INSTITUTE AND FACULTY OF ACTUARIES

Curriculum 2019

SPECIMEN SOLUTIONS

Subject CB2 – Business Economics

Institute and Faculty of Actuaries

Subject CB2 – Specimen Exam Solutions

Page 2

1 C

2 A

3 D

4 B

5 A

6 C

7 A

8 C

9 D

10 C

11 A

12 B

13 C

14 B

15 A

16 C

17 D

18 A

19 B

20 B

21 C

22 D

23 C

24 B

25 A

26 D

Subject CB2 – Specimen Exam Solutions

Page 3

27 (i) An indifference curve shows the combination of two goods that a consumer is

indifferent between; any combination of those two goods give the same level of utility. The

budget line shows the combinations that the consumer is able (rather than desires) to purchase

given their income and the prices of the two goods. [2]

(ii)

[2]

O

Units of Good Y

Units of Good X

I3

I2

I1

X1

Y1

Subject CB2 – Specimen Exam Solutions

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(iii)

[1]

O

’ O

Units of Good Y

Units of Good X

I3

I2

I1

X1 X2

Y2

Y1

Subject CB2 – Specimen Exam Solutions

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28 Unpredicted poor weather is likely to lead to a fall in supply. This is shown by a

leftward shift of the supply curve, resulting in a rise in price and a fall in quantity traded

(everything else being equal). At the initial price, there will be excess demand. To restore

equilibrium, the price must rise, this causes the quantity supplied to rise and the quantity

demanded to fall.

[2]

(ii) Unpredicted poor weather is likely to lead to future price increases. To combat this, the

government may use stocks built up during good harvests and release them back onto the

market. This will increase the supply and help to reduce prices.

[2]

29 (i) Explicit costs arise when a firm makes a payment to another supplier for inputs;

the firm does not own the factor of production. Examples would be electricity, rent of a

building or raw materials.

An implicit cost is associated with a factor that a firm owns; there is no direct payment to

another party. Examples could be the opportunity cost of using a piece of machinery or the

lost interest on savings that are used for investment.

[2]

(ii) Economies of scope arise when a firm is producing a range of products. The costs of

production for each individual product can fall because costs such as business overheads

(building rent) or financial and organisational economies can be shared. For example, a car

manufacturer will make several types of different models of car, there will be shared costs in

terms of raw materials such as paint which can be used across the range, standard interior

features of the car such as door handles and various electronic components. Moreover, other

costs such as marketing and shipping can be shared.

[3]

Price

Quantity

S1

D1

S

2

Q2 Q1

P2

P1

Subject CB2 – Specimen Exam Solutions

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30 (i) Third degree price discrimination is associated with different prices being charged

for the same good within different markets. Examples include lower bus or train fares for

children or pensioners. They receive the same service but pay a lower price. Other examples

could include peak and off peak prices on public transport or for gym usage or discounted

tickets for students at a cinema. The market can be separated in terms of; time, age, location,

status or income.

[2]

(ii) Firms using price discrimination are able to maximise their profits as they can increase

their revenue for any given level of output sold. If the firm sells Q2 and not use price

discrimination, it must charge a price of P2. The area of total revenue is P2Q2. If it uses 3rd

degree price discrimination, it can gain the darker grey shaded area in addition.

Some consumers pay a higher price and therefore have a smaller consumer surplus which

may be deemed as being unfair. However, those customers who pay a lower price will have a

greater consumer surplus, this may mean that they buy a good that they wouldn’t have been

able to otherwise and/or buy more of the good.

This form of price discrimination may be deemed as predatory pricing and drive other firms

out of the market. Firms may use the profits generated in one market to subsidise another

market which is less competitive/viable and drive out competitors. Subsidising one market

may also enable a firm to break into a new market and increase competition.

An increase in revenue and potential profits can be beneficial if those profits are then

reinvested into future innovation and/or lowering prices in the future.

