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Unformatted text preview: CA Counsellors Rise Intro to Economics Sir Asif, ACA CACOfficial.com CACOfficial.com CAF – 02 INTRODUCTION TO ECONOMICS AND FINANCE 1st Edition Study Notes and MCQs By: Muhammad Asif, ACA ALL RIGHTS RESERVED. 1st Edition: April 2017 Introduction to Economics and Finance, 1/e AUTHOR Muhammad Asif, ACA PREFACE Why a Chartered Accountant: Economics is a subject which is not seen as a critical subject for students of professional bodies, and therefore, is not taught by chartered accountants in our profession. However, I personally think that a chartered accountant is in a better position to teach any subject to the students of ICAP, as he himself has gone through the education and examination system of ICAP and is fully aware of specific requirements of examiner (which are quite different from requirements of examiners of academic institutes and universities). A chartered accountant also has overall picture of syllabus at CAF as well as CFAP Level, therefore, he is also aware how concepts learnt at basic level are going to be applied at advanced level and he can teach topics in such a way that these may help students in preparation of their advance topics also. For example, many of the concepts learnt in finance section of this subject will be applied by students in the CFAP – 4 (BUSINESS FINANCE DECISIONS). Why this Book: While teaching Economics, I have seen a lot of students having problem in preparing the subject. This problem arises for a number of reasons e.g. books available in the market on this subject are not student-friendly, key concepts from examination point of view are not spotlighted, students encounter many irrelevant paragraphs, and sometimes requirements are not arranged in logical and practical sequence. This book is an effort to make students’ life easy. I have tried to make this subject easy and interesting. I hope you will find it so. Is this book enough: Students often ask me a question, “Is it enough if we read this book, or we also have to read other study material e.g. official study text?”. Answer is “YES, this book is enough”. Your study text is automatically covered if you cover this book. However, there are certain paragraphs in ICAP’s Study Text which are not important from exam point of view and therefore, are not covered in this book (refer transition pages # iii to vi for list of such paragraphs). Once, you cover all concepts from this book, you are advised to cover such paragraphs too from ICAP’s study text. Additional study material: Students are advised to visit weekly (or atleast monthly) the following web-page for subject related queries, latest changes in syllabus, updates and other educational material on the subject: i ANY SUGGESTIONS/COMMENTS? This book is not the best book of economics. However, I am committed to make it the best book for students. This aim cannot be achieved by a single person. Therefore, your help is needed. If you find any errors in the book, any concept which needs to be improved (keeping in mind students’ perspective), or any other suggestion, I will highly appreciate if you share it with me so that in future this book may further be improved. For any comments/ suggestions/additional support, you can contact me through: Address: Cell # : RISE School of Accountancy 06 Aurangzaib Block, New Garden Town, Lahore 0331-4585358 (sms only) e-mail address: [email protected] facebook page: Muhammad Asif April 03, 2017 Lahore ii CROSS REFERENCE FOR TRANSITION FROM ICAP’S STUDY TEXT TO THIS BOOK Ch.# 1: Fundamentals of economics iii ICAP’s Study Text Reference Coverage in This Book 1.1, 1.2, 1.3 2.1 2.2, 2.3, 2.4 3.1, 3.2 LO 1 of Ch.# 1 LO 4 of Ch.# 1 Not Covered Not Covered 3.3 LO 3 of Ch.# 1 ("Importance and limitations" not covered) 3.4 3.5 3.6 LO 2 of Ch.# 1 LO 2 & LO 9 of Ch.# 1 LO 2 of Ch.# 8 3.7 LO 1 of Ch.# 1 ("Rational behaviour" not covered) 3.8 LO 9 of Ch.# 1 3.9 LO 10 of Ch.