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Key concepts, words and tips will work as linkers = 🔗

The syllabus is divided into six topic areas:

» Basic economic ideas and resource allocation

» The price system and the microeconomy
» Government microeconomic intervention
» The macroeconomy
» Government macroeconomic intervention
» International economic issues

The key concepts of the Cambridge 9708 syllabus:

The key concepts are designed to help you develop a deeper understanding of the subject. They
can open up new ways of thinking about, understanding or interpreting economic terms & theories.

Key Description
concept

Scarcity and In economics, there is a fundamental problem: resources are scarce but
choice wants are unlimited. Therefore, there is always a choice required between
competing possible uses for the resources. There is therefore an opportunity
cost in making this choice, such as when a decision is made to use a
particular piece of land for agricultural or industrial use.
The margin In economic theory, decisions by consumers, firms or governments will be
and decision based on choices taken at the margin. For example, firms will produce up to
making the point where the revenue generated by an extra unit of output is equal to
the cost of producing it. However, economic decision making can also be
based on values or ethical judgements, such as in relation to the need to try
to reduce the extent of pollution.
Equilibrium Individual markets, as well as the whole economy, move in and out of
and equilibrium, constantly altering the allocation of scarce resources. For
disequilibrium example, an individual market will be in a state of equilibrium when there is no
excess demand or excess supply in that market.
Time Economic conditions can change over a period of time. Time periods can vary
between the short run, the long run and the very long run. Individuals, firms,
markets and governments can respond to these changes in economic
conditions in different ways, depending on the particular time frame — for
example, trading off a cost in the present for a benefit in the future, such as
when a new road is built.
Efficiency It is possible for individual markets and the economy as a whole to be both
and efficient and inefficient in different ways when using scarce resources. For
inefficiency example, allocative efficiency occurs where price is equal to marginal cost.
The role of There will be a trade-off between, on the one hand, freedom for firms and
government individuals in unregulated markets and, on the other hand, greater social
and issues of equality and equity through different forms of government regulation of
equality individuals and markets — for example, when governments intervene to bring
and equity about a more equal distribution of income and wealth in an economy, such as
through a progressive tax.
Progress and Economics is concerned with how societies can make progress in measurable
development money terms and also how they can develop in a more normative sense in
relation to standards of living — for example, the increasing emphasis that is
now placed on sustainable development in many economies in the world.
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Key skills in economics:

Economics involves several key skills, including the following:

» Application: you need to be able to apply economic theories and concepts to real-world
examples.

» Analysis: you need to be able not simply to describe something, but also to analyse it in order to
demonstrate that you clearly understand its essential features.

» Evaluation: you need to be able to demonstrate the skill of evaluation and critical thinking in
particular situations. You should be capable of weighing up different arguments, prioritising certain
options or policies and making logical and reasoned judgements.

» Numerical skills: you need to be able to calculate percentages, percentage changes and
averages, and interpret index numbers.

» Diagrams: you need to be able to draw diagrams accurately and label them correctly to support
a description, explanation or analysis.

» Links between different topics: you need to understand the links between different topics.

» Problem solving: you need to be able to analyse the causes and consequences of a problem
and to make sensible suggestions about possible solutions.

» Interpretation of data: you need to be able to analyse given data critically, such as being able
to identify a particular trend or to understand the limitations of the data.

The command words used in the economics exam:

Directive Meaning of the directive or command word

or
command
Analyse Examine in detail to show meaning, identify elements and the relationship
between them
Assess Make an informed judgement

Calculate Work out from given facts, figures or information

Comment Give an informed opinion
Compare Identify/comment on similarities and/or differences
Consider Review and respond to given information
Define Give precise meaning
Demonstrate Show how or give an example
Describe State the points of a topic/give characteristics and main features
Discuss Write about issue(s) or topic(s) in depth in a structured way
Evaluate Judge or calculate the quality, importance, amount, or value of something
Explain Set out purposes or reasons/make the relationships between things
evident/provide why and/or how and support with relevant evidence
Give Produce an answer from a given source or recall/memory
Identify Name/select/recognise
Justify Support a case with evidence/argument
Outline Set out main points
State Express in clear terms
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As level:
1 Basic economic ideas and resource allocation

1.1 Scarcity, choice and opportunity cost

The fundamental economic problem and scarcity

• wants: items that are not essential for survival (e.g., a new car or television)
• needs: items that are essential for survival (e.g., food or shelter)
• resources: the inputs available to an economy for use in the production of goods and
services
• economic problem: a situation where there are not enough resources to satisfy all human
needs and wants
• opportunity cost: the benefit forgone from not choosing the next best alternative

» Scarcity refers to the fact that at any moment in time, the output that an economy is able to
produce will be limited by the resources and technology available. People’s wants and needs,
however, will always exceed the resources available to satisfy them — in other words, these
wants and needs are unlimited. This is known as the fundamental economic problem.
» As a result of this condition of scarcity, choices must be made.
» In all economies, therefore, there is an inevitability of choice at all levels of decision making — at
the level of the individual, the firm and the government.

This focus on choice stresses the need to recognise the implications not only of choosing one
thing, but also of not choosing something else. Opportunity cost is the benefit forgone from not
choosing the next best alternative. An example is using a piece of land for farming purposes rather
than building a factory on it.

🔗 It is important that candidates fully understand the difference between a want and a need, and
can clearly demonstrate this understanding to the examiner.

KEY SKILL:

Application: an example of a want would be a new car or television and an example of a need
would be food or shelter.

The need to make choices at all levels

As a result of the condition of scarcity, choices must be made. This could be at the level of:

» Individuals
» Firms
» Governments

The nature and definition of opportunity cost, arising from choices

The focus on choice stresses the need to recognise the implications not only of choosing one
thing, but also of not choosing something else. This is known as opportunity cost.

🔗 Candidates sometimes define opportunity cost as the benefit that is forgone (or sacrificed) as a
result of taking a decision. But it is not the result of any random choice; it is the cost of the next
best alternative forgone.
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🔗 Scarcity and choice: the fundamental problem in economics is that resources are scarce and
wants are unlimited, so it is always necessary to make a choice between competing uses for the
resources and there is always an opportunity cost in making this choice.

The basic questions of resource allocation

The emphasis on choice focuses on three basic economic questions:

» What to produce
» How to produce
» For whom to produce

The three basic economic questions are solved in different ways in various economies — in other
words, resource allocation can be approached through different systems or mechanisms.

🔗 Candidates should emphasise the importance of needing to make a choice as a result of the
condition of scarcity. Although choice can apply to various areas of economic activity, these three
economic questions are the most fundamental ones.

KEY SKILL:

Problem solving: Understanding the potential missed opportunities forgone by economic agents
when choosing one policy over another allows for better decision making.

1.2 Economic methodology

Economics as a social science

A social science can be defined as the scientific study of human society. Can economics be
regarded as a social science?
» Economics is social in the sense that it studies different aspects of human behaviour and, in
particular, the choices that humans make.
» Economics is a science in the sense that it uses an organised system of theories and facts
capable of making verifiable predictions.
» Economics can therefore be regarded as a social science because it uses scientific methods to
establish theories that can help explain the behaviour of individuals, groups and organisations in
societies.

Positive and normative statements

• positive statement: a statement that is factual and objective

• normative statement: a statement that is subjective and expresses a value judgement
• value judgement: an opinion that reflects a particular point of view

It is important in economics to be able to distinguish between two different types of statements

— positive statements and normative statements:

» A positive statement is one that can be checked against the facts to decide whether it is
true.
» A normative statement, on the other hand, reflects the norms or values of the person
expressing the statement — such a statement will involve a value judgement and will reflect
someone’s personal opinions. Normative statements often include the words ‘should’ or ‘ought
to’. The distinction between facts and value judgements is therefore very important in
economics.
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🔗 Candidates should understand that economics is one of the social sciences, so positive
statements play an important role in the subject, offering an objective approach, whereas, in
contrast, normative statements are more subjective and are reflections of value judgements.

The meaning of the term ‘ceteris paribus’

• ceteris paribus: a Latin term that literally means ‘other things being equal’
• economic law: an economic theory put forward by economists (e.g. the laws of demand
and supply)
• microeconomics: the study of the behaviour of relatively small economic units (e.g.
particular individuals, households or firms)
• macroeconomics: the study of economics at the national and international levels

» Although economics is one of the social sciences, with many aspects of the subject involving
scientific analysis, it is not really possible to study human behaviour under laboratory conditions.
» However, economic theory does assume that certain aspects of human behaviour can be held
constant.
» This assumption of ceteris paribus, that other things are equal, means that economists can
analyse one aspect of human behaviour at a time. For example, in this way it has been possible to
put forward economic laws of demand and supply. These economic theories have been put
forward in relation to both microeconomics and macroeconomics.

🔗 Candidates should appreciate that it is virtually impossible to keep all variables constant, and
this is why economists use the concept of ceteris paribus to indicate the idea of ‘everything else
being held constant’. This idea can be brought into a number of answers, such as showing the
relationship between changes in the price of a product and changes in the demand for that
product. If ceteris paribus applies, all other possible influences, such as changes in income, can
be assumed to be constant.

The importance of the time period

• short run: the time period when it is not possible to change all of the factors of production
• long run: the time period when it becomes possible to change all of the factors of
production
• very long run: the time period when technical progress is no longer assumed to be
constant, as is the case in the short run and the long run, and the conditions of supply in an
industry can be affected, e.g. by the impact of a new invention

Economists, when analysing economic behaviour, distinguish between three different time
periods:

» Short run: this refers to that time period in which only certain factors of production can change.
These are known as ‘variable factors’. In the short run it is not possible to change the ‘fixed
factors’. For example, in the short run it may be possible to change labour, but the same capital
will need to be used.
» Long run: this refers to that time period when the inputs of all factors of production can be
changed — for example, it will be possible to vary both labour and capital in the long run. It is not
possible to define exactly how long the short run or the long run is because it will vary depending
on the particular circumstances.
» Very long run: this refers to that time period when supply conditions can change because of
technical progress. In both the short run and the long run, technical progress is assumed to be
held constant. In the very long run, however, technical progress can change — for example, as a
result of a new invention in a particular industry — and this will have an effect on the supply
conditions in that industry.
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🔗 Time: economic conditions change in different time periods, such as the short run, the long
run and the very long run. Individuals, firms, markets and governments are able to respond to
these changes in different ways depending on the time frame.

1.3 Factors of production

The nature and definition of factors of production

• primary sector: production that takes place in agriculture, fishing, forestry, mining,
quarrying and oil extraction
• secondary sector: production that takes place in manufacturing, construction and energy
• tertiary sector: production that takes place through the provision of services
• land: the factor of production that includes all the gifts of nature, or natural resources, that
can be used in the process of production (e.g. minerals, forests and the sea)
• labour: the factor of production that includes all the human effort that goes into the process
of production, both mental and physical
• capital: the factor of production that includes all the human-made aids to production (e.g.
tools, equipment and machinery)
• enterprise: the factor of production that refers to taking a risk in organising the other three
factors of production
• entrepreneur: the individual who takes a risk in combining the factors of production

Production in an economy can take place in three sectors:

» Primary sector: this is the extractive sector, where minerals are taken from the ground, and is
concerned with production in areas of an economy such as farming, fishing, forestry, mining and
quarrying.
» Secondary sector: this is the manufacturing and construction sector, working with the
resources that have been extracted in the primary sector, and is concerned with areas of an
economy such as car production and the construction of airport runways.
» Tertiary sector: this is the services sector and is concerned with wide areas of economic
activity such as banking, insurance, tourism, teaching, medicine and the law.

There are four factors of production:

» Land: this refers to all the natural resources that can be used in the process of production. It can
include farmland, forests, lakes and rivers and all the mineral deposits of a country, such as coal
or oil.
» Labour: this refers to all the human input into the process of production. It refers not just to the
people themselves, but to their skills, training, education and qualifications. It can also be referred
to as ‘human capital’ or ‘intellectual capital’.
» Physical capital: this refers to the human-made aids that can be used in the process of
production. It can refer to equipment, machinery and factories.
» Enterprise: this refers to the factor that brings the other factors of production together to
produce products. The individual who combines the other factors of production, and takes a risk in
doing so, is an entrepreneur.

🔗 Candidates often confuse the use of the term ‘capital’ as a factor of production with another
use of the term to refer to money. It is important that these two meanings of the term are carefully
distinguished.

The difference between human capital and physical capital

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• human capital: the skills, knowledge and experience possessed by a population in terms
of their value or cost to a business or an economy
• physical capital: the tangible, human-made objects that a business uses to produce goods
and services (e.g. tools, machinery and equipment)

» Human capital refers to the human component of production — that is, the talent, knowledge,
abilities, training, education and skills of the labour force.
» Physical capital refers to the non-human resources used in the production of goods and
services — for example, the tools, equipment, plant, buildings and machinery.

🔗 Candidates often confuse the terms ‘human capital’ and ‘physical capital’. It is important that
these two terms are clearly distinguished.

The rewards to factors of production

• rent: the price paid for the use of land

• wage: the reward to labour based on the number of hours worked multiplied by an hourly
rate of pay
• salary: the reward to labour on an annual basis
• interest: the reward for parting with liquidity; the reward to capital for the use of the human-
made aids to production
• profit: the reward to enterprise, defined as the difference between total revenue and total
costs

The rewards to the factors of production are as follows:

» Rent: the reward to land.

» Wages or salaries: the reward to labour.
» Interest: the reward to capital.
» Profit: the reward to enterprise; many enterprises aim for profit maximisation.

Division of labour and specialisation

• specialisation: the process whereby individuals, firms and economies concentrate on

producing those products in which they have an advantage
• division of labour: the way in which production is divided into a sequence of specific tasks
which enables workers to specialise in a particular type of job
• Adam Smith: one of the founding fathers of economics (1723–90) and author of The
Wealth of Nations, published in 1776

Specialisation refers to a process of concentration on a particular aspect of production:

» A car assembly line is a good example of the way in which a manufacturing process can be
broken down into a sequence of specific tasks. Workers will concentrate on, or specialise in, these
particular tasks, giving rise to a division of labour.
» One of the first studies of this process was by the Scottish economist Adam Smith, who
described in his book The Wealth of Nations (1776) how division of labour in a pin factory enabled
a great many more pins to be produced than if each worker tried to do everything him- or herself.

KEY SKILL

Application: Adam Smith pointed out that the process of producing pins involved 18 specific
operations. If one person did all of these, that person would be able to produce 20 pins a day.
However, if division of labour was applied, it would be possible for each worker to produce 4,800
pins a day.
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The role of the entrepreneur in contemporary economies

• enterprise culture: an economy in which taking a risk in the production of new products is
encouraged in the hope of making a profit

Entrepreneurs play a crucial role in contemporary economies, performing two key functions:

» Organisation: entrepreneurs are responsible for organising and coordinating the other factors of
production — land, labour and capital — to produce goods and services.
» Risk: entrepreneurs take a risk in performing this organisation and coordination function; this
arises from the uncertainty that will be a feature of any initiative they take. Although there are
many famous entrepreneurs in the world, who have had success in a number of different business
ventures, there are many others who have failed.

Contemporary economies have provided many opportunities for the development of an enterprise
culture. This is where people are imaginative and creative, and are willing to take risks in order to
gain profit.

There are a number of ways in which a government could encourage the development of an
enterprise culture, including:

» Supporting business start-up programmes

» Encouraging venture capital financing (this is where private investors provide finance to start-up
businesses that are believed to have good long-term growth potential)
» Providing grants to support research and development
» Policies to promote competition in markets, such as deregulation
» Development of appropriate education and training to improve the quality of human capital
» Financial support for the development of technology parks and the fostering of innovation
» Favourable tax treatment for start-up businesses in the form of tax incentives
» Reducing administrative burdens, such as less ‘red tape’ in the form of excessive bureaucratic
paperwork

1.4 Resource allocation in different economic systems

Decision making and resource allocation in market, planned and mixed economies

• allocative mechanism: a method of taking decisions about the different uses that can be
made of factors of production

An allocative mechanism is needed for deciding how economic goods that are scarce are
produced and consumed.

There are three different types of allocative mechanism:

1. Market economies 2. Planned economies 3. Mixed economies

🔗 Although an allocative mechanism is necessary to allocate economic goods, free goods that
are in sufficient supply to satisfy demand do not need an allocative mechanism.

🔗 Candidates should understand that every country in the world (and there are over 200
countries) will allocate its scarce resources in different ways. This range of allocative mechanisms
is so broad that economists have focused on three main types: market economies, planned
economies and mixed economies.

1. Market economies:
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• market economy (or market system): an economy where decisions about the allocation
of resources are taken through the price mechanism
• market: a way in which buyers and sellers come together to exchange products

In a market economy, the allocation of resources is left to the market forces of demand and
supply, operating through the price mechanism.

Advantages and disadvantages of the market economy

Advantages of the market economy Disadvantages of the market

economy

• Decisions are made by individual • Some products will be underprovided and

consumers, who act in their own self- under consumed in a market economy;
interest, i.e. seek to maximise their utility these are known as merit goods (e.g.
or satisfaction when they consume a education and healthcare).
product.
• Some products will be overprovided and
• Decisions are made by individual overconsumed in a market economy;
producers, who act in their own self- these are known as demerit goods (e.g.
interest, i.e. seek to maximise their alcohol and tobacco).
profits.
• Some products will not be provided or
• The use of the price mechanism to consumed at all in a market economy
allocate resources (referred to as ‘the because it would be impossible to charge
invisible hand’ by the Scottish economist a market price for them; these are known
Adam Smith) means that there is no need as public goods (e.g. defence and
for any government intervention in the lighthouses).
allocation of resources.
• Income and wealth disparities can be
• Competition between firms can lead to very significant.
greater efficiency.

2. Planned economies

• planned (or command) economy: an economy where decisions about the allocation of
resources are taken by the state

Planned economies, aka command economies, involve the allocation of scarce resources
through government intervention with no (or very little) scope for market forces to operate.

Advantages and disadvantages of the planned economy

Advantages of the planned Disadvantages of the planned

economy economy

• Government intervention in the allocation • A system with such a large amount of

of resources means it can take decisions government influence and control will
in the national interest (e.g. it can tend to be bureaucratic and, as a result,
prevent the production of socially may be inefficient.
undesirable products such as drugs).
• The lack of competition and the lack of
• The government can intervene to bring the profit motive mean that products are
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about a more equitable distribution of often of poor quality with consumers

income and wealth. having little choice.

3. Mixed economies

• mixed economy: an economy where the allocation of resources is decided both by market
forces and by the state

A mixed economy combines elements of both market economies and planned economies — in
other words, there is some degree of state ownership and state intervention, but in many areas of
the economy market forces will be allowed to operate.

It could be argued that all economies today are, to some extent, mixed economies. However, there
are large differences between, say, China, where the government still plays an important role in
the allocation of resources, and the USA, where the government has only a limited role in the
allocation of resources.

KEY SKILL

Evaluation: you need to be able to evaluate the strengths and weaknesses of the different types
of allocative mechanism, coming to a judgement as to which is preferable and why. For example,
a strength of a market economy is that there is no, or very little, government intervention, but a
weakness is that without government intervention, there are likely to be many examples of market
failure. Therefore, if a market is uncompetitive, or there is a high level of market failure,
government intervention may be necessary to increase the degree of competition and reduce the
level of market failure in the economy.

🔗 Candidates need to demonstrate they understand that the degree of mixture in any economy is
not static. For example, since the credit crunch began in 2007, a number of banks in many
countries have either been brought under complete state ownership or been given financial
assistance by government to remain in business. One bank in the UK, NatWest, became 84%
state owned in 2008 and this bank was still 51% state owned in 2022.

Transitional economic systems

• transitional economy: an economy that was previously a command or planned economy

and which is now allowing a greater degree of scope for market forces to operate

A number of economies are going through a period of change where the extent of central planning
is being reduced and market forces are being allowed to have a greater degree of influence. China
and Cuba are examples of such a transitional economy. There are, however, possible problems
associated with transition.

Problems of transitional economies

Unemployment A planned economy is generally better able to keep down the rate of
unemployment in an economy; when there is a move towards greater
reliance on market forces, the rate of unemployment in an economy is likely
to increase because, in a market economy, firms aim to maximise profits
and this may lead them to reduce costs of production, possibly by laying off
some workers.
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Inflation In a planned economy, the state controls prices so it is easier to keep down
the rate of inflation; when prices are determined by the free-market forces
of demand and supply, it is more difficult to control prices and so inflation is
more likely.

Output In a planned economy, it is possible for the state to support inefficient firms
and industries; when state support is ended, such firms and industries may
not be able to compete and so output could fall.

Welfare A planned economy is able to provide housing and healthcare to everyone;

with the introduction of market forces, there may be a fall in welfare
provision and this may have a detrimental effect on levels of productivity in
the economy.

🔗Candidates should recognise that transitional economies can vary a great deal, depending on
the degree of change or transition that has taken place. Some of these economies will still be
similar to a planned economy, with only a small degree of private sector involvement. On the other
hand, other economies will have moved away from a planned economy towards more of a market
economy. It should also be understood that such economies are changing rapidly, and a great
deal of change can have taken place in a short period of time.

1.5 Production possibility curves

The nature and meaning of a production possibility curve (PPC)

• production possibility curve (or frontier): a graphic representation showing the

maximum combination of goods or services which can be produced from given resources
and with a constant state of technology

A production possibility curve (or production possibility frontier, as it is sometimes called)

shows the different combinations of products that can be produced if an economy is working at full
capacity.

The shape of the curve: constant and increasing opportunity costs

The shape of the curve shows that there are a number of

different combinations of products that can be produced. It
is drawn as a curve rather than as a straight line because
not all factors of production are equally efficient.

» The production possibility curve (PPC) in Figure 1.1

shows the combination of capital goods (shown on the
vertical axis) and consumer goods (shown on the horizontal
axis) that an economy can produce in a particular period of F1.1 A production possibility curve
time with the existing economic resources available.
» Point A shows one possible combination of outputs, where the economy produces K1 capital
goods and C1 consumer goods.
» Any movement along the curve from point A shows that the production of more of one type of
good leads to the production of less of the other (thus illustrating the concept of opportunity cost).
» Point C, which is inside the PPC, shows that the economy is not using its resources efficiently
and there is some unemployment of resources. Output of both capital and consumer goods is
lower than it could be.
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🔗 Scarcity and choice: the fundamental problem in economics is that resources are scarce and
wants are unlimited, so a choice is always required between competing uses for the resources and
an opportunity cost in making this choice.

Constant and increasing opportunity costs

» It has already been stated that a production possibility frontier is drawn as a curve, rather than
as a straight line, because not all factors of production are equally efficient.
» It is therefore necessary to distinguish between constant and increasing opportunity costs. If it
were possible to move from one point on the production possibility curve to another, with an equal
sacrifice of resources, then this would indicate a situation of constant opportunity costs.
» However, there will come a time when this is not the case. Increasing opportunity costs mean
that an ever-increasing amount of one product will need to be sacrificed to produce more of the
other product.
» The reason is that different factors of production have different qualities. As a result of this, the
production possibility frontier changes shape slightly as it approaches each axis.
» For example, in Figure 1.1, this is most clearly seen as the PPC gets closer to the horizontal
axis, showing the consumer goods produced per period of time.

KEY SKILL

Analysis: a production possibility frontier is drawn as a curve because of the existence of the law
of diminishing marginal returns (see Chapter 7, section 7.5). This states that employing an
additional factor of production will eventually cause a relatively smaller increase in output.

🔗 The margin and decision making: the shape of the production possibility frontier as a curve
illustrates the importance of decisions taken at the margin, given that resources are not equal
substitutes for each other.

The causes and consequences of shifts in a PPC

• economic growth: an increase in the national output of an economy over a period of time,
usually measured through changes in gross domestic product
1.2 Economic growth

» Point B in Figure 1.1, which is outside the PPC, is unreachable at the

present time given the resources that the economy currently has.
» However, over a period of time it is possible for there to be economic
growth resulting from the availability of more resources and/or the more
productive use of resources, and this would enable point B to be
reached

Economic growth enables an economy to produce more of both capital and consumer goods.
It refers to a situation where there is an expansion in the productive capacity or potential output of
an economy.
This is shown in Figure 1.2 by a rightward shift of the PPC from PPC1 to PPC2. Of course, if there
were a decrease in the quantity and/or quality of resources in an economy, this would lead to a
leftward shift of a PPC from PPC2 to PPC1.

🔗 It is important that candidates understand the difference between a movement along, and a
shift of, a production possibility curve:
» A movement along a curve indicates the different combinations of two goods that could be
produced from the given resources in an economy.
» A shift of a curve to the right would indicate an expansion in the productive potential or capacity
of an economy, allowing more of both goods to be produced.
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KEY SKILLS

Diagrams: it is important that candidates understand the correct labelling of the two axes of a
production possibility curve, especially when compared with the labelling of demand and supply
diagrams in Chapter 2. The two axes of a PPC are labelled as particular goods or types of goods
(e.g. capital goods and consumer goods in Figures 1.1 and 1.2). This is different from labelling the
two axes P and Q in demand and supply diagrams.

Diagrams: it is important that a PPC is drawn so that it touches both axes. This is because it is
assumed that all of an economy’s resources will be used to produce one or other of the two
products shown in the PPC diagram.

The significance of a position within a PPC

» It is important to understand the significance of a position within a PPC.

» point A is where an economy is using its resources efficiently, but point C, within a PPC, is
where an economy is using its resources inefficiently.
» At this point, not all resources are being utilised and the output of both products is lower than it
could be if all resources were being used.

1.6 Classification of goods and services

The nature and definition of free goods and private goods (economic goods)

1. Free goods

• free good: a good that is not scarce and so does not require a market price to be attached
to it

A free good is one which is consumed by people without a situation of scarcity arising — in other
words, there is enough of the good to satisfy everybody. As the good is not scarce, it does not
require a market. The supply of the good equals the demand for it at zero price. It takes no factors
of production to produce a free good and so, there is no opportunity cost involved.

2. Private goods

• private good: a good that is bought and consumed by individuals for their own benefit
• excludability: a feature of private goods whereby people can be excluded from consuming
a good
• rivalry: a feature of private goods whereby when a product is consumed by one person, it
cannot be consumed by another

A private good (or economic good) is one which is consumed by an individual for their own
private benefit. This applies to most products in an economy. Private goods have two important
characteristics:

» Excludability: one key feature of a private good is that people can be excluded from consuming
it.
» Rivalry: another key feature of a private good is that the consumption of it by one person
reduces its availability for other people; there is rivalry in such a situation because consumers are
in competition with other consumers to consume a particular product.

🔗 It is important that candidates can clearly distinguish between private goods and public goods
in their examination answers on this topic. The key characteristics of a private good are rivalry and
excludability.
 14

KEY SKILLS

Analysis: the situation of scarcity does not apply in the case of a free good because there is
enough of a good to satisfy everybody.

Application: examples of free goods include air and sunshine.

Application: examples of private or economic goods include food, clothing, cars and
smartphones.

The nature and definition of public goods

• public good: a good that is non-rival, non-excludable and non-rejectable

• non-excludability: where the consumption of a product by one person does not exclude
others from consuming the same product
• non-rivalry: where the consumption of a product does not prevent its consumption by
someone else
• free rider: the idea that it would be impossible to charge people for using a good or service
because it would be impossible to prevent someone who had not paid from benefiting
• government expenditure: the total of all spending by a government
• non-rejectability: where individuals cannot actually avoid the consumption of a public
good, even if they want to

In contrast to private goods, public goods are provided by society as a whole so that everyone
can benefit from them. Public goods have two important characteristics:

» Non-excludability: once a public good has been provided for one person, it is not possible to
stop other people from benefiting from such a good (i.e. no one is excluded).
» Non-rivalry: as more people consume the public good, the benefit to those already consuming it
is not reduced (i.e. consumption by one person does not prevent others from consuming it).

These products need to be provided by the state or the public sector because if they were
provided by the private sector, it would be impossible to exclude someone who had not paid. This
gives rise to the free rider problem.

For example, it would not be possible to provide street lighting through the private sector because
it would be impossible to prevent someone who had not paid from benefiting from the service.
When such products are provided by the public sector, they are part of government expenditure
and are financed out of taxation.

In addition to being non-rival and non-excludable, public goods are also non-rejectable. This
means that, even if a person does not want to be protected by their country’s defence and police
system, they are not actually able to reject it.

Whereas key features of a private good are that it involves rivalry and excludability, candidates
need to emphasise in their answers that key features of a public good are that it is both non-rival
and non-excludable.

KEY SKILL

Application: examples of public goods include street lighting, defence and police.

A. The nature and definition of merit goods

 15

• merit good: a product that is rivalrous and excludable but, if left to a free market, would be
likely to be underproduced and underconsumed
• information failure: where people lack the full information that would allow them to make
the best decisions about consumption
• market imperfection: a feature of a market which does not perform perfectly because of a
failure to make an optimal use of resources, necessitating government intervention
• market failure: a market imperfection which gives rise to an allocation of scarce resources
which is not as efficient as it might otherwise have been

» A merit good is a particular type of private good. Examples include education and healthcare.
» Like other private goods, merit goods are both rival and excludable, but what distinguishes a
merit good is that there is information failure which means that the good is likely to be
underprovided and underconsumed if provided through the private sector.
» For example, people don’t fully appreciate the value of a good education or good health. This
could be regarded as a market imperfection.
» Without government intervention, it is likely that there would be market failure because the
allocation of resources would be sub-optimal.
» Governments therefore intervene by providing such goods through the public sector, alongside
private sector provision, so that those who would not or could not afford to consume them in the
private sector will do so in the public sector.

🔗 Candidates sometimes get confused and describe merit goods as examples of public goods.
They are not examples of public goods, but of private goods. Like all private goods, they are
rivalrous and excludable.

Candidates also sometimes confuse a merit good with a free good, especially given that some
merit goods are free at the point of consumption, such as entry to a particular lesson. A free good,
however, is something completely different: it is where there is so much of a product that demand
can be satisfied without the need for an allocative mechanism, and supply will equal demand at
zero price (e.g. air).

B. The nature and definition of demerit goods

• demerit good: a product that is rivalrous and excludable but, if left to a free market, would
be likely to be overproduced and overconsumed

» Demerit goods are the opposite of merit goods. Whereas merit goods would be underprovided
and underconsumed in a free market, demerit goods would be overproduced and overconsumed
in a free market.
» A demerit good is socially undesirable in some way: for example, alcohol and tobacco.
» The overproduction and overconsumption of demerit gods is a result of imperfect information by
consumers. For example, they may not realise that alcohol and tobacco are bad for their health.
» Without government intervention, it is likely that there would be market failure because the
allocation of resources would be sub-optimal.

🔗 It is important that candidates indicate clearly how a demerit good is fundamentally different
from a merit good. Whereas a merit good is likely to be underproduced and underconsumed, a
demerit good is likely to be overproduced and overconsumed in a free market.

KEY SKILL

Application: examples of merit goods include education and healthcare. Examples of demerit
goods include alcohol and tobacco. Examples of public goods include street lighting and defence.
 16

2 The price system and the microeconomy

2.1 Demand and supply curves

Effective demand

• effective demand: demand for a product that is backed by the ability and willingness to
pay for it

Effective demand refers to that demand which can be supported by having the means to pay. In
this situation, consumers must not just want a particular product, but also be willing and able to
pay for it.

KEY SKILL

Analysis: the characteristics of effective demand need to be made very clear when the theory of
demand is being explained (i.e. the fact that people must be willing and able to buy something at a
particular price).

🔗 It is important that candidates demonstrate in their answers an understanding that demand

needs to be effective demand. It is not enough that consumers want something; they have to be in
a position to pay for it.

Individual and market demand and supply

1. Individual and market demand

A. Individual and market demand curves

• demand: the quantity of a product that consumers are willing and able to buy at a given
price in a given period of time
• law of demand: a law (or theory) which states that there is an inverse relationship between
the quantity demanded of a product and the price of the product, ceteris paribus

» Demand is the quantity of a product that consumers are willing and able to buy at a given price
in a given time period.
» An individual demand curve shows the quantity of a product that a particular consumer is willing
and able to buy at each and every price, ceteris paribus (i.e. with all other things unchanged).
» The individual demand curve will slope downwards from left to right, indicating that a consumer
is more likely to buy a product at a lower price than at a higher price. This is known as the law of
demand.

B. Aggregation of individual demand curves to give market demand

• demand curve: a curve that shows how much of a good or service will be demanded by
consumers at a given price in a given period of time
• demand schedule: a table giving the quantities sold of a product at different prices,
enabling a demand curve to be drawn from this information
• derived demand: where demand for the components of a product or for workers arises
from demand for the final product

» A demand curve can be drawn for every consumer in a society for every product, but in
economics it is more usual to focus on market demand curves.
 17

» Market demand for a product is derived from bringing F2.1 A demand curve for smartphones
together (or aggregating) all the potential buyers of a
product. It is the total quantity of a product that all potential
buyers would choose to buy at a given price in a given
period of time.
» A demand schedule can be produced for a particular
product, such as smartphones.
» This schedule can then be plotted to give a market
demand curve, as shown in Figure 2.1. The price of
smartphones is shown on the vertical axis and the quantity of smartphones bought is shown on
the horizontal axis.

The demand curve shows the relationship between price and the quantity demanded. It is
downward sloping, indicating an inverse relationship between the price of a product and the
quantity demanded of a product: that is, as the price falls, the demand rises.

Derived demand is where the demand for a component depends upon the final demand for a
product that uses that component. For example, the demand for rubber is derived from the
demand for car tyres. Derived demand can also be used in relation to the demand for workers —
for example, the demand for bus drivers derives from people’s demand for bus transport.

2. Individual and market supply

A. Individual and market supply curves

• supply: the quantity of a product that producers are willing to sell at a given price in a given
period of time
• law of supply: a law (or theory) which states that there is a direct relationship between the
quantity supplied of a product and the price of the product, ceteris paribus

Supply is the quantity of a particular product that firms are willing and able to sell at each and
every price in a given time period, ceteris paribus (all other things unchanged). A firm’s supply
curve will slope upwards from left to right, indicating that a producer will be more likely to sell a
product at a higher price than at a lower price. This is known as the law of supply.

B. Aggregation of individual firms’ supply curves

• supply curve: a curve that shows how much of a good or service will be supplied by
producers at a given price in a given period of time
• supply schedule: a table giving the quantities sold of a product at different prices, enabling
a supply curve to be drawn from this information
F2.2 A supply curve

supply curve can be drawn for every producer in an economy for

every product, but in economics it is more usual to focus on market
supply curves. Market supply of a product is derived from bringing
together (or aggregating) all the potential suppliers of a product. It is
the total quantity of a product that all potential sellers would choose to
sell at a given price in a given period of time.

A supply schedule can be produced for a particular product, such as smartphones. This schedule
can then be plotted to give a market supply curve, as shown in Figure 2.2.

The price of smartphones is shown on the vertical axis and the quantity of smartphones sold is
shown on the horizontal axis. The supply curve shows the relationship between price and the
 18

quantity supplied. It is upward sloping, indicating a direct relationship between the price of a
product and the quantity supplied of a product: that is, as the price rises, the supply rises.

The determinants of demand

Price

• change in quantity demanded: where demand for a product changes as a result of a

change in the price of the product; change in quantity demanded is shown by a movement
along a demand curve
• extension in demand: when the quantity demanded of a product increases as a result of a
fall in the price of the product, shown by a movement down the demand curve
• contraction in demand: when the quantity demanded of a product decreases as a result
of a rise in the price of the product, shown by a movement up the demand curve

A major influence on the demand for a product is its price. Figure 2.3
shows that there is an inverse relationship between a change in the price
of a product and the quantity demanded of a product, all other things
unchanged (ceteris paribus).

When it is only the price of a product that changes, the resulting change
in quantity demanded can be shown on a demand curve by a movement
along the curve.
F2.3 A movement along
» When the price of a product is reduced, for example, from P0 to P1, the the demand curve
quantity demanded goes up from Q0 to Q1.
This is represented by a downward movement along the demand curve, indicated in the diagram
by the downwards arrow.
This is known as an extension in demand.
» If, on the other hand, the price of a product is increased, the quantity demanded falls and this
would be shown as an upward movement along the demand curve.
This is known as a contraction in demand.

The determinants of supply

change in quantity supplied: where the supply of a product changes as a result of a change in
the price of the product; change in quantity supplied is shown by a movement along a supply
curve
extension in supply: when the quantity supplied of a product increases as a result of a rise in the
price of the product, shown by a movement up the supply curve
contraction in supply: when the quantity supplied of a product decreases as a result of a fall in
the price of the product, shown by a movement down the supply curve

Movements along a supply curve are determined by changes in the price of a product. Figure 2.4
shows the direct relationship between the price of a product and the quantity supplied of that
product. This is why the supply curve is upward sloping. A movement up a supply curve is known
as an extension in supply and a movement down a supply curve is known as a contraction in
supply.

Causes of a shift in the demand curve

• change in demand: where there is a change in the conditions of demand, i.e. something
other than a change in the price of a product; this is shown by a shift of a demand curve
• composite demand: the demand for a product that can be used for more than one
purpose
 19

Price is not the only factor that influences demand. If the ceteris paribus assumption is removed, it
is possible to consider all the other factors that were previously being
held constant. These other factors could include:

» a change in the incomes of consumers

» a change in the price of a substitute product (a substitute product is
one that could be used for the same purpose by consumers)
» a change in the price of a complementary product (a complementary
product is one that is directly related to, and used with, another product)
» an advertising campaign F2.4 A shift in the
» a change in population demand curve

» a change in the tastes and preferences of consumers

» a lowering of interest rates, making borrowing more affordable
» a change in the weather, possibly associated with different seasons

When one of these other factors affects demand, the result is described as a change in demand
and is shown by a shift of the demand curve.

In this diagram, there might have been an increase in incomes and/or an effective advertising
campaign. The demand curve shifts to the right, from D0 to D1, as shown by the rightward arrow.

Composite demand refers to the demand for a product that can be used for more than one
purpose. Stone, for example, could be used for building purposes and could also be used in the
construction of roads; a particular piece of land could be demanded to build both shops and
houses.

🔗 Candidates sometimes confuse movements along a demand curve and a shift of a demand
curve. It is important that you understand what will cause a movement along a demand curve and
what will cause a shift of a demand curve. A movement along a demand curve can only be caused
by a change in the price of a product, whereas a shift of a demand curve can be caused by
anything other than a change in the price of a product.

KEY SKILL

Diagrams: it is important to show clearly the direction of a shift in a demand curve:

for example, by labelling the two demand curves D0 and D1 and by including an arrow to show the
direction of the shift.

Normal and inferior goods

• normal good: a good for which the demand rises with an increase in income
• inferior good: a good for which the demand falls with an increase in income

» Figure 2.4 showed what usually happens when there is an increase in the incomes of
consumers — more of the product is bought at every price and there is
a rightward shift of the demand curve, showing an increase in
demand. Such goods are called normal goods.
» However, it is possible that the demand for some goods and
services decreases when there is an increase in incomes. For
example, while there might be an increase in the demand for cars as a
result of an increase in incomes, there might be a decrease in the
demand for public transport, such as bus journeys.
F2.5 A shift in the demand curve
following an increase in consumer
incomes (an inferior good)
 20

» This can be seen in Figure 2.5 where there is a leftward shift in the F2.6 Demand &
demand curve for bus journeys, showing a decrease in demand. Such income for a
normal good
goods are called inferior goods.

It is important to recognise that the demand for normal and inferior goods
shows the relationship between a change in the quantity demanded and a
change in income, not price. Figure 2.6 shows this relationship for a
normal good.

🔗 Candidates need to ensure that they understand the difference

between a normal good and an inferior good and can demonstrate this in F2.7 Demand & income
their examination answers. A normal good is one where demand will for an Inferior good

increase as a result of a rise in income. An inferior good is the opposite: it

is a good where demand will decrease as a result of a rise in income.

🔗 Candidates can sometimes confuse the effect of a change in price

and a change in income in examinations. These two effects need to be
clearly distinguished. For example, changes in the quantity demanded of
normal and inferior goods take place in response to a change in a person’s
income, not to changes in the prices of the goods.

KEY SKILL

Evaluation: it needs to be recognised that what is described as a normal good and what is
described as an inferior good may vary between different countries, or within one country at
different historical time periods.

Causes of a shift in the supply curve

Price is not the only factor that influences supply. If the ceteris paribus assumption is removed, it is
possible to consider all the other factors that were previously being held constant. These other
factors could include the following :

Indirect taxes

• indirect tax: a tax that is imposed on expenditure; it is indirect in that the tax is only paid
when the product on which the tax is levied is purchased

» A government may decide to impose an indirect tax, such as a

sales tax, on a particular good or service. Examples are value added
tax (VAT) and goods and services tax (GST).
» The effect of the imposition of such a tax can be seen in F2.8. In
this case, the tax is a specific tax with a fixed amount of tax per unit,
so the supply curve shifts upwards, parallel to the original supply
curve.
» Figure 2.8 shows how the imposition of an indirect tax will affect the
price of a product. As there is an upward movement of the supply curve,
this will lead to an increase in price. In order to determine the exact price F2.8 The effect of a
charged, it would be necessary to include a demand curve in the diagram. sales tax on supply

KEY SKILL

Analysis: if the indirect tax is an ad valorem tax, which adds a certain percentage on to the price,
the supply curve will not shift upwards parallel to the original supply curve but will move further
away from it.
 21

Subsidies

• subsidy: an amount of money paid by a government to a producer, so that the price

charged to the customer will be lower than would have been the case without the subsidy

» Whereas the imposition of a tax shifted the supply curve

upwards to the left, a subsidy has the opposite effect. If a
government pays firms a subsidy to produce a particular product,
this will have the effect of reducing their costs and encourage
firms to supply more output at any given price. This can be seen
with the supply curve shifting downwards to the right.
» The effect of the subsidy, in shifting the supply curve to the
right, will be a lowering of price. The actual price will be
determined where the ‘S with subsidy’ line intersects with the
F2.9 The effect of a
demand curve. The effect of the subsidy is that both subsidy on supply
producers and consumers may benefit.

🔗 The distinction between the effect of a tax and the effect of a subsidy is another area that
candidates often confuse in examinations. You need to remember that the effect of a tax is to shift
the supply curve to the left, whereas the effect of a subsidy is to shift the supply curve to the right.

Production costs

An important influence on supply is the costs of production. If the costs of

the inputs in the production process — that is, the costs of the factors of
production — increase, then firms will be inclined to supply less output at
any given price.

The increase in production costs causes the supply curve to shift to the
left from S0 to S1.
F2.10 The supply
The increase in costs can be seen by the vertical distance between S0 curve Shifts to the
and S1. left if production
costs increase

Technology of production

Another important influence on supply is the technology of production. If

the technology of production is improved, this means that firms will be
able to produce more effectively than before.
improved technology leads to firms supplying a greater output at any
given price. The supply curve shifts to the right from S0 to S1.
2.11 The supply curve shifts to
The prices of other goods the right if production costs fall

» There may be a degree of substitution on the supply side if the prices of different products
change.
» In many cases, the factors of production that a firm has can have alternative uses, so a firm may
be influenced by changes in the prices of different products to produce more of one product and
less of another.
» A rise in the price of a product could increase its profitability, so a firm may decide to switch
production towards this product. For example, car production companies are increasingly
switching production towards electric cars.

Expected prices
 22

A final influence on market supply relates to the expectations of firms about possible future prices.
This is especially the case in those situations where the production process takes quite a long
time. Firms will thus need to take supply decisions on the basis of expected prices in the future.
This is often the case in agriculture.

The distinction between the shift in the demand or supply curve and the movement along
these curves

» It has already been pointed out that it is important to distinguish between a movement along a
demand curve and a shift of a demand curve.

» If there is a change in the market price of a product, and nothing else changes (i.e. assuming
ceteris paribus), this will involve a movement along a demand curve. This shows how consumers
react to a change in the price of a product. This can be seen in Figure 2.3.

» If the situation of ceteris paribus cannot be assumed, however, and there is a change in any of
the other influences on demand, then the demand curve will shift. This could involve a shift to the
left, showing a decrease in demand (e.g. as a result of a lowering of incomes) or a shift to the
right, showing an increase in demand (e.g. as a result of an effective advertising campaign). The
latter case was shown in Figure 2.4.

» It is also important to distinguish between a movement along a supply curve and a shift of a
supply curve. If there is a change in the market price of a product, and nothing else changes
(again assuming ceteris paribus), this involves a movement along a supply curve. This shows how
firms react to a change in the price of a product and was shown in Figure 2.2.

» If the situation of ceteris paribus cannot be assumed, however, and there is a change in any of
the other possible influences on supply, then the supply curve will shift because this will affect the
willingness of firms to supply at any given price.

» As has already been indicated, this could involve a shift to the left: for example, as a result of the
imposition of an indirect tax on the consumption of a product (see Figure 2.8) or an increase in
production costs (see Figure 2.10). Alternatively, it could involve a shift to the right: for example,
as a result of the introduction of a subsidy (see Figure 2.9) or an improvement in technology
(see Figure 2.11).

🔗 The possible confusion between a movement along a demand curve and a shift of a demand
curve has already been pointed out. The possibility of confusion also applies to supply.
You need to be absolutely certain that you understand the difference between a movement along
a supply curve and a shift of a supply curve before taking the examination.

2.2 Price elasticity, income elasticity and cross elasticity of demand

The definition of price elasticity of demand (PED), income elasticity of demand (YED) and
cross elasticity of demand (XED)

The concept of elasticity of demand refers to the responsiveness of demand to a change in one of
its determinants, such as the price of a product, income or the price of another product.
There are three elasticities of demand:

1. Price elasticity of demand (PED): this measures the responsiveness of the demand for a
product to a change in its price.

2. Income elasticity of demand (YED): this measures the responsiveness of the demand for
a product to a change in income.
 23

3. Cross elasticity of demand (or cross-price elasticity of demand) (XED): this measures
the responsiveness of demand for a product to a change in the price of another product.

The formulae and calculation of price elasticity, income elasticity and cross elasticity of
demand

Elasticities of demand are calculated by dividing the percentage change in the quantity demanded
of a product by the percentage change in the determinant causing the change in demand.

The three elasticities of demand are as follows:

1. Price elasticity of demand measures the responsiveness of the demand for a product to a
change in its price. It is calculated by the following formula:

percentage change in the quantity demanded of a product

percentage change in the price of a product

2. Income elasticity of demand measures the responsiveness of the demand for a product
to a change in income. It is calculated by the following formula:

percentage change in the quantity demanded of a product

percentage change in income

3. Cross elasticity of demand or cross-price elasticity of demand measures the

responsiveness of demand for one product to a change in the price of another product.
It is calculated by the following formula:

percentage change in the quantity demanded of good A

percentage change in the price of good B

KEY SKILLS

Numerical skills: you need to be able to calculate PED. For example, if the price of a product
increases by 20% and the quantity demanded decreases by 10%, PED = 10%/20% = 0.5. There
should really be a minus sign before the 0.5 because it is a negative number: that is, there is an
inverse relationship between the change in price and the change in demand. However, the minus
sign is usually left out. This is because it is expected that there will be a negative or inverse
relationship between quantity demanded and price.

Numerical skills: you need to be able to calculate a percentage change. For example, to convert
35/86 into a percentage, the numerator (35) is divided by the denominator (86) and the answer
multiplied by 100, so 35 divided by 86 = 0.406976744 or 0.407. This is then multiplied by 100 to
arrive at the answer of 40.7%.

Numerical skills: you need to be able to calculate YED. For example, if income increases by 5%
and the quantity demanded of a product increases by 20%, YED = 20%/5% = 4.

Numerical skills: you need to be able to calculate XED. For example, if the price of a product
increases by 10% and the demand for another product increases by 15%, XED = 15%/10% = 1.5.

The significance of relative percentage changes, the size and sign of the coefficient of the
three elasticities

Price elasticity of demand

 24

• price elasticity of demand: measures the degree to which a change in the price of a
product leads to a change in the quantity demanded of the product

If the price of a good rises by 20%, and the quantity falls by 40%, then the price elasticity of
demand is 40% divided by 20% = 2. There should really be a minus sign before the 2 because it
is a negative number: that is, there is an inverse relationship between the change in price and the
change in demand.

Income elasticity of demand

• income elasticity of demand: measures the degree to which a change in incomes leads
to a change in the quantity demanded of a product

The income elasticity of demand for most products will be positive: that is, as incomes rise, the
demand for products will rise. As we have seen, these are known as normal goods. However, the
income elasticity of demand for some products will be negative: as incomes rise, the demand for
products will fall. These are known as inferior goods.

KEY SKILL

Application: a necessity is a normal good with a positive YED, but the income elasticity
of demand for such a product (e.g. an essential item of clothing) will be between
0 and 1. A luxury good, such as an expensive holiday, will also have a positive YED, but
with an income elasticity of demand of more than 1.

Cross elasticity of demand

• cross elasticity of demand (or cross-price elasticity of demand): measures the degree
to which a change in the price of one product leads to a change in the quantity demanded
of another product
• substitute goods: goods which are possible alternatives (e.g. gas or electricity as a source
of energy in a home); these goods have a positive cross elasticity of demand (i.e. a rise in
the price of one of them will lead to an increase in the demand for the other)
• complementary goods: goods which are consumed together (e.g. printers and ink
cartridges); these goods have a negative cross elasticity of demand (i.e. a rise in the price
of one of them will lead to a decrease in the demand for the other)

The cross elasticity of demand will be positive if two goods are substitutes, such as tea and
coffee. If good B increases in price, a number of people will switch to the substitute, good A, and
so the demand for good A increases.

If the two goods are complements, such as printers and ink cartridges, the cross elasticity of
demand will be negative. As the price of good B rises, fewer people will buy it and so fewer people
will buy good A as well.

🔗 A number of candidates write the formulas for the three elasticities of demand the wrong way
round in examinations. To avoid making this mistake, remember that in all three calculations (i.e.
price, income and cross elasticity of demand) the percentage change in the quantity demanded is
always on the top.

Descriptions of elasticity values

• perfectly inelastic: where a change in an independent variable has no effect on the

quantity demanded (or supplied); the calculation will be zero and it is shown as a vertical
straight line
 25

• inelastic: where the response of demand (or supply) is proportionately less than the
change in the independent variable; the calculation is less than 1
• unitary elasticity: where the proportionate change in demand (or supply) is exactly equal
to the change in the independent variable; the calculation will be equal to 1, it will be
represented by a rectangular hyperbola (in the case of demand) and a movement up or
down a demand curve will leave total revenue unchanged
• elastic: where the response of demand (or supply) is proportionately greater than the
change in the independent variable; the calculation is greater than 1
• perfectly elastic: where all that is produced is bought/sold; the calculation is infinity and it
is shown as a horizontal straight line
• total revenue: the total amount of income received from sales of a product, calculated as
the number of units sold multiplied by the price of each unit

Elasticity of demand can vary from perfectly inelastic to perfectly elastic:

Elasticity Figure

Perfectly inelastic Zero

Inelastic Greater than zero but less than 1
Unit elastic 1
Elastic Greater than 1 but less than infinity
Perfectly elastic Infinity

The variation in price elasticity of demand along the length of a straight-line demand curve

A straight-line demand curve does not indicate constant

elasticity of demand along the entire length, except in the
case of perfectly elastic and perfectly inelastic curves. The
price elasticity of demand will, in fact, vary along the line.

F2.12 Variation in price elasticity

of demand along the length of a
straight-line demand curve

The factors affecting elasticity of demand

The various factors affecting elasticity of demand can be seen in relation to the three different
types of elasticity.

The factors affecting price elasticity of demand

There are a number of factors affecting price elasticity of demand, including the following:

» Availability of substitutes: the more substitutes that are available for a particular product, such
as different types of tea or coffee, the more price elastic will be the demand.

» Definition of the product: the narrower the definition of a product, the more price inelastic will
be the demand: for example, the demand for tea or coffee will be more inelastic than the demand
for non-alcoholic beverages.
 26

» Amount spent on the product: if the amount spent on a product is a relatively small
percentage of a person’s income, the demand is likely to be inelastic: for example, the amount
spent on boxes of matches or on newspapers is likely to be a small percentage of weekly
expenditure, so the demand for such products is likely to be relatively inelastic.

» Time: demand for a product is likely to be more inelastic in the short run than in the long run: for
example, a decision to buy a new printer to replace one that has broken.

🔗 Time: the period of time can affect the price elasticity of demand for a product; it is likely to be
more elastic in the long run than in the short run because it gives consumers more time to think
about possible alternatives to a product.

🔗 A common error in examinations is to describe a particular good as elastic or inelastic. It is

important that you avoid this mistake. It is not a good that is elastic or inelastic, but the demand for
a particular good that is elastic or inelastic.

The factors affecting income elasticity of demand

There are a number of factors affecting income elasticity of demand, including the following:

» Proportion of income that is spent on a particular good: the demand for some products,
such as matches, will not be very sensitive to a change in income because they are not very
expensive; in these cases, income elasticity of demand will be virtually zero.

» Definition of the product: the income elasticity of demand for cars will be positive, but it may
be negative for particular, cheaper, models of cars.

