Basic Economic Problem

The basic economic problem is that people have unlimited wants but there are are limited
resources to satisfy these wants.

Decisions have to be made about how best to use the resources to satisfy as many of the wants as
possible.

Needs are the things that are essential for people to live adequatley.

Wants are the luxuries that people desire to make their life more comfortable

Land

The land for farming and building on, but it also includes the resources under the land (coal,
minerals, metals etc), the resources on the land (forests, lakes etc) and the fish stocks in the sea.

The supply of land is relatively fixed but the quantity of resources on/in it can change
considerably due to human activities such as mining, fishing, forestry etc.

The quality of land can be degraded through erosion or loss of soil quality due to intensive
farming techniques.

Figure 1.2: Land, factor of production

Labour

Labour is the human effort used to produce an item, bithe mentally and physically.

The supply of labour is determined by the number of workers available and the duration that they
can work for.

Factors that affect the supply of labour are:

 Retirement age.
 School leaving age.
 Length of working day (regulated and varies between countries).
 Holiday entitlement (again varies between countries).

Figure 1.3: Labour, factor of production

Capital

Capital is anything that is used to produce other goods and services rather than being used for its
own sake (machinery, tools, offices etc).
There are two main classifications of capital:

Working capital: this is used up in the process of production (raw materials, seeds etc).

Fixed capital: longer lasting and not used up in the production process (machinery, warehouses
etc).

Figure 1.4: Fixed capital, factor of production

Enterprise

This is the decision making and risk bearing in business by an entrepreneur. An entrepreneur has
to organise the factors of production, decide what to produce and how much to produce.

Some risks can be insured against (fire, theft etc), but others such as increases in costs of raw
materials or increased competition cannot.

The reward for taking the risk and getting it right is profit, however the risk is losing money and
being forced out of business.

Opportunity Cost

This is the cost of the best alternative that is given up when a decision is made. This can be
applied to products that we buy, the jobs that we undertake and the products firms decide to
make. Private firms generally base their decisions according to which product will maximise
their profit.

The Production Possibility Curve (PPC) indicates the points at which factors of production are
being used most efficiently. It is sometimes also known as the Production Possibility Frontier
(PPF).

Any point to the left of the curve means that resources are not being used to their potential
(uemployed labour, land not being used etc).

The curve can be moved outwards to the left through the discovery of new resources, new
technologies that increase efficiency or through increases in the quality of the factors of
production.

It is also known as the Opportunity Cost Curve as it shows the opportuntiy cost of producing
more of one product.
 eo

Planned Economies

 The government makes the decisions about what is produced how its produced & who
produces it.
 The government is the main owner of land, labour and capital.
 The government is the employer, sets wages and decides prices.
 The government issues its instructions through directives.
 There are few planned economies in the world.
 Goods produced may not match the consumers wants.

Example: North Korea

Market Economies

 Also known as free enterprise economies

 Minimum government involvement/intervention.
 Land & capital are privately owned.
 Consumers decide what is produced by paying more for the things they want.
 Firms and resources switch to things that are more popular.

Advantages: efficient use of resources, more choice & potential to make lots of money.

Disadvantages: profit maximisation aims mean that public goods are not likely to be supplied &
external costs not accounted for.

No pure market economies exist in the world.

Mixed Economies

 Combination of both the above systems.

 Public and private firms, land and capital.
 Market forces provide choice and efficiency in some industries.
 Government can provide public goods such as defence & street lighting.
  Government can encourage consumption of merit goods and discourage consumption of
demerit goods.
 Government can impose charges on private firms to reflect external costs such as
pollution.
 All economies are mixed but to different degrees.

Example: United Kingdom

In any country, we can catagorize production into three or four main industries:

 PRIMARY SECTOR- these are the firms that draw or extract natural resources from the
earth. This may be as varied as coal mining or fishing, corn growing or oil drilling.
 SECONDARY SECTOR - these are the firms involved in turning natural resources into
finished products. This may vary from car production to packaging. They manufacture
the goods.
 TERTIARY SECTOR- firms in this sector provide the retail outlet for the finished
products or provide a service for the customer. This may range from shops on the high
street to teaching. It can differ between high and low value jobs. Cleaners, waiters, retail
workers tend to have low incomes. Bankers, software developers, accountants earn high
incomes.
 QUATENARY SECTOR- firms in this sector are usually involved in intangible services
such as research and development.

