Economics Of Business

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Economic Environment of the Business Course # 5571

Khurram Mirza COL/MBA AD513306 Teacher: Prof. Rabia Malik.

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Question # 1= (a) How is microeconomics different from macroeconomics? Discuss also the subject matter of microeconomics in detail. (b) How different is a market economy from a centrally planned economy?

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WHAT IS MICROECONOMICS? Microeconomics can be variously defined as: Study of group behavior in individual markets (Frank, Robert H., Microeconomics and Behavior, 2nd ed., 1994). Study of the role of markets in which property rights are exchanged, and contracts and coalitions are formed to enable greater production and resolution of conflicts of interest (Alchian, Armen and William Allen, W, Exchange and Production, 3rd ed., 1983).

Price theory Many textbooks equate microeconomics with “price theory,” which at its core is a theoretical answer to the question: what determines the price of a good? The answer is usually given as: “supply and demand,” so that microeconomics is the study of what determines supply and demand. But of course, supply and demand does not exist in a vacuum; in fact they intersect in something called “a market,” which is of course a place where people who sell meet people who buy. When we consider that those who sell are “firms” and those who buy are “households,” we can say that microeconomics is the study of how households and firms make decisions and how they interact in markets. The textbook definitions suggest the thematic areas of microeconomics, and some of its subdisciplines: Supply and demand (markets as its intersection) Incentives (what drives behavior – utility or profit maximization for consumers or producers) Market failures (which arise when there are no property rights and when there are transaction and information costs), Game theory is a sub-discipline in microeconomics which is often used to analyze market failures (most famous example: the so-called prisoners’ dilemma) Public choice is another sub-discipline which studies the economics of democracy. Institutional economics is yet another sub-discipline which focuses on how economic institutions work. WHAT IS MACROECONOMICS? Macroeconomics is, like microeconomics, susceptible of many (equivalent) definitions. One way to define macroeconomics is to say that it is the economics of the national economy. At one point, I told you that the economy is the “social institutions” for production and consumption, based on Stigler’s definition of economics. Here, the word “national economy” does not refer to such social institutions. Instead it refers to the economy in terms of aggregates, as measured by national or global product or income, employment, and monetary and credit aggregates. Hence, macroeconomics is the study of aggregate figures, based on a concept of the national economy in terms of three markets (goods and services, labor, and money or credit). In one textbook (Mankiw), macroeconomics is defined as “a study of economy-wide phenomena.” Thus, it deals with such topics as unemployment and inflation, the effect of government activity (taxes, expenditures, subsidies) on the economy, and the exchange rate. Khurram Mirza COL MBA – AD513306 Tutor:

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Parkin defines macroeconomics as the study of the national and global economy, focusing on inflation, employment, aggregate (national or global) income and production. Sicat does not seem to have given an explicit definition of macroeconomics, though it may be inferred that he thinks of macroeconomics as a branch of economics that seeks to explain national income and monetary aggregates, inflation, unemployment, and the business cycle. HOW DO MICROECONOMICS AND MACROECONOMICS DIFFER FROM EACH OTHER? Some textbooks give an analogy for distinguishing macroeconomics from microeconomics: the former deals with aggregate behavior (the “forest”), while the latter deals with individual behavior (the “trees”). Microeconomics attempts to answer the so-called “big” economic questions relating to the goods that are produced and, of course, consumed: what to produce, how to produce them, who will consume, and what are the prices of these goods. Macroeconomics attempts to explain why there is unemployment, why the national economy goes through a boom-and-bust cycle, and what causes the value of money to fall because of price and wage inflation. I submit that the real distinction between microeconomics and macroeconomics is with respect to an important assumption – one relating to whether prices and wages are flexible or fixed. In microeconomics, the focus is on market equilibrium, and normally, prices and wages are thought (or assumed) to be flexible and determined by the market. In macroeconomics, it is assumed that prices and wages are “fixed” outside the market (they are said to be “rigid”), and the macroeconomist looks at the interaction of labor as consuming households, on the one hand, and firms as employers and producers, on the other hand. FOUNDATIONS OF MICROECONOMICS The following are the fundamental concepts of microeconomics: 1-Scarcity and opportunity cost, which are twin concepts. Scarcity means a choice has to be made. The “opportunity cost” of a choice is what you give up by not making that choice. Recall that opportunity cost is the next best alternative. Scarce good: A good that is scarce necessarily has an opportunity cost. What is the opportunity cost of P100 of cell phone load? It is what you can buy with P100 (say, a meal at the cafeteria for 2 people; or 200 pages of copying at the copy center). What is a free good? It is a good which you can consume without giving up anything else as a result. “Free-ness” depends on the point of view. It may be free to individuals, but it is not free for society. An example is information. It is free to individuals who receive it because as you “consume” information, you don’t destroy it; you can pass it on, and it doesn’t result in a loss in your ability to derive happiness from the information. But the originator of the information – the researcher or news reporter – needs to be paid for producing the information; society as a whole will have to pay for that, otherwise it will not be produced (see property rights below). A good may be free because it is so abundant, that there is not enough demand to use it all up. Example: sunlight, moonlight, starlight, and salt water on the high seas. If you couldn’t see, would you consider sunlight a good? There is a statement, often attributed to economists: “There is no free lunch.” Why is that true some things appear to be free because it is offered to you as such. But usually, there is a price to pay, at some later time. In other words, there is an opportunity cost to the lunch, because, well good food and wine, and pretty tablecloths are not exactly free goods. Khurram Mirza COL MBA – AD513306 Tutor:

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What about the statement that “The best things in life are free”? opportunity cost of “love”?

Is it really?

