Module 42: Economics, Strategy, and Globalization

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Overview

This module covers three interrelated topics: economics, business strategy, and globalization. The module begins with a discussion of microeconomic and macroeconomic concepts. These concepts are important in determining effective strategies for a business. It is important to understand the effects of the macroeconomic factors on the business, including actions by governments that impact global markets. Business managers must also understand the nature of the markets that the company purchases and sells in. These factors provide inputs into strategy formulation for the firm. Because business is truly global, managers must understand the global economy and how global factors provide opportunities and risks for their companies. Before you begin the reading, you should review the key terms at the end of the module.

MICROECONOMICS

A. Focus

Microeconomics focuses on the behavior and purchasing decisions of individuals and firms. In a market economy goods and services are distributed through a system of prices. Goods and services are sold to those willing and able to pay the market price. The market price is determined based on demand and supply.

B. Demand

Demand is the quantity of a good or service that consumers are willing and able to purchase at a range of prices at a particular time. Therefore, market demand for a product is actually a schedule of the amount that would be purchased at various prices, with all other variables that affect demand being held constant. Graphically a demand curve shows an inverse relationship between the price and quantity demanded. That is, fewer products are demanded at higher prices. Illustrated below is the demand schedule and demand curve for Product X.

MARKET DEMAND FOR PRODUCT X

As illustrated, at a price of $50, 3,000 units of Product X will be bought. If the price of Product X changes, more or less will be bought.

1. Demand curve shift. A demand curve shifts when demand variables other than price change. For example, if the price of substitute products for Product X increase in price, the demand for Product X would shift upward and to the right. A demand curve shift is illustrated in the graph below.

   

2. Variables that may cause a demand curve shift include changes in the price of other goods and services, consumer tastes, spendable income, wealth, and the size of the market. The table below summarizes the effects of these factors on the demand for a particular product.

   FACTORS AFFECTING THE DEMAND FOR A PRODUCT OTHER THAN ITS PRICE

   Factor	Effect
   Price of other goods and services (e.g. substitute goods)	Direct relationship. As goods that may be purchased instead go up in price the demand for the product goes up. As an example, if the price of pork increases the demand for beef may increase.
   Price of complement products (i.e., products that must be used with the product or enhance its usefulness)	Inverse relationship. As the prices of complement goods go up, the demand for the product goes down. As an example, if the price of hamburger increases the demand for hamburger buns decreases.
   Expectations of price increase	Direct relationship. If the price of the good is expected to increase in the future, there will be an increase in demand.
   Consumer income and wealth	Generally a direct relationship. As consumer income (wealth) goes up the demand for many products (normal goods) goes up. However, there are certain goods that are inferior (e.g., bread, potatoes, etc.) and the demand for such goods actually goes up as consumer income (wealth) goes down. This is because consumers buy more inferior goods when they are short of money.
   Consumer tastes	Indeterminate relationship. The effect depends on whether the shift is towards or away from the product.
   Size of the market	Direct relationship. As the size of the market increases, the demand for the product will increase.
   Group boycott	Inverse relationship. If a group of consumers boycott a product, demand will be decreased.

3. Price elasticity of demand. The elasticity of demand measures the sensitivity of demand to a change in price. It is calculated as follows:

   

   To make results the same regardless of whether there is an increase or decrease in price, the amount is usually calculated using the arc method as shown below.

   

   EXAMPLE

   Assume that you are operating a hot dog stand and sell hot dogs for $2.50. Your usual demand for hot dogs is 200 per day. To increase sales, you decide to run a $1.50 hot dog special and you sell 400 hot dogs for the day. The price elasticity of hot dogs is calculated as follows:

   The change in quantity demanded = 200 (400 − 200)

   The change in price = $1.00 ($2.50 − $1.50)

   The average quantity = 300 [(200 + 400) ÷ 2]

   The average price = $2.00 [($2.50 + $1.50) ÷ 2]

   

   Interpretation of the demand elasticity coefficient. If ED is greater than 1, demand is said to be elastic (sensitive to price changes). If ED is equal to 1, demand is said to be unitary (not sensitive or insensitive to price changes). If ED is less than 1, demand is said to be inelastic (not sensitive to price changes).

   The price elasticity of demand coefficient allows management to calculate the effect of a price change on demand for the product. In the example above, a 10% decrease in the price of a hot dog results in a 13.34% (10% × 1.334) increase in demand. The elasticity of demand is greater for a product when there are more substitutes for the good, a larger proportion of income is spent on the good, or a longer period of time is considered.

   NOTE: The demand for luxury goods tends to be more elastic than for necessities.

4. Relationship between price elasticity and total revenue. Total revenue from the sale of a good is equal to the price times the quantity. Price elasticity is an important concept because if demand is elastic an increase in sales price results in a decrease in total revenue for all producers. If demand is unitary total revenue remains the same if price changes, and total revenue increases if price is increased when demand is inelastic. These relationships are shown in the following table:

   EFFECT OF PRICE CHANGES ON VARIOUS TYPES OF GOODS

   

   In the example of the hot dog stand above, we calculated price elasticity to be 1.334. Therefore, demand is elastic and, as expected, we find that the price decline resulted in an increase in total revenue, $600 ($1.50 × 400) versus $500 ($2.50 ×200).

   Price elasticity is an important concept because it reveals whether the firm is likely to be able to pass on cost increases to its customers. Obviously, when demand is inelastic the firm can increase its price with less of a negative impact.

5. Income elasticity of demand. Income elasticity of demand measures the change in the quantity demanded of a product given a change in income. Income elasticity is calculated as follows:

   

   The income elasticity of demand can be used to describe the nature of the product. The demand for normal products increases as consumer income increases. For example, the demand for normal goods, such as beefsteaks, increases as consumer income increases. Therefore, EI for beefsteaks is positive. The demand for inferior goods, such as beans, decreases as income increases; EI is negative. The demand for inferior goods increases as income declines, because when individuals have less money they substitute these less expensive goods for normal goods.

6. Cross-elasticity of demand. Cross-elasticity of demand measures the change in demand for a good when the price of a related or competing product is changed. For example, Coca Cola Company would be interested in knowing how an increase in the price of Pepsi would affect the sales of Coca Cola. The coefficient of cross-elasticity is calculated as follows:

   

   In our case Pepsi would be Product Y, the competing product with the price change, and Coca Cola would be Product X. The coefficient describes the relationship between the two products. If the coefficient is positive, the products are substitutes (like Pepsi and Coca Cola). If the coefficient is negative, the products are complements (like hamburger and hamburger buns) and if the coefficient is zero, the products are unrelated. The table below illustrates these relationships.

   CROSS-ELASTICITY OF DEMAND

   Coefficient	Relationship between goods
   Coefficient of cross-elasticity positive (Exy > 0)	Substitutes
   Coefficient of cross-elasticity negative (Exy < 0)	Complements
   Coefficient of cross-elasticity zero (Exy = 0)	Unrelated

   EXAMPLE

   Assume that the cross-elasticity of demand for Product X in relation to Product Y is calculated to be 2.00. If the price of Product Y increases by 5%, then the demand for Product X would increase by 10% (5% × 2.00).

7. Consumer demand and utility
   1. As illustrated previously, the demand curve for a particular good is downward sloping. As the price of the good declines, consumers will purchase more because of substitution and income effects. The substitution effect refers to the fact that as the price of a good falls, consumers will use it to replace similar goods. As an example, as the price of pork falls, consumers will purchase more pork than other types of meat. The income effect refers to the fact that as the price of a good falls, consumers can purchase more with a given level of income.
   2. An individual demands a particular good because of the utility (satisfaction) he or she receives from consuming it. The more goods an individual consumes the more total utility the individual receives. However, the marginal (additional) utility from consuming each additional unit decreases. This is referred to as the law of diminishing marginal utility.
   3. A consumer maximizes utility from spending his or her income when the marginal utility of the last dollar spent on each commodity is the same. Utility maximization may be presented mathematically as shown below.

      

   4. To simplify this concept most economics books illustrate marginal utility with only two types of goods (e.g., chocolate bars and cans of soda). They construct a series of indifference curves which illustrate the combinations of chocolate bars and soda that provide equal utility. The optimal level of consumption of the two goods is then found where the individual's budget constraint line intersects the highest possible utility curve. At this point the individual receives the greatest amount of utility for the amount of money available. This relationship is illustrated below.

      

      As illustrated, the individual gets the greatest satisfaction for the funds available at point A.

   5. Consumption decisions depend on many factors but the main one is personal disposable income. This is the amount of income consumers have after receiving transfer payments from the government (e.g., welfare payments) and paying their taxes. When their personal disposable income goes up, consumers buy more. They buy less when it goes down.
   6. The relationship between changes in personal disposable income and consumption is described by a consumption function. The function is typically described as follows:

      

      The important factor from the above function is the slope, c1. It measures the consumer's marginal propensity to consume (MPC) describing how much of each additional dollar in personal disposable income that the consumer will spend. A consumption function is shown graphically below.

      

   7. The marginal propensity to save (MPS) is the percentage of additional income that is saved. Since a consumer can either spend or save money, the marginal propensity to consume plus the marginal propensity to save is equal to one as shown below.

      MPC + MPS = 1

   8. Certain nonincome factors may also affect consumption, including
      • (1) Expectations about future prices of goods
      • (2) Quantity of consumer liquid assets
      • (3) Amount of consumer debt
      • (4) Stock of consumer durable goods
      • (5) Attitudes about saving money
      • (6) Interest rates

C. Supply

A supply curve shows the amount of a product that would be supplied at various prices. Graphically a supply curve shows a direct relationship between price and quantity sold. The higher the price the more products that would be supplied. A supply schedule and supply curve for Product X are presented below.

MARKET SUPPLY FOR PRODUCT X

Price per unit	Quantity supplied
$70	10,000
60	6,000
50	4,000
40	1,800
30	1,000
20	500

A change in the market price of the product results in a shift along the existing supply curve. For example, at $50, the market would supply 4,000 units but if the price changes to $60, the amount supplied will increase to 6,000.

1. Supply curve shift. A supply curve shift occurs when supply variables other than price change. As an example, if the costs to produce the product increase, the supply curve would shift upward and to the left. A shift in the supply curve is illustrated below.

   

2. Variables that cause a supply curve shift include changes in the number or size of producers, changes in various production costs (wages, rents, raw materials), technological advances, and government actions. The effects of these variables are shown in the table below.

   FACTORS AFFECTING THE SUPPLY OF A PRODUCT OTHER THAN ITS PRICE

   Factor	Effect
   Number of producers	Direct relationship. Generally an increase in the number of producers will cause an increase in the amount of goods supplied at a given price.
   Change in production costs or technological advances	Inverse relationship. As production costs go up fewer products will be supplied at a given price. If costs go down, more products will be produced.
   Government subsidies	Direct relationship. Subsidies in effect reduce the production cost of goods and, therefore, increase the goods supplied at a given price.
   Government price controls	Price controls would tend to limit the amount of goods supplied by holding the price artificially low.
   Prices of other goods	Inverse relationship. If other products can be produced with greater returns, producers will produce those goods.
   Price expectations	Direct relationship. If it is expected that prices will be higher for the good in the future, production of the good will increase.

3. Elasticity of supply. The elasticity of supply measures the percentage change in the quantity supplied of a product resulting from a change in the product price. The elasticity of supply is calculated as follows:

   

   • Supply is said to be elastic if E_S > 1, unitary elastic if E_S = 1, and inelastic if E_S < 1.
   • Elastic supply means that a percentage increase in price will create a larger percentage increase in supply.

D. Market Equilibrium

A product's equilibrium price is determined by demand and supply; it is the price at which all the goods offered for sale will be sold (i.e., quantity demanded = quantity supplied). The equilibrium price is the price at which the demand and supply curve intersect as shown below.

1. Government intervention. Government actions may change market equilibrium through taxes, subsidies, and rationing. For example, a subsidy paid to farmers will reduce the cost of producing a particular farm product and, therefore, cause the equilibrium price to be lower than it would be without the subsidy. Import taxes, on the other hand, would increase the cost of an imported product causing the equilibrium price to be higher.
   1. Price ceiling. A price ceiling is a specified maximum price that may be charged for a good. If the price ceiling is set for a good below the equilibrium price, it will cause good shortages because suppliers will devote their production facilities to producing other goods.
   2. Price floor. A price floor is a minimum specified price that may be charged for a good. If the price floor is set for a good above the equilibrium price, it will cause overproduction and surpluses will develop.

   Therefore, we see that government intervention in terms of taxes, subsidies, or price controls interfere with the free market and can result in an inefficient allocation of resources. Too many resources are devoted to certain sectors of the economy at the expense of other sectors.

2. Externalities. Another factor that causes inefficiencies in the pricing of goods in the market is the existence of externalities. Externalities is the term used to describe damage to common areas that is caused by the production of certain goods. A prominent example of an externality is pollution. Because these externalities are not included in the production costs of the goods, the supply is higher and the price is lower than is appropriate. Government laws and regulations (e.g., Environmental Protection Agency regulations) attempt to force firms to change their production methods to make externalities part of the cost of production. This causes the market price of these products to be a more accurate reflection of the cost of the goods to society.
3. The effects of shifts in demand and supply. The effects on equilibrium of shifts in demand and supply are shown in the following graphs.

   

   

   The effects of shifts in demand and supply can be complex especially when both shift simultaneously. The following table describes the effects of these changes:

   Change in demand or supply	Effect
   1. Increase (decrease) in demand, no change in supply	Equilibrium price will increase (decrease) and quantity purchased will increase (decrease)
   2. Increase (decrease) in supply, no change in demand	Equilibrium price will decrease (increase) and quantity purchased will increase (decrease)
   3. Both demand and supply increase (decrease)	Quantity purchased will increase (decrease) and the new equilibrium price is indeterminate
   4. Demand increases and supply decreases	Equilibrium price will increase and quantity purchased is indeterminate.
   5. Demand decreases and supply increases	Equilibrium price will decrease and quantity purchased is indeterminate

E. Costs of Production

1. Short-run total costs
   1. In the short run, firms have both fixed and variable costs. Total fixed costs are those that are committed and will not change with different levels of production. An example of a fixed cost is the rent paid on a long-term lease for a factory. Variable costs are the costs of variable inputs, such as raw materials, variable labor costs, and variable overhead. These costs are directly related to the level of production for the period. In the short run, costs behave as follows:
      • Average fixed cost (AFC)—Fixed cost per unit of production. It goes down consistently as more units are produced.
      • Average variable cost (AVC)—Total variable costs divided by the number of units produced. It initially stays constant until the inefficiencies of producing in a fixed-size facility cause variable costs to begin to rise.
      • Marginal cost (MC)—The added cost of producing one extra unit. It initially decreases but then begins to increase due to inefficiencies.
      • Average total cost (ATC)—Total costs divided by the number of units produced. Its behavior depends on the makeup of fixed and variable costs.
   2. The cause of the inefficiencies described above is referred to as the law of diminishing returns. This law states that as we try to produce more and more output with a fixed productive capacity, marginal productivity will decline. The graph below illustrates the relationships between various short-run costs.

      

2. Long-run total costs
   1. In the long run all inputs are variable because additional plant capacity can be built. If in the long run a firm increases all production factors by a given proportion, there are the following three possible outcomes:
      • Constant returns to scale—Output increases in same proportion.
      • Increasing returns to scale—Output increases by a greater proportion.
      • Decreasing returns to scale—Output increases by a smaller proportion.
   2. In many industries, especially those that are capital intensive, increasing returns to scale occur up to a point, generally as a result of division of labor and specialization in production. However, beyond a certain size, management has problems controlling production and decreasing returns to scale arise. The following graph illustrates a long-run average total cost (ATC) curve which begins with increasing returns to scale (A), and proceeds to constant returns to scale (B), and eventually decreasing returns to scale (C) as the firm grows.

   

3. Profits. Economists refer to two different types of profit.
   1. Normal profit—The amount of profit necessary to compensate the owners for their capital and/or managerial skills. It is just enough profit to keep the firm in business in the long run.
   2. Economic profit—The amount of profit in excess of normal profit. In a perfectly competitive market, economic profit cannot be experienced in the long run.

F. Production

1. Management makes production decisions based on the relationship between marginal revenue and marginal cost. Marginal revenue is the additional revenue received from the sale of one additional unit of product. A good should be produced and sold as long as the marginal cost (MC) of producing the good is less than or equal to the marginal revenue (MR) from sale of that good. This relationship is shown in the following graph.

   

2. The price of input resources (e.g., labor, raw materials, etc.) is determined by demand and supply. If the price of an input increases, demand will decline. On the other hand, demand will increase if the price declines. In making decisions about the employment of resources, management considers the marginal product for each input resource. The marginal product is the additional output obtained from employing one additional unit of a resource. The change in total revenue from employing one additional unit of a resource is referred to as the marginal revenue product.

   EXAMPLE

   Thorp Corporation produces Product G and has developed the following chart illustrating relationships between number of workers producing the product, the number of units produced, and the revenue generated.

   

   The marginal product of employing the 6th worker is equal to 19 (139 − 120), and the marginal revenue product is equal to $35,000 ($275,000–$240,000).

3. The marginal revenue per-unit is calculated by dividing the marginal revenue product by the increase in products produced by employing one additional unit of resource. Using the above example of employing a 6th worker, the marginal revenue per-unit is equal to $1,842.11 [$35,000 (marginal revenue product) ÷ 19 (139 − 120) increase in products produced].
4. To be competitive management must produce the optimal output in the most efficient manner. The cost of production in the long run is minimized when the marginal product (MP) per dollar of every input (resource) is the same. Similar to utility maximization for a consumer, the least cost formula is

   

G. Market Structure

1. Industries are often classified by their market structure as perfect competition, pure monopoly, monopolistic competition, and oligopoly.
   1. Perfect (pure) competition
      • (1) An industry is perfectly competitive if
        • (a) It is composed of a large number of sellers, each of which is too small to affect the price of the product or service
        • (b) The firms sell a virtually identical product
        • (c) Firms can enter or leave the market easily (i.e., no barriers to entry)

        There are few perfectly competitive markets; common examples include the commodity markets, such as markets for wheat, soybeans, and corn.