Demand Curves

Demand Curves

 Individual demand is how much of a product a consumer will buy at a given price.
 Market demand is the sum of all the indivudual demand for a product at a given price.
 Demand is based on the actual ability of consumers to purchase the product, not just what
they would like but cant afford (sports car, jewellery etc). This is called effective
demand.
 Demand curves slope down from left to right - this is because the higher the price the
more of a consumers income must be spent on it & the more satisfaction they must get
from it to justify the opportunity cost.
 Figure: Demand Curve Characteristics

Movement along the Demand Curve (Price)

A change in price causes a movement along the curve

 The higher the price of a product, there will be less demand for it.
 If the price rises then demand will fall, this is known as an contraction in demand.
 The lower the pice of a product the more it will be demanded.
 If the price falls then demand will rise, this is known as an extension in demand.

Figure: Movements along the demand curve

Shift of the Demand Curve

A shift of the demand curve represents an increase or decrease of demand at a given price level.
This may be because of:

 a change in consumers incomes

 a change in price of competing products
 changes in tastes/fashion
 seasonal factors such as weather
 Figure: Shifts of the demand curve

Supply Curves

Movement along the Supply Curve (Price)

A change in price causes a movement along the curve

 The higher the price of a product, the more suppliers will produce.
 If the price rises then supply will rise, this is known as an extension in supply.
 The lower the pice of a product the less will be supplied.
 If the price falls then supply will fall, this is known as an contraction in supply.

Figure : Movements along the supply curve

Shift of the Supply Curve

A shift of the supply curve represents an increase or decrease in the quantitiy supplied at each &
every price. Causes of shifts in supply:

 Improvements in technology (increase efficiency & reduce costs).

 Weather, climate and disease (especially agricultural products).
 Taxes and subsidies can make the costs of production more/less expensive and therefor
increase or decrease supply.
 Natural disasters & wars can severly disrupt supply.
  Resources: discoveries of new resources or depleting reserves of resources can affect the
supply of products.

Figure : Shifts of the supply curve

Equilibrium & Excesses

Equilibrium

The equilibrium price is the point at which demand and supply are equal (where they cross on
the diagram). It is also called the market clearing price since it is the point at which all the items
supplied are demanded - therefor clearing the market of all the stock.

Consumers want low prices & suppliers want higher prices, this leads to adjustments in the price
of products until the equilibrium point is reached.

Figure: Market Clearing Point

Excess Supply

This situation occurs when the price level is too high which results in a larger quantity supplied
than quantity demanded.

Suppliers want to sell the extra stock that they have before it goes bad or out of season so they
will lower the price. This leads to an expansion in the quantity demanded and a contraction in the
quantity supplied bringing the market back into equilibrium.
 Figure: Excess Supply

Excess Demand

This occurs when the price is set too low which result in a larger quantity being demanded than
there is available from the suppliers.

Suppliers realise that they can charge a higher price and still sell more products so the price level
rises which leads to a contraction in demand (some people wont buy at the higher price) and an
extension in supply, bringing the market back into equilibirum.

Figure: Excess demand

Price Elasticity of Demand measures the responsiveness between a change in price and the effect
on quantity demanded. Measured using formula:

PEoD = (% Change in Quantity Demanded)/(% Change in Price)

Price Inelastic; tells us that a great change in price results in a small change in quantity
demanded. Has a PED of less than 1. Usually goods with low starting price or necessities.

Price Elastic; tells us that a small change in price results in a large change in quantity demanded.
Has a PED of more than 1. Usually luxuries or goods with many substitutes
 Figure : Price
inelastic

Figure ; Unitary
elasticity
Market Clearing Mechanism

The forces of supply and demand utilize fluctuations in price to achieve equilibrium and clear the
market.

Diagram 1

An exceptionally long drought in Spain destroys a significant proportion of the olive harvest.
The immediate effect is likely to be excess demand (B-A). This is then corrected as the decrease
in supply leads to higher prices (P1) and subsequently a contraction in demand until demand and
supply are in equilibrium again.

Diagram 2

The following year the climate leads to a much better harvest of olives. This leads to a situation
of excess supply (A-B). To correct this, the price decreases to the point at which the extension in
demand brings the market back into equilibrium.
 Figure:
Market clearance example

Figure:
Market clearance example

Competition
The presence of competition between suppliers in market systems enables consumers to have
choice. Firms use price as one form of competition, this leads to lower prices for consumers and
greater efficiency for firms as they attempt to minimize costs and maximize profits.

Competition also encourages better allocation of resources as firms that quickly recognize
changes in demand and switch their production into growing markets can benefit from increased
profit.

Firms that fail to recognize changes in consumers demand and allocate resources ineffectively
are likely to experience declining profits and eventually may go out of business.

Figure: Market clearance example

Failures of the Market System

Social Costs

When considering the cost of production or offering a service we need to take into account more
than just the cost to the company. There are wider costs that affect society such as air polltion
that are not accounted for on the price.