What is the

2. Rational choice means thinking at the margin. Averages don’t matter. The last unit does, whether it is the last one chosen or the last one given up. Recall that being rational is not the same as being “reasonable.” 3. Incentives matter in the sense that there are costs and benefits that drive rational behavior. Incentives generally can help to explain why airline food is not as good as food on earth, or why you can seldom find large-denomination money (or big bills) on the sidewalk. 4. Property rights are part of the incentive structure of an economy based on voluntary exchange (markets). A market cannot exist without property rights. 5. Transactions and information costs make a difference in how buyers and sellers might bargain with each other. 6. Efficiency and the production possibility curve (PPC): a process or rule is efficient, or a situation is in a state of efficiency, if, we cannot make any person better off without making another worse off. Efficiency also means that resources are put to their best use, i.e., we use resources to produce the goods we value the most. It also means that if we fix the amount of production of a given good, we will arrange resources and use them to produce the most that we can of another good. The concept of the production possibility curve illustrates how we can determine efficient from inefficient outcomes. Production on the PPC is efficient, whereas production at points “below” the PPC is inefficient. Production “above” the PPC is impossibility SAMPLE OF THE FINDINGS OF MICROECONOMICS The following are some interesting (possibly controversial) results or conclusions from microeconomics: 1. Inefficiency is usually due to market failure or to situations when a normal market process is impeded by some circumstances, such as the fact that the good in question is a public good, the presence of monopoly, or when there are unusual transactions costs that hinder bargaining. 2. Another cause of inefficiency is the use of the “wrong” social institution (dictatorship or regulation), when a market would have worked well enough. 3. The legal rule on abortions determines the crime rate (Levitt’s hypothesis). If you allow abortion, you lower crime. This leads to the surprising conclusion that an “immoral” society has less crime than a “moral” or righteous society. 4. If you strictly enforce the anti-drug laws, you increase the crime rate. This is true if the demand for drugs is inelastic (which appears to be the case). 5. Traffic problems arise from over-use of the roads, which is a finding that results from an economic model called The Tragedy of the Commons. One solution in medium-sized cities in Philippine provinces is to reduce the number of slow-moving traffic, such as motorized Pedi cabs, and this may actually be easy to implement if the collective income of all Pedi cab drivers will increase as their number declines, leaving enough extra to “buy out” those who hesitate to find other means of livelihood. A more general solution is to charge road users a fee during peak or congested hours of road use. 6. Even if we assume that firms attempt to maximize profits, competitive forces in a market economy will eventually drive profits down to zero (or to “normal” business profit). The process Khurram Mirza COL MBA – AD513306 Tutor:

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by which firms seek to maximize profits is the engine of “efficiency” of an economy. In other words, “greed” is good! Ref: Revised May 31, 2009 http://foolawecon.wordpress.com

(b) How different is a market economy from a centrally planned economy? Planned Economy A planned economy or directed economy is an economic system in which the state or workers' councils manage the economy. It is an economic system in which the central government makes all decisions on the production and consumption of goods and services. Its most extensive form is referred to as a command economy, centrally planned economy, or command and control economy. In such economies, central economic planning by the state or government is so extensive that it controls all major sectors of the economy and formulates all decisions about their use and about the distribution of income. The planners decide what should be produced and direct enterprises to produce those goods. Less extensive forms of planned economies include those that use indicative planning, in which the state employs "influence, subsidies, grants, and taxes, but does not compel." This latter is sometimes referred to as a "planned market economy". A planned economy may consist of state-owned enterprises, private enterprises directed by the state, or a combination of both. Though "planned economy" and "command economy" are often used as synonyms, some make the distinction that Command economy, the means of production is publicly owned. Planned economy is an economic system in which the government controls and regulates production, distribution, prices, etc. Important planned economies that existed in the past include the economy of the Soviet Union, which, according to CIA Fact book estimates, was for a time the world's second-largest economy, China during 1949 to 1978, and India, prior to its economic reforms in 1991. Planned economies are in contrast to unplanned economies, such as a market economy, where production, distribution, pricing, and investment decisions are made by the private owners of the factors of production based upon their own interests rather than upon furthering some overarching macroeconomic plan Beginning in the 1980s and 1990s, many governments presiding over planned economies began deregulating (or as in the Soviet Union, the system collapsed) and moving toward market-based economies by allowing the private sector to make the pricing, production, and distribution decisions. Although most economies today are market economies or mixed economies (which are partially planned), planned economies exist in some countries such as Cuba, Libya, Saudi Arabia, Iran, North Korea, and Burma. Khurram Mirza COL MBA – AD513306 Tutor:

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Scope of the Planned Economies Planned economies may be intended to serve collective rather than individual needs: under such a system, rewards, whether wages or perquisites are to be distributed according to the value that the state ascribes to the service performed. A planned economy eliminates the individual profit motives as the driving force of production and places it in the hands of the state planners to determine what the appropriate production of different sets of goods is. The government can harness land, labor, and capital to serve the economic objectives of the state. Consumer demand can be restrained in favor of greater capital investment for economic development in a desired pattern. It could be seen as the government deciding: Who produces what, where it is produced, how much it costs, and where it goes. The state can begin building a heavy industry at once in an underdeveloped economy without waiting years for capital to accumulate through the expansion of light industry, and without reliance on external financing. This is what happened in the Soviet Union during the 1930s when the government forced the share of GNP dedicated to private consumption from 80 percent to 50 percent. As a result, the Soviet Union experienced massive growth in heavy industry, at the expense of stifled growth of living standards. Advantages of Economic Planning Supporters of planned economies cast them as a practical measure to ensure the production of necessary goods one which does not rely on the vagaries of free market(s). An important advantage of a planned economy, it does not suffer from business cycles; it does not experience crises of overproduction such as the one that was believed to have contributed to the Great Depression. From the modern perspective, it does not result in asset bubbles irrational massive misallocations of resources such as the dot-com bubble of the late 1990's or the housing bubble of mid-2000. The other aspect is that a centrally planned economy can easily provide public goods which would not have been available at all, or would require explicit government intervention, in a freemarket economy. For example, a nationwide highway system is a public good - it benefits everyone, but no market participants would voluntarily spend money to build one. In a free-market economy, the government would have to achieve this goal through taxation. In a planned economy, state planners would simply allocate resources to building highways. Stability Long-term infrastructure investment can be made without fear of a market downturn (or loss of confidence) leading to abandonment of the project. This is especially important where returns are risky (e.g. fusion reactor technology) or where the return is diffuse (e.g. immunization programs or public education). Disadvantages of Economic Planning Inefficient resource distribution surplus and shortage Critics of planned economies argue that planners cannot detect consumer preferences, shortages, and surpluses with sufficient accuracy and therefore cannot efficiently co-ordinate production (in a market economy, a free price system is intended to serve this purpose). From the modern viewpoint, such a shortage indicates a mismatch between supply and demand Khurram Mirza COL MBA – AD513306 Tutor:

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Assignment # 1 suggesting that planners have misjudged the demand for the product, the equilibrium price, or both. An imbalance, which would've been corrected naturally in a matter of years in a free-market economy, persisted for decades, while central planners turned a blind eye on it. Critics of central planning say that a market economy prevents long-term surpluses because the operation of supply and demand causes the price to sink when supply begins exceeding demand, indicating to producers to stop production or face losses. This frees resources to be applied to satisfy short-term shortages of other commodities, as determined by their rising prices as demand begins exceeding supply. It is argued that this "invisible hand" prevents long-term shortages and surpluses and allows maximum efficiency in satisfying the wants of consumers. Free Markets or Market System in Action Laisssez-faire is from French: “allow to do” This is an economy in which individuals households and firms pursue their own self –interests without any central direction d or regulation. Today called free markets economy there is no directions ad regulations from the center to coordinate the decisions of the individuals households and firms. Some markets are simple and some are complex and they in any case engage the buyers and the sellers for exchanges of goods and services. The behavior of the buyer and seller in Lasissez-faire market economy determines that what gets produced, how it is produced and who gets to by the goods. Prices in a market act as a signaling device. An increase in the price indicates that these products become scarcer. The price increase gives signals to the consumer to purchase less or divert towards cheaper substitutes. The free markets consists of many interconnected markets the firms could assume to be highly competitive and to operate free of government interference. In reality many markets are imperfectly competitive and monopolistic influences and government interventions in the market system is a feature of even the most enthusiastically capitalistic societies. Indeed in some cir some intervention shown to be a necessary condition for achieving economic efficacy. Economic Planning Vs. The Command Economy A centrally-planned economy is one in which most of the economy is planned by a central government authority. This is further contrasted with a command economy, in which the state allocates its resources as needed, without having to adhere to market principles. An example of this is the expropriation that took place in the Communist states compared to the nationalization that took place in the Western European countries. Another key difference is that command economies are more authoritarian in nature whereas indicative economic planning controls the economy through incentive-based methods. Economic planning can be practiced in a decentralized manner through different government authorities. For example, in some predominately market-oriented and mixed economies, the state utilizes economic planning in strategic industries such as the aerospace industry. Mixed economies usually employ macroeconomic planning, while micro-economic affairs are left to the market and price system. The People's Republic of China currently has a socialist market economy in place. Within this system, macroeconomic plans are used as general guidelines and as government goals for the national economy, but the majority of state-owned enterprises are subject to market forces. This is heavily contrasted to the command economy model of the former Soviet Union. References:

Reference: http://en.wikipedia.org/wiki/Planned_economy Economic environment of Business (AIOU-MBA)

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Question # 2 Production process may be labor intensive or capital intensive. To achieve productive efficiency, what criteria must a firm apply in choosing the production process to produce a certain quantity of output?

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Production Process / Production Theory The act of transforming inputs into outputs is called Production Process. The production function shows a physical relationship between inputs and outputs. According to; Rojer.R.Miller “Production function is a schedule or mathematical equation that gives a maximum quantity of out put that can be produced form specified sets of inputs while techniques of the production are given”. The first production theory was presented by Von Thunen in 1826, in this contest Prof. Hicks presented the neo-classical production function in 1839. After Hicks the economists like Carison, Dano, Samison and Leontif have presented a lot of production functions. Classical Production Function The concept of classical production is concerned with the short sun period. Short Sun represents such particular period where some or at least one factor of production is kept constant. It is stated as; Q = f (L) K Here K is the capital which is constant. Neo-Classical Production Function It is concept concerned with the long sun period. Long Sun period that particular period where all the factors of the production are variables. It is stated as; Q = f (L, K) Or in general terms it can represents as; Q = f (L,K,N,Tech). Types of the production Process It is important to distinguish between capital-intensive and labour-intensive methods of production. Capital-intensive • • • • • • •

Capital' refers to the equipment, machinery, vehicles and so on that a business uses to make its product or service. Capital-intensive processes are those that require a relatively high level of capital investment compared to the labour cost. These processes are more likely to be highly automated and to be used to produce on a large scale. Capital-intensive production is more likely to be associated with flow production (see below) but any kind of production might require expensive equipment. Capital is a long-term investment for most businesses, and the cost of financing, maintaining and depreciating this equipment represents a substantial overhead. In order to maximize efficiency, firms want their capital investment to be fully utilized (see notes on capacity utilization). In a capital-intensive process, it can be costly and time-consuming to increase or decrease the scale of production.

