bill of exchange confirms that a customer owes £120,000 and is due to pay in
90 days. If this is sold to a discount house for £117,000, a firm has raised this
finance 90 days early, at a cost of £3,000. Assuming 360 days in a year, this is an
annual interest cost in percentage terms of:
3,000 360
× = 10.26%
117,000 90
(b) Commercial paper:

Similar to a bill of exchange except that a bill of exchange is signed by the
company confirming its obligation to pay the buyers of the 'bill' in the near
future (up to 270 days ahead).
Commercial paper is unsecured and can only be issued by companies with a
good credit rating.
(c) Bank bills:
Similar to commercial paper/bill of exchange, except that bill is signed by the
company's bank, guaranteeing (accepting) payment to the buyers of the 'bill'
in the near future.
This can be sold to banks or discount houses at a higher price because of the
bank's guarantee to pay. This is also called an acceptance credit.
Footnote – if a government issues bills, these are called Treasury Bills; like
other bills these are bought at a discount to their face value; they do not pay
interest.

Required
What is the annual cost of a bank bill which has a face value of $100,000 and
matures in 6 months' time if it is sold for $98,000 today?
Solution
225
3.3 Financial markets and long-term finance
The markets for long-term finance are called the capital markets. Available
financing products include:
(a) Shares:
Share capital might be in the form of ordinary shares (equity) or preference
shares. Bear in mind that only the ordinary shareholders are owners of the
company, and preference shares are comparatively rare.
Shares are bought (and sold) on organised stock markets, such as the London
Stock Exchange.
(b) Bonds (also called debentures or loan stock):
Bonds are (normally) fixed interest securities issued by companies that
are listed on the stock market.
Illustration 3
Here is an example of a bond that was issued in 2013 by Royal Dutch Shell.
Bond prices are quoted per $100 nominal value.

Royal Dutch Shell plc
A price of $98.65 or 98.65% means a market
IOU $100 price of $98.65 per $100 nominal value.
The 1.9% rate is called a coupon rate. The investor

Interest of 1.9% paid p.a.
will receive $1.9 interest each year. The rate quoted is
Redeemable in 10 years' time at $100 the gross rate, before tax.
Redemption is usually 5-15 years ahead, and is usually

at the par or nominal value of $100.
If a bond is sold for more or less than $100 then the yield to investors (or the cost of
the bond to the company) will be different to the coupon rate. The yield to investors
is sometimes called 'running yield' or 'interest yield'.

Required
What is the interest yield of the bond illustrated above if it is sold for $95?
Solution
226
3.3.1 Other types of bonds

 Eurobonds:
Bonds sold outside the jurisdiction of the country in whose currency the bond is
denominated and are often used by large companies to raise debt finance in a
range of different currencies.
 Convertible bonds:
The bond holder has the right to convert the bond into shares in the future. This
type of bond, which combines aspects of both debt and equity finance, is
sometimes referred to as mezzanine finance..
 Gilts:
Bonds issued by the government are called gilt-edged securities or gilts
(because they regarded as being very low risk) or Treasury Bonds.
227
Chapter summary
• The financial needs of firms can be separated into needs for short-term working
capital and needs for longer-term investment finance.
• Within an economy, some people, firms and organisations will have money which
is surplus to their needs, and others will have less money than they need for their
spending requirements. Financial intermediaries, such as banks, make the provision
of credit much easier, by taking deposits from savers and re-lending to borrowers.
• Financial intermediaries allow maturity transformation, aggregation and pooling.
• Businesses have access to short-term finance via the money markets and long-term
finance via the capital markets.
228
Keywords
 Matching concept: It is normal for a company to try to match the time period of
the finance to the life of the assets they finance. This is referred to as the matching
concept.
 Financial intermediaries: Financial intermediaries are institutions, such as
banks or building societies, which channel funds from savers (looking for an
economic return) to borrowers. In doing so, the intermediaries provide a link
between savers and borrowers.
229
Activity answers

 Using long-term finance for short-term working capital needs
– If finance is only required for a few months (eg the Christmas period for
toy manufacturers), then taking out a long-term loan to provide the cash
required for this short-time period will mean that the company is paying
interest during periods of the year (eg the non-Christmas period) where
the finance is not required. This will incur unnecessary extra finance
costs.
 Using short-term finance for long-term investment projects
– If an asset (eg a new aircraft for an airline) creates benefits for the long
term, then attempting to finance this with a short-term loan creates the risk
that the asset will not have created sufficient benefit to pay for the finance
by the time the finance is paid off. This creates a potential liquidity
(ie cash flow) problem.

D Matching – this is a principle of raising finance, not a function of a financial
intermediary.

(100  98) 12
  4.1%
98 6

1.9
100  2%
95
230
Test your learning

1 What is a financial intermediary?
2 List the main sources of finance available to businesses from the money markets.
3 What is meant by the 'matching concept'?
A That borrowing and lending should be at the same rate of interest
B The process by which banks introduce lenders to borrowers
C Ensuring loans and repayments are in the same currency
D Ensuring that the length of credit is similar to the life of the asset being bought
with it
4 What is meant by 'maturity transformation'?
5 The functions of commercial financial intermediaries include all the following except:
A Maturity transformation
B Reduction of transactions costs
C Aggregation
D Issuing government debt
231
232
Commercial and
Central banks
Learning outcomes

 explain the role of commercial banks in the process of credit creation and in determining the
structure of interest rates and the roles of the 'central bank' in ensuring liquidity
Chapter context
This chapter examines the functions of banks in facilitating commerce and development.
Syllabus context
233
Chapter overview
Types
 Clearing
 Commercial
 Wholesale
 Merchant
Goals
 Profitability
 Liquidity Yield
 Security
Banks
Affected by
 Inflation
Credit creation
 Risk
 Create money by  Demand & supply of
lending money
 Restricted by need for Commercial and  Government policy
liquid reserves
central banks
 Self-imposed or
government-imposed
level of liquidity
Regulation
 Basel III Role of central

bank
 Set interest rates

 Regulate banks
 Lend to banks, as last resort
 Quantitative easing
 Issue notes & coins
 Borrow for government
 Hold, buy & sell foreign currency
 Advise on monetary policy
234
14: Commercial and central banks
1 Commercial banks and credit creation

There are a number of different types of bank that you need to be aware of:
Types of bank
Wholesale banks
Retail or commercial banks
specialise in providing
financial services to large traditional 'High Street' banks.
organisations. Also may be In this section, we are mainly
referred to as: investment concerned with the activities of
banks, secondary banks or commercial banks.
merchant banks.
1.1 Conflicting aims

A commercial bank has three potentially conflicting aims which it must try to
keep in balance. These are:
(a) Profitability
A bank must make a profit (an economic return) for its shareholders.
The level of profit a bank earns depends on the rates of interest it charges on
the money it lends. A bank can earn bigger profits by lending at higher
interest rates, for example, by lending to higher-risk customers.
(b) Liquidity
A bank must have sufficient liquid assets (cash) to meet demands from
depositors for cash withdrawals. A bank might also need to have some
'near-liquid' assets which it can turn into liquid assets quickly, eg Treasury Bills.
However, liquid assets earn a relatively low return so a bank will try to keep
the quantity of such assets it holds to a safe minimum.
(c) Security
People deposit their money with banks because they are regarded as stable
and secure institutions.
Banks will charge higher interest rates on higher-risk loans. If lenders default
on these loans this could result in depositors having concerns about a bank's
stability. This can lead to depositors withdrawing their deposits from the bank.
235
1.2 Credit creation
In the process of trying to maximise profits, while maintaining sufficient liquidity,
banks will aim to lend a proportion of any money which is deposited with
them. They can do this because they know that not all of the money that has been
deposited will be withdrawn at the same time. This is commonly referred to as
fractional reserve banking because it involves the bank keeping only a
fraction of customers' deposits as cash reserves, and lending out the remainder.
When this loan is spent, it will flow into another bank account as a deposit and will
again be lent out by the bank.
In this way, banks 'create' extra deposits of a much greater magnitude than the
amount of money originally deposited. This process is called 'credit creation'.
Illustration of credit creation

We shall assume for simplicity that there is only one bank in the banking system.
Step 1
Let us assume a customer deposits $1,000 in cash in the bank.
This $1,000 is an asset for the customer but, for the bank, it is a liability.
Bank's liabilities (deposits) Bank's assets
(1) $1,000 deposit $1,000 cash
Step 2.
Let us assume that the bank has decided (on the basis of past experience and
observation) to keep 20 cents in cash for every $1 deposited, and then lend out the
other 80 cents.
In other words, the bank in this example is operating a 20% cash reserve ratio.
On the basis of the 20% cash ratio, the bank manager decides to keep $200 cash,
and make a loan of $800 to Company A.
Bank's liabilities (deposits) Bank's assets (cash and loans)
(2) $1,000 deposit $200 cash and $800 loans
Step 3.
Company A spends the money on goods that it purchases from Company B.
Company B pays the $800 into their bank account.
So the bank is now holding $1,000 in cash, but has total deposits of $1,800.
Bank's liabilities (deposits) Bank's assets (cash and loans)
(3) $1,000 deposit $200 cash and $800 loans
$800 extra deposit $800 extra cash
On the basis of the 20% cash ratio, the bank only needs to be holding $360
(20%  total deposits of $1,800) as cash.
236
However, the bank is currently holding $1,000 of cash.

So there is surplus cash of $1,000 – $360 = $640 available for further lending.
Step 4.
Accordingly the bank lends $640 to another customer seeking a loan.
Bank's liabilities (deposits) Bank's assets (= cash and loans)
(4) $1,000 deposit $200 cash and $800 loan
$800 deposit $160 cash
$640 loan
The bank can continue with this process of depositing and lending as long as the
cash reserve ratio is maintained.
However, even by the end of step (4) in our simple example, we can see that,
through the process of credit creation, the bank now has deposits of $1,800
compared to the initial deposit of $1,000. So, it has 'created' extra deposits of
$800.
Ultimately, if the bank kept on lending, applying the 20% cash ratio, total deposits
would rise to $5,000. They could not be allowed to rise to more than $5,000
because if this happened then the cash ratio of 20% would be breached and the
bank would be compromising its aim of providing liquidity to customers.
1.3 The credit multiplier

If the bank in the previous example decided that the 20% cash ratio was too low
and increased it to 25%, then for every $1,000 cash deposited with it, the bank
would now need to hold $250, and could only loan out the other $750 so the
credit creation effect would be smaller. Changes to the reserve ratio may be
imposed by the government to deliberately encourage or discourage bank lending.
We can summarise the quantitative side of credit creation in banks as follows:
Increase in deposits = initial cash deposit × credit multiplier

1
Credit multiplier =
reserve ratio
237
Illustration 1
If a bank decides to keep a cash reserve ratio of 20%, the credit multiplier
= 1 / 0.2 = 5. If the bank receives additional deposits of $1,000, the increase in
bank deposits will be $1,000 × 5 = $5,000.
If a bank decides to keep a cash reserve ratio of 25%, the credit multiplier
= 1 / 0.25 = 4. If the bank receives additional deposits of $1,000, the increase in
bank deposits will be $1,000 × 4 = $4,000.

Required
If all the commercial banks in an economy operated on a cash reserve ratio of 20%,
how much cash would have to flow into the banks initially for the money supply to
increase by $80 million in total?
Solution
1.4 Government borrowing and credit creation

The government funds its borrowing by issuing financial assets (eg Treasury Bills) to
the financial markets.
This creates extra money supply as follows:
 Banks buy these bills and hold them as reserves instead of cash. They lend the
money to the government but do not need to reduce their total deposit
liabilities.
 The government spends the money it has borrowed. The recipients put this
money into their bank accounts.
 The amount of money has increased by the amount the government borrowed.
2 Role of central banks

A central bank is a bank which acts on behalf of the government. The central bank
for the UK is the Bank of England. The main functions of a central bank are
considered in the following paragraphs.
238
2.1 Setting interest rates

The level of interest rates can be influenced by the central bank as described in
Chapter 10. To support interest rate policy, the central bank may use open
market operations. This involves the central bank supplying cash to the banking
system on days when the banks have a cash shortage by buying (for example) 'bills'
in exchange for cash.
When bills (described in Chapter 13) are sold, they are traded at a discount to their
face value, and there is an implied interest rate in the rate of discount obtained.
Illustration 2
A 182-day Treasury Bill is sold for an average price of $9,719.30 per $10,000
face value. Assuming a 360-day year, this creates a yield of:
10,000 – 9,719.3 360
× = 0.057 or 5.7%
9,719.3 182
2.2 Regulating the banking sector

Central banks will monitor the general stability of the financial system and, where
necessary, introduce regulations to reduce the risk of financial crisis.
Sometimes central banks will act with each other in order to take effective
international action. The Bank for International Settlements (BIS) is the
governing committee of central banks and is based in Basel, Switzerland. It hosts
the quarterly meetings of the Basel Committee on Banking Supervision which lays
down guidelines for banking supervision, the Basel Accords.
The Basel III Agreement (or Basel 3) was developed in the wake of the
worldwide collapse of banking in 2008 and the consequent bail-outs by
governments, and has added to the previous requirements that laid out banks'
capital management, including the introduction of a capital adequacy ratio and
stipulating the minimum capital requirements banks will be required to meet.
2.3 Maintaining financial stability

Apart from regulation, the central bank will also act as a 'lender of last resort'
when the banking system is short of money, ie the central bank will provide the
money the banks need – at a suitable rate of interest.
Even if the banking system is not short of money the central bank may inject
liquidity (ie cash) into the banking system by buying assets from commercial
banks. The surplus cash that commercial banks will then be holding will be lent out
to firms and will hopefully stimulate the economy through the process of credit
creation covered earlier. This is sometimes called 'quantitative easing', and has
been used by central banks in Europe, the UK, the USA and Japan in the aftermath
of the economic crisis of 2008.
239
2.4 Other functions of a central bank
Other functions of a central bank normally include:
 Banker to the commercial banks:
Commercial banks keep a bank account with the central bank. This enables
the cheque clearing system to operate. At the end of each day the net
balances on each bank's accounts with the other banks are settled through
their accounts at the central bank.
 Banker to the central government:
Dealing with long- and short-term borrowing by the central government and
repayment of government debt.
 Central note-issuing authority – responsible for issuing bank notes.
 Holding the country's foreign currency reserves:
It may use these to trade on the foreign exchange markets to stabilise the
exchange rate.

Required
Which of the following effects will result from a policy of quantitative easing?
A A rise in the interest rate
B A rise in the value of the domestic currency
C An increase in the money supply
D A fall in the rate of inflation
Solution
3 Yield on financial assets

3.1 Risk and return on financial assets
Individuals are exposed to varying degrees of risk when investing in financial
assets. It is rational to assume that investors will demand a higher return to
compensate for higher risk.
240
3.2 Ranking according to risk
Low risk
Treasury bills Issued by government, so
safe. No doubt over
return earned.
Government bonds Safe but return uncertain
as will vary on changing
market price of bond.
Corporate bonds Risky as company may
go bust or price may go
down, but annual cash
flow known.
Shares/equity Very risky as company
may fail, share price
High risk may fall, and level of
dividends is uncertain.
3.3 The impact of the central bank on financial market

yields
As central banks set short-term interest rates, this will have an immediate impact on
money market rates such as the London Inter-Bank Offered Rate (LIBOR), and these
in turn influence the 'benchmark' base rates of the major banks.
This in turn will have a knock-on effect on the expected yields on other financial
assets.
For example, an investor in equities will require a yield that would be at least equal
to the prevailing short-term interest rates, plus a risk premium appropriate to the
equities held. If interest rates go up, following an intervention by the central bank,
the required return by equity holders will go up and share prices will tend to fall.
Central banks can therefore play an important role in affecting yields and prices of
financial assets.
241
Chapter summary
• Banks must balance profitability against liquidity and security.