» Economic development of a particular economy: in some economies, a motorcycle may be

regarded as a normal good, so the income elasticity of demand will be positive, but as the
economy develops and more people can afford cars, the demand for motorcycles may fall, a
motorcycle may start to be regarded as an inferior good and so the income elasticity of demand for
motorcycles will be negative.

The factors affecting cross elasticity of demand

There are a number of factors affecting cross elasticity of demand. These include:

» Whether the relationship is between substitutes or complements (this would determine the XED
sign and not the value of the XED coefficient)

» Whether the substitutes are close or weak substitutes or whether the complements are close or
weak complements; the stronger the relationship between two products, the higher is the
coefficient of XED (examples of strong complements are smartphones and apps, whereas
examples of weak complements are shoes and polish)

» Whether there is any relationship at all between two products; unrelated products have a zero
cross elasticity of demand

The relationship between price elasticity of demand and total expenditure on a product

There is a close relationship between PED and total expenditure on a product:

» If price elasticity of demand is less than unitary (i.e. it is inelastic), a fall in the price of a product
causes a fall in total expenditure on the product and a rise in the price of a product causes a rise in
total expenditure on the product. When demand is inelastic, price and total expenditure move in
the same direction.
 27

» If price elasticity of demand is more than unitary (i.e. it is elastic), a fall in the price of a product
causes a rise in total expenditure on the product and a rise in the price of a product causes a fall in
total expenditure on the product. When demand is elastic, price and total expenditure therefore
move in opposite directions.

» If price elasticity of demand is unitary (i.e. equal to 1), a rise or fall in the price of a product
causes no change in total expenditure on the product.

» If price elasticity of demand is perfectly elastic, the slightest rise in price will lead to zero demand
for a product, so total expenditure will be zero.

» If price elasticity of demand is perfectly inelastic, a change in price will cause no change in the
quantity demanded of a product, so the change in total expenditure will depend on whether there
has been a fall in price or a rise in price.

The implications for decision making of price, income and cross elasticity of demand

Price elasticity of demand

Price elasticity of demand is very important to an understanding of business decisions, especially

because of the link with revenue:

» Price elastic: if the demand for a product is price elastic, a business should lower the price of
the product because more products will be bought, and this will produce a higher total revenue.

» Price inelastic: if the demand for a product is price inelastic, a business should increase the
price of the product because, even though fewer items will be bought, the increased revenue from
each product sold will offset this and therefore, total revenue will increase.

the link between price changes and revenue changes in relation to different price elasticities of
demand:

Price elasticity of For a price increase, total For a price decrease, total
demand revenue will revenue will

Inelastic …rise …fall

Unitary elastic …stay the same …. stay the same
Elastic …fall …rise

Income elasticity of demand

Income elasticity of demand is also important to an understanding of business decisions. Changes

in an economy, and particularly changes in the level of incomes, can influence what a business is
going to produce or stock. This is indicated by the following two examples:

» Rising incomes: if an economy is growing and incomes are rising, a business might want to
move from inferior goods towards producing normal goods; this will influence the planning of
businesses in the future, such as in relation to employment requirements.

» Falling incomes: if an economy is experiencing a recession and incomes are falling, a business
will want to be producing or stocking products with a relatively low income elasticity of demand; for
example, people will still want to buy food in a recession, but they are much less likely to want to
buy expensive cars.

Cross elasticity of demand

 28

Similarly, cross elasticity of demand is also important to an understanding of business decisions.

This is indicated by the following two examples:

» Substitutes: in the case of a substitute, a firm would be able to estimate the effect on the
demand for its product of a change in the price charged by another firm in the market, such as in
relation to a change in the price of tea and the demand for coffee.

» Complements: a firm would be able to estimate the effect on the demand for a product if there
was a change in the price of a complement; for example, a fall in the price of DVD players would
be likely to lead to an increase in the demand for DVD players and, therefore, an increase in the
demand for DVDs.

2.3 Price elasticity of supply

The definition of price elasticity of supply

• price elasticity of supply: measures the degree to which a change in the price of a
product leads to a change in the quantity supplied of the product

Price elasticity of supply measures the responsiveness of the supply of a product to a change in
its price.

The formula for, and calculation of, price elasticity of supply

Price elasticity of supply is calculated by the following formula:

percentage change in the quantity supplied of a product

percentage change in the price of a product

The significance of relative percentage changes and the size and sign of the coefficient of
price elasticity of supply

Price elasticity of supply can range from perfectly elastic to perfectly inelastic (from infinity to zero):

» If a firm will supply any quantity of a good at the going price, then supply is perfectly elastic or
infinite; a perfectly elastic supply curve will be horizontal.

» If the percentage change in supply is greater than the percentage change in price, then supply is
price elastic; an elastic supply curve will always intersect with the price axis.
» If the percentage change in supply is equal to the percentage change in price, then supply is
unitary elastic; any supply curve drawn from the origin will have a unit price elasticity of supply.

» If the percentage change in supply is less than the percentage change in price, then supply is
inelastic; an inelastic supply curve will always intersect with the quantity axis.

» If a firm will supply only a fixed quantity of a good at the going price, and cannot increase or
decrease the amount available, then supply is perfectly inelastic or zero; a perfectly inelastic
supply curve will be vertical.

The sign of the coefficient of price elasticity of supply is always positive.

🔗 As with price elasticity of demand, make sure you remember that the change in quantity goes
on top of the formula and the change in price on the bottom.

The factors affecting price elasticity of supply

 29

• stocks: goods that have been produced, but that are unsold and stored for sale in the
future (e.g. a firm that sells car tyres usually has considerable stocks of tyres to fit a wide
range of cars)
• perishability: the length of time in which a product is likely to decay or go bad — the
shorter the time, the more perishable the product (e.g. cheese usually has a sell-by date
and a date by which it should be consumed)

There are a number of factors affecting price elasticity of supply, including the following:

» Number of producers: the greater the number of suppliers, the more likely it is for the industry
to increase output in response to a price increase, so supply is likely to be relatively elastic.

» Amount of stocks: some products will be easier to stock than others, and this will make the
supply of them relatively more elastic; but some products will be perishable and so more difficult
to stock for long periods, making their supply less elastic (perishable products include meat,
seafood and dairy produce).

» Time period: supply is likely to be more elastic over a longer period of time (see Figure 2.13), as
this gives firms more time to invest in more factors of production and also gives more time for new
firms to join the industry.

» Existence of spare capacity: the greater the degree of capacity in the industry, the easier it will
be for firms to increase output if the price of products increases, and this is likely to make supply
more elastic.

» Length of the production period: supply is usually more elastic in manufacturing than in
agriculture because manufacturing usually involves a shorter production period than agriculture.

» Degree of factor mobility: the easier it is for economic resources to be transferred into the
industry, the more elastic the supply is likely to be.

🔗 Time: supply is likely to be more elastic over a longer period of time as it gives more
time for new firms to join an industry.

The implications for speed and ease with which firms react to changed market conditions

The various factors covered in the previous section give an indication of

the speed and ease with which firms in an industry can respond to
changed market conditions.

Figure 2.13 shows the relationship between the price elasticity of supply
and the time period:
» Supply curve Ss shows supply in the short run, when it will usually be
more difficult to alter supply at relatively short notice and supply tends to
be relatively inelastic. Figure 2.13 Short- and
long-run supply

» Supply curve Sl, however, shows supply in the long run, when firms are usually more able to
increase production and so supply tends to be relatively elastic.

» It is possible that there may be a situation of perfectly inelastic supply at a particular moment in
time; in this situation, it is not possible to increase supply, no matter how much price increases by.
Examples are seats in a cinema or spaces in a parking lot.
 30

» Agricultural products are a good example of perfectly inelastic supply

at a particular moment in time, as it can take a number of years to bring
such products to the market.

» At the other extreme, it is possible that there may be a situation of

perfectly elastic supply; in this situation, the firms in the industry would be
willing to supply any amount of the product at a given price. For example,
if resources are available, the supply of batteries by firms in the industry
may become perfectly elastic. F2.14 Perfectly elastic
and inelastic supply

KEY SKILL

Analysis: you need to be able to analyse how price elasticity of supply can vary between firms in
different industries, especially between those involved in the production of agricultural and
manufactured products.

2.4 The interaction of demand and supply

The meaning of market equilibrium and disequilibrium

• equilibrium: a situation where the quantity demanded in the marketplace is exactly equal
to the quantity supplied and there is neither excess demand nor excess supply in the
market; sometimes referred to as a state of rest or balance or stability where there is no
tendency to change
• disequilibrium: a situation where there is an imbalance between demand and supply in a
market (i.e. there is either excess demand giving rise to a shortage or excess supply giving
rise to a surplus)

Having considered both demand and supply, it is now necessary to

bring them together to establish what is meant by ‘market
equilibrium’.

» Market equilibrium is shown in Figure 2.15.

F2.15 Bringing
demand and
» The downward-sloping demand curve and the upward-sloping supply supply together
curve cross at the equilibrium position of price P* and quantity Q*.

» If the price were higher than this, there would be excess supply and this would cause the price to
move downwards to the equilibrium position.

» If the price were lower than this, there would be excess demand and this would cause the price
to move upwards to the equilibrium position.

» If a situation of excess supply or excess demand were to exist for a period of time, this would be
called disequilibrium until a position of equilibrium was eventually restored.

🔗 Equilibrium and disequilibrium: individual markets, and the economy as a whole, are always
moving into and out of equilibrium, constantly altering the allocation of resources.

🔗 It is important that candidates can distinguish between a situation of equilibrium and one of
disequilibrium in a market.

The effect of shifts in demand and supply on equilibrium price and quantity
 31

• equilibrium price: the price at which a market clears (this

means that at this price, the quantity demanded equals the
quantity supplied); the process of market clearing arises
because the price is free to change and settle at the equilibrium
level
• equilibrium quantity: the quantity at which a market clears,
with consumers getting all they want at the equilibrium price and
producers not being left with unsold products (i.e. there is no
excess demand or supply)
F2.16 The effect of a shift of a
demand curve to the right on
Now that demand and supply have been brought together, it is equilibrium price and equilibrium
possible to consider the effects of changes in demand and supply quantity in a market

on equilibrium price and equilibrium quantity.

In Figure 2.16, there has been an increase in the demand for a product
— for example, as a result of an increase in incomes in an economy.
The demand curve shifts to the right and there is a movement along
the supply curve. Equilibrium price goes up from P0 to P1 and
equilibrium quantity increases from Q0 to Q1.

In Figure 2.17, there has been an increase in the supply of a product — F2.17 The effect of a shift of a
supply curve to the right on
for example, as a result of a reduction in the costs of production. equilibrium price and
The supply curve shifts to the right and there is a movement along equilibrium quantity in a market
the demand curve. Equilibrium price falls from P0 to P1 and
equilibrium quantity increases from Q0 to Q1.

Application of demand and supply analysis

Demand and supply analysis can be applied to a wide variety of

different situations. For example, if an economy is experiencing an
increase in incomes, there is likely to be an increase in the demand
for cars, shifting the demand curve for cars to the right. At the
same time, an improvement in technology may have reduced the
cost of producing cars, shifting the supply curve to the right. The
effect of these two changes:

» The demand curve shifts to the right; the effect of this is F2.18 An application of demand
and supply analysis to cars
that equilibrium price rises from P0 to P1 and equilibrium
quantity increases from Q0 to Q1.

» The supply curve also shifts to the right; the effect of this is that equilibrium price falls back down
to P0 and equilibrium quantity increases from Q1 to Q2.

» Of course, whether equilibrium price actually returns to its original position will depend on the
extent of the shifts of the demand and supply curves.

KEY SKILLS

Application: demand and supply analysis can be applied to many different situations, such as in
relation to cars, houses, electrical products, clothing and holidays.

Diagrams: when drawing a diagram showing shifts of demand and/or supply, you need to make
sure that the shifts are in the right direction. It is useful to include arrows in the diagram to show
clearly the direction of the shifts. It is also important that you clearly label the points of equilibrium
in relation to both price and quantity.
 32

The relationships between different markets

• joint demand: a situation where two items are consumed together (i.e. they are
complements); an example is shoes and shoe laces
• alternative demand: a situation where two items are substitutes (i.e. one will be consumed
or the other); an example is tea and coffee
• derived demand: where demand for the components of a product or for workers arises
from demand for the final product

Joint demand (complements)

The existence of complements gives rise to the concept of joint demand where goods are
consumed together. It would be expected that an increase in the sales of one would lead to an
increase in the sales of the other.

Alternative demand (substitutes)

Some goods, on the other hand, are seen as examples of alternative demand: that is, they are in
competition with each other and either one is demanded or the other. It would be expected that an
increase in the sales of one would lead to a decrease in the sales of the other. Goods that are in
alternative demand are known as ‘substitutes’.

Derived demand

Derived demand is where the demand for a component depends upon the final demand for a
product that uses that component. Derived demand can also be used in relation to the demand for
workers.

KEY SKILLS

Application: another example of joint demand where two complementary goods are consumed
together is printers and ink cartridges.

Application: another example of alternative demand, where there are two substitute products in
competition with each other, is CDs and vinyl records.

Application: derived demand stresses the link between the demand for a component and the
demand for a final product that requires that component (e.g. the demand for rubber is derived
from the demand for car tyres). The concept can also be applied to the demand for workers (e.g.
the demand for bus drivers derives from people’s demand for bus transport).

Joint supply

• joint supply: a situation where the process of producing one product leads to the
production of another product

Joint supply occurs when the production of one good involves the production of another.

It can often take place in the chemical industry where one chemical may be produced as a by-
product of the production of another. It would be expected that a fall in the market price of one
may affect the quantity supplied of the other. However, an increase in the price of one of the
products could mean that a firm will decide to produce more of both goods.

KEY SKILL
 33

Application: meat and leather is an example of joint supply when the production of one good
involves the production of another.

The functions of price in resource allocation

Role of prices

• rationing: the rationing function of the price mechanism occurs where demand exceeds
supply, leading to a rise in price, a greater scarcity of resources and therefore a rationing of
these resources
• signalling: the signalling function of the price mechanism occurs where changes in price
provide information to both individuals and firms about changes in market conditions, with
prices rising and falling to signal scarcities and surpluses in the market
• price mechanism: the operation of changes in prices in a market to act as signals to
producers to allocate resources according to changes in consumer demand
• transmission of preferences: the willingness (or not) of consumers to pay particular
prices and so indicate their choices, sending information to producers about their
preferences in relation to changing needs and wants
• incentivisation: the incentivisation function of the price mechanism is where individuals or
firms are encouraged to act in a certain way as a result of higher or lower prices in a market
(e.g. individuals are incentivised by the prospect of greater satisfaction, while firms are
incentivised by the prospect of greater reward in the form of profit)

Prices perform three important roles in the allocation of resources in a market:

1. Rationing: prices perform an important function in a market as a rationing mechanism. If a

producer has a limited capacity to produce certain products, when these products are
expensive it will have the effect of rationing demand. For example, in the case of exclusive
brands of cars, which tend to be very expensive, the high price will limit demand to only
those people who can afford to pay this high price.

2. Signalling: the price mechanism allocates resources because price changes act as
signals when the conditions of demand and supply in a market change. The Scottish
economist Adam Smith (1723–90) argued that prices in a market therefore act as an
‘invisible hand’ in allocating scarce resources. This signalling function of the price
mechanism is very important in the transmission of preferences — it is the way in which
consumers indicate their preferences for one product rather than another.

3. Incentivisation: for a competitive market to work efficiently, all economic agents (e.g.
individuals and firms) need to be able to respond to incentives. For example, if there is an
increase in the demand for a product and the price goes up, firms know that for selling each
product they will receive a higher average level of revenue per unit, and the possibility of
earning a higher profit acts as an incentive.

KEY SKILL

Evaluation: you need to be able to offer a judgement about the role of price in the process of
resource allocation in an economy, contrasting its benefits and limitations in carrying out this role.
For example, one benefit is that the price mechanism acts as a rationing device as a result of
consumers expressing their preferences. However, one limitation is that some people have more
income and wealth than others, so they have more power to influence the allocation of resources
in an economy.
 34

🔗 Scarcity and choice: Price plays a key role in enabling consumers to exercise a choice
between different products, transmitting a signal to producers in relation to the products that they
should produce and therefore how scarce resources will be allocated.

2.5 Consumer and producer surplus

The meaning and significance of consumer surplus

• consumer surplus: some consumers will value a particular product more highly than other
consumers and yet they will pay exactly the same price for it as the other consumers; this
extra satisfaction is consumer surplus and is shown on a demand and supply diagram by
the triangle between the price line and the demand curve. It refers to the difference
between what a consumer is willing to pay and what they are actually required to pay.

» Consumers are able to obtain a value from consuming a F2.19 Consumer surplus
particular product that is above the price paid until at some point
consumers pay a price that is exactly equal to the value gained.

» In the diagram, this is P*. All the consumers up to Q* have

gained a value that is above the price and this is shown by the
shaded area between the price line and the demand curve.
When price is P* and quantity is Q*, the consumer surplus has
disappeared.

» The demand curve is actually showing the marginal social benefit (MSB) of the consumption.
This means that the demand curve combines all the points where consumers are gaining from the
fact that one price is being charged to all consumers in the market, despite the fact that they would
have been prepared to pay more (e.g. for concert tickets). They are gaining a marginal social
benefit by being able to buy the product at a lower
price than they were originally prepared to pay.

The meaning and significance of producer surplus

• producer surplus: the difference between the price that consumers are willing to pay for a
particular product and the price that producers require in order to supply it; it is shown on a
demand and supply diagram by the triangle between the price line and the supply curve

» Producers are able to gain because for all the units sold up to Q*, F2.20 Producer surplus
they receive a price that is above the cost of producing those units.

» The supply curve actually shows the marginal social cost (MSC)
of the production. This means that a firm will gain because the
price charged is higher than the cost of production, as shown by
the supply curve.

» In Figure 2.20 the producer surplus is shown by the shaded area

between the price line and the supply curve. When price reaches
P* and quantity is Q*, the producer surplus has disappeared.

Causes of changes in consumer surplus and producer surplus

When there is a change in the market price, the consumer surplus will also change.
» For example, if the equilibrium price increases above P* in Figure 2.19, and equilibrium quantity
falls below Q*, the extent of the consumer surplus will be reduced. This is because some
consumers will be unwilling to pay the higher price.
 35

» On the other hand, a fall in the market price below P* would lead to an increase in the consumer
surplus. This is because consumers will now be paying less for the product.

When there is a change in the quantity supplied of a product, the producer surplus will also
change.

» For example, if the equilibrium price increases above P* in Figure 2.20, and equilibrium quantity
increases above Q*, the extent of the producer surplus will increase as a result of the rise in the
quantity supplied.
» In contrast, if the quantity supplied falls, the extent of the producer surplus will be less. For
example, if the equilibrium price falls below P* in Figure 2.20 and the equilibrium quantity
decreases below Q*, there will be less producer surplus.

The significance of price elasticity of demand and price elasticity of supply in determining
the extent of changes in consumer surplus and producer surplus

Price elasticity of demand is significant in influencing the size of the consumer surplus:

» When the price elasticity of demand is inelastic, consumer surplus will be relatively large.
» When the price elasticity of demand is elastic, consumer surplus will be relatively small.
» When the demand for a product is perfectly elastic, consumer surplus is zero because the
demand curve is a horizontal line and the price that consumers pay matches exactly what they are
willing to pay.
» On the other hand, when demand is perfectly inelastic, consumer surplus is infinite. In this
situation, demand does not respond to a price change.

Price elasticity of supply is significant in influencing the size of the producer surplus:

» Price elasticity of supply is inversely related to producer surplus. If price elasticity of supply is
perfectly elastic, the supply curve will be a horizontal line and producer surplus will be zero.
» On the other hand, when supply is perfectly inelastic, it is shown as a vertical line and producer
surplus is infinite.

KEY SKILL

Evaluation: you need to be able to make a judgement about the potential impact of both price
elasticity of demand and price elasticity of supply in determining the extent of changes in
consumer surplus and producer surplus. For example, when demand is price elastic, the impact
on the consumer surplus will be greater because consumers will react more strongly than if
demand is price inelastic. When supply is price inelastic, and firms are unable to change their
output significantly, the impact on the producer surplus will be relatively small.

🔗 Efficiency and inefficiency: individual markets, and the economy as a whole, can be both
efficient and inefficient in different ways when using scarce resources. Consumer surplus and
producer surplus are examples of this. Economic efficiency is where it is impossible to improve the
situation of one party without imposing a cost on another. Economic surplus is the sum of the
consumer surplus and the producer surplus and this is larger at the equilibrium price and
equilibrium quantity than it will be at any other price and quantity. However, if a deadweight loss
exists in a market, this is an indication of inefficiency.

3 Government microeconomic intervention

3.1 Reasons for government intervention in markets

 36

Addressing the non-provision of public goods

» Public goods were discussed in section 1.6. It was pointed out there that it would not be possible
to provide a public good through a market because it would be impossible to prevent someone
who had not paid from benefiting from the service.
» This is known as the ‘free rider problem’ and comes about as a result of public goods having the
characteristics of non-rivalry and non-excludability.
» Therefore, a major reason for government intervention in a market is to address the problem of
the non-provision of public goods, an example of market failure because of the impossibility of
charging a price for them.

KEY SKILLS

Application: examples of public goods include street lighting, police and defence.

Analysis: you need to be able to explain why government intervention is necessary in relation to
the provision of public goods as a result of the impossibility of charging a price for such a product.

Addressing the overconsumption of demerit goods and the underconsumption of merit

goods

Merit goods

» Another reason for government intervention in markets is to address the problem of the
underconsumption of merit goods.
» Merit goods were discussed in section 1.6. It was pointed out there that merit goods, such as
education and healthcare, would be under consumed in a market as a result of imperfect
information.
» The problem is that there is information failure and people do not fully appreciate the value of a
merit good.
» Therefore, a major reason for government intervention in a market is to address the problem of
market failure in the form of the underconsumption of merit goods.

Demerit goods

» Governments also intervene in markets to address the problem of the overconsumption of

demerit goods.
» Demerit goods were discussed in section 1.6. It was pointed out there that demerit goods, such
as alcohol and tobacco, would be overconsumed in a market as a result of imperfect information.
» The problem is again that there is information failure and people do not fully understand the
potential dangers associated with the consumption of products such as alcohol and tobacco.
» Therefore, a major reason for government intervention in a market is to address the problem of
market failure in the form of the overconsumption of demerit goods.

KEY SKILL

Analysis: the analysis of government intervention in a market to encourage the consumption of

merit goods and discourage the consumption of demerit goods needs to be based on the
existence of information failure. This lack of information means that merit goods are undervalued
while the potential dangers of demerit goods are not fully understood.

Controlling prices in markets

Another reason for government intervention in markets is to control prices. This intervention can
be due to three possible situations:
 37

» High prices: the price of certain essential goods in a market, such as bread or rice, could rise
so high, without maximum price controls, that poorer sections of a community would not be able to
afford them and this could have detrimental effects on their health and standard of living. A
government might therefore decide to intervene in the market to prevent the price from rising
above a certain level (see section 3.2 of this chapter).
» Low prices: the price of certain goods in a market could fall so low, without minimum price
controls, that certain producers could go out of business. One example would be intervention in
certain agricultural markets to help producers maintain their incomes. A minimum price could also
be established in a market for demerit goods, such as tobacco and alcohol, to discourage
consumption (see section 3.2 of this chapter).
» Unstable prices: if left to free market forces, there is always a chance that prices will fluctuate
widely in those markets where there can be great variations in supply over a period of time due to
the weather. This is especially the case with agricultural markets, where supply is relatively fixed in
the short run, and in such a situation a government might need to intervene in the market.

3.2 Methods and effects of government intervention in markets

The impact and incidence of specific indirect taxes

• indirect tax: a tax that is imposed on expenditure; it is indirect in that the tax is only paid
when the product on which the tax is levied is purchased
• excise duty: an indirect tax on expenditure by consumers on such products as fuel, alcohol
and tobacco

In the case of a demerit good, a government could intervene in a market through taxation in an
attempt to discourage consumption of the good.
» For example, if an indirect tax, such as excise duty, is placed on demerit goods to such an
extent that the price is substantially increased, this is likely to discourage the level of consumption
of the demerit good.
» The equilibrium in a market without government intervention, where the demand and supply
curves intersect, would be a price of P0 and a quantity of Q0.
» A government, however, decides to intervene by imposing an indirect tax so that the supply
curve shifts upwards by the extent of the tax to ‘Supply plus tax’.
This increases the price to P1 with the effect that the quantity demanded decreases to Q1.
» The diagram shows how the incidence of the tax falls partly on the seller, but mainly on the
buyer.

F3.1 The effects of an

indirect tax on cigarettes

KEY SKILL

Analysis: the extent to which an indirect tax on a demerit good would discourage consumption
depends on the price elasticity of demand for the product. The PED for many demerit goods is
relatively inelastic, making it less likely that an indirect tax on a demerit good would be very
effective in discouraging the level of consumption for such a product.
 38

Distinguishing between impact and incidence

• impact of tax: the person, company or transaction on which a tax is levied

• incidence of tax: how the burden of taxation is shared between the producer and
consumer
• specific tax: an indirect tax that is a fixed amount per unit of output

It is important to distinguish between the impact and the incidence of specific indirect taxes.

The impact of a tax refers to the company on which, or the person on whom, a tax is levied: that
is, the entity legally responsible for handing the tax over to the authorities.

The impact of a tax, therefore, is essentially concerned with the legal situation, i.e. who has to pay
the tax to a government.

The incidence of a tax, however, refers to where the eventual burden of the tax falls — that is,
how the payment of a tax is divided between different people:

» For example, with an indirect tax on a retailer, the burden of the tax is likely to be shared
between the producer and the consumer.
» The more inelastic is the demand, and the more elastic is the supply, the greater the burden will
be on the consumer. If the price elasticity of demand is perfectly inelastic, and there is a vertical
demand curve, the incidence of the tax will be entirely on the consumer.
» On the other hand, if the price elasticity of demand is perfectly elastic, and there is a horizontal
demand curve,
the incidence of the tax will be entirely on the producer.

Indirect taxes on expenditure can take different forms

» An excise duty, for example, is usually a specific tax on a product — in other words, a specific
amount is required to be paid, not a percentage of the selling price.
» An ad valorem tax, on the other hand, requires a percentage of the selling price to be paid.

The impact and incidence of subsidies

• subsidy: an amount of money paid by a government to a producer, so that the price

charged to the customer will be lower than would have been the case without the subsidy
• impact of a subsidy: the effect of a subsidy on the price and quantity of a product in a
market
• incidence of a subsidy: how the gain from a subsidy is shared between the producer and
consumer

» Subsidies are an example of microeconomic F3.2 The effect of a

subsidy on supply
government intervention to encourage the production and
consumption of a particular product.
» If a government pays firms a subsidy to produce a
particular product, this will reduce their costs and
encourage firms
to supply more output at any given price. In Figure 3.2 the
supply curve shifts downwards to the right.

» The result of the subsidy, in shifting the supply curve to

the right, will be a lowering of price. The actual price will be
determined where the ‘S with subsidy’ line intersects with the
demand curve. Both producers and consumers may therefore benefit from the subsidy.
 39

» The impact of a subsidy in a market will be a reduction in price and an increase in output. The
incidence of a subsidy relates to who is made better off by the subsidy and by how much.
» The vertical distance between the two supply curves in Figure 3.2 indicates the size of the
subsidy, but the price that the consumer pays does not fall by the full amount of the subsidy. This
is because the producer gains some of the benefit in terms of extra revenue that they can keep.
» The effect of the subsidy is that there will be both a gain to the consumer and a gain to the
producer. The extent of the different gains will depend on the price elasticity of demand for, and
the price elasticity of supply of, the product.

The direct provision of goods and services

• direct provision of goods and services: where a government decides to provide

particular goods and services itself

Although a government can intervene in a market, such as through indirect taxes and subsidies, it
is also possible for a government to provide goods and services directly.

» A government could establish the direct provision of goods and services alongside the
private sector, financed by the revenue received from taxation. This is likely to be the case with
certain merit goods, such as the provision of healthcare and education. In many countries, these
services are provided through both the public and private sectors.
» Of course, a government may decide to provide a good or service through the
public sector by nationalising an industry (i.e. taking it under state control).

Maximum and minimum prices

Maximum price controls

maximum price: a price that is fixed in a market and which the price must not exceed

One form of government intervention in an economy is to

establish a maximum price in a market for a product — a
level above which the price cannot rise.

» This maximum price needs to be set below the equilibrium

price that would have resulted from the intersection of
demand and supply.

» Figure 3.3 shows that P* and Q* would be the equilibrium

price and equilibrium quantity in a market without
government intervention. F3.3 The effect of a maximum price in a market

» However, a government could decide to establish a maximum price below P* at Pmax. The
quantity demanded would now be Qd, but the quantity supplied would be Qs. There would
therefore be excess demand in the market, creating a shortage, and this could lead to queuing,
rationing or the emergence of a black market.

KEY SKILL

Application: examples of goods that could benefit from the establishment of a maximum price in
a market include essential foods (e.g. bread and rice). This is because without maximum price
controls, the price of these foods could rise so high that poorer sections of a community would not
be able to afford them. This could have detrimental effects on their health and standard of living.

Minimum price controls

 40

• minimum price: a price that is fixed in a market and below which the price must not fall

The establishment of a maximum price in a market for a

product is designed to prevent the price rising above a
specific level. However, it is also possible that a
government will wish to intervene in a market to set a
minimum price to prevent the price falling below a
specific level.

» The minimum price will need to be established above

the equilibrium price that would have resulted from the
intersection of demand and supply.
» Figure 3.4 shows that P* and Q* would be the
equilibrium price and equilibrium quantity in a market F3.4 The effect of a minimum price in a market

without government intervention.

» However, a government could decide to establish a minimum price above P* at Pmin. The
quantity demanded would now be Qd, but the quantity supplied would be Qs.
» There would therefore be excess supply in the market, creating a surplus, and this could lead to
producers becoming inefficient and the emergence of a black market where demerit goods, such
as tobacco and alcohol, are sold at prices below the minimum price.

KEY SKILL

Application: examples of minimum price controls include intervention in certain agricultural

markets to help producers maintain their incomes.

Buffer stock schemes

• price stabilisation: where a government intervenes to purchase stocks of a product when

supply is high and to sell socks of a product when supply is low
• buffer stock: a stock of a commodity that is held back from the market in times of high
production and released onto the market in times of low production

If a market is characterised by wide fluctuations in prices, such as agricultural markets, a

government could try to bring about price stabilisation by intervening through what is called a
buffer stock scheme:

» A target price is decided.

» When there is a good harvest, supply is very high in the market and the government purchases
some of the stock and stops it from entering the market; the effect of this is to stop the price going
too low.

» When there is a bad harvest, supply is very low in the market and the government releases
some of this stock; the effect of this is to stop the price going too high.

🔗 Efficiency and inefficiency: a buffer stock scheme could encourage the oversupply of
products if producers know that the government will buy any excess supply. So, the scheme could
encourage producers to be less efficient.

The advantages and disadvantages of a buffer stock scheme:

 41

Advantages Disadvantages
• The scheme provides greater • The cost of buying the excess supply could
stability of prices, which could be high, which could be a problem for a
encourage more investment in government that might need to raise taxation
agriculture. to obtain the necessary funds to operate the
buffer stock scheme.
• It ensures food supplies and
avoids shortages. • The scheme could encourage oversupply if
producers know that the government will buy
• It prevents producers going any excess supply.
out of business when there is a
large drop in prices. • The scheme could encourage producers to
be
• It helps to maintain the less efficient.
incomes of producers.
• It may not be possible to store all products
in a buffer stock as some may be perishable.

• It may be difficult for the government to

decide on the target price.

KEY SKILL

Problem solving: some markets, particularly agricultural markets, can experience a great deal of
price instability, so a buffer stock scheme can be used to reduce the extent of this volatility in
prices.

Provision of information

» Market failure can be caused by inadequate information. A government could therefore aim to
increase the availability of appropriate information to consumers in order to try to influence their
economic behaviour.
» It is assumed that consumers will always aim to maximise their utility or satisfaction, but they will
only be able to achieve this objective if they are in possession of the necessary information. If this
information is not available, it is unlikely that they will be able to make rational decisions.
» Information failure is a major cause of market failure, so a government will need to take
measures to improve the accuracy and availability of information that consumers need. This will
help them make rational decisions and ensure that scarce resources are allocated as efficiently as
possible.
» For example, a government could aim to make people as well informed as possible about the
potential advantages of consuming merit goods, such as education and healthcare. It could also
aim to make people as well informed as possible about the potential disadvantages of demerit
goods, such as alcohol and tobacco. A particular example of such an approach in relation to the
consumption of demerit goods is nudge theory.

KEY SKILL

Application: an example of nudge theory in relation to demerit goods is when a government puts
a health warning on cigarettes, such as ‘Smoking can kill’.

3.3 Addressing income and wealth inequality

The difference between income as a flow concept and wealth as a stock concept
 42

• income: money received, especially on a regular basis

• wealth: all assets that have a monetary value

It is important to distinguish between income and wealth. There are clear differences between
them and one of the most important is the idea of income as a flow and wealth as a stock.

Income

Income is a flow of money received by factors of production, including:

» wages and salaries: these are paid to people for the work they have carried out
» welfare benefits: money paid to people in the form of a state pension or a tax credit
» profits: these are received by businesses
» dividends: payments distributed to shareholders
» rental income: this is a flow to people who own, and rent or lease out, property
» interest: money paid to people who hold funds in interest-paying accounts with financial
institutions

Wealth

Wealth is a stock of money or assets, including:

» savings: these can be held in various forms of accounts

» shares: ownership of shares issued by limited companies
» property: ownership of houses and apartments
» bonds: money held in instruments of indebtedness
» pension schemes: wealth held in occupational pension schemes and life assurance schemes

🔗 The role of government and the issues of equality and equity: a government can intervene
in an economy to bring about greater equality and equity in relation to the distribution of income
and wealth.

Measuring income and wealth inequality

The Gini coefficient

• Gini coefficient: a statistical measurement of the degree of inequality of income in an

economy

A number of policies could be used with the objective of bringing about a redistribution of income
and wealth in an economy. However, it is necessary first to consider how that distribution can be
measured. This is achieved using a Gini coefficient:

» A Gini coefficient is a way of measuring the extent of inequality in the distribution of income in an
economy. It is measured by the ratio of the area between the diagonal line of total equality and the
Lorenz curve, on the one hand, to the total area under the diagonal line, on the other (see Chapter
11, section 11.4, for an explanation of the Lorenz curve).
» In this way, the Gini coefficient measures the extent to which the distribution of income in an
economy diverges from the position of total equality. The lower the value of the coefficient (i.e. the
closer the Gini coefficient is to 0), the more even is the distribution of income. The higher the value
of the coefficient (i.e. the closer the Gini coefficient is to 100), the less even is the distribution of
income.

Economic reasons for inequality of income and wealth

 43

There are a number of possible economic reasons for the inequality of income and wealth,
including the following:

» Employment: a major cause of income equality is variations in the ability of people to access
well-paid employment. When there is an increase in unemployment in an economy, there will be
fewer people receiving wages and salaries and more people receiving benefits. When there has
been a decrease in full-time employment and an increase in part-time employment, income
inequality will widen because rates of pay are usually lower in part-time than in full-time
employment.
» Government policy: for many workers, a difficult economic situation could have given rise to a
‘wage freeze’ or lower-than-inflation wage rises. This is particularly true of public sector workers
who may have experienced a fall in their real standard of living when increases in wages have
been less than increases in prices.
» Taxation: a government may decide to raise the levels of taxation in order to increase public
revenue. It might also make tax more regressive, taking proportionally more tax from people on
lower incomes than those on higher incomes.
» Distribution of wealth: people who already hold wealth are able to invest, which creates new
wealth. The existing concentration of wealth makes inequality a vicious cycle.

Policies to redistribute income and wealth

Minimum wage

• minimum wage: the lowest wage permitted by law (i.e. a price floor below which
employers cannot pay their employees)

A minimum wage is one way to redistribute income and wealth in an economy:

» A government could decide to establish a minimum wage rather than allow wages to be
determined by the forces of the demand for, and the supply of, labour in particular markets.
» One problem with a minimum wage, however, is that it could lead to income becoming more
unequal. For example, some employers may not be able to pay all their workers the minimum
wage, so some of them may become unemployed and be forced to live on benefits.
» Another potential problem is that a national minimum wage takes no account of variations in the
cost of living in different parts of a country.
» In some countries, there may be a large informal economy and a minimum wage would not
apply to such workers.

🔗 Problem solving: a major problem in all economies is inequality of income and wealth.
Governments can use policies in an attempt to redistribute income and wealth. These include
a minimum wage, transfer payments, progressive taxes and state provision of essential goods and
services.

Transfer payments

• transfer payment: a form of payment to those in society who are less well off, paid for out
of the revenue received from taxation
A government could decide to intervene in a market through the use of transfer payments:

» This means that revenue received from taxation is used to give financial support to people, such
as in the form of pensions and benefits.
» These transfer payments can be regarded as worthwhile because they are made to those in
society who are less well off.
 44

» Transfer payments can be criticised, however, for having a distorting effect: for example, in
some countries, people who are unemployed can be given financial support in the form of a
benefit, but if this benefit is too high, it may make such people less inclined to look for work.

Progressive income taxes, inheritance and capital taxes

Income taxes

» A government could address income inequality through the use of progressive taxes.
» Many economies use progressive taxation to achieve the macroeconomic objective of a fairer
and more equitable distribution of income.
» An income tax, for example, will not only take more from a person as their income rises, but a
higher proportion of that income.

Inheritance and capital taxes

» A government may also decide to intervene in an economy to try to bring about a more equitable
distribution of wealth, as well as income.
» Examples of taxes that can achieve this objective are progressive inheritance and capital taxes.
» Inheritance taxes apply to situations where money and/or property have been passed on to
someone in the event of a death, while capital taxes apply to situations where a profit has been
made by the selling of certain assets such as paintings or antiques.

State provision of essential goods and services

» State provision of essential goods and services helps to redistribute income and wealth because
the money to pay for the provision of these essential goods and services comes from the money
received from taxation.
» This helps to lessen inequality because the money received by the government pays for the
goods and services that poorer people are unable to afford. State provision of healthcare is a good
example of this.
» However, state provision of essential goods and services can be criticised for a number of
reasons. For example, the goods and services might be provided to some people who would have
been able to pay for them, so some public money could be wasted. Also, the quantity and quality
of provision would be limited by the amount of funds available to the government and this would
depend on the economy’s fiscal policy and the amount of tax revenue collected.

4 The macroeconomy

4.1 National income statistics

The meaning of national income

• national income: a general term for the total income of an economy over a particular
period of time

National income is often used as a generic term, but there are actually three different forms of
national income statistics:

» gross domestic product (GDP)

» gross national income (GNI)
» net national income (NNI)

The measurement of national income

 45

• gross domestic product (GDP): the total value of all that has been produced over a given
period of time within the geographical boundaries of a country
• gross national income (GNI): the gross domestic product of a country plus net income
from abroad
• net national income (NNI): the gross domestic product of a country plus net income from
abroad minus the depreciation of fixed assets

Gross domestic product

Gross domestic product (GDP) refers to all that is produced within the geographical boundaries
of a particular country. It does not matter whether the productive assets are owned locally or
foreign owned.

There are three different ways of measuring the value of a country’s GDP:

» The output method: this adds up the total amount of output produced by firms in an economy
— in terms of the value added by each firm to avoid double counting.
» The income method: this adds up the total amount of income received by people in an
economy, such as in terms of wages, salaries and profits.
» The expenditure method: this adds up all of the spending in an economy by households, firms
and the government, including net export spending.

Each of the three approaches will produce the same figure because they all measure the flow of
income in an economy over a particular period of time.

Gross national income

Gross national income (GNI) is GDP plus net income from abroad.

Net national income

Net national income (NNI) is calculated by taking GDP and adding to it the net receipts of wages,
salaries and property income from abroad, minus the depreciation of fixed capital assets.

The adjustment of measures from market prices to basic prices

GDP deflator

• at current market prices: data that are expressed in terms of the prices of a particular
year (i.e. they have not been adjusted to take account of inflation)
• at constant prices: data that have been adjusted to take into account the effects of
inflation
• GDP deflator: a ratio of price indices that is used in national income statistics to remove
the effect of price changes, so that the figures can be seen as representing real changes in
output
• exports: goods and/ or services that are produced domestically in one country and sold to
other countries
• imports: goods and/ or services that are produced in foreign countries and consumed by
people in the domestic economy

» It is important to distinguish between nominal value and real value.

» If a country is experiencing inflation, the value of its GDP will rise, but this increase could be due
solely to the rise in prices — in other words, there may not have been a real increase in value if
the effect of inflation is eliminated from the figures. This is a limitation of any data expressed at
current market prices. It is therefore important to distinguish between nominal and real variables.
 46

» Economists usually produce national income statistics at constant prices, so that changes in
real output can be identified rather than changes in value that are purely due to the inflation that
exists in a country.
» The GDP deflator is a price index that is used to convert the figures into real GDP. It measures
the prices of products produced in a country and not the prices of products consumed.
» It therefore includes the value not just of consumer products but also of the capital used in the
production of the products. It includes the prices of exports, but not the prices of imports.

KEY SKILL

Interpretation of data: it is important to consider whether data are nominal or real. Nominal data
have not been adjusted to take into account the effect of inflation, whereas real data have been
adjusted to take inflation into account.

🔗 It is important to demonstrate a clear understanding of the difference between a real change in

the value of a country’s output, after taking into account the effects of inflation, and a change in the
value of a country’s output that is purely due to inflation in that economy.

The adjustment of measures from gross values to net values

• depreciation (of capital): the decline in the value of a capital asset over a given period of
time (usually a year)
• net domestic product (NDP): the gross domestic product of a country minus depreciation
or capital consumption
• net national product (NNP): the gross national product of a country minus depreciation or
capital consumption

KEY SKILL

Interpretation of data: it is important to consider whether data have been adjusted to take into
account the effect of depreciation. If this has not happened, the data are gross; if it has happened,
the data are net.

🔗 Gross values are adjusted to net values by the deduction of depreciation or capital
consumption. This refers to where capital equipment has worn out or broken down.

Net domestic product

Net domestic product (NDP) is obtained by deducting depreciation from GDP.

Net national product

Net national product (NNP) is calculated by deducting depreciation from the gross national
product. As with net domestic product, this is done to take into account the money that will need to
be spent on replacing machinery and equipment that has worn out during the course of the year.

4.2 Introduction to the circular flow of income

The circular flow of income in a closed economy and an open economy

• circular flow of income: the flow of income around an economy, involving a mixture of
injections and withdrawals or leakages
• closed economy: an economy that does not trade with the rest of the world
• open economy: an economy that trades with the rest of the world
 47

The circular flow of income refers to the flow of income and spending around an economy. It is a
model of the economy in which the major exchanges are represented as flows of money between
different economic agents.

It is important to distinguish between a closed economy and an open economy:

» Closed economy: a basic approach is to consider the circular flow of income in a closed
economy. In a closed economy, it is assumed that a country does not trade with any other
countries. If the circular flow of income is limited to the movement of incomes between households
and firms, it is known as a ‘two-sector economy’. If government is then added to the circular flow, it
becomes a ‘three-sector economy’.

» Open economy: a more realistic approach would be to consider the circular flow
of income in an open economy. In an open economy, it is assumed that a country
does trade with other countries and so flows of money include the goods and
services that are exported to, and imported from, other countries.

In an open economy, therefore, the circular flow of income involves four groups:

» households
» firms
» the government
» the international economy

This is why such an economy is known as a ‘four-sector economy’.

KEY SKILL

Analysis: it is necessary to include the impact of all four sectors (i.e. households, firms,
government and the international economy) when analysing a four-sector economy. This is
because a four-sector economy includes all possible aspects of economic activity.

Injections and leakages

injection: spending that adds to the circular flow of income; this can come from investment,
government expenditure and exports
leakage (or withdrawal): money that leaks out of the circular flow of income; this can be as a
result of savings, taxation and imports

At any one time, there will be a number of injections of money into an economy and a number of
withdrawals or leakages of money out of an economy.

The basis of aggregate demand in an economy is consumption expenditure by households. Then

the injections can be added to, and the withdrawals or leakages taken from, this expenditure, as
shown below:

Injections Withdrawals or leakages

Investment spending by private sector firms Savings (S)

(I)
Government spending (G) Taxation (T)
Income from exports sold abroad (X) Income spent on imports from abroad (M)
 48

Candidates need to ensure that they understand, and can refer to the different injections into, and
the various leakages/withdrawals from, the circular flow of income.

Equilibrium and disequilibrium

» One way of showing equilibrium in an economy is through the

injection/ withdrawal approach.
» For the overall economy to be in equilibrium, the injections
into the circular flow of income need to be equal to the
withdrawals from the circular flow of income. where the
injections (I, G and X) are equal to the withdrawals (S, T and M)
at the Ye level of income.
» Equilibrium occurs when there is no stimulus to change any
of the values in the circular flow of income — that is, equilibrium
is defined as a situation in which there is no tendency for the levels F4.1 Equilibrium using the
of income, expenditure and output to change. injection/withdrawal
approach
» The condition for equilibrium in the macroeconomy is when total
planned injections are equal to total planned withdrawals.
» When injections are more than withdrawals (i.e. the additions from I, G and X are more than the
withdrawals from S, T and M), there will be a disequilibrium and this will cause the level of national
income to rise.
» If the withdrawals are more than the injections, this will cause
the level of national income to fall.

🔗 Equilibrium and disequilibrium: individual markets, and the economy as a whole, are always
moving into and out of equilibrium, constantly altering the allocation of resources. In this particular
context, equilibrium occurs in the macroeconomy when injections equal withdrawals. Whenever
they are not equal, disequilibrium will occur.

4.3 Aggregate demand and aggregate supply analysis

The definition of aggregate demand

Aggregate demand (AD) refers to the total amount of goods and services demanded in an
economy at a given overall price level at a given time.

The components of aggregate demand and their meanings

• aggregate demand (AD): the total amount that is spent on an economy’s goods and
services at a given price level over a given period of time; it is made up of four main
components: consumption, investment, government spending and net exports

There are four main components of aggregate demand:

» consumer spending by households on good and services (C)

» investment by firms in machinery and equipment (I)
» government spending (G)
» the net effect of international trade, i.e. exports (X) minus imports (M)

Aggregate demand is therefore the sum of consumption expenditure, investment

expenditure, government expenditure and net exports. It can be shown as:

AD = C + I + G + (X − M)

The determinants of aggregate demand

 49

A change in any of the four main components of aggregate demand will bring about a change in
aggregate demand. These changes could come about as a result of a number of factors, including
but not limited to changes in:

» interest rates (i.e. the price of money)

» the money supply (i.e. the quantity of money)
» taxation
» expectations of future economic conditions
» degrees of confidence (e.g. optimism or pessimism)
» exchange rates
» the accumulation of income/wealth
» technology

The shape of the aggregate demand curve

F4.2 An aggregate demand curve
The aggregate demand curve slopes downwards from left to right.
This can be seen in Figure 4.2. It shows the relationship between
the general price level and real output. If there is a fall in the price
level, this will cause a movement along the AD cu rve to the right
because with goods cheaper, consumers effectively have more
spending power. This is known as the ‘real money balance effect’
and leads to an expansion of aggregate demand. It is assumed
that the components of aggregate demand are constant at this
time.

The causes of a shift in the aggregate demand curve

» If there is a change in any of the components of AD, such as a

change in consumption expenditure, investment expenditure,
government expenditure or net expenditure on exports, the AD curve
will shift.
» If there is an increase in aggregate demand, the AD curve will shift
to the right. This can be seen in Figure 4.3 where the AD curve shifts
from AD0 to AD1.
» If there is a decrease in aggregate demand, the AD curve will shift
to the left.
F4.3 A shift in aggregate demand

The definition of aggregate supply

• aggregate supply (AS): the total output that firms in an economy are able and willing to
supply at different price levels in a given period of time; it includes both consumer and
capital products

The determinants of aggregate supply

Changes in aggregate supply are caused by a number of factors, including but not limited to
changes in the following:

» the state of technology

» the cost and productivity of capital
» the cost and productivity of labour
» the cost of raw materials
» taxation
» exchange rates
» government policy (e.g. rules and regulations)
 50

The shape of the aggregate supply curve in the short run and the long run

» The short-run aggregate supply curve (SRAC) slopes upwards from left to right.
» If there is a change in the price level, this will cause a
F4.4 Aggregate supply
movement along the AS curve. The upward slope represents in the short run
increasing marginal costs with an increase in production.
» When the price level is relatively low, the aggregate supply is
low; however, as the price level and potential profits increase,
aggregate supply increases, creating the upward-sloping SRAS
curve.

In the long run, however, the shape of the AS curve will change:

» At low levels of output, the long-run aggregate supply curve

(LRAS)
can be horizontal, indicating that it is perfectly elastic.
» At higher levels of output, the LRAS curve can be upward sloping.
» At very high levels of output, the LRAS curve can be vertical, indicating that
it is perfectly inelastic. Indeed, some economists argue that the long-run
AS curve is perfectly inelastic, indicating that an economy might operate at full capacity.

Causes of a shift in the aggregate supply curve in the short run and the long run

If there is a change for any reason other than a change in the price level, the AS curve will shift. If
there is an increase in aggregate supply, the AS curve will shift to the
right. This can be seen in Figure 4.5, where the curve shifts from AS0 F4.5 A shift in
aggregate supply
to AS1. If there is a decrease in aggregate supply, the AS curve will
shift to the left.

The distinction between a movement along and a shift in

aggregate demand and aggregate supply

As has already been indicated, it is important to distinguish between a movement along and a shift
in AD and AS.

» Figure 4.2 shows a movement along an AD curve as a result of a change in the price level,
whereas Figure 4.3 shows a shift in AD as a result of a reason other than a change in the price
level.
» Figure 4.3 shows the AD curve shifting to the right and this could have been caused by an
increase in business or consumer confidence or an expansionist fiscal or monetary policy, such as
lower tax rates, higher government spending, lower rates of interest or less spending on imports.
» Figure 4.4 shows a movement along an AS curve as a result of a change in the price level,
whereas Figure 4.5 shows a shift in AS as a result of a reason other than a change in the price
level.
» Figure 4.5 shows the AS curve shifting to the right and this could have been caused by cheaper
imported materials, lower money wages, lower rates of interest or improved technology.

The establishment of equilibrium in the AD/AS model and the determination of the level of
real output, the price level and employment
 51

Equilibrium is determined when planned aggregate demand equals

planned aggregate supply. This can be seen in F4.6, where the
equilibrium price level is P and the equilibrium real output level is Y.

This equilibrium position will not necessarily be at the full employment

level for an economy. This can be seen in F4.7. The equilibrium
where AD* crosses SRAS (short-run aggregate supply) is at price P*
and real output Y*. At this point, the macroeconomic equilibrium is at
full employment.
F4.6 Macroeconomic
equilibrium
However, the equilibrium where AD1 crosses SRAS is at price P1 and
real output Y1. At this point, the equilibrium is below the full
employment level in the economy, so there is surplus capacity.

F4.8 shows the equilibrium position in relation to long-run aggregate

supply. As indicated before, aggregate supply is initially elastic, but as
it gets nearer to the full employment level, shown by Y*, it becomes
increasingly inelastic, until it eventually becomes perfectly inelastic
when the full employment (Y*) level of output is reached.
F4.7 Will macroeconomic
equilibrium be at full employment?
🔗 Equilibrium and disequilibrium: national income equilibrium
occurs where AD and AS intersect. National income disequilibrium
occurs where AD is no longer exactly matched by AS.

🔗 Time: time is important in relation to aggregate supply.

In the short run, the AS curve will be upward sloping, but in the long
run it can become vertical when the full employment level of output
has been reached.
F4.8 Macroeconomic
equilibrium revisited
🔗 in the Keynesian model of the economy, the equilibrium of AD and
AS will not necessarily be at the full employment level of an economy.

The effects of shifts in the aggregate demand and aggregate supply curves on the level of
real output, the price level and employment

» Shifts in the AD and/or AS curve will have an effect on the level of real output, the price level and
employment.
» Figure 4.7 showed the effect of a shift to the left of the AD curve from AD* to AD1. The new
equilibrium is now where AD1 crosses SRAS at price P1 and real output Y1. At this point, the
equilibrium shows a fall in real output below the full employment level of output in the economy, so
there is surplus capacity. It also shows a lower price level, down from P* to P1.
» Shifts in the AS curve will also have an effect on real output, the price level and employment. For
example, a shift to the left of the AS curve, as a result of more expensive imported materials,
higher money wages or higher rates of interest, would lead to an increase in the price level, a
decrease in the level of real output and a decrease in employment.

4.4 Economic growth

The meaning of economic growth

• economic growth: an increase in the national output of an economy over a period of time,
usually measured through changes in gross domestic product
 52

Economic growth is defined as the increase in national output of a country over a period of time.
It is possible to distinguish between actual economic growth and potential economic growth.

The measurement of economic growth

Economic growth is usually measured in terms of a change in gross domestic product over a
particular period of time, usually one year. It can be shown by an outward shift of a production
possibility curve.