Private costs: these are the costs to individuals of consuming a product, often the monetary
value, but sometimes a health cost such as smoking. They are also the costs to a firm (fixed and
variable costs) of production.

Private benefits: the benefit to an individual from consuming a product, often satisfaction, more
knowledge etc. In the case of a firm these are likely to be the profits that are made.

External costs: the costs of production or consumption of an item to a third party - litter, air
pollution, water pollution are examples, these are often called externalities.

External benefits: the benefits of production or consumption to a third party - other firms &
society may benefit from the skills that workers learn through their jobs such as first aid, it skills
etc.

To establish the total cost or benefit to society the total value of the private costs and eternal
costs needs to be calculated. The sum of the private and external benefits need to be calculated.
If the social cost is greater than the social benefit then the resources & factors of production
should be used ot produce something else that is more socially beneficial.

Characteristics of money

 Acceptable: everyone must accept it as a form of payment at its set value.

 Portable: it must be easily carried without being bulky or heavy.
 Durable: it must last for a long time and withstand much use without devaluing. Many
countries are making plasticized bank notes now in an effort to increase their durability.
  Divisible: it must be easily divided in small denominations to make it suitable for all
types of transactions.
 Scarce: it must be limited in its supply or it will quickly lose value and become
worthless.

Functions of Money

For money to be successful it needs to perform several key functions or purposes.

 Medium of exchange: this means that it must enable people to sell products for money
and then take that money to another seller and use it to buy products.
 Measure of value: money must have a value in relation to all other products. This solves
one of the problems with barter - since it enables producers to know the value of their
product in relation only to money – rather than all other products.
 Store of value: money must not devalue (inflation aside). If a producer receives $10 for
their produce today they know that in a month that $10 note will still be worth $10. This
solves another problem of barter – an apple grower previously had the problem of apples
going bad relatively quickly and losing their value.
 Deferred payment: this enables lending and borrowing. Money should be able to be
borrowed and repaid later, and goods bought and paid for at a later date. The fixed value
of money allows deals to be negotiated and the lender to know exactly what they are
getting at the later date.

Central Banks

Central banks act as the government’s bank and are not accessible for individuals and businesses
(except commercial banks).

 The Government’s tax receipts go into the central bank and its holds any gold and foreign
currency reserves the government has.
 They print the notes and coins.
 They set the base rate of interest; this can be a powerful tool in managing the economy.
 Central banks also play a very important role in regulating commercial banks and making
sure that the banking system is functioning correctly.
 In a financial emergency a central bank can act as a lender of last resort to a commercial
bank that is in trouble.

Video 1.8 Outsourcing in the Philippines

Commercial Banks

Commercial banks are the high street banks that we are familiar with such as HSBC, Barclays
and Citibank. Profit maximization is their main aim and they are usually privately owned. They
traditionally make most of their money by offering savers a lower rate of interest than they
charge for lending out that money to others as loans. Individuals and businesses are their
customers and they provide a range of services:
  Checking/current accounts: this is a standard account for depositing money in that allows
you to access the money instantly if you need it. Due to the flexibility of this type of
account the interest rates are usually very low.
 Savings accounts: higher interest rates but customers don’t have an ATM card for
withdrawing cash instantly.
 Overdrafts: a pre-agreed debt facility which allows customers to spend more than they
have in their account.
 Loans and mortgages: commercial banks offer a range of loans and mortgages that vary
in the amount lent and the timescale for repayment.
 Credit cards: most commercial banks have a link with a credit card company such as Visa
or Mastercard and link these to your bank account.

Figure : Commercial Banks

Stock Exchange

Stock exchanges play an important role in economies since they facilitate the buying and selling
of shares in Public Limited Companies. This enables companies to raise capital for investment.
Stock exchanges regulate the selling of shares and provide a secure marketplace.

Only Public Limited Companies can trade shares on the stock exchange. To buy and sell shares
companies and individuals must use a stockbroker. A stockbroker is someone who is registered
to trade in the stock exchange on behalf of clients.

Why buy shares?

 Dividend payments: these are financial payments to all shareholders by the company
from some of the profits it has made.
 Capital gains: the rising value of shares (hopefully)
 Gaining control of the company: big investors and companies may use the stock
exchange to buy significant proportions of a company to gain influence in its
management decisions or even to completely purchase it.

age Factors

Generally the higher the amount of money offered as pay, the more attractive the job is likely to
be. The method of payment and performance incentives are also likely to influence the decision.