• Banks actually create money by lending to customers.
• Banks' lending is restricted by their need for a fractional reserve. This may be self-
imposed or enforced by the government, or may be a combination of both.
• Banks should follow the Basel III agreement.
• Central banks set interest rates, regulate banks, act as lender of last resort, act as
bankers for the government, hold, buy and sell foreign currency, and advise on
monetary policy.
• The central bank controls interest rates by setting the discount on bills it buys and
sells and controlling the supply of money.
• Yield is the return on investment. Similar products will always give the same yield at
one time because of market forces.
• Yield is mainly affected by risk. Higher risk means higher return.
242
Activity answers

initial cash deposited x credit multiplier = increase in deposits
The credit multiplier here is 1 / 0.2 = 5
Call the extra cash C. Then:
C x 5 = 80
So C = 80 / 5 = 16
If an extra $16 million is deposited, the total money supply will rise by $80 million.
This includes the initial $16 million deposited. So there is a further increase of $64
million after the initial deposit.

Correct answer: C
Quantitative easing is designed to stimulate the process of credit creation. This will
increase the money supply.
Probable results of an increase in the money supply are:
 Inflation (due to a rise in demand)
 A fall in the value of the local currency (due to an increase in the supply of the
currency)
 A fall in the interest rate (as money is more available, the price of money falls).
243
Test your learning
1 Define the credit multiplier.
2 What three aims must a commercial bank keep in balance?
3 List the main functions of a central bank.
4 If the banking system has liquid reserves of $225bn and seeks to maintain a reserve
ratio of 13%, what will the total amount of deposits be?
A $17bn
B $1,731bn
C $2,925bn
D $292,599bn
5 The ability of the banks to create credit is constrained by all the following except:
A Leakages of cash out of the banking system
B A reduced reserve ratio
C Low demand for loans
D Prudent lending operations
6 A $100 bond which pays 4% currently has a market price of $90. What is the
current yield on the bond?
A 3.6%
B 4%
C 4.44%
D 5%
244
Financial
mathematical
techniques
Learning outcomes

 calculate future values of an investment using simple and compound interest
 calculate the present value of a future cash sum, an annuity and a perpetuity
Chapter context
In general, financial mathematics deals with problems of investing money, or capital. If a
company (or an individual investor) puts some capital into an investment, a financial return will be
expected.
The two major techniques of financial mathematics are compounding and discounting.
Discounting is the reverse of compounding.
Syllabus context
This syllabus area has a weighting of 25% and is covered by Chapters 13-16 although there is also
a degree of overlap with Sections A and B which covers some of these areas (notably Chapter 2,
which introduced the concept of discounting).
245
Chapter overview
Simple & compound

interest
Financial maths
Compounding Discounting
 Compound interest  NPV

rate  Annuities
 Inflation  IRR
 Withdrawals
 EAR
246
15: Financial mathematical techniques
1 Simple interest vs compound interest

Interest is the amount of money which is earned on an investment, or paid on a
loan over time.
When a business is choosing how to invest (or borrow) money it will need to
understand the likely returns (or costs) of alternative investments (or loans). One way
of assessing this is to include the impact of the interest that is expected to be earned
(or paid) on the investment (or loan).
A possible complication in comparing different investments (or loans) is that interest
rates can be quoted as:
 Simple interest, or
 Compound interest
1.1 Simple interest
Simple interest is earned in equal amounts every year (or month) as a percentage
of the original amount invested.
The formula for simple interest is as follows.
S = X + nrX
Where X = the original sum invested
r = the interest rate (note that 10%, for example, = 0.1)
n = the number of periods (normally years)
S = the sum that is generated by the investment after n periods
Illustration 1: simple interest

How much will a business have after three years on an investment of $1 million
which earns 10% simple interest per annum?
Solution
Using the formula S = X + nrX
X = $1,000,000 n = 3 r = 10%
 S = $1,000,000 + (3  0.1  $1,000,000) = $1,300,000
247
$500,000 is invested in a bank account earning simple interest of 0.5% per month.
Required
Calculate the final value in the account after four years.
1.2 Compound interest

Compound interest is significantly different to simple interest. With compound
interest, as interest is earned, it is added to the original investment and starts to earn
interest itself.
One effect of compound interest is that, if no withdrawals are made, the amount
invested will grow by an increasing amount each year, because the interest
earned in earlier periods earns interest itself in later periods.
Illustration 2: compound interest

How much will a business have after three years on an initial investment of
$1,000,000 which earns 10% compound interest per annum?
After one year, the original principal plus interest will amount to $1,100,000.
$000
Original investment 1,000
Interest in the first year (10%) 100
Total investment at the end of one year 1,100
After two years the total investment will be $1,210,000.

$000
Investment at end of one year 1,100
Interest in the second year (10%) 110
Total investment at the end of two years 1,210
The second year interest of $110,000 represents 10% of the original investment,
and 10% of the interest earned in the first year.
Similarly, after three years, the total investment will be $1,331,000.
248
$000
Investment at the end of two years 1,210
Interest in the third year (10%) 121
Total investment at the end of three years 1,331
Note that the returns are significantly higher than the returns using a 10%
simple interest rate (as shown in the illustration in Section 1.1, the total
investment after three years would have been $1,300,000 if simple interest had
been used).
1.2.1 Formula
Instead of performing these calculations, we could have used a formula.
The basic formula for compound interest is S = X(1 + r)n

X = the original sum invested
r = the interest rate (note that 5%, for example, = 0.05)
n = the number of periods
S = the sum that is generated by the investment after n periods
You will need to be familiar with the power button on your calculator (x, x^, xy or
x
y ) to use this formula.
Applying the formula for compound interest S = X(1 + r)n to our illustration:
X = $1,000,000 r = 10% = 0.1 n = 3
S = $1,000,000  1.103
= $1,000,000  1.331
= $1,331,000.
This is the same answer as was calculated earlier using a longer method, but is
quicker to use in the exam. However, the longer method is still useful because it can
adjust for changes to the interest rate; the formula approach assumes the interest
rate is constant.
249
$500,000 can either be borrowed from a building society at compound interest
of 5.6% p.a. or from a bank account at a simple interest rate of 6% per year (as
in Activity 1). All of the loan (capital plus interest) is repayable in 4 years' time.
Required
How much more or less does the building society loan cost in total, compared to the
bank loan?
(Give your answer to the nearest whole $.)
Solution
2 Compounding – further issues

Compound interest is the normal way that interest is earned on an investment (or
paid on a loan). In a question you can assume that the interest rate stated is a
compound interest rate unless stated otherwise.
There are a number of practical business issues that involve the concept of
compounding, these are reviewed below.
250
2.1 Calculating the compound interest rate

The formula for compound interest can also be used to calculate the compound
interest rate if you are given S, X and n.
Illustration: calculating the compound interest rate

A business wants to borrow $1,000,000 and has been told that a loan is available
which will require a single repayment of $1,331,000 in 3 years' time. What is the
(compound) rate of interest on this loan?
Using the formula for compound interest, S = X(1 + r)n

S = $1,331,000 X = $1,000,000 n = 3
We need to find r. This requires us to rearrange this equation.
$1,000,000  (1 + r)
3
$1,331,000 =
3 $1,331,000
So (1 + r) = = 1.331
$1,000,000
3
So 1+r = 1.331 = 1.1
r = 0.1 = 10%
So the annual compound rate of interest implied by this loan arrangement is 10%.

Required
At what annual rate of compound interest will $2,000 grow to $2,721 after
4 years?
A 7%
B 8%
C 9%
D 10%
2.2 Inflation
The same compounding formula can be used to predict future prices after
allowing for inflation.
251
For example, if we wish to predict the salary of an employee in five years' time,
given that he earns $18,000 now and wage inflation is expected to be 10% per
annum, the compound interest formula would be applied as follows.
n
S = X(1 + r)
$18,000  1.10
5
=
= $28,989
say, $29,000.
2.3 Withdrawals
When a business is trying to assess the amount it will have from an investment that it
is withdrawing in stages, the basic rule is to break the calculation down into
segments for each addition/withdrawal.
Illustration 3: withdrawals
If a company invests $30,000 into a bank deposit account which pays interest at
8% per annum, and makes no withdrawals except at the end of year 2, when
$10,000 is withdrawn, what would be the balance in the account after three years?
$
Original investment 30,000
Interest in year 1 (8%) 2,400
Investment at end of year 1 32,400
Less withdrawal 10,000
Net investment at start of year 3 24,992
Alternatively:
$
2
Investing for 2 years at 8% would mean $30,000  1.08 = 34,992
Less withdrawal 10,000
24,992
$24,992 invested for a further year at 8% would increase in value to

$24,992  1.08 = $26,991
252

Company A invests $500,000 now with compound interest at 10% but at the end
of year 3 withdraws $300,000. The remainder of the investment is invested for
another two years at 10%.
Required
What is the value of the remaining investment at the end of year 5?
Solution
2.4 Equivalent annual rates

If compound interest is being charged every week or every month, this can be
converted into an annual equivalent, sometimes called an effective annual rate,
using the following formula. (This formula is NOT given in the exam.)
(1+R) = (1+r)n
R = effective annual rate r = period rate n = number of periods in a year.
The equivalent annual rate (EAR) is also called the annual percentage
rate (APR) by banks, building societies and credit companies.
Illustration 4: effective annual rates

A building society offers investors 5% interest payable half-yearly. (NB this is
sometimes called a nominal annual rate of 10%).
There are two 6-month periods in a year, so the effective, or equivalent, annual
rate of interest would be: [(1.05)2 – 1] = 0.1025 = 10.25% per annum.
253
Required
A bank charges compound interest on loans it has issued. The quarterly rate of
interest is 3.9%. What is the annual percentage rate (to one decimal place)?
Solution
3 Discounting
Many investment projects involve investing money now and receiving returns on the
investment in the future.
We have already mentioned in Chapter 2 that money received in the future
has a lower value than money received today. So the timing of the cash
received from investments needs to be carefully analysed to see if the value of the
cash inflows is sufficiently high to justify an investment.
This means that we need to discount future cash flows to express them in
today's terms, ie as present values.
We have already introduced discounting in the context of valuing a share in
Chapter 2.
3.1 Net present value

If the discounted value of the future cash inflows is higher than the cost of setting up
a project today, then the project is said to have a positive net present value
(NPV) and should be accepted.
Illustration 5: net present value

A company is considering an investment project that will involve spending
$1,000,000 today and is expected to provide cash inflows of $600,000 per year
for the next two years. Investors expect a return of 8% per year. (The return
expected by investors is often called the cost of capital).
Analysis of cash inflow in year 1
The cash inflow in one year's time of $600,000 can be converted into a present
1
value by multiplying it by where r = 0.08 and n = 1.
(1  r)n
1
The present value of this cash inflow is $600,000 x or
(1 0.08)1
$600,000  0.926 and this gives a present value of $555,600.
254
An investor will be indifferent between $600,000 in one year's time or $555,600

today because they could invest $555,600 today and they would then have
$600,000 in one year (555,600 x 1.08 = approximately 600,000).
The 0.926 is called a discount factor and is available to you in the exam in a table
of discount factors (available at the back of this workbook). At time of going to
print, CIMA have not confirmed the exact maths tables, etc, that will
be available to students in the CBA. Please visit the CIMA website for
formal guidance on this in due course, and before sitting your exam.
Analysis of cash inflow in year 2
The cash inflow in two years' time of $600,000 can be converted into a present
1
value by multiplying it by where r = 0.08 and n = 2.
(1  r)n
1
The present value of this cash inflow is $600,000 x or
(1 0.08)2
$600,000  0.857
This gives a present value of approximately $514,200.
The overall NPV can now be analysed:
Present value of year 1 cash inflow $555,600
Present value of year 2 cash inflow $514,200
Less
Investment in project ($1,000,000)
Net present value (NPV) $69,800
A positive NPV of $69,800 means that investors will get a return that is higher than
their required return (here 8%) and will be wealthier as a result of the project being
undertaken.
The project is therefore attractive from a financial perspective.
3.2 Discount factor formula

1
where r is the interest rate, and n is the number of time periods
1  r 
n
This is the general formula for a discount factor. However, discount factors are given
in the discount tables that you are provided with in the exam (see the tables at the
back of this workbook for example). So you will generally not need to use this
formula. At time of going to print, CIMA have not confirmed the exact
maths tables, etc, that will be available to students in the CBA. Please
visit the CIMA website for formal guidance on this in due course, and
before sitting your exam.
However, if you are asked to calculate a discount factor for an interest rate or a
year that is not covered in the tables then you will need to be able to use this
formula.
255
A project will cost $200,000 today and will generate cash inflows of $120,000 in
one year, $75,000 in two years and $60,000 in three years. Investors expect a
return of 8%. All cash inflows are received at the end of the year in question.
Required
Calculate the net present value (NPV) of the project.
Solution
Time 0 (today) 1 2 3
Cash flows
Discount factor (8%)
Present value
Net present value
3.3 Net present value and annuities

If cash inflows are equal each year then they are described as an annuity (a
series of equal cash flows).
Where this is the case, instead of discounting each cash inflow separately you can
discount the annuity once using an annuity factor (again provided in tables for you
in the exam, see the back of this workbook for an example of this). This is quicker
than discounting each cash flow separately.
At time of going to print, CIMA have not confirmed the exact maths tables, etc, that
will be available to students in the CBA. Please visit the CIMA website for formal
guidance on this in due course, and before sitting your exam
256
Illustration 6: annuities
A company is considering an investment project that will involve spending
$1,000,000 today and is expected to provide cash inflows of $600,000 per year
for the next 2 years. Investors expect a return of 8% per year.
Because the cash inflow is equal in both years, we can use the annuity factor for
Time periods 1-2 at 8%. This is (from the tables) 1.783.
It is calculated as the addition of the discount factors for year 1 and year 2
ie 0.926 + 0.857 = 1.783 and is therefore sometimes called a cumulative
discount factor.
Time 0 (today) 1 to 2
Cash flows (1,000,000) 600,000
Discount factor (8%) 1.783
Present value (1,000,000) 1,069,800
Net present value +69,800

A project will cost $200,000 today and will generate cash inflows of $40,000 per
year for the next 10 years. Investors expect a return of 8%.
Required
Cash flows
Present value
Net present value
3.4 Net present value and perpetuities

Finally, as noted in Chapter 2, an annuity (or constant cash flow) that is expected
for the foreseeable future is called a perpetuity. If you are asked to calculate the
present value of a perpetuity you need to use this formula for the discount factor.
257
Formula to learn
1
Discount factor to perpetuity =
Cost of capital

A project will cost $200,000 today and will generate cash inflows of $40,000 per
year in perpetuity. Investors expect a return of 8%.
Required
Time 0 (today) 1 onwards
Solution
Cash flows
Present value
Net present value
3.5 Internal rate of return