KEY SKILL

Numerical skills: you will need to be able to distinguish between the rate of change and the
percentage change in relation to economic growth. For example, if GDP in an economy has
increased from $300 billion to $320 billion, there has been an increase of $20 billion, and as a
percentage this would be an increase of 6.66%.

The distinction between growth in nominal GDP and real GDP

• nominal GDP: the value of all the goods and services produced by a country in a given
period at current market prices
• real GDP: the value of a country’s total economic output in a given period, adjusted for the
effects of price changes

Economic growth is the increase in the production of goods and services in an economy over a
specific period, but it is important to distinguish between nominal and real economic growth.
Nominal GDP is GDP that has not been adjusted to take into account the effects of inflation,
whereas real GDP is GDP that has been adjusted to take into account the effects of inflation

The causes of economic growth

• business (or trade) cycle: the fluctuations in the national output of a country, involving a
succession of stages or phases, including boom, recession, trough and recovery

Economic growth in an economy can be brought about by a number of factors, including:

» An increase in the number of workers
» An improvement in the quality of labour — for example, the acquisition of new skills leading to a
higher level of productivity
» a greater commitment to research and development, in terms of both invention (the discovery of
new products and new methods of production) and innovation (a process by which a good or
service is renewed by applying new processes or introducing new techniques to create new value)
» An improvement in the state of technology
» Investment in capital stock
» a move towards more capital-intensive production
» Increased mobility and flexibility of factors of production
» a more efficient allocation of resources
» Development of new markets for exports
» a reduction in taxes on company profits to allow firms more funds to finance investment
» An upturn in the business (or trade) cycle, which will increase business confidence and lead to
firms increasing output

🔗 economic growth is concerned not only with the quantity of the factors of production used in
the production process, but also with the quality of these economic resources. For example, net88
immigration could lead to an increase in the number of workers. However, the productivity of
existing workers could be increased as a result of various training and re-skilling schemes.
 53

The consequences of economic growth

The benefits and costs of economic growth:

Benefits Costs

• Economic growth will lead to an increase • There can sometimes be a shift away from the
in the standard of living of a country, production of consumer goods to capital goods
resulting from the greater number of goods in order to bring about economic growth; this
and services produced in the economy. could potentially be beneficial in the long run,
but not necessarily in the short run.
• An economy that is growing shows that
the economy is doing well; this should • Economic growth may deplete natural
result in greater confidence that should resources and do damage to the environment in
encourage future investment. terms of various forms of pollution; it is in these
senses that a high rate of economic growth is
sometimes said to be unsustainable.

• Economic growth is likely to lead to a • The benefits of economic growth may not
decrease in the level of unemployment in always be shared evenly among different
the country, although this will depend on people in the country.
the extent to which the extra output is
produced through labour-intensive or • There may be a reduction in the quality of life
capital-intensive methods of production. in the country (e.g. working hours may be
longer, reducing the amount of leisure time).
• An increase in output, much of which is
exported to other countries, may lead to
the reduction, or possibly the elimination, of
a deficit in the balance of payments.

• labour-intensive production: a process of production with a relatively high proportion of

labour inputs, compared to other inputs
• capital-intensive production: a process of production with a relatively high proportion of
capital inputs, compared to other inputs

🔗 If an examination question asks for a discussion of the concept of economic growth, you
should remember to include a consideration of both the benefits and the costs of growth for an
economy.

🔗 Progress and development: economics studies how societies can progress in measurable
money terms and develop in a wider, more normative sense regarding living standards, inclusivity
and sustainability. Economic growth enables people to have a higher standard of living than would
otherwise be the case. However, it must be remembered that although there are a number of
potential benefits of economic growth, there are also several potential costs.

KEY SKILL

Evaluation: you will need to be able to evaluate the advantages and disadvantages of economic
growth and come to a judgement as to whether the benefits outweigh the costs.

4.5 Unemployment
 54

The meaning of unemployment

• unemployment: where a number of people in an economy are able and willing to work but
are unable to gain employment

Unemployment refers to the situation which occurs when people are able and willing to work, but
are unable to find employment.

Measures of unemployment, with reference to possible difficulties in measurement

• unemployment rate: the number of unemployed people divided by the labour force

It is important to distinguish between the number of people who are unemployed in a country and
the unemployment rate. The unemployment rate refers to the total number of people who are
unemployed in a country divided by the labour force and this is expressed as a percentage.
Economists are interested in discovering patterns and trends in the rate of unemployment in a
country over a period of time. It is useful to establish whether the trend is upward or downward; if it
is upward, the government will need to devise appropriate policies to try to reduce the rate.

🔗 Candidates need to distinguish between the number of people who are unemployed in an
economy and the rate of unemployment in the economy. In the first case, it will be a number; in
the second case, it will be a percentage.

KEY SKILL

Interpretation of data: it is important to understand not just whether unemployment has

increased or decreased over a period of months or years, but whether the overall trend over a
period of time has been upward or downward. It is also important to understand that
unemployment data can be in the form of absolute values or in percentage terms.

The size and components of the labour force

• labour force: the number of people in a country who are employed or who are looking for
work

The labour force refers to all the people in a country who are employed as well as those who are
looking for work. It therefore consists of both the employed people and the people who are
unemployed. It is best defined as the number of people in a country who are economically active,
either in employment or unemployed.

The size of a country’s labour force depends on a number of factors, including:

» The total size of the population

» The birth rate
» The death rate
» The school leaving age
» The number of people who stay in full-time education after leaving school
» The retirement age
» The availability and value of welfare benefits to those who do not have a job
» The availability and cost of childcare
» The attitudes in the society to women working
» The state of the economy, such as whether an economy is in a boom or a recession
 55

🔗 Candidates often seem to believe that the term ‘labour force’ only applies to those people who
are employed — that is, to those people who actually have a job. However, it actually refers not
only to those people who have a job, but also to those who are unemployed.

The working population

• working population: the people in a country who are working or who are actively seeking
work
• dependency ratio: the number of dependent people in a country divided by those of
working age
• participation rate: the proportion of the population which is either in employment or
officially registered as unemployed
• claimant count: the number of people who officially register as unemployed
• labour force survey: a measure of unemployment that includes those people who are out
of work without a job, want a job and either have actively sought work in the last four weeks
and are available to start work in the next two weeks or have found a job and are waiting to
start it in the next two weeks

Another way of expressing the number of people in a country who are available to work is to refer
to the working population. There will always be some people who are too young to work, or who
stay on in education beyond the school leaving age, or who are too old to work. All these people
determine the dependency ratio of a country.

The participation rate

The labour participation rate is an indication of the people in a country who are either in work or
officially registered as unemployed. It gives an indication of the extent to which the population of a
country is economically active.

Difficulties involved in measuring unemployment

There is no one agreed method of measuring unemployment. This is significant because different
ways of measuring unemployment can give different results. Most countries use one of the two
following methods.

The claimant count

The claimant count is one method of measuring unemployment in a country. This is where the
number of people who officially register as unemployed is counted; they register so that they are
eligible to claim any benefits (known as ‘transfer payments’) that the state may provide for those
people who are unemployed.

The labour force survey

An alternative way of measuring the number of people who are unemployed in a country is to
identify the number of people available for work, and seeking work, but without a job. This is
known as a labour force survey.

Comparing the claimant count and the labour force survey

» There are specific difficulties with the claimant count method of measuring unemployment. For
example, it can include some people who are claiming benefit, but who are not actually available
or prepared to work. Also, it excludes some people who would like to work, and who are looking
for work, but who are not eligible for unemployment benefit, such as women returning to the labour
force after childbirth.
 56

» The claimant count does not meet the ILO definition of unemployment, because of the problems
associated with it, and so has largely been replaced by the ILO unemployment rate, a measure
based on the labour force survey. The ILO unemployment rate is a measure of the percentage of
the workforce who are without jobs, but are available for work, willing to work and looking for work.
» The two methods can give different figures of unemployment; in many countries, the labour force
survey measure has exceeded the claimant count measure by as much as 2% or 3% of the labour
force.
» The labour force survey measure is subject to the same problems as other surveys: there is the
potential for sampling error/bias in the data collection.
» No measure of unemployment is likely to be completely accurate because there will be some
people out of work who are not recorded in the official statistics.

🔗 you need to demonstrate that you understand that there are two different ways to measure the
number of unemployed people in an economy: the claimant count and the labour force survey.
However, the claimant count does not meet the International Labour Organisation (ILO ) definition
of unemployment and so has been replaced by the ILO unemployment rate, a measure based on
the labour force survey, as the official measure of unemployment in most countries.

The causes and types of unemployment

Unemployment in an economy can be caused by a number of factors and this gives rise to a
variety of different types of unemployment:

Type of Explanation of cause

unemployment

Structural Workers are unemployed as a result of a change of demand in an

economy; this creates a change in the country’s economic structure, and
the declining industries will not need to employ as many people, causing
a loss of jobs.

Regional Sometimes these declining industries are concentrated in particular areas

of a country and this can contribute to regional unemployment; this is
especially the case where workers lack the skills and training to move
from one job to another.

Cyclical (or Unemployment arising from a deficiency in aggregate demand, meaning

demand that there are insufficient jobs in the economy.
deficient)
Frictional At any one moment in an economy, some people will be between jobs
(i.e. they have left one job and are waiting to start another); this type of
unemployment reflects dynamic change in an economy, with some
sectors expanding while others are declining. It is possible to distinguish
between three different types of frictional unemployment:

• search unemployment, where people are prepared to keep looking

for the best possible job rather than take the first one offered
• casual unemployment, where certain types of work are not regular
and so at any one time some people will be out of work (e.g. in the
acting profession)
• seasonal unemployment, where people are out of work when it is
‘out of season’ (e.g. in the tourism or agriculture industry)
 57

Technological Technological unemployment occurs when developments in technology

and working practices cause some workers to lose their jobs due to a lack
of necessary skills.

Real wage (or This is where people are out of work because real wages in an economy
classical) are too high (e.g. because of the power of trade unions).

Disguised This is where there are people who do not have a job, but who are not
registered for unemployment benefits; they are not included in the
claimant count of the number of unemployed people in a country.

KEY SKILL

Evaluation: you will need to be able to compare different types of unemployment and come to a
judgement as to whether one type is likely to have a more damaging effect on an economy than
another.

The consequences of unemployment

Unemployment has a number of consequences, including the following:

Unemployment has a number of consequences, including the following:

» Economic resources are scarce, so any unemployment is a waste of scarce resources; an

economy will be underperforming and the level of national output produced will be lower than
would otherwise have been the case.
» A government will lose out on potential tax revenue, in terms of both direct taxes, such as
income tax, and indirect taxes, such as goods and services tax.
» A government will also find its fiscal situation worsened, not only because of the likely reduction
in revenue from taxation, but also because of the money that will need to be paid out in the form of
benefits to those who are unemployed. A government might also need to provide training in order
to make unemployed people more employable in the future, and this will be an additional cost.
» Higher levels of unemployment can be associated with a number of social problems, such as an
increase in the crime rate of a country.

🔗 Make sure that you read a question on unemployment carefully, to ensure that you do not
confuse the causes of unemployment with the consequences.

4.6 Price stability

The definition of inflation, deflation and disinflation

Inflation

• inflation: a general increase in the average level of prices in an economy over a period of
time

Inflation refers to the situation of a rise in the general level of prices in an economy over a period
of time.

🔗 Candidates need to realise that it is not necessary for all prices in an economy to be rising to
constitute a situation of inflation. It is often the case that, at any one time, the prices of some
products will be falling while the prices of other products are rising. What is important in an
inflationary situation is that the general level of prices on average is rising.
 58

Degrees of inflation

Inflation, as has been stated, is a situation of an increase in the average price level in an
economy, but there are varying degrees of inflation. In many economies, the government aims to
keep the rate of inflation down to about 2%. However, in some economies a rate of inflation of 4%
or 5% would not be regarded as a major problem.

In some economies, however, the rate of inflation has been significantly higher than this. In some
cases, countries have experienced a rate of inflation of over 1,000%. The following are examples
of countries that have experienced very high rates of inflation in the last 100 years:

» Germany in the early 1920s

» Hungary in the mid-1940s
» Zimbabwe in the mid-2000s
» Venezuela in 2017–21

Types of inflation:

Creeping inflation

• creeping inflation: a situation where the rate of inflation is reasonably low, say about 2%

When the rate of inflation in an economy is relatively low, say about 2%, and is reasonably stable
over a period of time, the situation is one of creeping inflation.

Accelerating inflation

• accelerating inflation: a situation where the rate of inflation is rising over a period of time

Accelerating inflation is where the rate of inflation in an economy is getting significantly higher
and is becoming a major problem in the economy as the real value of a currency is significantly
eroded.

Hyperinflation

• hyperinflation: a situation where the rate of inflation is becoming very high and is
damaging confidence in the country’s economy

It is difficult to be precise as to exactly when an economy has reached a situation of

hyperinflation, but it is generally where the rate of inflation has reached such a high level that it
affects confidence in the economy. It may even lead to the collapse of a country’s currency.
Two examples of this are as follows:

» Germany: the rate of inflation in Germany reached over 20,000% in 1923, leading to the
replacement of the currency.
» Zimbabwe: the rate of inflation reached over 230 million % in 2008, and this caused many
people in Zimbabwe to cease using the Zimbabwe dollar and to replace it with the US dollar.

Candidates should understand that it is not possible to give a precise percentage figure to indicate
when a situation of hyperinflation exists in an economy.

Deflation

• deflation: a general decrease in the average level of prices in an economy over a period of
time
 59

It is not inevitable that a country will always be faced with inflation. It is possible that a country
could experience a situation of deflation, or falling average prices. This has happened in Japan in
recent years.

🔗 Candidates can sometimes confuse inflation and deflation in their examination answers. It is
important to distinguish clearly between a situation of inflation, which refers to rising prices, and a
situation of deflation, which refers to falling prices.

Disinflation

• disinflation: a general increase in the average level of prices in an economy over a period
of time, where the rate of increase is less than in the previous time period

» Disinflation refers to a situation in an economy where there is a fall in the rate of inflation. The
general level of prices in the economy is still rising, but it is now rising more slowly than before.
» For example, if the rate of inflation in an economy was 5% in one year, and in the next year it fell
to 3%, this would be an example of disinflation because although the general level of prices is
continuing to rise, it is rising at a slower rate than in the previous year.

🔗 Candidates need to realise that in a situation of disinflation, the general level of prices in an
economy is still rising. It is just that the rate of increase of prices is not as high as it was in the
previous year.

The measurement of changes in the price level

• general price level: the average level of prices of all consumer goods and services in an
economy at a given time
• cost of living: the cost of a selection of goods and services that are consumed by an
average household in an economy at a given time

Changes in the general price level of an economy give an indication of the average price level of
the various consumer goods and services at a given time. It is a way of measuring the cost of
living in an economy.

The general price level in an economy is measured through the use of an index. There are a
number of different price indices that can be used to measure changes in the cost of living in an
economy over a period of time, but the most common one is the consumer price index (CPI).

The Consumer Price Index (CPI)

• consumer price index (CPI): a way of measuring changes in the prices of a number of
consumer goods and services in an economy over a period of time
• sampling: the use of a representative sample of goods and services consumed in an
economy to give an indication of changes in the cost of living
• household expenditure: a survey is taken on a regular basis (usually every month) to
record changes in the prices of a selection of goods and services that constitutes a
representative basket
• weights: the items in a representative sample of goods and services bought by people in
an economy will not all be of the same importance; weights are given to each of the items
to reflect the relative importance of the different components in the basket, and so a price
index involves a weighted average
• base year: a year chosen so that comparisons can be made over a period of time; the base
year for an index is given a value of 100
 60

There are a number of components involved in the construction of a price index:

Components Explanation

Basket of goods A sample of a number of goods and services is included in a

and services representative basket; the number of items is often around 600–700.

Household A survey is carried out, usually every month, which monitors changes in the
expenditure prices of these goods and services.

Weights An index is constructed to show the changes in these prices, but it is

recognised that some items are more important than others; these
differences in importance are reflected in weights that are given to the
different items in the basket. The more important the item, the greater the
relative weight assigned in the index.

Base year To show the changes in the general level of prices over a period of time, a
starting date is chosen; this is called a base year and is given an index
value of 100.

Calculation of The percentage change in price for each item is then multiplied by its
the index figure weight to give the average change in the index; this is usually calculated
each month and shows the change in the general price level over the
previous 12 months.

Possible difficulties in measurement

There are a number of possible difficulties in constructing and using a price index, such as a
consumer price index, to measure changes in the general price level of an economy:

» Changes in the quality of products mean that price rises may reflect not inflation, but
improvements in the quality of the products.
» One-off shocks, such as a rise in oil prices, will lead to a higher rate of inflation, but the price rise
may only be temporary and so it can give a misleading measurement.
» There are various price indices that can be used to measure inflation in an economy and they
are all slightly different — for example, some countries use both a consumer price index and a
retail price index and there is often a difference between the two measures. So, the rate of inflation
in an economy will depend partly on which price index is used to measure it.
» Different groups of people in an economy can have different inflation rates that apply to them —
for example, young people could experience a different rate of inflation than old people depending
on the goods and services bought by each group.
» The basket of goods and services can become outdated. Although the basket is regularly
updated, this may take some time.

The distinction between money values and real data

• nominal value: the value of a sum of money without taking into account the effects of
inflation
• real value: the value of a sum of money after taking into account (removing) the effects of
inflation

It is important to distinguish between nominal value and real value:

 61

» Nominal value: the nominal value of a given sum of money does not take into account the
effects of inflation.
» Real value: the real value of a given sum of money shows the value after the effects of inflation
have been removed.

An example of nominal value is if a person receives a wage rise of 8%. If, at that time, inflation is
7%, to obtain the real value of the wage increase, this 7% has to be subtracted from the 8%
nominal increase. The real value of the wage increase is therefore 8% − 7% = 1%.

🔗 It is important that candidates can demonstrate they understand what is meant by a ‘real
value’.

KEY SKILL

Numerical skill: you need to be able to calculate the real value of a nominal wage increase to
take into account the impact of inflation.

The causes of inflation

1. Demand-pull inflation

• demand-pull inflation: a rise in the general level of prices in an economy, caused by too
much demand for goods and services
• monetary inflation: a rise in the general level of prices in an economy, caused primarily by
too much money in an economy

One cause of inflation is a situation where there is too much demand in an economy — that is,
aggregate demand is greater than aggregate supply. Where an increase in demand cannot be met
by an increase in output, the general price level will rise — a situation of demand-pull inflation.

The excess demand in an economy can be due to monetary factors. An excessive increase in the
money supply can make such an increase in demand possible.

Monetary inflation is closely associated with the Monetarist perspective on economics, which
stresses the importance of the quantity theory of money.

2. Cost-push inflation

• cost-push inflation: a rise in the general level of prices in an economy, caused primarily
by a significant rise in the costs of production
• anticipated inflation: the expected future rate of inflation in an economy
• unanticipated inflation: the actual rate of inflation in an economy minus the anticipated or
expected rate of inflation
• imported inflation: a rise in the general level of prices in an economy, caused primarily by
a significant increase in the price of imports

» Whereas demand-pull inflation is essentially brought about from the demand side, cost-push
inflation is due to an increase in the costs of production that is passed on to consumers in the
form of higher prices. Labour costs, for example, could rise significantly, forcing firms to raise the
prices of products.
» There is also an element of anticipated inflation in relation to labour costs. If inflation is
anticipated or expected, workers will build this into their wage demands.
» It is therefore possible that anticipated inflation actually contributes to the inflation. In such a
situation, inflation becomes self-perpetuating and a self-fulfilling prophecy.
» The rate of inflation excluding anticipated inflation is known as unanticipated inflation.
 62

» Cost-push inflation can sometimes be seen as imported inflation. This stresses the importance
of an increase in the costs of imports in particular. This can either be in the form of imported raw
materials and component parts that are used in domestic production or the higher prices of
imported finished goods.

The consequences of inflation

• menu costs: the costs of continually having to change the prices of goods and services as
a result of an inflationary situation
• shoe leather costs: in a situation of very high inflation, people need to conduct searches to
ensure that their money is gaining interest; these searches are costly in time and effort
• fiscal drag: the idea that more people will be dragged into higher tax brackets in a situation
of inflation if tax allowances are not increased in line with the rate of inflation
• stagflation: a situation where an economy is experiencing high inflation and high
unemployment at the same time

the main negative and positive consequences of inflation for an economy:

Negative consequences Positive consequences

• The purchasing power of a given sum of • A relatively low rate of inflation, caused by
money will fall (i.e. it will be able to buy less in an increase in aggregate demand, could lead
real terms). to people feeling more optimistic about future
economic prospects.
• A country’s exports will become
uncompetitive, although the effect of this will • If prices rise by more than costs, this will
depend on the rate of inflation in one country help to increase the profits of firms, assuming
compared to that in another. that demand is price elastic.

• There will be a redistribution of income, with • Redistribution of income may work in favour
some people adversely affected, such as of some people in an economy, such as
those on fixed incomes, and creditors (people borrowers; inflation will make their debt less
who lend money) unless the loans are index in real terms. This may encourage people to
linked to the rate of inflation. Savers will also spend more, improving their standard of
be negatively affected, unless they can find a living.
savings account with a rate of interest that is
greater than the rate of inflation. • If the real cost of debt is reduced, but the
price of property rises in line with inflation,
• Menu costs — repeatedly changing the property owners will benefit significantly.
prices that are being advertised for various
products can be expensive and time • If firms experience an increase in their
consuming. profits, they may be encouraged to expand
and this could lead to a reduction in
• Shoe leather costs — searching unemployment (although high inflation can
continually for the best possible returns to try also be associated with high unemployment,
to keep ahead of inflation also involves extra a situation known as stagflation).
time and effort.

• Uncertainty in investment — some firms

may be reluctant to plan investment as
inflation creates a great deal of uncertainty in
an economy.
 63

• A situation of fiscal drag can occur if tax

allowances are left unchanged in an
inflationary situation; fiscal drag is where
inflation moves taxpayers into higher tax
brackets.

It should be clear, therefore, that the overall effects of inflation will depend on a number of factors.
These include:

» Whether the inflation is anticipated or unanticipated

» The extent of the increase in prices
» Whether the inflation rate is accelerating or creeping
» The extent to which other countries are experiencing inflation

🔗 Candidates often make broad generalisations in examinations in relation to the possible effects
of inflation. You need to make sure that you demonstrate an understanding that the effects of
inflation in any particular country will depend on a number of possible factors.

KEY SKILL

Evaluation: you will need to be able to come to a judgement in terms of an overall assessment of
the consequences of inflation, recognising that these can be both positive and negative. It is
important you realise that there are potential benefits and costs of inflation.

5 Government macroeconomic intervention

5.1 Government macroeconomic policy objectives

There are a large number of different government macroeconomic policy objectives, but this
chapter focuses on the use of government policy (i.e. fiscal policy, monetary policy and supply-
side policy) to achieve just three of these macroeconomic objectives:

» price stability
» low unemployment
» economic growth

🔗 Knowledge of policy conflicts and trade-offs will not be required at AS Level.

5.2 Fiscal policy

The meaning of a government budget

• fiscal policy: the use of public revenue and/ or public expenditure to influence the level of
aggregate demand in an economy
• government budget: a financial statement that outlines a government’s proposed revenue
and expenditure for a specific period of time

Fiscal policy is the deliberate use of revenue and expenditure decisions by a government to
influence economic activity in a country, especially the level of aggregate demand. The idea is that
by making changes to decisions about revenue and expenditure, an economy can be ‘fine-tuned’
to achieve particular aims.
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A government budget is a financial statement that outlines a government’s proposed

revenue/income and expenditure/spending for a specific period of time, usually the next financial
year.

🔗 Time: a budget is a financial statement that covers a particular period of time, usually 1 year.
You may need to refer to the time period when discussing government policies, such as when
analysing fiscal policy in relation to government expenditure and tax revenue. Time is also
important in medium- and long-term financial planning, such as in terms of how long it may take
for fiscal policy, monetary policy or supply-side policy to take effect.

The distinction between a government budget deficit and a government budget surplus

In each economy in the world, the government will produce its accounts in the form of a summary
of its income and expenditure.

A government can deliberately plan for one of three financial positions to achieve its objectives:
» a budget deficit
» a budget surplus
» a balanced budget

Budget deficit

• budget deficit: where projected government revenue is less than planned government
expenditure

» In the case of a budget deficit, the projected revenue is less than the planned expenditure (i.e.
more money is spent than is received). In such a situation, the government is injecting more into
an economy than it is withdrawing.
» For example, if an economy needs to be stimulated in order to reduce unemployment and to
increase economic growth, a government can plan for a budget deficit whereby taxation is reduced
and government expenditure increased.

Budget surplus

• budget surplus: where projected government revenue is greater than planned government
expenditure

» In the case of a budget surplus, the projected revenue is greater than the planned expenditure
(i.e. less money is spent than is received). In such a situation, the government is taking more out
of an economy than it is putting in.
» For example, if an economy needs to be deflated in order to reduce inflation, a government can
plan for a budget surplus whereby taxation is increased and government expenditure reduced.

Balanced budget

• balanced budget: where projected government revenue and planned government

expenditure are equal

In the case of a balanced budget, the projected revenue, such as from taxation, is exactly equal
to the government’s planned expenditure. In this sense, where both sides of the budget are equal,
it is neutral.

KEY SKILL
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Evaluation: you need to be able to discuss why a government might deliberately plan for a budget
deficit or a budget surplus rather than for a balanced budget. For example, a government might
deliberately plan for a budget deficit in an expansionary fiscal or monetary policy to reduce
unemployment in an economy. Alternatively, a government might deliberately plan for a budget
surplus in a contractionary fiscal or monetary policy to reduce inflation in an economy.

The meaning and significance of the national debt

• national debt: the total of all debt accumulated by a government

The national debt refers to the total of all debt that has been accumulated over a period of time
by the government or the public sector of a country — in other words, it is a government’s stock of
outstanding debt.

Changes in the size of a country’s national debt can be brought about by government policy:

» Increase in the size of the national debt: if there is a relatively high rate of unemployment in
an economy, a government may decide to plan for a budget deficit and the effect of this will be to
increase the size of the national debt.
» Decrease in the size of the national debt: if there is a high rate of inflation in an economy, a
government may decide to plan for a budget surplus and the effect of this will be to reduce the size
of the national debt.

🔗 It is important to understand that at a time when the size of a budget deficit is falling, the size
of the national debt will still be rising because as long as there is a budget deficit, a government
will be spending more than it is receiving. It is important also to understand that a budget surplus
does not necessarily mean a reduced national debt. A government would need to choose to use
the budget surplus for the purpose of reducing the size of the national debt.

🔗 It is important that the national debt of a country is distinguished from debt that is
accumulated in one financial year. The national debt refers to the debt that has been accumulated
over many years.

🔗 It is important that candidates are able to distinguish between a stock of money and a flow of
money. A country’s national debt is a stock of money that has been accumulated over many years.
A budget deficit refers to a flow of money in one financial year. If a government is successful in
reducing the size of a country’s budget deficit in a particular year, the size of the country’s national
debt may still increase during the year.

🔗 Time: a country’s national debt, like its government budget, is linked to the concept of time.
Whereas a budget usually covers a relatively short period of time, such as a year, a country’s
national debt will have accumulated over a much longer period of time, involving many years and
even centuries in some cases.

KEY SKILL

Analysis: you need to be able to analyse a government budget and a national debt in terms of a
distinction between a flow of money and a stock of money.

Taxation

Different types of tax

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• direct tax: a tax that is imposed on the incomes of individuals and firms; examples are
income tax (on the incomes of individuals), corporation tax (on the profits of companies)
and inheritance tax (on the wealth of individuals)
• income tax: a direct tax on the incomes of individuals
• indirect tax: a tax that is imposed on expenditure; it is indirect in that the tax is only paid
when the product on which the tax is levied is purchased
• specific tax: an indirect tax that is a fixed amount per unit of output
• ad valorem tax: an indirect tax with a percentage rate (e.g. a tax rate of 20% per product
sold)

It is possible to distinguish between different types of tax: some will be direct, while others will be
indirect, and they can also be distinguished as to whether they are progressive, regressive or
proportional.

Direct and indirect taxes

A direct tax is a tax imposed on the incomes of individuals and the profits of firms.
Examples of direct taxation include the following:

» Income tax (on the incomes of individuals). There is usually a personal allowance, which is tax
free, and then different tax rates for different levels of income over the tax-free allowance. Income
tax rates typically increase as incomes rise.
» Corporation tax, or corporate tax (on the profits of firms). In some countries, the tax rate will
vary depending on the size of a firm’s profits, while in other countries, the tax rate will be the same
for all firms.
» Inheritance tax: a direct tax on those people who have inherited money, property or
possessions from someone who has died. There is usually a threshold at which the tax is payable
depending on the value of the estate that has been inherited.

An indirect tax, on the other hand, is a tax imposed on expenditure. Indirect taxes can take
different forms:

» Specific tax: a specific tax on a product, such as an excise duty, involves a requirement to pay
a specific amount per unit in tax.
» Ad valorem tax: an ad valorem tax, on the other hand, requires a percentage of the selling price
to be paid in tax. For example, a tax such as value added tax (VAT) or goods and services tax
(GST) will require a particular percentage to be paid in tax, such as 20%.

It is important to distinguish between the incidence and the impact of a tax:

» Incidence of tax: this refers to how the burden of taxation is distributed between producers and
consumers. For example, with an indirect tax on expenditure, the burden of the tax is likely to be
shared between the producer and the consumer. However, if the price elasticity of demand is
perfectly inelastic, and there is a vertical demand curve, the incidence of the tax will be entirely on
the consumer. On the other hand, if the price elasticity of demand is perfectly elastic, and there is
a horizontal demand curve, the incidence of the tax will be entirely on the producer.
» Impact of tax: this refers to the impact on the individual or firm on which a tax is levied.

KEY SKILL

Application: you need to be able to give appropriate examples of different kinds of tax. For
example, income tax is an example of a direct tax, whereas VAT is an example of an indirect tax.

Progressive, regressive and proportional taxes

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• progressive taxation: where taxation takes a higher proportion of a person’s income as

that income rises
• regressive taxation: where taxation takes a larger proportion of low incomes than it does
of high incomes
• proportional taxation: where taxation takes an equal proportion of income whatever a
person’s income level
• flat-rate tax: a tax with a constant marginal rate

Progressive taxation

Many governments make use of progressive taxation to achieve the macroeconomic objective of a
more equal distribution of income. An income tax, for example, is usually a progressive tax as the
tax rate rises as the level of income rises — it not only takes more from a person as their income
rises, but a higher proportion of that income.

Regressive taxation

Whereas a progressive direct tax, such as income tax, has different rates of tax depending on a
person’s income (although, in theory, direct taxation can also be regressive), a regressive indirect
tax, such as a goods and services tax, is paid at a constant rate. In such a situation, all people
who buy a particular good or service will pay the same percentage, so this will have a greater
impact on relatively low-income as compared to relatively high-income individuals.

Proportional taxation

Another possible type of taxation is proportional taxation. This is where a tax takes an equal
proportion of income from a person whatever that person’s income. In this situation, the tax has
neither a progressive nor a regressive effect.

An example of a proportional tax is a flat-rate tax, which has a constant marginal tax rate.

Marginal and average rates of taxation

• marginal tax rate: the proportion of an increase in income that is paid in tax
• average tax rate: the average percentage of total income that is paid in tax

The marginal tax rate refers to the proportion of an increase in income that is paid in tax. This
can also be referred to as the marginal propensity to pay tax.

The average tax rate refers to the average percentage of total income that is paid in taxes. This
can also be referred to as the average propensity to pay tax.

🔗 The margin and decision making: a progressive tax is one where the proportion of income
taken in tax (the tax rate) rises with income. This is achieved by a system of rising marginal rates
of tax with increases in income (e.g. 20%, 30%, 40% and 50%).

🔗 The role of government and the issues of equality and equity: progressive taxation can be
used by a government deliberately to redistribute income and wealth so that the distribution
becomes more equal.

Canons of taxation

• canons of taxation: the main principles of taxation, to which any system of taxes should
adhere in order to be effective
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principles or canons of taxation:

Principle Explanation
Equity/fairness The burden of taxation should take into
account the ability to pay the tax.
Certainty/transparency Information about taxation needs to be made
available so that it is seen as transparent.
Convenience The payment and collection of taxes need to
be as convenient as possible.
Cost The cost of administering and collecting taxes
should be as low as possible.
Efficiency Taxation should not lead to any disincentives,
such as discouraging people from working.

Reasons for taxation

There are a number of reasons for taxation:

» To provide revenue for a government: taxation is used to enable a government to finance its
expenditure on a variety of different goods and services, such as the provision of public goods
(e.g. street lighting and national defence).
» To achieve government macroeconomic policy objectives: taxation is used to influence the
level of aggregate demand in an economy — for example, if there is a high rate of unemployment,
taxes could be lowered to stimulate the level of demand in an economy in an attempt to reduce the
level of unemployment.
» To redistribute income and wealth: taxation is used to finance the provision of a range of
transfer payments to those people in society who are relatively less well off.
» To avoid negative externalities: taxation is used to discourage firms from causing any
negative impact on third parties (e.g. taxes on firms can be used to reduce the level of pollution in
an economy).
» To discourage consumption/production of demerit goods: taxation is used in an attempt to
lower the level of demand for demerit goods (e.g. tobacco and alcohol).

Government spending

• capital (investment) spending: government spending on fixed assets

• current spending: government spending on day-to-day running costs

It is important to distinguish between two types of government spending:

» Capital (investment) spending: this refers to government expenditure on fixed assets, such as
expenditure on building a new road or on extra defence equipment.
» Current spending: this refers to government expenditure on the day-to-day running costs of a
government, such as expenditure on the wages or salaries of public sector workers.

Reasons for government spending

» It is a key component of fiscal policy: government spending is one of the components of

aggregate demand, so an increase in government spending (assuming the other components stay
constant) will increase aggregate demand in an economy and so aid the management of the
economy.
 69

» It is important in providing public goods: governments spend on public goods (e.g. street
lighting and national defence) because these goods would not be provided in the private sector
and so governments are required to provide them.
» It is important in providing merit goods: governments spend on merit goods (e.g. education
and healthcare) because, although these goods could be provided in the private sector, they are
likely to be under-consumed and so governments spend money on them to encourage their
consumption.
» It helps to achieve greater equity in an economy: a government could decide to spend
money on a range of benefits and transfer payments as a way of achieving greater equity (e.g.
state pensions and unemployment benefits).

🔗 Progress and development: government spending can contribute to the progress and
development of an economy, such as through spending on public goods (e.g. defence and police)
and on merit goods (e.g. education and healthcare).

🔗 The role of government and the issues of equality and equity: one reason for government
spending is that it could help to achieve greater equality and equity in an economy (e.g. through
spending on a range of transfer payments).
Discretionary fiscal policy and automatic stabilisers

• discretionary fiscal policy: the use of deliberate changes in taxation and/or public
expenditure with the intention of changing the level of aggregate demand in an economy
• automatic stabilisers: where changes in the level of taxation and/ or public expenditure
automatically bring about changes in an economy without the need for deliberate action by
a government

It is important to distinguish between discretionary fiscal policy and automatic stabilisers.

Discretionary fiscal policy

Sometimes a government will deliberately change taxation and/or public expenditure to bring
about a desired change in the level of economic activity in the economy. This is known as
discretionary fiscal policy.

Automatic stabilisers

» Whereas discretionary fiscal policy involves deliberate action by a government, automatic

stabilisers refer to a situation where changes in an economy take place without the need for
deliberate government action.
» For example, in a recession, when the level of unemployment in an economy is likely to rise, the
revenue received by a government from taxation is likely to fall, as fewer people are working, while
at the same time government expenditure is likely to rise, such as in the form of unemployment
benefits to those out of work. This results in ‘automatic stabilisation’ because the increased
government spending will impact on the trend rate of economic growth.
» Automatic stabilisers will be discussed in Chapter 9, section 9.2, in relation to the business
(trade) cycle.

The distinction between expansionary and contractionary fiscal policy

• expansionary fiscal policy: one that causes aggregate demand in an economy to

increase
• contractionary fiscal policy: one that causes aggregate demand in an economy to
decrease
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As previously explained, fiscal policy is the use of taxation and/or public expenditure to influence
the level of aggregate demand in an economy. It is important to distinguish between expansionary
and contractionary fiscal policy:

» Expansionary fiscal policy is where a government decides to increase its expenditure and/or
reduce taxation to boost the level of aggregate demand in an economy. This approach will be
appropriate if the objective is to encourage economic growth, lower the rate of unemployment or
increase the rate of inflation.
» Contractionary fiscal policy is where a government decides to lower its expenditure and/or
increase taxation to reduce the level of aggregate demand in an economy. This approach will be
appropriate if the objective is to lower economic growth or the rate of inflation.

AD/AS analysis of the impact of expansionary and contractionary fiscal policy

AD/AS analysis can be used to assess the impact of expansionary fiscal policy and contractionary
fiscal policy on equilibrium national income in relation to:

» the level of real output

» the price level
» the employment level

The impact of expansionary fiscal policy

» In Chapter 4, section 4.3, it was stated that if there is a change in any of the components of
aggregate demand, such as a change in consumption expenditure (C), investment expenditure (I),
government expenditure (G) or net expenditure on exports (X − M), the AD curve will shift. If there
is an increase in aggregate demand, the curve will shift to the right.
» This can be seen in Figure 4.3 on page 67, where there is a shift in the aggregate demand curve
from AD0 to AD1. This results in an increase in the level of real output and employment (from Y0
to Y1) and an increase in the price level (from P0 to P1).
» An expansionary fiscal policy could bring this about in a number of ways. For example, if a
government decides to raise its expenditure, this will increase G. If it decides to lower income tax,
this could increase C.

The impact of contractionary fiscal policy

» If there is a decrease in aggregate demand, the AD curve will shift to the left. This will cause a
decrease in the level of real output, employment and the price level.
» A contractionary fiscal policy could bring this about in a number of ways. For example, if a
government decides to lower its expenditure, this will reduce G. If it decides to increase income
tax, this could reduce C.

🔗 Equilibrium and disequilibrium: the position of equilibrium and disequilibrium, as shown

through the interaction of AD and AS, can be affected by expansionary or contractionary fiscal
policy.

5.3 Monetary policy

The definition of monetary policy

• monetary policy: the use of interest rates and/or the money supply to influence the level of
aggregate demand in an economy

Monetary policy is concerned with how the price and/or the quantity of money can be used to
influence the level of aggregate demand in an economy. It refers to actions that a country’s
 71

government, central bank or monetary authority can take to influence how much money and credit
is in an economy through the manipulation of the rate of interest and how much it costs to borrow
that money.

The tools of monetary policy

• hot money: flows of money that move from one country to another to take advantage of
higher rates of return in various countries
• quantitative easing: the process whereby the government, central bank or monetary
authority of a country deliberately buys bonds and bills in order to increase the money
supply in an economy
• open market operations: the process of a government, central bank or monetary authority
buying or selling bonds in order to influence the money supply in an economy

There are three main tools of monetary policy:

» interest rates
» money supply
» credit regulations

1. Interest rates

» The price of money refers to the interest rate.

» For example, a government, central bank or monetary authority could reduce the interest rate in
an economy to stimulate employment, but this could lead to an increase in the rate of inflation in
that economy.
» If a government decides to increase the interest rate in an economy, this will attract ‘hot money’
into the country, raising the value of the exchange rate and making export prices more expensive
and import prices less expensive, leading to the possibility of an adverse effect on the balance of
payments.

2. Money supply

» A second monetary approach is to influence the quantity of money in an economy (i.e. the
money supply).
» One way of doing this is through changes in credit regulations — for example, if credit
regulations are tightened, the money supply is likely to be reduced.
» Many countries, since the financial crisis of 2007–08, have decided to increase the money
supply in the economy through a process of quantitative easing. This is where the government
buys bonds and bills (i.e. securities), giving financial institutions more liquidity and so increasing
the money supply in the economy. This process of a government buying bonds is known as open
market operations.

3. Credit regulations

» Credit regulations refer to laws that relate to borrowing money on credit. They are concerned
with loans and/or hire purchase agreements.
» The regulations cover the information consumers should be provided with before they enter into
a credit agreement, the content and form of credit agreements, the method of calculating the rate
of interest and the procedures relating to default, termination and early settlement.
» As has already been pointed out, changes in credit regulations can impact the money supply. If
credit regulations are loosened, the money supply is likely to be increased.

The distinction between expansionary and contractionary monetary policy

 72

• expansionary monetary policy: one that causes aggregate demand in an economy to

increase
• contractionary monetary policy: one that causes aggregate demand in an economy to
decrease

As previously explained, monetary policy is the use of interest rates and/or the money supply to
influence the level of aggregate demand in an economy. It is important to distinguish between
expansionary and contractionary monetary policy.

» Expansionary monetary policy is where a government decides to increase the money supply
and/or lower interest rates to boost the level of aggregate demand in an economy. This approach
will be appropriate if the objective is to encourage economic growth or to lower the rate of
unemployment.
» Contractionary monetary policy is where a government decides to decrease the money
supply and/or increase interest rates to reduce the level of aggregate demand in an economy. This
approach will be appropriate if the objective is to lower economic growth or the rate of inflation.

AD/AS analysis of the impact of expansionary and contractionary monetary policy

AD/AS analysis can be used to assess the impact of expansionary monetary policy and
contractionary monetary policy on equilibrium national income in relation to:

» the level of real output

» the price level
» the employment level

The impact of expansionary monetary policy

» In Chapter 4, section 4.3, it was pointed out that if there is a change in any of the components of
aggregate demand, such as a change in consumption expenditure (C), investment expenditure (I),
government expenditure (G) or net expenditure on exports (X −M), the AD curve will shift.
» This can be seen in Figure 4.3 on page 67, where there is a shift in the aggregate demand curve
from AD0 to AD1. This results in an increase in the level of real output and employment (from Y0
to Y1) and an increase in the price level (from P0 to P1).
» An expansionary monetary policy could bring this about in a number of ways. For example, if a
government decides to increase the money supply and/or reduce the interest rate, this will
increase C. A reduction in the interest rate is also likely to increase investment (I).

The impact of contractionary monetary policy

» If there is a decrease in aggregate demand, the AD curve will shift to the left. This will cause a
decrease in the level of employment, real output and the price level.
» A contractionary monetary policy could bring this about in a number of ways. For example, if a
government decides to lower the money supply and/or increase the interest rate, this will decrease
C. An increase in the interest rate is also likely to decrease investment (I).

🔗 Equilibrium and disequilibrium: the position of equilibrium and disequilibrium, as shown

through the interaction of AD and AS, can be affected by expansionary or contractionary monetary
policy.

5.4 Supply-side policy

The meaning of supply-side policy

• supply-side policy: a policy designed to enable markets to work more efficiently

 73

Supply-side policy is a general term referring to a number of different actions that a government
can take to improve the efficiency of markets in an economy. It is different in approach from the
other two types of macroeconomic policy because it approaches economic issues from the supply,
rather than from the demand, side.

In particular, supply-side policy is designed to have an effect on long-run aggregate supply which
can be represented by the long-run aggregate supply curve (LRAS):

» Supply-side policies are aimed at making markets and industries operate more efficiently so that
they contribute to a faster rate of growth of real national output.
» Successful supply-side policies will have the effect of shifting the LRAS curve to the right,
leading to a rise in the productive potential output of an economy.
» The significant advantage of an improved supply-side performance in an economy is that
sustained economic growth can be achieved without causing a rise in inflation.

The objectives of supply-side policy

• productivity: the measurement of output per unit of input per period of time
• productive capacity: the maximum potential output of an economy
• labour productivity: productivity measures the level of efficiency in the use of resources;
labour productivity, therefore, measures the efficiency of labour in terms of the output per
person per period of time

The objectives of supply-side policy can include the following:

» Increasing productivity: supply-side policies, with their emphasis on bringing about greater
efficiency in the production process, can contribute to a greater rate of output (i.e. products
produced) per unit of input (e.g. labour and capital).
» Increasing productive capacity: supply-side policies can contribute to an increase in the
maximum possible output of an economy.

Labour productivity is the measurement of the efficiency of labour in terms of the output per
worker per period of time.
The productivity of workers can vary for several reasons, including differences in:

» education
» training
» skills
» experience
» technical knowledge
» availability of capital
» working methods and practices
» motivation

KEY SKILL

Analysis: you need to be able to analyse how labour productivity can be increased in an economy
over a period of time. For example, improvements in education and training will lead to a
workforce that is better qualified and appropriately skilled, resulting in an increase in the maximum
possible output of an economy.

🔗 Time: you need to understand that increases in productivity and productive capacity in an
economy will occur in the long run as a result of implementing different supply-side policies.
 74

🔗 It is important to distinguish between productivity and production. Candidates often confuse

these two terms. ‘Production’ refers to total output from resources, whereas ‘productivity’ refers to
the efficiency of an input (e.g. labour) into the production process.

The tools of supply-side policy

There are two main types of supply-side policy:

» Market-based supply-side policies to increase competition and efficiency

» Interventionist supply-side policies to overcome market failure

Market-based supply-side policies Interventionist supply-side policies

• Increasing incentives to work by lowering • Increasing expenditure on education to

income tax and unemployment benefits improve the quality, and therefore the
productivity, of the labour force
• Reforming trade unions so that labour is
not in such a powerful bargaining position • Increasing expenditure on training to
with employers; this could contribute to a enable workers to learn new skills and
reduction in the number of days lost move more easily from one type of work to
through industrial action in an economy another if they become unemployed; this
is likely to improve the flexibility and
• Encouraging privatisation in an economy occupational mobility of labour in an
so that firms, needing to make a profit to economy
survive, become more efficient
• Providing more information about job
• Encouraging deregulation, such as vacancies in different parts of a country;
through a reduction in the barriers to entry this is likely to improve the geographical
into an industry, which will allow more mobility of labour
private firms to enter a market
• Encouraging infrastructure development,
• Encouraging an increased level of such as the construction of new road and
competition in markets, such as through rail links to improve transport and reduce
tax incentives costs

• Support for technological improvement,

such as providing financial incentives for
research and development

AD/AS analysis of the impact of supply-side policy

» AD/AS analysis can be used to assess the impact of supply-side policy on equilibrium national
income in relation to the level of real output, the price level and the employment level.
» In Chapter 4, section 4.3, it was pointed out that equilibrium national income can be affected by
changes in the AS curve as well as the AD curve. If there is an increase in aggregate supply, as a
result of supply-side policies, the AS curve will shift to the right. This can be seen in Figure 4.5 on
page 68, where the curve shifts from AS0 to AS1. If there is a decrease in aggregate supply, the
curve will shift to the left.
» In the long run, the shape of the AS curve will change. At low levels of output, the LRAS curve
can be horizontal, indicating that it is perfectly elastic. At high levels of output, the LRAS curve can
be vertical, indicating that it is perfectly inelastic (see Figure 4.8 on page 70).
» Indeed, some economists argue that the LRAS curve is perfectly inelastic, indicating that an
economy will always operate at full capacity. That is why it is important that supply-side policy
 75

shifts the LRAS curve to the right, allowing for an increase in the productive capacity of an
economy.
» A shift to the right of the LRAS curve will increase the level of real output and the level of
employment, but will decrease the price level.
» A shift to the left of the LRAS curve will decrease the level of real output and the level of
employment, and increase the price level.

KEY SKILL

Application: you need to be able to apply supply-side policy to particular methods or tools,
including examples of both market-based and interventionist supply-side policies.

🔗 Equilibrium and disequilibrium: the position of equilibrium and disequilibrium, as

shown through the interaction of AD and AS, can be affected by supply-side policy. For
example, supply-side policies will be able to shift the LRAS curve to the right, leading
to an equilibrium position with a higher level of real output and employment and with a
lower price level.

6 International economic issues

6.1 The reasons for international trade

The distinction between absolute and comparative advantage

• absolute advantage: a situation where a country can produce a particular good or service
using fewer resources than another country
• comparative advantage: a situation where a country can produce a good or service
relatively more efficiently (at a lower domestic opportunity cost) than another country

International trade between countries is based on specialisation, whereby one country is more
efficient than another at producing a particular product. This gives rise to two types of advantage:

» Absolute advantage
» Comparative advantage

Absolute advantage

» Absolute advantage refers to a situation where one country is able to produce a particular good
with fewer resources than another country.
» As a result of this, the country will enjoy a cost advantage. This is why absolute advantage is
often referred to as ‘absolute cost advantage’.
» The reason for this advantage is that each country is endowed with a particular mix of factors of
production, so one country may be more efficient than another country at producing a particular
good.

KEY SKILL

Application: a country in the Caribbean, such as Jamaica, has an absolute advantage over the
UK in the production of bananas because the weather conditions are much more favourable. This
makes Jamaica more efficient at producing bananas than the UK, and so gives Jamaica a cost
advantage.

Comparative advantage
 76

• trading possibility curve: a means of showing the potential advantages of two countries
trading with each other, as long as the opportunity costs of production are different

» Comparative advantage takes into account not just the F6.1 The trading possibility curve
absolute efficiency of one country compared to another,
but its relative efficiency.
» This then allows a country to produce something in
which it has a lower opportunity cost than another
country. This can be seen in Figure 6.1:
» Two countries, country 1 and country 2, have different
comparative advantages, which can be seen by the slope
of their respective production possibility curves (PPCs).
» Country 1 has a comparative advantage in the
production of manufactured goods whereas country 2 has
a comparative advantage in the production of agricultural
goods.
» In the absence of international trade, each country is constrained to consume along its PPC.
» If, however, country 1 specialises in the production of manufactured goods and country 2
specialises in the production of agricultural goods, and if trade takes place on a one-to-one basis
(i.e. one unit of manufactured goods is exchanged for one unit of agricultural goods), this expands
the consumption possibilities for both countries.
» As a result of applying the principle of comparative advantage, the trading possibility curve
shows the potential consumption points for each country in this situation. This curve, shown in
Figure 6.1, illustrates the importance of opportunity cost in international trade.
» The principle of comparative advantage is reflected in differences in opportunity cost. World
trade will increase substantially if each country concentrates on producing the product(s) in which
it has the lowest opportunity cost.

Figure 6.1 shows the situation where just two countries are trading with each other. This is known
as bilateral trade. in the real world, the situation is more complex than this, given the existence of
multilateral trade. Multilateral trade has been made more likely by the process of globalisation.
This has been made possible by a number of factors, including progress in trade liberalisation.

• bilateral trade: where trade takes place between two countries

• multilateral trade: a more realistic situation than bilateral trade, where trade takes place
between a number of countries
• globalisation: the process whereby there is an increasing world market in goods and
services, making an increase in multilateral trade more likely; it has been made possible by
a number of factors, including progress in trade liberalisation

🔗 It is important that candidates can demonstrate their understanding of the distinction between
bilateral trade and multilateral trade. Economists use two countries on production possibility curve
diagrams, but in reality, trade will involve the participation of many more countries in the world.

The benefits of specialisation and free trade

• specialisation: the process whereby individuals, firms and economies concentrate on

producing those products in which they have an advantage
• free trade: trade that is not restricted or limited by different types of import or export control
• trade liberalisation: the removal or reduction of restrictions or barriers to the free
exchange of goods and services between countries
• trade creation: the creation of new trade as a result of the reduction or elimination of trade
barriers
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Some economists stress the potential advantages of specialisation and free trade for a country.
These potential advantages can be achieved through a process known as trade liberalisation.

The advantages of specialisation and free trade include the following:

» World output can be increased.

» Resources are allocated more efficiently as a result of the greater specialisation.
» The higher output can be produced at lower average cost, which could lead to lower prices for
consumers.
» Consumers can have a wider range of products to choose from.
» There can be a substantial increase in economic growth.
» By specialisation in the production of goods in which countries have a comparative advantage
and lower opportunity cost, there can be an increase in economic welfare for all countries.
» It can lead to an improved standard of living.

A reduction in trade barriers will bring about a greater degree of free trade and this process of
trade liberalisation will lead to trade creation.

🔗 Progress and development: international trade can lead to progress and development
because the increase in world output can give consumers in different countries a wider range of
products to choose from, possibly at lower prices, leading to an improvement in standards of
living.

KEY SKILL

Evaluation: you will need to be able to evaluate the potential benefits of specialisation and free
trade by comparing these with the arguments for protectionism. Arguments for and against
protectionism are covered in section 6.2.

The World Trade Organization

• World Trade Organization: an organisation set up in 1995 to promote global free trade in
the world through the reduction of trade barriers

The World Trade Organization (WTO) was set up in 1995:

» It is the only global organisation dealing with the rules of trade between countries.
» It replaced another organisation that had existed since 1948 with the same purpose of
encouraging free trade, the General Agreement on Tariffs and Trade (GATT).
» The head office of the WTO is in Geneva, Switzerland, and it currently has 164 member
countries.
» It has sought to regulate trade between countries through a series of discussions; the most
recent round of discussions is the Doha Round and these have been taking place since 2000.
» WTO agreements are negotiated and signed by the majority of the world’s trading countries and
the objective of these agreements is to ensure that international trade flows as smoothly,
predictably and freely as possible.
» If there are any trade disputes between countries, the WTO can help to resolve them.