      • (2) In this market, the firm's demand curve is perfectly elastic (horizontal). The firm can sell as many goods as it can produce at the equilibrium price but no goods at a higher price. The firm is a price taker. The market demand curve is downwards sloping. Therefore, demand will increase if all suppliers lower prices and will decrease if all suppliers raise their prices.
      • (3) In a perfectly competitive market a firm will continue to produce and sell products until the margin cost is greater than marginal revenue.
      • (4) Theoretically, no economic profits can be generated in the long run. The price will reflect the costs plus the normal profit of the most efficient producers.
      • (5) In a perfectly competitive market there is no product differentiation and the key to being successful is being the lowest cost producer in the marketplace. Innovation is restricted to attempting to make production, distribution, and sales processes more efficient.
   2. Pure monopoly
      • (1) A pure monopoly is a market in which there is a single seller of a product or service for which there are no close substitutes. A monopoly may exist for one or more of the following reasons:
        • (a) Increasing returns to scale
        • (b) Control over the supply of raw materials
        • (c) Patents (e.g., a drug manufacturer)
        • (d) Government franchise (e.g., a public utility)
      • (2) Monopolies that exist when economic or technical conditions permit only one efficient supplier are called natural monopolies.
      • (3) The monopolist sets the price for the product (unless it is set by regulation). The demand curve for the firm is negatively sloping; the company must reduce price to sell more output. The firm will continue to produce and sell products as long as the marginal revenue is greater than average variable cost.
      • (4) Entry barriers make it possible for the firm to make economic profit in the long run.
      • (5) In a pure monopoly, the company has little market incentive to innovate or control costs. The company has no market control on the price it charges. As a result pure monopolies are generally subject to government regulation. Price boards generally review the company's prices and costs. From a strategic standpoint monopolistic firms want to create a positive image with the public to forestall additional regulation. Therefore any advertising expenditures they incur tend to be for public relations. These firms also spend a lot of effort attempting to influence laws and regulations. They can increase total revenue if they can engage in price discrimination by market segment (e.g., charging business customers more than individual customers).
      • (6) The US government has passed legislation to discourage the development of monopolies because prices are higher and output less in such markets as compared to competitive markets. These laws include the Sherman Act of 1890, the Clayton Act of 1914, the Robinson-Patman Act of 1936, and the Celler-Kefauver Anti-Merger Act of 1950.
   3. Monopolistic competition
      • (1) Monopolistic competition is characterized by many firms selling a differentiated product or service. The differentiation may be real or only created by advertising, and there is relatively easy entry to the market but not as easy as in a perfectly competitive market. This type of market is prevalent in retailing, including the markets for groceries, detergents, and breakfast cereals.
      • (2) The demand curve in a monopolistic competitive market is negatively sloped and firms tend to produce and sell products until the marginal revenue is less than average variable cost. Therefore, goods tend to be priced somewhat higher than in a perfectly competitive market but less than in a monopoly. Also, there tends to be underproduction as compared to a perfectly competitive market.
      • (3) The strategies of firms in monopolistic competitive markets tend to focus on product or service innovation. Companies may spend heavily on product development. Customer relations and advertising necessarily are important to firm strategies.
   4. Oligopoly
      • (1) Oligopoly is a form of market characterized by significant barriers to entry. As a result there are few (generally large) sellers of a product. Because there are few sellers the actions of one affect the others. As a result, game theory is often used to analyze the behavior of the firms. An example of an oligopoly is the automobile industry. Other examples are found in the production of steel, aluminum, cigarettes, personal computers, and many electrical appliances.
      • (2) Oligopolists often attempt to engage in nonprice competition (e.g., by product differentiation or providing high levels of service). However, during economic downturns and periods of overcapacity, price competition in an oligopolistic market can turn fierce.
      • (3) The kinked-demand-curve model seeks to explain the price rigidity in oligopolistic markets. This model holds that the demand curve is kinked down at the market price because other oligopolists will not match price increases but will match price decreases. Generally, in the oligopolistic market there is a price leader that determines the pricing policy for the other producers.
      • (4) If left unregulated, ologopolists tend to establish cartels that engage in price fixing. Regulations in the US prohibit collusion by firms to set prices.

MACROECONOMICS

A. Focus

Macroeconomics looks at the economy as a whole. It focuses on measures of economic output, employment, inflation, and trade surpluses or deficits. It also examines the spending of the three major segments of the economy, consumers, business, and government. The levels of economic activity is measured using a number of benchmarks, including

• Nominal Gross Domestic Product (GDP)—The price of all goods and services produced by a domestic economy for a year at current market prices.
• Real GDP—The price of all goods and services produced by the economy at price level adjusted (constant) prices. Price level adjustment eliminates the effect of inflation on the measure.
• Potential GDP—The maximum amount of production that could take place in an economy without putting pressure on the general level of prices. The difference between potential GDP and real GDP is called the GDP gap. When it is positive, it indicates that there are unemployed resources in the economy and we would expect unemployment. Alternatively, when it is negative, it indicates that the economy is running above normal capacity and prices should begin to rise.
• Net Domestic Product (NDP)—GDP minus depreciation.
• Gross National Product (GNP)—The price of all goods and services produced by labor and property supplied by the nation's residents.

1. There are two ways to calculate GDP: the income approach and the expenditure approach.
   1. The income (output) approach adds up all incomes earned in the production of final goods and services, such as wages, interest, rents, dividends, etc.
   2. The expenditure (input) approach adds up all expenditures to purchase final goods and services by house-holds, businesses, and the government. Specifically, it includes personal consumption expenditures, gross private investment in capital goods (e.g., machinery). It also includes the country's net exports. The tables below illustrate these computations.

      THE INCOME SIDE OF GDP

      

      

      THE PRODUCT SIDE OF GDP

      

B. Aggregate Demand and Supply

1. An aggregate demand curve depicts the demand of consumers, businesses, and government as well as foreign purchasers for the goods and services of the economy at different price levels. The aggregate demand curve looks like the demand curve for a single product (presented above); it is inversely related to price level. The price level affects aggregate demand for several reasons.
   1. Interest rate effect—As price levels increase (inflation increases) nominal interest rates increase causing a decrease in interest sensitive spending. Interest sensitive spending includes spending for items such as houses, automobiles, and appliances.
   2. Wealth effect—When price levels increase, the market value of certain financial assets decreases (e.g., fixed rate bonds) causing individuals to have less wealth and therefore they reduce their consumption.
   3. International purchasing power effect—When domestic price levels increase relative to foreign currencies, foreign products become less expensive causing an increase in imported goods and a decrease in exported goods. This decreases the aggregate demand for domestic products.
2. An aggregate demand curve shifts when consumers, businesses, or governments are willing to spend more or less, or when there is an increase or decrease in the demand for domestic products abroad (i.e., an increase or decrease in net exports). Government can affect aggregate demand through its own spending levels, taxes, and monetary policy. For example, a reduction in individual or corporate taxes increases the spendable income of consumers or businesses. This would be expected to increase spending.
3. An aggregate supply (output) schedule presents the relationship between goods and services supplied and the price level, assuming that all other variables that affect supply are held constant. While there is not complete agreement on the shape of the aggregate supply curve, it is generally depicted as shown below.

   

   As shown, prices remain relatively constant until the economy reaches near capacity, at which time prices begin to increase at a significant rate. Shifts in the aggregate supply curve may be caused by technology improvements, changes in resource availability, or changes in resource costs.

4. Equilibrium GDP occurs when the output level of the economy creates just enough spending to purchase the entire output.
5. The multiplier. The multiplier refers to the fact than an increase in spending by consumers, businesses, or the government has a multiplied effect on equilibrium GDP. The reason for this is that increased spending generates increases in income to businesses and consumers which in turn increases their spending, which again increases the income of other consumers and businesses, etc. Therefore, the increased spending ripples through the economy increasing GDP by much more than the original increase in spending. The effect of the multiplier can be estimated by examining an economy's marginal propensity to consume (MPC) and marginal propensity to save (MPS). From our previous discussion we know that additional income is either spent or saved as shown below.

   MPS + MPC = 1

   The multiplier may be calculated from the following formula:

   

C. Business Cycles

1. A business cycle is a fluctuation in aggregate economic output that lasts for several years. Business cycles are recurring but vary in terms of both length and intensity. They are depicted as a series of peaks and troughs. A peak marks the end of a period of economic expansion and the beginning of a recession (contraction) while a trough marks the end of a recession and the beginning of an economic recovery (expansion). The chart below illustrates the nature of the business cycle.

   

2. Economic contractions are characterized by a decrease in real gross domestic product (GDP) due to reduced spending. In a period of expansion, real GDP is increasing. At the peak real GDP generally surpasses potential GDP causing a scarcity of labor and materials. These shortages generally cause inflation.
3. Unemployment and Output—In most cases, there is a clear relationship between the change in unemployment and GDP growth, as explained by Okum's law. High output growth is generally associated with a decrease in the unemployment rate. This makes perfect sense because when output increases less.
4. A recession is a period of negative GDP growth. Usually, recession refers to at least two consecutive quarters of negative GDP growth. A deep and long-lasting recession is referred to as a depression.
5. There are a number of explanations for the occurrence of business cycles but they generally relate to the level of investment spending by businesses, or the level of consumer spending for durable goods (e.g., automobiles and appliances). The effects of a business cycle vary by business sector. For obvious reasons, heavy manufacturing is one of the sectors that is most affected. Such businesses are referred to as cyclical businesses because they perform better in periods of expansion and worse in periods of recession. Some business sectors are called defensive because they are affected little by business cycles and some may actually perform better in periods of recession.
6. Economists attempt to predict business cycles using economic indicators. Some indicators lead future economic trends, others coincide with economic trends, and still others lag economic trends. The Conference Board, a private research group, has developed the following list of indicators:
   1. Leading indicators
      • Average weekly hours, manufacturing
      • Average weekly initial claims for unemployment insurance
      • Manufacturer's new orders, consumer goods and materials
      • Vendor performance, slower deliveries diffusion index
      • Manufacturer's new orders, nondefense capital goods
      • Building permits, new private housing units
      • Stock prices, 500 common stocks
      • Money supply, M2
      • Interest rate spread, 10-year Treasury bonds less federal funds
      • Index of consumer expectations
   2. Coincident indicators
      • Employees on nonagricultural payrolls
      • Personal income less transfer payments
      • Industrial production
      • Manufacturing and trade sales
   3. Lagging indicators
      • Average duration of unemployment
      • Inventories to sales ratio, manufacturing and trade
      • Labor cost per unit of output, manufacturing
      • Average prime rate
      • Commercial and industrial loans
      • Consumer installment credit to personal income ratio
      • Consumer price index for services
7. Investment. Investment includes expenditures for residential construction, inventories, and plant and equipment. The most important determinant of business investment is expectations about profitability. Accordingly, the following factors affect investment spending:
   1. The rate of technology growth. In periods of high technology growth, firms tend to invest more because new products and innovations tend to be more profitable.
   2. The real interest rate (nominal rate minus the inflation premium). Lower real interest rates reduce the cost of investment.
   3. The stock of capital goods. If there are already enough capital goods in the economy to meet aggregate demand there is little incentive to invest.
   4. Actions by the government. Government fiscal policy can be used to stimulate investment spending (e.g., reductions in taxes, tax incentives, or increased government spending).
   5. The acquisition and operating cost of capital goods. As the purchase price or operating cost of plant and equipment decreases, firms will invest more.

   Investment spending is the most volatile portion of GDP. Autonomous investment includes expenditures made by businesses based on expected profitability that are independent of the level of national income. That is, they are constant regardless of whether the economy is expanding or contracting. Induced investment is incremental spending based on an increased level of economic activity.

8. Accelerator theory. Accelerator theory states that as economic activity increases, capital investment must be made to meet the level of increased demand. The increased capital investment in turn creates additional economic demand which further feeds the economic expansion.

D. Economic Measures

Previously we described several important measures of economic activity: GDP, GNP, etc. In this section we will describe other economic measures, such as rates of unemployment, inflation, and personal disposable income.

1. Unemployment

   The unemployment rate is the percent of the total labor force that is unemployed at a given time. Individuals may be unemployed because of frictional, structural, or cyclical causes.

   1. Frictional unemployment occurs because individuals are forced or voluntarily change jobs. At any point in time some individuals will be temporarily unemployed while they look for a job. New entrants into the workforce also fall into this category.
   2. Structural unemployment occurs due to changes in demand for products or services, or technological advances causing not as many individuals with a particular skill to be needed. Structural unemployment is reduced by retraining programs.
   3. Cyclical unemployment is caused by the condition in which real GDP is less than potential GDP. Therefore, such unemployment increases during recessions and decreases during expansions.
2. Inflation
   1. Inflation is the rate of increase in the price level of goods and services, usually measured on an annual basis. Hyperinflation is a very high, unusually increasing level of inflation.
   2. Deflation is a term used to describe a decrease in the price levels. While Japan has experienced deflation in prices recently, the US has not experienced an annual rate of decrease in price level since the 1930s. Deflation is very damaging because businesses do not want to borrow money and pay it back with money that has more purchasing power, and they do not want to invest in plant and equipment given that the cost of plant and equipment is declining.
   3. High rates of inflation are not good for the economy either. Inflation generally causes economic activity to contract and redistributes income and wealth.
   4. A price index measures the prices of a basket of goods and/or services at a point in time in relation to the prices in a base period.
      • (1) The consumer price index (CPI) measures the price that urban consumers paid for a fixed basket of goods and services in relation to the price of the same goods and services purchased in some base period.
      • (2) The producer price index (PPI) measures the prices of finished goods and materials at the wholesale level.
      • (3) The GDP deflator measures the prices for net exports, investment, government expenditures, and consumer spending. It is the most comprehensive measure of price level.
3. Causes of inflation. There are generally two causes for inflation that are commonly referred to as demand-pull and cost-push.
   1. Demand-pull inflation occurs when aggregate spending exceeds the economy's normal full-employment output capacity. It generally occurs at the peak of a business cycle and is characterized by real GDP exceeding potential GDP. Because labor is short companies bid up the price and inflation occurs.
   2. Cost-push inflation occurs from an increase in the cost of producing goods and services. It is usually characterized by decreases in aggregate output and unemployment because consumers are not willing to pay the inflated prices.

   There is an inverse relationship between inflation and unemployment. When the unemployment rate is low, inflation tends to increase. Inflation tends to decrease when the unemployment rate is high. This relationship is depicted by the Phillips curve.

4. Personal disposable income is the amount of income that individuals receive and have available to purchase goods and services. Personal disposable income has a significant effect on the economy because it is a large determinant of consumer demand. Personal disposable income is equal to personal income minus personal taxes.
5. Interest rates. Interest is the price paid for the use of money. Economists typically focus on the risk-free or pure rate of interest. In practice, interest rates are also affected by credit risk, maturity, and administrative costs. As with other commodities, interest rates are determined by demand and supply. The intersection of the demand and supply curves for money determines the equilibrium price or interest rate. On the demand side, firms borrow money to make investments in assets and will continue to borrow as long as investment return exceeds the interest rate at which the funds are borrowed. The supply of funds is affected by the past and current savings of individuals and firms, but it is also affected by the monetary policy of the government. Interest rates are often quoted as
   1. Real interest rate—Interest rate in terms of goods. These rates are adjusted for inflation.
   2. Nominal interest rate—Interest rate in terms of the nation's currency. These are the rates that are quoted by financial institutions and in the financial pages of newspapers. The difference between the real rate and the nominal rate is the inflation premium, which represents the expected inflation rate. The higher the expected inflation rate the larger the inflation premium. The interest rate charged to a particular business or individual will be higher than the nominal rate due to credit risk, which is the risk that the firm will not pay the interest or principal of the loan.
6. Government budget surplus (deficit)—The excess (deficit) of government taxes in relation to government transfer payments and purchases. To finance a deficit the government issues debt (e.g., Treasury bonds).
7. Money. Money in an economy serves three major purposes—a medium of exchange; a common denominator to measure prices, revenue, expenses, and income; and a store of value allowing individuals and firms to save. Economists use three basic measures of money, M1, M2, and M3. M1 includes only currency and demand deposits, M2 is equal to M1 plus savings accounts and small-time deposits (less $100,000), and M3 is equal to M2 plus other (larger) time deposits. In regulating the economy the Federal Reserve focuses on M2.

E. Monetary Policy

Depository institutions (banks, savings and loans, and credit unions, etc.) borrow savers' money and lend the money to consumers, businesses, and governments. The Federal Reserve (the US central bank), through its open market controls the actions of depository institutions and can affect the supply of money in the following ways:

1. Reserve requirements. When a bank lends money, it gives the borrower a check drawn on the bank itself. The Federal Reserve controls a bank's ability to issue check-writing deposits by imposing a reserve requirement on checking deposits. The institution must hold in reserve (much of which is on deposit at a Federal Reserve Bank) a certain percentage of their total checking deposits. The Federal Reserve can influence interest rates by changing the reserve requirements and therefore increasing or decreasing the supply of money. However, making changes in reserve requirements is rarely done.
2. Open-market operations. A more common instrument of monetary policy is open-market operations (by the Federal Open-Market Committee), which involves the purchase or sale of government securities using the Federal Reserve Bank deposits. If the Federal Reserve purchases government securities, they are able to increase the monetary supply and, therefore, put downward pressure on interest rates. When a central bank is purchasing government securities and expanding the money supply, it is called an expansionary open-market operation. If a central bank is selling government securities it is said to be pursuing a contractionary open-market operation, because this reduces the money supply.
3. The discount rate. When a bank has a reserve deficiency it may borrow funds from a Federal Reserve Bank. By setting the discount rate for such borrowing, the Federal Reserve can influence interest rates in the economy.
4. Economic analysis. In making its monetary decisions, the Federal Open-Market Committee does extensive economic analysis. In speeches by the members and when providing the basis for its decisions insights are provided into the state of the economy. This information also may have an effect on economic factors such as interest rates, business spending, and the stock prices.
5. The Federal Reserve uses monetary policy to attempt to sustain economic growth while keeping inflation under control. Monetary policy works on the principle that a decrease in interest rates will stimulate the economy, and an increase in interest rates will slow the economy. Lower interest rates tend to encourage consumer and business spending because finance charges are lower. Higher interest rates tend to discourage spending because finance charges are higher. It also encourages saving because the return on savings is higher.
6. The effects of monetary policy depend on their effects on the expectations of investors, businesses, and consumers. If monetary expansion leads the financial markets to revise their expectations about inflation, interest rates and output, the effect on output will be dramatic. On the other hand, if expectations remain unchanged, the effects will be minimal.
7. Rational expectations assume that investors, firms, and consumers develop expectations about inflation, interest rates, and output based on a consideration of all available information. This is contrasted to adaptive expectations in which investors, firms and consumers adjust their expectations based on new information. As an example, if they find that inflation is higher than expected, they adjust their expectation upward.

F. Fiscal Policy

Fiscal policy is government actions, such as taxes, subsidies, and government spending, designed to achieve economic goals. As an example, a reduction of taxes increases personal disposable income, which will serve to stimulate economic activity. The economy may also be stimulated through increased government spending. An increase in deficit, either due to an increase in government spending or to a decrease in taxes, is called a fiscal expansion. On the other hand, increases in taxes to reduce a deficit is called fiscal contraction.