Internal rate of return (IRR) is another discounted cash flow technique. IRR
evaluates investments by calculating the % return generated by a project.
The IRR of a project is compared to the return expected by investors
(the cost of capital) to see if the project is acceptable.
Because IRR assesses a project's return as a percentage it is easier for non-
financial managers to understand.
3.5.1 Calculation of IRR
IRR is calculated by estimating the cost of capital at which NPV = 0.
If, for example, discounting a project at 10% delivers an NPV of zero we can say
that this project delivers exactly a 10% return.
258
IRR is calculated as a three-step approach:

Step 1 – calculate the NPV of the project at a low cost of capital
– an exam question will tell you which rate to use, or will give you the NPV
Step 2 – calculate the NPV of the project at a higher cost of capital
– again, a question will tell you which rate to use, or will give you the NPV
Step 3 – calculate the internal rate of return using the IRR formula
– you will need to learn the formula for the exam
Formula to learn
NPVa
IRR = a + (b – a)
NPVa – NPVb
Where a is the lower cost of capital
b is the higher cost of capital
Illustration 7: IRR
A project has a positive NPV of $15,000 when discounted at 6% and a negative
NPV of $3,000 when discounted at 12%. The cost of capital is 10%. Calculate the
internal rate of return and evaluate the project.
NPVa
IRR = a + (b – a)
NPVa – NPVb
a = 6% NPVa = +15,000
b = 12% NPVb = –3,000
15,000
IRR = 6 + (12 – 6)
15,000   3,000
Subtracting a negative number give a positive so 15,000 – –3,000 = 18,000
Using the IRR formula gives:
15,000
IRR = 6 +  6 = 11%
18,000
The IRR shows that the project gives a return of 11%.
Since this is above the cost of capital (10%) the project should be accepted.
259
DEF Co has a cost of capital of 10%.
Project B has an NPV of $8,000 when discounted at 12% and a negative NPV of
$1,000 when discounted at 16%.
Required
Calculate the IRR of project B (Give your answer to one decimal place.)
Solution
3.5.2 Problem with IRR

A problem with IRR is that it might lead to a small project being chosen over a
larger project because the smaller project has a higher IRR, despite delivering a
lower NPV (ie lower wealth for shareholders). We noted earlier IRR showing return
in % terms is an advantage because it is easier to understand for non-financial
managers. However, here we can see a drawback to the use of percentages.

DEF Co has a cost of capital of 12%.
DEF is selecting between two projects, A and B, which are mutually exclusive.
Project A has an NPV of $5,000 when discounted at 12%.
Project B has an NPV of $8,000 when discounted at 12%.
Project A has an IRR of 26.3% and Project B an IRR of 15.6%
Required
Select which of the following statements is correct?
A Both NPV and IRR indicate that Project A is the better project
B In order to maximise shareholder wealth Project A is the better project
C Neither project A nor project B should be accepted
D Project B will increase shareholder wealth more than Project A at the current
cost of capital
260
4 Loans and mortgages

A repayment mortgage is a loan which is repaid over a number of years,
which is secured against property owned by a firm. Interest is added to the loan at
the end of each year and a constant amount is paid back each year by the
borrower, in equal instalments (an annuity).
Illustration
TL Co borrows $50,000 now at an equivalent annual interest rate of 5 percent per
annum. The loan has to be repaid through three equal instalments at the end of
each of the next three years. What is the annual repayment?
Solution
Let us start by calculating the final value of the loan (at the end of year 3).
Using the formula S = X (1 + r)n
Where X = $50,000 r= 5% = 0.05
n = 3
S = the value of the loan after three years

S = $50,000 (1 + 0.05)3 = $57,881
The value of the annual repayments must equal $57,881.
The present value of $57,881 in three years' time can be calculated by
discounting using the year 3 discount factor at 5% of 0.864.
57,881 × 0.864 = 50,000 (there is a small difference because discount factors are
only shown to three decimal places in discount tables).
So we can see that the present value of the loan repayments will always equal
the amount of money that has been lent.
To calculate the repayments we can therefore use the same approach that we used
in the previous section for calculating an annuity. In the previous section we saw
that:
annuity (an equal cash flow) × annuity factor = present value
If we need to work out the annuity we can reverse this to:
present value ÷ annuity factor = annuity
Here this is 50,000 ÷ 2.723* = 18,362.
So the repayments on a $50,000 loan repayable over three years at 5% will be
$18,362 per year.
* see tables (year 3 cumulative discount factor at 5%)
261
John Johnstone borrows $50,000 now at an interest rate of 7% per annum. The
loan has to be repaid through ten equal instalments after each of the next ten years.
Required
What is the annual loan repayment?
Solution
262
Chapter summary
• Simple interest is interest which is earned in equal amounts every year (or month)
and which is a given proportion of the original investment (the principal).
• Compounding means that, as interest is earned, it is added to the original
investment and starts to earn interest itself.
• An effective annual rate of interest is the corresponding annual rate when interest is
compounded at intervals shorter than a year.
• A nominal rate of interest is an interest rate expressed as a per annum figure,
although the interest is compounded over a period of less than one year.
• The concept of present value can be thought of in two ways.
– It is the value today of an amount to be received some time in the future
– It is the amount which would have to be invested today to produce a given
amount at some future date
• IRR is the return delivered by a project, or the cost of capital that delivers a zero
NPV.
263
Activity answers

Here the interest rate was quoted per month, not per year.
This is something to look out for in exam questions.
Final value = 500,000 + (0.005 x 500,000 x 48 months) = $620,000
Alternatively 0.5% per month = 6% per year (ie 0.5 x 12 months) so
Final value = 500,000 + (0.06 x 500,000 x 4 years) = $620,000

The bank loan is a simple interest rate so using the formula S = X + nrX
X = $500,000 r = 0.06 n = 4
 S = $500,000 + (4  0.06  $500,000) = $620,000 (as Activity 1)
The building society loan is compound interest, so using the formula S = X(1 + r)n
X = $500,000 r = 0.056 n = 4
$500,000  1.056
4
S =
= $621,764
The building society loan is $1,764 more expensive than the bank loan ($621,764
- $620,000) in terms of the required repayments in four years' time.

Using the formula for compound interest, S = X(1 + r)n, we know that X = $2,000,
S = $2,721 and n = 4. We need to find r.
$2,000  (1 + r)
4
$2,721 =
4 $2,721
(1 + r) = = 1.3605
$2,000
4
1+r = 1.3605 = 1.08
r = 0.08 = 8%
The correct answer is B.
264

$
3
S3 = 500,000(1.1) = 665,500
withdrawal (300,000)
Balance at time 3 365,500
S5 = 365,500(1.1)2 = 442,255

There are four quarters in a year.
4
1 + R = (1 + 0.039)
1 + R = 1.165
R = 16.5%

Time 0 (today) 1 2 3
Cash flows (200,000) 120,000 75,000 60,000
Discount factor (8%) 0.926 0.857 0.794
Present value (200,000) 111,120 64,275 47,640

The project should be accepted

Cash flows (200,000) 40,000
Discount factor (8%) 6.710
Present value (200,000) 268,400

Time 0 (today) 1 onwards
Cash flows (200,000) 40,000
Discount factor (8%) 1 / 0.08 = 12.5
Present value (200,000) 500,000
265
NPVa
IRR = a + (b-a)
NPVa – NPVb
IRR (B) = 12 + 8,000/(8,000+1,000) x (16-12) = 15.6%
The cost of capital of 10% is a red herring because it has not been used to calculate
an NPV.

Answer D
The NPV at the current cost of capital will be the movement in shareholder wealth as
a result of the project being accepted. Project B (not A) will generate more
shareholder wealth (because it has the higher NPV).
NPV suggests that Project B is better, but the IRR suggests Project A is better.

The present value of the loan is $50,000.
The annuity factor over 10 years at 7% is 7.024.
$50,000 / 7.024 = $7,118 per annum.
266
Test your learning

1 A sum of $60,000 is invested for 10 years at 6% per annum. What is its final value
(to two decimal places) if interest is:
Simple
Compound
2 An investor has been offered two deals:

Option 1 1.1% compounded every three months
Option 2 3.2% compounded every six months
Which option offers the best APR?
3 What is the nominal rate of interest for an investment paying 2.5% interest every six
months?
4 What is the formula for discounting a constant cash flow that is received for ever?
5 Should a company accept a project if the internal rate of return was above the rate
of inflation?
267
268
Impact of interest &
exchange rate
changes on business
performance
Learning outcomes

 describe the impact of interest rate changes on market demand and the costs of finance
 calculate the impact of exchange rate changes on export and import prices and the value of the
assets and liabilities of a business
 explain the role of hedging and derivative contracts in managing the impact of changes in
interest and exchange rates
Chapter context
Changes in the state of the economy, especially exchange rates, can have a significant impact on a
company's reported financial performance. We also briefly consider how to manage these risks.
Syllabus context
This syllabus area has a weighting of 25% and is covered by Chapters 13-16 although there is
also a degree of overlap with syllabus Section A (Chapters 8, 10 and 11) which covers some of
these areas.
269
Chapter overview
Impact of interest rate and

exchange rate changes
Impact of interest Impact of interest rates Impact of exchange

rate changes on exchange rates rate changes
 Sales, cost, profits

 Assets, liabilities
Risk management
 Forwards
 Futures
 Options
270
16: Impact of interest & exchange rate changes on business performance
1 Impact of interest rates changes

1.1 Direct impact on business performance
We have seen that the net present value of a project (Chapter 15) and the value
of a company (Chapter 2) are affected by the cost of capital being used as a
discount factor. The relationship between the present value of future cash flows and
the cost of capital is shown below.
Future cash
Lower
Higher cost flows are
present
of capital more heavily
value
discounted
If interest rates rise (for example due to government policy) then investors will
expect a higher return and the cost of capital will rise. So the impact of higher
interest rates will often be to:
 Decrease the present value of cash inflows from planned investments
(remember, investment means spending on new asset creation, eg new
factories), leading to a fall in investment.
 Decrease the share price of a company: as we saw in Chapter 2,
share price is influenced by the present value of a company's forecast cash
inflows.
 In addition a company will have to pay a higher rate of interest on its
debt if interest rates rise, and so will see a rise in costs and a fall in profits.
These effects will have an adverse impact on business performance and
they are likely to lead to significant falls in a company's share price.

Required
Calculate the impact on the present value of a future cash flow of $100,000 per
year receivable into perpetuity, if the cost of capital rises from 4% to 5%.
Solution
271
1.2 Indirect impact on business performance
In Chapter 8, we saw that where the trade cycle is at its boom phase, and resources
are already fully employed, there may be an inflationary gap.
Prices
AS
P
Inflationary gap
PF
AD1
AD2
YF Real national income

Figure 16.1: title
If demand is too high the central bank may increase interest rates to shift the
aggregate demand (AD) curve to the left, from AD1 to AD2.
This fall in aggregate demand will result from the impact of a rise in interest
rates on each element of AD. In Chapter 7 we saw that AD consists of:
 Consumer spending on domestically produced goods (C)
 Investment spending (I)
 Government spending (G)
 Exports (X)
This is sometimes expressed as AD = C + I + G + X
This fall in demand will indirectly impact on business performance because the
general level of demand in the economy will fall.
Consumer spending falls Investment spending falls

- borrowing is more expensive and - borrowing is more expensive and
saving is more attractive the cost of capital rises
Impact on AD of an
interest rate rise
Export demand may fall

Government spending may fall
- due to exchange rate changes
- borrowing is more expensive
(see next section)
272
1.3 Impact of interest rate changes on exchange rates

We have seen in Chapter 11 that the exchange rate is determined by the forces of
demand and supply (ie demand for a currency in relation to supply of that
currency).
Interest rates will affect the demand for a currency, eg higher interest rates will
cause a rise in demand from overseas investors looking to put money on deposit in
the local economy, ie demand will rise.
Interest rates will also affect the supply of a currency, eg higher interest rates
cause a fall in consumer demand and therefore a fall in demand for imported goods
(as well as locally produced goods), ie supply will fall.
A rise in demand for a currency and a fall in the supply of currency will both lead to
a rise in the exchange rate. Therefore, an increase in interest rates in a
country would be expected to lead to an increase in the exchange rate for its
currency.
Higher Higher
interest exchange
rate rate
As we have seen in Chapter 11, a change in the exchange rate will have an impact
on business performance. This impact is summarised below and is developed in the
next section.
Export sales revenue will rise if: Costs of imported goods will fall if:
The exchange rate falls The exchange rate rises
A business will receive more of its domestic A business will pay less in its domestic
currency (eg £s) when it sells a unit currency (eg £s) when it buys a unit from
overseas (eg in $s). an overseas supplier (eg in $s).
This may allow prices (in $s) to be So a high exchange rate can result in
reduced, and sales to rise. lower costs and higher profits.
273
Required
Which of the following impacts is most likely to result from a fall in the value of the
euro for a European company located in the eurozone if that company only sells
within the eurozone but imports components from the USA?
A A rise in sales revenue
B A rise in total costs
C A fall in total costs
D A rise in the cost per unit
2 Impact of exchange rate changes

The impact of exchange rate movements can be beneficial or adverse for an
organisation. Here we briefly review the quantitative impact of exchange rate
changes, before moving on, in the next section, to outline methods of managing the
risk of adverse exchange rate (and interest rate) movements.
2.1 Impact on measures of economic performance (sales,

costs, profits)
We have already reviewed the general impact of exchange rate changes in
Chapter 11 and in the previous section.
If the exchange rate moves AFTER a transaction (an export or an import) has been
agreed, this risk is referred to as transaction risk. Any losses incurred by a
company due to transaction risk will be recorded in an exchange losses account
and will reduce the company's profit.
Illustration 1
In January 20X3 Company A (whose local currency is the A$) agreed a contract
with an export customer for €180,000. The exchange rate at that time (the spot
rate) was A$1: €1.5.
When the invoice was paid the exchange rate was A$1: €1.8
This means that at the time the sale was recorded in the accounts of Company A,
the expected revenue was €180,000 divided by 1.5 = A$ 120,000. However the
revenue that is received will be €180,000 divided by 1.8 = A$ 100,000.
The exchange loss (caused by the strengthening of the A$) will be A$120,000 –
A$100,000 = A$20,000.
274

In January 20X3 Company B (whose local currency is the A$) agreed a contract to
buy from an overseas supplier for €270,000. The exchange rate was A$1: €1.5 in
January 20X3.
When the invoice was paid the exchange rate was A$1: €1.8
Required
Calculate the exchange gain or loss to Company B on this transaction.
Solution
2.2 Impact on assets and liabilities denominated in a

foreign currency
Many companies will hold foreign assets (eg factory, land) and/or foreign
liabilities (eg a bank loan).
Movements in the exchange rate will affect the value in the domestic currency of
foreign assets and foreign liabilities. This is called translation risk.
Foreign asset value will rise if: Foreign liability value will fall if:
The exchange rate falls The exchange rate rises
Foreign assets will be worth more in the A business will pay less in its domestic
domestic currency. currency to repay foreign loans.
Illustration 2
It is approaching the year end, and Company A (whose local currency is the A$)
has assets in euros worth $12 million. These will be translated into A$ at the
year-end exchange rate.
If the year-end exchange rate is $1: €1.5 these assets will be worth €12m / 1.5 =
A$8m.
However, if the year-end exchange rate is $1: €1.8 then these assets will be worth
much less, €12m / 1.8 = A$6.7m.
275
2.2.1 Managing translation risk
To manage translation risk a company that has assets in a foreign currency will
often match them with foreign liabilities (eg by borrowing in a foreign currency).
3 Managing the impact of interest and exchange

rate changes
There are a number of techniques to help a business to manage the risk of interest
rate and exchange rate changes.
None of these are examinable numerically, but you need to be aware of
the main risk management (hedging) techniques.
3.1 Forward contracts