KEY SKILL

Analysis: you should be able to analyse the contribution of the World Trade Organization to the
growth of free trade and trade liberalisation through its role in promoting and supporting free trade,
the removal of trade barriers and the establishment of multilateral trade agreements.

Exports, imports and the terms of trade

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Exports are the goods and/or services that are produced domestically in one country and sold to
other countries.
Imports are the goods and/or services that are produced in foreign countries and consumed by
people in the domestic economy.

The measurement of the terms of trade

• terms of trade: the price of a country’s exports in relation to the price of the country’s
imports

The terms of trade refer to the relative value of export prices and import prices. They show the
amount of imports an economy can purchase per unit of exports. They are important because they
show the gain to a country from taking part in international trade. They are calculated by:

𝑖𝑛𝑑𝑒𝑥 𝑛𝑢𝑚𝑏𝑒𝑟 𝑠ℎ𝑜𝑤𝑖𝑛𝑔 𝑡ℎ𝑒 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑒𝑥𝑝𝑜𝑟𝑡𝑠

× 100
𝑖𝑛𝑑𝑒𝑥 𝑛𝑢𝑚𝑏𝑒𝑟 𝑠ℎ𝑜𝑤𝑖𝑛𝑔 𝑡ℎ𝑒 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑖𝑚𝑝𝑜𝑟𝑡𝑠

The causes of changes in the terms of trade

If, in one year, the terms of trade are equal to 100 and import prices rise by more than export
prices, the terms of trade will fall below 100. This is an unfavourable change because more
exports will need to be sold to buy the same number of imports.

However, if in another year, the terms of trade are equal to 100 and import prices rise by less than
export prices, the terms of trade rise above 100. This is a favourable change because fewer
exports will need to be sold to buy the same number of imports, assuming a situation of ceteris
paribus.

The impact of changes in the terms of trade

Changes in the terms of trade can have a significant impact on an economy:

» When the terms of trade fall below 100, this is regarded as an unfavourable change because
more exports will need to be sold to buy the same number of imports. However, this means that
exports have become relatively cheaper than imports, and if the price elasticity of demand for both
exports and imports is elastic, this will help to improve a country’s balance of trade situation.
» When the terms of trade rise above 100, this is regarded as a favourable change because fewer
exports will need to be sold to buy the same number of imports. However, this means that exports
have become relatively more expensive than imports, and if the price elasticity of demand for both
exports and imports is elastic, this will be likely to worsen a country’s balance of trade situation.

🔗 Candidates often confuse the terms of trade with the balance of trade. The terms of trade
simply indicate the relationship between changes in the prices of exports and imports; they give no
indication of the changes in the quantity or value of exports and imports that are traded between
countries.

🔗 Candidates sometimes regard a fall in the terms of trade as something that is unhelpful to a
country’s trading position. In fact, a fall in the terms of trade means that export prices have
become relatively cheaper, and if the price elasticity of demand for both exports and imports is
elastic, this will help to improve a country’s balance of trade situation.

KEY SKILL
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Numerical skills: if the index number showing the average price of exports is 104.2 and the index
number showing the average price of imports is 97.4, then the terms of trade will be (104.2/97.4) ×
100 = 106.98, rounded up to 107.

The limitations of the theories of absolute and comparative advantage

The theories of absolute and comparative advantage are helpful in explaining how total world
output can be increased as a result of specialisation, but there are a number of real-world
limitations to the predictions of these theories. They include the following:

» It is assumed that there are no transport costs involved in international trade, but this is
unrealistic — transport costs may actually offset any cost advantages arising from applying the
theories.
» It is assumed that there are constant returns to scale and constant costs of production, but it is
always possible that an increase in output will lead to diseconomies of scale and a situation of
rising average costs of production. (Returns to scale are discussed in Chapter 7, section 7.5.)
» It is assumed that there is free trade between countries, but in reality, there are many trade
restrictions that exist in different parts of the world.
» It is assumed that exchange rates are stable and that the benefits of international trade will not
be affected by fluctuations in exchange rates, but movements in exchange rates can help to make
trade more or less advantageous to a country in the real world.
» It is assumed that factor inputs can switch between different products easily and work with the
same efficiency, but this may not necessarily happen.

Other explanations and determinants of trade flows

Traditionally, economists have focused on the theories of absolute and comparative advantage as
the main explanation of international trade flows. However, given the existence of the real-world
limitations already discussed, economists have begun to look at other possible explanations and
determinants of trade flows. These include the following:

» Competitive advantage: this is the idea that it is not so much opportunity cost that is important,
but the actual cost of production in different countries, such as the decision of multinational
companies to locate production in particular countries to take advantage of differences in labour
costs.
» Factor endowment: differences in endowments of factors of production in various countries are
an element in the two theories, but some economists have stressed the significance of differences
in the quality and quantity of factors of production between countries.
» Government policy: a government may be concerned about the possible disadvantages of
overspecialisation in particular products and so might decide to encourage a greater degree of
diversification of production than might otherwise have been the case.

6.2 Protectionism

The meaning of protectionism in the context of international trade

• protectionism: the restriction of free trade between countries in an attempt to protect local
firms and industries from competition

Protectionism in the context of international trade refers to those policies that protect domestic
producers from international competition, or give support to them. It is also used to maintain the
independence and self-sufficiency of strategic domestic industries, such as energy or defence.
The various methods that can be used are designed to reduce the threat to domestic producers
from other firms operating in the world economy.
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🔗 Time: time is a key concept in relation to protectionism because some tools of protection, such
as a quota or an embargo, could take effect immediately if required, whereas other tools, such as
a subsidy, are likely to take a relatively longer period of time to have a significant impact on trade.

The different tools of protection and their impact

A number of different methods can be used to protect domestic industries:

Tool of protection Impact

Tariffs These are taxes that are imposed on imported
products; the effect is to make the imported
products more expensive than they would
otherwise be and this should lead to a reduction
in the demand for them, although the relative
size of the actual effect will depend on the
price elasticity of demand for the imported
product.

Import duties These operate in the same way as tariffs,

raising the price of imported goods and so
making them less likely to be demanded
compared with alternative products produced in
the domestic economy.

Import quotas These are restrictions on the number or value of

goods that can be imported, or the proportion of
market share that they represent; the effect is to
reduce the amount of imports purchased by
domestic consumers and firms.

Subsidies These are payments by a government to a

domestic firm to help it keep down the costs of
production; the effect is that, if the lower cost is
passed on to consumers in the form of
lower prices, domestic goods will be more
competitively priced compared to imports, and
demand for them is likely to increase.

Export subsidies These are payments by a government to a

domestic firm to help it keep down the costs
of production of the products that it is intending
to export; this is likely to increase the demand
for the country’s exports, if the demand for them
is price elastic.

Exchange controls These are restrictions on the buying and selling

of foreign currency; the effect is to make it more
difficult to finance the purchase of imported
products.

Embargoes These are complete bans on certain imported

products, a decision that is usually taken for
political, rather than economic, reasons; the
effect is to make it impossible to purchase
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imported products from particular countries.

Excessive administrative This is where paperwork or ‘red tape’ is made

burdens more difficult; the effect is to make it much
more difficult to get the imported products into
the country.
Voluntary export In some situations, one country might be fearful
restraints (VERs) that another country to which it is
exporting may decide to impose protectionist
barriers on that trade, which could have
dramatic consequences for the exporting
country’s economy. To reduce the likelihood of
such import controls being established, the
exporting country could establish a voluntary
export restraint or restriction, limiting the
amount that it will export. The importing
country may then decide against imposing
import controls on the exporting country.

• tariff: a tax that is imposed on an imported product to make it more expensive, in the hope
that this will reduce demand for the product
• import duty: a duty that is imposed on an imported product to make it more expensive, in
the hope that this will reduce demand for the product
• quota: a limit on the imported products that are allowed to enter a country; a quota can
take the form of a limited quantity, a limited value or a limited market share
• export subsidy: a payment by a government to a domestic firm to help it keep down the
costs of production of the products that it is intending to export, and thereby to increase
demand for exports
• exchange controls: restrictions on the buying and selling of foreign currency, which make
it more difficult to finance the purchase of imported products
• embargo: a ban on imports from particular countries, applied either to particular products
or to all products from particular countries, usually for political, diplomatic or military
reasons
• voluntary export restraint (VER): a decision, taken by an exporting country, to restrict its
exports voluntarily in the hope that a country that it exports to will decide against imposing
import controls

🔗 It is important that candidates can distinguish between a tariff and a quota as these two forms
of trade protection are often confused in examination answers. A tariff refers to a tax or duty that is
placed on an imported good. A quota is a restriction on the import of certain products, by quantity,
value or market share.

The arguments for and against protectionism

The arguments for protectionism The arguments against

protectionism
• Infant industry argument: infant or • Trade diversion: when trade barriers are
sunrise industries need protection, at least established, it can lead to trade diversion and
as a temporary measure, to allow firms to be a certain amount of trade will be lost.
strong enough to compete with already
established firms.
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• Inefficiency: protectionism can encourage

• Declining or sunset industries: these industries to remain inefficient because they
industries need to be protected, at least are protected from tough foreign competition,
temporarily, to give time for the factors of so there is an inefficient allocation of
production to be transferred to alternative resources.
uses.

• Strategic industries: these industries, • Monopolies: protectionism can allow

such as weapons production, may need to monopolies to be created as foreign
be protected because otherwise a country competition is reduced or eliminated.
may be vulnerable to attack by an enemy.
• Distortion of markets: protectionism
• Anti-dumping measure: firms that sell involves a deadweight loss of consumer
products that have been imported into a surplus and producer surplus, reducing
country may sell them not only cheaply to economic welfare through higher prices and
establish a market foothold, but at a price restricted consumer choice.
that is actually below the cost of production;
this is known as dumping and a country may
decide to use protectionist methods to • Reduced world output: trade barriers
protect itself from such dumping. reduce world production.
• Reducing a current account deficit: a • Quality of products: protectionist barriers
country may be experiencing a balance of encourage consumers to buy domestically
payments deficit on current account (e.g. the produced goods, but these may be of inferior
value of its imports may exceed the value of quality.
its exports), and protectionism may be
employed to try to overcome this deficit by
restricting the imports coming into the
country, although such a policy will not
overcome the underlying reasons for the
deficit.

• Raising revenue: some protectionist

methods, such as tariffs, raise revenue and
so a government may use them for this
reason.

• infant industry argument: the idea that a newly established industry should be given time
to establish itself; it will, therefore, need to be protected, at least temporarily
• sunrise industries: industries that are new, or relatively new, and which are growing fast; it
is expected that they will become very important in the future
• sunset industries: industries that have passed their peak and are now in decline, with no
realistic hope of recovery
• dumping: the practice of selling a product at a price that is less than the cost of production

Protectionism can reduce the potential benefits of free trade and this is why it is strongly
discouraged by the World Trade Organization.

🔗 Candidates often state that dumping is where a product is sold cheaply to gain access to a
market. Where a product is sold at a price that is cheaper than that charged by domestic
producers, this does not mean that it is an example of dumping. For dumping to take place, the
product has to be sold at a price that fails to cover the marginal cost of production.
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KEY SKILL

Evaluation: you should be able to evaluate the relative arguments for and against protectionism
and come to a judgement as to whether it is an appropriate policy for a country to adopt.

6.3 Current account of the balance of payments

The components of the current account of the balance of payments

The current account of the balance of payments is made up of the following four parts:

» Trade in goods — this is the balance of trade in goods account, i.e. of exports and imports
of goods (sometimes called ‘the visible trade balance’).
» Trade in services — this is the balance of trade in services account, i.e. of exported services
and imported services (sometimes called ‘the invisible trade balance’).
» Primary income — this refers to net income flows, such as net investment income (e.g.
dividends and interest).
» Secondary income — this refers to net current transfers (e.g. transfers of money by
governments and individuals); in the case of governments, this could relate to international aid or
contributions to international organisations, while in the case of individuals, it could relate to gifts
or charitable donations.

• current account of the balance of payments: this comprises trade in goods, trade in
services, primary income and secondary income
• balance of trade in goods account: the trade in goods (e.g. cars) between countries
• exports: goods and/or services that are produced domestically in one country and sold to
other countries
• imports: goods and/or services that are produced in foreign countries and consumed by
people in the domestic economy
• balance of trade in services account: the trade in services (e.g. banking) between
countries
• primary income: the net flows of profits, interest and dividends from investments in other
countries
• net investment income: the net income that relates to investments (e.g. dividends on
shares or interest payments)
• secondary income: net payments where there is no exchange of a product, including
government transfers of income and transfers of income by private individuals
• current transfers: the net payments by governments and private individuals (e.g. grants
for overseas aid or charitable donations)

🔗 It is important that candidates demonstrate an awareness of the four elements of the current
account of the balance of payments in their examination answers. Such knowledge would be
particularly useful in relation to multiple choice questions.

The definition of equilibrium and disequilibrium in the current account of the balance of
payments

deficit: a negative balance in the current account of the balance of payments when expenditure
exceeds income
surplus: a positive balance in the current account of the balance of payments when income
exceeds expenditure
external balance: the balance between receipts and payments in relation to international
transactions between one country and other countries in the world
 84

Equilibrium in the current account of the balance of payments refers to a situation where a country
is experiencing neither a deficit nor a surplus over a period of time in its current account.

Disequilibrium in the current account of the balance of payments refers to a situation where a
country is experiencing a deficit or surplus over a period of time in its current account.

» A deficit in the current account means that the money going out of a country through the current
account is greater than the money coming into the country.
» A surplus in the current account means that the money coming into a country through the
current account is greater than the money going out of the country.

The term ‘deficit’ or ‘surplus’ is therefore said to refer to the external balance of a country.

The calculation of the current account balance

The balance of trade in goods

The balance of trade was defined earlier as the difference in value of exports and
imports of goods (sometimes called ‘visibles’) over a given period.

An example of a calculation is:

Value of exports US$440 billion

Value of imports −US$620 billion
Balance of trade in goods −US$180 billion

The balance of trade in services

The balance of trade in services was defined earlier as the difference in value of exported services
and imported services (sometimes called ‘invisible inflows and invisible outflows’) over a given
period.

An example of a calculation is:

Value of exported services US$550 billion

Value of imported services −US$470 billion
Balance of trade in services US$80 billion

The balance of trade in goods and services

The balance of trade in goods and services is the sum of the balance of trade in
goods and the balance of trade in services.
An example of a calculation is:
Balance of trade in goods −US$180 billion
Balance of trade in services US$80 billion
Balance of trade in goods and services −US$100 billion

The current account balance

The current account balance (CAB) was defined earlier as the sum of the balance of trade in
goods, the balance of trade in services, the primary income and the secondary income.

An example of a calculation is:

Balance of trade in goods −US$180 billion

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Balance of trade in services US$80 billion

Primary income US$300 billion
Secondary income −US$50 billion
Current account balance US$150 billion

KEY SKILL

Numerical skills: you need to be able to calculate the current account balance from the balances
that are included in it.

The causes of imbalances in the current account of the balance of payments

There are a number of reasons why a country might be experiencing a persistent imbalance or
disequilibrium in the current account of the balance of payments.

Deficit

marginal propensity to import: the proportion of an increase in income that is spent on imported
goods and services

In relation to a persistent deficit, possible reasons could include the following:

» The foreign exchange rate could be too high, causing exports to be more expensive than they
would otherwise be. If demand for these exports is price elastic, this could have a significant effect
on the current account of the balance of payments, contributing to a deficit in the current account.
» Consumers in a country could have begun to increase their demand for imported products —that
is, as incomes have risen, there has been an increase in the marginal propensity to import. This
could also lead to a deficit in the current account of the balance of payments
» There could be changes in consumer tastes and preferences within the country and/or abroad
which reduce the demand for a country’s exports and increase the demand for imports.
» Low competitive strength in world markets, perhaps as a result of relatively low levels of
productivity or low levels of spending on research and development, will adversely affect a
country’s exports.

Surplus

In relation to a persistent surplus, possible reasons could include the following:

» Technological changes in methods of production in domestic industries may lead to lower costs,
lower prices and an improvement in the quality of products.
» A tightening of import restrictions will make it more difficult to import products from other
countries.
» A relatively low level of inflation in an economy, which makes exports more price competitive in
world markets, may increase the demand for them.

🔗 The margin and decision making: the marginal propensity to import is another example of
the importance of the margin in relation to decision making.

🔗 In examination questions on imbalances in the current account of the balance of payments,

candidates tend to assume that the question is referring to a deficit, but disequilibrium can refer to
either a deficit or a surplus. It is possible for a country to experience a persistent surplus, as has
been the case with China.

The consequences of imbalances in the current account of the balance of payments

 86

Consequences of a persistent current account deficit for the domestic economy

» There will be an increase in unemployment if there has been a decrease in the demand for
exports and an increase in the demand for imports, creating a deficit in the current account.
» A persistent deficit in the current account could lead to a reduction in business confidence,
resulting in a fall in the level of investment in the domestic economy.
» If corrective action is taken in an attempt to reduce, and hopefully eliminate, the deficit,
consumers will either have a restricted range of imported products to choose from (if quotas have
been introduced) or have to pay more for the imported products (if tariffs have been introduced).
» This increase in prices could have an inflationary effect on the economy.
» A current account deficit may lead to a depreciation in the value of a country’s exchange rate,
although this would help to restore a country’s competitiveness in world markets.
» A deficit may be caused by short-term consumption rather than long-term investment, although a
deficit can enable an economy to have a higher standard of living.

Consequences of a persistent current account surplus for the domestic economy

» It increases a country’s net assets by the amount of the surplus.

» A relatively high level of exports could lead to an increase in employment in the export sector of
the domestic economy.
» Lower import spending may mean consumers are spending more on domestic products rather
than buying foreign ones, and this greater demand for domestic goods could increase domestic
employment.

Consequences of a disequilibrium in the current account for the external economy

» If the disequilibrium is a deficit, there is likely to be a move towards greater protectionism in the
international economy, reducing the extent of the benefits that would otherwise have been
obtained from trade.
» If the disequilibrium is a surplus, a country will be able to accumulate foreign assets (e.g. China’s
investment in many African countries).
» It could cause less output and less employment in those countries experiencing a deficit in their
current account balance.

KEY SKILL

Analysis: it is important to be able to analyse the consequences of imbalances in the current

account of the balance of payments in terms of both the domestic and external economy and in
terms of both a deficit and a surplus. For example, there are potential issues involved in a country
experiencing a persistent surplus in the current account of the balance of payments, such as the
fact that one country’s surplus is another country’s deficit, and the country experiencing the deficit
could introduce protectionist measures that could have damaging effects on international trade.

6.4 Exchange rates

The definition of exchange rate

exchange rate: the value of one currency in terms of another

An exchange rate refers to the value of one currency in relation to another. It is the price of one
particular currency expressed in terms of another.

The determination of a floating exchange rate

 87

• floating exchange rate: an exchange rate that is determined, like any other free market
price, by the market forces of demand and supply

There are a number of different systems in which

exchange rates can be determined. One such
mechanism is the floating exchange rate.

» A floating exchange rate is one that allows the value

of a currency to be determined by the forces of demand
and supply, just like the price of anything else in a free
market.
» The vertical axis shows the price of UK£ in US$ and
the horizontal axis shows the quantity of UK£. F6.2 price of sterling in US$

» Equilibrium is established where the demand and supply

curves intersect — that is, at a price of P and a quantity of Q.

🔗 Equilibrium and disequilibrium: in a floating exchange rate system, the price or exchange
rate of a currency in terms of another currency will be determined by the equilibrium position,
where the demand for the currency is equal to the supply.

KEY SKILL

Evaluation: you need to be able to compare and contrast the various advantages and
disadvantages of a floating exchange rate and come to a judgement about such an exchange rate
in particular circumstances.

The advantages and disadvantages of a floating exchange rate

Advantages Disadvantages

• There is no need for a central bank to hold • Speculation, where buyers believe an
foreign currency reserves to use to intervene exchange rate is wrongly valued and so buy or
to maintain a particular exchange rate. sell currency with the aim of making a profit,
may affect the value of the exchange rate.
• The value of an exchange rate will be an
accurate price, determined by the demand • A floating exchange rate may be volatile,
for, and the supply of, the currency (i.e. the making economic planning and forecasting
value adjusts automatically). more difficult; this causes instability, which can
discourage investment and trade.
• Changes in the exchange rate will reflect,
and put right, disequilibrium in the balance of • A significant fall in the exchange rate can be
payments. For example, when there is a a major cause of a rise in the rate of inflation.
deficit, the exchange rate will depreciate,
which should encourage exports and
discourage imports.

• A floating exchange rate means that

interest rates can be set to meet domestic
economic aims rather than to maintain a
particular exchange rate value.
 88

The distinction between a depreciation and an appreciation of a floating exchange rate

• depreciation: a fall in the value of a floating exchange rate

• appreciation: a rise in the value of a floating exchange rate

It is important to distinguish between a depreciation and an appreciation of a floating exchange

rate:

» Depreciation describes the situation when the value of a floating exchange rate goes down.
» Appreciation describes the situation when the value of a floating exchange rate goes up.

Causes of changes in a floating exchange rate

Changes in a country’s floating exchange rate can be caused by a number of factors, including:

» the demand for the country’s exports from other countries

» the demand for imports into the country
» inflation rates in different countries affecting international competitiveness
» perceptions of quality/reliability in relation to both exports and imports
» changes in interest rates in different countries, affecting movements of ‘hot money’
» changes in average costs of production in various countries, affecting the relative level of
competitiveness
» differences in the changes in relative technology between countries
» trends in tourism
» changes in levels of confidence in the economies of different countries and/or the possibility of
speculation
» changes in a country’s current account balance
» changes in the economic growth rates of different countries

AD/AS analysis of the impact of exchange rate changes

AD/AS analysis can be used to assess the impact of changes in the exchange rate on the
domestic economy’s equilibrium national income in relation to:

» the level of real output

» the price level
» the employment level

A country’s exchange rate could be depreciated in order to encourage an increase in exports

and/or a decrease in imports. Aggregate demand is made up of consumption (C), investment (I),
government expenditure (G) and net exports (X − M). An increase in net exports, therefore, will
lead to an increase in aggregate demand.

» In Chapter 4, section 4.3, it was pointed out that if there is an increase in aggregate demand, the
AD curve will shift to the right.
» This can be seen in Figure 4.3 on page 67, where there is a shift in the aggregate demand curve
from AD0 to AD1. This results in an increase in the level of real output and employment (from Y0
to Y1) and an increase in the price level (from P0 to P1).
» This effect, however, may not happen immediately. The reason for this is that buyers take time
to adjust to price changes. A lower price for exports and a higher price for imports may have an
effect on the level of aggregate demand over time, but the expected changes will not happen
immediately.
» The depreciation may eventually have a positive effect on the external economy, if the purchase
of exports is encouraged, but the eventual effect on the domestic economy may be negative
because the cost of imported raw materials and component parts will have increased.
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Another factor to take into account when assessing the effect of a change in the exchange rate on
the domestic economy is in relation to the price elasticity of demand. A depreciation will make
exports cheaper and imports dearer, but the ultimate effect of these price changes will depend on
the price elasticity of demand for both the exports and the imports. If a depreciation is to be
successful in terms of improving the current account of the balance of payments situation, the sum
of the price elasticity of demand for exports and the price elasticity of demand for imports will need
to be greater than 1.

🔗 Equilibrium and disequilibrium: AD/AS analysis can be used to assess the impact of
exchange rate changes on a domestic economy’s equilibrium national income.

6.5 Policies to correct imbalances in the current account of the balance of

payments

Government policy objective of stability of the current account

» Three macroeconomic objectives of a government were identified in Chapter 5.

» It is now possible to add a fourth objective: the achievement of stability of the current account of
the balance of payments over a period of time.
» The aim is for an equilibrium over time in this account so that deficits and surpluses in the
current account of the balance of payments are approximately equal.
» However, such stability may not be possible, so a government may need to take action to correct
an imbalance or disequilibrium in the current account, whether that is a deficit or a surplus.

The effect of fiscal, monetary, supply-side and protectionist policies on the current account

Correcting a persistent current account deficit

Disequilibrium in the current account of the balance of payments can come about through a
persistent deficit. Government economic policies can be used to tackle this.

Fiscal policy

Deflationary fiscal policy (e.g. through an increase in taxation and/or a reduction in government
expenditure) will create a downward multiplier effect in the economy, bringing down the level of
aggregate demand. This is likely to reduce expenditure on imports.

Monetary policy

A deflationary monetary policy (e.g. through an increase in interest rates and/or a reduction in the
money supply) is likely to reduce expenditure on imports. A government could also depreciate the
exchange rate, making exports more competitive in world markets and imports less competitive in
the domestic market.

Supply-side policy

Economists are agreed that the main way to reduce or eliminate a balance of payments deficit is
to improve the quality of the goods produced in an economy, so that more people will buy them,
both within the domestic market and abroad, and also to lower the price. Many economies have
adopted a variety of supply-side policies to improve the competitiveness of their products. For
example, privatisation and deregulation will increase competition in markets and make domestic
firms more efficient, improving quality and lowering costs. Increased government spending on
training and education could also lead to an increase in exports, reducing a current account deficit.

Protectionist policies
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If a country is experiencing a deficit on the current account, protectionist policies can be used to
reduce the value of imports entering a country. They can include:

» Tariffs
» Import quotas
» Export subsidies
» Embargoes
» Excessive administrative burdens (‘red tape’)

The main problem associated with such protectionist policies is that they involve restraints on free
trade and are therefore generally opposed by the World Trade Organization.

Correcting a persistent current account surplus

Disequilibrium in the current account of the balance of payments can also come about through a
persistent surplus. The following policy measures could be adopted.

Fiscal policy

If a country is experiencing a surplus in the current account, the government could reduce income
tax, which would increase disposable income. This is likely to increase expenditure on imports and
this would reduce the size of the surplus in the current account.

Monetary policy

The government could tackle the surplus by increasing the growth of the money supply and/or
decreasing interest rates. This is likely to increase expenditure on imports. It could also appreciate
the exchange rate, making exports less competitive in world markets and imports more
competitive in the domestic market. These measures are likely to reduce the size of the surplus in
the current account, possibly eliminating it altogether.

Reduced protectionism

If protectionist methods are reduced or eliminated entirely, this is likely to increase expenditure on
imports and this will reduce the size of the surplus in the current account.
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A level:
7 The price system and the microeconomy

7.1 Utility

The definition and calculation of total utility and marginal utility

• total utility: the total amount of satisfaction obtained from the purchase of a number of
units of a product
• marginal utility: the increase in utility that a consumer gains from the consumption of an
extra unit of a product

The term ‘utility’ refers to the satisfaction that is derived from the consumption of a particular
product. It is possible to distinguish between total utility and marginal utility:

» Total utility is the total satisfaction obtained from the consumption of a given number of units of
a particular product. It is calculated by adding together all the utility or satisfaction derived from the
consumption of a given number of goods or services. The formula is:

TU = U1 + MU2 + MU3 etc.

It is therefore the utility gained from the first unit plus the marginal utility gained from the second
unit plus the marginal utility gained from the third unit and so on.

» Marginal utility is the increase in utility that a consumer gains from consuming an additional unit
of a product. It is calculated by measuring the increase that a consumer gains from consuming an
extra unit of a good or service. The formula is the difference in the total utility divided by the
number of goods or services.

Diminishing marginal utility

• diminishing marginal utility: the principle that the marginal utility of consuming
successive units of the same product will fall

» The law or principle of diminishing marginal utility states that the consumption of successive
units of a product will eventually lead to a fall in marginal utility — that is, as a person consumes
more units of a product, the satisfaction provided by each unit will be progressively less and less.
» The impact of diminishing marginal utility on total utility is that total utility will also start declining.
» Maximum total utility is achieved when marginal utility is zero because if marginal utility is zero,
this adds nothing to total utility.

The equi-marginal principle

equi-marginal principle: a consumer will maximise total satisfaction by equating the utility or
satisfaction per unit of money spent on the marginal unit of each product consumed

The equi-marginal principle is an example of consumer microeconomic equilibrium and shows

the relationship between the marginal utility obtained from the consumption of different products
and the prices paid for those products. It can be represented in the following way:

𝐌𝐔𝐚 𝐌𝐔𝐛 𝐌𝐔𝐜

= =
𝐏𝐚 𝐏𝐛 𝐏𝐜
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To maximise their utility or satisfaction, it is assumed that consumers will consume up to the point
shown above — that is, the extra satisfaction, in relation to the money spent, on the last unit of
product A will equal the extra satisfaction, in relation to the money spent, on the last unit of product
B and so on.

🔗 The margin and decision making: the importance of the margin as a key concept in
economics can be clearly seen in relation to diminishing marginal utility and the equi-marginal
principle. This is because a consumer will be in equilibrium, assuming a given level of income,
when it is not possible to switch expenditure from one product to another to increase total utility.

The derivation of an individual demand schedule

There is a relationship between the law of diminishing marginal utility and the derivation of an
individual demand schedule and curve. If the marginal utility of consuming an extra item of a
product continually falls, a consumer will be unwilling to pay as much for each successive unit
consumed. This explains why a demand curve is downward sloping from left to right, showing that
there is a relationship between changes in price and changes in the quantity demanded.

The limitations of marginal utility theory and its assumptions of rational behaviour

The law of diminishing marginal utility is based on a number of assumptions, and if these
assumptions do not apply, there are clear limitations to the theory.

The assumptions include the following:

» The idea of utility or satisfaction that a consumer gains from the consumption of particular items
of a product — but this assumes that satisfaction can be easily measured. Utils are a rather
abstract unit of measurement.
» The idea that consumers behave in a rational way — but is this always the case? Advertising
can impact on consumer behaviour and distort consumer choices, so that consumers do not act in
a rational way.
» The idea that consumers have limited incomes — but it is possible that incomes will rise
significantly over a period of time (although incomes would still be limited at any particular time).
» The idea that consumers aim to maximise their total utility — but is this always going to be the
case? For example, behavioural economics suggests that consumers may act on the basis of
impulse or emotion and not on the basis of utility maximisation.
» The idea that prices are constant — but it may be the case that the prices of products are
continually changing.
» The idea that consumer tastes and preferences remain constant — but this may not always be
the case.

KEY SKILLS

Evaluation: you need to be able to criticise the validity and usefulness of the theory of marginal
utility.

Analysis: you need to be able to critically analyse marginal utility theory and its assumptions of
rational behaviour, demonstrating an understanding of its limitations — for example, in analysing
the differences between rational behaviour and the ideas of behavioural economists.

Paradox of value

• paradox of value: the fact that certain products that are essential to survival (e.g. water)
are cheaper than products that are less important to survival (e.g. diamonds)
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• behavioural economics: an approach to decision making which argues that the behaviour
of individuals is often based on ideas that do not correspond to the traditional view of
rational economic behaviour

» Certain products that are vital to our survival, such as water, are not as expensive as products
that are less crucial, such as diamonds. This is known as the paradox of value.
» The explanation of this paradox can be seen in terms of marginal utility and total utility.
» For example, people will consume water up to the point where marginal utility is zero and total
utility is maximised, whereas they will demand diamonds where marginal utility is high, but total
utility is low.

🔗 Candidates need to show they understand why diamonds are more expensive than water,
illustrating the concept of paradox of value. Water is generally abundant and so its marginal utility,
and therefore its price, is relatively low.

Rational behaviour versus behavioural economic model

A major assumption that underpins marginal utility theory is that consumers can always be
expected to act rationally.

Rational behaviour essentially means the following:

» Individuals will take decisions to maximise their own utility or satisfaction.

» Individuals have access to all the information that they need to make a decision at zero cost.
» Individuals take decisions that are based on a very careful comparison of the benefits and costs
to achieve the optimum outcome.
» Decisions will be taken by individuals based on changes at the margin.
» The preferences of individuals and their attitude to risk are assumed to be fixed.

Behavioural economics, on the other hand, stresses that the behaviour of individuals may differ
greatly from these assumptions — in other words, it often appears to be ‘irrational’ rather than
rational.

Behavioural economics attempts to explain such behaviour. It is not limited to economics, but
brings in concepts and theories from sociology and psychology.

It is assumed that individuals take optimal decisions based on the information that is available to
them, but behavioural economics stresses that rational behaviour should not always be expected:

» Behavioural economists suggest that there may be so much information available that
individuals often take the same decision that they always have — that is, they often base
decisions on past experience.
» In this sense, individuals are ‘creatures of habit’ and are strongly influenced by brands and the
uses made of branding in marketing.
» The individual’s ability, and indeed willingness, to act in a rational manner is therefore restricted
in certain ways.

🔗 Candidates need to show they understand that behavioural economics suggests that
individuals may take decisions for reasons other than those that traditional economics has
stressed are rational.

KEY SKILL
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Evaluation: you need to be able to consider to what extent consumers act in a rational way when
taking decisions about expenditure, and are thus able to maximise their consumer welfare and
reach consumer equilibrium as predicted by marginal utility theory.

7.2 Indifference curves and budget lines

The meaning of an indifference curve and a budget line

Indifference curve

• indifference curve: a curve showing all the possible combinations of two products
between which an individual consumer is indifferent

Consumer preferences can be represented by an indifference F7.1 An indifference curve

curve. An indifference curve shows all the possible combinations of
two products between which a consumer is indifferent —that is, the
various combinations that provide equal satisfaction or utility.

» The indifference curve slopes downwards from left to right.

» It is convex to the origin.
» No two indifference curves can ever intersect.
» The slope of an indifference curve shows the marginal rate of
substitution — that is, the number of one good that an individual is
prepared to give up in order to obtain additional items of the other
good.

🔗 The margin and decision making: the slope of an indifference curve shows the marginal rate
of substitution — that is, the number of one good an individual is prepared to give up in order to
obtain additional items of the other good.

KEY SKILL

Diagrams: in drawing indifference curves, it must be remembered that no two indifference curves
can ever intersect.

Budget line

budget line: a line showing all the possible combinations of two products that a consumer would
be able to purchase with fixed prices and a given income; sometimes known as a ‘consumption
possibility line’
F7.2 A budget line

A budget line shows how consumers are constrained in terms of

what they are able to buy as a result of their limited income and the
prices of the goods and services.

A budget line has the following characteristics:

» It shows the possible combinations of two products that a consumer

is able to purchase with a given income and fixed prices.
» Each of the combinations would cost the same total amount.
» Any point along the line will show the maximisation of consumption at the given income level.

Figure 7.2 shows all the combination of products A and B that can be purchased by a consumer,
assuming that the income of the consumer and the prices of the products remain fixed.
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The causes of a shift in the budget line

Figure 7.2 assumes that the income of the consumer and the prices of the products remain fixed.
However, shifts in the budget line can occur because of changes in income and changes in price:

» Change in income: if there is an increase in income (assuming ceteris paribus), a consumer will
be able to spend more on both products. If the prices of the two products remain unchanged, the
budget line will shift outwards parallel to the original budget line.
» Change in price: if there is a change in the price (assuming ceteris paribus) of one of the
products, the budget line will not shift parallel to the right, but will pivot. For example, if the price of
product A remains the same, but the price of product B falls, then a consumer will buy the same
amount of product A, but more of product B.

🔗 You need to understand the difference between a parallel shift and a pivot of a budget line. If
the prices of the two products remain the same, the budget line will shift parallel to the original
budget line. However, if there is a change in the price of one of the products, the budget line will
pivot. Also, you need to consider relative prices; if the price of A and the price of B fall, but by
different percentages, the slope of the budget line will also change.

The income, substitution and price effects for normal, inferior and Giffen goods

Price effect

• price effect: the effect on the consumption of a product that occurs as a result of a price
change

A price effect refers to a change in the consumption of a product as a result of a change in its
price. A change in the price of a product can actually bring about two effects:

» an income effect
» a substitution effect

Income effect

• income effect: the effect on consumption of a change in real income that occurs as a result
of a price change

An income effect refers to the situation where a change in the price of a product will bring about a
change in real income. Although there is no change in nominal income, a rise or fall in the price of
a product will have a real income effect — a person will be able to buy more or less of a product,
and other products, as a result of the change in price of the product.
Substitution effect

substitution effect: the effect of a rise or fall in the price of a product on the utility or satisfaction
obtained from each unit of money spent on that product; as a result of the price change,
expenditure can be rearranged to maximise the utility or satisfaction gained

The second effect of a change in the price of a product relates to the utility or satisfaction obtained
from the consumption of a product. A substitution effect means that a rational consumer will
substitute in favour of a product that has now become relatively cheaper.

Normal, inferior and Giffen goods

• Giffen good: a good where a higher price causes an increase in demand, reversing the
usual law of demand
 96

It is important to understand how the price effect can apply to normal, inferior and Giffen goods:

» Normal good: with a normal good, if its price falls, the substitution and income effects work in
the same direction — there will be increased consumption of the good.
» Inferior good: with an inferior good, if its price falls, the substitution and income effects work in
opposite directions. However, there will be increased consumption of the good because the
substitution effect is greater than the income effect, leading to an overall positive price effect.
» Giffen good: with a Giffen good, a product for which demand increases as the price increases
and demand decreases as the price decreases, if its price falls, the substitution and income effects
work in opposite directions. However, there will be reduced consumption of the good because the
income effect is greater than the substitution effect.

🔗 It is important to remember that the income effect can be positive or negative and this is what
determines whether a good is a normal good or an inferior good.

KEY SKILL

Application: A Giffen good is a good for which demand rises as its price rises, thus contradicting
the law of demand. It is named after the Scottish economist, Sir Robert Giffen (1837–1910), who
observed poor people buying more bread as its price rose. Whereas the demand for a normal
good falls as its price rises, the demand for a Giffen good rises as its price rises, such as with
basic foods like rice and wheat.

Limitations of the model of indifference curves

There are a number of limitations of the model of indifference curves, including the following:

» It oversimplifies the situation in relation to consumer behaviour and consumer choices, as

indifference curve analysis is based on a two-product model.
» It makes unrealistic assumptions about human behaviour, assuming that consumer behaviour is
always rational.
» It is incompatible with the reality of economic action, which demonstrates preference rather than
indifference.
» Consumer preferences may change in time, making specific indifference curves less relevant.

KEY SKILL

Analysis: you need to be able to judge the strengths and weaknesses of the various limitations of
the model of indifference curves.

7.3 Efficiency and market failure

• efficient resource allocation: the optimal use of scarce inputs to produce the largest
possible output

The term ‘efficiency’ generally means efficient resource allocation — using resources in the
most economical way possible, or making maximum use of the resources that are available. It can
also refer to the idea of obtaining the maximum output for given inputs.

The concept of economic efficiency can be divided into two types:

» Productive efficiency
» Allocative efficiency

Definitions of productive efficiency and allocative efficiency

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• productive efficiency: where a firm operates at the minimum of its average cost curve; or
where a whole economy is operating on its production possibility curve
• average cost: the total cost of employing all the factor inputs divided by the number of
units produced; also known as ‘average total cost’
• technical efficiency: where a firm produces the maximum output possible from given
inputs, shown by the lowest point on the lowest possible average cost curve
• cost efficiency: where a firm uses the most appropriate combination of inputs of factors of
production, given the relative costs of those factors
• allocative efficiency: a situation that describes the extent to which the allocation of
resources in an economy matches consumer preferences and P = MC

Productive efficiency

One way of measuring productive efficiency is in terms of the average cost (or average total
cost) of production. Productive efficiency can be defined as the
F7.3 Productive efficiency
minimum average cost at which output can be produced.

Productive efficiency involves two elements:

» Technical efficiency is where the best possible use is made of

the inputs, or factors of production, used in the production
process. This means that as much output as possible is produced
from given inputs.
» Cost efficiency relates to whether the best set of inputs has
been used in the production process; this will be influenced by
the relative costs of different inputs, such as labour and capital.

Allocative efficiency

The most efficient allocation of resources in an economy will be the one that fits the needs and
wants of consumers most closely. The more that firms in an economy can respond effectively to
changes in the demand of consumers, the closer the economy can get to a situation of allocative
efficiency.

The conditions for productive efficiency and allocative efficiency

Productive efficiency

As well as being seen in the micro context of a particular firm, the concept of productive efficiency
can be seen in the macro context of the whole economy, as shown in Figure 7.3.

» An economy can decide between the production of manufactured goods (shown on the vertical
axis) and the production of agricultural goods (shown on the horizontal axis). It shows the
combination of these two types of goods in an economy.
» Productive efficiency is not taking place at point A, inside the PPC, because by moving to a point
on the PPC it would be possible
for the economy to produce more of both goods.
» Any point on the PPC will indicate productive efficiency — points B and C are both productively
efficient.
» There is a trade-off between points on the PPC in relation to the production of manufactured
goods and the production of agricultural goods. For example, at point C, more manufactured
goods will be produced in the economy than at point B, but fewer agricultural goods will be
produced.
 98

» Both points B and C are productively efficient, but it is not possible to make a judgement as to
whether the society is better off at point B or C without knowing the preferences of the consumers
in the society. It is therefore necessary to consider another type of efficiency, allocative efficiency.

🔗 Productive efficiency has been defined as where a firm operates at the minimum of its average
cost curve, but this does not necessarily have to be at the minimum point of the long-run average
total cost curve. It can be at any point of production along that curve.

Allocative efficiency

» Allocative efficiency can be clearly seen in the relationship between price and marginal cost.
» The marginal cost of production is the cost of producing one more product.
» When this cost is equal to the price charged for the product, there is a situation of allocative
efficiency. This is because the value that is put on the resources used to produce the product by
the producer (MC) is equal to the value put on the product by the consumer (price). If a greater or
lesser amount of the product were produced, price and marginal cost would no longer be equal.

🔗 In a question on economic efficiency, it is important that both productive efficiency and

allocative efficiency are considered. This is because economic efficiency is defined as the
maximum number of goods and services that can be produced with a given amount of inputs, and
for this situation to exist, the scarce resources in an economy need to be both productively and
allocatively efficient.

🔗 The margin and decision making: another example of the importance of the concept of the
margin in economics is in relation to allocative efficiency, where decisions are taken in terms of
how scarce resources in an economy are used, and this is where price is equal to marginal cost.

Pareto optimality

Optimum resource allocation

• optimum resource allocation: the best allocation of resources possible in the situation of
scarcity

» The word ‘optimum’ means the best possible outcome in a given economic situation.
» Optimum resource allocation refers to a situation where the best possible allocation of scarce
resources exists. This is when both productive efficiency and allocative efficiency occur.
» The idea of an optimum, or optimality, is an important concept in economics, given that
resources are scarce; when resources are allocated in an optimum way, it means that they are
used in the most efficient way possible.

🔗 Scarcity and choice: the idea of optimal resource allocation is very important given that
resources are scarce. When choices are made so that these scarce resources are allocated in an
optimum way, the effect is that they are allocated in the most efficient way possible.

🔗 In examination questions on the concept of efficiency, candidates should ensure the idea of
optimality is included in their answer, emphasising that this means the best possible allocation of
scarce resources in a given situation.

The meaning of Pareto optimality

• Pareto optimality: a particular use of the term ‘optimality’ associated with the Italian
economist Vilfredo Pareto, who stated that this situation existed when it was not possible to
reallocate resources to make someone better off without making someone else worse off
 99

» Vilfredo Pareto (1848–1923), an Italian economist, argued that the best possible allocation of
scarce resources existed when it was impossible to make one person better off without making
another person worse off. This is known as Pareto optimality.
» In such a situation, there must be an optimal allocation of resources — that is, the inputs or
resources are used in the most efficient possible way (productive efficiency) and the output
produced by the resources provides the maximum possible utility or satisfaction to consumers
(allocative efficiency).
» An improvement in optimality can only occur when one person is made better off without making
anyone else worse off.
» It can be shown using a production possibility curve as all points on a PPC are Pareto optimal.

🔗 It is important that candidates can demonstrate they understand what is meant by Pareto
optimality — the idea that it is impossible to make one person better off without making another
person worse off.

The definition of dynamic efficiency

• dynamic efficiency: the greater efficiency that can result from improvements in technical
or productive efficiency over a period of time

Productive efficiency and allocative efficiency can both be considered as examples of static
efficiency. This means that they are concerned with the allocation of scarce resources at a
particular moment in time.

Dynamic efficiency, on the other hand, is concerned with changes in the allocation of scarce
resources over a period of time. It can be shown by the downward movement of the LRAC curve.
It can occur for a number of reasons:

» Product innovation: as a result of new products appearing through research and development,
invention and innovation.
» Process innovation: it is also possible for new methods of production to be introduced as a
result of developments in technology.
» New techniques of management: there could also be changes in techniques of management
as a result of investment in human capital.

🔗 It is important that candidates can demonstrate they understand the difference between static
efficiency, as in the case of productive and allocative efficiency, and dynamic efficiency, which
takes place over a period of time.

The definition of market failure

• market failure: a market imperfection which gives rise to an allocation of scarce resources
that is not as efficient as it might have otherwise been

Market failure can be defined as a market imperfection which gives rise to an allocation of scarce
resources that is not as efficient as it might have otherwise been. It therefore occurs when there is
an inefficient allocation of resources in a free market.

The main reasons for market failure:

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Type of market failure Explanation

Merit goods These are goods that are regarded as socially

desirable and that would be underproduced and
underconsumed in a free market.

Demerit goods These are goods that are regarded as socially

undesirable and that would be overproduced
and overconsumed in a free market.

Public goods These are non-rival and non-excludable goods

that would not be provided at all in a free market
because it would be impossible to charge a
price for them.

Externalities Externalities are costs and benefits that affect

third parties. Negative externalities may result
from the overproduction and/or
overconsumption of a good or service and
positive externalities may result from the
underproduction and/or underconsumption of a
good or service.

Information failure There may be a lack of full information to make

an informed decision, so the allocation of
resources may not be as efficient as it otherwise
would be. The existence of asymmetric
information is a particular form of market failure;
this exists when one party has much more
information than another party and uses that
information advantage to exploit the other party.

Imperfect competition This occurs when there is a departure from the

situation of perfect competition. There can be
different market imperfections and one of these
is the existence of monopolistic elements in an
economy, where one firm can have monopoly
power in a market.

Inequality in the distribution of income and A free market may lead to a very unequal
wealth distribution of income and wealth, giving some
people more influence in a market than others.

Factor immobility In a perfect market, the factors of production

would be able to move easily from one market
to another, but the existence of occupational
and geographical immobility of factors means
that this does not always happen.

Price instability This occurs where prices can change rapidly in

a short period of time. In some markets, there
can be a great deal of price instability,
especially in agricultural markets.
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🔗 Efficiency and inefficiency: you need to understand the importance of efficiency in relation to
the different types (i.e. productive efficiency, allocative efficiency and dynamic efficiency), and you
also need to be aware of the existence of inefficiency in relation to different examples of market
failure.

KEY SKILL

Application: you need to be able to apply the idea of market failure to a variety of different
situations, such as in relation to the non-existence of public goods, the under provision of merit
goods and the overprovision of demerit goods.

7.4 Private costs and benefits, externalities and social costs and benefits

The definition and calculation of social costs as the sum of private costs and external
costs, including marginal social costs, marginal private costs and marginal external costs

• social costs: the sum of private costs and external costs (i.e. the total cost to society of an
economic decision or activity)
• external costs: the negative effects imposed on third parties not involved in an economic
decision or activity and not compensated for

Social costs (SC) represent the true cost to society — in other words, they include not only
private costs (PC), but also the external costs (EC) imposed on the whole society as a result of
an economic activity.

🔗 Candidates need to demonstrate that they understand that social costs include both private
costs and external costs. A common mistake is to confuse social costs and external costs.

The definition and calculation of social benefits as the sum of private benefits and external
benefits, including marginal social benefits, marginal private benefits and marginal external
benefits

• social benefits: the sum of private benefits and external benefits (i.e. the total benefit to
society of an economic decision or activity)
• external benefits: the positive effects gained by third parties not involved in the economic
decision or activity and not paid for

Social benefits (SB) represent the true benefit of an economic activity to society — that is, they
include not only private benefits (PB), but also the external benefits (EB) that are advantageous
to the whole society as a result of an action. An example of an external benefit is the additional
income that is created in an area when a new business locates there. This will lead to an increase
in spending in the community.

🔗 Candidates need to demonstrate that they understand that social benefits include both private
benefits and external benefits. A common mistake is to confuse social benefits and external
benefits.

The definition of positive externality and negative externality

Externality

• externality: a cost or benefit of either consumption or production that is paid for or enjoyed
not by the consumer or the producer, but by a third party
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• third party: individuals or groups that are not the main parties in a transaction, but are still
affected by it
• spill over effect: the effect of certain decisions that have an impact on third parties (i.e.
those who are neither the producers nor the consumers of a particular product)

An externality has certain characteristics:

» It arises if a third party is affected by the actions and behaviour of others.

» A third party can be regarded as someone who is not directly involved in an economic activity.
» An externality can also be described as a situation where there is a spillover effect.
» An externality is external to a market transaction and so is not reflected in market prices.
» It can occur in relation to consumption or production.
» It is a form of market failure because if the cost or benefit is not reflected in market prices, it
cannot be taken into account by all the parties involved in a transaction; that is why the costs or
benefits that result from such a transaction affect a third party that is not directly involved in the
transaction.

🔗 Candidates need to understand what is meant by a ‘third party’ — that is, someone who is not
directly involved in the consumption and/or the production of a product. The third party, however,
can still be affected in different ways by consumption and/ or production decisions taken by others.
For example, in the case of passive smoking, a person who is not actually smoking a cigarette can
be badly affected by the actions of others around them. Similarly, in the case of drink-driving, a
motorist may be sober and driving very well, but may be involved in an accident as a result of the
poor driving of another motorist under the influence of alcohol.

Positive externality

• positive externality: the external benefit that may occur as a result of an action, bringing
some benefit to a third party

A positive externality refers to the benefit that can be gained by a third party — that is, someone
who is not directly involved in a transaction. A positive externality can be seen in relation to either
consumption or production.

Negative externality

• negative externality: the external cost that may occur as a result of an action, bringing
some disadvantage to a third party

A negative externality refers to the disadvantage that can affect a third party — that is, someone
who is not directly involved in a transaction. Like a positive externality, a negative externality can
be seen in relation to either consumption or production. For example, a third party might be
negatively affected by the consumption of a loud music system by a neighbour. In terms of
production, a third party might be negatively affected by pollution caused by a factory in the
neighbourhood.

Positive and negative externalities of both consumption and production

Positive consumption externalities

• positive consumption externality: a third-party effect that influences the consumption

side of a market in a positive or beneficial way
• welfare gain: a situation that arises when the marginal social benefit exceeds the marginal
social cost, leading to a socially efficient allocation of resources
 103

» A positive consumption externality is where there is a beneficial

spill over effect on a third party arising from the consumption of a
good or service — for example, the enjoyment provided by the
views of private gardens.
» This can be seen in Figure 7.4. MPB shows the marginal private
benefit, but MSB shows the marginal social benefit.
» The equilibrium which takes into account the marginal social
benefit and the marginal social cost (i.e. the socially optimum
equilibrium) would be at quantity Q*, a greater output than at Q
where only the marginal private benefit is being taken into account.
» The welfare gain, resulting from increasing output to the socially optimum F7.4 A positive
consumption externality
equilibrium, where MSC crosses MSB, rather than MPB,
is shown by the shaded triangle.

Positive production externalities

• positive production externality: a third party effect

that influences the production side of a market in a
positive or beneficial way

» A positive production externality is where there is a

beneficial spill over effect on a third party arising from the
production of a good or service.
» For example, if a firm purifies its waste water, this might be
beneficial to a local fish farm in the area.
» This can be seen in Figure 7.5. MPC shows a firm’s
marginal private cost, but MSC shows the marginal social cost, which F7.5 A positive
production externality
is lower than the MPC. The equilibrium taking account of the positive
production externality is at output Q*
where MSC = MSB (the socially optimum equilibrium).
This output at Q* is greater than at Q. The welfare gain resulting
from the extra output is shown by the shaded triangle.

Negative consumption externalities

• negative consumption externality: a third-party effect that influences the consumption

side of a market in a negative or disadvantageous way
• welfare loss: a situation that arises when the marginal social cost exceeds the marginal
social benefit, leading to a socially inefficient allocation of resources

» A negative consumption externality is where there is a negative spill over effect on a third
party arising from the consumption — for example, a person playing loud music
that irritates the neighbours living nearby.
» This can be seen in Figure 7.6. An individual’s appreciation of the
music is shown by the marginal private benefit, MPB, but the
negative effect on the neighbours means that the social marginal
benefit, MSB, is lower.
» The equilibrium position for the person playing the music is at Q,
where MPB and MSC cross, but the equilibrium position for the
whole community, taking into account the negative effect of the loud
music on the neighbours, is at Q* where MSC and MSB intersect
(the socially optimum equilibrium). The welfare loss of the
additional output is shown by the shaded triangle.
F7.6 A negative
consumption externality
 104

Negative production externalities

• negative production externality: an externality that affects the production side of a market
in a negative or disadvantageous way

» A negative production externality is where there is a

negative spillover effect on a third party arising from the
production of a good or service — for example, a factory
producing noise and/or air pollution.
» This can be seen in Figure 7.7. on the right. The marginal
private cost, MPC, only takes into account the cost of
production to the firm. The marginal social cost, MSC, takes
into account the full social costs of the production.
» For the firm, the equilibrium position would be at Q, but for F7.7 A negative
society as a whole the equilibrium position would be at Q* where production externality
MSC and MSB intersect (the socially optimum equilibrium).
If output was at Q rather than Q*, there would be a welfare loss shown by the shaded triangle.