1. Taxes. Taxes are levied by a government based on two general principles: (1) the ability to pay (e.g., progressive income taxes), and (2) derived benefit (e.g., gasoline taxes used to pay for roads). The following are the major types of taxes:
   1. Income tax. Income taxes are levied on taxable income. In the US the rate structure is generally progressive. However, there are a number of social and economic incentives built into the system that dilute its progressive structure.
   2. Property tax. Property taxes are levied based on wealth. They generally are progressive based on the value of the property.
   3. Sales tax. Sales taxes are levied based on the amount of income spent. Sales taxes are viewed as regressive because low-income individuals pay the same percentage rate as high-income individuals.
   4. Wage taxes. The most significant wage tax in the US is the social security tax. This tax is borne both directly (the employee's share) and indirectly (the employer's share) by employees because without the tax, wages would be higher.
   5. Value-added tax. A tax commonly used in other industrial nations is the value-added tax (VAT). Value-added taxes are levied on the increase in value of each product as it proceeds through production and distribution processes. Ultimately, the tax is paid by the final consumer. The VAT is thought to encourage savings because it taxes consumption instead of earnings.
2. Both monetary and fiscal policy take time to have the desired effects for a number of reasons, including
   1. Consumers take time to adjust their consumption based on changes in personal disposal income
   2. Firms take time to adjust investment based on changes in sales
   3. Firms take time to adjust spending based on changes in interest rates
   4. Firms take time to adjust production based on changes in sales
3. Fiscal policies can have a large effect on the size of budget deficits. In the long and medium run, a budget deficit reduction is likely to be beneficial to the economy. Lower budget deficits usually mean more savings and investment, and therefore, more output. In the short run, a reduction in budget deficit leads to reductions in spending and therefore less output.

G. Economic Theories

1. Classical economic theory—This theory holds that market equilibrium will eventually result in full employment over the long run without government intervention. This theory does not support the use of fiscal policy to stimulate the economy.
2. Keynesian theory—This theory holds that the economy does not necessarily move towards full employment on its own. It focuses on the use of fiscal policy (e.g., reductions in taxes and government spending) to stimulate the economy.
3. Monetarist theory—This theory holds that fiscal policy is too crude a tool for control of the economy. It focuses on the use of monetary policy to control economic growth.
4. Supply-side theory—This theory holds that bolstering an economy's ability to supply more goods is the most effective way to stimulate growth. A decrease in taxes (especially for businesses and individuals with high income) increases employment, savings, and investments and is an effective way to stimulate the economy. The tax revenue lost from the reduction in taxes is more than offset by the increase in taxes from increased economic activity. However, this predicted effect only occurs when rates are too high. The Laffer Curve attempts to explain how consumers react to changes in rates of income tax. The curve illustrates that if taxes are already too low decreasing them will result in less tax revenue.
5. Neo-Keynesian theory—This theory combines Keynesian and monetarist theories. It focuses on using a combination of fiscal and monetary policy to stimulate the economy and control inflation.

H. The Global Economy and International Trade

Economic globalization refers to the increasing economic interdependence of national economies across the world through a rapid increase in cross-border movement of goods, service, technology and capital. It has led to a single world market in which developed economies have integrated with less developed countries by means of foreign direct investment, the reduction of trade barriers, and the modernization of the developing countries. The comparative advantages of natural resources or low-cost labor attract businesses and capital to developing (emerging) economies.

International trade is very important to almost every business. If a country has an absolute advantage (e.g., low-cost labor, technology) in the production of a particular good, there is an incentive for that country to produce more than its citizens need to export the good to countries with higher production costs. This is especially true if it also has a comparative advantage to producing the good. A comparative advantage means that country has no alternate uses of its resources that would involve a higher return (i.e., the opportunity costs are less). In the long term, production of specific goods and services will migrate to countries that have a comparative advantage. By exploiting its comparative advantages and exporting goods and services, a nation can import the goods for which it has a comparative disadvantage. In this manner all nations will be better off.

Michael Porter developed a “diamond of national advantage” to explain how a country can create new advanced factor endowments that contribute to the country's comparative advantage. The four points of the diamond can be described as

• Factor Conditions—A country can create its own important factors such as skilled resources and technology infrastructure. The stock of factors at a given time is less important than the country's potential. A country can overcome shortages of factors through innovation.
• Demand Conditions—A country has a comparative advantage for a particular product when it has a strong domestic market because the firms in the country devote more attention to the product than in other countries.
• Related and Supporting Industries—A country has a comparative advantage for a product when the supporting industries are strong because of the cost effective and innovative inputs that result.
• Firm Strategy, Structure, and Rivalry—Different types of comparative advantages accrue from different business organizational structures (e.g., hierarchal, matrix, extended family structures). Also, intense rivalry of an industry in a country tends to lead to a competitive advantage for that country's industry globally.

1. Obstacles to free trade. Even though trade can be a source of major gains, many nations restrict free trade by various means, for example by imposing tariffs and quotas. That is, they engage in protectionism. An import tariff is a tax on an imported product. Tariffs are designed to discourage the consumption of goods from foreign companies or to raise revenue, or both. A trigger price mechanism automatically imposes a tariff barrier against cheap imports by imposing a duty on all imports below a trigger price. An import quota is a restriction on the amount of a good that may be imported during a period. Finally, an embargo is a total ban on the importation of specific goods.

   An exporting country may elect to establish a voluntary export restraint to limit the quality of goods that can be exported to appease importing countries and keep them from imposing stiffer import restrictions.

   Another barrier to trade that a country may impose is a foreign-exchange control. A foreign exchange control is a control imposed by a government on the purchase or sale of foreign currencies by residents, or on the purchase or sale of local currency by nonresidents. Examples of such controls include

   1. Banning the use of foreign currency in the country.
   2. Banning possession of foreign currency by citizens.
   3. Restricting currency exchange to government-approved exchangers.
   4. Fixed exchange rates.

   Trade restrictions are advocated by labor unions and firms making products that are more inexpensively produced in other nations. Thus, trade restrictions generally impose a burden on society as a whole because they reduce the availability of goods and increase their prices. Arguments in favor of trade restrictions include

   1. To protect domestic labor against inexpensive foreign labor
   2. To reduce domestic unemployment
   3. To protect young or infant industries
   4. To protect industries important to the nation's defense

   Other arguments against unrestricted trade include the fact that the businesses of developed nations are disadvantaged by social laws in their countries that do not exist in developing countries (e.g., laws restricting pollution, child labor, minimum wage, etc.), and by disproportionate taxing of domestic manufacturing.

   Trade restrictions in the US are advocated by labor and firms in the US in industries that have lost their competitive advantage, such as producers of shoes, textiles, and steel. Some firms and industries in the US have been able to regain their competitive advantage through the introduction of new technology.

   Most of the arguments for trade restrictions are not valid. Trade restrictions generally have negative effects in that economic activity is inappropriately shifted to less-productive protected industries, resulting in a decline in total world output.

2. Dumping. A dumping pricing policy is a form of predatory pricing in which a manufacturer in one country exports a product at a price that is lower than the price charged in its home market or below the company's cost of production. Under the World Trade Organization (WTO) Agreement, dumping is condemned (not prohibited) if it causes material injury to a domestic industry in the importing country. US firms can file an antidumping petition with the International Trade Organization when products are being sold at less than “fair value,” as defined by Department of Commerce regulations. If the firm's case is proved, antidumping duties may be imposed on goods imported from the dumper's country.
3. Export subsidies are payments made by a government to encourage the production and export of specific products. Such payments may be made in various ways, including special tax benefits. Countervailing duties are duties imposed by an importing country to neutralize the negative effects of export subsidies.
4. The World Trade Organization (WTO) is an organization of countries designed to supervise and liberalize trade among participating countries. It facilitates trade agreements among participants and provides a resolution process to enforce the agreements. Under the WTO provisions, members afford all other members favored nation status, which means a member country will not establish trade barriers that discriminate against other members.
5. North American Free Trade Agreement (NAFTA)
   1. NAFTA is a free trade agreement between the countries of Canada, Mexico, and the US. It was adopted by the US Congress in 1993. NAFTA offers a number of advantages for US businesses including
      • (1) The ability to take advantage of the lower labor costs in Mexico for such functions as manufacturing and assembly.
      • (2) The opening of new markets for goods of US industries that have a comparative advantage, such as technology.
   2. Disadvantages to US businesses and labor markets include
      • (1) Some US industries, such as producers of shoes and apparel, are concerned that the firms will be hurt by the availability of less expensive products from Mexico.
      • (2) Certain jobs in the US will be lost because of the availability of lower-cost labor in Mexico combined with more lax environmental laws and regulations.
6. Balance of payments. The balance of payments is an account summary of a nation's transactions with other nations. It has three major sections: the current account, the capital account, and the official reserve account.
   1. Current account—Shows the flow of goods and services and government grants for a period of time.
      • (1) The balance of trade for a period is the difference between the total goods exported and the total goods imported.
      • (2) The balance on goods and services is the difference between the total value of goods and services exported and the total value of goods and services imported.
      • (3) When a nation exports more than it imports a trade surplus occurs.
      • (4) When a nation imports more than it exports a trade deficit occurs.
   2. Capital account—Shows the flow of investments in fixed and financial assets for a period of time.
   3. The balance of payments surplus or deficit is the amount that nets the current and capital accounts. In other words, when the sum of the outflows exceeds the inflows a deficit in balance of payment occurs. The deficit is settled in currency of other nations, or by an increase in the holdings of the nation's currency by other nations. A deficit is an unfavorable balance of payments while a surplus is a favorable balance of payments.
   4. Official reserve account—Shows the changes in the nation's reserves (e.g., gold and foreign currency).
7. The G-20 is a group of finance ministers and central bank governors from 20 economies (the European Union and 19 countries). It studies, reviews, and promotes discussion of policy issues affecting global financial stability, and seeks to address issues that go beyond the responsibilities of its individual members.
8. The European Union (EU) is an economic and political union of 27 countries primarily in Europe. The EU has developed a single market through a standardized system of laws that apply to all member countries. An economic and monetary union known as the eurozone (officially the euro area) is composed of 17 member countries that use the euro currency. The European Central Bank establishes monetary policy for the members of the eurozone.
9. Globalization has been facilitated by a number of factors, including the development of global financial institutions, reductions in trade and investment barriers, and technology. The major global institutions include
   1. The World Bank has the objective of promoting world-wide economic development.
   2. The International Monetary Fund has the objective of maintaining order in the international monetary system by preventing currency, banking, and financial debt crises.
10. Reduction in Trade and Investment Barriers
    1. Reduction in trade barriers can be traced to the establishment of the General Agreement on Tariffs and Trade (GATT).
    2. Reduction by countries on foreign direct investment (FDI).
11. Technology advances—improvements in information technology and transportation make global communication and movement of goods more economical.

I. Foreign Exchange Rates

Firms that do business internationally must be concerned with exchange rates, which are the relationships among the values of currencies. For example, a US firm selling products in Europe is very interested in the relationship of the euro to the US dollar.

1. Factors influencing exchange rates. As with any other market, the exchange rate between two currencies is determined by the supply of, and the demand for, those currencies. However, these rates are also subject to intervention by the central banks of countries. Therefore, exchange rates are often said to be determined by managed float. In general, the following factors will affect the exchange rate of a particular currency:
   1. Inflation. Inflation tends to deflate the value of a currency because holding the currency results in reduced purchasing power.
   2. Interest rates. If interest returns in a particular country are higher relative to other countries, individuals and companies will be enticed to invest in that country. As a result there will be increased demand for the country's currency.
   3. Balance of payments. Balance of payments is used to refer to a system of accounts that catalogs the flow of goods between the residents of two countries. If country X is a net exporter of goods and therefore has a surplus balance of trade, countries purchasing the goods must use country X's currency. This increases the demand for the currency and therefore its relative value.
   4. Government intervention. Through intervention (e.g., buying or selling the currency in the foreign exchange markets), the central bank of a country may support or depress the value of its currency.
   5. Other factors. Other factors that may affect exchange rates are political and economic stability, extended stock market rallies, or significant declines in the demand for major exports.
2. The exchange rate regime is the way a country manages its currency in respect to currencies of other countries. The basic types of exchange rate regimes include
   1. Floating exchange rate—One in which the exchange rate is dictated by market factors as described previously.
   2. Pegged exchange rate—One in which the country's central bank keeps the rate from deviating too far from a target band or value.
   3. Fixed exchange rate—One in which the rate is tied to the value of another currency, such as the US dollar or the euro.
   4. Managed exchange rate—One in which the country's central bank attempts to control the movement in currency value.
3. Spot rates and forward rates. The spot rate for a currency is the exchange rate of the currency for immediate delivery. On the other hand, the forward rate is the exchange rate for a currency for future delivery. For example, a forward contract might obligate a company to purchase or sell euros at a specific exchange rate three months hence. The difference between the spot rate and the forward rate is referred to as the discount or premium. If the forward rate is less (greater) than the spot rate, the market believes that the value of the currency is going to decline (increase).

   EXAMPLE

   Assume that a multinational company sells products to a French company for a receivable payable in 60 days in the amount of 10,000 euros. If at the time of the sale the exchange rate is 1.25 US dollars to the euro, the sale is equal to $12,500 (1.25 × 10,000). If the euro depreciates by 2% against the US dollar in the 60-day period between the sale and collection, the firm has experienced a loss. The 2% depreciation would mean that the new exchange rate is 1.225 (1.25 × 98%) euros to the US dollar. Therefore, the firm has lost $12,500 − $12,250 (1.225 × 10,000) = $250.

4. The forward premium or discount of one currency with respect to another is calculated using the following formula:

   

   EXAMPLE

   Assume the 180-day forward rate for the British Pound is $1.612 and the spot rate is $1.610. The forward premium is calculated to be 0.5% {[($1.612 − $1.610) / $1.610] × (360 days/180 days)}. Note that the result is a premium because the forward rate is higher than the spot rate.

5. The foreign exchange risk for a multinational company is divided into two types: translation (accounting) risk and transaction risk. Translation risk is the exposure that a multinational company has because its financial statements must be converted to its functional currency.
6. Transaction risk relates to the possibility of gains and losses resulting from income transactions occurring during the year. The example above involving the sale of goods for a receivable in euros illustrates transaction risk. Transaction risk can cause volatility in reported earnings that motivates management to use strategies to minimize the company's exposure. Companies can use various forms of contracts to hedge foreign currency risk, including
   1. Options—Allow, but do not require, the holder to buy (call) or sell (put) a specific or standard commodity or financial instrument, at a specified price during a specified period of time (American option) or at a specified date (European option).
   2. Forwards—Negotiated contracts to purchase and sell a specific quantity of a financial instrument, foreign currency, or commodity at a price specified at origination of the contract, with delivery and payment at a specified future date.

      EXAMPLE

      Assume that Company X has agreed to deliver 20,000 units of product in six months to a Japanese company who will pay for the product in yen. To mitigate the risk of losses from devaluation of the yen, Company X could enter into a forward contract to sell the yen for delivery in six months. This contract in effect locks in the price for the sale in terms of US dollars. Alternatively, Company X could purchase a put option allowing them to put the yen up for sale at a specific price in six months.

   3. Futures—Forward-based standardized contracts to take delivery of a specified financial instrument, foreign currency, or commodity at a specified future date or during a specified period generally at the then-market price.
   4. Currency swaps—Forward-based contracts in which two parties agree to exchange an obligation to pay cash flows in one currency for an obligation to pay in another currency.
   5. Money market hedge—A second way to eliminate the transaction risk described in b. is to borrow money in yen when the agreement is executed. This strategy immediately converts the yen to US dollars. Then, when the yen are collected from the sale, the loan can be repaid, resulting in no foreign exchange loss or gain over the six-month period.

J. Foreign Investment

1. Foreign direct investments are usually quite large and many are exposed to political risk (country risk). Repatriation (transfer) of a foreign subsidiary's profits may be blocked. In the extreme case a foreign government may even expropriate (take) the firm's assets. Strategies to reduce risk include the use of joint ventures, financing with local-country capital, and the purchase of insurance. An emerging country experiences certain advantages to allowing foreign investment, including less stock market volatility, increased investment, and reduced cost of capital.
2. Transfer pricing. Transfer pricing is the price at which services or products are bought and sold across international borders between related parties. As an example, if a US parent company purchases products from its French subsidiary, a transfer price must be established for the products. Because the transfer price affects the parent and subsidiary's net income, it affects the taxes that the firm pays in the US and France. Multinational companies can minimize their overall tax burden by using transfer prices to minimize net income in jurisdictions with higher income tax rates, and maximizing net income in jurisdictions with lower income tax rates. However, there are other reasons for setting transfer prices, including avoiding foreign withholding of taxes on cash payments, avoiding import duties, and circumventing profit repatriation restrictions. However, many governments have established tax regulations that are designed to help ensure that transfer prices estimate market prices. In the US, guidance of the appropriate allocation of income (including transfer pricing) is included in the Internal Revenue Code that provides that income should be allocated between entities under common control based on the functions performed and the risks assumed by each of the entities involved in arm's-length transactions. Methods used to determine transfer prices generally include
   1. The cost method—the price is determined based on the cost of producing the item. This method is commonly used when a market price for the product is not available.
   2. The market price method—the price is determined based on the external market for the item.
   3. The negotiated price method—the price is determined based on a negotiated agreement.

THE EFFECTS OF THE GLOBAL ECONOMIC ENVIRONMENT ON STRATEGY

A firm's objectives are the overall plans for the firm as defined by management. Management attempts to achieve these objectives by developing strategies (operational actions). However, achieving management's objectives is always subject to business risks faced by the firm. Business risks are conditions that threaten management's ability to execute strategies and achieve the firm's objectives. A comprehensive understanding of the firm's internal and external environments is necessary for management to understand the firm's present condition and its business risks. This understanding includes comprehension of both the general and industry environments.

A. The general environment includes the following factors:

• Economic—Inflation rates, interest rates, budget deficits, personal saving rate, gross domestic product, etc.
• Demographic—Population size, workforce, ethnic mix, income distribution, geographic distribution, etc.
• Political and legal—Antitrust laws, tax laws, deregulation philosophies, etc.
• Sociocultural—Workforce diversity, environmental concerns, shifts in consumer preferences, etc.
• Technological segment—Societal innovations in technology and products, focus of the economy on research and development, etc.
• Global—Important global political events, developments in global markets, etc.

The general aspects of the environment are out of the control of management of the firm. Management must adapt to its general environment.