Forward contracts are typically signed between a business and bank, that:
 Fix an agreed exchange rate that will be used on a future transaction, or
 Fix an agreed interest rate that will be applied to a future loan.
By fixing the rate, forward contracts remove risk, and they are cheap (normally free)
to arrange.
3.1.1 Drawbacks of forward contracts
 The bank is unlikely to offer an attractive interest or exchange forward rate,
because it is looking to make a profit on the transaction.
 If the exchange rate or interest rate moves in a way that benefits a company, it
does not benefit from this because it has fixed the rate.
 The forward contract is for a fixed date, so a company needs to be certain
about the timing of transactions before entering into a forward contract.
3.2 Futures
Futures contracts are similar to forward contracts, ie they:
 Fix an agreed exchange rate that will be used on a future transaction, or
 Fix an agreed interest rate that will be applied to a future loan.
3.2.1 Differences between futures and forwards

 Futures agreements are made available in large standard contract sizes
(eg 125,000 euros), so a company may not be able to manage the exact risk
associated with the precise size of their specific loan or currency transaction.
This is a drawback of futures.
 Futures agreements are traded on financial exchanges that only trade in a
narrow range of the world's main currencies. This is another drawback of
futures.
276
 Futures agreements are available for a period of time, not for a specific
date. This is an advantage of futures.
 Forwards are available for a longer time period than futures contracts.
3.3 Options
An option contract gives a company the right, but not the obligation, to use
an agreed exchange or interest rate at a date in the future.
Option contracts are available for interest rates and exchange rates.
 A put option is the right to sell a currency, or pay interest on a loan,
at an agreed rate.
 A call option is the right to buy a currency, or receive interest on
savings, at an agreed rate.
An option acts as an insurance policy.
If the exchange rate or interest rate moves in a way which is unfavourable for a
company then it can use the option rate. However, if the exchange rate or interest
rate moves in favour of a company then it can abandon the option rate and instead
use the more favourable spot rate.
3.3.1 Drawback of options
The main drawback of option contracts is that they are expensive. A premium is
paid to acquire the option at the time that the contract is taken out.

A company is expecting receipt from a foreign currency sale (in €s) in three months'
time and is concerned about the potential impact exchange rate movements could
have on the money it receives.
Required
Which of the following statements is correct?
A A call option in €s would allow the company to fix the rate.
B A futures contract would allow the company to hedge the exact size of the
transaction.
C A forward contract would remove risk but may be prohibitively expensive.
D A put option in €s would remove downside risk but would also allow the
company to benefit if the value of the € was significantly higher in three
months' time.
277
Chapter summary
 Interest rate increases will directly impact on business performance by

decreasing the present value of future cash flows and by deterring investment and
increasing finance costs. These will decrease a company's profitability and share
price.
• Interest rate changes will also indirectly impact on business performance by
affecting the level of aggregate demand in the economy and by impacting on the
exchange rate.
• An increase in the interest rate (eg in the UK) will lead to an increase in the
value of the local currency (eg £s) ie increase the exchange rate (the value of
the £).
• A rise in the exchange rate will increase the price of exports and
decrease the cost of imports. A fall will have the reverse effect.
• A rise in the value of the exchange rate will decrease the value of overseas assets
and increase the value of overseas liabilities. A fall will have the reverse effect.
• Forward and futures contracts are a cheap and easy way of fixing the interest
or exchange rate on future transactions.
• Option contracts for interest or exchange rates are a form of insurance policy
that protect against adverse movements in the interest or exchange rate. Options
are expensive but allow a firm to benefit from favourable movements in the interest
rate or exchange rate.
278
Activity answers
The present value of a constant cash flow in perpetuity is calculated by multiplying
the cash flow by 1/r.
If r = 4% the present value is $100,000 x 1 / 0.04 = $2,500,000
If r = 5% the present value is $100,000 x 1 / 0.05 = $2,000,000
This is a decline of $500,000 (ie 20% fall from the original value of $2,500,000)

Correct answer: D
The company does not export outside the eurozone, so the change in exchange
rates will not have a direct impact on revenue.
Total costs depend on the cost per unit and the quantity produced. The cost per unit
will rise because more euros will have to be paid to buy a component in dollars.
However, the volume produced is likely to fall if costs rise so the overall impact on
total cost is uncertain.

The cost recorded in the accounts of Company B, in January 20X3 will be
€270,000 divided by 1.5 = A$ 180,000. However the cost that is incurred will be
€270,000 divided by 1.8 = A$ 150,000.
The exchange gain (caused by the strengthening of the A$) will be A$180,000 -
A$150,000 = A$30,000.

Correct answer: D
A Incorrect. A call option in €s is an option to buy €s which is not needed here.
The company will be receiving €s and so will need to sell these, not buy them.
Also an option does not fix the rate.
B Incorrect. A futures contract is for fixed, standard contract sizes so it is unlikely
that this would allow the company to hedge the exact size of the transaction.
C Incorrect. A forward contract would remove risk but is generally free (or very
cheap) – the bank makes its profits on the deal by means of the forward rate
that it offers.
D Correct. A put option is an option to sell €s, which is what is needed. After
taking out the contract, the optional exchange rate does not have to be used
and if the value of the € was significantly higher in three months' time then this
means that the receipts will be worth more when they are converted at the spot
rate. So the option is unlikely to be used.
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Test your learning
1 What impact will a fall in the interest rate have on share prices?
2 What impact will a rise in the interest rate have on the exchange rate?
3 What impact will a fall in the exchange rate have on an exporter?
4 What impact will a fall in the exchange rate have on an importer?
5 Give an advantage of a forward contract compared to an option.
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Data and information
Learning outcomes

 explain the difference between data and information and the characteristics of good information
 identify relevant data from graphs, charts and diagrams
 describe the principal business applications of big data and analytics
Chapter context
Business decisions require the analysis of external data, this can be assisted by the effective use and
presentation of Big Data.
Syllabus context
This chapter is part of syllabus Section C which looks at the 'informational context of
business'.
281
Chapter overview
Data
Data and information
Information Bar charts Other charts
ACCURATE  Simple, component,  Ogives

percentage component  Scatter graphs
 Histograms
Big data
Big data analytics
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17: Data and information
1 Data and information

Data
Data is a collection of unprocessed facts and statistics.
During any year, companies will collect a vast array of different types of data, such
as number of customers, sales, complaints.
When data is processed, structured or presented in such a way that it
becomes meaningful (to managers for example) then it becomes information.
Examples of meaningful data could include number of new customers, sales
versus budget, complaints by product type.
Information
Information is data that is processed, structured or presented in such a way that it
becomes meaningful.
1.1 Characteristics of good information 'ACCURATE'

Accurate
Information should be free from deliberate bias or error. If this is the case,
information will be trusted by the managers who are expected to use it. The level of
accuracy should be sufficient for the needs of the user, eg an NPV analysis need not
be presented to the nearest $.
Complete
The information must give visibility to all dimensions of performance. This will often
require non-financial information.
Cost beneficial
The benefits obtainable from the information should exceed the costs of acquiring it.
User targeted (or Understandable)

Information should be at the level of detail appropriate to the user – senior
managers normally need brief, summarised reports highlighting key issues; more
junior managers normally need more detail.
Relevant
Information must be communicated to the right person, eg budgets are reported to
managers with influence over the costs being reported on.
283
Accessible
One medium of communication may be better than others, eg job vacancies should
be announced where they will be brought to the attention of the people most likely
to be interested, eg intranet.
Timely
Information should be communicated in time for the receiver to take appropriate
action, eg if cost control information is only reported on a quarterly basis, this is
unlikely to be appropriate as cost control should be taking place more frequently.
Easy to use
Information should be communicated in the style and format that is appropriate to
the end user. It may be more meaningful to non-financial managers if a graphical
form of presentation is used (charts, diagrams etc – see next section).
2 Bar charts
2.1 Simple bar chart
A simple bar chart is a chart consisting of one or more bars, in which the length of
each bar indicates the magnitude of the corresponding data item.
Illustration 1: A simple bar chart

Charbart Co's sales revenue for 20X7-X9 are as follows:
Year 20X7 20X8 20X9
Sales $'000s 2,400 2,800 3,400
The data could be shown on a simple bar chart as follows:
Sales
4,000
3,500
3,000
2,500
2,000
1,500
1,000
500
0
20X7 20X8 20X9
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2.2 Component bar chart

A component bar chart is a bar chart that gives a breakdown of each
total into its components. The total length of each bar and each part of the bar
indicates magnitude.
Illustration 2: A component bar chart

Further detail on Charbart Co's sales in $000s are below:
Year 20X7 20X8 20X9
Product A 1,000 1,200 1,700
Product B 900 1,000 1,000
Product C 500 600 700
Total 2,400 2,800 3,400
A component bar chart shows how total sales have changed from year to year and
the components of each year's total.
In this diagram the growth in sales is illustrated, and the significance of growth in
product A sales as the reason for the total sales growth is also apparent.
2.3 Percentage component bar chart

A percentage component bar chart is a component bar chart which does
not show total magnitudes.
The total length of each bar is the same – the size of the sections within the bar
shows the relative sizes of the components (ie the size of the section indicates the
percentage of the total that each component accounts for).
285
Illustration 3: A percentage component bar chart
The information in the previous example of sales of Charbart could have been
shown in a percentage component bar chart:
Working
20X7 20X8 20X9
$'000 % $'000 % $'000 %
Product A 1,000 42 1,200 43 1,700 50
Product B 900 37 1,000 36 1,000 29
Product C 500 21 600 21 700 21
Total 2,400 100 2,800 100 3,400 100
This chart shows that sales of C have remained a constant proportion of total sales
(21%), but the proportion of A in total sales has gone up quite considerably, while
the proportion of B has fallen correspondingly.
3 Histograms & frequency distributions

3.1 Frequency distributions
Data can be converted into meaningful information by arranging it by value and
organising the data into a frequency distribution (or frequency table) which
records the number of times each value occurs (the frequency).
If there is a large set of data or if every (or nearly every) data item is different, it is
often convenient to group frequencies together into bands or classes.
286
Illustration 4: Frequency distributions

The output per week (units) produced by a group of employees was as follows:
1,087 850 1,084 792
924 1,226 1,012 1,205
1,265 1,028 1,230 1,182
1,086 1,130 989 1,155
1,134 1,166 1,129 1,160
The range of output from the lowest to the highest producer is 792 to 1,265, a
range of 473 units.
This range could be divided into bands, or classes, of 100 units; the size of this
band or class is called the class width or class interval. The number of
employees producing output within each class could then be grouped as follows.
Output (units) Number of employees (frequency)
700 – 799 1
800 – 899 1
900 – 999 2
1,000 – 1,099 5
1,100 – 1,199 7
1,200 – 1,299 4
20
When the data are arranged in this way it is immediately obvious that the output of
most employees is between 1,000 and 1,199 but there is considerable variability
above and below this. (Note, however, that once items have been 'grouped' in this
way their individual values are lost).
3.2 Histograms
A frequency distribution can be represented by a histogram.
Histogram
A histogram is similar to a bar chart, but the frequencies of observations are
represented by the area covered by the bar, not its height.
If all the class intervals are the same, as in the previous illustration, the bars of the
histogram all have the same width and the heights will be proportional to the
frequencies. In this case the histogram looks identical to a bar chart except that the
bars are joined together.
287
A histogram of the previous illustration would be drawn as:
3.3 Interpreting a histogram with unequal class intervals

If a distribution has unequal class intervals, the heights of the bars have to be
adjusted for the fact that the bars do not have the same width.
Illustration 5: A histogram with unequal class intervals

The weekly wages of employees of Salt Lake Co are as follows.
Wages per employee Number of employees
Up to and including $60 4
> $60  $80 6
> $80  $90 6
> $90  $110 8
> $110  $140 6
> $140  $170 3
Note that the symbol < means 'less than' and  means 'less than or equal to'. The
symbol > means 'greater than' and  means 'greater than or equal to'.
Here the class intervals for wages are not all the same, and range from $10
(eg 80-90) to $30 (eg 140-170). So a bar chart would be misleading because
there will naturally be more employees in the bigger class intervals than the smaller
class intervals. This issue can be addressed by drawing a histogram.
A histogram is drawn as follows.
 A standard width of bar is selected.
This will be the most frequently occurring class interval; in our example this is
an interval of $20.
 Open-ended classes are made equal to that of the adjoining
class
eg 'up to & including $60' becomes >$40  $60.
288
 The width of each bar on the chart reflects the size of the class
interval
eg the bar representing > $60  $80, a range of $20, will be twice as wide
as the bar representing wages of > $80  $90, a range of $10.
 Each frequency is then multiplied by (standard class width 
actual class width) to obtain the height of the bar in the
histogram.
This adjusts the height of the bar for the fact that frequencies will naturally be
higher in the bigger class intervals than the smaller class intervals. This
adjustment is shown in the following table.
Class interval Size of Frequency Adjustment Height of

interval bar
> $40  $60 20 4  20/20 4
> $60  $80 20 6  20/20 6
> $80  $90 10 6  20/10 12
> $90  $110 20 8  20/20 8
> $110  $140 30 6  20/30 4
> $140  $170 30 3  20/30 2
Here, the height of the bars representing the first two class intervals are not adjusted
(multiplying by 20/20 has no impact).
The height of the bar of the third class interval (80-90) would be twice as high as
the class frequency (6) would suggest, to compensate for the fact that the class
interval, $10, is only half the standard size.
The height of the bars representing the final two class intervals will be two-thirds as
high as the class frequencies (6 & 3) would suggest, to compensate for the class
interval, $30, being above the standard size.
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Histogram of weekly earnings of Salt Lake
12
10
40 60 80 90 110 140 170

The heights of the bars are now more meaningful because they have been adjusted
to remove the distortion caused by the class intervals being different.
However, the most commonly occurring values are shown by the area of the bar,
not the height.