# 1 ("Applications" not covered) 4.1 4.2 4.3 4.4 4.5 4.6 4.7 5.1 5.2 5.3 5.4 LO 4 of Ch.# 1 LO 10 of Ch.# 1 LO 4 of Ch.# 1 LO 6 of Ch.# 1 LO 5 of Ch.# 1 LO 7 of Ch.# 1 Not Covered Not Covered LO 11 of Ch.# 1 LO 11 of Ch.# 1 LO 5 of Ch.# 14 Chapter 2: Microeconomics ICAP’s Study Text Reference Coverage in This Book 1.1 1.2 1.3 1.4 1.5 1.6 1.7, 1.8 2.1 2.2 2.3, 2.5 - 2.9 2.4 LO 3 of Chapter 1 LO 1 of Chapter 1 LO 8 of Chapter 1 LO 1 of Chapter 2 LO 3 of Chapter 2 LO 1 of Chapter 2 LO 3 of Chapter 1 Not Covered LO 2 of Chapter 2 LO 1 of Chapter 2 LO 7 of Chapter 2 2.10 - 2.12 LO 2 of Chapter 2 ("explaining giffen goods" not covered) 3.1 3.2 3.3, 3.5 - 3.9 3.4 3.10 3.11 4.1-4.2 4.3 4.4 4.5 LO 3 of Chapter 2 LO 4 of Chapter 2 LO 3 of Chapter 2 LO 7 of Chapter 2 LO 3 of Chapter 2 LO 4 of Chapter 2 LO 5 of Chapter 2 LO 6 of Chapter 2 LO 8 of Chapter 2 LO 9 of Chapter 2 Chapter 3: Demand and supply: elasticities ICAP’s Study Text Reference 1.1 1.2 1.3 1.4 1.5, 1.6 2.1 2.2 2.3 3.1 3.2 3.3 Coverage in This Book Not Covered LO 3 of Chapter 3 LO 1, LO 2, LO 6 of Chapter 3 LO 6 of Chapter 3 LO 4, LO 5 of Chapter 3 Not Covered LO 7, LO 8 of Chapter 3 LO 9 of Chapter 3 Not Covered LO 10 of Chapter 3 LO 11 of Chapter 3 Chapter 4: Utility analysis ICAP’s Study Text Reference 1.1 1.2 1.3 - 1.5 2.1 - 2.5 3.1 3.3 - 3.5 3.2, 3.6, 3.7 4.1 4.4 4.2, 4.5 4.3, 4.6 Coverage in This Book LO 3 of Chapter 4 Not Covered LO 2 of Chapter 4 LO 3 of Chapter 4 Not Covered LO 5 of Chapter 4 LO 6, LO 7 of Chapter 4 LO 4 of Chapter 4 Not Covered LO 8 of Chapter 4 LO 9 of Chapter 4 LO 10 of Chapter 4 Chapter 5: Costs, revenues and firms ICAP’s Study Text Reference Coverage in This Book 1.1 - 1.2 LO 4 of Chapter 5 1.3 LO 1 of Chapter 5 ('very long-run not covered) 1.4 - 1.5 1.6 1.7 - 1.10 2.1 - 2.4 2.5 3.1 3.2-3.3 4.1 4.2 4.3 4.4 4.5 4.6 LO 4 of Chapter 5 LO 5 of Chapter 5 LO 6 of Chapter 5 LO 7 & 8 of Chapter 5 Not Covered LO 2 of Chapter 5 LO 3 of Chapter 5 LO 1 of Chapter 5 LO 1 of Chapter 6 Not Covered LO 3 of Chapter 6 LO 4 of Chapter 6 LO 2 of Chapter 6 Chapter 6: Macroeconomics: An introduction ICAP’s Study Text Reference 1.1 1.2 1.3 1.4 - 1.5 2.1 2.2 - 2.4 2.5 3.1 3.2 3.3 - 3.6 4.1 4.2 iv Coverage in This Book LO 1 of Chapter 7 & LO 3 of Chapter 1 Not Covered LO 1 of Chapter 8 LO 6 of Chapter 8 LO 1 of Chapter 8 LO 4 of Chapter 8 LO 7 of Chapter 8 LO 4 of Chapter 8 LO 2 of Chapter 8 LO 3, LO 4 & LO 5 of Chapter 8 Not Covered LO 4 & LO 5 of Chapter 7 4.3 LO 2 & LO 3 of Chapter 7 (excluding Effective demand) 4.4 - 4.7 LO 6 of Chapter 7 Chapter 7: Consumption, savings and investment ICAP’s Study Text Reference Coverage in This Book ICAP’s Study Text Reference Coverage in This Book 1.1 - 1.2 1.3 1.4 - 1.6 1.7 2.1 - 2.3 2.4 - 2.5 2.6 LO 1 of Chapter 9 LO 2 of Chapter 9 LO 3 of Chapter 9 LO 2 of Chapter 9 LO 4 of Chapter 9 LO 5 of Chapter 9 LO 5 of Chapter 12 1.1 1.2 1.3 2.1 2.2 LO 3 of Chapter 15 LO 1 of Chapter 15 LO 2 of Chapter 15 LO 7 of Chapter 15 LO 8 of Chapter 15 Chapter 8: Multiplier and accelerator ICAP’s Study Text Reference Coverage in This Book 2.1 2.2 2.3 2.4 3.1 - 3.5 4.1 - 4.3 5.1 - 5.2 5.3 LO 6 of Chapter 7 LO 3 of Chapter 9 LO 7 of Chapter 9 LO 6 of Chapter 9 LO 1 of Chapter 10 LO 2 of Chapter 10 LO 3 of Chapter 10 LO 12 of Chapter 11 Chapter 9: Growth and taxes ICAP’s Study Text Reference 1.1 - 1.2 1.3 1.4 1.5 - 1.6 2.1 - 2.3 2.4, 2.6 2.5 3.1 3.2, 3.4, 3.6 - 3.7 3.3, 3.5 v Chapter 10: Public finance Coverage in This Book LO 1 of Chapter 8 LO 12 of Chapter 11 LO 13 of Chapter 11 LO 1 of Chapter 8 LO 7 of Chapter 7 LO 4 & LO 9 of Chapter 15 LO 1 of Chapter 7 Not Covered LO 5 of Chapter 15 LO 6 of Chapter 15 Chapter 11: Money ICAP’s Study Text Reference 1.1 - 1.6 2.1 - 2.5 3.1 - 3.3 3.4 3.5 3.6 3.7 4.1 4.2 4.3 - 4.4, 5.1 - 5.2 6.1 - 6.3 6.4 6.5 6.6 6.7 6.8 6.9 6.10 Coverage in This Book Not Covered LO 1 of Chapter 12 Not Covered LO 3 of Chapter 12 LO 2 of Chapter 12 LO 9 of Chapter 7 LO 3 of Chapter 12 Not Covered LO 2 of Chapter 12 LO 4 of Chapter 12 LO 1 & LO 2 of Chapter 11 LO 3 of Chapter 11 LO 4 of Chapter 