 Salary: This is a pre-agreed total for the year, split into monthly sections. Because it is a
set amount of money it does not depend on the hours worked – this may be a good or bad
thing. Advantages of a salary are that it gives security and people can make plans based
on the monthly income.
 Wage: this is when workers’ pay is based on the number of hours they work at an agreed
hourly rate. This has the advantage that workers may be able to do extra hours and
increase their income.
  Piece rate: this is when workers’ pay is based on their production. Often found in
primary agriculture at harvest time. Coffee pickers are paid based on the weight of coffee
cherries that they pick per day. If a worker is efficient they can make more money.
 Commission: this is a method of pay that is often found in sales jobs. Usually the basic
salary/ wage is very low but the employee will receive a percentage of the value of the
sales they make.
 Bonuses: these are financial rewards for good performance. These have the potential to
significantly increase the yearly payNon-wage Factors

 Geographical location: the proximity to the where the worker lives is likely to be
important since longer journeys to work cost time and money.
 Working hours: the number of hours required to work is important. But the timing of the
shift is often also very important. Some jobs require night shifts or weekend shifts.
 Working conditions: the physical demands of the job and the working environment are
often important.
 Job satisfaction: will the job stimulate the interest and provides a sense achievement.
 Holiday entitlement: how many holiday days are provided? Some professions such as
teaching have very favourable holiday provision. Some countries offer more holiday
entitlement than others.
 Pension provision: jobs that have a company pension scheme and one that offers a good
pension on retirement are an attractive prospect.

Trade Unions

Trade unions are organisations that represent workers’ rights. Workers become a member a trade
union and then the union will negotiate with employers for improved working conditions,
working hours and pay increases. The NUT (National Union of Teachers) and Unison are
examples of strong trade unions in the UK.

Trade unions are effective since they often represent a significant proportion of a firms workers.
This gives them more influence than if individual workers negotiated separately. The
representation of many workers is called collective bargaining.

It also benefits employers since they can deal with a much smaller number of people in making
decisions that affect the entire workforce.

If wages levels are pushed too high and not matched by an increase in productivity then this will
increase costs for the firm and make it less competitive. This may lead to unemployment – which
would be against the interests of the trade union and its workers.

It is possible for trade unions to try and raise the wages for its members through restricting the
supply of workers. This can be achieved by requiring specialist certifications or qualifications.
Its members refuse to work any overtime hours, or even go on strike (refusing to come into work
at all).
Trade unions need to be relaistic since theur actions may also be damaging to the workers since
they may find the firm retaliates in some way (through loss of benefits or future unemployment
for example).

Specialisation

Specialisation in the sense of individuals refers to the worker focusing their training and
experience on a specific part of the production process.

 Highly skilled specialisation: When workers want to obtain a highly specialized job they
are likely to need extensive training. This may require extras years in education at
universities, or it may be professional training received whilst working. Jobs often offer
high wages, job satisfaction, good working conditions and more job security since they
are difficult to replace.
 Workers may specialise in much lower skilled tasks. Some, such as hair-dressing, may
provide much job satisfaction and a reasonable wage level.
 Production lines in factories: workers perform the same unskilled tasks over and over
again. This form of specialization is often low paid and has little sense of job satisfaction.
With low skilled specialization it is relatively easy for the worker to be replaced and so
job security may be low.

Saving

There are several ways in which people save and different reasons for saving. Reasons for saving

 Target saving: saving for future purchase such as a car, a house or maybe a TV.
 Contingency saving: many people save to have a sum of money to fall back on in the case
of an emergency or unforeseen event. Medical bills, car repairs etc.
 Retirement saving: pension plans and specialist saving accounts are often used to save for
the time when there is no longer an income from working.

Those on low wages will inevitably spend a large proportion of their income on necessities. This
leaves little money for luxuries and saving. People receiving higher incomes are unlikely to
spend significantly more on the necessities and subsequently have a larger proportion of their
income available for saving.

Borrowing

Borrowing money is likely to feature in most people’s lives at some point. Most people
borrowmoney to buy their first house. Others borrow money more frequently to purchase smaller
items such as cars and to pay for holidays.

Interest rates affect borrowing. These represent the cost of borrowing money. If interest rates are
it will dissuade people for borrowing money since the repayments will be high. If however
interest rates are low then borrowing becomes cheap and many people will be enticed to buy now
and pay later through borrowing.
Spending

Peoples’ motivation for spending is usually linked to the level of disposable income that they
have. If disposable income decreases for any reason, people are likely to reduce their level of
spending.

Interest rates often affect spending. If interest rates are rising or high, loans become expensive
and people are unlikely to borrow money for large purchases. If interest rates are low or credit is
easy to obtain people are likely to increase their expenditure level.