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Labour-intensive • • • • • • •

Labour' refers to the people required to carry out a process in a business. Labour-intensive processes are those that require a relatively high level of labour compared to capital investment. These processes are more likely to be used to produce individual or personalized products, or to produce on a small scale The costs of labour are: wages and other benefits, recruitment, training and so on. Some flexibility in capacity may be available by use of overtime and temporary staff, or by laying-off workers. Long-term growth depends on being able to recruit sufficient suitable staff. Labour intensive processes are more likely to be seen in Job production and in smallerscale enterprises.

How to achieve the efficacy in Productivity Physical productivity is the quantity of output produced by one unit of production input in a unit of time. For example, certain equipment can produce 10 tons of output per hour. Economic productivity is the value of output obtained with one unit of input. For example, if a worker produces in an hour an output of 2 units, whose price is 10$ each, then his productivity is 20$. It is clear that both technological and market elements (as output quantities and prices, respectively) interacts to determine economic productivity. Computation Average economic productivity is computed by dividing output value and (time/physical) units of input. If the production process uses only one factor (e.g. labour) this procedure gives the productivity of that factor, in this case labour productivity. When more than one input is used, for each factor it is possible to compute by the same procedure its productivity, called in this case "partial". "Total factor productivity" is the attempt to construct a productivity measure for an aggregation of factors. The meaningfulness of such an aggregation requires additional hypotheses, thus it is not assured in a general framework. Determinants Factors Technology determines the maximal physical quantity of output that can be reached as well as the number and the quality of inputs required. Adopted technology is in turn an economic choice, taken upon both economic and technological reasons. The spectrum of concurrent technologies that can be chosen is influenced by available innovations and adopter's compatibilities. Reversibility of this choice is often low because of high switch costs. Technological change is fast only in some industries, whereas in many others it is much more gradual. The typical examples are the “computer” and “software” industries where the change in the technologies and technological supports are very fast where as in heavy machinery like MTF (machine tool factory Pakistan) is using gradual shift in the technology and technological supports. Khurram Mirza COL MBA – AD513306 Tutor:

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Assignment # 1 In any case, the diffusion of worse technology than that presently in use is a marginal and irrelevant phenomenon. Technology always improves. Physical productivity, too. Economic productivity will depend also on pricing and demand. If consumers require fewer products than potentially producible, plants will not work at full productive capacity. Thus economic productivity can well fall, as with decreasing demand and prices. On a macroeconomic level, labour productivity, i.e. GDP per worker, depends on the corresponding dynamics of the two aggregates (GDP and employment). Productivity will rise if GDP increases faster than employment. A prolonged structural increase in productivity is the result of many factors, among which the following:

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Capital accumulation through investments;

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The long-lasting process of diffusion of new technologies (often imported from abroad), which in turn can be accelerated by a pro-diffusion tax;

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Domestic innovative efforts;

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Imitations of organizational and technological modes of production from world-class practices;

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Enhanced division of work;

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The development of physical and social infrastructure;

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Higher levels of education;

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A higher involvement and motivation of workers in the production processes.

At firm level, firms' incentives increase workers productivity through a stimulating environment and the removal of obstacles to their effective work. In a broader perspective, an increase of productivity is due to a squeeze in waste of resources, to narrower limits of irrational processes of production and governance, to an effective link between market and social needs. Impact on other variables Higher productivity impacts on Profits Then, with lags and without automatic mechanisms, on wages. If production costs do not overshoot that productivity increase, unit cost of production will be lower, opening the possibility of price fall or stability. In this vein, higher productivity is conducive to lower inflation. International competitiveness will increase by the same chain of reasons. If the increase of GDP is slower than the increase in productivity, a fall in employment will take place (as a matter of definition!). If a firm dismisses workers after having invested in new machines, technological unemployment will take place. If on the contrary the improved production can be sold at higher prices or produced with less wasted materials and energy, output value added can rise and one can obtain Khurram Mirza COL MBA – AD513306 Tutor:

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Assignment # 1 even an increase in employment. Employment in machine-producer industries will rise in both situations.

Productivity as a Business Cycle Behavior Economic productivity usually shows a pro-cyclical behavior, while at the same time it is necessary to distinguish smaller sub-phases and wider multiplicity of paths than in the case of other variables. Just after high peaks, GDP slowing dynamics is not immediately matched by employment. Productivity per worker falls. As far as recession takes momentum, firms begin to dismiss workers in attempt of reducing losses. This move should increase productivity again, but dismissed workers reduce their consumption and GDP contract further. The net effect on productivity depends on the speed and strength of the two factors. When recovery begins, once more employment is lagging, thus there is a drastic improvement in productivity and productive capacity utilization. These developments positively impact on profits and on the willingness of firms to invest. Opt for the right approach to maximize the productivity Depending on institutional incentives, firms can opt for an unbalanced mix of the following strategies: 1. Better exploit existent employment and massively use overhead, so that per-worker productivity rises dramatically. 2. Enlarge employment proportionally to output, keeping productivity stable. 3. To invest in labour-saving machinery, with a lagged increase of productivity and, potentially, a negative impact on employment. Depending on the aggregated effect of these decentralized choices, productivity will be more or less increase with GDP rise.

Reference: 1. http://www.economicswebinstitute.org/glossary/prdctvt.htm 2. http://economics.harvard.edu/faculty/jorgenson/files/EconOfProductivity_Elgar_2009.pdf 3. http://ablog.typepad.com/keytrendsinglobalisation/2009/05/investment-savings-and-growth-internationalexperience-in-relation-to-some-current-economic-issues-f.html 4. Course book: Economic Environment of the Business (AIOU-COL/MBA)

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Question # 3 (a) Does the existence of a shadow or ‘black’ economy imply that the price system is not working? Is its existence consistent with the laws of demand and supply? (b) The government gains revenue by imposing a sales tax. Who stands to lose the most, the consumer or the producer, or both?