B. The industry environment is the set of factors that influence the firm's competitive actions. Michael Porter developed a model for industry analyses that focuses on five forces: (1) competitors, (2) potential entrants into the market, (3) equivalent products, (4) bargaining power of customers, and (5) bargaining power of input suppliers.¹

1. The industry environment directly affects the firm and the types of strategies it must develop to compete. It is most relevant to the firm's profit potential. Management attempts to position the firm where it can influence the industry factors and successfully defend against their influence. Remember, management has little or no control over the general environment factors but through its actions may have significant influence over industry factors. Generally, the larger the firm's market share the more influence it can have on its industry environment.
2. Since firms must make strategic decisions that involve long-term commitments (e.g., investments in technology, plant, etc.), management must not only deal with the current environment, it must forecast the future. Effective management must analyze and forecast the general environment to identify opportunities and threats to the firm. In doing so, the following techniques are used:
   1. Scanning—A study of all segments in the general environment. The objective is to predict the effects of the general environment on the firm's industry. Management can use this information to modify its strategies and operating plans. Scanning of the general environment is critical to firms in volatile industries. Sources of information for scanning include trade publications, newspapers, business publications, public polls, government publications, etc.
   2. Monitoring—A study of environmental changes identified by scanning to spot important trends. As an example, the trend in aging of the population in this country would definitely be important to firms that provide services to retired individuals. Effective monitoring involves identifying the firm's major stakeholders (e.g., customers, investors, employees, etc.).
   3. Forecasting—Developing probable projections of what might happen and its timing. As an example, management might attempt to forecast changes in personal disposable income or the timing of introduction of a major technological development.
   4. Assessing—Determining changes in the firm's strategy that are necessary as a result of the information obtained from scanning, monitoring, and forecasting. It is the process of evaluating the implications of changes in the general environment on the firm.

C. Industry Analysis

1. An industry is a group of firms that produce products that are substitutes or close substitutes. Industries are often classified by their fundamental economics as perfect competition, pure monopoly, monopolistic competition, and oligopoly.
2. The competitive market of the firm determines the intensity of competition and threats to new entrants to the industry. However, the firm must also consider the threat of substitute products, bargaining power of suppliers, and bargaining power of its customers.
3. Threat of substitute products. Substitute products are goods or services from outside a given industry that perform similar functions. As an example, plastic containers constrain the price of glass containers.
4. Bargaining power of suppliers.
   1. The power of suppliers affects a firm's ability to negotiate price or quality concessions. When suppliers have a good deal of power, they will be able to increase prices, and the firm purchasing those supplies may or may not be able to pass the cost on to its customers. Suppliers have power, for example, when the market is dominated by a few large companies, the industry firms are not significant customers for suppliers, or there are large costs to switching to another supplier.
   2. The supplier market also includes the firm's labor market. The firm's ability to influence wage rate will depend on the other firms that are competing for the labor, and actions of the government and labor unions.
   3. A monopsony is a market where only one buyer exists for all sellers. A monopsonist has monopoly power in the purchase of a resource. The marginal cost curve for a monopsonist is different from other firms' in that each time it purchases an additional unit of product or labor it increases the cost of all of the resource.
5. Bargaining power of customers. The power of customers determines the firm's ability to increase prices or lower quality of their products. When customers are powerful, the firm has difficulty passing cost increase on to them. Therefore the firm must concentrate on controlling costs. Customers are powerful, for example, when they purchase a large percentage of the industry output, they could switch to another product with little cost, the industry's products are standardized and the customers pose a threat to integrate backward into the firm's market.
6. Techniques for industry analysis. Firms use a variety of techniques to analyze their industries. In this section we will describe three of those techniques, competitor analysis, price elasticity analysis, and target market analysis.
   1. Competitor analysis. In formulating strategy, management must consider the strategies of the firm's competitors. Competitor analysis is of vital importance to devising strategies in concentrated industries. Competitor analysis involves two major activities: (1) gathering information about competitors' capabilities, objectives, strategies, and assumptions (competitor intelligence), and (2) using the infonnation to understand the competitors' behavior. Management uses a number of sources of infonnation for competitor analysis including the competitor's
      • Annual reports and SEC filings
      • Interviews with analysts
      • Press releases

      However, management must also consider information derived from the actions of the competitor such as the following:

      • Research and development projects
      • Capital investments
      • Promotional campaigns
      • Strategic partnerships
      • Mergers and acquisitions
      • Hiring practices

      In a competitor analysis, management seeks to understand

      • What are the competitor's objectives?
      • What can and is the competitor doing based on its current strategy?
      • What does the competitor assume about the industry?
      • What are the competitor's strengths and weaknesses?

      Information from the analysis of the competitor's objectives, assumptions, strategy and capabilities can be developed into a response profile of possible actions that may be taken by the competitor under varying circumstances. This will allow management to anticipate or influence the competitor's actions to the firm's advantage.

   2. Price elasticity analysis. Recall that the price elasticity of demand measures the effect of a change in price on the demand for the product. It is calculated with the following equation:

      

      In order to develop a pricing strategy, management may perform price elasticity analysis of product or service. By observing the effects of price changes management can obtain a better understanding of the relationship. Regression analysis may be used to perform a more sophisticated analysis.

D. Strategic Planning

Strategic planning involves identifying an organization's long-term goals and determining the best approaches to achieving those goals. To facilitate strategic planning an organization may establish a planning department, committee, or planning officer. Strategic planning should include involvement from decision makers at all company levels—the corporate, business, and functional levels. It is important to get as many stakeholders as possible involved in the process. Because strategic decisions have a huge impact on the company and require large commitments of financial resources, top management must approve and embrace the strategic plan.

Strategic planning begins with the development or review of the organization's mission. The mission sets forth the purpose of the organization, including its distinguishing characteristics. The organization may also develop a vision which sets forth where the organization would like to be in the future.

Next, a situational analysis will be performed which involves collection and evaluation of past and present economical, political, social, and technology data (an environmental scan) to (1) identify internal and external forces that may affect the organization's performance and choice of strategies, and (2) to assess the organization's strengths, weaknesses, opportunities, and threats (a SWOT analysis).

The SWOT analysis is then used to develop strategies to minimize risks and take advantage of major opportunities. This analysis is usually displayed in a SWOT matrix.

SWOT Matrix

After performing the situational analysis, specific strategies will be developed consistent with the mission and vision of the organization. Then, the strategies will be implemented within the organization. Effective implementation requires communication of the strategies throughout the organization and establishment of incentives and performance expectations that are consistent with the strategies. Finally, controls and outcome measures should be developed and monitored to provide feedback on whether the strategies are effectively implemented and achieving the desired results.

1. Generic Business Strategies. Generic business strategies are generally classified as being product differentiation or cost leadership. These two strategies have been broken down by Michael Porter into industry-wide or market segment strategy as illustrated below.

   

   1. Product differentiation. Product differentiation involves development of a unique product to make it more attractive to the target market or to differentiate it from competitors' products. Products may be differentiated in the following ways:
      • (1) Physical characteristics (e.g., aesthetics, durability, reliability, performance, serviceability, features, etc.)
      • (2) Perceived differences (e.g., advertising, brand name, etc.)
      • (3) Support service differences (e.g., exchange policies, assistance, after-sale support, etc.)

      By differentiating its products, the firm may be able to charge higher prices than its competitors or higher prices for the same products sold in different market segments.

   2. Cost leadership. Striving for cost leadership fundamentally involves focusing on reducing the costs and time to produce, sell, and distribute a product or service. A number of techniques are used to attempt to reduce costs and time, including process reengineering, lean manufacturing (production), supply chain management, strategic alliances, and outsourcing.
      • (1) Process reengineering involves a critical evaluation and major redesign of existing processes to achieve breakthrough improvements in performance. Process reengineering differs from total quality management (TQM) in that TQM involves gradual improvement of processes, while reengineering often involves radical redesign and drastic improvement in processes. Many of the significant improvements in processes over the last few years have been facilitated with innovations in information technology.
      • (2) Lean manufacturing is a management technique that involves the identification and elimination of all types of waste in the production function. Operations are reviewed for those components, processes, or products that add cost rather than value. A basic premise underlying lean manufacturing is by focusing on improving design, increasing flexibility, and reducing time, defects, and inventory, costs can be minimized.
      • (3) Supply chain management.
        • (a) The term supply chain describes the flow of goods, services, and information from basic raw materials through the manufacturing and distribution process to delivery of the product to the consumer, regardless of whether those activities occur in one or many firms.

          NOTE: A supply chain is illustrated below.

          

          As shown, the firm's operations include only the assembly and distribution processes. Other firms supply raw materials, perform subassembly, and are the resellers of the final product. In viewing the supply chain, it is critical to go beyond the firm's immediate suppliers and customers to encompass the entire chain.

        • (b) To improve operations and manage the relationships with their suppliers many firms use a process known as supply chain management. A key aspect of supply chain management is the sharing of key information from the point of sale to the final consumer back to the manufacturer, the manufacturer's suppliers, and the suppliers' suppliers. As an example, if a manufacturer/distributor shares its sales forecasts with its suppliers and they in turn share their sales forecasts with their suppliers, the need for inventories for all firms is significantly decreased. The manufacturer/distributor, for example, needs far less raw materials inventory than normally would be the case because its suppliers are aware of the manufacture's projected needs and is prepared to have the materials available when needed. Specialized software facilitates this process of information sharing along the supply chain network.
        • (c) Supply chain management also focuses on improving processes to reduce time, defects, and costs all along the supply chain. By focusing on the entire supply chain, management may evaluate the full cost of inefficient processes, defective materials, and inaccurate forecasts of sales.
        • (d) However, supply chain management presents the company with a number of problems and risks including those arising from
          • 1] Incompatible information systems
          • 2] Refusal of some companies to share information
          • 3] Failure of suppliers or customers to meet their obligations
2. Target market analysis
   1. In implementing a generic strategy a firm will often use target market analysis. A firm's target market is a market in which the firm actually sells or plans to sell its product or services. A thorough understanding of the market is key to accurate sales forecasts. Just defining the market in geographic terms is not enough. Management should perform target market analysis to understand exactly who the firm's customers are. Management needs to understand why customers purchase the firm's product or service. For an individual customer the purpose might be to satisfy a basic need, to make things easier, or for entertainment. Target market analysis generally involves market segmentation, which involves breaking the market into groups that have different levels of demand for the firm's product or service. For example, a clothing store like GAP, that sells clothing primarily for teens, is interested in the size of the segment of the market—the number of teens in the geographical area that the store serves. Segmentation may be performed along any dimension that defines the firm's market, including
      • (1) Demographics (e.g., sex, education, income, etc.)
      • (2) Psychographics (e.g., lifestyle, social class, opinions, activities, attitudes, etc.)
   2. If the firm's customers are businesses, segmentation might be performed in terms of other relevant dimensions including
      • (1) Industry
      • (2) Size (in terms of sales, total employees, etc.)
      • (3) Location
      • (4) How they purchase (e.g., seasonality, volume, who makes the purchasing decision)

      Unlike individuals, businesses purchase products to increase revenue, decrease costs, or maintain status quo.

   3. Target market analysis may be essential to the firm's success. The greater the understanding management has of the firm's market, the more effective it can be at making marketing decisions. Advertising, for example, can be tailored to particular market segments. The firm may even be able to use differential pricing in which they charge different prices to different market segments. As an example, airlines have long attempted to develop fare schedules and restrictions that segment the business traveler from the vacation traveler because the business traveler will generally pay more for a ticket.
3. Strategic alliances involve collaborative agreements between two or more firms. They may be organized as joint ventures, equity ventures, equity investments, or simple agreements (such as comarketing or codevelopment agreements). Firms enter into strategic alliances for a number of reasons, including to
   1. Refocus the firm's efforts on its core competencies and value creation activities
   2. Speed innovation
   3. Compensate for limited resources
   4. Reduce risk
4. Globalization involves developing strategies to deal with, and capitalize on, markets in other countries. Companies in developed countries are able to compete with companies in developing countries in a number of ways, including
   • Use of sophisticated technology to reduce costs
   • Effective process management
   • Innovation in products or services
   • Product quality
   • Customer service
   • Adopting a global strategy

   In operating in a global economy, it is important that executives understand the cultural differences among countries. Differences in customs, values, and behavior result in problems that can only be managed by cross-cultural communication and interaction. These cultural differences affect negotiations, personnel management, and commerce.

   Multinational companies generally pursue a global strategy in which they locate and consolidate operations in countries with the greatest strategic advantages. Organizations that pursue a global strategy can benefit in a number of ways, including

   • Pooling international production to one or a few locations can achieve increased economies of scale
   • Manufacturing costs can be cut by moving production to low-cost countries
   • A firm that can switch production among different countries has increased bargaining power over labor, suppliers, and host governments
   • Worldwide access to resources, labor, suppliers and customers
5. Outsourcing involves contracting for the performance of processes by other firms. Outsourcing provides a way for firms to focus on their core competencies and value creation activities. Any processes, such as information technology, human resources, product service, etc., for which the firm does not have a competitive advantage may be outsourced to other firms that can perform the process more effectively or efficiently. In doing so, the firm may be able to decrease its costs. Outsourcing may provide the following advantages to a firm: (1) cost savings, (2) higher quality, (3) reduced time to delivery, and (4) scalability.

   Outsourcing can present a firm with new risks. For example, agreements must be appropriately structured to allow the firm to control performance, quality, and ethical employment practices of the other firm. Also, the firm may face risks to its reputation due to low quality or for outsourcing jobs, especially if the work is outsourced to another country. Finally, outsourcing may present the firm with legal risk and foreign currency risk.

E. Estimating the Effects of Economic Changes

1. Successful management involves being able to anticipate changes in economic conditions and competitor actions and devising strategies and plans to react to those changes. To begin with, management must thoroughly understand the effects of economic changes on the firm. “How will demand for the firm's products or services be affected?” and “How will the change affect the firm's costs?” are key questions. In order to estimate the effects, management will collect and analyze historical data. Quantitative techniques such as regression analysis may be used. Management will also examine the effects of any competitor analysis that has been performed. The following table illustrates the process.

   

2. On the CPA exam you can expect questions that will require you to determine the effects of economic changes and competitor actions on the firm's financial results. If no data to predict the effect of the change are provided, the solution to the question will merely require you to predict the direction of the change. For example, if personal disposable income increases, how are sales for a chain of jewelry stores affected? Obviously, the effect will be an increase in sales. However, without historical data on the effect of changes in personal disposable income on jewelry sales there would be no way to detennine the extent of the effect. Other questions may provide you with indications of the effects of economic changes allowing the determination of a more precise answer. For example, if you were provided with the price elasticity of demand for a product, say 1.5, and told that the price was to be increased by 10% you could estimate the effects of the price increase on demand using the formula for price elasticity as shown below.

   

   We know that the percentage change in quantity demanded can be calculated as follows:

   

   Still other questions might provide you with historical data on the effect of changes in economic variables on the firm's results, and ask you to estimate the impact of some anticipated change in economic conditions on the firm's future financial results.

KEY TERMS

Absolute advantage. An advantage a country has over other countries in the production of a good or service.

Business cycle. A fluctuation in aggregate economic output that lasts for several years.

Comparative advantage. An advantage a country has in producing a good or service because it has no alternative users of its resources that would involve a higher return.

Consumption function. Depicts the relationship between changes in personal disposable income and consumption.

Cost leadership. A strategy that involves focusing on reducing the costs and time to produce, sell, and distribute a product or service.

Demand. The quantity of a good or service that a consumer is willing and able to purchase at a given price.

Deflation. The rate of decline in the price level of goods and services.

Depression. A deep and long-lasting recession.

Dumping. A form of predatory pricing in which a manufacturer in one country exports a product at a price that is lower than the priced charged in its home country.

Economic profit. The amount of profit in excess of normal profit.

Export subsidies. Payments made by a government to encourage the production and export of specific products.

Government budget surplus (deficit). The excess (deficit) of government taxes in relation to government transfer payments and purchases.

Inflation. The rate of increase in the price level of goods and services.

Marginal product. The additional output obtained from employing one additional unit of resource (e.g., one additional worker).

Marginal revenue. The additional revenue received from the sale of one additional unit of a product.

Marginal revenue product. The change in total revenue from employing one additional unit of a resource.

Market equilibrium. The price at which all the goods offered for sale will be sold.

Monopolistic competition. A market characterized by many firms selling a differentiated product or service.

Nominal gross domestic product. The price of all goods and services produced by a domestic economy for a year at current market prices.

Nominal interest rate. The interest rate in terms of the nation's currency.

Normal profit. The amount of profit necessary to compensate the owners for their capital and/or managerial skills.

Oligopoly. A market characterized by significant barriers to entry. As a result there are few sellers of the product.

Personal disposable income. The amount of income that individuals receive and have available to purchase goods and services.

Potential gross domestic product. The maximum amount of production that could take place in an economy without putting pressure on the general level of prices.

Price ceiling. A specified maximum price that may be charged for a good, usually established by a government. A price ceiling will cause goods shortages.

Price floor. A specified minimum price that may be charged for a good, usually established by a government. A price floor will cause overproduction of the good.

Product differentiation. A strategy that involves modification of a product to make it more attractive to the target market or to differentiate it from competitors' products.

Pure competition. An industry in which there are a large number of sellers of virtually identical products or services. No individual seller is able to affect the market price.

Pure monopoly. A market in which there is a single seller of a product or service for which there are no close substitutes.

Real gross domestic product. The price of all goods and services produced by a domestic economy at price level adjusted (constant) prices.

Real interest rate. The interest rate adjusted for inflation.

Recession. A period of negative gross domestic product growth.

Substitution effect. The fact that as the price of a good or service falls, consumers will use it to replace similar goods or services.

Supply. The quantity of a good or service that will be supplied by producers at a given price.

Unemployment rate. The percentage of the total labor force that is unemployed at a given time.

Multiple-Choice Questions (1–126)

Demand, Supply, and Market Equilibrium

^**1. If both the supply and the demand for a good increase, the market price will

1. Rise only in the case of an inelastic supply function.
2. Fall only in the case of an inelastic supply function.
3. Not be predictable with only these facts.
4. Rise only in the case of an inelastic demand function.

^**2. A supply curve illustrates the relationship between

1. Price and quantity supplied.
2. Price and consumer tastes.
3. Price and quantity demanded.
4. Supply and demand.

3. As a business owner you have determined that the demand for your product is inelastic. Based upon this assessment you understand that

1. Increasing the price of your product will increase total revenue.
2. Decreasing the price of your product will increase total revenue.
3. Increasing the price of your product will have no effect on total revenue.
4. Increasing the price of your product will increase competition.

Items 4 and 5 are based on the following information:

Assume that demand for a particular product changed as shown below from D1 to D2.

4. Which of the following could cause the change shown in the graph?

1. A decrease in the price of the product.
2. An increase in supply of the product.
3. A change in consumer tastes.
4. A decrease in the price of a substitute for the product.

