DLMBA

Economics of the Business Environment July 2011 start Written Answer to Lesson Task electronic submission sheet Student Name Student Number
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Lesson Task: Tutor Name

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(You should read this in conjunction with the published Guideline Answers. Your aim is to demonstrate a good level of reading, and research where appropriate; inferences and conclusions showing correct application of relevant economic concepts; and a good standard of presentation that clearly demonstrates all these see grading guide below) Reading (and research) Inferences from reading Application of relevant economic concepts Presentation (including relevant diagrams) OVERALL

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The grid at the top of the feedback sheet shows your progress against certain key criteria, assessed as follows: A Good level of reading and research; sensible inferences and conclusions showing correct application of relevant economic concepts; good presentation Generally sound, but attention needed to one or more identified areas This would be borderline for a pass in final assessment: there are some serious weaknesses or misunderstandings we need to address Serious deficiency in most of the above: standard needs to be improved to obtain pass in final assessment This is designed to help show you where you may need to focus your attention in the final assignment.

B C

Lesson 2 task Question 1 Define: a. b. c. d. e. f. public goods externalities public investment transfer payments PSBR (also called PSNCR) public debt.

Answers
a)

Public Goods

Public goods refer to goods or services provided by government which arise due to market failure when private market fails to provide it. Public goods are non excludable which means when provided to one customer, it is impossible to exclude another customer from enjoying the benefits from it. Private market does not enter into this segment because they cannot exclude other beneficiaries who will free ride while providing this good or service. Defence, law and order, fire service etc are examples of public goods. Public goods are also non-rivalrous which means that consumption by one consumer doesnt reduce the consumption of another. Street lighting is an example of a public good which is non rivalrous in nature.
b)

Externalities

Externalities are the effects of consumption or production on third parties(Begg and ward page 188). Externalities occur when the production or consumption of a good or service results in costs or benefits being passed on to individuals not involved in the production or consumption. Externality can be either positive or negative. If production or consumption by one group improves the well being of third parties, then a positive externality has occurred. Provision of basic education, vaccination against

infectious diseases etc are examples of positive externalities. There are calculable social benefits from these provisions. If production or consumption by one group reduces the well being of third parties, then a negative externality has occurred. There are social costs associated with negative externalities. Pollution of environment by vehicles and factories is a good example of negative externality.
c)

Public Investment

Public investment is defined as the capital spend by government towards social well being and economic welfare. Public investment or government spending can be divided into two categories. 1) Current public spending (G) is the spending necessary to meet the running cost of publically provided services. 2) Capital public spending (Ig) is the long term capital investment on new infrastructure and services Total public investment is the sum of G and Ig. Government meets the cost of public investment through taxation, which can be either direct taxes (Td) or indirect taxes (Te)
d)

Transfer Payments

Transfer payments refer to governments mechanism adopted towards bridging inequalities in income and wealth between rich and poor, by use of tax system. It is used to redistribute income within the economy. Tax money generated from relatively well off would be passed as benefits to who qualify. Family income supplement, job seekers allowance etc are examples of transfer payments within the society. Countries could transfer funds to areas of low income and high unemployment to encourage businesses to relocate those locations and hence prosper that geographic location. Countries could also this mechanism to transfer income to other developing economies.
e)

PSBR

Public Sector Borrowing Requirement (PSBR) or Public Sector Net Cash Requirement (PSNCR) is defined as the difference between government spending and tax revenues. This is the additional amount government has to borrow in order to meet overall expenditure for public spending. PSBR = (G+Ig) (Td+Te) where, G = Current Public Spending Ig = Capital public spending Td = Direct Taxes Te = Indirect Taxes
f)

Public Debt

Public debt or government debt is the sum of all public borrowings which has taken place in the past. Current borrowing in each year adds to the volume of public debt. Cumulative debt is the total outstanding government debt from borrowings over many years.

Question 2

Show the effect on aggregate demand, GDP, unemployment, the balance of trade (exports - imports) and public sector borrowing of: a. a rise in current public spending b. a fall in the rate of direct tax c. a rise in the rate of VAT.

Answer The table below summarizes effects of each change.

BALANC E OF TRADE AGGREGA TE DEMAND Rise in current public A spending Fall in the rate B of direct tax Rise in the rate C of VAT up up down (EXPOR TSIMPORT S) worsen worsen improve s PUBLIC SECTOR BORROWIN G increase increase decrease

GDP up up down

UNEMPLOYME NT down down up

A) Rise in current public spending The effect of rise in current public spending can be explained by the below diagram.

In this example, current public spending is increased from G1 to G2. This causes the curve to shift upwards. Aggregate demand increases and GDP increases from Y1 to new equilibrium point Y2. Due to increased spending, more jobs are created and unemployment rate comes down. Increased income encourages more imports. Hence balance of trade, which is difference between exports and imports, worsen. PSB is the difference between government spending and total tax. Since component G within government spending increases, PSB increases. B) Fall in the rate of direct tax The effect of fall in the rate of direct tax is explained by the below diagram. Fall in rate of direct tax causes increase in disposable income in households and businesses. This increases demand for consumer goods C to shift from C1 to C2. This shifts the equilibrium point. Aggregate demand increases and GDP increases from Y1 to Y2. Due to increase in GDP, more job opportunities are created and unemployment reduces. Increase in income causes more imports and hence balance of trade worsens. PSB being the difference between government spending and total tax, increases because direct tax has reduced.

C) Rise in the rate of VAT VAT is one form of indirect tax. Effect of rise in VAT can be explained by the below diagram.

Increase in VAT from Te1 to Te2 will cause a flatter curve. This will reduce the income and GDP will come down from Y1 to Y2. This reduces aggregate demand. Decrease in aggregate demand will increase unemployment. Reduction in effective disposable income will cause a lesser demand for imports. Net exports for that reason would improve. Total tax collected would increase due to increase in indirect tax. PSB being difference between government spending and total tax therefore would decrease.