🔗 the margin and decision making: the concept of the margin is very important in relation to
decisions that bring about externalities in terms of marginal private benefit, marginal social benefit,
marginal private cost and marginal social cost.

Deadweight welfare losses arising from positive and negative externalities

• deadweight loss: the loss of economic efficiency that occurs when the socially optimal
quantity of a product is not produced

» Deadweight loss is a measure of lost economic efficiency when the socially optimal quantity of
a product is not produced.
» Non-optimal production can be caused by a positive or a negative externality.
» Externalities bring about a deadweight loss as a result of the differences between marginal
social cost or benefit and marginal private cost or benefit.
» The deadweight loss, or welfare loss as it can also be called, is the decreased economic well-
being caused by the existence of negative externalities. It is shown by the shaded triangle in
Figure 7.6 (in the case of a negative consumption externality) and in Figure 7.7 (in the case of a
negative production externality).
» There can also be a welfare gain in relation to positive externalities. It is shown by the shaded
triangle in Figure 7.4 (in the case of a positive consumption externality) and in Figure 7.5 (in the
case of a positive production externality).

Asymmetric information and moral hazard

Asymmetric information

• Asymmetric information: a situation in which there is unequal knowledge between the

parties of a transaction, resulting in an advantage to the party with additional knowledge

Asymmetric information is a form of market failure that exists when one individual or party has
much more information than another individual or party and uses that information advantage to
exploit the other party. Information asymmetry therefore creates an imbalance of power — for
example, when the seller of a product, such as a used/second-hand car, knows more about the
good or service than the buyer.

Moral hazard
 105

• moral hazard: a situation in which a person takes a decision about how much risk to take
in the knowledge that someone else bears the cost of that risk

» Moral hazard occurs when someone increases their exposure to risk because someone else
bears the cost of those risks.
» It therefore refers to a situation where an individual has an incentive to alter their behaviour
when the potential risk is borne by others.
» For example, if a government promises to support businesses that are operating at a loss, such
as at a time of economic recession, it can encourage those businesses to take greater risks.
» Another example is in relation to insurance when a person is more willing to take a risk in the
knowledge that this will be covered by the insurance policy.

The use of costs and benefits in analysing decisions

• cost–benefit analysis: an analysis of a project which includes a valuation of the total costs
and total benefits involved, including private and external costs and private and external
benefits

Cost–benefit analysis provides a framework where all the costs and benefits of an investment
project can be analysed, not only private ones. It is a particular feature of major transportation
projects.

the four key stages of a cost–benefit analysis:

Stage Description

1 The identification of all the The first stage involves identifying all relevant costs and
relevant costs and benefits benefits: the private costs, the private benefits, the external
involved in the project costs and the external benefits.

2 Deciding the monetary value The second stage involves putting a monetary value on all of
of all the relevant costs and these costs and benefits, including those where a market
benefits involved in the project price can be established and those where a market price is
not easily established, such as placing a value on time.

3 The forecasting of the future The third stage involves forecasting the costs and benefits of
costs and benefits involved in an investment project into the future; this forecasting will be
the project based on estimates of future costs and benefits.

4 The interpretation of the The fourth stage involves the compilation of all the data
results of the cost–benefit obtained as a result of the cost–benefit analysis and using
analysis so that an appropriate them to ensure that the decision-making process is an
decision can be taken informed one.

The key features of cost–benefit analysis are as follows:

» It takes the full social costs and the full social benefits into account before a decision is made as
to whether a particular investment project should go ahead.
» It takes a wide view of a project, considering its full impact on an economy and society over a
period of time.
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🔗 In an answer to a question on cost–benefit analysis, candidates should emphasise that the

advantage of this approach is that it can take into account the full social costs and social benefits
involved in an investment project.

KEY SKILL

Application: cost–benefit analysis can be used whenever it is necessary to compare the

advantages and disadvantages of a project, such as the building of a road, an airport runway or a
railway line.

The problems facing the process of cost–benefit analysis:

Problem Explanation

Absence of market prices Cost–benefit analysis takes into account all

costs and benefits, but not all of these will
have a market price. For example, it is hard, if
not impossible, to establish the price of
pollution.

Need to use shadow prices In the absence of market prices, values will
need to be estimated through the use of
shadow prices (i.e. prices that are estimated
rather than accurately calculated), but this will
not always be accurate (e.g. the valuation of
time or an accident).

The future The costs and benefits of any project, such as

the building of a road or a runway, will be
spread over a long period of time, so it will be
difficult to compare the interests of present
and future generations.

Spillover effects It is recognised that a project will have

spillover effects, but it may be difficult to
establish what these are and how far they
extend. For example, the external costs of
pollution of building an airport are likely to be
concentrated around the airport, while the
benefits of building the airport can be more
widely dispersed, such as the benefits of
increased tourist flow.

Political versus economic decisions Cost–benefit analysis may produce a decision

in favour of a particular project, but it may still
be rejected because of political decisions.

🔗 Knowledge of net present value is not required in answers to questions on cost–benefit

analysis.

KEY SKILL

Application: there are many examples of investment projects that have used cost–benefit
analysis, including the Hong Kong to Macau Bridge in China, Bengaluru Airport in India, the
 107

London Underground Victoria Line in England, California High-Speed Rail in the USA and the
provision of solar power in China.

7.5 Types of cost, revenue and profit, short-run and long-run production

The short-run production function

Fixed and variable factors of production

• fixed factors of production: resource inputs that exist in the short run when the quantity of
the factors used cannot be changed (e.g. capital equipment)
• variable factors of production: resource inputs that can be varied in the short run (e.g.
raw materials), when at least one factor of production is fixed
• production function: the ratio of inputs to output over a given time period; it shows the
resources needed to produce a maximum level of output, assuming that the inputs are used
efficiently
• total product: the total output produced by the factors of production
• average product: the output per unit of the variable factor (e.g. output per worker per
period of time); also referred to as ‘productivity’
• marginal product: the additional output that is produced from employing another unit of a
variable factor (e.g. the extra output from employing an additional worker)

In the short-run period of the production process, there will be at least one fixed factor of
production or resource input. For example, it will be difficult to change the number of machines in
a factory in the short run.

It will be possible, however, to change the quantity of variable factors of production in the short
run. For example, it will be relatively easy to buy in more component parts and raw materials in the
short run.

The production function shows the relationship between inputs and output over a given time
period. It indicates how a given level of output is produced as a result of using the various factors
of production involved in the production process.

🔗 It is difficult to be precise about just how long a period of time the ‘short run’ is; it is simply
defined as a period of time when at least one factor of production is fixed.

🔗 Time: it is important to distinguish clearly between the short run and the long run-in relation to
the production process. The short run is the period of time when at least one factor of production is
fixed, whereas the long run is the period of time when all factors of production are variable.

The definition and calculation of total product, average product and marginal product

It is important to distinguish clearly between these three different types of product:

» Total product is the total output resulting from the use of the factors in the production process
over a period of time; it is calculated by adding together the total output produced by the factors of
production.
» Average product is the output per unit of the variable factor, such as the output per worker per
period of time. This is also known as ‘productivity’. It is calculated by dividing the total output by
the variable factor involved to give a per unit figure.
» Marginal product refers to the additional or extra output that is produced as a result of
employing one more variable factor (e.g. one more worker). It is calculated by dividing the extra
output from employing another unit of a variable factor by that variable factor.
 108

🔗 Questions on the different types of product can often feature in multiple-choice questions in
Papers 1 and 3, so it is important that you are able to distinguish clearly between them. For
example, the distinction between average and marginal data is very important.

🔗 The margin and decision making: the concept of the margin is important in terms of
distinguishing between marginal product, total product and average product. These concepts are
important in relation to how a firm makes its production decisions. Whereas total product refers to
the total output produced by a firm, average product refers to the output per variable factor (i.e. the
productivity of that factor), while marginal product refers to the extra output from employing
another unit of a variable factor, such as employing one additional worker.

The law of diminishing returns or law of variable proportions

• law of diminishing returns: as additional units of a variable factor (e.g. labour) are added
to a fixed factor (e.g. capital), the additional output (or marginal product) of the variable
factor will eventually diminish; also known as the ‘law of variable proportions’

» In the short run, the production process involves the combination of fixed and variable factors.
Additional units of a variable factor, such as labour, could be employed and combined with a fixed
factor of production, such as capital equipment.
» The law of diminishing returns states that, although the total output (or total product) is still
increasing, it will increase at a diminishing rate. This is because the extra output, resulting from the
employment of the additional worker, will eventually diminish.
» The law of diminishing returns is also known as the ‘law of variable proportions’.

🔗 It is important to remember that the law of diminishing returns is a concept used in analysing
the short run, when one factor of production (e.g. capital) remains fixed.

The short-run cost function

The definition and calculation of fixed costs and variable costs

fixed costs: the costs of production that remain constant at all levels of output, including zero
production (e.g. rent and interest payments)
variable costs: the costs of production that vary with changes in output; the cost is zero if nothing
is produced (e.g. the cost of raw materials and component parts)

» It has already been pointed out that it is important to be able to distinguish clearly between fixed
and variable factors of production. It is also important to distinguish between fixed and variable
costs of production.
» Variable costs are costs that vary with changes in output. If output is zero, there will be no need
to pay for raw materials or component parts, so these are examples of variable costs.
» On the other hand, even if output is zero, there will be some costs of production, such as the
cost of renting a factory or the interest payments on a loan. These are fixed costs, which remain
constant at all levels of output in the short run.

The definition and calculation of total, average and marginal costs

total cost: the sum of all costs incurred by a firm in producing a particular level of output
average cost: the total cost of employing all the factor inputs divided by the number of units
produced; also known as ‘average total cost’
marginal cost: the additional cost of producing an extra unit of a product
average fixed cost: the total fixed cost of production divided by the number of units produced
average variable cost: the total variable cost of production divided by the number of units
produced
 109

It is important to distinguish between these three different types of cost:

» Total cost is the sum of all costs resulting from the use of the factors in the production process.
» Average cost is the total cost of production divided by the number of units that are being
produced.
» Marginal cost is the addition to the total cost of producing one additional unit and can be
calculated by dividing the change in total cost by the change in output.

The short-run average cost curve

» Figure 7.8 shows a number of short-run average cost

(SRAC) curves. Each of these is U-shaped and shows the
relationship between output and cost on the basis that
capital is fixed in the short run.
» Each is U-shaped as a result of decreasing average fixed
cost and increasing average variable cost as output is
increased.
» If a firm wishes to change output, it will have to change the
amount of the variable factor being used, such as labour.
» The position of the average cost curves in the short run will F7.8 Short-run cost curves with
different levels of capital input
therefore depend on the quantity of capital being used in the
production process — in other words, there is a short-run average
cost curve for each quantity of capital used, such as SRAC1 and SRAC4.

The marginal cost curve

The marginal cost curve is U-shaped. This is because when a firm initially increases its output,
total costs, as well as variable costs, start to increase at a diminishing rate. At this stage, marginal
cost falls until it is at its minimum. Then, as output continues to rise, marginal cost increases.

🔗 It is important to understand that the marginal cost curve will always cross the average cost
curve at its lowest point. The reason for this is that when marginal cost is less than average cost,
average cost will be falling; when marginal cost is more than average cost, average cost will be
rising.

🔗 The margin and decision making: another example of the importance of the concept of the
margin can be seen in relation to the existence of marginal cost in the production process. The
concept of marginal cost is important in the theory of the firm because it helps the firm make its
production decisions. The marginal cost curve, above where it crosses the average variable cost
curve, is the firm’s supply curve in the short run.

The long-run production function

• returns to scale: the relationship between the level of output produced by a firm and the
quantity of inputs required to produce that output

There are two distinctive characteristics of the long-run production function:

» It takes into account the fact that all factors of production are variable in the long run — that is,
there are no fixed factors of production — unlike the situation with the short-run production
function.
» The relationship between a firm’s level of output and the quantity of units of factors of production
(factor inputs) needed to produce it can change in the long run. A business
can change its scale of production and, if there are:
 110

increasing returns to scale, then economies of scale are being experienced.

The long-run cost function

The explanation of the shape of the long-run average cost curve

Just as the short-run average cost curve (SRAC) is U- F7.9 Long-run average cost curve, showing
economies and diseconomies of scale
shaped, it is the same with the long-run average cost
(LRAC) curve. This can be seen in Figure 7.9. As output
increases, there is initially a decrease in the average cost of
production and this is shown by the falling part of the LRAC
curve. The curve reaches its minimum point at Q* and then
starts to rise again, indicating an increase in the average
costs of production.

The concept of the minimum efficient scale

• minimum efficient scale (MES): the lowest level of output where average cost is at the
minimum

The level of output where the LRAC is first at its lowest point is known as the minimum efficient
scale (MES) —in other words, achieving MES minimises long-run average total cost. It is the
minimum quantity of output at which internal economies of scale are fully exploited; no further
economies of scale can be achieved beyond this scale of operation.

The relationship between economies of scale and decreasing average costs

• economies of scale: the benefits gained from a fall in long-run average costs of production
as the scale of operations grows and the output of a firm increases

In Figure 7.9, the LRAC curve is falling up to a point when it is at its minimum. These decreasing
average costs of production resulting from an increase in output are known as economies of
scale. This process is also referred to as increasing returns to scale.

It is possible to distinguish between internal and external economies of scale.

Internal and external economies of scale

Internal economies of scale

• internal economies of scale: the advantages of a firm growing in size in the form of a
reduction in the average cost of production
• financial economies: a reduction in average cost as a result of a larger firm being able, for
example, to negotiate more favourable borrowing terms on a loan
• technical economies: a reduction in average cost as a result of the application of
advanced technology in a firm, which brings about a greater degree of efficiency
• economies of large dimensions: a reduction in average cost as a result of using larger
factors of production (e.g. larger containers in the transportation process)
• risk-bearing economies: by diversifying into different markets, the overall pattern of
demand is more predictable, so a firm can save on costs (e.g. by reducing the amount of
stocks held in reserve)
• diversification: where a firm decides to operate in a number of markets to spread risk

Decreasing average costs of production can come about as a result of a firm becoming larger.
There are various examples of these internal economies of scale:
 111

Type of Explanation
internal
economy
of scale

Financial Larger firms may be able to benefit from negotiating a loan at a lower rate of
interest than a smaller firm, mainly because financial institutions regard them
as less of a risk.

Purchasing Larger firms are often able to take advantage of their size by negotiating
favourable terms with suppliers as a result of bulk buying.

Managerial As a firm increases in size, its employment of managers does not usually need
to grow at the same rate, so the cost of management per unit of output is likely
to fall. Larger firms can also employ specialist managers and this is likely to
increase the efficiency of a firm.

Technical Economies of increased or large dimensions can come about more easily in a
large firm, reducing costs of production — for example, if a firm doubles the
size of containers that it uses, it is not likely to lead to a doubling of the cost.

Marketing A larger firm may be better able to negotiate a lower rate — for example, in
relation to buying advertising time on television.

Risk A larger firm is likely to be more diversified, spreading risks across a wider
bearing range of markets. This enables average costs to be reduced. For example,
diversification will lead to more stable and predictable demand, and this
means that a firm will not need to keep as much stock as before, reducing the
costs of stockholding.

KEY SKILL

Analysis: you need to be able to analyse the different ways in which a firm can benefit from the
existence of internal economies of scale — for example, the ability of a firm to benefit from a
higher return on capital investment and the possibility of an increase in profitability.

External economies of scale

• external economies of scale: when costs of production fall because of developments

outside a particular firm

The fall in the average costs of production of a firm can also be the result of external, rather than
purely internal, factors.

Examples of external economies of scale:

Type of external Explanation

economy of scale
 112

Concentration If a number of firms are located in a particular area, this may

encourage the development of specialist ancillary or support firms in
the area that supply component parts to the firms, reducing the
average costs of production.

Specialised labour A pool of specialised skilled labour may be available in a particular

area, which all firms in that industry in the area can benefit from.

Knowledge Firms in an industry may benefit from specialist research or

marketing agencies, and so be able to reduce the costs of acquiring
and using this information.

🔗 Candidates need to demonstrate they clearly understand the distinction between internal
economies of scale, which relate to a particular firm, and external economies of scale, which relate
to a much wider aspect, such as a whole industry.

KEY SKILL

Diagrams: whereas internal economies of scale involve a movement down along a long-run
average cost curve, external economies of scale will involve a downward shift of the whole long-
run average cost curve.

Returns to scale

• constant returns to scale: where average costs remain the same as the level of output
increases
• increasing returns to scale: where an increase in factors of production leads to a more
than proportionate increase in output
• decreasing returns to scale: where an increase in factors of production leads to a less
than proportionate increase in output

Constant returns to scale indicate a situation where average costs remain the same even as the
output produced increases. In this situation, a firm will add factors of production in the same
proportion so that there are constant additions to total output.

Increasing returns to scale indicate a situation in which output can be increased using a
proportionately smaller quantity of units (i.e. it refers to a change in output, not cost).

Decreasing returns to scale indicate a situation in which an increase in all factors of production
leads to a less than proportionate increase in output.

Internal and external diseconomies of scale

Diseconomies of scale

diseconomies of scale: where the same proportional increase in productive factors gives rise to
decreasing additions to total output; also known as ‘decreasing returns to scale’

the long-run average cost curve, after initially falling, begins to rise as output is increased beyond
Q*. This indicates that there are diseconomies of scale. As with economies of scale, it is
possible to distinguish between internal and external diseconomies of scale.

Internal diseconomies of scale

 113

• internal diseconomies of scale: the disadvantages of a firm growing in size, resulting in

an increase in the average cost of production

Increasing average costs of production can come about as a firm grows too large.
There are various examples of these internal diseconomies of scale:

Type of internal Explanation

diseconomy of
scale
Problems with There may be poorer communication in a large firm, which adversely
communication affects efficiency.
Problems with There may be lower levels of motivation in a large firm, with some
motivation employees feeling alienated. This may lead to a greater likelihood of
industrial disputes.

Problems with Problems of poor communication and low levels of motivation can
management lead to difficulties in managing a firm effectively.

Problems with Larger firms may become less flexible, making it more difficult to
flexibility respond to changing market conditions.

External diseconomies of scale

• external diseconomies of scale: when average costs of production rise because of the
growth of an industry

The rise in the average costs of production of a firm can also be the result of external, rather than
purely internal, factors.

Examples of external diseconomies of scale:

Type of Explanation
external
diseconomy
of scale

Competition for The increase in the size of firms, and indeed the whole industry, can lead
inputs to greater competition for a limited number of productive inputs and, as a
result, the cost of these inputs may increase. For example, there could be
an increase in the cost of labour or land.
Congestion If a number of firms tend to be located in a particular area, this can lead to
greater congestion, reducing the efficiency and effectiveness of the
transport system and leading to an increase in costs.

The definition and calculation of revenue: total, average and marginal revenue

• total revenue (TR): the total amount of income received from sales of a product, calculated
as the number of units sold multiplied by the price of each unit
• average revenue (AR): the total revenue obtained by a firm from sales divided by the
number of units sold
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• marginal revenue (MR): the extra revenue obtained by a firm from the sale of an additional
unit of a product

It is important to distinguish clearly between these three different types of revenue:

» Total revenue (TR) refers to the money received from sales of a product. It is calculated using
the equation:
TR = Q × P

» Average revenue (AR) indicates the total revenue obtained from selling a product divided by
the number of units sold. It is calculated using the equation:
𝐓𝐑
AR =
𝐐

» Marginal revenue (MR) refers to the additional revenue received when one more unit of a
product is sold. It is calculated using the equation:
𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐓𝐑
MR =
𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐐

🔗 The margin and decision making: the concept of the margin is important in the production
process in relation to marginal revenue. You need to be able to distinguish clearly between
marginal revenue, average revenue and total revenue.

The definition of normal, subnormal and supernormal profit

• profit maximisation: the situation where marginal cost is equal to marginal revenue
• profit: the reward to enterprise, defined as the difference between total revenue and total
costs
• break-even point: the level of output at which a firm is making neither a loss nor a profit

It is generally assumed that the main objective of a firm is profit maximisation.

Profit is defined as the difference between the total revenue received by a firm and the total costs
involved in producing what is sold — in other words, it is equal to total revenue minus total costs.
Profit maximisation is a situation where marginal cost is equal to marginal revenue.

The break-even point is the level of output at which a firm is making neither a loss nor a profit.

It is important, however, to distinguish between normal profit, subnormal profit and supernormal
profit.

🔗 The margin and decision making: the concept of the margin is very significant in terms of
profit maximisation because this refers to the situation when marginal cost is equal to marginal
revenue.
Normal profit

Normal profit refers to the amount of profit that needs to be made by a firm to stay in a particular
market. It is the profit necessary to just cover the opportunity cost of the resources used in
production. It is actually included in the average cost curve of a firm. It is where price is equal to
average cost (AR = AC) and where total revenue equals total cost.

Subnormal profit

Subnormal profit is any profit less than normal profit and where AR < AC. It is where average
cost is greater than price. In the short run, a firm will continue producing while making subnormal
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profit (i.e. making a loss), as long as the average variable cost (AVC) is covered. However, in the
long run, the firm will close down.

Supernormal profit

• normal profit: the level of profit that a firm requires to keep operating in the industry
• subnormal profit: any profit less than normal profit
• supernormal profit: the level of profit over and above normal profit; also known as
‘abnormal profit’

A firm may, however, wish to make a profit that is above normal profit. This level of profit that is
over and above normal profit is known as supernormal profit. It is where price is greater than
average cost (AR > AC).

🔗 Candidates need to be able to distinguish clearly between normal profit, subnormal profit and
supernormal profit, both in terms of how they are shown in diagrams and how they can be defined
using AR and AC.

The economist’s and the accountant’s definition of profit

As an extension point, it is useful to understand that an economist’s definition of profit will be

different from that of an accountant.

» The economist’s definition of normal profit includes within it a rate of return that is needed for the
firm to remain in that particular market or industry.
» An accountant, however, takes a different view, pointing out that this assumed rate of return
cannot be formally and explicitly identified in the accounts of a firm. An accountant is concerned
with the actual figures that can be produced by a firm as a resul t of its various trading activities.
» An economist is prepared to build into their assumptions that a firm will need to make a certain
profit that is just enough to keep it in its present line of business.
» For an accountant, however, the fact that it is impossible to say precisely what the size of this
normal profit needs to be is sufficient for such a figure not to be included in any accounting data.

🔗 Candidates need to know that an economist and an accountant will consider profit from
different points of view.

The calculation of supernormal and subnormal profit

Supernormal profit

Supernormal profit occurs when total revenue is greater than total cost and is calculated by total
revenue minus total cost (including both the fixed and the variable costs). The total costs include a
reward to all the factors, including normal profit.

Subnormal profit

Subnormal profit occurs when total cost is greater than total revenue and is calculated by total
revenue minus total cost. As total cost is greater than total revenue, this will give a negative figure.

7.6 Different market structures

Perfect competition and imperfect competition

It is important to distinguish between the different types of market structure that can occur in an
economy. There are five main market structures:
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» perfect competition
» monopolistic competition
» oligopoly
» monopoly
» natural monopoly

The last four structures are all examples of imperfect competition.

Perfect competition

• perfect competition: a market or industry consisting of many virtually identical firms which
all accept the market price in the industry
• barriers to entry or exit: various obstacles that make it very difficult, or impossible, for new
firms to enter or exit an industry (e.g. technical economies of scale, patents or heavy capital
investments)

The market structure of perfect competition is based on a

number of assumptions, which include the following:

» There are many buyers and sellers.

» The buyers and sellers are price takers — that is, they just
have to accept the price that prevails in the market and are
unable to influence it in any way.
» There is perfect knowledge among producers and
consumers, so the buyers and sellers know which products
are for sale and at what price. F7.10 A firm making supernormal profit in
the short run under perfect competition
» The product is homogeneous, so there is no possibility of
product differentiation.
» There are no barriers to entry or exit, so firms can enter or
leave the industry in the long run, if they so wish.
» There is perfect factor mobility in the long run.
» There are no transport costs.
» All producers have access to the same technology.
» Each firm faces a perfectly elastic demand curve for its
product (although the demand curve for the whole industry is
downward sloping from left to right).
» Firms aim to maximise profits.
» Only normal profit can be earned in the long run.
F7.11 Long-run equilibrium
under perfect competition
In the short run, a firm could make supernormal profits, normal profits or
subnormal profits. If it were unable to cover its short-run average variable
cost, it would need to exit from the market.

Figure 7.10 shows the equilibrium situation of a firm in perfect competition that is making
supernormal profits. The profit maximisation position, where MC equals MR, is at output Q, but at
this point the price is shown by P and the average cost by AC. At this point, AR is greater than AC
and this explains the existence of supernormal profits in the short run, shown by the shaded area.

In the long run, if a firm makes supernormal profits, new firms will be attracted into the industry. If,
however, a firm makes subnormal profits (that is, where AC is greater than AR), it will decide
to leave the industry. As a result of such changes, only normal profits
will be made by the firms in the industry in the long run.
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Figure 7.11 shows the equilibrium situation of firms in perfect competition in the long run. AR is
equal to AC at a price of P* and a quantity of Q* and so only normal profits are made.

Perfect competition is very much a theoretical model of the behaviour of firms, based on a number
of assumptions. It has therefore been criticised for being unrealistic, but it is still useful as a model
of economic behaviour. There are some markets that come relatively close to the features of
perfect competition, such as agricultural markets and street food vendors.

🔗 It would be relatively easy for candidates to dismiss the theory of perfect competition for being
unrealistic, but the theory is important in providing a benchmark to consider other theories of
market structures.

Imperfect competition

• imperfect competition: a market that lacks some, or all, of the features of perfect
competition

imperfect competition covers all of the following:

» monopolistic competition
» oligopoly
» monopoly
» natural monopoly

Monopolistic competition

• Monopolistic competition: a market or industry where there is competition between a

large number of firms that produce products that are similar but differentiated, usually
through the use of brand images

The market structure of monopolistic competition is based on a number of assumptions, which

include the following:

» There are a large number of firms (although fewer than in perfect competition).
» Products are differentiated — they are not homogeneous.
» Each firm faces a demand curve that is downward sloping from left to right.
» Demand for a product is relatively price elastic, but not perfectly elastic.
» Great use is made of advertising brand images to build up brand loyalty.
» There are no barriers to entry and exit, so firms can enter or leave the industry in the long run, if
they so wish.
» Firms aim to maximise profits.
» Only normal profits can be earned in the long run.

In the short run, a firm could make supernormal profits, normal profits or subnormal profits. As
there are no barriers to entry or exit, this will enable firms to leave or enter the industry in response
to these profits.

F7.12 shows the equilibrium situation of a firm in monopolistic

competition that is making supernormal profits. The profit
maximisation position, where MC equals MR, is at output Q and
price P. AR is above AC, so the firm is making supernormal
profits, shown by the shaded area.

F7.12 Short-run equilibrium under

monopolistic competition
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In the long run, if a firm makes supernormal profits, new firms

will be attracted into the industry. If, however, a firm makes
subnormal profits — that is, where AC is greater than AR — it
will decide to leave the industry. As a result of such changes,
only normal profits will be made by the firms in the industry in
the long run.

Figure 7.13 shows the equilibrium situation of firms in

monopolistic competition in the long run. AR (or D) is equal to AC at 7.13 Long-run equilibrium under
monopolistic competition
a price of P and a quantity of Q* and so only normal profits are made.

Monopolistic competition is generally regarded as a more realistic model of the behaviour of firms
than perfect competition because it is often the case that there is a great deal of competition
between firms that are selling products that are similar, but not identical

🔗 in some questions which require candidates to compare monopolistic competition and

monopoly, it is not always clear when a candidate is referring to monopolistic competition and
when they are referring to monopoly. It is important that candidates clearly indicate which market
structure they are referring to throughout their answer.

Oligopoly

• oligopoly: a market or industry in which there are a few large firms competing with each
other

The market structure of oligopoly is based on a number of assumptions, which include the
following:

» There are a small number of firms (if there are only two firms, it is called a duopoly).
» There are differentiated products.
» Great use is made of advertising brand images to build up brand loyalty.
» Barriers to entry make it difficult for new entrants to enter the market.
» Firms can make supernormal/abnormal profits in the long run, as well as in the short run.
» There could be a mixture of price makers and price takers.
» The firms are interdependent.
» There could be a degree of collusion between firms operating in a cartel.
» There is a kinked demand curve.
» There is a great deal of price stability/rigidity.

An important distinctive feature of oligopoly is the existence of a kinked demand curve. This
results from the fact that firms in an oligopolistic market structure try to anticipate the reactions of
rival firms to their actions.
F7.14 The kinked demand curve
The kink in the demand curve can be explained as follows:

» Above the kink: it is assumed that if an oligopolistic firm

increases its price, other firms in the market will not follow, so
demand above the kink is elastic.
» Below the kink: it can also be assumed that if an oligopolistic
firm reduces its price, other firms in the market will follow, so
demand below the kink is inelastic.

Figure 7.14 shows the equilibrium situation of oligopolistic firms.

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The profit maximisation position, where MC equals MR, is at output Q* and price P*. Above the
kink (i.e. to the left of Q*), demand is elastic; below the kink (i.e. to the right
of Q*), demand is inelastic. It should be noted that the marginal revenue line is discontinuous,
shown by the dotted line between MC1 and MC0.

Oligopoly is generally regarded as a reasonably realistic model of the behaviour of firms, but it is
more complex than the other market models because there are many ways in which firms in such
a market may interact with each other.

Monopoly

• monopoly: a market or industry where there is a single firm which controls the supply of
the product

The market structure of monopoly is based on a number

of assumptions, which include the following:

» There is one firm in an industry — that is, just one single seller.
» Legally, a monopoly can be defined in terms of a percentage of market share — for example, in
the UK it is 25%.
» The monopoly is a price maker.
» There are no substitutes for the product.
» Barriers to entry make it virtually impossible for new firms to enter the market.
» Supernormal profits can exist in both the short run and the long run because of the existence of
barriers to entry, preventing them from being competed away.
» The demand for the firm’s product is also the market or industry demand, so the demand curve
is downward sloping from left to right.
» Marginal revenue is always less than average revenue. F7.15 Profit maximisation
» The firm aims to maximise profits. and monopoly

Figure 7.15 shows the equilibrium situation of a

monopolistic firm. The profit maximisation position, where
MC is equal to MR, is at price P* and quantity Q*.
Supernormal profits are being made, but because of the
existence of barriers to entry, it is impossible for new firms
to enter the market. As a result, these profits can exist in
the long run as well as the short run.

A monopoly is generally regarded as a market structure that has disadvantages for the consumer,
but this need not always be the case, as in the case of a natural monopoly.

Natural monopoly

• natural monopoly: a situation where average cost will be lower with just one provider,
avoiding the wasteful duplication of resources

A natural monopoly exists where a single supplier has a very significant cost advantage as a
result of being in a monopoly situation. If there were competition with other producers in the
market, the costs of production would actually increase. In such a situation, the monopoly can be
described as natural because it avoids the extra costs that would come about as the result of a
duplication of resources.

It may well be the case in a natural monopoly that one firm will have sufficient economies of scale
to satisfy market demand more efficiently than two or more firms.
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🔗 In examination questions on monopoly, especially those which require candidates to discuss

or evaluate a monopoly market, it is important to include both the potential advantages and the
possible disadvantages of monopoly before coming to a conclusion.
🔗 Equilibrium and disequilibrium: the different market structures can be compared in
relation to positions of equilibrium and disequilibrium in the various markets.

The structure of markets

the main distinguishing features of the four types of market structure:

Perfect Monopolistic Oligopoly Monopoly

competition competition

Number of Many buyers and Many buyers, but Many buyers, but Many buyers,
buyers and sellers the number of few sellers but one seller
sellers sellers is not as
large as under
perfect
competition
Degree of Not restricted Not restricted Some barriers to High barriers
freedom of entry, especially to entry
entry in the long run

Firm’s None; the firm is Some Some Price maker,

influence a price taker subject to the
over price demand curve

Product Homogeneous Differentiated Differentiated No close

differentiation substitutes

Availability of Perfect Lack of perfect Lack of perfect Lack of

information knowledge knowledge knowledge perfect
Knowledge

Examples Cauliflowers; Fast-food outlets; Cars; mobile PC operating

carrots travel agents phones systems; the
market for
local water
supply

Barriers to entry and exit

Barriers to entry into, and exit from, markets are the various factors that can prevent firms entering
or leaving a market, or make it difficult for them to do so. The existence of barriers to entry and exit
makes a market less competitive; the greater the barriers that exist, the less competitive a market
will be.

There are a number of barriers to entry and exit, including the following:

» Legal barriers: a patent can act as a legal barrier to entry into a market because other firms will
not have permission to produce and sell a particular product.
» Market barriers: in some markets, a great deal of money is spent on establishing a strong
brand image and the expense of such advertising could act as a barrier to entry.
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» Cost barriers: economies of scale occur when increased output leads to lower average costs,
so new firms, with relatively low output, will experience relatively higher costs and this can act as a
barrier to entry.
» Physical barriers: some countries will have supplies of a particular product, but other countries
will not (e.g. oil reserves are only found in certain countries), and the absence of such resources
will act as a barrier to entry into this market.

The performance of firms in different market structures

• x-inefficiency: a situation where average cost is not at its lowest point because monopoly
power has given rise to inefficiency
• contestable market: a situation where it may be relatively easy for new entrants to enter a
market or industry; the effect of this is that existing firms in an industry face the threat of
new firms coming into the industry and increasing the degree of competition
• sunk costs: costs which were paid when a firm entered a market and are non-recoverable
when it leaves, e.g. for research and development

The performance of firms in different market structures can be compared in various ways,
including the following:

» Revenues and revenue curves: the AR and MR curves are horizontal in perfect competition
(the AR curve is also the firm’s demand curve because AR is the amount of revenue per unit sold
and this is equal to the price at which the product is sold), but are downward sloping in
monopolistic competition, oligopoly, monopoly and natural monopoly, with the MR curve below the
AR curve (in oligopoly, the AR curve is kinked and the MR curve is discontinuous).
» Output in the short run and the long run: the profit-maximising output in all of the market
structures is determined where MC = MR.
» Profits in the short run and the long run: it is possible for firms in all market structures to
make supernormal profits in the short run, but in perfect competition and monopolistic competition
these will be competed away in the long run and only normal profits will be made; this will not be
the case with the other market structures.
» Shutdown price in the short run and the long run: a firm can make subnormal profits in the
short run and continue in production as long as average variable costs are being covered,
otherwise it will be forced to shut down; in the long run, a firm will need to make at least a normal
profit — price will need to equal average cost.
» Derivation of a firm’s supply curve in a perfectly competitive market: in the short run, a
firm’s supply curve in perfect competition is its MC curve above the point where it intersects the
AVC curve; in the long run, a firm’s supply curve in perfect competition is its MC curve above the
point where it intersects the ATC curve (i.e. equal to or above its break-even point).
» Efficiency and x-inefficiency in the short run and the long run: firms in perfect competition
are efficient in the long run, in terms of both productive efficiency and allocative efficiency; in the
other market structures, there is
x-inefficiency — that is, production is not at the minimum average cost and price is not equal to
marginal cost.

🔗 Time: time is an important concept in relation to market structures because there can be
significant differences in terms of what can happen in the short run and the long run in different
markets.

🔗 Efficiency and inefficiency: firms in different market structures can be compared in terms of
their efficiency and inefficiency.

Contestable markets
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The key feature of a contestable market is that because it is relatively easy for a new firm to
enter a market, the existing firms in the market are continually influenced by the threat of the
possible entry of such firms, making them behave as if these potential firms were actually already
operating in the market.
The idea of contestable markets is based on a number of assumptions, including the following:

» There are no barriers to entry or exit; entry into, and exit from, an industry is relatively easy and
costless.
» Firms already in the market continually face the threat of competition.
» This puts pressure on the firms to be efficient.
» Supernormal profits are made in the short run, but only normal profits in the long run.
» There are degrees of contestability; a perfectly contestable market will have no sunk costs —
costs that a firm paid when it entered the market, and which are non-recoverable when it leaves,
such as research and development.
» There is perfect information.
» All firms, including those in a market and those planning to enter a market, have access to the
same level of technology.

There are a number of implications of contestable markets:

» The existence of low barriers to entry and exit means that new firms can come into a market to
provide competition to established firms.
» This threat of market entry means that existing firms will be efficient in terms of productive,
allocative and dynamic efficiency.
» The absence of sunk costs reduces the risk involved in entering a market.
» The continuous possibility of new firms entering a market causes existing firms in a market to
focus more on sales maximisation than profit maximisation.
» The size and number of firms is irrelevant.

🔗 It is important that candidates clearly understand that in a contestable market, it is not so much
the entry of new firms into a market that is important but the threat of such entry.

Also, it is important that candidates understand that a contestable market is not actually a
separate market structure, but a feature that can exist to different degrees in each of the other
market structures.

Price competition and non-price competition

Price competition

• price competition: a process of setting competitive prices to achieve particular objectives

in a market
Price competition is one of the ways that a product can compete in the marketplace. It refers to a
situation in which firms try to sell their products at lower prices than similar products sold by other
firms. Firms develop different price strategies to beat their competitors, usually setting the same or
a lower price than that charged by the competitors.

🔗 Price competition is not used in perfect competition because all of the firms in that market
structure are price takers. It is also not used very often in oligopoly.

Non-price competition

• non-price competition: a process of using a variety of ways to increase sales other than
price
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The conduct of firms can be compared in relation to whether they rely on pricing policies or non-
price policies. In most markets, firms compete in terms of price, but in monopolistic competition
and oligopoly there is a great deal of non-price competition — rather than using changes in price
to compete, the firms use other ways to compete with each other.
Non-price competition involves any form of competitive activity, other than changes in price, and
can include:

» advertising and product promotion

» branding and the creation/maintenance of brand image and customer loyalty
» sales promotions (e.g. through such special offers as BOGOF, ‘buy one, get one free’)
» distribution (e.g. controlling the distribution of products to particular retail outlets or particular
internet sites)
» distinctive/exclusive packaging
» differences in quality or design
» establishment of a unique selling point (USP) through product differentiation
» warranties and after-sales service
» the provision of a loyalty card which gives different types of reward
» establishment of a clear ethical and/or environmental reputation

Collusion and the prisoner’s dilemma in oligopolistic markets, including a two-player pay-
off matrix

• price agreement: where firms in an oligopolistic market agree to fix prices between
themselves
• cartel: where a number of firms agree to collude, such as by limiting output to keep prices
higher than would be the case if there were competition between them
• prisoner’s dilemma: a situation where two prisoners must decide whether to confess,
without knowing whether the other will confess or not

Collusion

It has already been stressed that a key feature of oligopoly is that firms may sometimes act
together — in other words, there might be collusion between two or more firms which cooperate
for their mutual benefit. Firms in oligopoly are interdependent and so will consider the likely
reactions of the other firms in a market. Collusion is a way of lowering some costs so as to
maintain supernormal profits, reducing consumer welfare.

This collusion can take different forms, including a price agreement and a cartel.

» A price agreement is where firms in an oligopolistic market agree to fix prices between
themselves.
» A cartel is where a number of firms agree to work together, such as by limiting output to keep
prices higher than would be the case if there were competition between them.

The prisoner’s dilemma

» Firms operating in an oligopolistic market make decisions in the face of

uncertainty about how their rivals will react to their moves.
» Game theory is a technique of analysing the behaviour of firms in such a situation.
» The prisoner’s dilemma is a game theory idea, based on the situation of two
prisoners who are being questioned over their guilt or innocence of a crime. They
must decide whether to confess, without knowing whether the other will confess
or not, and where a confession carries the possibility of a lighter punishment.
» It shows why two individuals might not cooperate, even if it is collectively in
their best interest to do so.
 124

The two-player pay-off matrix

» The prisoner’s dilemma is similar to an economic situation where two firms exist in a market (i.e.
there is a duopoly).
» Just as self-interest drives the prisoners in the prisoner’s dilemma to confess, self-interest may
make it difficult for an oligopoly firm to maintain a cooperative outcome.
» The pay-off matrix is a visual representation of all the possible outcomes that
can occur when two people or two firms have to make a strategic decision, such
as whether to cooperate with each other or to ‘go it alone’.

KEY SKILLS

Analysis and application: you need to be able to analyse the contribution that a knowledge and
understanding of collusion and the prisoner’s dilemma can make to the study of firms, especially
firms operating in oligopolistic markets. The prisoner’s dilemma provides a framework for
understanding how to balance cooperation and competition, and is a useful tool for strategic
decision making.

The definition and calculation of the concentration ratio

• concentration ratio: the percentage of a market controlled by a given number of firms (e.g.
the five largest firms in an industry might control 80% of the output of the industry)

The concentration ratio shows the percentage of a particular market that is accounted for by a
certain number of firms. For example, it may well be that four or five firms in a particular industry
have an 80% share of a market between them.

In an oligopolistic market structure, there are usually only a few large firms — in other words, the
concentration ratio of the largest firms is usually very high.

🔗 The higher the concentration ratio of an industry, the more imperfect the market is. On the
other hand, the lower the concentration ratio of an industry, the more competitive the market is.

7.7 Growth and survival of firms

Reasons for the different sizes of firms

• firm: a particular and distinct organisation that is owned separately from any other
organisation
• industry: a collection of firms producing similar products

Small firms exist in many economies. Reasons for the continued survival of small firms include the
following:

» The size of the market is small.

» The firm may be in a very specific niche market.
» The firm is providing customers with a service that requires personal attention.
» The firm may have only just started and so is relatively small at present.
» The owners of the firm prefer it to remain small.
» Small firms may receive specific financial support from government.
» Small firms may be more flexible in responding to changes in consumer demand.
» Small firms may be more innovative and pioneering.
» The small firm may not be able to grow because of difficulties in raising the necessary finance.
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» In some industries, there has been an increase in the process of ‘outsourcing’ and ‘contracting
out’, and small firms may benefit from this.
» A small firm may be more efficient — for example, labour relations and levels of motivation may
be better than in a large firm.
However, despite the potential advantages of small firms, there are many reasons for the growth
of firms, including the following:

» To decrease costs: to take advantage of possible economies of scale, leading to a decrease in

the costs of production of a firm.
» To reduce risk: to be stronger and therefore safer from a hostile takeover or merger proposal
(in the case of a firm becoming larger through external growth).
» To increase profits: a larger firm may able to gain greater profitability.
» To fulfil management objectives: a possible desire of owners and/or managers to expand.
» To dominate a market: to take advantage of opportunities to gain increased sales from a larger
market share.

The concepts of firm and industry

It is important to distinguish between a firm and an industry:

» A firm is a distinct organisation that is owned separately from any other organisation; in a firm,
an entrepreneur will bring together factors of production in order to produce particular products.
» An industry involves a number of firms which produce broadly similar products.

Firms can grow through two different ways:

» internal growth
» external growth

🔗 Candidates often confuse the terms ‘firm’ and ‘industry’, making it difficult sometimes for
examiners to follow the logic of a candidate’s answer. It is important that you clearly understand
the difference between ‘one firm’ and ‘a number of firms operating in an industry or market’.

The internal growth of firms

The internal growth of a firm comes about as a result of a firm increasing in size through producing
and selling more products. The extent of this growth can be measured by:

» the volume of sales

» sales revenue (turnover)
» the number of employees
» market share
» the size of profits

The external growth of firms

• merger: where two or more firms combine together as a result of mutual agreement
• takeover: where two or more firms combine together as a result of some form of hostile bid
by one firm for another; also known as an ‘acquisition’
• integration: the process whereby two or more firms come together through a takeover or
merger
• horizontal integration: where firms at the same stage of production merge
• vertical integration: where a firm joins with another firm at an earlier stage of the
production process (backward vertical integration) or a later stage of the production process
(forward vertical integration)
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• conglomerate integration: a merger between firms that are operating in completely

different markets rather than in different stages of the same market
• diversification: where a firm decides to operate in a number of markets to spread risk

The external growth of a firm comes about as a result of a merger or takeover in which two or
more firms combine together. This process is known as integration.

Methods of integration

Horizontal integration

One form of external growth is horizontal integration. This is where two or more firms at the
same stage of the production process join together.

KEY SKILL

Application: examples of horizontal integration would include two banks or two car manufacturing
companies.

Vertical integration

Another form of external growth is vertical integration. This is where two or more firms at
different stages of the production process merge. If it involves going back to an earlier stage in the
production process, it is known as ‘backward vertical integration’. If it involves going forward to a
later stage in the production process, this is known as ‘forward vertical integration’.

KEY SKILL

Application: an example of backward vertical integration is a tyre producer taking over rubber
plantations; an example of forward vertical integration is a car producer taking over a chain of
petrol stations and garages to act as distributors of the vehicles.

Conglomerate integration

Both horizontal and vertical (whether backward or forward) integration involve mergers of firms
operating in the same market.

In contrast, conglomerate integration is where two or more firms merge together even though
they are operating in entirely different markets that do not always have any relationship with each
other. Although this may appear illogical, it has the benefit of spreading risks in different markets
through the process of diversification.

🔗 In examination questions on integration, candidates often write about horizontal and vertical
integration only, making no reference at all to conglomerate integration. Candidates should
consider all three types of integration in their answers. Conglomerate integration has the
advantage of offering diversification, and this spreading of risks in different markets can be of
fundamental importance to a large number of firms.

KEY SKILL

Application: an example of diversification resulting from conglomerate integration is the brewing

company Guinness diversifying into publishing, producing the Guinness Book of Records among
other titles.

The reasons for integration

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The reasons for integration will depend on the type of integration:

» Horizontal integration: where firms operate in the same industry and at the same stage of
production, they can benefit from economies of scale (e.g. two banks decide to merge).
» Backward vertical integration: where firms operate in the same industry, but at different
stages of production, one firm might want to acquire a firm operating earlier in the supply chain
(e.g. a retailer decides to buy a wholesaler).
» Forward vertical integration: where firms operate in the same industry, but at different stages
of production, one firm might want to acquire a firm operating further up the supply chain (e.g. a
vehicle manufacturer decides to buy a car parts distributor).
» Conglomerate integration: firms in different unrelated industries can benefit from the spreading
of risk through diversification (e.g. the merger between the Walt Disney Company, a film
production company, and the American Broadcasting Company, a television company, giving the
Walt Disney company more extensive distribution of its products).

The consequences of integration

There are a number of possible consequences of integration, including the following:

» Economies of scale: integration enables firms to take advantage of different economies of

scale, such as a cost savings associated with marketing and technology; this will enable them to
keep costs and prices down.
» Rationalisation: this is the process of eliminating those parts of the operation of a business that
are inefficient and unprofitable, and integration could help to bring this about
» Sharing of knowledge: integration enables knowledge to be shared and this could reduce or
remove elements of asymmetric information.
» Strength: integration could send out a signal to other firms not to attempt a takeover bid; it could
also strengthen anti-takeover defence/protective strategies.
» Research and development: integration may enable more funds to be allocated to research
and development so that new innovative products can be produced, increasing the
competitiveness and profitability of the business in the long run.

Cartels

The conditions for an effective cartel

The possible existence of cartels has already been referred to in relation to oligopoly. A cartel is a
grouping of producers that work together to defend their shared interests. Cartels are created
when a few large producers decide to collude — for example, to fix prices for members so that
competition on price is avoided. They can also restrict output released onto the market.

There are a number of conditions for an effective cartel, including the following:

» Barriers to entry: a cartel is more likely to be effective when there are high barriers to entry into
a market or an industry.
» Control over both price and output: a cartel is more likely to be effective if it can not only fix
prices for members, but also restrict output.
» Setting rules: a cartel will need to set rules governing the behaviour of members; if members
follow these rules, risks that would exist without a cartel are reduced.
» Policing rules: a cartel is more likely to be effective when all members can be ‘policed’ in some
way to ensure that the rules are being obeyed.
» Leading firm: a cartel is more likely to be effective when there is a leading firm and
homogeneous product, as well as a similar cost structure.

KEY SKILLS
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Application: an example of a cartel is OPEC — the Organisation of the Petroleum Exporting

Countries, consisting of 13 countries, established in 1960. It controls about 50% of global oil
production and about 80% of the world’s oil reserves.

Analysis: you need to be able to demonstrate a knowledge and understanding of these conditions
in order to analyse the potential effectiveness of a cartel.

The consequences of a cartel

the positive effects for producers and the negative effects for consumers:

Positive effects for producers Negative effects for consumers

• Protection of shared interests: • Higher prices: the members of a cartel

members of a cartel work together to can all raise prices together, which
defend their shared interests. reduces the price elasticity of demand for
any particular member and makes
products more expensive for consumers.
• Avoidance of price competition: cartels
fix prices for their members, so that • Lack of transparency: members of a
competition on the basis of price is cartel may agree to hide prices or
avoided. withhold information, such as in relation
to hidden charges to consumers involved
• Effect on revenue: where a cartel is able in certain transactions.
to control both price and output, revenue
will be substantially increased. • Restricted output: members of a cartel
may agree to limit output onto a market,
• Control of market: the existence of a such as through a quota system, reducing
cartel will give members a dominant competition.
position in a market (e.g. OPEC controls
over 50% of the oil-producing market). • Carving up a market: members of a
cartel may collectively agree to break up
a market into regions or territories and not
compete in each other’s area, reducing
choice for consumers.

KEY SKILL

Evaluation: in evaluating the consequences of a cartel, you would need to contrast the potential
advantages for producers with the potential disadvantages for consumers.

The principal–agent problem

• principal–agent problem: the problem that can occur as a result of the different objectives
of an owner (i.e. the principal) and a manager (i.e. the agent)

It is important to understand the distinction between the ownership and the control of a firm and
there may be a problem arising from this divorce of ownership from control. For example, the
shareholders may own a firm, but they will not be in day-to- day control of it.

The principal is the owner and he or she will hire an agent (i.e. a manager) to run the firm on an
everyday basis. The problem, however, is that the agent may not run the firm in exactly the way
that the shareholders/owners would like. The two may have differing objectives for a firm. For
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example, the principal may have the objective of profit maximisation but the agent may have the
objective of salary maximisation.

KEY SKILL

Analysis: you need to be able to analyse why it is possible that a problem could arise between
the principal of a firm and an agent, such as between the owner and a manager.

7.8 Differing objectives and policies of firms

The traditional profit-maximising objective of firms

Profit maximisation has traditionally been regarded as the main objective of a firm. Profit
maximisation is defined as occurring at that level of output where the marginal cost of production
is equal to the marginal revenue obtained by a firm from that level of production (MC = MR). The
distinction between normal and supernormal profit was referred to in section 7.5 of this chapter.

Other objectives of firms

• satisficing: when the objective of a firm is to produce a level of profits that is satisfactory to
stakeholders (e.g. shareholders and managers)
• revenue maximisation: when the objective of a firm is to maximise the total income, rather
than the profits, of a firm
• sales maximisation: when the objective of a firm is to maximise the volume of products
sold

It is necessary, however, to consider that a firm may have other objectives:

Model Explanation

Profit Where there is a distinction between ownership and control, managers may
satisficing just want to deal in an appropriate manner with all of the stakeholders
involved in a firm, so that all stakeholders are satisfied. In such a situation,
satisfactory profits, rather than maximum profits, may be the aim.

Revenue This is likely to be the objective where the salaries of managers are linked
maximisation to revenue rather than to profits. In this situation, revenue is maximised
when MR = 0.

Sales In this situation, managers aim to maximise the volume of sales rather than
maximisation the revenue resulting from such sales.

Growth This refers to a situation where managers aim to increase the size of the
maximisation firm because this will make it less vulnerable to a merger or takeover and it
is also possible that salaries of managers will be linked to the size of a firm.
Survival An objective of a firm, particularly in the first few years of its existence, may
simply be to survive. This is especially the case in those markets where
firms do not tend to survive for very long, such as take-away food retail
outlets.

Strategic A firm may establish its objectives within a broad strategic approach, such
objective as in relation to ‘corporate social responsibility’ and the aim to operate
without causing any ethical issues or environmental problems.
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🔗 In examination questions on the objectives of a firm, candidates need to remember not to write
exclusively on profit maximisation, but also to consider other possible objectives.

KEY SKILL

Analysis: when analysing the different objectives and policies of firms, you need to be able to
consider other aims of a firm besides profit maximisation, such as survival, profit satisficing, sales
maximisation and revenue maximisation. It is important that you understand why (i.e. under what
circumstances) a firm could aim for an objective other than profit maximisation. It is also important
that you understand that the objectives of a firm may change over a period of time for a variety of
different reasons as economic circumstances change.

Price discrimination

• price discrimination: the process of charging different prices in different markets where
there are differences in the price elasticities of demand

Price discrimination involves charging a different price to different groups of people for the same
good. It is mainly practised by monopolies.

The conditions for effective price discrimination

The conditions for effective price discrimination include the following:

» Different elasticities of demand: there must be different price elasticities of demand in the
different markets.
» Different prices do not reflect different costs: the differences in price should not be a
reflection of differences in the costs of production.
» Market segmentation: the monopoly firm is able to keep different markets separate; this
separation could involve different geographical regions, different times of the day or people of a
different age or status.
» No resale: the firm needs to be able to prevent individuals in one market buying at a lower price
in another market and reselling at the higher price.
» Monopoly power: the firm must have some control over the price — that is, it must be a price
maker rather than a price taker.