[3]

Price

Quantity

D

P2

P1

Q1 Q2

Subject CB2 – Specimen Exam Solutions

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31 Legal restrictions can be used to completely ban certain activities or set standards of

acceptable levels within markets; this effectively restricts activity within the market. In the

case of water pollution, certain substances can be banned from being allowed to be in the

water supply at any level or it may be agreed that there are limits which are deemed to be

safe.

An advantage of legal restrictions is that once agreed levels are set, adhering to the agreed

standards in principle is relatively straightforward and inspectors can be used to ensure that

the agreed standards are maintained.

In the case of very dangerous substances being in the water supply, legal restrictions are a

more effective tool than taxes which seek to discourage behaviour; reducing particular

pollutants may be insufficient.

Legal restrictions can also be used reasonably quickly, rather than waiting for people to

adjust their behaviour in response to a change in a tax or subsidy rate.

One of the challenges with using legal restrictions is that firms may decide to comply with

the legislation but not seek to reduce their pollution even further, which may be the case with

a tax or subsidy. The incentive to go beyond the requirements of the legislation can be weak

and provide no continuing incentive for improvement.

Another possible solution to controlling pollution is the use of a regulatory body; this may be

used in conjunction with a legal restriction and or to support legal rules. Regulatory bodies

can be used to monitor activities, such as undertaking testing, providing reports and making

recommendations. It may also have the ability to enforce its decision.

A benefit of a regulatory body is that it can deal with each case under investigation on an

individual basis and seek to recommend appropriate solutions which may not be standardised.

A disadvantage of this approach is that undertaking testing can be expensive, the regulator

requires access to the organisation in question and it’s time consuming.

To ensure compliance, testing of the water supply must take place on a regular basis and

follow ups of non-compliant firms must be undertaken. The regulator also needs the support

of law to ensure that firms are compliant and it may need to be able to exert punitive damages

to ensure that pollution is reduced.

[8]

32 (i) 260+70+85+20-25 = £410 billion [1]

(ii) GDP at market price – indirect taxes = 410 -60 = £350 billion [1]

(iii) Answer GNY at market prices = GDP at market prices + net property income from abroad

= 410 + 5 = £415 billion [1]

(iv) Answer GNY at market prices less depreciation = £415 billion – capital depreciation

= 415 - 20 = £395 billion. [1]

(v) The UK national income will rise measured in US dollars if the pound appreciates. [1]

Subject CB2 – Specimen Exam Solutions

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33

The fall in the money supply will result in a shift to the left of the LM curve from LM1 to

LM2. The result will be a rise in the rate of interest from r1 to r2 and a fall in the level of

national income/output in the economy from Y1 toY2.

[4]

Subject CB2 – Specimen Exam Solutions

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34

(i) Cost-push inflation is inflation that results from an initial increase in costs.

There are four main sources of increased costs:

1. An increase in the money wage rate

2. An increase in the money price of a raw materials, such as oil and commodities.

3. A depreciation of the exchange rate which raises import costs

4. Decreased labour or capital productivity

[2]

(ii)

Cost push inflation will shift the short run aggregate supply curve. A shift to the left of the

short run aggregate supply curve from AS1 to AS2 will lead to upward pressure on prices and

a fall in output. The precise initial inflationary impact will depend upon the steepness of the

aggregate demand curve. Cost push inflation is likely to be accompanied by a lower level of

output rather than a higher output associated with demand pull inflation.

[3]

Subject CB2 – Specimen Exam Solutions

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35

The ASL schedule shows those that will accept a job at the going real wage rate while the N

schedule shows the quantity of workers that will register as part of the labour force at a given

real wage, while DL is the demand for labour at a given real wage. Disequilibrium

unemployment results from the real wages w2 being above the equilibrium real wage w1.

This results in a labour force of size N5 while the demand for labour is only N3. The result is

total unemployment equal to N3 N5 of which N3 N4 is disequilibrium unemployment and N4

N5 is equilibrium or the natural level of unemployment.

The supply side solution to such disequilibrium unemployment is to get the real wage down

to its equilibrium level w1 where the total unemployment N1 N2 is entirely equilibrium

unemployment as workers that are unemployed (N1 N2) are not willing to work at that wage

rate.