High income groups are likely to spend a larger amount than lower income groups, but
importantly this larger amount usually represents a lower proportion of their income. Someone
who receives double the income of another person is unlikely to consume twice as much food,
water and electricity. This leaves them with more income to save and/or spend on luxuries of
they wish.

Sole Trader

A business that is owned by a single person is known a sole trader business. The owner may
employ other people to work in the company but they have no ownership of the firm. Usually
small in size and has low set up costs.

Typical examples are plumbers, electricians and gardeners.

Benefits

 the owner gets to keep the profit and make any decisions.
 They be responsive the consumers demands and also establish good customer
relationships.

Disadvantages

 the owner is usually liable for any debts that the company has.
 Having a single owner may limit the range of skills and ideas in the decision making
processes.
 The amount of capital/money that a single person can raise is also likely to be relatively
small low.

Partnership

These are companies that have 2 or more owners (partners) and usually not more than 20.
Common examples of partnerships may are dentists, accountants, solicitors and doctors
practices.

Benefits
  Increased capital injections,
 Wider range of skills and ideas in the decision making processes
 Liability is shared between more people.

Disadvantages

 Profits are shared between the partners.

 There may disagreements about the decisions made.
 Between the partners there is still liability for any debts.

Private Limited Company (Ltd)

Private Limited Companies are owned by several people through the sale of shares. The shares
are not available to the public through the stock exchange, but sold privately to friends and
family. Private Limited companies must publish annual reports for their shareholders giving
details about the company’s performance.

Advantages

 Ability to raise more capital (although it is limited to the finance that friends and family
have and are willing to invest).
 The company itself is liable for any losses and this means the share holders only have
limited liability.
 Shareholders can only lose the value of their shares

Disadvantages

 They tend to remain relatively small since the levels of capital that can be raised from
friends and family is usually fairly low.

Public Limited Company (Plc)

Public Limited Companies are listed on a stock exchange and their shares are available for
anyone to buy through a stockbroker. They are often relatively large in size.

To become a Plc, the company must publish information about its operations and accounts in a
prospectus to inform any potential investors about the company, its direction and financial
health. Each year reports must also be sent to all its investors about the previous year’s
performance, accounts and future direction.

Advantages

 They can usually raise large sums of capital due to the global supply of investors.
 They can grow quickly and/ or invest in the necessary capital.
  Shareholders have limited liability and can vote at meetings about the decisions being
made.

Disadvantages

 Higher administrative costs of informing all investors about extraordinary meetings and
publishing yearly reports.
 The owners of the company may lose control of the decision making since all investors
can vote at the AGM (annual general meeting) if they are not happy with the performance
or decisions being taken.

Cooperative

These are organizations that are owned jointly by their members and run in the members’
interests. There are several types of co-operatives:

Trading co-operatives

Formed when a group of producers team up to become a cooperative. This is common in

agriculture; coffee farmers may form co-operatives to share equipment (reduce costs) and to
have more influence in the market place due to controlling a larger supply.

Consumer co-operatives

They buy in bulk to benefit from reduced prices, this is then passed on to their members as
cheaper prices.

Public Corporations

These are government run organizations and tend to be large in size. They are funded by the
government and are not profit orientated. Their main aim is to provide the best service to the
public. Utility and train operations are often state run (nationalized), in the UK the BBC (British
Broadcasting Corporation) is a public corporation.

Advantages

 Making the decisions that are in the public’s interest rather than for profit maximization.
 In some situations such as railways and public water infra-structure it makes economic
sense to just have one set of rails and pipes rather than duplicating them for different
private companies.

Disadvantages

 Inefficiencies since the corporation will be subsidized if it fails to cover its costs.
 The lack of competition may lead to lower levels of innovation and possibly quality.
  The size of public corporations can often lead to inefficient communication within the
company.

Fixed Costs

These are the costs that don’t vary with output such as rent, interest on loans etc. This means that
the Total Fixed Cost (TFC) line is straight.

The Average Fixed Cost (AFC) line is sloped. TFC/output = AFC. If fixed costs are $10 and 1
item is produced then the AFC is $10, however if 2 items are produced then the AFC is $5.

Figure : Fixed
Costs Curve

Variable Costs

These are the costs that change as output changes such as raw materials, wages, utility bills. As
output increases Total Variable Costs (TVC) increase.

Average Variable Costs (AVC) initially fall as productivity of workers increase and the firm
benefits from economies of scale but these diminish & may reverse with increased output.
TVC/output = AVC
 Figure :
Variable Costs Curve

Total Costs

Fixed Costs + Variable Costs = Total Costs.