Degrees of piece discrimination

It is possible to distinguish three degrees of price discrimination:

» First degree: this involves considering individual customers — the firm needs to be able to find
out what each customer is willing to pay for a product and then sell it to the customer at that price.
This means that each unit of a product is sold at a different price — for example, where a
customer orders a specific item of designer jewellery and the price is negotiated between the
buyer and the supplier.
» Second degree: this involves allowing customers to choose a particular deal — the firm offers a
special deal to those customers who meet certain conditions, such as a special price for bulk
purchases of a product.
» Third degree: this involves offering special discounts to members of certain groups, such as
students, senior citizens or people travelling on trains at certain times of the day (generally known
as off-peak travel).

KEY SKILL
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Analysis: you need to be able to distinguish between the three degrees of price discrimination in
any analysis of price discrimination.

The consequences of price discrimination

There are a number of consequences of price discrimination for both the producer and the
consumer.

Consequences for the producer include the following:

» Increase in revenue and profit: a monopoly firm is able to increase its revenue and profit by
practising price discrimination; it is able to extract consumer surplus and turn it into supernormal
profit.
» Cross-subsidisation: a firm practising price discrimination will be able to use the supernormal
profit to cross-subsidise loss-making activities in other operations that could have important social
benefits.
» Economies of scale: an increase in total output resulting from selling extra units of a product at
a lower price might help a monopoly firm to exploit economies of scale, resulting in lower long-run
average costs.
» Capacity utilisation: price discrimination may enable more effective management of capacity
utilisation by a firm, as with the example of trains.

Consequences for the consumer include the following:

» Consumer payments: each customer pays the price that he or she is willing to pay rather than
forgo the product (the actual price paid will depend on the whether the price discrimination being
practised is first degree, second degree or third degree).
» Consumer surplus: the consumer surplus is reduced in most cases, representing a loss of
welfare; however, some consumers, who can now buy a product at a lower price, may benefit.
» Contestable markets: price discrimination might make a market more contestable, allowing
cheap prices to be charged to certain customers.

🔗 A common error in examination answers on this part of the syllabus is to assume that
differences in price are because of differences in cost. The key point to emphasise in answers to
questions about price discrimination is that the price differences do not reflect differences in cost.

KEY SKILL

Evaluation: you need to be able to weigh up the various consequences of price discrimination for
both the producer and the consumer before making a judgement on it.

Other pricing policies

• limit pricing: the selection of a price that is below the profit maximising price
• predatory pricing: where a market leader reduces prices in a deliberate attempt to force
other firms out of a market

There are a number of other different pricing policies, including the following:

» Limit pricing: this refers to a situation where a price is selected below the profit-maximising
price. A firm may decide to price in this way to discourage new firms from entering an industry.
This will help to protect the competitive position of the firm that adopts this pricing strategy.
» Predatory pricing: oligopoly can sometimes give rise to predatory pricing. This is where a firm
charges a price that is lower than those of competitors in a deliberate attempt to force other firms
out of the industry.
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» Price leadership: this can happen in an oligopoly market structure where there is informal or
tacit collusion between firms in the market. In this situation, firms in the market will follow the price
leadership of one firm. The aim is to maximise the profits of all the firms by behaving as if they
were a monopolist — that is, a single seller. As stated above, this agreement on price or output
gives rise to a cartel arrangement.

🔗 It is important that you understand the difference between limit pricing and predatory pricing.
Limit pricing is used to discourage new entrants into an industry whereas predatory pricing is used
in relation to existing firms in an industry.

The relationship between price elasticity of demand and a firm’s revenue

The relationship in a normal downward-sloping demand curve

F7.16 Elasticity and
total revenue
Figure 7.16 shows the relationship between price elasticity of demand
and total revenue, average revenue and marginal revenue for a
downward-sloping demand curve.

If the demand curve is perfectly elastic, then marginal revenue is equal

to price. If, however, there is a downward-sloping demand curve, it
means that marginal revenue is less than price. This is because price
has to be reduced for all products to sell just one more product.
Average revenue is in fact the downward-sloping demand curve. A
firm’s total revenue is rising when demand is elastic, at its maximum
when there is unitary elastic demand, and falling when demand is
inelastic.

The relationship in a kinked demand curve

» It has already been pointed out that the demand curve in oligopoly is kinked. This occurs
because firms in an oligopolistic market structure try to anticipate the reactions of rival firms to
their actions.
» The kinked demand curve is an example of how the behaviour of firms can be analysed when
there is no collusion between them, and it shows the mutual interdependence of firms in an
oligopoly market.
» It is assumed that if an oligopolistic firm increases its price, other firms in the market will not
follow and so demand above the kink is price elastic. In this situation, a fall in price will lead to a
rise in total revenue.
» It is also assumed that if an oligopolistic firm reduces its price, other firms in the market will
follow and so demand below the kink is price inelastic. In this situation, a rise in price will lead to a
rise in total revenue.

8 Government microeconomic intervention

8.1 Government policies to achieve efficient resource allocation and correct

market failure

Application and effectiveness of measures to tackle different forms of market failure

• specific tax: an indirect tax that is a fixed amount per unit of output
• ad valorem tax: an indirect tax with a percentage rate (e.g. a tax rate of 20% per product
sold)
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Specific and ‘ad valorem’ indirect taxes

Indirect taxes can be used to achieve the efficient allocation of resources and to correct market
failure. For example, indirect taxes can be employed to discourage the consumption of demerit
goods, such as tobacco.

It is important to understand that indirect taxes can be of two types:

» Specific tax: where a specific amount of tax is required to be paid.

» Ad valorem tax: where the tax to be paid is a percentage of the selling price.

Subsidies

Subsidies can be used to achieve efficient resource allocation and to correct market
failure. For example, subsidies can be used to encourage the consumption of merit
goods, such as education and healthcare. Chapter 3, section 3.2 covered the impact
and incidence of subsidies.

Price controls

Another policy that can be used to correct market failure is the use of price controls. These are of
two types:

» Maximum price control: if the equilibrium price of a product in a market is too high for many
people to afford, a maximum price control can be established by a government to prevent the price
rising above a certain level.
» Minimum price control: if the equilibrium price of a product in a market is too low, encouraging
overconsumption, a minimum price control can be established by a government to prevent the
price falling below a certain level.

KEY SKILLS

Application: an example of a product that could have a maximum price control is an essential
food item, such as bread or rice. You will need to be able to analyse maximum price controls in
terms of how they can improve the efficiency of resource allocation in an economy.

An example of a product that could have a minimum price control is a demerit good, such as
cigarettes. You will also need to be able to analyse minimum price controls in terms of how they
can improve the efficiency of resource allocation.

Problem solving: if a government decides that there is a problem with excessive consumption of
demerit goods, such as alcohol or cigarettes, then it could impose a minimum price control to
discourage the consumption of such products.

Application: examples of an ad valorem tax include value added tax (VAT) and goods and
services tax (GST). You will need to be able to assess the effectiveness of indirect taxes, in terms
of both specific taxes and ad valorem taxes, in tackling different forms of market failure.

Application: you will need to be able to assess the effectiveness of subsidies in tackling market
failure, especially in terms of the underconsumption and underproduction of education and
healthcare.

Production quota
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• production quota: a limit to the quantity produced of a product over a certain period of
time

» A government could decide to set a limit to the quantity of a product that may be produced in a
specified time period. This is called a production quota.
» A quota is often used as an import control, but it could be used in a domestic economy to limit
production.
» For example, if the production of a certain product is too high, lowering the market price, a quota
can be used as a ‘cap’ on a certain level of production. If a producer exceeds this quota, a levy
could be imposed on them which they would be required to pay.
» This might be the case in relation to the existence of negative externalities.

🔗 Candidates sometimes confuse a production quota and an import quota in their examination
answers. A production quota involves a restriction on the domestic production of a product,
whereas an import quota involves a restriction on a product entering a country from another
country.

🔗 Time: a production quota is likely to take a certain length of time to have an impact. This time
dimension is likely to reduce, or at least delay, its effectiveness.

KEY SKILL

Application: you will need to be able to analyse production quotas in terms of how they can
improve the efficiency of resource allocation in an economy. For example, they could be used to
reduce the extent of a negative externality, such as pollution.

Prohibitions and licences

• prohibition: the banning of a certain product in an economy

• licence: where permission to produce or sell is given by a government to a supplier, but
this permission is restricted in some way

Another approach to the correction of market failure is the use of prohibitions and licences in an
economy.

» A prohibition refers to a ban on certain products being supplied in an economy — a product

subject to prohibition would be made illegal and consumers would be banned from the
consumption of it. However, there might be a time lag before such a prohibition was actually put
into effect.
» A licence is where suppliers are given permission by a government to produce or sell a product.
The use of a licence gives the government some degree of control because it can limit the number
of licences that it issues. However, its effectiveness may be limited by a government decision to
issue only a certain number of licences.

Regulation and deregulation

Regulation

• regulations: a variety of legal and other rules that apply to firms in different circumstances

One way that a government could intervene to achieve an efficient resource allocation is through
the use of regulations. A regulation refers to a law or rule that can be used by a government to
reduce the extent of market failure in an economy.

There are often examples of such regulations in different economies:

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» Control of monopolies: in some countries, a government may establish regulations to control

monopolies. If a firm has too much monopoly power in a market, it can be referred to a
commission (a body that can look into a monopoly situation). This can be effective by investigating
whether the monopoly is acting against the public interest. Proposed mergers or takeovers might
also be referred to such a regulatory body whenever it is thought that they might be against the
public interest in limiting the degree of choice for consumers.

» Consumer protection: regulations could also exist in relation to consumer protection. In many
countries, regulations have been passed that give certain rights to consumers. For example, one
regulation could cover the description of a product that is being sold to ensure that consumers are
properly informed. A regulatory body usually exists to ensure that such regulations are adhered to,
thereby increasing their effectiveness.

» Protection of the environment: in some countries, regulations could be used to protect the
environment, such as through controls on the level of pollution. Regulatory bodies could be given
the power to fine those who are responsible for the pollution of the environment and this would
certainly help to enhance their effectiveness.

Deregulation

• deregulation: a reduction in the number of regulations, rules and laws that operate in an
industry or economy

Deregulation involves a reduction in the number of regulations that exist in an economy. The aim
is to:

» allow a greater degree of competition to exist in a market than would otherwise be the case
» increase the level of efficiency as a result of the greater competition
» reduce the extent of market failure

The direct provision of goods and services

Another way in which a government could attempt to achieve efficient resource allocation and
correct market failure is through the direct provision of goods and services. A government could
provide goods and services itself, alongside the private sector. This is likely to be the case with
certain merit goods, such as healthcare and education. It is likely to be effective as a government
can use the funds it has received from taxation. In many countries, such services are provided
through both the public and private sectors.

Pollution permits

• pollution permit: a particular type of licence that is given to a firm with the intention of
reducing the level of pollution created over a period of time

» A pollution permit or ‘tradable permit’ is a particular example of a licence that can be issued by
a government.
» The permit allows a firm to pollute the environment in some way, but only up to a certain level.
This level will be less than the pollution that is taking place when the permit was first issued.
» The aim is that over time a number of permits will be issued, each allowing a lower level of
pollution than the previous one. It may not be possible to eliminate the pollution completely, but
issuing pollution permits should have some effect on bringing the level of pollution down over a
period of time.
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🔗 Time: the level of pollution in an economy could be reduced over a period of time by a
government issuing pollution permits, each allowing a lower level of pollution than the previous
one.

🔗 Efficiency and inefficiency: a government aims to encourage the extent of competition in a

market to increase the level of efficiency.

🔗 The role of government and the issues of equality and equity: a government could decide
to provide certain goods and services directly in an economy in order to bring about greater
equality and equity. For example, it could provide certain merit goods, such as education and
healthcare. This is likely to be effective because a well-educated and healthy person is likely to be
able to earn a higher income than someone less educated and less healthy.

Property rights

• property right: the right of the owner of a good to decide how it should be used

A property right is the right of an owner of an economic good to decide how such a good is to be
used. Market failure can occur in an economy because of the absence of clear property rights.
In such a situation, a government could decide to extend property rights through the
encouragement of a voluntary agreement. For example, people in a community might object to the
level of pollution caused by a firm in an area and an informal agreement could be reached
between the community and the firm. However, if such a voluntary agreement were not
successful, a government could, for example, introduce a system of pollution permits to deal with
the market failure.

Nationalisation and privatisation

Nationalisation
F8.1 Comparing perfect
competition and monopoly
• nationalisation: where a government decides to take
over the ownership of a particular firm or industry
• x-inefficiency: a situation where average cost is not at
its lowest point because monopoly power has given
rise to inefficiency
• deadweight loss: the loss of economic efficiency that
occurs when the socially optimal quantity of a product
is not produced

» A government could decide to provide a particular good or service itself by providing it through a
state-owned or nationalised industry.
» Nationalisation refers to the process by which a government takes a firm or an industry into the
public sector. In other words, ownership of the firm or industry is transferred from the private
sector to the public sector.
» This is often done if it is thought that such an action would be in the public interest.
» However, a nationalised industry may not always be as effective as one operating in the private
sector because nationalisation involves the creation of a monopoly. This is a situation where there
is just one firm in an industry and this firm can control the supply of a product in the market. it is
important to see how monopoly is an example of market failure.
» Monopoly power is regarded as a market imperfection because the equilibrium price is likely to
be higher and the equilibrium quantity lower than would be the case in perfect competition.
» Unlike the situation in perfect competition, supernormal profits are not competed away in the
long run because there are significant barriers to entry, which make it very difficult, if not
impossible, for new firms to enter the market.
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» A particular form of inefficiency that can exist in monopoly is when a firm’s average cost curve is
not at its minimum level; monopoly power can mean that the lack of competition reduces the level
of efficiency, so that unit costs of production are not minimised.
» This form of inefficiency is known as x-inefficiency. A particular example of such a market
imperfection is the existence of deadweight losses.
» A deadweight loss arising from positive and negative externalities was covered in Chapter 7,
section 7.4.
» Deadweight loss also occurs when there is a monopoly situation leading to a higher price and a
lower quantity compared to the situation that would exist in a perfectly competitive market. In this
sense, a consumer is worse off and so there is said to be a welfare loss.
» This can be seen in Figure 8.1, which compares the situation of perfect competition with that of
monopoly. In perfect competition, the equilibrium price will be Ppc and the equilibrium quantity will
be Qpc. The consumer surplus will be APpcE.
» If, however, the market becomes one with just one firm (i.e. a monopoly), the equilibrium price
will now be at Pm and the equilibrium quantity will be at Qm.
» The price will therefore be higher and the quantity lower than was the case in perfect
competition.
» The consumer surplus is now much less, shown by the triangle APmB.
» This creates a loss to society shown by the triangle BCE; this is the deadweight loss.

KEY SKILLS

Application: an example of a situation where there is an absence of clear property rights is a

large open space where there are common community rights rather than private property rights.

Evaluation: you need to be able to compare the advantages and disadvantages of nationalisation
before coming to a judgement as to whether it is likely to be an effective policy option or not.

Problem solving: you need to be able to consider the advantages of a firm or industry being
nationalised by a government to solve a problem. For example, in some countries, loss-making
private railway companies have been taken over by a government and the train service has then
been provided by the state through the public sector.

Evaluation: you need to be able to weigh up the various advantages and disadvantages of
privatisation before coming to a judgement as to whether it is a correct policy option to take.

Privatisation

• privatisation: the transfer of the ownership of an industry from the state or public sector to
the private sector
• deregulation: a reduction in the number of regulations, rules and laws that operate in an
industry or economy
• contracting out: the transfer of responsibility for the provision of a service from the public
to the private sector
• supply-side economics: the approach to change in an economy that puts the focus on the
supply side, rather than the demand side (e.g. privatisation, deregulation and contracting
out)
• information failure: where people lack the full information that would allow them to make
the best decisions about consumption

It has been shown that a nationalised industry may not always be as efficient as one operating in
the private sector because a public sector monopoly may lead to inefficiency and the sub-optimal
use of resources. A government may therefore decide to privatise an industry by transferring
ownership from the public to the private sector.
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potential advantages and disadvantages of privatisation:

The advantages of privatisation The disadvantages of privatisation

• Improvement in efficiency: • Creation of a private monopoly:

a private sector firm is likely to be more privatisation may not necessarily lead to
efficient and therefore more profitable. greater competition and it could lead to a
public sector monopoly being replaced by
• Greater competition: a private sector monopoly; this could be
privatisation usually leads to the creation more difficult to regulate than a public
of a number of firms in an industry, sector monopoly.
creating a greater degree of competition.

• Reduction in political interference: • Focus on profits:

decisions should be taken on the basis of there may be a focus on profit rather than
economics rather than politics. the public interest in the provision of
essential services (e.g. healthcare).

• Fragmentation of an industry:
competition between privatised firms may
not necessarily improve an industry as a
whole (e.g. where a train service is
provided by many different firms).

The term ‘privatisation’ can also apply to a number of other government initiatives, including
deregulation and contracting out.

» Deregulation refers to the process of reducing the regulations, laws and rules which apply in an
industry. When these are removed, it usually allows for a greater degree of competition to take
place, which, it is argued, should lead to a greater degree of efficiency in the industry.
» Contracting out is another form of privatisation where a service that was originally provided by
an enterprise in the public or state sector is now provided by a firm in the private sector. This,
again, should lead to a greater degree of efficiency.

Measures such as privatisation, deregulation and anything that leads to the promotion of
competition can be regarded as supply-side measures. These are government attempts to bring
about change to improve efficiency in an economy by taking action on the supply, rather than on
the demand, side.

🔗 Candidates need to understand that in an examination question on privatisation, it would be

appropriate to include references to both deregulation and contracting out in their answers.

Provision of information

Market failure can be caused by inadequate information. A government could therefore aim to
increase the availability of appropriate information to consumers in order to try to influence their
economic behaviour.

It is assumed that consumers will always aim to maximise their utility or satisfaction, but they will
only be able to achieve this objective if they are in possession of the necessary information. If this
information is not available, it is unlikely that they will be able to make rational decisions.

Information failure is a major cause of market failure, so a government will need to take
measures to improve the accuracy and availability of information that consumers need. This will
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help them make rational decisions and ensure that scarce resources are allocated as efficiently as
possible. A particular example of such an approach in relation to the consumption of demerit
goods, such as cigarettes, is nudge theory.

KEY SKILL

Application: a government could aim to make people as well informed as possible about the
potential advantages of the consumption of merit goods (e.g. education and healthcare). It could
also aim to make people as well informed as possible about the potential disadvantages of demerit
goods (e.g. alcohol and tobacco). The effectiveness of such provision of information depends on
the amount of money available to be spent on it and the accessibility of the communication
methods used to get the information across to people.

Behavioural insights and nudge theory

• nudge theory: an attempt by a government to alter the economic behaviour of people in

some particular way, by encouraging or discouraging consumption of certain goods or
services

This is the idea that consumers do not always act in what could be regarded as a rational manner.
Behavioural insights into economic decision-making stress the importance of understanding the
actual behaviour of people in an economy, in contrast to the traditional approach, which
emphasises the importance of acting rationally.

Nudge theory is an example of this behavioural insight into economic behaviour. The theory is
based on the idea that the behaviour of consumers can be ‘nudged’ in a particular way, such as in
relation to discouraging the consumption of demerit goods and encouraging the consumption of
merit goods.

In the case of discouraging the consumption of demerit goods, such as tobacco:

» Medical evidence is very clear about the damage that tobacco can cause and yet millions of
people carry on consuming tobacco. A government could decide to ‘nudge’ people away from the
smoking of this harmful product. This could take the form of a moderate ‘nudge’, such as a
government health warning that states that ‘smoking can damage your health’. If this moderate
‘nudge’ did not appear to be working as effectively as had been hoped, a government could make
the wording of the warning stronger, such as by changing it to ‘smoking can kill’ and/or by putting
graphic pictures on the cigarette packets.

In the case of encouraging the consumption of merit goods, such as education:

» Positive reinforcement of the value of education could be achieved by a government informing

people of the link between education and income, stressing that better-educated people generally
tend to earn a higher income than less educated people.

KEY SKILLS

Application: an example of nudge theory would be discouraging the consumption of demerit

goods (e.g. alcohol or tobacco).

Problem solving: nudge theory can be analysed in relation to attempts to solve certain problems
in an economy, including the excessive consumption of demerit goods, such as tobacco.

Government failure in microeconomic intervention

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The definition of government failure

• Government failure: a situation where government intervention to correct market failure

does not actually improve the level of economic efficiency; such intervention may even
reduce the efficiency of the allocation of scarce resources in the economy

The causes of government failure

Government failure occurs when government intervention in an economy causes an inefficient

allocation of resources and a decline in economic welfare. Government failure often arises from
attempts to solve market failure, but it can lead to the creation of different problems, such as other
distortions or imperfections in the market.

The causes of government failure can include the following:

» Lack of incentives: the profit motive is usually lacking in the public sector and public sector
workers may be paid less than equivalent workers in the private sector; these factors could lead to
inefficiency.
» Poor information: a government’s policy will be effective only if it has all the required
information, but politicians may not always have all the information necessary to take appropriate
decisions — for example, it is not easy to place a monetary value on a negative externality, such
as pollution.
» Time lags: there may be a time lag between when a government decides to introduce a certain
policy and when it actually comes into effect, by which time the economic situation might have
changed.
» Political interference: a government decision may be taken for short-term political gain rather
than for more long-term economic reasons.
» Moral hazard: a government could take decisions that encourage risk taking — for example, a
decision to support financial institutions to avoid any of them failing and going out of business.
» Regulatory capture: a government could become too friendly with those it is trying to regulate.
» Unintended consequences: a government policy to reduce poverty through the provision of
benefits could lead to a situation of ‘welfare dependency’.

The consequences of government failure

There are a number of possible consequences of government failure, including the

following:

» Taxation: a government may decide to use a progressive income tax to bring about a more
equitable distribution of income, but if the top rate of tax is very high, there may be a disincentive
for the higher paid to work as much; some workers may even decide to leave the country and seek
employment elsewhere.
» Employment: a government may be reluctant to take a decision that makes people redundant
— for example, if workers are relatively unproductive — because this will lead to an increase in the
level of unemployment.
» Net welfare loss to society: when the consequences of government intervention are contrasted
with the original problem that necessitated the intervention, it may be that the overall effect is a net
welfare loss to society — in other words, the consequences of the government failure have
actually made the situation worse than before.
» Distortion of price signals: one of the advantages of a free market is that it gives out price
signals that lead to an efficient allocation of resources, but government intervention in a market
could distort those signals so that the outcome could be an inefficient allocation of resources — for
example, a government may decide to support a failing industry through subsidies when a better
decision might have been to allow it to fail.
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8.2 Equity and redistribution of income and wealth

The difference between equity and equality

Equity

• equity: the idea of fairness or justice (e.g. in relation to the distribution of income and
wealth in an economy)

One objective of government microeconomic policy is the achievement of equity. This can be
seen in terms of government policies aimed at bringing about a fairer and more equitable
distribution of income and wealth.

Equality

• equality: the same rights and responsibilities for all the members of a group or society

Equality refers to a situation where everyone is at the same level — for example, the idea of
equal life chances or of everyone having the same income and wealth. It is where there is the
same status, rights and responsibilities for all the members of a group or a society.

🔗 The role of government and the issues of equality and equity: a government could decide
to implement various policies to bring about a greater degree of equality and equity in an
economy, such as through a negative income tax.

🔗 You need to be able to distinguish between equity and equality. Equity is concerned with
fairness and justice whereas equality is concerned with people being the same in different
respects.

The difference between equity and efficiency

• efficiency: the use of scarce resources in the most economical or optimal way

» Equity: the concept of equity was discussed above in relation to the key feature of fairness.
» Efficiency: another objective of government microeconomic policy is the achievement of
efficiency. This involves the achievement of both productive and allocative efficiency. The
attainment of such efficiency would ensure that the scarce resources in an economy were
allocated in the best possible way — that is, it is concerned with optimality in the allocation and
use of resources.

🔗 Efficiency and inefficiency: a key concept in relation to the scarcity of resources in an

economy is that they should be allocated and used in the most efficient way possible.

The distinction between absolute poverty and relative poverty

• absolute poverty: a condition where household income is below the level necessary to
maintain basic living standards in relation to food, shelter and housing
• relative poverty: a condition where household income is a certain percentage below the
median income of a country

It is important to distinguish between absolute poverty and relative poverty:

» Absolute poverty is a type of poverty that occurs when the resources required for minimum
physical health are lacking, defined as limited access to food, clothing and shelter. The World
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Bank defines the poverty line as US$1.90 a day (using purchasing power parity, which takes into
account price levels in different countries). It refers to a particular condition that is the same in
every country and that does not change over a period of time

» Relative poverty is a type of poverty that means low income relative to others in a country. For
example, it could be stated as an income that is below 50 or 60% of the median income of people
in a particular country.

The poverty trap

• poverty trap: the situation where a person receives benefits that increase their income but
means that they are no longer entitled to receive as much as was the case before

A potential problem of means-tested benefits given by a government to reduce poverty is that, as

people receive money in the form of benefits, they may no longer be entitled to as much support
as was the case before. This gives rise to what has been termed the poverty trap.

Policies towards equity and equality

• negative income tax: the payment of money to those people on low incomes instead of
taking part of their income from them through income tax
• universal benefits: benefits that are provided to everyone who is entitled to them without
taking into account the income of those people
• means-tested benefits: benefits that are provided to those people entitled to them after
taking into account their income and, therefore, their need for the benefits
• tax credits: a form of benefit that is paid to people on low incomes to boost their income
and raise their standard of living
• universal basic income: a payment by a government to all those entitled to it without a
means test
• transfer payment: a form of payment to those in society who are less well off, paid for out
of the revenue received from taxation

Negative income tax

Income tax has already been referred to as a way of redistributing income because an income tax
is likely to be progressive. Many economies make use of progressive taxation to achieve the
macroeconomic objective of a fairer and more equitable distribution of income. A progressive
income tax not only takes more from a person as their income rises, but a higher proportion of that
income.

A negative income tax can also be used to redistribute income. This involves people on low
incomes receiving money from a government instead of paying income tax to it.

🔗 Candidates sometimes confuse an income tax and a negative income tax in their examination
answers. An income tax involves taking money from people, whereas a negative income tax
involves giving money to people.

Universal benefits

Sometimes a government will provide universal benefits to people that do not take into account
their income.

Means-tested benefits
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A government can also decide to provide benefits to those people who are less well-off through
means-tested benefits. An example of a means-tested benefit is tax credits, which are paid to
those people who have children or who have a job that pays a very low wage.

Universal basic income

A universal basic income is a government guarantee that each person in a country receives a
minimum income. The idea is that the basic income will provide enough money to cover the basic
cost of living.

Transfer payments

A government can decide to bring about a more equitable distribution of income and wealth
through the use of transfer payments. This means that revenue received from taxation is used to
give financial support to people, such as in the form of pensions. These payments can be
regarded as worthwhile because they involve money being received by those in society who are
less well off.

Inheritance and capital taxes

A government may also decide to intervene in an economy to try to bring about a more equitable
distribution of wealth, as well as income. Examples of taxes that can achieve this objective are
inheritance tax and capital gains tax.

KEY SKILL

Analysis: there might be examples of government failure as a result of a government deciding to

intervene in a market. You need to be able to analyse the possible causes and consequences of
such failure.

8.3 Labour market forces and government intervention

The demand for labour as a derived demand

• derived demand: where demand for the components of a product or for workers arises
from demand for the final product

Labour is not demanded for its own sake, but for what it can contribute to the production process.
This is known as derived demand.

Factors affecting the demand for labour in a firm or an occupation

• marginal physical product: the amount of extra output that is produced if a firm increases
its input of labour by one unit

A number of factors can affect the demand for labour in a firm or an occupation, in addition to the
quantity demanded of the product produced by the labour, referred to above. These include the
following:

» The price of labour and the other factors of production: the demand for labour will depend,
to some extent, on the price of labour (i.e. the wage or salary), compared with the prices of the
other factors of production.
» The productivity of labour and the other factors of production: the demand for labour will
depend, to some extent, on the productivity of labour relative to the productivity of the other factors
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of production. The demand for labour is closely linked to the marginal physical product of
labour; this refers to the additional output produced if a firm increases the labour input by one unit.

🔗 The margin and decision making: the concept of the margin can be analysed in relation to
marginal physical product; this is the additional output produced by a firm as a result of a decision
to increase the labour input by one unit.

Causes of shifts in and movement along the demand curve for labour in a firm or an
occupation

The demand curve for labour is a function of the wage paid. The higher the wage rate, the lower
the demand for labour; the lower the wage rate, the higher the demand for labour. The demand
curve for labour, therefore, slopes downwards from left to right. Other possible factors affecting the
demand for labour are assumed to be constant. Therefore, if the wage rate changes, there will be
a movement along the demand curve.
A shift of a demand curve for labour occurs when there is a change in a determinant of the
demand for labour, apart from a change in the wage rate. These changes include:

» changes in the productivity of labour

» changes in the skills of labour
» changes in the prices of the products produced
» changes in the demand for the products
» changes in the prices of substitutes and complements of the products

The demand curve for labour will shift inwards at a time of recession when the demand for
products falls and there will be a decline in the demand for labour at each wage rate. The demand
curve for labour will shift outwards in a boom when the demand for products rises and there will be
a rise in the demand for labour at each wage rate.

KEY SKILL

Diagrams: the demand curve for labour slopes downwards from left to right because the higher
the wage rate, the lower the demand for labour; and the lower the wage rate, the higher the
demand for labour.

Marginal revenue product theory

• marginal revenue product: the extra revenue obtained by a firm as it increases its output
by using an additional unit of labour

Firms are interested not only in the extra output that is produced by employing one more unit of
labour, but also in the revenue obtained from selling the additional output that has been produced.
The marginal revenue product of labour is obtained by multiplying the marginal physical product
of labour by the marginal revenue received by a firm.

The derivation of an individual firm’s demand for labour using

marginal revenue product

F8.2 shows the profit-maximising position where the marginal cost

of labour (MCL) equals the marginal revenue product of labour
(MRPL) at a wage of W* and a quantity of Q*. In F8.2, it is
assumed that a firm is in a perfectly competitive market for labour
and so cannot influence the price of labour (i.e. the wage). The firm
therefore regards labour supply as perfectly elastic, as shown by F8.2 The labour input decision
MCL. of a profit-maximising firm
under a perfect competition
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🔗 The margin and decision making: The concept of the margin can be analysed in relation to
marginal revenue product; this is obtained by multiplying the marginal physical product of labour
by the marginal revenue received by a firm deciding to employ that labour.

KEY SKILL

Diagrams: it is important to remember that the demand curve for labour is MRPL —the marginal
revenue product of labour.

Factors affecting the supply of labour to a firm or occupation

• pecuniary advantages: the advantages of employment that are in the form of financial
rewards or benefits
• non-pecuniary advantages: the advantages of employment, other than the money that is
gained, such as the job satisfaction gained from a particular form of employment
• net advantages: the overall advantages of employment, taking into account both the
pecuniary and the non-pecuniary advantages

The factors affecting the supply of labour can be divided into two types:

» wage factors
» non-wage factors

For the industry as a whole, the supply curve of labour will be upward sloping from left to right
because more people will make themselves available for work when the wage is increased.

For an individual worker, an increase in wages may persuade that

worker to work fewer hours in order to enjoy more leisure time. This
situation gives rise to a backward-bending supply curve for a
particular individual. Up to a wage of W*, the worker decides to work
more hours as the wage increases, but as the wage increases
above W*, they may decide to work fewer hours.

The backward-bending supply curve of a particular worker reflects

the importance of the pecuniary advantages of work to that
F8.3 A backward-bending
employee — the reward or benefit that is paid in the form of money. individual labour supply curve
Of course, there are also non-pecuniary reasons why people
work — that is, nonwage factors. These can include:

» the working conditions

» the promotion prospects and career opportunities
» the hours of work
» the pension provision
» the availability of fringe benefits
» the facilities available at work
» the strength of vocation/job satisfaction
» the training/professional development provided

Net advantages

The balance between the pecuniary and the non-pecuniary advantages of employment is known
as the net advantages.
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Causes of shifts in and movement along the supply curve of labour to a firm or an
occupation

Labour supply is defined as the number of workers willing and able to work, multiplied by the hours
they are willing and able to work:

» The higher the wage rate, the more labour is supplied; the lower the wage rate, the less labour is
supplied.
» The supply curve of labour, therefore, slopes upwards from left to right.
» Other possible factors affecting the supply of labour are assumed to be constant.
» Therefore, if the wage rate changes, there will be a movement along the supply curve.

A shift of a supply curve of labour occurs when there is a change in a determinant of the supply of
labour, apart from a change in the wage rate. These changes include:
» the size of the working population of a country — that is, the number of people of working age
who are willing and able to work — and this will be affected by such factors as changes in the
retirement age and the school leaving age
» the tax and benefit levels
» net migration (i.e. the extent of immigration and emigration)
» people’s preferences for work
» net advantages of work

KEY SKILL

Diagrams: the supply curve of labour slopes upwards from left to right because the higher the
wage rate, the greater the supply of labour; and the lower the wage rate, the lower the supply of
labour.

Wage determination in perfect markets

Equilibrium wage rate and employment in a labour market

Equilibrium in a labour market is just like equilibrium in any other

market — it is where demand is equal to supply. This can be seen in
F8.4 where the downward-sloping demand curve for labour and the
upward-sloping supply curve of labour intersect at a wage of W* and
a quantity of Q*.

🔗 Equilibrium and disequilibrium: situations of equilibrium and

disequilibrium can be seen in labour markets, just like in any other
market. F8.4 Labour market equilibrium

Wage determination in imperfect markets

• trade union: an organisation of workers that is involved in collective bargaining with

employers to achieve certain objectives (e.g. improvements in pay and working conditions)
• collective bargaining: the process of negotiation between trade union representatives of
the workers and their employers on such issues as remuneration (payment) and working
conditions
• closed shop: a requirement that all employees in a specific workplace belong to a
particular trade union

A labour market may not necessarily operate as a perfect market:

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» The workers may be members of a trade union, and trade unions may therefore have an
influence on the process of wage determination.
» A government may decide to intervene in the process, such as through the establishment of a
national minimum wage.
» There might be a single employer of labour, known as a monopsony employer.

The influence of trade unions on wage determination and employment in a labour market

It may be the case that workers belong to a trade union that

is involved in collective bargaining with employers on behalf
of the workers. A trade union may insist on the existence of a
closed shop to increase its bargaining power with employers.
A trade union can reduce the supply of labour — for example,
by pressurising the government and/or employers into making
entry into particular employment more difficult — and this will
have an effect on wages. This can be seen in Figure 8.5.
Without a trade union, the equilibrium position will be wage W*
F8.5 A trade union restricts
and quantity Q*. the supply of labour

However, if a trade union makes it more difficult for people to enter employment in that particular
industry, supply will shift from S to S1, the wage will now b e higher, at W1, and the quantity of
labour will now be lower, at Q1.

A trade union, in addition to restricting the supply of labour, could also try to increase the demand
for labour, such as through the negotiation of a productivity agreement with the employer. It could
also negotiate with the employer for a higher wage for the workers.

The influence of government on wage determination and employment in a labour market

using a national minimum wage

» In a free market, there would be no government

intervention, but governments do intervene in economies,
including in labour markets.
» For example, a government might decide to introduce a
minimum wage to prevent employees being paid below a
certain level.

» The effect of this can be seen in Figure 8.6. Without

government intervention, the equilibrium would be at a wage
of W* and a quantity of Q*, an equilibrium determined by the
intersection of demand and supply. F8.6 The effect of a minimum
» A government might decide, however, that the wage of W* is too low wage on a firm in a perfectly
and so might intervene in the market by introducing a national minimum competitive labour market

wage. This will be set above W* at a wage of Wmin. The advantage of

this is that those employed will gain a higher wage, but the disadvantage
is that fewer workers will be employed (Qmin rather than Q*).

🔗 A common error in examination answers on this part of the syllabus is to show the minimum
wage below where supply and demand intersect, rather than above this point. Candidates should
understand that there would be no point in having a minimum wage below what the wage in the
economy would have been without any form of intervention.

🔗 The role of government and the issues of equality and equity: a government could decide
to intervene in a labour market in an attempt to bring about a greater degree of wage equality,
such as through the establishment of a national minimum wage.
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KEY SKILL

Evaluation: you will need to be able to discuss the various advantages and disadvantages of
the establishment of a national minimum wage by a government in order to be able to make a
judgement as to whether it is a worthwhile policy option for a government to take.

The influence of monopsony employers on wage determination and employment in a

labour market

• monopsony: a single buyer of a product or of a factor of production such as labour

» In terms of wage determination, it has been assumed so far

that the industry demand curve is made up of a number of
firms in an industry. It could be the case, however, that there is
just one firm in the market to employ a factor of production.
Such a firm is known as a monopsony.
» In a competitive market, there will be many firms in an
industry and so each firm must accept the prevailing market
wage.
» If a firm is a monopsonist, however, the situation will be
different. This can be seen in Figure 8.7. If the market were a F8.7 A monopsony
competitive one, the equilibrium position would be where demand is equal to buyer of labour

supply; this would be at wage W* and quantity Q*.

» A monopsonist, however, would be at an equilibrium position where marginal cost was equal to
demand; this would lead to a lower wage of Wm and a lower quantity of Qm.

KEY SKILL

Analysis: you will need to be able to analyse the process of wage determination in imperfect
markets in relation to all three possible factors — that is, the role of trade unions, the role of
government and the role of monopsony employers.

The determination of wage differentials by labour market forces

If labour markets are very competitive, with identical workers and perfect mobility of labour, wages
will move towards the same equilibrium level. However, wages can differ greatly and these wage
differentials can be determined by a number of possible factors, including the following:

» Variation in human capital: this can result from differences in education and training.
» Differences in productivity: these can result from variations in the skills and experience of
workers.
» Discrimination: this can exist in relation to gender, ethnicity, disability and age.
» Compensation: wages can compensate for risk taking, working in poor conditions or having to
work unsocial hours.

These factors will influence the elasticity of supply of workers, as well as the elasticity of demand
of workers. Wages will tend to be higher, the more inelastic the supply and the more inelastic the
demand.

KEY SKILLS

Analysis and application: you will need to be able to analyse possible reasons for the existence
of wage differentials. You will also need to be able to apply your knowledge and understanding to
a particular example of wage differentials, such as between engineers and waiters.
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Transfer earnings and economic rent

• transfer earnings: the minimum payment required to keep a factor of production in its
present use
• economic rent: the extra payment received by a factor of production above what would be
needed to keep it in its present use

Transfer earnings refer to those earnings that are the F8.8 Transfer earnings
and economic rent
minimum that would be necessary to keep a factor of
production in a particular use.

Economic rent is the additional payment that a worker

receives above the transfer earnings. This can be seen in
Figure 8.8, where an employee receives a wage of W*. Some
of this wage will be in the form of transfer earnings (shown by
OBAQ*) and some of it will be in the form of economic rent
(shown by BAW*).

🔗 A common error in examinations is to confuse where economic rent and transfer earnings
should be shown in the diagram, as they are often labelled the wrong way round. It is important
that candidates include appropriate diagrams
wherever possible in their examination answers, but the diagrams
need to be accurately drawn and correctly labelled.

It is possible to draw a comparison between transfer earnings and normal profit and between
economic rent and supernormal profit.

KEY SKILL

Diagrams: in a demand and supply diagram where both economic rent and transfer earnings are
shown, the area indicating economic rent should be above the area indicating transfer earnings.

Factors affecting transfer earnings and economic rent in an occupation

• mobility of labour: the degree to which labour finds it easy to move from one job to
another (occupational mobility) and/or from one location to another (geographical mobility)
• immobility of labour: the degree of occupational immobility and geographical immobility of
labour that makes a labour market less flexible than it would otherwise be
• wage drift: a situation where the average level of wages in an industry tends to rise faster
than the supposed wage rates

The elasticity of demand and the elasticity of supply will determine the relative size of economic
rent and transfer earnings in an occupation.

The amount of economic rent that a worker is able to obtain is limited by the fact that in many
occupations there is not usually a high level of mobility of labour; in fact, in many labour markets,
there is a high degree of immobility of labour.

There can sometimes be differences in wages in an industry in different parts of a country. This is
because although there might be an officially agreed wage rate in an industry that is supposed to
apply across a whole country, specific demand and supply circumstances may mean that the
actual earnings of some workers in some parts of the country are higher. This situation is known
as wage drift.

KEY SKILL
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Application: a very good professional footballer will be able to gain a relatively large economic
rent because both demand and supply are relatively inelastic. A cleaner, on the other hand, will
receive a relatively small economic rent because both demand and supply are relatively elastic.

9 The macroeconomy

9.1 The circular flow of income

The multiplier process

The definition of the multiplier

• multiplier: the amount by which an increase in an injection into the circular flow of income
will bring about an increase of national income in an economy

The multiplier is an important concept in the determination of the level of income in an economy:
» It measures the extent to which an increase in an injection into the circular flow of income brings
about a magnified effect on the level of national income.
» An increase in injections, however, is also likely to have an effect on the withdrawals out of the
circular flow of income in an economy.
» Each successive increase in aggregate demand will therefore become progressively less.

🔗 Even if a particular examination question does not make explicit reference to the concept of
the multiplier, this does not mean that it should not be included in answers. If a question is
concerned with the determination of the level of income in an economy, candidates should
assume that they should refer to the multiplier in their answers.

The calculation of the multiplier

The size of an economy’s multiplier will depend on how many sectors are involved.

The calculation of the size of the multiplier in an economy:

Type of economy Calculation

Two-sector economy 1
(households and firms) marginal propensity to save

Or
1
𝑀𝑃𝑆

Three-sector economy 1
(households, firms and marginal propensity to save + marginal propensity to tax
government)

Or

1
𝑀𝑃𝑆 + 𝑀𝑃𝑇

Four-sector economy 1
(households, firms, marginal propensity to save + marginal propensity to tax +
government and foreign marginal propensity to import
 151

trade)

Or

1
𝑀𝑃𝑆 + 𝑀𝑃𝑇 + 𝑀𝑃𝑀

1
Another way of expressing the multiplier is
marginal propensity to withdraw

KEY SKILL

Numerical skills:
the size of the multiplier in a four-sector economy is calculated by the formula of:

1
MPS + MPT + MPM
Therefore, if the MPS is 0.10, the MPT is 0.20 and the MPM is 0.30, the multiplier will be 1/0.60 =
1.667

🔗 The margin and decision making: the margin is important in relation to the multiplier
because it is calculated by the formula:

1
𝑀𝑃𝑆 + 𝑀𝑃𝑇 + 𝑀𝑃𝑀

The multiplier is crucial in decision making as it will have an impact on decisions taken by a
government, such as in relation to expansionary or contractionary fiscal policy.

The average and marginal propensities to save, consume, tax and import

• consumption: the spending by consumers in an economy over a period of time

• average propensity to consume: the proportion of income that is spent
• average propensity to save: the proportion of income that is saved
• dissaving: a situation that can occur when consumption exceeds income, so people have
to rely on savings that have been accumulated in the past
• saving: the amount of disposable income that is not spent on consumption
• paradox of thrift: the contradiction between the potential advantages and the potential
disadvantages of saving in an economy
• marginal propensity to consume: the proportion of an increase in income that is spent
• marginal propensity to save: the proportion of an increase in income that is saved
• average propensity to tax: the proportion of income that is taxed
• marginal propensity to tax: the proportion of an increase in income that is taxed
• average propensity to import: the proportion of income that is spent on imports
• marginal propensity to import: the proportion of an increase in income that is spent on
imported goods and services

The proportion of income that is spent on consumption can be measured in two ways. The first
way is the average propensity to consume.
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The average propensity to consume refers to the average proportion of income that is actually
spent on buying goods and services in an economy. The proportion of income that is not spent is
saved, so it is also possible to refer to the average propensity to save.

It is possible that consumption actually exceeds income and so would need to be financed by
using past savings. This is known as dissaving.

Saving is generally regarded as a good thing for an individual, providing the person with the
opportunity to buy something in the future. But it is also possible to view it in a negative way in
terms of a society because it is a leakage or withdrawal from the circular flow of income in an
economy and so could contribute to a fall in national income. This contradiction is known as the
paradox of thrift.

The second way of measuring consumption is the marginal propensity to consume. Whereas
the average propensity to consume is concerned with a given income, the marginal propensity to
consume is concerned with a change in income and, in particular, with the proportion of that extra
income that is spent. The proportion of the extra income that is not spent is saved, so it is possible
to refer to the marginal propensity to save.

Although the main influence on consumption is the level of disposable income in an economy,
there are other possible determinants. These include:

» the distribution of income and wealth

» the rate of interest
» the availability of credit
» expectations about future economic prospects

It is not only important to consider average and marginal propensities to save and consume, but
also average and marginal propensities to tax and import. This is because knowledge of these
will be required in order to calculate the multiplier in a four-sector economy.

🔗 Candidates need to demonstrate they understand what is meant by the ‘paradox of thrift’.
Saving is generally regarded as a good thing to do in an economy, but it is important to recognise
that there may be possible disadvantages to saving, given that it constitutes a leakage or
withdrawal from the circular flow of income

National income determination using the aggregate demand and income approach

There are two ways to determine the level of income in an F9.1 A 45-degree diagram

economy. One way is by using the withdrawal (leakage) and

injection approach. The other way is by using the aggregate
demand and income (AD–income) approach.

The level of income in an economy is determined at the point

where aggregate demand is equal to output. Such a diagram
is also known as a ‘45-degree diagram’. The economy is in
equilibrium where AD crosses the 45-degree line, at Ye. Real
GDP is shown on the horizontal axis and aggregate demand
on the vertical axis.

Calculation of the effect of changing aggregate demand on national income using the
multiplier
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» A change in aggregate demand can have a much greater

final impact on the level of equilibrium national income than
the initial change because of the multiplier effect.
» This refers to the fact that an initial injection into the circular
flow of income stimulates further rounds of spending — one
person’s spending is another person’s income.
» This will eventually lead to a bigger effect on output and
employment than the initial injection.
» The operation of the multiplier can be seen in Figure 9.2.
The diagram shows the effect of an increase in injections
(shown by J) into the circular flow of income in an economy; this can be seen by F9.2 The effect of an
the vertical distance between J and J1. The effect of this has been to increase increase in injections
into the circular flow
national income from Y to Y1. The size of the multiplier (denoted by the symbol of income
k) can be calculated by dividing the change in Y by the change in J.

It is possible to distinguish between a positive multiplier and a negative multiplier:

» Positive multiplier: when an initial increase in an injection, or a decrease in a leakage, leads to

a greater final increase in real GDP.

» Negative multiplier: when an initial decrease in an injection or an

increase in a leakage, leads to a greater final decrease in real GDP.

The components of aggregate demand and their determinants

• autonomous savings: savings that are not related to changes in the level of national
income in an economy
• induced savings: savings that are related to changes in the level of national income in an
economy
• investment: spending on capital equipment (e.g. a machine or a piece of equipment that
can be used in the production process)

Aggregate demand (AD) refers to the total demand for, and expenditure on, all that is produced
in an economy. It can be represented in the following way:

AD = C + I + G + X – M

The consumption function

The consumption function shows the relationship between consumer spending and the various
factors affecting it. The main influence on consumption is the level of disposable income in an
economy and the consumption function shows the relationship between income and consumption.

Autonomous and induced consumer expenditure

It is important to distinguish between autonomous consumption and induced consumption:

» Autonomous consumption: this refers to consumption that is not related to income — that is,
consumption when income is zero.
» Induced consumption: this refers to consumption that is related to income — that is, as extra
income is gained, some of this will be spent (the percentage of extra income that is spent is known
as the ‘marginal propensity to consume’).
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🔗 Time: consumption refers to household expenditure in an economy over a period of time, not
just at one particular moment in time.

The savings function

The savings function shows the relationship between saving and the various factors affecting it.
Autonomous and induced savings

In the same way that it was possible to distinguish between autonomous and induced consumer
expenditure, it is possible to distinguish between autonomous and induced savings:
» Autonomous savings: this refers to savings that are not related to income — that is, savings
when income is zero.
» Induced savings: this refers to savings that are related to income — that is, as extra income is
gained, some of this will be saved (the percentage of extra income that is saved is known as the
‘marginal propensity to save’).

The investment function

Investment refers to the capital expenditure by firms in an economy over a period of time, such as
expenditure on factories, machinery and equipment. The investment function shows the
relationship between investment spending and the various factors affecting it.
There are many influences on the investment decisions of firms, but the main determinants are:

» the rate of interest

» changes in technology
» the productivity of labour
» the cost of capital goods
» changes in consumer demand
» expectations about future economic prospects
» government policies, such as in relation to taxes and subsidies

Autonomous and induced investment; the accelerator

It is important to distinguish between two types of capital investment:

» autonomous investment
» induced investment

Autonomous investment

• Autonomous investment: capital investment that is not related to changes in the level of
national income in an economy
Autonomous investment refers to expenditure on capital investment that is not the result of any
changes in the level of national income in an economy – in other words, it is independent of any
such changes. An increase or decrease in autonomous investment can be represented in a
diagram by an upward shift of the aggregate demand curve for an increase in autonomous
investment and a downward shift of the aggregate demand curve for a decrease in autonomous
investment.

Induced investment

• induced investment: capital investment that is related to changes in the level of national
income in an economy
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Whereas autonomous investment refers to expenditure on capital equipment that is unrelated to

changes in income in an economy, induced investment refers to expenditure on capital
equipment that is directly related to changes in income. For example, a rise in national income will
bring about an increase in induced investment. Induced investment is an important part of the
accelerator theory of investment.

The accelerator

• accelerator: a way of calculating the effect of a change in national income on investment in

an economy
• capital: output ratio: a way of measuring the amount of capital employed in the production
of a given level of output

The concept of the accelerator theory of investment is based on the link between changes in the
level of national income in an economy and changes in induced investment. It has two key
features:

» It states that investment is a function of a change in national income.

» It assumes a fixed capital : output ratio.

It is important to understand that the accelerator is concerned with the relationship between
investment and the rate of change of output — it is not the level of output that is important, but the
rate of change of that output.

🔗 Candidates sometimes confuse the multiplier and the accelerator; it is important to be able to
clearly distinguish between them. The multiplier shows the effect of a change in an injection, or in
a withdrawal, on the level of national income in an economy. The accelerator, on the other hand,
shows the effect of a change in the level of national income in an economy on the induced
investment; it is a measure of how much additional capital is required to produce each extra unit of
output.

Government spending

This can include government current spending on the wages and salaries of people who work in
the public sector and government capital spending on investment projects, such as a new road.
There are many influences on the spending decisions of a government, but the main determinants
include:

» government policy commitments on particular aspects of society

» the amount of tax revenue
» demographic changes

Net exports

The concept of net exports refers to exports minus imports. The determinants of net exports can
include:

» the relative prices of a country’s exports and imports

» the quality, reliability and reputation of a country’s exports and imports
» exchange rate movements

The full employment level of national income and equilibrium level of national income

Inflationary gap
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• inflationary gap: a situation where the level of aggregate demand in an economy is

greater than the aggregate supply at full employment, causing a rise in the general level of
prices in the economy

It is important to understand that equilibrium in an economy may F9.3 An inflationary gap

not necessarily be at the full employment level of income. An
inflationary gap shows a situation where equilibrium income is
greater than the full employment equilibrium — that is, aggregate
demand in an economy is greater than the full employment level of
aggregate supply.

Equilibrium income is at Ye where the withdrawals are equal to the injections. The full employment
level of income, however, is shown by Yf. The vertical distance between W and J at this point
shows the inflationary gap in the economy.

Deflationary gap

• deflationary gap: a situation where the level of aggregate demand in an economy is less
than the aggregate supply at full employment, causing unemployment in the economy
• output gap: the difference between the actual output and the potential output of an
economy

Whereas an inflationary gap shows a situation where F9.4 A deflationary gap

equilibrium income is greater than the full employment
level of income, a deflationary gap shows a situation
where equilibrium income is less than the full
employment equilibrium — that is, aggregate demand
in an economy is less than the full employment level of
aggregate supply.

Equilibrium income is at Ye where the withdrawals are equal to the injections. The full employment
level of income, however, is shown by Yf. The vertical distance between W and J at this point
shows the deflationary gap in the economy.

It should be noted that the terms ‘inflationary gap’ and ‘deflationary gap’ can also be referred to as
an output gap.

🔗 Equilibrium and disequilibrium: the concepts of equilibrium and disequilibrium are

particularly important in relation to the analysis of an inflationary gap or a deflationary gap.