Required
In the previous histogram, which class interval represents the most frequently
occurring weekly wages?
A 80–90
B 60–80
C 90–110
D 100
4 Ogives
4.1 Cumulative frequency distributions
A cumulative frequency distribution (or cumulative frequency table) can be used to
show the total number of times that a value above or below a certain
amount occurs.
290
Cumulative frequencies are obtained by adding the individual

frequencies together.
Illustration 6: Cumulative frequency distributions

Here is a cumulative frequency distribution for the illustration in Section 3.1 showing
output levels per week:
Output Frequency Cumulative
frequency
< 800 1 1
< 900 1 2 (1+1 =2)
<1,000 2 4 (1+1+2 = 4)
<1,100 5 9 (1+1+2+5=9)
<1,200 7 16 (1+1+2+5+7=16)
<1,300 4 20 (1+1+2+5+7+4=20)
The cumulative frequency distribution shows that, of the total of 20 employees, one
produced under 800 units, two produced under 900 units, four produced under
1,000 units and so on.
Just as a frequency distribution can be graphed as a histogram, a cumulative
frequency distribution can be graphed as an ogive.
4.2 Interpreting an ogive
Ogive
An ogive is a graph of the cumulative number of items with a value less than or
equal to, or alternatively greater than or equal to, a certain amount.
It is drawn by plotting a diagram of a cumulative frequency distribution.
291
Illustration 7: Ogives
The ogive is drawn by plotting the cumulative frequencies from the illustration on a
graph, as follows:

Required
Using the ogive in the previous illustration, estimate the percentage of employees
whose output per week was at least 1,050 units.
Solution
5 Scatter diagrams
Scatter diagrams are graphs which are used to show data, to compare the way in
which two variables relate to each other. One variable, the dependent variable,
will be caused by movements in the other variable, the independent
variable.
292
5.1 Constructing a scatter diagram

The horizontal axis (the x axis) of a scatter diagram is used to represent the
independent variable.
The vertical axis (the y axis) of a scatter diagram is used to represent the
dependent variable.
Illustration 8: Scatter diagram

The output at a factory each week for the last ten weeks, and the cost of that output,
were as follows.
Week 1 2 3 4 5 6 7 8 9 10
Output (units) 10 12 10 8 9 11 7 12 9 14
Cost ($000s) 42 44 38 34 38 43 30 47 37 50
Required
Plot the data given on a scatter diagram.
Solution
Scatter diagram
60
50
40
Cost ($000s)
30
20
10
0
0 2 4 6 8 10 12 14 16
Output
 Cost depends on the volume of output: output is therefore the

independent variable and is shown on the horizontal ('x') axis.
 You can see from the scatter graph that the data, although scattered, lies
approximately on a rising line, with higher total costs at higher output levels.
5.2 The trend line

Scatter diagrams can be used to try to identify the relationship between the two
variables; this can be drawn as a trend line.
293
Using our example of the factory output, the trend line can be estimated by putting a
ruler over the data, and estimating a 'line of best fit'. This is shown below.
5.3 The trend line equation

The equation of a straight line is given by y = a + bx
 a is the intercept on the y axis (y is the vertical axis, here y = cost) ie the y
value where x = 0 (x is the horizontal axis, here x = output)
 b is the slope of the trend line.
Here the trend line passes through the point x = 0 where y = 15,000
(approximately), so a = 15,000. Here 'a' represents the level of fixed costs (costs
that do not relate to production volume, eg rent).
The line also passes through x = 14, y = 50,000 so, as output changes by 14, costs
rise by 50,000 – 15,000 = 35,000 (approximately); the slope of the trend is
approximately 35,000/14 = 2,500
So b = 2,500. Here 'b' represents the variable costs per unit.
The trend line can be estimated as y = 15,000 + 2,500x
5.4 Using trend lines to make predictions

Once we have an estimate for the trend line, we can use it to forecast what we think
costs will be, approximately, if output were, say, 20 units in any week.
These 'expected' costs could subsequently be compared with the actual costs, so
that managers could judge whether actual costs were higher or lower than they
ought to be.
If a scatter diagram is used to record sales over time, we could draw a trend line,
and use this to forecast sales for next year.
294

Required
Using the trend line from the previous example (y = 15,000 + 2,500x), estimate the
change in total costs if output increases from 20 to 30 units per week.
Solution
In the next chapter on forecasting we will encounter statistical techniques (moving

averages and regression) that allow the trend line to be assessed more accurately.
6 Big data
Big data
Big data is a term used to describe the proliferation of data generated by digital
interactions, from email to online shopping, text messages to tweets, Facebook
updates to YouTube videos, and traffic sensors in traffic lights (showing congestion
hotspots.
A common theme in relation to big data is the diversity of source data, eg keywords
from conversations people have on Facebook or Twitter, and content they share
through media files (tagged photographs, or online video postings).
One of the key challenges facing today's business managers is how they can use
big data to improve business performance.
Online retailers are able to compile records of each 'click' and interaction
a customer makes while visiting a website, rather than simply recording
the final sale at the end of a customer transaction. Retailers who are able to utilise
information about customer clicks and interactions quickly – for example, by
recommending additional purchases – can use this speed to gain an advantage
over their competitors.
295
6.1 Big data analytics
The process of collecting, organising and analysing 'big data' to discover useful
information is referred to as big data analytics; this can result in:
 Better understanding of customer behaviour
For example, identifying what customers are saying in social media about an
organisation's products or its customer service could help the organisation
identify how well it is meeting customers' needs.
Customers' conversations could help identify potential changes which are
needed to products, or the way they are delivered, in order to meet customers'
needs more effectively – and thereby to increase sales.
 Targeted marketing messages
Big data could facilitate targeted promotions and advertising – for example,
by sending tailored recommendation to customers' mobile devices while they
are in the right area to take advantage of the offers.
 Improved logistics
Delivery companies can optimise package delivery routes taking into account
the order of delivery, the traffic situation and the availability of the recipient.
Demand for deliveries can also be anticipated by analysis of correlations
between, for example, weather conditions and the online purchases of
consumers. Such analysis reveals that bad weather leads to increases in the
volume of purchases made online. That, in turn, directly affects the volume of
packages sent.
 New products and services
More generally, big data could also enable organisations to introduce new
products or services.
Illustration 9: Big data

 Amazon makes recommendations for customers linked to the purchases made
by other customers with similar interests.
 Some airlines offer customers an 'app' to track their luggage.
6.2 Criticisms of big data

Some critics have argued that, while the data sets available through big data are
often very large, they are still not necessarily representative of the entire data
population as a whole; eg if an organisation uses 'tweets' from the social
networking site Twitter to provide insight into public opinion on a certain issue, there
is no guarantee the 'tweets' will accurately represent the view of society as a whole
(or even a representative view of the organisation's customers).
296
Chapter summary
 Data is unprocessed information.

• The characteristics of good information can be remembered as ACCURATE.
• Charts often help to convey the meaning or significance of data.
• There are three main types of bar chart: simple, component and percentage
component.
• Frequency distributions are used if values of particular variables occur more than
once.
• A frequency distribution can be represented visually by means of a histogram. The
number of observations in a class is represented by the area covered by the bar,
rather than by its height.
• An ogive shows the cumulative number of items with a value less than or equal to,
or alternatively greater than or equal to, a certain amount.
• Scatter diagrams are graphs which are used to illustrate and compare the way in
which two variables relate to each other.
297
Keywords
 Data: Data is a collection of unprocessed facts and statistics.
 Information: Information is data that is processed, structured or presented in such
a way that it becomes meaningful.
 Histogram: A histogram is similar to a bar chart, but the frequencies of
observations are represented by the area covered by the bar, not its height.
 Ogive: An ogive is a graph of the cumulative number of items with a value less
than or equal to, or alternatively greater than or equal to, a certain amount.
It is drawn by plotting a diagram of a cumulative frequency distribution.
 Big data: Big data is a term used to describe the proliferation of data generated
by digital interactions, from email to online shopping, text messages to tweets,
Facebook updates to YouTube videos, and traffic sensors in traffic lights (showing
congestion hotspots.
298
Activity answers
We need to look at the area of the bar (height x width) to answer this.
Option A 80–90 has an area of 12 (height) x 10 (width) = 120
Option B 60–80 has an area of 6 (height) x 20 (width) = 120
Option C 90–110 has an area of 8 (height) x 20 (width) = 160
Option D is the mid-point of the class interval in option C but is incorrect because
bar charts and histograms do not provide exact values if class intervals are used.
The correct answer is C.
Ogive
25
Comulative frequency
20
15
10
0
0 < 800 < 900 <1,000 <1,100 <1,200 <1,300
Weekly output
The cumulative frequency is approximately 7 which as a percentage of

20 = 7 / 20  100 = 35%

Output is the independent variable 'x' (ie output causes cost)
If output = 20 costs are estimated as 15,000 + (2,500  20) = 65,000
If output = 30 costs are estimated as 15,000 + (2,500  30) = 90,000
Costs are estimated to rise by 25,000 starting from 65,000 which is a percentage
change of 25,000 / 65,000  100 = 38.5%
299
Test your learning
1 Which of the following is not recommended when producing a table of information?
A Keeping accuracy to a maximum
B Clearly labelling all columns
C Eliminating unnecessary information
D Ordering columns and rows by order of importance and magnitude
2 When selecting a standard width of bar in a histogram you would select the size of
the class interval which occurs most frequently.
True 
False 
3 Select the appropriate word (histogram/ogive) to complete this sentence correctly. A
grouped frequency distribution can be drawn as a(n) histogram/ogive, whereas a
cumulative frequency distribution can be graphed as a(n) ogive/histogram.
4 Identify which axis on a scatter diagram represents the dependent variable and which
represents the independent variable.
x axis
y axis
 ?  independent variable
dependent variable
5 In a histogram, one class is ¾ the width of the other classes. If the score in that class
is 33, the correct height to plot on the histogram is
6 A cumulative frequency distribution of output of employees is as follows:

Weekly output Cumulative frequency
Units
Less than 150 90
Less than 200 250
Less than 300 310
Less than 400 340
Less than 600 350
How many employees produced 200 units or more?
How many employees produced between 200 and 300 units?
300
Forecasting
Learning outcomes

 demonstrate the relationship between data variables
 demonstrate trends and patterns using an appropriate technique
 prepare a trend equation using either graphical means (covered in Chapter 17) or regression
analysis
 identify the limitations of forecasting models
Chapter context
Business decisions require the analysis of data, to establish relationships and patterns that can be
useful for the purpose of forecasting.
Syllabus context
This chapter is part of syllabus Section C which looks at the 'informational context of
business'.
301
Chapter overview
Limitations of
forecasting models
Forecasting
Time series Regression Correlation

analysis
 Correlation
coefficient
Trend
 Coefficient of
Seasonal variation determination
Cyclical variation  Spearman's rank
Residual variation
Additive model
Multiplicative model
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18: Forecasting
1 Forecasting – using time series analysis

Time series
A time series is a series of figures or values recorded over time, eg monthly sales
over the last two years, or annual costs for the last ten years.
If a time series can be analysed it may be possible to develop a reliable method for
forecasting future trends (in revenue and costs, for example).
1.1 Main components of a time series

There are two key components of a time series:
 Trend
– this is the underlying long-term movement over time
 Seasonal variations
– short-term fluctuations in recorded values, due to different circumstances
which affect results, for example at different times of the year, on
different days of the week, or at different times of day etc.
The main problem we are concerned with in time series analysis is how to identify
the trend and then the seasonal variations which cause fluctuations around
that underlying trend.
These two components of a time series can be identified using statistical techniques
that are covered in this chapter.
1.1.1 Other components of a time series
There are two other components of a time series which you should be aware of, but
are unlikely to be tested with numbers:
 Cyclical variations:
commonly associated with the trade cycle, ie successive booms and
slumps in the economy. Cyclical variations are longer term than seasonal
variations.
 Residual variations:
caused by something other than trend, seasonal or cyclical variations.
1.2 Methods of finding the trend

The main methods of finding a trend are:
1 A line of best fit: this can be drawn by eye on a graph; this was
discussed in the previous chapter.
2 Linear regression analysis: this is covered in Section 2.
3 Moving averages. These are explained in this section.
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1.2.1 Use of moving averages to find the trend
A moving average is an average of the results of a fixed number of
periods.
It is common for a moving average to be measured over an even number of time
periods eg a four-quarter moving average of sales revenue is an average of four
quarters (of a year) of sales revenue.
By analysing the four-quarter moving average of sales, seasonal variations will be
smoothed out and it will be possible to identify the trend, ie the long-term
movement over time.
For example, the four-quarter moving average of the following sales figures in
$000s is shown below.
Spring (Q1) 200

Summer (Q2) 120
average 190
Autumn (Q3) 160
Winter (Q4) 280
The average is calculated as total sales divided by 4, ie 760 / 4 = 190.
This average relates to the mid-point of the period ie between summer
and autumn.
However, the moving average needs to relate to a particular quarter, otherwise
seasonal variations cannot be calculated.
The following example illustrates how to deal with this difficulty.
Illustration 1: Moving averages

Calculate a four-quarter moving average trend line of the following results.
Sales in $'000
Spring Summer Autumn Winter
20X7 200 120 160 280
20X8 220 140 140 300
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18: Forecasting
Solution
Sales 4-quarter
average
20X7 Spring 200
Summer 120
190 (200 + 120 + 160 + 280) / 4
Autumn 160
195 (120 + 160 + 280 + 220) / 4
Winter 280
200 (160 + 280 + 220 + 140) / 4
20X8 Spring 220
195 (280 + 220 + 140 + 140) / 4
Summer 140
200 (220 + 140 + 140 + 300) / 4
Autumn 140 Can't calculate without further data
Winter 300
To align these moving averages to a specific quarter, we need to average the

moving averages to create a 'centred moving average':
Sales 4-quarter Centred
average average
20X7 Spring 200
Summer 120
190
Autumn 160 192.5 ie (190 + 195) / 2
195
Winter 280 197.5 ie (195 + 200) / 2
200
20X8 Spring 220 197.5 (200 + 195) / 2
195
Summer 140 197.5 (195 + 200) / 2
200
Autumn 140
The centred moving average now relates to a specific quarter (eg 192.5 relates to
Autumn 20X7) – this is the trend, ie the long-term movement over time.
305
Required
Calculate a four-quarter moving average trend centred on actual quarters from the
following.
Sales in $'000
20X8 220 140 140 300
20X9 200 120 180 320
Solution
1.2.2 Use of additive model to find the seasonal variation

One method of calculating season variation that you may be asked to use is the
additive model.
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18: Forecasting
Additive model
The additive model assumes that:
time series = trend + seasonal variation
To calculate the seasonal variation using the additive model we need to:
Step 1
Identify the trend
using centred moving averages as before
Step 2
Deduct the trend from the time series data to obtain the seasonal
variation
the logic here is that if time series = trend + seasonal variation then re-
arranging this gives seasonal variation = time series – trend
Step 3
Calculate average seasonal variation for each quarter.
Illustration 2
Calculate the average seasonal variations from the following data.
Sales in $'000
Actual data Spring Summer Autumn Winter
20X7 200 120 160 280
20X8 220 140 140 300
20X9 200 120 180 320
Trend data
20X7 192.5 197.5
20X8 197.5 197.5 197.5 197.5
20X9 195 202.5
307
Solution
Time Seasonal
Series Trend variation
(Y) (T) (Y–T)
20X7 Spring 200
Summer 120
Autumn 160 192.5 –32.5
Winter 280 197.5 +82.5
20X8 Spring 220 197.5 +22.5

Summer 140 197.5 –57.5
Autumn 140 197.5 –57.5
Winter 300 197.5 +102.5
20X9 Spring 200 195.0 +5.0

Summer 120 202.5 –82.5
We can now average the seasonal variations.