The total cost line starts at the level of the fixed cost line since these costs must be paid despite
no production.

Figure : Total
Costs Curve
Revenue

Revenue: This is the total amount of money a firms recieves from selling goods (before costs are
deducted).

Average Revenue: Total revenue/output

Productivity

The output per worker is known as productivity.

Firms aim to maximise the productivity of their workers in an effort to increase profits. There are
several ways in which they may aim to achive this:

 Investing in training should increase the speed or skill of the workers.

 Mechanising some of the processes.
 specialize their workforce in certain stages of production.

Diminishing returns to labour

Increasing the labour force can initially bring increased productivity as many jobs are made
quicker through specialization. There are limits though to these benefits and at some point
adding additional workers will lead to decreases in productivity.

If workers get in each other’s way, have to wait for shared machinery or cannot communicate
effectively, their productivity will diminish, this is known as the Law of Diminishing Marginal
Returns.

Perfect Competition

 Firms in perfect competition cannot compete on price. In this type of market situation the
price elasticity of demand is perfectly elastic. If a firm raises its price consumers will not
buy from it.
 Products are identical and consumers have complete knowledge of the other suppliers
prices they will all buy from somewhere else.
 Firms make what is known as ‘normal profit’ in the long-run.
 They are unable to reduce their price since this would result in them making a loss.
 Firms must accept the market price which is set by the forces of supply and demand.
 Perfect competition makes the best use of resources since it reallocates the resources to
the production of goods that are in demand and profitable. Inefficient producers will
quickly go out of business.
 If there is an increase in the demand then in the short run the suppliers will make higher
than normal profits (super-normal profits). Others quickly join this market which will
increase the supply and push the price back down to a point at which normal profit is
again being made.
  If there is a decrease in demand then the price will fall. This will quickly result in some
suppliers leaving the industry and switching to something that is more profitable. This wil
redcue the supply.

Figure : Perfect competition in the market place

Monopolies

Monopoly situations occur when there is a single firm that is the sole supplier. In some cases it
makes sense to have a single supplier since duplicating the infra-structure would be inefficient
and wasteful. These industries are known as natural monopolies and include water companies,
some rail companies (if they own the track) and electricity suppliers.

Characteristics

 The firm has 100% share of the market.

 High barriers to entry.
 The firm controls supply and subsequently the price level

Monopolies might have complete control over the supply and therefore be able to set prices, but
they cannot control the demand. This leaves them with an important choice. They can either:

1. Decide the price level they want to achieve and supply the quantity that would achieve
this.
2. Decide the quantity they want to sell and accept the market price.

Disadvantages of monopolies

 Inefficiency: the lack of competition allows monopolies to operate less efficiently than
companies in a competitive market would.
 Lack of innovation/poor quality: they can offer a poorer service/product without losing
many customers.
 Higher prices: they can set the price and earn super-normal profit levels.

Aggregate Demand

This is the total demand in the economy.

It is made up of:

 Consumption
 Investment
 Government Expenditure
 Exports - Imports
 Figure 1: Aggregate Demand

Aggregate Supply

This is the total supply in the economy.

 It is initially flat due to the ability to employ more resources (labour) and increase supply.
 It becomes steeper & then vertical when the economy reaches full employment which
means we cannot increase supply.
 At this stage prices increase if AD increases (inflation)

Figure 2: Aggregate Supply

igure represents a simplistic model of an economy.

Leakages
  Imports represent money leaking out to other economies.
 Taxation removes money from households and takes it out of the economy unless the
Government spends it.
 Savings by households represent money taken out & stored by banks (although its often
lent for investment).

Injections

 Exports by firms represent additional money coming into the economy

 Government spending injects more money into the economy
 Capital investment by firms (often borrowed).

Government Aims

 Full employment: having all the people who are able to work and looking for work in
employment. Usually there will be some frictional unemployment existing.
  Price stability: governments aim to keep inflation at a steady rate (around 2%). This
allows firms and individuals to plan for the future more accurately.
 Economic growth: increasing the output of the economy (Real GDP). In the long run they
aim to push the PPB (Production Possibility Boundary) outwards.
 Redistribution of Income: governments may aim to take money from the rich (through
higher taxes rates) and give it to the poorer population (through unemployment and social
benefit schemes).
 Balance of Payments stability: keep imports and exports balanced swell as flows of
finance.

Government Production

Governments may provide goods/services that are a natural monopoly (water/electricity).

Essential goods such as health care, education and police forces are often provided by the
government.

Governments may provide merit goods such as public swimming pools, libraries and sports
centres.

