ANSWERS TO SELECTED QUESTIONS

Chapter 1 Economic Activity and Value Creation

1. Propose a test for deciding whether or not a particular resource is scarce. Use this test to decide whether
water is a scarce resource.

Answer (to second part of question): If you live in Glasgow, Manchester, Amsterdam or Venice, you may
think not; those who live in desert regions are likely to disagree! However, the answer depends on whether
the use of water involves trade-offs. If using water in one way prevents some other use being made of it
then it is scarce. This is nearly always likely to be the case.

2. Explain how the concept of opportunity cost can be used to assist decision making in:

a. a business firm
b. the British National Health Service (NHS).

(If you do not have any experience of the NHS, here are a few basic facts to help you understand the
system. The service is provided free at the point of use, in doctors’ surgeries or in hospitals. The
government provides the national budget for the service. This budget is made available as limited annual
resources to a large number of area health authorities that provide the finance for all operations, drugs, and
other medical care including salaries and running costs of hospitals.)

Answer:

a. Firms have limited budgets, with many available uses. Profits will be maximised if these limited
resources are used in the way that minimises opportunity cost to the firm; that is, if the most
valuable outcome is chosen.
b. The NHS has to make awkward choices about how to use its limited budget; any item of spending
will involve trade-offs. More expenditure on major heart surgery, for example, means less
available for preventative medicine. The problem here is basically one of finding out what value
society places on alternative forms of health care. If managers knew this then rational choices
would be possible.

3. How does added value differ from value added? Does the pursuit of value-added make sense as a
business objective?

4. The opportunity cost of using a resource is:

a. the present market price of that resource

b. the highest valued alternative necessarily foregone
c. the actual money payment made for the use of that resource
d. the lowest valued alternative necessarily foregone?

Answer: The correct answer is (b). Of all the alternative uses to which a resource could be put, the one that
gives the highest value represents the opportunity cost. Answers (a) and (c) are incorrect because although
the market price for a resource is often equal to its opportunity cost, this is not always the case. For
example, some resources require no money payment to secure their use (capital and labour supplied by an
owner in her own firm) but nevertheless have an opportunity cost.

5. How can the added value generated in different activities within a firm assist in its internal allocation of
resources?

6. We have explained added value at the level of a single firm in the context of a commercial business.
Does the concept of added value also apply to not-for-profit organisations such as charities, universities and
public health organisations? If you think it does, how could one measure the added value of these
organisations, and what difficulties would arise in doing this?

Chapter 2 The Operation of the Market

2.1 Analyse how the price of large family saloon cars is likely to be affected by a substantial increase in the
price of crude oil.

2.2 A rise in consumers’ income will increase the demand for cars. Is this statement correct?

Answer: This is not necessarily correct. If cars are normal goods, then demand will increase as income
rises; however, it would decrease if cars are inferior goods.

2.3 Construct a diagram to show the effects on the equilibrium price of cars and the equilibrium quantity
traded of cars as a result of a decrease in the price of capital equipment in the manufacture of cars.

2.4 Show diagrammatically a situation of excess supply in a market. What would be the consequence of
this in a free market? Show how excess supply may arise in the labour market if a statutory minimum wage
were to be introduced or increased.

Answer: See Figure Q2.4. This illustrates excess supply at the price P3. Such excess supply would tend to
be eliminated; suppliers, unable to sell their planned output, would cut price to get rid of unwanted stocks.
The price would tend to fall to the level at which the quantities supplied and demanded are equal. You can
see this happening in OPEC where some producers have cut price to try and sell their target outputs.

5. How do changes in resource allocation occur in planned economies? Are the appropriate changes
likely to be made quickly and smoothly?

Answer: Changes in supply and demand will show up in planned economies as shortages or surpluses, just
as is initially the case in market economies. However, these imbalances will not alter the pattern of relative
prices; hence the signals to consumers and producers that would alter behaviour are not transmitted.
Planned economies will be successful in allocating resources to the extent that:

a. imbalances are quickly and accurately monitored and

b. planned targets are revised and implemented.

Changing plans is an immense task, and adjustment is likely to be poor as a result.

2.6 Will the following shift the demand curve or the supply curve, and in which direction?

a. A rise in the good’s own price.

b. An increase in the price of a competing (substitute) good.
c. A decrease in consumers’ income.
d. An increase in the price of energy?

Answer:

a. A change in the good’s own price does not cause a shift of either curve but rather produces a
movement along these curves.
b. An increase in the price of a competing good might shift both supply and demand curves. The
demand would tend to increase as consumers switch away from the competing good. The supply
curve might decrease as producers find the competing good to be relatively more profitable, and
reallocate resources into its production.
c. If the good is normal, the demand curve would shift inwards (to the left); the reverse is true for
inferior goods. The supply curve would be unaffected.
d. An increase in the price of energy would tend to make production more expensive, and so less
profitable. The supply curve would shift inwards. If the good in question is complementary to
energy, the demand curve might shift inwards as consumers buy less of both the good and energy.
If the good is a substitute for energy, consumers may switch from energy, leading to a rise in
demand for the substitute.