Spring Summer Autumn Winter Total
20X7 –32.5 +82.5
20X8 +22.5 –57.5 –57.5 +102.5
20X9 +5.0 –82.5
+27.5 –140.0 –90.0 +185.0
Average variations +13.75 –70.00 –45.00 +92.50 –8.75

($'000) (27.5/2) (–140/2) (–90/2) (185/2)
The total of seasonal variations is –8.75; in fact it should be zero; the –8.75 is a
rounding difference. This can be dealt with spreading the rounding difference over
each quarter (8.75 / 4 = 2.19) as follows:
+13.75 –70.00 –45.00 +92.50
Adjust so sum is zero 2.19 2.19 2.19 2.19
Adjusted average +15.94 –67.81 –42.81 +94.69
variations
These might be rounded up or down to:

Spring $16,000, Summer –$68,000, Autumn –$43,000, Winter $95,000
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18: Forecasting
1.2.3 Multiplicative model and seasonal variation

The additive model assumes that seasonal variation does not increase over time.
This is unlikely – for example, companies that are growing rapidly will have
increasing sales figures in $000s and therefore higher seasonal variations in $000s
too.
This drawback of the additive model is picked up by the alternative,
multiplicative model.
Multiplicative model
The multiplicative model assumes that:
time series = trend  seasonal variation
To calculate the seasonal variation using the multiplicative model we need to:
Step 1 Identify the trend

using centred moving averages as before
Step 2 Divide the time series by the trend data to obtain the
seasonal variation
the logic here is that if time series = trend  seasonal variation then re-
arranging this gives seasonal variation = time series ÷ trend
Step 3 Calculate average seasonal variation for each quarter.
Illustration 3: Multiplicative model

The previous example above can be reworked on this alternative basis.
Sales in $'000
Actual data Spring Summer Autumn Winter
20X7 200 120 160 280
20X8 220 140 140 300
20X9 200 120 180 320
Trend data
20X7 192.5 197.5
20X8 197.5 197.5 197.5 197.5
20X9 195 202.5
309
Solution
Time Seasonal
series Trend variation
(Y) (T) (Y – T)
20X7 Spring 200
Summer 120
Autumn 160 192.5 0.83
Winter 280 197.5 1.42
20X8 Spring 220 197.5 1.11
Summer 140 197.5 0.71
Autumn 140 197.5 0.71
Winter 300 197.5 1.52
20X9 Spring 200 195.0 1.03
Summer 120 202.5 0.59
We can now average the seasonal variations.

Spring Summer Autumn Winter Total
20X7 0.83 1.42
20X8 1.11 0.71 0.71 1.52
20X9 1.03 0.59
2.14 1.30 1.54 2.94
Average variations 1.07 0.65 0.77 1.47 3.96

(total divided by 2)
Instead of summing to zero, as with the absolute approach, these should sum (in
this case) to 4 (an average of 1 per period).
They actually sum to 3.96 so 0.04 / 4 has to be deducted from each quarter. This
is too small to make a significant difference to the figures above.
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18: Forecasting

Required
Using the following trend information, calculate the expected time series in spring
and summer of 20Y0. (Give your answers to one decimal place).
Sales in $'000
Spring Summer
Forecast trend data
20Y0 206.7 208.1
Average seasonal 1.07 N 0.65

variation
Solution
1.2.4 Multiplicative model and additive models compared

The multiplicative model is more suitable than the additive model for
forecasting when the trend is increasing or decreasing over time.
In this situation, seasonal variations are likely to be increasing or decreasing too.
The additive model simply adds absolute and unchanging seasonal variations to the
trend figures, whereas the multiplicative model, by multiplying increasing or
decreasing trend values by a constant seasonal variation factor, takes account of
changing seasonal variations.
1.2.5 Seasonally-adjusted data

Seasonally-adjusted (or de-seasonalised) data is data which has had any seasonal
variations taken out, so leaving a figure which shows the trend.
311
Unemployment numbers actually recorded in a town for the first quarter of 20X9
were 4,700.
The underlying trend at this point was 4,400 people and the seasonal factor is
0.85.
Required
Using the multiplicative model for seasonal adjustment, the seasonally-adjusted
figure (in whole numbers) for the quarter is
A 5,529
B 5,176
C 3,995
D 3,740
1.3 Using trend & seasonal variation for forecasting

Forecasts can be made by extrapolating the trend and adjusting for seasonal
variations, using the following steps:
Step 1 Identify the trend using moving averages, and calculate the average
trend growth per period
Step 2 Extrapolate the trend figures to cover the forecast period, using the
expected average trend growth.
Step 3 Adjust forecast trends by the applicable average seasonal
variation to obtain the actual forecast.
 Additive model:
add or subtract variations from the forecast trends
 Multiplicative model:
multiply forecast trends by the seasonal variation
312
18: Forecasting
Illustration 4: Forecasting
The actual sales (in $'000) of swimwear by a large department store for each
quarterly period (of three months) are as follows.
Quarter 20X5 20X6 20X7
$'000 $'000 $'000
First 20 40
Second 50 62
Third 60 80 92
Fourth 20 40
The trend sales (in $'000) have been identified as:

Quarter 20X6 20X7
$'000 $'000
First 40 57
Second 45
Third 50
Fourth 54
Average seasonal variations (using the additive model) are:

Quarter
1 2 3 4
–18.25 +2.80 +29.80 –14.25
Required
Predict sales for the last quarter of 20X7 and the first quarter of 20X8, stating any
assumptions.
Solution
Step 1
The trend line is rising by (57 – 40)/4 = average of 4.25 per quarter in the period.
Step 2 & 3
We can forecast the trend in the fourth quarter 20X7 and first quarter 20X8 starting
from the trend in the first quarter of 20X7. And then we add or subtract the seasonal
variation (as the additive model is being used).
313
Seasonal
Trend variation Forecast
1st quarter 20X7 57
4th quarter 20X7 (+ (3 quarters × 4.25)) 69.75 –14.25 55.50

1st quarter 20X8 (+ (4 quarters × 4.25)) 74 –18.25 55.75

Sales of product Z each quarter for the last three years have been as follows (in
thousands of units). Trend values, found by a moving averages method, are shown
in brackets.
Year 1st quarter 2nd quarter 3rd quarter 4th quarter
1 18 30 20 (18.75) 6 (19.38)
2 20 (20.00) 33 (20.50) 22 (21.00) 8 (21.50)
3 22 (22.13) 35 (22.75) 25 10
Average seasonal variations for quarters 1 to 4 are –0.1, +12.4, +1.1 and –13.4
respectively.
Required
Use the trend values and estimates of seasonal variations to forecast sales in the first
quarter of year 4.
Solution
314
18: Forecasting
2 Forecasting – using regression analysis

Regression analysis (the least squares method) is an alternative to estimating a
line of best fit (covered in the previous chapter). Once an equation for a line of best
fit has been determined, forecasts can be made.
y
Dependent variable: eg total costs
X = a + bx
X
X
X X
Gradient: eg variable cost/unit

X
X
Intercept: eg fixed costs
Independent variable: no. of

units
Figure 18.1: Line of best fit

2.2 Linear regression finds the line of best fit using mathematical formulae to
identify the line that is closest to the data points on the diagram. This is also
known as the 'method of least squares'.
2.4 The method can be used to find the relationship between any pairs of data,
not just output and cost.
The least squares method of linear regression analysis involves using the
following formulae for a and b in Y = a + bX.
b (the gradient) = n XY – X Y
n X 2 – ( X)2
a (the vertical intercept) = Y – b X

n is the number of pairs of data
X is the mean (average) value of X
Y is the mean (average) value of Y
315
Some helpful hints
 The value of b must be calculated first as it is needed to calculate a.
X
 X is the mean of the X values =
n
Y
 Y is the mean of the Y values =
n
 Remember that X is the independent variable and Y is the
dependent variable
Illustration 5: Linear regression analysis

We have the following pairs of data about output and costs.
Month Output Costs
'000 units $'000
1 20 82
2 16 70
3 24 90
4 22 85
5 18 73
Required
Determine the expected level of costs, for any given volume of output, using the least
squares method.
Solution
 Remember that X is the independent variable (here output) and Y is the
dependent variable (here cost)
Workings
X Y XY X2
20 82 1,640 400
16 70 1,120 256
24 90 2,160 576
22 85 1,870 484
18 73 1,314 324
X = 100 Y = 400 XY = 8,104 X2 = 2,040
n = 5 (There are five pairs of data for x and y values)
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18: Forecasting
n  XY   X  Y (5 8,104)  (100  400)

b = =
n  X   X 
2
2
(5 2,040) 100 2
40,520  40,000 520
= = = 2.6
10,200  10,000 200
400  100 
a = Y – bX = – 2.6    = 28
5  5 
Y = 28 + 2.6X
Where Y = total cost, in thousands of pounds
X = output, in thousands of units
Note that the fixed costs are $28,000 (when X = 0 costs are $28,000) and the
variable cost per unit is $2.60.

A firm has estimated the relationship between total costs and output as
Y = 28,000 + 2.6X
Required
Calculate the expected cost if output is 22,000 units.
Solution
3 Correlation
Correlation
The strength of the relationship between the two variables, x and y, is called
correlation.
317
There are different types and degrees of correlation as shown below:
1. Perfect correlation
All the pairs of values lie on a straight line. An exact linear relationship exists
between the two variables.
2. Partial correlation
In (c), although there is no exact relationship, low values of X tend to be associated

with low values of Y, and high values of X with high values of Y.
In (d) again there is no exact relationship, but low values of X tend to be associated
with high values of Y and vice versa.
3. No correlation
The values of these two variables are not correlated with each other.
3.1 Positive and negative correlation

Correlation, whether perfect or partial, can be positive or negative.
 Positive correlation
High values of one variable (eg output) are associated with high values of
the other (eg cost) and vice versa as in figures (a) or (c) above.
 Negative correlation
High values of one variable (eg price) are associated with low values of the
other (eg demand) and vice versa as in figures (b) or (d) above.
3.2 The correlation coefficient

The degree of correlation between two variables is measured by Pearson's
correlation coefficient, r.
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18: Forecasting
It is calculated using a formula which will be given to you in the assessment. It looks
complicated but, with a systematic approach and plenty of practice, you will be
able to answer correlation questions in the assessment.
Correlation coefficient, r = nXY – XY

[nX2 –  X  ][nY 2 –  Y  ]
2 2
Where X and Y represent pairs of data for two variables, X and Y

n = the number of pairs of data used in the analysis
The correlation coefficient, r must always fall between –1 and +1.

 r= +1 means that the variables are perfectly positively correlated
 r= –1 means that the variables are perfectly negatively correlated
 r= 0 means that the variables are uncorrelated
Illustration 6: The correlation coefficient

The cost of output at a factory is thought to depend on the number of units
produced. This means that output is X (the independent variable) and cost is Y (the
dependent variable). Data has been collected for the number of units produced
each month in the last six months, and the associated costs, as follows.
Workings for correlation coefficient
2 2
Output Cost XY X Y
(000s units) ($000s)
2 9 18 4 81
3 11 33 9 121
1 7 7 1 49
4 13 52 16 169
3 11 33 9 121
5 15 75 25 225
Total = 18 66 218 64 766
Required
Assess whether there is there any correlation between output and cost.
Solution
X = independent variable, here this is output
Y = dependent variable, here cost
n  XY   X  Y
r=
[n  X   X  ][ n  Y 2   Y  ]
2 2 2
319
Workings
(X)2 = 182 = 324 (Y)2 = 662 = 4,356 n=6
X=18 Y = 66 XY = 218 X2 = 64 Y2 = 766
(6  218)  18  66

r =
[(6  64)  324] [(6  766)  4,356]
1,3081,188
=
384  324  4,596  4,356
120 120 120
= = = =1
60  240 14,400 120
There is perfect positive correlation between the volume of output at the factory and
costs which means that there is a perfect linear relationship between output and
costs.

A company wants to know if the money it spends on advertising is effective in
creating sales.
The following data have been collected over the last five months.
Advertising
expenditure Sales
(A) (S) A2 S2 AxS
1.2 132.5 1.44 17,556 159

0.9 98.5 0.81 9,702 89
1.6 154.3 2.56 23,809 247
2.1 201.4 4.41 40,562 423
1.6 161.0 2.56 25,921 257
7.4 747.7 11.78 117,550 1,175
Required
Calculate Pearson's correlation coefficient for the data and explain the result.
Solution
320
18: Forecasting
3.3 The coefficient of determination, r2

Unless the correlation coefficient, r, is exactly or very nearly +1, –1 or 0, its
meaning or significance is a little unclear.
For example, if the correlation coefficient for two variables is +0.8, this would tell us
that the variables are positively correlated, but the correlation is not perfect. It would
not really tell us much else. A more meaningful analysis is available from the
square of the correlation coefficient, r, which is called the coefficient of
determination, r2
Coefficient of determination
The coefficient of determination r2 measures the proportion of the total variation in

the value of one variable that can be explained by variations in the value of the
other variable.
3.3.1 Interpreting r2
Suppose that a company has found that the correlation coefficient between
advertising spending and sales, r = 0.993, therefore r2 = 0.986.
This means that over 98% of variations in its sales are associated with changes in
advertising, leaving 0.014 (less than 2%) of variations to be explained by other
factors.
We do not necessarily conclude that 98.6% of variations in y (sales) are caused by
the variations in x (advertising). We must beware of reading too much significance
into our statistical analysis. For example it may be the case that the advertising
budget is linked to sales levels, so that in fact the level of advertising spending
reflects the level of sales, rather than causes it.
3.4 Spearman's rank correlation coefficient

In the examples considered above, the data were given in terms of the values of the
relevant variables, such as the value of sales. Sometimes, however, they are given
in terms of order or rank rather than actual values. In this case, Spearman's
rank correlation coefficient is used to evaluate correlation.
321
Spearman's rank correlation
 6  d2 
R=1–  2 
 n(n  1) 
n = number of pairs of data
d = the difference between the rankings
The coefficient of rank correlation can be interpreted in exactly the same way as
the ordinary correlation coefficient. Its value can range from –1 to +1.