[5]

Subject CB2 – Specimen Exam Solutions

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36

(i)

The Phillips curve shows an inverse relationship between inflation and unemployment as

depicted above. According to the demand side explanation, the Phillips curve could be explained

by fluctuations in aggregate demand. When aggregate demand is high then inflation would be

high and unemployment low since high demand for goods and services gives employers an

incentive to boost output and employment. Conversely, when aggregate demand is weak then

demand pressures would be low and so too would inflation, but weak demand would also

translate into job losses and high unemployment.

[2]

(ii)

According to the supply side explanation, the Phillips curve could be explained by looking at

the labour market and the influence of Trade Unions. If unemployment was low and labour

market conditions tight then workers and the Trade Unions that represented them would be in

a position to ask for high wage demands and employers would tend to give in, resulting in

high wage and price inflation. Conversely, if unemployment was high and the labour market

weak then workers and the Trade Unions that represented them would not be in a position to

seek high wage demands and trade unions would be weakened due to the fear of job losses

leading to wage and inflation moderation. Indeed, employers would also strongly resist

excessive wage demands.

[3]

Subject CB2 – Specimen Exam Solutions

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37

(i)

Demand deficient unemployment is widespread unemployment across the economy caused by a

fall in aggregate demand with no corresponding fall in the real wage rate.

In the above diagram there is a fall in the demand for labour from ADL1 to ADL2 the real

wage remains w1 and hence the demand for labour falls from Q1 to Q2 and the demand

deficient unemployment is Q2 Q1.

The main solution for demand deficient unemployment advocated by Keynesian economists

is an expansionary fiscal policy. The expansionary fiscal policy is usually associated with an

increase in government expenditure which it is believed will then have a multiplier effect on

aggregate demand. The simple multiplier is given by 1/s where s is the marginal propensity to

save (or equivalently 1/(1-c) where c is the marginal propensity to consume out of disposable

income). An alternative to increasing government expenditure is cutting the tax rate which

should in turn lead to increased demand in the form of higher consumption and investment

although Keynesians regard this as a less effective means of stimulating aggregate demand.

[4]

(ii) Crowding out occurs when increased government expenditure leads to lower private

sector consumption and investment, that is, the government expenditure crowds out the

private sector. To the extent that crowing out occurs there will be less of a boost to aggregate

demand. At one extreme some economists argue there is 100% crowding out while others

argue that the crowing out effects are likely to be more limited. [2]

Subject CB2 – Specimen Exam Solutions

Page 13

(iii) Four mechanisms from the following list could be discussed

1) If the government has a large fiscal deficit it will have to raise the money by selling bonds

onto the financial markets; the more bonds it sells the more it will have to raise the coupon or

rate of interest to attract new buyers. The rise in long term interest rates will then reduce

private sector consumption and investment.

2) The government could of course finance increased expenditures by raising taxes such as

income and corporate taxes or indirect taxes such as VAT but if it does so this will have the

effect of curtailing private sector consumption and investment.

3) If the government decides to finance the increased fiscal expenditure by selling bonds and

widening the fiscal deficit it is quite possible that economic agents will conclude that the

higher fiscal deficits today will mean higher taxes in the future. As such they might save

more today so as not to suffer when the higher taxes come in the future.

4) Large fiscal deficits might cause the financial markets uncertainty about how the deficit

might be reduced in future which could lead to rising long term interest rates and the

increased cost of raising capital.

5) There may be adverse supply side effects on the economy of increased government taxes

to finance increased government expenditure. Higher taxes could adversely affect the

incentive to work and indirect taxes could drive up employers’ costs which would directly

reduce labour demand.

6) In an open economy it is possible that an expansionary fiscal policy involving an increase

in the domestic interest rate might lead to a sharp appreciation of the currency which can

reduce exports (since they become more costly in terms of the foreign currency) and raise the

price of imports (since they become more expensive in terms of the domestic currency). This

will mean a slowing down of aggregate demand and so to some extent offsetting the effects

of the increased government expenditure.

[4]

END OF SOLUTIONS