5. What will be the result on the equilibrium price for the product?

1. Increase.
2. Decrease.
3. Remain the same.
4. Cannot be determined.

^**6. Which one of the following has an inverse relationship with the demand for money?

1. Aggregate income.
2. Price levels.
3. Interest rates.
4. Flow of funds.

^**7. An improvement in technology that in turn leads to improved worker productivity would most likely result in

1. A shift to the right in the supply curve and a lowering of the price of the output.
2. A shift to the left in the supply curve and a lowering of the price of the output.
3. An increase in the price of the output if demand is unchanged.
4. Wage increases.

8. Which of the following market features is likely to cause a surplus of a particular product?

1. A monopoly.
2. A price floor.
3. A price ceiling.
4. A perfect market.

^**9. A decrease in the price of a complementary good will

1. Shift the demand curve of the joint commodity to the left.
2. Increase the price paid for a substitute good.
3. Shift the supply curve of the joint commodity to the left.
4. Shift the demand curve of the joint commodity to the right.

^**10. Demand for a product tends to be price inelastic if

1. The product is considered a luxury item.
2. Few good complements for the product are available.
3. The population in the market area is large.
4. People spend a large share of their income on the product.

11. Which of the following has the highest price elasticity coefficient?

1. Milk.
2. Macaroni and cheese.
3. Bread.
4. Ski boats.

^**12. The local video store's business increased by 12% after the movie theater raised its prices from $6.50 to $7.00. Thus, relative to movie theater admissions, videos are

1. Substitute goods.
2. Superior goods.
3. Complementary goods.
4. Public goods.

*13. An individual receives an income of $3,000 per month, and spends $2,500. An increase in income of $500 per month occurs, and the individual spends $2,800. The individual's marginal propensity to save is

1. 0.2
2. 0.4
3. 0.6
4. 0.8

^**14. In any competitive market, an equal increase in both demand and supply can be expected to always

1. Increase both price and market-clearing quantity.
2. Decrease both price and market-clearing quantity.
3. Increase market-clearing quantity.
4. Increase price.

^**15. Given the following data, what is the marginal propensity to consume?

1. 1.33
2. 1.16
3. 0.95
4. 0.75

*16. Which of the following will cause a shift in the supply curve of a product?

1. Changes in the price of the product.
2. Changes in production taxes.
3. Changes in consumer tastes.
4. Changes in the number of buyers in the market.

^**17. When the federal government imposes health and safety regulations on certain products, one of the most likely results is

1. Greater consumption of the product.
2. Lower prices for the product.
3. Greater tax revenues for the federal government.
4. Higher prices for the product.

18. In which of the following situations would there be inelastic demand?

1. a. A 5% price increase results in 3% decrease in the quantity demanded.
2. A 4% price increase results in a 6% decrease in the quantity demanded.
3. A 4% price increase results in a 4% decrease in the quantity demanded.
4. A 3% price decrease results in a 5% increase in the quantity demanded.

^**19. In a competitive market for labor in which demand is stable, if workers try to increase their wage

1. Employment must fall.
2. Government must set a maximum wage below the equilibrium wage.
3. Firms in the industry must become smaller.
4. Product supply must decrease.

*20. A polluting manufacturing firm tends, from the societal viewpoint, to

1. Price its products too low.
2. Produce too little output.
3. Report too little profitability.
4. Employ too little equity financing.

^**21. If the federal government regulates a product or service in a competitive market by setting a maximum price below the equilibrium price, what is the long-run effect?

1. A surplus.
2. A shortage.
3. A decrease in demand.
4. No effect on the market.

^**22. A valid reason for the government to intervene in the wholesale electrical power market would include which one of the following?

1. A price increase that is more than expected.
2. Electricity is an essential resource and the wholesale market is not competitive.
3. The electricity distribution companies are losing money.
4. Foreign power generators have contracts with the local government at very high prices.

23. If the income elasticity of demand coefficient for a particular product is 3.00, the good is likely

1. A luxury good.
2. A complementary good.
3. An inferior good.
4. A necessity.

^**24. Long Lake Golf Course has raised greens fees for a nine-hole game due to an increase in demand.

Which one of the following is correct?

1. The regular weekday and weekend demand is inelastic.
2. The regular weekday and weekend demand is elastic.
3. The senior citizen demand is elastic, and weekend demand is inelastic.
4. The regular weekday demand is inelastic, and weekend demand is elastic.

^**25. Which one of the following would cause the demand curve for a commodity to shift to the left?

1. A rise in the price of a substitute product.
2. A rise in average household income.
3. A rise in the price of a complementary commodity.
4. A rise in the population.

^**26. Price ceilings

1. Are illustrated by government price support programs in agriculture.
2. Create prices greater than equilibrium prices.
3. Create prices below equilibrium prices.
4. Result in persistent surpluses.

*27. X and Y are substitute products. If the price of product Y increases, the immediate impact on product X is

1. Price will increase.
2. Quantity demanded will increase.
3. Quantity supplied will increase.
4. Price, quantity demanded, and supply will increase.

28. Wilson Corporation has a major competitor that produces a product that is a close substitute for Wilson's good. If the coefficient of cross-elasticity of demand for Wilson's product with respect to the competitor's product is 2.00 and the competitor decreases its price by 5%, what is the expected effect on demand for Wilson's product?

1. A 5% increase in demand.
2. A 5% decrease in demand.
3. A 10% increase in demand.
4. A 10% decrease in demand.

^1**29. As the price for a particular product changes, the quantity of the product demanded changes according to the following schedule:

Total quantity demanded	Price per unit
100	$50
150	45
200	40
225	35
230	30
232	25

Using the arc method, the price elasticity of demand for this product when the price decreases from $50 to $45 is

1. 0.20
2. 10.00
3. 0.10
4. 3.80

^**30. As the price for a particular product changes, the quantity of the product demanded changes according to the following schedule:

Total quantity demanded	Price per unit
100	$50
150	45
200	40
225	35
230	30
232	25

Using the arc method, the price elasticity of demand for this product when the price decreases from $40 to $35 is

1. 0.20
2. 0.88
3. 10.00
4. 5.00

^**31. If a group of consumers decide to boycott a particular product, the expected result would be

1. An increase in the product price to make up lost revenue.
2. A decrease in the demand for the product.
3. An increase in product supply because of increased availability.
4. That demand for the product would become completely inelastic.

32. Which of the following is not likely to affect the supply of a particular good?

1. Changes in government subsidies.
2. Changes in technology.
3. Changes in consumer income.
4. Changes in production costs.

^**33. If a product's demand is elastic and there is a decrease in price, the effect will be

1. A decrease in total revenue.
2. No change in total revenue.
3. A decrease in total revenue and the demand curve shifts to the left.
4. An increase in total revenue.

^**34. All of the following are complementary goods except

1. Margarine and butter.
2. Cameras and rolls of film.
3. VCRs and video cassettes.
4. Razors and razor blades.

^**35. The law of diminishing marginal utility states that

1. Marginal utility will decline as a consumer acquires additional units of a specific product.
2. Total utility will decline as a consumer acquires additional units of a specific product.
3. Declining utilities causes the demand curve to slope upward.
4. Consumers' wants will diminish with the passage of time.

^**36. In the pharmaceutical industry where a diabetic must have insulin no matter the cost and where there is no other substitute, the diabetic's demand curve is best described as

1. Perfectly elastic.
2. Perfectly inelastic.
3. Elastic.
4. Inelastic.

Costs of Production

^**37. Because of the existence of economies of scale, business firms may find that

1. Each additional unit of labor is less efficient than the previous unit.
2. As more labor is added to a factory, increases in output will diminish in the short run.
3. Increasing the size of a factory will result in lower average costs.
4. Increasing the size of a factory will result in lower total costs.

^**38. In the long run, a firm may experience increasing returns due to

1. Law of diminishing returns.
2. Opportunity costs.
3. Comparative advantage.
4. Economies of scale.

^**39. The measurement of the benefit lost by using resources for a given purpose is

1. Economic efficiency.
2. Opportunity cost.
3. Comparative advantage.
4. Absolute advantage.

Items 40 and 41 are based on the following information:

^**40. The total cost of producing seven units is

1. $90.02
2. $168.00
3. $258.02
4. $280.00

^**41. The marginal cost of producing the ninth unit is

1. $23.50
2. $23.75
3. $25.75
4. $33.75

^**42. Daily costs for Kelso Manufacturing include $1,000 of fixed costs and total variable costs are shown below.

The average total cost at an output level of 11 units is

1. $113.64
2. $125.00
3. $215.91
4. $250.00

Items 43 through 45 are based on the following information:

^**43. The marginal physical product when one worker is added to a team of 10 workers is

1. 1 unit.
2. 8 units.
3. 5 units.
4. 25 units.

^**44. The marginal revenue per unit when one worker is added to a team of 11 workers is

1. $105.00
2. $225.00
3. $35.00
4. $47.50

^**45. The marginal revenue product when one worker is added to a team of 11 workers is

1. $42.00
2. $225.00
3. $105.00
4. $47.50

^**46. Marginal revenue is

1. Equal to price in monopolistic competition.
2. The change in total revenue associated with increasing prices.
3. Greater than price in pure competition.
4. The change in total revenue associated with producing and selling one more unit.

^**47. In microeconomics, the distinguishing characteristic of the long run on the supply side is that

1. Only supply factors determine price and output.
2. Only demand factors determine price and output.
3. Firms are not allowed to enter or exit the industry.
4. All inputs are variable.

48. What is the main factor that differentiates the short-run cost function from the long-run cost function?

1. Nothing, the two functions are identical.
2. The level of technology.
3. Changes in government subsidies.
4. The nature of the costs.

Items 49 and 50 are based on the following information:

Karen Parker wants to establish an environmental testing company that would specialize in evaluating the quality of water found in rivers and streams. However, Parker has discovered that she needs either certification or approval from five separate local and state agencies before she can commence business. Also, the necessary equipment to begin would cost several million dollars. Nevertheless, Parker believes that if she is able to obtain capital resources, she can gain market share from the two major competitors.

^**49. The large capital outlay necessary for the equipment is an example of a(n)

1. Entry barrier.
2. Minimum efficient scale.
3. Created barrier.
4. Production possibility boundary.

^**50. The market structure Karen Parker is attempting to enter is best described as

1. A natural monopoly.
2. A cartel.
3. An oligopoly.
4. Monopolistic competition.

^**51. The distinguishing characteristic of oligopolistic markets is

1. A single seller of a homogeneous product with no close substitutes.
2. A single seller of a heterogeneous product with no close substitutes.
3. Lack of entry and exit barriers in the industry.
4. Mutual interdependence of firm pricing and output decisions.

^**52. Economic markets that are characterized by monopolistic competition have all of the following characteristics except

1. One seller of the product.
2. Economies or diseconomies of scale.
3. Advertising.
4. Heterogeneous products.

53. Which type of economic market structure is characterized by a few large sellers of a product or service, engaging primarily in nonprice competition?

1. Monopoly.
2. Oligopoly.
3. Perfect competition.
4. Monopolistic competition.

54. Which type of economic market structure is composed of a large number of sellers, each producing an identical product, and with no significant barriers to entry and exit?

1. Monopoly.
2. Oligopoly.
3. Perfect competition
4. Monopolistic competition.

^**55. A natural monopoly exists because

1. The firm owns natural resources.
2. The firms holds patents.
3. Economic and technical conditions permit only one efficient supplier.
4. The government is the only supplier.

^**56. A market with many independent firms, low barriers to entry, and product differentiation is best classified as

1. A monopoly.
2. A natural monopoly.
3. Monopolistic competition.
4. An oligopoly.

^**57. Which of the following is not a key assumption of perfect competition?

1. Firms sell a homogeneous product.
2. Customers are indifferent about which firm they buy from.
3. The level of a firm's output is small relative to the industry's total output.
4. Each firm can price its product above the industry price.

^**58. An oligopolist faces a “kinked” demand curve. This terminology indicates that

1. When an oligopolist lowers its price, the other firms in the oligopoly will match the price reduction, but if the oligopolist raises its price, the other firms will ignore the price change.
2. An oligopolist faces a nonlinear demand for its product, and price changes will have little effect on demand for that product.
3. An oligopolist can sell its product at any price, but after the “saturation point” another oligopolist will lower its price and, therefore, shift the demand curve to the left.
4. Consumers have no effect on the demand curve, and an oligopolist can shape the curve to optimize its own efficiency.

Aggregate Demand and Business Cycles

59. If consumer confidence falls, the impact upon the economy is

1. A downturn.
2. An upturn.
3. No change.
4. Consumer confidence does not have an impact upon the economy.

^**60. If an increase in government purchases of goods and services of $20 billion causes equilibrium GDP to rise by $80 billion, and if total taxes and investment are constant, the marginal propensity to consume out of disposable income is

1. 0.75
2. 0.25
3. 1.25
4. 4.00

^**61. During the recessionary phase of a business cycle

1. The purchasing power of money is likely to decline rapidly.
2. The natural rate of unemployment will increase dramatically.
3. Potential national income will exceed actual national income.
4. Actual national income will exceed potential national income.

*62. For a given level of tax collections, prices, and interest rates, a decrease in governmental purchases will result in a(n)

1. Increase in aggregate demand.
2. Increase in aggregate supply.
3. Decrease in aggregate demand.
4. Decrease in aggregate supply.

^**63. In national income terms, aggregate demand is the

1. Demand for money by the community in a period of full employment.
2. Total expenditure on capital goods by entrepreneurs during a period of full employment.
3. Demand that is needed if a country's economy is to operate at optimum level and the level of investment is to be raised.
4. Total expenditures on consumer goods and investment, including government and foreign expenditures, during a given period.

*64. Which one of the following would not be included in the calculation of the gross domestic product (GDP)?

1. Purchase of a new home.
2. An automotive worker's wages.
3. A doctor's fee.
4. Purchase of common stock.

65. An upturn in economic activity is indicated by all of the following, except

1. Increased housing starts.
2. Reduction in the quantity of unemployment claims.
3. Increase in personal travel.
4. Reduction in the amount of luxury purchases.

66. Which of the following may provide a leading indicator of a future increase in gross domestic product?

1. A reduction in the money supply.
2. A decrease in the issuance of building permits.
3. An increase in the timeliness of delivery by vendors.
4. An increase in the average hours worked per week of production workers.

*67. Disposable income is calculated as

1. Gross domestic product minus the capital cost allowance.
2. Net domestic product minus indirect business taxes plus net income earned abroad.
3. Personal income minus transfer payments.
4. Personal income minus personal taxes.

*68. The primary reason for allowing legal immigration into industrial nations is the immigrants' potential for

1. Reducing a trade deficit.
2. Fulfilling a trade agreement.
3. Contributing to economic growth.
4. Fulfilling a political agreement.

*69. Some economic indicators lead the economy into a recovery or recession, and some lag it. An example of a lagging indicator is

1. Chronic unemployment.
2. Orders for consumer and producer goods.
3. Housing starts.
4. Consumer expectations.

^**70. Government borrowing to finance large deficits increases the demand for lendable funds and

1. Increases the supply of lendable funds.
2. Exerts downward pressure on interest rates.
3. Has no impact on interest rates.
4. Puts upward pressure on interest rates.

Economic Measures and Policy

^**71. A period of rising inflation

1. Increases the price level, which benefits those who are entitled to receive specific amounts of money.
2. Enhances the positive relationship between the price level and the purchasing power of money.
3. Will not be affected by contracts that include the indexing of payments.
4. Increases the price level, which is negatively related to the purchasing power of money.

^**72. The most effective fiscal policy program to help reduce demand-pull inflation would be to

1. Decrease the rate of growth of the money supply.
2. Increase both taxes and government spending.
3. Decrease taxes and increase government spending.
4. Increase taxes and decrease government spending.

*73. The money supply in a nation's economy will decrease following

1. Open-market purchases by the nation's central bank.
2. A decrease in the discount rate.
3. An increase in the reserve ratio.
4. A decrease in the margin requirement.

^**74. The Federal Reserve Board most directly influences a corporation's decision of whether or not to issue debt or equity financing when it revises the

1. Corporate income tax rate.
2. Prime rate at which the Federal Reserve Bank lends money to member banks.
3. Discount rate at which the Federal Reserve Bank lends money to member banks.
4. Discount rate at which member banks lend money to their customers.

^**75. According to fiscal policy principles, a tax increase will

1. Increase spending and increase aggregate demand.
2. Increase spending and reduce aggregate demand.
3. Reduce spending and increase aggregate demand.
4. Reduce spending and reduce aggregate demand.

^**76. If the Federal Reserve Board wanted to implement an expansionary monetary policy, which one of the following actions would the Federal Reserve Board take?

1. Raise the reserve requirement and the discount rate.
2. Purchase additional US government securities and lower the discount rate.
3. Reduce the reserve requirement and raise the discount rate.
4. Raise the discount rate and sell US government securities.

^**77. The Federal Reserve System's reserve ratio is

1. The specified percentage of a commercial bank's deposit liabilities that must be deposited in the central bank.
2. The rate that the central bank charges for loans granted to commercial banks.
3. The ratio of excess reserves to legal reserves that are deposited in the central bank.
4. The specified percentage of a commercial bank's demand deposits to total liabilities.

*78. Which of the following instruments of monetary policy is the most important means by which the money supply is controlled?

1. Changing the reserve ratio.
2. Open-market operations.
3. Manipulation of government spending.
4. Changing the discount rate.

*79. If a government were to use only fiscal policy to stimulate the economy from a recession, it would

1. Raise consumer taxes and increase government spending.
2. Lower business taxes and government spending.
3. Increase the money supply and increase government spending.
4. Lower consumer taxes and increase government spending.

^**80. The federal budget deficit is the

1. Total accumulation of the federal government's surpluses and deficits.
2. Excess state, local, and federal spending over their revenues.
3. Amount by which the federal government's expenditures exceed its revenues in a given year.
4. Amount by which liabilities exceed assets on the federal government's balance sheet.

*81. Which of the following is a tool of monetary policy that a nation's central bank could use to stabilize the economy during an inflationary period?

1. Selling government securities.
2. Lowering bank reserve requirements.
3. Lowering bank discount rates.
4. Encouraging higher tax rates.

^**82. Economists and economic policy makers are interested in the multiplier effect because the multiplier explains why

1. A small change in investment can have a much larger impact on gross domestic product.
2. Consumption is always a multiple of savings.
3. The money supply increases when deposits in the banking system increase.
4. The velocity of money is less than one.

83. Assume that the United States Congress passes a tax law that provides for a “rebate” to taxpayers. One of the goals of the rebate is

1. Increase consumer disposable income and expand the economy.
2. Increase consumer disposable income and contract the economy.
3. Decrease consumer disposable income and expand the economy
4. Decrease consumer disposable income and contract the economy.