Government Employment

 The government employs people in public sector jobs such as teaching, police and fire
services, doctors, nurses and military personnel.
 Through its employees it can set examples of good practise and restrict wage increases to
limit inflation.
 The government can also increase or decrease its number of employees to manipulate
unemployment figures.

onetary policy

Key Characteristics

This focuses on controlling changes in the money supply, interest rates & exchange rate.

 Money Supply: changed by printing money & encouraging/discouraging lending by

commercial banks. Increased money supply = Increased Aggregate Demand (AD).
 Interest Rates: Central Bank raises or lowers these. Raised interest rates make saving
more attractive and borrowing more expensive. This should lower AD & therefor firms
are also likely to invest less.
 Exchange Rates: these can be fixed to another currency (dollar) to control inflation or
they can be floating.

Contractionary Monetary Policy: raising interest rates and reducing money supply to reduce AD.
Expansionary Monetary Policy: reducing interest rates and increasing the money supply to
increase AD.

Fiscal Policy

Key Characteristics

This focuses on changes in government expenditure and taxation.

 Government Expenditure: increases in spending will increase AD, decreases in

spending decrease AD.
 Taxation: increases in taxation will leave people with less money to spend & so reduce
AD.
 Budget: the government has a surplus when it takes more money than it spends & a
deficit when it spends more than it takes.

Market Orientated Supply Side Policies

 Getting rid of red-tape and bureaucracy – oftentimes firms produce less than they
ought to because they have so many forms and rules they have to follow. Getting rid of
these makes it faster to produce, saving time and money.
 Reducing the power of trade unions – trade unions keep wages high. Wages are a big
part of a firms’ costs of production. If trade unions were made less important, firms could
spend less on their workers by reducing the wage.
 Changing laws and legislations – if previously firms were only allowed to supply a
certain amount, then when this is changed they are free to produce more.
 Reducing taxes on firms – this allows them to produce more at the same price.

Interventionist Supply Side Policies

 Investment in healthcare – this makes the workforce able to produce more as they are
healthier.
 Research and Development – can lead to new ways of doing things, or the discovery of
new production techniques like genetically modifying crops.
 Investment in technology – combine harvesters do a lot more work, at a faster rate, than
humans. Car plants in Tokyo are now almost all totally automated.
 Subsidizing entire industries – this allows firms to spend money on the above, or to buy
more factors of production which make them more productive.

Taxation Aims

 To reduce income inequalities - we can take from the rich and give to the poor.
 To increase government revenue in order to pay off debt
 To increase merit and public goods and services
 To reduce external and social costs caused by polluting firms
But taxation itself is a general term, as there are different types of taxes. In general we can
identify:

 Direct tax – a tax on income, profits or wealth

 Indirect tax – a tax paid on the value of a good or service. For example, if you buy a meal
at a restaurant, you will have to pay for the meal and for a tax (of around 13%) on the
value of your meal. This is known as Value Added Tax (VAT).

Tax Systems

Progressive Taxation

With a progressive taxation system, citizens are put into ‘income earning bands’ and charged
taxation according to these bands. The higher your income, the greater percentage of taxation
that you need to pay on income in a particular bracket.

Regressive Taxation

Regressive taxation is the opposite to progressive taxation; the higher your income, the less
percentage you pay in tax. Once again, citizens are allocated a tax band and must pay
accordingly.

Proportional Taxation

In this case, citizens pay the same percentage in tax, regardless of their income. There are no tax
bands – everyone pays the same % - for example 10%. If you earn $100 a year, you thus pay
$10. If you earn $100 000 a year, you pay $100. Again, note that the amount each person pays is
different but the percentage is the same.

he Retail price Index (RPI)

 This is a price index that shows the general change in prices over time as a %.
 A hypothetical basket of goods and services which represents a normal households
spending.
 The items are ‘weighted’ to reflect the % of income spent on them.
 Each month the prices of the goods & household spending patterns are monitored and the
RPI is calculated.
 The index has a ‘base year’ and the % change is measured from this.

Video: What is inflation?

Causes of Inflation

Cost-Push Inflation
  Increases in wages & raw material costs push production costs up and result in higher
prices.
 If increases in wages are matched by an increase in worker productivity then unit costs
should not rise.
 A ‘wage spiral’ may occur when workers demand higher wages leading to higher prices
& so workers then demand higher wages again & so on.

Demand-Pull Inflation

 Excess demand (an increase in demand without an equal increase in supply) pulls prices
higher.
 Usually output can be increased to match demand but if there is full employment then
extra workers cannot be employed to increase output. It could also be a shortage of a raw
material that limits supply.

Monetary

 Increases in the money supply that are greater than increases in output (more money
chasing same output).
 Can be classed as demand-pull inflation.