2.7. Why may some goods be inferior? What types of goods are these likely to be?

Answer: Goods may be inferior if they are considered to be second-best substitutes to another good, but
which are purchased during times when income is tight; increased income may induce the consumer to
switch to his or her preferred alternative

2.8 If, as a result of an increase in price from £13 to £14 a bottle, the consumption of gin fell from 10,000
to 8,000 bottles a week (with other things remaining unchanged), what is the value of the arc elasticity of
demand between these two points?

2.9 Consider the following information on the demand for coffee:

1996 1997 1998

Price (£) per lb. 1.21 2.10 3.40

Quantity (lbs.) per person per year 16.8 13.6 12.0

Is it possible to calculate the price elasticity of demand for coffee from this information? If it is possible,
what is the elasticity. If it is not possible, explain why it is not.

Answer: The total revenues at each price are:

Price Quantity Total revenue

1.21 16.8 20.33

 2.10 13.6 28.56

3.40 12.0 40.8

As price rises from 1.21 to 2.10, and then to 3.40, total revenue rises. Thus demand appears to be inelastic.
However, you should be careful about this conclusion. It has been assumed that the quantity bought (to
which the data refers) is the same as ‘demand’. This clearly is not necessarily the case; strictly speaking, we
cannot really say anything about elasticity from data on purchases alone. (For example, the data may refer
to supply rather than demand!)

Chapter 3 Individual Choices, the Supply of Work, and the Demand for Goods

1. What effects on desired labour supply would you expect from

a. an increase in the marginal rate of income tax;

b. an increase in the rate of value added tax on expenditure?

2. Suppose we regard consumption today and saving today (leading to extra consumption tomorrow) as two
"goods", and that they are the only goods available. Moreover, any income saved will earn an interest rate
of 10% per period. Assuming a fixed amount of earned money income in both periods, and that prices
remain constant, what does the consumer’s budget line look like for these two goods? Use indifference
curve analysis to illustrate the consumer’s optimum saving-consumption choice.

3. Which of the following statements must hold when an individual is maximising her utility?

a. The marginal utility of all goods equals unity.

b. The marginal utility from the last £1 spent on each good must be the same.
c. The ratio of the marginal utilities of the goods consumed equals the ratio of their prices.
d. The marginal utility of all goods consumed is the same.

Answer: Statements (b) and (c) both hold when the individual is maximising utility.

4. Are all Giffen goods inferior goods? Are all inferior goods Giffen goods?

Answer: All Giffen goods are inferior. For a Giffen good, the income effect must be negative; that is a fall
in income increases demand. This effect must, furthermore, be strong enough to outweigh the substitution
effect whereby higher prices induce consumers to switch away from this good. Not all inferior goods will
be Giffen goods too; if the income effect is small relative to the substitution effect, a usual shaped demand
curve results.

5. Which of the following is always true?

a. As a good’s own price falls, the quantity demanded of the good will increase.
b. The substitution effect of a fall in a good's own price will lead to an increase in the quantity
demanded.
c. As an individual’s income rises, the quantity demanded of a good will rise.

Answer: The correct answer is (b). Statement (a) is not correct as a price fall leads to a rise in real income
which could result in falling demand if the good is strongly inferior. Statement (c) is incorrect as it only
applies to normal goods.
6. ‘If an increase in the price of oil reduces the demand for cars, an increase in the price of cars must reduce
the demand for oil.’

Is this statement true? Explain your answer.

Answer: This statement is not correct. If we ignore the income effect of price changes (and thus look only
at the substitution effect) the statement would then be correct. Since the income effect will work differently
on different goods, we have no reason to believe the overall effects will be symmetrical.

7. If all prices rose by 15% and an individual’s income rose by 10%, the individual’s real income:

a. Would rise, because the increase in money income offsets any increase in prices.
b. Would fall, because the increase in money income does not fully compensate for the increasing
prices.
c. Would fall, because real incomes always fall during inflation.
d. Might rise or fall. It is not possible to tell with these data.

Answer: The correct answer is (b). If all prices rose by 15%, with money income
unchanged, real income falls by 15 %. The specified rise in money incomes is clearly
insufficient to compensate.

Chapter 4 The Nature, Purpose and Objectives of Firms

1. What are transactional difficulties and costs and why do we need to be concerned with them?

2. What factors give rise to transactional difficulties and costs?

3. According to the transactional view of the world what exactly are firms for?

4. According to the transactional view of the world what exactly is the function of entrepreneurship?

5. Think of a famous entrepreneur, for example Bill Gates of Microsoft or Richard Branson of Virgin.

Do you recognise them and their activities in the description of entrepreneurship given in this chapter?

6. Explain the nature and the significance of the terms added value, economic profits, and rent. How

does the added value approach suggest we judge business performance? Does this seem sensible to you?

7. Evaluate the view that successful high street retailers such as Marks ans Spencer are successful because
they were lucky enough to have acquired the best high street locations before their value was really
appreciated.