84. The rate of unemployment caused by changes in the composition of unemployment opportunities over time is referred to as the

1. Frictional unemployment rate.
2. Cyclical unemployment rate.
3. Structural unemployment rate.
4. Full-employment unemployment rate.

85. The producer price index measures

1. The price of a basket of commodities at the point of the first commercial sale.
2. Price changes for all products sold by domestic producers to foreigners.
3. Price changes of goods purchased from other countries.
4. The price of a fixed market basket of goods and services purchased by a typical urban consumer.

86. The formula for calculating a price index for the year 2013, using the year 2008 as a reference period is

^**87. The discount rate set by the Federal Reserve System is the

1. Required percentage of reserves deposited at the central bank.
2. Rate that commercial banks charge for loans to each other.
3. Rate that commercial banks charge for loans to the general public.
4. Rate that the central bank charges for loans to commercial banks.

88. Which of the following is true about deflation?

1. It motivates consumers to borrow money.
2. It motivates businesses to make investments.
3. It results in very low interest rates.
4. It results in economic expansion.

89. Economies often experience inflation but seldom experience long periods of deflation. Which of the following true about a deflationary economy?

1. Companies are hesitant to make investments.
2. The lower prices encourage consumers to make major purchases.
3. Interest rates tend to be high.
4. Actual GDP is above potential GDP.

90. What factor explains the difference between real and nominal interest rates?

1. Inflation risk.
2. Credit risk.
3. Default risk.
4. Market risk.

Global Economics

^**91. All of the following are true about international trade except that

1. The gains from international trade depend on specialization with comparative advantage.
2. Absolute advantage without comparative advantage does not result in gains from international trade.
3. Absolute advantage is defined as the ability of one nation to produce a product at a relatively lower opportunity cost than another nation.
4. Where there is reciprocal absolute advantage between two countries, specialization will make it possible to produce more of each product.

^**92. If the central bank of a country raises interest rates sharply, the country's currency will most likely

1. Increase in relative value.
2. Remain unchanged in value.
3. Decrease in relative value.
4. Decrease sharply in value at first and then return to its initial value.

^**93. Which one of the following groups would be the primary beneficiary of a tariff?

1. Domestic producers of export goods.
2. Domestic producers of goods protected by the tariff.
3. Domestic consumers of goods protected by the tariff.
4. Foreign producers of goods protected by the tariff.

94. In the law of comparative advantage, the country which should produce a specific product is determined by

1. Opportunity costs.
2. Profit margins.
3. Economic order quantities.
4. Tariffs.

^**95. Assuming exchange rates are allowed to fluctuate freely, which one of the following factors would likely cause a nation's currency to appreciate on the foreign exchange market?

1. A relatively rapid rate of growth in income that stimulates imports.
2. A high rate of inflation relative to other countries.
3. A slower rate of growth in income than in other countries, which causes imports to lag behind exports.
4. Domestic real interest rates that are lower than real interest rates abroad.

^**96. If the US dollar declines in value relative to the currencies of many of its trading partners, the likely result is that

1. Foreign currencies will depreciate against the dollar.
2. The US balance of payments deficit will become worse.
3. US exports will tend to increase.
4. US imports will tend to increase.

^**97. Exchange rates are determined by

1. Each industrial country's government.
2. The International Monetary Fund.
3. Supply and demand in the foreign currency market.
4. Exporters and importers of manufactured goods.

^**98. If the value of the US dollar in foreign currency markets changes from $1 = 6 marks to $1 = 4 marks

1. The German mark has depreciated against the dollar.
2. German imported products in the US will become more expensive.
3. US tourists in Germany will find their dollars will buy more German products.
4. US exports to Germany should decrease.

*99. Which of the following measures creates the most restrictive barrier to exporting to a country?

1. Tariffs.
2. Quotas.
3. Embargoes.
4. Exchange controls.

100. Which of the following is not a foreign exchange control that may be implemented by a country?

1. Banning possession of foreign currency by citizens.
2. Fixed exchange rates.
3. Restricting currency exchange to government approved exchangers.
4. Requiring a floating exchange rate.

101. Which of the following accurately describes a dumping pricing policy?

1. Selling goods domestically at a price less than cost.
2. Selling goods in another country at a price less than cost.
3. Selling goods in another country at an excessive price.
4. Selling goods domestically at an excessive price.

102. What is an appropriate response by an importing country for the payment of export subsidies by an exporting country?

1. Countervailing duties.
2. Foreign exchange controls.
3. Trade embargo.
4. A dumping pricing policy.

103. Which of the following describes a pegged exchange rate?

1. A currency rate that is tied to the US dollar.
2. A currency rate with its value determined by market factors.
3. A currency market in which the country's central bank keeps the rate from deviating too far from a target band or value.
4. A currency rate that is tied to the prime rate.

104. Assume that the three-month forward rate for the euro is $1,367 and the spot rate is $1,364. What is the forward premium or discount on the euro?

1. 0.88% premium.
2. 0.88% discount.
3. 0.23% premium.
4. 0.23% discount.

^**105. When net exports are negative, there is a net flow of

1. Goods from firms in foreign countries to the domestic country.
2. Money from foreign countries to the firms of the domestic country.
3. Goods from the firms of the domestic country to foreign countries.
4. Goods and services which result in a trade surplus.

106. Which of the following factors is least likely to affect a country's currency foreign exchange rates?

1. Interest rates in the country.
2. Political stability in the country.
3. Inflation in the country.
4. The tax rate in the country.

107. Assume that the exchange rate of US dollars to euros is $1.80 to 1 euro. How much would a US company gain or lose if the company has a 10,000 euro receivable and the exchange rate went to $1.75 to 1 euro?

1. $10,000 loss.
2. $10,000 gain.
3. $500 loss.
4. $500 gain.

108. Simon Corp., a US company, has made a large sale to a French company on a 120-day account payable in euros. If management of Simon wants to hedge the transaction risk related to a decline in the value of the euro, which of the following strategies would be appropriate?

1. Lend euros to another company for payment in 120 days.
2. Enter into a forward exchange contract to purchase euros for delivery in 120 days.
3. Enter into a futures contract to sell euros for delivery in the future.
4. Purchase euros on the spot market.

109. Which of the following is not a means by which a firm might hedge the political risk of an investment in another country?

1. Insurance.
2. Buy futures contracts for future delivery of the country's currency.
3. Finance the operations with local-country capital.
4. Enter into joint ventures with local-country firms.

Economics and Strategy

^**110. Patents are granted in order to encourage firms to invest in the research and development of new products. Patents are an example of

1. Vertical integration.
2. Market concentration.
3. Entry barriers.
4. Collusion.

^**111. The market for product RK-25 is perfectly competitive. The current market price is $30, and the quantity demanded is 4 million. Due to changes in consumer tastes, a permanent increase in demand for RK-25 is expected in the near term. If nothing else changes in this market, which of the following would be the most feasible levels of short-term and long-term prices?

112. The ultimate purpose of competitor analysis is to

1. Identify the competition.
2. Determine the competition's strength and weaknesses.
3. Identify the competition's major customers.
4. Understand and predict the behavior of the competition.

113. Which of the following is not an important aspect of supply chain management?

1. Information technology.
2. Accurate forecasts.
3. Customer relations.
4. Communications.

114. Which of the following types of organizations would most likely engage in public relations type advertising?

1. An airline.
2. A hotel chain.
3. A toy manufacturer.
4. An electric utility company.

115. Target marketing analysis involves

1. Analyzing the firm's input markets.
2. Understanding and segmenting the firm's customer markets.
3. Analyzing the firm's market structure.
4. Deciding on whether to offer a new product line.

116. If a firm's customers are businesses, market segmentation might be performed along all of the following dimensions, except

1. Industry.
2. Location.
3. Lifestyle.
4. Size.

Items 117 and 118 are based on the following information:

Yeager Corporation has used regression analysis to perform price elasticity analysis. In doing so management regressed the quantity demanded (y variable) against price (x variable) with the following results:

Multiple R	.86798
Adjusted R squared	.72458
Standard error	542.33
Intercept	56400.50
Price coefficient	−4598.20

117. What percentage of the variation in quantity demanded is explained by price?

1. 86.798%
2. 72.458%
3. 56.4%
4. 54.233%

118. Calculate the predicted quantity demanded if price is set at $7.00.

1. 24,213
2. 88,588
3. 31,234
4. 18,454

119. Which of the following is not one of the five forces in Porter's model for industry analysis?

1. Competitors.
2. Bargaining power of customers.
3. Bargaining power of suppliers.
4. General economic conditions.

120. Which of the following is a defining characteristic of supply chain management?

1. Focuses on the sharing of information with suppliers and customers.
2. Focuses on redesigning processes.
3. Focuses on improving quality.
4. Focuses on strategic alliances.

121. Which of the following is not a likely strategy for a firm in a purely competitive market?

1. Lean manufacturing.
2. Supply chain management.
3. Process reengineering.
4. Development of a brand name.

122. What is the purpose of a response profile in competitor analysis?

1. To develop an understanding of the firm's industry.
2. To analyze the firm's strengths in relation to its competitors.
3. To identify possible actions by competitors.
4. To understand the nature of the firm's major markets.

^**123. The process of dividing all potential consumers into smaller groups of buyers with distinct needs, characteristics, or behaviors, who might require a similar product or service mix, is called

1. Strategic planning.
2. Market segmentation.
3. Product positioning.
4. Objective setting.

124. Which of the following measures of unemployment would be of least importance to management when trying to predict the future state of the economy?

1. Structural unemployment.
2. Cyclical unemployment.
3. Frictional unemployment.
4. Overall unemployment.

125. Which of the following best describes the steps involved in performing competitor analysis?

1. Gathering information about the competitor and using it to predict the competitor' behavior.
2. Determining the type of market structure and the number of competitors.
3. Assessing the general environment and determining how that affects competition.
4. Assessing the market structure to predict when new competitors will enter the market.

126. All of the following are ways that companies in developed countries generally may compete with companies in developing countries except

1. Technology.
2. Customer service.
3. Quality.
4. Low-cost resources.

Multiple-Choice Answers and Explanations

Answers

Explanations

1. (c) The requirement is to predict the market price based on an increase in both supply and demand. The correct answer is (c) because without additional information about the extent of the change, the effect on price is not determinable. Answers (a), (b), and (d) are incorrect because the price elasticity of the demand or supply function does not provide enough information to determine the effect.

2. (a) The requirement is to describe the relationship shown by a supply curve. A supply curve illustrates the quantity supplied at varying prices at a point in time. Therefore, the correct answer is (a). Answers (b) and (c) are incorrect because they deal with demand. Answer (d) is incorrect because it deals with demand-supply equilibrium.

3. (a) The requirement is to apply the concept of price-elasticity of demand. If demand is inelastic an increase in price will increase total revenue. Answer (a) is correct because it accurately states this rule. Answer (b) is incorrect because if demand is inelastic the quantity demanded will not be affected significantly by a change in price. Answer (c) is incorrect because if the quantity demanded is not significantly affected by an increase in price, total revenue will increase. Answer (d) is incorrect because an increase in price may, or may not, increase competition.

4. (c) The requirement is to identify the reason for the shift in demand. The correct answer is (c) because a shift in demand could result from a change in consumer tastes. Answer (a) is incorrect because this would result in movement along the existing demand curve. Answer (b) is incorrect because a change in supply would not affect the demand function. Answer (d) is incorrect because a decrease in price of a substitute would result in a shift of the curve to the left.

5. (a) The requirement is to determine the effect of the shift in the demand function on the price of the product. The correct answer is (a) because the shift (increase) in demand will increase the price of the product. Answer (b) is incorrect because a shift of the demand curve to the left would have to occur to decrease price. Answers (c) and (d) are incorrect because the effect on price will not be to remain the same and it can be determined.

6. (c) The requirement is to identify the item that has an inverse relationship with the demand for money. The correct answer is (c) because as interest rates increase the demand for money decreases. Answers (a), (b), and (d) are incorrect because they do not have an inverse relationship with the demand for money.

7. (a) The requirement is to describe the effect of an improvement in technology that leads to increased worker productivity. If the cost of producing a good declines, more will be supplied at a given price. Therefore, the supply curve will shift to the right and answer (a) is correct. Answer (b) is incorrect because a shift to the left would result in decreased supplies. Answer (c) is incorrect because price would not increase, and answer (d) is incorrect because wages would not necessarily increase.

8. (b) The requirement is to identify the market feature that is likely to cause a surplus of a particular product. Answer (b) is correct because a price floor, if it is above the equilibrium price, will cause excess production and a surplus. Answer (a) is incorrect because a monopoly market is likely to be characterized by underproduction of the product. Answer (c) is incorrect because a price ceiling, if it is below the equilibrium price, will cause underproduction and shortages. Answer (d) is incorrect because in a perfect market with no intervention demand and supply will be equal.

9. (d) The requirement is to describe the effect on demand for a good if a complementary good decreases in price. If the price of a complementary good decreases, demand for the joint commodity will increase. This is due to the fact that the total cost of using the two products decreases. If demand for a product increases the demand curve will shift to the right. Therefore, answer (d) is correct. Answer (a) is incorrect because a shift in the demand curve to the left depicts a decrease in demand. Answers (b) and (c) deal with supply and are not relevant.

10. (d) The requirement is to identify a characteristic of a product with price inelastic demand. The correct answer is (d) because price inelasticity means that the quantity demanded does not change much with price changes. This would be a characteristic of a good with few substitutes. Answers (a), (b), and (c) are characteristics of goods that have price elastic demand.

11. (d) The requirement is to apply the concept of price elasticity of demand. If substitutes for a good are readily available then the demand for the good is more elastic. Answer (d) is correct because there are many substitutes for luxury goods. Answers (a), (b), and (c) are all considered to be necessities and demand for them is less elastic.

12. (a) The requirement is to identify the relationship between two products for which one has increased demand when the other's price increases. Answer (a) is correct. Substitute goods are selected by a consumer based on price. When the price of one goes up, demand for the other increases. Answer (b) is incorrect because superior goods are those whose demand is directly influenced by income. Answer (c) is incorrect because complementary goods are used together and when the price of one goes up, demand for the other goes down. Answer (d) is incorrect because a public good is one for which it is difficult to restrict use, such as a national park.

13. (b) The requirement is to calculate the marginal propensity to save. Answer (b) is correct because the marginal propensity to save is the change in savings divided by the change in income [($700 − $500)/($3,500 − $3,000) = .4]. Answer (a) is incorrect because the average propensity to save would be calculated by dividing the new savings by the new income ($700/$3,500 = .2). Answer (c) is incorrect because the marginal propensity to consume is the change in spending divided by the change in income [($2,800 − $2,500)/($3,500 − $3,000) = .6]. Answer (d) is incorrect because the average propensity to consume would be calculated by dividing the new consumption by the new income ($2,800/$3,500 = .8).

14. (c) The requirement is to describe market conditions in a competitive market when both demand and supply increase. In a competitive market, the market will always clear at the equilibrium price. If there is an equal increase in both demand and supply, the equilibrium price may increase, decrease, or remain the same. However, there will be more units sold and, therefore, answer (c) is correct. Answers (a), (b), and (d) are incorrect because the equilibrium price may increase, decrease, or remain the same.

15. (d) The requirement is to calculate the marginal propensity to consume. Answer (d) is correct because the marginal propensity to consume is calculated by dividing the change in consumption by the change in disposable income. Therefore, the marginal propensity to consume would be .75 [($44,000 − $38,000)/($48,000 − $40,000)].

16. (b) The requirement is to determine the item that will cause a shift in the supply curve. A shift in the supply curve may result from (1) changes in production technology, (2) changes or expected changes in resource prices, (3) changes in the prices of other goods, (4) changes in taxes or subsidies, (5) changes in the number of sellers in the market, and (6) expectations about the future price of the product. Answer (b) is correct because it identifies changes in production taxes, which will alter the supply curve. Answer (a) is incorrect because a change in the price of the product involves movement along the existing supply curve, not a shift in the supply curve. Answers (c) and (d) are incorrect because they identify changes that result in a shift in the demand curve.

17. (d) The requirement is to identify the effects of government regulation on a product. Government regulation increases the cost of the product and therefore will most likely result in higher prices. Thus answer (d) is correct. Answer (a) is incorrect because the regulation has no relationship to consumption. Answer (b) is incorrect because an increase in cost is not likely to result in a decrease in price. Answer (c) is incorrect because tax revenue will likely decline due to the added production costs and reduced sales.

18. (a) The requirement is to identify which of the situations indicate inelastic demand. Elasticity of demand is measured by the percentage change in the quantity demanded divided by the percentage change in price. If the quotient is greater than one, demand for product is price elastic, and if it less than one, demand for the product is price inelastic. A quotient of exactly one indicates unitary elasticity. Answer (a) is correct because the price elasticity quotient is equal to 0.6 (3%/5%). Answer (b) is incorrect because the quotient is 1.5 (6%/4%). Answer (c) is incorrect because the quotient is 1 (4%/4%). Answer (d) is incorrect because the quotient is equal to 1.67 (5%/3%).

19. (a) The requirement is to describe the effect of an increase in wages on demand for labor. Answer (a) is correct because, like any other good or service, if price is increased for labor, the demand will fall and employment will fall. Answer (b) is incorrect because setting a maximum wage will not allow workers to increase wages. Answer (c) is incorrect because firms may or may not change in size. Answer (d) is incorrect because supply will only decrease if the price of the product decreases.

20. (a) The requirement is to identify the market effects of a polluting manufacturer's actions. Answer (a) is correct because a polluting firm calculates its profits without considering the costs of environmental damage and, as a result, prices its products too low. Answer (b) is incorrect because the polluting manufacturer is producing too much, not too little output. Answer (c) is incorrect because the manufacturer reports too much, not too little profitability. Answer (d) is incorrect because there is no direct relationship between the use of equity versus debt financing and the externalities involved in the production activities of the firm.

21. (b) The requirement is to describe the effects of a government-mandated maximum price. If the government mandates a maximum price below the equilibrium price, the product will be selling at an artificially low price resulting in shortages. Thus the correct answer is (b). Answer (a) is incorrect because price floors result in surpluses. Answer (c) is incorrect because price ceilings would probably result in more demand. Answer (d) is incorrect because the market would be affected.

22. (b) The requirement is to identify a valid reason for government intervention in a wholesale market. Answer (b) is correct because a valid reason for government intervention is the lack of a competitive market. Answers (a), (c), and (d) are incorrect because they provide no indication that the market is not competitive.