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(a) Shadow Economy

The underground economy or black market is a market where all commerce is conducted without regard to taxation, law or regulations of trade. The term is also often known as the underdog, shadow economy, black economy, parallel economy or phantom trades. In modern societies the underground economy covers a vast array of activities. It is generally smallest in countries where economic freedom is greatest, and becomes progressively larger in those areas where corruption, regulation, or legal monopolies restrict legitimate economic activity. Characteristics of the Shadow Economy • • • • •

Low initial capital and qualification requirements. Small scale of operation. Qualifications are often acquired outside of the formal education. Methodologies demand big expenditure of labour and adaptation of new technologies. People within shadow economy do not have their own representation in the democratic structures.

The shadow economy has been growing stably in the developing countries during last 30 years. In order to survive large surplus of labour force has to create their own source of income not minding formalities. Causes of the Shadow Economy Legal economy has limited possibilities of absorption of labour force. Costs of launching new legal enterprises are growing: because of over-regulation, corruption cost of licenses, property rights, etc. Weakly developed institutions that should provide training, education, infrastructure and other encouragements. Structural adaptation programs of the 1980s and ‘90s accelerated shadow economy in the developing countries: disappearance of public sector and shutting down non-competitive state businesses. Incomes form taxes are smaller because of growing shadow economy. It results in poorer public services which in large extent begin to be carried out by the shadow economy. Global integration (globalization) discriminates labour force in favor of capital, especially labour force which is unqualified and immobile. Big capital much more easily crosses the borders. Informal economy is strongly supported by continuously growing migration from rural areas to cities what is combined with demand for low quality products and services.

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Assignment # 1 Many governments remain unaware of economic influences of informal economy and do not consider intervention as necessary. They believe that the informality is going to die out spontaneously; shadow economy left to it has very few obstacles in its development.

The number of women entering the non-farming labour market is growing. Although many of them run micro-businesses only small number enters the formal economy. In Pakistan The condition of black economy is as acute in Pakistan as India. It has been assumed by the State Bank of Pakistan. In fact, the size of the black economy in Pakistan is equivalent of half of a formal economy. The entire situation is pretty critical as the black economy there could have a negative impact on the public welfare plans in Pakistan. The black economy in Pakistan has grown throughout the years as a result of the immense amount of unethical and unlawful practices that have exploited the lack of documentation in Pakistani economy. Pricing System and Shadow Economy Goods acquired illegally take one of two price levels: • They may be cheaper than legal market prices. The supplier does not have to pay for production costs or taxes. This is usually the case in the underground market for stolen goods. Criminals steal goods and sell them below the legal market price, but there is no receipt, guarantee, and so forth. • They may be more expensive than legal market prices. The product is difficult to acquire or produce, dangerous to handle or not easily available legally, if at all. If goods are illegal, such as some drugs, their prices can be vastly inflated over the costs of production. Black markets can form part of border trade near the borders of neighboring jurisdictions with little or no border control if there are substantially different tax rates, or where goods are legal on one side of the border but not on the other. Products that are commonly smuggled like this include alcohol and tobacco. However, not all border trade is illegal. Consumer issues Even when the underground market offers lower prices, most consumers still buy on the legal market when possible, because: • They may prefer legal suppliers, as they are easier to contact and can be held accountable for faults • In some customers may be charged with a criminal offence if they knowingly participate in the black economy, even as a consumer. • They may feel in danger of being hurt while making the deal • They may have a moral dislike of black marketing Khurram Mirza COL MBA – AD513306 Tutor:

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Assignment # 1 • In some jurisdictions (such as England and Wales), consumers in possession of stolen goods will have them taken away if they are traced, even if they did not know they were stolen. Though they themselves commit no offence, they are still left with no goods and no money back. This risk makes some averse to buying goods that they think may be from the underground market, even if in fact they are legitimate (for example, items sold at a car boot sale).

But some actively prefer the underground market, particularly when government regulations hinder what would otherwise be a legitimate service. For example: the changing prices of petrol and increasing amount of levies on the petrol in Quetta a city of Pakistan where due to this regulations and price constrain the local people are using the smuggled petrol from Iran, As Iran extends the boarders with Quetta that is the reason the summgulled goods are easily spill out from the boarder areas. Transition from shadow economy to formal economy: Transition to formal economy occurs spontaneously in the moment when barriers disappear (regulations, corruption, high cost of capital, high labour costs). Attempts of civilizing the shadow economy in the region: (a) “Patent” Lithuania (low price ticket legalizing micro-business), (b) Russia: simplifying tax systems for micro-business (taxation does not consider profit or turnover but for example square meters of business activity space, amount of used water or other indicators) World Bank recommendations a) Reduction of number of licenses b) Easy administrative process (streamlining) c) Adopting simple tax system (flat tax?) d) Access to capital Conclusion: The shadow economy cannot be treated as temporary phenomenon any longer. Moreover the shadow economy has growing potential of creating jobs and creating income and enables the poor to access low priced goods and services.

References: http://www.economypedia.com/wiki/index.php?title=Black_economy http://wikipreneurship.eu/index.php5?title=The_good_shadow_economy Economic Environment of the Business AIOU.