The following data relates to seven members of staff:
Staff member Ranking by pay Ranking by performance
A 2 1
B 1 3
C 4 7
D 6 5
E 5 6
F 3 2
G 7 4
Difference in
rankings Difference 2
A 1 1
B 2 4
C 3 9
D 1 1
E 1 1
F 1 1
G 3 9
Total 12 26
Required
Judge whether the performance of staff correlates with their performance.
Solution
322
18: Forecasting
4 The limitations of forecasting models

Remember that all forecasts are subject to error. There are a number of factors
which will affect the reliability of forecasts.
 The further into the future the forecast is for, the more unreliable it is likely to
be.
 The less data available on which to base the forecast, the less reliable the
forecast.
 Forecasting often assumes that what has happened in the past will provide a
reliable guide to the future. However, this is not necessarily the case.
 Forecasting usually involves extrapolation of a trend outside the given range of
observations within which the trend was established – this is inaccurate if, for
example, economies of scale are created when output rises.
4.1 The reliability of time series analysis forecasts

 There is always the danger of random variations upsetting the pattern of trend
and seasonal variation.
4.2 The reliability of regression analysis forecasts

 Regression analysis assumes that a linear relationship exists
between the two variables (since linear regression analysis produces an
equation in the linear format) whereas a non-linear relationship might exist.
 It also assumes that the value of one variable, Y, can be predicted or estimated
from the value of one other variable, X. In reality the value of Y might depend
on several other variables, not just X.
323
Chapter summary
• A time series is a series of figures or values recorded over time. Any pattern found
in the data is then assumed to continue into the future and an extrapolative forecast
is produced.
• There are four components of a time series: trend, seasonal variations, cyclical
variations and random variations.
• The trend is the underlying long-term movement over time in the values of the data
recorded.
• Seasonal variations are short-term fluctuations in recorded values, due to different
circumstances which affect results at different times of the year, on different days of
the week or at different times of the day etc.
• One method of finding the trend is by the use of moving averages.
• When finding the moving average of an even number of results, a second moving
average has to be calculated so that trend values can relate to specific actual
figures.
• Seasonal variations can be estimated using the additive model (Time series = trend
+ seasonal variation) or the multiplicative model (Time series = trend  seasonal
variation).
• Forecasts can be made by extrapolating the trend and adjusting for seasonal
variations.
• When the value of one variable is related to the value of another, they are said to
be correlated.
• Two variables might be perfectly correlated, partly correlated or uncorrelated.
Correlation can be positive or negative.
• The degree of correlation between two variables is measured by Pearson's
correlation coefficient, r. The nearer r is to +1 or –1, the stronger the relationship.
• The coefficient of determination, r2, measures the proportion of the total variation in
the value of one variable that can be explained by variations in the value of the
other variable.
• Spearman's rank correlation coefficient is used when data is given in terms of order
or rank, rather than actual values.
• Regression analysis (the least squares method) is one technique for estimating a line
of best fit. Once an equation for a line of best fit has been determined, forecasts
can be made.
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18: Forecasting
Keywords
 Time series: A time series is a series of figures or values recorded over time, eg
monthly sales over the last two years, or annual costs for the last ten years.
 Additive model
The additive model assumes that:
time series = trend + seasonal variation
 Multiplicative model
The multiplicative model assumes that:
time series = trend × seasonal variation
 Correlation: The strength of the relationship between the two variables, x and y, is
called correlation.
 Coefficient of determination: The coefficient of determination r measures the
2
proportion of the total variation in the value of one variable that can be
explained by variations in the value of the other variable.
325
Activity answers

Sales 4-quarter Centred
average average
20X8 Spring 220
Summer 140
200
Autumn 140 197.5 ie (200 + 195) / 2
195
Winter 300 192.5 ie (195 + 190) / 2
190
20X9 Spring 200 195.0 (200 + 190) / 2
200
Summer 120 202.5 (200 + 205) / 2
205
Autumn 180
Winter 320
Spring Summer
Forecast trend data
20Y0 206.7 208.1
Average seasonal 1.07 N 0.65
variation
Forecast time series 221.2 135.3
(trend  seasonal variation)

The correct answer is A.
Actual results 4,700
Seasonally adjusted data = = = 5,529
Seasonal factor 0.85

The trend line indicates an increase of about 0.57 per quarter. This can be
confirmed by calculating the average quarterly increase in trend line values
between the third quarter of year 1 (18.75) and the second quarter of year 3
(22.75).
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18: Forecasting
The average rise is

22.75 –18.75 4
= = 0.57
7 7
Taking 0.57 as the quarterly increase in the trend, the forecast of sales for year 4,
before seasonal adjustments (the trend line forecast) would be as follows.
Year Quarter Trend line
3 *2nd (actual trend) 22.75 22.75
3rd (+0.57) 23.32
4th (+0.57) 23.89
4 1st 24.46
* last known trend line value
(Note that you could actually plot the trend line figures on a graph, extrapolate the
trend line into the future and read off forecasts from the graph using the
extrapolated trend line.)
Seasonal variations should now be incorporated to obtain the final forecast.
Average
Trend line seasonal Forecast of
Quarter forecast variation actual sales
'000 units '000 units '000 units
Year 4 1st 24.46 –0.1 24.36

If the output is 22,000 units, we would expect costs to be
28,000 + (2.6  22,000) = $85,200.

X = independent variable, here this is advertising (A)
Y = dependent variable, here sales (S)
(X)2 = 7.42 = 54.8 (Y)2 = 747.72 = 559,055 n = 5
X= 7.4 Y = 747.7 XY = 1,175 X = 11.78
2
Y 117,550
2
(5 1,175)  (7.4  747.7)

r =
[(5 11.78)  54.8]  [5 117,550)  559,055]
5,875 5,533
=
4.1 28,695
342
=
117,650
342
= = 0.997
343
327
0.997 is very close to 1, therefore there is a strong positive correlation between
sales and advertising expenditure.

Correlation must be measured by Spearman's coefficient because we are given
the data as rankings.
6  d2
R=1–
n(n2 1)
where d is the difference between the rank in pay and performance for each
member of staff.
6  26 156
R=1– =1– = 0.536
7 (49 1) 336
The correlation is positive, 0.536, but the correlation is not strong.
328
18: Forecasting
Test your learning

Fill in the blanks
1 correlation means that low values of one variable are

associated with low values of the other, and high values of one variable are
associated with high values of the other.
2 correlation means that low values of one variable are
associated with high values of the other, and high values of one variable with low
values of the other.
3  Perfect positive correlation, r =
 Perfect negative correlation, r =
 No correlation, r =
The correlation coefficient, r, must always fall within the range to
4 If the correlation coefficient of a set of data is 0.95, what is the coefficient of

determination?
5 If Y = a + bX, it is best to use the regression of Y upon X where X is the dependent
variable and Y is the independent variable.
True 
False 
If x = 30, y = 62, x = 238, y = 1,014, xy = 485, n = 4
2 2
6
What is the correlation coefficient? (to two decimal places)
7 When de-seasonalising data, which of the following rules apply to the additive
model?
I Add positive seasonal variations
II Subtract positive seasonal variations
III Add negative seasonal variations
IV Subtract negative seasonal variations
A I and II
B II and III
C II and IV
D I only
329
8 The trend for profit (y) is related to time (t) by the equation y = 50 + 1.5t.
What is the estimate of the profit to the nearest $ at time t = 21 if the seasonal
component at that point is 0.9 using a multiplicative model?
9 Unemployment last quarter was 738,000. The trend figure for that quarter was
700,000 and the seasonal factor using the additive model was –17,500.
What is the seasonally adjusted unemployment figure for the last quarter?
330
Test your learning – answers

Chapter 1
1 The stakeholders of an organisation are people or organisations who have a
legitimate interest in the strategy and behaviour of that organisation.
2 C By definition, mutual organisations do not have shareholders, because they
are owned collectively by their customers.
3 B High interest/low power
4 A Most corporate governance codes encourage the opposite by putting directors
on three-year maximum-term contracts and outlawing financial pay-offs if they
are sacked earlier. This is to deter directors from becoming complacent.
5 B Directors are agents of the shareholders. Response C is incorrect because a
non-executive director would not be running a division.
6 Unincorporated means that the organisation does not have its own separate legal
identity and therefore is no different in law from the people that own it.
7 C This would be a Public Private Partnership
Chapter 2
1 C Shares give wealth as income from dividends and also by the profit the
shareholder will enjoy if they rise in price.
2 C
3 Systematic risk
PBIT Profit from operations
4 ROCE = % = %
Capital employed Total assets less current liabilities
Profit after tax and preference dividends
5 EPS =
Number of equity shares in issue
6 D
7 B It will fall. The cost of equity is the discount rate for this calculation. An
increase in the discount rate used for a present value calculation will
inevitably produce a fall in the present value computed.
8 Discounting.
331
Chapter 3
1 The price of the good
The price of other goods
Household income
Taste and fashion
2 Substitutes are goods that are alternatives to each other (for example, Coca-Cola
and Pepsi).
Complements are goods which are bought and used together (for example, cars
and petrol).
3 The price obtainable for the good
The prices obtainable for other goods, particularly goods in joint supply
The costs of making the good
Disruptions such as bad weather and strikes
4 The price at which the volume of demand and the volume of supply are equal; there
is neither surplus nor shortage.
5 C Demand curves express the quantity demanded at each given market price.
Non-price determinants such as income must be held constant when looking at
the effect of price movements in isolation.
Chapter 4
1 PED is a measure of the extent to which the demand for a commodity changes
relative to a change in its price.
It will help the manufacturer to assess how revenue is likely to be affected if it
changes price.
2 If a good has low elasticity of demand, the manufacturer can increase the price
without losing much sales revenue. If demand is inelastic, people will buy almost the
same amount of the good even if its price goes up.
3 D Assuming a normal good, a decrease in price results in a greater quantity
being demanded. Given that demand is price elastic, the increase in quantity
will be proportionally greater than the price fall.
4 D Price elasticity of demand is likely to be less than 1 because this is a cheap
high quality product with few substitutes.
5 D Percentage change in quantity = 50%. Percentage change in price = 25%.
Chapter 5
1 C This is a deliberately tricky question because B looks correct. However, C is
better because fixed costs are fixed for both rises and falls in output.
2 Diseconomies of scale are problems of size and tend to arise when the firm grows
so large that it cannot be managed efficiently. Communications may become
difficult, motivation may deteriorate because of alienation and senior management
332
may find it difficult to identify the information they need in the vast volumes
available.
3 C This is a disadvantage of the division of labour.
4 D Economy of scope due to spreading fixed costs across a wider range of
products.
5 C This is an external economy of scale.
A is a diseconomy of scale.
B and D are both internal economies of scale.
Chapter 6
1 An externality is an effect caused by an economic transaction which extends
beyond the parties to that transaction.
2 Direct provision
Regulation of products and prices
Indirect taxation
Subsidies
3 D The need to limit or avoid these weaknesses is the chief argument in favour of
some government involvement in the allocation of economic resources.
4 A This is correct because the benefits to local shops are additional to the private
benefits of the sports firm and as such are external benefits.
B is an external cost of the project, since increased volumes of traffic are
harmful to the environment.
C is a private benefit for the firm.
D would only be an external benefit if a building is better for society than the
use of open land, which is unlikely.
5 C As the consumer's consumption is not altered by the price rise, the supplier can
pass the price rise on in full.
6 C The price rise will be lower for products with a higher price elasticity of
demand. In the extreme case, if demand is perfectly elastic, there will be no
increase in the price at all.
Option A would be true if the good or service had a perfectly inelastic
demand, but that is the only condition under which it would be true. Equally,
Option B would be true if demand was relatively more elastic than supply, but
it will not always be true.
333
Chapter 7
1 When a household receives an increase in income, some will be spent and some
will be saved. The proportion which is spent is the marginal propensity to consume.
Note: the proportion which is saved is the marginal propensity to save.
2 Lower interest rates, investment grants and tax incentives may encourage investment.
Governments can also stimulate demand by tax cuts or lower interest rates and
improve business confidence by business-friendly and growth-enhancing policies like
deregulation and controlling inflation. Policies to encourage technological
development may also lead to increased investment.
3 C Injections are any additional expenditures which do not arise from the circular
flow of income itself. Consumption is part of the circular flow so it is not an
injection.
4 C Equilibrium occurs when E = Y.
E = Consumer spending + injections = 750 + 0.4Y + 500.
Therefore 0.6Y = 1,250, therefore Y = 2,083.
5 The multiplier effect explains how the increase in total national income will be much
greater than an initial injection into an economy, due to the injection being recycled
through the economy.
1
6 6.67 The multiplier is
1 – MPC
1 1
=
1 – 0.85 0.15
Chapter 8
1 A government's fiscal policy is concerned with taxation, borrowing and spending,
and their effects upon the economy.
Monetary policy is concerned with the money supply, interest rates, inflation and the
exchange rate.
2 Recession, depression, recovery, boom.
3 A government can increase demand by spending more itself or by reducing taxation
so that firms and households have more after-tax income to spend.
4 Demand-pull inflation is linked to changes in demand and this in turn is linked to
different stages of the trade cycle.
5 Cyclical unemployment is linked to changes in demand and this in turn is linked to
different stages of the trade cycle.
6 Higher interest rates will help to reduce aggregate demand and to control demand-
pull inflation.
334
Chapter 9
P1
1 (a) Price index =  100
P0
Q1
(b) Quantity index =  100
Q0
2 Fixed base method Changes are measured against the base period
Chain base method Changes are measured against the previous period
3 212.63
Index number for base year
Deflated cash flow = Actual cash flow in given year 
Index number for given year
100
= $421 
198
= $212.63
4 143
130  (1 + 10%)
= 130  1.1 = 143
5 166.8
20X4 20Y8 20Z0

20X4 = 100 100 139
20Y8 = 100 100 120
Between 20Y8 and 20Z0, prices increased by 20%. The price index for 20Z0
with 20X4 as the base year should also show a 20% increase on the 20Y8
index of 139.
= 139  120% = 139  1.2
= 166.8
Chapter 10
1 A regressive tax takes a higher proportion of a poor person's income than a rich
person's. A progressive tax takes a higher proportion of a rich person's income and
a lower proportion of a poor person's. A proportional tax takes the same proportion
of all incomes.
2 Direct taxes are levied on income while indirect taxes are levied on expenditure.
Indirect taxes are regressive. Direct taxes can be progressive.
3 A A flat-rate poll tax, with no concession for the lower-paid, would take a higher
proportion of the income of lower-income earners than of higher income
earners. This is a regressive tax system.
335
4 B The disincentive effect refers specifically to the disincentive of individuals to
work.
5 B The main purpose of taxation will be to raise revenue for the government.
Other aims might be to redistribute wealth or affect demand in the economy.
Changes in rates of tax do not have a direct influence on interest rates, which
can be influenced by a government's monetary policies.
6 The crowding-out effect is the argument that public (government) expenditure merely
displaces private sector spending in an economy rather than adding to it and
boosting output.
7 By shifting the supply curve to the right, a new equilibrium between aggregate
supply and aggregate demand will be reached with levels of lower inflation and
higher output (lower unemployment).
Chapter 11
1 Deflationary policies cut demand, including demand for imports. Also, in response
to the reduction in demand, domestic producers will be encouraged to switch to
export markets.
2 B Learn this definition. The balance of trade is the surplus or deficit on trade in
goods only.
3 B Exports of manufactured goods are part of the balance of trade element of the
current account. Expenditure by tourists is part of the trade in services in the
'invisibles' part of the current account. Foreign investment by multinational
companies is part of the financial accounts.
4 C Free floating exchange rates mean that market forces restore equilibrium in the
market. A balance of payments deficit will mean that supply exceeds demand
for a country's currency, and so its exchange rate will fall. This will improve
competitiveness of the country's exports, so exports will increase and restore
equilibrium in the balance of payments. (Answers A and D are benefits of a
single cross-border currency such as the euro).
5 C A decrease in a country's inflation will make its exports cheaper, and therefore
more attractive. The increase in demand for exports will lead to an increase in
demand for the country's currency (for customers to pay for the exports) and
this will lead to its exchange rate rising.
Conversely, a decrease in the level of exports (A) will lead to a fall in demand
for a country's currency, so this will lead to its exchange rate falling.
Likewise, if interest rates fall (B) it will be less attractive to invest money in a
country's banks, so again there will be less demand for the country's money,
from foreign investors looking to invest in it.
A decrease in the level of capital inflows will also mean demand for the
currency falls, and so, again, the exchange rate will fall.
336
6 B The fall in the exchange rate will make a country's exports cheaper, therefore
the volume of exports will increase. Conversely, the currency depreciation
will make imports more expensive, so demand for imports will fall. The net
of these two will lead to an improvement in the country's balance of payments.
The rising price of imports will increase domestic inflation.
7 C A rise in domestic interest rates will attract portfolio investment and this
increases demand for its currency.
Chapter 12
1 A tariff is a tax on imports; it is a protectionist measure designed to make imported
goods relatively more expensive compared to domestically produced goods
2 A free trade area exists when there is no restriction on the movement of goods and
services between countries. In a customs union there is a free trade area
between all member countries of the union and, in addition, there are common
external tariffs applying to imports from non-member countries into any part of
the union.
3 The WTO provides a mechanism for identifying and reducing trade barriers and
resolving trade disputes. The IMF's main purpose is to support the stability of the
international monetary system by providing support to countries with balance of
payments problems, for example problems in making debt repayments to
international creditors.
4 A company with production or sales facilities in more than one country
5 Political, Economic, Social, Technological, Environmental/Ecological, Legal
Chapter 13
1 A financial intermediary is any organisation that stands between borrowers and
lenders and facilitates transactions.
2 Money markets are sources of short-term finance, for example, bills of exchange,
commercial paper and bank bills.
3 D
4 Maturity transformation describes the way financial intermediaries bridge the gap
between lenders' desires for liquidity and borrowers' desires for loans over longer
periods.
5 D Issuing government debt is the role of a central bank.
Chapter 14
1 The credit multiplier (or bank multiplier) is the name given to banks' ability to create
credit, and hence money, by maintaining their cash reserves at less than 100% of
the value of their deposits. It is calculated as 1/reserve ratio.
2 Liquidity, profitability and security.
337
3 Setting interest rates
Banker to the government
Central issuer of banknotes
Manager of the national debt
Manager of the nation's foreign currency reserves
Banker to the clearing banks
Lender to the clearing banks (lender of last resort)
Supervision of the banking system
4 B $225bn  credit multiplier = total deposits.
Therefore total deposits = $225bn  (1/0.13) = $1,731bn
5 B A falling reserve ratio will increase the credit multiplier.
4
6 C Current yield = = 4.44%
90
Chapter 15
6
1 Simple 96,000.00 60,000 + (10   60,000)
100
60,000  (1.06)
10
Compound 107,450.86
2 2
4
APR of option 1 = (1+ 0.011) –1
= 0.0447
= 4.47%
2
APR of option 2 = (1 + 0.032) – 1
= 0.065
= 6.50%
Option 2 therefore offers the best APR.
3 There are two six- month periods in a year, so 2  2.5 = 5%
4 1 / r (where 'r' = the cost of capital)
5 No, not necessarily; the relevant benchmark is the cost of capital. A company
should only accept a project if the internal rate of return is above the cost of capital.
Chapter 16
1 This should increase share prices (see Section 1.1)
2 This should increase the exchange rate (see Section 1.3)
338
3 It will allow the exporter to increase profits and/or make profits on export sales (see
Section 1.3)
4 It will cause importers to pay more for imports and will reduce profit margins (see
Section 1.3)
5 Forwards are free, a payment has to be made for an option (see Sections 3.1 and
3.3.1)
Chapter 17
1 A Maximising accuracy would make the table too detailed and hard to
understand.
2 True
3 A grouped frequency distribution can be drawn as a histogram, whereas a
cumulative frequency distribution can be graphed as an ogive.
4 x axis
y axis
  independent variable
dependent variable
5 44
33
= 44
0.75
6 100 produced 200 units or more (ie 350-250)