11 Not Covered LO 5 of Chapter 11 LO 7 of Chapter 11 LO 8 of Chapter 11 LO 10 & LO 11 of Chapter 11 Chapter 12: Monetary policy ICAP’s Study Text Reference Coverage in This Book 1.1 - 1.3 2.1 - 2.2 2.3 - 2.5, 2.7 2.6 3.1 - 3.2 LO 5 of Chapter 12 LO 1 of Chapter 13 LO 8 of Chapter 7 LO 1 of Chapter 7 LO 2 of Chapter 13 Chapter 13: Credit ICAP’s Study Text Reference Coverage in This Book 1.1 1.2 - 1.3 1.4 - 1.6 Not Covered LO 3 of Chapter 13 LO 4 of Chapter 13 Chapter 14: Balance of payments and trade ICAP’s Study Text Reference 1.1 - 1.3, 1.5 - 1.8 1.4, 1.9 2.1 - 2.5 3.1 - 3.3 3.4 4.1 - 4.2 Coverage in This Book LO 1 of Chapter 16 LO 2 of Chapter 16 LO 3 & LO 4 of Chapter 16 LO 6 of Chapter 16 LO 5 of Chapter 16 LO 7 of Chapter 16 Chapter 15: Financial markets vi ICAP’s Study Text Reference Coverage in This Book 1.1 1.2 1.3 1.4 Not Covered LO 3 of Chapter 14 LO 2 of Chapter 14 LO 4 of Chapter 14 Note for Students These transition pages are prepared to ensure that all concepts of ICAP’s study text have been covered in this book. This list will also be helpful for students who want transition from ICAP’s study text to this book. However, there are certain paragraph which are not important from exam point of view and therefore, are not covered in this book. Once, you cover all concepts from this book, you are advised to cover such paragraphs too from ICAP’s study text. TABLE OF CONTENTS Chapter No. Chapter Title SECTION A: FUNDAMENTAL CONCEPTS 1 Fundamental Economic Concepts SECTION B: MICRO ECONOMICS 2 Demand, Supply and Market Equilibrium 3 Elasticity of Demand and Supply 4 Consumer Equilibrium 5 Revenue, Costs and Firm Equilibrium 6 Types of Firms SECTION C: MACRO ECONOMICS 7 Overview of Macroeconomics 8 Calculation of National Income 9 Analysis of Consumption and Investment Expenditures 10 Multiplier and Accelerator 11 Inflation, Unemployment and Business Cycle 12 Money SECTION D: BANKING AND FINANCE 13 Banks and Their Functions 14 Financial Markets and Their Instruments SECTION E: PUBLIC FINANCE 15 Public Finance, Fiscal Budget and Taxation SECTION F: INTERNATIONAL ECONOMICS 16 Balance of Payment and Exchange Rates viii Page Number Notes MCQs 1 154 14 26 36 50 62 156 159 162 164 167 75 86 95 104 110 121 169 171 174 175 177 180 128 133 182 183 138 185 146 187 Economics – Study Notes Chapter 1 Fundamental Economic Concepts CHAPTER ONE FUNDAMENTAL ECONOMIC CONCEPTS LO # LEARNING OBJCTIVE PART A– DEFINITIONS OF ECONOMICS LO 1 DEFINITIONS OF ECONOMICS LO 2 AGENTS/PARTICIPANTS OF AN ECONOMY LO 3 DIFFERENCE BETWEEN MICRO ECONOMICS AND MACRO ECONOMICS PART B– BASIC ECONOMIC PROBLEM AND ECONOMIC SYSTEMS LO 4 BASIC ECONOMIC PROBLEM LO 5 MARKET ECONOMY / FREE ECONOMY / LAISSEZ-FAIRE ECONOMY LO 6 PLANNED/COMMAND ECONOMY LO 7 MIXED ECONOMY PART C – OUTPUTS AND INPUTS OF AN ECONOMY LO 8 TYPES OF GOODS (OUTPUTS) LO 9 FACTORS OF PRODUCTION (INPUTS) PART D – HOW ECONOMY CHOOSES AMONG ALTERNATIVES LO 10 PRODUCTION POSSIBILITY FROENTIER/CURVE PART E – ISLAMIC CONCEPTS OF ECONOMICS LO 11 ISLAMIC ECONOMIC SYSTEM 1 Economics – Study Notes Chapter 1 Fundamental Economic Concepts PART A – DEFINITIONS OF ECONOMICS LO 1: DEFINITIONS OF ECONOMICS: By Adam Smith: (Classical Economist) Definition: “Economics is the science which studies the production, distribution, consumption and exchange of wealth”. Criticism: Economics revolves around ‘wealth’ only and teaches selfishness. Its scope is narrow and ignores the most important concepts of economics i.e. scarcity and choice. By Alfred Marshal: (Neo-Classical Economist) Definition: “Economics is a study of mankind in the ordinary business of life. It examines that part of individual and social action which is most closely connected with the attainment and use of material requisites of well-being”. Criticism: Although this definition shifted focus of economics from “wealth” to “welfare”, however, it narrows scope of economics by classifying only material goods in economics. Non-material goods should also be studies in economics, provided