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(b) TAX “It is a compulsory contribution or payment paid by a person to the public authority to cover the cost of services rendered by the state for the general benefit of its people and the person who pays tax cannot claim a definite service in return.” SALES TAX “A sales tax is a consumption tax charged at the point of purchase for certain goods and services.” The tax is usually set as a percentage by the government charging the tax. When you buy the products subject to sales taxes, you pay the price tag plus the tax. In Pakistan sales taxes cover a large number of goods and services. There is usually a list of exemptions. The tax can be included in the price (tax-inclusive) or added at the point of sale (tax-exclusive). WHO STANDS TO LOOSE MORE – PRODUCER or CONSUMER? Most sales taxes are collected by the producer, who pays the tax over to the government which charges the tax. The economic burden of the tax usually falls on the purchaser, but in some circumstances may fall on the seller. Sales taxes are commonly charged on sales of goods, but many sales taxes are also charged on sales of services. Ideally, a sales tax is fair, has a high compliance rate, is difficult to avoid, is charged exactly once on any one item, and is simple to calculate and simple to collect. This can be best explained by the Following example:

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As in the above figure, when the sales tax is introduced, it leaves the demand curve intact while it raises the supply curve by the amount of tax, $0.05. To see the logic remember that the supply curve represents the quantities that a firm is to offer at alternative process. The supply curve in figure reflects prices excluding taxes charged by the seller. When the tax is levied, the price charged by the seller must reflect the tax. Therefore the supply curve jumps up (a decrease in supply) by the amount of tax (5 cents on vertical axis). Note that this shift is a parallel shift since the amount of tax is fixed per liter of gasoline and does not change with the volume of consumption. The tax inclusive supply curve reflects the fact that sellers are willing to supply the same quantities only if they get paid 5 cents more than before per liter. The 5 cents added to the price is the seller’s new obligation to the government. At new equilibrium, point B, the price has risen and volume of transactions has fallen. However the equilibrium price of $0.53 is the price paid by consumers. Note that the price does not rise by the full amount of 5 cents to consumers even though the government has levied a 5 cent tax. In order to see this point more clearly, remember that the vertical distance b/w the two supply curves is 5 cents. As long as the demand curve is not perfectly vertical, consumer will pay only a portion of tax. The remaining portion is paid by the sellers (producer) that are receiving $0.48 per liter as opposed to $0.50 (point C). Therefore the burden of tax is shared by both consumers and producers, 3 cents by the consumer and 2 cents by the seller. The government collects its 5 cents regardless how the burden is shared. In this example, consumer’s share in sales tax (3 cents) is greater than the producer’s share (2 cents). In general, who is going to loose more is the function of slopes of demand and supply curve. The steeper the gasoline demand curve, greater will be the portion paid by the consumers, the flatter the demand curve, smaller will be the consumer’s share. Also, the flatter the supply curve, greater the portion paid by the consumer and vice versa. Reference: http://en.wikipedia.org Economic Environment of Business (AIOU)

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Question # 4 (a) Define the concepts: (i) price elasticity of demand; (ii) cross-elasticity of demand; and (iii) income elasticity of demand. How are these elasticity estimated? Explain why it might be important for a firm to know their values. (b) What does the demand curve facing the firm in imperfect competition look like? How is the marginal curve drawn in relation to the demand curve in imperfect competition?

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(a) PRICE ELASTICITY OF DEMAND: An important aspect of a products demand curve is how much the quantity demanded changes when the price changes. The economic measure of this response is called price elasticity of demand. PED measures the responsiveness of a change in demand, after a change in price. The formula for the Price Elasticity of Demand (PED) is: PEoD = % change in Quantity Demanded. % change in price To calculate the price elasticity, we need to know what the percentage change in quantity demand is and what the percentage change in price is. It's best to calculate these one at a time. Calculating the Percentage Change in Quantity Demanded The formula used to calculate the percentage change in quantity demanded is: [QDemand (NEW) - QDemand (OLD)] / QDemand (OLD) Calculating the Percentage Change in Price Similar to before, the formula used to calculate the percentage change in price is: [Price(NEW) - Price(OLD)] / Price(OLD) Final Step of Calculating the Price Elasticity of Demand PEoD = (% Change in Quantity Demanded)/(% Change in Price) IMPORTANCE OF PRICE ELSTICITY OF DEMAND. Price elasticity of demand it is used to see how sensitive the demand for a good is to a price change. The higher the price elasticity, the more sensitive consumers are to price changes. Very high price elasticity suggests that when the price of a good goes up, consumers will buy a great deal less of it and when the price of that good goes down, consumers will buy a great deal more. Very low price elasticity implies just the opposite, that changes in price have little influence on demand. ii). CROSS ELASTICITY OF DEMAND It is also known as cross price elasticity of demand. The Cross-Price Elasticity of Demand measures the rate of response of quantity demanded of one good, due to a price change of another good. The common formula for the Cross-Price Elasticity of Demand (CPEoD) is given by: CPEoD = (% Change in Quantity Demand for Good X)/(% Change in Price for Good Y) Substitute goods are alternative. There CPEoD will be positive, •

The weak substitutes like tea and coffee will have a low CPEoD.

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Assignment # 1 •

Dawn bread and Gourmet bread are close substitutes so CPEoD is higher.

Complements goods, these are goods which are used together, therefore CPEoD is negative.

•

If the price of DVD players falls, then there will be a increase in demand for DVD disks,

IMPORTANCE OF CROSS PRICE ELSTICITY OF DEMAND. The cross-price elasticity of demand is used to see how sensitive the demand for a good is to a price change of another good. High positive cross-price elasticity tells us that if the price of one good goes up, the demand for the other good goes up as well. A negative tells us just the opposite, that an increase in the price of one good causes a drop in the demand for the other good. A small value (either negative or positive) tells us that there is little relation between the two goods. •

If CPEoD > 0 then the two goods are substitutes

•

If CPEoD =0 then the two goods are independent (no relationship between the two goods