23. (a) The requirement is to identify the type of good that is likely to have an income elasticity coefficient of 3.00. Answer (a) is correct because an income elasticity coefficient of 3.00 indicates that demand for the good is very sensitive to income levels. This is a characteristic of a luxury good. Answer (b) is incorrect because while the good may be complementary, it would have to be complementary to a luxury good. Answer (c) is incorrect because an inferior good's coefficient will be negative. Answer (d) is incorrect because demand for a necessity is not sensitive to income levels.

24. (c) The requirement is to calculate the price elasticity of demand for golf. The price elasticity of demand is calculated as the percentage change in quantity divided by the percentage change in price. If the result is greater than one, demand is elastic; if it is less than one, it is inelastic; and if it is equal to one, it is unitary elastic. The regular weekday demand is elastic as calculated below.

The weekend demand is inelastic as calculated below.

The senior citizen demand is elastic as calculated below.

The only statement that correctly defines these relationships is answer (c).

25. (c) The requirement is to identify the factor that would cause the demand curve for a product to shift to the left. Answer (c) is correct because a shift in the demand curve to the left would be indicative of a decrease in demand for the product, and an increase in the price of a complementary commodity would cause such a shift. Answers (a), (b), and (d) are incorrect because they would all potentially cause an increase in demand, causing the demand curve to shift to the right.

26. (c) The requirement is to describe the effect of price ceilings. Price ceilings cause the price of a product to be artificially low resulting in decreased supply. The price is below the equilibrium price as indicated by answer (c). Answer (a) is incorrect because government price support is an example of a price floor. Answer (b) is incorrect because price ceilings create prices less than equilibrium prices. Answer (d) is incorrect because price ceilings create shortages, not surpluses.

27. (b) The requirement is to determine the immediate effect upon one product of an increase in the price of a substitute good. The demand and price of substitute products are directly related. If the price of a good increases, the demand for its substitute will also increase. Answer (b) is correct because it depicts this relationship. Answer (a) is incorrect because the price of a product will not increase due to an increase in a substitute product's price. Answer (c) is incorrect because the quantity supplied will not be impacted by an increase in price of a substitute product. Answer (d) is incorrect because even though the quantity demanded will increase with an increase in price of a substitute product, the price and supply will not be directly affected.

28. (d) The requirement is to calculate the effect a decrease in the price of a substitute good has on demand for a good. Answer (d) is correct because if the coefficient of cross-elasticity is 2.00, a 5% decrease in price will result in a 10% (5% × 2.00) decrease in the demand for Wilson's product. Answers (a), (b), and (c) are incorrect because they misstate the relationship.

29. (d) The requirement is to calculate the price elasticity of demand for a product. Price elasticity using the arc method is calculated by dividing the percentage change in quantity demanded by the percentage change in price, using the average changes. In this case, price elasticity is calculated below.

Therefore answer (d) is correct.

30. (b) The requirement is to calculate the price elasticity of demand. Answer (b) is correct because the formula for price elasticity is equal to the percentage change in quantity demanded divided by the percentage change in price. In this case, the percentage change in price is 0.88 as calculated below.

31. (b) The requirement is to identify the effect of a boycott on demand for a good. Answer (b) is correct because a boycott means less people are purchasing the good. Therefore, demand is decreased. Answer (a) would not occur because, if anything, a decrease in demand would lead to a decrease in price. Answer (c) is incorrect because demand does not affect supply. Answer (d) is incorrect because the elasticity of demand for a good is determined by its nature.

32. (c) The requirement is to identify the factor that is not likely to affect the supply of a good. Answer (c) is correct because changes in consumer income could affect the demand for the good, but not its supply. Answer (a) is incorrect because government subsidies reduce the cost of producing a good, and therefore, affect supply. Answer (b) is incorrect because changes in technology can alter production costs, and therefore, affect supply. Answer (d) is incorrect because changes in production costs affect the supply of a good.

33. (d) The requirement is to identify the effect on total revenue of a decrease in price of a price-elastic product. Answer (d) is correct because if a product's demand is price-elastic, a decrease in price will lead to an even larger percentage increase in quantity demanded. Therefore, total revenue will increase. Answers (a), (b), and (c) are incorrect because they do not describe the appropriate effect.

34. (a) The requirement is to identify the goods that are not complementary goods. Complementary goods are those that are used together because they enhance each other's use. Margarine and butter are substitute goods, not complementary goods. Therefore, (a) is correct. Answers (b), (c), and (d) all are pairs of complementary goods.

35. (a) The requirement is to describe the law of diminishing marginal utility. The law states that marginal utility declines as consumers acquire more of a good. Therefore, answer (a) is correct. Answer (b) is incorrect because total utility will not decline as more of a good is acquired. Answer (c) is incorrect because the demand curve slopes downward.

36. (b) The requirement is to identify the price elasticity of an essential product with no substitutes. The correct answer is (b). Demand for the product is perfectly inelastic because the diabetic will purchase the product regardless of the price.

37. (c) The requirement is to define the implications of economies of scale. In the long run firms may experience increasing returns because they operate more efficiently. With growth comes specialization of labor and related production efficiencies related to the law of diminishing returns. This phenomenon is called economies of scale. Answer (c) is correct because it accurately describes this concept. Answers (a) and (b) are incorrect because they describe inefficiencies. Answer (d) is incorrect because total costs do not decline but average costs do.

38. (d) The requirement is to identify the reason for increasing returns. In the long run firms may experience increasing returns because they operate more efficiently. With growth comes specialization of labor and related production efficiencies. This phenomenon is called economies of scale and, therefore, answer (d) is correct. Answer (a) is incorrect because the law of diminishing returns states that at some point firms get too large and diminishing returns occur. Answer (b) is incorrect because opportunity cost is the benefit forgone by the use of a particular resource. Answer (c) is incorrect because comparative advantage deals with the production choices of countries.

39. (b) The requirement is to identify the term used to describe the benefit lost by using resources for a given purpose. The correct answer is (b) because opportunity cost is the benefit given up from not using the resource for another purpose. Answer (a) is incorrect because economic efficiency is a comparison among uses of resources. Answers (c) and (d) are incorrect because they involve comparisons across countries.

40. (c) The requirement is to calculate the total cost of producing seven units. Total cost is equal to average total cost multiplied by the number of units produced. Therefore, the correct answer is (c) because 7 × $36.86 = $258.02.

41. (c) The requirement is to calculate marginal cost. Marginal cost is the additional cost of producing one additional item. To calculate the marginal cost of producing the ninth unit we take the total cost of producing nine units and deduct the total cost of producing eight units. Thus, the correct answer is (c) because (9 × $33.75) − (8 × $34.75) = $25.75.

42. (a) The requirement is to calculate the average total cost at an output level of 11 units. Answer (a) is correct because the average total cost is calculated by dividing total cost by the number of units: [($1,000 fixed cost + $250 variable cost)/11] = $113.64.

43. (c) The requirement is to calculate the marginal physical product. The marginal physical product is the additional output obtained by adding one additional worker. When one worker is added to a team of 10, five (25 − 20) additional units are produced. Therefore, the correct answer is (c).

44. (c) The requirement is to calculate the marginal revenue per unit. The total revenue of adding one additional worker to a team of 11 is equal to the difference between total revenue at 12 workers and total revenue at 11 workers, or $105 [(25 × $49) − (28 × $47.50)]. Answer (c) is correct because the marginal revenue per unit is $35 = $105/3. Answer (d) is incorrect because it is the average selling price for one unit.

45. (c) The requirement is to calculate the marginal revenue product when one worker is added. The marginal revenue product is the increase in total revenue received by the addition of one worker. The total revenue from adding one additional worker to a team of 11 is equal to the difference between total revenue at 12 workers and total revenue at 11 workers, or $105 [(25 × $49) − (28 × $47.50)]. Therefore answer (c) is correct.

46. (d) The requirement is to define marginal revenue. The correct answer is (d) because marginal revenue is the change in total revenue associated with the sale of one more unit of output. Answer (a) is incorrect because in a monopolistic competitive market, price is greater than marginal cost. Answer (b) is incorrect because marginal revenue is the increase in revenue associated with the sale of one additional product. Answer (c) is incorrect because in a purely competitive market, marginal revenue is equal to price.

47. (d) The requirement is to identify the distinguishing characteristic of long-run supply. Answer (d) is correct because the distinguishing characteristic of the long-run production function is that all costs are variable. Answers (a) and (b) are incorrect because price and output are determined by demand and supply. Answer (c) is incorrect because firms can enter or exit the industry.

48. (d) The requirement is to identify the main factor that differentiates the short-run cost function from the long-run cost function. Answer (d) is correct because in the short run firms have fixed and variable costs, whereas in the long run all costs are variable. Answer (a) is incorrect because all costs are variable in the long run. Answer (b) is incorrect because the level of technology will affect short-run and long-run cost functions in a similar manner. Answer (c) is incorrect because changes in government subsidies will not affect an industry's cost functions.

49. (a) The requirement is to describe how a large required capital outlay affects a market. The correct answer is (a) because a large capital outlay constitutes a barrier to entry into the market. Answer (b) is incorrect because minimum efficient scale indicates that a company must be of sufficient size to compete. This is not indicated by the scenario. Answer (c) is incorrect because a created barrier is one created by the competing firms. Answer (d) is incorrect because the production possibility boundary shows the maximum combination of outputs that can be achieved with a given number of inputs.

50. (c) The requirement is to identify the type of economic market. The correct answer is (c) because an oligopoly is characterized by a few firms in the industry. Answer (a) is incorrect because a natural monopoly has only one firm. Answer (b) is incorrect because a cartel is a group of firms that have joined together to fix prices. Answer (d) is incorrect because monopolistic competition is characterized by a large number of firms selling similar but differentiated products.

51. (d) The requirement is to identify the distinguishing characteristics of oligopolistic markets. The correct answer is (d) because of the small number of suppliers in an oligopolistic market, the actions of one affect the others; there is mutual interdependence with regard to pricing and output in an oligopolistic market. Answers (a) and (b) are incorrect because they describe monopolies. Answer (c) is incorrect because oligopolistic markets typically have barriers to entry.

52. (a) The requirement is to identify the characteristic that is not representative of monopolistic competition. The correct answer is (a) because monopolistic competition is a market that has numerous sellers of similar but differentiated products. Answers (b), (c), and (d) are incorrect because they are all characteristic of monopolistic competition.

53. (b) The requirement is to identify the market that is characterized by a few large sellers. Answer (b) is correct because it is the definition of an oligopoly. Answer (a) is incorrect because a monopoly has a single seller of a product or service for which there are no close substitutes. Answer (c) is incorrect because perfect competition is characterized by many firms selling an identical product or service. Answer (d) is incorrect because monopolistic competition is characterized by many firms selling a differentiated product or service.

54. (c) The requirement is to identify the different types of economic markets. Answer (c) is correct because it is the definition of perfect competition. Answer (a) is incorrect because a monopoly has a single seller of a product or service for which there are no close substitutes. Answer (b) is incorrect because an oligopoly is a form of market in which there are few large sellers of the product. Answer (d) is incorrect because monopolistic competition is characterized by many firms selling a differentiated product or service.

55. (c) The requirement is to identify the definition of a natural monopoly. The correct answer is (c) because a natural monopoly exists when, because of economic or technical conditions, only one firm can efficiently supply the product. Answer (a) is incorrect because while owning natural resources may contribute to the establishment of a natural monopoly, the firm would still have to be the best possible producer of the product. Answer (b) is incorrect because a patent establishes a government-created monopoly. Answer (d) is incorrect because if the government is the only provider, the market is a government-created monopoly.

56. (c) The requirement is to identify the market described as one with low barriers to entry and product differentiation. The correct answer is (c) because monopolistic competition is a market that is characterized by a large number of small producers of a differentiated product. Answer (a) is incorrect because a monopoly has only one producer. Answer (b) is incorrect because a natural monopoly is an industry in which there is only one producer based on the economics of the industry. Answer (d) is incorrect because an oligopoly is an industry that has a few large producers with barriers to entry.

57. (d) The requirement is to identify the item that is not characteristic of perfect competition. In a perfectly competitive market there are a large number of small producers selling a standard product. Answer (d) is correct because all sellers must sell at the industry price. Answers (a), (b), and (c) are all characteristics of perfect competition.

58. (a) The requirement is to describe the reason for the kinked demand curve in an oligopolist market. An oligopolist faces a kinked demand curve because competitors will often match price decreases but are hesitant to match price increases. Therefore, answer (a) is correct. Answer (b) is incorrect because an oligopolist does not face a nonlinear demand for its product. Answer (c) is incorrect because an oligopolist cannot sell its product for any price. Answer (d) is incorrect because consumer demand determines the demand curve in all markets.

59. (a) The requirement is to identify the impact of consumer confidence upon the economy. Answer (a) is correct because if consumer confidence falls then consumers will delay spending until the uncertainty is resolved. The end result is a downturn in the economy. Answers (b), (c), and (d) are incorrect because they do not properly state the relationship between consumer confidence and the economy.

60. (a) The requirement is to determine the marginal propensity to consume given the multiplier. The multiplier refers to the fact that an increase in spending has a multiplied effect on GDP. The effect of the multiplier can be estimated using the economy's marginal propensity to consume, or vice versa. In this case, the multiplier is 4 ($80/$20) and the marginal propensity to save is 25% (1.00/4). Therefore, answer (a) is correct because the marginal propensity to consume is one minus the marginal propensity to save, or 75% (100% − 25%).

61. (c) The requirement is to identify a characteristic of the trough of a business cycle. In the trough of a business cycle, actual output and income are below potential output and income. Therefore, the correct answer is (c). Answer (a) is incorrect because purchasing power is not directly related to business cycles. Answer (b) is incorrect because in a recession it is cyclical unemployment that is high, not natural unemployment. Answer (d) is incorrect because potential income will exceed actual income.

62. (c) The requirement is to describe the effect of a decrease in government spending on the economy. The government represents one segment of the economy that demands goods and services. If government spending decreases, aggregate demand decreases. Thus, answer (c) is correct. Answer (a) is incorrect because a decrease in government spending will result in a decrease in aggregate demand. Answers (b) and (d) are incorrect because a decrease in government spending will not immediately affect supply.

63. (d) The requirement is to define aggregate demand. The correct answer is (d) because aggregate demand is the total amount of expenditures for consumer goods and investment for a period of time. It includes purchases by consumers, businesses, government, and foreign entities.

64. (d) The requirement is to identify an item that would be included in GDP. Gross domestic product is the value of all final goods and services produced by the country by both domestic and foreign-owned sources. Answer (d) is correct because common stock is not a good or service; it is an ownership interest in a company. Answers (a), (b), and (c) are all incorrect because they all represent the value of goods or services produced.

65. (d) The requirement is to identify the indicator of an upturn in economic activity. Answer (d) is correct because a reduction in the amount of luxury purchases is an indicator of a downturn in economic activity. Answers (a), (b), and (c) are all indicators of positive economic changes.

66. (d) The requirement is to identify a leading indicator of economic expansion. Answer (d) is correct because an increase in weekly hours worked by production workers is a favorable leading indicator. Answer (a) is incorrect because a falling money supply is an indicator associated with falling GDP. Answer (b) is incorrect because a decline in the issuance of building permits signals lower expected building activity and a falling GDP. Answer (c) is incorrect because an increase in the timeliness of delivery by vendors indicates slacking business demand and potentially falling GDP.

67. (d) The requirement is to identify the definition of disposable income. Answer (d) is correct because disposable income equals personal income minus personal taxes. It is the portion of income that can be spent by the consumer. Answer (a) is incorrect because gross domestic product less the capital cost allowance is net domestic product. Answer (b) is incorrect because net domestic product minus indirect business taxes plus net income earned abroad is national income. Answer (c) is incorrect because disposable income is not measured by deducting transfer payments from personal income.

68. (c) The requirement is to identify the primary reason for allowing legal immigration into industrial nations. Answer (c) is correct because immigration will increase the supply of labor and lower its equilibrium price. This results in greater domestic and world output and increases income in the country to which workers migrate. Answer (a) is incorrect because the impact on trade deficit is less than that on growth. Answers (b) and (d) are incorrect because trade agreements and political agreements are not primary reasons.

69. (a) The requirement is to identify a lagging economic indicator. Lagging indicators include (1) average duration of unemployment in weeks, (2) the change in the index of labor cost per unit of output, (3) the average prime rate charged by banks, (4) the ratio of manufacturing and trade inventories to sales, (5) commercial and industrial loans outstanding, (6) the ratio of consumer installment credit outstanding to personal income, and (7) the change in the CPI for services. Answer (a) is correct because chronic unemployment is a lagging indicator. Answers (b), (c), and (d) are incorrect because they are all leading indicators.

70. (d) The requirement is to identify the true statement about government borrowing to finance large deficits. The correct answer is (d) because increased borrowing by the government increases the demand for money, which puts upward pressure on interest rates. Answer (a) is incorrect because government borrowing reduces the amount of lendable funds; it does not increases them. Answer (b) is incorrect because government borrowing exerts upward pressure on interest rates not downward pressure. Answer (c) is incorrect because government borrowing puts upward pressure on interest rates.

71. (d) The requirement is to describe the effects of rising inflation. Answer (d) is correct because rising inflation increases the price level of goods, which means that individuals can purchase less. Answer (a) is incorrect because individuals that receive specific amounts of money lose purchasing power. Answer (b) is incorrect because there is an inverse relationship between price level and purchasing power. Answer (c) is incorrect because if the contracts have indexing provisions, the prices will increase.

72. (d) The requirement is to describe the most effective fiscal policy for reducing demand-pull inflation. Demand-pull inflation is caused by excess demand that bids up the cost of labor and other resources. The correct answer is (d) because the most effective government policy would involve reducing demand that could be done by taxation and reduced government spending. Answer (a) is incorrect because it involves monetary policy. Answers (b) and (c) are incorrect because increasing government spending would feed demand-pull inflation.

73. (c) The requirement is to identify an action that will cause a decrease in money supply. The correct answer is (c) because an increase in the reserve requirement will leave financial institutions with less money to lend and therefore decrease the money supply. Answers (a), (b), and (d) are incorrect because they would all result in an increase in the money supply.

74. (c) The requirement is to identify how the Federal Reserve Board most directly influences the decision of whether or not to issue debt or equity financing. Answer (c) is correct because the Board sets the discount rate at which the Federal Reserve Bank lends money to member banks, which directly influences the rates that commercial banks charge their customers. Answer (a) is incorrect because the Board does not affect the income tax rate. Answers (b) and (d) are incorrect because the Federal Reserve Bank charges member banks the discount rate.

75. (d) The requirement is to identify the effects of a tax increase. Answer (d) is correct because a tax increase reduces household income and, therefore, reduces spending and decreases aggregate demand.