they have values. By Robbins: (Modern Economist) Definition: “Economics is the science, which studies human behavior as a relationship between ends and scarce means, which have alternative uses". Important aspects of the definition: Human wants are unlimited. Resources are Scarce. (Scarcity means resources available to humanity are insufficient to satisfy all of man's wants). Therefore society has to make choice. (Choice means deciding to how to allocate limited resources between alternative wants). Study Tip: Needs, Wants and Goods Sometimes a distinction is made between Needs and Wants. Needs are the basic requirements for the citizens of society e.g. food, clothes, shelter. Wants are the desires of society. This is a broader concept which includes what citizens wish to have. Goods (including services) are materials that satisfy human wants. LO 2: AGENTS/PARTICIPANTS OF AN ECONOMY: There are four agents/participants of any economy: 1. Households: (also called buyer, consumer, individual): The collective group of individuals consuming goods and services in an economy, and providing labor for firms. 2 Economics – Study Notes Chapter 1 Fundamental Economic Concepts 2. Firm: (also called seller, producer, business): Firm is an organization which converts Inputs (i.e. factors of production) into Outputs (i.e. production). 3. Government: (also called State): Organisation that governs society through a combination of customs, exercises and laws. 4. Foreign Traders: (also called importers and exporters): The collective group who exchange goods and services between different economies. Importers purchase from other countries. Exporters sell to other countries. Study Tip: Production and Consumption Firms produce goods. Production refers to the process that creates value i.e. converts of inputs (factors of production) to outputs (goods or services). Individuals consume goods. Consumption is the purchases of goods and services by consumers. LO 3: DIFFERENCE BETWEEN MICRO ECONOMICS AND MACRO ECONOMICS: There are two branches of economics i.e. Microeconomics and Macroeconomics. Microeconomics Micro means small. Microeconomics is the branch of economics concerned with the behavior of individual entities such as markets, firms, and households. Microeconomic is concerned with Market equilibrium, Consumer Equilibrium, Firm Equilibrium, Factors influencing demand and supply and their effect on market equilibrium. What it is What it covers Macroeconomics Macro means large. Macroeconomics is the branch of economics concerned with the overall performance of the economy. Macroeconomics is concerned with National Income, National equilibrium, Economic Growth, Employment Level and Price Level, Interest Rate, Balance of Payment in a country. CONCEPT REVIEW QUESTION Highlight the main differences between microeconomics and macroeconomics. (06 marks) (ICAP, CAF 02 Level – Autumn 2008) PART B – BASIC ECONOMIC PROBLEM AND ECONOMIC SYSTEMS LO 4: BASIC ECONOMIC PROBLEM: Basic Economic Problem: Due to scarcity of resources, every human society must select how to allocate its resources i.e. 1. What to produce in what quantity (e.g. whether capital goods or consumer goods) 2. How to produce (i.e. with what resources, and what production techniques to use), and 3. For whom are goods produced. (deciding about distribution of goods and services i.e. who gets the goods and how much) Economic System: An economic system is a system which resolves the basic economic problem by making three resource allocation decisions i.e. what to produce, how to produce, and for whom to produce. There are three economic systems: 1. Free/Market/Laissez-Faire Economy (e.g. Capitalism) 3 Economics – Study Notes Chapter 1 Fundamental Economic Concepts 2. Planned/Command Economy (e.g. Socialism or Communism) 3. Mixed Economy Briefly explain the Laissez Faire. What do you mean by ‘economic system’? CONCEPT REVIEW QUESTION (02 marks) (ICAP, CAF 02 Level – Spring 2010) (ICAP, CAF 02 Level – Spring 1999) LO 