•

If CPEoD < 0 then the two goods are complements

iii) INCOME ELASTICITY OF DEMAND The Income Elasticity of Demand measures the rate of response of quantity demand due to a raise (or lowering) in a consumer’s income. The formula for the Income Elasticity of Demand (IEoD) is given by: IEoD = (% Change in Quantity Demanded)/(% Change in Income) IMPORTANCE OF CROSS PRICE ELSTICITY OF DEMAND Income elasticity of demand is used to see how sensitive the demand for a good is to an income change. The higher the income elasticity, the more sensitive demand for a good is to income changes. Very high income elasticity suggests that when a consumer's income goes up, consumers will buy a great deal more of that good. Very low price elasticity implies just the opposite, that a change in a consumer’s income has little influence on demand. •

If IEoD > 1 then the good is a Luxury Good and Income Elastic

•

If IEoD < 1 and IEOD > 0 then the good is a Normal Good and Income Inelastic

•

If IEoD < 0 then the good is an Inferior Good and Negative Income Inelastic

Reference: http://www.economicshelp.org http://www.netmba.com/econ/micro/ Economic Environment of Business (AIOU)

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(b)

Market Structures Traditional price theory delineates four basic market structures. • • • •

Pure Competition Monopolistic Competition Oligopoly Monopoly

Features of the Four market Structures

Perfect Competition It is market where uniform price is charged for all units of goods. These markets has homogeneity in products those are identical to each other that is the reason the price charged for the units an goods will remain the same throughout the market. Imperfect Competition Imperfect competition means either having differentiated products and/or significant barriers to entry. The extent of the differentiation and the level of significance of the barriers will determine what kind of general market structure the market will take. Barriers to entry will determine both number of firms in the market and whether it will be easy for new firms to enter. Generally higher barriers to entry entail fewer firms and difficult entry to the market. Though other factors like market size and symmetric information does play a part in determining market structure, lets Khurram Mirza COL MBA – AD513306 Tutor:

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Assignment # 1 assume all else constant(ceterus paribus). Therefore, excluding the perfect competition rest of the market structures are in Imperfect Competitive environment. • • •

Monopolistic Competition Oligopoly Monopoly

Imperfect Competition and Market Dynamics All firms seek to obtain and expand market power, and many firms have some degree of such power. A minority of firms has significant market power and account for a large portion of the market, if not the entire market. To understand the market system, you need to know how the system functions when individuals firms possess significant market power. Lets proceed by looking at Monopoly, next in the logical sequence is Monopolistic Competition and at conclusion the findings on Oligopoly. Demand Curve Faced by a Firm The firm under an imperfect market faces the market demand curve or part of it. In either case, the firm faces a downward sloping demand curve this implies that if the firm wants to sell more, it should lower the price; if it wishes a higher price, he should restrict output. In contrast, a perfectly competitive firm, since it has no control over price, faces a horizontal demand curve. Monopoly In contrast with the perfectly competitive market if there is only one seller of a particular product and service called Monopoly. When a firm has monopoly it has a significant power to determine the price for its outputs. For example, there may be only one store in the shopping mall of particular area (Clifton Karachi) that sells the gourmet coffee. when ever a firm has monopoly in particular markets or market , the economy theory state that it still must adhere to the MR=MC (marginal revenue = marginal cost) rules to maximize its short term profit because it is price maker rather a price taker firm. Therefore, Monopoly can define as “A market structure in which only one producer or seller exists for a product that has no close substitutes.” Characteristics of Monopoly • • • •

The degree of control over price that is held by the monopolist The individual supply of the monopolist coincides with the market supply Market demand equals the demand for the monopolist’s product or service The monopolist is a “price maker”

Sources of Monopoly Economies of scale In capital intensive industries, the economies of large-scale production may lead to a small number of firms producing the product Natural monopolies: Public utilities

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Assignment # 1 In cases where one or two firms can adequately supply all the service needed, it may be desirable to limit the number of firms within a given territory. Government regulation of these monopoly franchises. Control of raw materials An effective barrier to entry is ownership or control of essential raw materials Patents The exclusive right to use, keeps, or sells an invention for a period of 20 years Threat of infringement suits against the new entrants will restrict the entry in the monopoly. Competitive tactics Aggressive production and merchandising techniques, Illegal predatory pricing policies, Aggressive innovation techniques. All those tactics support monopoly. Determining the monopoly price The monopolist’s demand curve slopes downward to the right because it is the market demand curve of all consumers. The first question the monopolist asks is, “How many units of my good can I expect to sell at various prices?” With one firm in a monopoly market, there is no distinction between the firm and the industry. In a monopoly, the firm is the industry. The market demand curve is the demand curve facing the firm, and total quantity supplied in the market is what the firm decides to produce.

The demand curve facing a perfectly competitive firm is perfectly elastic; in a monopoly, the market demand curve is the demand curve facing the firm.

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Assignment # 1

Case Study; We can show how the monopoly (a hairdresser, for example) would precede to the price her product by combining its cost structure with the type of demand and marginal revenue. Quantity Sold (Q) Hairstyle per day 1 2 3 4 5 6 7 8 9 10

Price (P) (P) - $ (PXQ) 10 9 8 7 6 5 4 3 2 1

Total Revenue TR (TR/Q) 10 18 24 28 30 30 28 24 18 10

Average Revenue AR dTR/dQ 9 8 7 6 5 4 3 2 1

Marginal Revenue MR 8 6 4 2 0 -2 -4 -6 -8

The table shows that the total revenue, column 3, reaches a peak b/w unit 5 and 6. Marginal Revenue, column 5. Is initially positive up to the 6th unit and subsequently becomes negative.