60 produced between 200 and 300 units (ie 310-25)
Chapter 18
1 Positive correlation
2 Negative correlation
3  r = +1
 r = –1
 r=0
The correlation coefficient, r, must always fall within the range –1 to +1.
4 Correlation coefficient = r = 0.95
2 2
Coefficient of determination = r = 0.95 = 0.9025 or 90.25%
This tells us that over 90% of the variations in the dependent variable (Y) can be
explained by variations in the independent variable, X.
5 False. When using the regression of Y upon X, X is the independent variable and Y
is the dependent variable (the value of Y will depend upon the value of X).
339
nΣxy  ΣxΣy
6 0.76 r =
[nΣx 2  ( Σx)2 ][nΣy 2  ( Σy)2 ]
(4  485)  (30  62)

=
[(4  238)  302 ]  [(4  1,014)  622 ]
1,940 – 1,860
=
52  212
80
=
104.995
= 0.76
7 B
8 73 y = 50 + (1.5  21)
= 81.5
Forecast = 81.5 × 0.9
= 73.35
9 755,500 The seasonally adjusted value is an estimate of the trend.
Trend = Actual value – Seasonal component
= 738,000 – (–17,500)
= 755,500
340
Appendix A: Present value tables
Appendix A: Present Value tables

At time of going to print, CIMA have not confirmed the exact maths tables and
formulae, that will be available to students in the CBA. Please visit the CIMA
website for formal guidance on this in due course, and before sitting your exam.
Present value table

Present value of 1.00 unit of currency, that is (1 + r)–n where r = interest rate; n =
number of periods until payment or receipt.
Periods Interest rates (r)

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180
19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149
341
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.079 0.065
16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054
17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045
18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038
19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031
20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026
342
Test your learning answers
Cumulative present value table

Cumulative present value of 1.00 unit of currency per annum, Receivable or
1  (1+ r )n
Payable at the end of each year for n years .
r
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201
19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365
20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514
343
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675
16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730
17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775
18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812
19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843
20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870
344
Bibliography
Bibliography
NAO Value for money. (2016, June 6th). Retrieved from NAO.org.uk: Available at:
https://www.nao.org.uk/successful-commissioning/general-principles/value-for-
money/assessing-value-for-money/[Accessed 11 July 2016]
Eyles. (2012). Food Pricing Strategies. PLOS Medicine, Volume 9 Issue 12.
OECD. (2013). Government spending. Retrieved from OECD: Available at:

https://data.oecd.org/gga/general-government-spending.htm[Accessed 11 July
2016]
ONS. (2016, March 16). UK welfare spending. Retrieved from ONS: Available at:
http://visual.ons.gov.uk/welfare-spending/[Accessed 11 July 2016]
345
346
Index
Index
A Compounding, 245
Conditions of demand, 48
Acceptance credit, 225
Conditions of supply, 51
Additive model, 306
Conglomerate integration, 93
Advantages of international trade, 209
Conglomerate mergers, 93
Aggregate demand, 143, 182
Constant returns to scale, 86
Aims of the banks, 235
Consumer prices index, 160
Annuity, 256
Co-operatives, 17
Automatic stabilisers, 147
Corporate governance, 22
Average method, 69
Correlation, 317, 325
Correlation coefficient, 319
B Cost-push inflation, 150
Balance of payments, 142, 193 Credit creation, 236
Balance of payments, and the capital account, Credit multiplier, 237, 239, 240
193 Basel III Agreement, 239
Balance of payments, and the current account, Credit Multiplier
194 Lender of last resort, 239
Balance of payments, and the financial Cumulative frequency curve, 292
account, 194 Cumulative frequency diagram, 292
Balance of trade, 193 Cumulative frequency distribution, 290
Balanced budget, 181 Cumulative frequency polygon, 292
Bank bills, 225 Current account, 193, 195
Bank of England, 238 Current account balance, 193
Bar charts, 284 Current weighted price index, 163
Base weighted price index, 161 Curve fitting, 293, 294
Benchmark, 241 Customs union, 210
Big data, 295, 298 Cyclical budget, 180
Bill of exchange, 224 Cyclical unemployment, 147, 153
Bonds, 226
Borrowing, 224, 226
Budget deficit, 180
D
Data, 283, 298
Business cycles, 143, 144, 181
Deflationary gap, 147, 149
Demand, 47
C Demand curve, 47
Capital markets, 226 Demand-pull inflation, 149, 153
Central bank, 238, 240 Demerit good, 104
Chain base, 159 Dependent variable, 292
Charts, 284 Determinants of price elasticity of demand.,
Circular flow of income model, 124 75
Coefficient of determination, 321 Dimensional economies of scale, 88
Commercial paper, 225 Direct tax, 178
Common market, 210 Discounting, 254
Component bar chart, 285 Diseconomies of scale, 86, 90
Compound interest, 248, 249 Division of labour, 88, 97
Calculating the compound interest rate,
251
Equivalent annual rates, 253
E
Earnings per share, 33
Inflation, 251
Economic union, 210
Withdrawals, 252
347
Economies of scale, 85 Independent variable, 292
Elastic demand, 70, 79 Index numbers, 159, 160
Elasticity of supply, 77 Indirect tax, 106, 178
EPS, 33 Inelastic demand, 72, 79
Equilibrium price, 52, 58 Inflation, 141, 252
Equity, 226 Inflationary gap, 149
Equivalent annual rates Information, 283, 298
Annual percentage rate, 253 Injections, 125
Eurobonds, 227 Interest rates, 183
Expectational inflation, 142 Internal economies of scale, 86
External economies of scale, 89 Financial economies of scale, 87
Externalities, 103, 114 Managerial economies of scale e, 89
Technical economies of scale, 87
F Trading economies of scale, 86

Investment, 127, 133
Financial intermediaries, 222
Invisibles, 193
Risk transformation, 222
Issued share capital, 226
Financial intermediaries, 222
Financial markets, 224
Financial mathematics, 245 L
Fiscal (or budget) deficit, 181 Laspeyre indices, 161, 163
Fiscal policy, 143, 181 Laspeyres index, 161
Fiscal surplus, 181 Law of demand, 47, 58
Fixed base, 159 Law of supply, 49, 58
Fixed exchange rate, 201 Least squares method of linear regression
Flexible staffing, 95 analysis, 315
Fractional reserve banking, 236 Limitations of forecasting models, 323
Free cash flows to equity, 36 Liquidity, 235
Free cash flows to the firm, 37 London Inter-Bank Offered Rate, 241
Free floating exchange rate, 201
Free rider problem, 105 M
Free trade, 209 Marginal efficiency of investment, 127
Free trade area, 210
Marginal propensity to consume, 124
Frequency distribution, 286
Market, 47
Frictional unemployment, 148, 153
Market failure, 103, 114
Fundamental imbalance, 194
Matching concept, 221
Maximum price, 112
G Mendelow's matrix, 20
GDP, 121, 133 Merit good, 103
Globalisation, 212 Mezzanine finance, 227
GNP, 121, 133 Minimum efficient scale, 91
Minimum pricing policies, 110
Minimum wage, 111
H Monetarists, 184
Histogram, 287, 298 Monetary policy, 143
Horizontal integration, 93 Money markets, 224
Horizontal mergers, 93 Money supply, 182
Mortgages, 261
I Moving average, 304
IMF, 211 Moving averages method, 304
Incentive schemes, 22 Moving averages method, 304
348
Index
Multinational enterprises, 213

Multiplicative model, 309
Q
Quantity index to be calculated using current
Multiplier, 129
year price weightings, 167
Multiplier effect, 128, 130
Quantity index using base year price
Mutual organisations, 17
weightings, 167
Quantity indices, 160
N Quantity theory of money, 184
National debt, 181
National income, 121, 133
Negative correlation, 318
R
Recession, 143, 144, 181
Net present value, 254
Redistribution of wealth, 142
Network organisations, 95
Regression analysis, 315
North American Free Trade Agreement
Regressive tax, 179
(NAFTA), 210
Return on capital employed, 31
ROCE, 31
O
Off shoring, 95
Ogive, 290, 291, 298
S
Scatter diagrams, 292
Organisation, 15
Seasonally-adjusted data, 311
Outsourcing, 94, 95
Seasonally-adjusted data, 311
Secondary market, 224
P Security, 235
Paasche index, 163 Shared service centre, 95
Paradox of thrift, 146 Simple bar chart, 284
Partial correlation, 318 Simple indices, 160
Percentage component bar chart, 285 Simple interest, 247
Perfect correlation, 318 Simple point method, 67
Positive correlation, 318 Single market, 210
Present value to perpetuity, 37 Stakeholders, 18
Price elasticity of demand, 67 Stock Exchange, 226
Price elasticity of supply, 77 Structural deficits, 180
Price indices, 160 Structural unemployment, 148, 153
Price mechanism, 55 Substitution effect, 48
Primary market, 224 Supply, 49
Principal, 21 Supply curve, 49
Principal sources of short-term capital, 224, Supply Side, 143, 144
227 Supply-side policies, 184, 188
Principal-agent problem, 21 Systematic risk, 34
Private limited company, 18
Private sector, 15
Private-finance initiative, 15
T
Tariffs, 209
Profitability, 235
Time series, 303, 325
Progressive tax, 179
Cyclical variations, 303
Proportional tax, 179
Residual variations, 303
Protectionism, 209
Seasonal variations, 303
Public goods, 105, 114
Time series analysis, 303
Public limited company, 18
Trade cycle, 143, 144, 181
Public sector, 15
Boom, 145
Public-private partnership, 15
Depression, 144
349
Recession, 144 Venture capital, 224
Recovery, 145 Vertical integration, 93
Treasury Bills, 225 Vertical mergers, 93
Trend line, 293
W
U Wage-price spiral, 142
Unemployment, 147 Withdrawals, 125
Natural rate of unemployment, 148 World Bank, 212
Unequal class intervals, 288 WTO, 211
Unsystematic risk, 34
X
V X-inefficiency, 22
Value for money, 16
350
Notes
Notes
351
352
Notes
353
354
Notes
355
356
Notes
357
358
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CIMA BA1

CIMA Certificate Course Book

Fundamentals of Business Economics

For exams in 2017

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ISBN 9781 5097 0631 0 A note about copyright

Welcome to BA1 Fundamentals of Business Economics 4

Syllabus Areas and their weighting

Weight Syllabus topic

25% A. Macroeconomic and Institutional

25% D. Financial Context of Business

The Objective Test exam

LEVEL LEARNING OBJECTIVE VERBS USED DEFINITION

LEVEL LEARNING OBJECTIVE VERBS USED DEFINITION

LEVEL LEARNING OBJECTIVE VERBS USED DEFINITION

Lead Component Level

1. Explain the principal (a) Explain determination of macroeconomic 2

(c) Explain the main principles of public 2

(d) Describe the impacts on business of 2

(e) Calculate indices for price inflation and 3

2. Explain the factors (a) Explain the concept of the balance of 2

(c) Explain the impacts of exchange rate 2

3. Explain the influences (a) Explain the concept of globalisation and 2

B. Microeconomic and Organisational Context of Business (30%)

Lead Component Level

1. Distinguish between the (a) Distinguish between the goals of profit 2

(b) Explain shareholder wealth, the 2

(c) Distinguish between the potential 2

2. Demonstrate the (a) Identify the equilibrium price in 2

(d) Calculate the effects of price elasticity 3

3. Explain the influence of (a) Identify the influence of costs on the 2

Lead Component Level

1. Apply techniques to (a) Explain the difference between data 2

2. Demonstrate the uses of (a) Describe the principal business 3

(c) Demonstrate trends and patterns using 3

(d) Prepare a trend equation using either 3

(e) Identify the limitations of forecasting 2

D. The financial context of business (25%)

Lead Component Level

1. Explain the functions of (a) Explain the role of various financial 2

(b) Explain the role of commercial banks 2

(c) Explain the role of the foreign 2

Lead Component Level

2. Apply financial (a) Calculate future values of an 3

3. Demonstrate the impact (a) Describe the impact of interest rate 2

(c) Explain the role of hedging and 2

A key definition which is important to be

A formula you will need to learn as it will not

A formula which is provided within the

An example which allows you to apply your

A worked example which can be used to

Assessment focus point A high priority point for the assessment

Having studied this chapter you will be able to:

Manager does not own

Not for profit organisations

Goals of organisations Corporate