5: MARKET ECONOMY / FREE ECONOMY / LAISSEZ-FAIRE ECONOMY: Definition: This is an economic system in which decisions about resource allocation are made by individuals and private firms through market-mechanism without intervention of government. Market Mechanism or Price Mechanism: Market/Price Mechanism refers to the system where price and quantity of goods are determined by interaction of free forces of demand and supply. Features of Market Economy OR Allocation of resources OR Resolving economic problem: Below is the description how market economy (or price-mechanism/market mechanism) resolves basic economic problem): What to produce: What to produce is determined by consumer demand. Firms produce the commodities that give the highest prices. How to produce: Producers use those factors of production and production techniques which provide least cost e.g. if labor is cheaper than machine, more of labor and less of machine will be used in production technique (and vice-versa). For whom to produce: For whom to produce is determined by purchasing power. Production is made only for those who have the ability and willingness to pay. Merits/Benefits of Market Economy: Retains consumer sovereignty No costly planning of bureaucracy Dynamic and responsive to changes in demand and supply conditions Freedom of choice for consumers Freedom of entrepreneur Auto-adjusted price mechanism to remove surplus and shortage Demerits/Drawbacks of Market Economy: In a free market, there may inefficient allocation of resource which is called “Market Failure”. Market failures may occur for many reasons e.g. 4 Economics – Study Notes Chapter 1 Fundamental Economic Concepts Creation of Monopolies: Due to free working, big fish eats small fishes. Wealth may be concentrated in the hands of large entrepreneur. Thereby, monopolies and oligopolies may be created causing disproportionate balance of economic powers. Social Costs of production and consumption are ignored: Market works for Profit. In the process of earning profit, social costs and public welfare are ignored e.g. ignoring air or water pollution, stress and crimes. Some undesirable products may be produced e.g. drugs. No Provision of Public Goods: Public or merit goods (e.g. health, education, housing) are costly for poor. They may not afford high prices for these necessities of life. Risk of Unemployment and Inflation: Unusual fluctuations in demand and supply may result in inflation and unemployment. Waste of Resources: Market economy may result in waste of resources e.g. advertising due to competition or allocation resources to produce luxury goods for rich neglecting necessities of the poor. Failure to plan long-run: Market economy focuses on short-term objectives and does not plan about long-run. CONCEPT REVIEW QUESTION What is “Market mechanism”? Explain how it resolves the basic economic problems. How does the Market Economy function? Enumerate the merits and demerits of Market Economy. (07 marks) (ICAP, CAF 02 Level – Spring 2013) (02 marks) (ICAP, CAF 02 Level – Autumn 1996) (10 marks) (ICAP, CAF 02 Level – Autumn 2004) LO 6: PLANNED/COMMAND ECONOMY: Definition of Planned Economy: It is an economic system in which Government makes all important decisions about resourceallocation. Features of Planned Economy OR Allocation of resources OR Resolving economic problem: Government decides what a “common good” is, which should be produced. Resources are state-owned and state decided how to allocate them in production. State decides pricing of factors of production and production. Government produces for the entire economy through an administrative process. Advantages of Planned Economy: 1. The social costs of production and consumption are fully considered in economic decisions. 2. Production is carried out for the needs of society and not for the benefit of the few. 3. Permits long term industrial and social planning fostering economic stability. 4. Full employ...
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