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Assignment # 1

Price $

10 0

Ep > 1

Ep = 1 MR

Ep < 1

D

5

Quantit y

6

30 $

TR

5

6

A monopolist’s marginal revenue is always less than its price. The reason is that in order for the monopolist to sell an extra unit of output, the firm must cut its price, and the price cut applies to all units sold. The additional unit as well as all previous units. However, the addition to revenue from selling an extra unit is less than the price change. In order to consider and understand the point

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Assignment # 1

Price

Losses

7 6

Gains

D 4

5

Quantity

As it is clear from the fig that when the price is 7 and 6 $ respectively, total revenue is 28$ and 30$ respectively, marginal revenue however is 2$. Here we can appreciate that a monopolist has to decrease his price from 7 to 6 but in return the revenue generated is not in compliance with the price change. Marginal Revenue Curve Facing a Monopolist For a monopolist, an increase in output involves not just producing more and selling it, but also reducing the price of its output to sell it. At every level of output except one unit, a monopolist’s marginal revenue is below price.

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Short run Profit Maximization

Price MC

PM

A

ATC

C B MR QM

D Quantity

The figure represents the demand cure D faced by the monopolists market. And corresponding marginal revenue MR curve. Superimposed on this the cost curves of the monopolist-the short run average cost ATC and marginal cost MC curves. The profit maximization is up to the point when marginal cost per unit rises to produce up to meet the falling marginal revenue. This point occur at output level Qm. Notice that every unit to the right of the Qm has marginal cost grater than its marginal revenue; it therefore, not be produced. Likewise, every unit to the right to the Qm cost less than it earns (marginally or incrementally). The firm’s profit can be seen as PmABC. For a management point of view if a firm in a monopoly should not sell the products at high price where as sell the product at right price which equates the firm’s profits. The right price is one that is the marginal cost with marginal revenue, in doing so the firm’s could earn maximum profits.

Monopolistic Competition Monopolistic competition is a common form of industry (market) structure, characterized by a large number of firms, none of which can influence market price by virtue of size alone. Some degree of market power is achieved by firms producing differentiated products. New firms can enter and established firms can exit such an industry with ease.

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Assignment # 1

Product Differentiation Reduces the Elasticity of Demand Facing a Firm Based on the availability of substitutes, the demand curve faced by a monopolistic competitor is likely to be less elastic than the demand curve faced by a perfectly competitive firm, and likely to be more elastic than the demand curve faced by a monopoly.

Oligopoly A market structure in which relatively few firms produce identical or similar products Two basic characteristics: 1. Each firm has some ability to influence price 2. The interdependence among firms in setting their pricing policies Entry barriers exist. Competition in Oligopoly Firms in oligopolies tend to concentrate on non-price competitive policies like advertising Frequently use administered prices A predetermined price set by the seller rather than a price determined solely by demand and supply in the marketplace Use of non-price competition e.g. rebates promotional deals, etc.

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Assignment # 1

References: www.wiki.answers.com Economic Environment of Business (AIOU)

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Question 5

What are the assumptions of the theory of monopolistic competition? In what way do these assumptions differ from those of the perfectly competitive and monopoly models?

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Assumptions of the Monopolistic Competition The assumptions in monopolistic competition 1. There are large no buyers and sellers in the market place, non of whom are large enough to influence the price. 2. The sellers are described as price takers.

3. There is freedom of entry and exit into the market i.e. barriers to entry are low and firms must be able to quickly established themselves in the market place. 4. Buyer and seller have perfect knowledge; economic agents are fully informed of prices and out put in the industry. 5. Firms produce non homogeneous differentiated products

Monopolistic Competition Monopolistic competition is a common form of industry (market) structure, characterized by a large number of firms, none of which can influence market price by virtue of size alone. Some degree of market power is achieved by firms producing differentiated products. New firms can enter and established firms can exit such an industry with ease. Product Differentiation Reduces the Elasticity of Demand Facing a Firm Based on the availability of substitutes, the demand curve faced by a monopolistic competitor is likely to be less elastic than the demand curve faced by a perfectly competitive firm, and likely to be more elastic than the demand curve faced by a monopoly.

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Monopolistic competition in short run In the short-run, a monopolistically competitive firm will produce up to the point where MR = MC.

This firm is earning positive profits in the short-run. Profits are not guaranteed. Here, a firm with a similar cost structure is shown facing a weaker demand and suffering short-run losses.

Monopolistic Competition in long run

The firm’s demand curve must end up tangent to its average total cost curve for profits to equal zero. This is the condition for long-run equilibrium in a monopolistically competitive industry.

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Perfect & Imperfect Markets Compared •

High degree of competition benefits consumers

•

Under perfect competition, firm tend to have lower prices, produces more outputs and obtain normal profits in the long run.

•

Each firm produces at the minimum ATC curve and P (AR) = MC (and ATC).

Perfectly Competitive versus Monopolistic Pricing: Possible Long-Run Price under Monopolistic Competition

Possible Equilibriums under Perfect Competition, Monopoly, and Oligopoly

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Prefect competition There are large no buyers and sellers in the market place, none of whom unite and influence the price. The sellers are described as price takers. There is freedom of entry and exit into the market i.e. barriers to entry are low and firms must be able to quickly established themselves in the market place. Buyer and seller have perfect knowledge; economic agents are fully informed of prices and out put in the industry. The goal of the firm is profit maximization. Firms produce homogeneous non-differentiated products

Monopoly There is only one firm in the industry, the monopolist The sellers are described as price makers Barrier to enter into the market Entry and exit for the firm is difficult.

Buyer and seller have perfect knowledge; the goal of the firm is short term profit maximization. Firms produce Unique products

Monopolistic Competition There are large no buyers and sellers in the market place, none of whom are large enough to influence the price. The sellers are described as price takers. There is freedom of entry and exit into the market i.e. barriers to entry are low and firms must be able to quickly established themselves in the market place. Buyer and seller have perfect knowledge; economic agents are fully informed of prices and out put in the industry. Firms produce non homogeneous differentiated products

It can be seen that the assumptions in monopolistic competition are as perfect competition despite the monopolistic firms only produce non homogeneous differentiated products. as for as monopoly is concerned it is single dominant market situation.

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