9.2 Economic growth and sustainability

• economic growth: an increase in the national output of an economy over a period of time,
usually measured through changes in gross domestic product

Economic growth is defined as the increase in national output of a country over a period of time.
It is usually measured in terms of a change in gross domestic product (GDP). It is important to
distinguish between two types of economic growth in national output:

» actual growth
» potential growth

🔗 Time: economic growth refers to the increase in the national output of an economy over a
period of time.
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Actual growth versus potential growth in national output

• actual growth in national output: a movement from within the production possibility curve
of an economy to a position on the production possibility curve, resulting from the better
utilisation of the existing factors of production
• potential growth in national output: a shift outwards of the production possibility curve,
resulting from an increase in quantity and/or quality of factors of production in an economy

» Actual growth: economic growth in an economy can F9.5 Production possibility curves
come about by using the existing factors of production
more effectively, such as by reducing the number of people
unemployed. This can be shown by a movement from
within a country’s production possibility curve to a position
on the curve. This is known as actual growth in the national
output of an economy. Actual economic growth is also
known as demand-side economic growth because it is
affected by changes in the demand in an economy
measured by an increase in real GDP over a period of
time.

» Potential growth: it is also possible for the production possibility curve to shift outwards. This
would be due to an increase in the quantity of the factors of production available in an economy
and/or an increase in the quality of those factors. This is known as potential growth in the national
output of an economy.

The movement from X, within the production possibility curve, to Y, on PPC1, shows actual
growth. Potential growth is shown by the shift of the PPC curve from PPC1 to PPC2. The shift
from point Y to point Z is the realised increase in potential growth.

🔗 It is important to make sure that you understand the distinction between actual growth and
potential growth, and the distinction between a movement from inside a production possibility
curve to
a position on a production possibility curve and a shift outwards of the whole curve.

Positive and negative output gaps

An output gap indicates the difference between the actual output of an economy and the maximum
potential output of an economy. It is expressed as a percentage of GDP.

A country’s output gap may be either positive or negative:

» Positive output gap: where an economy is outperforming expectations because its actual
output is higher than the economy’s recognised maximum capacity output.
» Negative output gap: where actual output in an economy is below the economy’s full capacity
output.

The business (trade) cycle

• business (or trade) cycle: the fluctuations in the national output of a country, involving a
succession of stages or phases, including boom, recession, trough and recovery

Phases of the cycle

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The business or trade cycle refers to the fluctuations F9.6 The business cycle
in the full employment level of national output that take
place in an economy over a period of time.
The cycles vary in length and seriousness, but they
tend to follow the path of economic growth.

The cycle involves four stages in a sequence:

» Boom: a period of relatively high economic growth

» Recession: a period of economic downturn, defined as two successive quarters of negative

GDP growth

» Trough: a period of low aggregate demand and relatively high unemployment

» Recovery: a period when the level of aggregate demand begins to increase

🔗 Time: the business or trade cycle refers to the fluctuations in output and employment that take
place in an economy over a period of time.

The causes of the trade cycle

A number of factors can cause different phases of the cycle to occur, including:

» changes in interest rates

» changes in technology
» changes in global trade
» changes in levels of economic confidence
» changes in exchange rates
» changes in house prices
» the multiplier effect
» the accelerator effect
» changes in the level of liquidity in the financial sector
» volatility in stock market indices
» changes in fiscal policy

The role of automatic stabilisers

Automatic stabilisers are fiscal instruments that influence the rate of GDP growth and help counter
swings in the business cycle:

» Reducing the rate of economic growth: when there is a boom and a high rate of economic
growth, automatic stabilisers will help to reduce it — for example, a government will receive more
tax revenue, creating a greater withdrawal from the circular flow of income.
» Increasing the rate of economic growth: when there is a trough and a low rate of economic
growth, automatic stabilisers will help to increase it — for example, a government will increase
spending on unemployment benefits, creating an injection into the circular flow of income.

The policies to promote economic growth and their effectiveness

Economic growth in an economy can be brought about by a number of factors, including:

» an increase in the number of workers
» an improvement in the quality of labour (e.g. through acquiring new skills leading to a higher
level of productivity)
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» a greater commitment to research and development, in terms of both invention (i.e. the
discovery of new products and new methods of production) and innovation (i.e. the bringing of
these inventions to the marketplace)
» an improvement in the state of technology
» investment in capital stock
» a move towards more capital-intensive production
» increased mobility and flexibility of factors of production
» a more efficient allocation of resources
» development of new markets to export to
» a reduction in taxes on company profits to allow firms to have more funds to finance investment
» an upturn in the business (trade) cycle

The effectiveness of these factors will depend on the particular economic circumstances at a given
time, but key factors will be: investment, which increases productivity; education and training,
which enhance the quality of human capital; technological change, which leads to the availability
of better machines; and new markets for exports, which increase demand for a country’s goods
and services.

🔗 Don’t forget that economic growth is concerned not only with the quantity of the factors of
production used in the production process, but also with the quality of these economic resources.

🔗 Progress and development: economic growth can lead to an increase in the standard of
living and quality of life of people, and so can contribute towards progress and development.

Inclusive economic growth

• inclusive economic growth: growth that combines increased prosperity with greater
equality, creates opportunities for all and distributes the benefits of increased prosperity
fairly

Impact of inclusive economic growth on equity and equality

Inclusive economic growth is a concept that advances equitable opportunities for economic
participants with benefits enjoyed by every section of society. It aims to ensure that economic
growth benefits everyone and therefore has a positive impact on equity and equality in an
economy.

🔗 The role of government and the issues of equality and equity: inclusive economic growth
aims to ensure that growth benefits everyone and so has a positive impact on equality and equity
in an economy.

🔗 It is important that you are able to differentiate clearly between equality and equity. Although
both promote fairness, equality achieves this through treating everyone the same regardless of
need, whereas equity achieves it through treating people differently dependent on need.

Policies to promote inclusive economic growth

Policies to promote inclusive economic growth need to be concentrated in a number of specific

areas, emphasising that it:

» takes place in the sectors in which the poor work (e.g. agriculture)
» occurs in places where the poor live (e.g. undeveloped areas with few resources)
» uses the factors of production that the poor possess (e.g. unskilled labour)
» reduces the prices of consumption items that the poor consume (e.g. food, fuel and clothing)
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Policies to promote inclusive economic growth therefore need to focus on poverty reduction and
eradication. They need to address inequality and enhance growth and economic inclusion by:

» expanding access to quality education

» expanding access to quality healthcare
» investing in infrastructure
» deepening financial inclusion to reach the most vulnerable
» incentivising increased female labour force participation

There are various ways to bring inclusive economic growth about, including the following:

» Progressive incomes and wealth taxes can contribute to reducing inequality without sacrificing
growth.
» A universal basic income, where a government provides a guaranteed minimum income for all,
has the potential to reduce poverty and inequality; it indicates the state’s responsibility to support
incomes in a universal way.

Sustainable economic growth

• sustainability: the capacity to endure; it is the potential for the long-term maintenance of
well-being in an economic environment so that the interests of future, as well as present,
generations are taken fully into account

• sustainable economic growth: a rate of growth that attempts to satisfy the needs of the
present generation and sustain natural resources and the environment for future
generations

Sustainability refers to the ability to use existing resources to satisfy the needs of the present
generation without compromising the ability of future generations to satisfy their needs.
Sustainable economic growth can therefore be defined as economic growth that takes into
account the needs of future generations as well as those of the present generation.

Sustainable economic growth refers to a rate of growth that a country can maintain without
creating other economic problems, especially for generations to come. It stresses the idea of a
trade-off between rapid economic growth today and growth in the future. For example, rapid
growth today could exhaust resources and create environmental problems for the future.

🔗 Time: the concept of sustainability stresses the importance of time, in that the satisfaction of
the needs of the present generation should not be at the expense of those of future generations.

Using and conserving resources

The contrast between the potential benefits and costs of economic growth can be seen in relation
to the use or conservation of resources. The use of resources can contribute significantly to
economic growth, but it needs to be remembered that many natural resources are finite in supply
— in other words, they will eventually run out.

This is why it is strongly argued in many economies that there should be conservation of
resources. It is stressed that this is a more sustainable approach, taking into account the needs
not only of the present generation, but also of future generations.

The impact of economic growth on the environment and climate change

Rapid economic growth today may create environmental problems for future generations,
including the depletion of oil and fish stocks, and global warming.
 161

There are clear environmental costs to economic growth:

» higher levels of resource consumption

» the depletion or loss of non-renewable resources
» greater pollution, which can cause health problems and reduce the quality of life

Some of the key facts of climate change during the last 30 years include the following:

» Global temperatures have increased by 0.5°C.

» Sea levels have risen by 10 cm.
» Carbon dioxide in the atmosphere has increased by 17%.

🔗 Sustainability is an important concept in economics, taking into account the importance of the
needs of future generations and not just those of the present generation. Candidates should
include a consideration of sustainability in any answer to a question on the use and conservation
of resources.

Policies to mitigate the impact of economic growth on the environment and climate change

Policies to promote sustainable economic growth include the following:

» Technology: a government can provide financial incentives for private firms to invest in new
technology (e.g. alternative sources of energy such as wind power and solar power).
» Human capital development: government investment in human capital by allocating more
resources, and widening access to, education and training.
» Deregulation: a reduction of ‘red tape’ could encourage foreign direct investment in economies.
» Incentivisation: government can provide incentives to encourage people to start up their own
small and medium-sized businesses.
» Pollution permits: these can be reduced to lower the extent of pollution in an economy over a
period of time; fines can be imposed on those firms that do not respond appropriately to these
permits.
» Alternative transport to cars: government promotion of cycling and walking, and investment in
public transport, including buses, trams and trains.
» Taxation: a government could impose taxes on airline tickets to discourage consumption and
reduce the carbon footprint, and impose carbon taxes on energy suppliers to reduce the level of
carbon emissions; such initiatives would be drivers of decarbonisation.
» Legislation: a government could ban sales of new conventional petrol and diesel cars to
encourage the purchase of greener alternatives, such as electric cars or use of bio-fuel as a
source of energy, although this would require money to be spent on developing the necessary
infrastructure to provide for the charging of electric vehicles.
» Financial support: a government could offer interest-free home and business renovation loans
to drive energy efficiency; it could also offer such loans for environmentally efficient new buildings.
» Recycling: a government could use financial incentives to encourage recycling schemes and
initiatives that will reduce demand for scarce raw materials.
» Commitment to action on climate change: the United Nations (UN) is encouraging countries
to raise their emissions targets to include net zero emissions by 2050 (at the point of going to
press, 121 out of 193 UN member countries have agreed to this target of achieving carbon
neutrality) to protect people from the dangerous impact of climate change; achieving this target will
require appropriate actions to be implemented.
» Reforestation: a government could encourage firms to commit to a policy that requires them to
plant a new tree for every tree that they cut down.

Each of these policies is likely to have an impact on sustainable economic growth,

reducing the potentially damaging effect of growth on the environment.
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9.3 Employment/unemployment

The definition of full employment

• full employment: the level of employment as a result of everyone who is able and willing to
work having a job

There is some debate as to what actually constitutes a situation of full employment in an

economy, but it is generally taken to be a situation where everyone who wants a job has a job. In
many economies, this would be when there was an unemployment rate of about 4%.

Equilibrium and disequilibrium unemployment

• unemployment: where a number of people in an economy are able and willing to work but
are unable to gain employment
• equilibrium unemployment: a situation where jobs exist but people are unable or
unwilling to take them
• disequilibrium unemployment: a situation where the labour market is prevented from
clearing because wage rates are above their equilibrium value

Unemployment is where a number of people in an economy are able and willing to work but are
unable to gain employment.

It is possible to further to distinguish between the following two broad types of unemployment:

» Equilibrium unemployment: this type of unemployment exists when the labour market is at
equilibrium, meaning jobs exist but people are either unable or unwilling to take the jobs.
Examples of equilibrium unemployment are frictional unemployment, seasonal unemployment and
structural unemployment.
» Disequilibrium unemployment: this type of unemployment exists when the wage rate rises
above equilibrium and the labour market is prevented from clearing. Examples of disequilibrium
unemployment are cyclical/demand-deficient unemployment and real-wage or classical
unemployment.

🔗 Equilibrium and disequilibrium: these concepts can be used to analyse two distinct types of
unemployment, one where unemployment is due to people being unwilling to accept a job and the
other where unemployment is due to wage rates being higher than their equilibrium value

Voluntary and involuntary unemployment

• voluntary unemployment: a situation where a worker chooses not to accept a job at the
going wage rate
• involuntary unemployment: a situation where a worker is willing to work at the prevailing
wage but cannot find a job

It is also possible to distinguish between voluntary and involuntary unemployment:

» Voluntary unemployment: a situation where a worker deliberately chooses not to work

because of a low wage rate.
» Involuntary unemployment: a situation where a worker is willing to work at the market wage,
but is prevented from doing so by factors beyond their control, such as a deficiency of aggregate
demand or inflexibility in the labour market, especially wage rigidity. Geographical and
occupational immobility of labour can be a major cause of involuntary unemployment. In an
economy with involuntary unemployment, there is a surplus of labour at the current real wage.
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The natural rate of unemployment

• natural rate of unemployment: the non-accelerating inflation rate of unemployment (NAIR

U) or equilibrium unemployment; the rate of unemployment in an economy that will prevent
the rate of inflation increasing

The natural rate of unemployment stresses the link between the level of unemployment and the
rate of inflation in an economy. It is that level of unemployment which contributes towards a rate of
inflation that is nonaccelerating. It is essentially an equilibrium situation where the aggregate
demand for labour is equal to the aggregate supply of labour at the current wage rate; as a result
of this situation of equilibrium, there is no upward pressure on the level of prices in the economy.

Determinants of the natural rate

The natural rate of unemployment is the rate of unemployment when the labour market is in
equilibrium and is caused by structural, supply-side factors, such as a mismatch of skills, rather
than by demand-side factors.

There are a number of determinants of the natural rate of unemployment, including the following:

» Availability of information about jobs: this will be an important factor in determining how
quickly the people who are frictionally unemployed find jobs.
» Level of state benefits: relatively generous unemployment benefits may discourage people
from taking jobs at the existing wage rate; however, if the level of benefits is low, this will lead to a
fall in the natural rate of unemployment.
» Skills and education: the quality of skills and education will influence the level of occupational
mobility — a better trained and better educated workforce will be more occupationally mobile and
this will help to reduce the natural rate of unemployment.
» Level of geographical mobility of labour: the more willing people are to move to different
parts of a country, the more geographically mobile they will be and this will help to reduce the
natural rate of unemployment.
» Flexibility of the labour market: trade unions may be able to restrict the supply of labour to
certain labour markets, making them less flexible, and this will increase the natural rate of
unemployment.
» Hysteresis: a recession may cause a rise in the natural level of unemployment because when
people are unemployed for a relatively long period of time, they become deskilled and
demotivated, making it more difficult for them to find jobs (‘hysteresis’ refers to the delayed effects
of something).

Policy implications

The way to reduce the natural rate of unemployment in an economy is to implement supply-side
policies, including, but not restricted to:

» improved education and training to reduce the occupational immobility of labour

» better information about job vacancies in different parts of a country to reduce the geographical
immobility of labour (mobility of labour is covered later in this section)
» greater flexibility of labour markets, such as through the reduction of the powers of trade unions

Patterns and trends in (un)employment

• unemployment rate: the number of unemployed people divided by the labour force
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» It is important to distinguish between the level of unemployment, which is expressed as the

number of people who are unemployed in a country, and the unemployment rate, which is
expressed as a percentage.
» The unemployment rate refers to the total number of people who are unemployed in a country
divided by the labour force.
» Economists are interested in discovering patterns and trends in the rate of unemployment in a
country over a period of time. It is useful to establish whether the trend is upward or downward; if it
is upward, the government will need to devise appropriate policies to try to reduce the rate.
» The unemployment rate of a country will fluctuate, moving up and down in line with changes in
economic activity and different phases of the business (trade) cycle, but economists are interested
in the long-term trend.
» Economists are interested not only in the long-term trends in employment/ unemployment, but
also in the long-term changes in the patterns of employment, such as in relation to employment in
the primary, secondary and tertiary sectors of economic activity.

🔗 Candidates need to distinguish between the number of people who are unemployed in an
economy and the rate of unemployment in the economy. In the first case, it will be a number; in
the second case, it will be a percentage.

KEY SKILL

Interpretation of data: economists are interested in discovering not only the rate of
unemployment in an economy in particular months and years, but also the overall trend in that rate
over a period of time.

Mobility of labour

• geographical mobility of labour: when a worker has the ability to move from one place to
another within a country or from one country to another
• occupational mobility of labour: when a worker has the ability to move from one
occupation to another, either in the same industry or in a different industry

Forms of labour mobility

Mobility of labour refers to the ability and willingness of labour to move from one place to another
or from one occupation to another. There are thus two types of labour mobility:

» Geographical mobility refers to a worker’s ability to move from one place to another within a
country or from one country to another.
» Occupational mobility refers to a worker’s ability to move from one occupation to another,
either in the same industry or in a different industry.

Factors affecting labour mobility

There are a number of factors affecting labour mobility, including the following:

» Education and training: labour mobility is affected by the extent to which the labour force is
educated and trained; the more a person is educated and trained, the greater their occupational
mobility is likely to be.
» Transport and communication: a more developed transport and communication system is
likely to encourage labour mobility, especially geographical mobility.
» Job information: the availability of appropriate information about jobs and job vacancies will
impact on labour mobility, both geographical and occupational.
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» Wage differences: differences in wages in different regions of countries, or in different

countries, and in different occupations will have an influence on the extent of geographical and
occupational mobility.
» Cost of living: the cost of living can vary a great deal between different regions of a country and
between different countries, and this could have an impact on the geographical mobility of labour,
especially in relation to the affordability of accommodation.
» Immigration policy: the ability of labour to move from one country to another may be restricted
by the immigration policies of governments.

Policies to reduce unemployment and their effectiveness

A number of different policies can be used to reduce unemployment in an economy.

Fiscal policy

» Fiscal policy, used to reduce unemployment, will involve the reduction of taxation, both direct
and indirect, to increase the level of consumption. Taxes on companies can also be reduced to
encourage greater investment. Government expenditure can also be increased.
» A reduction in taxation and/or an increase in government expenditure will increase the level of
aggregate demand in an economy and this is likely to reduce the level of unemployment.

Monetary policy

» Another possible approach to the reduction of unemployment is through the use of monetary
policy.
» Interest rates could be lowered and/or the money supply increased to encourage spending in an
economy.
» If the cost of borrowing is reduced, this will encourage people to spend more and save less.
Also, if interest rates in an economy are lowered, this is likely to lead to a fall in the exchange rate;
if this happens, it will make a country’s exports more price competitive in international markets and
this could lead to an increase in demand for them and therefore an increase in the derived
demand for labour to produce them.

Supply-side policy

» Whereas fiscal policy and monetary policy operate to influence the level of aggregate demand in
an economy, it is also possible to reduce the level of unemployment in an economy through the
use of supply-side policy.
» Supply-side policies would be particularly effective in trying to reduce the natural rate of
unemployment in an economy. Any policies that help markets to work more efficiently would be
likely to increase the number of workers employed.
» For example, policies to make the labour market more flexible, such as restrictions on trade
unions, would be likely to lead to greater employment. Education and retraining schemes would
help to make workers more employable.

KEY SKILLS

Problem solving: you need to understand that there are three broad policies to reduce the
problem of unemployment in an economy: fiscal policy, monetary policy and supply-side policy.

Evaluation: you will need to be able to evaluate the policies that could be used to reduce
unemployment in an economy, weighing up the different benefits and limitations of the various
policies, before coming to a judgement as to their relative effectiveness.

9.4 Money and banking

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The definition, functions and characteristics of money

• barter: the direct exchange of one good or service for another

• double coincidence of wants: a situation in a barter system where a seller finds a buyer
who wants what is being sold and where the seller also wants something that the buyer has
and is willing to trade in exchange
• money: anything that is generally acceptable in a society as a means of payment
• near money: something that can perform some, but not all, of the functions of money
• liquidity: the extent to which a financial asset can be turned into cash (e.g. if some shares
in a company are sold, the paper asset becomes money)
• cash: the notes and coins issued in a country that are legal tender
• bank deposits: deposits of money in accounts in financial institutions, many of which in a
modern economy are in electronic form
• cheque: a method of payment (i.e. a means of transferring money from one account to
another); it is not, however, a form of money
• legal tender: any form of payment that is legally recognised to settle a debt or make a
payment

Before the development of money, barter was used. This involved the direct exchange of goods
and services without the use of any form of money.

Barter, however, had a number of disadvantages:

» It needed a double coincidence of wants — that is, each person was required to need what
the other person was offering.
» It was often very difficult to compare the value of different products.
» Some of the products would be indivisible, such as animals.
» Some products might be difficult to store during the time that a seller was looking for a buyer.

For these reasons, money came to replace barter. Money is defined as anything that is generally
acceptable as a means of payment in an economy. The following concepts are important:

» Near money refers to an asset that can be immediately changed into money and can be used to
settle some, but not all, debts. It can therefore perform some of the functions of money, but not all
of them; it would be difficult for near money to perform the function of medium of exchange (see
the next section).
» Liquidity is defined in relation to how easy it is to turn a financial asset into cash, with cash
itself being 100% liquid. In a modern economy, some deposits are still in the form of cash, but
many deposits are in the form of bank deposits. In this case, the money is mainly in an electronic
form.
» A cheque can be used as a means of payment, but it is not the same as money because a
cheque is not always acceptable.
» The reward for parting with liquidity is interest. If a person deposits cash in a savings account,
which they can no longer use for a period of time, their reward is an additional sum of money that
they receive in the future together with the amount of money originally deposited.

🔗 Time: if an amount of money is deposited in an account for a period of time, a reward is given
in the form of interest.

🔗 Candidates should understand that the great advantage of money over barter is that it avoids
the need for a ‘double coincidence of wants’. This does not mean, however, that barter has
completely disappeared. In many economies, barter still exists.

The functions of money

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• medium of exchange: the use of money as an acceptable means of payment between

buyers and sellers of a product
• unit of account (or measure of value): the use of money to establish the value of a
product
• store of value or wealth: the use of money to store wealth
• standard for deferred payment: the use of borrowed money to purchase a product now
and repay the debt in the future
• credit: a contract agreement in which a borrower receives a sum of money now and repays
the lender at a later date, usually with interest

The four functions of money:

Function of Explanation of function

money
A medium of Money works much more effectively than barter, in that money is
exchange generally acceptable as a means of payment for goods and services.
This is the main reason that money is usually preferred to barter — there
is no need to establish a double coincidence of wants between two
people.

A unit of account Money enables the value of different products to be compared. This is
or another distinct advantage of money over barter.
measure of value
A store of value Wealth can be stored as money and this is much more convenient than
or wealth storing items that might have been used in a barter system, such as
cattle. Of course, one problem with this function of money is that inflation
will reduce its purchasing power and therefore its value.

A standard for This function of money enables people to borrow money and pay it back
deferred at a later date. This encourages credit and can act as an incentive to
Payment trade. Payment can be spread over a period of time — something that
was much more difficult with barter.

🔗 Time: the function of money as a standard of deferred payment means that people can borrow
money and pay it back at a later date (i.e. payment can be spread over a period of time).

The main characteristics of money in a modern economy

Acceptability Money needs to be generally acceptable in a society if it is going to be

used as a medium of exchange for buying and selling goods and services.
Portability Money needs to be easily transported if it is going to perform its functions
effectively.

Scarcity Money needs to be relatively scarce, otherwise it will become worthless.

Recognisability Money needs to be easily recognised; this will help to establish it and
maintain people’s confidence in it.

Stability of Money needs to be reasonably stable in value over a given period of time if
value people are going to have confidence in it, although inflation can negatively
affect this characteristic.
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Divisibility Money must be divisible into smaller parts, or denominations, if it is going

to be able to carry out its functions.

Durability Money needs to be durable (i.e. relatively hard-wearing) over time.

🔗 Don’t confuse the functions of money with the characteristics of money.

Definition of money supply

Broad and narrow money supply

• money supply: the amount of money available to the general public and the banking
system in an economy
• broad money supply: a measure of the stock of money that reflects the total potential
purchasing power in an economy
• narrow money supply: a measure of the stock of money in an economy, which is mainly
cash
• monetary base: the cash held by the general public and by the banking system, including
the balances of the financial institutions with the central bank of the country; it acts as the
basis for any expansion of bank lending in an economy

The money supply refers to the total amount of money in an economy at any one time. It is an
important macroeconomic variable. Different countries use different definitions of the money
supply, but it can be broadly classified into broad money supply and narrow money supply:

» A broad money supply reflects the total purchasing power that is available in an economy at a
particular time. It is often termed M4 and includes notes and coins plus all bank and building
society deposits.
» A narrow money supply is mainly the cash that is available in an economy at a particular time.
It is often termed M0 and includes the notes and coins held by the general public, in cash
machines and in balances that the financial institutions have with a country’s central bank. This
narrow money supply is also sometimes known as the monetary base.

The quantity theory of money

• quantity theory of money: the hypothesis that, since MV = PT, and the velocity of
circulation (V) and the volume of transactions (T) are constant, changes in the price level
(P) in an economy are directly proportional to changes in the money supply (M)

The quantity theory of money shows the relationship between the money supply, the general
price level and the level of output in an economy.

It hypothesises a theoretical relationship between variations in the price level and variations in the
money supply. It can be expressed in terms of MV = PT, which is sometimes known as the Fisher
equation, where:

» M is the value of the money supply

» V is the velocity of circulation
» P is the general price level
» T is the number of transactions
V and T are assumed to be constant over a period of time because it is unlikely that there is going
to be a great deal of difference in the velocity of circulation or in the number of transactions in an
economy from one year to the next.
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In this case, M and P are directly linked. This means that if the money supply rises, people will
have access to more funds, giving them greater purchasing power, and as a result of this, the
general level of prices in the economy will rise — that is, a situation of inflation will exist. Persistent
inflation can therefore only arise through persistent excessive growth in the money supply, which
can be seen in terms of persistent outward movements of the aggregate demand curve.

The theory has been widely discussed over the years, especially in relation to whether it is correct
to assume that V and T are constant over a period of time. It has also been criticised for being less
of a theory and more of an identity that is necessarily true — in other words, MV represents total
spending in an economy and PT represents the total money received for the goods and services.
It is the same situation, but looked at in different ways.

The functions of commercial banks

Financial institutions, including commercial banks, provide an important link between borrowers
and lenders, and given this position in the financial system, they are known as ‘financial
intermediaries’.

The functions of commercial banks include the following:

» Providing deposit accounts: commercial banks provide a variety of different accounts,

including demand deposit or current accounts where money can be deposited and withdrawn at
any time, fixed deposit accounts, where money is deposited for a fixed period of time, and various
kinds of savings accounts.
» Lending money: commercial banks can lend money in different forms, including an overdraft,
where a current account is allowed to be overdrawn up to a certain maximum amount, a loan,
where a specific amount of money is lent for a particular period of time, and a mortgage, similar to
a loan but usually for a longer period of time in order to buy a property.
» Holding or providing cash, securities and equity: commercial banks can hold or provide
cash, in the form of notes and coins, and various kinds of securities, such as shares or equities in
limited companies and government securities.

The reserve ratio and capital ratio

• reserve ratio: the proportion of the funds that a commercial bank has that it is required to
maintain with the central bank and that are not available for commercial lending
• capital ratio: the amount of a commercial bank’s capital in relation to the amount of risk it
is taking

» The reserve ratio of a commercial bank refers to central bank regulations that establish the
minimum capital reserves that a commercial bank must hold as a percentage of its deposits. The
bank reserve ratio is also sometimes known as the ‘cash reserve ratio (CRR)’ or ‘bank reserve
requirement’.
» A higher proportion of reserves indicates financial soundness because a commercial bank would
be better able to meet any future losses.
» The reserve ratio is a reserves to capital ratio and is calculated by reserves divided by capital.
» The capital ratio of a commercial bank measures the funds that it has against the riskier assets
that it holds that could be vulnerable in the event of a financial crisis.
» Commercial banks are sometimes required to carry out stress tests to check that they have
enough of a capital buffer to cope with any possible economic or financial circumstances.
» Commercial banks are usually required to maintain a capital ratio of at least 8%, i.e. this is a
bank’s core equity capital divided by its total risk-weighted assets, expressed as a percentage.

KEY SKILL
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Numerical skills: the reserve ratio is calculated by reserves divided by capital. As an example, if
the reserve ratio was 11% and a commercial bank had deposits of $1 billion, it would be required
to have $110 million on reserve.
The objectives of commercial banks

Commercial banks have three key objectives:

» Liquidity: as indicated earlier in this section, this refers to the ease with which assets can be
converted into cash. In relation to commercial banks, it refers to their ability to finance all of their
monetary obligations to their creditors when due — these obligations can be in relation to lending,
investment, the withdrawal of deposits and the maturity of liabilities.
» Security: commercial banks need to clearly demonstrate that they are a safe, secure and
trustworthy means of storing money so that customers have confidence in them.
» Profitability: commercial banks are usually examples of public limited companies and, like any
such company, their main aim is to make a profit for their shareholders.

The causes of changes in the money supply in an open economy

There are a number of different causes of changes in the money supply in an open economy.

Commercial banks as sources of credit creation and the bank credit multiplier

• credit creation: the process by which financial institutions are able to expand their lending
by a multiple of any new deposits received; this multiple is known as the ‘credit multiplier’
• credit multiplier: the relationship between new money created and cash deposits made

» Financial institutions are able to create ‘new’ money as a result of additional cash deposits. This
is known as ‘credit creation’. Commercial banks know from experience that only a certain
proportion of customers will want to take out money at any particular time.
» This means that a large proportion of money deposited can be loaned to new or existing
customers through a process known as ‘fractional reserve banking’ — the requirement that such
institutions only need to hold a certain percentage of their total liabilities, say 10%, in the form of
cash reserves.
» The ratio of new money created to the initial money deposited is known as the ‘credit
multiplier’. The value of the multiplier is calculated by 1 divided by the desired cash ratio that the
commercial banks decide to hold. The smaller the cash ratio, the larger is the credit multiplier.

🔗 Despite financial institutions having a great deal of experience of how much to lend, the
decision of many financial institutions to lend out too much money was a major cause of the
financial crisis in 2007–08. This created a lack of confidence in financial institutions, some of which
became bankrupt.

KEY SKILL

Numerical skills: the credit multiplier is calculated by 1 divided by the cash ratio. Therefore, if the
cash ratio is 5%, the credit multiplier will be 1/0.05 = 20.

The role of a central bank

• central bank: the main bank in a country that is responsible for oversight of the banking
system

A central bank may wish to control the ability of commercial banks to lend money, such as
through open market operations. This is the process of buying or selling government securities —
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that is, bonds and/or shares issued by the government. If a central bank wants to encourage bank
lending, it will buy government securities.

Government deficit financing

» If government expenditure is greater than government revenue, there will be a budget deficit.
» ‘Deficit financing’ refers to the generation of funds to finance the deficit which results from this
excess of expenditure over revenue.
» The deficit could be financed by borrowing from commercial banks or from the central bank. If
the government borrows from commercial banks, for example, this will increase the banks’ liquid
assets, which will increase their ability to lend. This will lead to an increase in the money supply.

Quantitative easing

• quantitative easing: the process whereby the government, central bank or monetary
authority of a country deliberately buys bonds and bills in order to increase the money
supply in an economy

The process of the central bank buying existing government securities, such as bills and bonds,
from financial institutions, such as commercial banks, is known as quantitative easing. Existing
securities are bought by the central bank, leading to an increase in bank deposits, and this creates
more liquidity and a greater money supply in the system. In some countries, it is known as ‘credit
easing’.

🔗 Candidates should understand that quantitative easing has been used by a number of
countries, including the USA and the UK, to stimulate economic activity where the financial crisis
of 2007–08 has led to a recession.

KEY SKILL

Evaluation: you need to be able to assess the potential benefits and limitations of quantitative
easing. For example, although it can lead to an increase in aggregate demand in an economy, the
greater money supply could have an inflationary impact.

Changes in the balance of payments

• total currency flow: an element of the balance of payments that refers to the total inflow or
outflow of money which results from a country’s international transactions with other
countries

The total currency flow is a part of a country’s balance of payments and shows the total inflow
and outflow of money resulting from a country’s international transactions with the rest of the
world. If the flow is positive, it is likely to increase the foreign exchange reserves of a country. This
net inflow of money into a country will have the effect of increasing its money supply.

Policies to reduce inflation and their effectiveness

There are three possible ways to reduce the rate of inflation in an economy: fiscal policy, monetary
policy and supply-side policy.

Fiscal policy

A relatively high rate of inflation can be corrected by fiscal policy. For example, if a government
decides to reduce expenditure and/or increase taxation, this will have the effect of reducing the
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level of aggregate demand in an economy. This is a particularly useful approach to adopt when
the inflation has been caused by demand-pull factors.

Monetary policy

A relatively high rate of inflation can also be corrected by monetary policy. For example, if a
government decides to increase the rate of interest and/or reduce the money supply, this will have
the effect of reducing the level of aggregate demand in an economy. This is also a useful
approach to adopt when the inflation has been caused by demand-pull factors.

Supply-side policy

It is also possible to use supply-side policies to reduce the rate of inflation in an economy. If
supply-side policies are used to make the labour market more competitive and more efficient, such
as by reducing the power of trade unions or reducing unemployment benefits, this will have the
effect of increasing aggregate supply. Another approach would be to use supply-side policies to
increase the degree of competition in a market, such as by privatising state-owned firms and
encouraging small and medium-sized businesses, which would also have the effect of increasing
aggregate supply.

KEY SKILLS

Problem solving: you need to understand that there are three possible ways to solve the problem
of inflation in an economy: fiscal policy, monetary policy and supply-side policy.

Evaluation: you will need to be able to evaluate the policies that could be used to reduce inflation
in an economy, weighing up the different benefits and limitations of the various policies, before
coming to a judgement as to their relative effectiveness — for example, supply-side policy could
be successful in reducing inflation in an economy, but it might take longer and cost more money
than either fiscal or monetary policy.

The demand for money: liquidity preference theory

• liquidity preference theory: the Keynesian theory of interest rate determination, based on
three motives for holding money — the transactions motive, the precautionary motive and
the speculative motive
• transactions demand for money: money that is demanded to pay for everyday
purchases; it is an active balance and is interest inelastic
• active balances: money that is flowing through the economy, underpinning the
transactions and precautionary motives for holding money
• precautionary demand for money: money that is demanded to pay for unexpected
expenses; it is an active balance and is interest inelastic
• speculative demand for money: money that is demanded to buy government bonds; it is
an idle balance and is interest elastic
• idle balances: money that is withdrawn from the circular flow of money in an economy,
underpinning the speculative motive for holding money
• yield: the annual income obtained from a bond or a share as a proportion of its current
market price
• liquidity trap: a situation at low rates of interest when changes in the money supply will
have no effect on the rate of interest and where the demand for money is perfectly elastic

The demand for money in an economy and the determination of interest rates can be analysed
through the liquidity preference theory.
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This Keynesian approach to the demand for money and the determination of interest rates is
based on three motives for holding money:

» the transactions demand for money

» the precautionary demand for money
» the speculative demand for money

The transactions demand for money is where money is

demanded to pay for everyday purchases. This is an active
balance and is interest inelastic — in other words, this demand
for money does not respond to changes in interest rates. F9.7 The liquidity trap

The precautionary demand for money is where money is demanded to pay for unexpected
expenses. Like the transactions demand for money, it is an active balance and is interest inelastic.

The speculative demand for money is where money is demanded to buy government bonds.
Unlike the transactions and precautionary demand for money, it is regarded as an idle balance
and one that is interest elastic. An important influence on the demand for a bond is the yield,
which is the annual income obtained from the bond as a proportion of its current market price. The
price of government bonds and the rate of interest will move in opposite directions because, if the
interest rate is high, this will reduce the desire to hold money. On the other hand, if the interest
rate is low, there will be less of an incentive to switch out of money into other assets.

Another distinctive feature of the speculative demand for money, unlike the other two motives, is
that the demand curve is downward sloping. In fact, at low rates of interest, the liquidity preference
(or demand) curve becomes horizontal, indicating that a change in the money supply will have no
effect on the rate of interest. At this point, the demand for money is perfectly elastic. This is known
as the liquidity trap and it occurs when an increase in the money supply does not affect the
interest rate and so does not affect investment or aggregate demand.

A shift of the money supply curve to the right would normally lead to a lowering of the rate of
interest. However, when there is a liquidity trap, an increase in the money supply does not affect
the interest rate, which beyond MS0 remains at r0.

Interest rate determination: loanable funds theory and Keynesian theory

Keynesian theory

» The Keynesian theory stresses that interest is a reward for parting with liquidity for a specified
period of time. According to Keynes, interest is a purely monetary phenomenon and the theory of
interest is a monetary theory of interest.
» The Keynesian theory stresses that the rate of interest is determined by the demand for, and the
supply of, money.
» As has already been pointed out, according to Keynesian theory, the demand for money comes
about as a result of three motives: the transactions, precautionary and speculative motives.
» The supply of money is fixed and controlled by the monetary authority and is perfectly interest-
inelastic.

Loanable funds theory

• loanable funds theory: the idea that interest rates are determined by the demand for, and
the supply of, loanable funds in financial markets

» An alternative approach to the determination of interest rates is the loanable funds theory.
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» This states that the rate of interest is determined by the demand

for, and the supply of, loanable funds in financial markets.
» In other words, the rate of interest is a price and, just like any
other price in an economy, it is determined by the interaction of the
demand for, and the supply of, loanable funds (the supply of funds
from savings and the demand for funds for investment).

The demand for loanable funds comes from:

» firms wanting to invest

F9.8 The loanable
» households wanting to buy consumer products funds theory
» a government aiming to fund a budget deficit

The demand curve for loanable funds slopes down from left to right.

The supply of loanable funds comes from savings.

The supply curve for loanable funds slopes up from left to right. the rate of interest is determined
by the demand for, and the supply of, loanable funds. A rate of interest of R is established for a
quantity Q of funds.

10 Government macroeconomic intervention

10.1 Government macroeconomic policy objectives

Government macroeconomic policy objectives

three macroeconomic policy objectives were stated: price stability, low unemployment, economic
growth and stability of the current account of the balance of payments. It is now possible to
complete the full list by adding three more areas: development, sustainability and the redistribution
of income and wealth.

It is clear that governments generally have a wide range of objectives in relation to

macroeconomic policy, but in most cases, they tend to focus on a combination of the following
seven objectives:

» a relatively low and stable rate of inflation

» equilibrium in the balance of payments over a period of time
» a low rate of unemployment/full employment
» an appropriate rate of economic growth
» an appropriate rate of development
» growth and development that is regarded as sustainable
» the redistribution of income and wealth

🔗 Time: at any one moment in time, the government of a particular country may have certain
priorities in relation to the achievement of these objectives, but over a period of time all
governments will aim to achieve a degree of success in each of them.

10.2 Links between macroeconomic problems and their interrelatedness

It should be stressed that macroeconomic problems are not separate and distinct, but are often
interrelated in different ways.

The interrelatedness of macroeconomic problems:

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Relationship Challenge

The relationship It is important to distinguish between the internal and the external
between the internal value of money, but it should also be recognised that the two values
and the external are interrelated. For example, if the internal value of a currency falls
value of money as a result of a high rate of inflation in a country, exports too will
become more expensive. If the demand for these falls, so will the
demand for the currency to pay for them. In this situation, there will be
a depreciation in the external value of the country’s currency.

The relationship A relatively high rate of inflation in a country will make exports more
between the expensive, and therefore demand for them is likely to fall, but the
balance of demand for imports may remain unchanged, as many countries have
payments and a relatively high marginal propensity to consume imported products.
inflation In such a situation, the balance of payments is likely to deteriorate.

The relationship If fiscal and monetary policies are used in an economy to stimulate
between economic economic growth, this could lead to an increase in the rate of inflation.
growth and inflation However, if supply-side policies are used instead, leading to a
rightward shift in the long-run aggregate supply curve, this could
enable economic growth to be achieved without necessarily leading to
an increase in the rate of inflation.
The relationship An increase in economic growth could result in an increase in higher
between economic real incomes and this could lead to an increase in the imports of
growth and the goods and services. If this happened, it could have a negative effect
balance of on the balance of payments.
payments

The relationship between inflation and unemployment

The traditional Phillips curve

» The relationship between the level of inflation and the rate of F10.1 The Philips curve
unemployment in an economy can be seen in the Phillips curve
» Such a curve shows the trade-off between inflation and
unemployment — as the rate of inflation increases, this will be
accompanied by a fall in the rate of unemployment, and as the
rate of inflation decreases, this will be accompanied by a rise in
the rate of unemployment.
» For example, if a government deliberately aims to bring down
the rate of aggregate demand in an economy, such as through an
increase in taxes or interest rates, this is likely to put some people
out of work.
» It needs to be pointed out, however, that this traditional Phillips
curve has now been largely discredited.

KEY SKILL

Diagrams: the Phillips curve shows the relationship between the rate of inflation and the rate of
unemployment in an economy; there is a trade-off between inflation and unemployment and this is
why the curve is downward sloping from left to right.

The expectations-augmented Phillips curve

» Figure 10.1 shows the Phillips curve as a downward-sloping curve.

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» However, some economists have argued that there is not a F10.2 The long-run
Phillips curve
trade-off between inflation and unemployment in the long run.
It is argued that if actual inflation rises, expected inflation will
also increase and the Phillips curve will move upwards so as
to give the same expected real wage increase at each
employment level. It is therefore necessary to build
expectations of inflation into the relationship.
» The long-run Phillips curve therefore shows that there is a
rate of unemployment that occurs when inflation is stable.
» This is known as NAIRU — the non-accelerating inflation
rate of unemployment.
» Figure 10.2 shows how expectations about inflation can influence the position of the Phillips
curve. SRPC0 shows the initial downward-sloping Phillips curve in the short run with the economy
in equilibrium at point A. If the rate of inflation rises from 3% to 5%, there will be a movement
along SRPC0 to point B.
» However, once there is a higher rate of inflation, people adjust their expectations about inflation
so that the Phillips curve moves to another short run Phillips curve, SRPC1. Unemployment
returns to Unat.
» The new equilibrium is now at point C with the same level of unemployment as before but with a
higher rate of inflation.
» The long-run expectations-augmented Phillips curve is shown as a vertical straight line (LRPC).

🔗 Equilibrium and disequilibrium: the position of equilibrium and disequilibrium is seen in

relation to the expectations-augmented long-run Phillips curve.

KEY SKILL

Diagrams: whereas the short-run Phillips curve is shown as a downward-sloping curve from left to
right, the long-run Phillips curve can be shown as a vertical straight line.

10.3 Effectiveness of policy options to meet all macroeconomic objectives

The effectiveness of different policies in relation to different macroeconomic objectives

Fiscal policy

Fiscal policy is the deliberate adjustment of government spending and/or taxation to achieve
particular macroeconomic objectives by changing the level and composition of aggregate demand.

There are two types of fiscal policy:

» Discretionary fiscal policy: this refers to policies that are implemented by specific one-off
policy changes.
» Automatic fiscal stabilisers: these refer to a situation in which automatic changes in
government spending and/or taxation work to help reduce the volatility of the economic cycle.

The effectiveness of fiscal policy is largely dependent on the balance between taxation and
spending. Fiscal policy can be either expansionary (when there is a budget deficit) or
contractionary (when there is a budget surplus).

Expansionary fiscal policy can help to reduce the level of unemployment in an economy and
contractionary fiscal policy can help to reduce the level of inflation.
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Taxation can fund government projects, which could help to stimulate economic growth.
Progressive taxation can be especially relevant to the redistribution of income and wealth in an
economy.

The advantages and disadvantages of fiscal policy

the main advantages and disadvantages of fiscal policy in relation to meeting macroeconomic
objectives:

The advantages of fiscal The disadvantages of fiscal policy

policy

• Public spending can have a • There may be a significant time lag before a particular
significant impact on the level of revenue or expenditure decision begins to take effect
aggregate demand in an (e.g. between a reduction in income tax and an increase
economy. in household spending).

• Public spending can help to • The potential benefit of a fiscal decision may not be fully
reduce the level of seen because of the existence of information failure.
unemployment in an economy.
• There may be side-effects of any fiscal policy (e.g.
• Direct taxes (e.g. income tax) unemployment may be reduced, but at the cost of a
can help to redistribute income higher rate of inflation).
in an economy.
• Changing tax rates, allowances and bands is more
• Indirect taxes can be targeted complex than changing interest rates as part of monetary
at altering certain kinds of policy.
behaviour (e.g. taxes on a
demerit good such as tobacco). • Higher taxes may have a disincentive effect on work and
enterprise (e.g. higher taxes may encourage people to
• If the spending is on work less so as to have more leisure time).
infrastructure, this can help
increase economic growth. • A government needs to be able to estimate reasonably
accurately the likely effects of any change in taxation
and/or public expenditure, otherwise the desired
objectives may not be achieved.

• Some decisions that are justified by economic reasoning

may not be taken by a government for political reasons,
especially if an election is due in the not-too-distant
future.

🔗 Scarcity and choice: a government, in carrying out fiscal policy, will need to make a choice
between different areas of spending — for example, more money spent on infrastructure may
mean less money spent on defence and national security, giving rise to an opportunity cost.

🔗 Progress and development: fiscal policy can be used to encourage economic growth and
this can contribute to progress and development in an economy.

KEY SKILL
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Evaluation: when analysing fiscal policy in relation to the achievement of different

Macroeconomic objectives, it is necessary to evaluate the policy in terms of its various benefits
and limitations. For example, fiscal policy can be effective in encouraging economic growth and
reducing unemployment, but there could be a trade-off in terms of higher inflation.

Laffer curve analysis

• Laffer curve: a way of showing the relationship between changes in the rate of tax and
changes in the total revenue gained from the tax; when the tax rate is increased, the total
tax revenue first begins to rise and then falls

The effectiveness of fiscal policy can be considered in terms F10.3 The

of Laffer curve analysis. A Laffer curve shows the Laffer curve
relationship between the rate of tax and the revenue gained
from it.

The Laffer curve in Figure 10.3 shows that as the rate of a tax
is increased — that is, as the tax rate moves from 0 to 100%
along the horizontal axis — the revenue gained from it
increases up to a point. However, if the tax rate is increased
further, the total tax revenue begins to fall. At these high rates
of taxation, therefore, the tax is not worthwhile as it actually
brings in less revenue than at the lower rates of tax.

Monetary policy

» Monetary policy is the deliberate adjustment of the money supply or interest rates to achieve
particular macroeconomic objectives by changing the level and composition of aggregate demand.
» Monetary policy can be either expansionary (when there is an increase in the money supply
and/or a decrease in the interest rate) or contractionary (when there is a decrease in the money
supply and/or an increase in the interest rate budget).
» Expansionary monetary policy can help to reduce the level of unemployment in an economy and
contractionary monetary policy can help to reduce the level of inflation.

The advantages and disadvantages of monetary policy

The advantages and disadvantages of monetary policy in relation to meeting macroeconomic

objectives:

The advantages of The disadvantages of monetary policy

monetary policy

• Changes in interest • There is a time lag between a change in an interest rate and the
rates can have a impact of that change on an economy; it is difficult to be precise
significant effect on about how long that time lag might be, but a number of
spending in an economy, economists have suggested that it could be as long as 18
indicating that demand is months.
interest elastic.
• People may react differently to a change in interest rates — in
• A central bank in many other words, not everyone will have the same interest elasticity of
countries where it is demand. For example, relatively high-income / high-net-worth
independent from individuals in an economy are likely to have a relatively inelastic
government can make interest elasticity of demand, whereas relatively poor people are
decisions about changes likely to have a relatively elastic interest elasticity of demand. This
in interest rates and/or makes it difficult to estimate the likely effects of a change in
 179

changes in the money interest rates in an economy.

supply without political
interference. • Any increase in the money supply of an economy, such as
through the process of quantitative easing at a time of recession,
• Interest rates can be is likely to have an inflationary effect in that economy, resulting
adjusted on a monthly from the increase in the level of aggregate demand.
basis; this contrasts with
discretionary fiscal policy, • The accuracy of inflation forecasts may be relatively poor;
which cannot be so easily monetary policy tries to reduce inflationary pressures (or increase
changed at such regular them, depending on the economic conditions) before they occur,
intervals. but if inflation is higher than predicted, the interest rate may be
too low to control the rate of inflation effectively in an economy.
• Interest rate changes
can have a relatively • An increase in interest rates to control inflation could have a
immediate effect on negative effect on other areas of an economy (e.g. it could have a
levels of confidence in an negative impact on investment spending and therefore on
economy. economic growth, and changes in interest rates could also affect
the exchange rate and the balance of payments).

• The money supply may be difficult to control in practice.

KEY SKILL

Evaluation: when monetary policy is being analysed in relation to the achievement of different
macroeconomic objectives, it is necessary to evaluate the policy in terms of its various benefits
and limitations. For example, a reduction in the interest rate is likely to lead to an increase in
aggregate demand, leading to a fall in unemployment, but there could be a time lag before this has
a significant effect in an economy.

Supply-side policy

Supply-side policies can be divided into:

» market-based policies (e.g. reducing the size of government, lower taxes and opening up more
flexible markets)

» interventionist policies (e.g. regional policies and education and training initiatives)

The main advantages and disadvantages of supply-side policy in relation to meeting

macroeconomic objectives:

The advantages of supply-side The disadvantages of supply-side

policy policy

• Policies such as better education and • There is no guarantee that a firm in the
training can increase aggregate supply in an private sector will be more efficient than one
economy and improve an economy’s in the public sector; privatisation may involve
productive capacity and potential output, the need to make some people unemployed,
shifting the LRAS curve to the right. leading to an increase in the rate of
unemployment.
• Supply-side policies are of particular
importance in reducing the natural rate of • A privatised firm may be in a monopoly
unemployment in an economy, especially in position in an economy, so all that has been
relation to structural and frictional achieved is a move from a state-owned to a
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unemployment. privately owned monopoly.

• Supply-side policies can improve the level • A lowering of unemployment benefits and/or
of competition, encouraging greater efficiency a lowering of taxes might persuade more
in markets. people to look for work, but this will have no
effect if there are no jobs available for them.
• Supply-side policies enable sustained
economic growth to be achieved without • The effects of supply-side policies can take
causing a rise in inflation (depending on how a long time to show, as in the case of
the policy impacts on aggregate demand in improvements to the quality of human capital
the short run); they help reduce inflationary through initiatives in training and education;
pressure in an economy in the long run the potential benefits of deregulation may also
because of the achievement of efficiency take a long time to have an effect in markets.
and productivity gains in the product and
labour markets. • Supply-side policy can be very costly to
implement, such as improvements in the
• Supply-side policies can not only help to provision of education and training.
achieve a lower rate of unemployment and a
higher rate of sustainable economic growth • Some supply-side policies may be strongly
through their positive effect on labour resisted if they have the effect of reducing the
productivity and competitiveness, but also power of certain interest groups, such as
help to improve a country’s balance of trade unions where their influence has been
payments. reduced by certain labour market reforms.

• Supply-side policy is, on the whole, less • There could be a conflict with the aim of
likely to create conflicts between the equity, such as when supply-side policies
macroeconomic objectives of stable prices, have a negative effect on the distribution of
sustainable economic growth, full income in an economy, at least in the short
employment and balance of payments run. For example, reductions in the power of
equilibrium compared with the use of fiscal trade unions and greater privatisation could
and/or monetary policy. contribute to a widening of the gap between
high-income/high-net-worth and low-
income/low-net-worth individuals.

🔗 Efficiency and inefficiency: supply-side policies can lead to the more efficient use of factors
of production. For example, policies such as better education and training can lead to an increase
in labour productivity, increasing aggregate supply in an economy and improving an economy’s
productive capacity and potential output, shifting the LRAS curve to the right.

KEY SKILL

Evaluation: when supply-side policy is being analysed in relation to the achievement of different
macroeconomic objectives, it is necessary to evaluate the policy in terms of its various benefits
and limitations. For example, policies that make labour markets more flexible are likely to lower
unemployment, but deregulation and privatisation could lead to a higher rate of inflation.

Exchange rate policy

» The exchange rate of an economy affects the level of aggregate demand through its impact on
export prices and import prices.
» Deliberate changes in exchange rates to affect macroeconomic objectives can be regarded as a
type of monetary policy.
 181

» Changes in exchange rates have an impact on an economy through their effect on prices, in
terms of both exports and imports.

The advantages and disadvantages of exchange rate policy in relation to meeting macroeconomic
objectives:

Advantages of exchange rate policy Disadvantages of exchange rate

policy

• A depreciation or a devaluation can have an • A depreciation or a devaluation, whilst

expansionary impact (i.e. raising the level of lowering the price of exports, will increase
aggregate demand in an economy if that is the price of imports, and so it could contribute
what is required). to an increase in the rate of inflation.

• A depreciation or a devaluation can • There will be a time-lag between any

increase national output (GDP). change in an exchange rate and its impact
on an economy.
• A depreciation or a devaluation can create
jobs, leading to a reduction in unemployment. • The scale of any change in an exchange
rate may be extremely small and, in this case,
• A depreciation or a devaluation can lead to it is unlikely to have much of an effect.
an improvement in the current account of a
country’s balance of payments, assuming that • It is generally assumed that the PED for
the PED for exports and imports is greater both exports and imports is likely to be
than 1. relatively elastic, but this may not necessarily
be the case.
• An appreciation or a revaluation can have a
contractionary impact (i.e. lowering the level • An appreciation or revaluation of an
of aggregate demand in an economy, if that is exchange rate would increase the price of
what is required). exports, so it could contribute to an increase
in the rate of unemployment, depending on
• An appreciation or a revaluation can reduce the relative size of the export sector in the
the rate of inflation. economy.