76. (b) The requirement is to describe an expansionary monetary policy. The correct answer is (b) because purchasing US securities would increase the amount of money in the economy. Answer (a) is incorrect because raising the reserve requirement would decrease the amount of money in the economy. Answer (c) is incorrect because raising the discount rate would discourage borrowing by banks and therefore reduce the amount of money in the economy. Answer (d) is incorrect because both of the actions would tend to reduce the money supply.

77. (a) The requirement is to define the reserve ratio. The reserve ratio is the percentage of total checking deposits that a financial institution must hold on reserve in the central bank. Thus, the correct answer is (a). Answer (b) is incorrect because it is the description of the discount rate.

78. (b) The requirement is to identify the most important way that the money supply is controlled. The correct answer is (b). The purchase and sale of government securities (open-market operations) is the most important way that the government controls the money supply. Answers (a) and (d) are incorrect because, while they are instruments of monetary policy, they are not the most important ways of controlling money supply. Answer (c) is incorrect because it describes an instrument of fiscal policy.

79. (d) The requirement is to define how the government uses fiscal policy to stimulate the economy. To stimulate the economy with fiscal policy, the government would lower taxes and/or increase spending. Therefore, the correct answer is (d). Answer (a) is incorrect because raising taxes does not stimulate the economy. Answer (b) is incorrect because decreasing government spending does not stimulate the economy. Answer (c) is incorrect because increasing the money supply involves monetary policy.

80. (c) The requirement is to define the federal budget deficit. The federal budget deficit is the amount by which the government's expenditures exceed its revenues in a given year. Thus, answer (c) is correct. Answer (a) is incorrect because it defines the government debt. Answer (b) is incorrect because state and local government amounts are not included in the federal budget deficit. Answer (d) is incorrect because the deficit does not deal with assets and liabilities of the government.

81. (a) The requirement is to identify the tool that would serve to control inflation. Answer (a) is correct because selling government securities serves to reduce capital available for other investments and, therefore, serves to contract the economy. Answer (b) is incorrect because lowering reserve requirements serves to increase the amount of funds available for investment. Answer (c) is incorrect because lowering the discount rate serves to decrease the cost of funds and increase investment. Answer (d) is incorrect because encouraging higher tax rates is a fiscal policy.

82. (a) The requirement is to determine the reason for the importance of the multiplier. The multiplier provides an indication of the impact of an increase in consumption or investment in GDP. An increase in spending ripples through the economy because individuals and business save only a portion of the increase in income. Therefore, the correct answer is (a).

83. (a) The requirement is to identify the purpose of a tax rebate. Answer (a) is correct because increasing the amount of funds available to the consumer increases disposable income that should stimulate economic activity. Consumers will spend the additional funds and correspondingly expand the economy. Answers (b), (c), and (d) are erroneous statements about the effects of the rebate.

84. (c) The requirement is to identify the definition of structural unemployment. Answer (c) is correct because structural unemployment exists when aggregate demand is sufficient to provide full employment, but the distribution of the demand does not correspond precisely to the composition of the labor force. This form of unemployment arises when the required job skills or the geographic distribution of jobs changes. Answer (a) is incorrect because frictional unemployment results from imperfections in the labor market. It occurs when both jobs and workers to fill them are available. Answer (b) is incorrect because cyclical unemployment is caused by contractions of the economy. Answer (d) is incorrect because the full-employment unemployment rate is the sum of frictional and structural unemployment.

85. (a) The requirement is to identify the nature of the producer price index. Answer (a) is correct because the price index measures the combined price of a selected group of goods and services for a specified period in comparison with the combined price of the same or similar goods for a base period. The US government's producer price index (PPI) is an example. It measures the price of a basket of 3,200 commodities at the point of their first sale by producers. Answer (b) is incorrect because the export price index measures price changes for all products sold by domestic producers to foreigners. Answer (c) is incorrect because the import price index measures price changes of goods purchased from other countries. Answer (d) is incorrect because the consumer price index measures the price of a fixed market basket of goods purchased by a typical urban consumer.

86. (a) The requirement is to identify the formula for calculating a price index. Answer (a) is correct because the 2013 price index using 2008 as a reference period is the price of the 2013 market basket in 2013 relative to the price of the same basket of goods in 2008. The correct formula is

Answer (b) is incorrect because the 2008 market basket is used. Answer (c) is incorrect because it uses two different market baskets. Answer (d) is incorrect because it uses the 2008 prices in the numerator and the denominator and different market baskets.

87. (d) The requirement is to describe the discount rate. The correct answer is (d) because the discount rate is the rate the central bank charges commercial banks for loans. Answer (a) is not correct because it describes the reserve requirement.

88. (c) The requirement is to identify which of the statements is true about deflation. Answer (c) is correct because deflation results in very low interest rates. They could even turn negative. Answer (a) is incorrect because consumers are not motivated to borrow money because they will be paying back the debt with money that has greater purchasing power. Answer (b) is incorrect because businesses are hesitant to make investments because prices for capital goods are declining. Answer (d) is incorrect because deflation typically stalls the economy.

89. (a) The requirement is to identify the characteristics of a deflationary economy. The correct answer is (a) because businesses are hesitant to make investments when the prices of assets are declining. Answer (b) is incorrect because consumers are hesitant to make major purchases when prices are declining. Answer (c) is incorrect because interest rates are very low in periods of deflation. Answer (d) is incorrect because when actual GDP exceeds potential GDP inflation will exist.

90. (a) The requirement is to identify the factor that explains the difference between real and nominal interest rates. Real interest rates are in terms of goods; they are adjusted for inflation. The difference between real and nominal rates is the inflation premium. Thus, answer (a) is correct. Answers (b) and (c) are incorrect because credit risk and default risk explain the difference between the nominal rate and the rate a particular borrower receives. Answer (d) is incorrect because market risk explains the difference between the nominal rate and the rate paid in a particular market.

91. (c) The requirement is to identify the statement that is not true regarding international trade. Answer (c) is correct because absolute advantage is the ability to produce a product for less than other nations. Comparative advantage is the ability of one nation to produce at a relatively lower opportunity cost than another nation. Answers (a), (b), and (d) are all incorrect because they are true.

92. (a) The requirement is to describe the effect of an increase in the interest rate on a currency's value. The correct answer is (a) because if the interest rate is increased investors will be able to get a larger return on investment in the country. Therefore, demand for the currency will increase for investment purposes, and the relative value of the currency will increase.

93. (b) The requirement is to identify the group that would most benefit from a tariff. The correct answer is (b) because a tariff restricts the amount of imports of a specific good, and the group most benefiting would be the domestic producers of that good. Answers (a), (c), and (d) are incorrect because these groups would not benefit from the tariff.

94. (a) The requirement is to identify the description of comparative advantage. Answer (a) is correct because the respective opportunity costs determine which country will produce which product. Answer (b) is incorrect because profit margins do not enter into the decision. Answer (c) is incorrect because economic order quantity determines optimum inventory levels. Answer (d) is incorrect because tariffs would only come into play after each country produced its respective products.

95. (c) The requirement is to identify the scenario that would result in appreciation in the value of a country's currency. The correct answer is (c) because the lag in imports in relation to exports means that there will be more demand for the currency from other countries to pay for the country's exported goods. Answer (a) is incorrect because if the country is importing goods this will increase demand for other currencies and cause the country's currency to decline in relative value. Answer (b) is incorrect because a higher rate of inflation depresses a country's currency. Answer (d) is incorrect because lower interest rates means there will be less demand for the currency for investment.

96. (c) The requirement is to identify the effect of a decline in the US dollar. The correct answer is (c) because US goods will be cheaper in foreign countries and, therefore, US exports will increase. Answer (a) is incorrect because foreign currencies will appreciate if the dollar depreciates. Answer (b) is incorrect because the US balance of payments should improve due to the increase in exports. Answer (d) is incorrect because US imports will decline because of the increase in cost of foreign goods in dollars.

97. (c) The requirement is to describe how exchange rates are determined. The correct answer is (c) because exchange rates are determined in the same way price is determined for other goods, based on demand and supply. Answers (a), (b), and (d) are incorrect because while they can have a temporary influence on exchange rates, supply and demand is the major determining factor.

98. (b) The requirement is to determine the effect of changes in exchange rates. Answer (b) is correct because the dollar's value has declined against the mark and therefore German goods become more expensive. Answer (a) is incorrect because the German mark has appreciated against the dollar. Answer (c) is incorrect because the dollar will buy less in Germany. Answer (d) is incorrect because US exports to Germany should increase because they are less expensive in German marks.

99. (c) The requirement is to identify the most restrictive barrier to an exporting country. The correct answer is (c) because an embargo is a total ban on certain types of imports. Answer (a) is incorrect because a tariff is merely a tax on imports. Answer (b) is incorrect because quotas are merely restrictions on the amounts of imports. Answer (d) is incorrect because exchange controls are limits of the amount of foreign exchange that can be transacted or exchange rates.

100. (d) The requirement is to identify the item that does not describe a foreign exchange control. Answer (d) is correct because requiring a market-driven (floating) exchange rate involves no controls on the market. All others describe ways of controlling foreign exchange.

101. (b) The requirement is to identify the item that describes a dumping pricing policy. Answer (b) is correct because a dumping pricing policy involves sales of goods by a company of one country in another country at a price that is lower than its cost or significantly lower than the price charged in the company's country.

102. (a) The requirement is to identify the item that describes an appropriate response by importing country to export subsidies. Answer (a) is correct because countervailing subsidies is an appropriate response, as they serve to offset the export subsidies.

103. (c) The requirement is to identify the item that describes a pegged exchange rate. Answer (c) is correct because a pegged exchange rate is one that is kept from deviating far from a range or value by the central bank.

104. (a) The requirement is to calculate the forward premium or discount on the euro. Answer (a) is correct because the premium or discount is calculated as follows:

105. (a) The requirement is to identify the effect of negative net exports. Answer (a) is correct because when a country has negative net exports, it imports more than it exports. Therefore, it results in a net flow of goods from firms in foreign countries to the domestic country.

106. (d) The requirement is to identify the factor that is least likely to affect a country's currency foreign exchange rate. Answer (d) is correct because the country's tax rate is least likely to affect the country's currency exchange rate. Answers (a), (b), and (c) are incorrect because they are all factors that affect the value of the country's currency.

107. (c) The requirement is to compute the foreign exchange loss or gain. The correct answer is (c) because before the decline in value, the receivable had a value of $18,000 (10,000 × $1.80), and after the decline in value, the receivable had a value of $17,500 (10,000 × $1.75). Therefore, the loss is equal to $500. Answers (a), (b), and (d) are incorrect because they inaccurately calculate the loss.

108. (c) The requirement is to identify the appropriate hedging strategy. The correct answer is (c) because by selling euros in the futures market, the firm has locked in the exchange rate today. Answer (a) is incorrect because lending euros puts the company at greater risk for changes in value of the euro. It would need to borrow euros to lock in the exchange rate. Answer (b) is incorrect because it involves the purchase of euros; the appropriate strategy would involve the sale of euros. Answer (d) is incorrect because the purchase of euros on the spot market would put the firm more at risk to losses from decline in the value of the euro.

109. (b) The requirement is to identify hedging strategies that are not appropriate for political risk. Political risk is the risk related to actions by a foreign government, such as enacting legislation that prevents the repatriation of a foreign subsidiary's profits or seizing a firm's assets. Answer (b) is correct because purchasing or selling futures contracts is designed to hedge transaction risks relating to foreign exchange rates. Answer (a) is incorrect because a firm can purchase insurance to mitigate political risk. Answer (c) is incorrect because if the firm finances the investment with local-country capital, it may not be forced to repay the loans if assets are seized by the government. Answer (d) is incorrect because by entering into joint ventures with local-country firms, the firm can reduce the risk of seizure of the investment by the government.

110. (c) The requirement is to describe how patents affect markets. The correct answer is (c) because a patent prevents another firm from coming into a market and selling the same or a very similar product. Therefore, it is a barrier to entry into the market. Answer (a) is incorrect because vertical integration refers to expansion into another phase of producing the same product. Answer (b) is incorrect because market concentration refers to how many firms compete in the market. Answer (d) is incorrect because collusion refers to firms acting collectively to control the market.

111. (c) The requirement is to estimate the short-term and long-term effects of an increase in demand in a perfectly competitive market. Answer (c) is correct because in the short term the price of the product will increase but in the long term it will return to the equilibrium price for the market. Answers (a), (b), and (d) are incorrect because the long-term price will not likely increase.

112. (d) The requirement is to identify the ultimate purpose of competitor analysis. Answer (d) is correct because the ultimate purpose of competitor analysis is to understand and predict the behavior of a major competitor. Answer (a) is not a part of competitor analysis. Answers (b) and (c) are part of competitor analysis but not the ultimate purpose.

113. (c) The requirement is to identify the item that is not an important aspect of supply chain management. Supply chain management is primarily designed to manage the firm's relationships with suppliers by sharing key information all along the supply chain. The correct answer is (c) because the area of customer relations is not a primary focus of supply chain management. Answer (a) is incorrect because information technology is used extensively to share information electronically. Answer (b) is incorrect because accurate forecasts are essential to effective supply chain management. Answer (d) is incorrect because communication is the basis for supply chain management.

114. (d) The requirement is to identify the type of organization that would most likely engage in public relations-type advertising. Firms that have monopolies are more likely to engage in public relations-type advertising to forestall additional regulation. Therefore, the correct answer is (d).

115. (b) The requirement is to identify target market analysis. The correct answer is (b) because target market analysis involves obtaining a thorough understanding of the market in which the firm sells or plans to sell its product or services.

116. (c) The requirement is to identify an unlikely market segmentation dimension for business customers. Answer (c) is correct because lifestyle is a possible individual customer market segmentation dimension for individuals, not businesses. Answers (a), (b), and (d) are incorrect because they all represent possible dimensions for business customer segmentation.

117. (b) The requirement is to identify the percentage of variance in quantity demanded explained by price. Answer (b) is correct because the adjusted R squared (.72458) measures the percent of the variance in the dependent variable explained by the independent variable. Answer (a) is incorrect because it is the Multiple R that is the coefficient of correlation. Answer (c) is incorrect because it is the intercept that is used in the equation to predict quantity. Answer (d) is incorrect because it is the standard error that measures the standard deviation of the estimate of quantity.

118. (a) The requirement is to calculate the predicted quantity demanded. The correct answer is (a) because the formula is

119. (d) The requirement is to identify the item that is not one of the forces in Porter's model for industry analysis. The correct answer is (d) because consideration of general economic conditions is not part of industry analysis. Answers (a), (b), and (c) are incorrect because the five forces include the threat of new entrants, the bargaining power of customers, the bargaining power of suppliers, the threat of substitute products or services, and the rivalry of the firms in the market.

120. (a) The requirement is to identify the defining characteristic of supply chain management. The correct answer is (a) because a key aspect of supply chain management is the sharing of key information from the point of sale to the consumer back to the manufacturer, the manufacturer's suppliers, and the supplier's suppliers. Answer (b) is incorrect because it is the focus of process reengineering. Answer (c) is incorrect because it is the focus of total quality management. Answer (d) is incorrect because strategic alliances involve joint ventures and partnerships.

121. (d) The requirement is to identify an unlikely strategy for a firm in a purely competitive market. The correct answer is (d) because in a purely competitive market firms compete based on price, and developing a brand name is a product differentiation strategy. Answers (a), (b), and (c) are all cost leadership strategies and appropriate for a firm in a purely competitive market.

122. (c) The requirement is to identify the purpose of a response profile. The correct answer is (c) because a response profile is a description of possible actions that may be taken by a competitor in varying circumstances. Answers (a), (b), and (d) all involve aspects of industry analysis.

123. (b) The requirement is to define the process of dividing all potential consumers into smaller groups of buyers with distinct needs, characteristics, or behaviors. Answer (b) is correct because this describes market segmentation. Answer (a) is incorrect because strategic planning involves deciding on the appropriate strategic initiatives for a period. Answer (c) is incorrect because product positioning involves deciding on a strategy for a particular product. Answer (d) is incorrect because objective setting involves establishing short-term goals.

124. (c) The requirement is to identify the least important measure of unemployment in predicting the future state of the economy. Answer (c) is the correct answer because frictional unemployment measures the temporary unemployment that always exists as workers change jobs or new workers enter the workforce. Answer (a) is incorrect because structural unemployment measures the workforce that is unemployed due to a mismatch in job skills. Significant amounts of structural unemployment can drag down the economy. Answer (b) is incorrect because cyclical unemployment measures the workforce that is unemployed due to economic conditions. Answer (d) is incorrect because overall unemployment includes the workforce that is unemployed for all reasons.

125. (a) The requirement is to identify the steps involved in performing competitor analysis. Answer (a) is correct because competitor analysis is designed to predict the behavior of major competitors. Answers (b) and (c) are incorrect because they describe aspects of industry analysis. Answer (d) is incorrect because it describes aspects of general environment and industry analyses.

126. (d) The requirement is to identify the item that is not a way in which companies in developed countries can generally compete with companies in developing countries. Answer (d) is correct because developing countries typically have low-cost resources. Answers (a), (b) and (c) are incorrect because they all represent ways that a company in a developed country may compete with companies from developing countries.

Written Communication Task

Written Communication Task 1

The chief executive officer of Urton Corp., Geroge Jones, is preparing for a strategic planning session with the corporation's board of directors. The company has pursued a product differentiation strategy in the past but is having difficulty maintaining margins due to significant competition from domestic and foreign competitors. Write a memorandum describing the product differentiation strategy and another strategy that might be pursued if product differentiation is not working.

To:	Mr. George Jones, CEO
	Urton Corp.
From:	CPA Candidate

Written Communication Task solution

Written Communication Task 1

To:	Mr. George Jones, CEO
	Urton Corp.
From:	CPA Candidate

As you requested, this memorandum is designed to discuss some alternative strategies that may be implemented by Urton Corp. Historically, Urton has implemented a product differentiation strategy. This strategy involves providing products that have superior physical characteristics, perceived differences, or support service differences, which allows the products to command higher prices in the market. When effective, this strategy allows the company to effectively compete with companies that sell lower priced products.

For a product differentiation strategy to be successful, the company must continue to invest in the differentiating factor. Since Urton is no longer effectively competing using a product differentiating strategy, the management should consider whether additional investment in product innovation, support services, or brand identity might allow the company to revive the strategy.

On the other hand, if management believes that pursuing a differentiation strategy is no longer feasible, consideration should be given to a cost leadership strategy. Pursuing a cost leadership strategy would involve cutting costs and improving efficiency to allow the company to offer products at lower prices.

To be competitive, it is essential that the company select a strategy and begin to align management's decisions with that strategy. If you need any additional information, please contact me.