8. Is it appropriate to assume that the objective of the enterprise is generally the same as the objective of the
entrepreneur, or the owner of the enterprise surplus?

9. ‘The Prisoner’s Dilemma is an interesting story but it isn’t very realistic?’ Discuss.

10. What factors ultimately determine the objectives of the enterprise?

11. Is the value or profit maximising view of the purpose of enterprise too narrow, too finance oriented, for
the analysis of business policy?
Chapter 5 The Search for Added Value and the Costs of Production

1. Consider a producer (extractor) of crude oil. What kinds of input are likely to be fixed in the short
run and the long run for such a firm? Now answer the same question for (a) a crude oil refiner and
(b) a commercial football club.

Answer: In the short run, a large part of the capital equipment of producers of crude oil is fixed,
particularly capital items associated with exploration, drilling, extraction, piping and storage. The
quantity employed of these will not vary in the short run as the amount of oil extracted changes. It
follows that increases in the demand for oil will, in the short run, need to be met with the existing
installed quantity of such capital. Demand variations will alter the intensity with which fixed
capital is operated. If demand increases when little or no spare capital capacity exists, crude oil
prices may rise sharply. In contrast, significant reductions in demand will in the short run leave
firms with a problem of underutilized plant and equipment.

In the long run, none of these items of capital is fixed. Indeed, no input is fixed. The oil-producing
firm can select a scale at which to operate and produce this output by using whichever level and
combination of inputs minimises production costs.

2. Draw the isoquant for an output level of 100 for the linear production function

Q = 2K + 3L

If input rental prices were PK = £1 and PL = £1, use isocost lines to deduce what would be the cost-
minimising input choice in the long run.

3. Diseconomies of scale in the production of a good exist if:

A An extra worker taken on with existing equipment would reduce the average amount produced per
worker.

B A doubling of output requires more than doubling all inputs.

C Output can be increased by using all inputs in a more technically efficient way at the same scale.

a. B only
b. A and C only
c. B and C only
d. A and B and C

Answer: The correct answer is (a). Economies and diseconomies of scale always refer to what happens in
the long run, ie when all factors are variable. Diseconomies of scale would mean that the long run average
cost curve was rising. A refers to diminishing average returns to a single factor, which does not imply
diseconomies of scale. C is irrelevant. B does give an instance of diseconomies of scale.

4. Which of the following statements concerning the long run average cost curve are correct:

a. If there are economies of scale, one would expect the long run average cost curve to be downward
sloping.
 b. The minimum efficient scale of production is the level of output where long run average costs are
minimised.
c. The long run average cost curve is U-shaped because of the law of diminishing returns.

Answer: Statement (a) is correct. If there are economies of scale, average inputs per unit of output fall as
output increases. As long as input prices do not rise to an extent great enough to offset these reductions,
average cost will fall as output increases. Statement (b) is correct. The notion of the Minimum Efficient
Scale is used with an L shaped long run average cost curve, defining the point at which the curve becomes
horizontal.(ie where all scale advantages have been exhausted .) Statement (c) is incorrect. The law of
diminishing returns has nothing to do with long run behaviour.

5. Look again at Figure 5.10, in particular at the isocost line corresponding to total costs of £2000. Use
isoquant and isocost analysis to verify the following assertions:

If the rental price of labour were to remain at £10 per unit, but the rental price of capital rose from £10 to
£20

a. the cost-minimising input mix would comprise a smaller quantity of capital than labour, and
b. the total cost of producing 100 units of output would exceed £2000.

6. The relative costs of oil pipelines fall rapidly as the diameter of the pipeline increases. More specifically,
a quadrupling of pipeline volume (and so maximum throughput) can be obtained at just a doubling pipeline
costs. Using the formulae for the area and circumference of a circle, demonstrate why this saving in
average costs will take place.

7. The term ‘long run’ as applied to a firm’s decision making refers to:

a. the number of years over which a firm can expect to produce with unaltered factors of production
b. any period of time between 3 and 5 years in which a firm can increase or decrease all the factors
of production it employs
c. any period of time over 5 years in which a firm can increase or decrease all the factors of
production it employs
d. the time period in which a firm can increase or decrease all the factors of production which it
employs.

Answer: (d) is the correct answer; the long run is not defined by any number of years. It refers simply to the
condition in which the inputs of all factors can be varied. Since in the long run amounts of all factors used
can be varied, there are no fixed costs in the long run and hence all costs are variable.

8. How do the concepts of the short run and the long run apply to a publicly funded hospital operating
under borrowing limits imposed by central government?

9. Consider the long run average cost function of a business school institution specialising entirely in the
provision of taught postgraduate degree courses in business economics.

i. Would you expect this cost function to exhibit economies of scale, diseconomies of scale or
neither?
ii. What kinds of scope economies might be available if this institution broadened the range of
courses it provided?
iii. Show how the concepts of development costs and learning effects can be used to explain what will
happen to average costs of the provision of a new course by this institutio