• The change in an exchange rate may take

place at an unfavourable phase in the
business (trade) cycle.

KEY SKILL

Evaluation: when exchange rate policy is being analysed in relation to the achievement of
different macroeconomic objectives, it is necessary to evaluate the policy in terms of its various
benefits and limitations. For example, a depreciation of an exchange rate will reduce the prices of
exports and this could help to lower unemployment in an economy, but such a depreciation will
also increase the price of imports and this could help to raise inflation.

International trade policy

The impact of international trade policy on the macroeconomic objectives of a government will
depend on the degree of liberalisation in relation to world trade, especially the extent to which
protective trade barriers, such as tariffs and quotas, have been reduced or removed.

the advantages and disadvantages of international trade policy in relation to meeting

macroeconomic objectives:
 182

The advantages of international trade The disadvantages of international

policy when it promotes free trade trade policy when it promotes free
trade

• The promotion of free trade will secure • The promotion of free trade could bring in
market openings with trade partners. more partners wanting to trade with a country.

• This could lead to an increase in the level of • This could lead to an increase in the level of
exports to such partners. imports from such partners.

• This could reduce the level of • This could increase the level of
unemployment in the export sector and unemployment in an economy and lower
encourage economic growth. economic growth.

The advantages of international trade The disadvantages of international

policy when it promotes protectionism trade policy when it promotes
protectionism

• Infant/sunrise industries are protected, • Resources are not allocated efficiently.

maintaining employment.
• Consumers have a smaller range of
• Declining/sunset industries are protected, products to choose from.
maintaining employment.
• Economic growth may be lower than would
• Strategic industries (e.g. agriculture and otherwise be the case if there was no
defence) are protected, which is likely to be protectionism.
important to an economy.

KEY SKILL

Evaluation: when international trade policy is being analysed in relation to the achievement of
different macroeconomic objectives, it is necessary to evaluate the policy in terms of its various
benefits and limitations. For example, a free trade policy could reduce unemployment and
increase economic growth if an economy benefits from the greater trade, but free trade could also
lead to an increase in imports, increasing unemployment and reducing economic growth. A
protectionist policy could help to keep down unemployment, but economic growth might be lower
than would otherwise be the case.

Problems and conflicts arising from the outcomes of these policies

It is not easy for a government to achieve success in all its policy objectives because there may
often be a conflict between them. Examples of possible problems and conflicts include the
following:

» A depreciation or devaluation of an exchange rate could be used to increase the demand for
exports and decrease the demand for imports, thus reducing the size of a balance of payments
deficit. However, if the price elasticity of demand for imports is relatively inelastic, as it often is in
many countries, the demand for the more expensive imports will not be affected very much. The
consequence of this is that it will contribute to inflation in an economy, both in terms of the import
of raw materials and component parts and in relation to the import of finished goods.
 183

» The possible trade-off between inflation and unemployment has already been pointed out (see
section 10.1 of this chapter). Policies to control unemployment will usually have a positive effect
on the rate of economic growth in an economy, but there may then be a conflict between the goal
of economic growth and the need to protect the environment. Economists have certainly pointed
out that a very high rate of economic growth may not be sustainable — that is, it may lead to
environmental degradation and a depletion of resources that do not take the needs of future
generations into account.
» If a government decided that it needed to stimulate the economy, this would have a positive
effect on the level of unemployment, which would be likely to fall, and on the rate of economic
growth, which would be likely to rise, but if the increase in aggregate demand were greater than
the increase in aggregate supply, this would be likely to be inflationary. Moreover, if there were a
relatively high marginal propensity to import, this increase in demand would be likely to worsen the
economy’s balance of payments position.

🔗 The margin and decision making: the concept of the margin is important in relation to the
marginal propensity to import because if this was relatively high, an increase in aggregate demand
in an economy could worsen the balance of payments position.

The existence of government failure in macroeconomic policies

It is also possible that a government may fail in its macroeconomic policies. For example:

» Taxation: a government could use taxation to try to bring about a more equitable distribution of
income and wealth in an economy, but a number of people may decide to leave a country as a
direct result of such a policy, especially if income tax becomes so progressive that people believe
that they are paying too much of their income in tax.
» Information failure: there could be a time lag between the decision to introduce a policy and
the time when that policy begins to take effect, but in the meantime, the economic situation may
have changed. For example, a decision could have been taken to raise interest rates to control the
level of inflation in an economy, but by the time this has begun to have an effect, inflation might
have been replaced by unemployment as the main economic problem.

🔗 Time: there may be a time lag between a decision to introduce a particular policy and the time
when that policy begins to take effect.

11 International economic issues

11.1 Policies to correct disequilibrium in the balance of payments

The components of the balance of payments accounts

• balance of payments: a record of all transactions linked with exports and imports, together
with international capital movements; it consists of the current account, the capital account
and the financial account

The balance of payments is a record of the transactions that a country has with the rest of the
world. It shows the payments and receipts arising from this international trade. It consists of three
accounts:

» the current account

» the financial account
» the capital account
 184

There is also a balancing item.

The current account of the balance of payments

The current account of the balance of payments was discussed in Chapter 6, section 6.3.

The financial account of the balance of payments

• financial account of the balance of payments: records the capital inflows and capital
outflows resulting from investment in different countries

The financial account is that part of the balance of payments which records the capital inflows
into a country and the capital outflows out of a country resulting from investments. It comprises:

» direct investment (e.g. the building of a factory in another country)

» portfolio investment (e.g. the buying and selling of government securities)
» other investment (e.g. bank loans and government loans)
» reserve assets (e.g. government holdings of gold and foreign exchange reserves)

The capital account of the balance of payments

• capital account of the balance of payments: records transactions where there is a

transfer of financial assets between one country and another; a financial asset could
include the purchase of a physical asset such as land

The capital account is that part of the balance of payments which records capital movements, in
terms of assets and liabilities, into and out of a country. These could include physical assets such
as the purchase of land, the sales and purchase of patents, copyrights and royalties, and dealings
such as debt forgiveness.

Net errors and omissions

• net errors and omissions: records those transactions in the balance of payments that go
unrecorded

It is not always possible to identify all payments accurately, so there may well be some
transactions that go unrecorded: these are shown in the balance of payments as net errors and
omissions.

The balancing item

• balancing item: a positive or negative figure that accounts for any statistical errors in the
balance of payments and ensures that the accounts, when added together, come to zero

The balance of payments should eventually balance — in other words, when all of the various
parts of the balance of payments are included, the eventual figure should be zero. There may,
however, be an imbalance resulting from statistical discrepancies between payments in and
payments out, so the balancing item is used to make the balance of payments accounts balance.

The effect of fiscal, monetary, supply-side, protectionist and exchange rate policies on the
balance of payments

It is now necessary to extend this discussion to include exchange rates and to consider the effect
of all of them on the whole balance of payments — not only the current account, but the other
accounts as well.
 185

Fiscal policy

» If a country is experiencing a deficit in the financial account, this is not necessarily a problem as
it will bring about an inflow of profits, interest and dividends in the future.
» The government could reduce taxation and/or increase public expenditure. This is likely to
improve confidence in a country’s economic prospects, encouraging investment and a reduction of
the deficit on the financial account.
» If a country is experiencing a surplus in the financial account or the capital account, the
government could increase taxation and/or reduce expenditure.

Monetary policy

» If a country is experiencing a deficit in the financial account or the capital account, the
government could increase interest rates.
» This is likely to increase the flow of hot money coming into the country in search of higher
interest rates.
» If a country is experiencing a surplus in the financial account or the capital account, the
government could increase the growth of the money supply and/or decrease interest rates.

Supply-side policy

» If a country is experiencing a deficit in the financial account or the capital account, the
government could use supply-side measures to improve the performance of the economy.
» For example, privatisation and deregulation will increase competition in markets and make
domestic firms more efficient, improving quality and lowering costs.
» Increased government spending on training and education could also lead to an increase in
productivity. This is likely to lead to a movement of firms and funds into the country.

Protectionist policies

» If a country is experiencing a deficit in the financial account or the capital account, the
government could impose a tariff on imports.
» This would make the imported goods more expensive and so discourage their consumption, with
consumers now more inclined to buy domestically produced substitutes. This would be likely to
attract investment and capital into the country.

Exchange rate policies

If a country is experiencing a deficit in the current account, the government could lower the
exchange rate to make its exports more competitive in world markets. However, if it was
experiencing a deficit in the financial account or capital account, the government could raise the
exchange rate to encourage capital movements into the country.

KEY SKILL

Problem solving: if a country is experiencing a deficit or a surplus in its balance of payments

accounts (i.e. the current account, the financial account or the capital account), the government
could use a variety of fiscal, monetary, supply-side, protectionist or exchange rate policies to try to
overcome this problem.

The difference between expenditure-switching and expenditure-reducing policies

Two approaches can be used in an economy to correct an imbalance or disequilibrium in the

balance of payments:
 186

» expenditure-switching policies
» expenditure-reducing policies

Expenditure-switching policies

• expenditure-switching policy: a policy that attempts to bring about a change in the

pattern of demand in an economy by reducing the demand for imports

Expenditure-switching policies are intended to switch demand away from some products and
towards others. In particular, they aim to encourage an increase in the demand for exports and a
decrease in the demand for imports. Different methods can be used to reduce the demand for
imports. They can include:
» tariffs
» import duties
» quotas
» subsidies to domestic producers of goods that are imported
» exchange controls
» embargoes
» excessive administrative burdens on imported goods
» voluntary export restraints (VERs)

One problem associated with such policies is that they involve restraints on free trade and are
therefore generally opposed by the World Trade Organization. This is why many economies
decide to use expenditure-reducing policies rather than expenditure-switching policies. Another
problem associated with them is that they often generate retaliation from aggrieved trade partners.

Expenditure-reducing policies

• expenditure-reducing policy: a policy that attempts to bring about a reduction in the level
of aggregate demand in an economy in order to reduce the value of imports

Whereas an expenditure-switching policy is concerned with changing the patterns of demand for
different products, an expenditure-reducing policy is concerned with producing a more general
reduction in the demand for all products in an economy.

This will have two effects:

» The demand for imported goods will fall.

» The demand from within an economy for all goods will fall, so domestic producers will need to
compensate for this by increasing the level of exports.

This process of expenditure-reducing can be carried out by various strategies, including the
following:

» Deflationary fiscal policy: for example, through an increase in taxation and/or a reduction in
government expenditure; the effect will be to create a downward multiplier effect in the economy,
bringing down the level of aggregate demand.

» Deflationary monetary policy: for example, through an increase in interest rates and/or a
reduction in the money supply.

Economists agree that the most efficient way to reduce or eliminate a balance of payments deficit
is to improve the quality of the goods produced in an economy, and to reduce the unit cost of
production/price, so that more people will buy them, both within the domestic market and abroad.
 187

Many economies have adopted a variety of supply side-policies to improve the competitiveness of
their domestic goods and services.

🔗 Balance of payments disequilibrium has been discussed in terms of a persistent deficit, but
don’t forget that disequilibrium can also refer to persistent surpluses in the balance of payments.

11.2 Exchange rates

Measurement of exchange rates

The distinction between nominal and real exchange rates

• nominal exchange rate: an exchange rate that is expressed in money terms without taking
into effect the possible effects of inflation
• real exchange rate: an exchange rate that takes into account the effects of inflation in
different countries
• purchasing power parity: the value of a currency in terms of what it would be able to buy
in other countries

» The usual way to express the value of one currency in terms of another is through a nominal
exchange rate. A nominal value is expressed in money terms, without taking inflation into
account.
» However, this will not take into account the purchasing power of a nominal sum of one currency
in relation to the purchasing power of another currency.
» It is necessary, therefore, to express an exchange rate as a real exchange rate.
» In this situation, exchange rates will be expressed in terms of purchasing power parity (PPP)
— by taking into account price levels in different countries, exchange rates can be adjusted so as
to give a more accurate comparison of the purchasing power of currencies. PPP is therefore a
method of accounting for differences in the cost of living when comparing different economies.

KEY SKILL

Numerical skills: there are different ways of calculating PPP . One way is known as ‘absolute
PPP ’. This refers to the equalisation of price levels across countries. It is calculated by dividing
the price level in one country by the price level in another country. For example, if a product is
priced at €375 in France and £250 in the UK, absolute PPP is calculated by €375/£250 =
€1.50/£1.

Trade-weighted exchange rates

• trade-weighted exchange rate: a way of measuring changes in an exchange rate in terms

of a weighted average of changes in other trade partner currencies

Another way of expressing an exchange rate is to relate it to changes not in one other currency,
but in a number of other trade partner currencies. These different currencies are weighted to take
into account their importance in international trade. As with other indices, a base year is selected
and given a value of 100. The trade-weighted exchange rate is also called the ‘effective
exchange rate’.

🔗 Candidates need to demonstrate a clear understanding of the concept of purchasing power

parity. This concept is important because it enables the purchasing power of a currency to be
established by taking into account different price levels in various countries.

The determination of exchange rates under fixed and managed systems

 188

Two other systems in which exchange rates are determined are fixed and managed systems.

Fixed exchange rate system

• fixed exchange rate: an exchange rate that is determined at a particular level by a

government

Whereas a floating exchange rate system allows exchange rates to be determined by the forces of
demand and supply in a free market, a fixed exchange rate system is where exchange rates are
set at a particular level by a government. They are not determined by the forces of demand and
supply.

A fixed exchange rate system is operated in the following ways:

» The central bank of a country continually buys and sells its domestic currency in order to
maintain its value; it will need sufficient amounts of foreign reserves and/or gold to buy the
currency when needed to maintain its value.
» The central bank can change the rate of interest to maintain a fixed exchange rate. If the
exchange rate is about to fall, interest rates will be increased, whereas if the exchange rate is
about to rise, interest rates will be lowered.

The advantages and disadvantages of a fixed exchange rate system

Advantages of a fixed Disadvantages of a fixed exchange rate system

exchange rate system

• It provides greater certainty in • It limits a central bank’s ability to adjust interest rates for
relation to economic planning domestic economic reasons (e.g. in relation to economic
and forecasting; this can growth).
encourage investment and
trade. • It prevents adjustments to the exchange rate when a
currency becomes overvalued or undervalued (although
• It can help a government the fixed rate could be adjusted from time to time).
maintain a relatively low rate of
inflation. • If a currency becomes extremely overvalued or
undervalued, there will be a need for large devaluations or
• It provides more stability and revaluations periodically, which can be more disruptive to
therefore helps to limit an economy than the regular adjustment of a floating
speculation. exchange rate system.

• It requires a large amount of foreign reserves to support a

currency when it is under pressure (i.e. when economic
conditions necessitate intervention by a government,
central bank or monetary authority).

Managed exchange rate system

• managed (or dirty) float: an exchange rate that is partly determined by the forces of
demand and supply, but is also managed by a government, so that it is only allowed to float
between certain parameters
 189

Sometimes a government may allow the exchange rate to be determined by market forces to
some extent, but will intervene to restrict the degree of floating between a minimum and maximum
value. This is often referred to as a ‘dirty float’. A managed exchange rate system, therefore,
combines elements of a floating and a fixed exchange rate system, maintaining a value which has
upper and lower limits.

🔗 Candidates need to demonstrate an understanding that a managed exchange rate system is a

mixture of a floating and a fixed exchange rate system.

The distinction between the revaluation and devaluation of a fixed exchange rate system

• revaluation: the rise in value of a currency that is fixed

• devaluation: the fall in value of a currency that is fixed

It is important to distinguish between a revaluation and a devaluation of a fixed exchange rate:

» When the value of a fixed exchange rate goes up, it is known as a revaluation.
» When the value of a fixed exchange rate goes down, it is known as a devaluation.

🔗 In the examination, candidates need to distinguish clearly between a revaluation/devaluation,

which will occur in a fixed exchange rate system, and an appreciation/depreciation, which will
occur in a floating exchange rate system.

KEY SKILL

Numerical skills: when the value of the UK£ against the US$ is reduced from £2.00 to £1.60, it is
a devaluation of 20% because now a UK£ will buy less than it did before.

Changes in the exchange rate under different exchange rate systems

» These changes take place continually in response to changes in the demand for, and the supply
of, a currency.
» With a fixed exchange rate system, changes in an exchange rate take place at periodic intervals
when the fixed rate has become extremely overvalued or undervalued.
» If the problem is one of overvaluation, there will be a devaluation. If the problem is one of
undervaluation, there will be a revaluation.
» With a managed exchange rate system, minor changes in an exchange rate will take place
continually but only within certain parameters — that is, the changes will be within a narrow band.

The effects of changing exchange rates on the external economy

The Marshall–Lerner condition

• Marshall–Lerner condition: the requirement that, for a depreciation or devaluation to be

successful in correcting a current account deficit, the sum of the price elasticity of demand for
exports and the price elasticity of demand for imports must be greater than 1

» An important factor to take into account when assessing the effect of a change in the exchange
rate on an economy relates to the price elasticity of demand of imports and exports.
» A depreciation or devaluation is generally expected to bring about an increase in the demand for
exports, because they are now relatively cheaper than they were, and a reduction in the demand
for imports, because they are now relatively dearer than they were.
» However, the ultimate effect of these price changes will depend on the price elasticity of demand
for both the exports and the imports.
 190

» If a depreciation or devaluation is to be successful in terms of improving a current account

deficit, the sum of the price elasticity of demand for exports and the price elasticity of demand for
imports needs to be greater than 1. This is known as the Marshall–Lerner condition.

The J-curve effect

• J-curve effect: a situation, after a depreciation or devaluation, when the current account of the
balance of payments gets worse before it gets better

» A country’s exchange rate can be F11.1 The J-curve effect of a devaluation

depreciated/devalued in value in order to encourage
an increase in exports and a decrease in imports.
» These effects, however, may not happen
immediately and there may be a period of time when
the current account deficit becomes greater before it
gets better. This is known as the J-curve effect. It
depends on the price elasticity of demand for both
exports and imports.
» The reason for this J-curve effect is that buyers take time to adjust to price changes. It initially
gets worse; a lower price for exports and a higher price for imports may eventually have an effect
on demand, but the expected changes will not happen immediately.
» Eventually the lowering of an exchange rate may have a positive effect on the external economy,
if the purchase of exports is encouraged and the purchase of imports is discouraged.

Time is measured on the horizontal axis and current account on the vertical axis. The current
account is initially in deficit. A devaluation at time A will initially push the current account further
into deficit because of the price inelasticity of domestic supply. The deficit will eventually reduce,
but only at time B, when domestic firms have had time to expand their output to meet the demand
for exports, will the current account move into a surplus.

🔗 Time: it is important to understand that the success of a depreciation in bringing about an

increase in exports and a decrease in imports can be expected to take a period of time, giving rise
to what has been termed a ‘J-curve effect’.

🔗 Candidates need to demonstrate in their examination answers that they understand what is
meant by a J-curve effect. This is the idea that there is likely to be a period of time, after a
depreciation or devaluation, when the current account of the balance of payments gets worse
before it gets better. It is impossible to be precise about how long this period of time is likely to be
because it will vary from one country to another. You also need to make it clear that you
understand that the J-curve effect depends on the price elasticity of demand for both exports and
imports.

11.3 Economic development

The classification of economies in terms of their level of development

• BRICS/BRICs: refers to the countries of Brazil, Russia, India and China; South Africa is now
usually included

Economies can be compared in terms of their level of development. It is possible to use a number
of indicators to compare the characteristics of developed, developing and emerging (BRICS)
economies.

Indicators to compare developed, developing and emerging (BRICS) economies:

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Indicator Explanation

Economic Differences in the balance of the economic structure (i.e. the proportion of
output produced in the primary, secondary and tertiary sectors of production)
Monetary Differences in the level of income, usually measured by GNI per capita —
countries can be divided into high income, middle income and low income;
also, differences in percentage of GNI spent on education and health

Non- Differences in social factors (e.g. the rate of adult literacy, the number of
monetary doctors per thousand of population, the number of hospital beds per
thousand of population and the quality of water)
Demographic Differences in terms of population growth rates, birth rates, death rates,
fertility rates, average age and life expectancy

🔗 It is important that you demonstrate in the examination an understanding of the fact that
features of different economies tend to be rather general and that there may be exceptions. For
example, there are some high income/high net worth individuals in economically developing
countries and some low income/low net worth individuals in economically developed countries.

The characteristics of economically developing economies

• birth rate: the average number of live births per 1,000 of population of a country in a given
time period, usually a year
• death rate: the number of people per 1,000 of population in a country who die in a given time
period, usually a year
• natural increase: a natural increase in the population of a country is determined by the crude
birth rate minus the crude death rate of a population (i.e. the difference between the number of
live births and the number of deaths in a country during a year)
• optimum population: the number of people in a country that will produce the highest per
capita economic return, given the full utilisation of the resources available
• migration: the movement of people from one area to another, either within a country or
between countries

Population There will typically be a relatively high rate of population growth, resulting
growth from the difference between the birth rate and the death rate (i.e. the
natural increase in a country’s population); this means that, in many
developing countries, the size of the population is well above the
optimum population.

Population There is likely to be a relatively high proportion of young people, creating

structure a high dependency ratio (i.e. a high proportion of people who are reliant
on others in an economy).

Income level Income levels tend to be lower than in economically developed countries,
and and there is usually a great deal of inequality in the distribution of that
income.
distribution
Economic In many economically developing countries, a relatively large proportion
structure of workers is employed in the primary or extractive sector and a relatively
low proportion of workers is employed in the tertiary or services sector.
Employment Many economically developing countries depend on the exportation of
composition primary products and these often experience greater price variations than
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manufactured goods, creating greater instability.

External Many economically developing countries depend on the exportation of

trade primary products and these often experience greater price variations than
manufactured goods, creating greater instability.

Urbanisation The proportion of people who live in rural areas tends to be higher in
economically developing countries than in economically developed
countries, and where there has been rural–urban migration, this can put
pressure on resources in the urban areas.

Dependency Many developing countries have become dependent on economically

developed countries, and the role of multinational corporations has been
significant in this; although they bring employment to the economically
developing countries, much of the profit made is repatriated to the home
country.
External Many developing countries have a high level of external debt and debt
debt repayment is a major burden; in some countries, the debt is over 100% of
the gross national product.
Social Many economically developing countries have greater social problems
than is the case in economically developed countries, as can be seen
through such indicators as life expectancy, literacy rate, the number of
doctors per thousand of the population and access to good-quality water.

The classification of countries in terms of their level of national income

It is also possible to classify economies in terms of their level of national income. The World Bank
classifies countries according to their gross national income (GNI) per capita. It uses four
categories of countries.

The World Bank classification of economies in terms of the level of national income:

Category GNI per capita in US$

Low-income countries Below US$1,026

Lower-middle-income countries US$1,026–3,995
Upper-middle-income countries US$3,996–12,375
High-income countries Above US$12,375

The indicators of living standards and economic development

Monetary indicators

Monetary indicators include real per capita national income statistics. it was already pointed out
that there are three different measurements of national income:

» gross domestic product (GDP)

» gross national product (GNP)
» gross national income (GNI)

Purchasing power parity

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One issue that needs to be considered when comparing living standards and economic
development in different countries is the value of the statistics in terms of what a given sum of
money can buy in different countries. *

Issues of comparison using monetary indicators

• distribution of income: the degree to which income in a country is evenly distributed

The main method used to compare living standards and economic development in different
countries is changes in real GNI. There are, however, a number of potential problems in using real
GNI data.

Problems in using real GNI to compare living standards:

Problem Explanation

The hidden, informal or These terms refer to economic activity that is not declared and so will
underground economy not be included in the official GNI data (e.g. it may be illegal).

Non-marketed goods The GNI data are likely to be reasonably accurate when the vast
and services majority of economic output is recorded through market transactions,
but in many economies there is a lot of economic activity that is not
marketed (i.e. there is no price attached) and so it goes unrecorded.

The difficulties of In some countries, it can be difficult to measure spending by the

measuring government government because it is not always easy to value the output of
spending something that is not sold in a market (e.g. defence).
Sustainability A country may have a relatively high rate of economic growth, but this
will not necessarily be regarded as good if the needs of future
generations are not sufficiently taken into account (i.e. if the growth is
not sustainable because natural resources may be depleted and an
unacceptable level of pollution created).
Unequal distribution Real GNI can be divided by a country’s population to give an
of indication of the average standard of living, but this average may be
income and wealth misleading if there is an unequal distribution of the GNI.

The contrast between A rise in living standards will come about as a result of an increase in
increases in consumer consumer goods available, but in the short run there may be an
goods and increases in increase in the production of capital goods which will eventually help
capital goods to make this possible.

The quantity and GNI statistics measure the quantity of a country’s output, but they do
quality of output not take into account the quality of that output.

The effect of exchange When comparing standards of living between people in different
rate changes countries, it is necessary to take into account the effect of changes in
the exchange rates between countries which would otherwise distort
any comparison; economists achieve this through the use of
purchasing power parities.
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🔗 Progress and development: sustainability needs to be taken into account when evaluating
the progress and development of societies.

Non-monetary indicators

Although monetary indicators are used to compare living standards and economic development in
different countries, non-monetary indicators can also be used. However, there are also problems
with using these.

Problems in using non-monetary indicators to compare living standards:

Problem Explanation

The level of The literacy rate can vary a great deal between countries and those
literacy countries with a relatively low rate of literacy may not produce very
accurate data.

Working hours The GNI data record the quantity of output produced in different countries,
and working but they do not take into account the way in which that output is produced
conditions — a country’s output may have increased substantially, but this may have
been at a cost of a significant increase in working hours and a deterioration
in working conditions.

Political Although not directly an economic consideration, it could be argued that

freedom political freedoms and civil/human rights need to be taken into account
when assessing the quality of life in different parts of the world.

Composite indicators

• Measure of Economic Welfare: a broader measure of economic welfare than real GNI per
capita; it takes into account such aspects as the value of childcare and looking after the sick
and elderly, any depletion of natural resources and changes in the natural environment
• Human Development Index: a composite measure that combines life expectancy, average
income in the form of GNI per capita (PPP US$), and years of schooling
• Multidimensional Poverty Index: this replaced the Human Poverty Index in 2010 and is
made up of three dimensions and ten indicators; like its predecessor, it focuses on the
extent of deprivation in different countries

differences in real per capita GNI are the most established way of comparing standards of living in
different countries, but they are not the only method used to make such comparisons. Other
approaches have been used, many of which use both monetary and non-monetary elements.
They are called composite indicators because they use more than one indicator and compile these
different indicators into a single index. Composite indicators include the following:

» Measure of Economic Welfare (MEW): this approach includes such elements as leisure hours,
crime rates and levels of pollution.
» Human Development Index (HDI): this takes into account gross national income per head (at
PPP in US$), life expectancy and years of schooling.
» Multidimensional Poverty Index (MPI): like the Human Poverty Index, which it has replaced,
this focuses on the extent of deprivation in different countries.

The Human Development Index

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The HDI uses three dimensions:

Dimension Indicators

Education Mean years of schooling Expected years of schooling

Life expectancy A life expectancy component is calculated

Standard of living Gross national income (GNI) per capita adjusted for purchasing power
parity

Each country is classified into one of four groups according to the HDI figure:

» Low: HDI score between 0.00 and 0.54.

» Medium: HDI score between 0.55 and 0.69.
» High: HDI score between 0.70 and 0.79.
» Very high: HDI score above 0.80.

🔗 Candidates should note that the Human Development Index was revised in 2010 to use GNI
per capita rather than GDP per capita to measure income.

KEY SKILL

Numerical skills: the HDI is constructed from three separate indices: one-third from the
Education Index, one-third from the Education Index and one-third from GNI.

The Measure of Economic Welfare

The MEW incorporates four dimensions:

» the value of GDP

» the value of leisure time
» the value of unpaid work
» the value of environmental damage

The Multidimensional Poverty Index

The MPI uses ten indicators in three dimensions:

Dimension Indicators

Health • Child mortality

• Nutrition

Education • Years of schooling

• Child school attendance

Living standards • Electricity

• Sanitation
• Drinking water
• Type of floor
• Type of cooking fuel
• Ownership of assets
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🔗 Candidates need to be clear about what is, and what is not, included in these various
composite measures. For example, the quality of drinking water is not included in the Human
Development Index, but is included in the Multidimensional Poverty Index.

In examination questions on the comparison of living standards and economic development in

different countries, it would be helpful if candidates brought as many of the various indicators of
the standard of living between countries as are relevant into their answers.

The quality of life

• quality of life: a wider concept than the standard of living used to compare living conditions
in different countries; it could take into account such criteria as the number of doctors per
thousand of population, the quality of drinking water and the average size of school classes

Economists have tended to focus on the concept of standard of living, especially when GDP per
capita was the main measure. There has, however, been greater use of the concept of quality of
life in recent years, reflecting the use of these composite measures. The concept of quality of life
is a broader concept than standard of living and takes into account a wider range of criteria.

The Kuznets curve

• Kuznets curve: a curve that shows that as an economy develops, economic inequality first
increases and then decreases

The Kuznets curve shows that as an economy develops over time, F11.2 The Kuznets curve
economic inequality first increases and then decreases. This idea
was first put forward by the economist, Simon Kuznets, in the 1950s.
It has since been heavily criticised for being overly simplistic.

the Kuznets curve with the Gini coefficient on the vertical axis and the
level of development on the horizontal axis. The curve shows that, to
begin with, inequality increases, but over a period of time, as a
country develops, the degree of inequality begins to decrease.

🔗 Time: the Kuznets curve shows that as an economy develops over time, economic inequality
first increases and then decreases.

The comparison of economic growth rates and living standards

It is possible to make comparisons of economic growth rates and living standards:

» over time
» between countries

Over time

» Real GNI data can be analysed over time to recognise trends in economic growth in a country.
These may relate to significant upturns or downturns at particular times which will have important
effects on standards of living.
» For example, many countries experienced a downturn after the financial crisis of 2007–09.
Economic growth rates can be averaged out so that comparisons over time can be made.
» Changes in productivity rates can also help to explain economic growth rates over time. Another
factor to take into account when comparing living standards over time is whether a country is
experiencing a persistent trade deficit and, if it is, by how much.
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» If a country is experiencing a persistent trade deficit, it means that it is living beyond its means. It
is also necessary to consider changes in the level of public debt and especially whether the level
of debt is rising or falling as a percentage of GNI.

Between countries

There may be similarities in economic growth rates between countries, especially in the long run,
for a number of reasons, including the following:

» Technological developments: a key factor in determining similarities in economic growth rates

and living standards is the development and implementation of new technologies. All countries
have been able to benefit to varying degrees from similar improvements in technology.
» The role of multinational companies: multinational companies operate in many economies all
over the world and this can contribute to improvements in productivity in all countries where they
are located.
» Global shocks: all countries, to varying degrees, are subject to the same global shocks, such
as when there is a significant rise in oil prices or an international financial crisis.

However, there may be differences in economic growth rate trends between countries, especially
in the short run, for a number of reasons, including the following:

» Government demand management policies: governments may pursue different

macroeconomic policies — for example, one country may pursue deflationary policies of higher
taxation and lower spending, while another country pursues reflationary policies of lower taxation
and higher spending.
» Industrial relations: some countries may experience better industrial relations than other
countries, contributing to higher productivity growth.
» Entrepreneurial culture: some countries may experience a greater level of dynamism and
innovation than other countries, perhaps because of differences in the level of government support
for the development of an entrepreneurial culture.

🔗 Time: it is important to be able to make comparisons of economic growth rates and living
standards in a particular country over a period of time.

11.4 Characteristics of countries at different levels of development

Population growth and structure

It is important to have an understanding of the measurement and causes of changes in:

» the birth rate » the death rate

» the infant mortality rate » net migration

Birth rate

The birth rate is the number of individuals born into a population in a given length of time. It is
measured by the annual number of live births per 1,000 inhabitants. Possible causes of changes
in the birth rate are as follows:

» The need for large families, so that children can work at an early age, can contribute to an
increase in the birth rate.
» Improvements in education and healthcare can contribute to a decrease in the birth rate.

Death rate
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The death rate (also known as the ‘mortality rate’) is the number of deaths in a particular
population during a particular period of time. It is measured by the annual number of deaths per
1,000 inhabitants.

Possible causes of changes in the death rate are as follows:

» An epidemic or pandemic can contribute to an increase in the death rate.

» Better food and nutrition and improved health services can contribute to a decrease in the death
rate.

Infant mortality rate

• infant mortality rate: the number of children dying under one year of age divided by the
number of live births that year

The infant mortality rate (also known as the ‘infant death rate’) is the number of deaths in a
group younger than 1 year of age. It is measured as the annual number of deaths of those under 1
year old per 1,000 live births.

Possible causes of changes in the infant mortality rate are as follows:

» An increase in infectious diseases can contribute to an increase in the infant mortality rate.
» Better healthcare can contribute to a decrease in the infant mortality rate.

Net migration

• net migration: the number of immigrants into an area minus the number of emigrants from
an area

Net migration is the difference between the immigrants coming into, and the emigrants leaving, a
country. It is measured by the number of immigrants minus the number of emigrants over a given
period of time, usually 1 year.

Possible causes of changes in net migration are as follows:

» An increase in the number of immigrants coming into a country, with the number of emigrants
constant, will increase net migration.
» A decrease in the number of immigrants coming into a country, with the number of emigrants
constant, will decrease net migration.

The optimum population

The optimum population has a number of features:

» It refers to the ideal number of population that a country should have, after taking into account its
available resources.
» It is not a fixed or rigid population size, but is variable depending on possible changes in the
quantity and quality of resources and in the level of technology.
» It is therefore defined as that size of population enabling maximum per capita output to be
achieved, accompanied by the highest possible standard of living within a given set of economic
and technological conditions.

The level of urbanisation

• urbanisation: the process of the movement of people from rural areas to urban areas
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» A key aspect of population structure is the level of urbanisation in a country. It needs to be

pointed out that the definition of what constitutes an urban area can vary between countries.
» Urbanisation describes the movement of people from rural areas, i.e. hamlets and villages, to
urban areas, i.e. towns and cities.
» As countries become more developed, the level of urbanisation increases. Today, 55% of the
world’s population live in urban areas, a proportion that is expected to increase to 70% by 2050.

Income distribution

Calculation of the Gini coefficient and Lorenz curve analysis

The Gini coefficient

It is necessary to consider how income distribution can be measured in an economy.

» The Gini coefficient is a way of measuring the extent of inequality in the distribution of income in
an economy. It can also be used to measure wealth distribution in an economy.
» The Gini coefficient was discussed in Chapter 3, section 3.3. It is measured as the ratio of the
area between the diagonal line of total equality and the Lorenz curve (see below) to the total area
under the diagonal. The bigger this area, the more unequal is the distribution of income.
» In this way, the Gini coefficient measures the extent to which the distribution of income in an
economy differs from the position of total equality. The lower the value of the coefficient, the more
even is the distribution of income. The higher the value of the coefficient, the less even is the
distribution of income.

The Lorenz curve

• Lorenz curve: a graphical representation of the degree of inequality in the distribution of

income in an economy

The Lorenz curve is a graphical representation that F11.3 The Gini coefficient and the Lorenz
shows the extent of inequality in the distribution of
income in an economy. The more unequal the
distribution of income in an economy, the more
divergent the Lorenz curve will be from the diagonal
line of total equality.
the Gini coefficient is obtained by calculating the ratio
of the area between the equality line (the straight line
in the diagram) and a country’s Lorenz curve (area A
in the diagram) to the whole area under the equality
line (area A + B in the diagram).

KEY SKILL

Interpretation of data: the lower the value of the Gini coefficient, the more even is the distribution
of income. The higher the value of the Gini coefficient, the less even is the distribution of income.

Economic structure

Employment composition

• industrialisation: the process by which an economy is transformed from primarily

agricultural to one based on the manufacture of goods
• deindustrialisation: a reduction in the size or share of the manufacturing sector in an
economy
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Production in an economy can take place in three sectors: the primary sector, the secondary
sector and the tertiary sector. As a country becomes more developed, its employment structure
and composition changes:

» Primary sector: mechanisation reduces the need for agriculture and raw material extraction, so
the percentage of workers employed in the primary sector decreases.

» Secondary sector: as a country becomes more industrialised, many workers leave jobs in
agriculture, forestry and fishing (i.e. the primary sector), and take up jobs in the growing secondary
sector (e.g. manufacturing). However, as a country develops further, there will to some extent be
an element of deindustrialisation, and the percentage of people employed in the secondary
sector, having first increased, will then decrease.

» Tertiary sector: the decline in the proportion of people working in the primary and secondary
sectors will continue and the proportion of people working in the tertiary sector will increase (e.g.
service occupations such as education and finance).

Indonesia is an example of this change in employment composition as it has become more

developed.

Changes in the Indonesia employment composition (%):

Sector 1920 2020

Primary sector 51 33
Secondary sector 32 22
Tertiary sector 17 45

The pattern of trade at different levels of development

As a country becomes more developed, its pattern of trade changes:

» Developing countries tend to have economies that are largely based in the primary sector, so
most of their exports are agricultural and/or other primary products, and most of their imports are
manufactured products.
» Developed countries tend to have economies that are largely based on manufacturing and
services, so most of their exports are from the secondary and tertiary sectors.
» This pattern of trade at different levels of development tends to favour developed, rather than
developing, countries in that the price of agricultural products tends to be lower than the price of
manufactured products.

11.5 Relationship between countries at different levels of development

International aid

Forms of international aid

• aid: the process of economically developed countries providing financial support to

economically developing economies

International aid refers to any form of assistance by one country or institution to another. It is
usually given by economically developed to economically developing economies and it can come
in various forms. These can include:

» bilateral (i.e. involving just two countries)

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» multilateral (i.e. involving a number of countries and/or agencies, such as the World Bank)
» humanitarian assistance (e.g. aid for medical or educational reasons)
» emergency or short-term aid (e.g. after a sudden disaster)
» conditional or tied aid (e.g. a grant or loan with conditions attached)
» unconditional or untied aid (e.g. a grant or loan without any conditions)
» charitable aid (e.g. funded by donations from organisations such as Oxfam)

Reasons for giving international aid

There are a number of reasons for giving international aid, including the following:

» It helps countries fight diseases.

» It helps countries to respond to disasters and humanitarian emergencies.
» It helps countries affected by a hunger crisis.
» It helps countries to improve their health and education systems.
» It helps to save the lives of people living in poverty.
» It helps countries around the world to improve their infrastructure (e.g. in relation to water
supply).

The effects of international aid

As has been indicated, international aid can assist the social and economic development of a
country and/or help it to respond more effectively to a disaster.

There have, however, been a number of problems in relation to international aid, including the
following:

» Some aid has been used in investments which have become relatively unsuccessful. For
example, some major construction projects, such as dams, have been criticised for not being in
the long-term interests of particular countries.
» There have been some examples of the aid money being spent on defence, rather than on, say,
education, healthcare or improving the water supply.
» Some aid has actually been counterproductive and has made the situation worse — for
example, supplies of large amounts of food to some countries have reduced the prices in the local
economy, lowering incomes and making it difficult for local farmers to survive.
» Some of the aid has been ‘tied’ in some way — that is, there are conditions attached to the aid,
so the receiving country has not been totally free to decide how to spend the money.
» In some cases, there has been corruption in the receiving country, with the result that much of
the money has been kept in the hands of a few, rather than spread across the whole economy.
» While in some cases the interest rate charged on the aid has been at a lower rate — that is,
concessional — in many cases it has been at market rates of interest.
» The loan repayments have, in many cases, been difficult for the economically developing
countries to pay, although some debts have been rescheduled or cancelled; organisations such as
Jubilee 2000 and Make Poverty History have been active in trying to persuade lenders to cancel,
or at least reschedule, the debts.

The importance of international aid

International aid has been of importance for a number of reasons, including the following:

» It helps the economy of the receiving country to grow.

» It helps to improve the level of employment in a country.
» It helps a country to improve its balance of payments position.
» It allows for experts to come into a country to provide technical advice and assistance.
» It can save the lives of millions of people living in poverty around the world.
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» It helps to address health, education, infrastructure issues.

» It helps to address humanitarian emergencies.
» It helps to promote international trade.
» It helps to redistribute global wealth.

Trade and investment

The theory of comparative advantage indicates that all countries can benefit from free trade as
long as there are differences in opportunity cost ratios. International trade will therefore lead to an
increase in world output and this will ultimately lead to an improvement in the quality of life and
economic welfare in all countries, including economically developing economies.

Economically developing economies, however, have experienced particular problems, which

means that they have not gained from international trade as much as might have been expected.
These problems include the following:

» Whereas economically developed economies have tended to specialise in the production of

manufactured goods, economically developing economies have tended to specialise in the
production of primary products; some economically developing economies rely on a single
commodity for over half of their export earnings. The problem is that the prices of primary products
have, on the whole, declined relative to the prices of manufactured goods, although many
economically developing economies are now much less dependent on the exports of primary
products than used to be the case.
» Primary production is likely to be more volatile in terms of supply conditions, with the effect that
prices for primary products are usually less stable than for manufactured goods; a key issue is that
the demand for, and the supply of, primary products is more price inelastic than is the case with
secondary products.
» The demand for many primary products, such as different types of food, is more income inelastic
than demand for manufactured goods.
» Much of the investment in economically developing economies has come from multinational
companies; much of their profit is repatriated back to their home countries.

Some economically developing economies, given these problems, have actually introduced a
number of different forms of trade protection to bring about import substitution in their economies,
aiming to replace imports with domestically produced goods. Some economically developing
economies, however, recognising the enormous potential offered by free trade, have taken a
different approach and have aimed for an export-led strategy in order to benefit from free trade.

The role of multinational companies

Definition of a multinational company

• multinational company (MNC): a firm that operates in different countries

A multinational company (MNC) is one that has facilities and other assets in at least one country
other than its home country. It generally has factories and/or offices in different countries.

The activities of multinational companies

MNCs are involved in a range of activities in different countries, including:

» producing and selling goods and services

» exporting goods and services
» making significant investments in those countries
» buying and selling licences
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🔗 note that it is not enough for a company just to sell products in other countries to be described
as a multinational; it needs actually to have operations located in other countries, such as
factories.

The consequences of multinational companies

The advantages and disadvantages of MNCs:

The advantages of MNCs The disadvantages of MNCs

• They can bring jobs, creating more income, • They may use capital-intensive methods of
which can contribute to a local multiplier production, which means that not many local
effect, reducing unemployment. jobs are created.

• They can provide more choice for • The jobs that are created may be relatively
consumers, leading to a higher standard of unskilled (they are sometimes known as
living. ‘screwdriver’ jobs).

• They can lead to an increase in tax revenue • Much of the profit may be repatriated back
for the domestic government, such as from to the MNC’s home country and not
taxes paid on profits. reinvested in the local economy.
• They can bring technical knowledge that
could lead to higher levels of productivity. • They may damage the environment.

• They can stimulate economic growth. • They may try to influence the government
of the country, leading to the possibility of
• If the output produced is exported, this corruption.
could lead to an improvement in the current
account of the balance of payments. • When a MNC leaves a country, the void
created could be worse in the long run than if
it had never been there.

Foreign direct investment

• foreign direct investment (FDI): investment by a company, with a head office in one
country, in another country in the form of a factory or distribution outlet

Foreign direct investment (FDI) is investment in a country by an investor from another country. It
is a form of entry into a foreign market. The Organisation of Economic Cooperation and
Development (OECD) defines control when the foreign investor owns 10% or more of the
business.

The consequences of foreign direct investment

The advantages and disadvantages of foreign direct investment:

Advantages of foreign direct Disadvantages of foreign direct

investment investment

• Foreign expertise can be an important factor • It can be a hindrance to domestic

in the improvement of the existing technical investment because the investor is investing
processes in a country. elsewhere than in the investor’s home
country.
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• It can help improve the quality of products

and processes in particular sectors of an • Political issues can quickly arise, making
economy. FDI potentially very risky.

• It can help in the creation of jobs and so • A government could decide to take control
reduce the level of unemployment. of the investment for political purposes.
• It provides a source of external capital for a • FDI can sometimes have an influence on
country that can improve its level of economic exchange rates to the advantage of one
development. country and the detriment of another.

• It provides a source of tax revenue to a • Investment in some countries could be

government. relatively expensive and it may be more
expensive to locate production abroad than to
export goods.

External debt

The nature of external debt

External debt (also known as ‘foreign debt’) refers to the portion of a country’s debt that has been
borrowed from foreign lenders, including commercial banks, governments and international
financial institutions.

External debt represents the amount that a particular country owes to other countries. It includes
both public sector debt and private sector debt. It also includes both short-term liabilities (e.g.
loans that need to be repaid in the near future, such as within 1 year) and long-term liabilities (e.g.
loans that need to be repaid over a longer period of time).

The causes of external debt

The causes of the existence of external debt include:

» outstanding loans to foreign private sector financial institutions, including the outstanding interest
» payments due to international organisations, such as the International Monetary Fund
» outstanding payments for a balance of payments deficit

The consequences of external debt

It is not easy to be precise when deciding when a country’s external debt has become a problem.
One of the key issues is the ability of a country to meet the interest payments on the external debt.
These payments will need to be met from:

» foreign currency earnings from exports

» foreign currency reserves
» gold reserves
» further borrowing

The existence of external debt can be a significant obstacle to the economic growth and economic
development of a country. The repayment of the debt can become a major burden and there is an
opportunity cost involved: the funds used to repay the debt could have been used in other ways
that would have been more productive, such as spending on healthcare and education.

It is as a result of the problems caused by the repayment of external debt that the following
institutions have been established:
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» the International Monetary Fund

» the World Bank

The role of the International Monetary Fund

• International Monetary Fund (IMF): set up in 1944 to promote international trade through
such measures as providing financial support in the form of a loan, which will help a country
to overcome, or at least reduce, a deficit in the balance of payments; it has 190 member
countries

A number of international organisations have been established since 1944 to encourage free trade
and to reduce the extent of trade protectionism in the world market. One of these is the
International Monetary Fund (IMF). It was set up to secure international monetary cooperation,
to stabilise currency exchange rates, and to expand international liquidity through access to hard
currencies.

The IMF aims, in particular, to:

» reduce the extent of global poverty

» encourage international trade
» secure financial stability
» promote sustainable economic growth
» promote high employment
» foster global monetary cooperation

The IMF achieves these aims by overseeing economic development, lending and capacity
development. It has played a significant role in stabilising exchange rates and thereby facilitating
international payments. It has also helped to enforce monetary discipline among its member
countries.

The role of the World Bank

• World Bank: set up in 1944 mainly to provide finance to developing countries to help
various kinds of projects; it has 189 member countries

Another international organisation established since 1944 is the World Bank. The World Bank
Group comprises five different institutions, of which one key department is the International Bank
for Reconstruction and Development.

The World Bank aims to:

» provide low-interest loans, interest-free credit and grants to middle-income and low-income
countries to reduce the extent of poverty
» improve the health, education and infrastructure facilities of countries
» modernise the financial sector, agriculture and natural resources and environmental
management of different countries

The World Bank has set two goals for the world to achieve by 2030:

» end extreme poverty by decreasing the percentage of people living on less than US$1.90 a day
to no more than 3%
» promote shared prosperity by fostering the income growth of the bottom 40% for every country

11.6 Globalisation
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The meaning of globalisation and its causes and consequences

The meaning of globalisation

• globalisation: the process whereby there is an increasing world market in goods and
services, making an increase in multilateral trade more likely; it has been made possible by
a number of factors, including progress in trade liberalisation

» Globalisation is a process of interaction and integration among people, companies and

governments worldwide.
» It refers to the increase of trade around the world, especially by large companies producing and
trading goods in many different countries.
» It involves an increase in international competition through the development of a global free
market, with companies able to gain a competitive advantage. Developments in transport and
financial deregulation, in particular, have helped to facilitate this.
» It refers to the free movement of goods, services and people across the world and involves a
process that enables financial and investment markets to operate internationally.

The causes of globalisation

Globalisation describes an economic interdependence of countries around the world fostered

through the development of trade liberalisation and free trade. The reduction of protectionism,
involving the removal or reduction of tariffs and other import controls, has been a significant cause
of globalisation. It is also the result of deregulation and improvements in communications
technology.

The consequences of globalisation

The benefits of globalisation The limitations of globalisation

• It has led to the increased spread of • Job creation and economic growth have not
products, technology, information and jobs been distributed evenly across industries or
across national borders. countries.

• It has created new jobs and enhanced • Specific industries in certain countries have
economic growth through the international suffered disruption or collapse as a result of
flow of goods, capital and labour. increased competition.

• Companies have been able to reduce costs • It has benefited large multinational
by manufacturing abroad and have been able companies, but its impact remains mixed for
to gain access to millions of new customers. certain workers and small businesses around
the world, in both developed and developing
• Significant improvements in standards of countries.
living have been achieved in many countries,
as free markets and free trade are a means of • It can have a significant detrimental effect
reducing the extent of poverty in the world. on the environment.
• Global competition in markets has led to the • It can create a domino effect where a crisis
production of better-quality products at lower or economic downturn in one country has a
prices. severe impact on many other countries in the
world.

The distinction between a free trade area, a customs union, a monetary union and full
economic union
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Economic integration

There are different forms of economic integration in various parts of the world and it is important
that these different types of integration are clearly distinguished.
The different forms of economic integration are:

» a free trade area

» a customs union
» a monetary union
» an economic union

Free trade area

• free trade area: a group of countries that promote free trade between themselves, but that
retain a separate set of trade barriers against other countries
• common external tariff: where all of the countries in an economic organisation impose the
same tariff towards other countries outside the organisation

A free trade area refers to a situation where a number of countries come together to trade freely
between each other, but where each of these countries maintains its own trade barriers with other
countries outside the free trade area — in other words, there is no common external tariff barrier
between the member countries and other countries.

Examples of free trade areas include:

» the European Free Trade Area (EFTA), comprising Iceland, Liechtenstein, Norway and
Switzerland
» the North American Free Trade Area (NAFTA), comprising the USA, Canada and Mexico,
although this has now been replaced by the United States–Mexico–Canada Agreement (USMCA)
» the South Asian Free Trade Area (SAFTA), comprising Afghanistan, Bangladesh, Bhutan, India,
The Maldives, Nepal, Pakistan and Sri Lanka

Customs union

• customs union: a group of countries that promote free trade between themselves, and that
impose a common external tariff on imports from countries outside the area

A customs union refers to a situation where a number of countries come together to trade freely
between each other, and in addition to this, the countries establish a common external tariff
against all other countries that are not members of the customs union.

The European Union was a customs union at one point in its development before it achieved full
economic integration. The Southern Africa Customs Union (SACU), comprising Botswana,
Namibia, South Africa, Lesotho and Eswatini, is an example.

Monetary union

• monetary union: a group of countries that decide to bring their economies closer together
through the adoption of a single currency

A monetary union refers to a situation where a group of countries come together and adopt a
single currency. They may also adopt a number of common monetary policies to support the
operation of that currency.

Economic union
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• economic union: a group of countries which agree to integrate their economies as much
as possible through various rules, laws, policies and regulations

» An economic union refers to a situation where a number of economic policies, rules and
regulations are established which affect all the member countries.
» An economic union may have a single currency, but it is not necessary that all member countries
agree to use that currency.
» The European Union (EU) consists of 27 countries (a 28th country, the United Kingdom,
withdrew from the European Union on 31 January 2020), but only 19 of them use the single
currency, the euro. The total population of the European Union is 450 million.
» The Eurasian Economic Union (EEU) came into existence on 1 January 2015 and comprises
five countries: Russia, Belarus, Armenia, Kyrgyzstan and Kazakhstan. It has a population of 183
million. There is no common currency and each of the five countries uses its own currency.

🔗 A number of candidates seem to believe that all countries in the European Union use the
single currency, the euro. This is not the case. In 2021, 8 of the 27 member countries did not use
the euro. Latvia became the 18th member country of the Eurozone in 2014 and Lithuania became
the 19th member country of the Eurozone in 2015.

🔗 Candidates often confuse a free trade area with a customs union. Both types of integration
encourage free trade between the member countries, but the key difference between them is that
in a free trade area the member countries retain their own trade barriers with countries outside the
area, whereas in a customs union the member countries adopt a common external tariff towards
countries outside the union.

Trade creation and trade diversion

• trade creation: the creation of new trade as a result of the reduction or elimination of trade
barriers
• trade diversion: where a certain amount of trade is lost as a result of the imposition of
trade barriers

» When a trading bloc has been created, business will begin to take advantage of the
opportunities arising from free trade between the member countries.
» As a result of the establishment of the trading bloc, there will be fewer trade barriers. New
markets are likely to open up and businesses will try to take advantage of the opportunities offered
by this situation. There will be increased specialisation and more trade. The overall effect,
therefore, is likely to be one of trade creation.
» However, when a new trading bloc is established, there is the possibility that there will be some
degree of trade diversion.
» The member countries of the bloc may want to shift to buying more from member countries and
to buying less from non-member countries. The absence of trade barriers between the member
countries of the bloc encourages them to trade with each other rather than with countries outside
of the bloc.

Learn by heart!