Effects of Inflation

 The value of money falls (each $ buys less). Hyperinflation may lead to loss in
confidence of the currency.
 Redistribution of income:
o savers lose out as their savings lose ‘real’ value & borrowers gain as they repay
less in ‘real terms’ than they borrowed.
o People on fixed incomes (pensioners, students) see their real income fall unless it
is ‘index-linked’ (linked to the changes in the rate of inflation).
 Increased costs for firms: changing prices, labels, working out future costs.
 Balance of Payments: increased prices make a country’s exports less desirable & imports
seem comparatively cheaper. This can lead to further issues such as unemployment.

Measuring Unemployment

Measured as the % of the labour force who are willing & able to work and looking for a job.

Methods for measuring unemployment vary & generally the official rate is lower than the actual
number of people looking for work.

Video 1.8 Outsourcing in the Philippines

Types of Unemployment
  Frictional unemployment: people between jobs - tends to be short term.
 Structural unemployment: industrial change over the long term can leave sectors of the
labour force with skills that the economy no longer demands.
 Seasonal unemployment: labour only demanded at certain times of the year (fruit
pickers/ tour guides).
 Cyclical unemployment: high unemployment in times of recession.
 Immobility of labour: workers are generally fairly immobile (home, family) & only seek
work in their region.
 Technology: increases in technology have replaced some jobs and reduced number of
workers in others.
 Minimum wage: increased labour costs may force employers to hire less workers.

Effects of Unemployment

 Increases in unemployment lead to higher costs for the Government (support & benefits)
& at the same time less income for the Government (income tax). This could mean higher
taxes for the working population or reduced spending on schools/hospitals/emergency
services etc.
 Increased unemployment means less output & so less goods and services for people to
share.
 Increased costs to society through higher crime rates, higher health bills
(alcoholism/depression), increased rates of divorce.

Measuring Output

Gross Domestic Product (GDP)

Definition: The total value of the goods and services produced in an economy over a given time
period.

This is the standard measurement but there are several variations that are used to provide a
clearer picture of what is happening in the economy.

 Nominal GDP: GDP valued using the current prices (no inflation consideration).
 Real GDP: GDP that has had the effect of inflation removed.
 Real GDP per capita: average Real GDP per person in the country. This allows any
changes in the population size to be reflected.

Measuring Quality of Life

Human Development Index (HDI)

This is an index that takes into account 3 factors (each is an index itself):

 Life expectancy index

  Education index
 Income index

It generates a score between 0 and 1. The closer to 1 the higher the quality of life.

It is considered a better measure of overall development then GNI or GDP because it takes into
account social factors aswell as purely economic ones.

Why do Countries Trade?

 To acquire goods/resources that are not available or produced in their own country
(spices, oil etc).
 To benefit from lower prices due to specialization.
 To reach larger markets.

Why Specialize?

If countries focus on producing what they are best at & then trade with other countries for the
products they need, it should result in all the countries having more goods & services to share in
total.

Absolute Advantage

This is the ability of a country to produce more of a certain good than other countries can with
the same amount of resources.
Therefore countries should specialise in what they have an absolute advantage in & then trade.

Comparative Advantage

This occurs when a country does not have an absolute advantage in the production of anything.
In this case it makes sense for it to specialise in producing the item in which it is most efficient.
Other countries should produce the items they have the most advantage in & through trade
everybody should end up better off.

The Current Account

This shows the income and spending from trade with other countries. The main parts are:

 Trade: revenue from imports & exports of physical goods (manufactured items, food
etc).
 Services: revenue from buying & selling services with other countries (financial, airlines
etc)
 Income: adds wages from residents working abroad, subtracts foreign workers wages.
Adds profits & dividends sent back by firms abroad, subtracts these leaving the country.
 Transfers: Aid sent & received between governments, taxes/payments to/from E.U. etc.
 Tariffs
 These are a tax on imports. If a country wants to protect a domestic industry they could
tax imports of the competing firms. Foreign prices are therefore higher, leading
consumers to buy the domestic goods instead.
 Quotas
 These are a physical limit on the amount of imports allowed into a country. A country
can protect domstic producers through these since once the import quota is reached
everyone else has to buy domestic alternatives.
 Embargoes
 These are a complete ban on a country’s exports. Examples would include countries that
are at war (in the 1920s the equivalent of the UN tried to put an embargo on oil against
Italy for their invasion of Abyssinia).
 Subsidies
 Subsidies are when a government seeks to stop imports by making domestic goods
cheaper. They do this by giving money to small domestic firms. This protects them from
large companies that can create economies of scale through trade.